Tuesday, December 30, 2008

Chevron: Cheap and a Winner in An Economic Turn Around

Every investor, except pure technicians, must operate from some basic belief about the shape of things to come. In this regard, I believe that the US and world economies will gradually find their footings in 2009 and will regain their long-term growth trends.
The world's economies have made it through bubbles before, and we will do so again. As I have said before, I cannot offer chapter and verse how it will happen, but I remain convinced it will happen.
In light of this, for some weeks now, I have been thinking more and more about the other side of this valley. Who wins? What does it look like? How long does it take? I don't have many answers yet, but I do have one: When the world economy emerges from current recession, the energy crisis will be standing their waiting on us. For this reason, and because the big international oil stocks are very cheap, we have begun to nibble on selected oil stocks. Chevron is our first pick.
We like Chevron (CVX) because of its strong double-digit dividend growth over the last 5 years, and their success in finding new oil reserves.
The chart above shows our Dividend Valuation Model for CVX over the last 20 years. The stripped bar at the far right of the chart suggests that the fair value for CVX over the next 12 months may be near $100 per share. That would be a nice gain from its present value of $74.
In my mind, the only thing we need for CVX to reach that figure is if we see a bottom in the economy in the first half of 2009. That may seem overly optimistic, but since I said at the beginning that I believe a bottom will come in 2009, it does not require much convincing for me to think that we might see CVX at $100 per share over the next 12 months.
The chart at the right compares the yield on a 10-year US Treasury bond versus the dividend yield of CVX. In recent days, the dividend yield (shown in red) has pushed above the yield on a T-bond (blue line). This intersection is saying that the market now believes that CVX is over valued and is likely to cut its dividend to return to a more normal spread versus the T-Bond. I just don't agree with the market's logic here at all.
I believe the only way that that could happen is if the Obama Administration trashes the oil industry. That is not a good bet, especially in the next two -three years.
The author, clients, and employees of Donaldson Capital Management own CVX.

Wednesday, December 24, 2008

A Christmas Short Story

We thank the Lord for this wonderful season of the year, when we gather together with family and friends to celebrate Christmas with gift-giving and feasts fit for a king. This is as it should be because at this time of the year, we do celebrate the birth of our King, Jesus Christ. We know family is very important to God. Jesus said that through Him we would become children of God, and we could call God "abba." As most everyone knows abba means something more akin to daddy, than king. Our country is going through a very difficult time economically, and there are many who preach gloom and doom as far as the eye can see. I just can't bring myself to be in that camp. I can't give you chapter and verse of how we are going to work our way out of the mess we find ourselves in, but I do know that God's word also says that His hand is upon the government of our country. Thus, I am confident that there will be government programs that God will bless and will become a blessing to us all. He will also continue to bless the sweat of our brows, as His word says. Finally, in these times when answers are so few and questions so many, more and more people turn to God for his divine protection and benevolence. When we do that, we are doing what Jesus instructed us to do, and he offered to us in advance how God will respond. Luke 11:11-13 gives us comfort that God hears our prayers, and will respond. Luke 11:11“You fathers—if your children ask for a fish, do you give them a snake instead? 12 Or if they ask for an egg, do you give them a scorpion? Of course not! 13 So if you sinful people know how to give good gifts to your children, how much more will your heavenly Father give the Holy Spirit to those who ask him.” We are not in this alone. The God of all creation has made known his love for his creation and he has promised to provide for us and to give us the strength to endure. I don't know about you, but I have found God's word not only to be a source of great wisdom and revelation, but also a source of great comfort and hope. On a cold night over 2000 years ago, a child was born in a manger. A child who would change the way the world understood God and the way the world would relate to God. Even though that child was later killed, we Christians believe he rose again and is still alive and still offers His peace and promises to every human being. Thank you, Jesus, for becoming one of us and feeling in your flesh our bumps and bruises, our sorrows, our hopes and fears, and finally our indescribable joys when we understand that it is in your stripes that we are healed. Merry Christmas to all,

Thursday, December 18, 2008

McDonald’s: Having It Their Way

McDonald (MCD) may be as well positioned as any company I can think of to prosper during these difficult times. The reason is the effects of three forces that all appear to be driving business to their stores.

  1. Trading down effect: It is clear that Wal-Mart (WMT) is winning over a bigger segment of the populace in these tough times with their low prices. I believe the same thing is going on at McDs. Eating out is the American way, but I’m betting that more and more Americans will be eating a little lower on the hog at their local McDs.
  2. Brand battle: The McCafe concept, which is being rolled out nationwide, will do battle head-on with Starbucks in specially brewed coffee. This thought might take a while to accept, but judging from the locations where I have seen it introduced, it is a big success. It is driving a different kind of consumer to McDs – more upscale, a little higher income demographic. By all accounts I have heard from my coffee-drinking friends and family, the coffee is top notch and it is less expensive than at Starbucks. Could be a big win.
  3. Competitive atrophy: The other big burger companies have almost all moved their target audiences out of direct competition with McDonalds. Burger King is appealing now almost exclusively to men and Wendy’s appears to be aiming at attracting women. Both appear to have given up much of the kid’s market to McDs.

The Dividend Valuation Chart below shows that MCD is undervalued for the first time in three years. It is trading nearly 20% under its average MCD 12-18-08 3PE of the last 20 years. Click chart to enlarge.

Mike Hull, our consumer strategist, believes that MCD can post 6% higher earnings in 2009 over 2008, and that the dividend will grow close to 9%. That kind of relative performance will draw buyers to the stock, especially when the average stock will have lower earnings in the coming year.

Mike believes that MCD’s business model is putting increasing pressure on their competitors, which could add up to big market share gains in the year ahead for McDonalds.

As always, this blog is for information only. Do not make buy or sell decisions based on what has be written here. The authors and clients of the authors own the stock. Although we have no plans to sell the stock, we will not comment here when we do so.

Wednesday, December 17, 2008

The Madoff Crying Shame

The news that Bernard Madoff may have stolen $50 billion from his clients puts an exclamation point on a tragic year for the finance industry. It’s one thing to make stupid subprime investmentments, as much of Wall Street and some of the banks have done, but it's another ball game when an individual outright steals people’s money. That is bottom of the barrel stuff, especially when so much of the money belonged to foundations whose aim it is to help those less fortunate.

There are many parts of the Madoff story that just defy credulity. He seemed to operate in the cracks of all of the various regulatory bodies.

One part of his operating procedures that we faced some years ago is that of being both a money manager, and the custodian of the assets. As a custodial investment manager, Madoff not only managed his client’s assets, but he also had direct access to the assets. To us that seemed like a lot of added risk and expense. Thus we chose to be a non-custodial manager. As most of you know, TD Ameritrade is our custodian. They hold the assets and make the trades. Our clients sign what is known as a limited trading authority that allows us to manage their accounts and collect our fees.

While being a custodial investment manager has some advantages for clients, such as more flexibility in moving money, the added risks, regulations, and capital costs that we would have had to incur to become a custodian manager outweighed the conveniences.

The only real encumbrance that we have to deal with as a non-custodial manager is that, since we have no direct access to our clients’ funds, TD Ameritrade requires a little more paperwork to authorize moving money around.

As the years have gone by, however, with faxes and email, this has gotten a lot easier, and knowing that we have a very capable custodian partner like TD Ameritrade gives us confidence that no money ever leaves an account that does not have the consent of the client and corroborating paperwork. I can tell you that having TD Ameritrade on board is a comfort to me, and I hope after the Madoff scandal, it is a comfort to our hundreds of clients spread across 29 states.

Friday, December 12, 2008

My Interview on Bloomberg About the Bank of America Job Cuts

I was interviewed on Bloomberg Television this morning about my reaction to the 35,000 job cuts announced by Bank of America (BAC). Since the nearest video up link is 100 miles away, Bloomberg just did an audio interview. Thank goodness for that because I would not have been a pretty site at 5:30 this morning in my bathrobe. Here is what I told the interviewer. The job cuts were not a surprise to me. After Citigroup cut 15% of their work force a few weeks ago, I expected job cuts from all the big banks. In this regard, BAC's 11% cuts were more modest than Citigroup's. I think the job cuts were 75% about the weak economy and only 25% about BAC's recent merger with Merrill Lynch. There will be some redundancy between Merrill's and BAC's investment banking operations, but it should not amount to much. BAC is just using the Merrill merger as an excuse to lower their cost structure. This, however, is an important step when considering that banks face more quarters of loan losses. BAC's job cuts will improve operating earnings by reducing costs by nearly $7 billion over the next three years. Aside from the obvious negatives at the personal level for those people who will lose their jobs, it is a negative that BAC will take a hit to net capital of some magnitude for the severance pay. This is important because capital is at a premium for all banks and this action will, indeed, lower BAC's net capital. I believe the job cuts are necessary and the key question is how rapidly and effectively they can get them done. If these job cuts drag on for three years, the morale at BAC will collapse and the productivity will suffer, diminishing the positive impact of the cost savings. It is a question of execution. In this regard, I am more optimistic than I was when I heard the news that BAC was buying Merrill Lynch. I would have preferred BAC stick to their knitting with more traditional banking activities. But the deal having been struck, BAC has an impressive record of integrating acquisitions. Their Fleet Boston and MBNA mergers, by most accounts, went very well. I'm guessing the Merrill Lynch merger will be the same. I told the interviewer for the present we were holding our BAC, but we were carefully analyzing all of the public statements BAC executives were making about future business. BAC and other banks must offer some hope of a turnaround for us to want to continue to hold them.

The Collapse of the Auto Bailout: Not As Bad As It May Seem

Even though news of the breakdown in talks to bail out the Big Three Automakers will send stocks lower at the opening on Friday, is the news so bad? I don't think so. What good does it do to bailout companies with an operating model and cost structure that has failed. The Big Three will only be back to the bailout window again, and again. The US automakers are hamstrung with thousands of dollars per car in so called legacy costs: costs associated with generous pensions and other benefits that have been agreed to by management and labor over the years. There is one small problem with these legacy costs -- Americans and world buyers won't pay them. Instead auto buyers the world over have, increasingly, switched to foreign based cars, many of which are manufactured in the US. Toyota is now the largest car company in the world. Nissan, Honda, and Hyundai have all made huge gains in the US and around the world. The common denominator of these companies is that compared to the Big Three US auto makers, they all produce cars that have lower costs feature against feature, offer better gas mileage, and possess better customer satisfaction ratings. It's tough for the Big Three to compete against those kinds of results, and it is not likely to change anytime soon. The Big Three auto makers need a new, lower cost structure, and the only way to get it is probably to seek bankruptcy protection. Under bankruptcy, they will able to renegotiate all contracts and debt. Bankruptcy may seem a harsh pill to swallow, particularly in these tough economic times, but bankruptcy does not mean an end to the US auto industry; it just means a time when the industry, creditors, and the unions can put together an operating model that has a chance to succeed in the global market. You and I have all flown on bankrupt airlines. In bankruptcy, planes still fly, most employees still have jobs; indeed, business is conducted pretty much as usual. It just means that management gets protection from creditors and contracts that are draining away their viability. Importantly, it is a time when management, creditors, and unions are under the gun of a bankruptcy judge whose job it is to keep the pressure on all the players to agree to a plan that has a chance to survive in the market place. The current high-cost structure cannot and should not survive. The US auto industry needs a complete overhaul. The breakdown in bailout talks may offer all the participants an opportunity to get it right. The markets won't like the uncertainty, but the markets will, ultimately, ecstatically embrace a plan that has a chance to survive. There may still be a reprieve and a bailout deal may be yet struck, but in my mind any deal that leaves the current operating and cost structures in place is doomed to ultimate failure.

Tuesday, December 02, 2008

Bill Gross and Stocks: Still Wrong After All These Years

Let's face it, the last time Bill Gross, manager of the $800 billion Pimco Total Return Fund, was bullish on stocks was a long-time ago. Indeed, in 2002, he said stocks were on their way to 5,000. Shortly thereafter a bull market began that drove stocks, ultimately, to 14,000. But then again, why would a bond manager ever put in a good word for stocks. That's not his "job." His job is to tout bonds. Today Mr. Gross said that bonds were a better buy than stocks. I agree that corporate bonds and some preferred stocks, which have bond-like qualities, are very good values, and we have been nibbling on them and will continue to do so. Having said this, stocks, in my mind, are dirt cheap compared to riskless US Treasury bonds. For the first time since 1958, the dividend yield on the Dow Jones Industrials at 3.65% is higher than the 2.7% yield on a 10-year T-bond. In addition, the Dow Jones Industrials are now trading at a P/E of about 11 times operating earnings. If you invert P/E, you get what is called earnings yield. A P/E of 11 equates to about a 9.9% earnings yield. The importance of earnings yield being this high is that if you owned the averaged company in the Dow, you would be earning about 9.9% yield on your investment from the income alone, irrespective of any future capital appreciation. In the lexicon of Warren Buffett and big investors of his ilk, earnings yield is seen as owner's income -- the money they can make from buying the whole company. In short, stocks as cheap as they are today will at some point kick off a buying spree from big money players. The only reason it has not happened yet is because stock prices have not been able to find a bottom. When the bottom is formed and tested, I predict a wave of takeovers will begin that will carry stocks to higher levels than most people would now believe. These are my personal thoughts. Please do not act upon anything I have said here. I'm just passing on my thoughts for what they are worth. Please consult your own investment advisor.