Thursday, December 28, 2006

What's Berkshire Hathaway Worth, Anyway -- II ?

In October I shared a valuation analysis of Berkshire Hathaway Cl A common stock based on a multiple regression of BRK/A's book value and interest rates compared to its price. While the calculation is very simple it has had a surprisingly good fit with BRK/A selling price over the last 15 years.

At the time, based on the book value through mid-year, I estimated that the year-end 2006 fair value of BRK/A was about $105,000 per share. The chart above shows that Mr. Buffett's stock will likely finish the year near $110,000 and, according to our model is slightly over priced. Having said this, I have estimated BRK/A's year-end 2007 book value at $77,000. Using that figure and my estimate of interest rates, I arrive at a 2007 year-end "fair value" for BRK/A of just over $124,000. That is approximately a 13% expected return.

That seems like a good bet to me. Berkshire Hathaway is in a sweet spot in almost all of their businesses. I am still in the camp that believes that housing problems will slow economic growth more than expected. If this is the case, there is no stock I can think of that has more quality and profit potential than BRK/A.
PS. If anyone has a book value guess that you would like for me to plug into my model, please comment below, or email me. There are no Wall Street estimates that I see that I believe are reliable.

We own the stock in our Capital Builder style of management. It is the only stock we own that does not pay a dividend. DCM employees and my family own the stock.

This blog is for information purposes only. Do not make buy and sell decisions based on anything you read here. Please consult your own financial advisor.

Monday, December 25, 2006

Altria is Most Overvalued Dow Stock

Last week we explained that our Dividend Valuation Model was signalling that the Dow Jones Industrial Average was about 10% undervalued. We showed that with GE's recent dividend hike it was nearly 25% undervalued and one the cheapest stock in the Dow.

The obvious question that report raised was -- are there any stocks that are significantly overvalued? There are two stocks that our models rate as overvalued by at least 20%, Hewlett Packard, and Altria, the former Philip Morris. Of the two, Altria's Dividend Valuation Model is most convincing.

The chart below shows that Altria's current price is approximately 20% above its valuation "steps." The model also shows that the two previous times in the last 20 years when MO became overvalued for an extended period of time it experienced a sharp pullback.

We are not calling for a sharp pullback in MO, but we have a lot of confidence in our models and we believe MO is at least entering a period when valuation headwinds are likely to be swirling.

......................Altria Dividend Valuation................

Monday, December 18, 2006

Pfizer Hikes Dividend 21%: Good News or Bad News

A wise old doctor once told me that pharmaceuticals can harm and they can heal; they always have and they always will. He said that sometimes investors will focus on the healing side, and the drugs stocks will skyrocket; other times investors will focus on the harming side and they will go lower than you can imagine. Furthermore, there does not seem to be much in-between time, and the bad times can go on for a long time, just as can the good times. I have no idea when the current obsession with the harming side of the drug companies will end. I recently heard that 25 years ago the average person died of heart ailments in his or her late 60s. Today, at least in part because of incredible advances in medications related to the heart, the average person dies much later in life of cancer. Yet, new drugs to fight cancer are giving hope and longer years to millions of people. Today, Pfizer announced it was increasing its dividend 21%. Is this good news, or bad news? Is this a company with so many troubles that it is starting to pay people to stick with it? Or is this a company that is proud of its accomplishments in preserving and advancing health and is showing its belief in it own future and that of the pharmaceutical industry? Time will tell. For my money, I am a great fan of life, and most of the people I love have been granted longer life by medications from the drug companies. I know the harming side of the industry will always be with us, but as another wise person I know once said, "A person starts dying the day he is born." With today's announcement, Pfizer is now yielding over 4.5%. It's starting to look like a bond. Hmmm, I can receive bond-like income that is 85% free of federal income tax. In addition, our Dividend Valuation Model is signaling that PFE is nearly 20% undervalued. Not bad, especially when you consider, that one day I may wake up and the drug stocks will be "miracle healers" again. A wise man, or woman would not bet against that happening. This blog is for information purposes only. Do not make buy and sell decisions based on any information contained here. Please consult your own financial advisor.

Wednesday, December 13, 2006

GE: Price-Valuation Divergence is Growing

By Greg Donaldson and Mike Hull,

Donaldson Capital Management

We just completed a look at each stock in the Dow Jones Industrial Average through the lens of our Dividend Valuation Model.

Here's the good news. Among the 30 Dow stocks, the model shows that the average stock is about 10% undervalued. That is an important level because it is the same level of undervaluation that our top-down dividend valuation model is showing.

One of the most undervalued stocks in the Dow is General Electric. The interesting thing about GE is that it has had some good news lately that the market has completely ignored. CEO Jeffrey Immelt recently announced a 12% dividend hike, the third such double digit hike in as many years. He also confirmed earnings guidance for 2007 in the range of 10-13%.

GE has been a disappointing stock for the last few years. But a look at our dividend valuation chart for the company shows a wide gap has formed between the current selling price and the "fair value," as measured by historical relationships between dividends, interest rates and price.

Dividend Valuation Chart

The green candy cane at the far right of the chart below shows our dividend valuation model estimate of GE's price for the coming year. This is not an exact science, but it does give clues about how GE has acted in the past with the dividend growth and interest rates we are predicting for the coming year.

Probably the most important signal we see in the chart is that GE's valuation "steps" have been rising consistently for the last three years while the stock price has been flat to down. While the fit between GE and it dividend valuation is not particularly tight, it is clear that, except for the bubble in the late 1990s, GE's price has trended at the same angle as the model.

The divergence between price and valuation over the past three years is not likely to hold. Either valuation will come tumbling down, and soon, or price has a lot of catching up to do.

Our best guess is that GE might be as much as 25% undervalued.

..............GE Dividend Valuation........

This blog is for information purposes only. Do not buy and sell decisions based on the information contained here. Consult your own financial advisor.

Monday, December 11, 2006

Housing: It Ain't Over 'Til Its Over

There is a lot of wishful thinking about housing in the headlines. Today the National Association of Realtors projected that housing would turn NEXT quarter. So let me get this straight. That condo next to mine in the West, which sold for $X three years ago and is now is on the market for nearly $2X is likely to sell next quarter. At the risk of being persona non grata West of the Rockies, my answer to the National Association of Realtors and real estate speculators is, "Ain't no way." The skyrocketing prices of housing and the concurrent new construction in many parts of the country over the past 4 years have caused a glut that will take another year, maybe more, to work through. The reason is simple. Right across the street from my neighbor and me is a whole new development of handsome, nicely appointed units priced at $1.9X. I took a self guided tour through the development a few weeks ago, and I stumbled on one of the sub-contractors. I voiced my admiration of the workmanship and then asked him how they were selling. He said, "Funny thing; we had lots of interest in the project eight months ago, even some earnest money, but to my knowlege we have not sold any. That's not funny. That's called lack of demand, that's called too much supply. That's bad news for real estate and real estate investors. My story is purely anecdotal, but it is a symptom of why real estate in some parts of the country has a long way to go before its supply and demand reach equilibrium. Much of the Midwest is in good shape, but as I have said before, housing at the "right" address, or with a view of the mountains, lakes, oceans, or the 18th hole of a course that Jack built, is in for a long period of stagnation. Too much of it has been built, and in my judgment, some prices are likely to fall by more than most people believe, including my neighbors, mine, and the new development across the street. The reason is the banks. The developer of the project across the road from me probably hasn't thought about it, but his banker has been watching his progress. Bankers are nosey that way when it's their money. Bankers have sophisticated models that tell them how things are going, and they know in certain areas things are not going well. In another generation, in another real estate contraction, the banks played the bag holder. They hung in there with all the builders and speculators, and in the end, their bags held all the real estate, which they then sold for pennies on the dollar. A long history of bag holding has been a slow but sure teacher to the banks. They have decided they are not going to be the bag holder this time. They will call loans early and often. The reason is because they have a ready buyer -- private equity funds. Private equity funds will buy anything for the right price, and the banks have decided if they are always to be the bag holder when the dust clears they might as well sell their loans to the private equity funds sooner rather than later. This scenario sounds like tough medicine for the economy, and while it will be difficult if you are a big borrower with slow moving properties. The news is not all bad, however. This scenario implies a sharp, narrow correction in real estate that will resolve itself without major damage to the banks or to the economies of whole regions of the country. But having said this, this process will not be complete by next quarter. Furthermore, there will be very worrisome headlines in the weeks and months ahead about mortgage defaults and foreclosures that could make it Feel like the housing problem will go on indefinitely. The operative words in my judgment are sharp and narrow, but I'll keep you posted. The stock market is painting the best face on the financial facts at this time. But the facts will soon turn darker as a result of the lingering housing slowdown, and the current bull market will narrow dramatically. High-quality, blue chip stocks will be the only bull standing by the middle of 2007. Blue Chips will continue to get a lift from their international business, which will continue to be strong in 2007. Stocks have already priced in a Fed rate cut in March. Recent employment data is much too strong for a March rate cut. I think the cut will come much later and for cause. History shows us Fed rate cuts are not presaged by such a celebratory atmosphere as the one we are currently witnessing in the US stock market. Blue Chips are, indeed, underpriced by 10%, but the average stocks in no bargain. Next time: A look at some undervalued stocks. This blog is for information purposes only. Do not make buy and sell investment decisions as a result of anything you read here. Please consult your own financial advisor.

Wednesday, December 06, 2006

Donaldson Capital's New Website

At long last, Donaldson Capital has completed its new website. The link below will take you to the site directly. We began research on what kind of a website we really needed over a year ago. We wanted something that would share the "head and heart" of our firm. Mike Hull, Tom Piper, and Nick Donaldson did a great job of pulling together the content. A local advertising agency completed the creative work. This is our beta version, so if you see changes that need to be made, please email Nick Donaldson at Here is the link to the site: Merry Christmas and Happy New Year

Wednesday, November 29, 2006

Wachovia: Know Them by the Companies -- They Buy

Sometimes the best way to know someone is by observing the company they keep. I believe that is the case with Wachovia Bank. Wachovia(WB) became one of our largest holdings when it bought our favorite bank, Birmingham Al. based Southtrust. We owned Southtrust(SOTR) because we thought it was the best regional Sunbelt bank, which was largely the result of the leadership of chairman, Wallace Malone. Malone was a straight-talking old fashioned banker who kept his costs low and never missed an opportunity to go where the the gettin' was good. I thought he understood the power of a bank and how to squeeze profits out of it as well as anyone. When he sold Southtrust to Wachovia, I was shocked. Among the 4 or 5 big banks headquartered in Birmingham, I thought Southtrust would be the last to merge. But not only did he sell out to Wachovia, he sold at a modest premium to the banks market price, and well under what he could have received if he would have sold the bank at auction. Wallace Malone is nobody's fool and the more I thought about it, the more I became convinced that Malone had concluded that bigger was better and that even though SOTR would not be the surviving bank, he wanted a "southern culture" and a commitment to maintain his cost control and entreprenerial beliefs. In short, Malone was not selling out as much as he was arranging a marriage where SOTR's unique culture would be honored and preserved. The integration of the two companies went well and, indeed, Wachovia's increased emphasis on cost controls, combined with the strong Sunbelt economy, pushed the company's stock up nearly 30% through early 2006. Then the company announced it was buying another icon Oakland California's Golden West Financial(GDW). GDW was as unique to the West as SOTR was to the South. It thrived in a very competitive leading market on incredibly nibble and flexible mortgage products and very tight cost controls. Husband and wife co-CEOs Herbert and Marion Sandler built Golden West from $38 million in assets to nearly 130 $billion in assets during their 40 years with the company. Again when I saw the news that GDW had sold out, I was surprised. The Sandlers were getting older, but they had been so successful and GDW had reached a critical mass where it could have easily remained independent. The market did not like anything about Wachovia's purchase of Golden West. There were few economies of scale, GDW was heavy into California mortgages at a time when it was clear the housing market was softening, and WB appeared to pay a premium for the company. WB's stock fell by nearly 20% in the month after the announcement of the purchase. WB's price is still under pressure but I think the GDW purchase will ultimately be seen as a brilliant move. GDW is, indeed, very heavy in California real estate, but they have among the most stringent credit controls of all lenders. This has kept their loan loss ratios very low, and the real estate market would have to get a lot worse than I see it getting for them to have any trouble. More importantly, WB has now taken a kind of watermelon rind approach to their geographic footprint. Beginning on the eastern seaboard their market extends to Florida; then continues through the Sunbelt and the Southwest before smiling up through California and the Nortwest. This watermelon rind market area includes most of the fastest growing markets in the United States. I think there will be few large banks that will be able to rival WB's earnings and dividend growth over the next decade. Finally, and perhaps most importantly, two of the most impressive banking families that this country has produced over the last 40 years have thrown their lots in with Wachovia and now will be among its largest shareholders. In my judgment, neither of these deals was entirely about the money. And that speaks volumes about Wachovia. Mr. Malone and the Sandlers chose WB to act as stewards of everything that they have built. If the Malones and the Sandlers, who built multibillion dollar banks from scratch are confidant in WB's future, I feel like I am in good company in holding the stock. This blog is for information only. Do not make buy and sell decisions based on the information contained here. Please consult your own financial advisor.

Wednesday, November 22, 2006

Are the REITS too High?

In most of our Dividend Valuation Models, the Real Estate Investment Trusts (REITs) have been slightly overvalued for months. We have cut back just a bit, but we have continued to hold the REITs, thinking that the fall in rates would continue to push them higher. That has been the case. We are value investors, but in our years of watching the interplay between prices and values, we have noticed that stocks tend to stay overvalued and undervalued for long periods of time, often as long as three years. Most REITS are only modestly overvalued and not worrisome to us, but a couple we own are starting to resemble tech stocks of old. Of these, the stock that is the most difficult to value is Prologis. PLD is an international logistics firm that provides warehousing to large multinational firms all over the world. A quick search indicates that PLD is the most international of all US REITs, and importantly, the most global of all warehousing REITs. It has been a prime benefactor of the global economy, and its price has reflected it, rising over 30% year to date. Attempting to value PLD is tough because it is among a handful of REITs that are self funding. Being able fund growth from internal cash flow, has allowed PLD to grow funds from operations at 10% per year over the last 10 years, which is much higher than the average REIT. In attempting to determine a value for PLD, I resorted to Bloomberg's Dividend Discount Model and entered funds from operations data, which is much more reflective of PLD's business that are earnings. ..................Prologis Dividend Discount Model............... I estimated that the Funds From Operations and dividends would grow at 10% per year over the next 5 years and then decline over the next 5 years to 5% long-term growth. I used a discount factor of 9%, which I think is about right with 10-year T-bonds at 4.5%. Using these data points, the model --click to enlarge the table -- shows that PLD's theoretical value is $66.83. With the price about $64 that means that PLD is, actually, about fairly valued. If that is the case, I would expect it to go sideways from here. If it continues going straight up, and anyone starts using those dangerous words, "It's different this time," I would run for the hills. This blog is for information purposes only. Do not make buy and sell decisions based on what you read here. Please consult your own financial advisor.

Wednesday, November 15, 2006

About Bonds

If you have been following the economic fundamentals over the past year, you have been worried about higher long-term interest rates. Unemployment is at a 5-year low; GDP and CPI, year over year, are high; the operating capacity of US manufacturers is near 82%; and the stock market is on a run. According to my regression model, the current confluence of economic data is consistent with 30-year Treasury bond yields near 5.9% -- approximately a 3% premium over the Core CPI. So what is the rationale for 30-year Treasury yields at 4.6%? The answer can be defined in three words: inverse yield curve. An inverse yield curve is when short-term interest rates are higher than long term interest rates. At a very basic level, an inverse yield curve is the bond market betting that the trend of long-term inflation will be less than the current rate. For an inverse yield curve to be correct, the forces of inflation must be diminishing. That can only come through a slowing of the economy. I have long thought that long-term bond traders are the most accurate readers of the economic tea leaves. With 30-year Treasuries yielding 4.6% and overnight Fed Funds trading at 5.25%, the bond traders are clearly saying--betting-- that inflation will fall. Indeed, according to my models, a 4.6% long-term bond yield implies that Core CPI would need to fall to under 2% during the coming 12 months to be in equilibrium with its normal yield spreads. Therein lies the proverbial rub. Core CPI is now at 2.9%, and since Core CPI does not include food and energy, it will get little help from falling energy prices. There are two paths to a Core CPI under 2%: 1. A sharp slowing of the economy that might result in a recession, and 2. A protracted period of sub 3% GDP (driven by weak housing), perhaps lasting for 12 months or more. The long and short of the present level of interest rates is that the economy will be tepid for the next 12 months. This will almost certainly dampen corporate profits during this time. With corporate earnings growth having blown away estimates quarter after quarter this past year, I believe the market is being set up for disappointments in the year ahead. Having said this, as I have been repeating, I believe the disappointments will be mainly in the small and mid cap sectors whose businesses are tied primarily to the US domestic economy. Blue chips, which are much more international in scope, will be only modestly affected by the slowing US economy, and will increasingly be seen as the place to be by investors. Bond buyers have a very difficult decision. Do you keep rolling over the higher yielding short-term bonds or do you extend your maturities and take a lesser yield, in the hopes that the bond traders are right and both short and long-term interest rates will be lower in 12 months? I think you can guess my answer -- don't bet against the long-term bond traders. This blog is for information purposes only. Do not make buy and sell decisions based on the information contained here. Please consult your own financial advisor.

Thursday, November 09, 2006

Stocks Are Still Undervalued

With stocks having staged a strong rally, and changes in political leadership stealing all the headlines, I thought it would be interesting to see an update of our Dow Jones Dividend Valuation Model. The model is a regression of dividend growth and changes in interest rates versus changes in the Dow's price over the last 45 years. The model can best be understood by thinking of the green bars as valuation steps. The chart shows that as a result of very strong dividend growth and moderate changes in interest rate that stocks are more undervalued now than they were at the start of the year, even considering their solid price performance this year. The model is being pushed higher by bond yields being lower than their long-term average and dividend growth being much higher than its long-term average. The Dividend Valuation Model is signaling that stocks are still nearly 10% undervalued, which would target a level above 13,000. Another 10% move seems a bit ambitious, especially when considering the gains made so far this year and the uncertainties in the political arena. The change in political leadership is not a great surprise to the market. The polls and various overseas betting lines showed such a possibility for months. The momentum remains positive for stocks and, in my judgment, there is a clear valuation gap that is likely to close to some degree over the next year.

Thursday, November 02, 2006

Coke Bubbles Up

Few stocks has been more disappointing over he last few years than Coke. After the death of Robert Goizeuta in 1997, the company elevated a series of men to CEO whom the troops refused to follow. The absence of a strong leader for this most multinational of all US companies caused the unthinkable to happen: the company whose brand was thought to be so powerful that an idiot could run it, buckled under ill-conceived new products, frequent quality issues, and internal struggles that bordered on mutiny. Nowhere has the disappointment been more visceral than between the company and old-line Wall Street analysts. In short, Wall Street believes that Coke has managed to tarnish the single most recognized brand on the planet. Bloomberg research shows that few of the largest Wall Street firms have "buy" recommendations on the company, even though Coke's business appears to have turned. Our Dividend Valuation Model (DVM) is suggesting that the old-line analysts might be judging the company from the rear view mirror. If Coke's prospects have turned, as I believe they have, then we should have plenty of fresh money pouring into the stock over the next few years as Wall Street is forced to admit that Coke is, indeed, The Real Thing -- again The chart below shows that the correlation between Coke and its DVM is not high. But, interestingly, it does show that the market has a history of mispricing Coke in regular patterns. ...............Coke Dividend Valuation Model............... Think of the green bars as "value" steps, or intrinsic value. For the 7 years from 1986 through 1993, Coke's market price (blue line) consistently sold below its intrinsic value. Beginning in 1995, things changed and under valuation was replaced with over valuation, as Coke appeared to be climbing a stairway to heaven. By 1998, with Coke levitating 40% above its DVM, there was no shortage of buy recommendations by Wall Street analysts. Coke's downtrend over the last 7 years has been caused by a combination of a normal correction back to its intrinsic value, and its own abysmal performance. Two years ago, Coke finally appeared to correct their leadership problem by promoting Irishman Neville Isdell to CEO. By most accounts, he has the support of Coke employees and bottlers. In recent quarters, sales and earnings have bottomed and begun to firm. Recently, the company reported much better than expected earnings, which push the stock higher. I noticed that the consensus ranking by Wall Street analysts did not budge with the good news on earnings. They still rank the stock as an average performer for the coming year. With the stock undervalued and big cap blue chip stocks back in favor, to ignore the progress that Coke has made is shortsighted. Besides seven years is a long time for Wall Street to hold a grudge. Look for Coke to begin a long slow climb as more and more Wall Street types forgive the company for past missteps and admit that there is no such thing as an idiot proof company. The Dividend Valuation Model says we are in the first year of an upturn. I wonder if that means, we can count on 6 more years of price gains? Stay tuned. This blog is for information purposes only. Do not make buy and sell decisions based on what I have said here. Clients, Employees, and Principals of Donaldson Capital Management may own shares of Coke.

Friday, October 27, 2006

Slowing Economy, Rising Stocks

Friday's announcement of 1.6% GDP growth for third quarter is slightly weaker than I was looking for, and it is a very real indicator of just how weak real estate is. The good news is the inflation data in the release fell to 1.8%, much lower than the consensus estimate of 2.8%. That is very good news to the Fed. Even in the face of the slowing economy, I believe that the S&P 500 and the Dow Jones Industrials, which both contain blue chip multi-national stocks, will continue to perform well over the next year to 18 months. The slowing economy will not be good for smaller domestic stocks, and I believe their performance will likely lag that of the blue chips. I also believe that blue chip international stocks will continue to perform well. This divergence between stock market performance and economic performance will be the opposite of what happened in the previous 24 months, when the US economy was strong and US blue chip stocks were flat. The reason for the unfolding divergence is two fold: (1) The stocks in the major blue chip indices produce nearly 50% of their earnings outside the US, and for the first time in many years, in 2007, the rest of the world will be growing faster than the US. (2.) Blue Chips were poor performers in 2004 and 2005, even though earnings were strong, and because of this , they are underowned on Wall Street. As it becomes increasingly clear that the rest of the world is growing faster than the US, big money will pile back into US blue chips. Finally, according to S&P analysts, blue chip stocks are as cheap as they have been in years and 2007 S&P 500 Index earnings estimates are still expected to reach double digits. Markets seldom feel right because we human beings have a habit of projecting today's headlines onto tomorrows stock performance. Remember, the stock market is not a democracy. Prices move in the direction that big money pushes it. Fortunately, big money is normally rational and understands economic cycles and the power of the Fed to slow and speed up the economy. Big money has a problem. The places where it has been treated well over the past few years are all rolling over. Treasury bonds yield are under 5% in most of the major industrialized nations of the world. Bonds simply are not competition to stocks. Real Estate and commodities are no longer competing effectively for investors against stocks because they are now in downtrends. Blue Chip stocks, alone, stand out as a value now that bonds, real estate, and commodities have become over owned and over valued. Finally, blue chip stocks are in an uptrend. This positive momentum is a rarity in today's world's financial markets. As long as earnings growth holds near 10%, stocks will continue their strong advance. This blog is for information purposes only. Do not make purchase and sell decions on the basis on what is discussed here.

Tuesday, October 24, 2006

The Pigs Are Flying

When you look into the portfolios of almost any large mutual funds, you will likely see Johnson and Johnson, Coca-Cola, and Wal-Mart. They will be present, but in many cases, they will be significantly under-owned in relationship to their representation in the S&P 500. This is what I call benign neglect; the manager really does not like the stocks but owns them in some small measure -- just in case. Just in case, their fortunes change and their prices begin to rise, which, in the mind of the manager, will be about the same time that pigs fly. The question might be asked: why do the managers even bother with these exercises in benign neglect? The answer is simple, even though the aforementioned companies are often a drag on performance, they look good in the annual report; they denote a conservative philosophy, and a respect for companies that have stood the test of time -- in some instances, even a bold contrary view. There is always the thought in the manager's mind that he or she can quickly raise the weighting of an under-owned company, when, as, and if it gets its act together. The reality is different. Because the manager may have 300-500 stocks in his or her portfolio, the under-owned big cap stocks fall off the radar screen because the manager thinks he or she knows them. One day Mr. or Mrs. Portfolio Manager wakes up and realizes that they don't know the benignly neglected companies at all. That is what has happened for JNJ, KO, and WMT in recent days, and sure enough, the pigs took flight. There is another well-honed exercise on Wall Street. It is called flying pig catching. This happens when the neglected stocks come to life and Mr. or Mrs. Portfolio manager engages in a pitched battle to buy the stocks competing against the like-minded crowd that is trying to cover their shorts. It is a beautiful sight if you own the stocks when this happens. Johnson and Johnson, Coke, and Wal-Mart have all reported strong earnings, or earnings guidance in recent days. The market has rewarded all three with sharply higher prices. I have discussed in previous blogs that these companies were undervalued and that their businesses were improving. In addition, our models show that all three are still undervalued, even after their recent spikes. There is another thing about flying pigs that Mr. and Mrs. Portfolio Manager know all too well: They can fly higher and farther than a rational person would think possible. The link to Yahoo shows the last 12 months prices for all three stocks and the recent spikes higher. Yahoo Charts Clients and employees of Donaldson Capital may own one or all three of these stocks, depending on their investment styles. This site is for information purposes only. Do not use it to make investment decisions based on what you have read here. If you are not a client of DCM, please consult your own financial advisor.

Thursday, October 19, 2006

Healthcare Sector: In the Pink?

The chart below shows the Healthcare Sector Ishares going back to 1999. It is easy enough to say it, but more difficult to believe it, but this past week, Healthcare broke to a new 7 year high. This is completely contrary to the plethora of bad news that has surrounded this sector. The Healthcare sector is dominated by the drug stocks and, let's face it, the drugs, in some quarters, are held in as low esteem as their namesakes of the illegal variety. ................................S&P Healthcare........................ So what is the sector doing making new highs when sales and earnings growth are still so meager and lawsuits are as common and curable as a cold? When I showed this to Mike Hull, the first thing he said was: go long the Republicans. By that I think he means that since the Democrats have led the attacks against the drug companies, a break to a new high by the sector would mean that big investors are betting that the Republicans are going to remain in power in the November elections. That is a completely counterintuitive thought because the main stream media has virtually ceded control of at least the House of Representatives to the Democrats. On the other hand, since the break out is coming so near the elections and the Democrats are leading in the polls, the market may be saying that the drug companies can cut a better deal under new political leadership. Unfortunately, that is neither easy to say or believe. I prefer to believe that the agony of the past 7 years, has provided the drug companies with a new model that investors believe is viable and sustainable. That model is based much more on cost savings and a more focused approach to research and development. Even though sales gains have been tough in the sector, many of the main players such as JNJ and PFE have reported earnings growth much higher than Wall Street estimates. From a valuation perspective, the drugs are about as cheap on a relative basis as any group. In our September 16th edition, we showed JNJ was nearly 20% undervalued. That is probably about the average of the stocks in the sector. Having negotiated all these "what ifs," I think the Healthcare breakout should be seen as good news for stocks, in general, because it is such an important sector in the S&P 500. In addition, with the drugs so out of favor among big investors, there is good reason to believe that this breakout will likely get a lot of attention and draw in fresh money. I'll keep you updated as we go.

Saturday, October 14, 2006

What's Berkshire Hathaway Worth, Anyway?

This past week Berkshire Hathaway Class A common stocks briefly traded above $100,000 per share. Yes, indeed, 10 shares of Warren Buffett's pride and joy makes you a millionaire. Mr. Buffett the, "Oracle of Omaha" has given us professorial lectures for 30 years in his annual reports as to how to value the stock of Berkshire Hathaway. For 30 years, Wall Street has ignored him. According to Zacks, only two analysts make earnings estimates for the stock and both are very wide of the mark. From time to time, someone will value Berkshire Hathaway Class A stock by valuing the sum of its parts. Berkshire is essentially a holding company of many disparate and independent companies. By individually valuing each company relative to like companies that trade in the open market, one should be able to get a reasonably good idea what the stock is worth. I think there is a better way. Berkshire Hathaway is the only non-dividend paying stock that we have bought in years. (See our general dividend theory) The reason is simple: even though Buffett eschews dividends (we've asked him to change)by listening to his annual-report lectures, we believe he's right about how to value the stock: book value. BRK/A almost defies normal valuation because of the complexity of the wide range of companies it owns and the lumpiness of its results, as a result of its insurance business. But Buffett's insistance on high quality companies with strong cash flows lends itself to valuing the stock using book value and interest rates. The chart below is a multiple regression of BRK's book value and long-term interest rates versus it price. ....................Berkshire Hathaway Valuation............. Click to enlarge The last green bar (far right) shows the expected value of BRK/A based on projected year-end 2006 book value and current interest rates. Our model suggests that the fair value of Berkshire is over $105,000. We would expect that book value will grow by low double digits in 2007. That would push its fair value even higher. In our judgment, the close fit between BRK/A and our regression model suggest Mr. Buffett's net worth will be rising in the year ahead. We own the Class B stock of Berkshire Hathaway in our Blue Chip Growth investment style. Clients, employees, and principals of our firm own the stock. We offer this analysis for information purposes only. Do not make buy and sell decisions based on this blog.

Friday, October 06, 2006

Still Room to Go

Blue Chip stocks have had a very strong 45 day run and eventually some profit taking will occur. An updated look at our Dividend Valuation Model, however, shows that there is still plenty of value left in the Dow Jones 30 stocks. The model is currently saying that based on year-end 2006 projected dividends and interest rates that the Dow Jones 30's "fair value" is near 13500. As I have noted in other blogs and shown on the chart, the model became "undervalued" in 2005 and the undervaluation has widened in 2006, even though stock prices have risen. The reason is simple. Dividends have grown faster than prices over the last 24 months. The model, as with any model, is not something you can take to the bank, it does provide a kind of order of magnitude of how the Dow Jones would be priced today if it were priced in accordance with long term averages. The main reason the model is so undervalued is the very low level of interest rates combined with higher than average dividend growth. I think the odds of these two trends continuing are very high. For that reason, I see valuation creation growing above historical long-term trends for the next several quarters. There are certainly issues in the economy and the geopolitical arena, but in my estimation, they are amply discounted in the current prices of the Dow. If there is a surprise, it is that high quality Blue Chip stocks will continue to rise even as the economy slows. More on that later.

Thursday, September 28, 2006

Real Estate and the Tipping Point

I have traveled to many of the hot real estate areas of the country over the last two years. I am not an avid real estate investor, but it is such an important part of the economy that where ever I go for business or pleasure, I check out, as best I can, what' s going on in the local market. One reason for my keen interest in real estate is that I have been convinced that the employment statistics, as measured by official government measures, have been undercounting self-employed real estate contractors. I described this phenomenon in 2004 when the naysayers were castigating the "jobless" recovery. I said then there was no such thing as a jobless recovery, and I believe the events of the last two years have born me out. Unfortunately, I now believe that real estate in many parts of the country is much weaker than official statistics show. If I am right, this has big implications for the economy and employment. The danger I see in real estate is in what I will call the "cool" areas of the US: Mountains, water, skylines, golf scapes, and the "in spots," in general, in many parts of the country just cannot sustain the prices at which properties have recently sold. The surest indication of this is the prices at which these same properties can command as rental units. Whether one acknowleges it or not, in the recreational areas, the prices are, ultimately, set by the rental market. It was the rental market that drove prices higher in Florida, Arizona, California, Colorado, the Northwest, the upper Midwest, and New England. Property values shot up because the prices that long and short-term leases could command went up. But, now rental prices are softening even faster than housing prices in many of these areas. I have a place in Central Oregon. My family I are great fans of Oregon and the great people of the eastern slopes of the Cascade Mountains. Unfortunately, I see things going on in one of my favorite places on earth that portend a contraction in real estate prices. Long-term rental prices in central Oregon are a fraction of the underlying values of the properties. In my recent visits, I have seen condos valued at $400,000 advertised for lease at $1500 per month for a a 24 month term. That level of monthly lease represents less than half the underlying value of the property. This phenomenon is not isolated to Oregon. The speculators day of reckoning is near. A person can keep lots of real estate afloat as long as prices are rising, but if prices start to fall, the banks get grouchy quickly. I believe that time is very near, and for that reason, I believe lots of real estate in the recreational areas of the country will soon be coming on the market. In my judgment, when that happens, there will be few buyers because speculators have been selling to speculators for quite a while now. Banks never handle these secular slow downs very well because they have been speculating in real estate along with everyone else. Bonuses, profit sharing, stock prices, and promotions have all become dependent upon rising real estate prices. Some banks will figure out quickly that the true economic value of properties in their portfolios are dramatically lower than the price of the last sale, and they will call in their loans quickly. They will loose a lot of public relations points, but they will escape serious trouble. Other banks will try to ride it out. It won't work. They have loaned up to 95% of the property value, but even as I write this, these properties are only worth 75%-80% of their selling prices if a lot of properties hit the market. Banks who try to ride it out are in for a lot of headaches, losses, and bad press. I want to close by repeating that I am not a real estate expert, so don't follow what I am saying here blindly. However, I am a student of human nature and of the economy. In 1999, our money management firm stopped taking new clients because we believed that speculation in tech stocks had reached the tipping point. That was one of the best decisions of my life. One of the worst decisions of my life was in my not having had the courage to put my foot down and say that the tech bubble was about to burst and sell not only the tech stocks but everything that was trading for more than 30 times earnings. I cannot see the future and there are those who know the forces of real estate much better than I. I am sharing my thoughts because my views of the future are colored by the past and there is a shape and form to bubbles that has become very familiar to me. In my mind, there is a bubble in residential real estate in many parts of the country and the bubble is not sustainable. I will stop here. This is a complex subject and there are hundreds if not thousands who will read what I am saying. I have one suggestion. If you are holding more real estate than you can live in, please talk to someone you trust in the real estate business other than the person who sold you the property. You may think that you can catch the falling knife, but let me remind you that Procter and Gamble sold at 60x earnings in 1999. Today it sells for 20 times earnings. .

Sunday, September 24, 2006

Dow Jones Industrials New High -- About Time

By the time you read this, the Dow Jones Industrial Average may be sitting at a new all-time high. At the close today, the Dow was within 50 points of its old high and the momentum feels like it will carry us beyond the previous high, which was set in early 2000. As usual the market has been climbing a wall of worry, and the 30% of American's who believe the US economy is in bad shape -- including many on Wall Street -- are going to have a heck of a time trying to figure out how stocks can be hitting new highs in the face of such a "lousy" economy. There must be a conspiracy here somewhere. Our stock market model indicates that the "fair value" of the Dow Jones Industrials is closer to 13,000, so from a valuation perspective, the market would seem to have a long way to go. Unfortunately, we also have an inflation model that suggests a little different story. With the 30-year T-Bond at a yield of 4.75%, our model calculates that core inflation should now be slightly under under 2%. With the core inflation rate running at 2.7%, getting down to even 2% in the next 12 months would seem to be a tall order. The only way I can see such a fall is on the back of housing. One reason for this is that food and energy are excluded from the core CPI, so falling oil prices won't help much. Since housing is one of the largest components of the core CPI, if current bond yields are correct, it would seem to presuppose that housing is going to be a bigger problem over the next 12 months than the market now thinks. Since housing is directly tied to banking and since banking and finance are nearly 23% of the S&P 500, it is very difficult to project a continuation of the recent record pace for the S&P. Ahh, but here is were the compositions of the Dow Jones 30 and the S&P 500 come into stark contrast. Financials represent only about 15% of the Dow, with none of the companies being a mortgage driven regional bank or a pure mortgage broker. The S&P 500, on the contrary, is loaded with mortgage driven regional banks, mortgage brokers, mortgage insurers and many more companies tied directly to housing. In this regard, as it relates to housing, the Dow is much less sensitive to the unwinding of the housing bubble than is the S&P 500. Having split this hair, I believe it is quite possible that the Dow will continue to move higher over the next few months, while the S&P 500 may not do as well. This is not idle mental castle building, we have sold almost all of our regional banks and cut back modestly on some money center banks with big mortgage holdings. This is a significant action because Sunbelt regional banks were our largest holdings at the beginning of the year. We still like banking, but US money center banks and strong foreign banks look like better values to us over the next couple of years. Their portfolios are diversified worldwide, and their investment banking divisions are minting money with all the mergers and private-equity buy outs. It will be good for the Dow to take out the old high. In my mind, it should have happened a long time ago. The values have been there to support much higher prices. But let's face it, the psychology has been lousy. Today, I believe the value are so compelling that, even in the face of lots of unknowns, the path of least resistance is up.

Thursday, September 21, 2006

Sam Would Be Proud -- Wal-Mart

From Bentonville Arkansas, Sam Walton built one of the most remarkable businesses the US has ever seen. He delivered on the greatest selling pitch of all time:"I can get it for you wholesale." The rest of the retailing world could get it for you "wholesale" during "White sales," "President Day sales," "Inventory reduction sales," and "Lost our lease sales," but Sam and his disciples offered it to us every day. Sam did not "give it to us" in the sense that his detractors charge. He became our "buyer" and he was remarkable at passing along his volume discounts. My mother thinks Wal-Mart (WMT) is one of the greatest inventions of her 86 years. She does not understand that it is not politically correct to think that Wal-Mart does anything good. There are those who think that the blood has run a little thin at WMT since Sam died. Who knows maybe Sam has felt the same way, but not today. Today, Sam is looking down on the firm he started on that dusty parking lot in Bentonville so many years ago and he is happy. He is happy because his disciples have come up bold. And Sam knows destiny favors the bold. Today Wal-Mart announced that they will begin offering generic drugs at sharply discounted prices. Starting first in the Tampa area, they will offer nearly 300 generic drugs for a flat $4.00 per month. That news took about $5 billion out of Walgreen,CVS, and other drug retailers, but drew no response in WMT's price. I think this news is about as big a strategic move as I have seen a company make in a long time. Wall Street probably won't like the deal because it does not seem to drive very much to the bottom line. The Wal-Mart haters won't like it, well, because they know that Americans will love it, and their jobs just got tougher. California won't like it because this will likely clutter up their pristine streets with noisy, smelly cars going to Wal-Mart. But the bottom line is my mom is going to love it. The way I figure it, she will save about a hundred dollars per month when the program comes to Indiana. And speaking of Indiana, I would like to make the following plea to Wal-Mart: Dear Mr. Scott, Indiana is a big fan of Wal-Mart. We don't hang you in effigy; file countless nuisance lawsuits against your company; or fight you every time you want to open a store in the Hoosier state. Do my mom and other Hoosiers a favor and bring your new generic drug pricing program to Indiana after its rolling in Florida. My mom said she would cook dumplings for you if you want to stop by. Our model shows that WMT is about 20% underpriced and the biggest reason for the undervaluation is the incredible negative public relations battle that has been waged against the company. In my mind, with this discount generic drug pricing initiative, WMT, at least for the near term, has regained the high ground against their detractors. This company is growing 2-3 times as fast as most utilities, but is trading at a PE 30% less than the average utility. Sam would be buying. Blessings, Clients and employees of Donaldson Capital own WMT.

Saturday, September 16, 2006

Johnson and Johnson -- Ready for A Turn?

Positive market breadth has widened over the past two weeks as more cyclical sectors have ticked higher, betting that the Fed has likely finished hiking rates. I agree that the Fed is on the sidelines, but I believe the optimism about prospects for the average stock are premature. Recent data clearly show that the economy is slowing, and wages are now rising faster than prices, as was revealed by Friday's CPI report. Indeed, Friday's tame CPI release, which the markets interpreted as good news, is probably strong evidence that corporate profit growth has peaked and is now trending lower. Taken together, recent data strongly suggest that profits will likely disappoint in the year ahead. In this scenario, I continue to believe that high quality consumer defensive stocks offer compelling values. Our research shows that Johnson and Johnson, a leader in the healthcare sector, is continuing to put up good results, which are being ignored by the market. The chart below is of our proprietary Dividend Valuation Model for JNJ. ...................Johnson and Johnson............ Please click to enlarge. Very simply, the model is saying that based on JNJ's 20-year average relationships between price growth, dividend growth, and changes in interest rates its stock is cheap. Furthermore, 2007 earnings are expected to rise sharply over 2006. There are a lot of cheap drug stocks, and they deserve to be cheap because they are not the companies today that they were a decade ago. That is not the case with JNJ. Almost alone among US drug stocks, JNJ has weaved its way through the land mines of drug recalls, patent battles, and mind-boggling lawsuits that have blown up so many heretofore great companies. JNJ's reliance on block buster drugs is much less than many of the pharmaceuticals, and they have developed a solid line of OTC drugs that were formerly only available by prescription. Our model says JNJ is significantly undervalued. That does not guarantee success. It is just an indication that JNJ's current earnings and dividends are not as highly prized as they have been on average over the las 20 years. My belief is that JNJ's accelerating earnings in 2007 will look very good compared to the many earnings disappointments I expect during the coming year. A lot of traders are avoiding the drug stocks like the plague because the drugs are having so much trouble. But for longer term investors, buying stocks that are out of favor yet whose prospects appear to be improving makes good sense. The model shows that buying JNJ when its "fair value" line (gold) has been higher than its price line (green) has always worked out. I can't see the future, and I'm sure you know that the past is no gurantee of the future, but I would not be surprised to see JNJ trading in the mid 70s sometime in the next year or two. You guessed it. I own the stock.

Friday, September 08, 2006

Is Procter and Gamble Fairly Valued?

My research shows that stocks spend very little time at "fair value." They wiggle and wobble around and through "fair value," but the animal spirits of momentum investors seem to preclude long stays there. As we have been saying for many months, the economy is slowing and money has been moving from cyclical and smaller companies to larger more defensive stocks. Many of the defensive stocks have had strong moves, prompting the question, "Do they have anything left." To answer that question, I will analyze Procter and Gamble - PG, one of the key stocks in the consumer staples sector, which is at the heart of the defensive group. Our Dividend Correlation Model and Bloomberg's Dividend Discount Model both are saying PG is cheap. Not only relative to itself, but relative to other big cap stocks. Chart I shows our DCM valuation of PG over the past 20 years. .............................Procter and Gamble............................. To see the model more clearly please click the image. The green line (dark) shows PG's annual price since 1986. The gold line (light) is our Dividend Valuation Model's indicated "fair value" for each year. You will note a lot of wiggling and wobbling between the two lines, but they are clearly highly correlated, and, as we have shown previously, price does most of the wiggling and wobbling. The model currently says that the expected "fair value" for 2007 is 71.80, or about 17% above the current price of $61.50. Our model says PG is very cheap. ..............................Procter and Gamble........................... Chart II shows Bloomberg's Dividend Discount Model valuation of PG. A Dividend Discount analysis is a forward looking computation of the discounted present value of PG's future dividend payments. Looking at the lower half of the table you can see that the Theoretical Price of PG, as computed by the Dividend Discount Model, is $77.04, or 25% higher than the current price. I'll leave for another time a wider discussion of the table. Here's the last word. The slowing economy will cause many stock groups to either go flat or fall. The consumer staples sector is not likely to be affected much by the slowing economy because the products they sell are modestly priced and we use them everyday. As the economic slowdown becomes more apparent, I believe the consistent earnings and dividend growth of PG (and many of the other stocks in the consumer staples sector) will become more highly prized by Wall Street, and the momentum players will drive PG's price higher. The valuation models shown here suggest that PG has a ways to go just to reach "fair value," and as I said in the beginning, stocks don't spend much time fairly valued. I would argue that PG might see a time during the next 18 months when the momentum players will push it above fair value. You do the math. Blessings, Donaldson Capital clients, employees, and I own PG. This is not a buy recommendation, it is an example of valuation models and macro-economic analysis. In addition, we may sell PG in the future without notice.

Monday, September 04, 2006

DCM President, Mike Hull, Responds to a Client's Question

Mike -- I came across an interesting article this morning on the market and its prospects. It made a lot of sense to me and, therefore, I'm passing it on to you. To link to the article, click here What do you think? Peace, my friend. Bill ......................................... Bill, We may come at it through a slightly different angle, but our conclusion is pretty much the same -- a soft landing that the stock market will absolutely love. Corporate profit growth has been astounding while the Fed has been raising interest rates. Because the big money in the market never wants to "fight the Fed," we haven't seen stock prices respond to the ever-improving fundamentals of the companies. As the article described, that can happen even as the economy slows. We are already seeing it in our high-quality, dividend-paying companies. The stocks in your accounts have returned twice that of the Dow and five times better than the S&P 500 -- had to get that plug in there. Specific areas to watch: Oil -- the media is making far more of this than what is really going on (surprise). The members of OPEC do not want to see oil prices any higher than they are right now. Already, the US is making a serious effort to reduce our dependency on foreign oil. If you quesiton that, check out the price of corn futures. Housing -- this could be a wild card. It very much appears to be a soft landing for the housing market. And, lower interest rates are helping that. Interest Rates -- again the media doesn't tell the true story. No surprise that the media only shouts the bad news. The truth is that during the last month interest rates on the ten and thirty year treasury notes dove well below 5%. This will keep mortgage rates very attractive and keep the housing market from coming apart. Interest Rates -- these low, long term rates also indicate the bond market has no worry about inflation. Interest Rates -- these low interest rates, and the inverted yield curve, do seem perplexing, however. They also seem to be saying that the bond market is looking for a serious slow down, maybe not a recession, but a much slower economy than the stock market is indicating right now. Seat of the pants -- Money has to go somewhere. Investment decisions are always relative. We have corporate bonds and government agencies yielding right around 5%. We have the steam coming out of the real estate market. And, we have high quality companies with dividend yields running between 3.5% and 4.5% , and those dividends are growing in double digits. Those same companies have been accumulating cash like crazy, buying back their own stock, and bolstering their balance sheets with cheaper debt. Money has to go somewhere. I cannot see the big money ignoring the great values in blue chip stocks, at least until something in this scenario changes. Good to hear from you. I'll try to get with you during the next couple of months on one of my trips to Indy. Take care, Mike Donaldson Capital Management, LLC 800-321-7442 812-421-3200

Thursday, August 31, 2006

BAC's Dividend Growth and the Cure for Jim Cramer

CDs yield about 4.5%, 10-yr T-bonds yield near 4.7%, and 30 year T-bonds yield 4.8%. Bond investors all over the world move and shake for the best deals they can get, but at the end of the day, almost everything they buy begins with a 4. They go home at night, kiss their spouses, and watch the mad mad world of CNBC's Jim Cramer for laughs (If you haven't seen him, he's a kick). They think Cramer is bad for their profession. They think Cramer's antics might cause the investing public to get the idea that investment people are clowns at best, or deranged, at worst. Cramer, indeed, does acts like a cross between the Hunchback of Notre Dame and Knute Rockne. He twists himself into contortions while shouting gibberish, pounds on circus horns, and chews out callers for dumb questions. But then, in the persona of Knute Rockne, gives his take on 25 stocks in 10 minutes with a lucidity and passion that the Gipper would envy. The bottom line is you can call him crazy but Jim Cramer "ain't" buying nothing with a 4 on the front of it. I can debate a lot of issues with Mr. Cramer, and his style is not my style ( although I do like the circus horns), but I share his aversion to bond yields beginning with a 4. While he shoots for 20%ers in stocks of every stripe, I see many good prospects for 10%ers in good old dividend paying stocks. Let me give you one idea. Our old friend Bank of America is currently yielding 4.35%. There's that 4 again, but this is a different kind of 4. With modest success, this 4 can grow into a 10 over the next few years. Here's how to look at it: BAC is as close to a nationwide bank as we have in this country, so their growth, at the very least, ought to mirror the economic growth of the United States. The US economy has grown at a nominal rate of between 6% and 7% for decades. Let's estimate, then, that BAC can grow earnings at least at 6% per year over the next decade. BAC's earnings and dividends have grown at about the same rate for the past decade, so let's assume that the dividend will also grow at 6%. Finally, even though BAC's current dividend yield at 4.35% is higher than its 10-year average, let's assume that ten years from now it will still yield 4.35%. Using these assumptions, the 10 year internal rate of return for BAC would be approximately the current yield of 4.35% plus the dividend growth of 6% or 10.35%. Jim Cramer might be in and out of BAC a dozen times a year, and he might make a whole lot more than 10.35%, but then again, just as he "ain't" looking for nothing with a 4 on the front of it, he probably "ain't" looking at BAC's dividend yield and dividend growth the way that we are. And who knows, if he did look at the solid long-term prospects of many dividend-paying stocks, he might sleep better. This improvement is his sleep habits could diminish his hyper-activity and affinity for horns and shouting at inanimate objects. He might even stop shouting altogether, which would add a more professional demeanor to his program. With any kind of luck, he might raise the level of his program to, say, that of Lou Dobbs. Forget that I said that. Lou Dobbs has become so sane and serious that he has moved from the business of analyzing investments to the world of analyzing politics. Now that's crazy. Honk the horn all you like, Jim, I lose myself in your antics everytime I watch you. And in these days, all of us need something to take us away from the latest episode of man's inhumanity to man that we see stretched across the globe.

Sunday, August 27, 2006

Energy: The New Y2K: Investing in Prudence

A few weeks ago, I said that energy is the new Y2k. That is, people who do any kind of planning realize that our present sources of petroleum are largely in the hands of people who are not our friends. Prudence dictates alternatives. I mentioned that new energy-saving technologies for automobiles, the home, and corporations will make obsolete many of today's propulsion machines and a lot sooner than most people think. If you do not believe me that something big is going on, then maybe you'll believe the big commodities traders. The table below is from The Wall Street Journal's commodity page. It shows the price of corn futures through 2009. ................................Corn Futures................... The fourth column under Corn is the price. To transpose it into dollars per bushel, just put the decimal point after the first digit, ie. the price for the contract for Sep '06, which reads 225'0, would mean $2.25 per bushel. As you go down the table; you will notice that prices go up every year until we reach a high price of $3.30 for the Dec '09 contract. For a speculator to make a profit on the Dec '09 contract, the price of corn will have to exceed $3.30 per bushel. That is nearly 50% higher than today's price, and much higher than would ordinarily be expected. Why are commodity traders so bullish on corn? Do they know something about the weather that we don't know? That is possible because they can now trade the weather, but I think the reason corn futures are so high is contained in one word: ethanol. Lots of big money believe, as I do, that changes are coming in the way we power our machines. In this case, they are betting that corn (ethanol) will have an increasing role as a fuel for our cars, trucks, and tractors. To me the growing use of ethanol ( no matter its actual energy efficiency) is a forgone conclusion among the big players in both the agricultural as well as the automotive industries. As shown here, this will drive up corn prices (you might want to hoard some corn flakes for the kids and some whiskey for yourself), but it will give Americans some feeling of greater control over their energy needs. But, in my judgment, the greater use of ethanol and biodiesels are just the beginning. There are scores of hybrid engines on the way that will get up to 50 miles per gallon and more. They will cost more, but what is given up in dollars will be more than made up in a growing sense of prudence. Prudence may seem like an old fashion word, but billions of dollars are spent annually on prudence called by another name: insurance. Archer Daniel Midland -- ADM -- is the way most people are playing ethanol and biodiesel. I'm kind of a "picks and shovels" guy. I like Deere. Ethanol and biodiesel will mean fence row to fence row planting throughout the world. Deere is dominant between the fence rows. Donaldson Capital nor I own either of the stocks, although we are evaluating Deere. Both companies are first rate, even in the absence of ethanol and biodiesel opportunities.

Wednesday, August 23, 2006

Welcome to Normal

From a pure statistical perspective, stocks, bonds,inflation and the economy are all about normal. Three years of terrific earnings growth and lackluster price growth from large caps have driven PEs back to historical norms. Based on 2006 earnings, both the S&P 500 and the Dow Jones 30 are trading at about 14.5X earnings, which is near their 80 year averages (Down from 30+ PE in 2000). Inflation, on a year over year basis, is about 4%, again at approximately the long-term average of inflation. The 30 year Treasury bond is about yielding 5%, just under the long-term average of 5.5%. Annual GDP growth is approximately 3.5%, you guessed it, near the long-term average. Since we all know there is no such thing as an average market, what do all these reversions to the mean, mean? You can think about this for a few minutes or a few weeks and you will come to the same conclusion: both the stock and bond markets are signaling slow growth and a fair amount of confusion. If we extend all of the normalcy we have identified here, the market appears to be saying that we cannot expect any more earnings growth for the next several years than the 80-year average of 7%. If this is the case, then my recent mantra of big over small, value over growth, and dividends over all makes more sense. If 7% earnings growth is about all we can expect from the average stock, why not take the less risky route of high quality, dividend-paying banks, utilities, and REITs that yield 4% or more with secure dividend growth of 3%-9%, and selected energy,industrial, and consumer staples companies that offer 2%-4% dividend yields and 7%-12% dividend growth? Tech is anybodies guess, basic materials don't work well in slowing economies, consumer cyclicals have housing weakness and energy cost headwinds; and telecommunications are running in place. With the US economy slowing, doesn't that put question marks on China and the emerging markets? Finally, why do I want to pay near 18X earnings for small and midcap stocks that pay little or no dividends and take the chance that they can dodge the slowing economy. Things can always be different this time, but will they? Big money goes where it is treated the best. It has been in cyclical, international, and riskier small and mid caps for the last 4 years and has been rewarded handsomely. However, the flight path of the economy over the next two years appears to be down and, as earnings accidents become more widespread among the more economically sensitive sectors, the move to large, quality, dividend-paying companies will accelerate. That is what normally happens, and it's a hard to argue that things will not be "normal" this time.

Sunday, August 20, 2006

Don't Count Your Shekels

The stock market turned in a very strong performance last week, ostensibly on the back of the peace accord between Israel and "Leb-bollah" (I hope this is not a bad word in either language). If peace in the Middle East is a prerequisite for higher stock prices, then hit the "undo" arrow on your spreadsheet because this peace is not likely to hold. Israel got nothing of what it wanted in the skirmish, and Hezbollah got everything they could have hoped for. Israel certainly won the battle in Lebanon, but Hezbollah won the war for the hearts and minds of their benefactors in Iran and their faithful among the Islamists of the world by putting up a good fight. Neither entity will give the current peace a chance. Hezbollah does not want peace with Israel, and Israel cannot live with the situation as it is. Fighting will inevitably break out again, and when it does, the market will give up some of its gains. The reason that I say this is that last week's rally was broadbased, indicating, at a minimum, better times ahead for earnings. In my mind, for the average stock, that is many months away. Even in the absence of bullets flying in the Middle East, the economy is slowing and earnings are going to start to disappoint (See Lowes). This is not a market for the average stock. This is a market for large caps over small caps, and higher quality over lower quality, and dividend-paying over non-dividend paying. That is not what we saw in last week's rally, and, therefore, the rally is likely to be undone as the tensions in he Middle East flare up again.

Tuesday, August 15, 2006

The Y2K Effect, Here It Comes Again

In 1995, I left a large capital management firm and started Donaldson Capital Management. I had lots of contacts among investment company vendors, and a software company did me a big favor by selling me a state of the art investment management software package for $15,000. It did everything but tie your shoes. In 1998, I received a letter from the company saying that the software may not be Y2K compliant. I brought up the fact that I had just bought the software three years earlier, and I would have expected it would be Y2K compliant. They were so sorry, but no one knew what effect the year '00 was going to have on computers and software the world over. They said they were working on a new software package with many new features and guaranteed that it would be Y2K compliant. The cost $80,000. Needless to say I had many conversations with "my friends" from California, but they always said something to the effect that they did not know for sure whether or not my software would work after 12-31-1999. They believed that it would but could not guarantee that it would. They apologized in the humblest of language, but in the end, directed me to language in the contract that dealt with Y2k issues. I was stuck. Investment management software is the lifeblood of an investment firm. It is impossible to operate without it. I had no choice but to move to another software package. I did show my unhappiness with the situation by moving to another firm, but I spent another $20,000 in 1999 and moved to another software vendor. I had no choice and neither did millions of companies across the globe who got the same letters from their vendors--no matter who they were. No one knew for sure if there would be a problem with Y2K or not. But prudence mandated action. That prudence manifested itself in the biggest technological boom the world has ever seen, as individuals, companies, and governments around the world "upgraded." Another Y2K is upon us and soon every member of the "global village" will get the message: We don't know what energy will cost in the future, but it may be more than you can imagine. Oh, no one will say it exactly like that, but the body language and the "hems" and "haws" will say it loud and clear -- prudence dictates a change in your energy consumption patterns and devices. For individuals, the pressure to move to a more energy efficient automobile will become a mania. In three years, if you have the means, you won't dare show up at church in a vehicle that gets under 20 miles to the gallon. To do so would be like killing baby seals. You will be a pariah. New home heating systems will be like the aluminum siding boom of the 1960s. There will be "heating and cooling" consultants going door to door all over the country, proclaiming the good news of energy savings. Companies will face the same juggernaut of self doubt and public recriminations for their energy profligacy. The environmentalists will web sites that will show the amount of energy that every company consumes per employee, per dollar of sales, per % of GDP, per. . . you know the rest. Few corporate brass will have the guts to stand up to the public "dis"-relations that the "main street media" will lay on them if they have an unfavorable Energy Activity Ratio (EAR -- get it?). This means more efficient automobiles, heating and cooling systems, people movement and handling systems, technologies, lighting, and air transportation. Darn the cost-benefit analysis, oil prices are going nothing but up, and we must control what we can control. We must cut back our use of energy, and we can do so by "unconserving" our capital budgets. All across America at breakfast tables and in board rooms, the mantra will be the same: "The majority of the world's oil is controlled by people who hate us. We cannot sit idly by any longer. We must act, and we must act now." I am not a doom sayer. I do not share these words to scare anyone, and no one should think the worst from what I have said here. What I am saying is that the question of the supply of energy has reached the consciousness of the American consumer. The flare up in Lebanon was the final straw. Is there anyone who does not know that the next flare up will probably involve Iran and its 17% of the world's energy supply? I see a new car and a new heating and airconditioning system in your future. The same goes for corporate American, but add elevators, computer systems, and airplanes. The good news is this: there are three companies in the world that stand to be the biggest benefactors of the energy uncertainties: Toyota, United Technologies, and Boeing. In my judgment all of these companies have multi-year head starts over their competition when it comes to producing energy efficient products. Toyota with its high-mileage and hybrid cars, United Tech with its Carrier high efficiency heating ventilation and airconditioning systems for the home and commercial use, also its Otis Elevator division for commercial and government people moving systems, and Boeing for its fuel efficient fleet of new generation jet aircraft. You don't need to rush out and do anything tomorrow or even next month, but over the next few years, increasingly, the world is going to Y2K these companies. That is in an act of prudence, people, corporations, and governments are going to choose doing something to conserve energy over conserving dollars. I predict that in the next few years table talk among friends will center around the family's EAR as opposed to how much their house has risen in value. Notes: I made up EAR (Energy Activity Ratio) This will be an index using year 2000 (pre 9-11) btu per capital consumption and costs. Even though I made this up, you can be sure such an index is in your future. Employees (including me) and clients of Donaldson Capital Management own Toyota and United Technologies. One day we may own Boeing, but not today. Also one day we may sell any or all of the aforementioned companies without advertising it on this blog. That day might or might not occur when I read in the Wall Street Journal that the government has initiated an EAR index and that Toyota, United Technologies, and Boeing are the likely beneficiaries of such an action. There are many other companies that will benefit from the energy Y2K that I see unfolding. I will discuss them in the weeks and months ahead. Final Note: The software system I bought in 1995 still works. Go figure.

Wednesday, August 09, 2006

Big Over Small, Dividends Over All

In a recent Blog, I showed that the Dow Jones Dividend Index, which is comprised of quality, large-cap companies with high and growing dividends, has made a very sharp turn and in recent weeks has broken to a new high. I said this action signaled a flight to safety, as well as a search for predictable income. In a second blog, I detailed the fall in 30-year Treasury bond yields, which I described as signaling a top in interest rates and providing additional evidence that investors' concerns for safety have become paramount. Let me complete the trilogy by working backwards among capitalization, growth vs. value, and security types to show how powerful this shift in investment momentum has become and how long it is likely to last. This analysis of the relative strength of various kinds of stocks is key because small and mid cap stocks have outperformed large caps for the last six years, leaving many people muttering to themselves (including me) why the great fundamentals of high quality companies were being almost ignored. I have cited on at least two occasions in these blogs that by my calculations for the fair value of the Dow Jones Industrials is closer to 13,000 than it current fixation with 11,000. ......................S&P Small Cap Index............ The first chart is of the S&P 600 Small Cap Index vs. the S&P 500 index. The graph on the top of the chart shows the Index itself, while the lower graph shows the Index vs. the S&P 500. The index looks very toppy, but the lower graph shows a serious breakdown compared to the S&P 500. In other the words, small cap stocks are not only falling, they are falling at an accelerating pace relative to large cap stocks. Another blow to small caps may be near. Notice that the lower graph (most recent data at lower right) appears to be breaking down from its recent consolidation attempt. Small Caps have underperformed large caps by nearly 11% over the past three months. The chart makes clear that, at least over the last 3 months, big caps have overtaken small caps, and this trend looks pretty solid to me. ..................S&P 500 vs. S&P 500 Value................ If big cap stocks are outperforming, our next question is, is there a distinction between value and growth? The second chart is of the large cap S&P 500 Value Index. The lower graph is comparing the Value Index with the S&P 500 itself. The S&P Value Index includes those stocks in the S&P 500 with lower price to book, price to earnings, and price to sales, and higher dividend yields. The growth sector(not shown) is the other half of the index. Since we are dividing the S&P 500 into only two sectors, if the value sector is rising vs. the S&P 500, as it is on the bottom graph, that means that the growth sector is falling on a relative basis. The value sector's angle of ascent(shown on the lower graph) is very convincing. This means that not only is value outperforming growth, but the growth is in a freefall. This would corroborate the notion that investors are less willing to bet that high earnings growth will continue. Thus far in our analysis, large-cap stocks are performing better in the near term than small caps, and among the large-cap stocks, the value sector is performing dramatically better than the growth sector. The final part of the trilogy is a further "drilling down" to determine what type of large-cap, value stocks are doing the best in the near term. That answer is as you might expect: stocks with a higher than average dividend yield and consistent dividend growth, such as those contained in the Dow Jones Dividend Index. ..........DJ Dividend Index vs. S&P Value Index...... There are two key features to this chart. The top graph shows that dividend stocks have broken to a new 12 month high in recent weeks. No other major indices has done this. Second, the lower graph shows that the relative strength, which had been heading in the wrong direction until April, has made a remarable u-turn and is now headed sharply higher. Value stocks are doing better than almost all other major sectors, but on a relative basis, the Dow Jones Dividend Index is gaining ground almost daily. I expect this trend to continue. Large over small, value over growth, dividend over all. That's the picture I see, and the evidence is clear that this trend has a way to go. I'll describe these trends in the weeks ahead. Dividends are our world, and dividends have come to the forefront in these uncertain times. It is too simple to say that sooner or later they always do, but that says it about as well as we know how.

Friday, August 04, 2006

Cash Is King

I showed last time how the Dow Jones Dividend Index has caught the S&P 500 Index, on a price basis, for the last 12 months. I made the point in that edition that such a big relative shift towards dividend paying stocks was related to the uncertainties of oil prices and supply, the bloodshed in the Middle East, and the belief that the economy is slowing. In the last few weeks, investors have shifted away from risk and growth toward quality and stability. Whenever I see big shifts in the market, I always look for corroboration from other significant indicators. If big, savy investors are on the move, they will leave a trail that will show up in other markets and securities. Today's chart is of the 30 year US Treasury Bond Yield. It holds many important clues as to what big investors may be up to. Click to enlarge. ......................30-Year T-Bond Yield.............. The chart is of the yield on a 30-Year T-Bond. The chart covers the last 12 months. A year ago the yield stood at about 4.6%. Rates stayed in a narrow band through the end of '05, even though the Fed was raising short rates. As it became clear, that economic growth was taking off in early 2006, the yield on the 30-T-Bond began a steady rise to near 5.25%. It was at this point that Fed chairman Bernanke started talking tough. The Fed does not control long rates, such as 30-Year T-Bonds; they are set by the market. Thus, the yield on the 30-year T-bond is a kind of monitor of how well investors believe the Fed is doing its job of fighting inflation. Rising rates on 30-year T-Bonds indicate the market believes the Fed is not tough enough; falling rates say just the opposite. From March through May of this year, the market was saying that the economy was growing too fast and ran the risk of pushing inflation higher, which drove rates higher. After Bernanke and other Fed members began to talk tough, bond investors were relieved and bond yields fell. But two straight higher-than-expected inflation reports at mid-year pushed rates back toward their 12-month highs. In July, as bond yields returned to their May highs, Israel and Hezbollah began bombing each other. Unexpectedly, bond yields began to fall and have continued to trend lower. At first, this may seem counterintuitive. After all, the war in the Middle East has pushed oil prices higher and rising oil prices will surely mean higher inflation, won't it? That line of thinking would conclude that interest rates should have risen when the shooting began. But thinking about it more broadly, falling rates make sense. Bond yield are falling primarily because of a flight to safety(T-Bonds are considered to be among the safest bonds on earth). Additionally, I believe, bond yields are now falling because of recent economic data that suggest the economy is slowing, and the recognition that $3.00 a gallon gasoline will extract a lot of money from consumers' wallets. Here's the bottom line: Bond yields look like they have peaked. That's good news, but what is even more important is the relative strength graph at the bottom of the chart. For most of the last year, the rise in T-Bond yields has been greater than the growth in stock prices. Since June, however, the S&P 500 has been outperforming bonds. This can be seen in the downward slope of the lower graph since that time. I believe the rally in dividend-paying stocks and the rally in bonds has the same root: The Fed is nearing the end of its rate hikes. That is the good news, but there is also a bit of bad news. If the Fed is ending its rate hikes, it must be convinced the economy is slowing, and a slowing economy will result in slowing earnings growth. The risks of earnings disappointments in the coming year are now on the rise. The rally in quality dividend-paying stocks and bonds in the face of all of the uncertainties is natural. Money always goes where it is treated the best, and history shows that in times of turmoil and slowing economic growth "cash is king." Dividend-paying stocks and T-Bonds are the best sources of high and predictable cash flow and they will continue to rally until the uncertainties subside.

Friday, July 28, 2006

A Thousand Words

You know the old saying, and you know that in most cases it is true that, indeed, a picture is worth a thousand words. Click to enlarge. ................Dow Jones Dividend Index .........

The chart is of the Dow Jones Select Dividend Index. This is collection of companies that meet specific requirements for dividend yield, dividend growth, and dividend payout. While this index is not a carbon copy of our Rising Dividend style of investing, it is comparable its industry mix and strategy. The top of the chart shows the index's price graph over the last 12 months. The bottom of the chart shows the relative strength graph of the dividend index vs. the S&P 500 index. Both charts are eye popping. The top graph shows that dividend-oriented stocks have broken out of a year-long trading range. Actually, the trading range was more like 18 months. The new 12 month high price for the dividend index may be a bit counter intuitive at first. There is a war in the Middle East, isn't their? Oil prices keep moving higher. Commodity prices keep moving higher. The Fed just raised rates for the umpteenth time. Everyone knows the mood on Wall Street is cool at best. Yet, in this "fog of war" and "fog of feelings" the dividend index has risen to a new high. This is important!! In addition, the lower graph tells an even more interesting story. The graph shows that from about September of last year through April of this year, the dividend index consistently underperformed the S&P 500. At its nadir, the difference reached almost 7%. In my years in the business, I have seldom seen quality stocks so ignored -- shunned. I say quality stocks here because the dividend index, as constructed by Dow Jones, has a credit rating much higher than the average stock in the S&P 500. But in April, things began to change and the dividend index began to show solid relative strength improvement, indicated by the graph turning up. The turn was sharp and strong but was interrupted by the Federal Reserves' tough talk and fears of inflation in June. The short downtrend changed directions again with the outbreak of the Middle East war. This time investors, in my mind, correctly saw that dividend-paying companies were a safer vehicle to ride out not only the fog of war, but also the slowing economy. Now the dividend index has come all the way back to nearly catch the S&P Index for the year on a relative strength basis. To my way of thinking, the break out to a new high for the top graph (price) suggests that this pattern of outperformance by the dividend index will continue. Our own model Rising Dividend Portfolio has had similar relative performance in the last three months versus the S&P 500 and has modestly outperformed the dividend index during this time on a median return basis. In my judgment, a very big worm has turned, and big worms don't do much zig zagging, so I believe the swing back to high quality dividend-paying stocks will continue. They are cheap vs. growth-oriented stocks and now the momentum in in their favor. In the ways of Wall Street that is a tough combination to beat.

Enough said.

Wednesday, July 19, 2006

Good News, Bad News: Even Ben Doesn't Know?

There is the story of the old Chinese farmer whose only horse ran off with some wild horses that came through his farm one day. His neighbors came to console him, and when he was asked about his misfortune, he said only, "Good luck, bad luck: who knows?" A few days later, his horse returned and brought some of the wild horses with him. Now the farmer had many horses, and the neighbors came back proclaiming his good luck, but the farmer only muttered, "Good luck, bad luck: who knows." His only son then tried to break one of the wild horses and was thrown off and broke his leg. The neighbors came and offered their condolences for his son's bad luck, and the farmer again, said, "Good luck, bad luck: who knows." A war broke out, and the local militia came to conscript all the able bodied young men of the village. Because the farmer's son had a broken leg, he was passed over for conscription. Again, the neighbors came and said their piece, and the farmer only said, "Good luck, bad luck: who knows." I have told this story many times over the years, and everyone, at some level, understands its truth. The only constant to life is change. In January the Fed said the rate hikes were nearing an end. As a result, the market rallied almost 1,000 points over the next few months. Fed Chairman Ben Bernanke was asked if the market had it right? He said no, and within 30 days the 1,000 points had disappeared. After the most recent Fed rate hike, the language softened and the market again began to rally. Then, Israel and Hezbollah started hurling bombs at each other, and the market gave up most of what it had gained again. What is the lesson here? There are several: Today's hot news won't last; good news will not likely grow to heaven; bad news does not always destroy us; Ben Bernanke is a bit green in his public pronouncements; Ben Bernanke is doing as good a job as anyone could do under the circumstances; maybe the news of the days and the stock market's gyration on most days is just noise. The important thing to remember is that these are not unusual times. History shows us again and again that the news and the markets are always doing the tango. Every great investor that I have ever studied has said the same thing. The single most important investment precept is to buy companies that can stand the test of time. Why, because in time, every company will be tested. Good luck and bad luck will befall every company, and either kind of luck can destroy a company that is not equipped for change. The second most important precept is to buy companies that are valuable and undervalued. Warren Buffett says to buy great companies at good to great prices. Mr. Buffett does not say what he means by good to great prices, but he gives the clear indication that when prices are "good to great" for a company the investment world will probably be "down" on its prospects. Another way of saying this is that the company will be going through a time of testing, and investors are betting that the company won't make it this time. I believe I have heard Mr. Buffett say, that he looks more at the companies hitting new yearly lows than at the companies hitting new annual highs. I attribute the third precept primarily to John Templeton, the founder of the Templeton Funds. Mr. Templeton spoke often of acting on the courage of your conviction. He also spoke of the concept of maximum pessimism. J. Paul Getty and Ben Graham also echo these sentiments. To stick with the courage of your convictions, even in the face of a run of bad luck. This is not to say that Mr. Templeton advocates relying on blind luck; it is to say that if the companies you own have proven in the past that they can stand the test of time, do not abandon them in their time of testing. One day their luck will change, and the investment world will take note of it and drive their price to the moon. The sages of the investment pantheon all agree that you must have some means of determining the probable value of a company or the market. Without that, most people cannot stand bad luck very long. If you know the probable value of a company, bad luck is almost a cause for celebration because you know that the investors who invest only in prices will be selling and good to great prices may be just around the corner. Fed Chairman, Ben Bernanke, spoke today, and tomorrow the financial media will all say that he had some "good news" in his speech and that was the reason that stocks rocketed over 200 points higher, even though rockets of another sort are still flying in the Middle East. My belief is simple, and the same as I have been saying for months: sooner or later the Fed is going to stop their rate hikes, and when they do, investors will find that many stocks are too cheap and rush to push them higher, as they did today. Our valuation models suggest that the average stock in our Rising Dividend Strategy is 15% underpriced. The story of the old farmer has no ending. Good luck and bad luck will come to everyone, but if we let the world define when we should zig and when we should zag, there is a good chance of mistaking one for the other. The masters say that investing is not a function of zigging and zagging, but of zeroing in on companies that can fly in either kind of weather