Saturday, June 25, 2005

Summer Stroll #10 -- 15% Anyone?

At the beginning of trading on Friday June 24, if you would have looked at Bank of America in the Wall Street Journal or other financial media, you would have seen the following: Price Dividend Yield $46.60 $1.80 3.86% During the day, BAC announced an 11% increase in their annual dividend. As the market opens on Monday the 27th the Wall Street Journal will look like this: Price Dividend Yield $46.75 $2.00 4.28% A remarkable event occurred that will be almost completely missed by 99% of investors. BAC increased their dividend by 11%. However, at Donaldson Capital Mgt., it is as though the heavens have opened and someone threw out some stone tablets guiding us toward successful investing. Here's what the stone tablets are saying to us. 1. BAC, which is a nationwide financial services company, is giving us our cut of their profits for the last 12 months. That seems fair and not unusual, but in our judgment only about a fourth of the companies in the S&P 500 pay a fair dividend. 2. In increasing their dividend, they are signaling to us that they believe they can continue to grow earnings and dividends in the low double digits. Wall Street estimates for earnings growth are more in the 9% level. In our minds, BAC is saying to anyone who wants to listen, "We are going to grow faster than the street thinks." 3. BAC is saying we know the future is uncertain, indeed, our whole business is built on lending money to people taking chances, which might fail, but we believe economic growth and corporate profits will continue their current trends. In a manner of speaking, you can say we have bet the whole company on it. 4. If you buy our stock, we believe you will make somewhere near 15% per year over the next 5 years. You will notice I do not have quotes around this last comment, because BAC did not say it, but simple math shows us that a 15% compounded return is the end result of everything else they are saying in raising their dividend by 11%. Here is the simple math: If BAC's dividend grows at 11% per year over the next 5 years, they will be paying a dividend of $3.40 in 2010. To determine BAC's price might seem like a big stretch, but I believe those stone tablets tell us the very best guess is that the stock will trade for at least $84.25. To compute this price all I am doing is dividing BAC's projected 5-year dividend of $3.40 by 4%, which is BAC's average dividend yield over the last 5 years. A person can debate this simple method of determining expected price all they want. But BAC is one of those companies that has had a very predictable dividend growth pattern and the statistics and the odds greatly favor the outcome I have put forward. But, you may ask how do we make 15% when the dividend is only growing at 11%. It's simple, the dividend yield is starting near 4% and combining the 11% annual dividend growth, which based on the historical data will mean that prices will also grow at about 11% per year, we arrive at a total return of 15%. I really believe you must grab hold of this concept of "implied return." This is the best way to make decisions about stocks with your head instead of your emotions. We have used BAC as an example many times. It is a favorite of ours, but we will discuss in an upcoming article a few companies in our portfolios that have as high as a 17% "implied rate of return. Now pause for a moment and consider the alternatives. a 5-year Treasury bond is yield 3.5%. I don't know about you, but 15% with some modest risk sounds a whole lot better to me that 3.5% with no risk. Let me say that again: 15% with some risk sounds a whole lot better that 3.5% with no risk.