Tuesday, January 30, 2007

Dividend Valuation Update -- P&G and Colgate Shine

I just completed an update of the dividend valuations of the 10 major industry sectors. The leaders and laggards have not changed much in six months, but the earnings news in recent days corroborates some of the data that I see. The two sectors that are most undervalued are the Consumer Staples and the Industrials. I will have more to say about the Industrials in a future edition.

Today both Proctor and Gamble and Colgate reported better than expected earnings, emanating from their emerging markets businesses. P&G was strong in China and Asia, while Cl had an outstanding quarter in Latin America, where the company claims it has a market share over 70%.

In the face of interest rate worries, these two companies would seem to be a natural place for money to flow because neither company is particularly sensitive to rising interest rates. Indeed, according to our models both stocks are undervalued with Colgate being the best bargain at nearly 15% below its Dividend Valuation's intrinsic value. The chart below shows the historical relationship between CL's Dividend Valuation Model and its actual price.

............................ Colgate Dividend Valuation .................

The green-striped bar is our model's projection of CL's value during the next 12 months. Including dividends the expected return is nearly 17%.

Of course, you can't take that kind of a return to the bank. It's just an educated guess, but looking at the economic landscape before us, I would not be surprised to see the staples, and particularly Colgate, continue to shine in 2007.

Friday, January 26, 2007

Mike Hull Was Right. . . So Far

In September, DCM president Mike Hull answered a question from a client regarding the medias' worries that a hard landing was inevitable and gave our case for a soft landing. Mike said the media was wrong, as usual, on the hard landing scenario because they did not understand that while the Fed had pushed short-term interest rates much higher, long-term rates were still very tame, which would allow the economy to continue to put up positive numbers. So far, he has been right on. The worries of a recession have faded with every new economic release, and the corporate earnings reports have just been terrific. Indeed, the talk in recent days has been that the Fed may have to raise rates because employment has stayed so strong, which has kept core CPI higher than many had hoped. In our investment meeting this week, we discussed what to make of these "hot" numbers. We are still firmly in the camp that's calling for a soft landing, but we believe the recent stronger-than-expected economic data are being modestly inflated by the unseasonably warm weather that the country has enjoyed this winter. The data that the government reports is seasonally adjusted. Over the years, we have witnessed countless times when economic releases were distorted by weather. Hurricane Katrina distorted economic data for six months after she made landfall. Fourth quarter 2005 GDP was nearly 40% less than had been expected and everyone began to fret that the hurricanes would cause a recession. We explained, then, that a rebound was coming. First quarter 2006 GDP completely made up for the fourth quarter shortfall. We believe the same thing will happen again. The economy is putting up strong numbers now, but the numbers are inflated by the warm weather, and we do not believe thet are sustainable. Over the next few months, we should see a rapid retracement of much of the data. And we suspect the doomsayers will start talking about a hard landing again. But we believe once the data calms down they will show that a soft landing is, indeed, underway. Recently, in our client letter we said that we thought the Fed's next action was to cut rates, but that they would be doing so later rather than sooner. That is still our position. We also said that the stronger-than-expected economic data could be a headwind to the stock market in the short run, but that the headwinds would pass as it became clear that the economy was not accelerating. That is also still our position. Recent strong economic data has thrust Ben Bernanke and the Fed back in the headlines. There will be lots of "will they or won't they" talk regarding interest rates. We are convinced that the Fed is done raising rates, and we aren't worried that they will change course. One big reason is that the mild weather has masked the weak real estate markets. While real estate weakness is not nationwide, sooner or later its effects will become apparent in the economic data. Blessings,

Thursday, January 25, 2007

Phoenix Trip

I will be in the Phoenix area for the next few days visiting family and clients. If any Donaldson Capital clients are vacationing in the area and would like to meet, please email me at gdonaldson@dcmol.com, and I will try to arrange something. Never seen so much blue sky.

Wednesday, January 17, 2007

Dividends Over All

For most of the last twelve months, our mantra, as it related to stocks, has been: big over small, value over growth, and dividends overall. The relative performance of the sectors has waxed and waned during the year, but, for the most part, our mantra was correct.

In looking at the data recently, however, we were very surprised just how much of a "dividend" year it was. Breaking the S&P 500 into quintiles from highest dividend yields to lowest, we see the following total rates of return:

The table shows that stocks of all styles and sizes enjoyed solid double-digit returns, but the top 100 highest yielding stocks had a total return of nearly 20%.

I have not seen much discussion of this phenomenon. In fact, I am a dividend watcher, and I was not aware of just how strong high-yielding stocks were during 2006 until I was doing some attribution work and noticed it.

The first thought that came to my mind was--why? What was it about 2006 that gave such a lift to high dividend yields? Had interest rates fallen? No, in fact they had risen. Had there been a flight to safety? No, I would have say there was a move back to quality, but not an outright flight to safety.

In the top 100 yielding stocks in the S&P 500, there are an abundance of REITs, Banks, Utilities, and Energy stocks. Of the four sectors, energy stocks having a good year is easiest to explain. REITs had real estate worries, Banks had Fed rate hike and real estate worries, and Utilities had runaway energy cost worries. Yet all three of these sectors outperformed the energy stocks and the major indices.

What story or scenario could push all of these sectors higher in the face of rising interest rates? Certainly, one answer would be slow growth. All these sectors tend to do well in slow growth environments because their earnings are relatively stable. But 2006 was a hot earnings growth year and GDP was above the trend of the last 80 years. Under these circumstances, I would have thought that performance would have been best among the big earnings growers like the consumer staples, capital goods, techs, and basic materials, not the more defensive sectors.

I am not sure, at this point, that I have an answer that really suits me, but the one that makes the most sense was that investors decided that if $75 a barrel oil could not push long-term interest rates above 5.0%, then nothing would. And if inflation and interest rates were destined to be tame, REITS, Utilities, and Banks all deserved to sell at lower dividend yields. Energy stocks rose in the old fashion way-- their huge earnings pushed them higher.

One last point on attribution work. I noticed that earnings growth in almost every sector was greater than price growth. That leads me to believe that growth stocks have some catching up to do. More on that later.


Wednesday, January 10, 2007

E + I + E + I = O: The Barnyard Forecast - 2007

Our Barnyard Forecast for 2006 was very close to the mark on much of the year's actual results. Our two key predictions were that 10-year T-bonds would rise in yield but end the year below 5% and that stocks would end the year between 12,000 and 13,000. We correctly described the trends of both economic growth and inflation. As we said in our recent client letter, it could have just been luck, or that our models were dialed in pretty well. To find out what our models are saying about the coming year, we are sharing a condensed version our 2007 Barnyard Forecast.

E+I+ E+ I=O is taken from the acronym of the financial data we analyze: Economy, Inflation, Earnings, Interest, and Opportunities for stocks.

The Economy will weaken in the coming year to near 2.5% GDP growth with the primary reason being that the Fed will cut rates later rather than sooner. That will not harm stocks, significantly, because the weakening economy, ultimately, will help slow inflation and permit the Fed to cut rates, which will be a positive for stocks. We rate the economy positive for stocks. Inflation is improving, but the Core CPI rate is still a bit too high. We do not view this as a problem in the long run, but it may create some headwinds for stocks in the short run. The weak Housing market can solve a lot of this problem, and we believe Core CPI will end the year under 2%. Inflation is neutral for stocks. Earnings are very strong, and we see few signs that they will slow by much in the coming year. We estimate that S&P 500 and Dow Jones 30 earnings will both grow near 10%. We rate earnings as positive for stocks. We rate Interest Rates as neutral for stocks. Even though the Fed has stopped raising rates, as we said earlier, Core CPI is too high and we think that will keep the Fed on the sidelines longer than many analysts are predicting. We believe Fed Funds and 10-year Treasuries, however, will end the year under 5%. That gives a total of two positive scores and two neutral scores. On a balance, that produces a positive rating for stocks in the year to come. One of our most reliable stock market valuation models, our Dividend Valuation Model, has a fair market estimate for the Dow Jones 30 of close to 14,000. That sounds like a pretty good number from all that we see.

Friday, January 05, 2007

Housing and the Three-Handed Economist

The markets appear to be facing winds from three directions: high Core CPI, weak housing, and surprising employment growth and economic strength. There is a divergence among these elements of the economy that is perplexing. Most economists believed that the weak housing market would spill over into total consumer spending and slow the whole economy. Even the Fed has said the weak housing market could take as much as a percent off of GDP. On the other hand, Core CPI is still a worrisome 2.6%, much higher than the 1.5%-2.0% range that the Fed wants, and the job market is stronger than almost anyone had forecast. This is another one of those "conundrum" things, isn't it? The only way I can properly line up all the stars to reconcile a scenario such as the one we have today is if there is a V-shaped bottom in the housing market. Construction is only about 6%-7% of GDP, so the direct effect of a weak housing market on the economy is not huge, and if housing is, indeed, turning, contractors will hang on to construction crews, mortgage bankers will keep staff, etc., etc. A recovery in housing can explain continued strong employment, retail sales, and to some extent, high core CPI. Ah, but the professor has three hands, and with his third hand, he points to the reality of anecdotal and government data that shows that housing in many parts of the country is just very weak. You remember my place in the West that was valued at $X in 2003? My neighbor, who has an identical place, now has his property on the market for $2X. There is a new development across the street that is offering brand new units at $1.9X, for the same square footage and amenities. Today I received an email from a real estate broker offering another unit of the same vintage as mine with comparable square footage and amenities for . . . you guessed it, $1.4X. This past week the stock market has been worried about an economy that might be too strong for the Fed to cut rates anytime soon, which caused stocks to sell off. I am not in that camp, and the news on the ground supports my belief that the weakness in the housing market has not shown its full impact on consumer spending and the economy. Having said that, I believe that a weak housing market will be better for stocks in the coming year than an a upturn in housing. The reason is simple. Housing is 40% of core CPI and weak housing will lower inflation almost by itself and allow the Fed to begin cutting rates. If housing has bottomed and is starting to turn, it is tough to imagine core CPI heading lower, and no turn in core CPI means no cut in interest rates. I'm certainly not trying to bash housing, but I can assure you if housing has bottomed, the world's most important economist, Ben Bernanke, is one worried fellow.

Wednesday, January 03, 2007

Real Estate: It Ain't over 'Til its over: II

Whew! what difference a few minutes make. In the span of 15 minutes today, the Dow Jones went from up nearly 100 points to down 40 points. The reason is our old friends real estate and inflation. When the much-awaited minutes of the Fed's December 12 meeting were released today, investors found a lump of coal, actually two lumps in their stockings. Housing was described as having substantially cooled (read Cold) and core inflation was described as remaining persistently higher than desired. Sounds like one of those conundrum things again, doesn't it? If housing is falling off the table, the Fed would like to be cutting rates sooner rather than later, but if Core CPI is still too hot for comfort that would seem to preclude the "sooner rather than later" strategy. I believe this is a false conundrum because the worries over inflation will subside soon. Here's my reasoning: I believe housing is weaker than most people think(see previous post). Housing prices have fallen in two of the last three reports, and they are likely to fall farther. Having said this, housing almost by itself can cure the problem of the Core CPI. The reason: it receives nearly 40% of the weighting of the Core index. Thus for every one percent fall in housing prices, we should get nearly .4% percent fall in Core CPI. In this way, Core CPI should fall sharply in the coming months and move off the Fed's radar screen. In my judgment, that leaves us with one lump of coal -- housing. I have grown progressively more bearish on the soft landing in housing as I said my December 11, post. I believe there is more pain coming in housing and it will also manifest itself in slower overall economic growth in 2007 than the consensus estimates. The housing issue is not all bad news for the economy, however, I'll have more to say on that in the coming days.