Tuesday, July 29, 2008

Best of the Rest? Dow Jones Industrial Average

A few days ago, I profiled an eight stock selection of the Dow Jones Industrial Average (DJIA) that I felt would outperform the DJIA over the next couple of years.

The selection was based on using a strategy similar to the Dogs of the Dow, wherein I used high yields to favourably indicate the potential for mispriced stocks in the Dow. I chose eight out of the 16 highest yielding stocks, names that included drug and health care companies, telecommunicators, as well as Coca-Cola, Procter & Gamble, and General Electric. I felt these stocks in the aggregate, would produce a total return greater than the DJIA over the next few years.

Generally, drug companies (Pfizer, Merck) selected have had a long cold winter in relation to any positive changes in share prices, despite numerous predictions and suggestions that these offered good value, relative to their moat and prices. Also, payouts are generally at the high end of the earnings range, indicating limited ability for further upward payouts, itself a negative signalling factor about the intermediate future prospects of earnings growth. While Johnson & Johnson doesn't strictly fit into the same criteria, it's greatest revenues are from it's pharmaceutical division, and therefore the share price growth might be stifled by association.

To some extent, the telecommunications companies have had limited payout increases over the past few years, and this can indicate that their earnings growth isn't as robust as it once was.

This leaves, in my mind, three candidates as offering the best combination of safety, dividend yield and potential growth, and potential share price appreciation.

Procter & Gamble has the lowest dividend yield of the remainders (and in fact was in the bottom half of the Dow 30), and also one of the highest PE's of this group. Therefore, it is felt to be more susceptible to share price pull-backs than some others in the group.

This leaves Coca-Cola (KO), and General Electric GE).

Over the past twenty years, Coke (KO) has been one of the most attractive businesses on the planet. It has proven its long-term sustainable competitive advantage, has enormous brand recognition, and achieved very, very, high returns on equity (30-33% over the past five years) over very long periods of time, with minimal use of leverage. Further, earnings growth, while rarely dramatic, is highly visible going forward.

It currently provides a yield in the upper end of the Dow with, in my opinion, far, far, lower than DJIA average business risk. Wall Street consensus estimates suggest that the earnings in 2009 will be $3.36, versus $2.57 in 2007. The business derives 27% of its net income from the US, with 26% from investments in bottling operations likely adding to that figure marginally - suggesting that somewhere in the order of 2/3 of net income is derived from elsewhere on the planet - a nice hedge if you are concerned about the long term stability of the USD.

The dividend payout ratio has varied over the past five years between 50-57%, with 2007 clocking in at 53%.

All-in-all, Coca-Cola has fallen (earnings risen) to become a relative value proposition, and a potential cornerstone building block for a portfolio.

At a different end of the investment spectrum, we have General Electric (GE). It has been priced by the market as if it is a regional bank employing bank-style leverage and with all the attendant troubled homeowner loans. One only needs to look at the current/forward PE ratio at around 13 in either instance, and the yield of 4.5%, to suggest that the market is pricing it like a bank. I suggest that this diversified giant has been egregiously mispriced by the market.

While the company does have a finance division, the retail finance portion (mortgages, credit cards, etc) comprised only 15% of revenue/net income in 2007, and there is a commercial finance division accounting for 20% of revenue/net income in 2007. In total, only 35% of the company looks like or smells like a bank of any sort and certainly the commercial division can't be considered like a retail bank.

Of the remaining revenues and net income, some 35% of the revenue/net income of GE comes from its infrastructure division - hello market, I thought the world infrastructure market still has a "long-tail" of growth?!

Ten percent of revenues relates to health care, also a growth industry, considering the rapid aging of the Western World in particular, but really, now much more of the world since population growth rates are decelerating world-wide.

Finally, the Industrial division (appliances, industrial equipment) at 10% of revenues, and NBC Universal (10%) make up the balance.

Furthermore, 50% of its revenues are derived outside of the United States.

Sorry, tell me again why this is priced and is yielding like a regional bank?

In seriousness though, earnings have continued to rise nicely over the past five years, from $1.55 per share to $2.20 in 2007, with 2008 consensus estimates at $2.21 and $2.34 for 2009.

Dividend payout ratios have ranged tightly from 50-53% in the past five years and, when measured against cash-flow, even tighter from 34.3% to 35.9%. Dividends have risen nicely over that five year period, with substantial raises every year; five years ago they were $0.77 and in 2007, $1.15. Today, they're at $1.24. Returns on equity are very good, ranging between 17-22% over the past five years.

Overall, this isn't a bank, and it's not a highly cyclical stock warranting a low PE. Two different CEO's have proven it's a pretty good business over the past couple of decades.

In summary, I believe that the GE stock is the most obviously undervalued of the two, but that the business dynamics of Coke provide exceptional long-term peace of mind.

In either case, a dealer's choice of outperformance for the next few years, I believe.

Disclosure: Long GE.

Monday, July 28, 2008

DJIA - Diving in Deeper

I recently profiled an eight stock basket chosen from the 30 stock Dow Jones Industrial Average (DJIA) that I felt would, over the next 2-3 years, outperform the DJIA.

It was essentially chosen using a Dogs of Dow strategy, wherein I used the dividend yield to provide clues to potential mispricings. With one exception (Procter & Gamble), all had yields in the top half of the DJIA.

Certainly, you can't view all of these stocks as a monolithic pick. Generally, the stocks with payouts at high ratio relative to their earnings, had dividend yields at the high end of the range, suggesting that the market considers that either the dividend is at risk itself, or the prospect is for limited dividend increases over the next while.

Having said that however, six of the eight stocks have had meaningful (excluding special dividends) dividend increases in virtually every one of the past five years. The two stocks that don't meet that criteria are Merck and Verizon, with a total dividend increase of under 7% each over the entire five years.

In my view, the dividend payments generally appear safe over the next year or two, given that the lowest yielders have comfortable payment ratios, generally not above 55% of earnings.

For the ones above that, such as Verizon and AT&T, these telecomm's spin out plenty of cash, with cash-flows running at a 2:1 or better ratios compared to earnings over the past five years. This suggests that, even while payout ratios may appear high against earnings, there's plenty of cash spinning off the business to support the current dividends.

In terms of Pfizer and Merck, there's lots of cash on the balance sheet, together with reasonable cash-flow to easily support dividend payments for some time. Nevertheless, given the long winter in drug firm valuations and share price growth, I think you've got to be willing to take a bit of a flyer that the drug pipelines will provide additional earnings growth five years out, if you want to be comfortable with those particular purchases over the longer haul.

Tomorrow, I'll cover the two of these eight stocks that I think comprise the best combination of safety, dividend yield (and dividend growth), and potential share price growth over the next two to three years.

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The Confused Capitalist

Hated: Just about everything!

I took a quick trip over to the StockScouter, which is also a link on my sidebar.

According to the algorithm, there are no stock types liked right now.

Those in the "out of favor" category include VALUE & GROWTH (the only two styles they measure) as well as every stock size, ranging from micro cap to large cap. Virtually every sector is also out of favor, with only Health Care and Consumer Non-Durables managing to make the "Neutral" category.

What's "in favor" in terms of Style, Size or Sector?
Nada, Nil, Nothing, Zero, Zilch ... Yada, yada, yada.

Which, folks, is generally the cue to rummage through the so-called trash, looking for those stock bargains.

Happy hunting!

Saturday, July 26, 2008

Not quite the Dogs of the Dow

A recent article in the paper reminded me of the importance of dividends in outperforming the market. Many academic studies have shown that dividend-paying stocks outperform their non-paying brethren by leaps and bounds over time.

Further to that, I took a look at the current constituents of the Dow Jones Index, and the current yields available there, with the idea that, based on today's share prices, some of the companies are better situated to outperform the index over the next while. Here are the recent stock prices and the most recent dividends payable for each company (sorted by dividend yield):

Stock - Current Price - Dividend Yield (%)

Bank of America - $29.58 - 8.65%
Pfizer - $18.89 - 7.09%
Citigroup - $18.85 - 6.79%
AT&T - $31.40 - 5.48%
Verizon Comm. $34.45 - 4.99%
Merck - $32.68 - 4.65%
General Electric - $28.71 - 4.53%
Home Depot - $23.80 - 3.91%
JPMorgan Chase - $39.52 - 3.85%
Dupont - $43.81 - 3.74%
Chevron - $82.56 - 3.23%
American Int'l. Group $27.24 - 3.23%
Coca-Cola - $52.06 - 3.07%
3M - $70.95 - 2.90%
Johnson & Johnson - $69.03 - 2.72%
Boeing - $63.83 - 2.66%
McDonalds - $58.65 - 2.64%
Procter & Gamble - $64.46 - 2.64%
Intel - $22.01 - 2.61%
Caterpillar - $70.48 - 2.47%
United Technologies - $65.23 - 2.19%
Alcoa - $31.81 - 2.14%
American Express - $36.62 - 2.05%
ExxonMobil - $81.70 - 2.02%
Microsoft - $26.16 - 1.80%
Wal Mart - $56.83 - 1.74%
IBM - $128.53 - 1.63%
Disney - $31.10 - 1.25%
Hewlett Packard - $43.71 - 0.73%
General Motors - $11.90 - nil (dividend suspended)

These stocks have a median yield as represented by Johnson & Johnson/Boeing of 2.68% and a mean average yield of 3.25%.

What I am looking for here is stocks that seem to be mispriced in my favor - in other words, the dividend yield is higher than might be expected, while the prospects going forward over the intermediate term (5 years or so) for the company remain decent or better. Furthermore, I am looking for companies whose future is less likely to be impacted by higher inflation than average - typically, companies that have lower than average CAPEX requirements. Overall, this is an approach similar to a "Dogs of the Dow" strategy.

Leaving aside the prospects for the financial companies, who have an uncertain outlook - to say the least - over the next while, I like the following basket as likely to outperform:

Drug Companies:
Merck, Pfizer
Verizon, AT&T
Coca-Cola, Johnson & Johnson, Proctor & Gamble
General Electric

These stocks have a median dividend yield of 4.59% and a mean average dividend yield of 4.40%.

While I like some of the companies prospects whose dividends lie in the bottom half, I think that their yield indicates that the market likes them a bit too much at present. If their dividend yield were to rise, the following companies might also interest me:

Hewlett-Packard, Disney, Wal-Mart, Microsoft, Intel, McDonalds (good news already priced in).

That's it - we'll check back on this basket at my annual review cycle, versus the Dow Jones Industrial Average ETF "DIA" which is currently priced at $113.17.

Disclosure: No positions held.


The Confused Capitalist

Thursday, July 10, 2008

GE - Looks good to me

Just a quick post here before GE's earnings announcement. It's not often you get to buy a quality company with a 4.6% yield, based on the currrent $1.28 annual dividend payment and current price of $27.64. Nevertheless, GE has good prospects going forward.

Yes, there's some hiccups right now - if there weren't - the stock would be priced at >$45 with a sub 3% yield (like it has been for almost all of the past decade). You don't get to buy good solid companies at high yields very often. Stocks like these, with prices like this, are cornerstones of solid portfolio building.

Disclosure: no position.


The Confused Capitalist