Sunday, July 31, 2005

Summer Stroll #15 -- Cheap, Very Cheap

Earlier on the Summer Stroll, I said that the DJIA's dividend has had over an 90% correlation to its stock price during the past 45 years. I stumbled on this bit of data in the early 1990s, and it is the primary reason I began to study dividends. If you look at other price correlations such as earnings, GDP, book value, etc., you also find correlations that are high. Earnings have about the same correlation as dividends, GDP is in the range of 80%, and book value in the 70% range. As I explained in Summer Stroll #3 my decision to use dividends as my primary indicator of value was simple: Dividends have far less volatility than earnings (about a third as volatile). That means dividends are easier to predict, which ultimately allows for the computation of a narrower "valuation window" for the DJIA. A few years ago I began studying the correlation of combinations of financial data on DJIA price. I found that adding bond yields to dividends could explain the price movement of the DJIA at over the 95% correlation level and also lowered volatility. Computing a multiple correlation on today's market using only the DJIA's current dividend and the yield from a long-term corporate bond, results in an expected price level of 11,540. Combining dividends, earnings, and interest rates results in a expected DJIA price of 11,800. Any way you slice it, the stock market, as measured by the fundamentals of the Dow Jones and interest rates, is cheap, very cheap. In my judgment, the only thing that is holding the market back is the threat of higher oil prices. High oil prices have had remarkably little effect on inflation or the economy, but they are seen as a wild card by big money. That is the reason that stocks have had such a tough time getting through the 2000 highs. My sense, however, is there is a day coming soon when the market will reconnect with its historical relationships, and stocks will spike higher toward the range of values my multiple correlations are indicating.

Sunday, July 24, 2005

Summer Stroll # 14 -- Out of Your Mind, Not Out of Your Head

This past week the Wall Street Journal reported the findings of a study from the field of neuropyschology. Researchers at Carnegie Mellon, Stanford, and the University of Iowa reported in the journal "Psychological Science" that a certain kind of brain-damaged person makes better investment decisions that a control group. "The 15 brain-damaged participants that were the focus of the study had normal IQs, and the areas of their brains responsible for logic and cognitive reasoning were intact. But they had lesions in the region of the brain that controls emotions, which inhibited their ability to experience basic feelings such as fear or anxiety. The lesions were due to a range of causes, including stroke and disease, but they impaired the participants' emotional functioning in a similar manner. The study suggests the participants' lack of emotional responsiveness actually gave them an advantage when they played a simple investment game. The emotionally impaired players were more willing to take gambles that had high payoffs because they lacked fear. Players with undamaged brain wiring, however, were more cautious and reactive during the game, and wound up with less money at the end." While the researchers admitted that more investigations were needed before a definitive conclusion could be made, I believe the finding are in keeping with the two articles I wrote on My 28, and June 2, entitled "The Adversary." In those articles I stated that investment decisions made out of greed or fear, were doomed to failure. To make matters worse, the financial media is in the business of endgendering greed and fear. Thus, to get your head straight, so to speak, and improve your odds of making decisions from your reasoning mind, instead of "out of your mind," it is imperative that you have a valuation tool. A valuation tool that is simple and intuitive. A speedometer or barometer of sorts, that will give you an honest reading on the investment values of the day. I have studied this matter for nearly 20 years, and I believe that tool should be the dividend. There is an illusion in the land. It is the illusion that the market is always right. Academia proclaims it. Wall Street preaches it. The media contorts and confuses it. I talk to too many people every day, who are betting on the news with everything they've got. They always want to keep their powder dry when uncertainties push the market down; they can't resist charging ahead when prices are spiking higher. They know they ought to do the opposite of what they feel, but they seem incapable of getting beyond their feelings and getting on the right side of the ups and downs of the market. They think that every new terrorist attack or bad earnings report or Fed rate hike is the beginning of disaster. They believe that a "60 Minutes" expose on the "evils" of a company they own will destroy the company; they believe every tout that CNBC makes is a sure winner. They are wrong. They are wrong. They are wrong. But few really learn from their mistakes because few understand that it is precisely their "feelings" that is blinding them to the reality of the situation. The media is in the entertainment business, nothing more, nothing less. No one ever became truly successful by following the medias' picks and pans. The only time I read the Wall Street Journal is on my vacation. It's for fun. If I am correct, even remotely, you must get busy and find your barometer, your speedometer, or your weathervane; whatever you are going to use to measure the actual weather of the day. And you must test this measure of investment value over time against your own gut feels. Few people I know who have adopted the value-investing approach are whip sawed by the market. I know what you are thinking, but you can't go there either. Buying a bunch of mutual funds to gains someone else's valuation tools can be just as fraught with fear and greed as doing it on your own. What fund are you going to buy? Well of course you'll buy one with a good track record. But that methodology has been studied ad nauseum, and it has been found wanting. Yesterday's winners are not necessarily tomorrow's winners. As Mike Hull, our president says, "Every day more people with more money than at anytime in history are retiring, who must earn their retirement wage out of a finite body of capital for as long as 30-40 years." The job can be done. It can be done for most people safely and surely. But for those who are trying to feel their way along, who trust every Wall Street claim, who recoil at every media sniping attack or dose of bad news, they will begin and end everyday of with the same question: What next? On the contrary, those who know value will look to be buying when people are most pessimistic and be selling when everyone is bullish. To be continued.

Monday, July 18, 2005

You've Got to be Kidding

I said at the beginning of this adventure, that I would limit my comments to dividends and dividends only. I did so because I wanted to offer an indepth look at the world of dividends in bite-sized pieces. But something happened on the way in yesterday morning that literally blew my mind, and I feel compelled to pass on my thoughts on the economy. NPR, that bastion of capitalism, provided results of a recent poll that showed 53% of American believe the economy is on the wrong track. My recollection is the reporter said that only 43% think things are good. As I heard the announcer breathlessly discuss the significance of these data for the political races in 2006, I found myself saying out loud, "You have got to be kidding me." Then I heard myself say it again, "You have got to be kidding me." Then,"What planet is this yehhoo from." Then I remembered that the NPR correspondent was from Washington DC, that tiny planet near the earth. But even if the analysis is from another planet, it is just utter nonsense. By almost any historical measure, the US economy is very strong. I'm not talking OK. I'm talking Strong. The following is a short list of recent economic data from, an on-line economic and market research firm. 1. Real GDP is at record levels. 2. GDP growth of 3.8% over the past year is well ahead of the 3.1% average since 1970. 3. The June unemployment rate at 5.0% is below the past 30-year average of 6.6% for June and lower than all but five of those years (the low was 4.0% in the bubble year of 2000). 4. Industrial production is at record levels. 5. Housing starts are running at record levels. 6. Home ownership is at record levels with 69.2% of households owning homes. That includes 53.0% of households that have below average income. 7. The year-over-year increases in total CPI is a very modest 2.5%, despite higher gas prices. 8. The 10-year note yield is at an amazingly low 4.17%. 9. Corporate profits are at record levels, and growing at a 10% annual rate. 10. The dollar has rallied sharply from 1.35 euros to 1.21 euros over the past 6 months 11. The budget deficit forecast has dropped $100 billion due to strong tax receipts the past six months, and the deficit has a percentage of GDP is forecast below 3%. That is lower than most major European countries and Japan. Of course we have terrorism, the war in Iraq, and oil prices approaching $60. These are all problems that have been with us for awhile, and I believe the American people are adapting to them remarkably well. Life is going on. NPR and the East and West coast media can have all the opinions they want. They can even use their dwindling power to put forth their view that things could be better. But they have no right to play fast and loose with the facts of the economy, and in my judgment that is what they are doing. Any developed nation in the world would ring church bells for a week (Thats all they do with Churches in Europe) if they had the kind of strong economic growth coupled with low unemployment rates we have. Our goods friends the French and the Germans, who seem to want to lecture us about how to do things regularly, have economic growth less than a third of ours and unemployment twice our 5% rate. Maybe NPR, the New York Times, the Lost Angeles Times, France, and Germany are, indeed, on another planet, where the miracle of the free market economy is a quaint old-fashioned idea from an eccentric Scotsman. I have no idea how the current "very good" economy will play in the next election. I do know that the American people will not learn about it from the mainstream media. I guess Americans will just have to figure it out for themselves. In that case, we need to pass on the truth to one another. The statistics I show on this page are from one of the most respected research firms I know, and I have double-checked them. Please forward this blog to as many people as you think would benefit from knowing the truth. Let's help get the truth out to counteract the "kidding" that is emanating from the media elite.

Thursday, July 14, 2005

Summer Stroll#13 -- Two Buckets*

A recent question from a reader asked what a rising dividend stock might mean in retirement, and if non-growth high yield stocks ever work. This is the way I think of it. A rising dividend stock has two buckets of return, a cash bucket and a price appreciation bucket. Let's use Wells Fargo as an example. WFC's dividend yield is currently 3.5%. That means on $1,000,000 the actual cash income is about $35,000 per year. So the first bucket produces a predictable and growing cash of that amount. The second bucket comes from the dividend growth of WFC. It is not guarantee or consistent, but the odds of its coming are very high. We currently estimate that WFC will increase its dividend by 10% per year. This is about 3 to 4 times what we estimate inflation will trend over the next decade. If WFC does in fact hit our target, we would expect its price would also grow about 7-10% per year. That means the second bucket would produce an annual return of between $70-$100,000. It will be spotty and come and go, but over the next decade, we would expect this sort of annual gain. Obviously, the total of the two buckets is between $105,000 and $135,000, or 10.5-13.5% annual returns. These kinds of rates of return seem out of reach, judging from recent experience, but if WFC's price does not go up the dividend yield will continue to rise, and the first bucket will continue to increase. Under this circumstance, the total return will not be as much as if the price rises along with dividend growth, but the buckets will continue to increase in value. Companies with stagnant dividends only have the income bucket. The only reason they would rise in price is if interest rates fall, which we do not believe will happen. Thus, pure high dividend yield is not the same as rising dividend investing. As the commentor said, we would choose a bond over a stagnant dividend stock. *PS. Someone just mentioned that there are really three buckets, and I have to admit that, strictly speaking, there are, indeed, three buckets. 1. Current dividend income bucket. 2. Dividend increase income bucket. 3. Price appreciation bucket. I'll have to think about the second bucket. It might really be a part of the first bucket. I do believe the power of the whole bucket approach, however, is that the dividend growth (2nd bucket), not only increases cash flow but also pushes price higher. I'll let it brew a while. I might come back and rename this Three Buckets.

Wednesday, July 06, 2005

Summer Stroll #12 -- Under the Sun

To everything there is a season, and a time to every purpose under heaven. Ecc. 3:1-8 I think I must have read the Old Testament book of Ecclesiastees a dozen times before I began to understand why it was included in the Bible. I will not go into its deeper meanings here, only to say the teacher who wrote this book foresaw that there really wasn't much new under the sun. It has all come before; it will all come again. Here's my point. Over the next decade, I believe the dividend payout ratio for the Dow Jones 30 Industrials and other major large-cap indices will return to their 80 year averages of 50%. That may not make you want to turn cartwheels in the office, but it is a very big deal. In almost every decade since the 1920s the companies in the Dow Jones Industrial Average have paid out approximately 50% of there earnings in dividends. For whatever reason, beginning in the 1990s the payout ratio began to trend down and it reached as low as 30%. It now stands at about 33%. Over the next 10 years, I believe it will move back to its historical norms. Wall Street is estimating that earnings will grow at about 7% per year over the next 3-5 years. If that is the case, I believe dividends will grow at 9%. At this 2% premium growth of dividends above earnings it will take about 8 years to return to a 50% payout for the overall DJ 30. The reason is simple. Profits are growing nicely, cash flow is growing even better, and costs are under control. Capital expenditures will be weighed very carefully vs outsourcing. Companies must turn the tide of negative press, and clean up legal issues to regain the trust of the American investor. Talk won't do it. Good intentions won't do it. Cash will do it, and the season is right. Little by little investors will discover that dividends are real money and they will, in time, flock to companies that are increasing their dividends. A time to tear down, a time to build up.[Order of verses reversed]