Welcome Aboard

We want to welcome all the clients of Donaldson Capital Management to our blogsite. We hope you enjoy the rest of the Summer Stroll. Please begin at Summer Stroll # 1 and work your way up to the current article. This discussion of dividend investing is wide ranging yet very specific. We will be discussing in detail how we arrive at purchase decisions. Unfortunately because this site in now open to the public, we will not speak in great detail about why we like one stock over another one. The Summer Stroll is to help you acquaint yourself with how to think about what dividends mean to the investment process and how we came to understand their significance. Please ask any questions that come to mind. That is the best way to understand what we are saying and also it is the best way for us to find out where you are in your understanding of the determinants of the intrinsic value of a stock. The Stroll continues, Greg Donaldson

Summer Stroll #7 -- Of Golden Eggs and Geese

Did you every stop to think what the goose that was laying the golden eggs was worth before the farmer killed it? Remember in the folk tale, the goose was laying one egg per day of fine, pure gold. The greedy farmer wanted more than one egg per day, so he killed the goose and opened her up expecting to see a belly full of gold. But on the inside the goose was just like all geese: there were no eggs, and the farmer's foolishness has lived on in infamy. We consider many of our Rising Dividend companies to be similar to the goose in their abilities to produce golden eggs in the form of earnings and dividends growth. Having learned from the farmer's folly, we are content to take the eggs as they come. We consider ourselves to be in the business of collecting the golden eggs. We are not about to kill the goose to see if we can squeeze out a few more eggs. We think the goose is doing just fine. Furthermore, we do not jump from goose to goose trying to pick up an extra egg here and there. We have studied the ways of the goose we own, and we think she is the real thing. If we were in the business of trading geese, the next goose, or the one after that might be a turkey that is painting her eggs, and we would lose all that we have gained. We work hard at valuing the goose's future stream of golden eggs. The market for golden eggs comes and goes, and every once in awhile a fool, on the order of the farmer, comes along who thinks he can squeeze more eggs out of the goose; and he is willing to pay us far more for the goose than our calculations say she is worth. This is the great benefit of being in the golden egg business instead of the goose trading business. It is relatively easy to calculate the present value of the eggs over the remainder of the goose's life, while it is very difficult to figure out what the goose is worth based on its color, size, type, or beauty. In these matters of style, our guess is no better than anyone else's. But when it comes to valuing the future stream of golden eggs, we have that down to a science. Let's say the average goose lays 20 eggs per month and produces eggs for 5 years. Each egg weighs about one ounce and gold is selling for about $400 per ounce. Figuring what the goose will be worth over its expected life is easy. It is just the number of eggs per month (20) times the price of gold ($400) times the number of months the goose will lay eggs (60) = $480,000. But things get a little tougher when we realize that it will take us 5 years to produce the $480,000, and to calculate a present value, we need to take into consideration the time value of money. We all know that a dollar we get today is worth more to us that a dollar we will receive 5 years from now because if we get the dollar today, we can invest it, and in 5 years it will be worth much more than one dollar. Because of this, we must discount the $480,000 that we expect to receive by some appropriate interest rate. Let's use 6%. The present value of a monthly stream of gold over the next 5 years totally $480,000 is approimately $417,000. The market for geese can careen all over the place but we don't care because we know what our goose is worth on the basis of the stream of golden eggs. There are only about three things that can affect the value of the stream of eggs: 1. the health of the goose, 2. the price of gold, and 3. the interest rate we are using to discount the future stream of income. Certainly one or all of these things will change, but as they do, we will just change our formula and recalculate the present value of the golden eggs. But, there is a guy in the yard, who say he wants to make an offer on our goose. We'll see what he has to say next time.

Summer Stroll # 6 -- Your Adversary -- Part 2

People argue with us all the time about relying on dividends. Once while I was discussing our investment strategy with the CEO of an insurance company, the guy just got up and left. On his way out, he said he was not interested in an investment style that was so conservative. He said he wanted to make the highest rate of return he could, and he believed our approach aimed way too low. I asked him what his target rate of return was, and he said, "As much as I can get." I told him in my years of following the dividend approach, I had always been surprised that it had consistently made more than I thought it would. I suggested he may want to hear me out, perhaps because these surprisingly good results could measure up to his "All I can get" goal. But his mind was made up and I found my own way to the door. There is a new name on the door of the building the insurance firm was in. I don't know what happened to the company or the man, but I do know that he was trying to emulate the success of Conseco, which at that time was a hot shot Indianapolis-based insurance firm. That turned out to be a disastrous strategy. Conseco's hot streak went cold when it was forced into bankruptcy in the 1990s as a result of a string of "as much as I can get" investments that appeared to vaporize as fast as they were made. One horn of the beast we must ride is greed, the other horn is fear. Unless you know what you are doing, you will find yourself making investment decisions out of one horn or the other, and not out of the area between the two horns. Valuations matter and if you don't know how to value an investment, by default, you will find yourself thinking out of your emotions. Greed and fear are terrible partners in any investment. They will never give you peace, and in your saner moments, you will realize that you must have been out of your mind to have invested in this tech stock or that real estate venture--and of course you were. Your adversary is not the investment beast you attempt to ride. Your primary adversary is you: Your emotions, your politics, your understanding of the nature of the beast. The sum total of everything you are and are not will be laid bare in the investment arena. And, in the end, you will reap what you sow. The dividend approach is a very narrow path that you may follow. It is a place where you can sow reason and reap what is reasonable. It is a sane place, where horns must be checked at the door. It is a place where you mostly wait, not a boring wait but a hopeful and exciting wait like an expectant father.

Summer Stroll #5 -- The Adversary You Face

Thus far on the stroll, I have offered you nothing but statistics attempting to define the beast we seek to ride in the investment arena, and indeed, to invest in the stock market is to ride an unseen beast. As I say this, the question that should pop into your mind, immediately, is: "Is the beast friend or foe?" Is it a beast of burden like an ox that will safely carry us to the other side, or is it a wild beast that we can only hope to ride successfully for a few moments, like a rodeo bull? If you have not come to grips with the notion that the stock market is a beast, you will do poorly in the long run at investing. Investing is not for fun, it is for profit and, ultimately, for survival. It is not like golf, where you can practice the various strokes in the relative comfort of a driving range and become proficient enough to enjoy a round on an actual course. It is more like boxing. You can shadow box all you want in front of a mirror, or against a punching bag, but when you step in the ring against another fighter, one thing becomes immediately clear: This is going to hurt. Win or lose the nature of this game is to endure the hits you are going to take. The hits in the investment game are psychological and financial, not physical like boxing, but the effects are the same. You must learn to navigate the investment arena suffering from a host of destructive blows to your pride, self confidence, and wallet -- maybe even to your way of life. If you insist on "just winging it" as do 80% of investors, you will be shaken silly by just the normal movements of the beast you seek to ride. And even though the beast can be ridden to great profit, it can never be tamed. It will always be wild. It will always be unpredictable in the short run, and it will hurt you at times, even if you know the nature of the beast. But if you know the game you are in, understand the nature of the beast, and accept it for what it is and what you must endure to ride it, the beast will take you to high places you can not imagine. I have read hundreds of books on investing. None of them adequetely prepares investors for the psychological ride they must make to become a sucessful. Intelligence, by itself, will not ensure good results, experience helps only a little, taking a college course in investing is virtually worthless, unless it is taught by a successful fulltime investor. The one thing everyone misses except the successful investor is the psychological and financial hurts that must be endured in the short run to obtain a profitable long-term result. At Donaldson Capital, when we talk to our clients we are just as apt to speak of our failures in the markets, as our successes. This may not sound like good marketing strategy, but we learned a long time ago that we can always find new clients. What we are interested in is helping our existing clients to know what the investment game is all about, understand that by its nature it will bring hurts that must be endured, and that by not letting the beast's good or bad temper scare us off that we will win. Someone once said that investing is a bloodsport, if so dividends assure us of our "cut."

Summer Stroll #4 -- Why Do Stocks Go UP?

Did you ever wonder why stocks have risen over almost all of recorded history? You realize of course, if you can answer that question you will have the basis to answer the more important question -- where are stocks going from here? It turns out the answer is really quite simple. Stocks in the United States have risen because earnings and dividends have grown, and earnings and dividends have grown because the economy has grown. As you will see, the numbers are so similar we often wonder why we don't see more written about it in the popular media. As we said in our last edition, over the last 45 years, earnings and dividends have grown at 6.7% and 5.4%, respectively. Since 1960, Nominal Gross Domestic Product ( The measure of all goods and services produced in the US) has grown at 7.3% per annum. Nominal GDP is not a term you hear very often, but it is simply GDP not adjusted for inflation. Think about it. Stock prices are not adjusted for inflation, so to compare apples to apples we need the gross figures for economic growth and not the net figures. The GDP growth that we hear most often is in the range of 3%-4%, but that is after subtracting inflation. The US economy has actually grown at an annual rate of 7.3% for the last 45 years. Inflation, during this time, has averaged about 4.3%, leaving net GDP growth of about 3% on average for the period. What is the bottom line on all this data? As it relates to the Dow Jones Industrial Average, we believe it means that stock prices will continue to grow in the range of 6.5%-7%. Adding in the current dividend yield of 2.4% gives us a projected total rate of return over the next few years of 8.9%-9.4%. With 10 year Treasury bonds at 4.2%, stocks look awfully cheap to us.

Summer Stroll #3 -- Volatility Feels Like Risk

Please begin at the beginning of the Summer Stroll blogs to best understand this edition. The question always comes up, why dividends when Wall Street focuses on earnings and earnings are required to pay dividends? I always admit that earnings are, indeed, the most important ingredient to a successful investment, but earnings share a common trait with prices -- high volatility. As mentioned in the last piece, stock prices, exclusive of dividends, have grown at an annual rate of 6.7% over the last 45 years. During this same time earnings have grown at an average annual rate of 7%. Remember also that dividends have grown at 5.4%. Now, 7% sounds a whole lot closer to the 6.7% annual growth of price than the 5.4% growth of dividends, so again, why use dividends as the best indicator of true investment value? The title of this piece should give it away, volatility. Stock prices have an annual standard deviation of near 15%. That means that in a normal year we should expect stock prices to range from -8.3% (15%-6.7%) to +21.7% (6.7%+15%). This means that about 28% of the time we should expect stocks to fall, or about once every three to four years. There are all kinds of behavior studies that show that people are not very good losers. They wrongly conclude that things have changed and there will be no return to the three up years for every down year. I have managed money for a long time, and I can tell you this is absolutely true. People get crazy when they have a sizeable loss in their portfolio. But the reality of the situation is that losses are unavoidable. You must take the bad with the good, but you must have something to hang your hat on, other than prices, because prices will spook you on a fairly regular basis. And the bad news is, even though earnings have grown at about the same rate as prices, they are even more volatile. Earnings for the Dow Jones 30 have an annual standard deviation of near 22%. That means earnings in a normal year will be somewhere between -15.3% and +28.7%. Earnings simply do not help us make it through the bad years, they are more nerve wracking than prices. Now comes the lowly dividend. It has averaged 5.4% growth, but its standard deviation is only about 8%. Now we are talking. That means in a normal year we would expect dividends to produce between -2.6% and a +13.4%. It is the dividend's stability that gives it its power in predicting future stocks prices, as well as to help us to hang in there during the down years in price. Falling dividends represent only about a 16% probability, thus if you are watching dividends it is rare to have a bad year, so to speak. Now here is the important statistic to keep in mind. There is a 92% correlation between price and dividend. If we add interest rates, we can get the correlation up to almost 95%. We use the term: So goes the dividend, so goes the price. Dividends have the highest volatility adjusted correlation to price of any fundamental data, and that is the main reason we use them to determine "investment value." Couple this with the fact that dividends are real money and have represented 36% of the total annual return of stocks for the last 45 years, and we now have a powerful weapon with which to go hunting in the investment jungle. PS. I can't answer every question, but toss something out. It's a little quiet in here.

A Summer Stroll #2 -- The Story Begins

Note: To best understand this blog, please start at A Summer Stroll -- Part 1 The story of dividend investing is really a story within a story: the first is the series of events that led to my becoming a dividend investor and the second is what I have learned along the way. There has been much written about dividends in the past few years, including many academic studies, that show, conclusively, that dividends matter. I will cite a couple important studies later, but first let me share some of my own findings. I mainly use the Dow Jones 30 for my analysis because I have found that using this smaller group of companies, rather than the 500 in the S&P, has given me additional insight into what was driving my findings. Most academic and Wall Street research is done on the S&P 500. Please note when I change back and forth between the two. The data are very similar, but they do differ at times. In the 44 years from 1960 throughout the end of 2004, the total return of the Dow Jones 30 Industrials has averaged 10.4% annually, consisting of 6.7% price growth and 3.7% in dividend return. This means that nearly 36% of the total return of this important index has come from dividends. Many of you have read this statistic before, but you still see dividends as a bonus, rather than the powerful indicator of the true investment value that they are. Dividends have two qualities that put them in a class by themselves as far as offering a reliable long-term gauge of rate of return: they are real money( and it's real money we are after, not paper profits) and their growth trend is much more stable than earnings or sales, the most commonly followed corporate financial data. To start to visualize the power of the dividend as an indicator of total return, first consider that since 1960, dividend returns have ranged between 1.6% and 6.1%, a difference of only 4.5%, while price returns have ranged from -17.8% to 35.1%, a difference of 52.9%. At first these data do not appear to help us because, even though dividends have represented over a third of total return and are very stable, it is nearly impossible to estimate the future price return of the markets or a stock because prices are so volatile. The volatility of prices would seem to destroy any hope we have of estimating future total returns, and I will add, it is this volatility that damages investors' ability to stay the course in their investment strategies. Time and again, I see investors cut and run in periods of high volatility, and my heart sinks when they do. In my judgment there is no other passive investment on earth that rivals the wealth producing capacity of the stock markets, but this wealth-producing capacity comes with a price -- volatility. To find a way to see through volatility, as you will see later, became my quest during the crash of 1987. I will describe that story in a later edition of our walk. But here is where the second important quality of the dividend comes to the rescue -- its much lower volatility. Long-term dividend growth has been similar to long-term price growth, 5.4% to 6.7%. If we could prove that there is some correlation between long-term dividend growth and long-term price growth, we could use dividend growth as a less volatile proxy for price growth, and we would then have an instrument to cut throughout the fog of the day to day high volatility of stock prices and determine a "true" expected expected return from the markets or an individual stock. This is the search that I have been on for over 20 years. For my money, I have found the relationship that connects the two, and in doing so, as many of you know, I don't pay much attention to the day to day machinations of the stock market, however, come dividend time I am like a lion on the prowl. In the weeks ahead, I will share with you what I discovered that connects dividend growth with price growth and how we use it. I will also, hopefully, acquaint you with the term dividend total return, or dividend return as the primary was of valuing a security. Talk to you soon.