Don't Fret, It's Picks and Shovels Time in the AI Gold Rush

• Fears of a sharp economic slowdown, and worldwide heavy selling of stocks have hit U.S. stocks in recent weeks.

• Recent economic releases have shown that unemployment is rising, home sales are slowing, manufacturing production is softening, and wage gains are flattening out. These weaker economic data points have caused fears of a recession and a move out of stocks and into bonds. 

• This flight to safety has seen 10-year U.S. Treasuries to fall from near 4.75% a few months ago to 3.75% on Tuesday. The slowing economy fears have caused the S&P 500 to fall by nearly 10%. 

• The sell off in stocks and specifically in the tech stocks is hard to reconcile in the face of the solid second quarter earnings growth reports across almost all industry sectors, from AI leaders to banks and industrial companies.

• Does this big sell off mean the AI gold rush is already over? Moreover, does it mean the bull market in non-tech stocks, which was signaled in recent weeks, is also only a head fake?  

It is important to remember that gold rushes are driven by forces other than “there’s gold in them thar hills.”  At times, reality sneaks in to play a role in the pricing. The reality in this case is investors have become worried that the tech stocks have come too far too fast, and they no longer offer value at their inflated prices. There is nothing new about that worry. It’s very realistic and has been around as long as the tech stocks have been. The techs are trading at about 30-35 times earnings and projected to have earnings growth of 15-25% over the next 3-5 years. In an earlier post, I stated that if the current earnings projections for the techs and the S&P 500 prove correct for year-end 2024 and 2025, the market will go higher. My valuation model still says 5800 is the best guess of the current fair value of the S&P 500.

It is necessary to square the recent week economic news and sharp sell offs in worldwide stocksand interest rates with corporate earnings that are being reported every day. All these data

are being collected in the same time frame, and history tells us that earnings and dividend growth

have more predictive power in the long run than do changes in GDP and interest rates.

In my judgment, the billions of dollars that corporate America is investing in AI have not had nearly

enough time to find gold. We are in the “picks and shovels,” or early stages of the gold rush where

the miners are assembling the people and tools, and identifying where to mine. In short, nowthe big winners are the chip companies that manufacture the AI chips. The products

and services that will be forthcoming in the years ahead are still concepts. Yet, when giant sums

of capital are being placed in the hands and minds of the smartest tech people in the world,

life-changing products and services are assured.    

I believe an AI gold rush is underway. AI gold will be found and lead to huge stock gains in many existing, as well as start-up companies. My calling it a gold rush is not a total disparagement. The operative questions are: How much gold is there to be found, and who will find it? Almost certainly, too much money will ultimately join the gold rush, but it is far too early to declare AI dead. That being the case, the huge selloff in tech stocks is way overdone and offers a buying opportunity in the coming weeks and months.

Warren Buffett selling a huge chunk of Apple is probably the best news I have seen to assure us that AI has real merit. I am a great fan of Mr. Buffett, but he is anything but a gold rush player. He is strictly a “picks and shovels” guy. He did not sell out entirely. He just took some profits.   

In an earlier post, I said we are traversing a gold rush in AI, and almost all gold rushes end poorly for the average investor. However, for the recent sell off in AI and the stock market to be anywhere near correct, AI would have to be a complete bust. My bottom line is all gold rushes  are driven by periods of reality and illusion. AI has been called the driver of a new industrial revolution. That is big talk, but to say that AI is a bust is just as big an exaggeration.

Stay tuned.

It's Official: The AI Goldrush Is Underway

 

1. Near the end of the dot-com bubble in 2000, my business partner and I stumbled onto the notion that the techs were acting much like a gold rush. Gold was being found in the dot-com world and creating riches, but its passion was producing ever more gold miners with golden dreams.

2. Our company had traversed the dot-com craze during the late 1990s, chasing the gold like everyone else. But in early 2000, our valuation models simply could not justify the tech prices . .  . not by a mile.

3. A simple truth spoke to us: Never in the history of the US stock markets had an industry grown fast enough, long enough, to justify the prices of most tech and big consumer stocks.

4. We decided to cut back on the hottest of the highflyers. It changed our company and our lives forever.

This seemingly bold move was not based on something we were convinced we knew, but just the opposite. It was because we knew we did not know how to value the techs, and that being the case, we decided to stand aside. Even then, there was nothing bold about our decision to start cutting back on techs. In fact, we visited every client we had and admitted to them we believed the techs had reached the gold-rush state, but they might just keep going higher like they had over the last decade. The only thing we could say for sure was that our valuation models showed that many slower-growing companies were great values. We advised them we recommended placing sell orders 15% below the current prices on the six most overvalued tech stocks. Should any of these sell orders be triggered, we would invest the proceeds in undervalued dividend-paying stocks with dominant positions in their industries. 

During the year 2000, all six of the stocks' sell orders were triggered, and we bought financials, consumer staples, and industrial companies whose prices had gone flat in recent years because their sales and earnings were growing in the high single digits, much less than the 25-50% annual earnings growth of the techs. Interestingly, these undervalued dividend-paying stocks actually rose in 2000 when the overall market fell by over 10% and the dot-com gold rush ended. 

Why am I sharing this old tale? Am I predicting the AI gold rush is near its end? Indeed, are there other stocks that offer much better value with good prospects for future growth? No I’m not. I am announcing; however, that the gold rush in AI is now a reality and there are two truisms about gold rushes of the past. 1) When everyone, everywhere knows that an industry or a particular stock is the center of the investing universe, there is a good chance that everyone owns the stocks and the new money needed to push the stock higher will soon be tapped out. 2) The analysis at the end of gold rushes has always revealed that the companies that sold the picks and shovels for the miners were the best place to put your money, not in the gold miners themselves.

As one who is old enough to remember the dot-com collapse, my reason for writing this blog is to just give everyone a heads up that in my judgment, the AI phenomenon has officially reached the gold rush state. I said last time, my valuation models are showing that an S&P 500 level of 5700 is reasonable. If the AI world can produce overall sales and earning growth for corporate America of 11-12% over the next five years, the market is fairly priced. If earnings growth is higher than that, stocks still have a good run ahead of them. However, if the earnings growth falls back to a 7% or 8% handle, stocks will fall. Additionally, I do not see a long list of undervalued non-AI companies. Thus, I conclude the gold rush has room to run. I’ll keep you posted on what my models are saying as we go.

If you would like to communicate with me directly, email me at info@gregdonaldson.com  

Dividends: A Guiding Compass in Choppy Stock Market Waters

At the close of the market on January 27th, the S&P 500 was down 3.1% from its record high on January 15th.  This modest pullback has caused nervousness amongst many investors.

Is this pullback something long-term investors should be concerned about?  We don't think so.  Here's why:

1. Stock Market Volatility is Normal

The market's unbroken march upward in 2013 caused many investors to forget what market turbulence looks like.

With so many forces at work in the stock market, it is difficult for one particular trend to last for a sustained period of time.  The market is positive 7 out of 10 years, but the standard deviation of 20% around the long-term average of 10% would make anything between 0% and 30% normal.  Rarely does the market advance higher without

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

Investment Policy Committee Notes

Summary Points:

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

Discussion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

More Answers to Your Questions: Why There Are so Many Widely Divergent Views of the Economy

Randy Alsman, Senior Portfolio Manager and Strategist, discusses the wide variance of economic viewpoints in the current market place and some reasons why they exist.

Posted Question: How can the opinions of so many bright people be so far apart? Where is reality? Who do you listen to other than yourself?



People/Groups we listen to:

Ed Yardeni - http://www.yardeni.com/
Bank Credit Analyst - http://www.bcaresearch.com/
Standard and Poors - http://www.standardandpoors.com/
Value-Line - http://www.valueline.com/
Morningstar - http://www.morningstar.com/
Briefing.com - http://www.briefing.com/
Bloomberg Professional - various strategists and economists
Wall Street Professional
Argus Research - http://www.argusresearch.com/
We also have access to many investment research resources through our relationship with TD Ameritrade.

See all the DCM portfolio managers' bios on our website http://www.donaldsoncapitalmanagement.com/content/our-staff

Germany's Tough Medicine Can Save Europe . . .And Others

"Americans can always be counted on to do the right thing...after they have exhausted all other possibilities." -- Winston Churchill If we’re lucky, we may be about to see the European corollary to this Churchill quote. The reverse corollary would be that European politicians can be counted on to do the right thing for their debt crisis. . . when they no longer have any other choice. (It’s probably generally true of all politicians, but for today, we’ll focus on Europe.) The sovereign debt crisis in Greece has spread to become a crisis of confidence in the European Economic Union (EEU) and has the potential to explode into a global credit crisis on the scale of last year’s subprime debt crisis. However, since Europeans – the Germans and the Greeks more specifically – are very close to having exhausted all other possibilities, there is a good chance that a positive solution could come out of the mess in the days and weeks ahead. The unfolding events in Europe prove that a monetary union without a fiscal (budgeting) union leads to chaos. Greece, which represents only 2% of European GDP, now threatens to break up the whole European Union, an area of the world with nearly 400 million people and GDP about the same as the United States. That would be like a looming bankruptcy in the state of Tennessee bringing down the whole United States. Doesn't seem possible, but it's playing out before our eyes. We are now at the point where Greece can no longer sell bonds to finance its profligate ways unless other European governments agree to back them up. And, other EEU countries – really, it’s Germany that’s in charge here – can’t afford to let Greece implode without potentially causing a collapse of the euro and their own banks. The potential positive outcome mentioned at the top would be that Germany is successful in persuading Greece and the other PIIGs countries (Portugal, Ireland, Italy, Greece) to adopt dramatic, lasting, and effective austerity measures. In addition it is critical that the EEU figures out how to put more teeth into its paper-tiger requirement that no member country have an annual budget deficit greater than 3% of GDP. If these two steps are accomplished, in our judgment, the crisis will be averted and stability will return to Europe and the world markets. Admittedly Germany's fiscal measures for Greece and the PIIGS will be painful in the short run. But from what we know of them, they are the kind of common sense budgeting that every household on the face of the earth must abide by. We are hopeful that something close to the German austerity plan prevails in the capitols of Europe. Then let's start a petition that would require that the United States send a delegation to Berlin to see what our country can learn from the Germans about fiscal sanity. This would ensure that our country will not end up one day begging the world for a hand out. Investment Policy Committee Greg Donaldson Mike Hull Rick Roop Randy Alsman, Editor

The Barnyard Forecast: Has Europe Changed Things?

Our regular readers, will remember that the Barnyard Forecast is our short-hand version of determining the prospects for US stocks over the next 6-12 months. The Forecast receives its name from the acronym we use to "score" the prospects for stocks: Economy+Inflation+Earnings+Interest Rates=Opportunity (EIEI=O). Economy: We believe that the huge bail out fund that Europe announced over the weekend will continue to support stocks around the world. If Europe would have continued to dither, then there would have been trouble plenty. The way it is, though, we still see 3.5% world wide GDP growth and 3% US GDP growth. We were only counting on Europe gaining 1% before the bailout, and with the new taxes and cuts in government spending, they'll be lucky to achieve even that low level. A 3%-3.5% level of economic growth is not likely to put the Fed or central banks around the world on the warpath. Thus we would rate the Economy as positive for stocks. -- 2 points. Inflation: We believe the events in Europe will actually keep inflation contained. We still expect about 1.5% core inflation for the US. That is at the lower end of Fed targets and not likely to cause Bernanke and crowd to start hiking rates before the end of the year. Inflation is positive for stocks. -- 2 points. Earnings: We started off the year predicting 20+% growth in corporate earnings. It looks like S&P 500 earnings may actually rise closer to 30% for the year. This is an outstanding underpinning for the stock market for the rest of the year. Earnings are positive for stocks. -- 2 points. Interest Rates: We still believe 10-year US Treasury bonds will likely end the year near 4.5%. That would be appreciably higher than December of 2009, and thus negative for stocks. Zero points. The Barnyard Forecast totals 6 points out of a possible of 8. That is a bullish score. In light of the bailout of the troubled countries in Europe, we believe that the path of least resistance for US stocks is up. Had the problems been left to fall where they may, a domino effect could have continued to pound world wide stock markets. However, since European leaders have put forth such a massive bailout package, we believe the markets are likely to return their focus to the fundamentals and the fundamentals, particularly in the US, are utterly outstanding. The Barnyard Forecast is only based on what it can see. It cannot see the potential for new crises developing in places that are not now apparent. But from what it can see, it still signals an environment that is positive for rising stock prices.

The Riots in Greece Reach the US Security Markets

A friend called today and asked the question that is on every one's mind: "How in the world can the financial troubles of a tiny nation like Greece cause the world's financial markets to screech to a halt? As I listened to him I saw the stock market fall off a cliff: down 60 points on the Dow Jones, down 100 points, down 200 points, down 300, 400, 500, 600 points. I did not see the print of down 900 points because I turned away from my screen for a moment.

Before I could begin trying to explain my thoughts about Greece, my friend asked another question: "Are we going to go back to the bottom of the market we saw in March of 2009?"

My answer was quick, but I have been thinking about it ever since I saw the first riots break out in Greece. "I don't think so," I said.

"I was looking for a more positive answer from you. You have been optimistic lately," he replied.

I told him that I was much more optimistic about the subprime crisis in the US because I could see that the various important players in the drama were all doing their parts. The Fed pushed every lever they had to keep money flowing in the banking system. Congress appropriated enough seed capital to head off a liquidity crisis in the economy. Businesses rightsized their costs relative to their revenues. Consumers reduced spending but did not freeze up. The US Treasury department orchestrated a step by step program to return confidence to the banking system. This enabled the banks to raise hundreds of billions of dollars in new capital to offset the mind-boggling losses they were taking in real estate. I told my friend that as ugly as the subprime crisis was that I remained reasonably confident throughout because I could see there was a unified effort to control the damage and the full power of the United States was being invested to execute the plan. There was a will and a way to get past the crisis.

I explained that taming the financial crisis in Europe was different than taming the subprime crisis in the US for these reasons: Europe is not a single unified entity. Even though they have a common currency with a framework for a kind of United States of Europe, that little of the framework has been codified into law. Thus, the idea of Europe as a single nation is a complete illusion. Europe is still a collection of independent countries. Thus, it is quite possible that nationalistic tensions could sabotage the best intentions and plans of the nominal leaders. In short, European leaders may see a way out of their mess, but there might not be the collective or individual will to do it. In addition, there is no one really in charge. It is like a big club.

The frugal citizens of Germany do not want to loan money to the bankrupt citizens of Greece, who in turn do not want to change any of their financially profligate ways. There does not appear to be a unity of purpose, even if the resources are available to solve the problem.

My friend asked, "So is there reason for optimism that the wealthy nations of Europe can rein in Greece and the other countries that are having trouble?"

I answered, "There is and it is based on the strongest of human emotions: survival. Sooner or later the citizens of Greece will realize they are doomed as a nation without the loans. They may be burning bank buildings today, but one day soon when the lights go out and water doesn't flow from the taps, they will realize that as a nation and as citizens they have been living beyond their means so long that they are no longer free to run their own affairs. The water has been turned off, so to speak. They will agree to the loan arrangements and begin the process of trying to live with them. There is really no alternative.

Portugal and Spain are also having debt issues. Watching Greece crash and burn will be a reminder to them of where any intransigence they may harbor will likely end."

The world wide economy is gaining traction. Almost every economic measure in the US has been better than expected in recent weeks. After a long period of weekly job losses, job gains have now occurred in the last three weeks. The developing world is still growing rapidly. Indeed, economist Ed Yardeni recently reported that 60% of US exports were going to the developing world. The economic fundamentals appear to be improving almost everywhere but in Europe. That is not likely to change with the internal squabble that has erupted.

The economic world did not just evaporate today. There are many rumors of so-called "black-box" automated trading systems that generated errant trades, causing precipitous falls in stocks ,which had no negative news of any kind.

So the eternal question hangs heavy in the air: Was the market efficient today? Did the economic underpinnings of companies really fall by as much as did the market prices?

I think what we are seeing is a pure trading frenzy that has little to do with the intrinsic valuation of underlying companies. Here is the best proof I can offer of this. Procter and Gamble, one of the largest, best managed companies in the world, a company that has paid a dividend since the late 1890s and who has raised their dividend for 53 consecutive years, was selling for around $60 late in the afternoon. In a matter of moments the stock fell to $39.37. It then climbed all the way back to close at $60.75. PG's stock movement today had nothing to do with its underlying value. It had everything to do with the noise and mayhem of a video game played by hedge fund tech-savy kids with real money.

Does it mean that we long-term investors have to acquire the latest programed trading machines, so we can beat the money gunners at the their own game. Heavens no. There is a secret that we know about Procter and Gamble that the money gunners could care less about. Over the last 20 years our model indicates P & G's annual price gain has been nearly 90% correlated to its annual dividend increase. At it current dividend rate, our model says Procter and Gamble is very undervalued. As for me, I would rather trust 20 years of mathematical probabilities that one day of video game idiocy.

Vectren: 49 Years And Counting . . .

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

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

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

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

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

Barclay's Dividend Hike is Good News

Dividend investors always look for the bits of dividend news that go unnoticed or underappreciated. This kind of news usually occurs on a day when hot news breaks on other subjects. Stocks faded yesterday as the price of oil rose to $100 per barrel, but there was a very important piece of dividend news that went largely unreported: Barclays Bank (BCS), the third largest bank in Britain, raised its dividend nearly 10%. This is important because Barclays, like so many of the world's large banks, has had to take write-offs of subprime loans. They did so again in yesterday's report, but overall their financial results were above expectations and the market reacted favorably with Barclays US ADRs rising nearly 9%. With a price rise of that magnitude, it may seem like the market moved right in step with the good news in Barclay's report, but I believe it missed something. In the report, Barclays forecast that earnings growth over the next 5 years would be in the 5%-10% range. For Barclays to raise their dividend 10%, which is at the high end of their stated target, signals to me that they are more confident about their near-term growth prospects and remaining exposure to the subprime situation than most investors are giving them credit for. A 10% dividend hike in a tough year reveals some real moxie on the part of Barclay's top management. It shows a commitment to their shareholders to keep the dividend growing at a reasonably steady pace in spite of the ups and downs of the banking business. This is something I wish more companies would do. I'm hoping Barclay's price has seen the bottom. If it has, a little more air will have been taken out of the winds of the subprime financial storm. The bottom of the subprime mess will come company by company, as each becomes more transparent and proves to investors that they are not irreparably damaged by the bad loans they made in the subprime area. Remember that write-offs are a very serious and damaging event for a bank, but they are a paper loss. No one knows what the real loss will be until the collateral is sold. A cash dividend is real money paid at a specific time in a specific amount; cash dividends are not subject to recall, nor can they be fudged for very long. Barclays' 10% dividend hike, in my judgment, is much more important than the write-off they took. Not in terms of money, but in terms of the message the company is sending regarding its future. Barclays is one of the world's most valuable banking franchises. Their 10% dividend hike is the kind of validation I look for in tough times that the company believes better times are near. If better times, are indeed near, Barclays should play. With the 10% dividend hike they now yield over 7%. That compares pretty favorably to the yield on the average stock of about 2%.

Oh Canada !

Whether or not the central banks of many of the world's developed nations acknowledge it or not, they will soon begin cutting interest rates. The reasons are plentiful but two stand out: the US economy will soon begin to trend lower and with it most of the rest of the G-7 nations.

Europe has already slowed, Japan is having one of its never-ending political upheavals, and China and India are attempting to slow their economies in the face of rising inflation.


Additionally, the recent cut in rates by the US Federal Reserve has spiked the US dollar lower against most of the other world currencies. This will give US companies a powerful competitive advantage in the global markets, and at the same time, make foreign exports to our nation more costly. Taken together, these forces will cause a string of interest rate cuts around the world, probably beginning with Canada.



In the picture I see forming, our Canadian neighbors may well come out looking very good for a period of time. They are a natural resource exporting nation, so their products will continue to be in demand, even if prices begin to stabilize.



Canada's banks are strong, with few of the subprime issues that will continue to nip at the heals of American banks, and finally, the country's Conservative government is finally beginning to deliver on some campaign promises. Importantly, as I said last time, Canada just cut corporate income taxes to near 30%, among the lowest in the developed world, and well under US corporate tax rates.

In running Canadian companies through our Dividend Valuation Model, I see many that are cheap. In the coming months, I will describe a few here.



The best valuation I see is Toronto Dominion Bank (see chart above). It is the second largest bank in Canada and has been making strategic acquisitions in the US. Its combination of a 2.8% dividend yield and low double-digit dividend increases over the past few years has made it a solid performer but has still left it significantly undervalued.

Our model says (I am showing TD in its local currency) that the stock may be as much as 15% undervalued, based on my estimate of next year's dividend growth.

Canada's natural resource oriented economy will insulate it from the economic slowdown that may hit most of the rest of the G-7 nations. Indeed, Canada and the US may be the only G-7 nations that will not experience any negative quarters of economic growth over the next six months to a year.

Barclays is Cheap

After Wells Fargo and Bank of America raised their dividends in early August by 12% and 14%, respectively, we said it was a clear sign to us that they were not in the eye of the storm of the subprime problems, and their stocks were too cheap.


The chart at the right shows that both stocks have recovered smartly over the last two weeks, as it has become clear that, indeed, neither is likely to take big losses. As we write this, however, we believe both stocks may be still as much as 15% undervalued based on the long-term relationships between their dividend growth, interest rates, and their stock prices.



We want to add another stock to the list of banks that we believe has been unfairly punished by the recent liquidity crisis. Barclays Bank is a London-based bank with offices spanning the globe. They have three world-class divisions: banking, capital markets, and asset management (ishares Exchange Traded Funds).

The stock has fallen by nearly 20% over the last 60 days on fears of Barclay's involvement with sub-prime loans, private equity, and hedge funds. There is no way for us to know their precise exposure to these groups, but the company has repeatedly stated that they are not experiencing any large scale losses.


Barclays recently raised their dividend by nearly 18%. A dividend hike of that magnitude is real money since they now yield over 5%.



The chart at the right is Barclay's Dividend Valuation Model. The blue line is the actual annual price over the last 15 years, and the green bars are the model's predicted values. The chart shows a close association between the model and prices over the last 15 years and a predicted 2008 value of just over $55.

From today's price of approximately $49, including the dividend, our model is suggesting that Barclay's may be even more undervalued than BAC or WFC.

Barclays has been in business since 1736. With that kind of longevity, we believe they might know a thing or two about how to navigate financial storms. Their AA bond ratings ensures access to the capital markets and minimizes liquidity issues.

The bank has been in a pitched battle with the Royal Bank of Scotland to acquire ABN Amro, a Dutch banking giant. We believe that the market is worried that Barclays may be dragged into a bidding war. In our minds, Barclays had done a lot of things right over the past 270 years. We're inclined to follow with their judgment with ABN Amro.

Boeing Is a Dream

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

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

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

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

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

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

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

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

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

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

The stock is owned in our Capital Builder investment style.

A Few Thoughts on the Private Equity Phenomenon

Private Equity is not going away. It will continue to grow and 10 years from now, we will think of it as just being another money management vehicle along side mutual funds, exchange traded funds, managed accounts, etc. Whereas mutual funds began as a way for small investors to improve diversification and have access to professional money managers, private equity funds are a means for institutions and the very wealthy to have access to more of a "hands on" business arrangement with corporate America. It is just another means of owning equity. As I have mentioned previously here, there is a growing feeling that a kind of imperial attitude has sprung up in corporate America. Corporate chieftains have figured out that they answer to everyone, while at the same time, answering to no one, and little by little they have begun to take advantage of their positions in ways that are increasingly unacceptable to many investors. I could not have imagined that this sort of imperial attitude would have become apparent so soon after the Enron fiasco, but $100 million dollar retirement packages for CEOs have become a way of life, with no end is in sight. I have always said that big money thinks and acts differently -- that's how they become "big money." I have a friend who is in this category. When he owns a stock, he will own several million dollars worth. He genuinely thinks that the CEO and the board of directors work for him ( he usually owns more stock than any of them), and if they act in ways that do not suit him, he does not cut bait and try another stock, he will pay the CEO a visit. He does not rant or rave, he just advises the person that he is unhappy, and he expects things to change. He usually has a list of things he does not believe are being handled well, as well as a list of costs that he believes are out of line. He asks for explanations, and if the answers are either not forthcoming or are evasive, he advises the CEO that he will attempt to change the make up of the board. I used to cringe every time he started off on one of his campaigns, but I have come to see things more his way. There are too many boards of directors who are not looking out for the good of the shareholders they are supposed to represent. They are only riding the gravy train just like everybody else. There are too many boards of directors who are not properly supervising their firms' strategies or top managements. They are just honored to be one of the "good old boys or girls" on an important board. My friend says says you can throw a dart at the Wall Street Journal and the odds are whatever company you hit can be run much more efficiently and much more profitably for shareholders if the company were being run by managers who ran the enterprise for the "owners." If my friend is right, and I believe he is, the private equity folks have enough companies to "clean up" to last a lifetime. The mutual fund industry is primarily engaged in the business of investing in stocks. The private equity industry is primarily engaged in investing in companies. There is an absolute world of difference between the two. Too many investors believe that the private equity crowd is bad for the markets and, like the leveraged buyout crowd, are destined to dry up and blow away. They are just as wrong in that assumption as they are in believing that the majority of boards of directors in this country are primarily serving the interests of their shareholders. There are private equity deals being announced every day. There is a simple meaning for their actions: US stocks are cheap, too cheap. With low interest rates and cash flows in good shape, if you throw a dart at the Wall Street Journal, you are likely going to hit a company that can not only be run more efficiently with a "owner" driven CEO, it can be bought with its own net worth. Private equity is just another way to own companies. My guess is that it is in its infancy and that is good news for the stock markets here and around the world. The surest evidence that this is true is that the government is moving to regulate it and tax it. I'm not going to tell you what my friend has to say about the government and taxes.

Sock it to 'em Sarkozy

Nicolas Sarkozy won a bruising battle over his socialist rival Segolene Royal for the Presidency of France with 53% of the vote to 47%. This was as the polls and the betting parlors were predicting. I will limit my comments on the elections because I have written two previous pieces on the importance of the French elections to the global economy, but I would like to comment on the commentators. The main stream media in the US and abroad is essentially saying that Sarkozy's election does not mean much because the French are the French, and they have it pretty good. Nothing could be farther from the truth. France is bleeding from both ends of the financial spectrum and they know it. There is virtually no hope of landing a meaningful job for young immigrants in the country. They have become a permanent non-working class, and increasingly violent. Yet, their existence is subsidized by the wealthy, where taxes can reach as high as 72% of income. In recent years, the wealthy have been voting with their feet and moving to lower-tax countries. Sarkozy is very direct and he believes he has a mandate to get people off the dole and put them back to work. This will not likely be an easy job in a country that has large segments of the population that are anti-capitalist and rally under the banners of communists, socialists, and, yes, even anarchists. France is a colorful nation in every way, even in it politics. I am more optimistic than many and my reason is this. If the French are anything, they are proud. Indeed, they are the originators of the products that epitomize fine living: perfume, wine, design, architecture, cooking, etc,. Increasingly, these products and services are beyond the budget of the average French citizen, and there is a growing recognition that the bon vivant lifestyle that the French brought to the world is now slipping from their grasp. Sarkozy will have a very difficult time in putting France back to work, but he is said to be a very tough minded person, and I believe he will bring increasingly seen by the French as a man who can help them reclaim their glory. Recently, we bought our first French company, Axa, one of the world's largest insurance companies. We see two or three other French companies that we like, and if we can get them at our price, we will add them as well. Blessings,

Why the French Elections Matter

From an economic perpective, France matters because the European Union (EU) matters and the EU matters because it now totals 495 million people in 27 countries and has an economy larger than that of the US. The European Union is fast becoming a power in the world's economic order. Yet, while it has mass and some clout, because it comprises 27 different countries spread over thousands of miles and many languages, it does not have a unified political or economic structure that has been able to drive the big ideas in the world. France is not one of the largest members of the Union, but it has a prominence in the EU that gives it a cachet far greater than its size. France's prestige and importance come from three things:

1. It was an originator and charter member of the EU 2. France has long promoted the "third way" or middle ground between the US and its foes around the world. 3. France is a squeeky wheel in terms of its culture, language and desire for a position of power on the world stage. While France has authentic prominence and a clear desire to lead the EU, it's leadership has been thwarted because it has lagged most of the other nations in the EU economically. I described the reason for that last time: a lack of faith in the free and flexible markets for commerce and labor. Many observers now believe that the economic malaise in France has reached the proportions that the French people are willing to give up some of their state-sponsored security blanket for the greater economic growth and employment gains that they see bubbling up in countries that are following a more free market approach. If France moves politically and economically to the right, by electing pro-business Nicolas Sarkozy over socialist Segolene Royal, the entire economic world will be the winner, and Sarkozy will assume almost an immediate leadership role in the EU, and consequently the world.

France and much of Europe has tremendous untapped growth potential that is likely to blossom if Sarkozy can lower taxes on entrepreneurs and deconstruct France's maze of job-stifling limits on employers' hiring and firing flexibilities.

Over the past decade, the EU has grown at only about half of the rate of the US, England, Canada, and Australia, where more pro-business policies are in place. With a pro-growth President in France leading the way and offering the proper incentives, the EU could increase its rate of growth by nearly a third.

Finally, as country after country in the EU has adopted more business friendly policies, we have shifted more funds into companies in the region. We now hold between 15% and 20% of our equity assets in European companies.

If Sarkozy wins, we believe the opportunities for continued stock appreciation from companies in the region are greatly enhanced.

Below is the most recent Intrade.com betting line on a Sarkozy win in the election. It has risen from near 70% last week to near 80% today. Bettors are not necessarily voters, but these betting lines have been remarkably accurate in recent years.

I'll keep you posted on the outcome.

A Few Thoughts About Private Equity

As I write this I am admiring the Cascade Mountains of Oregon. It is 17 degrees outside. It was 80 when I left Indiana. Gee, you mean you can't believe the Weather.com's predictions for Oregon's mountain country? With all this time on my hands that was supposed to be dedicated to learning to fly fish, I find myself just staring at these magnificent mountains while random thoughts flow through my mind. The thought that keeps appearing most often is,"What do all of the private equity deals mean?" Are they a good thing, or a bad thing. Are they an indication of just how cheap the market is, or are they just one more Wall Street gimmick that is going to crash and burn one day? Obviously, our firm has been collectively thinking about this for a long time. But in recent weeks, the buyouts have reached the point where Kohlberg Kravis Roberts, Blackrock, and Texas Pacific seem to be buying a company a day. These are high risk players, but they are obviously not fools. If you would have told me a year ago that companies as diverse as Biomet, TXU, The Tribune Companies, First Data, and Equity Office Properties would all be bought out by private equity firms in the span of six months, I would have told you that the Dow Jones Industrials would be over 14,000, maybe pushing 15,000. Something just does not add up about the rampant, almost frantic, pace of the buyouts and stock market's apathetic attitude towards it. Let me see, last month the markets sold off 5.5% in about a week. At the very same time, large buyouts were being announced almost everyday. Don't investors realize that the private equity money is only buying companies where cash flows over the next 5-10 years are expected to produce an annual rate of return of 15%-20%. Don't investors realize that this onslaught of private equity buyouts is going to keep rolling until prices of US stocks are much higher, and thus, puts a floor under any big market correction? But, as I sit here pondering the disconnect between big money buying everything in sight and the stock markets trading at PE multiples about the same as they were at the bottom of the bear market in 2002, I catch a beauty of a thought. If it's correct it might answer both behaviors. Let me sleep on it and I'll see if it still makes sense tomorrow. My wife just came in with snow shoes and a hiking map. She says we are adapting.

When China Sneezes . . . The US Doesn't Have to

As I write this, the Dow Jones is down about 400 points or just over 3%. The fall in US stocks is a carry over of the selling that occurred in China and the Far East overnight. Stocks in China fell by almost 10%, as investors sought to lock in profits in the face of a rumored Chinese crackdown on speculative buying and stock manipulation. The Shanghai domestic stock market has been nothing short of phenomenal, recently, racking up a gain in 2006 of 127% and 13% year to date. To say the Chinese market may have been a bit overbought, is an understatement of monumental proportions. But what does a sell off in the frothy markets in China have to do with the rest of Asia, Europe, and the US, where stocks have also sold off sharply? The answer is the interrelatedness of the world wide capital markets and economy. Welcome to the global economy. If any of the world's major economic players sneezes, there is the chance that the rest of the world may catch a cold. If you think of this in reverse, it may be more understandable. If the US would have reported an Enron like scandal yesterday that caused US stocks to fall sharply, today all the major stock markets around the world would be down in sympathy with us. We are so important to the world's economy that any disturbance in our economic prospects or confidence impacts everyone, because we are the largest consuming nation in the world. How about China? How important is it in the world's economic scheme of things. On an exchange adjusted basis, China is about one sixth the size of the US, and represents about one thirtieth of World Gross Production. Trouble in such a small portion of the world's economy would not seem to justify such a violent reaction to stock markets in the world's economic capitols. Indeed, we see few fundamental reasons for the world wide stock sell off, and we do not believe that economic growth estimates will change much as a result of today's sell off. Stocks sold off, mainly, because of the ease of selling. All you have to do is to turn go on your Internet and sell until your fingers wear out. In our judgment, in the days and weeks ahead today's selloff will be seen for what it is: a trading event and not a fundamental economic event. The fundamentals are still strong and stock prices will, ultimately, follow the fundamentals. How about the prospects that the US stocks markets, which had a good year in 2006, could be overvalued? There is good news on that front. US stocks did rise over 15% in 2006, but they are now selling at about the same PE and dividend yield than did at the beginning of 2006. The price rise in 2006 was entirely justified by the growth of earnings and dividends. US corporate earnings were better than expected in all four quarters of the year just past. The US economy is growing near 3%, and the Fed has stopped raising rates. If the economy were to slow for any reason, the Fed would quickly cut rates to spur economic growth. Finally, my friend Dr. Spear sent me an email and said, "Is this 1929 or 1987?" The answer, Doc, is neither. In 1929, on Black Monday, stocks fell by almost 13%. That would be equivalent today of nearly 1650 points. On Oct. 19, 1987, stocks fell by an amazing 22.6%, equivalent to nearly 2850 points today. The US markets have experienced numerous 3%-5% selloffs in its history. Few have led to any serious economic downturns. We are confident this one will not either. With US stocks having recently reached all time highs, some profit taking was probably inevitable sooner or later. The sell offs in Asia and Europe last night were just a good excuse for it to happen today here. While we believe the volatile markets will calm down in the days ahead, we expect that some additional selling may occur in the near term. We have put together a buy list of terrific companies that we would like to own, we hope we get the chance to do some nibbling. China may have sneezed. They might even have a cold, but our economic strength will help us ward off any cold bug, and, indeed, help pull them out of their chill. We'll keep you posted on any changes in our thinking.