Becton Dickinson: Another Undervalued Stock on the Move

As I promised last time, I am showing our Dividend Valuation Model for Becton Dickinson (BDX).  BDX is the second highest ranked stock in our universe behind United Technologies (UTX) in a combination of predictability, valuation, and momentum.

The chart at the right shows the actual prices of BDX in red compared to our model's annual predictions over the last 20 years in blue.

BDX is a global medical technology company engaged in the manufacture and sale of a wide range of medical devices and instruments used by many sectors of the health-care industry. 

The Dividend Valuation Chart shows a tight fit between BDX and the valuation bars.  The R-squared is .94. 

BDX has one of the best long-term earnings and dividend growth records of any company we follow.

1. Dividends have grown by nearly 13% per annum over the last 20 years. 
2. Earnings have grown by nearly 12% per year.
3. Over the last three years dividends and earnings have grown at 13.7% and 11.4%, respectively.
4. Wall Street is estimating that 3-5 year earnings will grow at nearly 10%.
5. The model is suggesting that based on next years estimates the stock is undervalued by nearly 14%.

A company with such a high R-squared at BDX seldom gives table-pounding buy signals.  The chart clearly shows that BDX's price has pretty much run along the tops of it annual valuation bars, but it is now buried in undervalued territory.

Health-care stocks have underperformed the S&P 500 over the last two years.  In recent weeks, however, they have perked up as investors have moved to a more defensive posture.  We would not be surprised to see BDX move higher in part because it has one of the highest expected dividend and earnings growth profiles of any stock in the health-care sector.  In short it is a standout company in a battered industry.


We own BDX in our Capital Builder investment style. Do not use this blog for investment advice.  Please consult your own investment professional for his or her analysis of the company.

Next time Johnson and Johnson (JNJ).

Dividend Valuation Model: United Technology Is #1

Dividends play two important roles in our stock selection process.  1) They produce a cash return that has represented nearly 40% of the total return of the S&P 500 Index over the last 80 years. 2)  For select companies, dividend growth and changes in interest rates provide an excellent valuation tool.

Each week we run all the stocks in the Russell 1000 through our Dividend Valuation model.   The model does two important things for us.  Statistically, it tells us how good it has been in predicting movements in each stock over the last 20 years, and it provides us with a single formula that has produced the best fit of prices versus dividends and interest rates.

At this point in the process, we can easily identify which stocks are most "predictable."  Next we make a projection of the dividend growth for each company and estimate changes in interest rates for the coming year.  With this information, the model can now tell us which stocks are most undervalued.  Finally, we run all stocks through a multi-period momentum filter.  This tells us which stocks have what we call "sponsorship," meaning which companies are performing at least as well as the average stock over four different time frames..

This may sound complex, and the process is, but the result is very simple.  We have identified the companies that are most predictable, most undervalued, and have the best sponsorship, or momentum.

We then assign a rank between 1 and 100 for each of the three metrics for each company.  Summing the ranks for predictability, valuation, and sponsorship, we can identify the company with the highest overall total rank in  the Russell 1000 and the also among the companies we own.

Using this process, of calculating predictability, valuation, and sponsorship, we can determine those stocks with the best prospect for the year ahead

 A look at the model as of Friday reveals that the stock we own with the best overall score is United Technology (UTX).  As shown above, the model (blue line) for UTX has been very tightly associated with UTX's actual price (red line) over the last 20 years.  The R-squared is .94.  The models suggests that UTX is undervalued by about 12%, including dividend. UTX's sponsorship or momentum score is 67, which means that it has outperformed 67% of all stocks over four time frames, from 12 months to one month.  Importantly it is outperforming 74% of all stocks over the last three months.  UTX recently hiked it dividend 13%, which is about in line with the company's dividend actions over the last ten years.  Finally, earnings were recently reported as having grown 19% in the first quarter versus a year ago.  That provides a nice cushion for future dividend hikes.

There are a handful of stocks with better scores than UTX.  Our strategists are researching them.  We'll report later if any of them meet our standards.

The stock with the second highest score in our model is Becton Dickinson (BDX).  We will report on it next time.

The investment world has definitely discovered dividends.  We have not seen this kind of attention being paid to dividend investing in our own 20 years of a dividend-centric approach.  Because dividends have become so popular, we are turning our focus to valuation in our blogs for a while.  We have learned the hard way too many times that just because a company pays a dividend, or has increased its dividend for 20 or 30 years in a row does not mean that it is fairly priced.  Indeed, we see many companies with long dividend-paying track records that have already priced in the next two years of dividend growth.

If you have specific dividend-paying companies that you would like for us to review, please add a comment to this blog.  We'll get to as many as we can.    

Sell in May And Go Away . . . . At Your Own Risk

Because stocks have had solid double-digit gains over the last 12 months, we hear many people predicting that they are ready for a fall.  In addition, the "Sell in May and Go Away" crowd is giving us all the statistics of how stocks have fared between May and November historically.

The reasons given for a stock sell off are full of language about momentum, price gains, and too much-too soon. We want to add very quickly that few of the "stocks are too high" crowd today were among the "stocks are too low" crowd  at the market bottom in March of 2009.  Indeed, if you go back to their blogs and read what they were saying around the bottom of the market, you will find many of them were saying "stocks are too high," even then.

In the blizzard of words we see written about the stock market, we seldom see the word valuation.  Valuation, it would seem, has no meaning in a high-octane traders' market, where computers are trading with computers for about 70% of the daily volume.  Individual investors seem to have decided that long-term value investing has gone the way of the Oldsmobile.

Ah, but we beg to differ!   In the long-run, valuation will rule just like it always has.The reason is over the last 80 years, S&P stock prices are highly correlated to both After Tax Profits and Dividends.  The computers and traders will wage their daily battles of betting on zig or zag, but in the long-run, zigs and zags will ultimately be seen as vanity, a chasing after the wind.

From a valuation perspective, stocks are still cheap and could only become expensive if the economy were to fall off a cliff and drag earnings and dividends with it.  The chart below shows index of the S&P 500 (red line) compared to Total U.S. After Tax Profits Index (blue line).  Please note that After Tax Profits reached an all time high in December of 2010 and, based on S&P estimates, will rise by nearly 13% in the second quarter of 2011 versus the same quarter a year ago. Tracking the After Tax Profits Index is our favorite way of measuring earnings, because it measures only earnings that companies actually paid taxes on.  

The graph below vividly shows that while After Tax Profits have reached an all time high, the S&P 500 has not. In fact, the chart suggests that the S&P has a long way to go to reach fair value.

Corroborating the view that stocks are still undervalued is the graph of the S&P 500 Index (red line) compared to Total Corporate Dividends Index (blue line).  Total Corporate Dividends paid is an important indicator of the health of the current turn-around in the stock market, because dividends are paid in cash and not promises.  As the chart shows, dividends took a hit during the sub prime crisis.  Importantly the chart also shows that they have turned higher.  S&P is predicting that dividends will grow nearly 10% on a year over year basis for the first quarter of 2011.  Dividends have not reached a new high, but we believe the old record will be eclipsed over the next 12 months.  This would be good news for continued stock price gains.

These two simple, yet important measures of stock market valuations are still flashing green.  That does not mean that stocks will go straight up from here.  In our judgment, it does mean, however, that saying stocks are too high is nonsense, and "Sell in May and Go Away" is worse.

The Dollar's Slide: Terminal or Temporary?

We’ve had a number of clients write or call us lately concerned about the continuing weakness of the U.S. dollar. (It’s down about 10% since December against a basket of currencies.)  Here’s a representative example of their concerns:

“I feel the weak dollar (and growing weaker) is causing us problems and will cause greater problems if the world loses confidence in the US dollar as the world's monetary standard.  Oil is priced in $'s and the dollar's weakened position is costing US and world consumers.  When will the world say enough is enough and then what happens to the US economy?”

There is and old saying among economists that goes: “The solution to high prices is high prices.”  By this they mean that because of the law of supply and demand, higher prices tend to lead to lower demand.  Eventually, this lower demand will cause the sellers of the products to cut prices in order to regain the lost demand.  In this way, higher prices are self-correcting.

The dynamics of currency exchange rates are similar.  To a great extent, the problems tend to correct themselves over time.  As a quick primer, there are five major dynamics that have the most influence over the value of a country’s currency:

Interest Rates:  Holding everything else constant, higher interest rates for a given country relative to its trading partners would cause its currency to strengthen because the high rates would attract buyers.

Inflation:  Higher inflation in a country relative to its trading partners normally weakens its currency.

Balance of Trade: Shifts in a country’s balance of trade exert pressure on its currency.  Growing exports relative to imports strengthen its currency; weakening exports do just the opposite.

Budget Deficits:  Higher budget deficits as a percent of GDP weaken a country’s currency, while lower budget deficits strengthen its currency.

GDP: So long as a country’s inflation rate is muted, the higher the country’s GDP, the stronger will be its currency.

As with most aspects of investing, the expectations of how each of the above factors will behave in the future have as much impact on the value of the currency as their current levels.

This analysis, unfortunately, may produce as many questions as it answers, but such is the nature of discussing currencies.  Someone once said, “When it comes to currencies, everything affects everything.” Having said this, currency fluctuations are a daily concern for us because we own so many foreign based stocks.  Thus, based on our current holdings, we are keeping an eye on the Canadian dollar, the British pound, the Chinese yuan, the Swiss Franc, the Danish krone, and the euro.

Using the above five factors, let us offer a brief analysis of the most likely trend of the U.S. dollar over the next few years. 

• Short-term interest rates in the U.S. are among the lowest in the world.   However, when the current round of quantitative easing (QE2) ends in June, those rates should rise, at least a little.  Further, the Fed is expected to begin raising the Federal Funds Rate (FFR) – now at 0.0% - 0.25% by year end.  So, both ending QE2 and raising the FFR should lift the US$.
•  Core inflation in the U.S. is hovering around 1%, very low compared to our trading partners.  Thus, this is favorable for the dollar.  However, if inflation gets too high, the Fed will raise interest rates to fight it.  (Higher interest rates = stronger currency, part of that self-limiting mentioned above.)
• A cheap dollar makes U.S.-manufactured goods more competitive overseas, helping to boost U.S. exports.  Higher exports improve our balance of trade and GDP and should give a lift to the dollar.  This is a prime example of the self-correcting qualities of a weak dollar.  Ironically, however, a weak dollar means that the cost of imports rise, especially oil.  This puts upward pressure on inflation.  Are you getting the picture of the concept of “everything affects everything?"
• Budget deficits and high U.S. debt relative to GDP are the big killers right now for the value of the dollar.  Standard and Poors’ (S&P), in its recent change of outlook for US debt from stable to negative, said one of the reasons for the action was their belief that prospects for meaningful deficit reduction in the current political climate were low.  As you remember, the Dow Jones fell over 200 points for the day on that news, and S&P’s action jumped from the financial pages to the dinner table.  In doing so, S&P may have done us all a favor by turning up the heat on Washington to make progress on budget cutting.  S&P’s message was clear: clean up your financial house or face a downgrade of your bonds.  Downgrade or no, deficits will continue to play a role in the direction of the dollar.
• The United States GDP is the largest in the world, so that helps.   But it is not growing as fast as GDP in the developing countries of China, India, Brazil and other Asian countries.  Indeed, U.S. GDP is growing more slowly than the global average right now, which has somewhat of a weakening influence on the dollar. 

So there you have it. Combining all these factors and comparing them with similar data from our major trading partner nations is producing a negative demand for the US dollar against most other major currencies.

We believe the two primary drivers of the weak dollar are the negative attitudes by some about QE2 and the size and growth rate of the US budget deficit.  As you know, we have been in favor of QE2 because we believe it has provided needed stimulus for the economy and consumer confidence.  We also believe the Federal Reserve has the will and the power to terminate it without disrupting the markets.  Our view has been validated by the rising stock prices over the last six months; unfortunately our optimism has not been shared by the currency traders.  With QE2 coming to an end, it would seem some pressure on the dollar should abate.  

The problem with the budget deficit is too big to solve in the near term.  Indeed, it is exacerbated by the political divide in Washington.  Yet, the problem is too big to ignore any longer.

As we have evaluated the issues surrounding the weakness in the U.S. dollar, in many cases, we believe they are self-limiting or self-correcting.  However, as we said earlier, the biggest problem facing the dollar is the lack of confidence in Washington’s willingness to make the tough decisions to limit the growth of the U.S. debt.  In light of this, pressure on the dollar may continue.

This discussion of the dollar is not simply an answer to a client question.  We deal with currency decisions everyday.  Four years ago we concluded that the dollar was likely to trend lower.  That was even before, the huge increase in government debt.  We redirected our portfolios to benefit from a falling dollar.  At present, more than 60% of the revenues of the companies we own comes from outside the US. Not only are our companies more competitive as a result of the lower dollar, but when their foreign profits are converted back into dollars, they are higher than if they had been produced in the U.S.  Additionally, nearly 20% of our portfolio companies are domiciled outside the US.  With these companies we are benefiting not only from their growing earnings and dividends, but also from the currency translations.  As an example, one of our biggest holdings is Nestle (NSRGY).  A few years ago Nestle’s stock price in Switzerland ended the year flat.  Taking into consideration the currency translations from the falling dollar versus the Swiss franc, NSRGY made a total return of nearly 11%.

Next time we’ll take a swing at the U.S. dollar’s declining importance as the reserve currency of choice.

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.

So Far Municipal Finances Are Not As Bad As Feared

Analyst Meredith Whitney in December sent the municipal bond world into a hissy fit when she predicted that hundreds of billions of dollars of municipal bonds would default over the next year.  Early on we joined countless municipal experts in disagreeing with Ms. Whitney's prediction.

Governments of all stripes are groaning under their debt loads.  Unfortunately, some politicians seem less intent on balancing their budgets than saving the out-sized fringe benefits of government workers. Yet in spite of some cases of politics a usual, and . . . unusual as in the states of  Wisconsin and Indiana, where runaway legislators shut down the legislative process, progress is being made in almost all corners of the United States in getting costs in line with revenues.

In recent weeks many municipalities across the country have released their 2010 financial reports.  This gives us the opportunity to take a hard look at how our holdings are faring in these tough times.  Thus far almost all the municipalities we have studied have shown improved financial conditions over a year ago.  We own 574 tax-exempt bond issues so we have a ways to go, but there is another important indicator that gives us confidence that things are on the mend.  Of the 574 issues we own, none were downgraded by Standard and Poors or Moodys in the last six months.  Indeed, the ratings changed on only 12 issues and they all rose by at least one rating level.  With tax revenues ticking higher in most states and cost cutting grudgingly underway, we belive we will see a continuation of more rating hikes than cuts during the rest of the year.

We believe even more strongly than we did in December that Ms. Whitney will be wrong in her prediction of massive defaults among municipal bonds.  We now believe unless there are a few anarchists among the legislators of this country -- people who genuinely want municipalities to default -- that the defaults will be few.   

We'll keep you posted as we continue to study our holdings.

Blessings


We own lots of municipal bonds.

Big Dumb Trends: Oil and Gas Are Even More Important After Japan

There are times when the questions seem to be wielding bazookas and the answers butter knives.  In these times we have found that the most profitable action we can make is to focus on what we can know, not dwell on the myriad of issues that no one appears to know.  You may have heard us refer to this as  identifying the Big Dumb Trends.

Earlier this week we emailed to our clients a multiple page analysis of our how we believe the unfolding events in Japan would impact the worldwide economy. (You may request a copy of that document by calling Carol @ 812-421-3203.)  In short, in looking at many major disasters over the last 20 years, we cannot find lasting economic effects from such disasters. In short the devastation is counterbalanced by the rebuilding process.  The cost of human suffering is high and gut wrenching, but the economies of the afflicted region and the world have not been materially affected, as long as adequate capital was available for the rebuilding.  Based on what we know today, we believe this will be the case in Japan.

Please forgive us if we sound insensitive.  You know us well enough to understand that that is not our intention.  Our goal in this blog is to refocus our attention away from the carnage that has befallen our friends in Japan and view a world that is inhabited by 6 billion people and a world that will go on.

Then what is the single most obvious "answer" for the future that we can glean from the disaster in Japan.  We believe that answer is obvious and it is the definition of a Big Dumb Trend.  Nuclear energy as an alternative to  fossil based energy will likely go into a long period of under utilization.  Couple that with the unrest in oil-rich North Africa and the Middle East and you come to one conclusion:  Oil prices are not coming down anytime soon, and will probably trend higher once the economies of the world move to a higher growth rate.  Alternative energy will continue to draw lots of talk and lots of dollars, but the questions these technologies offer have been muted by just as many questions.

Oil and gas will continue to play an out-sized role in the energy needs of the whole world.  If that is the case, what is the best way to play energy?  Buying oil and gas stocks is an easy answer, and we believe will be profitable.  But in zeroing in on  the best idea we have at this point, we arrive at the oil field services companies.

They will benefit in two ways. 1) There will be more highly technical-deep drilling (expensive), 2) There will be tremendous retro-drilling in former productive fields in areas that were thought to be tapped out.  New technologies are showing good results in this retro-drilling field.

Simplifying our idea even further, we believe the best company for the future we see unfolding is Schlumberger LTD. (SLB).

Our reason is simple.  SLB is the largest oil-field services company in the world and possesses a unique position in the industry.  They have what we call the "Goldman Sachs" advantage; that is, they get invited to bid in every major drilling activity.  They don't win every contract, but they see them all and if you get invited to the table often enough, you can pick and choose the ones you want to gear up for.  SLB has done that for years, and we believe, they will continue to do so to their shareholders benefit.

Our Dividend Valuation Model says SLB is about 20+% undervalued.  As you know our valuation model identifies how the market has priced SLB's dividend growth over the years.  Right now, even in the face of all the uncertainties related to energy, our model says the company is undervalued and we have been buying it.  SLB has raised its dividend over 10% per annum over the past decade.  Last year it raised its dividend by nearly 19%.  We predict dividend increases in the 12%-14% over the next 3-5 years.

We'll have more to say on the energy situation and opportunities both obvious and not so obvious in future blogs. 

With regard to the Japanese people and the people in the region, we lift up our prayers to God for mercy and resolution of the current travail. 

We own Schlumberger LTD.

Oil Prices: Ouch or Oh No!

As I sat in his chair my barber-economist stated emphatically that, "Four bucks a gallon gasoline will send the economy back into recession."  I told him that he seemed pretty sure about his prediction, and I wondered what he was basing it on.  He said it was simple; in 2008 the economy was humming along and when a gallon of gasoline pushed toward four bucks, the economy just fell apart.

As he began snipping away at the few locks of hair that I still have, he asked, almost as an afterthought, "What do you think?"  My barber is a good guy and he can carry on a conversation on just about any subject with anybody, and I could tell that the hottest topic in the barbershop in recent weeks had been the skyrocketing price of oil. It was also clear that the consensus of my barber and his patrons was that another recession loomed.

As I began to answer, I thought about the proper degree of diplomacy one should display in disagreeing with a man who is both bigger than I am and armed with scissors and a straight edge.  Thus, I began philosophically, which is always a good way to disagree with someone and yet, blame it on someone else.  I answered, "Mark Twain once said that history does not repeat itself, but it rhymes."

Because I did not understand what Mr. Twain was saying the first half dozen times I heard his aphorism, I quickly interpreted.  "Consumers and businesses can adapt to about anything that they have seen before and can quantify."  I continued on for a few minutes by explaining that I had just read an article in the New York Times about how people and businesses were becoming more efficient in their automobile use. Whereas, prior to the rise in gasoline prices a person might do some form of shopping everyday, they were now working more from a shopping list and making fewer trips.  Thus, the total dollars of their purchases was about the same, but the money they were spending on gasoline was lower

He wondered about all the people, such as himself, who did not have a choice in the matter because they had to drive to work everyday.  I said the article explained that even everyday drivers were conserving by minimizing impulse driving on the weekends.

He is not only an economist-barber, but also a fast barber, as well, and he finished my haircut without much further discussion about oil or the economy. I was sitting in my car with my hand on the ignition when an awkward thought crossed my mind: What if he's right and I am wrong?

It may surprise you to know that I think that thought a lot.  I seldom have any serious doubts about the strategies we employ in managing portfolios.  We are conservative and we pay close attention to our valuation models, so we have far fewer sleepless nights than, say, a hedge fund manager or an aggressive growth manager.  Having said that, we still have to take sides on lots of macro-economic issues and the biggest issue we have to deal with today is the rise in oil prices.

As I drove out of the barbershop parking lot, I began an exercise I must have done a thousand times:  computing how much the average family pays for gasoline in a year. If the average family drives about 20,000 miles per year and their automobiles get about 20 miles to the gallon, they will use about 1,000 gallons of gasoline a year. At $3.00 per gallon, the price before the recent run up, they would spend approximately $3,000 per year.  At $4.00 per gallon the average household would spend a thousand dollars more per year.(As I write this, Reuters is reporting that the average family will spend approximately $700 more at current prices.)

We know that the median family income in the US is about $50,000 and in 2010 the savings rate was approximately 6%, or $3,000.  That would mean that there is plenty of room in the average American's budget to pay an additional $1,000, excluding their attempts to economize that the New York Times described.

The problem, of course, is what if consumers decide to maintain their 6% savings rate.  That means they would reduce annual spending on other goods and services by a thousand dollars per family.  History, however, shows us that the savings rate has fallen in almost all of the oil spikes.  Consumers appear to intuitively determine that the oil spike is temporary and they do not dramatically adjust their overall spending.

As I drove down the road, I concluded that neither $100 per barrel oil, nor $4.00 per gallon gasoline would send the economy back into recession. Furthermore, with most measures of the economy pointing firmly in a positive direction, I could not agree with my barber friend, nor those who are predicting an imminent recession.

Driving a little farther, another awkward thought crossed my mind.  If the current regime in Saudi Arabia were toppled and control of their oil fields fell into the hands of radicals, oil prices could go to $200 per barrel and an worldwide economic recession would be much more likely.

When I got back to the office, I did some quick analysis of the relative prosperity of Saudi Arabia versus some of the other embattled African countries.  I found that the average per capita GDP of Saudi Arabia is nearly $30,000 per year.  That is over two times the per capita income of Libya and five times that of Egypt.  There are issues other than income that are causing the revolutions in North Africa, but the average Saudi Arabian is much better off than the citizens of almost any other country in the region.

In addition, Saudi Arabia has formidable military and police forces that are well cared for by the Saudi princes.  It is doubtful that the military would turn on the rulers as they did in Egypt. Indeed, the royal family has it own military.  Finally, the royal family, much to the displeasure of the US and our allies, has funded the Wahhabi Islamic clerics in the country for many years.  Thus, the clerics are not likely to lead a revolt.

Religious tensions do exit between the ruling Sunnis and the minority Shiites Islamic sects. Iran has long been rumored to be trying to incite a Shiite uprising.  Without some complicity by the military or an invasion by Iran it is very doubtful that the Shiites have the critical mass to overthrow the government.

My conclusion is that the royal family in Saudi Arabia will survive and in doing so, should preclude oil prices reaching prices that would produce a worldwide recession.  It is only a guess, but I would say that the odds of the Saud royal family falling are less than one in twenty.

We are in for some very volatile days in the stock market as the serial revolutions unfold in North Africa.  It will take many months for new leadership to form in many of the countries. Also, the civil war in Libya could last longer than most people think.  In the meantime, as long as oil prices don't go up another 50%, I believe worldwide economic growth will continue at near its current pace.

As I said earlier, we have to come down on one side of the impact of higher oil prices or the other.  For the present, after reviewing the available facts, we are taking the optimistic view.  We believe the oil spike is just that, a spike that will later be at partially erased. As events unfold, however, we could change our minds in short order.  If we do, we'll let you know.

If our view of things is correct, any sell off in the market would provide good buying opportunities for many of our current holdings, including some of the purchases we have made in recent weeks.