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.

Dividends Are Rocking and Rolling

Dividends have rocked and rolled over the past five and half years.  The question is where will they be dancing from here?

The chart at the right shows dividends paid by S&P 500 companies on a rolling 12 month basis since December of 2005.

For the first three years of this period, dividends rolled higher, peaking near $31.  Beginning in August of 2008, dividends fell like a rock, a move that more than wiped out the gains since 2005.  Since the early part of 2010, dividends have once again reversed course and are now rolling back toward their old highs.  Can this roll continue, or are there more rocks in our future?

Over the last 12 months, S&P 500 companies have paid roughly $25, still far below the nearly $31 all-time high they recorded at the peak in 2008.  However, the red dashes at the far right of the chart show Bloomberg's quantitative estimate of total dividends paid by year-end 2011.  Bloomberg believes that the current roll will continue.  They estimate total dividends for 2011 will reach $29, not far from the all-time high.  Bloomberg also estimates that the old high will be reached by the end of 2012.

If 2011 total S&P 500 dividends paid do reach the $29 estimate, it would mean that dividends would have grown for the year by nearly 21%.  Many analysts estimated that S&P 500 earnings would likely grow at that rate,  however, almost no analyst we follow made such a bold estimate for dividends.  After all, corporations have been fiercely focusing on free cash flows, and dividend payouts diminish cash.

We believe this dividend revival makes complete sense.  Corporations have produced tremendous free cash flows in recent years.  This build up in cash has three main potential uses: 1. share buy backs, 2. acquisitions, and 3. dividend hikes.  The companies we follow have done a little of all three, but they have hiked dividends at a higher rate of growth than we would have expected.  We believe the reason for this has been the growing recognition by many firms that dividend-paying stocks are enjoying renewed interest among many investors, particularly those near or in retirement. In hiking dividends they are just doing what their shareholders want.  I realize this is a very novel idea -- that a company would do what its shareholders want -- but we believe that is exactly what is happening.  There are some firms that have hiked their dividends two and three times in the last twelve months.  Activity of that kind is not an accident.  They know what they are doing and they have the cash flows to afford it.  We believe this dividend roll will continue.

If dividend hikes have been on a roll and stock prices follow dividends, a theory to which we subscribe, then current stock prices may roll a lot higher.  We would not be surprised to see them back to their old highs seen in 2008.  This won't happen in the next six months, but we can see it occurring by the end of 2012.

There are certainly all kinds of worries to contend with, but having a positive outlook is sometimes the best strategy when everyone seems to be throwing rocks at the market's prospects.

A Lot of Bullet Points That Add Up to Stocks Being Higher by Year-End

Summary Points:

• Continuing to assess stock market outlook – balance still positive
• Recent pullback in stock prices has been moderate on low volume

Discussion

The Donaldson Capital Management Investment Policy Committee continued our review of economic data and forecasts for the year. While the economic headwinds are much in the news, it is our experience that positive events get less play in the media than negative ones. To try to identify an appropriate balance, while recognizing that items listed are not all equal in impact, we built our own list of significant headwinds and tailwinds.

 Headwinds

• QE 2 ends this month.
• The May new jobs number came in way below trend.
• The European Economic Community has not yet solved the Greece problem.
• Consensus 2011 global GDP growth expectations have dropped 0.5% or so.
• National average house prices are still dropping.
• The unemployment and “functionally unemployed” rates have ticked higher.
• State and local governments are still eliminating jobs.
• Savings rates are high, potentially reducing consumer spending.
• Gas prices are ~$1/gal. higher than a year ago.
• Congress has not passed a solution to the Deficit and Debt problems.
• Regulatory uncertainty exists in regards to: health care, taxes, and banking.
• 3/11 Tsunami had bigger effect on supply chains than was previously thought.

Tailwinds

• Reported corporate profits remain strong.
• Estimates for 2011 corporate profits have held, despite economic headwinds.
• GDP growth outside the U.S. and Europe remains robust.
• Capital asset purchases (e.g. trucks, cars) are recovering significantly.
• Banks are seeing a slowing of defaults on mortgages and credit card debt.
• The weaker U. S. dollar is boosting U. S. exports.
• A debt default by the U.S. is seen as very unlikely by most economists we follow.
• Stock values (price/earnings) are now lower than the 80-year average. No bubble
• About 50% of S&P 500 sales come from faster growing, non-US economies.
• Crude oil and gasoline prices are dropping from recent highs.

The Committee also reviewed a discussion by The Bank Credit Analyst of the US economic outlook. BCA is a Canadian firm (which we believe gives them objectivity about the U.S.) that we’ve followed for many years. Their analyses are well reasoned; they do not rant or get emotional; and, they use data to develop and explain their views. A synopsis of their June 8 presentation follows:

• US growth will accelerate later this year.
• Tsunami-related supply chain problems are easing.
• The savings rate is high, but slowly dropping, benefiting consumer purchases later.
• Housing is too low to sink much further, reducing its drag on the economy.
• US structural deficits are only about 5% of GDP, more manageable than many think.
• The US tax/GDP ratio is the lowest in G-20, encouraging economic growth.
• The US has added more than 1.3 million net new jobs over the past year.

The Committee was concerned about the Fed’s recent lobbying for the 35 largest banks to raise their Tier 1 capital levels from 7% to 10%. This will continue to put pressure on bank stocks in the near term because of the potential dilutive effects of big equity underwritings. So far, this is still in the talking stage, and the banking industry is pushing back very hard. It remains to be seen how this will play out, but for the moment it has already been priced into the stocks, so any softening of the Fed’s position should provide a quick lift to the banks.

Although industrial stocks have dropped more than the S&P 500 lately, most industrial companies continue to have very bullish outlooks for 2011. CEO Sandy Cutler of Eaton Corp (ETN), for instance, is very confident his firm will see 14% revenue growth with earnings growth much higher than that. Many of Eaton’s customers delayed purchases of expensive capital goods during the recession, but these customers are now back in the market because the average age of their equipment has reached multiyear highs, causing repair costs to jump. This same dynamic is playing out across the spectrum of a number of industries.

Unemployment remains stubborn. Historically, however, the correlation between increased corporate profits and increased employment is very tight. The two trends separated during the recession. However, the average work week, especially in the industrial sector, has extended to the point where more overtime just may not be possible. The longer corporate sales volumes and profits grow, the more pressure there will be for businesses to increase hiring.

While major new negative developments in the Middle East, a major economic slowdown in China, or a fiasco on the debt limit in Washington D.C. could turn the 2011 outlook decidedly negative, we don’t consider any of them as having a high probability at this time. Our views are echoed by the economists and strategists that we follow. The market pullback over the past six weeks – the first six-consecutive week pullback in 10 years – has been relatively modest, less than 5%. Finally, trading volumes have been relatively light, potentially indicating there is not a lot of urgency in the selling.

After considering all the above, the Committee is holding to its outlook for stocks to return 5% - 10% for all of 2011. Of course, we will continue to monitor the data and the economic and political environments.

Edited by Randy Alsman

Greg Donaldson Mike Hull Rick Roop Randy Alsman

We own many industrial stocks including Eaton.

If Analyst Estimates Are Correct, Stocks Are a Buy!

A year ago the stock market fell into a deep swoon buffeted by troubles in Greece, worries about a double-dip in the US economy, and the prognostications by many analysts that the Federal Reserve was powerless to stimulate growth.

The red line on the chart at the right shows that in 2010 the S&P 500 fell from about 1250 in April to under 1050 in June, nearly a 20% plunge.

Reading the headlines today and watching the recent activity in the stock market, one gets the feeling that we've seen this movie before. Greece is still in danger of default; economic growth in the US slowed to 1.8% in the first quarter; and the Fed has just announced that QE2 will end at the end of June.  So the obvious question is, "Are stocks headed for another 20% correction?"

We don't think so and we believe the above chart provides the best argument against a big sell off.  We explain ad nauseum that what stocks are doing in June has little correlation to what they will do for the full year.  The chart shows that stocks reversed their 2010 April-June tailspin and recovered to close over 15% higher on the year.  Those investors who sold out in the midst of all the negative blab in summer missed a terrific year for stocks.

Was there any signal last summer that told us that the stock market swoon was just noise?  Yes, analysts earnings estimates for year-end 2010 for the S&P 500, as shown by the black dashed line, never dipped.  Indeed, for most of the summer the analysts were hiking S&P 500 earnings in the face of falling stock prices.  Looking closer, the chart reveals that analysts started the year estimating that S&P 500 earnings (left scale) for the year would be about $77.  They actually ended the year at about $85.

Another clue that stocks, and for that matter the economy, were not headed for a double dip was the fact that actual reported earnings, as shown by the blue stair-step line, were moving sharply higher.

Obviously we could not have seen year-end earnings in mid 2010, but earnings in the first and second quarters were strongly and surprisingly higher.  It was clear by early July that a big earnings rebound was underway.

So where do we stand today, and what are the analysts forecasting for year-end 2011 S&P 500 earnings?  The chart at the right shows the 2011 data discussed in the first chart.

In short, the picture for mid-June 2011 is similar to mid-June 2010.  Stocks (red line) are selling off, while actual earnings (blue line), and analysts' year-end earnings estimates (black dashes) are continuing to rise.

In our judgment, the key component in this chart and in the ultimate direction of stocks is the trend of the analysts' earnings for year-end 2011.  They have risen throughout 2011 and are still trending higher.  The analysts are in close communications with the companies they cover, and if they were hearing bad news from the companies their earnings estimates would be already headed down.  We see little evidence of weakening earnings estimates among the companies we hold.

We will continue to report on the analysts' estimates for 2011 in future blogs.

This is a good time to remind our readers that we invest in global companies and not just the US economy.  Our companies produce over 60% of their earnings outside the US, with much of it coming from the fastest growing nations in the world.  We as Americans still have great difficulty conceptualizing that the US now represents only 25% of world GDP.  The global economy has become a very big place, and we no longer dominate the world's economic growth like we once did.  The good news is the world economy is growing much faster than that of the US.

If corporate earnings continue to be strong, as we believe they will, we envision that stock market activity in 2011 might turn out to be a movie that we have seen before -- down in the summer, up by year-end.

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.