Simple Dividend Model Says PepsiCo Is Better Value Than Coke

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. In a recent post, I showed mathematical valuations of Coke and PepsiCo based on their last 15 years of price and fundamental data. As it turned out for both companies, dividends alone had the highest correlation with their prices over this period.

3. I chose Coke (KO) and PepsiCo (PEP) for my first valuation calculation because both are powerful brands that have won over our taste buds, grocery shelves, and portfolios. Since they are so dominant and so similar in their products and marketing, most people assume they are both always about fairly valued because they are so large and their products are a staple of everyday life for many people. 

4. Last time I showed a chart for each company as shown below. The green line on each chart is the actual annual price over the last 15 years. The red line is the predicted price my model calculates. A closer look at the two charts shows that PepsiCo's current price is about 9% lower that its predicted price, based on the correlation between its dividend and price growth over the last 15 years. Coke, on the other hand, appears to be selling about 9.5% above its predicted price using he same metrics. 

Studying the two dividend correlation charts suggests PepsiCo is clearly the better value. But, as I said last time, my dividend correlation model is looking only at historical data. The future is in the future for all stocks. So, let's take a swing at estimating the future growth of both companies. Remember, dividend growth alone trumps all other indicators for these two stocks, and in both cases the correlation between the companies' dividends and stock prices is over 90%.

 

In valuing Coke and Pepsi, I am using a simple linear regression model that measures the average changes of prices versus dividends for each company over the last 15 years, and then performs annual standard deviations to determine how tight the fit is. This model generates what is known as a correlation coefficient, or R2. Both Coke and Pepsi have R2s between annual price and dividend growth above .90. Put another way, annual changes in dividends for both companies has been able to explain over 90% of the annual changes in their stock prices. It's not perfect, but few investment professionals will be willing to bet you that this .90 correlation between prices and dividends is going to change very much in the coming year or years.  

A linear regression calculation, as the name implies, assumes that the movement of prices v. dividends will form a line. The important things about lines is they all have a slope and slopes have formulas. Thus, here in November 2024, if we have a good prediction or guess about how much each company will increase its dividends in 2025, (both have unbroken strings of increasing dividends for over 50 years) we can plug that figure into the formula and have a predicted stock price for the coming year.

PepsiCo's linear regression formula is .52+35x, where x is next year's dividend. PepsiCo's current indicated dividend is $5.42. For this analysis let's just increase PepsiCo's dividend by 7%, which is its average increase of the last five years. Here are the results of the formula:

.52+35 x 5.80 = $203.52

This simple regression model is projecting that PepsiCo's price will reach $203.52 by the end of 2025. That would be a rise in the price of over 20%. Remember, this is a model, not an analytical projection of what I think the price will be. But, with a correlation so high, one might think of it as a ballpark figure of the upside potential of PepsiCo.

Coke's dividend growth over the last five years has averaged only 3.5%. Plugging dividend growth of that level into the regression model for Coke gives us a 2025 best guess price of $67.25, only slightly above today's selling price. 

As always, this is not a Wall Street type deep dive type valuation analysis of either company, and it should not be taken as investment advice. This is just a mathematical look at financial data for both companies that has had a very high correlation over the last few years. Using this simple analysis, PepsiCo is our clear winner. 

Someone might want to break the news to Warren Buffett. He holds a tremendous amount of Coke.

Next time I will compare two other name-brand blue chip stocks in the tech industry sector. That will be a tougher challenge because dividends probably won't work as well in these companies, and I will have to dig deeper to determine is any of the companies' fundamental data have a tight correlation with prices. If there is a fit, it should also give us an idea of how fairly valued some of the techs are after their huge run over the last two years. 

Until next time.

If you would like to offer companies for me to value using this correlation process, please send me a note at info@gregdonaldson@gmail.com.

Thanks to several of you who informed me that my colors were wrong on the charts last time. 

I own Pepsico.

Answers to Your Questions: General Mills -- How Our Dividend Model Gives Buy and Sell Signals

Dividend Valuation Model

General Mills (GIS) is up 22% over the last twelve months.  A questioner wants to know what our dividend valuation model is signaling about the stock's prospects for the coming year.  In addition, several questioners have asked if we are a pure "buy and hold" manager, or if we take profits under certain conditions. 

In answering the second question first, we are not a "buy and hold" investment manager.  We are a "buy undervalued and sell overvalued" manager.  We find that our average holding time of a stock is about 5 years.

Let's use our Dividend Valuation chart above of General Mills (click to enlarge) to look more closely at the buy and sell signals we believe have the most validity.

First a cursory looks reveals that over the past 20 years there has been a reasonably tight fit between the movement of GIS's price (red line) and its projected valuation (blue bars), as calculated by our Dividend Valuation model.  Indeed, the R2 is near 90%.  It is important to remember that the Dividend Valuation model calculates a single formula that is used for all years, with the only difference from year to year being the inputs of dividend growth and changes in interest rates.

So how do we read GIS's prospects for the coming year?  The checkerboard bar at the far right is the model's calculation of the predicted price using our projections of GIS's dividend growth over the next twelve months and the change in the yield of a 30-year US Treasury bond. That predicted price is approximately $40 per share. If we include GIS's dividend, that would produce an approximate total return over the coming year of near 12%.

As a reminder, while our model has done a good job of predicting value over the last 20 years, the model is based on historical relationships and, thus, is not a guarantee that GIS's predicted price of near $40 per share will be met.  You probably knew that already.   

Let's look more broadly at GIS's valuation chart to see the various buy and sell signals it has made.  Remember the actual price is the red line and the model's predicted price is the blue bar.  Thus, simplistically, when the red line intersects a blue bar in a particular year, that would mean that price is below value, and it would signal that the stock is undervalued and a buy candidate.  Conversely, if the red price line is higher than the top of a blue bar it is considered overvalued, and a sell candidate if owned.

According to the model, GIS was undervalued between 1993 and 1998,  in 2000, 2005, 2009, and 2010.  Simply speaking, if we were following the model without other considerations, we would have bought the stock in 1993 and sold it in 1999.  We would have bought again in 2000 and sold in 2001; repurchased it in 2005 and sold again in 2006.  Finally, we would have bought in 2009 and we would still be holding the stock.

In actual practice, we follow a more rigorous standard for buying and selling.  In the case of a stock like GIS, we require that the stock be at least 10% undervalued or overvalued to trigger buy and sell signals.  We find this provides about the same rate of return with far less turnover and capital gains taxes.

We do not currently own General Mills in any of our Rising Dividend models.  We have looked at it many times over the years, but other stocks appeared to be more undervalued each time.  Indeed, its current 12% undervaluation is not exceptional.  Our models are suggesting that the average stock is nearly 25% undervalued.  GIS is an outstanding company, and if it retreats in price or begins to grow its dividend at a higher rate than our model now projects, we would become much more interested in buying it.

We'll be tackling some of the questions about the economy and the Federal Reserve next week.

The author does not own General Mills.  

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.

Real Estate and Mortgage Woes Do Not Mean a Recession is Inevitable

Yesterday American Home Mortgage, a specialized mortgage company, lost 90% of its value, when its lenders refused to advance the company more funds to meet its reserve requirements and lending demands. When the news was announced, the Dow Jones was higher by over 100 points, after the news hit, the market immediately turned lower and finished down over 100 points, wiping out hundreds of billions of stock market value.

The question that everyone is asking is how much more bad news are we likely to get from the mortgage and real estate businesses, and do their problems have the potential to endanger the banking systems and the economy?

Here’s my short answer. From what I read, American Home Mortgage’s –AHM -- biggest problem was that their banks pulled the plug on them because of the falling values of AHM’s underlying collateral, so it was not necessarily a case of them being swallowed up in sea of bad loans.

The big banks and investment banks in the US, in an effort to protect their own assets, have begun to cut off additional loans to all but prime mortgage credits. This will likely lead to more headlines for specialized mortgage lenders who are forced into bankruptcy because of being cut off by their lenders. So the answer to the first part of the question is the mortgage mess will be with us for a while, yet.

Having said this, I do not believe the odds are very high that the problems of the subprime and specialized mortgage lenders will cause severe damage to the major banks in this country or to our overall economy. My reason for saying this is that the banks in this country entered the year 2007 in as a good a financial position as they have been in 20 years. The best way to look at this is to compare the cumulative financial condition of the major banks at the beginning of 2007 with their condition when they entered the last period of financial stress, which was in the late 1980s—to early 1990s, resulting from the S&L debacle and a severe pull back in corporate profitability.

The table shows that there is little comparison between the financial position of the major banks today and that of 1989.

Today the banks’ equity capital as a % of assets is 60% higher than it was in 1989; non-accrual loans (loans on which the bank is not receiving

payment), at 0.5% of total loans are only about 20% of what they were in 1989; the banks’ current loan loss reserves (money that is set aside to cover potential losses) is 274% of their actual loan losses, compared to 1989, when loan loss reserves were only fractionally higher than actual losses at 102.5%. Finally, At the beginning of 2007, actual loan losses were only 2.3% of equity capital compared to an 11.2% rate in 1989.

The bottom line is the banking system is strong, and I believe it can withstand the current real estate and mortgage problems very well.

The stock market is retreating because of fears that the banking system will be threatened by the current mortgage mess, which will result in a recession for the whole economy.

The best argument against that line of thinking is the aforementioned strength of the banks, but beyond that is recent US economic data. US Gross Domestic Product was just reported to have grown 3.4% (annualized) in the second quarter and the US unemployment rate has remained steady at only 4.5% of the workforce. Remember these data occurred simultaneous with the bad news in real estate and mortgage lending. Finally, if a recession were imminent, the Federal Reserve would have an obligation to start cutting rates.

As I mentioned in my last blog, I listened to the quarterly earnings reports of three of the biggest banks in the country. None of the three reported big jumps in loan charge offs, or greatly increased their loan loss reserves. And, to remind you, two of the three increased their dividends more than we were predicting.

Gyrating markets are not much fun for most people, and they always raise the question: “What are these stock worth, anyway?” If all you are only looking at prices, you might decide that stocks aren’t worth very much, but when you look at companies from the perspective of the cash dividend they are paying and the dividend's rate of growth over the long-term, another picture becomes clear. Many companies are veritable cash flow machines and will be worth more in 10 years than you can imagine.

Cash dividends are real money and determining the value of companies that have long histories of raising their dividends is much easier than it is for companies who must be valued on earnings alone.

As I have said in these blogs before (see my series on The Rising Dividend Story on the side bar)[from the beginning], it was during the severe market correction of October 1987 that our Rising Dividend investment style was born. I knew those dark days would pass because I was convinced the selloff was not fundamentally driven, but I did not know what to buy, and so I sat on the sidelines and let one of the best buying opportunities in the history of the capital markets go by. Now 20 years later, we have a few pretty good valuation tools, and they are signaling that some truly wonderful companies are being put on sale (some of which we already own). I don’t think we need to be in a big hurry, but there are a few that I have been trying to buy for a long time. I’ll be discussing some of those companies in the days and weeks ahead.

Table and data from BCAresearch.com and FDIC

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.

Barnyard Forecast -- Stocks Going Higher

The Donaldson Capital Management Barnyard Forecast is our subjective model for the prospects of the stock market over the next 12 months. We like to roll it out when the times or the markets are confusing. The Forecast is a simple check list of the levels and trends of the major economic data and their historical relationships to stocks. The Forecast's name is taken from the acronym of its components: Economy, Inflation, Earnings, Interest Rates. Each component is rated as follows: positive for stocks --2 points, neutral for stocks -- one point, or negative for stocks-- 0 points.

Economy: The optimum rate of real economic growth is near 3%. The Forecast is positive when economic growth is below 3% and negative when its above 3%. At first that may seem counter intuitive, but the idea is to capture the projected actions of the Federal Reserve in the coming year. If the economy is growing slowly, the Fed can be expected to cut rates; if the economy is steaming, the Fed will likely raise rates. The most recent GDP data was this week's .6% reading for the first quarter. That is well under 3% and, thus, is positive for stocks, 2 points.

Inflation: This is the most worrisome indicator currently. The important threshold for the Core Consumer Price Index (Core CPI) inflation is 2%. The core CPI has been consistently above that level for nearly two years and has caused many analysts to be skeptical about rate cuts anytime soon. The reading for the 12 months ending April was 2%. Under the circumstances, that is a negative reading. 0 points.

Earnings: Corporate earnings have been nothing short of sensational over the last three years. Most analysts were predicting that first quarter earnings would fall below 10% on a year over year basis for the fist time since 2002. The final numbers are not in yet, but it appears first quarter earnings for the S&P 500 may have edged over that level. In any case, earnings have continued stronger longer than almost anyone would have guessed. The most important threshold for earnings is 7% annual growth, which is the long -run average. We expect 2007 earnings growth will stay comfortably above that level. Earnings are positive for stocks. 2 points.

Interest Rates: Long-term interest rates have been creeping higher over the last few months. Bond investors appear to be worried that the slowing economy will prompt the Fed to cut rates before inflation is completely subdued. Having said this, 30 year Treasury yields are about where they were a year ago. That is a neutral reading. One point.

The Barnyard Forecast totals 5 points. That is a modestly bullish reading for stocks in the coming year.

With stocks having had a strong run over the past 4 months, the media is full of prognosticators who are turning bearish. As seen below from the website Tickersense.com , currently nearly 47% of stock market commentators included in their survey are bearish, with only 25% bullish. We have never seen a market turn decisively lower in the face of such negative sentiment. Stocks almost always turn lower when everyone is bullish. Just the opposite is true today and, thus, at the very least we should have another surge higher to force all the naysayers to capitulate and come off the sidelines.

This might sound like simplistic thinking, but over the years, we have found that markets that are littered with doubt and worry tend to be more profitable than those when the sentiment is overwhelmingly bullish.

Our Dividend Valuation Models say the market is still cheap. Our Barnyard Forecast says that economic forces favor a rising stock market. Lots of traders are bearish. It hasn't been this good in a long time.

US Bank's 80% Pledge -- A New, Old Idea.

US Bank (USB), the big Minneapolis based bank, has a continuing pledge, which they reiterate periodically, to return to their shareholders 80% of their earnings in either dividend increases or share buybacks. I know of no other company that has this specific a pledge. REITs, of course, by law must pay out 90% of their earnings, but USB is unique, as far as I know, in communicating a commitment to shareholders that even my elderly mother sitting in a small town in Indiana can understand. Pledges like USB's were common place in the early days of stock trading in the US when early traders on Wall Street gathered under the buttonwood tree. They had none of today's ever lengthening list of rules and regulations. Yet, somehow they made deals and bought and sold securities based on the "word" of the men who ran corporations in those days. Those were the days of "a man's word is his bond." Today things have changed. Now its "A man's bond is his contract, unless he or she can find the loop holes." I personally believe that salt-of-the-earth Americans are near a tipping point in their level of trust for corporate America and Wall Street. The images of both have been sullied by the incessant news of broken promises and broken laws by the people we have hired to run "our" companies. In company after company "fast and loose" is not a bad word; it is a way of life. The attitude seems to be: "D__n the shareholders. "Whose company do they think this is, anyway?" US Bank with their Midwestern mindset must be hearing the same things we are, and they are responding the way plain talking Minnesotans and Hoosiers do, by eliminating as much "maybe" from their conversation with their shareholders as possible. I think USB's 80% pledge will catch on with other companies trying to distance themselves from the bad actors. USB is a AA rated company that is currently yielding 4.7%, and over the last 5 years, they have raised their dividend by an average of 15% per year. We have been buying USB in our Income Builder style of management.

John Burr Williams: Investing Versus Speculating

John Burr Williams believed that the stock market was far more volatile than the long-run dividend paying abilities of the underlying companies would justify. This fixation with the short-term, led to periods of gross over and undervaluation in stocks, which, in turn, led to booms and busts in the economy. Williams believed that the cycle of booms and busts caused many people to lose faith in the free market economy and the markets, which ultimately led to the socialist-like economic policies of the 1930s. His book was not about beating the market, or getting rich in the market, it was really a wake-up call to the investment elite of his time to offer them a theory of investment value that would encourage more long-term investing and less speculation. Williams realized that speculators would always be with us, and were a legitimate enterprise, but he wanted to provide tools for investors to aid them in making decisions based on the “investment value” of a company, not just its price momentum. Williams postulated that investors’ inability to properly value stocks, increasingly, led them to become speculators. Most people would not admit that they were speculators, but when they were asked to explain their buy and sell decisions, it was clear that they were not appraising the intrinsic value of companies, but betting that they knew something that the market did not. In one of Williams’s most insightful observations, he makes the following statement: “To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . . Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment. Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either cheat in the matter, or study the forces at work. Cheating has been outlawed, so far as can be, by the Security Act of 1934. The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ‘’coming events cast their shadows before.’ But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator. Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late. That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever. Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.” John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).” This is the sum total, essence, bottom line, and raison d'etre of Donaldson Capital Management. Long-term values of companies are determinined by what you can get out of them. That is why we scrutinize dividend levels and dividend growth. This is where value is created. This is where value can be measured. Finally, this is where we can find opportunties. Opportunities that are being shunned because today's news is not positive or is murky, but opportunities that have already discounted all the bad news and now stand ready to rise, driven by the intrinsic value of the company. Amen

John Burr Williams and the Theory of Investment Value, Part 2

Mr. Bernhard was echoing Williams in pointing out the need for generally accepted criteria to value stocks. He also joined Williams in warning that the effect of not having such criteria resulted in excess stock market and economic volatility, which damaged investor confidence not only in the stock market but also in the free markets. Bernhard then boldly states, “In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock. Whenever, over a period of years, the dividend, or the ability to pay dividends, went up, so too did the price of the stock. When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.” In applauding Williams’s theory, however, Bernhard inserted a subtle twist to Williams’s basic premise by adding the words, “the dividend, or the ability to pay dividends.” By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value. Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist. He is famous for saying that investing is easy: “just buy wonderful companies at good to great prices.” When asked to explain what good to great prices means, he credits John Burr Williams’s formula for intrinsic value, but defines it with a different twist: “The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.” Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings. Neither Buffett nor Bernhard nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said. Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his thesis a section titled “A Chapter for Skeptics.” There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company..” Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following: “Earnings are a means to an end, and the means should not be mistaken for the ends. In short, a stock is worth only what you can get out of it.” [Italics are the author’s.] He then added the following poem: “ Even so, the old farmer said to his son: A cow for her milk, A hen for her eggs, And a stock, by heck, For its dividends. An orchard for fruit Bees for their honey, And stocks, besides, For their dividends. The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.” In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets. Williams answered this issue with the following statement, “The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading, and dividends for years to come, not income for the moment only.” John Burr Williams struck a bright line between being in the chicken business and being in the egg business. He believed, as we will see later, that buying and selling chickens had no predictor and thus was pure speculation. On the other hand, investing in egg-laying chickens was completely different. It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.

John Burr Williams and the Theory of Investment Value

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, and it remains so today.  

This is Part 1 of series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: “The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [riskless] interest rate demanded by the investor.” 

Mr. Williams’ dissertation, entitled “The Theory of Investment Value,” did not immediately earn him his doctorate. That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only foolish greed could compel a doctoral student to sell his thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible. Since he had come for the knowledge and not the degree and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method of determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the state-sponsored programs of President Franklin Roosevelt. Williams devotes an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’s teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks was of enough significance to justify a doctorate in economics from Harvard.  After a heated debate he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting. That has certainly been the case with John Burr Williams’ theory. What had angered his Harvard professors, at first, caused Wall Street brokers to scoff. The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product. Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandis. 

Blaming Wall Street 

But, a closer reading of the book turned Wall Street’s ridicule to scorn. The ways of Wall Street were being blamed, at least partly, for the stock market crash. Williams' thesis stated the following: 
“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long-run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his 1959 book, The Evaluation of Common Stocks, and echoed his concerns, “Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

 Next Time: Investing versus Speculating

The Rising Dividend Story -- Can a Stock Be Valued Like a Bond?

With the market catching a little Bernanke Flu recently, I temporarily suspended The Rising Dividend Story as I used this space to address the economy, interest rates, and the stock market. But for those of you who have asked, the story continues: When a person finds a truth 180 degrees from where he thought it resided, there is a sense of awe, a stillness , and a peace; and when you catch sight of it, it encompasses everything you do and think. We left off last time discussing the last thought that went through my mind before I fell asleep on Black Monday night – “Is it possible to value a stock like a bond?” It had never occurred to me before that night that it might be possible, and there was nothing that had happened during the day to encourage such an idea, but the question kept coming nevertheless. The reason the question hung in the air was because of my purchase of the Indiana University bonds. In retrospect, the realization that I had bought a bond without knowing its market price and in the middle of a stock market crash had astonished me. I realized some people may believe that such a purchase was foolish; but, as I mentioned before, the way the bond buy unfolded was as though I was watching myself doing something that I had never done before, yet at every turn knowing what to do next. It was like time slowed down so that I would understand what it wanted me to know. The unmistakable message the bond buy gave me was that investments have a value apart from their price. Price represents a best guess at value, but it is NOT value. Value is something inherent to an enterprise; price is an opinion, a convenience with which to get in and out of the market. Over the next few days, as I analyzed my purchase of the IU bond, I came to the realization that the key factors that gave me the confidence to buy the bond were its undisputed quality and the ability to calculate its rate of return over its life. Because a bond has a fixed interest rate and a fixed length of maturity, it is possible to calculate its minimum rate of return on the day of its purchase. This meant that with a bond, an investor did not need for the price of the bond to go up to achieve a rate of return. An investor needed only for time to pass to collect the interest payments to achieve the calculated rate of return – time alone produced results, not timing, as was the case when trading stocks. Before Black Monday, I thought timing and trend-following were the truths of investing, but now I understood they were really just forms of gambling. I had devoted 12 years to perfecting these techniques, and now Black Monday had exposed their folly. Black Monday was instead showing me that time, quality, and valuation were the truths of successful investing. But I’m getting ahead of myself here. These may be the truths of investing in bonds, but in the aftermath of the crash of 1987, I did not know how to value a stock like a bond. Indeed, that would not come for several more years. What I did have was the palpable sense that just as the truth of bond valuation had visited me during my purchase of the IU bonds, so too it would one day speak of stocks. This “sense” manifested itself on the following Monday. For many years, I provided a weekly market commentary via teleconference to the brokers of the firm spread across three states. On Monday, October 26, 1987, one week after Black Monday hit, I was in my office early preparing my comments when I noticed the prayer journal lying on my desk. I remembered on Black Monday having the grand idea to use the journal to document my experiences of the crash. As I opened the book, I saw that I had made entries only on Monday and Tuesday. Monday’s comment was about the huge fall in stocks and our decision not to sell. Tuesday’s comment was very short: “Market up 100+ points – glad to see rebound – but not very convincing.” I flipped the pages to the day’s date - October 26th. There, across the top of the page was the scripture for the day: “For God is not the author of confusion, but of peace. . .” 1 Corinthians 15:57 When I read this verse, it made sense on three levels. First, everything about the past week had been confusing. Everyone tried to make sense of it. People I previously considered wise were making fear-induced and idiotic statements about the many disasters that lurked. Chaos reigned. Secondly, my mind replayed my conversation with Billy T. Whether it had been because of my own weariness and wishful thinking, or Billy’s fragile state of mind, I had told him that every good thing comes from God. Investing in quality US stocks had been a good thing for a hundred years; therefore, in someway the stock market was a part of God’s blessing. If God decided to withhold His blessing, we are all doomed. There was no hiding place. But if God is still in control, blessings will continue, no matter what the Wall Street Journal or the gurus say. And if God is still in control, peace will prevail. Lastly, if God is involved in the stock market, it will have an underlying order. Everything in creation has order: gravity, the speed of sound, the parts of a cell, the parts of an atom… If there is order in the stock market, there will be a means to evaluate it, a formula, a gauge, a meter of some kind. I knew if I pursued it long enough, I would find it.

The Rising Dividend Story -- Black Monday Night

As I lay in bed on Black Monday night, questions ran through my mind, each one leading to another. I knew I needed an overarching investment strategy that would guide my clients and me in the days and months ahead. I remember thinking I couldn’t drive the race in front of me and read the roadmap at the same time. Tomorrow morning I had to speak to the firm’s brokers by conference call about what Black Monday meant in the short and longer terms. I knew about half of what I was going to say: Black Monday was a financial accident. The value of Corporate America was unchanged except for whatever lingering effects the crash may have had on consumer confidence. The market may have been overvalued heading into Black Monday, but the crash was the result of computer trading gone out of control. I believed completely that Black Monday was an accident, but I knew after I gave my explanation, someone would invariably ask if it meant that we should start buying, and if so, what should we buy. I had come to that question dozens of times since the close of business and had been left with only question marks. I did not know how bad the financial accident was, or how strong the aftershocks would be. I only knew there would be aftershocks; the market is never neat and orderly as it tries to make a bottom. As I kept asking myself what was safe to buy, I remembered my purchase of the Indiana University bonds. I had received a yield above 9% completely free of all taxes and backed by one of the most conservative states in the union. If that wasn’t a good buy, then what was? Bonds are it. Tomorrow morning I was going to take my turn at the microphone and tell the firm’s brokers to buy municipal bonds. Everyone wanted to know what stocks to buy, but it just did not feel right to me yet to be jumping into the stock market until the bottoming process was further along. With my comments for the next morning put to rest so to speak, my mind turned to a recap of the people I had spoken with throughout the day. I had made and received scores of calls, but the calls from Mrs. H, my friend with the IU bonds, and Billy T. resonated inside of me, still. Somehow I knew they were seminal and would, ultimately, reshape my understanding of investing. I did not know everything these three calls meant, but as I thought through them I realized that in each case it was as though something was speaking to me, even though I was the one doing most of the talking. When I had some free time, I knew I had to dig deeper into what had gone on in each call. For now, the call from my friend who wanted to sell the IU bonds took front stage. As I replayed the events surrounding the purchase of the bonds, I was both delighted and indicted. I was delighted because I realized that I had bought a substantial amount of bonds without the benefit of knowing exactly where the market for them was trading. I had evaluated the bonds, put a price on them, and said I was willing to buy them when bond traders at most bond desks around the country had passed. In retrospect, I realized that in the midst of all the unknowns something kept telling me to “do the math”; to get that right and everything else will take care of itself. I was indicted because I had been in the investment business for 12 years with two different firms, and today I realized I did not know how to value a stock apart from its selling price on the exchange. If the stock markets had been closed and somebody would have called and wanted to sell me some General Electric common stock, I would have laughed at them. It was impossible. Prior to Black Monday, in my mind the market price dictated what a stock was worth. After all, the market was efficient wasn’t it? That is what I had been hearing for nearly a decade. The price of a stock reflected the collective decisions of millions of buyers and sellers, which produced a sort of “handicapping” similar to what goes on in horseracing. The best horses, while offering a high probability of being “in the money,” paid very little for a win. On the other hand, horses with poor track records and thus, not having a high probability of winning, paid big odds when they did win. Stocks were like horses weren’t they? The odds – prices – were always right, right? But on the night of Black Monday, I realized the notion that the market (the bettors) always puts the right price on a stock was nonsense. The average stock had fallen 23%. It was utterly clear that investors were not trying to make informed decisions about the value of companies; they were just running from the fight. I was convinced of that, but I knew no math that could pinpoint which stocks were the best values. As these thoughts circled through my mind, I realized that the “math” for the bond purchase was not as easy as I had originally thought. The interest rate on the IU bonds was 7.5%, and I agreed to buy them to yield 9.4%. Bond traders use special bond calculators to compute cost from yield or vice versa. I had no bond calculator, thus, I used a “rule of thumb” method to compute the approximate price for the IU bond. The current yield of a bond is current income divided by price. This simple formula works if you are paying par (face value) for the bond, which is usually $1000. However, if you are buying a bond in the secondary market, it might be selling for more or less than the face amount, and thus, you need to make a calculation that takes into consideration any capital gain or loss the bond may realize during the holding period. The term “yield to maturity” is used to describe this adjusted rate of return for a bond. With an interest rate of 7.5% and a yield to maturity of 9.4%, it was obvious that the IU bond’s additional rate of return would come from buying the bond for less than its maturity value of $1000. That would mean that when the bond matured (paid off) it would produce a capital gain, which when added to its interest rate would total 9.4%. As I dozed off, the last thought I remember thinking was is it possible to use the rule of thumb method of valuing a bond to value a stock? Was it possible to turn stocks into bonds? Note: It has taken us three weeks to reach the end of Black Monday, yet this is not a story about Black Monday but of Rising Dividend Investing. From this point on, I will quicken the pace of explaining my search for methods of determining the approximate value of a stock. This may be of particular interest in light of the recent fall in stock prices. Has the value of corporate America really fallen 5% in recent weeks? Do the stock traders –bettors – have it right, or are they just betting the jockey’s colors. Our stock market model is saying that the value of corporate American is on the rise, not decline.

The Rising Dividend Story -- Call # 3 -- Billy T. -- Part II

Billy said he was so worn out that he didn’t think he could stay awake another 5 minutes. He said he would listen to the story as long as he could, but he was making no guarantees that he wouldn’t fall asleep. The story I began to share with him was neither fully formed in my mind, nor entirely clear to me. But as Billy’s mood grew darker, something inside of me started to speak in a way I had never thought of before, so I started slowly. “Billy you know there is a drought in this part of the country. Corn and bean yields are way down, and some farmers have plowed under whole fields. Have you seen that field at the corner of Highway 57 and Kansas Road?” (Billy lived North of Evansville, and I knew he drove past the field nearly everyday.) “It’s burned up,” He answered. “Yeah, I know the farmer, and he said he’s going to plow it under. There is nothing to harvest. The sun has just roasted the beans. What do you think the odds are of anything ever growing in that field again?,” I asked. “Better yet, are you willing to bet me that that field is somehow broken and will never produce crops again?” Billy wouldn’t take the bet because he knew, as I did, that the field would indeed grow crops next year. I asked him on what basis he believed this. He said it’s only natural. I said, “Billy, just think of everything that has to go right for that field to produce crops—just the right amount of rain all year, not too much or too little; the absence of a blight and destructive insects; the right seed, the right fertilizer, and the skill of the farmer.” I asked Billy if he thought the value of the field had gone down because of the poor crop this year. He said he did not think so. I asked him why not. He said because in nine out of ten years the field would produce a crop, and some big crops would make up for the shortfall this year. Billy was warming to the discussion, but I knew he would soon grow quiet. I said, “Billy, what if I told you that the force that produces the crops--and the rain and sunshine that they need to grow -- is the same force that produces corporate profits?” Billy did not say anything, and I went on. “What if I told you that the same force that provides for a harvest 9 out of 10 years is not Mother Nature. . . but God? And what if I said that God is not only in control of nature, but He is also responsible for profits of all kinds?” I said, “Billy, I realize I might be in alien territory here, but if it’s OK, I’d like to go on.” Billy said, “Go ahead.” I said, “Billy, I have no idea where you stand on matters of faith, but let me give you a short course in biblical economics. When God kicked Adam and Eve out of the Garden of Eden, He said, ‘You will eat your bread by the sweat of your brow.’ In those words were a curse and a blessing. The curse was that they were being thrown out of the Garden of Eden and had to work to eat, but the blessing was that this work would work. They would eat. God did not say that Adam and Eve might eat, he said they would eat. In doing so, he blessed work. In short, work works. Many people believe that, but I suspect that few people have thought about what I am going to tell you next.” There was a brief pause. Then I continued, “Billy, what if I told you God is involved in the stock market.” Billy was silent, so I asked him, “Are you still with me?” “Yes,” was his only reply. I was almost wishing Billy had fallen asleep on me at this point, because as I went deeper into where my heart was taking me, I honestly did not know where it would lead. I was worried that I might say something wrong and make matters worse for Billy. I continued, “The Bible says that the world and everything in it is God’s doing. He created it, He sustains it, and He loves it. The part of His creation, however, that He loves the most, is us – human beings. In the book of Isaiah, God says something that is just amazing: ‘. . . because you are precious in my sight, and because I love you. . .’ ” I went on, “Most people get hung up in the ‘thee’s’, the ‘thou’s’ and the ‘thou shalt nots’, but I believe that the Bible is at its core a love story. God is not a cop, but a lover. He does not wish to destroy us; that would be easy for Him to do since we are such fragile beings. No, instead, He desires to bless us; to commune with us. Because God cannot be seen, he provides another kind of evidence of His presence. He provides order: gravity, seasons, night and day – the nature of things. Billy, there are lots of theories floating around that attempt to explain why things are the way they are, and I have listened to them all, but a few years ago I realized that for me, the one that spoke to every molecule of my body was God’s story revealed in the Bible. The bottom line on this story is that God has dominion over all things. For the first time in my life, tonight, Billy, I am coming to the realization of how God is involved in the stock market. Billy, a corporation is nothing more than group of people working together for a common goal. I don’t know if God blesses businesses directly, but I believe He blesses the work of the people who make up the corporation and that blessing manifests itself as profits. When you and I invest in a company, we are sharing in that blessing, and likewise the company is blessed by our investment.” I continued, “The thing to remember is that God’s blessing is in the fruits of labor of the workers’ hands and minds, not necessarily on the price that the market says this fruit is worth. Prices on the New York Stock Exchange are man’s attempt to value God’s blessing. While the prices may reflects man’s best guess of what a company is worth, prices also contain man’s greed, fear, and biases of all kinds. In short, prices are the best man can do, but price is a poor substitute for how God values things, which is revealed in the fullness of time. Billy, you said that even though that field at Highway 57 and Kansas Road is burned up that it would produce crops again, and that the true value of the field had changed very little because the owner could expect crops nine out of ten years. What I’m trying to say is that the stock market, by extension, is like the field on Highway 57. It caught on fire today and some of this year’s harvest has burned up, and it may burn even more in the weeks ahead. But, the ability of the millions of groups of people that work together in what we call corporations to produce profits is unchanged. The true value of corporate America is unchanged unless God has changed his nature and is no longer blessing work.” I said, “Billy, if God has decided he will no longer bless work, there is no place to hide. Everything will fail. On the other hand, if God is still true to his word and is still blessing the work of people; better yet, if He is still a lover rather than a destroyer, the value of most companies will continue to grow, and in time so will prices.” As this story came out of my mouth, I thought surely I must be out of my mind to try to explain the mind of God. I prayed that God would guide me to the end of this story and forgive me if I veered too far in my explanation to Billy. Billy asked, “What if my understanding of God is not the same as yours?” I said, “Billy, what I just told you I have never told anyone before. I don’t know if I have ever thought these thoughts before. But tonight, we both need peace. Either I am making all this up, or God is talking to us both, and he is saying, ‘Do not be afraid. I do not seek your destruction; indeed, I seek to bless you’.” I continued, “Billy, I am going to ignore your instructions to sell everything. Sleep on it tonight, and if you still want me to sell, call me tomorrow before 9:00 am.” Billy did not call the next morning, and we never spoke about that night again during the next 20 years I continued to work for him. I had never thought the thoughts that I told Billy that night, and I am sure I would not have told him had I not been concerned about his state of mind. Billy was special to me, and I was honored to serve him. I have thought a hundred times about the story I told Billy that night, and as I explained to him, I believe God was speaking to the both of us in the story that I told Billy. I realize some of what I told him could be debated by theologians, but Billy wasn’t talking to a theologian that night, he was speaking to an investment guy who, when he came to his wits end, found that a bigger, infinitely better Wit was there with a story of hope. This was the third call of Black Monday that would change my mind about investing forever, but it was not the last call. At 12:00 AM my friend Dr. S. called. He said, “Sorry to call so late, but your note said you would be up ‘til midnight, and your phone has been busy all night. How are you doing?” “I’m shot,” I replied. He said, “Hey, you don’t need to waste much energy on me. While I was trying to reach you it dawned on me that three more days like this and we’ll be starting all over. (The market was down over 500 points and had closed at just over 1700.) He, said, “I don’t know why, but seeing what happened today and realizing that there cannot be many more days like this convinced me that this whole thing is not real. The market is going to turn around, and it’s going to turn around faster than most people think. I’m thinking about getting a second mortgage on my house so we can be a buyer in through here.” “Stop,” I said. “Can we just sleep on it?” “Goodnight,” he replied. “I just wanted to be sure you were hanging in there.” I told him, “I’m on fumes, but thanks for the call.” Next time: What the three calls meant to me and where they led me.

The Rising Dividend Story -- Call # 3 -- Billy T. -- Part I

Introduction: The third important call I received on Black Monday came near midnight. It was from an important and influential client whom I had not spoken to during the day. He was very troubled. In the years since Black Monday, I have told very few people the nature of that call. It was an intensely personal call to a person I cared a lot about. I have changed the circumstances of the person completely for matters of privacy. I am sharing the essence of the call because in my inability to calm my client with rational arguments, a new way of thinking about business and investments was born for me. A way that I may have believed all along but had never put into words. But in those critical moments, when my client had lost his ability to think clearly, and I had exhausted every way I knew of reaching him, a story came to my mind. A story that was like a rope of truth handed down to us that pulled both of us out of the dark place where we had fallen. Due to the length of the description of the third call, I have broken it into two parts. Part II will follow shortly. The Third Call, Part I Billy T was in his own words “large and loud.” He had one of the keenest minds of anyone I have ever known. He was a voracious reader, a student of history, and a computer wizard. Billy T advised me regularly that he did not need a money manager because he had done well on his own for years. Indeed, the million dollar account I managed for him was only a third of the assets that I knew he had. But while he regularly told me he did not need me, I continued to manage a large portfolio for him for over 20 years. Billy T was a mystery to me. He’d be my best friend one day and interrogate me the next. He always seemed to delight in telling me that the portfolios he managed were outperforming the one I managed. The odd thing was that every time I asked him why he still did business with me, he would say only that he needed me because I managed his conservative money. On Black Monday, I traded calls with Billy T all day. It was the pre-cell phones days, and he was on the road trying to reach me as he hop-scotched across the country from pay phone to pay phone. He knew that I was not selling into the crash, and he informed my assistant that he agreed with that strategy. As Black Monday closed, Billy T was one of the few clients I had not spoken with directly. So, just before I left the office, I called his home telephone and left a message saying that I would be working at home all evening and that he could call me anytime up until midnight. At 11:00 PM, my phone rang, and I heard a voice on the other end that I did not recognize. It was very faint and almost sounded like a child’s voice. “Gregor,” the voice said. “Glad I caught you. I just got in, and I’m shell-shocked at my losses.” Each word was labored, and spoken as if it was being read from a piece of paper. I knew it was Billy T, but he was anything but large and loud. “Gregor, how much is my account with you down?” he asked. I told him somewhere between 15%-20%. He said that he was down much more than that in his other accounts because they were fully margined. He explained that he was sure he would have margin calls in the morning, and he wanted to know what I thought was going to happen in the next few weeks. I told him my best guess was that the market would continue its volatility and that I would be surprised if it did not go at least 10% lower before finding its footing. I added that big sell-offs are usually followed by a rally, then a retesting of the bottom. He said he was so stunned by the day’s events that he was having trouble comprehending it. He said he thought he might have lost a million dollars. He asked me to remind him why I had decided not to sell into the crash. I repeated to him what I had been telling everyone, that I did not think it was prudent to throw good companies at bad prices, and that it was becoming increasingly clear that Black Monday’s bad prices were the result of a structural malfunction in the market that had caused the system to crash. I told him the news was full of stories of computerized trading that had careened out of control, and that there was talk that the New York Stock Exchange was going to suspend computerized trading. He said that one of the gurus on his stock hotline was calling for a bottom in the Dow Jones 30 of 400 points. That was over thirteen hundred points lower than Black Monday’s close of 1738 for the Dow. . I asked who was making the prediction. He told me the advisor’s name, and I responded to Billy that the guy had never seen a sunny day in his life. I told him that the advisor in question had been predicting the sky would fall, for one reason or another, for the past decade with little to show for it. I asked Billy why he continued listening to the guy when he had been so wrong for so long. Billy T then informed me that the advisor had been predicting a crash for a long time and that he should have listened earlier. The way Billy said it, it was clear he had not heard me. Billy T said that if the market fell to 400, he would be wiped out, and he just couldn’t take the chance of staying in the market. Somehow talking about the advisor’s doomsday prediction had sent him into a downward spiral. He repeated several times that if the Dow fell to 400 he would be wiped out. Again I countered with the Black Monday talking points I had been using all day and again realized he wasn’t listening. Losing everything had become a certainty to him, and my arguments were like bubbles against the hard steel of his state of mind. It was now clear to me why I worked for Billy. The morbidity with which he now saw the market was not the Billy T of living loud and large. Indeed, in the course of this short conversation, the terror in Billy’s voice caught me by surprise, and I did not know what I was dealing with for several minutes. A dark state of mind had engulfed him; a darkness that, perhaps, he had never confessed to anyone; a darkness that he had just learned to live with. But, in the grip of this dark mood, Billy T told me to sell everything at the opening of trading tomorrow. It was now 11:30 PM. After a hard day of dealing with everyone’s emotions, including my own, and speaking with clients for going on 17 hours, there was little left of my voice, or my energy. Billy T’s irrational and dark mood had found a crevice in my own psyche, and the slow-motion clarity and confidence that I had felt all day were being eclipsed by his sense of dread and loss. Billy had lost hope, and witnessing the despair of such a bright and seemingly well-adjusted man now shook my own confidence. For a moment, I forgot my responsibility to do the right thing for Billy, and like him, started to run. I realized that Black Monday was the first of many long days and nights for me. If I was to save the relationships with my clientele for our small firm, I would have to come up with a post-crash strategy and work it night and day. I could not exhaust myself on any one person, because there would be nothing left for everyone else. I remember muttering, “If that’s what you want, Billy, I’ll do my best. . . .” But as I said the word “want,” I remember realizing that in Billy’s state of mind I was doing him no favor to do what he wanted. I was the captain of one of his financial ships, and I knew better than he did how to navigate this storm. I knew in the current stock market that there was a complete disconnect between prices and values. I did not know what the correct price for the Dow Jones 30 was, but I was sure that bailing out now was wrong. I also knew that trying to have an intelligent discussion with Billy in his present state of mind was useless. Billy had been there for me when I needed him, it was time for me to be there for him, no matter the cost. I stopped in mid-sentence and said, “Billy, you realize in giving me these instructions to sell everything, you are firing me. We will never work together again.” He tried to protest, but I interrupted him and said, “I think what you are doing is dead wrong, and you will soon be sorry.” Billy did not respond and I continued, “As we have been talking, something keeps coming into my head. I’m not sure you will agree with it, and it might even offend you, but I cannot let our relationship end without telling you what is on my mind. Would you allow me to tell you a story?”

The Rising Dividend Story -- Call #2 -- The Bond Purchase

After finishing my call with Mrs. H., I received a telephone call from a friend and fellow employee of the Indianapolis based investment firm I was with at the time. He was a broker, and I was in the money management department. He explained that he needed a bid on some Indiana University bonds for a customer who was panicked by the crash and wanted to sell. I asked him why he called me and not the bond desk. As he put it, the bond desk was “shut down.” Actually, what was happening was that the stock market crash overloaded the quotation systems, and no one knew for sure if the prices we were seeing on our Quotrons were current or hours old. Under normal circumstances, municipal bonds trade with a spread to US Treasury bonds. The collapse in stocks had caused a flight to the perceived safety of Treasury bonds, thus the prices of municipal bonds like IU’s should have been rallying along with Treasuries. But correctly valuing municipal bonds in the middle of the stock market crash was next to impossible because, again, no one was sure if the prices on our Quotrons were accurate, and no one knew if the normal spreads between Treasuries and municipals were holding. As a result, many bond desks at firms across the country had almost suspended operations. When I heard the news that our bond desk was not bidding on bonds, my heart sank. This was a proud and prosperous firm. To effectively shut down the bond desk was shocking to me, and opened my eyes to how big the crash was. It was starting to shut down the whole system. Shutting down the bond desk was like the power company shutting down one of its generating plants. The only reason they would do it was to salvage the system. Stocks were collapsing and bond desks nationwide were shutting down. Momentarily, I was seized with the notion that maybe this was, indeed, another 1929-type crash and everyone would lose everything. I had to practically shout at my ruminations that this kind of thinking was not true. The economy was strong. Furthermore, only about 25% of the American people owned stocks. They would wake up tomorrow, brush their teeth, eat an Egg McMuffin, drink a cup of coffee or a Coke, get in their car, and drive to work. Life would go on. My friend said that the seller of the bonds was a long-time client who was convinced that a 1929-type depression was imminent and wanted to hold cash. My friend said, he really needed the favor. He needed a bid on the bond because the client was intent on selling and the bond desk could not help him. I told him I could not do favors with other people’s money. He said he didn’t mean a favorable bid; he just wanted a bid, any bid he could show his client. I asked him, “If the bond desk doesn't know where the market was trading, how was I supposed to know?” He said he understood the problem, but that he had nowhere else to go. He thought that since I bought bonds for the firm’s money management clients that maybe one of them would be interested in his client’s bonds. He was in luck by mentioning this last point. I had several clients tell me during the day to keep an eye out for bargains on bonds. I told my friend that I would think about it, and that he should call back in 45 minutes. I also told him that if he could sell the bonds somewhere else he should do so since I was unsure I would make a bid. By law, the State of Indiana cannot have direct debt. The law was the result of the Wabash and Erie Canal debacle of the 1840s, which forced the state into bankruptcy and produced an 1851 statute prohibiting any future issuance of debt by the state. The law was still in effect, and the prohibition against debt meant that Indiana had one of the strongest financial conditions of any state in the nation. As I thought about the bonds, I realized that Indiana University was as close to state debt as you could get. The good citizens of the Hoosier state would sell off their family jewels before they would let Indiana University go under. In addition, Bobby Knight and his Indiana Hoosier basketball team had won the NCAA championship the preceding March, and the state would have probably sold off the capitol rotunda rather than give up the basketball arena. The bonds were safe. The only question was…what were they worth? The toughest hurdle to get over in valuing the bonds was that they were 20 years from maturity. As I thought about it, however, I realized life and taxes would go on no matter what happened in the crash, and that the tax exempt interest the bonds paid would always be prized by investors in high income tax brackets. I knew that US Treasury bonds had started the day yielding about 10.25%, and I knew that bond prices were rallying, so the yields were probably near 10%. I remember thinking that if I could buy the IU bonds to yield 10% that I had a real bargain, and one that I was comfortable making. The broker called me back and I told him I would buy the bonds to yield 10%. I told him to call the bond desk and get their approval before he told his client about my bid. The head of the bond desk called me immediately and tried to explain what was going on with the bond market and his inability to bid. I stopped him and told him that I was aware of what was going on, but the broker had asked me to make a bid, and if he approved it, I was willing to buy the bonds. He said he thought that 9% might be a better level for the bonds. I told him he was welcome to buy them there, but my bid was 10%, and if he did not think it was fair, I was fine with dropping the whole matter. He said he had learned through my broker friend that the client wanted the bonds sold by the end of the day, and that he could find no one else to bid. I told him my bid was good until the close of business. He said he would call me back right away. The broker called back in minutes and said the bond desk would not approve the 10% level. I said that that was fine with me. He stopped me and said, “but they will allow it at 9.40*%.” I told him if his client would take it, I would buy the bonds at that level. I then called the bond desk and told them I would offer a bid on any other bonds that people wanted to sell. I had budged on my level, but I realized that buying Indiana University bonds when no one would make a bid was sure to be a good buy, ultimately. The destruction of hundreds of billions of dollars by the crash was a deflationary event, and I was convinced that this would cause interest rates to fall. As I returned to my blinking phone, I paused for a moment. Something had happened here -- something that was new to me; something that I had never done before. I had just valued a bond in the absence of a trading market. I had just committed my clients to up to 20 years of ownership of this bond, and I had done it in the middle of a panic unlike anything I had ever seen. But what surprised me the most was, as I said earlier, that it moved almost in slow motion and almost intuitively I was able to clear away all of the clutter surrounding the decision and zero in on just the few details I needed to make the decision. *This is my best recollection of the final level. I know it started at 10% and the bond desk asked that it be lowered. I have checked the records as far back as I can, but the company has changed hands twice and no one seems to know where the old records are.

The Rising Dividend Story -- Call # 1-- Mrs. H.

When you pass through the waters, I will be with you; and when you pass through the rivers, they will not sweep over you. When you walk through the fire, you will not be burned; the flames will not set you ablaze. Isaiah 43:2. A friend of mine gave me a daily prayer journal just days before Black Monday. I sat at my desk before the market opened that morning, and seeing the prayer journal, I opened it to October 19. The above verse from Isaiah was written across the top of the page followed by blank space for personal observations. When I saw the passage, I realized how much I needed to hear those words this morning. The financial storm that was Black Monday had demolished the Japanese and Europeans markets and within minutes would slam ashore here in the US. I tried to collect my thoughts and take a few minutes to meditate on the scripture, but the phones had begun to ring and my thoughts were not collectible. I just bowed my head and uttered, “Lord, give me your strength and your wisdom.” I said last time that I received three calls during the day that changed my perspective of investing forever. Two were from clients; the third was from a colleague. The first call came from a client. Mrs. H. was (and is) a remarkable woman. She had given birth to twelve children. She and her husband had built one of the largest farming operations in this part of the country, and after her husband died, she added coal and oil to her business interests. She was a delightful lady, and I had had the privilege of working with her in municipal bonds for many years. Around midmorning, she called and waited on hold for several minutes. When I was able to get to her, I was surprised to hear her voice. Thinking she was worried about the market’s effect on her holdings, I started into my Black Monday talking points. Mrs. H. was surprisingly direct. She asked how much money she could borrow from her account. I read the amount to her, which was in the hundreds of thousands of dollars. She said that she had been listening to the radio and knew that the market was down over 200 points and wanted to buy some stocks. I was surprised to hear that she wanted to buy stocks because, normally, she bought only municipal bonds. I had no doubts Mrs. H. was of sound mind and meant what she said, but I did not think buying into the crash was a good idea. I told her that in my opinion the day’s selling would likely be followed by more selling, and it might take weeks, even months, before the markets could put in a solid bottom. I told her I thought buying into the crash was very risky. She then became more direct. She said that she had watched her husband accumulate thousands of acres of prime farm ground by buying when everyone else was selling. She had continued that strategy after he had died, and it had always eventually resulted in large gains. I tried to get a word in, but she continued. She said, “Greg, I know what I am doing, and I am a big girl. If I am wrong and it doesn’t work out, I won’t blame you. And while I have no intentions of losing this money, if I do, my life will not change.”I asked her, “If your decision is final, what would you like me to do?” She said, “Erwin always bought when everyone else was selling, but he only bought the best ground. I want you to give me a list of what you consider to be the best companies I can buy; companies that are going to come out of this bad market stronger than they went in. That is what I saw my husband do time and time again, and that is what I want to do now.”In all the years I had worked with Mrs. H, I had rarely heard her speak of her husband. I don’t believe I knew his name before that day. I realized in the span of a few minutes a very successful person -- a self-made person -- had shared with me a priceless bit of investment wisdom. Everyone says the secret to success is to buy low and sell high. Hardly anyone, however, invests that way. Most people really want to buy high and sell higher; they have no appetite for buying low, because when prices are low, times are usually tough and tough times call for tough minds. She told me how much she wanted to spend and asked me how long it would take for me to come up with a list of companies. I told her I was swamped, but that I’d pull something together by 1:00 PM. Then I asked the only intelligent question I would ask during the entire conversation. “Mrs. H., are you thinking of buying these stocks to take a short-term profit if the market bounces back, or are you thinking of holding them for awhile?” She said, “Greg, I want to buy companies that I can own for the rest of my life. That’s the way I buy farm ground, and that’s the way I’m thinking about these stocks.” In between calls, I kept thinking about which stocks were the “best.” Words like: “test of time,” “blue chip,” “high quality,” “powerhouse,” “winner,” and “sure-fire” passed through my mind. What did it mean to own the best stock? I realized that before the crash, my definition of the best stock was the one that made the most money in the shortest time. But I quickly realized that this way of thinking about “best” was only possible by looking back. In this case, Mrs. H. wanted to know the best company on a present and forward-looking basis. She was not asking me to pick a company with the best value, she was not asking me to pick a winner; she was just asking me to pick a small group of the best companies. The more I thought about it, the more I realized that there was no answer to her request. There was no such thing as the best company. There were companies that were great values, and companies with the best risk/reward ratios, but “best” was just too relative of a term to apply to companies. For a while I thought I’d have to tell her I could not help her. Then I thought about what she was asking me to do according to her perspective in the world of farming. I had grown up in a farming town. I had friends and relatives who were farmers. If I were to ask them what the best land in their county was, I knew they would have an answer. They would use terms like lay of the land, richness of the soil, length of the rows, and width of the fields. They would consider access, creeks, out-buildings, and locations. But this line of thinking was not helping either; farm ground was tangible, stocks were intangible. Was anything tangible about a company? Stocks possessed a book value, but it was not what truly gave most companies their value. Book value was just a measure of the value of the means of their production. What gave a company its value was how much its products and services were prized by consumers, the company’s ability to successfully extend their products to new markets, the company’s profitability, and how good the company was at bringing new products to market. Then it hit me. At the county fair, the best animal wins the blue ribbon; the most attractive girl in the beauty contest wins the crown. A man gives his best girl a diamond. A great athlete becomes a star. In all societies, the best are given the prize and are prized. So what companies in the US were most prized? Immediately Coca-Cola came to mind, then Disney (it was a much different company then than it is now), General Electric, Wrigley, and Johnson & Johnson were also prized. They were not just blue chips; they were icons that had stood the test of time, defeated all comers, were very profitable, and had star quality. As I ticked down through their qualities, I realized that they were what some people called their “brand.” The strength of a brand was as close as a company could get to being tangible. I called Mrs. H. back and gave her my line of thinking and the shortlist of names. I asked her one more time to wait a few days. The market was coming apart and I told her that I had no idea where these stocks were trading. She agreed. We did, however, start to buy some of the “best” stocks by the end of the week. It still did not feel right to me, but it was what she wanted. Sure enough, just as she had predicted, eventually almost all of her “best” stocks did very well. I spoke to Mrs. H. this week and asked if I could tell this story. We had a delightful converstation. She is 84 years of age. She recently remarried – in a barn – to a man she met bowling. “He’s a great guy,” she said. I would say you could bank on that. The second of the three important calls on Black Monday was from a colleague and friend who had a problem. Next time I'll describe that call.

The Rising Dividend Story -- The End of the BIG Trend

As I said last time, the crushing of my BIG Trend investment strategy didn’t knock me off balance as much as it put me into slow motion. It was as though everything around me moved in the frames of a filmstrip. I’m not saying I didn’t feel anxiety or worry. I did; but it did not bother me that I didn't know what I was going to do next. That was because I knew that I was going to sit tight until the storm blew over. If any companies were going to weather Black Monday, the companies we owned would. After all, they were still big, growing, industry leaders; and by the end of the day, they would be 23% cheaper. Their rising price trends were devastated, but they were not going to just dry up and blow away. The phone calls poured in that morning, and didn’t relent the entire day. I spoke with nearly every client I served. Sometimes, up to four calls waited at one time. I was running so far behind because every time I hung up the phone it rang again. I ended my last call of the day around midnight. Surprisingly, people remained relatively calm, considering the circumstances, and agreed with my decision not to sell into the crash. As I spoke with each person, a type of “Black-Monday talking points” started to emerge in my mind. I was convinced from watching the action of the market that the collapse was, at least in some way, a structural problem. The normal interaction between buyers and sellers was corrupted. I believed this because of the wild swings in stock prices. As an example, on Black Monday, General Electric opened 15% lower than its previous close. It then retraced the entire loss, before falling again by 25%, a swing of over 50% for the day. GE was a one hundred-year old company that produced a wide range of products that people all over the world used everyday. There was no way the fortunes of this company could change that much in a day. As I thought about it, GE’s price swing for the day was wider than it was in a normal year. The talking points went on to explain that our portfolios were full of “essential services”: companies such as banks, food and beverage, health-care, energy, transportation, and utilities. I explained that no one knew what these companies would sell for in the coming days and months, but their existence was not in danger. Indeed, because they had strong balance sheets and were already the leaders in their industries, there was good reason to believe that their businesses would improve. I concluded by saying that it was important to remember that we own companies and not stocks. Lastly, the economy was strong going into Black Monday, and it was inconceivable that it could fall apart in a short time. No one listened to the talking points more than I did. My “Price Trend” philosophy was dying with each additional 100 point fall in the Dow. Yet, it was becoming clear to me that the violent action of the market was only marginally connected to the underlying values of most companies. I realized that while the “Trend” part of BIG Trend investing was dead, the BIG part was going to save the day because big companies that were industry leaders and growing were holding up much better than small and highly leveraged companies. While this was good news, I was careful not to offer anyone false hope to the people I was speaking to. I tried to explain to everyone that the crash was going to take a long time to fix. Indeed, it took almost two years. On Black Monday, in the midst of the demise of what I thought I knew about investment strategy, almost outside the realm of my consciousness, a new investment strategy was beginning to take shape in me. On that day, The Rising Dividend strategy was set in motion by way of three phone calls I received. Each one was surprising, and each one went against the grain of the day’s events. In the end, each one helped me see a way out of the wreckage of Black Monday by presenting an opportunity and asking me to consider it from a different perspective. Next time: The Three Calls

The Rising Dividend Story -- Black Monday

No investment strategy comes to a person's mind fully formed. Neither does it come entirely through the intelligence of a wise professor, or the persuasion of an insightful author. An investment strategy a person is willing to bet his or her life savings on is one that has been molded and tested in the fires of adversity and has shown its mettle and its worth. These pages have been full of stories about the merits of rising dividend investing. Many of you who are reading this blog are sold on this strategy; while many of you may think it is just a clever marketing strategy. During the next few weeks, I would like to share with you the story of how I came to understand the hidden value of rising dividend investing. As you will see, the Rising Dividend Story is really a story within a story. I have experienced this story first hand, but it is not mine. Indeed, I was aware of many of the elements of this story years ago, but it took the keen intellects of Mike Hull and Rick Roop and a book written in 1937 to fully understand the breadth and width of the power of rising dividends. I will retell the story as faithfully as possible. But please do not mistake my telling of the Rising Dividend Story for the truth of it. When the truth of it apprehends you, you will see investing with entirely new eyes. I'm not sure whether telling the story will take 10 installments or 20, but we will work our way along in a logical and chronological way. Many of you who are reading this will find yourself included in the story. So many of you have contributed to the Rising Dividend Story that I am dedicating it to the clients of Donaldson Capital Management. While perhaps not suitable for framing, you may wish to pass the story along to friends and family, especially to young adults. Rising Dividend Investing is not the only way to invest, but we believe it is understandable to almost anyone and it works. It allows a person to disconnect from the frantic search for the next hot tip or hot stock and rest in the knowlege that you own real-live growing companies and not a collection of ticker symbols. The Story Begins Black Monday, October 19, 1987, was agonizing, devastating, and surreal, yet from a long-term investment perspective, it was the best thing that ever happened to me. On that day the Dow Jones Industrials fell by 511 points; 22.6% of its value, which would be the equivalent of over 2500 points today. Black Monday’s percentage loss dwarfed the 12.8% one-day loss in the crash of 1929. When I say Black Monday was the best thing that ever happened to me, I do not mean a kind of Dickinsonian best of times and worst of times happening together. From a financial and psychological perspective for me, it was the worst of times. The only good thing that happened as a result of the crash was the destruction of most of my illusions about investing. If you would have asked me prior to Black Monday what stocks to buy, I had a quick answer and I was convinced I was right. My investment strategy was contained in the acronym BIG trend. BIG stood for Big companies that were Industry leaders and Growing. Trend meant I invested only in BIG stocks whose prices were trending higher. I made the claim regularly that in sticking with big companies I could know as much about them as the Wall Street analysts, because big companies were widely covered in the popular and financial media. In focusing on industry leadership, I was merely stating the obvious; that size mattered, and companies that were number one or two in their industries were generally the most profitable, efficient, and valuable. However, I must have said ten thousand times in my life that there were lots of big companies that were leaders in their industries, but few of them were growing. Thus, the core of my investment strategy was that earnings growth was the dynamo that propelled price growth. Finally, since the markets were made up of very bright people with lots of tools for uncovering successful investments, my strategy was to wait until price trends clearly began to move in concert with earnings growth, giving me what I called convergence, and a probable winner.Once I had convergence, I bought the stock and owned it until its price and earnings diverged. Between the two, the price trend was the final word. It was my theory that the so-called “mind of the market”, the millions of investors making buy and sell decisions, would get into a kind of buzz where everyone was looking at the same price and earnings trends. This would pull more and more investors into the buzz and push particular stocks and industries higher. My approach had been successful for many years. I was confident that if I watched the markets closely enough, I could see which way the winds were blowing and which of them held the most promise. Other than the trend of earnings growth, I paid little attention to the valuations or fundamentals, such as P/E, sales, and dividends. I believed that my best chance of success depended on watching the trends and not the values. On Black Monday, the price of every stock suddenly collapsed. Ironically, the crash was made worse because there was no negative economic or political news that appeared to be fueling it. The market just seemed to implode. The companies I owned in my clients’ accounts were still big, industry leaders, and growing, but not a single one now had a friendly trend. All stocks were headed down. The strategy I had used for years was saying to sell everything, but as I thought about the wisdom of selling all the stocks under our management, I found myself recoiling. It flashed through my mind that it made absolutely no sense to throw good stocks at bad prices. I could feel it in my bones that something was wrong with the markets and not our companies, but I was now faced with the dilemma of ignoring my long-established strategy of selling stocks that had broken rising price trends. At the moment I decided not to sell everything, I realized I was cut adrift from any experiential confidence I possessed. If I ignored sell signals, then when did I sell? And perhaps, if I was not willing to throw good stocks at bad prices, I should be taking advantage of the collapse and start buying. These questions cycled through my mind continuously. As they did, a strange sense of unknowing took up residence in me, and I came face to face with the reality that the BIG trend investment strategy that I had followed for so many years was at an end. Circumstances had shown it was suitable only for “fair weather” investing, and the weather had turned as bad as it had been in 60 years. Yet, having said this, the sense of unknowing was not a feeling of hopelessness or confusion. I had an intuitive feeling that there was no smart way to escape the crash, and the most important thing to do was to keep things very simple and avoid emotional responses both in myself and in my clients. Short of another 1929 depression, the companies we owned would make it through these times, and I knew when things calmed down, they would be the first to rebound. As Black Monday wore on and the telephone calls from frightened clients kept coming, I realized that I had few answers for them. Even if they insisted on selling, the market was running so far behind that the prices I saw on my screen, at times, were an hour behind the actual trading. It was anybody's guess what a person would actually receive for the sale of a stock. A big day for the Dow Jones at that time was a positive or negative change of 20 points. The market opened the day down 200 points before rallying back to down only 80 points by mid morning . When it again fell by over 200 points, something inside of me gave way, and I knew the market was going a lot lower before the end of the day. Lower than I could have ever imagined. As the market continued to fall through each succeeding 100 point drop, I found myself with a growing recognition that the crash would likely do as much psychological harm as financial harm. It also posed a serious threat to the existence of the small investment firm that I had helped start in the previous year. I had been in the investment business for 12 years, and this small investment firm was the culmination of my dreams. This would be a battle not only to protect our investor’s assets, it would also be a battle to save our company.