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 And importantly, "Can growth last after the massive government bailouts are withdrawn?"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.