Saturday, August 28, 2010

Answers to Your Questions: General Mills -- How Our Dividend Model Gives Buy and Sell Signals

Dividend Valuation Model
General Mills (GIS) is up 22% over the last twelve months.  A questioner wants to know what our dividend valuation model is signaling about the stock's prospects for the coming year.  In addition, several questioners have asked if we are a pure "buy and hold" manager, or if we take profits under certain conditions. 

In answering the second question first, we are not a "buy and hold" investment manager.  We are a "buy undervalued and sell overvalued" manager.  We find that our average holding time of a stock is about 5 years.

Let's use our Dividend Valuation chart above of General Mills (click to enlarge) to look more closely at the buy and sell signals we believe have the most validity.

First a cursory looks reveals that over the past 20 years there has been a reasonably tight fit between the movement of GIS's price (red line) and its projected valuation (blue bars), as calculated by our Dividend Valuation model.  Indeed, the R2 is near 90%.  It is important to remember that the Dividend Valuation model calculates a single formula that is used for all years, with the only difference from year to year being the inputs of dividend growth and changes in interest rates.

So how do we read GIS's prospects for the coming year?  The checkerboard bar at the far right is the model's calculation of the predicted price using our projections of GIS's dividend growth over the next twelve months and the change in the yield of a 30-year US Treasury bond. That predicted price is approximately $40 per share. If we include GIS's dividend, that would produce an approximate total return over the coming year of near 12%.

As a reminder, while our model has done a good job of predicting value over the last 20 years, the model is based on historical relationships and, thus, is not a guarantee that GIS's predicted price of near $40 per share will be met.  You probably knew that already.   

Let's look more broadly at GIS's valuation chart to see the various buy and sell signals it has made.  Remember the actual price is the red line and the model's predicted price is the blue bar.  Thus, simplistically, when the red line intersects a blue bar in a particular year, that would mean that price is below value, and it would signal that the stock is undervalued and a buy candidate.  Conversely, if the red price line is higher than the top of a blue bar it is considered overvalued, and a sell candidate if owned.

According to the model, GIS was undervalued between 1993 and 1998,  in 2000, 2005, 2009, and 2010.  Simply speaking, if we were following the model without other considerations, we would have bought the stock in 1993 and sold it in 1999.  We would have bought again in 2000 and sold in 2001; repurchased it in 2005 and sold again in 2006.  Finally, we would have bought in 2009 and we would still be holding the stock.

In actual practice, we follow a more rigorous standard for buying and selling.  In the case of a stock like GIS, we require that the stock be at least 10% undervalued or overvalued to trigger buy and sell signals.  We find this provides about the same rate of return with far less turnover and capital gains taxes.

We do not currently own General Mills in any of our Rising Dividend models.  We have looked at it many times over the years, but other stocks appeared to be more undervalued each time.  Indeed, its current 12% undervaluation is not exceptional.  Our models are suggesting that the average stock is nearly 25% undervalued.  GIS is an outstanding company, and if it retreats in price or begins to grow its dividend at a higher rate than our model now projects, we would become much more interested in buying it.

We'll be tackling some of the questions about the economy and the Federal Reserve next week.

The author does not own General Mills.  

Wednesday, August 25, 2010

We Would Like to Hear Your Questions

Ever since July 21 of this year when Fed Chairman Ben Bernanke described the economy as "unusually uncertain," stocks and bonds have moved in opposite directions.  Bond prices shot much higher in a flight to safety, and stock prices fell.  A year ago, everyone was worried about inflation.  In recent weeks however, some economists are now predicting deflation.

In recent posts, we have explained what we believe to be the best places to put money in these uncertain times.  We believe now as much as ever in our rising dividend style of management, which primarily invests in companies paying ever-increasing dividends year after year.  However, we realize that there are many questions and concerns that we have not addressed that you may wish to have answered.

We'd like to hear these questions that are on your mind.  Over the next few weeks we are going to conduct an initiative to field as many of your concerns and questions related to the economy, investing, and the companies we invest in as we can.  We invite you to write your questions in the box on the right side bar of the blog and click the submit button.  This process will keep your identity completely anonymous.  Please don't hesitate to ask away.  We will combine the questions into similar groups and begin answering them with as much supporting data in the days and weeks to come.


The DCM Investment Committee

Randy Alsman
Rick Roop
Mike Hull
Greg Donaldson

Saturday, August 14, 2010

Royal Bank of Canada is the Epitome of a Bond-Like Stock

In these uncertain times, we are asked over and over by our clients : "How can I invest in the stock market with less volatility and more predictability?"  Our answer is: "By investing in Bond-Like Stocks."

Bond-Like stocks aren't for everyone, but once you get to know them, you might find they are just what you have been looking for.  In our last audio blog (see link) we introduced the concept of Bond-Like stocks.  These are stocks that have very high financial strength and credit ratings, a dividend yield higher than that of a 10-Year US Treasury bond, and a history of raising their dividends. 

Royal Bank of Canada (RY) probably fits these criteria as well as any stock I can think of.  Here are the particulars for RY.
  1. RY is one of 5 AAA rated companies in the world.
  2. Its current dividend yield is 3.9%, much higher than the 2.8% yield on a 10-year T-bond.
  3. It has raised its dividend an average of 10% per annum over the last 10 years.
In addition, RY, along with all the other Canadian banks, largely escaped the subprime crisis as a result of its conservative lending practices.

A look at Royal Bank of Canada's most recent earnings report reveals some very interesting data points.
  1. Quarterly allowances for loan losses were 48% lower than a year ago.
  2. Shares outstanding were almost flat, very different from big US banks which increased shares by up to 35% to meet government mandated net capital requirements.
  3. Total loans grew modestly, again contrasting the shrinking loan balances at most US banks.
  4. Perhaps the most striking data point was RY's return on equity (ROE).  ROE for its second quarter was near 17%, almost as high as its 10-year average and almost double that of the big US banks.   
At the above right is our proprietary Dividend Valuation Mode for RY (click to enlarge).  The model suggests that the company may be as much as 14% undervalued, based on the year-ahead dividend growth we project.  As we have said before, the Dividend Valuation Model is based on historical relationships of price versus dividend growth and changes in interest rates.  These relationships may not hold true into the future, but on a historical basis the model has been able to predict the annual movement in the price of the stock at near 90%.

We'll have more to say about Bond-Like stocks in the coming weeks.  Next time we'll describe the hidden value of rising dividends.
Clients and principals of Donaldson Capital Management own RY.  See the conditions for use of this blog site at the right.


    Thursday, August 12, 2010

    Bond-Like Stocks

    Greg Donaldson describes the firm's concept of Bond-Like Stocks and why they may return a better total rate of return than treasury bonds in the years to come.

    Donaldson Capital Management Clients and Principals own Procter and Gamble.  We would like to get your impressions on this new series of audio blogs that we are doing.  Just click on comments to give us your feedback.