AAPL AIN'T CHEAP . . . MSFT IS

• 1. In my recent book, The Hidden Power of Rising Dividends (available at Amazon), I argue that very few individuals or professional investors are confident in how to calculate the intrinsic value of a stock.

• 2. The typical stock investor today has largely become a trend follower. Put another way, they are really momentum investors.  

• 3. I have been in the investment business for nearly 50 years, and I have learned many people who admit to being momentum investors, find that they cannot pull the trigger to buy or sell when the momentum trend changes. In failing to sell at the right time, most of them become "stuckholders."

• 4. In my many years of exploring every classical and "wild hair" investment strategy I could find, I have found that many slow-growing stocks can be valued very precisely. Most companies; however, require a deep dive into their fundamentals, looking for "tell" signals. Finally, valuing very fast-growing companies is always an educated guess at best.

• Last time, I showed valuation guesstimates on PepsiCo (PEP) and Coke (KO). These are both slow growing, high dividend-paying companies with powerful brands. My models predict that Coke (KO) is modestly overpriced and PepsiCo (PEP) is significantly underpriced when using year-ahead estimates.   

• This time I am comparing Microsoft (MSFT) and Apple (AAPL). The valuation correlation metrics for these two tech stocks are much more difficult to find because dividend growth alone does not offer high correlations for either stock. For Apple, earnings growth offer a 90%+ correlation with stock prices over the last decade, and gives us a decent guesstimate of the company's current valuation. 

• For Microsoft, it is necessary to use a proprietary valuation model that includes some portion of dividends, earnings, and interest rates. The chart below shows the remarkable tightness between MSFT's actual stock price (red line) and the model's annual predicted price, shown in green. Currently, the model says MSFT should trade at approximately $422 per share. It is currently trading for near $430. At least in this first step, MSFT would appear to be about fairly priced.

The picture for Apple indicates a bit more risk.

Apple's correlation model shows that its actual price of $239 per share, shown in red, is clearly higher than its predicted price, in green, of $206. 

Based on historical data over the last 13 years, my models are saying MSFT is selling about where it should be, and AAPL is selling nearly 15% higher than its fair value. But as I said last time, "the future is in the future" for all stocks, so we must plug in next year's estimates for both companies to determine if that makes any difference.

Using the mean forecasts from Wall Street analysts, my model predicts a year-end 2025 price of $483 for MSFT and $228 for AAPL. That would offer an approximately 12% gain for MSFT and a relatively flat rate of return for AAPL in the coming year. Indeed, selling at $239, AAPL is already trading above my modeled $228 predicted year-end 2025 price. 

I own both stocks and do not have plans at this time to sell either. However, seeing Apple's valuation does cause me some concerns that I had not thought through before I began this exercise. MSFT, on the other hand, looks even better than I would have guessed. As I said last time, this is not Wall Street research. I am using simple correlation models to arrive at the price estimates I am showing. Thus, this article should not be viewed as investment advice, but just a simple analysis of fundamental data within each company that is highly correlated with changes in its annual stock price. 

 

The (Smart) Trend is Your Friend: Stocks Moving Higher

In the world of investing, you have to see things a little bit differently than everyone else.  You don’t win by following the “big dumb trends”.  These are the things that everyone already knows about.  These trends are - at best - fully reflected in the stock price.  At their worst - they create the types of bubbles we have seen balloon out of control and then pop. 

The danger in the stock market comes when everyone starts to see things the same way.  When investors start all herding together towards the same industry (see Technology in the late 1990s and early 2000s) or stock (Apple’s recent tumble from $700) or idea (homes will never decrease in value) - that is when things are most dangerous. 

Investors who buy or sell based upon what that they read about in the Wall Street Journal or see on CNBC don’t find out about the party until after it has happened.  They miss out on the biggest returns before the trends start or get scared out of good opportunities. 

A key to long-term stock market performance is

Wells Fargo Tops Our New Fundamental Index

We describe our new Donaldson Fundamental Index in an article we wrote for Seeking Alpha financial website.  Please follow the link to see what our model has to say about the prospects for Wells Fargo.

 http://seekingalpha.com/article/468621-wells-fargo-the-highest-ranked-stock-in-our-new-fundamental-index

United Technologies: The Hidden Dividend Star

United Technology (UTX) is the Dividend Star most of the simple dividend-growth filters miss.  This is because they do not raise their dividend every year. UTX takes action on its dividend every six quarters, not every four quarters, as do many dividend stars.

I have even tried to explain to the company's investor relations department that while their every-six-quarters dividend hikes has been quite predictable, that such a policy means that about every three years their annual dividends flat line. Thus, the company is not included on many lists of companies with long-term histories of consecutive dividend hikes.  No matter says the company. They like to do it the their way.

In this case who am I to push against such a winning record, just to make it simple.  UTX has one of the most consistent dividend growth records of any company I follow.  The following are their 20, 5, and one year annual dividend growth rates.

1. 20-year growth rate  11.3%
2. 5-year growth rate    12.5%    
3. 1-year growth rate    12.9%

To top it off, the estimate of UTX's three to five year dividend growth rate is just under 12%.  At that rate of growth its dividend will triple over the next ten years.  Not bad for a company that has a current yield of 2.6%.

Despite UTX's consistent dividend hikes and earnings growth over the last twenty years, the Dividend Valuation chart at the top of this page suggests that the company is significantly undervalued based on the historical relationships among its price growth, dividend growth, and interest rates.  UTX's current price (red line) is much lower than its current valuation (blue bar) and even lower yet, than our estimate for next year (checkered blue bar).

The so-called Correlation Index, which measures how tightly the average stock is tracking the major indices, has risen to as high as 85% in recent weeks.  Its normal reading is near 15%.  This means that the constant on again off again European bail out proposals have turned what is normally a market of stocks into a stock market.  What I mean by this is that almost all stocks have been caught in the maelstrom of big up and down days, which would indicate that all companies have about the same future profit and dividend potentials.  If you take a few minutes to think about this, the truth almost smacks you in the face.  The one thing we know for sure is that the future prospects are not the same for all stocks, thus, it is just a matter of time before stocks start to trade on the bases of their own unique fundamentals, not the generalized fears of the European situation, no matter how things turn out.

In this regard, we believe UTX has quite a pedigree and will ultimately break away from the pack and show it star quality..   

I own UTX.

Have Multinational, Dividend-Paying Companies Become the World's Safest Investment?

Investment Policy Committee Notes

Summary Points:

•  Debt ceiling saga continues to keep markets in flux
•  Debt Rating agencies forewarn of credit downgrades for the world’s few AAA rated countries
•  The European Union scrambles to reschedule Greek debt
• The Municipal bond market somewhat stagnant as investors await Congress’ decision on the debt ceiling
•  2^nd Quarter company earnings continue to outperform

Discussion

Needless to say, there is a barrage of perceived and real worries in the world today.  Most pressing in our view, however, is the topic of the United States debt ceiling, and the anticipated outcome of Congress’ decision to either raise the limit or let the U.S. default.  The Donaldson Capital Management Investment Policy Committee (“IPC”) discussed at great length what truly constitutes a default. We have read many publications, and watched several news conferences in order to learn of the possible outcomes.

Timothy Geithner, the U.S. Secretary of the Treasury, seemed to dance around an interview question on the plausibility of the U.S. defaulting on its obligations.  Although he did not confirm that the U.S. would default, he did say that by definition the U.S. could be in a ‘technical default’.   Essentially we understood this to mean that without the debt ceiling being raised, with the current level of Government outlays exceeding tax revenues, certain obligations would not be paid.

This is where it gets a bit fuzzy.  There will be a natural order to things, or rather, a priority of who will get paid first in the hierarchy, but how that order is defined is the real question.  While difficult to determine who would get paid and who wouldn’t, the Government realizes that its creditors are made up of countries and large institutions with a strong investing prowess. Therefore it is very important the U.S. make good on its debt obligations to these creditors because we will have to go back to them for future borrowing needs.

However, should the U.S. fix its deficit issues off the backs of those dependent upon their monthly paychecks such as retirees or the disabled by taking away or reducing these benefits?  Either way you look at this issue, it’s very difficult to determine the best way to solve the problem at hand. 

The markets have responded to the expanding uncertainties with mixed emotions.  They have become more volatile in the past few weeks but have traded in a reasonably narrow range.  What seems to be the issue with the uncertainty is uncertainty itself. 

Another correlating variable to the volatility of the markets is the debt rating agencies’ warnings of decreasing credit ratings for some of the strongest countries in the world.  Standard & Poor’s rating agency, along with Moody’s and Fitch’s have all stated they will remove the U.S's AAA rating should either no deal, or a perceived insignificant deal, be passed.  This trend has extended, however, to other countries such as Germany.  This is rather surprising considering the positive attention the Germans have received for their strong fiscal budget and spending discipline.

This may be an unprecedented time in history to have the world’s ‘riskless’ investment (i.e. U.S. Treasury bonds) take on the risk by being downgraded.  What, then, should the world use as a benchmark for risk premiums, capital cost configurations, and the like?  It is the belief of the IPC that no matter the outcome, the U.S. policymakers will do what they can to prevent default and perhaps safeguard the status quo.

Not only so, but as it pertains to investors, differing investment options are graded on a curve. When surveying the world and all the differing investment securities available (from stocks, to bonds, to cash, to foreign currencies or securities, etc) investors perform a mental accounting to rank various investment options against each another.  While there is the real possibility the U.S. debt rating could be downgraded, generally speaking the U.S. is still one of the safest places in the world to invest one’s money. 

A comparison to the bailout plan offered by the European Union to support Greece shows the situation in the U.S. could be much worse.  Private holders of Greek debt are taking a 21% haircut on their investments, which is causing grumbling among investors.  As we have seen, a rippling effect can occur across the European Union should one country default on its obligations.  We are optimistic, however, to see that a new Greek debt restructuring plan should whittle down the country's debt-to-GDP ratio closer to 100% (a more manageable level). 

The IPC then turned its attention to the municipal bond market and noted that the issuance of new bonds has slowed dramatically.  It would take several more paragraphs to explain why, but Congress’s decision to limit new Treasury bond issuance as we near the federal debt ceiling has had the effect of reducing the number of new municipal bonds coming to market.  Therefore, the municipal bond market has now been, at least temporarily, impacted, by the debt-limit standoff.

That is not good news, but there is some good news about credit quality in the municipal bond market.  A recent analysis of our bond holdings showed significantly more upgrades than downgrades.  In fact, the municipal bond market as a whole has fared very well this year, especially in retrospect to analyst Meredith Whitney's dire prediction.  If you remember, she proclaimed there would be hundreds of billions of dollars worth of defaults in 2011.  So far in 2011, only $750 million have defaulted; a far cry from her forecast.  This compares to the amount defaulted in 2010 and 2009 of $2.5 billion and $4 billion, respectively.

Lastly, the IPC discussed corporate earnings for the 2nd Quarter.  So far in this earnings reporting season, a little over 200 companies within the S&P 500 have reported.  Earnings have continued to outperform in both year-over-year growth,18%, as well as earnings surprises,7.5%. (defined as the difference between actual earnings and analysts’ estimated earnings.)  These big earnings gains have also resulted in sizable dividend hikes.  In our two main dividend investment styles, dividend increases over the last year have averaged nearly 14%, the highest growth rate in many years. 

In the spite of all the news that is causing volatility in the stock market, U.S. companies are still expanding and growing at an impressive rate.

Many questions remain regarding the final outcome of the debt-limit stalemate in Congress.  Because this stalemate involves the heretofore safest investment on earth, U.S. debt securities, the options for a perfectly safe hiding place are very few.  Furthermore, we remain convinced that this stalemate will be broken and when it is the few investments that are doing well right now like gold and Swiss,Canadian, and Australian currencies will fall in price.  In essence to invest in these securities at this time is to bet that the U.S. will not only default but remain in a defaulted condition for an undetermined time.

As we have said on many occasions, it is becoming clear that high-quality, multinational corporations may now be the safest investments in the world.  They have piles of cash, significant free cash flows, modest debt loads, compete in every corner of the world and charge a price for their services dictated by the market and not decree, pay taxes in every country in which they operate, and return a significant portion of their annual earnings to their shareholders in the form of dividends.  Go back through this list of attributes and you will find few similarities with most sovereign debt in the world.

We'll report again next week on how the fiasco in Washington DC is playing out.

A Lot of Bullet Points That Add Up to Stocks Being Higher by Year-End

Summary Points:

• Continuing to assess stock market outlook – balance still positive
• Recent pullback in stock prices has been moderate on low volume

Discussion

The Donaldson Capital Management Investment Policy Committee continued our review of economic data and forecasts for the year. While the economic headwinds are much in the news, it is our experience that positive events get less play in the media than negative ones. To try to identify an appropriate balance, while recognizing that items listed are not all equal in impact, we built our own list of significant headwinds and tailwinds.

 Headwinds

• QE 2 ends this month.
• The May new jobs number came in way below trend.
• The European Economic Community has not yet solved the Greece problem.
• Consensus 2011 global GDP growth expectations have dropped 0.5% or so.
• National average house prices are still dropping.
• The unemployment and “functionally unemployed” rates have ticked higher.
• State and local governments are still eliminating jobs.
• Savings rates are high, potentially reducing consumer spending.
• Gas prices are ~$1/gal. higher than a year ago.
• Congress has not passed a solution to the Deficit and Debt problems.
• Regulatory uncertainty exists in regards to: health care, taxes, and banking.
• 3/11 Tsunami had bigger effect on supply chains than was previously thought.

Tailwinds

• Reported corporate profits remain strong.
• Estimates for 2011 corporate profits have held, despite economic headwinds.
• GDP growth outside the U.S. and Europe remains robust.
• Capital asset purchases (e.g. trucks, cars) are recovering significantly.
• Banks are seeing a slowing of defaults on mortgages and credit card debt.
• The weaker U. S. dollar is boosting U. S. exports.
• A debt default by the U.S. is seen as very unlikely by most economists we follow.
• Stock values (price/earnings) are now lower than the 80-year average. No bubble
• About 50% of S&P 500 sales come from faster growing, non-US economies.
• Crude oil and gasoline prices are dropping from recent highs.

The Committee also reviewed a discussion by The Bank Credit Analyst of the US economic outlook. BCA is a Canadian firm (which we believe gives them objectivity about the U.S.) that we’ve followed for many years. Their analyses are well reasoned; they do not rant or get emotional; and, they use data to develop and explain their views. A synopsis of their June 8 presentation follows:

• US growth will accelerate later this year.
• Tsunami-related supply chain problems are easing.
• The savings rate is high, but slowly dropping, benefiting consumer purchases later.
• Housing is too low to sink much further, reducing its drag on the economy.
• US structural deficits are only about 5% of GDP, more manageable than many think.
• The US tax/GDP ratio is the lowest in G-20, encouraging economic growth.
• The US has added more than 1.3 million net new jobs over the past year.

The Committee was concerned about the Fed’s recent lobbying for the 35 largest banks to raise their Tier 1 capital levels from 7% to 10%. This will continue to put pressure on bank stocks in the near term because of the potential dilutive effects of big equity underwritings. So far, this is still in the talking stage, and the banking industry is pushing back very hard. It remains to be seen how this will play out, but for the moment it has already been priced into the stocks, so any softening of the Fed’s position should provide a quick lift to the banks.

Although industrial stocks have dropped more than the S&P 500 lately, most industrial companies continue to have very bullish outlooks for 2011. CEO Sandy Cutler of Eaton Corp (ETN), for instance, is very confident his firm will see 14% revenue growth with earnings growth much higher than that. Many of Eaton’s customers delayed purchases of expensive capital goods during the recession, but these customers are now back in the market because the average age of their equipment has reached multiyear highs, causing repair costs to jump. This same dynamic is playing out across the spectrum of a number of industries.

Unemployment remains stubborn. Historically, however, the correlation between increased corporate profits and increased employment is very tight. The two trends separated during the recession. However, the average work week, especially in the industrial sector, has extended to the point where more overtime just may not be possible. The longer corporate sales volumes and profits grow, the more pressure there will be for businesses to increase hiring.

While major new negative developments in the Middle East, a major economic slowdown in China, or a fiasco on the debt limit in Washington D.C. could turn the 2011 outlook decidedly negative, we don’t consider any of them as having a high probability at this time. Our views are echoed by the economists and strategists that we follow. The market pullback over the past six weeks – the first six-consecutive week pullback in 10 years – has been relatively modest, less than 5%. Finally, trading volumes have been relatively light, potentially indicating there is not a lot of urgency in the selling.

After considering all the above, the Committee is holding to its outlook for stocks to return 5% - 10% for all of 2011. Of course, we will continue to monitor the data and the economic and political environments.

Edited by Randy Alsman

Greg Donaldson Mike Hull Rick Roop Randy Alsman

We own many industrial stocks including Eaton.

Dividend Valuation Model: United Technology Is #1

Dividends play two important roles in our stock selection process.  1) They produce a cash return that has represented nearly 40% of the total return of the S&P 500 Index over the last 80 years. 2)  For select companies, dividend growth and changes in interest rates provide an excellent valuation tool.

Each week we run all the stocks in the Russell 1000 through our Dividend Valuation model.   The model does two important things for us.  Statistically, it tells us how good it has been in predicting movements in each stock over the last 20 years, and it provides us with a single formula that has produced the best fit of prices versus dividends and interest rates.

At this point in the process, we can easily identify which stocks are most "predictable."  Next we make a projection of the dividend growth for each company and estimate changes in interest rates for the coming year.  With this information, the model can now tell us which stocks are most undervalued.  Finally, we run all stocks through a multi-period momentum filter.  This tells us which stocks have what we call "sponsorship," meaning which companies are performing at least as well as the average stock over four different time frames..

This may sound complex, and the process is, but the result is very simple.  We have identified the companies that are most predictable, most undervalued, and have the best sponsorship, or momentum.

We then assign a rank between 1 and 100 for each of the three metrics for each company.  Summing the ranks for predictability, valuation, and sponsorship, we can identify the company with the highest overall total rank in  the Russell 1000 and the also among the companies we own.

Using this process, of calculating predictability, valuation, and sponsorship, we can determine those stocks with the best prospect for the year ahead

 A look at the model as of Friday reveals that the stock we own with the best overall score is United Technology (UTX).  As shown above, the model (blue line) for UTX has been very tightly associated with UTX's actual price (red line) over the last 20 years.  The R-squared is .94.  The models suggests that UTX is undervalued by about 12%, including dividend. UTX's sponsorship or momentum score is 67, which means that it has outperformed 67% of all stocks over four time frames, from 12 months to one month.  Importantly it is outperforming 74% of all stocks over the last three months.  UTX recently hiked it dividend 13%, which is about in line with the company's dividend actions over the last ten years.  Finally, earnings were recently reported as having grown 19% in the first quarter versus a year ago.  That provides a nice cushion for future dividend hikes.

There are a handful of stocks with better scores than UTX.  Our strategists are researching them.  We'll report later if any of them meet our standards.

The stock with the second highest score in our model is Becton Dickinson (BDX).  We will report on it next time.

The investment world has definitely discovered dividends.  We have not seen this kind of attention being paid to dividend investing in our own 20 years of a dividend-centric approach.  Because dividends have become so popular, we are turning our focus to valuation in our blogs for a while.  We have learned the hard way too many times that just because a company pays a dividend, or has increased its dividend for 20 or 30 years in a row does not mean that it is fairly priced.  Indeed, we see many companies with long dividend-paying track records that have already priced in the next two years of dividend growth.

If you have specific dividend-paying companies that you would like for us to review, please add a comment to this blog.  We'll get to as many as we can.    

Toyota: One Year Later -- It May Be Stronger Than Ever

We have an old saying at DCM that goes back a long way.  "Buy Coke when they are accused of poisoning someone."  This is not some morbid silly aphorism, it is truly how we think about investing.  Bad news that is widely known is probably fully discounted in the current stock price, and thus, financially strong, dominant companies that hit bumps in the road are probably a buy.  This is not the case with smaller, less financially strong firms.  With smaller firms there is always the risk that the banks will take over and ruin the company.

But with big, strong companies, particularly those with a powerful brands, bad news to us is often good news.  It does not mean that we buy every big company with trouble, but we do look at them.

A year or so ago, Toyota (TM) was embroiled in the sticking accelerator issue.  Lawsuits were piling up. Congress had hauled in newly-elected president Toyoda, grandson of the founder, for his obligatory tongue lashing. Local TV news teams were hounding Toyota dealers and customers like the paparazzi for candid shots of the fall of one of the most powerful brands on earth.  It turns out, the death of Toyota may have been announced prematurely.

During those times, Mike Hull, our consumer strategist wrote a piece that was upbeat and suggested that we were nibbling on the stock.  The bottom line of what he said was that Toyota was a powerful brand with customer loyalty that ran much deeper than most people thought.  Additionally TM was one of the strongest companies in the world and had the financial resources to deal successfully with all the issues that it faced. 

The chart at the right is of TM over the last twelve months.  It shows the violent collapse in February, followed by a long bottoming out phase that ended with a sharp upturn in the price of the stock in November of 2010 that reached as high as $86 per share.  The stock has risen nearly 14% since Mike wrote his blog.  That does not make it a hall-of-fame type stock pick, but it does, at least for now, give us further reasons to continue to look closely at great companies who stumble.

By the way, Mike thinks TM has begun a long strategic battle with the other auto companies in the US that may have domestic car companies crying "uncle" again one day.  For all the issues, real and imagined, that came from the sticking accelerator debacle, TM has survived. Mike believes the company is even more dedicated to quality today than they were before the problems, and they are still financially one of the strongest companies in the world. 

If GM, Ford, and the other car companies think they have turned the corner and can now compete effectively with TM across broad product lines, our guess is that time will put everything back in its rightful place.  In our judgment, even though TM may have had some glitches in recent years, they are committed to being in the high-quality personal transportation business.  We believe most other auto companies are in the, well, car business.  Think about it.  There is a difference.   

GE's Second Dividend Hike: Good News or Bad News?

GE's announcement of a 17% dividend hike on top of their 20% hike earlier this year was the topic of lively discussion at our investment policy meeting on Monday.

We all agreed that on the surface the news was good for GE and stocks in general, but several committee members voiced a surprising concern.

First let me share the positive implications we believe GE's dividend actions signal.

1. Their loan loss ratios in GE Capital (35% of the company) must be improving faster than previously expected.  This would be good news for both GE and the US economy.
2. An up-tick in their long-cycle industrial sector (jet engines, healthcare electronics, and power generation) may be underway.  Better news in these industries would be very good news for US trade balances with developing nations.
3. Short-cycle businesses (appliances and electrical system equipment) may have bottomed.  This would be modestly good news about US consumer spending.

We were surprised and delighted by GE's second dividend hike, and because GE is so large and so broadly diversified across the US economy, we believe many other companies may also be experiencing better-than-expected results. This would portend more higher-than-expected dividend hikes. And since our theory is that dividend hikes are the best sign that a business is growing, a spate of better-than-expected dividend hikes should also lead to higher stock prices.

The surprising concern that arose in our discussions was the possible negative implications of the dividend news. Two of us voiced the concern that because Jeffrey Immelt, GE CEO, has become so unpopular among many investors and analysts, the dividend hikes may only be his attempt to win favor with his constituents. This line of thinking didn't go far because one of the committee members reminded us that CEOs don't dictate dividend policy. That authority belongs to the board of directors.

The chart at the top of the page shows that GE is stair-stepping its way higher. The recent new, intermediate high signals the stock may attempt to move higher over the near term. If our notion that GE's business is improving starts showing up in their earnings, we could soon see GE take a run at a new 12-month high.

We own the stock. Do not make investment decisions based on this information. Please consult your personal financial advisor.  

  

Becton Dickinson : A Dividend Star with a Lagging Price

Last time we showed research that revealed that dividend-paying stocks have outperformed non dividend-paying stocks over the last three years.  Importantly, the research also showed that the higher the dividend growth of a stock, the higher its total rate of return, up to a point.  That point of diminishing returns occurred in the quintile that included companies with the highest dividend growth rates.  These companies did not perform as well, pricewise during the period, as did companies in the second quintile of dividend growth.

We have previously offered research showing that among dividend paying stocks that dividend growth is the best indicator of long-term price growth.  Thus, companies that are producing high dividend growth and not being rewarded with high price appreciation are of particular interest to us.  Our experience has taught us that these kinds of companies will at some point have a price growth spurt that will close the performance gap. 

Let us give you an example of what we mean by this:.

Becton Dickinson (BDX) is a global medical technology company that is focused on improving drug therapies, enhancing the quality and speed of diagnosing infectious diseases, and advancing research and discovery of new drugs and vaccines.

Over the past three years, BDX has hiked its dividend by an average of nearly 15% per year. During this time, its stock price has risen by only about 5% per annum.  Of course this has been a time when almost all health-care stocks have underperformed the market.  However, the difference between BDX and it brethren in the sector are stark.  BDX has not only produced dividends and earnings growth  much higher than the average stock in the health-care sector, but it has also enjoyed higher dividend and earnings growth than the average stock in the S&P 500.  Yet this strong fundamental performance has produced sub-par price gains.

The sub-par price performance of BDX, in the face of its outstanding dividend and earnings growth, has left the stock undervalued in our dividend model by about 17%, as shown on the chart above.  The dividend model also reveals that BDX has been undervalued for the last three years. 

As we have said many times before, a stock can stay undervalued or overvalued for a long time, but eventually price will seek to close the valuation gap. We often find that three years is about the limit of valuation gaps.

BDX recently announced a dividend increase for the coming year of 11%, the 38th consecutive year the company has raised its dividend.  This again is a bigger dividend hike than that of the average stock during the last twelve months.  In our minds, BDX's wide valuation gap cannot withstand many more above average dividend hikes.  The time for the the market to play some catch up may be near. 

We will show you more of these stocks with valuation gaps in the weeks ahead.

We own BDX in our Capital Builder investment style.  Do not use this blog for investment advice.  Please seek the advice of your own professional investment manager.

Railroads May Soon Lose Some Steam



During the last two years, the rail stocks have acted more like rockets of the 21st century than lumbering piles of steel left over from the 19th century.

Since 2009 when Warren Buffett announced he was buying Burlington Northern, investors have been steaming back into the rail stocks, hoping another big hitter would follow Mr. Buffett's lead and take out another of the big rail companies.

The rail stocks today are certainly not your grandfather's bloated, broken-down companies.  Today railroads are key players in the inter-modal freight handling business.  Importantly, they are widely seen as the most economical and environmentally friendly mode of hauling goods over long distances..  But there is little question that Mr. Buffett's purchase of Burlington Northern has added a shine to the appeal of railroad stocks that wasn't there before.

That shine may be in the process of dulling a bit.  Our Dividend Valuation model for Union Pacific  (UNP) shows an interesting feature that we have seldom seen for any stock since the beginning subprime crisis: overvaluation.

The chart shows that UNP's current price (red line) is just over $85 per share, more than 15% above our model's current predicted value, and nearly 8% above next year's predicted price. (The other major rail stocks show similar overvaluations)  

As we have said before, overvaluation and undervaluation are not precise fall-off-the-cliff events.  Stocks can stay overvalued or undervalued for a long time.  But a look at UNP's valuation model shows that it has rarely been significantly overvalued: only 4 times in 20 years.  Each time it became overvalued its price ultimately fell back to its valuation bar. 

We doubt if the current momentum in the rail stocks gives a hoot about our valuation models, but we don't have to remind anyone that stocks get undervalued and overvalued and eventually they return to their value tracks.


A relative of the author owns UNP.  Please do not use this blog for investment decisions.  Please consult a licensed investment professional.

Southern Company Looks Undervalued

We believe many high quality, dividend-paying companies are very attractive compared to US Treasury bonds.  We have previously described the concept we call "bond-like" stocks.  Bond-like stocks to us mean companies that

1. Have strong balance sheets 
2. Have a history of paying dividends
3. Display a history of raising its dividends,and
4. Possess dividend yields that are close to the yield on a 10-year US Treasury bond.  

 We have previously written about two such companies, Procter and Gamble (PG) and Royal Bank of Canada (RY).  The third stock in this series to meet the bond-like stock criteria is Southern Company(SO).  SO is one of the nation's largest electric utilities, and we believe it has a lot going for it that is being ignored by investors.

Our Dividend Valuation Model above (click to enlarge), which is based on the relationship between SO's price versus its dividend growth and the level of interest rates on long US Treasuries, suggests that the stock may be undervalued.  Indeed, the model is projecting that the total return of SO over the next 12 months may approach 17%.  As we always say, our model is based on historical relationships and thus is certainly not a guarantee of the future, but we are inclined to believe that SO is positioned to do well over the next year.  Here's why:

1. SO's bonds are A rated by both rating agencies, among the highest rated utilities in the US.  
2. It is the second largest utility in the US and the largest in the Sunbelt, where the population is still growing.
3. SO has a near monopoly in its service areas and produces power through a diverse array of power sources from coal to nuclear power.
4. SO has generated a 14% annualized return over the last 10 years, far outpacing the S+P.
5. The company has paid a dividend since 1948, and its current dividend yield is just under 5%.
6. SO has raised its dividend for 9 consecutive years at an annual rate just over 4%.

Our conclusion:

SO sells a product necessary for our daily lives and is as well run as any utility in the US.  It has a current dividend yield of nearly double that of the 10-year Treasury bond.  SO's implied return of 9% (5% dividend yield plus 4% dividend growth) compares favorably to the 10-year Treasury yield of 2.75%.

We believe the recent aversion to risk that has gripped the markets can not last forever. As investors realize that they cannot live very well on CDs paying .3%, they will begin looking for quality alternatives, and the first place they will look will be the electric and natural gas utilities.  When they start looking at the utilities, it will be hard to beat what they find in Southern Company.

Clients and principals of Donaldson Capital own SO.  Please see Term and Conditions of this blogsite on the right sidebar.
                                

Royal Bank of Canada is the Epitome of a Bond-Like Stock

In these uncertain times, we are asked over and over by our clients : "How can I invest in the stock market with less volatility and more predictability?"  Our answer is: "By investing in Bond-Like Stocks."

Bond-Like stocks aren't for everyone, but once you get to know them, you might find they are just what you have been looking for.  In our last audio blog (see link) we introduced the concept of Bond-Like stocks.  These are stocks that have very high financial strength and credit ratings, a dividend yield higher than that of a 10-Year US Treasury bond, and a history of raising their dividends. 

Royal Bank of Canada (RY) probably fits these criteria as well as any stock I can think of.  Here are the particulars for RY.

1. RY is one of 5 AAA rated companies in the world.
2. Its current dividend yield is 3.9%, much higher than the 2.8% yield on a 10-year T-bond.
3. It has raised its dividend an average of 10% per annum over the last 10 years.

In addition, RY, along with all the other Canadian banks, largely escaped the subprime crisis as a result of its conservative lending practices.

A look at Royal Bank of Canada's most recent earnings report reveals some very interesting data points.

1. Quarterly allowances for loan losses were 48% lower than a year ago.
2. Shares outstanding were almost flat, very different from big US banks which increased shares by up to 35% to meet government mandated net capital requirements.
3. Total loans grew modestly, again contrasting the shrinking loan balances at most US banks.
4. Perhaps the most striking data point was RY's return on equity (ROE).  ROE for its second quarter was near 17%, almost as high as its 10-year average and almost double that of the big US banks.   

At the above right is our proprietary Dividend Valuation Mode for RY (click to enlarge).  The model suggests that the company may be as much as 14% undervalued, based on the year-ahead dividend growth we project.  As we have said before, the Dividend Valuation Model is based on historical relationships of price versus dividend growth and changes in interest rates.  These relationships may not hold true into the future, but on a historical basis the model has been able to predict the annual movement in the price of the stock at near 90%.

We'll have more to say about Bond-Like stocks in the coming weeks.  Next time we'll describe the hidden value of rising dividends.

Clients and principals of Donaldson Capital Management own RY.  See the conditions for use of this blog site at the right.

 

Johnson and Johnson Raises Dividend 6.5%

In recent days, almost everyone was expecting a dividend hike announcement from Johnson and Johnson (JNJ). Predicting an increase wasn't a tough call. JNJ had raised their dividend for 44 years in a row. What was a tough call was the amount of the hike. On April 23, they announced a 6.5% dividend increase. In these days of dividend cuts, I applaud JNJ's hike, but I thought it was a bit light. The estimates ranged from 6% to 9.5%. The consensus was in the 8% range. With earnings over the last twelve months having risen nearly 9.5%, I was hoping for an increase between 8% and 9.5%, say 8.5%. Thus, the increase of 6.5% was at first a bit disappointing. To find reasons why the hike was less than expected is not a tough task. The current administration seems bent on sticking their noses and fingers deeper and deeper into America's economic system. With the administration's talk of big changes to our current health-care reimbursement programs, JNJ may be signaling a new, less optimistic view of their long-term prospects. That notion is also born out by Wall Street analysts' 3-5 year forward earning estimates for JNJ, which are now at 8%. In these days of weak earnings reports, 8% long-term growth sounds exceptional, but in JNJ's case that is far lower than their last 5-year earnings growth rate of 11.5%. Indeed, current estimates project that 2009's earnings will be about flat with 2008. As I think about it, however, I believe JNJ is just being pragmatic. I think they are building in a cushion that will enable them to hike their dividend again in 2009 when earnings growth may be meager. I just can't be too pessimistic about a company that has done as many things right over the last 20 years as has JNJ. Furthermore, is it not remarkable that JNJ is currently selling at about 11 times trailing 12-month earnings. That is about half their 20-year average of 22x. Combine this low PE with a dividend yield of almost 4% and you have one of those old fashioned "value" stocks. Funny, I always thought JNJ was a growth stock. These metrics, however, would suggest that it is now being priced like a value stock. That seems odd especially when we consider it has a strong consumer brand (33% of sales) that is not encumbered by health-care pricing issues. In these days, it is very easy to beat up on any stock, but I have a very strong feeling that investors are underestimating JNJ's broad product line and worldwide clout. We own the stock. Please do not use this information for investment purposes. Please consult your own investment adviser.

My Interview on Bloomberg About the Bank of America Job Cuts

I was interviewed on Bloomberg Television this morning about my reaction to the 35,000 job cuts announced by Bank of America (BAC). Since the nearest video up link is 100 miles away, Bloomberg just did an audio interview. Thank goodness for that because I would not have been a pretty site at 5:30 this morning in my bathrobe. Here is what I told the interviewer. The job cuts were not a surprise to me. After Citigroup cut 15% of their work force a few weeks ago, I expected job cuts from all the big banks. In this regard, BAC's 11% cuts were more modest than Citigroup's. I think the job cuts were 75% about the weak economy and only 25% about BAC's recent merger with Merrill Lynch. There will be some redundancy between Merrill's and BAC's investment banking operations, but it should not amount to much. BAC is just using the Merrill merger as an excuse to lower their cost structure. This, however, is an important step when considering that banks face more quarters of loan losses. BAC's job cuts will improve operating earnings by reducing costs by nearly $7 billion over the next three years. Aside from the obvious negatives at the personal level for those people who will lose their jobs, it is a negative that BAC will take a hit to net capital of some magnitude for the severance pay. This is important because capital is at a premium for all banks and this action will, indeed, lower BAC's net capital. I believe the job cuts are necessary and the key question is how rapidly and effectively they can get them done. If these job cuts drag on for three years, the morale at BAC will collapse and the productivity will suffer, diminishing the positive impact of the cost savings. It is a question of execution. In this regard, I am more optimistic than I was when I heard the news that BAC was buying Merrill Lynch. I would have preferred BAC stick to their knitting with more traditional banking activities. But the deal having been struck, BAC has an impressive record of integrating acquisitions. Their Fleet Boston and MBNA mergers, by most accounts, went very well. I'm guessing the Merrill Lynch merger will be the same. I told the interviewer for the present we were holding our BAC, but we were carefully analyzing all of the public statements BAC executives were making about future business. BAC and other banks must offer some hope of a turnaround for us to want to continue to hold them.

Vectren: 49 Years And Counting . . .

Hats off to Vectren (VVC), our home town utility. VVC recently announced their 49th consecutive annual dividend increase. That puts the company near the top of the list of companies with the longest uninterrupted strings of dividend hikes.

VVC provides regulated gas and electric services to approximately one million customers in Indiana and Ohio. They also have a non-regulated division that is involved in power sales and management, and VVC is one of the largest coal producers in our area.

Vectren currently yields 5%, and our expectation is that its dividend will continue to grow over the next 3-5 years at just over 3% per annum. Three percent growth may not seem like much, but when added to its current 5% yield gives a projected total dividend return of 8%. That's not bad when compared to the 3.5% current yield on a 10-year T-bond, especially when considering the defensive nature of the utility business and VVC's long history of success.

Finally, the lower chart above shows that 5% is at the high end of VVC's dividend yield range over the last 7 years.

The current management team of VVC, headed by Niel Ellerbrook, carries on a long tradition of being good stewards of their shareholders' and their customers' trust.

Is GE's Dividend Safe?

Jeffrey Immelt's job may not be safe, but I believe GE's dividend is as safe as any stock I can think of. GE will be reporting its earning for the second quarter this week and the chorus of Wall Street analysts are singing in complete discord. There is wide disagreement over whether or not GE's mark-to-the-market problems are behind them at GE Credit, and whether or not they will make their earnings estimates. I believe GE will land on the good side of their earnings estimates and the heat will come off their stock for a while. Additionally, I believe GE is too big and too strong to continue on its descent as though it were only a financial stock. This is one of the greatest amalgamations of businesses the world has ever seen; if GE has lost his way, it is because Immelt has lost his way with a company that, as Peter Lynch of Fidelity used to say, "Any fool could run." I don't mean to minimize the complexity of the organization. From jet engines to wind turbines and gas powered electric generating plants; from medical imaging products to NBC, CNBC, and MSNBC, this company is the epitome of American ingenuity and power. It is safe, sure, sound, and secure, yet it has languished below $30 per shares since April, when they announced the shocking write off of loans in their GE Credit division. In the weeks that followed the write-offs, rumors flowed that the write off had already been recovered. If that is the case, GE will provide surprisingly good earnings this quarter, if not, Jeffrey Immelt's days are numbered. The reason is simple, he has the infamous "heir apparent" disease. He followed a legend in Jack Welch. That's tough enough, but Mr. Welch, who is trying to polish his own image, after an ugly divorce battle, seems to be throwing Mr. Immelt from the train. He has panned him on numerous occasions, only to say he was sorry later. It has been my observation that Jack Welch doesn't say things he doesn't mean. Saying he's sorry pales compared to his spearing Immelt on a regular basis. Immelt has a job much like we have at Donaldson Capital Management. He allocates capital. He runs an organization that is too large to manage. He manages the portfolio. The write-off blunder was an act of extreme mismanagement, because it means that his top lieutenants in the GE Credit division were not keeping him posted on the problems. If Immelt were a manager, he would be in the loop; as an asset allocator, he seemingly found out about the problem about the same time as we did, and that is not good enough. He is damaged goods and unless he can pull a rabbit or two out of his hat in the next couple of quarters, he will be history. GE's stock is still lower than it was the day that Immelt took over. GE is one of the proudest and toughest minded companies in the world; the results have not been forthcoming, Wall Street has not embraced Mr. Immelt, and Jeffrey's hairdo is beginning to look very colored and very coiffed. These are all signs that his days are numbered. Having said this, the dividend is safe. GE pays out only about half of their earnings in dividends, and their free cash flows are even bigger than their earnings. Indeed, GE raised their dividend earlier this year by over 10%. The dividend is safe, Immelt's job is not.

The Gods at Goldman Taketh Away, But Are They Right -- This Time?

Goldman Sachs research analysts are widely attributed, at least in part, to have been responsible for last weeks collapse in stock prices. As analysts are seemingly wont to do, they went into a crowded room and yelled sell and everybody did. They weren't alone in dissing stocks. As a result of the Fed's recent turnabout from worrying about recession and cutting rates to worrying more about inflation and potentially raising rates in the near term. Indeed, this shift came so swiftly that it was hard to catch in most hometown newspapers. We literally went from recession watch to inflation watch in a matter of days, as a result of upward revisions to GDP and clear signs that a recession is nowhere to be seen. The stronger-than-expected economic data would normally be seen as a good thing by the stock market, but in these days of skyrocketing oil and food prices, it was taken as giving the Fed enough breathing room to begin fighting inflation by hiking rates. Goldman analysts came out last week with sell signals on Citigroup and General Motors and downgraded the Brokerage and Industrial stocks. On Wednesday and Thursday, they lowered the proverbial boom on all these sectors in a curiously timed call on stocks groups that, for the most part, had already been hammered. Their only downgrade regarding a strong performing group was in the Industrial sector. Here they really couldn't find a lot wrong, but the rise in steel prices may put a drag on the group's earnings. Goldman has cachet, as they say. They have become the axe, the most powerful analysts on the street, and if they are saying sell or buy, the automatons of Wall Street follow, even if several other Wall Street analysts are calling things in the opposite direction, and even if Goldman's earlier predictions on almost all of these stocks were dead wrong. Goldman's axe comes from lots of success, but three stand out in particular: 1. They have been the most powerful investment banker for a decade or longer; 2. They have taken far fewer losses on subprime debt than their Wall Street brethren; indeed, they made billions by going short the subprime index; 3. Their oil analyst nearly a year ago called for oil to hit $100 per barrel, at a time when prices were not much more than half that price. Success breeds success, and success calls for more calls. Goldman in recent weeks has obliged those who have been anticipating their every word. First, their oil analyst suggested that oil prices could reach $200 per barrel. Immediately prices started lurching toward this new official Goldman target. Late last week they made sell recommendations on Citigroup and General Motors. Again their minions threw Citi and the General from the train. They don't like the Industrials because steel prices are going up, and , well, you know, these industrial bend a lot of steel. Finally, they think the big brokerages are in for more rough times ahead, reducing the group from buy to neutral. By my count on the days that they made these "bold" calls the markets were down a total of nearly 450 points, nearly 4%. But there is something wrong with this picture. Goldman is big and powerful and they know they can move just about any stock they want to pick on in these skittish markets. But to pick on a group of stocks that have already been mauled seemed like piling on to me. Something that smacks of mudslinging; after all, most of the companies they downgraded were in their own industy, if not direct competitors. It would be like in yesterday's Euro Cup soccer finals if one of the Spanish soccer players ran over and kicked Germany's Michael Balak after he was lying on the ground bleeding from catching a Spanish defender's head in his eye. Spain kicked the ball out of bounds like the true sportmen they are. Balak was sewn up on the sidelines in relative safety and returned to the match dazed but mobile. One just has the sneaking feeling that Goldman is not doing big investment banking work for Citi or any of the other brokers that they downgraded. I have not checked General Motors, but I would be surprised if Goldman was their lead investment banker, either. It is very curious to me that on October 1, 2007, even in the face of the subprime crisis, Goldman had good things to say about Citi and Merrill Lynch. Indeed, my recollection is that both had buy ratings for the year ahead. At the time Citigroup was trading at around $42, and Goldman had a year-ahead target price of $57. When Goldman cut their rating on Citigroup to a sell last week, Citi was selling near 18. In October of 2007, Merrill Lynch was trading at around $70, with a year-ahead target price of $94. When Goldman cut Merrill's rating last week to neutral, it was trading at $35. In September of 2007, with GM trading near $30 -- again after the subprime crisis was widely known -- Goldman had a buy rating and year-ahead price target of $37 for GM. Last week with the stock was selling for about $14, Goldman cut it to sell. The market gobbled up these bold calls by Goldman last week and kicked all of these stocks in the teeth. In my judgment, it is no act of courage to put out sell signals on beaten down stocks. The problem I have with Goldman's calls is that they were dead wrong six-nine months ago when they rated all of these stocks buys. Why should we be so pessimistic now when they are putting out sell signals or downgrading stocks that in most cases are nearly 50% far lower than they were when Goldman rated them buys? If history is any judge, we may be near the bottom in all of them.

Johnson and Johnson Wants to Go Higher

Drug stocks have become persona non grata for most investors over the last 7 years, as a long list of blockbuster drugs have gone off patents with no replacements. Few pure drug companies are anywhere near their price levels of early 2000.

Johnson and Johnson (JNJ) is one of the few drug-related stocks that has been able to achieve price gains during this time. The reason is simple. In addition to JNJ's pharmaceutical business, it has a broad portfolio of products in such diverse areas as consumer goods, orthopedic implants, and stints. Even in their drug business, they have focused their research in areas where they have little competition, avoiding the "me too" approach that most of the major drug companies have employed.

The Dividend Valuation Chart at the right shows that JNJ has made choppy gains over the past 7 years and is modestly undervalued at its current price. Projecting my estimates for JNJ's dividend growth and interest rates ahead one year, as shown on the black striped bar, the stock may be as much as 20% undervalued.

However, the most important quality that JNJ possesses is that it has broken free of most other major drug-related stocks and it, and perhaps Abbott Labs, are now on a very short list of what might be considered "safe" healthcare stocks. For such a big stock market sector as healthcare to have so few safe stocks, would seem to mean that JNJ is likely to gain weighting in many investment manager's portfolios.

JNJ is a very good story in an industry sector with a lot of bad stories. The relative performance might prove interesting over the next couple of years.

Dividend Investing is a Good Thing in a Bad Market

It's a good time if you are a dividend investor. Stocks may be crumbling day after day, the headlines may be crying: Recession Looms. Big banks may be taking write offs like some sort of plague and selling pieces of themselves to countries the size of Delaware that just happen to have assets the size of Texas. As dividend investors, if we have done our homework, our companies' cash dividends are unchanged or growing. Our cash dividends are big enough to produced a reasonable rate of return, even without capital gains; and as the market goes down, our cash rates of return for new purchases is actually getting better. If you think about it, bad markets are actually good markets for dividend investors.