Monday, March 05, 2007

Everything Isn't Enron

By Greg Donaldson and Mike Hull

When emotions begin to run high in the stock market and fears seem to spring from the four corners of the earth, it can seem as though common stocks are nothing more than a flickering image on a computer screen. They have no substance, no value-added, no raison d'etre.

The fact that a company has been in business for a hundred years and has weathered every form of natural and man-made disaster, that it has not only survived but has produced a regular and growing profit, paid taxes and passed some of the remaining profit along as a dividend to it shareholders mean very little when traders are fearful and terra incognita surrounds them.

Sell before______happens and its too late. Everything is Enron, nothing is safe, nothing has any substance.

We have been through these kinds of markets and emotions hundreds of times and nothing ever changes. Good stocks, valuable stocks are thrown out as though they were worth nothing more than the stock certificates they were once printed on.

A person sees enough of these kinds of market swoons and you come to the conclusion that they are a natural part of investing. It is a time when the speculators and day traders sell at bargain prices to the long-term investors, who will then sell back to the speculators and day traders two to three years hence -- at much higher prices.

The chart below shows a glimpse of this:

Click to enlarge.

The chart is of the Exchange Traded Fund for the S&P Dividend Aristocrats (symbol SDY). The Aristocrats are a remarkably unique collection of companies that have raised their dividends for at least 25 consecutive years. They also tend to have higher quality ratings than the average company.

The top of the graph shows the price of the SDY. On the bottom is a relative strength chart comparing the movement of the SDY to the S&P 500.

Notice that even though the SDY was rising (top graph) along with the market from June of '06 through January '07, that on a relative performance basis it was trending lower (bottom graph).

In June, when it was clear the Fed had stopped its rate hikes, money moved away from these high quality, dividend payers and went to higher octane stocks. In mid-January '07 these trends reversed, and in the recent market sell off, even though SDY has fallen in price, on a relative basis it has actually risen.

At first this may seem like a hollow victory. The truth is SDY went down; so what if it went down less than the average stock? It means a lot if you take into account that the high-quality companies contained in SDY are now selling on a valuation basis just about where there average stock is.

The market will continue to be choppy for a while longer, but it is clear to us that there are plenty of buyers of high quality dividend-paying stocks. It may not show on an absolute basis, yet, but when the current selling pressure abates, we believe rising dividend stocks will be the new leadership. We believe they are undervalued and better suited to the heightened sense of risk that is in full bloom in the world wide stock markets.

We are not recommending SDF. We are using it as an example because it is a kind of extreme example of what we believe is the best predictor of value -- rising dividends.