Friday, May 22, 2009

Green Shoots For Deere

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

Thursday, May 14, 2009

Dividends Are Still the Linchpin

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

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

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

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

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

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

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

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

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

Monday, May 04, 2009

Stocks: Climbing a Wall of Worry

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