Tuesday, March 25, 2008

Tough Questions, Controversial Answers

The air is thick with concerns, worries, and just plain confusion regarding the economy and stocks. Over the next few editions, I will try to answer the most prevalent and important questions our portfolio managers are receiving. Question: Recession, yes or no, and if yes, how deep and how long. Answer: I really believe this is the wrong question for 95% of investors to be asking. The reason is that most of the stocks in the major indices derive nearly 50% of their earnings outside the US and whatever happens here will be buffered by what happens around the world. Here is an import point to ponder. Nearly 30% of the world's economic growth is now coming from so-called developing nations -- China, Russia, India, Brazil, etc. These nations' rates of GDP growth is nearly twice that of the US and Europe and shows no signs of slowing, to any significant degree. With the dollar having fallen, US exports will continue to grow relative to imports and may continue to surprise on the upside. As a result of this, first quarter corporate earnings may well be better than most people and the markets are now pricing in. Having said this, it would surprise me if the first quarter shows much real GDP growth. The combination of $3.25 p/gal gasoline, subprime headlines, and rugged weather probably combined to slow US GDP growth to a crawl or even a dip. The slashing of interest rates by the Federal Reserve and the $150 billion dollar stimulus package due in May probably will lift 2nd quarter GDP. And, continued bold Fed action should free up of the banking system, which should assure some lift to the economy by the third quarter. I agree with many economists, who are forecasting one quarter of 2008 negative GDP growth, but with positive overall GDP growth for the year. Importantly, I agree with many analysts who are estimating that corporate earnings may well rise in the low double digits in the coming year. That is good news for stocks. Question: If you say that we are investing in multinational companies and not the GDP of the US, why have US stocks been hit so hard over the last 90 days. Answer: In short, it is primarily due to the belief that the economic and investment world is hardwired to what happens in the US. Thus, if economic growth is slowing in the US, then growth must be slowing worldwide. We believe that is just not facing the facts. The US now represents less that a third of world GDP growth, and the rest of the world is showing solid growth. We believe corporate earnings in the year ahead will be lifted by worldwide growth and continue to suprise to the upside. Question: Do you think that we have seen the bottom of the stock market slide? Answer: I think there is a 70% chance we have, and there is one primary reason for this belief: The Federal Reserve. I complained initially about the Fed's tin ear to the markets and the pace of rate cuts. I'm not complaining anymore, and the reason is not only the big rate cuts they have made, but the bold move they made in rescuing Bear Stearns. I won't get into the details because I don't understand all the details, but this much we know: The Fed bailed out Bear Stearns, knowing that they had billions of dollars of subprime mortgage pools on their balance sheet. The market has rallied ever since the bailout because many market followers know where this is all headed. The Fed and the US Government will ultimately put together some sort of bail out plan for the $300 billion in subprime bad debt. The amount is smaller than the S&L bailout in the late 1980s, and it is the only way to keep the real estate market from being a drag on the economy for years to come. Question: What about the precedent of bailing out people and institutions who made unwise investments? Answer: It is not the Fed's job to impose moral judgment on society. It is their job to maximize sustainable economic growth and minimize inflation. One could just as easily use the argument about the moral hazard of people in the US who live directly in hurricane alley, or tornado alley, or wildfire alley, or earthquake alley, or any other dangerous alley in the country. Why should the rest of us have to pay when Katrina rips away New Orleans or Houston, or a tornado tears through a city in Kansas. These people all build homes or bought homes in harms way. Shouldn't we just leave it to them to clean up their own piles of trash? No, that is not the way this country works. There is no hiding place from the storms of life, physical or financial or whether they are caused by people or nature. Of course, there were egregious lapses of judgment on Wall Street, but they are paying for it not only in the hundreds of billions of dollars in write offs they have taken, but in the 37,000 jobs that have been lost since the beginning of the subprime debacle. I don't like bailouts any better than than most of our readers, but some bailouts are necessary when the foolishness of one group imperils the general populace. I believe the subprime-real estate crisis rises to that level. Had the Government not bailed out he S&Ls in the late 1980s, the S&L problems would have lasted a decade, cost hundreds of billions of dollars, and slowed overall economic growth to a crawl. As it was, the Resolution Trust Corp. cleaned up the majority of the mess in only a few years at a fraction of the $500 billion at stake. In almost all economic crises, the killer wave is the freezing up of valuable assets, behind fear and risk aversion. In essence, when the government steps in they act as an icebreaker by taking over the frozen assets, thawing them out, and then putting them up for sale on a piecemeal basis. That is what happened in the S&L crisis. That is what I predict will happen in the subprime crisis. I realize these views might be controversial in some quarters, but I am convinced this is where we are going, and soon.

Thursday, March 13, 2008

Proctor and Gamble: Defensive, Global, Growth

There are few stocks that qualify as defensive global growth stocks (GGS). Colgate, Pepsico, Coke, and Nestle would also qualify on my short list. A GGS in my estimation must possess three qualities: 1. Their business is not subject to interest rates or economic cycles; 2. The majority of their business is not centered in any one country; and 3. They must have double digit earnings and dividend growth.

I believe one of the companies that best fulfils these criteria is Procter and Gamble. PG has a wide array of products that we use everyday, whether there is a subprime crisis or not. From Crest toothpaste, to Tide, to Oil of Olay, they are in the cupboards that all of us visit everyday

Their dividend has been the picture of consistency. Over the last 20 years, PG's dividend has grown at 11.0%. Their 10 year growth average is 10.7%, and last year they increased their dividend 12.5.

Even though the stock has bucked the subprime headwinds and produced a 10% total return over the last 12 months, I believe they have more room to go because of the geographic mix of their business. Nearly two-thirds of their revenues and earnings come from outside the US. Nearly half of their global business comes from developing nations, which are growing much faster than the US or Europe.

Remarkably, they have raised their dividend for over 50 consecutive years, the longest running streak of any American company.

Our Dividend Valuation Model (Click to enlarge) has been a good fit with the actual annual movement of PG, except the late 90s. The stripped black "value bar" to the far right on the chart is our model's best guess of what we might expect from PG in the year ahead. If it were to attain that level, it would be more than a 15% gain. The Valuation is based on the historical relationship among PG's price, dividend, and changes in interest rates. The past in no guarantee of the future, it is only our best guess.

The last 12 months have not seen many winning stocks. PG has been one, and the odds are very good it can do it again if they can sustain their enviable long-term trends of earnings and dividend growth.

You guessed it. Everyone I know owns the stock. Please see disclaimer link

Sunday, March 02, 2008

Dividends Are Not Signalling Recession

If the US economy is falling into recession, you could not discern it from the dividend actions of major US companies over the last two weeks. As you know, one of our theories on dividends is that since dividends are decided by a company's board of directors, they speak as much about the future as the past . This is because no board wants to set a dividend policy that will lead to a cut in the dividend in the future. If our theory is correct, business is not as bad as the headlines would have us believe. According to the chart at the right, dividend growth remains strong. (Click to enlarge)

Over the last two weeks 19 major companies raised their dividend. No major company lowered its dividend. The table above shows some very strong and surprising dividend hikes. I have highlighted 5 in green in column 7. Abbott Labs hiked their dividend nearly 11%. This is much higher than their 3-5 year trend shown in column 6. Abbott has taken the lead among health care stocks in assembling the right mix of products.

Coke raised its dividend nearly 12%, another sign that the world leader in soft drinks continues to regain in once dominant position in the industry.

Colgate. CL is one of our favorite stocks, and we were pleased to see their 11% dividend hike. While this is slightly lower than their average of recent years, we believe it signals good things for this important consmer staple in the year ahead.

ITT, an industrial company, raised their dividend nearly 25%. This is well above their recent trend, and another sign that the industrial sector is still growing at a solid rate through their international sales.

Nordstrom's double-digit hike was impressive coming from a company in the retail industry, which most people believe is headed for trouble. Nordstroms must be of the mind "that this too shall pass."

Toronto Dominion put most US banks to shame by hiking their dividend over 11%. Minimal subprime exposure and a strong Canadian economy are obviously the drivers of TD's impressive dividend hike.

Since we began tracking this dividend data (near the first of the year), dividend growth has averaged approximately 12.4%, only slightly less than the average of the last 3-5 years, and as shown at the bottom of the table, approximately 60% of the companies have made dividend hikes that were higher than their 3-5 year averages.

It is difficult to be too pessimistic about company profits for 2008, when dividend hikes continue to be so strong. I realize something has to give sooner or later -- dividend growth cannot continue to be strong should a deep recession occur in 2008. Having said this, the people who run these corportations are reading all the same newspapers you are, and they are saying by their actions that their businesses are still in a growth trend.

Clients and employees of DCM own ABT, KO, CL, and WRI.