UTX: Primed for the Global Economy

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

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

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

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

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

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

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

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

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

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

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

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.

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.

April New Homes Sales Hot, Housing Still Cold.

Today the market sold off because of fears that a hot New Home Sales report will delay the Fed from cutting rates. I do not believe that will be the case. Indeed, as a result of the widening trade balance, the next GDP report will likely show that US economic growth has slowed to under 1%. Today's housing report is loaded with volatile data, and will likely be forgotten quickly.

New home sales did, indeed, shoot higher in April on the back of mild weather and price cuts. The two charts at the right, however, show that Housing is still in a free fall.

The National Association of Home Builders now claims that Housing is bottoming, but, hey, I thought they said that 5 months ago. The top chart, New Home Sales, shows the uptick has done little to change the trend of housing, and the lower chart, Median New Home Prices, is anything but positive for housing.

The lower chart shows that home prices in the month of April fell sharply (-11% year over year.) An 11% drop in prices on the average house is over $30,000. That is not good news for consumers. Neither is the fact that it puts lots of mortgage balances underwater relative to their underlying home prices, which will keep pressure on the mortgage banks.

The only good news I see in the report is that a capitulation stage is probably beginning in housing where speculators and builders with unsold inventories are beginning to cut bait. That makes for a kind of coincident beginning of the end and beginning of the beginning. But it is months off before we will see any true year over year growth in housing.

That means this report will be forgotten quickly as further economic reports are released showing very slow growth.

I am convinced that the headlines in the coming weeks will have more worries about slow growth than strong growth and that will be good news for stocks in the consumer staples, health-care, finance, and selected global industrials.

10 Thoughts after Looking at 2,000 Stocks

Stocks in the US and around the world have made a series of new highs over the last three months, which has prompted a chorus of boo birds to start chanting that the market has come too far too fast. They are just as wrong now as they were when they said that the Dow could not get through 11,000 last year. I spent two days this week running almost every big stock in the US and Europe through our dividend and earnings models. This is what I see:

1. US big cap stocks are about 8-10% undervalued.
2. Europe is pushing close to fair values in a number of countries.
3. There are lots of formerly dead cats bouncing all over the world. This is not a bad thing, it is in recognition of the growing global economy and the consolidation in many industries.
4. The most overvalued sectors worldwide are the Utilities, REITs and Basic Materials.
5. The most undervalued are the consumer staples, and to a lessor extent the health-care stocks.
6. The banks are still cheap in almost every country I looked at, especially in the US.
7. Telecommunications, except in rare cases, are running on something other than value. They are the new Tech stocks. The old Tech stocks are, well, old.
8. The Industrials are the most surprising sector in the US and abroad. These stocks have had good moves, but are as much as 15-20% undervalued in our models. Their gains and those to come, again, are the result of the explosive growth in the developing nations.
9. Energy stocks are high and going higher. The global economy is showing no signs of slowing and ethanol's limitations are coming into view.
10. The keys to a continuation in the bull market are the staples and banks. They represent 35% of the market cap of the S&P 500 and are underperforming. I believe they will catch their wind as we move through the summer and the slowing economy causes the boo birds to start chanting recession.
11. When US retail stocks begin to participate, this phase of the bull run will enter a period of consolidation.

Blessing,

Berkshire Hathaway -- New Valuation Estimate

As regular readers know, 99.9% of our research is directed toward dividend paying stocks. We follow dividends because, as it says in the masthead above, we believe they are more predictable than earnings and are an actual component of a stock's total return.

Having said this, for many years we have held Berkshire Hathaway in our Capital Builder style of management because we have found that BRK's price is highly correlated to changes in its book value and interest rates. Periodically, we update our valuation model on BRK using a multiple regression of its book value and interest rates relative to its stock price. Below is a chart of our valuation model going back 15 years. You will see that the fit is very tight and, based on the just-released data, BRK class A is selling just about at fair value of $109,500.

Using our internal estimates of the growth of BRK's book value and the changes in 10-year Treasury bond rates, we arrive at a year-end value for BRK class A of $119,800.

We think that is as good a guess as we can make, and in light of the slowing economy, we still believe BRK class A is a good hold for the year ahead.

BRK class B is 1/30 of class A, therefore its current projected year-end value is near $4,000 per share.

Our First Webcast -- Market Comments

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