Friday, December 16, 2011

Dividend Investors Are Willing to Pay Much More For a Bird in The Hand Than for Multiple Birds in the Bush

Dividends matter and a brief look at our three investment strategies reveals a remarkable symmetrical total return distribution.  All three strategies are selected from the same stock-filtering and valuation models.  Stocks are slotted into each individual strategy by our Investment Policy Committee based on financial strength, dividend yield, and rate and consistency of dividend growth.

The Income Builder Strategy -- High Dividend Yield, Low Dividend Growth
  • Current dividend yield approximately 4.50%
  • Last twelve month dividend growth 6.0%
  • Total Return last twelve months approximately 10.0%
The Cornerstone Strategy -- Above Average Dividend Yield, Above Average Dividend Growth
  • Current dividend yield approximately 3.5%
  • Last twelve months dividend growth of  almost 12.0%
  • Total Return last twelve month of almost 7.0%
The Capital Builder Strategy -- Low Dividend Yield, High Dividend Growth
  • Current dividend yield approximately 2.2%
  • Last twelve months dividend growth of approximately 15%
  • Total Return last twelve months of approximately 4.0%.
A simple look at the three different investment strategies reveals that investors have been willing to pay up for higher yielding stocks.  The Income Builder portfolio with its 4.5% dividend yield has run away from the other two strategies on the basis of total return.

Cornerstone, which is our flagship investment strategy, has had good returns over the last twelve months but has under-performed the Income Builder Strategy, even though Cornerstone companies have increased their dividends at twice the rate of Income Builder companies. Finally, Capital Builder companies have had one of the best earnings and dividend performances we have witnessed in many years, yet the strategy has not performed as well as either of the two higher-yielding strategies.

What are we to glean from these data?  The obvious and most simple answer is that in this very low interest rate environment (10-year US Treasury Bonds are yielding under 2.0%), investors have been willing to pay up for higher dividend yield, while dividend growth is being discounted, if not ignored.

While the data clearly show the attraction of high dividend yields, history reveals that over longer periods companies with higher dividend growth normally outperform slower growing companies.  In short, companies that can increase their dividends at low to mid-double digit rates fall in and out of favor, but the long-term trend line of their total return growth is higher than the trend growth of slower growing companies. This means that today the high growth companies are becoming spring-loaded.  That is they are very cheap, and as the European crisis begins to subside, we believe higher growth companies will run away from lower growth companies.

Then the question becomes: when do these spring loaded companies start springing?  Our answer is we don't know.  Furthermore, we don't think anyone knows.

In keeping with the old fashioned concept of "the trend is your friend" we have tilted all of our portfolios to a slightly higher dividend yield relative to the S&P 500 than normal.  Our models tell us that the high-yield, low-growth stocks, which include many utilities, are still undervalued based on historical measures of dividend yield and growth versus interest rates.  For this reason, we believe quality, high yield stocks have room to go higher.

However, because the high dividend growth companies have become the most undervalued of all types of stocks, we continue to nibble on selected stocks, even though they are flat lining price wise.

Our best guess is that there might be as much as six more months of this symmetrical affinity for relative dividend yield. After the Fed has completed its "Operation Twist" initiative, the markets will no doubt reappraise inflationary forces and reprice long time bonds and high dividend yielding stocks.  Until then, the markets are clearly saying that they are willing to pay more for the bird in the hand than the birds in the bush.

Next time we'll talk about another high dividend yield stock that we believe is still undervalued.


Tuesday, November 29, 2011

United Technologies: The Hidden Dividend Star

United Technology (UTX) is the Dividend Star most of the simple dividend-growth filters miss.  This is because they do not raise their dividend every year. UTX takes action on its dividend every six quarters, not every four quarters, as do many dividend stars.

I have even tried to explain to the company's investor relations department that while their every-six-quarters dividend hikes has been quite predictable, that such a policy means that about every three years their annual dividends flat line. Thus, the company is not included on many lists of companies with long-term histories of consecutive dividend hikes.  No matter says the company. They like to do it the their way.

In this case who am I to push against such a winning record, just to make it simple.  UTX has one of the most consistent dividend growth records of any company I follow.  The following are their 20, 5, and one year annual dividend growth rates.
  1. 20-year growth rate  11.3%
  2. 5-year growth rate    12.5%    
  3. 1-year growth rate    12.9%
To top it off, the estimate of UTX's three to five year dividend growth rate is just under 12%.  At that rate of growth its dividend will triple over the next ten years.  Not bad for a company that has a current yield of 2.6%.

Despite UTX's consistent dividend hikes and earnings growth over the last twenty years, the Dividend Valuation chart at the top of this page suggests that the company is significantly undervalued based on the historical relationships among its price growth, dividend growth, and interest rates.  UTX's current price (red line) is much lower than its current valuation (blue bar) and even lower yet, than our estimate for next year (checkered blue bar).

The so-called Correlation Index, which measures how tightly the average stock is tracking the major indices, has risen to as high as 85% in recent weeks.  Its normal reading is near 15%.  This means that the constant on again off again European bail out proposals have turned what is normally a market of stocks into a stock market.  What I mean by this is that almost all stocks have been caught in the maelstrom of big up and down days, which would indicate that all companies have about the same future profit and dividend potentials.  If you take a few minutes to think about this, the truth almost smacks you in the face.  The one thing we know for sure is that the future prospects are not the same for all stocks, thus, it is just a matter of time before stocks start to trade on the bases of their own unique fundamentals, not the generalized fears of the European situation, no matter how things turn out.

In this regard, we believe UTX has quite a pedigree and will ultimately break away from the pack and show it star quality..   

I own UTX.

Friday, October 21, 2011

12 Random Ramblings

Every working day of our lives we get questions.  Questions about the stock and bond markets.  Questions about how natural disasters, politics, or economic and business crises will play out in the market place.

In this weekly blog we try to keep our comments narrowly focused on our dividend investment strategy.  As we were composing our most recent quarterly letter we admitted to our readers that at times we sound like a one trick pony:  our solution for every challenge and every opportunity is always -- buy and hold quality rising dividend stocks.  In the long run we know that will work.

Yet the matters we discuss and decide at our weekly investment policy meetings cover the waterfront of issues.  In this regard, heaven help us, we are like politicians because we have to have a basic understanding and a few talking points on just about everything that is going on in the world.  

We thought our readers would appreciate our short takes on a long list of issues facing our nation and the world.  Normally, when we write these blogs or our client letters, we try to offer solid proofs for our positions.  In this piece, we are not going to do that.  We are just going to give our views, without supporting arguments.  This way we can cover a wide range of issues that you may have questions about.  It is our plan to periodically offer an update to what we are calling 12 Random Ramblings from the Investment Policy Committee.
  1. Stocks are undervalued by about 25%.  Energy, Industrial, and Consumer Cyclical stocks are very cheap.
  2. US Government bond yields are at historic lows, but will not rise much over the next year.
  3. Inflation will fall.
  4. US Corporate profits will continue to surprise to the upside, driven by business in developing nations.
  5. Greece is already bankrupt, but the European Union will keep the country on life support for an extended time.
  6. The market has already priced in a Greek default.
  7. The US economy will not fall into recession and may surprise to the upside in the fourth quarter of this year.
  8. The worldwide economy will grow by at least 3%, after inflation, this year.
  9. Dr. Doom, Nouriel Roubini, has signaled better times may be on the horizon for the US and the world by putting his investment advisory firm up for sale. 
  10. The average dividend payout ratio for the S&P 500, which is now, under 40%, will move back toward its 80-year average of 50% over the next five years.
  11. There is still a chance that Hillary Clinton will run against President Obama if his polling numbers don't improve by December.  She would likely beat any Republican, and the stock markets would rally, not because her views are so much different than Obama's, but because the economy and the markets did so well under Bill Clinton.
  12. If  Roubini is selling his company, the price of gold may have already seen its highs.

Greg Donaldson, Chairman of the Investment Policy Committee
Donaldson Capital Management, LLC

Friday, October 14, 2011

Nextera Energy: A Dividend Star on The Rise

Normally we are suspicious when old-line companies take on new names.  We have too many bad memories of the collapse of many of the new-name crowd during the Tech bubble. In rare cases, we believe changes in a company's name makes good business and strategic sense.

We believe Nextera's (NEE) name change is both an improvement over their old name, FPL Group, and an important milepost of the maturing of an exciting business strategy.

NEE changed its name from FPL Group a little over a year ago.  The name FPL Group was a change from the company's original name of Florida Power and Light and became necessary when the company began expanding well beyond Florida.

But the most important reason we like the new name is because we believe NEE is truly a very different kind of power company.  Indeed, since 1989 they have increasingly taken on a "Next Era" attitude toward electric power generation.  In the above link, they state that they now produce nearly 95% of their electric power from clean or renewable sources.  They are now North America's leader in sun and wind energy.  In addition they have a long history of safely operating nuclear power plants.  In short, today Nextera is one of the nation's top clean and renewable electric power producers.  We believe they are just beginning to reap rewards for their 20+ years of investing in alternative energy sources.

Recently, we have been adding to our NEE holdings because we believe the stock has a very bright future and our Dividend Valuation Model (above) indicates the stock is approximately 20% undervalued.

Even with President Obama's pullback on more stringent EPA emissions standards, existing clean air regulations are forcing more and more electric utilities to close old, less efficient coal-fired generating plants and abandon new coal-fired plants.  The bottom line is that many Midwestern power companies are scrambling to gain access to clean and renewable energy sources, and NEE has it for sale.

Here is a short list of other reasons why we like NEE:
  1. Current dividend yield is near 4%.
  2. 5-year dividend annual growth of just under 8%.
  3. Projected 3-5 year dividend growth of near 6%.
  4. Current dividend payout ratio is near 50%, much lower than industry average of 70%.
  5. Paid a dividend since 1990
  6. Increased its dividend for 15 consecutive years.
  7. Stock is currently selling at a PE of 12, much lower than the industry average of 15. 
  8. Company operates in 26 states mainly in the growing southern region of the US.
  9. One of the most forward thinking management teams in the industry. 
NEE's exposure to nuclear power may be seen by some as a negative.  However, with Southern Company's recent application to construct the first nuclear power plant built in the United States since the 1970s, we believe there is a growing belief among many investors that nuclear power will continue to be an important low cost source of electric power. 

We own NEE and have no plans to sell it.

Wednesday, October 05, 2011

Greece is Burning But Many Multinational Dividend-Paying Stocks Are Still Cool recently quoted excerpts from one of our blogs about the great values in dividend-paying multinational corporations.'s article included our views along with other money managers that are saying the same thing.  Here is the link to the article:

The quote used in the article was taken from a July 29 blog written by Randy Alsman, one of our senior portfolio strategists.  Here is a link to Randy's full blog: Rising Dividend Investing.

We are happy that CNBC picked up our story-line.  We believe the evidence is conclusive that global companies have a flexibility and financial power that is being completely ignored in today's stock market.  We are particularly pleased that it is CNBC that is digging into the great story of multinational dividend payers.  CNBC and its multiple media brands have a reputation of being aimed at traders and speculators, spending little time and attention on long-term value investing. In that regard, we tip our hats to  They took the time to talk with some veterans in the business who have been through crises before and believe that the current level of fear in the market cannot last.

One day the panic will subside, and when it does we believe the first place investors and even traders and speculators will go is to the financially strong, multinational companies for exactly the reasons that Randy detailed in his blog.

Yet, as we write this edition of our blog, traders and speculators are abandoning stocks of all stripes and rushing into US government bonds, driving bond prices to unbelievable heights and bonds yields to depths not seen since the 1950s.  Is there a bubble under Treasury bond prices? -- you bet!

When considering that our government is borrowing 40 cents of every dollar it spends, and is so politically stalemated that the only thing legislators can agree on is TGIF (but only if G stands for goodness), the confidence speculators are bestowing on US Treasury bonds is nothing short of amazing. 

Multinational corporations possess qualities that are not being fully appreciated or valued in today's market.  That old saying about cream rising to the top is very applicable today in our judgment.

Greece is burning.  Indeed there are signs of smoke in many countries in Europe, but the earth will still be spinning when this most recent "debt spiral" winds down.  For reasons included in the long list of attributes that Randy detailed in his blog, the safest bet we know of is to stick with with what we know and what we know is good.  That is multinational corporations that pay a generous dividend.

Thanks again to  To our knowledge this is the first time they have quoted us. We are honored that they included us in their story of the merits of dividend-paying companies.

We own many multinational companies that pay a generous dividend.  

Friday, September 23, 2011

Southern Company: Our Top Pick Among the Utilities

Here's a pop quiz for you:  What are the yields on 10-year and 30-year US Treasury bonds?  Unless you are an extremely keen observer of the bond markets, my guess is you will be shocked to learn that 10-year US Treasuries now yield only 1.80% and 30-year Treasuries are yielding a paltry 2.9%.

Just think of it, if you want a supposedly risk-free investment, the highest rate available is under 3%, and to get it you have to tie up your money for 30 years and pay taxes on the income.

Rates have fallen to these levels as a result of the Federal Reserve's attempts to stimulate the economy.  In driving rates to such low levels, the Fed is essentially trying to force investors to look away from Treasury bonds toward other investments that offer a better return.  We think it will work.

The chart above shows our 20 year Dividend Valuation Model for Southern Company (SO).  The chart clearly shows that SO's price (red line) and value (blue bars) have moved in close proximity over this time frame.  The statistical correlation is above 80% and suggests that SO is approximately 25% undervalued.

Southern is one of the country's biggest and best run utilities. You might call it the Sunbelt's power company because it serves most of the southern half of the United States east of the Mississippi River.  This is key to it long-term prospects.  It is well-know that the Sunbelt climate is popular with both people and businesses.  There has been a steady migration of both into the region for the last 30 years.

We believe one of the first places investors will look as they move away from bonds is at utilities.  Utilities offer high dividend yields, dividend growth, some governmental protection, and provide a service that is essential to our way of life.  Here's the bottom line on Southern Company.

  1. SO's current dividend yield is 4.5%, much more than the aforementioned Treasury bonds.
  2. They have paid a dividend since 1948
  3. They have increased their dividend for nine consecutive years, which means they did not cut their dividend during the recent recession.
  4. Dividends have grown at just over 4% per year over the last 5 years.
  5. They have a balanced electric power generating capacity with plants that use gas, coal, nuclear, and a small amount of alternative power production.
  6. Most importantly, they are well managed and serve a growing area.
Southern Company and many other high quality electric, gas, and telephone utilities offer good dividend yields, solid balance sheets, and modest growth prospects.  As investors come to grips with just how low interest rates are, we believe they will increasingly move to investments that offer higher yields.  We think the first place they will look is the utility sector and Southern is our top pick.

We own Southern Company and have no plans to sell it.

Friday, September 16, 2011

The Market is Wrong About United Technologies -- And A Lot of Other Companies

Our Dividend Valuation Model suggests that United Technologies (UTX) may be as much as 17% undervalued.  The chart at the left shows this undervalued condition in the price (red line) being much lower than the current value (blue bars).

Additionally, the models suggests that UTX is undervalued nearly 30% (blue checkered bar) when we input our dividend and interest rate estimates for next year.  The chart shows that one would have to go back to 1998 to find UTX as undervalued as it is today.

Undervaluation is not a term that means much to speculators and traders in today's market.  Indeed, recent data from the CBOE puts the Correlation Index at nearly 80.  This means that the average stock in the S&P 500 is now nearly 80% correlated to the movement of the Index itself, thus discounting almost all individual company fundamentals.  According to Bloomberg, this is the highest Correlation Index since 1987.

So what does it all mean?  Worries about european defaults, political stalemate in Washington DC, and slowing US and european economic growth have turned almost all big US stocks into commodities.  Most are acting about like their underlying index.  Not only are the daily price movements of United Technologies (UTX) and Boeing (BA) highly correlated, as you might expect from companies in the same sector, but also the price movements of UTX, General Mills (GIS), and Walmart (WMT) are also moving together.  As the old timers would say, we now have a stock market instead of a market of stocks. 

You will note that the last time the Correlation Index was this high was during 1987 when all stocks shot higher for the first six months of the year, and then all fell like a rock over the last six months of the year.  They all went in the same direction, regardless of their diverse underlying prospects.

I said in 1987 that the stock market had lost its mind, and I still believe it.  I believe history will show that today's congealed group think will be proved just as wrong.

Companies like United Technologies have huge free cash flows, lots of cash, and firm orders for future business.  It would not surprise me to see UTX trading near our model's target price of $95 per share in the next 12 months.  Indeed, I think the odds of UTX rising 30% over the next year are much higher than the odds of it falling 30%.  The main reason is they are a financially strong, innovative, and decisively managed company.  They can handle whatever is thrown at them.  There are untold companies that are bouncing up and down just like UTX that cannot make the same claim.

We own UTX. 

Friday, September 02, 2011

Barnyard Forecast: Conditions Are Still Positive for Higher Stock Prices

Periodically, we publish an update of our Barnyard Forecast (BF).  The BF is a back-of-the-envelope quick method of predicting how stocks will perform over the next 6-18 months.  If you do a search on our blogsite, you can see our previous updates.  On the whole, the BF has been reasonably good over the years at giving a sort of directional bias for the market.  As you remember the BF is taken from the acronym Economy+Inflation+Earnings+Interest Rates=Opportunity, in short EIEI=O.

For many years, the BF was calculated using a very simple scoring system that gave a thumbs up or down for the indicator as it related to its historical relationship with stock prices.  Over the last year we have made few updates that we believe improve the statistical integrity of the model.

Our last update on the BF was an audio blog by Randy Alsman on September 23, 2010.  In that blog, Randy went over each of the indicators and concluded that the model was forecasting rising stock prices over the next year.  Since that time, The Dow Jones 30, including dividends, is up almost 8.60%, even with the recent sell-off.

The following is the Barnyard Forecast's estimate of the next 6-18 months for the major stock market averages.

Economy: The first indicator is counter intuitive.  US GDP growth above 3.5% gives 0 points.  GDP growth of 2.0%-3.5% produces a neutral score of 1 point, and GDP growth below 2.0% is considered positive and produces the maximum score of 2 points.  The counter intuitive quality of this indicator is attempting to gauge the Fed's year-ahead bias.  Historically stock markets haven't done well when the Fed is hiking interest rates and vice versa.    With GDP currently running under 2.0% on a year over year basis, this indicator is positive for stocks and receives 2 points.

Inflation: The fulcrum level for inflation is Core CPI Inflation of 2.5%.  Above that level receives 0 points, near that level gets 1 point, and below that level receives the full 2 points.  Core CPI has stayed well below 2.5% for the entirety of the last year.  That performance is considered positive for stocks and receives the maximum of 2 points.

Earnings:  The fulcrum point on corporate earnings is year over year growth of 7%.  Seven per cent is the 80 year average of corporate earnings and has proved to be a good predictor of stock prices.  Again this indicator receives the full 2 points with S&P 500 earnings having risen nearly 12% over the last twelve months.

Interest Rates:  This is the indicator that we have sharpened up a bit.  We used to measure only the relative change in interest rates on a year over year basis: falling interest rates were positive and rising interest rates were negative.  Statistically, we found, however, that the yield spread between the 10-year US Treasury Bond and the 2-year US Treasury Note had better predictive qualities than the original method.  In this case, the fulcrum point is 0.  This means that if 10-year interest rates are higher than 2-year interest rates, the model receives the full 2 points.  If 2-year Treasury Notes are yielding more than 10-year T-bonds, the model would receive 0 points.  Currently, 10-year T-bonds yield 2.0% more than 2-year notes and receive the maximum 2 points.

Opportunity: With all of the indicators in the Barnyard Forecast receiving the maximum of 2 points, the model's total score is 8 points.  That is a score that I don't believe I have ever seen in the last 15 years and would indicate that stocks should perform well over the next 6-18 months.  Indeed, with a score that high, one could say that stocks should perform "better than well."  However, let me offer just a few words of caution.  This is not an econometric model.  additionally, it is really not a pure forecast of what stocks will do over the next year.  It is simply a measure of how the stock market has acted in the past when the EIEI=O indicators scored as they do today.  I will add, however, that the model's buy and sell signals have been correct about 77% of the time.  The only problem is that it has spent up to a year and a half giving the wrong signal, so it is not an indicator that we follow blindly.  

It is saying, however, that in the past when the the aforementioned indicators have scored as they do today, that there has been a good probability that stocks have gone higher. 



Friday, August 19, 2011

Dividend Myths Uncovered and Discussed, Part I

The single biggest misconception about dividend investing is that rising or falling stock prices are directly linked to the dividend paid by a company.  Investors, particularly those in retirement, are often pleasantly surprised to learn that even though stock prices might be falling their incomes from stock holdings are unchanged or even rising.

Such is the case today.  Stock prices have fallen sharply over the last two months, but in those same two months dividend income for both the S&P 500 and the Dow Jones 30 has risen.

Clearing up the confusion is easy.  Dividends are declared and paid by a company on a per share basis, not on a yield basis.  For example, let's look at McDonalds (MCD).  MCD currently pays a dividend per share of $2.44.  At today's price of  $85.61 per share, that $2.44 dividend equates to a current yield (dividend/price) of 2.8%.  Whether the stock goes up down or sideways, the dividend will stay at $2.44 per share until the company changes it.  In this case MCD has raised their dividend for the last 38 consecutive years.

This brings us to the second most common mistake that investors make about dividend investing, i.e., the current dividend yield as stated on the internet or in the paper is not necessarily your dividend yield at cost.  This is a somewhat more difficult concept to understand, but the math is still simple.  Let's say you bought MCD in 2007 when the price was near $49 per share.  To calculate your yield at cost, you divide the current dividend of $2.44 by your purchase price of $49.  Your yield at cost is nearly 5%.  When people learn of the concept of yield at cost, their first reaction is, "Am I really making 5% on my money today?"  The answer is yes.  Indeed, you are making a lot more that 5% per annum on MCD because its price has nearly double over the last four years.

Yield at cost is one of the most overlooked concepts in all of investing.  It is also why a lower yielding stock with a high dividend growth rate may actually produce a higher long-term cash flow than a high yielding stock with low dividend growth.  This is all courtesy of the power of compounding.  A dividend growing at 3% doubles in about 24 years; a dividend growing at 7% doubles in about 10 years; and a dividend growing at 15% doubles in just less than 5 years.  In this way, a stock yielding 2% today with its dividend growing at 15% per year will yield nearly 8% in 10 years.  We cannot overemphasize the power of growing dividends too much.

Most people know that dividends, unlike bond interest, are not guaranteed.  Dividends are paid solely at the discretion of the board of directors of the company.  Many people worry that falling stock prices are just a precursor to dividends being cut.  We always remind people of our experience in 2009.  Of the 30 stocks that we held in our Cornerstone portfolio at year end, 20 had raised their dividends, five had held their dividends steady, and five had cut their dividends.  That was the most companies we have ever had cut their dividends in a single year.

Our world is the world of rising dividends.  Companies that can raise their dividends almost every year are very rare birds.  Next time we will talk about some of the qualities we look for in selecting stocks for our portfolios.

We own McDonalds in our portfolios.

Wednesday, August 10, 2011

Are Dividend-Paying Stocks Becoming Better Than Bonds?

Speculators are throwing stocks around like dead fish, but even a simple analysis of companies in the S&P 500 shows that they are very much alive.  There are now 214 companies in the S&P 500 that have a dividend yield higher than the 2.10% yield of a 10-year US Treasury bond. 

These 214 companies have an average current dividend yield of 3.70%.  Importantly, as an indicator of their vitality, these companies have increased their dividends by an average of 8.20% over the last 12 months. This level of dividend hikes is eye-popping when considering that the US economy grew at only 1.60% during this time.

For the S&P 500 as a whole, the current dividend yield is 2.25%, also higher than the 10-year Treasury bond.  But when including the additional 286 companies whose yield is lower than the 10-year Treasury bond yield, or pay no dividend at all, the average 12-month dividend growth has been just over 14.0%.  During the same time, earnings for the S&P 500 grew by close to 12%.  That means that companies actually grew their dividends modestly faster than their earnings were growing.  Would dead fish companies do that?  Absolutely not.  A company would only hike its dividend at a faster rate than its earnings if it was completely confident that it would not need the money later.

So we have another one of those conundrums here.  The average company in the US is reasonably optimistic about its future.  We would add that the Wall Street analysts agree.  Last Friday, the analysts raised 2012 earnings to new all-time highs.  Thus, at the very time when the speculators were beginning to sling dead fish like there was no tomorrow, the analysts were pushing up 2011 and 2012 earnings. The actions of the analysts are vitally important in solving the conundrum:  It was almost exactly a year ago when the analysts also went against  the fish tossers by continuing to hike earnings for 2010 and 2011 even though stocks were selling off.  We all know now that they were right.  Earnings and dividend increases kept on rolling in and stock prices exploded.

We are not completely discounting the action of the fish tossers.  There certainly is a foul smelling odor coming from Washington these days, and the puny growth of the US economy stinks; but we believe speculators are missing the bigger picture.  World-wide economic growth is projected to be near 3.5% for 2011.  That rather spritely figure includes the smelly slow grow rates in the US and Europe.  The truth is the developing world is still showing solid growth, and, of equal importance, the developing world is a lot bigger than most investors understand.

In previous blogs we have extolled the concept of bond-like stocks.  Our view is for many companies the current dividend payments are very safe; indeed, we believe they will grow at solid rates over the next few years.  Mathematically, a stock yielding 3.7%, with its dividend growing at 7%-8% should clobber the current 2.10% return on a 10-year US Treasury bond.  It is not a guarantee, . . . but perhaps in light of recent events, we might say that questions have been raised about the credit quality of US Treasury bonds, as well.

Tuesday, August 09, 2011

Johnson and Johnson: A Regal Dividend Stock That Is Very Cheap

To dividend investors big sell offs like the one we have witnessed over the last couple of weeks provide tremendous buying opportunities. That may sound like a big DUH, but as Warren Buffett says, "When the water goes out it's easy to see who was swimming naked." We believe Mr. Buffett meant that statement in the context of wrong bets related to debt.  We have found, however, that "when the water goes out" in the stock market, it is much easier to see those companies that are not only fully clothed but are regally attired.  Regally attired in the sense of having the rare qualities of unquestioned safety and consistent growth.

There are a handful of companies in the world that can qualify under our most stringent safety and growth standards, unfortunately, these companies are almost always fully priced.  Everyone knows they are outstanding companies and everyone owns them.  The only time we can buy these regal companies at bargain prices is when a big sell off in the market causes people to abandon stocks in general.  When that happens, like over the last few days, the regal stocks get thrown out with the common folk.

Let us discuss one stock that we consider regal, Johnson and Johnson (JNJ).  Here is a brief thought process of why we rate it so highly and why it is the kind of stock we buy every time the "water goes out."

  1. Safety:  JNJ is one of only four companies in the US that is still rated AAA.  Yes you heard that right.  S&P, in cutting the rating of US debt, went to great lengths to explain that JNJ's rating was not dependent on that of the US.  JNJ is AAA on its own merits of financial strength, diversification of business lines, geographic diversification, growth, and sound leadership. JNJ has more cash than debt. 
  2. Growth:  JNJ has grown its earnings by an average annual rate of 7.5% over the last 10 years.  It dividend has grown in the low double-digits%.  With the uncertainties of the new health-care plan, we project that JNJ's dividend growth rate will slow to the 7.5%-8% level over the next 3-5 years. At that rate, JNJ's dividend will double in about 10 years.
  3. Dividends:  JNJ's current dividend yield is 3.7%.  That is nearly 1.3% more than the yield on a 10-year US Treasury bond.  The company has paid a dividend since 1944 and has raised it dividend every year for the last 48 years.
  4. Valuation: Our proprietary Dividend Valuation Model is estimating that JNJ is just over 30% undervalued. 
  5. Timing: We don't try to time the market, but the manner in which stocks have fallen in recent days usually takes time to calm down.  We think JNJ is a good value at current prices, but with a bit of patience one might be able to buy it a bit cheaper over the next few weeks.
We own JNJ and plan to buy more.

Thursday, August 04, 2011

A Prayer For Our Leaders And Our Country

A dear friend of mine called today and was mad as a hornet about the recent sell off in stocks.  He quickly stated that he knew that stocks go up and down and that volatility was always present in the stock market.  He was not angry so much about his big paper losses because he was living off the income of his portfolio, and he agreed with me that the income was secure.  He said his anger was directed toward the United States Congress and the President because they had all brought on the carnage in the stock market by their recent show of ineptitude in passing the debt-ceiling increase.  He said, "They have made us the laughingstock of the world and given us the feeling that they are so rabid on both sides that only a crises can provoke them to agree on anything."  

He explained that only 50% of American pay Federal income taxes and yet the Democrats want to raise taxes on only those who already pay taxes, not on the hundreds of millions of people who pay no taxes. He uttered, "Everyday this feels more like we live in a socialist country."  

He was equally upset, however, at the Republican leadership because they could not reign in the wild bunch who were ready to shut down the government rather than raise taxes.  He said, "Where are the statesman?  Where is the reason?  Who is willing to serve their country rather than their ideology?"  He said a lot more that I cannot print.

I told him that I believed there were many other factors that had contributed to the recent weakness in stocks, the credit problems in Europe being number one.  "He said Europe is a zombie headed for 20 years of tepid growth just like Japan, but they despise the US so much that they would rather go bankrupt as a united entity rather than save their necks by abandoning their common currency."

I started to answer his latest mortar blast when I realized my answers were not the solution.  I said,"Sounds like we need to pray."

He almost shouted at me that that was the only thing that could save a corrupt and dimwitted world.  And so I asked him,"Do you want to start the prayer or should I?"

He said he was too wound up to pray and that my prayer would be much appreciated.

"Oh creator God;  Alpha and Omega, look down upon us your stiff-necked and self-serving people.  Grant us a measure of your wisdom; teach us your ways; and save us from our self serving ways.  Break our hearts, Lord, and help us to understand that even your Word says there will always be the poor among us whom you called blessed.  Those whose wounds You ask use to minister to.  Wounds You invite us to enter into that we may find our own healing, our own better selves.  

Teach us Lord when enough is enough.  Give us the joy of living in your Spirit, and the assurance that in You we have everything we need.  Indeed, more than we than we can imagine. Rest your heart and hand on the leadership of our country, Lord.  Humble the deceivers and the proud.  Enliven your Holy Spirit on this country we love and help us both to know the path we must follow--and to follow it.  But not just the US, Lord, but also the world You so love.  

Finally, God we ask that you walk with us as we pass through this dark season, that we might be comforted and guided by your light.  Amen. 

Do you have anything to add?"

"Do you really believe I can count on my income?"

"Yes, I do.  You have only high quality dividend paying stocks and investment grade bonds.  Your portfolio was built to handle this kind of weather.  The weather might be rough, but I believe the portfolio can handle it."  

"Amen.  Tell me the truth; you're just as mad as I am aren't you?"

"Yes,  I am, but you used up all the good lines.  That left me with only a prayer."

Friday, July 29, 2011

Have Multinational, Dividend-Paying Companies Become the World's Safest Investment?

Investment Policy Committee Notes

Summary Points:
  •  Debt ceiling saga continues to keep markets in flux
  •  Debt Rating agencies forewarn of credit downgrades for the world’s few AAA rated countries
  •  The European Union scrambles to reschedule Greek debt
  • The Municipal bond market somewhat stagnant as investors await Congress’ decision on the debt ceiling
  •  2nd Quarter company earnings continue to outperform

Needless to say, there is a barrage of perceived and real worries in the world today.  Most pressing in our view, however, is the topic of the United States debt ceiling, and the anticipated outcome of Congress’ decision to either raise the limit or let the U.S. default.  The Donaldson Capital Management Investment Policy Committee (“IPC”) discussed at great length what truly constitutes a default. We have read many publications, and watched several news conferences in order to learn of the possible outcomes.

Timothy Geithner, the U.S. Secretary of the Treasury, seemed to dance around an interview question on the plausibility of the U.S. defaulting on its obligations.  Although he did not confirm that the U.S. would default, he did say that by definition the U.S. could be in a ‘technical default’.   Essentially we understood this to mean that without the debt ceiling being raised, with the current level of Government outlays exceeding tax revenues, certain obligations would not be paid.

This is where it gets a bit fuzzy.  There will be a natural order to things, or rather, a priority of who will get paid first in the hierarchy, but how that order is defined is the real question.  While difficult to determine who would get paid and who wouldn’t, the Government realizes that its creditors are made up of countries and large institutions with a strong investing prowess. Therefore it is very important the U.S. make good on its debt obligations to these creditors because we will have to go back to them for future borrowing needs.

However, should the U.S. fix its deficit issues off the backs of those dependent upon their monthly paychecks such as retirees or the disabled by taking away or reducing these benefits?  Either way you look at this issue, it’s very difficult to determine the best way to solve the problem at hand. 

The markets have responded to the expanding uncertainties with mixed emotions.  They have become more volatile in the past few weeks but have traded in a reasonably narrow range.  What seems to be the issue with the uncertainty is uncertainty itself. 

Another correlating variable to the volatility of the markets is the debt rating agencies’ warnings of decreasing credit ratings for some of the strongest countries in the world.  Standard & Poor’s rating agency, along with Moody’s and Fitch’s have all stated they will remove the U.S's AAA rating should either no deal, or a perceived insignificant deal, be passed.  This trend has extended, however, to other countries such as Germany.  This is rather surprising considering the positive attention the Germans have received for their strong fiscal budget and spending discipline.

This may be an unprecedented time in history to have the world’s ‘riskless’ investment (i.e. U.S. Treasury bonds) take on the risk by being downgraded.  What, then, should the world use as a benchmark for risk premiums, capital cost configurations, and the like?  It is the belief of the IPC that no matter the outcome, the U.S. policymakers will do what they can to prevent default and perhaps safeguard the status quo.

Not only so, but as it pertains to investors, differing investment options are graded on a curve. When surveying the world and all the differing investment securities available (from stocks, to bonds, to cash, to foreign currencies or securities, etc) investors perform a mental accounting to rank various investment options against each another.  While there is the real possibility the U.S. debt rating could be downgraded, generally speaking the U.S. is still one of the safest places in the world to invest one’s money. 

A comparison to the bailout plan offered by the European Union to support Greece shows the situation in the U.S. could be much worse.  Private holders of Greek debt are taking a 21% haircut on their investments, which is causing grumbling among investors.  As we have seen, a rippling effect can occur across the European Union should one country default on its obligations.  We are optimistic, however, to see that a new Greek debt restructuring plan should whittle down the country's debt-to-GDP ratio closer to 100% (a more manageable level). 

The IPC then turned its attention to the municipal bond market and noted that the issuance of new bonds has slowed dramatically.  It would take several more paragraphs to explain why, but Congress’s decision to limit new Treasury bond issuance as we near the federal debt ceiling has had the effect of reducing the number of new municipal bonds coming to market.  Therefore, the municipal bond market has now been, at least temporarily, impacted, by the debt-limit standoff.

That is not good news, but there is some good news about credit quality in the municipal bond market.  A recent analysis of our bond holdings showed significantly more upgrades than downgrades.  In fact, the municipal bond market as a whole has fared very well this year, especially in retrospect to analyst Meredith Whitney's dire prediction.  If you remember, she proclaimed there would be hundreds of billions of dollars worth of defaults in 2011.  So far in 2011, only $750 million have defaulted; a far cry from her forecast.  This compares to the amount defaulted in 2010 and 2009 of $2.5 billion and $4 billion, respectively.

Lastly, the IPC discussed corporate earnings for the 2nd Quarter.  So far in this earnings reporting season, a little over 200 companies within the S&P 500 have reported.  Earnings have continued to outperform in both year-over-year growth,18%, as well as earnings surprises,7.5%. (defined as the difference between actual earnings and analysts’ estimated earnings.)  These big earnings gains have also resulted in sizable dividend hikes.  In our two main dividend investment styles, dividend increases over the last year have averaged nearly 14%, the highest growth rate in many years. 

In the spite of all the news that is causing volatility in the stock market, U.S. companies are still expanding and growing at an impressive rate.

Many questions remain regarding the final outcome of the debt-limit stalemate in Congress.  Because this stalemate involves the heretofore safest investment on earth, U.S. debt securities, the options for a perfectly safe hiding place are very few.  Furthermore, we remain convinced that this stalemate will be broken and when it is the few investments that are doing well right now like gold and Swiss,Canadian, and Australian currencies will fall in price.  In essence to invest in these securities at this time is to bet that the U.S. will not only default but remain in a defaulted condition for an undetermined time.

As we have said on many occasions, it is becoming clear that high-quality, multinational corporations may now be the safest investments in the world.  They have piles of cash, significant free cash flows, modest debt loads, compete in every corner of the world and charge a price for their services dictated by the market and not decree, pay taxes in every country in which they operate, and return a significant portion of their annual earnings to their shareholders in the form of dividends.  Go back through this list of attributes and you will find few similarities with most sovereign debt in the world.

We'll report again next week on how the fiasco in Washington DC is playing out.

Thursday, July 21, 2011

Dividends Are Rocking and Rolling

Dividends have rocked and rolled over the past five and half years.  The question is where will they be dancing from here?

The chart at the right shows dividends paid by S&P 500 companies on a rolling 12 month basis since December of 2005.

For the first three years of this period, dividends rolled higher, peaking near $31.  Beginning in August of 2008, dividends fell like a rock, a move that more than wiped out the gains since 2005.  Since the early part of 2010, dividends have once again reversed course and are now rolling back toward their old highs.  Can this roll continue, or are there more rocks in our future?

Over the last 12 months, S&P 500 companies have paid roughly $25, still far below the nearly $31 all-time high they recorded at the peak in 2008.  However, the red dashes at the far right of the chart show Bloomberg's quantitative estimate of total dividends paid by year-end 2011.  Bloomberg believes that the current roll will continue.  They estimate total dividends for 2011 will reach $29, not far from the all-time high.  Bloomberg also estimates that the old high will be reached by the end of 2012.

If 2011 total S&P 500 dividends paid do reach the $29 estimate, it would mean that dividends would have grown for the year by nearly 21%.  Many analysts estimated that S&P 500 earnings would likely grow at that rate,  however, almost no analyst we follow made such a bold estimate for dividends.  After all, corporations have been fiercely focusing on free cash flows, and dividend payouts diminish cash.

We believe this dividend revival makes complete sense.  Corporations have produced tremendous free cash flows in recent years.  This build up in cash has three main potential uses: 1. share buy backs, 2. acquisitions, and 3. dividend hikes.  The companies we follow have done a little of all three, but they have hiked dividends at a higher rate of growth than we would have expected.  We believe the reason for this has been the growing recognition by many firms that dividend-paying stocks are enjoying renewed interest among many investors, particularly those near or in retirement. In hiking dividends they are just doing what their shareholders want.  I realize this is a very novel idea -- that a company would do what its shareholders want -- but we believe that is exactly what is happening.  There are some firms that have hiked their dividends two and three times in the last twelve months.  Activity of that kind is not an accident.  They know what they are doing and they have the cash flows to afford it.  We believe this dividend roll will continue.

If dividend hikes have been on a roll and stock prices follow dividends, a theory to which we subscribe, then current stock prices may roll a lot higher.  We would not be surprised to see them back to their old highs seen in 2008.  This won't happen in the next six months, but we can see it occurring by the end of 2012.

There are certainly all kinds of worries to contend with, but having a positive outlook is sometimes the best strategy when everyone seems to be throwing rocks at the market's prospects.

Tuesday, June 14, 2011

A Lot of Bullet Points That Add Up to Stocks Being Higher by Year-End

Summary Points:
  • Continuing to assess stock market outlook – balance still positive
  • Recent pullback in stock prices has been moderate on low volume

The Donaldson Capital Management Investment Policy Committee continued our review of economic data and forecasts for the year. While the economic headwinds are much in the news, it is our experience that positive events get less play in the media than negative ones. To try to identify an appropriate balance, while recognizing that items listed are not all equal in impact, we built our own list of significant headwinds and tailwinds.

  • QE 2 ends this month.
  • The May new jobs number came in way below trend.
  • The European Economic Community has not yet solved the Greece problem.
  • Consensus 2011 global GDP growth expectations have dropped 0.5% or so.
  • National average house prices are still dropping.
  • The unemployment and “functionally unemployed” rates have ticked higher.
  • State and local governments are still eliminating jobs.
  • Savings rates are high, potentially reducing consumer spending.
  • Gas prices are ~$1/gal. higher than a year ago.
  • Congress has not passed a solution to the Deficit and Debt problems.
  • Regulatory uncertainty exists in regards to: health care, taxes, and banking.
  • 3/11 Tsunami had bigger effect on supply chains than was previously thought.
  • Reported corporate profits remain strong.
  • Estimates for 2011 corporate profits have held, despite economic headwinds.
  • GDP growth outside the U.S. and Europe remains robust.
  • Capital asset purchases (e.g. trucks, cars) are recovering significantly.
  • Banks are seeing a slowing of defaults on mortgages and credit card debt.
  • The weaker U. S. dollar is boosting U. S. exports.
  • A debt default by the U.S. is seen as very unlikely by most economists we follow.
  • Stock values (price/earnings) are now lower than the 80-year average. No bubble
  • About 50% of S&P 500 sales come from faster growing, non-US economies.
  • Crude oil and gasoline prices are dropping from recent highs.
The Committee also reviewed a discussion by The Bank Credit Analyst of the US economic outlook. BCA is a Canadian firm (which we believe gives them objectivity about the U.S.) that we’ve followed for many years. Their analyses are well reasoned; they do not rant or get emotional; and, they use data to develop and explain their views. A synopsis of their June 8 presentation follows:
  • US growth will accelerate later this year.
  • Tsunami-related supply chain problems are easing.
  • The savings rate is high, but slowly dropping, benefiting consumer purchases later.
  • Housing is too low to sink much further, reducing its drag on the economy.
  • US structural deficits are only about 5% of GDP, more manageable than many think.
  • The US tax/GDP ratio is the lowest in G-20, encouraging economic growth.
  • The US has added more than 1.3 million net new jobs over the past year.
The Committee was concerned about the Fed’s recent lobbying for the 35 largest banks to raise their Tier 1 capital levels from 7% to 10%. This will continue to put pressure on bank stocks in the near term because of the potential dilutive effects of big equity underwritings. So far, this is still in the talking stage, and the banking industry is pushing back very hard. It remains to be seen how this will play out, but for the moment it has already been priced into the stocks, so any softening of the Fed’s position should provide a quick lift to the banks.

Although industrial stocks have dropped more than the S&P 500 lately, most industrial companies continue to have very bullish outlooks for 2011. CEO Sandy Cutler of Eaton Corp (ETN), for instance, is very confident his firm will see 14% revenue growth with earnings growth much higher than that. Many of Eaton’s customers delayed purchases of expensive capital goods during the recession, but these customers are now back in the market because the average age of their equipment has reached multiyear highs, causing repair costs to jump. This same dynamic is playing out across the spectrum of a number of industries.

Unemployment remains stubborn. Historically, however, the correlation between increased corporate profits and increased employment is very tight. The two trends separated during the recession. However, the average work week, especially in the industrial sector, has extended to the point where more overtime just may not be possible. The longer corporate sales volumes and profits grow, the more pressure there will be for businesses to increase hiring.

While major new negative developments in the Middle East, a major economic slowdown in China, or a fiasco on the debt limit in Washington D.C. could turn the 2011 outlook decidedly negative, we don’t consider any of them as having a high probability at this time. Our views are echoed by the economists and strategists that we follow. The market pullback over the past six weeks – the first six-consecutive week pullback in 10 years – has been relatively modest, less than 5%. Finally, trading volumes have been relatively light, potentially indicating there is not a lot of urgency in the selling.

After considering all the above, the Committee is holding to its outlook for stocks to return 5% - 10% for all of 2011. Of course, we will continue to monitor the data and the economic and political environments.

Edited by Randy Alsman

Greg Donaldson Mike Hull Rick Roop Randy Alsman
We own many industrial stocks including Eaton.

Friday, June 10, 2011

If Analyst Estimates Are Correct, Stocks Are a Buy!

A year ago the stock market fell into a deep swoon buffeted by troubles in Greece, worries about a double-dip in the US economy, and the prognostications by many analysts that the Federal Reserve was powerless to stimulate growth.

The red line on the chart at the right shows that in 2010 the S&P 500 fell from about 1250 in April to under 1050 in June, nearly a 20% plunge.

Reading the headlines today and watching the recent activity in the stock market, one gets the feeling that we've seen this movie before. Greece is still in danger of default; economic growth in the US slowed to 1.8% in the first quarter; and the Fed has just announced that QE2 will end at the end of June.  So the obvious question is, "Are stocks headed for another 20% correction?"

We don't think so and we believe the above chart provides the best argument against a big sell off.  We explain ad nauseum that what stocks are doing in June has little correlation to what they will do for the full year.  The chart shows that stocks reversed their 2010 April-June tailspin and recovered to close over 15% higher on the year.  Those investors who sold out in the midst of all the negative blab in summer missed a terrific year for stocks.

Was there any signal last summer that told us that the stock market swoon was just noise?  Yes, analysts earnings estimates for year-end 2010 for the S&P 500, as shown by the black dashed line, never dipped.  Indeed, for most of the summer the analysts were hiking S&P 500 earnings in the face of falling stock prices.  Looking closer, the chart reveals that analysts started the year estimating that S&P 500 earnings (left scale) for the year would be about $77.  They actually ended the year at about $85.

Another clue that stocks, and for that matter the economy, were not headed for a double dip was the fact that actual reported earnings, as shown by the blue stair-step line, were moving sharply higher.

Obviously we could not have seen year-end earnings in mid 2010, but earnings in the first and second quarters were strongly and surprisingly higher.  It was clear by early July that a big earnings rebound was underway.

So where do we stand today, and what are the analysts forecasting for year-end 2011 S&P 500 earnings?  The chart at the right shows the 2011 data discussed in the first chart.

In short, the picture for mid-June 2011 is similar to mid-June 2010.  Stocks (red line) are selling off, while actual earnings (blue line), and analysts' year-end earnings estimates (black dashes) are continuing to rise.

In our judgment, the key component in this chart and in the ultimate direction of stocks is the trend of the analysts' earnings for year-end 2011.  They have risen throughout 2011 and are still trending higher.  The analysts are in close communications with the companies they cover, and if they were hearing bad news from the companies their earnings estimates would be already headed down.  We see little evidence of weakening earnings estimates among the companies we hold.

We will continue to report on the analysts' estimates for 2011 in future blogs.

This is a good time to remind our readers that we invest in global companies and not just the US economy.  Our companies produce over 60% of their earnings outside the US, with much of it coming from the fastest growing nations in the world.  We as Americans still have great difficulty conceptualizing that the US now represents only 25% of world GDP.  The global economy has become a very big place, and we no longer dominate the world's economic growth like we once did.  The good news is the world economy is growing much faster than that of the US.

If corporate earnings continue to be strong, as we believe they will, we envision that stock market activity in 2011 might turn out to be a movie that we have seen before -- down in the summer, up by year-end.

Tuesday, May 17, 2011

Becton Dickinson: Another Undervalued Stock on the Move

As I promised last time, I am showing our Dividend Valuation Model for Becton Dickinson (BDX).  BDX is the second highest ranked stock in our universe behind United Technologies (UTX) in a combination of predictability, valuation, and momentum.

The chart at the right shows the actual prices of BDX in red compared to our model's annual predictions over the last 20 years in blue.

BDX is a global medical technology company engaged in the manufacture and sale of a wide range of medical devices and instruments used by many sectors of the health-care industry. 

The Dividend Valuation Chart shows a tight fit between BDX and the valuation bars.  The R-squared is .94. 

BDX has one of the best long-term earnings and dividend growth records of any company we follow.
  1. Dividends have grown by nearly 13% per annum over the last 20 years. 
  2. Earnings have grown by nearly 12% per year.
  3. Over the last three years dividends and earnings have grown at 13.7% and 11.4%, respectively.
  4. Wall Street is estimating that 3-5 year earnings will grow at nearly 10%.
  5. The model is suggesting that based on next years estimates the stock is undervalued by nearly 14%.
A company with such a high R-squared at BDX seldom gives table-pounding buy signals.  The chart clearly shows that BDX's price has pretty much run along the tops of it annual valuation bars, but it is now buried in undervalued territory.

Health-care stocks have underperformed the S&P 500 over the last two years.  In recent weeks, however, they have perked up as investors have moved to a more defensive posture.  We would not be surprised to see BDX move higher in part because it has one of the highest expected dividend and earnings growth profiles of any stock in the health-care sector.  In short it is a standout company in a battered industry.

We own BDX in our Capital Builder investment style. Do not use this blog for investment advice.  Please consult your own investment professional for his or her analysis of the company.

Next time Johnson and Johnson (JNJ).

Sunday, May 15, 2011

Dividend Valuation Model: United Technology Is #1

Dividends play two important roles in our stock selection process.  1) They produce a cash return that has represented nearly 40% of the total return of the S&P 500 Index over the last 80 years. 2)  For select companies, dividend growth and changes in interest rates provide an excellent valuation tool.

Each week we run all the stocks in the Russell 1000 through our Dividend Valuation model.   The model does two important things for us.  Statistically, it tells us how good it has been in predicting movements in each stock over the last 20 years, and it provides us with a single formula that has produced the best fit of prices versus dividends and interest rates.

At this point in the process, we can easily identify which stocks are most "predictable."  Next we make a projection of the dividend growth for each company and estimate changes in interest rates for the coming year.  With this information, the model can now tell us which stocks are most undervalued.  Finally, we run all stocks through a multi-period momentum filter.  This tells us which stocks have what we call "sponsorship," meaning which companies are performing at least as well as the average stock over four different time frames..

This may sound complex, and the process is, but the result is very simple.  We have identified the companies that are most predictable, most undervalued, and have the best sponsorship, or momentum.

We then assign a rank between 1 and 100 for each of the three metrics for each company.  Summing the ranks for predictability, valuation, and sponsorship, we can identify the company with the highest overall total rank in  the Russell 1000 and the also among the companies we own.

Using this process, of calculating predictability, valuation, and sponsorship, we can determine those stocks with the best prospect for the year ahead

 A look at the model as of Friday reveals that the stock we own with the best overall score is United Technology (UTX).  As shown above, the model (blue line) for UTX has been very tightly associated with UTX's actual price (red line) over the last 20 years.  The R-squared is .94.  The models suggests that UTX is undervalued by about 12%, including dividend. UTX's sponsorship or momentum score is 67, which means that it has outperformed 67% of all stocks over four time frames, from 12 months to one month.  Importantly it is outperforming 74% of all stocks over the last three months.  UTX recently hiked it dividend 13%, which is about in line with the company's dividend actions over the last ten years.  Finally, earnings were recently reported as having grown 19% in the first quarter versus a year ago.  That provides a nice cushion for future dividend hikes.

There are a handful of stocks with better scores than UTX.  Our strategists are researching them.  We'll report later if any of them meet our standards.

The stock with the second highest score in our model is Becton Dickinson (BDX).  We will report on it next time.

The investment world has definitely discovered dividends.  We have not seen this kind of attention being paid to dividend investing in our own 20 years of a dividend-centric approach.  Because dividends have become so popular, we are turning our focus to valuation in our blogs for a while.  We have learned the hard way too many times that just because a company pays a dividend, or has increased its dividend for 20 or 30 years in a row does not mean that it is fairly priced.  Indeed, we see many companies with long dividend-paying track records that have already priced in the next two years of dividend growth.

If you have specific dividend-paying companies that you would like for us to review, please add a comment to this blog.  We'll get to as many as we can.    

Monday, May 02, 2011

Sell in May And Go Away . . . . At Your Own Risk

Because stocks have had solid double-digit gains over the last 12 months, we hear many people predicting that they are ready for a fall.  In addition, the "Sell in May and Go Away" crowd is giving us all the statistics of how stocks have fared between May and November historically.

The reasons given for a stock sell off are full of language about momentum, price gains, and too much-too soon. We want to add very quickly that few of the "stocks are too high" crowd today were among the "stocks are too low" crowd  at the market bottom in March of 2009.  Indeed, if you go back to their blogs and read what they were saying around the bottom of the market, you will find many of them were saying "stocks are too high," even then.

In the blizzard of words we see written about the stock market, we seldom see the word valuation.  Valuation, it would seem, has no meaning in a high-octane traders' market, where computers are trading with computers for about 70% of the daily volume.  Individual investors seem to have decided that long-term value investing has gone the way of the Oldsmobile.

Ah, but we beg to differ!   In the long-run, valuation will rule just like it always has.The reason is over the last 80 years, S&P stock prices are highly correlated to both After Tax Profits and Dividends.  The computers and traders will wage their daily battles of betting on zig or zag, but in the long-run, zigs and zags will ultimately be seen as vanity, a chasing after the wind.

From a valuation perspective, stocks are still cheap and could only become expensive if the economy were to fall off a cliff and drag earnings and dividends with it.  The chart below shows index of the S&P 500 (red line) compared to Total U.S. After Tax Profits Index (blue line).  Please note that After Tax Profits reached an all time high in December of 2010 and, based on S&P estimates, will rise by nearly 13% in the second quarter of 2011 versus the same quarter a year ago. Tracking the After Tax Profits Index is our favorite way of measuring earnings, because it measures only earnings that companies actually paid taxes on.  

The graph below vividly shows that while After Tax Profits have reached an all time high, the S&P 500 has not. In fact, the chart suggests that the S&P has a long way to go to reach fair value.

Corroborating the view that stocks are still undervalued is the graph of the S&P 500 Index (red line) compared to Total Corporate Dividends Index (blue line).  Total Corporate Dividends paid is an important indicator of the health of the current turn-around in the stock market, because dividends are paid in cash and not promises.  As the chart shows, dividends took a hit during the sub prime crisis.  Importantly the chart also shows that they have turned higher.  S&P is predicting that dividends will grow nearly 10% on a year over year basis for the first quarter of 2011.  Dividends have not reached a new high, but we believe the old record will be eclipsed over the next 12 months.  This would be good news for continued stock price gains.

These two simple, yet important measures of stock market valuations are still flashing green.  That does not mean that stocks will go straight up from here.  In our judgment, it does mean, however, that saying stocks are too high is nonsense, and "Sell in May and Go Away" is worse.

Wednesday, April 27, 2011

The Dollar's Slide: Terminal or Temporary?

We’ve had a number of clients write or call us lately concerned about the continuing weakness of the U.S. dollar. (It’s down about 10% since December against a basket of currencies.)  Here’s a representative example of their concerns:

“I feel the weak dollar (and growing weaker) is causing us problems and will cause greater problems if the world loses confidence in the US dollar as the world's monetary standard.  Oil is priced in $'s and the dollar's weakened position is costing US and world consumers.  When will the world say enough is enough and then what happens to the US economy?”

There is and old saying among economists that goes: “The solution to high prices is high prices.”  By this they mean that because of the law of supply and demand, higher prices tend to lead to lower demand.  Eventually, this lower demand will cause the sellers of the products to cut prices in order to regain the lost demand.  In this way, higher prices are self-correcting.

The dynamics of currency exchange rates are similar.  To a great extent, the problems tend to correct themselves over time.  As a quick primer, there are five major dynamics that have the most influence over the value of a country’s currency:

Interest Rates:  Holding everything else constant, higher interest rates for a given country relative to its trading partners would cause its currency to strengthen because the high rates would attract buyers.

Inflation:  Higher inflation in a country relative to its trading partners normally weakens its currency.

Balance of Trade: Shifts in a country’s balance of trade exert pressure on its currency.  Growing exports relative to imports strengthen its currency; weakening exports do just the opposite.

Budget Deficits:  Higher budget deficits as a percent of GDP weaken a country’s currency, while lower budget deficits strengthen its currency.

GDP: So long as a country’s inflation rate is muted, the higher the country’s GDP, the stronger will be its currency.

As with most aspects of investing, the expectations of how each of the above factors will behave in the future have as much impact on the value of the currency as their current levels.

This analysis, unfortunately, may produce as many questions as it answers, but such is the nature of discussing currencies.  Someone once said, “When it comes to currencies, everything affects everything.” Having said this, currency fluctuations are a daily concern for us because we own so many foreign based stocks.  Thus, based on our current holdings, we are keeping an eye on the Canadian dollar, the British pound, the Chinese yuan, the Swiss Franc, the Danish krone, and the euro.

Using the above five factors, let us offer a brief analysis of the most likely trend of the U.S. dollar over the next few years. 
  • Short-term interest rates in the U.S. are among the lowest in the world.   However, when the current round of quantitative easing (QE2) ends in June, those rates should rise, at least a little.  Further, the Fed is expected to begin raising the Federal Funds Rate (FFR) – now at 0.0% - 0.25% by year end.  So, both ending QE2 and raising the FFR should lift the US$.
  •  Core inflation in the U.S. is hovering around 1%, very low compared to our trading partners.  Thus, this is favorable for the dollar.  However, if inflation gets too high, the Fed will raise interest rates to fight it.  (Higher interest rates = stronger currency, part of that self-limiting mentioned above.)
  • A cheap dollar makes U.S.-manufactured goods more competitive overseas, helping to boost U.S. exports.  Higher exports improve our balance of trade and GDP and should give a lift to the dollar.  This is a prime example of the self-correcting qualities of a weak dollar.  Ironically, however, a weak dollar means that the cost of imports rise, especially oil.  This puts upward pressure on inflation.  Are you getting the picture of the concept of “everything affects everything?"
  • Budget deficits and high U.S. debt relative to GDP are the big killers right now for the value of the dollar.  Standard and Poors’ (S&P), in its recent change of outlook for US debt from stable to negative, said one of the reasons for the action was their belief that prospects for meaningful deficit reduction in the current political climate were low.  As you remember, the Dow Jones fell over 200 points for the day on that news, and S&P’s action jumped from the financial pages to the dinner table.  In doing so, S&P may have done us all a favor by turning up the heat on Washington to make progress on budget cutting.  S&P’s message was clear: clean up your financial house or face a downgrade of your bonds.  Downgrade or no, deficits will continue to play a role in the direction of the dollar.
  • The United States GDP is the largest in the world, so that helps.   But it is not growing as fast as GDP in the developing countries of China, India, Brazil and other Asian countries.  Indeed, U.S. GDP is growing more slowly than the global average right now, which has somewhat of a weakening influence on the dollar. 
So there you have it. Combining all these factors and comparing them with similar data from our major trading partner nations is producing a negative demand for the US dollar against most other major currencies.

We believe the two primary drivers of the weak dollar are the negative attitudes by some about QE2 and the size and growth rate of the US budget deficit.  As you know, we have been in favor of QE2 because we believe it has provided needed stimulus for the economy and consumer confidence.  We also believe the Federal Reserve has the will and the power to terminate it without disrupting the markets.  Our view has been validated by the rising stock prices over the last six months; unfortunately our optimism has not been shared by the currency traders.  With QE2 coming to an end, it would seem some pressure on the dollar should abate.  

The problem with the budget deficit is too big to solve in the near term.  Indeed, it is exacerbated by the political divide in Washington.  Yet, the problem is too big to ignore any longer.

As we have evaluated the issues surrounding the weakness in the U.S. dollar, in many cases, we believe they are self-limiting or self-correcting.  However, as we said earlier, the biggest problem facing the dollar is the lack of confidence in Washington’s willingness to make the tough decisions to limit the growth of the U.S. debt.  In light of this, pressure on the dollar may continue.

This discussion of the dollar is not simply an answer to a client question.  We deal with currency decisions everyday.  Four years ago we concluded that the dollar was likely to trend lower.  That was even before, the huge increase in government debt.  We redirected our portfolios to benefit from a falling dollar.  At present, more than 60% of the revenues of the companies we own comes from outside the US. Not only are our companies more competitive as a result of the lower dollar, but when their foreign profits are converted back into dollars, they are higher than if they had been produced in the U.S.  Additionally, nearly 20% of our portfolio companies are domiciled outside the US.  With these companies we are benefiting not only from their growing earnings and dividends, but also from the currency translations.  As an example, one of our biggest holdings is Nestle (NSRGY).  A few years ago Nestle’s stock price in Switzerland ended the year flat.  Taking into consideration the currency translations from the falling dollar versus the Swiss franc, NSRGY made a total return of nearly 11%.

Next time we’ll take a swing at the U.S. dollar’s declining importance as the reserve currency of choice.

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.