Wednesday, December 30, 2009

The Non-Consensus View of Things to Come

For many years, I have begun each year with a back-of-the-envelope analysis of the prospects for stocks, bonds, and the economy in the coming year. In this first look, I am only interested in how my views compare to the published consensus estimates. The reason is simple--many studies have shown that the consensus view is almost always wrong. So, in effect, the one place investors can be sure that the financial and economic markets are NOT going is where the current consensus is now pointing. It may sound almost sacrilegious, if not foolish, to use the consensus estimates of the smartest, most respected strategists and economists in the world in this way. My own experience and the aforementioned studies have convinced me, however, that to get the coming year right, so to speak, it is necessary to be sure I am not following the most widely accepted view of things. I'll have more to say about this in coming letters, but here's how we at Donaldson Capital Management view the financial prospects for the coming year in comparison to the consensus view of the Bloomberg Survey. Our view was constructed this past Monday in our Investment Policy Committee meeting in discussion among all four of our portfolio managers.
  • Economy: The consensus is for 2.6% GDP growth in 2010. We believe economic growth will be closer to 3%. Thus we are more optimistic about the year-ahead economy than the consensus.
  • Inflation: Consensus for core CPI is 1.3%. We believe the core rate will be closer to 1.5%. That's close enough, however, to say we agree with the consensus that inflation will remain tame.
  • Earnings: The current estimates by analysts is that S&P 500 company earnings will grow by over 20%. Our estimate is similar to the consensus.
  • Interest Rates: Bloomberg economists predict that the 10 year T-bond will yield right at 4.0% by year-end 2010. We believe interest rates on T-bonds will be more in the range of 4.5%.

In summary, we agreed with the consensus on core inflation and corporate earnings, and diverge on the strength of the economy and interest rates. In trying to move away even farther from the consensus, we would lean toward higher earnings growth than investors are now forecasting and higher core inflation. If our non-consensus financial view of the coming year were to prove correct, we believe it would have big implications for stocks.

We believe our non-consensus view would result in stocks moving strongly higher during the first six months of the year, on the back of better-than-expected earnings and economic growth. Stocks would then flatten out or retreat modestly as this better-than-expected growth would prompt the Fed to start raising interest rates sooner than Wall Street is now predicting.

In our estimation, if the economy unfolds the way we currently see things, stocks will likely end the year with a low double digit total rate of return. On the heels of the big turnaround for stocks in 2009, we would be very pleased to see another good year for stocks.

Blessings to you all and may you have a happy, safe, and prosperous New Year.

Greg Donaldson

Friday, December 11, 2009

Our Valuation Model Signals Stocks Are Still Undervalued

Stocks have moved a long way since March and there are many analysts that are calling for a correction of these gains. We are not in that camp. In an August blog, with the Dow at near 9,200, we showed that our valuation model was indicating that the fair value of the Dow was near 10,900. With the Dow now approaching 10,500, we thought it would be interesting to recalculate the model. The graph shows the valuation model going back to 1960. The red line is the actual annual price of the Dow Jones. The blue bars are the model's output of the predicted values. The ouput is derived from a multiple regression of the DJIA's dividend, earnings, and the yield on 20 year bonds against the price of the DJIA. The way the model works is to mathematically produce what we might call a "normal" price of the Dow based on the historical relationship among the various inputs. Today the model calculates a "normal or fair value" of 11,400 for the DJIA. In addition, remember this is what we call a "coincident" indication of value. Since the model is positively correlated to rising dividends and earnings, a rise in both of these inputs will push the fair value of the DJIA higher. Knowing how the model works, we would not be surprised if the fair value of the DJIA rose to near 12,000 sometime in 2010. We'll revist what the model is saying after 4th quarter earnings are released. Please read the Terms and Conditions at the right.

Tuesday, December 01, 2009

Nike Is Poised for a Christmas Season Run

Optimism is in short supply among many analysts regarding the Christmas selling season this year. Indeed, economists are predicting that Christmas sales will fall for the second year in a row.
Since we have been saying for many months that corporate earnings would continue to surprise to the up side, we see no reason to get cautious now.
We believe the the odds are very good that analysts' earnings for many important retail stocks will prove to be too low for the holiday season of 2009-2010. Notice that we say the Christmas selling season of 2009-2010. Indeed, research shows that the old fashion Thanksgiving to Christmas Eve selling season has morphed into a much longer season. Our best guess is that the Christmas season now begins well before Thanksgiving and ends after the first of the year. We know in our own office of many extended-family Christmas celebrations that occur after the first of the year.
We also believe in the maxim, "Christmas always comes." Almost every year we hear retailers and analysts fretting that this is the year that people will stay at home and give up the gift giving habit. Without a doubt this has been a very tough year. Consumers will not be spending money foolishly, however, Christmas is such a deeply held part of our culture that we find it difficult to believe that people will give up the joy of giving. The joy of giving, after all, is one of the things that makes Christmas such a wonderful time of the year.
One retail stock that we like is Nike (NKE). NKE's Dividend Valuation Chart is shown above. The model is indicating that NKE's current share price is at a discount to its 2010 valuation, which is based on its normal relationship with its dividend growth and changes in interest rates. Additionally, from a contrarian point of view, NKE is always the subject of lots of nay saying about their ability to sell "pricey" athletic shoes and apparel in a tough economy. We believe for many young people the "one" gift they want, to the exclusion of others, is something with the swoosh on it.
In short, we think NKE's earnings will surprise to the up side.
We own the stock. Please click the Terms and Conditions link at the right.

Sunday, November 15, 2009

The Hidden Power of Rising Dividends

I have written and spoken about the Hidden Power of Rising Dividends compared to bonds for nearly 20 years. Yet, I find that many people do not grasp and retain the concept. The primary reason for this is that most people think of stocks as investments you trade and bonds as investments that you hold to maturity. If you would think of stocks as more like bonds, however, a new vision of the power of stocks as income producers comes into view. For example, let's compare Johnson and Johnson (JNJ) common stock with a 10-year US Treasury bond. Today the dividend yield of JNJ is 3.2% (1.96/62) compared with the yield on a 10-year T-bond of 3.4%. On the surface, from an income perspective, the T-bond would seem to offer a better deal. It is AAA rated, it is an obligation of the full faith and credit of the United States, and it offers a modestly higher yield than does JNJ's common stock. Yet, if a person is looking for safe and secure income, I would argue that JNJ common stock might be a better investment than the US T-bond. Here are a few reasons: JNJ's bonds are also rated AAA, one of only six or so companies in the world with such a rating. This strong credit rating for JNJ means that it has the financial strength to endure about anything that may come along over the next 10 years. Next, JNJ common stock has paid a dividend since 1944 and has raised its dividend for 46 consecutive years. Over the past 20 years, JNJ has increased its dividend by an average of about 14% per year. If JNJ were to continue hiking it dividend at 14% per annum, its dividend would nearly quadruple over the next 10 years. In light of pressures in the health-care industry, we do not believe they can maintain the 14% dividend growth, thus, for simplicity sake, let's assume JNJ's dividend grows at about 7.2% per year. At that rate of growth, its dividend will double over the next 10 years. Starting with today's dividend of 1.96, a 7.2% growth rate would produce the following annual dividends for a share of JNJ stock:
  1. 2.10
  2. 2.25
  3. 2.41
  4. 2.59
  5. 2.77
  6. 2.97
  7. 3.19
  8. 3.42
  9. 3.66
  10. 3.93

Now comes the part that most people miss. Our dividend yield ten years from now will be the then current dividend divided by our purchase price. Today JNJ is selling for $62 per share. Thus, based on today's price, if JNJ does increase its dividend at a 7.2% rate over the next decade the yield on today's price would be 3.93/62=6.33%.

So does it mean that we will make a cash on cash yield of 6.33% if we hold JNJ for the next decade? No, it won't be quite that good. You have to remember that it will take 10 years to produce the 6.33% dividend yield. To find the precise rate of return would require doing an internal rate of return calculation. We can, however, do a simple calculation that will give us a good idea of what we will make for JNJ over the next decade. If we average the starting and ending dividend yields, we'll achieve a ball park idea of the cash on cash return over the next 10 years. (3.20%+6.33%)/2= 4.77%.

So when we compare JNJ common stock with a 10-year T-bond, we should take into consideration that JNJ's dividend income will grow, while the income from the T-bond will be static.

There is certainly risk that JNJ won't hike it dividend by our projected rate, but I would argue that there is just as much of a chance that the dividend growth will be higher than our example. So for my money, JNJ, as a pure income investment, will provide a better return over the next decade than a T-bond just from the dividends alone.

However, as they say on late night TV, "But wait, there's more!" JNJ is not only an income security, it is an equity security. Therefore it's price will fluctuate over the next 10 years along with its prospects. At first that might swing your investment choice back to the bond. But consider the following, if JNJ's current 3.2% dividend yield is still in effect 10 years from now, and its dividend has, indeed, doubled, then its price will also double to near $124 per share. The computation for this is straight forward: ending dividend (3.93) divided by ending dividend yield (3.2%). If that is the case, then our total return for the period would approximate 10.5% per annum.

I realize there are a lot of moving parts in this discussion and that may make your eyes roll back in your head. Believe me, however, it is worth your time to get your mind around the simple math that is the basis of the Hidden Power of Rising Dividends.

We have owned the stock for many years. Do not buy it because we own it. This blog is for information purposes only.

Monday, November 09, 2009

Third Quarter Earnings Derby: Bears on the Run

With only few companies left to report earnings for the third quarter, some striking trends are apparent in the data.
  1. For four consecutive weeks the % positive surprises have held steady at between 80% and 85%. This is the highest quarterly earnings-beat rate that I have ever seen and shows that US businesses are right-sizing their cost structures in a remarkable fashion. Alan Greenspan used to speak glowingly about the flexibility of American business management. This right- sizing of costs is vivid proof of just how flexible the average company in this country is.
  2. While the average earnings for all reporting companies are 15% lower than the third quarter of 2008, the results are better than the -20% estimate at the beginning of the earnings season.
  3. The positive average surprise has been nearly 15%, again an extremely high figure and higher than last quarter's surprise rate.
  4. Overall corporate sales are down approximately 12% from a year ago, right on Wall Street estimates. Wall Street analysts, however, are now estimating that both earnings and sales will be higher, on a year over year basis, for the fourth quarter of 2009.
  5. Larger companies are reporting better earnings than smaller companies.
  6. Multi-national companies are reporting better earnings than domestic companies, as a result of their greater global sales, as well as the falling dollar.
Revenues and earnings for major US companies are estimated to be higher in 2010 than in 2009. The coming year will likely be the first up year for earnings since 2007. In the face of this "on balance" good news, the path of least resistance for stocks is up. The ferocious roars of the bears is increasingly sounding like the wailings' of ghosts of nightmares past.

Thursday, October 29, 2009

Third Quarter Earnings Derby: The US of A Gets in the Act

Third quarter S&P 500 earnings results for the first three weeks of the season continue running far ahead of Street estimates. Importantly, however, recent weakness in some economic data has overshadowed the better-than-expected earnings and caused stock prices to fall sharply. The pullback in stocks was largely erased today as third quarter US GDP showed growth of 3.5%, the first positive economic growth in four quarters and also beating Wall Street estimates by nearly 10%. Even with some oil stocks reporting disappointing earnings, stocks soared by nearly 200 points on the Dow Jones Industrial Average. The beat-rate for S&P 500 companies' earnings for the third quarter is running at a rate that I have never seen before. With 60% of companies reporting, 84% have reported earnings higher than Wall Street estimates, and 60% have reported better-than-expected sales. Here's a short breakdown of the results thus far for the S&P 500 companies: Earnings Reported through Thursday Positive Surprises: 258 Negative Surprises: 45 % Positive Surprises: 84% The beat ratio of 84% so far this quarter is far higher than we expected, and we were as optimistic as anyone that earnings would again be better than Street estimates. Revenues for Reporting Companies Positive Surprises: 183 Negative Surprises: 118 % Positive Surprises: 60% The common thread among the good earnings reports continues to be cost control. Early this week, the markets appeared to begin looking past the good news on earnings, as some economic reports showed that the economy continues to struggle with housing and employment headwinds. The good news on US GDP growth for the third quarter, however, appears, at least for the moment, to have assuaged investors' concerns that the recent gains in the economy might stall out. I'll update next week. Data courtesy of Bloomberg.

Friday, October 23, 2009

Third Quarter Earnings Derby: The Beat Goes On

Third quarter S&P 500 earnings results for the first two weeks of the season are running far ahead of Street estimates. Importantly, sales are also faring much better than expected. Here's a short breakdown of the results thus far for the S&P 500 companies: Earnings Reported through Friday Positive Surprises: 146 Negative Surprises: 25 % Positive Surprises: 85% Year over Year earnings growth for reporting companies: -14% This is just short of remarkable. Last quarter the beat ratio was 75%, the highest in many years. The beat ratio of 85% so far this quarter is far higher than we expected, and we were as optimistic as anyone that earnings would again be better than Street estimates. In addition, the growth for all reporting companies stands at a minus 14%. Just prior to the beginning of the reporting period, the consensus estimate was for a negative 20% year over year earnings growth rate. Revenues for Reporting Companies Positive Surprises: 112 Negative Surprises: 60 % Positive Surprises: 65% Year over Year revenue growth: -2.8% The picture for revenue surprises is far less striking than earnings surprises. However, overall, revenues are much better than expected. The most important data, perhaps of the whole list is that average year over year revenues are down only 2.8%. Prior to the reporting period, revenues were expected to be down more than twice that amount. Two weeks do not a season make, but thus far, with many important companies reporting, S&P 500 companies are knocking the socks off of Street earnings estimates. The common thread among the good earnings reports is cost control. American companies are just doing an amazing job of right-sizing costs. If this beat-ratio continues, I believe that stocks will continue to move higher in the weeks and months ahead. I'll update next week. Data courtesy of Bloomberg.

Friday, October 16, 2009

John Burr Williams' Lament

John Burr Williams is widely credited as being the father of dividend investing and the creator of the forerunner of today's dividend discount models. Williams was also a first rate economic strategist.

Williams was already a successful Wall Street investor, when in 1937 he went back to Harvard. Williams sought to earn his PhD in Economics with the hopes of learning what had caused the stock market crash of 1929 and the subsequent economic depression of the 1930s. By the end of his time at Harvard, Williams had concluded that the primary causes of the depression were high stock market volatility, which he believed was caused by a lack of an accurate method for valuing stocks; and ill-conceived government actions and inactions in the economy.

Williams’ doctoral dissertation, which was published as a book, was entitled “The Theory of Investment Value.” In it he explained that the prevailing (then and now) method of determining the value of a company by analyzing earnings was inherently inaccurate. Instead, he urged, that dividends should be the primary determinant of a stock’s value because dividend payments were far less volatile than earnings.

The following is a brief excerpt of the formula, which would later become known as the dividend discount model, that Williams proposed as a more accurate method for valuing stocks.

“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”

Williams’ Lament:

Williams' lament was that the volatility of the stock market in the 1930s was not justified by the long-run dividend growth prospects of the underlying companies. But because most investors focused on short-term earnings and not long-run dividends, they got caught up in running from and chasing after illusory earnings-driven prices. In doing so, they met themselves coming and going and began to question whether or not there was a true underlying or intrinsic value to stocks. When they came to this conclusion, it was only a matter of time before they were willing to turn the whole thing over to the government.

Williams believed that in abandoning the free markets in favor of more government control of the economy, investors helped usher in a period of sub par growth for the economy and share prices. He explained that the government is neither a good allocator of capital nor is it geared toward innovation. In his mind, where there was a lack of efficient capital allocation, there would be a shortage of innovation, and where there was a shortage of innovation there would be a shortage of growth and profits.

Williams’ also voiced great skepticism toward the theories of John Maynard Keynes and President Franklin Roosevelt's "New Deal," both of which promoted the idea that government spending could lead to prosperity. Williams was convinced that the government’s “mismanagement” of the economy was partly responsible for the depression of the early 1930s.

While his disdain for the theories of Keynes was universally criticized by the dons of Harvard, Wall Street, at first, ignored Williams’ book, not realizing that he took aim at them in its pages, as well. Eventually, however, the investment elite were to learn that Williams’ heaped some of the responsibility for the depression of the 1930s on them.

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long- run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?”

If John Burr Williams were alive today, he would be, undoubtedly, be lamenting the markets' volatility over the past three years and its effect on the economy. During this time, the Dow Jones Industrial Average rose from about 11,000 to near 14,000, then collapsed to near 6,500, before rallying recently to just over 10,000. He would say (as we would) that during this time the long-run dividend paying ability of companies did not fluctuate nearly as much as did either earnings or prices. He would also say that in light of this stock market volatility and its impact on the the economy, it is not surprising that the citizens of this country are questioning the merits of the free markets. However, he would also be warning anyone who would listen that to think that the government can produce sustainable economic growth is an illusion. He would point to the 1930s and remind us of the last time that the government sought to supplant the private sector in stimulating economic growth. It didn't work and there is not much optimism that it will work this time either.

It is because of the slow-growth environment that we see unfolding in the US, that we have been moving more and more of our clients’ assets to stocks either domiciled outside the US, or domestic companies that do a preponderance of their business in developing nations. This move to more international stocks is still focused in high quality companies that have a history of sharing their prosperity with their shareholders through dividends. Indeed, it is this dividend-history that, as John Burr Williams would say, shows us where the values are.

Friday, October 09, 2009

The 3rd Quarter Earnings Derby Is About to Begin

Next week 3rd quarter corporate earnings reports will begin in earnest. We project that this quarter's earnings will, again, beat expectations by a wider margin than is now anticipated by most investors. We said the same thing just prior to second quarter releases and the earnings results even outdid our best guesses as 75% of S&P 500 companies beat their Wall Street estimates. We know all the arguments that last quarter companies beat earnings on "cost saves" and not on truly better business. Indeed, S&P 500 earnings were nearly 25% lower than 2nd quarter 2008 earnings. Our view, however, is that the cost saves were so sharp and accomplished so swiftly that corporate America is to be commended for their flexibility and dexterity in right-sizing their cost structures. This means that as the economy begins to turn higher, which we believe will happen this quarter, that earnings will be highly leveraged to the economic uptick. Third quarter earnings are also projected to be lower than a year ago. But that is not what will drive stock prices. That will be determined again by how 3rd quarter earnings compare to the Street estimates. In this regard, we believe investors will like what they see. Our best guess is that 65%-70% of companies will beat their estimates. This will be a lower "beat rate" than the second quarter, but higher than the five-year average. We expect earnings in the techs, consumer cyclicals, materials, and industrials will lead the "beat" parade on a percentage basis. While we are optimistic that earnings will be better than expected, we do not predict that the markets will rally another 1000 points on the DJIA as they did in the two weeks from July 15 to August 1. We would be very surprised, however, if the stock market were not able to push through DJIA 10,000 by the end of the earnings season. In short, we believe the run up in stock prices is anticipating an uptick in the economy, which will, ultimately lead to higher year over year earnings. When that finally happens, many of the holdout bears will be forced to capitulate and begin buying. We would guess that that is when the stock market will go into a long pause and bore the new bulls half to death. We'll keep you posted for a few weeks on how the Earnings Derby is unfolding.

Thursday, October 01, 2009

Survivor's Bounce About Over

I recently completed a simple analysis of the S&P 500 that argues strongly for a shift in leadership in the market. I computed the 6-month total returns of all stocks in the S&P 500 and then compared the top 250 performers with the bottom 250. Here are my findings. Performance Metrics Total Return Last 6 Months: The top 250 performers, a preponderance of which are cyclical stocks, produced a median total return of 75.2%, compared to a median total return for the bottom 250 (mostly stable-growth companies) of 15.8%. This amazing performance of the cyclicals (consumer cyclicals, financials, industrials, materials, and techs) over the last six months needs some clarification. Randy Alsman, one of our portfolio managers, coined the term "survivors' bounce" in the early days of the current upturn in stocks. At one of our investment meetings, after it was clear that the market had turned, he noted that the stocks that were performing the best week after week were the same stocks that had fallen off the cliff from October of 2008 through March 2009. His line of thinking went like this: When investors thought that another 1929-type depression was a sure thing, they abandoned almost all cyclical stocks. As the Fed pulled out all the stops to under gird the banking system, and as it became clear that the big banks were not going to fail, investors returned to the bombed-out cyclical sectors and began to buy. Thus, the incredible performance of the cyclical stocks as revealed in the performance of the top 250 stocks over the last six months has been a rebound from their incredibly bad performance in the prior six months. This can be seen in the next data point. Total Return Last 12 Months: Holding constant the stocks in the top 250 and bottom 250 groups over the last 6 months and extending their performances to 12 months, we see a very different picture. The top group produced a total return of -9.3% compared to a median return of -9.4% for the bottom group. The remarkable performance that the cyclical stocks have achieved over the last six months has only brought them back to equivalency with the more stable-growth stocks (consumer staples, health-care, energy, and utilities) for the 12 month period. The twelve month data vividly show how badly the cyclical stock got banged up from October of 2008 through March of 2009. But if the last six months has been so good for the cyclicals, why can't it continue? The reason is in the valuation metrics. Valuation Metrics Trailing PE: The median trailing PE for the top 250 stocks is currently 23.7, while the PE for the bottom 250 stocks is 15.8. The top group would appear to be pricing in an awful lot of good news. Let's look at the long term earnings estimates to see if it is justified. Long Term Earning Growth Estimates: Analysts are estimating the top 250 stocks will achieve median earnings growth over the next 3-5 years of 9.6% per annum. That is virtually identical to the predicted growth rate for the same period of the bottom 250 stocks of 9.5%. The bottom line on my analysis is simple. The cyclical stocks, which have been leading the S&P 500 in its remarkable run over the last 6 months, are running out of valuation gas. For the cyclical sectors to continue to lead stocks higher from here would require dramatic increases in their predicted 3-5 year earnings rate of growth. I don't believe that will happen. In my judgment, that means that savvy investors may soon begin to move back to the much cheaper stable-growth sectors. There are question marks in some of these stable-growth sectors, particularly in health care and utilities. Both sectors have been held back by the uncertainties in the ongoing debates on health care and cap and trade, respectively. I believe in both cases, however, the final legislation will be less damaging to these two industries than is now priced in. Stable-growth companies are where you find the great long-term dividend growers. Our Dividend- Valuation models indicate that companies like Procter and Gamble, Johnson and Johnson, McDonalds, Abbott Labs, Pepsico, and Nestle are as much as 35% undervalued. They performed much better than the average stock last year but have been idling most of this year. I believe that will change as more and more investors become aware of the valuation gap between the stable-growth and cyclical-growth stocks. As Randy Alsman recently said, "The survivor's bounce" is coming to an end. We own all the stocks mentioned here. See the Terms and Conditions.

Thursday, September 17, 2009

Nestle's Recent Dividend Growth Is Impressive

We like foreign stocks. They have been outperforming domestic stocks since March, and we think they will continue to do so. Here are three reasons:
  1. Most of these companies derive a minority of their earnings in the US. This will benefit them as it becomes clear that the US economy will lag the global uptick in economic growth.
  2. The falling dollar, which we believe will continue, helps shareholders of these stocks due to currency translations.
  3. We believe that many international companies are much more adept at dealing with state owned or state controlled enterprises than more pro-capitalistic companies in the US. This may help them navigate the swing to the left of US governmental policies.

We believe many international companies will be growing faster than their counterparts in the US, and they may rack up currencies gains on top of that. Thus, it may be possible to make money in two ways over the next few years in many top quality international stocks.

Nestle (NSRGY) (click to enlarge the chart above) is one of the world's leaders in many branded consumer products. Nestles leads many categories of chocolate, ice cream, premium bottled water, and pet care. Nestle, shown above in Swiss francs, has a current dividend yield of 3.2% and has grown its dividend at about 11% per annum over the last 20 years. They raised their dividend by 14% in the last twelve months, a time when many companies were cutting their dividends or holding them flat.

In looking at our Dividend Valuation Chart, above, one can see that NSRGY (Nestle's US ADR symbol) is now as much undervalued as it was in 2004. That turned out to be a good entry point for the stock.

There are worries that branded consumer goods may be facing increased competition from generic producers. The consumption of generic branded consumer goods, indeed, has grown steadily over the last few years, and especially during the recent recession. Nestle, however, has positioned themselves in many of their markets with a premium product and a lower priced, near-generic product. This should insulate them from cost conscious consumers trading down.

We like Nestle's management. We think they are more shareholder friendly than many international companies. We also commend them for making a number of very tough-minded decisions when dealing with intractable labor problems.

We own Nestle. Please do not use this information for buying and selling decisions. Consult your own investment adviser. Please review the Terms and Conditions link at the right.

Friday, September 11, 2009

More Principles of Dividend Investing

I read article after article about dividend investing and, in many cases, I hope that no one is really following the suggestions being made. The reason for my concern is that I have tried about every form of dividend investing known to man, including dividend capture strategies, since I became a dividend investor in the late 1980s, and I have found that there is no single strategy that assures success. For this reason, in all three of our dividend investing styles we break the portfolios into three smaller portfolios. These three smaller portfolios each follow one of the following stock selection disciplines: (1) High Yield -- companies with much higher than average dividend yield and very low dividend growth; (2) High Growth -- companies with low dividend yield and high dividend growth; and (3) Balanced --companies with slightly above average dividend yield and growth. Our three styles of dividend investing, then, overweight one of these smaller portfolios. Income Builder overweights the high yield stocks; Capital Builder overweights high growth stocks; and Cornerstone consists, primarily, of balanced stocks. Performance for Capital Builder and Cornerstone goes back nearly 15 years. During this time, they have both outperformed the S&P 500. However, they have accomplished this feat traveling very different paths. As you would imagine, the faster growing companies in the Capital Builder portfolio have a volatility very near that of the S&P 500, while Cornerstone's volatility has been only about 75% of that of the S&P 500. Rising Dividend Investing is the name of this blog and the single ingredient that powers all of our portfolios. Yet, while growing dividends are essential, over the years we have averaged about a company a year that has cut its dividend. Our preference in these cases is to sell the stock right away. Oftentimes, however, that is not wise because a dividend cut is normally associated with a steep selloff in the stock when the news is announced. Our experience has shown us that holding the stock for a few months is usually rewarded with significantly better prices. This year has been the toughest year for dividends I have seen in my 34 years in the investment business. Dividends for the S&P 500 Index will fall for the second year in a row. Having said this, however, it may seem remarkable that in our current portfolio holdings only about 15% of the companies cut their dividends, 10% kept their dividend the same, and 75% of the companies increased their dividends by an average of nearly 10%. Almost all of the banks we held were forced to cut their dividends during the year, either by the government or to save capital. We decided to hold most of the banks because we believed they were being priced as though they were going out of business. Since we did not believe that would happen, we held the majority of our positions and even added to some. That decision has been a good one, with many of our banks stocks having risen 3x to 6x since March. Some of those banks have now repaid their TARP loans; all have repaired their capital ratios; thus, most, in our judgment, are in a position to raise their dividends in the coming years. We continue to do extensive research into the banks. From this point, we will sell any bank that we do not believe will begin raising its dividend in the next couple of years. There are about 212 companies in the world that can pass all of our financial strength and dividend growth requirements for possible inclusion in our portfolios. Of that figure, we rate fewer than 100 stocks as being outright buys. Think of it, in a world of perhaps as many as 15,000 major stocks, fewer than 0.6% can get through all the doors to reach our portfolios. If we can say that over the long run, our brand of dividend investing has been a success, we believe it is due to three important tenets: (1) Investing in companies with financial staying power whose products and services we use everyday, (2) Investing in companies who use the dividend as the linchpin between themselves and their shareholders, and (3) Buying when the markets forget that there are companies in the world who can meet points 1 and 2.

Friday, August 21, 2009

The Barnyard Forecast Smells Good for Stocks

Randy Alsman authored this blog. Randy is Vice-President, Portfolio Manager, and Member of Donaldson Capital Management's Investment Policy Committee. Please read more about Randy here. Donaldson Capital Management for years has developed our long-term stock market forecast through a set of analyses that we call the"Barnyard Forecast." It is also known by its mnemonic, "E+I+E+I= O. E I E I O stands for Economy+ Inflation+Earnings+Interest Rates = the Opportunity for Stocks. We believe the interplay and trends of these measures of the economic environment will dictate the direction of stocks over the next 12 months. Each of the four elements is rated as positive for stocks (2 points), neutral for stocks (1 point), or negative for stocks (0 points). The total points are then added to arrive at a final score between zero and 8. An overall score of 4 is considered neutral. Anything above 4 is considered a positive environment for stocks; anything below a negative environment. The score we give each element is based on our historical analysis of its effect on Federal Reserve Policy. That is, will the element's status likely cause the Fed to be accomodative, neutral, or restrictive toward economic and ultimately stock market growth? This can lead to scores that are counter intuitive. For instance a low GDP reading is positive for stock market growth, as the Fed will likely be stimulating the economy, which will ultimately be good for stocks. We also use this EIEIO framework to guide our weekly investment policy discussions. What follows is our current market outlook as seen through the eyes of our EIEIO model? Economy: Score 2 - Positive Note: Three percent GDP growth is considered optimal, non-inflationary growth. Our model scores any 12 month GDP growth greater than 3% as negative, and vice versa. We do take into consideration the recent GDP trend and outlook. But the latest 12 month's GDP has historically had the greatest impact on Fed actions. This sounds counter intuitive, because it is. But remember we are talking about whether the Fed is going to add stimulus or restriction based on the GDP level. On a year over year basis, the most recent data show that GDP stands at negative 2.5%. With GDP in negative territory we believe the Fed is still in an aggressive stimulative phase that should return the US economy to growth in the coming months. The weak economy is positive for stocks. Inflation: Score 2 - Positive Note: The Fed has said the optimum level for core inflation is approximately 2%, year over year. The core inflation rate excludes food and energy. Core Inflation greater than 2% will cause the Fed to tightened credit and slow the economy. Inflation under 2% will allow the Fed to stimulate the economy. Moderate inflation of 2% - 2.5% is actually necessary for healthy economic growth. Core inflation for the year ended 07/31/09 was 1.5%. A reading this much below the optimal level is positive for stocks because it means inflation fears will not thwart the Fed’s initiatives to stimulate economic growth. The current core inflation rate is positive for stocks. Earnings: Score 0 - Negative Note: Year over year corporate earnings growth has averaged about 7% over the long term. Therefore, EPS YOY growth greater than 7% is positive for stocks, and less than 7% is negative. Q2 '09 earnings were much better than expected. However, they were still 30% below Q2 '08. Cost cutting has helped profits, but until revenues actually begin increasing again, earnings will likely not increase over the prior year. The Earnings element of our model receives a negative score. Interest Rates: Score 2 Points - Positive Note: We generally look at the current rates for both the Federal Funds Rate and the 10-Year U.S. Treasury Note vs. the prior year. If the current rate is less than the prior year – positive for stocks. If the current rate is higher – negative. This one’s easy. The Federal Funds Rate (a key rate that determines many others) is at 0% to 0.25%, and 10-year T-Notes are only yielding 3.5%. Both of these rates are lower than a year ago. This is very positive for stocks. Outlook for Stocks Score: Total 6 Points - Positive EIEIO is currently signally a positive environment for stocks in the year ahead. That does not mean stocks will go straight up. Indeed, we believe they will continue a “saw tooth” path higher. There are still many unknowns and much healing is needed in many parts of our economy. Nevertheless, our model has a good track record of anticipating stock market trends, and we are in agreement with its findings, that stocks will enjoy a positive rate of return in the year ahead.

Friday, August 14, 2009

Diverging From the Consensus for 2010

When we said that the stock market was turning in mid March of this year, cries of "pollyanna" rang out. When we said that second quarter earnings were going to be better than expected --much better--cries of "you've got to be kidding me" landed all around us. It is now clear that the naysayers were wrong on both counts. I believe they were wrong because most people in and out of the investment business believe that whatever happens today is destined to happen forever. There are economic principles, however, that tell us that this linear thinking does not and has never worked. Investors simply mistake the power of the Federal Reserve over and over. If anyone doubts what I am saying all you have to do is to look at the Tech boom of the late 1990s to see the evidence of the Fed's power. Booms and bubbles do carry the seeds of their own destruction, but the Tech bubble was popped by the Fed and any serious student of the markets and the economy knows it. They popped the Tech bubble by slowly raising interest rates until the overall economy slowed. This ultimately took the wind out of the Tech stocks' sails as their quarter-over-quarter earnings growth stopped and their stock prices collapsed. The consensus of pundits are now saying that for a variety of reasons the economy and stock prices in 2010 and beyond will be sub-par. The biggest argument for this belief is that the US consumer is tapped out and are being forced to become savers instead of spenders. This may or may not be true, but I have learned over the years that the consensus is almost always wrong. Thus, in my mind that means that either there will be no growth in 2010 and beyond, or growth will be much higher than most investors now are thinking. Of these two scenarios, I land on the higher-than-average growth view. That would mean that economic growth in 2010 will exceed the 80-year average of 3% . If that is the case, stocks will grow much faster than the 10% estimates that I regularly see for the year ahead. But that's not all. We Americans have a lot of trouble understanding that we now represent only about a third of world GDP growth. Europe, on a GDP basis, is slightly greater in economic size than we are. Surprisingly several countries in Europe are reporting positive growth for this quarter, again, much better than expected. The other third of the world's economic growth comes from China, India and the other developing nations. The key thing here is China and India have cruised through this deep recession without ever reporting a negative quarter. S&P stated a few weeks ago that international sales of S&P 500 companies are now greater than 50% of total sales. The percentage of foreign earnings is even higher. Too many people have written off the US economy. I think they are wrong, and even if they are correct, foreign economies could lift S&P 500 company earnings to levels much higher than are now being forecast. My bottom line is that 2010 will be a much better year than most people think. There are many fundamental reaons for this belief, but the main reason I believe we are in for a surprise is because so many people are sure the economy will be lukewarm.

Wednesday, August 05, 2009

The Fair Value of the Dow Jones Industrial Average

I have no idea how high the stock market can go over the next year. I have the theory that stocks trade at fair value about once every three years. Having just come through one of the most destructive bear markets since the Great Depression, it is unlikely that the market will suddenly become efficient and sit on top of its statistical fair value in the coming year. Having said that, our Dow Jones Fair Value Model is signaling that stocks have a long way to go just to reach their statistical fair value. The chart at the right shows the Dow Jones 30's actual price (red line) versus our Fair Value Model (blue bars) over the last 50 years. A quick glance at the chart shows that the fit between the actual prices of the Dow and the Fair Value model has been reasonably good. The model, indeed, shows that stock prices were way too high relative to values in the late 1990s. Currently, the model is saying that stocks are modestly undervalued, as shown by the price line being buried in the value bar at the far right. The top of the value bar, or the statistical Fair Value of the Dow Jones 30 is at 10,900. If stocks were to reach our model's Fair Value over the next twelve months it would produce a return of over 18%. Thinking of gains when we just went through a 55% fall in prices is a difficult notion to grab on to. However, we believe the path of least resistance for stocks is now higher, and we believe our model's calculation of where stocks might be in a year is as good a guess as we can make. The model is a multiple regression of trailing twelve-month Dow Jones 30 earnings, dividends, interest rates, and prices. It has an R2 in excess of .90 over the last 50 years.

Friday, July 31, 2009

Above Expectations in Earnings and GDP Mean Stocks Will Continue Higher

The answer to yesterday's question about whether better-than-expected earnings would lead to better-than-expected GDP is, "Yes." Thankfully, the deepest recession since the Great Depression may be coming to a close. Government data show that second quarter GDP fell by only 1%, less than the 1.5% consensus estimate. However, all the news was not good. Two important pieces of bad news came in the form of 1) less than expected consumer spending, and 2) first quarter GDP was revised downward. Having said this, we believe that the economic bears will gradually come off their doomsday prognostications and realize that, at least for the next few quarters, economic GROWTH will reappear. Mainstream strategists are now asking themselves, "What kind of growth can we expect over the next few quarters?" And importantly, "Can growth last after the massive government bailouts are withdrawn?" While these are tough questions, we believe the better question is, "What will corporate earnings look like over the next few years?" The reason for this is simple. S&P recently released data showing that S&P 500 companies now generate over 50% of their earnings from outside the United States. As it relates to stocks, then, the greater question is, "What will worldwide economic growth be compared to US growth?" We have been thinking about this a lot, and we will have a special report on the subject of earnings in the weeks ahead. We believe there are some surprises coming that investors may not have factored into their thinking--earnings growth in the coming years might be higher than many investors expect. We believe this better-than-expected GDP report will lead to a continuation of the recent up-leg for stocks. The market won't go straight up, but on balance, the earnings news will continue to be good and so will stock prices. The earnings derby is winding down with nearly 70% of companies now having reported. Three key elements were again present in earnings reports for this week: 1) Earnings surprises continued at a 75% rate, 2) Average earnings surprises were near 10%, 3) Earnings surprises were present in all major stock market sectors. We continue to believe that the 2008-2009 bear market for stocks has ended and that a new bull market is underway. In addition to the special report on earnings, we will have a second special report on the "fair value" of the Dow Jones Industrial Average in the coming days.

Wednesday, July 29, 2009

Do Better-Than-Expected Earnings Predict the Same for GDP?

We said in an earlier blog that better-than-expected earnings combined with better-than-expected Gross Domestic Product (GDP) could be the catalyst for a new up leg for stocks. At the moment, the Dow Jones is stuck in a trading rage between about 8,000 and 9,000. The recent uptick in the markets has brought us back to about where we were in mid-June. With earnings season winding down, we don't think the better-than-expected earnings by themselves will be good enough to drive stocks toward the 10,000. In essence the safest call on the market in the near term is for a zig zagging sideways movement for a few months. However, on Friday the government will release figures on second quarter US GDP. If second quarter GDP figures would come in close to positive territory, we believe the animal spirits would take over again and the markets could push to 10,000 very quickly. It may surprise you to learn that the consensus estimate of economists surveyed by Bloomberg is for negative 1.5% GDP growth for the second quarter. That number was closer to negative 2.5% just a few months ago. It has improved due to better economic data, as well as significantly better international trade data. If the actual GDP growth for the quarter were to come in at negative .5% or, cross your fingers, perhaps zero, that would cast a whole new light on the speed of recovery. Almost all analysts have written off the consumer, saying that they have become savers instead of spenders. But there is a little problem with this pessimistic view of consumers: The consumer discretionary stock market sector has been the biggest surprise in the second-quarter earnings derby. We do not have an official estimate of second-quarter GDP, but in keeping with our call for better-than expected earnings, we believe the most likely scenario is that GDP will be better than expected as well. If that happens, as we said earlier, stocks will react favorably in the coming months.

Friday, July 24, 2009

The Earnings Derby, Week Three: Beat Rate Pushes Stocks Higher

Stocks got another lift this week from second quarter earnings surprises. In our June 29, blog we said that earnings for the second quarter would be better than expected. In that blog, we said that cost controls would be the driving force behind the better-than-expected earnings. It is now clear that cost controls at all levels and in all sizes of companies are winning the day and producing earnings surprise after earnings surprise. Here's the scorecard so far with 179 of the S&P's 500 companies reporting:

  1. The average surprise or beat rate is 11%, higher than the normal 3%-5% surprise.
  2. Thus far, there have been 136 companies that have beaten their Wall Street estimates versus 43 that have missed. This 75% beat rate compares favorably with the 62% beat rate from last quarter.
  3. The most important earnings surprises continue to be in the Consumer Discretionary sector, where 22 companies have reported positive surprises versus 2 negative surprises. In the Finance sector, there have been 26 positive surprises compared with 14 negative surprises. The Health-care sector has also registered impressive results with 21 earnings beats and only four earnings misses.

These better-than-expected earnings have driven stock prices through the 9,000 on the Dow, a level not seen since January. We believe the earnings surprises will continue, although we continue to think it will get progressively tougher to impress the market. This could lead to a flattening of the markets for a few weeks, as investors digest the new data.

Another key ingredient in this quarter's earnings is how they stack up with last years earnings. At the beginning of the quarter, the analysts were predicting that earnings this quarter would be about 30% lower than a year ago. Thus, far earnings are about 26% lower than a year ago. The Energy and Basic Materials sectors are weighing down the average earnings results, with both showing more than 50% declines in earnings.

We'll give you another report the end of next week.

Friday, July 17, 2009

The Earnings Derby Week Two: Still Better Than Expected

In our June 29, blog we said that earnings for the second quarter would be better than expected. Our reason for taking that position is that three of the four portfolio managers at our firm have managed large businesses. In their roles as presidents or general managers of Health-care, Consumer, or Industrial companies they have seen first hand how powerful new management tools, such as Enterprise Resource Management (ERM), were giving them clearer pictures of revenue and expense trends. This increase in clarity enabled them to better calibrate capital and resources, which lead to better control over profits. Second quarter earnings are now in full swing, and as we had surmised, cost controls are winning the day and producing earnings surprise after earnings surprise. Here's the scorecard so far. With 38 of the S&P 500 companies reporting:
  1. The average surprise or beat rate is 16%, much higher than the normal 3%-5%.
  2. Thus far, there have been 30 companies that have beaten their Wall Street estimates versus 8 that have missed.
  3. This 80% beat rate compares favorably to the 62% beat rate from last quarter.

The most important earnings surprises have come in the Consumer Discretionary sector, where 7 companies have reported positive surprises versus 0 negative surprises. Importantly, in the Finance sector, there have been 7 positive surprises compared with 4 negative surprises. The Health-care sector has registered 4 earnings beats and no earnings misses.

Only about 10% of the companies have reported in this earnings season, so early success does not assure the whole season will continue at this rate. However, we do believe there is a good argument that can be made that earnings for the whole season will now come in much better than expected, as our portfolio managers had predicted.

There is no question that these better-than-expected earnings have driven stock prices higher this week. We believe the earnings surprises will continue, although we think it will get progressively tougher to impress the market. This could lead to a flattening of the markets for a few weeks, as investors digest the new data.

Another key element in this quarter's earnings is how they stack up with last years earnings. The analysts were predicting that earnings this quarter would be approximately 30% lower than a year ago. For stock markets to continue their recent upward climb, we believe the total earnings for the quarter need to finish down closer to 20%.

We give you another report the end of next week.

Tuesday, July 14, 2009

Capitalism Means Giving the Ball to Jimmy Chitwood

Whatever your political persuasion, the truth is capitalistic principles that have served humanity well, are currently under attack in the halls of Congress. Yesterday's Wall Street Journal sounded the alarm that the highest tax bracket may soon rise 11%, from 35% to 46%, by the time the Democrats in Congress are done. "Soak the rich! Soak the rich!" can be heard in stereophonic surround sound if you drive by the Capitol these days. Indeed, the most important allocators of capital are no longer found on Wall Street. They now reside on Capitol Hill. The Administration and the Democratic leadership have declared war on the business class. In doing so, they are dooming the country's hopes for a strong economic turnaround. Here's why. The very people who know best how to create jobs, the business class, are being tied up in a never ending barrage of new taxes, regulations, and anti-business rhetoric and legislation. But just as the Law of Gravity still holds, so do the laws of economic growth, even if House Ways and Means Chairman, Charles Rangel, says they don't. I have no doubts that he will find a return to normal economic growth increasingly difficult to accomplish should his tax hikes become law. Let me take a different tack to explain the problem, basketball, for example. Isn't our objective to win, not just allow every player on the team equal playing time, regardless of their ability? Further, say we're down to the wire with only 10 seconds left on the clock. The object is to win, not to make heroes, not to please parents, or sponsors, or girlfriends. The object is to win. If you are the coach, would you call the team trainer off the bench and set up a play for him to take the last shot because it's his turn to shoot? Or would you get the ball into the hands of the best SCORER on your team? The answer is so simple children can figure this out. Get the ball to the guy or gal on the team who has a demonstrated gift for putting the ball in the basket. Do that and you will have a long career as a coach. Give it to a player with less ability and wins become losses, and you will be out of coaching. This concept is graphically shown in the movie "Hoosiers." With just a few seconds left, Gene Hackman, who plays Hickory's coach, calls a time out. He wants to run the "picket fence" and that Jimmy Chitwood, the teams prolific scorer, will act as a decoy. The team is stunned and turn away from the fiery coach, but no one says anything. Every guy on the team knows the coach is wrong, but no one speaks. Finally, Jimmy, who has been almost stoic throughout the whole movie, says, "I'll make it." Hackman immediately agrees and says get the ball to Jimmy and give him room. You know what happens. See it here on this link. Coaches don't win games, trainers don't win games, equipment managers don't win games, and bench warmers don't win games. All these people are important contributors to success, but ultimately it is great players who win games. As it relates to business, businessmen and women produce economic growth, not politicians, regulators, or tax collectors. Until the Obama Administration grasps this basic truth, the economy will trudge along in low gear. Over the weekend, Vice President Joe Biden and President Obama were both apologizing for still skyrocketing unemployment, even though they said it wouldn't happen if the Congress passed their $750 billion stimulus plan. After Congress finally passed the measure, I said it was actually 30% a stimulus plan and 70% a welfare plan. The money went to the wrong places and until it gets to the right places, the Administration is going to be apologizing, a lot, about unemployment. A wide gulf has formed between business people and politicians. All business people are being painted with the ugly brush of the big banks and their subprime destruction. Ninety-five percent of business people had nothing to do with the subprime fiasco and don't deserve to be treated as villains. However, every business person in this country now knows that he or she will be picking up the tab for the health-care plans of the Obama Administration. We know that we will be paying for the Administration's ill-conceived "Cap and Trade" environmental programs. Finally, we know that we will be paying for the huge deficits that the Congress has saddled our country with as far as the eye can see. Business people, particularly small business people, where most of the jobs have been created over the last decade, know that they are in the gun sights of Congress and the Administration. That will keep a lid on employment gains for the foreseeable future. The main reason for this is that all these new taxes and regulations require that a businessman or woman's first order of business is to cut costs to defend profitability. The truth about costs is that the biggest one is labor. In the back of most entrepreneurs" minds is the fact that, in the stroke of a pen, the government could at some future date make it very costly if not impossible to reduce employment. The Soviet Union was full of big talk and government-created, five-year economic plans for growth. As the years wore on, the bigger the talk grew the more failures the five-year plans produced. I would have thought that the complete collapse of the illusory workers paradise that was the Soviet Union would have been proof enough for almost any politician of what does not work. But, what is going on in Washington today would make Karl Marx smile for the first time in a long time. If you consider yourself a businessperson, I recommend that you start communicating regularly with your politicians. As the employment news gets worse, they might actually start to listen.

Saturday, July 11, 2009

Earnings Derby: And They Are Off!!

We said in a recent post that we thought that corporate earnings would lead the next up leg of a new bull market. It may be the height of optimism, and we are sure we will be scolded for it, but we believe that "less bad" earnings growth will be rewarded by Wall Street with an uptick in stock prices. We say less bad because earnings growth for the S&P 500 Index stocks is currently estimated to be down by nearly 30% from the second quarter of 2008. This past week was the official beginning of the earnings-reporting season. Because we believe that earning results are so important this quarter, we will keep a running scorecard provided by Bloomberg, for our readers . Of the 500 companies in the S&P Index, four front runners made their reports this week. Granted this is a very small sample, but the results are encouraging. Three of the four early-reporters beat estimates by wide margins. Although Alcoa (AA) reported lower earnings, they beat Wall Street's estimates handily. Of particular good news, Family Dollar Stores (FDO), the deep-discount chain, reported earnings 36% higher than a year ago and 5% better than Wall Street estimates. In our judgment, last quarter's good stock performance was propelled by the better-than-expected earnings for the quarter, as we detailed in our May 4th blog. Bespoke Investment Group at has a nice piece on last quarter's better-than-expected earnings and what they think it will take this quarter to get the market's attention. Bespoke is saying that the earnings beats must exceed last quarter's 62% beat rate. We are in the camp that believes the beat rate will be better than that. We also predict that the average beat rate is important. We will keep the scoreboard coming each week, good or bad. We are certainly aware that the company guidance will also be important, but that is a very subjective exercise, so we'll stick to just scoring the beat rate.

Thursday, July 02, 2009

Ten Principles of Dividend Growth Investing

Many people forward on to me articles on dividend investing. These articles cover the waterfront from writers opposed to dividends completely to those who believe companies should pay a stated amount of their earnings in dividends. I find that I agree with very few of the articles I see. In most cases, I find it is not a theoretical objection but a practical objection: I have tried it their way and found it didn't work for me.

Elsewhere in earlier blogs I explained how I first learned of the merits of dividend investing in the 1980s and how those early ideas have evolved over time. The following is a short list of the principles of dividend investing as practiced by Donaldson Capital Management.

  1. Consistent Dividend Growth is the most important element of dividend investing.
  2. Beware of high dividend yields where dividend payouts are in excess of 60% for industrial companies, 70% for utilities, and 90% for REITs.
  3. Beware of any company that pays out more in dividends than their free cash flows.
  4. Look for companies where there is at least a 70% correlation between price growth and dividend growth over the long run.
  5. Companies with consistent dividend growth permit valuation using regression models. These regression models can offer an investor an educated guess at the expected total return of a stock over a future period of time.
  6. It is remarkable that many so-called cyclical companies with volatile earnings will have a much lower price volatility if they employ a normalized dividend approach, instead of a lumpy approach.
  7. We are always on the prowl for dividend-paying companies that the market has rewarded with a high correlation between their dividend growth and their price growth and who have temporarily fallen out of favor.
  8. For almost all companies, even the most highly predictable companies in our universe, changes in interest rates will affect relative valuation.
  9. Consistent dividend growing stocks seldom get highly over or undervalued. They get overvalued when the band is playing, the birds are singing, and stocks are flying high. They get undervalued when the media is shouting duck and cover.
  10. Watch carefully at dividend actions in good times and in bad. In good times, dividend growth should be less than earnings growth. In bad times dividend growth should be higher than earnings growth.

We are now enduring a time when the media is doing what they do best: broadcasting duck and cover stories. Save a copy of the most pessimistic article on the economy and stocks you can find. Set a note on your calendar to look at it in three years.

In three years, as the birds sing softly in the background, re-read today's duck and cover article. As you hear the band warming up in the background and the media are cautiously suggesting that things are looking up call me. Surprise me and ask me the following question: How much is Procter and Gamble overvalued?

We own Procter and Gamble.

Monday, June 29, 2009

Second Quarter Earnings Could Be Catalyst For Next Leg Up

The stock markets and many other markets, as well, appear to be waiting for new news to give them direction. Most investors are now looking for a very gradual uptick in the economy in the third quarter, as well as modestly better housing news, and fewer nerve wrenching headlines from the banking sector. Yet, even though things are "less bad" now, few strategists are able to find many of the green shoots that Chairman Bernanke speaks of sprouting leaves. In our investment meeting this morning, we went over the news of the day and the most recent economic data, and we find that our views are essentially those of the consensus except in one area -- earnings. We believe corporate earnings in the second quarter will be better than expected. To you old pros that is like saying nothing because quarterly reported earnings are almost always better than expected. That is the game that corporate America plays: beat the consensus earnings estimates by a penny or so. However, we think this quarter may show more corporations beating earnings estimates more than usual. Three of our four portfolio managers have run large organizations in their previous careers. They all agree that the revolution in corporate management tools of the last 25 years has given top management a much wider field of vision in terms of input needs and utilization. Enterprise Resource Planning (ERP) software, Just-in-time inventory management processes, and new more flexible labor arrangements have all come together to enable the top management of most companies to "right size" employment and inventory. In our view, this right sizing translates into a much higher probability that companies can price right, and by extension price profitably. We believe these smarter and more flexible management tools will begin to reveal themselves in the upcoming second quarter earnings results. Having said this, strap yourselves in; even good earnings news will send stocks gyrating.

Tuesday, June 16, 2009

The Pause

About two weeks ago, I wrote a blog entitled "The Bottom Is For Real, But a Pause is Due." My reason for that blog and this one is to help my readers understand the push and shove of markets. You may wonder why a number of my recent blogs have discussed elements of technical analysis, such as moving averages, levels of support and resistance, etc. Chart reading coming from a guy whose motto is, "so goes the dividend, so goes the stock," would seem to be a contradiction in terms. Technical analysis is for traders, isn't it. Technicians are people who couldn't care a twit about the fundamentals of a company or the products they make. The truth is I grew up reading charts. I managed money in my early years using almost exclusively charts combined with a bit of macro-economics. That all changed in the crash of Black Monday in 1987. Something in me gave way that day. Something said that I should be buying, even though all my charts were saying to sell. Since that day, I have become predominantly a fundamental investor. After searching for a number of years for a fundamental metric that best predicted stock prices, by the early 1990s, I was convinced that the metric I was in search of was dividend growth. Having said that, at Donaldson Capital Management, we use any indicators we can find that work. Thus in our firm at present, we use three markers or predictors to determine what to buy and sell: 1.) dividends to select individual stocks and determine market valuations; and, 2.) macroeconomics to grasp the lay of the economic landscape; and, 3.) technical analysis to validate the first two predictors, as well as to provide clues about the economic landscape that the fundamentals do not explain. Here is what our assorted markers are saying about the current situation. 1.) Using data from our Dividend Valuation Models, we believe that stocks are at least 25% undervalued based on the long-term relationship of prices, dividends, and interest rates. Thus, from a valuation perspective, the path of least resistance for stocks is up. 2.) Our macroeconomic view is that things are "less bad" than they were just a few months ago. A number of economic data points such as the sales of existing homes are trying to bottom but few, if any, economic data are showing genuine growth. This suggests that there is little fuel in sight to push stocks significantly higher. This would argue for stocks to pause at this level. 3.) This is where technical analysis comes in very handy. The chart above shows that in recent months stocks have made a solid turn, pierced the 50 day moving average, and are now trying to move through the 200 day moving average. Our experience in technical analysis tells us that a move through the 200 day moving average without a fundamental catalyst will be difficult. Thus, technically speaking, stocks are a bit overbought and in need of some consolidation, or sideways motion. This sideways trading is likely to be of a sawtooth pattern because the economic news is "less bad" and not yet good. We believe that increases in corporate earnings expectations will ultimately be the catalyst that will push stocks through their 200 day moving average. Earnings have fallen like a stone for the past two years. But corporations have been slashing costs and earnings expectations for the S&P 500 recently ticked higher for the first time in a long time. Cobbling together the three markers, we believe argues that stocks are likely to trade in a sideways range for at least another month or so. Coincidentally that is about the amount of time until the next earnings season. If corporate earnings come in better than expected for the second quarter, we believe stocks will pierce the 200 day moving average and push to higher levels. If earnings fail to surprise to the upside, stocks will likely continue to trade between 8000 and 9000 on the Dow Jones 30, awaiting better economic and earnings news. We do believe that the March 9th bottom in stocks will hold under almost any circumstances. In March, stocks were pricing in the worst case scenario. The stabilization of the banks and the better news coming from the real estate market argue that the worst is over. We are now awaiting some of the green shoots that Fed Chairman, Ben Bernanke, described to blossom.

Friday, June 05, 2009

The Shotgun Weddings That the US Performed on Chrysler and GM

Many observers charge that the US government, in its attempts to clean up the auto industry mess, has used strong-arm tactics to force speedy bankruptcies for Chrysler and General Motors. In doing so, the rule of law and our country's reputation as a safe place to do business may have taken a very bad hit that will resound for years.
The State of Indiana, representing its state retirement plans which hold secured Chrysler bonds, has filed suit in the Chrysler bankruptcy case. Indiana claims laws were broken when the US Government gave the United Auto Workers (UAW) 55% of the ownership of the post bankruptcy company, far in excess of the UAW's secured interests. Indeed, the deal the government struck with the Chrysler assets appears to go against all existing legal precedents and statutes. The secured bondholders were thrown from the train in favor of the mostly unsecured union claims.

The fact that President Obama was widely supported by the UAW brings some clarity to the situation. Political spoils, however, should not extend to rewriting the bankruptcy laws on the run.

I have spoken with many legal authorities in recent weeks. Not one of them could explain how the UAW could have ended up with such big pieces of the post-bankruptcy auto industry. "Politics" was the only consistent answer I received.

Here's the problem. Who will ever loan GM or Chrysler money again? Indentures are no good, precedents are no good, and laws are no good. The answer is no one will loan these dinosaurs money again, except perhaps in some form of equipment trust certificate arrangement. That means the United States government will be in the auto business for a very long time. And that means US taxpayers will be asked again and again to ante up to support the UAW.

Here's hoping that Indiana can get their case to the Supreme Court. If the case gets there, things might get very interesting. If it doesn't the shotgun wedding that was performed by the United States Government will stand and fairness and the rule of law will fall.

I do not own any GM or Chrysler securities. This blog is for information purposes only.

Tuesday, June 02, 2009

The Bottom is For Real, But A Pause is Due

The stock market has rallied sharply since the middle of March leaving a lot of bears wandering and wondering in the woods. The chart at the right shows that the Dow has rallied close to 2000 points, or nearly 30%, since the bottom on March 9. The chart also shows that the Dow has now reached the 200 day moving average (blue line). We think the market may pause here. One reason for this belief is the long sideways trading action from July 2008 through the middle of October 2008. This trading range left a lot of traders with significant losses as stocks collapsed in February. Human nature says those traders will become sellers as the market moves closer to Dow 9,000. We believe this pause in the market's recent upward march will be temporary. Stocks will continue higher later in the summer as Wall Street earnings estimates begin to turn higher in recognition of an improving economy. As you may remember, we said on March 20, that we believed forces were in place to produce a turn in stocks. We have reiterated that call three additional times since then. The bottom line on these calls was and is the undergirding and strengthening of the banks. We believe the collapse in the market in February was caused by Treasury Secretary Timothy Geithner's February 10th speech that was supposed to answer all of our questions about how the government was going to rescue the banks. Mr. Geithner did not distinguish himself in that speech and questions began to fly about the possibility of "nationalizing" the banks. Bank nationalization fears were unleashed when Mr. Geithner announced that the banks would be subjected to rigorous stress tests. Nationalization of the banks combined with the realization that the US auto industry was bankrupt caused investors to "think the worst" and abandon stocks. Stocks finally found a bottom as the Administration repeatedly promised that they had no intentions of nationalizing the banks. Indeed, the Administration continued to champion the idea that the banks were in reasonably good shape but needed more capital, which they were willing to provide. By late April the results of the stress tests were announced and showed that only about half of the banks tested needed additional capital and none of them appeared to be close to a government takeover. Stocks gained upward momentum as those banks who were cited as needing more capital were able to sell additional stock in the open market. This would have been impossible before the results of the stress tests. Adding power to the run-up in stocks has been a string of economic news that can best be described as "less bad" than before. Few data show truly good numbers, but it is clear that the economy is starting to respond to the Fed's very low interest rates and numerous programs to aid homeowners. The news will not show positive data for many months yet, but we believe the worst is behind us.

Friday, May 22, 2009

Green Shoots For Deere

We are in the camp that believes the economy will show positive numbers by the fourth quarter of this year and that the stock market has seen its bottom. With our view being what it is, what kinds of stocks are attractive to us? What sectors should do well in the scenario that we see unfolding? Let us deal with the sectors first: We believe the leading sectors over the remainder of this year will likely be small caps, consumer cyclicals, techs, financials, and industrials. Of these sectors, the surprise to many may be our inclusion of the industrials. Normally the industrials do better a little later in the business cycle. We think this time will be different and the main reason is that the developing economies of the world are still expanding. China and India both had positive growth in 2008 and will do so again in 2009. The industrials are primarily about automation and the movement and manufacturing of equipment and materials. These are all elements greatly needed in the developing world. We believe a very important stock among the industrials is Deere (DE). Deere has long been a great company, and there are numerous reasons for liking it. However, to us DE is a play on China, India, and other developing nations. Here's the reason. People by the hundreds of thousands are leaving the lands and moving to the cities to take manufacturing and service jobs in the developing world. The peasants from the countryside in China and India must now be fed by a mechanized process. Where once all of these people provided for their own food, now a supply chain of some magnitude is needed to feed them. At the front of that supply chain is the agricultural equipment that produces the food. Today's tractors and other farm equipment are automated and computerized at a level that is simply remarkable. My brother-in-law farms thousands of acres in Southern Indiana. He recently told me that he no longer drives his own tractors. His John Deere GPS drives the field rows and he makes the turns. He says that the yields from his corn crop have risen by 10% just from the precise line the GPS-driven tractor takes. There is less human error and greater efficiency. The chart above shows DE has made a very sharp correction from the ethanol-induced euphoria of 2007. Deere has fallen deep into undervalued territory. While the analysts are estimating lower earnings for both 2009 and 2010 for DE, we believe they are being too pessimistic. If the US economy turns positive later in 2009 and Europe turns up by mid 2010, Deere's earnings should turn higher much sooner than the analysts are now forecasting. With the stock very undervalued and better news on the rebound, we like Deere at these levels. We own Deere. This blog is for information purposes only. Please do not make investment decisions based on this blog.

Thursday, May 14, 2009

Dividends Are Still the Linchpin

With all of the dividend cuts of the last 18 months, many pundits are sounding the death knell for the dividend. There are lots of reasons they give:

  1. Companies can't afford them anymore
  2. They complicate capital adequacy and flexibility
  3. The capital they represent is too hard to raise
  4. Obama tax hike will make them less attractive to investors

The arguments that dividends are a relic of the past or a fatality of the credit crunch are silly. The recession we are crawling through will not last forever, and when it ends, companies will once again reinstate most of the dividend cuts as soon as they are able.

The reason is simple: almost all of the companies that have cut their dividends by any significant amount have faced a hornet's nest of angry shareholders. In addition, it is hard to find a company whose price is higher after a dividend cut. Indeed, in most cases, if a company has cut its dividend, it has been hammered.

According to Bloomberg data, dividends are very much alive. Bloomberg shows that of the 500 stocks in the S&P Index, 362 currently pay a dividend. During the past twelve months, 94 companies reduced their dividends, 115 paid the same amount as last year, and 130 raised their dividends. Thus, in a year when the headlines have been full of dividend cuts, there were actually more dividend hikes than cuts.

The median dividend hike for the 130 companies that raised their dividends during the year was about 6%. Importantly, the median total return of these companies outperformed the S&P Index by nearly 8%.

There are still many great companies that are quietly raising their dividends and in doing so, reconfirming their commitment to give back to their "owners" a fair cut of the profits.

As I have said before, the root of the word dividend is dividere, which means to cut or divide. Dividends are not a bonus or a gift; dividends are the shareholders' cut of the profits. Corporate managers who ignore this may find themselves looking for a new job.

The linchpin that best ties the interests of corporate America together with its shareholders is a consistent and intelligent dividend policy. Most shareholders understand that recessions mean lower earnings and dividends. But, in my judgement, the pundits are wrong if they assume that shareholders will be less interested in dividends after the recession than they were before. I think it will be just the opposite.

Monday, May 04, 2009

Stocks: Climbing a Wall of Worry

With first quarter earnings for the S&P 500 now expected to be down nearly 34%, it is a fair question to ask why the stock market has been so excited recently? There are many answers but the simplest one is that when the first quarter earnings season began, earnings were expected to be down nearly 39%. It appears that the market has translated the 5% better-than-expected earnings growth into a 13% move in stock prices. At first that may not add up. How does a 5% earnings surprise translate into a 13% price hike? Actually, the nominal difference between negative 39% and 34% is 5%, but on a percentage basis, it is 12.8% (5/39). So stocks have rallied by about the amount of their better-than-expected earnings. That would almost seem to be too perfect. Surely there have been other factors driving stocks higher in recent weeks? There has been some isolated good news in real estate, durable goods, and more recently in a slowing of initial unemployment claims, but I believe the main driver of the recent market rally is the better-than-expected earnings for the first quarter. The market apparently now believes that first quarter 2009 earnings are as bad on a year-over-year basis as we are likely to see. According to Bloomberg, for companies in the S&P 500 that have reported thus far, there have been 236 positive surprises and 111 negative surprises. That may sound impressive until you realize that positive surprises usually outnumber negative surprises by about this margin. I believe the earnings data point that is driving the recent surge in stock prices is the higher than normal average surprise of 12%. Importantly, the financials have produced an average positive surprise of 36%. Almost all of the big banks have reported earnings that were better than expected. These results have been cussed and discussed, but in this very tough environment when the accountants are tougher than waterfront cops, the banks appear to be doing better than most people expected. That, my friends, is cause for a modest rally in stocks. Now many of you will say that there is still lots of bad news coming for the banks and that this quarter's earnings were a case of financial engineering. In addition, the stress test results will be released later this week, which could cause all of the positive momentum for the banks to evaporate. I believe the markets have discounted these issues. The recent sharp rally in bank stocks is clearly signalling that the need for additional capital resulting from the stress tests is expected to be manageable and won't result in widespread nationalization of the banks, as was feared only a few months ago. We have been saying for the last couple of months that the market was bottoming. There are many who are saying the rally can't last. We continue to believe that this rally is for real. It won't continue straight up, but we believe it will continue to climb a wall of worry.

Monday, April 27, 2009

Johnson and Johnson Raises Dividend 6.5%

In recent days, almost everyone was expecting a dividend hike announcement from Johnson and Johnson (JNJ). Predicting an increase wasn't a tough call. JNJ had raised their dividend for 44 years in a row. What was a tough call was the amount of the hike. On April 23, they announced a 6.5% dividend increase. In these days of dividend cuts, I applaud JNJ's hike, but I thought it was a bit light. The estimates ranged from 6% to 9.5%. The consensus was in the 8% range. With earnings over the last twelve months having risen nearly 9.5%, I was hoping for an increase between 8% and 9.5%, say 8.5%. Thus, the increase of 6.5% was at first a bit disappointing. To find reasons why the hike was less than expected is not a tough task. The current administration seems bent on sticking their noses and fingers deeper and deeper into America's economic system. With the administration's talk of big changes to our current health-care reimbursement programs, JNJ may be signaling a new, less optimistic view of their long-term prospects. That notion is also born out by Wall Street analysts' 3-5 year forward earning estimates for JNJ, which are now at 8%. In these days of weak earnings reports, 8% long-term growth sounds exceptional, but in JNJ's case that is far lower than their last 5-year earnings growth rate of 11.5%. Indeed, current estimates project that 2009's earnings will be about flat with 2008. As I think about it, however, I believe JNJ is just being pragmatic. I think they are building in a cushion that will enable them to hike their dividend again in 2009 when earnings growth may be meager. I just can't be too pessimistic about a company that has done as many things right over the last 20 years as has JNJ. Furthermore, is it not remarkable that JNJ is currently selling at about 11 times trailing 12-month earnings. That is about half their 20-year average of 22x. Combine this low PE with a dividend yield of almost 4% and you have one of those old fashioned "value" stocks. Funny, I always thought JNJ was a growth stock. These metrics, however, would suggest that it is now being priced like a value stock. That seems odd especially when we consider it has a strong consumer brand (33% of sales) that is not encumbered by health-care pricing issues. In these days, it is very easy to beat up on any stock, but I have a very strong feeling that investors are underestimating JNJ's broad product line and worldwide clout. We own the stock. Please do not use this information for investment purposes. Please consult your own investment adviser.

Wednesday, April 15, 2009

Procter and Gamble -- Dividends Talk

Procter and Gamble announced late Tuesday that they were hiking their dividend by 10%. This increase was nearly twice what many analysts were estimating and offers important clues about PG's view of the current economy. Here's the reason: Dividends have been under attack over the last year as a result of the weak economy, but also because of many companies' need to conserve capital. For these reasons and others, the notion has developed that even companies with plenty of free cash flow like PG would use this opportunity to set their dividend growth rates on a lower track. PG's 10% dividend hike blows that idea away. Indeed, it is a message that I believe will be corroborated by many more companies. Companies that are committed to a dividend aren't going to change their ways very much. They will only do so if it is a matter of sound business practices or survival. PG could have raised their dividend by anything between 5% and 7% and most people would have been happy. In my judgment, by hiking the dividend 10%, PG is making a statement about their view of the unfolding economic landscape. In short, they believe the world hasn't changed as much as the headlines might suggest. They must believe their worldwide business is still on a double digit growth track, and that people won't abandon brand name products for cheaper private label offerings. Dividends are the most tangible link between a company and its long-term shareholders. We are going through a very difficult time in some industries, but wise companies will think twice before tampering too much with this link to their most patient and dedicated owners. Thank you Procter and Gamble for showing us your stuff.

We own the stock. This blog is for information purposes only. Please consult your own investment advisor.

Thursday, April 09, 2009

Is This The Bottom? Part III

I think it is; I think it is. Maybe if I say it twice it will make it so. On March 20, I asked the "bottom" question for the first time. My reasons for asking were mainly technical in nature, although I said I believed the enormous under girding of the banking system by the Fed and other governmental agencies was starting to have an effect. I asked the "bottom" question again on March 26. This time I explained that my reasons for leaning to the affirmative were not only based on the technical action of stocks, but most importantly on the fundamentals. The last two weeks of March saw four economic releases for February housing data that were all better-than-expected. Good grief surely housing could not be turning, especially when home prices were still falling and defaults were still on the rise. But yes, new housing permits, new home sales, exiting home sales and pending home sales all turned higher in February and beat estimates by between 6% and 22%. I think yesterday's Wells Fargo pre-announcement of better-than-expected earnings validates the February housing data. It was clear from Wells Fargo's earnings pre-announcent that a big increase in mortgage originations was driving their good results. Now for some additional good news. I'm hearing anecdotal reports from realtors that I know around the country that March real estate readings in many of the most troubled areas of the country, such as Florida, California, and Arizona are turning up. In almost all cases the year over sales are up substantially, and the inventory of homes is shrinking. Home prices in all areas are still falling, but unit sales are increasing and walk-through business is growing rapidly. I have said many times before that real estate got us into this mess, and improvements in real estate will need to get us out. Increases in unit sales are good news for real estate and the economy, but we need for real estate prices to stabilize. That would seem to be many months off. However, the Fed's purchases of long-term Treasury bonds and mortgage backed securities has driven down 30-year mortgage rates to about 4.75%. That is proving to be a boon to refinancings as well as new buyers. My brother in Indianapolis says he has a number of buyers who are ready to buy, but they cannot sell their houses. That may not sound like good news, but it is. Just a few month ago, he said things were completely dead. The fall in mortgage rates is definitely putting more people in the market, and I'm hoping that one of them is interested in one of my brother's clients' homes, so a fortuitous chain reaction can begin. My sister-in-law in Arizona, says she has had more activity in the last few weeks than she has seen in months. It may seem early to call a bottom in the economy with only one month's data and a few anecdotes. Indeed, the good news may later be seen as false hope, but when you combine good data and anecdotes with the fact that stocks have staged a bona fide technical rally, the turn around appears to be sprouting legs.