Wednesday, November 26, 2008
I have a contrary rule that has worked well over the years. When the sirens of Wall Street are trying to canonize Warren Buffett, don't get too excited about his company, Berkshire Hathaway. When the street is treating him like a guy whose run of luck has run out, get interested in his stock. I noticed this contrary indicator during the tech bubble. Buffett was excoriated for not getting on board that wave to nowhere. I remember a writer on one of the financial websites saying that Buffett should apologize to his shareholders. Well history shows that Mr. Buffett was wise in staying far away from the tech bubble. In the intervening years, his ascent to cult figure status began again when it was clear that Buffett had made the right moves during the tech craze. Over the last 12 months, Berkshire Hathaway stock has fallen nearly 30%. That is less than the S&P 500, but very un-Buffettlike. Lately, he is being chastised for making what now look to be bad investments in Goldman Sachs and GE. His insurance company has not had a good year, and his options bets seem to be going in the wrong directions. To all this, I say only look at the body of this guy's, work and you see something we are never likely to see again: a guy who not only makes a lot of profitable decisions; he makes them in tough times. Our valuation model for Berkshire Hathaway Class A shares (above) shows that its price is buried deep into its value. The model says that BRK should sell for nearly $140,000 twelve months from now (striped bar). Today it closed at just over $100,000 per share. Our model is based on a multiple regression of BRK's book value and interest rates. It isn't a guarantee or a promise. It is just a model that has done a pretty good job of tracking BRK's price over the last 15 years. In these crazy markets, has Mr. Buffett lost his touch? With his track record, I don't think it would be wise to bet against him. We own the stock. Do not make investment decisions based on this blog. It is for information purposes only.
Tuesday, November 25, 2008
It has been my contention since my March blog that the subprime crisis would eventually lead to the government buying subprime loans. I likened it to an icebreaker. Frozen subprime assets clogged banks', insurance companies', and other financial institutions' balance sheets and, thus, blocked the free flow of capital and normal economic activity. That is the reason that I was at first optimistic when the TARP plan was announced to do just as I had hoped. My optimism was dimmed when the TARP plan was altered in such a way that the purchase of the frozen assets was set aside in favor of direct government investment into the major banks. I was certainly not against the infusion of government capital into the banks, there will have to be more of that, but in my judgement, the frozen assets won't just thaw on their own. They must be broken up by the government. Today's announcement that the Fed will buy up to $600 billion in Fannie Mae and Freddie Mac notes and mortgage backed securities (MBS) is a giant step in the right direction and should push mortgage rates lower and benefit housing. It does not assure that subprime assets will be bought because the details of the plan have not yet been made public. But here is my thinking, today the Fed also announced that they were buying up to $200 billion in "AAA" rated asset backed securities backed by auto loans, education loans, credit cards, and SBA loans. The Fed's announcement regarding the purchase of mortgage backed securities made no mention of the ratings of the mortgages to be bought. I have a gut feeling that they plan to purchase mortgage backed securities with ratings lower than AAA. If they do that, they will begin the unfreezing process. The reason that I think the Fed will begin to buy loans with lower ratings is because there is a reasonably efficient market for AAA rated MBSs. It is the lower rated MBSs that are frozen. I'm hoping the lack of a rating announcement today means that the Fed is beginning the process of breaking loose the MBSs that include subprime collateral. If it does, it should significantly improve the housing market by freeing up billions of dollars that can be loaned to willing and qualified buyers of homes.
Friday, November 21, 2008
Timothy Geithner is a person you probably don't know much about; you may have never even hear his name, but over the next four years, you'll get to know him very well. The reason is simple: Geithner has apparently been tabbed to be the next Secretary of the Treasury. Perhaps his job is now behind only the President of the US in power, influence, and importance. I have been hoping that he would be named for the position for the last several weeks. I spoke with a writer from Reuters right after the election, and she asked me who I thought should be the new Secretary of the Treasury and I said "the Chairman of the New York Fed." I couldn't even remember his name. It even surprised me at first, but then I realized that in his position as Chairman of the New York Federal Reserve Bank, he had been instrumental, according to news reports, for the actions taken with Bear Stearns, AIG, Lehman Brothers and probably a host of others. He has had skin in the game, so to speak. The other candidates President-elect Obama apparently considered were Lawrence Summers and Paul Volker. In my judgement, Summers is certainly qualified for the job and perhaps would offer some name recognition, something that might help us through this period of lack of trust. However, as I rolled his name over in my mind, I kept coming up with the thought that if he could't handle the faculty at Harvard, how would he handle the power elite of the world. As for Paul Volcker. I cringed when his name came up on the list. Don't mistake my thinking here. My admiration for what Mr. Volcker has done for this country is very high, but he is 81 years old and I questioned whether or not a man, even a brilliant and strong man, of his age could withstand the 24 hour-a-day struggle that lies ahead for the new Secretary. Geithner is 45 years old and has been instrumental in working through international financial crises going back to the Clinton years. He is in a powerful position now as New York Fed Chief, and by all accounts, he has a thoughtful and deliberate style, but is a bold decision maker. The stock market certainly liked Mr. Geithner's slotting. The market was trading about flat when I first saw the news, within the next 30 minutes it was up nearly 500points. Secretary Geithner just gave us a good day; let's keep him in our prayers in hopes that he might give us many more. Click here for Mr. Geithner's bio.
Thursday, November 20, 2008
I have managed money using some form of a dividend investment strategy for nearly 20 years. In 1993, I discovered that a "rising" dividend strategy produced better results than just focusing on high dividend yields alone. Indeed, I call that 1993 discovery my eureka moment because I was not expecting to find such a relationship, and it came almost by accident. I'll share the story in a future blog. The question I have been asked a lot recently is, "What if we have now entered a time when dividends won't be rising anymore. Indeed, what if we have entered a time when dividends will be falling for most companies? How will you decide what stocks to own, then?" If the economy slows as much as the alarmists are telling us, then the universe of rising dividend stocks from which we would have to choose would shrink. However, in the tens of thousands of stocks that trade on the world's stock exchanges, we firmly believe there will still be a group of 25-30 wonderful companies whose dividends would still be rising. Those would be the stocks on which we would focus and build our portfolios. Thankfully, we have had very good dividend growth in our portfolios over the past 12 months, and based on our research we believe most of our portfolio companies will have dividend hikes again in 2009. Over the last twelve months in our Cornerstone Investment Style (our main dividend style), we have owned 31 companies. In that time, one company cut its dividend, and we sold it immediately, and two other companies have cut their dividends, but we have held them because our dividend valuation models indicate that the companies are still solid values. The remaining 28 companies have all raised their dividends at an average rate of just over 11%, about the same as the portfolio's recent 5-year average dividend increases. These dividend increases in the face of one of the worst economic crises in memory convince us that dividend growth is not a thing of the past. In these bear markets it is important to remember that while almost all stocks are moving with the bearish trend, the prospects for all companies are not going down. Indeed, I believe the great majority of our companies will have better earnings and dividends in 2009 than they did this year. Our companies are unique in that they are very adaptable, as well as being multinational. They can shift resources anywhere in the world to where ever the sweet spots lie. These are very tough markets and good news has been hard to find, but Bloomberg had an item that will give you some idea of how cheap stocks have gotten. For the first time since 1958, the dividend yield of the S&P 500 is now higher than the yield on a 10-year T-bond. In addition, the PE ratios of the S&P and Dow Jones Industrials, based on next years expected earnings, are also at a multi year lows.
Tuesday, November 18, 2008
Hats off to Vectren (VVC), our home town utility. VVC recently announced their 49th consecutive annual dividend increase. That puts the company near the top of the list of companies with the longest uninterrupted strings of dividend hikes.
VVC provides regulated gas and electric services to approximately one million customers in Indiana and Ohio. They also have a non-regulated division that is involved in power sales and management, and VVC is one of the largest coal producers in our area.
Vectren currently yields 5%, and our expectation is that its dividend will continue to grow over the next 3-5 years at just over 3% per annum. Three percent growth may not seem like much, but when added to its current 5% yield gives a projected total dividend return of 8%. That's not bad when compared to the 3.5% current yield on a 10-year T-bond, especially when considering the defensive nature of the utility business and VVC's long history of success.
Finally, the lower chart above shows that 5% is at the high end of VVC's dividend yield range over the last 7 years.
The current management team of VVC, headed by Niel Ellerbrook, carries on a long tradition of being good stewards of their shareholders' and their customers' trust.
Monday, November 10, 2008
By Randy Alsman, VP and Portfolio Manager The bear market of the last year coupled with the seemingly spasmodic daily jumps and falls in price have shaken the confidence of many investors. Many days it seems that logic has left the building, with apologies to Elvis fans for borrowing the phrase. Also, people caught up in the visible market’s gyrations can lose sight of what the market really represents. A brief refresher might help restore faith in long-term investing for at least some of you. The stock market is nothing more than a place for centralizing and organizing the exchange of value. One part of that exchange is most often money…cash. That’s the visible part if you will. The other part of that exchange is equally, if not more, important. That other part, sometimes lost in the drama, is ownership. In the case of the stocks that we focus on, it’s ownership of some very high-quality companies. More specifically, shareholders own parts of tangible, and even more importantly, intangible assets. Obviously, buildings, equipment, inventory, etc. are some of those assets. And they have real and often significant value. But down yet another layer, shareholders own the most powerful and valuable of assets – ideas. Those ideas can be comprehensive and formal, such as patents, copyrights, and brand equities. A powerful new drug, a more energy efficient jet engine, a brand name that evokes high quality, are all intangible assets that can generate billions in revenue and profit. Equally or even more powerful are the smaller, daily ideas of thousands of employees trying to figure out how to better serve customers, outsmart competitors, or do their job more efficiently. In the best companies, job candidates are screened for their ability and tendency to think that way. Once they’re hired, millions of dollars are invested in training them to get even better at those thought processes and how to act on them more effectively. None of those intangible assets are much affected by short term stock market moves. Think about yourself, you go to work every day with some part of your brain trying to figure out how to do something better, earn a promotion through superior results, stretch your department’s budget to accomplish more with less, etc. Often, a setback on a project or a market downturn actually can cause you to work even harder for great new ideas. Those intangibles are the most powerful assets owned by an investor in a high quality company…the hearts and minds of thousands of talented, motivated people working every day to create more value. They can be defeated, and some of them are each day. But far more are finding new and better ways to win. When they do, they add to their small part to the larger total value that their shareholders own. When the market and the economy go through their down times, don’t lose sight of what a long-term investor in great companies actually owns. He owns a powerful force that does not accept permanent defeat. In total, across a portfolio of top companies, those hearts and minds have always found a way, and I think they always will. Hearts and minds may be the most powerful argument for taking the long view when investing. Temporary defeats may grab the headlines. The best employees of the best companies, however, never stop trying…and then they succeed. Those successes are often not directly reflected in stock prices over a few days, weeks, even over many months. But, for those who take the longer view, those accumulated victories have been rewarded handsomely.
Labels: Philosophy of Investing
Friday, November 07, 2008
By Rick Roop, VP and Portfolio Manager With President-elect Obama having been ahead in the polls for many months, we have been digging into his statements on his proposed energy policies trying to figure “what’s next” particularly in the area of the electric generating industry. This industry has been in a state of confusion ever since it became clear Obama would likely be the next president because of the great differences between his public statements on the environment and reliance on alternative energy and the policies of the Bush Administration. This confusion has left a big question mark in the minds of many in the utility industry as to where to invest capital for the next generation of electricity producing assets. According to the most recent Annual Energy Outlook from the Department of Energy’s Energy Information Administration (EIA) electricity demand from 2006 to 2030 is expected to increase 25%, using the middle forecast; 30% if you go with the upper forecast. However, nowhere in the report is there a weighting for the additional load required from the use of electric cars by U. S. citizens between now and year 2030. According to the Obama/Biden New Energy for America Plan, a goal is to place at least 1 million Plug-in Hybrid cars on the streets of America by 2015. The production of electricity is a highly capital-intensive business. New power plants, transmission lines or gas pipelines are not only very expensive but they take years to build. With the recent crisis in the financial markets, financing has become more difficult and expensive, adding more risk to any utility wishing to add additional capacity. Add to that the 5 to 7 years it takes to permit and build a coal fired or nuclear plant, and you have just layered on additional risk to process. Our research at DCM has led us to choose utilities that in the short term (3 to 5 years) appear to have low risks in the areas of finance, regulatory environment, and industry concentration as we wait for a concrete Obama plan to come into view. One such company in our opinion that meets this risk profile and yet offers solid growth potential is Southern Company (SO). For over 25 years through my work with the International Society for Automation, I have been privileged to get to know a wide range of SO’s managers. I believe they are among the most “heads up” of all electric utility management teams in the nation. Southern Company is a good fit for our clients at DCM because of management’s ability to minimize their risk profile without limiting opportunities for growth. This has been accomplished by successfully maintaining 85% of their business under the protection of the regulated utility umbrella, while building a competitive wholesale business outside the regulated service territory. Southern company has leveraged their ability to generate good profits under their protected territory by maintaining a very cooperative relationship with regulators. As a further hedge against risk, it has been Southern Company’s policy to insist on fixed long-term energy contracts for capacity added outside their protected territory. Going forward we believe that any utility with fossil fired power plants will come under much tighter clean air regulations, which will in the end drive costs up for the end consumer. New clean air compliance equipment will raise the cost of production for all coal fired power plants. As a result, any utility that can avoid or diminish these costly capital additions will increase their profit margins. Southern Company will benefit in this regard because they are already 15% nuclear and have applications in place to increase that level. Southern is a rare utility in many ways. They have maintained an A debt rating, which makes their cost of capital lower than many companies in the industry. They serve a part of the country that is experiencing population growth, thus, they are growing faster than many utilities. They have a long-term track record of increasing their dividend. With a current dividend yield of 4.9% and prospects for dividend growth in the 4% range, SO offers a generous potential return from a high quality company that sells a product we can’t live without. We own the stock. This blog is for information only. Please consult your own financial advisor about SO.
Wednesday, November 05, 2008
President-elect Obama has promised to roll back the Bush tax breaks on dividends and capital gains. Many people have asked me if such a change in taxation would change our favorable view of companies with consistently rising dividends. The answer is no. Many years ago I experienced a kind of eureka after an extensive look at 50 years of data for the Dow Jones Industrial Average (DJIA). I found that dividends and earnings were both highly correlated to price over this long expanse of time. But there was an important difference. Earnings had an annual standard deviation, think volatility, of nearly 23%, while dividends had a standard deviation of just over 8%. Indeed, I was surprised to find that DJIA earnings had a higher standard deviation than that of the Dow's price, which has been 14.5%. Annual dividends have fallen very few times over the last 50 years, while earnings have fallen about every 4 years. In short, I found that using dividends in combination with interest rates could produce a very tight fit between a prediction of the year-end price of the Dow and what actually happened. In our investment strategy, dividends represent not only a cash payment to us, which we prize, it also serves as a sort of tracer bullet to let us see the trajectory of the path of the market. The only change we may make in our clients' portfolios is that for clients in the top tax bracket we may suggest they switch to our Capital Builder investment style, which features lower dividend yielding stocks whose dividends are growing much faster than the average company. The overall performance difference between Capital Builder and Cornerstone (our higher yielding, lower dividend growth investment style) has been very small.
Monday, November 03, 2008
By Mike Hull, President Portfolio Mgr. and Greg Donaldson Director of Portfolio Strategy
Nearly 15 years ago Mike Hull oversaw the building of a plant for a Fortune 500 company in China and was instrumental in marketing the firm's nutritional products throughout the country. After his time in China, he came back to the US with the notion that the Chinese had gone too far down the road of capitalism to turn back, but they still had a lot to learn about the rule of law in property, both real and intellectual. He says that the best way to understand China's business prospects is to understand that the Chinese government will do anything they can to keep economic growth going strong. They need economic growth to keep the millions of peasants that have come in from the countryside working. Any long-term disruption in economic activity would throw people out of work and be a threat to the Chinese Communist Party.
Mike believes that among foreign companies, Procter and Gamble, (PG) caught on to the Chinese way of doing business earlier than most other companies. He remembers early on PG sold shampoo in small tubes that might resemble samples in the US. Yet in China these small tubes of shampoo, which were still expensive to the average Chinese worker, were a sign that a family was moving up in the world, and Chinese women by the millions bought the tubes of shampoo almost as a status symbol. Today P&G does about 20% of their business in Asia and it is growing very rapidly.
PG now does less than 50% of its business in the US, and that figure will continue to fall as developing world growth, albeit slowing, continues to outpace US growth.
The chart above compares the dividend yield of PG versus the yield of a 10-Year US Treasury bond over the last 20 years. We have been showing these "yield" charts because we believe they tell a powerful story: many high quality companies are very cheap.
Our research reveals that in the case of companies that consistently raise their dividends, which PG has done for over 50 consecutive years, the long-term growth of their prices will mirror the long-term growth of their dividends.
The chart shows that 20 years ago, investors expected PG's dividend to grow about 5% (8.5% - 3.5%) That is what it would have taken for PG's total return to equal a T-bond's yield ( 3.5% dividend yield plus 5% price growth).
Looking at the right hand side of the chart, we see today that investors are only requiring dividend growth of 1.5% for PG yield to equal a T-bond's yield. We realize, of course, that there is great fear in the market, which has driven bond yields down and PG's dividend yield up, but we think it is highly probable that PG will grow its dividend by more than 1.5% over the next few years. Especially since they are doing more and more business in China and the developing world.
We believe PG will continue to build their businesses in the fast growing parts of the world, and that they will likely increase their dividend in the range of 8%-10% over the next decade, just as they have over the last 50 years. If we are right, PG's total return over the next 10 years will dramatically outperform that of T-bonds.
We own the stock. This blog is for information only. Please consult your own financial advisor about P&G.