Thursday, May 27, 2010

Nestle and Procter and Gamble: Are They Safe?

I've had a lot of people telling me lately that cash is king. I don't want to pop anyone's illusions, but for my money cash is certainly not king. Indeed, cash is dust because the rate of return for cash these days is almost zero. So in a world where everything seems like it is coming apart, where can you go with confidence? I think there are many safe places where one can achieve a reasonably good long-term rate of return. The key words here are safe and long-term. If you are trading the market on a day to day basis, you will never understand the power of the words "safe and long-term." Here's what you are missing. There is an old saying that goes something like this, "He who finishes first is often, he who can last." Easy money is simply one of those oxymorons that are kept alive by politicians and late night infomercials. Anytime someone starts talking easy money to me, I start heading for the door. Making money is hard, but if one invests in companies that can "last," it puts time on your side and not working against you. Among the qualities of companies that can last, are strong balance sheets, ample free cash flows, skilled and fair-minded management, and companies that, indeed, have stood the test of time. What I mean by "companies that have stood the test of time" might surprise you: I want to invest in companies that have not only prospered over time, but companies that at some point in their histories messed up and survived. Companies that have been tested in the fires learn something about reality. They come to a new and clearer understanding of what is valuable and what is not; what is doable and what is not; and what is within both their reach as well as their grasp. Genuine wisdom seldom comes from people (companies) who have never known suffering. Truth seldom springs from the lips and minds of people who only know the taste of sweet wine and have never tasted the teeth-jarring brew of wine turned to vinegar. I'm asked every day,"Where do I put my money?" As you might guess, I tell them put it where it is safe and where you are willing to leave it. If you put it where it is safe, time alone should make you money. Most people have no idea of how to identify a safe company. Therefore their only measure of the value of the company is the current selling price of its stock. If it's going up, it's valuable. If it's going down, it's trash. That is what I used to think before the crash of 1987. On that day stocks fell 23%. It was the first time in my career that I understood without a shadow of a doubt that price was not value. I saw crazy things happen that day, even more crazy than the actions of the markets lately. I realized on that day that I was clueless about true value. I was just like everybody else. I thought price and value were always pretty close. On that day I realized that price and value were not only not identical or fraternal twins, they were like pen pals in two different countries. It was in the days immediately after the Black Monday that I set out on a quest to try to find a way of determining the intrinsic value of a stock by means other than its current selling price. It is now 23 years later and I'm still learning, but, as you know, I am convinced the true value of a company has much to do with its current and future stream of dividends. Let me use two companies as examples of the epitiome of Rising Dividend companies: Procter and Gamble (PG) and Nestle (NSRGY). US based PG has paid a dividend since 1891. They have raised their dividend for 56 years in a row. They have a AA- rating by S&P. They have had positive free cash flow almost as far back as I can see. The long-time CEO Arther Laffley just retired and was replaced by company veteran Robert McDonald. PG has adapted to the changing tides of consumer tastes as well as any company in the world. However, the company has had several serious missteps over the years when the execution of their strategy or the strategy itself was flawed and the stock took a beating. A good time to have bought PG over the last 20 years was during these mess ups. Over the last 20 years, PG has hiked its dividend at an average annual rate of 11.3%. Its stock has achieved an average annual total return of near 12%. Switzerland based Nestle (NSRGY) is another company that has rightly judged consumer tastes for years. It is the world #1 food company, selling products in literally every corner of the world. Nestle is rated AA+ by S&P. It too has had an enviable free cash flow record for the last 20 years. Nestle has a more quixotic dividend policy than PG in that it does not hike dividends every year. However dividends have grown significantly over the last 20 years. Nestle has had its brushes with trouble on a few occasions over the years. Indeed, right now it is struggling with its lagging bottled-water business, of which they are the leader in the world. Changing consumer attitudes about the ecological qualities of the plastic in bottled waters has caused sales to plummet. Nestle is working hard to solve the problem, but a solution is not at hand. I have no doubts, however, that they will get it right and find another product that will contribute to their bottom line. Nestle, similar to PG, has hiked its dividend over the last 20 years by an average annual rate of 11.7%. During this time, its stock has risen at an average annual rate of 11.6%.

We are proud to own both Proctor and Gamble and Nestle.

Tuesday, May 18, 2010

Germany's Tough Medicine Can Save Europe . . .And Others

"Americans can always be counted on to do the right thing...after they have exhausted all other possibilities." -- Winston Churchill If we’re lucky, we may be about to see the European corollary to this Churchill quote. The reverse corollary would be that European politicians can be counted on to do the right thing for their debt crisis. . . when they no longer have any other choice. (It’s probably generally true of all politicians, but for today, we’ll focus on Europe.) The sovereign debt crisis in Greece has spread to become a crisis of confidence in the European Economic Union (EEU) and has the potential to explode into a global credit crisis on the scale of last year’s subprime debt crisis. However, since Europeans – the Germans and the Greeks more specifically – are very close to having exhausted all other possibilities, there is a good chance that a positive solution could come out of the mess in the days and weeks ahead. The unfolding events in Europe prove that a monetary union without a fiscal (budgeting) union leads to chaos. Greece, which represents only 2% of European GDP, now threatens to break up the whole European Union, an area of the world with nearly 400 million people and GDP about the same as the United States. That would be like a looming bankruptcy in the state of Tennessee bringing down the whole United States. Doesn't seem possible, but it's playing out before our eyes. We are now at the point where Greece can no longer sell bonds to finance its profligate ways unless other European governments agree to back them up. And, other EEU countries – really, it’s Germany that’s in charge here – can’t afford to let Greece implode without potentially causing a collapse of the euro and their own banks. The potential positive outcome mentioned at the top would be that Germany is successful in persuading Greece and the other PIIGs countries (Portugal, Ireland, Italy, Greece) to adopt dramatic, lasting, and effective austerity measures. In addition it is critical that the EEU figures out how to put more teeth into its paper-tiger requirement that no member country have an annual budget deficit greater than 3% of GDP. If these two steps are accomplished, in our judgment, the crisis will be averted and stability will return to Europe and the world markets. Admittedly Germany's fiscal measures for Greece and the PIIGS will be painful in the short run. But from what we know of them, they are the kind of common sense budgeting that every household on the face of the earth must abide by. We are hopeful that something close to the German austerity plan prevails in the capitols of Europe. Then let's start a petition that would require that the United States send a delegation to Berlin to see what our country can learn from the Germans about fiscal sanity. This would ensure that our country will not end up one day begging the world for a hand out. Investment Policy Committee Greg Donaldson Mike Hull Rick Roop Randy Alsman, Editor

Tuesday, May 11, 2010

The Barnyard Forecast: Has Europe Changed Things?

Our regular readers, will remember that the Barnyard Forecast is our short-hand version of determining the prospects for US stocks over the next 6-12 months. The Forecast receives its name from the acronym we use to "score" the prospects for stocks: Economy+Inflation+Earnings+Interest Rates=Opportunity (EIEI=O). Economy: We believe that the huge bail out fund that Europe announced over the weekend will continue to support stocks around the world. If Europe would have continued to dither, then there would have been trouble plenty. The way it is, though, we still see 3.5% world wide GDP growth and 3% US GDP growth. We were only counting on Europe gaining 1% before the bailout, and with the new taxes and cuts in government spending, they'll be lucky to achieve even that low level. A 3%-3.5% level of economic growth is not likely to put the Fed or central banks around the world on the warpath. Thus we would rate the Economy as positive for stocks. -- 2 points. Inflation: We believe the events in Europe will actually keep inflation contained. We still expect about 1.5% core inflation for the US. That is at the lower end of Fed targets and not likely to cause Bernanke and crowd to start hiking rates before the end of the year. Inflation is positive for stocks. -- 2 points. Earnings: We started off the year predicting 20+% growth in corporate earnings. It looks like S&P 500 earnings may actually rise closer to 30% for the year. This is an outstanding underpinning for the stock market for the rest of the year. Earnings are positive for stocks. -- 2 points. Interest Rates: We still believe 10-year US Treasury bonds will likely end the year near 4.5%. That would be appreciably higher than December of 2009, and thus negative for stocks. Zero points. The Barnyard Forecast totals 6 points out of a possible of 8. That is a bullish score. In light of the bailout of the troubled countries in Europe, we believe that the path of least resistance for US stocks is up. Had the problems been left to fall where they may, a domino effect could have continued to pound world wide stock markets. However, since European leaders have put forth such a massive bailout package, we believe the markets are likely to return their focus to the fundamentals and the fundamentals, particularly in the US, are utterly outstanding. The Barnyard Forecast is only based on what it can see. It cannot see the potential for new crises developing in places that are not now apparent. But from what it can see, it still signals an environment that is positive for rising stock prices.

Thursday, May 06, 2010

The Riots in Greece Reach the US Security Markets

A friend called today and asked the question that is on every one's mind: "How in the world can the financial troubles of a tiny nation like Greece cause the world's financial markets to screech to a halt? As I listened to him I saw the stock market fall off a cliff: down 60 points on the Dow Jones, down 100 points, down 200 points, down 300, 400, 500, 600 points. I did not see the print of down 900 points because I turned away from my screen for a moment.

Before I could begin trying to explain my thoughts about Greece, my friend asked another question: "Are we going to go back to the bottom of the market we saw in March of 2009?"

My answer was quick, but I have been thinking about it ever since I saw the first riots break out in Greece. "I don't think so," I said.

"I was looking for a more positive answer from you. You have been optimistic lately," he replied.

I told him that I was much more optimistic about the subprime crisis in the US because I could see that the various important players in the drama were all doing their parts. The Fed pushed every lever they had to keep money flowing in the banking system. Congress appropriated enough seed capital to head off a liquidity crisis in the economy. Businesses rightsized their costs relative to their revenues. Consumers reduced spending but did not freeze up. The US Treasury department orchestrated a step by step program to return confidence to the banking system. This enabled the banks to raise hundreds of billions of dollars in new capital to offset the mind-boggling losses they were taking in real estate. I told my friend that as ugly as the subprime crisis was that I remained reasonably confident throughout because I could see there was a unified effort to control the damage and the full power of the United States was being invested to execute the plan. There was a will and a way to get past the crisis.

I explained that taming the financial crisis in Europe was different than taming the subprime crisis in the US for these reasons: Europe is not a single unified entity. Even though they have a common currency with a framework for a kind of United States of Europe, that little of the framework has been codified into law. Thus, the idea of Europe as a single nation is a complete illusion. Europe is still a collection of independent countries. Thus, it is quite possible that nationalistic tensions could sabotage the best intentions and plans of the nominal leaders. In short, European leaders may see a way out of their mess, but there might not be the collective or individual will to do it. In addition, there is no one really in charge. It is like a big club.

The frugal citizens of Germany do not want to loan money to the bankrupt citizens of Greece, who in turn do not want to change any of their financially profligate ways. There does not appear to be a unity of purpose, even if the resources are available to solve the problem.

My friend asked, "So is there reason for optimism that the wealthy nations of Europe can rein in Greece and the other countries that are having trouble?"

I answered, "There is and it is based on the strongest of human emotions: survival. Sooner or later the citizens of Greece will realize they are doomed as a nation without the loans. They may be burning bank buildings today, but one day soon when the lights go out and water doesn't flow from the taps, they will realize that as a nation and as citizens they have been living beyond their means so long that they are no longer free to run their own affairs. The water has been turned off, so to speak. They will agree to the loan arrangements and begin the process of trying to live with them. There is really no alternative.

Portugal and Spain are also having debt issues. Watching Greece crash and burn will be a reminder to them of where any intransigence they may harbor will likely end."

The world wide economy is gaining traction. Almost every economic measure in the US has been better than expected in recent weeks. After a long period of weekly job losses, job gains have now occurred in the last three weeks. The developing world is still growing rapidly. Indeed, economist Ed Yardeni recently reported that 60% of US exports were going to the developing world. The economic fundamentals appear to be improving almost everywhere but in Europe. That is not likely to change with the internal squabble that has erupted.

The economic world did not just evaporate today. There are many rumors of so-called "black-box" automated trading systems that generated errant trades, causing precipitous falls in stocks ,which had no negative news of any kind.

So the eternal question hangs heavy in the air: Was the market efficient today? Did the economic underpinnings of companies really fall by as much as did the market prices?

I think what we are seeing is a pure trading frenzy that has little to do with the intrinsic valuation of underlying companies. Here is the best proof I can offer of this. Procter and Gamble, one of the largest, best managed companies in the world, a company that has paid a dividend since the late 1890s and who has raised their dividend for 53 consecutive years, was selling for around $60 late in the afternoon. In a matter of moments the stock fell to $39.37. It then climbed all the way back to close at $60.75. PG's stock movement today had nothing to do with its underlying value. It had everything to do with the noise and mayhem of a video game played by hedge fund tech-savy kids with real money.

Does it mean that we long-term investors have to acquire the latest programed trading machines, so we can beat the money gunners at the their own game. Heavens no. There is a secret that we know about Procter and Gamble that the money gunners could care less about. Over the last 20 years our model indicates P & G's annual price gain has been nearly 90% correlated to its annual dividend increase. At it current dividend rate, our model says Procter and Gamble is very undervalued. As for me, I would rather trust 20 years of mathematical probabilities that one day of video game idiocy.