Thursday, June 29, 2006

The Rising Dividend Story -- Can a Stock Be Valued Like a Bond?

With the market catching a little Bernanke Flu recently, I temporarily suspended The Rising Dividend Story as I used this space to address the economy, interest rates, and the stock market. But for those of you who have asked, the story continues: When a person finds a truth 180 degrees from where he thought it resided, there is a sense of awe, a stillness , and a peace; and when you catch sight of it, it encompasses everything you do and think. We left off last time discussing the last thought that went through my mind before I fell asleep on Black Monday night – “Is it possible to value a stock like a bond?” It had never occurred to me before that night that it might be possible, and there was nothing that had happened during the day to encourage such an idea, but the question kept coming nevertheless. The reason the question hung in the air was because of my purchase of the Indiana University bonds. In retrospect, the realization that I had bought a bond without knowing its market price and in the middle of a stock market crash had astonished me. I realized some people may believe that such a purchase was foolish; but, as I mentioned before, the way the bond buy unfolded was as though I was watching myself doing something that I had never done before, yet at every turn knowing what to do next. It was like time slowed down so that I would understand what it wanted me to know. The unmistakable message the bond buy gave me was that investments have a value apart from their price. Price represents a best guess at value, but it is NOT value. Value is something inherent to an enterprise; price is an opinion, a convenience with which to get in and out of the market. Over the next few days, as I analyzed my purchase of the IU bond, I came to the realization that the key factors that gave me the confidence to buy the bond were its undisputed quality and the ability to calculate its rate of return over its life. Because a bond has a fixed interest rate and a fixed length of maturity, it is possible to calculate its minimum rate of return on the day of its purchase. This meant that with a bond, an investor did not need for the price of the bond to go up to achieve a rate of return. An investor needed only for time to pass to collect the interest payments to achieve the calculated rate of return – time alone produced results, not timing, as was the case when trading stocks. Before Black Monday, I thought timing and trend-following were the truths of investing, but now I understood they were really just forms of gambling. I had devoted 12 years to perfecting these techniques, and now Black Monday had exposed their folly. Black Monday was instead showing me that time, quality, and valuation were the truths of successful investing. But I’m getting ahead of myself here. These may be the truths of investing in bonds, but in the aftermath of the crash of 1987, I did not know how to value a stock like a bond. Indeed, that would not come for several more years. What I did have was the palpable sense that just as the truth of bond valuation had visited me during my purchase of the IU bonds, so too it would one day speak of stocks. This “sense” manifested itself on the following Monday. For many years, I provided a weekly market commentary via teleconference to the brokers of the firm spread across three states. On Monday, October 26, 1987, one week after Black Monday hit, I was in my office early preparing my comments when I noticed the prayer journal lying on my desk. I remembered on Black Monday having the grand idea to use the journal to document my experiences of the crash. As I opened the book, I saw that I had made entries only on Monday and Tuesday. Monday’s comment was about the huge fall in stocks and our decision not to sell. Tuesday’s comment was very short: “Market up 100+ points – glad to see rebound – but not very convincing.” I flipped the pages to the day’s date - October 26th. There, across the top of the page was the scripture for the day: “For God is not the author of confusion, but of peace. . .” 1 Corinthians 15:57 When I read this verse, it made sense on three levels. First, everything about the past week had been confusing. Everyone tried to make sense of it. People I previously considered wise were making fear-induced and idiotic statements about the many disasters that lurked. Chaos reigned. Secondly, my mind replayed my conversation with Billy T. Whether it had been because of my own weariness and wishful thinking, or Billy’s fragile state of mind, I had told him that every good thing comes from God. Investing in quality US stocks had been a good thing for a hundred years; therefore, in someway the stock market was a part of God’s blessing. If God decided to withhold His blessing, we are all doomed. There was no hiding place. But if God is still in control, blessings will continue, no matter what the Wall Street Journal or the gurus say. And if God is still in control, peace will prevail. Lastly, if God is involved in the stock market, it will have an underlying order. Everything in creation has order: gravity, the speed of sound, the parts of a cell, the parts of an atom… If there is order in the stock market, there will be a means to evaluate it, a formula, a gauge, a meter of some kind. I knew if I pursued it long enough, I would find it.

Thursday, June 22, 2006

Odd Lots: Some New Functions

We have made some modification to the blog that we believe our readers will find helpful. In the right sidebar you will note three new headings: Categories, About Us, and Links. The "Categories" sidebar provides a link to a search page showing all the blogs we have written concerning the five general subjects listed. For instance, if you want to know what we have been saying over the past year and a half concerning the economy, you can click the Economy button and see all blogs that we have written that deal with the economy. The other general topics of Dividend Growth, Stocks, and The Market link to our comments pertaining to these general subjects. All of the categories are in chronological order so you can see what our batting average is on the calls we have made at critical junctures. You might like to go back and see the series of blogs we wrote on the economic implications of Hurricane Katrina. You will see that we wrote about Katrina on September 1st, 6th, and the 16th. The "About Us" sidebar is something everyone has been requesting -- pictures and bios of our key staff people. We have completed the section that covers the portfolio managers. The pictures of some of the Client Service people are shown, and more pictures and bios will be added soon. Please spend some time looking through the bios. We have a collection of outstanding people on our team. Now you will be able to put a face with a voice when you call. You will notice the heading DCM Quarterly Letters is also under "About Us". DCM Quarterly Letters links to a sort of White Paper collection of reports we have written over the years pertaining to various topics in the economy and the markets. The final new addition to the blog is the "Links" section. For now, we are listing only two links: Dividend News and Companies Increasing Their Dividends. Both of these links exit the Donaldson Capital Management blog and connect with the website You may be particularly interested in the link to Companies Increasing Dividends. This link shows all dividend increases for the past month. The Dividend News link is a real-time display of all dividend news. We do not use our blog to make political comments (well, sometimes). It's focus is very narrow: companies that reward their shareholders with a consistent stream of rising dividends. We do try to address the big issues in the economy, but our main mission is the educate and inform people that there is another way to invest. One that is much more peaceful, much more predictable, and yet, in the long run, offers solid profit potential. We have been doing this for a long time, and we firmly believe that once you really understand the Rising Dividend investment strategy, you will never go back to "trading stocks on rumors and tips."

Friday, June 16, 2006

Gasoline Prices and the US Economy

There have been a number of stories in the news in recent days concerning the implications of Iran or Venezuela cutting back oil production in retaliation for US policies. Iran is threatening to slow oil production because they claim we are not respecting their sovereignty in our demands that they stop their Uranium enrichment program. Venezuela is threatening to shut off oil because Hugo Chavez is concerned the US might seek to overthrow his government. When confronted with tough issues, a man I respect very much always says, "Let's not faint over this. Let's walk around it and see if it can hold water." In this case, walking around these threats is a short walk. Any sane economist will tell you that neither of these countries could keep us from getting the oil we need. Prices would go up, but all nations of the world would also pay higher prices, including the nations of Iran and Venezuela. These two countries are now subsidizing the costs of petroleum to their citizens. Even though they are "growing their own," so to speak, the cost of their subsidies would skyrocket because of the concept of opportunity cost (The actual cost to them is not their cost, but the market price). In addition, the public in both of these nations is not 100% on the side of the leadership. There are reports everyday about unrest in Iran, and there is evidence of huge capital flows leaving Venezuela from the disenfranchised investor class in the country. Any cut in oil production by Iran and Venezuela will ultimately fall on their own people, and the citizens of these two countries are not so sure they want to be in the gun sights of the United States. The Wall Street Journal is claiming that oil could spike $11 per barrel if either country stopped exporting oil. An $11 a barrel hike would add about 15% to the price of oil and a similar amount to the price of gasoline. That would push gasoline toward $3.25 per gallon. That is a high price, but its effects on the US economy would be negligible. Oil prices hit that level right after Hurricane Katrina. In addition, for years gasoline prices in Europe have been 2-3 times what they are in the US with only modest negative effects on their economies. Citizens of England, France, and Germany are all now paying over $5.00 per US gallon (The difference is taxes. European nations just love to tax). The US economy is amazingly resilient because Americans are a free people who are very adept at making choices about where they want to spend their money. Americans won't wait on the government to solve their energy problems; they will conserve energy, substitute other energy sources, and move to new technologies. Even if oil prices were to rise to $100 per barrel, as some believe possible, I don't think the impact would be as harmful as it might seem. In addition to making changes in energy consumption, Americans are wonderfully innovative. Most of the big computer companies in this country were started in a garage or college dorm room. The founders of most of the big drug companies worked in kitchen sinks and basement labs. Thomas Edison, Alexander Graham Bell, and Bill Gates did not make their discoveries working for the government. As I write this, bright-innovative Americans working in garages, basements, college dorm rooms, yes, and even in corporate and governmental laboratories are focusing on finding a new source of energy. The current "OPEC energy-extortion" can not stand because one of these innovators is going to wake up one morning with an idea of how to produce motion in a new and different way. When he or she does, there will be no shortage of lawyers, accountants, bankers, and investment bankers to bring the new idea to the market. This is not pollyanna, this is the history of the United States. How can anyone be pessimistic about the future when we have such a long track record of "figuring things out." We are not a nation that looks to governments or kings and queens to solve our problems. Good grief, governments and kings and queens the world over seem to need our help solving their own problems. I note with great interest that this week the Bank of America announced that they will contribute up to $3000 to employees purchasing hybrid automobiles. This is just the beginning. I believe many companies will follow Bank of America's lead and offer incentives to their employees for energy conservation of all kinds. To believe that things won't change, that we are going to continue to be held hostage to by nutballs like Iran's Ahmadinejad or Venezuela's Chavez is to ignore American history. The New York Times may believe it (although I doubt they really do. They just like to hurl newsprint bombs to watch people scatter.), but even a short walk around the energy problem reveals that the medias' gloom and doom arguments don't hold water.

Tuesday, June 06, 2006

Market Comment: Stagflation -- Not

Did you ever wonder why the comments of the Fed seem to be taken so seriously by stock market traders? Yesterday Ben Bernanke said in speech to a group of international economists that inflation was running near the high end of his comfort level, and if it did not show signs of slowing, further rate increases may be necessary. His comments sent the Dow Jones down nearly 200 points. If you think about it, the Dow Jones started the year at about 10,700. It then rallied just above 11,600 on the notion that the Fed was near the end of its string of rate hikes. When the media were full of the "Fed is almost done" talk, a reporter from CNBC, Maria Bartiromo, asked Mr. Bernanke if the market was correct in its optimism. Mr. Bernanke said no. Ms. Bartiromo was quick to report Mr. Bernanke's answer the next morning, and the markets have been heading lower ever since. Although Mr. Bernanke has apologized for spilling the beans to a reporter at a non-public function, it was a goof that has put everyone on edge. He has stated that he wants the Fed's actions and thinking to be more transparent, but passing the word to a reporter is not what most of us had in mind by the word transparent. Having said this, I believe all the fuss about the action or inaction of the Fed is missing the point. I have never doubted that the Fed would raise rates for as long or as high as they needed to to keep inflation under control. That is absolutely what they should do, and, indeed, the current core inflation rate is trending the wrong direction. However, it is clear that the economy is slowing, and a slowing economy will diminish inflationary pressures in the months ahead. The reason the sell off has been so sharp in recent weeks is because of the fear, on the part of some, that "stagflation" may be returning. If you search the web, you will find that the name was coined in the late 1970s and early 80s when inflationary pressures were persistent and kept the Fed on the alert for years. As the Fed kept pushing rates higher and higher in response to the inflation reports, the economy grew weaker and weaker, as did corporate profits. This became a double-edged sword for investors. Let me give you an example of this double-edged sword. I found many years ago that you could add 3% to the CPI and divide the sum into 1 to provide a "rule of thumb" normal PE for the Dow Jones Industrial Average. The expected price level of the Dow Jones 30 can then be found by multiplying the rule of thumb PE by the expected earnings for the Dow. I have provided a chart comparing my rule of thumb predicted level of the Dow Jones with its actual level over the last 46 years.

Currently, the CPI on a year over year basis stands at 3.4%. Adding 3% to that level totals 6.4%. We then divide this amount into 1 to find an expected PE of 15.6X. We can then multiply the predicted PE of 15.6 by $744, the 2006 expected earnings for the 30 companies in the Dow Jones. This computation indicates that the Dow should be selling about 11,600, or about where it was a month ago when the market thought the Fed was about finished with its rate hikes. As I write this, the Dow is selling just over 10,900. This would imply an inflation rate of 3.8%, if we hold earnings stable. The problem with stagflation quickly becomes visible. If inflation really takes root and pushes toward 4%, it would keep the Fed raising rates, and the higher rates would surely slow the economy. That would mean the $744 of earnings for the Dow is called into question. Let's say the earnings come in for the year at $700. With an inflation rate of 3.8%, that would imply a Dow of 10,290. That is the reason the market has been selling off ever since Bernanke indicated inflation is at the high end of his comfort level. But let me stop this line of thinking in its tracks. Stagflation is not a reality, and the odds of it returning are very low. Paul Volcker taught us how to deal with runaway inflation in the late 1970s, and there is not a central banker in the world who does not know the script. All investors bemoan higher interest rates, but my studies show that the correlation between inflation and PEs is much greater than the correlation between interest rates and PEs. In short, the market can handle higher interest rates if it believes that inflation will be held in check. The Fed's job is to push interest rates where ever they need to go to fight inflation. The sell off in the market, as usual, is making the worst case for both earnings and inflation. That is simply not the most probable outcome for either. I said at the beginning of the year that inflation will be trending toward 3% by the end of the year, and I still believe it. In addition, in both of our dividend styles of investment management dividend growth is far surpassing what we expected. The Rising Income Portfolio has shown dividend growth of over 11% and the Blue Chip Growth Portfolio has shown dividend growth of over 15%. Dividends are real money. The companies we own would not be surprising us with better-than-expected cash distributions if their results were falling off the table.

Do you remember in 2002, the great worry was deflation. The deflation did not materialize and neither will stagflation, and the reason will be the same: The Federal Reserve. I am convinced that deflation could have sprouted in 2002, but the Fed used the tools at its disposal and headed it off. They will do the same with stagflation. They have the tools and they will use them.

My Rule of Thumb model says the fair value of the Dow at 3.4% inflation is approximately 11,600. At 3% inflation the level is 12,400. That's not my prediction, but that is what comes out of a model that has called a pretty good game for a long time.

Monday, June 05, 2006

The Rising Dividend Story -- Black Monday Night

As I lay in bed on Black Monday night, questions ran through my mind, each one leading to another. I knew I needed an overarching investment strategy that would guide my clients and me in the days and months ahead. I remember thinking I couldn’t drive the race in front of me and read the roadmap at the same time. Tomorrow morning I had to speak to the firm’s brokers by conference call about what Black Monday meant in the short and longer terms. I knew about half of what I was going to say: Black Monday was a financial accident. The value of Corporate America was unchanged except for whatever lingering effects the crash may have had on consumer confidence. The market may have been overvalued heading into Black Monday, but the crash was the result of computer trading gone out of control. I believed completely that Black Monday was an accident, but I knew after I gave my explanation, someone would invariably ask if it meant that we should start buying, and if so, what should we buy. I had come to that question dozens of times since the close of business and had been left with only question marks. I did not know how bad the financial accident was, or how strong the aftershocks would be. I only knew there would be aftershocks; the market is never neat and orderly as it tries to make a bottom. As I kept asking myself what was safe to buy, I remembered my purchase of the Indiana University bonds. I had received a yield above 9% completely free of all taxes and backed by one of the most conservative states in the union. If that wasn’t a good buy, then what was? Bonds are it. Tomorrow morning I was going to take my turn at the microphone and tell the firm’s brokers to buy municipal bonds. Everyone wanted to know what stocks to buy, but it just did not feel right to me yet to be jumping into the stock market until the bottoming process was further along. With my comments for the next morning put to rest so to speak, my mind turned to a recap of the people I had spoken with throughout the day. I had made and received scores of calls, but the calls from Mrs. H, my friend with the IU bonds, and Billy T. resonated inside of me, still. Somehow I knew they were seminal and would, ultimately, reshape my understanding of investing. I did not know everything these three calls meant, but as I thought through them I realized that in each case it was as though something was speaking to me, even though I was the one doing most of the talking. When I had some free time, I knew I had to dig deeper into what had gone on in each call. For now, the call from my friend who wanted to sell the IU bonds took front stage. As I replayed the events surrounding the purchase of the bonds, I was both delighted and indicted. I was delighted because I realized that I had bought a substantial amount of bonds without the benefit of knowing exactly where the market for them was trading. I had evaluated the bonds, put a price on them, and said I was willing to buy them when bond traders at most bond desks around the country had passed. In retrospect, I realized that in the midst of all the unknowns something kept telling me to “do the math”; to get that right and everything else will take care of itself. I was indicted because I had been in the investment business for 12 years with two different firms, and today I realized I did not know how to value a stock apart from its selling price on the exchange. If the stock markets had been closed and somebody would have called and wanted to sell me some General Electric common stock, I would have laughed at them. It was impossible. Prior to Black Monday, in my mind the market price dictated what a stock was worth. After all, the market was efficient wasn’t it? That is what I had been hearing for nearly a decade. The price of a stock reflected the collective decisions of millions of buyers and sellers, which produced a sort of “handicapping” similar to what goes on in horseracing. The best horses, while offering a high probability of being “in the money,” paid very little for a win. On the other hand, horses with poor track records and thus, not having a high probability of winning, paid big odds when they did win. Stocks were like horses weren’t they? The odds – prices – were always right, right? But on the night of Black Monday, I realized the notion that the market (the bettors) always puts the right price on a stock was nonsense. The average stock had fallen 23%. It was utterly clear that investors were not trying to make informed decisions about the value of companies; they were just running from the fight. I was convinced of that, but I knew no math that could pinpoint which stocks were the best values. As these thoughts circled through my mind, I realized that the “math” for the bond purchase was not as easy as I had originally thought. The interest rate on the IU bonds was 7.5%, and I agreed to buy them to yield 9.4%. Bond traders use special bond calculators to compute cost from yield or vice versa. I had no bond calculator, thus, I used a “rule of thumb” method to compute the approximate price for the IU bond. The current yield of a bond is current income divided by price. This simple formula works if you are paying par (face value) for the bond, which is usually $1000. However, if you are buying a bond in the secondary market, it might be selling for more or less than the face amount, and thus, you need to make a calculation that takes into consideration any capital gain or loss the bond may realize during the holding period. The term “yield to maturity” is used to describe this adjusted rate of return for a bond. With an interest rate of 7.5% and a yield to maturity of 9.4%, it was obvious that the IU bond’s additional rate of return would come from buying the bond for less than its maturity value of $1000. That would mean that when the bond matured (paid off) it would produce a capital gain, which when added to its interest rate would total 9.4%. As I dozed off, the last thought I remember thinking was is it possible to use the rule of thumb method of valuing a bond to value a stock? Was it possible to turn stocks into bonds? Note: It has taken us three weeks to reach the end of Black Monday, yet this is not a story about Black Monday but of Rising Dividend Investing. From this point on, I will quicken the pace of explaining my search for methods of determining the approximate value of a stock. This may be of particular interest in light of the recent fall in stock prices. Has the value of corporate America really fallen 5% in recent weeks? Do the stock traders –bettors – have it right, or are they just betting the jockey’s colors. Our stock market model is saying that the value of corporate American is on the rise, not decline.