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

Tuesday, July 18, 2006

How Not to Run an Economy

The principles of economics remain an absolute mystery to a lot of people, especially politicians. The following story is taken from the Washington Post. It describes the "rich" flight out of France by many of the country's most successful people. France has near double digit unemployment and GDP growth of a fraction of that of the US, but France does not get it. Let me say that again: France does not get it. And for all that they try to protect their "civilized" way of life, they are sentencing hundreds of thousands of non-blue blood youths to unemployment and government hand outs. Ronald Reagan talked about the need for a tax system that rewarded people to get off the wagon and help pull. In France the tax system assures that those pulling the wagon are becoming an endangered species. Please follow this link to the Washington Post.

Thursday, July 13, 2006

Implications of the current Middle East Flare Up Between Israel and Lebanon.

The flare-up in hostilities between Lebanon and Israel, obviously, creates a wild card to normal economic and stock market predictions, but, in my judgment, it actually augments the trends that I have been discussing. I believe that the US economy will slow over the remainder of 2006 to a 3% growth rate. The odds of this are increased as a result of today’s record high oil prices. The following is a short list of observations regarding the implications of the Middle East hostilities. I will expand on these points later, but I want to get my thoughts in front of everyone as soon as possible. There will be plenty of hand wringing going on, but I don’t think things are anywhere near as dire as the news media will portray it, or the stock market will reflect it. 1. World wide economic growth will not be significantly impacted by the fireworks in the Middle East.

2. Higher oil prices will act much more like a “tax,” slowing the economy, than adding to inflation problems.

3. The slowing economy will favor larger companies over smaller companies, higher quality companies over lower quality companies, and multi-national companies over domestic companies.

4. If the fighting intensifies, the odds of additional Fed hikes diminish.

5. If hostilities continue, the most attractive industry sectors over the next 12 months would likely be Consumer Staples, Energy, Utilities, Healthcare, Financial, and Real Estate Investment Trusts. Basic Industries, Technology, Telecommunications, and Consumer Cyclicals will be weak. Industrials will be neutral, but Aerospace and Defense within the sector will perform well.

6. Quality bonds and preferred stocks will do well. Interest rates have likely seen their highs. The outbreak of fighting between Lebanon and Israel could include Syria very quickly, and we all know that Iran is behind all of it. Because Iran is the second largest producer of oil, oil prices will be dicey for the near future. That is why we are buying more oil stocks today. This situation is different from Iraq. World powers are aligned with the US against Iran in it adventures in enriching Uranium. Not every country sees it the way the US or Israel does, but they all realize that it is not in their best interests to allow Iran to continue its talk of “eliminating Israel from the face of the earth.” I have said this before and I do not want to minimize the situation in the Middle East, but oftentimes when the fighting actually breaks out, the solution is closer than during all the rhetoric. Having said this, I still pray for the peacemakers and that wisdom and peace will prevail. Anyone reading this knows that we are very conservative and slow to make changes in fluid times. Having said this, we believe the sell off in stocks is a buying opportunity. We will be nibbling in the areas I mentioned earlier. I will have more later.

Tuesday, July 11, 2006

The Consumer Staples Sector Comes to Life -- More to Follow

I have been saying for nearly a year that quality was being undervalued by the market. By that I have meant companies with AA and AAA financial strength ratings and solid earnings have been priced like East Pearidge Sand and Gravel. Indeed, I have commented to many people my amazement at the fact that nearly all of the high quality multinational growth stocks have been trading at a PE of near 20, about the same as the average small cap stock, whose fortunes are not nearly so established or predictable. I have concluded that lack of appreciation for and consequent lack of price appreciation in the great blue chip growth stocks was because of the strong economy and the lack of concern about risk. In this kind of environment, Wall Street will often move to smaller companies whose prospects are not so predictable, hoping to get lucky, so to speak. In recent blogs and client letters, I have explained that as the Fed continues to push rates higher, risk will soon become much more important. The reason is simple: the higher rates will slow the economy, and the slowing economy will impact earnings. The companies whose earnings will be impacted the most are those companies most directly tied to the US economy -- small and mid cap companies. High-quality, multinational companies derive as much as 70% of their earnings outside the US. Additionally, their businesses are much more apt to be what I call necessary services -- consumer staples, healthcare, energy, and financial services -- all less sensitive to the economy that lower quality companies. I believe the first evidence of this is now occurring. The chart below is of the S&P Consumer Staples. The staples, which include Coke, Pepsi, Procter and Gamble, Colgate, Walmart and many more, have been laggards for the past couple of years. In recent weeks in the face of thought talk by the Fed, that underperformance has turned abruptly and convincingly. Click to enlarge** The chart shows that the price trend (the top graph) has broken out of year-long sideways movement to hit a new intermediate high. In addition, the lower chart, which shows the relative strength of the consumer staples vs. the S&P 500, also shows a upside breakout. This double breakout is a very good sign that the staples are signaling a move to even higher ground. Our valuation work shows that while this sector's financial strength rating is amongst the highest of all sector ratings, it is one of the most undervalued sectors in the current market. Timing is a tricky thing in the market, but it would appear that the valuation gap for the staples sector is beginning to close. I'll keep you updated from time to time on its progress.