Using Simple Mathematical Calculations to Value Coke vs. PepsiCo

 1. In my recently released book, The Hidden Power of Rising Dividends, I described my 40-year journey into finding methods of valuing stocks.

2. My journey of valuation discovery was always about finding methods that worked, not just focusing on dividend investing, although for many companies, dividends are the best indicator.

3. Over the next few months, I am going to do a series of valuation comparisons of great companies of our country and the world. These comparisons will describe the various methods I have found to be helpful. The first two are Coke and Pepsi.

4. Coke and Pepsi are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Most people are in one camp or the other, but these two companies are very similar in many ways. My blindfolded taste test can't tell them apart.

5. Since they are so dominant and so similar in their products and marketing, I have found that most people assume they are almost always efficiently priced and valued at about the same level. In this first look at the tools I have learned to use, a surprise may be in store for you.

 In valuing Coke and Pepsi, I am using a multi-stage correlation model. This model computes a correlation score, called R2, for eight different fundamental indicators for each company, such as earnings, dividends, sales, profit margin, GDP, etc., compared to changes in the company's annual stock prices. With both companies, the correlation, R2, between their annual dividends and stock prices is above 90%, and overrides the need to include any of the other fundamentals. Very simply, this means that over the last 15 years, the annual changes in the dividends for each company were able to explain 90% of the annual changes in its price. 

Next, look at each chart and note that stock prices are on the vertical axis and dividends per share are on the horizontal axis. The red line is the actual annual price over the last 15 years and the green line is the predicted price using the correlation formula. Here is where the model begins to talk. While these two companies are very similar in what they do, they are not similar in prospective valuation. PepsiCo's chart shows its current selling price of over $175.00 is well under its predicted price of $190.44. Coke's story is just the reverse. It is currently selling for over $68 per share, but its predicted price says it should sell for $63.74.

Remember, this analysis is pure math. It is not a deep analysis of each company's intrinsic value. This is just a statistically significant computation comparing the changes in each company's annual dividends with changes in their annual stock prices. Yet, with 90+% correlations for both companies, to ignore what the dividends are saying would be unwise. Indeed, these computations are saying Coke is over 15% more expensive than PepsiCo. A spread that wide would seem to favor PepsiCo at present. Next, however, we all know that the market always looks ahead. Next time I will share with you howe we can adjust the current valuations for a look into the future. In the meantime, let's just see how the the two stocks perform over the next few months.   

The ABC’s and XYZ’s of Dividend Investing

Let’s face it dividends are no longer a novelty.  They were very much so when we began writing this blog in December of 2004.  Thus, over the last ten years, a time when stocks have experienced both ecstasy and agony, many investors have come to understand the value of dividends as central to their investing strategies.  We have written a number of articles on the ABC’s of dividend investing, so some of this blog will be repetitive, but hang in there, when we get to the XYZ’s you’ll hear some new thoughts and tactics.

ABC’s

The two data points we discovered in the late 1980’s that really got our attention and set us on the road to becoming pure dividend investors were the following:    

1. Since 1960, dividends have produced nearly 40% of the total return of the Dow Jones Industrial Average (DJIA)
2. DJIA dividend growth during that time has averaged about 5.7%, and price growth has averaged near 5.9%.

When we first saw these two data points, it created a kind of eureka experience for us.  The fact that dividends represented such a high percentage of DJIA total return said that if we paid attention to dividends they gave us a 40% head start on achieving an attractive long-term return.  In addition, the remarkable similarity between the long-term average DJIA price and dividend growth had all kinds of implications.  When we first saw it, we realized in an instant how important dividend growth was to total return. 

Yet, with the numbers being so similar, there was a humongous thought that seemed almost too good to be true:  if the average annual rates of growth of DJIA dividends and prices were so similar, were they also highly correlated.  If they were, that would help to explain the other 60% of the DJIA’s total return because if the statistical significance of the correlation between dividend growth and price growth were high enough it would give us a tool to predict price growth.  To be more specific, if what is known as the coefficient of determination (R^2) were high enough, then so goes the dividend, so goes the stock.

Minutes after this thought went careening though our minds the answer was appearing on our Excel spreadsheet.  The coefficient of determination, or R^2 was nearly .90 (one is a perfect correlation). Over the last 54 years, dividend growth had been able to predict nearly 90 percent of the annual price growth of the DJIA. This is a fact that few people who consider themselves dividend investors are aware of.

The chart for this statistical study of dividend growth and price growth is shown below.

Dow Jones Industrial Average Price vs. Dividend
Since 1960

But, just as fast as this eureka occurred, another finding diminished our grand hopes.  Even though the cumulative prices of the 30 stocks in the DJIA were highly correlated with their cumulative dividends paid over the years, there were few of the individual members of the Index that had as high a correlation as did the DJIA itself.  In fact, only about eight of the companies had statistically significant correlations between their prices and their dividends.  

With such a short list, we turned to the S&P 500.  The S&P 500 prices and dividends were not nearly as highly correlated as was the case with the DJIA.  Nevertheless, when we ran correlation analyses of the 500 stocks in the Index, we found nearly 125 that had very solid correlations between prices and dividends, and many of these stocks were giving us buy signals on the basis of this simple correlation analysis.

For many years, we puttered around with our price-dividend models with some success.  Then came the mid-1990s and all the correlations fell apart.  Stocks price were growing at a much faster rates than were dividends.  Modern Portfolio Theory was in full swing by then and the wizards of academia were saying that share-buybacks were a more efficient way to reward shareholders than cash dividends because the former would be taxed at the then lower capital gains rate, while the latter would be taxed as ordinary income.

For almost the next six years, our correlation models gathered dust.  They were saying that stocks were significantly over valued as early as 1997, well before the Tech bubble was in full view.  During this time, we relied on our dividend discount models to ascertain buy and sell signals and used predominatly stocks with above average dividend yields and solid dividend growth in our portfolios.   

This first part of the story is what we call the ABC’s of dividend investment.  It identificed the importance of dividends in total return and lead us to stocks with higher than average dividend yields and solid dividend growth. We used these tools successfully for many years; then things changed, and we went looking for another valuation model to pinpoint over and undervalued companies. Between 2000 and the end of 2002, we learned a very hard lesson: estimates of future growth aren't guaranteed, indeed, sometimes projected dividend growth become actual dividend cuts.  

XYZ's

In early 2002, with stocks down from their highs of 2000 nearly 40%, almost by accident, we stumbled again onto our old correlation models.  As we ran correlation analyses of the S&P 500, we found company after company was significantly undervalued, many by as much as 25%.  The big sell off had pushed stocks too low relative to their dividend growth during this time.  As the year wore on, our confidence that our old correlation model was telling us the truth about the market steadily increased.  The main reason was that companies in a wide range of industries, from banking to capital goods to energy, were hiking dividends at an impressive pace.  The market was ignoring the hikes, but these companies were signaling with their dividends that their business was good and improving. In addition, there was a lot of talk about President Bush’s tax break for dividends.

Since we had not used the correlation model in several years, we called in consultants and statistical experts to look at our models and tell us how much we ought to trust the data we were seeing.  All the consultants were quick to warn us that correlation does not equal causation.  In essence, something other than dividend growth might be the real driver of the very high correlations that we were seeing. Interest rates had been falling, so we added interest rates to the formula.  In fact, we added just about everything we could think of to the formulas to ascertain what else might be driving the high correlations which revealed that stocks were undervalued.

In the end, only dividend growth and interest rates remained in the formulas for most stocks, and the story they told was clear: stocks were cheap.  As a witness to how convincing the data were, both consultants became clients and remain so to this day.

The real XYZ story, however, did not become apparent until late 2003.  Gradually our weekly correlation run, which took four and half hours to complete, showed that the companies with the highest correlations between their dividend growth and price growth were not the high-yielding stocks that we had traditionally used, but the companies with lower yields and faster dividend growth.

That trend has continued through the present.  In most cases, even during the 2008-2009 banking crisis, many of these faster growing companies had continued to hike their dividends at double digit rates and their prices have responded in kind. 

The following charts show the price-dividend correlations for four stocks: Praxair, Union Pacific, ONEOK, and Nike. All of these companies with the exception of ONEOK are XYZ stocks. They have yields as low as 1.2% for Nike but have generated double digit dividend growth over the last ten years.  

The first stock is Praxair (PX). PX is an industrial gas company with a remarkable 20 year record of rising dividends and prices. The chart is a scatter plot which shows dividends along the horizontal axis and stock price on the vertical axis. Importantly, look at the mathematical formula at the top of the chart. On the second line is the R^2 of the fit between PX's dividend growth and its price growth. That right! PX's dividend growth has been able to predict 98% of its price growth over the last twenty years. At present, the graph is showing that PX is at about fair value. However, if we use estimated dividend growth for 2015, the stock is a bargain.

Praxair (PX)

      

The next stock is Union Pacific (UNP). UNP is one of the largest railroads in the U.S. It has about a 2% current dividend yield. It has not had quite the twenty-year performance as has PX, but again it has a very high R^2 at .94 and the stock is about fairly valued. As with PX, using next year's numbers makes it a bargain.

Union Pacific (UNP)

Next, for those of you who insist on higher yielding stocks, ONEOK (OKE) may be your choice. It has a 3.4% current dividend yield and has increased its dividend over the last five years at a high double digit rate. OKE is one of the largest pipeline companies in the U.S. Their management team has taken bold steps to solidify their position as an important player in the oil and gas fields. Their R^2 is .98. OKE appears to be about fairly valued, as well.

ONEOK (OKE)

The last stock is Nike (NKE). You may wonder how in the world NKE can be counted at a dividend stocks. Well it may not be an old fashion ABC dividend stock, but it definitely is an XYZ dividend stock. Its current yield is only 1.2% but its dividend has grown at near 14% per year over the last fiver years. Nike has a .95 R^2, but with the price nearly $10 above fair value is not a bargain. Neither does it become a bargain when we add next year's projected dividend hike. However, it then becomes about fairly valued and thus, we continue to hold the stock.

Nike (NKE)

So there you have it. The ABC's and the XYZ's as we describe them in our dividend world. The ABC's might be considered the more traditional higher than average dividend yielders with long histories of hiking their dividends at modest rates. The XYZ stocks are those with average or below average dividend yield but with much higher than average dividend growth. In addition, these stocks are highly correlated to their dividend growth, usually over the long term.

In general, we believe most traditional ABC type stocks are fairly valued, or even a bit overvalued. On the other hand, we are find many bargains in the XYZ stocks. We'll talk more about them in coming blogs. Happy hunting.

Clients and employees of DCM own all of the above listed stocks. Please do not use this information for stock selection purposes. Please consult your financial professional.

The ABCs of Dividend Investing: Divi-do or Divi-don't?

Low interest rates have propelled dividend income investing to greater popularity in recent years than at any time in the past six decades.

Despite dividend-investing's recent popularity, many investors still only look at one facet of the power of dividend investing: dividend yield.  These investors point to the fact that dividends have represented 40% of the total return of stocks since 1960 and that many dividend stocks yield more than short-term Treasury bonds.  But that is where they stop, and in doing so, they miss an important quality of dividend investing: dividends are more than income, much more. 

The most important element of dividend investing is the statistically significant long-term relationship between dividend growth and price growth.  Understanding this relationship is the key to unlocking the true power of dividend investing.

Pent Up Demand: A Future Driver of Economic Growth

Pent Up Demand Pushing Cyclical Stocks

We are coming out of a lengthy period of decreased spending in the wake of 2008-09, which has built pent up demand for automobiles, housing and capital expenditures.  The average age of vehicles on the road has reached a record high of 11.4 years.  Demand for new houses fell off dramatically since the Great Recession.  The average U.S. home was built in 1974 and continues to age. 

As people have chosen to fix rather than replace their vehicles and homes, we’ve seen the replacement-type industries do very well.  Auto Retail’s 2^nd quarter sales and earnings per share were up 14.7% and 18.6%, respectively.  Home improvement retail grew sales nearly 10% with earnings up 20% from 2^nd quarter 2012.

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.   

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.

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.

A Few Thoughts for Bank of America's Mr. Lewis

Our firm and clients have been riding with you for six to seven years. It has not always been easy since we have had to hold our collective breaths every time rumors started to fly that, yes Bank of America might be extending it product lines or its footprint by making yet another acquisition. Unfortunately, few of the rumors have turned out to be false. We have been with you when you belly-flopped our stock with your Fleet Boston purchase and genuflected our stock with your MBNA purchase. In each case, we held our collective noses because we are big believers in Peter Lynch's notion of "diworsification:" diversification and mergers oftentimes make a company "worse" not better. Through your aggressive program of "diworsification" we now own the bank with the biggest footprint and broadest product line of any bank in the US. But we are none the richer for your diworsification; your stock price is lower than it was six years ago. In our judgment, you are one decision away from joining your good friend Kennedy Thompson, late of Wachovia. That decision, as you know, is if you cut your dividend. If you cut your dividend, we will leave you and we won't be alone. It will prove that all that you have cobbled together over these last few years is a pile of rubbish -- the crown jewels were impostors, the gold was folly. If you can find the money in the middle of the subprime crisis to buy Lasalle National, Countrywide Financial, and put another couple of billion in China, you can keep paying the dividend. If you cut it, you will have proved, as so many analysts have said all along, that you didn't know what you were doing, and we will have to fall on our swords and admit that we followed you. You said recently that the condition of the economy will dictate your dividend decisions. Wrong, with your spending spree you have asked us to believe that the future is bright, why would you need to cut the dividend if the future is bright? I don't like the tone of this piece anymore than you do, but I am giving you fair warning: if you cut the dividend you'll be playing golf everyday with Kennedy Thompson. By all accounts, you are a good man; a man who loves banking, your employees, small business people, and your shareholders (I think the list is pretty long). This is a time to show boldness for your stakeholders interests. Lay down the gauntlet and say that Bank of America will not cut its dividend under your leadership. You cannot brag about your dividend hikes for a decade and wipe them all away in a year. That is pretty much what you said about your investment bankers actions. You decided on their behalf that you had had about a much fun in investment banking as you could stand. You know that is what many investors will decide about you and Bank of America if you wipe out five years of dividend increases. Wall Street is laying odds on you cutting the dividend. Why don't you prove them wrong for once by saying "the dividend is safe on my watch." Of course your investment bankers will say that that kind of statement is a foolish thing to do, but good grief how much bad advice are you going to take from them? They were the ones who told you all the smart things that are now blowing up in your face. The banking system needs someone to stand up and risk his own neck for the benefit of his shareholders. Why do you constantly leave that up to Wells Fargo. Why not just say it: "If the dividend goes, I go." At least you can leave with your dignity when this is all over. Nearly tw0-thirds of our client are at or near retirement. They need for you to stand firm for them. We can stand a few years of no increase, but please, stand firm for your shareholders. We have not given up on you. We believe you are the man to begin the healing process between investors and banks: do it with a dividend imperative, Mr. Lewis.

Strong Banks are Very Cheap

This is the second part of a recent discussion between an old friend and client about the economy, markets, and interest rates.

Friend: So I think we both agree the subprime fiasco, while bad for housing and many banks, may not spill over as far into the overall economy as investors and the media now believe. If that is the case, what do your valuation models now say about stocks in general? I guess I'm particularly interested in the real bargains you might be finding.

GCD: We actually see bargains across almost all industry sectors, as well as, international stocks. But if you want to go where the bargains are, you go straight toward where the damage is the greatest: Financials. We still have to get through mid-January when all the banks and insurance stocks will be going to confession again, but if you stick to the highest quality institutions around the world, we believe their writeoffs will be well contained within their present capital structures, and if not, all they have to do is ask their friends in Asia for a little help. Selective banks are very cheap. Let's look at one in particular.

Wells Fargo is arguably the strongest bank in the US. They have a high double AA financial strength, a strong growth record, and enviable returns on total assets and equity. Finally, their largest shareholder is Warren Buffett, who would probably buy the bank and put in his hip pocket if they would let him. Thus, capital for expansion is not an issue.

The reason Mr. Buffett would buy WFC in a heartbeat is the chart above. It shows the comparison of WFC's dividend yield vs. the yield on a 10-year T-bond over the last 20 years.

The chart speaks a simple reality: 20 years ago there was nearly a 4% difference between the bond yield and WFC's dividend yield. Today it is zero, nada, zip.

20 years ago investors were betting that WFC's dividend growth would be at least 5% over the coming 10 years. If growth would not have been at least that much, the bond would have been a better buy by a wide margin. Indeed, over the last two decades WFC has grown its dividend in the low double digits and its stock has achieved a similar rate of return, beating bonds by a big margin.

Today, with WFC's dividend yield and T-bonds yielding the same, investors appear to betting that WFC will have zero growth over the next few years. That is hogwash. WFC will grow at least as fast as nominal GDP, which we estimate will run in the 5.5% - 6.0% range.

Almost all banks are as cheap as WFC. Some deserve their low prices, but a handful, at a minimum do not. Others that appear oversold to us are Bank of America and US Bancorp.

Banks have certainly made a wrong turn and now find themselves out wandering around in the weeds, but bad times for the average bank means good times for the big, financially strong banks such as WFC, Bank of America, and US Bancorp. With so many banks out in the weeds, these three big banks, along with a short list of foreign banks will gain market share over the coming years at an unprecedented rate.

Next time I'll discuss some other industries that look good to us.

We own all three of the banks discussed here, plus others.

Berkshire Hathaway: Is It Overvalued?

Our valuation model for Berkshire Hathaway is suggesting that Mr. Buffett's pride and joy is modestly overvalued based on data from its recent financial report. This can be seen on the Valuation Chart at the right. The price line (in blue) is modestly above the green value bar for November 2007.

BRK/A is selling near $136,500 ($4,550 for class B) per share and the model indicates that its "normalized" value is just under $125,000 ($4, 170).

Having said this, our model's primary objective is to determine a company's probable price 12 months ahead. Plugging in our best guess for book value growth and interest rates in the year ahead, we get a price of $144,000 (4,800), shown by the green candy cane at the far right. That would put the stock approximately 7% undervalued.

In December of 2006, we arrived at a similar conclusion when we calculated that BRK was slightly overvalued on a near-term basis but undervalued based on a year ahead book value of $77,000. It now appears that BRK will end 2007 with a per share book value approaching $80,000, a remarkable performance in a tough market.

BRK/A is a great company and we have owned it for many years in our Capital Builder accounts. It's terrific performance in 2007 is a combination of its own solid results and a flight to the safety of Buffett's stable of "wonderful companies" and BRK's AAA rating.

Another driver has been Buffet's remarkable ability to find the gold in every crisis. BRK came out of 9/11 stronger than it went in. Buffett built 2007's powerful financial results partly in the aftermath of Hurricane Katrina by betting, though his insurance companies, that such devastation was an aberration and not an annual occurrence.

Since the rise of the subprime problems, he has been buying big pieces of Wells Fargo, Bank of America, and US Bancorp. He is rumored to be involved in taking positions in the municipal bond insurance crowd.

Buffett and Berkshire Hathaway have been on a powerful winning streak, and there are those who say he is due for a spectacular flop. Couple this with our Valuation model signalling that the company is fairly valued, and one might think it wise to take some profits in Berkshire Hathaway.

We are not following that plan. We think the current subprime crisis and Buffett's track record are likely to propel BRK much higher. Markets are not efficient. Greed and fear are powerful forces that do not end when valuations appear over or undervalued. They end when they exhaust themselves. To the extent that the subprime crisis stays in the headlines, BRK is likely to continue to climb. We do have a level in mind that we believe factors in all the possible good news for the next couple of years, but obviously, for the present, we are keeping it to ourselves.

Target is on Target

We believe one of the best signals for investing in the retail sector is right after the retailers bemoan the fact that for whatever reason, "This year Christmas will not come." This week Target warned about potentially soft sales and earnings through year end. Since Target (TGT) is a leader in mass retailing, we would expect many more retailers to be making similar declarations in the weeks and months
ahead.


Real estate news is gripping the headlines, but it is interesting to note that only 2.7% of "prime" mortgage loans are in default and that is where 90% of all mortgage loans are located. The subprime mess is a small part of the mortgage pie, and even though it is causing lots of pain, it does not drive the economy of the United States. Jobs drive the US economy and America is at work and that is the reason that delinquencies on prime mortgages are so low.

Indeed, as it relates to the retailers, we have also found that "he who hollers first" is often the ultimate winner. In this regard, Target is a company we like a lot. They have the right strategy, the right product mix, and we believe they will have a solid Holiday selling season and continue to gain on Walmart.

Our Dividend Valuation Model above shows that TGT is as good a value as it has been since 1996.

Target may not seem like an obvious pick for these times, but who doesn't know that? The "Christmas isn't coming" crowd got out of retail a long time ago. When they see that they are wrong, they will be back pushing Target and the other top flight retailers higher.

Energy: The New Y2K -- Boeing, Toyota, and United Technologies

While we are grappling to understand the height, width, and breadth of the mortgage crisis, another crisis that we have detailing has fallen off the front pages: the energy crisis. Here's why we have been describing energy as the next Y2K:

1. 9-11 was a harsh lesson in the Islamists' visceral hatred of our Western way of life, and the fiendish extremes to which they would go to harm us.
2. The internecine fighting in Iraq, if anything, should be a constant reminder that the terrorists seek to destroy anyone who stands in their way, even their own people.
3. Katrina showed how fragile our refining and energy distribution systems were.
4. Too much of the American, yes the Western, way of life is held hostage to energy; and too much of the world's energy supply is in countries who hate not just Americans, but any country that follows an open society of free markets and democracy.

The recent sell off has hit almost all stocks and sectors. During this sell off, we have been nibbling on the three stocks that we believe currently possess the best technology and products to dramatically reduce energy consumption, without abandoning out our way of life-- Boeing, Toyota, and United Technologies. These three companies currently have products on the market that can reduce energy consumption by up to 50%(compared to older technologies) in planes, automobiles, and heating and air conditioning systems, respectively.

Here's our bottom line, and we are borrowing from a press release by the World Business Counsel for Sustainable Development (WBCSD): There is a talk about "green" this and "green" that, but, thus far, most individuals, companies, and governments have done very little to diminish energy consumption.

Energy conservation may seem like an oxymoron, but we believe that a true cost-benefit inflection point is near, when people will realize that the technology is available and affordable here and now to dramatically reduce energy consumption.

The reason we call this an Energy Y2k is because when that day comes, there will be a mad rush to get aboard the new technology. We don't know what will cause it, and we have no special skills at seeing the future, but no individual, corporation, or government can live beyond its means indefinitely.

In saying this, we are not talking about doomsday or end-times. We are just saying that there are technologies available that offer people some insurance against rising energy prices, resulting from uncertain energy supplies, and the wisest course of action may be to own both the new technologies and the companies who own them.

Viewing the Market Selloff from the Perspective of a Dividend Investor

By Greg Donaldson and Mike Hull Yesterday's 300 point loss in the Dow is not the end of the stock market nor the demise of our clients' assets. Every time the stock prices fall like water out of a boot, everyone throws their hands in the air and tries to shield themselves from the pieces of sky that surely must be falling. The sky is not falling, and neither will every bank in America collapse in the face of the housing debacle. Stock prices will gyrate and the media will pontificate on all the things that are wrong, but that is their way -- to fan the fires, so they can sell more kindling. We listened to three earnings calls this week: Wachovia, Wells Fargo, and Bank of America. These are three of the largest banks in the county, and all are deeply involved in the mortgage market. None of these companies said they were seeing big increases in their non-performing credits, and none said that they were experiencing big defaults in their loan portfolios. Two of the companies, Wells Fargo and Bank of America, signaled their confidence in the future by hiking their dividends, 11% and 14% respectively. How can these companies raise their dividends in the face of all this bad news and falling stock prices? Two answers: 1) These companies have strong balance sheets and their earnings are good. They are confident that they will come through this challenging mortgage market just as strong, if not stronger, than they are today. 2) They know that stock prices have nothing to do with their fundamental businesses. We love dividends because they ignore what is going on today. They reflect, in large part, the track record of the company paying them, and they give us wonderful insight into what their leaders believe about the future. This week Bank of America raised its dividend 14%, to $2.56. That means that an investor buying BAC today could expect to receive a yield of 5.4% in dividends over the next twelve months. And, we're betting BAC will raise that dividend by at least 7% per year year over the next decade. At that rate of growth, BAC's dividend in 10 years would rise to $5.12 per share. That would mean that based on today's price of $47 per share, in 10 years, BAC would be offering a yield on today's cost of 10.8% ($5.12/$47). Now let's compare that to a riskless 10-year US Treasury bond. Today the yield on a 10-year T-bond is 4.8%. BAC's current dividend yield of 5.4% is higher, but let's face it T-bonds have no risk, so based on yield alone we would not choose BAC over the T-bond. However, when we factor in the dividend growth of only 7%, which is much less than their dividend growth over the past decade, BAC offers a much better potential total rate of return over the coming decade. We would be much more worried about the economy if the major banks were not in such good financial shape. All three of the banks we mentioned earlier have at least a AA rating, as reported by Bloomberg. These are solid outfits run by seasoned managers. These companies, like so many of our other "Rising Dividend" companies, are attractive just from their dividends alone. However, when you add in the their prospects for future dividend growth, they are tough to beat by pure growth investments. Pure growth investing requires that an investor buy right and sell right because the timing of these two actions determines the entire rate of return. That is why the stock market is correcting right now. For traders, when the markets start to fall like they have this week, they must sell out fast or risk losing all of their gains. With dividend investing, our rate of return is much more a function of the cash flows that we receive while we "own" the stock. Thus, from the perspective of we dividend investors, if we are happy with the dividend growth and financial strength of a company we own, a big selloff in stocks is an opportunity to add to our positions and look for other solid, dividend-paying companies that the market is "putting on sale." The panic of the day will scare the traders and they will do what they always do-- run -- and this correction in the market may last a while longer. In the end, however, cooler heads will do their homework and conclude that many stocks are too cheap, and that the mortgage mess in this country will pass, like all the crises before it.

Boeing Is a Dream

The Boeing 787 Dreamliner was introduced to the world on July 8. While you may not have seen much about the new plane in your local newspaper, it may be the most important new product of the 21st century.

The 787 Dreamliner is a show stopper. It is the world's first mostly composite commercial airplane. It will not only use 20 percent less fuel per passenger than similarly sized airplanes, but also produce fewer carbon emissions, and yet offer quieter takeoffs and landings.

The Dreamliner has been so successful in its advance orders that Airbus, its European rival, has suffered some order cancellations for some of its new products.

As Boeing's success with the Dreamliner has become more apparent, the stock has begun to rise. Indeed, it has tripled over the past 4 years. Recently, I have seen many analysts say that Boeing has come too far too fast. I do not agree. Our Dividend Valuation Model for BA shows why.

The Chart shows BA's actual annual prices (blue line) and our model's predicted values( green bars) over the last 20 years. You can see that over the last four years, BA's prices and predicted values have been almost a perfect fit. Therefore the current price of the stock is fully substantiated by the recent dividend growth of the company.

The striped bar to the right is the predicted value of BA based on my year-ahead dividend growth and interest rate predictions. That price is near $120 per share. That would be nearly a 20% increase from the current price of $102.40.

My guess is the Dreamliner will be an even bigger success than the market now believes, and thus, my year ahead prediction may be low. You know I can't see the future and the airline business is a treacherous business, so success is not assured. Having said that I want you to think about Boeing in a little different way.

There are only two major airplane manufacturers in the world, Boeing and Airbus. With the growing global economy, these two companies have what amounts to a toll road connecting every continent of the world. If you want to go to China, you will go on a plane made by Boeing or Airbus. The same for Europe, Japan, and South America. The only way a human being can reasonably travel long distances in on aircraft made by these two companies.

The airline business may continue to be a cutthroat business, but the aircraft manufacturing business is a duopoly. Unless these companies are run by fools they both have a very bright future, especially when the world is clamoring for more fuel efficient planes. Boeing is certainly not run by a fool. James McNerney has a proven track record of turning businesses around and maximizing profits.

There are all kinds of reasons why my optimism might not come to fruition, but I believe there are many more that say it will.

The stock is owned in our Capital Builder investment style.

Wells Fargo -- The Package is Delayed, but the News is Good

I was hoping to end the mystery of WFC's dividend hike today, as they completed their board meeting and made their usual announcements. I was disappointed to learn that they had pushed the decision on the dividend to their July meeting. My apologies that we will all have to hold our collective breaths for another 30 days to see how much additional cash money WFC will give us in the year ahead. As you remember, my focus on WFC's dividend hike was because they are such a huge factor in the mortgage business and their 2006 dividend hike was a bit light(See my previous Blog). My interest is still keen to see what July 24th will bring, but I believe a partial answer to questions surrounding the state of the mortgage business was revealed in a management change announced today: Richard Kovacevich, the legendary leader of WFC, has stepped down as CEO of the firm and is being replaced by John Stumpf (no relation to our own Carol Stumpf, even though her husband is also named John). I believe this management change should be viewed as good news for WFC and, by extension, their mortgage business. Here's the reason. Kovacevich is a relatively young man of 63. I do not believe he would have willingly retired unless the ship was in pretty good shape. He has built WFC into the premier-earning big bank in the country by thinking very differently about banking and the role of bankers. Indeed, he does not call his branch banks, banks, at all, he calls them stores. His employees are not bankers, but sales associates. He took the idea of "cross sell" to a whole new level. Years ago when he was at Norwest, I remember he had a goal of each "store" customer using 4.7 of the company's products and services -- checking, mortgage, credit card, investments, etc. WFC now has initiative called GR8, where they are trying to cross sell 8, count 'em, 8 products to their customers. Kovacevich would never have built WFC just to turn it over to his long time lieutenant John Stumpf if the "store" was in trouble. He would have ridden out the tough times just as he has done for these many years. In addtion, the board would never have agreed to promote John Stumpf to CEO if they had any worries about the strategy or current state of the bank because Mr. Stumpf has been "riding shotgun" for Mr. Kovacevich for the last 25 years. I take this change in leadership as saying that WFC is not experiencing any alarming acceleration in their loan losses, and by extension, since they are so big in the mortgage business, the troubles in the subprime mortgage business still do not appear to be spilling over to the mainstream segment of the business. Unless there is a health issue with Mr. Kovacevich, I think today's news is good news for WFC, because he will stay on as the non-executive Chairman; and good news to the US economy because one of the biggest players in the mortgage business thinks the times are good enough to make a leadership change. These are just my thoughts on a rainy day in Indiana.

Dividends Talk -- Wells Fargo Will Soon Give Us a Reading on Real Estate

In late June of 2006, Wells Fargo (WFC) raised their dividend by 7.7%. This increase was below their trailing 20 year, 10 year, and 5 year average hikes of near 15% per annum. When I first saw the 7.7% print, I thought it made some sense. The Fed had been raising interest rates for two years, WFC's net interest margins were being squeezed, and business was beginning to slow. All these factors would appear to justify a slower dividend growth rate. However, the more I thought about it the more I realized that the weak dividend hike was signalling something more significant. WFC's earnings through the 12 months ending in June of 2006 had grown at nearly 12%, and its earnings and dividend growth had been very comparable for many years. So the 7.7% rate hike required an explanation. When I called the company, I got the distinct feeling that they were trying to explain away the dividend action as though it was no big deal. That was a very different attitude for them to take, because they had been touting their dividend growth for a number of years. As I hung up the phone, I was sure that WFC was signalling a weaker year ahead. Then it hit me. It was real estate. WFC was one of the largest mortgage underwriters in the country. It was a big part of their business. If they were being cautious, it had to be because of they had real estate worries. I discussed my concerns with our investment committee and we agreed the right thing to do was to lighten up on US banks and particularly regional mortgage banks. We also scaled back our holdings of WFC. WFC's June 2006 weak dividend hike, in my judgment, signaled housing was going to be a bigger problem than was generally believed at the time. Twelve months later it is clear that they were right. Next week at their regular board meeting, WFC is set to announce their dividend for the coming year . Here's my impression of what their dividend hike will signal. If the hike is between 5% and 7%, we can expect real estate woes to continue for another year. A 7% to 9% hike would suggest a bottom in real estate is in sight. A hike of more than 9% would mean that they not only see the mortgage business bottoming very soon, but also that they are gaining market share. A dividend hike of under 5% would be a very unwelcomed occurrence. That would mean that WFC is bracing for even more bad news in the housing market. We'll let you know their decision next week.

Dividends Talk

By Greg Donaldson and Mike Hull If you listen very closely, you will find that dividends talk. Indeed, they speak in the universal language of money on the barrel head, not in the wink-and-a-nod dialect of earnings or price. Twenty years ago we began a search for a way to determine the intrinsic value of a stock. For approximately 25% of the S&P 500, we believe we have found it -- listening to the dividends. They talk. Not very much and not very often, but watching their trends over about any 5-year time frame can offer a very good idea of what a stock is worth if you have the right tools. If you include interest rates and, in some cases, earnings, the picture becomes clearer. For the 12 months ending May 31, our Rising Dividend--Cornerstone investment style has experienced the best 12-month dividend growth we can remember, nearly 12.5%. During this time, its dividend yield averaged about 3.25%. If you add the two numbers together, you get 15.75%. That is what we call the Total Dividend Return(TDR). Our dividend theory(and what we believe our Dividend Valuation Models show) is that over the long-term, the total return(price appreciation + dividends) of most consistent dividend payers will approximate its Total Dividend Return. Thus, theoretically, we would have expected that the total rate of return of our Cornerstone style of management over the last 12 months would have been around 15.75%, not the near 19% that it actually returned. A 19% total return when we were expecting under a 16% return is good, right? Well, let's say it's not bad, but not something to get all excited about either, because the extra 3+% was not "earned"in our way of viewing things. You might say it just happened. The question, of course, is isn't that the way all money is made in the stock market, it just happens, doesn't it? Stock returns are random; that is what the dons of academe have been trying to tell us for about the last 40 years. We agree with the dons that in the case of many companies there does not appear to be a value driver, but in the case of consistent dividend payers its a different story. Our research shows that almost all consistent dividend payers have a unique and quantifiable relationship between dividend growth and price growth. Additionally, dividend growth and price growth intersect, or reach a kind of equilibrium about every 3 to 5 years. This means that our Cornerstone's outperformance over the last year can be explained in one of two ways: 1) It is a make up for an underperformance in the last three years, or 2) the portfolio's actual performance will lag a bit until more dividend hikes become apparent. Our best estimate for dividend growth for the portfolio over the next 12 months is just above 10%. With the portfolio's current dividend yield near 3%, that would mean that a good guess of what the Cornerstone portfolio might produce over the next 12 months is near 13%. This strong dividend growth implies double digit returns this year and next. Recently, rising interest rates have been a headwind to almost all dividend stocks, but history shows us that rising interest rates, unless they continue to rise on a secular basis, are not the main driver of very many stocks, even utilities and REITs. The main driver of most dividend stocks is the trend of their dividend growth. Thus, if the trend of dividend growth is sustainable, which we believe it is for many stocks, stock prices will soon stop their swoon and begin to climb again. Here's a real example of Dividend Talk. UTX, which I discussed a few blogs ago, recently announced a 21% dividend increase. The analysts were looking for a 14.5% hike. We think UTX's above trend dividend hike is a clear signal that it is likely to have a better year earnings-wise than Wall Street now is projecting. That means as the year progresses, UTX is likely to find new buyers with each successive positive earnings report. We are awaiting with great anticipation Wells Fargo's next dividend hike. We'll tell you why in a future edition.

UTX: Primed for the Global Economy

Stocks have had a good run over the past 12 months, but our models, as I said last time, are showing that many blue chip stocks are still undervalued. During the next few weeks, I will show our Dividend Valuation Models for a handful of stocks in the Dow Jones 30 that appear to have a ways to go.

The first stock is United Technologies (UTX.) We own the stock in our Capital Builder and Cornerstone portfolios. UTX owns Carrier Heating and Air, Otis Elevator, UTC Fire and Security, and three aerospace units, Hamilton Sunstrand, Sikorsky, and Pratt and Whitney.

Please click to enlarge
The blue line on the chart shows that over the last 20 years, UTX, except for the period right at the turn of the century, has been a remarkably consistent grower.

The green bars represent the prices that our Dividend Valuation Model (DVM) calculated were the corresponding "fair values" of the stock in each given year.

What is important about the green valuation bars is that in 9 of the last 12 years they have come remarkably close to predicting the average annual price of UTX. When you stumble upon a valuation tool that has been as accurate as our DVM has for UTX, it might not be the worst idea to see what it is projecting for the next 12 months.

The model's valuation level for 2008, which is based on dividend growth and changes in interest rates, is $80 (green striped bars). The way our model works the $80 figure is a kind of central tendency, not an exact forecast.

With the stock currently selling at near $70, a move to near $80 would represent over a 14% increase. In addition, UTX's current dividend provides a 1.5% current yield. Totalling the capital appreciation and the dividend yield, we arrive at nearly a 15.5% projected total return in the coming 12 months.

But there is more: UTX is not a one year wonder, their product lines touch almost all of the macro trends that are driving the worldwide economy.

Carrier is deeply involved in cleaner and more fuel efficient heating and airconditioning. In addition, they are a prime benefactor of the global expansion. Otis Elevator is a key player in the global expansion with elevators, escalators, and moving sidewalks. UTC Fire and Safety is primarily a surveillance and security firm, think terrorism and safety. The aerospace division is full of technology used in defense and air travel. Think terrorism and global expansion.

On a daily basis stocks can bob and weave like a yo yo, but if you dig hard enough, some stocks are found to follow their fundamentals very closely. We believe UTX is one of them.

If you have not read our disclaimers recently, please click on the link at the right. The discussion here is for information purposes only. Yes, and I do own the stock.

Our First Webcast -- Market Comments

In this our first webcast, Mike Hull and I discuss the stock market's recent run up and the prospects for its continuation. The webcast lasts about 20 minutes and covers a wide range of topics from the global economy to inflation, interest rates, Fed policy, and the areas of the stock market that we believe are most undervalued. Since this is our first shot at putting "voice" to our thoughts, please let us know what you think. You can also pick the winner of our little debate. (To start webcast, click the green play button on the player above.) gdonaldson@dcmol.com mhull@dcmol.com