Wednesday, June 27, 2007

Wells Fargo -- The Package is Delayed, but the News is Good

I was hoping to end the mystery of WFC's dividend hike today, as they completed their board meeting and made their usual announcements. I was disappointed to learn that they had pushed the decision on the dividend to their July meeting. My apologies that we will all have to hold our collective breaths for another 30 days to see how much additional cash money WFC will give us in the year ahead. As you remember, my focus on WFC's dividend hike was because they are such a huge factor in the mortgage business and their 2006 dividend hike was a bit light(See my previous Blog). My interest is still keen to see what July 24th will bring, but I believe a partial answer to questions surrounding the state of the mortgage business was revealed in a management change announced today: Richard Kovacevich, the legendary leader of WFC, has stepped down as CEO of the firm and is being replaced by John Stumpf (no relation to our own Carol Stumpf, even though her husband is also named John). I believe this management change should be viewed as good news for WFC and, by extension, their mortgage business. Here's the reason. Kovacevich is a relatively young man of 63. I do not believe he would have willingly retired unless the ship was in pretty good shape. He has built WFC into the premier-earning big bank in the country by thinking very differently about banking and the role of bankers. Indeed, he does not call his branch banks, banks, at all, he calls them stores. His employees are not bankers, but sales associates. He took the idea of "cross sell" to a whole new level. Years ago when he was at Norwest, I remember he had a goal of each "store" customer using 4.7 of the company's products and services -- checking, mortgage, credit card, investments, etc. WFC now has initiative called GR8, where they are trying to cross sell 8, count 'em, 8 products to their customers. Kovacevich would never have built WFC just to turn it over to his long time lieutenant John Stumpf if the "store" was in trouble. He would have ridden out the tough times just as he has done for these many years. In addtion, the board would never have agreed to promote John Stumpf to CEO if they had any worries about the strategy or current state of the bank because Mr. Stumpf has been "riding shotgun" for Mr. Kovacevich for the last 25 years. I take this change in leadership as saying that WFC is not experiencing any alarming acceleration in their loan losses, and by extension, since they are so big in the mortgage business, the troubles in the subprime mortgage business still do not appear to be spilling over to the mainstream segment of the business. Unless there is a health issue with Mr. Kovacevich, I think today's news is good news for WFC, because he will stay on as the non-executive Chairman; and good news to the US economy because one of the biggest players in the mortgage business thinks the times are good enough to make a leadership change. These are just my thoughts on a rainy day in Indiana.

Wednesday, June 20, 2007

Dividends Talk -- Wells Fargo Will Soon Give Us a Reading on Real Estate

In late June of 2006, Wells Fargo (WFC) raised their dividend by 7.7%. This increase was below their trailing 20 year, 10 year, and 5 year average hikes of near 15% per annum. When I first saw the 7.7% print, I thought it made some sense. The Fed had been raising interest rates for two years, WFC's net interest margins were being squeezed, and business was beginning to slow. All these factors would appear to justify a slower dividend growth rate. However, the more I thought about it the more I realized that the weak dividend hike was signalling something more significant. WFC's earnings through the 12 months ending in June of 2006 had grown at nearly 12%, and its earnings and dividend growth had been very comparable for many years. So the 7.7% rate hike required an explanation. When I called the company, I got the distinct feeling that they were trying to explain away the dividend action as though it was no big deal. That was a very different attitude for them to take, because they had been touting their dividend growth for a number of years. As I hung up the phone, I was sure that WFC was signalling a weaker year ahead. Then it hit me. It was real estate. WFC was one of the largest mortgage underwriters in the country. It was a big part of their business. If they were being cautious, it had to be because of they had real estate worries. I discussed my concerns with our investment committee and we agreed the right thing to do was to lighten up on US banks and particularly regional mortgage banks. We also scaled back our holdings of WFC. WFC's June 2006 weak dividend hike, in my judgment, signaled housing was going to be a bigger problem than was generally believed at the time. Twelve months later it is clear that they were right. Next week at their regular board meeting, WFC is set to announce their dividend for the coming year . Here's my impression of what their dividend hike will signal. If the hike is between 5% and 7%, we can expect real estate woes to continue for another year. A 7% to 9% hike would suggest a bottom in real estate is in sight. A hike of more than 9% would mean that they not only see the mortgage business bottoming very soon, but also that they are gaining market share. A dividend hike of under 5% would be a very unwelcomed occurrence. That would mean that WFC is bracing for even more bad news in the housing market. We'll let you know their decision next week.

Friday, June 15, 2007

Dividends Talk

By Greg Donaldson and Mike Hull If you listen very closely, you will find that dividends talk. Indeed, they speak in the universal language of money on the barrel head, not in the wink-and-a-nod dialect of earnings or price. Twenty years ago we began a search for a way to determine the intrinsic value of a stock. For approximately 25% of the S&P 500, we believe we have found it -- listening to the dividends. They talk. Not very much and not very often, but watching their trends over about any 5-year time frame can offer a very good idea of what a stock is worth if you have the right tools. If you include interest rates and, in some cases, earnings, the picture becomes clearer. For the 12 months ending May 31, our Rising Dividend--Cornerstone investment style has experienced the best 12-month dividend growth we can remember, nearly 12.5%. During this time, its dividend yield averaged about 3.25%. If you add the two numbers together, you get 15.75%. That is what we call the Total Dividend Return(TDR). Our dividend theory(and what we believe our Dividend Valuation Models show) is that over the long-term, the total return(price appreciation + dividends) of most consistent dividend payers will approximate its Total Dividend Return. Thus, theoretically, we would have expected that the total rate of return of our Cornerstone style of management over the last 12 months would have been around 15.75%, not the near 19% that it actually returned. A 19% total return when we were expecting under a 16% return is good, right? Well, let's say it's not bad, but not something to get all excited about either, because the extra 3+% was not "earned"in our way of viewing things. You might say it just happened. The question, of course, is isn't that the way all money is made in the stock market, it just happens, doesn't it? Stock returns are random; that is what the dons of academe have been trying to tell us for about the last 40 years. We agree with the dons that in the case of many companies there does not appear to be a value driver, but in the case of consistent dividend payers its a different story. Our research shows that almost all consistent dividend payers have a unique and quantifiable relationship between dividend growth and price growth. Additionally, dividend growth and price growth intersect, or reach a kind of equilibrium about every 3 to 5 years. This means that our Cornerstone's outperformance over the last year can be explained in one of two ways: 1) It is a make up for an underperformance in the last three years, or 2) the portfolio's actual performance will lag a bit until more dividend hikes become apparent. Our best estimate for dividend growth for the portfolio over the next 12 months is just above 10%. With the portfolio's current dividend yield near 3%, that would mean that a good guess of what the Cornerstone portfolio might produce over the next 12 months is near 13%. This strong dividend growth implies double digit returns this year and next. Recently, rising interest rates have been a headwind to almost all dividend stocks, but history shows us that rising interest rates, unless they continue to rise on a secular basis, are not the main driver of very many stocks, even utilities and REITs. The main driver of most dividend stocks is the trend of their dividend growth. Thus, if the trend of dividend growth is sustainable, which we believe it is for many stocks, stock prices will soon stop their swoon and begin to climb again. Here's a real example of Dividend Talk. UTX, which I discussed a few blogs ago, recently announced a 21% dividend increase. The analysts were looking for a 14.5% hike. We think UTX's above trend dividend hike is a clear signal that it is likely to have a better year earnings-wise than Wall Street now is projecting. That means as the year progresses, UTX is likely to find new buyers with each successive positive earnings report. We are awaiting with great anticipation Wells Fargo's next dividend hike. We'll tell you why in a future edition.

Friday, June 08, 2007

Life at Sea

In our recent quarterly letter we explained that one of our core investing principals is that we will invest in only companies that we are willing to hold for 10 years with no option of getting out early. As you know, we do not hold all companies for 10 years, indeed we sometimes sell a company in only months, but the point is on the day we buy a company for the first time, the first question we ask ourselves is, "Based on everything we can see today, are we willing to hold this stock for 10 years." This is not just marketing hype. We mean it, and we learned about this concept from a very unusual source. Many years ago I (GCD) went sailing with a group of colleagues in the Caribbean on a beautiful boat named "Amazing Grace." The captain, who was named Tomas, had escaped from Poland when the country was still behind the Soviet Union's Iron Curtain. Since I was very interested in sailing at the time, he indulged me with tales of his own adventures around the world and what it was like to sail the high seas. I learned a lot about sailing in those few days, but through the stories of Captain Tomas, I also learned something about investing that I believe differentiates us in many ways from other firms. Over dinner one night, I asked the captain if he had any suggestions about what size boat he would recommend if I wanted to get into sailing. He just looked at me and laughed. He said "I have only one rule about boats. I will not set foot on any boat that is going more than 10 meters from shore, on which I would not be willing to spend the night." The dazed look on my face must have convinced him that I did not understand what he was talking about, so he continued. "The thing you have to remember is that sailing is as much about the weather as it is about the boat or the water. Great sailing weather is very close to dangerous sailing weather, and indeed, rough weather, by its very nature, comes fast and hard. In addition, boats that are built for speed are seldom built for sleep. I asked him if he literally meant that he would not set foot on a boat that he was not prepared to sleep on for the night. He answered, "I can't tell you the number of times in my life that I have been caught in rough weather just a few meters from shore. I could have practically thrown a rock and hit the shore, but the winds and the tides were against me, and I was forced to spend hours in high seas until the weather let up and I was able to come ashore. He continued,"Everyone assumes that a nice cruise across the bay, or down the river, or up the coast is what boating is all about. The weather is fine, the light is just right, the sea air is invigorating. Few people take into consideration how big the water is and how little the boat is, even in good weather. But when the bad weather comes, and it always does, in a moment they know they are in trouble, and their only hope is that they and their boat can endure the storm." I told him that his story reminded me of the stock market and people's reaction to it. I explained that too many investors I knew thought the greatest invention of the investment world was the ability to buy and sell, and as a result, they were willing to take a flyer on any idea because, after all, they could always get out. But the truth was when the storms hit the stock market, as they always did, they couldn't get out very easily and certainly not without great cost. Because of this, many investors either became "stuckholders," or traders. He said, "I figured out a long time ago, that my life would be on the water. Almost all of my eating, drinking, and sleeping would be done on the water, and as a result I became more and more particular about the kind of boat I would spend my time on. Gradually, I came to the idea I mentioned earlier of judging the boat by whether or not it and I could survive an overnight storm." He said, "Your story of the "stuckholders" and the traders reminds me of what I call the shorehuggers. They think they are sailing, but they don't have the boat or the experience to go into the deep, and thus, they don't know sailing at all." I asked him what was so important about getting into the deep water. What were the shorehuggers missing? "This little boat ( The Amazing Grace was 60ft. long) has carried my wife and me around the world. . ." He hesitated, and then said,"It's not something I can explain. You'll have to experience it for yourself one day." I never went into sailing. The more I thought about it, the more it reminded me of investing. I already had enough "weather" in my life, but as a result of the discussion I had with Captain Tomas, I began to think about investing differently. It would not happen for a few more years, in some ways not until Mike Hull and Rick Roop came aboard, but eventually, I began to build portfolios that could handle the storms, not try to run from them. Portfolios that ate well, slept well, and performed admirably. Portfolios that could take you around the world, or through the rest of your life no matter what the weather.

Wednesday, June 06, 2007

UTX: Primed for the Global Economy

Stocks have had a good run over the past 12 months, but our models, as I said last time, are showing that many blue chip stocks are still undervalued. During the next few weeks, I will show our Dividend Valuation Models for a handful of stocks in the Dow Jones 30 that appear to have a ways to go.

The first stock is United Technologies (UTX.) We own the stock in our Capital Builder and Cornerstone portfolios. UTX owns Carrier Heating and Air, Otis Elevator, UTC Fire and Security, and three aerospace units, Hamilton Sunstrand, Sikorsky, and Pratt and Whitney.

Please click to enlarge
The blue line on the chart shows that over the last 20 years, UTX, except for the period right at the turn of the century, has been a remarkably consistent grower.

The green bars represent the prices that our Dividend Valuation Model (DVM) calculated were the corresponding "fair values" of the stock in each given year.

What is important about the green valuation bars is that in 9 of the last 12 years they have come remarkably close to predicting the average annual price of UTX. When you stumble upon a valuation tool that has been as accurate as our DVM has for UTX, it might not be the worst idea to see what it is projecting for the next 12 months.

The model's valuation level for 2008, which is based on dividend growth and changes in interest rates, is $80 (green striped bars). The way our model works the $80 figure is a kind of central tendency, not an exact forecast.

With the stock currently selling at near $70, a move to near $80 would represent over a 14% increase. In addition, UTX's current dividend provides a 1.5% current yield. Totalling the capital appreciation and the dividend yield, we arrive at nearly a 15.5% projected total return in the coming 12 months.

But there is more: UTX is not a one year wonder, their product lines touch almost all of the macro trends that are driving the worldwide economy.

Carrier is deeply involved in cleaner and more fuel efficient heating and airconditioning. In addition, they are a prime benefactor of the global expansion. Otis Elevator is a key player in the global expansion with elevators, escalators, and moving sidewalks. UTC Fire and Safety is primarily a surveillance and security firm, think terrorism and safety. The aerospace division is full of technology used in defense and air travel. Think terrorism and global expansion.

On a daily basis stocks can bob and weave like a yo yo, but if you dig hard enough, some stocks are found to follow their fundamentals very closely. We believe UTX is one of them.

If you have not read our disclaimers recently, please click on the link at the right. The discussion here is for information purposes only. Yes, and I do own the stock.

Sunday, June 03, 2007

Barnyard Forecast -- Stocks Going Higher

The Donaldson Capital Management Barnyard Forecast is our subjective model for the prospects of the stock market over the next 12 months. We like to roll it out when the times or the markets are confusing. The Forecast is a simple check list of the levels and trends of the major economic data and their historical relationships to stocks. The Forecast's name is taken from the acronym of its components: Economy, Inflation, Earnings, Interest Rates. Each component is rated as follows: positive for stocks --2 points, neutral for stocks -- one point, or negative for stocks-- 0 points.

Economy: The optimum rate of real economic growth is near 3%. The Forecast is positive when economic growth is below 3% and negative when its above 3%. At first that may seem counter intuitive, but the idea is to capture the projected actions of the Federal Reserve in the coming year. If the economy is growing slowly, the Fed can be expected to cut rates; if the economy is steaming, the Fed will likely raise rates. The most recent GDP data was this week's .6% reading for the first quarter. That is well under 3% and, thus, is positive for stocks, 2 points.

Inflation: This is the most worrisome indicator currently. The important threshold for the Core Consumer Price Index (Core CPI) inflation is 2%. The core CPI has been consistently above that level for nearly two years and has caused many analysts to be skeptical about rate cuts anytime soon. The reading for the 12 months ending April was 2%. Under the circumstances, that is a negative reading. 0 points.

Earnings: Corporate earnings have been nothing short of sensational over the last three years. Most analysts were predicting that first quarter earnings would fall below 10% on a year over year basis for the fist time since 2002. The final numbers are not in yet, but it appears first quarter earnings for the S&P 500 may have edged over that level. In any case, earnings have continued stronger longer than almost anyone would have guessed. The most important threshold for earnings is 7% annual growth, which is the long -run average. We expect 2007 earnings growth will stay comfortably above that level. Earnings are positive for stocks. 2 points.

Interest Rates: Long-term interest rates have been creeping higher over the last few months. Bond investors appear to be worried that the slowing economy will prompt the Fed to cut rates before inflation is completely subdued. Having said this, 30 year Treasury yields are about where they were a year ago. That is a neutral reading. One point.

The Barnyard Forecast totals 5 points. That is a modestly bullish reading for stocks in the coming year.

With stocks having had a strong run over the past 4 months, the media is full of prognosticators who are turning bearish. As seen below from the website , currently nearly 47% of stock market commentators included in their survey are bearish, with only 25% bullish. We have never seen a market turn decisively lower in the face of such negative sentiment. Stocks almost always turn lower when everyone is bullish. Just the opposite is true today and, thus, at the very least we should have another surge higher to force all the naysayers to capitulate and come off the sidelines.

This might sound like simplistic thinking, but over the years, we have found that markets that are littered with doubt and worry tend to be more profitable than those when the sentiment is overwhelmingly bullish.

Our Dividend Valuation Models say the market is still cheap. Our Barnyard Forecast says that economic forces favor a rising stock market. Lots of traders are bearish. It hasn't been this good in a long time.