Sunday, February 28, 2010

Two Stocks That Are Not Cheap

We are dividend investors and lost among all the talk about dividend investing is the subject of valuation.  We say that dividends are important for two reasons: 1. They have represented almost 50% of the total rate of return of stocks over the last 50 years; and 2. In many cases dividend growth is highly correlated with price growth. 

We can conclude from these two facts that correlation modeling can reveal the "normative" value of a stock at any point in time.  This of course does not mean that these normative valuation models can predict the future, nothing can do that; but it does give us a good idea of how the market has valued a company's dividend profile in the past. That coupled with the fact that dividends have been approximately one-third as volatile as earnings over the long-term, in our judgment, gives us the best guess possible about the approximate value of a company. 

The "unknowns" have been winning the battle against the "knowns" in the economy and the markets in recent months.  In this environment, it is not surprising that the Processed Food Industry group has flourished.  Not only is the group defensive in nature, but also with such a weak economy, investors are betting that more meals are being eaten at home than away from home.  Thus, the Processed Food group has been riding high. 

Our dividend valuation models, however, suggest that the group may now be discounting all the good that is likely to come over the next twelve months.

The two charts above are of Kellogg (K) and General Mills (GIS), two leaders in the Processed Food category.  The red lines are the anual price movements of the two stocks and the blue bars are the annual dividend valuations based on a multiple regression of their stock prices versus dividend growth and interest rates. 

The picture is nearly the same for both stocks.  They ain't cheap.  The price lines are now above their current dividend valuations, but more importantly, their current prices are above their projected growth in dividends and valuations (the striped bars) over the next 12 months.  In short, to our way of thinking, these two stocks, and many others in the group are not cheap.

Oddly enough, the Household Products group, not shown here, which includes Procter and Gamble (PG) and Colgate (CL), is still selling far under its dividend valuation.  We'll be watching for a shift away from the Processed Food group to the Household Products group in the weeks and months ahead.

We own CL and PG.  Please see Conditions of Use of this blogsite on the right side-bar.

Thursday, February 18, 2010

A Rate Hike That Wasn't

After the close of the market today, the Fed raised the "discount rate" by .25% to .75%. Headlines immediately appeared on many Internet sites that the Fed had begun the process of tightening interest rates. Stock futures fell by 1%. Mr. Bernanke tell us it IS so; tell us that you have evidence that we do not yet see. Evidence that the economy is improving enough to start hiking rates. From the cliff hanging experience of 1929-type depression fears that we have been nursing over the last year, such an expression of good news would be cause for, well, a Mardi Gras type party right down the middle of Wall Street, or whichever street we happen to inhabit. But alas, a hike in the discount rate is technically a non event because banks only use the discount window in emergencies. The Fed Funds market is where most bank short-term lending and borrowing is done, and the Federal Reserve's news release is clear that the Fed Funds rate is not changing. Indeed, the most recent language from the Fed suggests that the Fed Funds rate is not likely to change anytime soon. But if the discount rate hike is completely unimportant, then why did the Fed go to the trouble of raising it? Call it the Fed's adherence to protocol. While the discount window is normally a place for emergency borrowing, it was a tool that the Fed used during the "valley of the shadow of death" when banks were so fearful of each other that they would not loan excess reserves to their brethren, even on an overnight basis. The Fed encouraged many big banks to borrow from the discount window as cover for banks who were being shut out of the Fed Funds market, as a result of loan losses and liquidity fears. The good news in the discount rate hike is the implication that the Federal Reserve now believes that the Fed Funds market has healed and that banks no longer fear each other's balance sheets the way they did a year ago. I think the Fed is merely giving cover to the banks that they encouraged to use the discount window to exit and return to the Fed Funds market. A true Fed rate hike would not be welcome news to most investors, but it would be to me. It would speak volumes about the nascent strength that is building in the US economy. We should all be hoping that a strengthening economy would force the Fed to move. The market won't like it for a day or two, but after what we have been through, it would be the surest sign that growth has taken root. Unfortunately, the Fed's action tonight doesn't carry that implication. But it does signal that the Fed Funds market has returned to normal, or close to it. That may be better news than most of us can understand.

Monday, February 15, 2010

Dividend Paying Stocks: The New Gold Standard

On one of the blackest days of the financial crisis in late 2008, I received a telephone call from a fellow investment manager. He is a person I respect very much and has built a great firm. He said he wanted to pick my brain on a matter that was urgent. He went on to explain that on that day he had $40 million in bonds coming due and the reinvestment options he was being given by his institutional brokers were all bad. Remarkably on that day he was being told that T-bills had a negative return. That is, he could put the money away in a safe place, but when it matured he would get back slightly less than he had put in. These were scary times. The man in question is a "Cool Hand Luke" kind of a guy and his voice was as steady as a rock as he went down the list of how bad things had gotten. The commercial paper market had frozen up; the corporate bond market was in a free fall; and stocks were collapsing. He said ordinarily he would just negotiate an overnight rate with a bank, but he had no idea which of the banks he dealt with were safe. Indeed, he wasn't even sure if his custodial bank where the assets were held was safe. His said he knew that I was a long-term investor and that I usually did not deal in the overnight market debt market, but he wanted to know what I felt "sure" about. What part of the financial system did I believe had the highest probability of making it through what looked like, at the time, an economy that was headed toward a 1929-type depression. I asked him if he was talking about stocks or bonds. He said both, but bonds first. I said the bonds I had the most confidence in were high quality municipal bonds. I added that I would stay away from the areas of the country that were having the most problems with real estate delinquencies. I went on to explain that municipal bonds had fared well during the 1930s depression, and I had a lot of confidence they could make it through this economic collapse, as well. He knew this as well as I did and concurred with my thinking. He asked about where I would invest in stocks. I think I surprised him when I said, "I believe one of the safest investments you can make in this market is what I will call "Gold Standard" common stocks. I told him that I thought there were approximately 100 companies in the world that might be safer than any government and would not only survive the crisis but would come out on the other side even stronger. I told him these companies would survive and prosper because of seven reasons:
  1. They did business all over the world, so they were insulated from what was going on in the US or Europe.
  2. They had a low debt to equity ratios.
  3. They generated enough free cash flow to fund their working capital needs, so they did not need to be begging the banks for money. This free cash flow also gave them access to the capital markets.
  4. They sold products that we use every day, what I call "essential services" products.
  5. They were the undisputed leaders in their businesses, which allowed them to influence the competitive landscape for their whole business sector.
  6. They had been around long enough to establish a powerful brand, and they were extending their brands in the developing countries of the world.
  7. They treated their shareholders like owner-partners by paying a generous dividend.

I told my friend that these companies did not have the power to issue currency, nor field a standing army, but in an increasingly global economy, they had something better. They had created mutually beneficial relationships with billions of people the world over, who, on a daily basis, chose these "Gold Standard" companies' products and services more often than those of their competitors.

I concluded with the following. "I said I called these companies "Gold Standard" companies. I mean that literally in this way. Gold has long held the mystique, if not the reality, of being the ultimate store of value. Thus, in very difficult times when the financial system creaks and groans lots of money always goes into gold until the dust clears. But Gold's rate of return over very long periods of time has been poor, little better than inflation. The "Gold Standard" companies that I was thinking of had just as impressive a record of surviving the bad times, but had produced a compounded annual return that beat gold handily."

"Gold Standard" companies have been refined in the flames of countless tough economic times. Companies rise to the level of the "Gold Standard" not because they have survived for 25 to 50 years, but because they have grown for 25 to 50 years.

My conversation with my friend was now over a year ago, and while things have gotten better, there are still worries a plenty. But as I remind our clients often, "We are not investing in countries we are investing in companies. Companies that have been tested by time and have become more powerful because of the testing."

Sunday, February 07, 2010

Customer Loyalty Will Save the Day for Toyota

From Mike Hull, President Donaldson Capital Management Consumer Strategist Like every corporation, Toyota has three obligations. It must be fair to its customers, employees, and shareholders. Being unfair to any of these stakeholders will cause them to take their contributions toward the company’s success elsewhere. Customers will buy what they need from another company. Employees will find work where they are treated better. And, shareholders will take their capital where it gets treated more profitably. Historically, Toyota has always treated all three stakeholders well. Today, however, it has a crisis with its customers with regard to unintended acceleration issues. To help recover from the crisis, employees are stepping up around the globe. Shareholders are scratching their heads and asking, “Is this still the company I thought it was or has the quality of its products and its reputation been irretrievably harmed? Indeed, would my money be better off somewhere else?” Employees are the easiest group with which to reach a conclusion. Toyota expects a lot from its people. But it trains them well, gives them all they need to do their jobs, and it pays them well. Insiders tell us Toyota treats their employees like family, which means, among other things, that they have almost no layoffs. From all we can see, Toyota is in good standing with its 320,000 employees. Toyota customers appear to be a loyal bunch. We have access to very little of the market research the car companies have performed. From anecdotes and general observations, however, Toyota has offered its customers quality and reliability for decades. That is evident in the way its customers have been willing to pay up a bit for those benefits, even as those cars hit the used car market. While most Toyota models are stylish, they do not command a crowd of “Toyota Enthusiasts” like Corvette or Porsche might. Toyota loyalists have come to look at their cars as highly dependable, quality rides. If Toyota can regain its quality and dependability, we believe the customers will remain loyal to the company. In the paragraph above, the word loyal stands out. We know loyalty can be won and it can be lost. We also know that loyalty does not depend on perfection. Everyone makes mistakes. Humans run car companies. Humans buy cars. In our judgment, if Toyota solves their current problems, their customers will forgive them. The company’s CEO said on Friday, “The company is prepared to cooperate fully and sincerely, and we are doing our utmost to deal with the matter in a way that brings safety and peace of mind to our customers.” We believe he'll deliver on his promises. Further, we are banking on two things happening over the next several months: 1) People owning Toyotas involved in the current recalls (8.1 million autos) will be treated far better than they would expect when they take their cars into their Toyota dealers. This great service will cause Toyota owners to regain their loyalty and become advocates for the company. 2) When people looking to purchase a new car think about Toyota, a new logic will come to mind that will sound something like this: “Toyota knows that they cannot afford to put another car on the road with any kind of quality issues. Surely, at this point, they have gone as far as a company can go to assure that the new cars coming from their factories are built of quality that is beyond challenge.” The media has beaten up the company pretty well on its slow response to these quality issues. Even Congress is going to jump into the act. Indeed, life-threatening problems with cars are serious business, but the number of reported cases of sudden acceleration is remarkably low compared to the total number of cars that are on the road. Furthermore, other auto companies have almost as many reported incidents of the acceleration problems as does Toyota. Bottom line: everywhere we look the news is about as negative as it could get for Toyota right now, and we believes it ignores the loyalty of Toyota owners. Oh yes, the third stakeholders: we the shareholders. Toyota is a company with huge financial strength; they can weather their current difficulties no matter how long it takes to clean them up. Because of this, we are much more optimistic about the company's prospects than many investors who have thrown in the towel on Toyota. Here's our reasons: Global auto sales fell dramatically over the last two years, pushing the average age of cars on American roads above 10 years. It is well known that the number of repair incidents for cars above 8 years rises geometrically. That means that repair costs for the average family in the US are rising rapidly. Additionally, repair costs are not the whole story. An unreliable car adds significantly to the nuisance factor in the lives of American families. In short, there is a lot of pent up demand for new autos that is building everyday. Toyota has built almost their entire strategy on quality and loyalty. Quality may be in doubt at present, but it will take more than the few issues they have today to break the loyalty they have with their customers. That is what we believe, and if that is true, Toyota common stock will recover and we will be rewarded along with their employees and customers. The best time to have bought Johnson and Johnson was during the Tylenol scare. We are convinced that history will show that the best time to have bought Toyota was during the accelerator scare. At current prices, we believe TM offers good value and we are nibbling on the stock for clients who don’t already own it. We own the stock. Please see "Conditions" on the right sidebar.

Monday, February 01, 2010

The CRUD Will Pass

Donaldson Capital Investment Policy Committee Meeting 2/01/10 For the past two weeks or so the market has reacted to very positive earnings and GDP news in a very unexpected and negative way. Q4 2009 earnings and revenue news is better than expected – much better. Q4 2009 GDP change came in at +5.7%, more than a full point higher than consensus. Further, it wasn’t just inventory rebuilding. In fact, inventories actually continued to decrease in Q4, although at a significantly reduced rate. The consumer spending element of Q4 GDP was better than expected. In our view, the market’s negative action over the past two weeks was a result of news beyond solid earnings and GDP reports that caused greater uncertainty on several major fronts. And, the market almost always reacts negatively to greater uncertainty. In our meeting today we coined the acronym CRUD to explain the issues we believe were most responsible for this increase in uncertainty: C = China tightening their money supply to slow their double-digit growth R = Real estate and housing data that suggest the uptick may have stalled. U = Unemployment claims moving higher than recent trends. D = The Democrats’ loss in Massachusetts, causing chaos in the political scene. The above new developments caused investors to be less certain about the strength of the economic recovery as well as about how the shift in the balance of power in the Senate might affect pending and future legislation. In the case of the latter, it was sort of “The devil you know is better than the devil you don’t know.” Business generally wasn’t crazy about health care reform, cap and trade, tax hikes, etc. But at least they had some idea of what the future ground rules would be. With the upset in MA being so recent, no one has any idea of what to expect out of Washington over the next several years . . . therefore increased uncertainty. All of this has been aggravated by a tendency for the market in the short-term to have a “boom or bust” psychology. That is, it tends to operate as though there are only two possible outcomes; things will be terrific, or things will be terrible. The actual economic data, however, is playing out fairly consistently with what the Investment Committee has been expecting:
  • Q4 earnings are surprising to the upside, in large part because of aggressive cost cutting.
  • Quarterly year over year earnings are higher for the first time in almost 2 years.
  • Revenues are no longer declining, they are starting to grow modestly.
  • GDP was very strong in Q4.
  • Unemployment remains stubbornly high, around 10%
  • The Fed is keeping the Fed Funds Rate low at 0% - 0.25%
  • Dividend stocks have outperformed non-dividend stocks over the past 1, 3, & 6 months, reversing the “Survivors’ Bounce” effect of March-September.
  • Dividend paying stocks have lower P/Es than the market average.
  • Emerging market economies are strong; Europe is weak; US is recovering In our view, the CRUD uncertainties are a temporary issue. The fundamentals of business and the economy are headed in the right direction, and in general, valuations still favor our dividend-paying stocks. The primary remaining uncertainty with Rising Dividend stocks is just how much they will increase their dividends for 2010. We have no idea yet, but two of the earlier announcements were good omens. Praxair (PX) and CVS (CVS) Drugs each increased their 2010 dividends per share by about 13%. EPS estimates for the coming year for the S&P 500 are at $77.95, a near 25% increase over 2009. The 2011 earnings forecast is $94.56, a 21% increase. If the estimated P/E ratio for the market were to be at its long-term average of 15 at the end of this year, and expected 2011 EPS were still $94.56, the S&P 500 would be at 1418, or nearly 30% higher than today’s market close. The Committee is not predicting a 30% gain in the market. But, with fundamentals improving for the economy and businesses, we continue to believe that total returns for 2010 will be quite good. A newly added variable to the market psychology equation is President Obama’s proposed fiscal 2011 budget. His official budget proposal was made public this morning. Over the next several weeks, the Investment Policy Committee will be studying the budget’s major elements, as well as their interpretation by investors.


Randy Alsman, Editor

Mike Hull

Rick Roop

Greg Donaldson