Wednesday, August 20, 2014

The ABC’s and XYZ’s of Dividend Investing

Let’s face it dividends are no longer a novelty.  They were very much so when we began writing this blog in December of 2004.  Thus, over the last ten years, a time when stocks have experienced both ecstasy and agony, many investors have come to understand the value of dividends as central to their investing strategies.  We have written a number of articles on the ABC’s of dividend investing, so some of this blog will be repetitive, but hang in there, when we get to the XYZ’s you’ll hear some new thoughts and tactics.

The two data points we discovered in the late 1980’s that really got our attention and set us on the road to becoming pure dividend investors were the following:    
  1. Since 1960, dividends have produced nearly 40% of the total return of the Dow Jones Industrial Average (DJIA)
  2. DJIA dividend growth during that time has averaged about 5.7%, and price growth has averaged near 5.9%.
When we first saw these two data points, it created a kind of eureka experience for us.  The fact that dividends represented such a high percentage of DJIA total return said that if we paid attention to dividends they gave us a 40% head start on achieving an attractive long-term return.  In addition, the remarkable similarity between the long-term average DJIA price and dividend growth had all kinds of implications.  When we first saw it, we realized in an instant how important dividend growth was to total return. 

Yet, with the numbers being so similar, there was a humongous thought that seemed almost too good to be true:  if the average annual rates of growth of DJIA dividends and prices were so similar, were they also highly correlated.  If they were, that would help to explain the other 60% of the DJIA’s total return because if the statistical significance of the correlation between dividend growth and price growth were high enough it would give us a tool to predict price growth.  To be more specific, if what is known as the coefficient of determination (R^2) were high enough, then so goes the dividend, so goes the stock.

Minutes after this thought went careening though our minds the answer was appearing on our Excel spreadsheet.  The coefficient of determination, or R^2 was nearly .90 (one is a perfect correlation). Over the last 54 years, dividend growth had been able to predict nearly 90 percent of the annual price growth of the DJIA. This is a fact that few people who consider themselves dividend investors are aware of.

The chart for this statistical study of dividend growth and price growth is shown below.
Dow Jones Industrial Average Price vs. Dividend
Since 1960
But, just as fast as this eureka occurred, another finding diminished our grand hopes.  Even though the cumulative prices of the 30 stocks in the DJIA were highly correlated with their cumulative dividends paid over the years, there were few of the individual members of the Index that had as high a correlation as did the DJIA itself.  In fact, only about eight of the companies had statistically significant correlations between their prices and their dividends.  

With such a short list, we turned to the S&P 500.  The S&P 500 prices and dividends were not nearly as highly correlated as was the case with the DJIA.  Nevertheless, when we ran correlation analyses of the 500 stocks in the Index, we found nearly 125 that had very solid correlations between prices and dividends, and many of these stocks were giving us buy signals on the basis of this simple correlation analysis.

For many years, we puttered around with our price-dividend models with some success.  Then came the mid-1990s and all the correlations fell apart.  Stocks price were growing at a much faster rates than were dividends.  Modern Portfolio Theory was in full swing by then and the wizards of academia were saying that share-buybacks were a more efficient way to reward shareholders than cash dividends because the former would be taxed at the then lower capital gains rate, while the latter would be taxed as ordinary income.

For almost the next six years, our correlation models gathered dust.  They were saying that stocks were significantly over valued as early as 1997, well before the Tech bubble was in full view.  During this time, we relied on our dividend discount models to ascertain buy and sell signals and used predominatly stocks with above average dividend yields and solid dividend growth in our portfolios.   

This first part of the story is what we call the ABC’s of dividend investment.  It identificed the importance of dividends in total return and lead us to stocks with higher than average dividend yields and solid dividend growth. We used these tools successfully for many years; then things changed, and we went looking for another valuation model to pinpoint over and undervalued companies. Between 2000 and the end of 2002, we learned a very hard lesson: estimates of future growth aren't guaranteed, indeed, sometimes projected dividend growth become actual dividend cuts.  
In early 2002, with stocks down from their highs of 2000 nearly 40%, almost by accident, we stumbled again onto our old correlation models.  As we ran correlation analyses of the S&P 500, we found company after company was significantly undervalued, many by as much as 25%.  The big sell off had pushed stocks too low relative to their dividend growth during this time.  As the year wore on, our confidence that our old correlation model was telling us the truth about the market steadily increased.  The main reason was that companies in a wide range of industries, from banking to capital goods to energy, were hiking dividends at an impressive pace.  The market was ignoring the hikes, but these companies were signaling with their dividends that their business was good and improving. In addition, there was a lot of talk about President Bush’s tax break for dividends.

Since we had not used the correlation model in several years, we called in consultants and statistical experts to look at our models and tell us how much we ought to trust the data we were seeing.  All the consultants were quick to warn us that correlation does not equal causation.  In essence, something other than dividend growth might be the real driver of the very high correlations that we were seeing. Interest rates had been falling, so we added interest rates to the formula.  In fact, we added just about everything we could think of to the formulas to ascertain what else might be driving the high correlations which revealed that stocks were undervalued.
In the end, only dividend growth and interest rates remained in the formulas for most stocks, and the story they told was clear: stocks were cheap.  As a witness to how convincing the data were, both consultants became clients and remain so to this day.
The real XYZ story, however, did not become apparent until late 2003.  Gradually our weekly correlation run, which took four and half hours to complete, showed that the companies with the highest correlations between their dividend growth and price growth were not the high-yielding stocks that we had traditionally used, but the companies with lower yields and faster dividend growth.
That trend has continued through the present.  In most cases, even during the 2008-2009 banking crisis, many of these faster growing companies had continued to hike their dividends at double digit rates and their prices have responded in kind. 

The following charts show the price-dividend correlations for four stocks: Praxair, Union Pacific, ONEOK, and Nike. All of these companies with the exception of ONEOK are XYZ stocks. They have yields as low as 1.2% for Nike but have generated double digit dividend growth over the last ten years.  

The first stock is Praxair (PX). PX is an industrial gas company with a remarkable 20 year record of rising dividends and prices. The chart is a scatter plot which shows dividends along the horizontal axis and stock price on the vertical axis. Importantly, look at the mathematical formula at the top of the chart. On the second line is the R^2 of the fit between PX's dividend growth and its price growth. That right! PX's dividend growth has been able to predict 98% of its price growth over the last twenty years. At present, the graph is showing that PX is at about fair value. However, if we use estimated dividend growth for 2015, the stock is a bargain.

Praxair (PX)
The next stock is Union Pacific (UNP). UNP is one of the largest railroads in the U.S. It has about a 2% current dividend yield. It has not had quite the twenty-year performance as has PX, but again it has a very high R^2 at .94 and the stock is about fairly valued. As with PX, using next year's numbers makes it a bargain.

Union Pacific (UNP)
Next, for those of you who insist on higher yielding stocks, ONEOK (OKE) may be your choice. It has a 3.4% current dividend yield and has increased its dividend over the last five years at a high double digit rate. OKE is one of the largest pipeline companies in the U.S. Their management team has taken bold steps to solidify their position as an important player in the oil and gas fields. Their R^2 is .98. OKE appears to be about fairly valued, as well.

The last stock is Nike (NKE). You may wonder how in the world NKE can be counted at a dividend stocks. Well it may not be an old fashion ABC dividend stock, but it definitely is an XYZ dividend stock. Its current yield is only 1.2% but its dividend has grown at near 14% per year over the last fiver years. Nike has a .95 R^2, but with the price nearly $10 above fair value is not a bargain. Neither does it become a bargain when we add next year's projected dividend hike. However, it then becomes about fairly valued and thus, we continue to hold the stock.

Nike (NKE)

So there you have it. The ABC's and the XYZ's as we describe them in our dividend world. The ABC's might be considered the more traditional higher than average dividend yielders with long histories of hiking their dividends at modest rates. The XYZ stocks are those with average or below average dividend yield but with much higher than average dividend growth. In addition, these stocks are highly correlated to their dividend growth, usually over the long term.

In general, we believe most traditional ABC type stocks are fairly valued, or even a bit overvalued. On the other hand, we are find many bargains in the XYZ stocks. We'll talk more about them in coming blogs. Happy hunting.

Clients and employees of DCM own all of the above listed stocks. Please do not use this information for stock selection purposes. Please consult your financial professional.

Monday, July 28, 2014

This B-U-L-L Market Is Getting L-O-U-D

Throughout the history of the U.S. stock market, there have been many bull and bear markets. Studying these market cycles can teach investors a great deal about how the market behaves and the underlying reasons behind it.  If you can identify the driving forces of a bull or bear market, you can make more intelligent decisions to either protect yourself against a looming bear market or take advantage of a bull market.

In the 20-year history of our firm, we’ve seen several of these market cycles and have studied countless others.  While no bull or bear market looks exactly the same, the past provides us with useful insights about the future.  In the words of Mark Twain, “History doesn’t repeat itself, but it does rhyme.”

Today, we are going to see how the current bull market “rhymes” with years prior and what information we can gather from its historical patterns.

Anatomy of a Bull Market

The anatomy of almost all bull markets can be broadly defined by four primary characteristics that make up the acronym B-U-L-L, which you can read more about here.

1. Breadth
2. Unrelenting
3. Leadership Rotation
4. Loud

The “Loud” part of the equation is of particular interest in today’s market.    Bull markets attract a lot of attention from media and Wall Street.  Everywhere you turn, it seems like you hear about the stock market.  The local newspaper, CNBC, Wall Street, and even outings with family and friends can turn into investment discussions.

That’s typical of bull markets.  They grab you and force you to pay attention.  For all of those investors who have been out of the market since 2009, the run-up in stocks over the past five years has shown them just how wrong they have been.

Bull markets attract their fair share of commentators on both sides of the fence.  Some say the bull market will keep going, while others continually predict it’s demise.  The longer the bull market goes, the louder the shouting on both sides become.  Amongst all of the noise, it’s difficult to discern between what is truly relevant information and what is just that - noise.  

A lot of the chatter lately has been speculation about when the current bull market will end.  If you look back on nearly every bull market we have ever had in the United States, you will find that the vast majority of them don’t die of old age, they are killed.  There are two primary killers of bull markets:

(1) Recessions

Pullbacks and corrections can occur at any time, but it is really difficult to have a real bear market unless there is an economic recession that negatively impacts company fundamentals.  Remember, prices will always follow valuation in the long-term.  So if long-term values are increasing, the long-term trajectory of the stock market should also be increasing.

The majority of the data we see coming out of the economy have been very positive.  We thought the Q1 economic data were mostly weather-related, which turned out to be correct.  Employment numbers have improved significantly.  The economy has now added at least 200,000 jobs for the past five consecutive months.

As the economy starts to heat up, we should see increased activity from consumers and better sales growth for U.S. corporations.  Unless there is an unforeseen major geopolitical issue or natural disaster that disturbs the global economy, neither our Macroeconomic Team or the economists we follow foresee any recessions on the horizon.

That leads us to the second major killer of bull markets...    

(2) The Federal Reserve  

In the absence of any major economic shocks, the Fed is the primary suspect in the death of most Bull Markets.  

When interest rates are low, investors look outside the safety of U.S. Treasuries and into more traditionally risky assets such as stocks.  As the stock market increases from the inflow of funds, people begin to experience the “wealth effect” from watch their account values go up.  As consumers feel more wealthy, they increase their spending, which puts upward pressure on capacity.  To meet the rising demand, businesses hire more people and invest in new factories and technology to push up supply. When the Fed raises interest rates, the opposite tends to occur.

Even when the Fed raises rates, however, the stock market has historically been very slow to respond. Looking back to previous bull markets, it has taken several months of interest rate increases before the stock market has had any meaningful reaction.  This is not to say that this time will be the same - but it does contradict the widely held belief that the stock market will be hurt by the Fed raising short-term rates in the coming year or two.  Using history as our guide, that just doesn’t seem to be the case.

Furthermore, the small body of evidence we have about Federal Reserve Chair Janet Yellen suggests that she isn’t going to be quick to raise interest rates. Yellen believes wholeheartedly in the Fed’s dual mandate of both maintaining price level control (inflation) and in promoting employment.  As long as the economy continues to have above average unemployment, it is very likely that Yellen will push the Fed to keep rates low.  And as long as rates stay low, there is nowhere for investors to go but stocks.

When Is The End?

While we would consider ourselves to continue to be optimistic about the future of stocks, we certainly are not raging bulls.  We know that all bull markets must come to an end at some point, we just don’t believe that will happen in the near-term.  

While no one can know for sure when the bull market will end, there are often signs that start show up ahead of time.  One of the things we look for are the “one percent days.”  If stocks start moving up rapidly with a series of these large increases, that is likely a sign that Mr. and Mrs. America are starting to get tired of sitting in cash.  As they pour into the market, the buyers dry up and leave nothing but sellers.  On the flip side, a long string of negative one percent days typically indicates that the market is going through more than just a batch of profit taking.

We get a lot of questions about what we would do if we sense weakness in the market.  When we see potential trouble on the horizon, we don’t just immediately move to cash or try to time the market. We find it in our clients’ long-term interests to “take air out of the ball.”  

If things were to get rowdy, we would strategically reduce more volatile positions (“A” stocks) and look to add more “Royal Blue (RB)” stocks to stabilize our portfolio.  This does two things: (1) it reduces the volatility of our portfolio and (2) provides solid earnings growth and dividends to get our clients through the worst of the storm.  In bad markets, the RB stocks become defensive strongholds.  They are so big and strong that they can absorb huge amounts of shock without damaging the intrinsic value of their businesses.

Current Outlook

At this moment, we don’t see much sign of weakness. Despite the geo-political issues in Russia, the market has continued to move higher.  If shooting planes out of the sky doesn’t spark even a small pullback, that’s a pretty strong indicator that the market can continue to drive north.

Valuations for some companies are getting frothy, but the overall market is about fairly valued and well within its normal statistical range.  With interest rates so low, even higher valuation multiples than we are currently seeing would not be out of the question. While that’s a possibility, we don’t anticipate getting any additional return from valuation multiple expansion.  

In our opinion, stocks are likely to return what they generate in net earnings and dividend growth over the next 6-12 months.  If Q2 earnings are any indication, growth is starting to accelerate along with the economy.  As long as the companies continue to be the stars that they have been, this bull market still has strength to keep charging on.

Wednesday, July 09, 2014

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Thursday, June 19, 2014

Fixed Income, Part I: Relationship Between Interest Rates & Bond Prices

With interest rates at historic lows, and the Fed saying they will keep short rates low for an “extended time,” there is much confusion among financial pundits as to where interest rates and bond prices are headed in the coming years. With so much disagreement among the experts, many of our clients have asked that we provide an in-depth discussion of our views on inflation and interest rates, and the path these rates may follow in the coming years.

Although we regularly answer these questions in our client meetings, using our blog allows us to quickly explain our current views and strategies to a larger audience.

This particular series of blogs focuses primarily on the bond market; beginning with the basics before tackling the more complicated issues.

The format is Q&A. The first installment is a brief analysis of the fundamentals of bond investing, which we hope will build a solid foundation of understanding as we move forward. Nathan Winklepleck, co-editor of the blog, has assembled a list of our most frequently asked questions. He will serve as the moderator for the Q and A and will ask Joe Zabratanski our Senior Fixed Income Manager and Greg Donaldson our Chief Investment Officer to provide answers and commentary.

Q: Nathan: We have received several questions from clients about the impact of changing rates on bond prices.  Could you explain the relationship between interest rate fluctuations and fixed income prices?  How and why does one influence the other? 

Thursday, May 22, 2014

Economic Indicators Point to Slow, Steady Growth in Economy & Stocks

We have several economic metrics that we follow very closely at DCM.  These indicators give us a peek into the health of the economy and indicate where we may be headed.  We want to share three of those indicators with you and provide an overall outlook on current U.S. economic conditions and what they might mean for the stock market for the remainder of 2014.

1. After-tax Profits

The price of the S&P 500 index (blue line/right axis) plotted against after tax profits for the entire U.S. market (red line/left axis), which is measured in trillions of dollars.

Of all the indicators we watch, this one might be the most compelling argument for the strength of U.S. corporations.  After-tax profits reached a high around $1.4 trillion in late 2006 before their sharp decline during the Great Recession of 2008-09.  Today’s levels are well above where they were pre-2008 and show no signs of slowing down.  Companies are operating with incredible efficiency.  Many of the companies we follow can produce as much or more than they did prior to the Great Recession with significantly fewer employees. While this hasn’t been good news for employment (more on that in a minute), it is very positive for corporate earnings.

Tuesday, May 13, 2014

John Burr Williams and Chickens For Their Eggs

This is the third blog in a series exploring the theories of John Burr Williams. You can read the first post here and second post here.

In Part I of this series, we quoted Arnold Bernhard, founder of the Value-Line Investment Survey, as being an early advocate of the theories of John Burr Williams.  He agreed entirely with Mr. Williams’ belief that investors needed a generally accepted valuation criteria. He also joined Williams in warning that the effects of not having such a methodology had resulted in excess stock market and economic volatility over the years that had damaged investor confidence not only in the stock market but also in the free markets.
Bernhard boldly stated,
“In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock.  Whenever, over a period of years, the dividend or the ability to pay dividends, went up; so too did the price of the stock.  When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.”  
In applauding John Burr Williams’ theory; however, Bernhard inserted a subtle twist to Mr. Williams’ basic premise by adding the words, “ . . . or the ability to pay dividends.”  By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value.

Thursday, April 24, 2014

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.