The Influence of Dividends

Borrowed the chart below from this article. The graph suggests the dominant influence of dividends on stock performance over time.

Since 1871, dividends account for more than half the nominal gains in the S&P 500 Index. Today many folks shun dividends in search of capital gains. Over time, however, capital gains have accounted for less than 2% of the 8.8% annual return.

Parenthetically, note that there was no inflation prior to the mid 1910's. The Federal Reserve Act was passed in 1913.

Before running out and loading up on dividend paying stocks right here, keep in mind that average dividend yields rest at the low end of historical benchmarks. Current yield on the SPX is about 2%. Historical buying opportunities in stocks have typically corresponded to aggregate yields in the 5-6% range or higher.

While there may be special situations here or there that are paying outsized dividends, I'm trying to remain patient for much higher dividend yields in aggregate before 'buying the list.'

position in SPX

Bearish End of Week Action

Late week action, including a -2.5% day for quarter end on Friday for the SPX, left weekly chart with a bearish looking 'inverted hammer' bar. The Fri close was a few handles above the 1120 level that has been challenged multiple times over the past couple of months.

Am having an increasingly difficult time visualizing the 1120 support level holding. Technically, we know that support tends to weaken a bit more each time it is challenged (as another layer of demand is stripped away). Combine this with rich aggregate valuations and an increasingly ugly macro picture and you have the recipe for lower prices.

Chart gazing suggests the 1025-1050 area as the next layer of support below. After that, 950.

I did kick some incremental short side trading exposure added early in the week in the Fri after hrs session (indexes drifted a bit lower after the regular session closed).

How they trade early next week will dictate next move...

position in SPX

Sold MSFT Position

Unloaded my Microsoft (MSFT) position into this morning's lift. This position was built ahead of the signing of the debt deal. MSFT was trading well in a drekky tape and the thesis was that any relief rally would find MSFT leading the way higher.

Instead, the debt deal was met with a nasty sell off, and renewed probs in the EU opened the trap doors. MSFT went down the drain w/ the tape. Important lesson: a stock can trade great...until it doesn't...

After lugging this position thru the morass of the past two months, I feel fortunate to have salvaged a profitable shekel or two on the trade.

MSFT is now back up to where is was before the collapse. Can it go higher? Fer shure, dude. But resistance looms directly above, and to me there's more downside than upside in the name.

Although I became bullish on MSFT on a valuation basis early in the year, I have revised my view given the darkening macro context. That context has me thinking that MSFT is no great value here, since a slower economy may drag cash flows significantly lower.

MSFT's current enterprise value is about $190 billion. My interest will be rekindled if EV reaches gets down to the $120-130 zone, or 1/3 off the current price.

no positions

Cisco's Strength

Cisco (CSCO) has been trading with relative strength of late. Traders seem to be perking up to this. A couple opined that perhaps CSCO is about to break its year long downtrend.

Chartgazing suggests that we're still a buck away from such an event. The downtrend line and the 50 day moving average are tracking almost exactly right now.

Am currently carrying a pretty sizable CSCO position. In past posts I have laid out the fundamental and valuation thesis that has made me bullish. The last couple of months, however, have brought me visions of 2008, where even stocks of good value are likely to be sold if we encounter a broad deleveraging event. I assign the chances of this scenario as pretty good over the next few months.

As such, I plan to lighten my CSCO position into strength. Should CSCO approach that $17.50ish area, I'll be making significant sales.

position in CSCO

Nice General Market Valuation Piece

Fine weekly note by John Hussman. Particularly noteworthy was the 'Valuation Review' section. I continue to view John's work on general market valuation as among the best.

Note the graph that plots projected 10 year projected annual return of the SPX versus current SPX price level. Today's level of about 1200 projects to about 5 1/2% annualized.

To achieve projected returns corresponding to the oft cited 10% historical returns of stocks would require the SPX to be at about 800.

As Dr J observes, those rare secular buying opportunities (e.g., circa 1982), those that correspond to single digit P/Es and 6-8% dividend yields correspond to an SPX of 400.

John notes that while this may seem 'utterly ridiculous,' historical evidence suggests otherwise.

position in SPX

Segmenting Financial Markets

Marketing managers learn early about the value of segmenting their markets. Segmenting involves identifying categories of buyers so that markets can be better understood.

I've often wondered why investment managers don't make a habit of segmenting. In his letter last week, John Hussman takes a shot at it. Dr J proposes four categories of investors and their influence on supply and demand in the current market dynamic.

Fundamentally oriented long term investors are value conscious investors with time horizons of a decade or more. They prefer to buy stocks when valuations are at secular lows. At secular bear market troughs, P/Es have historically fallen to the 4-6 range and dividend yields rise to 5-6% or higher. While stock prices are off 10% from their highs, aggregate valuations are still far from the levels that suggest deep value. As such, fundamentally oriented long term investors are not likely to be a major source of buying demand at current levels since prices do not yet look intriguing to this group. If markets continue to fall, then this group is likely to scale bids as prices suggest compelling value.

Fundamentally oriented short term investors are value-conscious, but in what Hussman calls in an 'erroneous and myopic' way. This group often takes cues from forward P/E multiples which often provide deceptive signals of value. Forward multiples tend to be overly optimistic and cause this group to buy much higher than the long term group discussed above. They are likely to see recent price declines from last month's highs as a buying opportunity. Thus, this group surely constitutes one source of demand currently.

Technically oriented long term investors look at long term chart patterns and other technical indicators to assess secular bullish and bearish trends. Currently, this group is undoubtedly quite concerned over multi-year breakdowns in index and individual stock uptrends. In fact, as prices broke through major support levels, this group was more likely to be a source of supply as sell stops were elected below these support levels. Currently this group is trying to assess direction of the next multi-year trend. After the major damage that has occured in many technical indicators, technically oriented long term investors may be prone to see the next multi-year trend as being lower. Thus, this group may be a persistent source of supply from these levels.

Technically oriented short term investors are also chart watchers, but their time horizon is measured in hours, days, or weeks rather than in years. After the meltdown in prices over the past week or so, many in this group saw markets as oversold in the near term and due for a bounce. This group has likely been a major source of demand over the past few sessions.

I find this a useful framework for determining who may be on either side of the trade currently.

Which of the four 'buckets' do I fall into? Well, under this scheme I participate in multiple categories. While I my strength and interest is primarily as a fundamentally oriented long term investor, there has been little for there to do from the long side. As such, I have been attracted to shorter term fundamental and technical opportunities. For example, I was buying them in the hole last week into what appeared to be an oversold market in the near term (technically oriented short term investor category).

Of course, that source of demand has already become a source of supply as I have been piecing out inventory as prices have moved higher...

Personally, I'm trying to once again elongate my horizon as the short term space seems pretty crowded.

position in SPX

The Sentiment Cycle

Anyone looking at a chart of stock prices can see that markets move in ebb-and-flow cycle patterns. In fractal-like fashion, cyclical patterns reveals themselves across various time frames--from granular minute-to-minute action to secular decade-long swings.

The nascent field of socionomics equates cycles with changes in 'social mood'--alternating periods of collective optimism and pessimism that cause investors to run with the pack (a.k.a. 'herd behavior').

Here is an interesting diagram that reflects various emotional states as a market cycle progresses. Note that extreme optimism is associated high risk. This is because euphoria has driven investors to bid up prices. At some point, extreme optimism reverses as do prices.

This model suggests that best value is obtained at lows in the sentimental cycle. Extreme pessimism drives investors to sell and to stay away from assets marked way down.

I personally find it useful to overlay these concepts on my fundamental analyses. For example, a question that I've been asking myself over the past couple of weeks is where on the diagram is general stock market sentiment currently?

We entered a bullish uptrend off the March 2009 lows. Since then, markets have been rising on increasing optimism. This has been a strong bull run, with major indexes like the S&P 500 (SPX) up nearly 100% off the lows. Now, however, the uptrend is more than 24 months old and general market valuations are extremely rich. Technically, we're approaching a level (SPX 1250) which, if decisively pierced, would reflect a trend change.

From where I sit, collective sentiment may have topped out at 'Euphoria' at the end of April (approx SPX 1370). Investors are currently at 'Anxiety' after a 7% decline from the highs. If correct, then we have more work to do on the downside. Stages of fear, panic, capitulation (e.g., 'forced selling') lie somewhere ahead. I have been trying to position accordlingly.

I'm not totally pessimistic, however, as some individual names have been beaten down to the point where the negative sentiment coupled with interesting fundamentals suggests value. Cisco Systems (CSCO) is one of those names.

Over the past few months, CSCO has reversed nearly all of its gains off the 2009 lows as recent quarters have fallen short of expectations. Sentiment in this name is horrid, and portfolio managers have been busy unwinding positions in CSCO as prices go down.

Our diagram, of course, suggests that extremely negative sentiment is likely to wring risk out of a security. Pessimism encourages selling over buying. All else equal, the lower the price of a security, the better the value.

I happen to believe that CSCO's competitive advantage is still intact and durable. Using similar reasoning to my entry into this name, I now think I can buy a large multinational company with a durable franchise, strong balance sheet, and $9 billion in free cash flow, that I conservatively value at $90 billion, for a market price of about $60 billion.

The risk, of course, is that the fundamentals of the company have been permanently impaired, and markets are in the process of revaluing the franchise.

Could be, but the current disparity (market says it's worth $60 billion; I think it's worth $90 billion), gives me a decent margin for error in my assessment.

position in CSCO, SPX

Selling Strength

Am moving into 'sell strength' mode in my personal accounts. While I believe that there is some value in select large cap stocks, there are just too many negative factors that, in my view, serve as headwinds against higher prices here.

Beyond the myriad macro factors (debt, EU, Mid East, etc), overall metrics suggest conditions of extreme stock market valuation. Couple that with the pending end of QE2 and one has to wonder what will keep stock prices levitating at nosebleed levels.

I have therefore been trying to use price to my advantage to unwind some risk. Sold positions in Intel (INTC) and Merck (MRK) yesterday. On further strength, will likely do same for Johnson & Johnson (JNJ). All of these stocks have had nice 15-20% moves off their spring lows and are trading near the upper end of technical band tags.

Should the price action in Cisco (CSCO) and Microsoft (MSFT) strengthen, I may make some partial sales here as well although I still perceive some value in these names. Currently, however, neither of these stocks can get out of their own way--which may be telling in and of itself.

If commodity prices strengthen, then I will likely lighten up on a number of related ETFs although I plan to retain a core position in the SPDR Gold Trust (GLD).

Hard not to eye the action in the general indexes without wondering whether we're putting in a significant top. First near term confirmation of such in the SPX would be a decisve break of the multi-month uptrend line (1330ish).

positions in CSCO, MSFT, GLD, SPX

The Case for Extreme Overvaluation

This analysis provides insight into the general relationship between aggregate stock valuations and long term returns. The study indicates a strong relationship between real returns and the level of valuation at which an investment is made.

The chart below captures one presentation of the results.

Essentially, the proposition goes like this:

The higher the market P/E ratio when an investment is made, the lower the return over the next decade.

The same thing holds true when dividend yields are low:

The lower the market dividend yield when an investment is made, the lower the return over the next decade.

This analysis suggests that, presently, markets offer little value in aggregate. Currently the S&P 500 sports a ten year normalized P/E of about 27 and dividend yield of 1.8%. Subsequent ten year returns associated with made at these levels have historically averaged about 1% annually or less.

In fact, the case could be made that current markets are extremely overvalued in aggregate.

btw, these findings very closely parallel the work of John Hussman.

position in SPX

Free Cash Flow

This weekend while doing some valuation work, I began to wonder about the free cash flow (FCF) calcuation, typically found as follows:

FCF = operating cash flow (OCF) - capital expenditures

My question: What exactly should be included in capex? In addition to the capital expeditures line item, which nearly always appears as the first item in Cash from Investing Activities directly underneath OCF, aren't other line items, such as 'acquisitions,' also capex?

By ignoring acquisitions, we would significantly over-estimate FCF for acquisitive companies like Johnson and Johnson (JNJ).

After some research and thought, however, the answer to this question is 'no.' While acquisitions are certainly a form of capex, they should typically not be included in FCF calcuation. The 'free' in FCF is supposed to denote the cash that is 'free' for deployment to shareholders after a company has laid out money to maintain and advance its current asset base. That money deployed toward a company's current asset base is what should be considered capex in FCF terms.

Acquistions nearly always involve procurement of new assets, which is one opportunity of many that FCF may be used for to enhance shareholder value (other opportunities might include new product development, issuing dividends, or paying down debt).

Thus, I have confidently concluded that I have not been miscalculating FCF all these years...

position in JNJ

On Chasing Higher Prices

For the past week or so I've been wanting to add to a 'starter' position in Johnson & Johnson (JNJ). My valuation work has me liking it below $60, and last week I had limit orders in at about $59.50.

As the chart indicates, price never came in for a fill, and today the stock gapped higher on big volume on positive earnings news. Technically, previous resistance at $61.50ish has now become support. Seemingly the stock is now significantly out of range.

It can be hard to keep emotions in check in such situations. "I knew that price was heading higher!" "Why didn't I raise my limit price a dime or so last week?" "You're letting the stock get away from you--better grab some up here at these higher levels in case it's never going to come back down now." "Way to go doofus...another example of being penny wise and pound foolish."

After that bout of second guessing, I remind myself that I am building this JNJ position on an investment thesis rather than on a trading thesis. And investment performance depends on finding attractive gaps between intrinsic value and market price. My work has identified a price that provides a comfortable margin for error.

If I give up on that analysis, and blindly chase the stock higher, then my margin for error goes down and my risk goes up.

So I'll sit on my hands, revaluate the story in the context of the ongoing information flow, and keep an eye out for a price point that I deem more favorable to long term investment returns.

position in JNJ

JNJ Rumors

Relevant to our upcoming class investment proposal discussion, note that rumors have Johnson & Johnson (JNJ) making a bid for Swiss medical device maker Synthes. The chatter places the deal at about $20 billion.

JNJ's business model is grounded in acquisitions. The company has made more than 30 material deals in the last 15 years. However, most of JNJ purchases are on the small side; only a few have exceeded $2 billion.

Should the Sunthes purchase rumors become reality, it would be the largest acquisition in JNJ history.

position in JNJ

Personal Stock Screen

At the RISE conference two weeks ago, many portfolio managers and analysts noted that they employed 'stock screens' to whittle the universe of possibilities into a subset more conducive to in-depth analyses. Most of the screens employed by these people are software algorithms that scour databases and identify stocks with attractive characteristics such as high return return on equity, low dividend payout ratios, or strong price momentum.

Many brokers (like Schwab) and investment info sites (like Morningstar) possess screening capability.

When looking for equity investments (not short term trades but long term investment), there is a screen that I like to employ. However, it is a low tech, non-mechanical screen--one that builds on my analytical strengths and personal taste preferences. One 'edge' that I may have over some market participants is skill in industry analysis and knowledge of factors that drive sustainable competitive advantage. I also have a taste for value, and believe that lower prices reduce risk and provide margin for error.

As such, I like to use that following criteria when looking for potential equity candidates:

Favorable industry structure. Think Porter's (1980) five forces. I like industries where the forces are favorable for industry profits over time. A pile of research suggests that choice of industry explains more variance in company profits than company-specific factors. Thus, I would rather consider stocks where the industry forces are blowing at the propsective company's back rather than in its face. It has become harder and harder, btw, to locate such favorable industry contexts.

Organizational factors. Research (e.g., Collins & Porras, 1994) suggests a number of factors that relate to sustainable competitive advantage over time, such as home grown experienced management, ideosyncratic cultures, demonstrated track records at coping with disruptive change. To evaluate these factors I need access to the inner workings of organizations. This can be obtained by personal contact, or (more frequently) by devouring what has been written about potential candidates by the media. You might be surprised at how much you can learn about organizations thru secondary sources.

Strong, dominant brands. I prefer firms that have gained mindshare with customers and marketshare from competitors. Strong brands drive higher profit margins as customers are willing to pay more for a branded goods relative to me-too generics. Moreover, large market share increases bargaining power and helps companies be a price maker rather than price taker.

High profit margins. I like enterprises that consistently produce gross profit margins north of 50% and net margins of at least 10%.

High cash/low debt. Debt reduces strategic freedom, even when the cost of credit is low. As an investor, I like my companies to have piles of cash since it is likely come back to me either directly or indirectly. As a general rule, I like to see balance sheet cash of at least 2x debt. Conceptually, I like to know that companies I own can extinguish all their debt overnight while still having a nice cash stash left over.

Free cash flow. Cash flow is the lifeblood of a business. Cash flow is also the theoretical basis for securities analysis and valuation. I am attracted to firms that generate gobs of free cash flow (FCF).

Valuation. While I review tradional valuation metrics such as P/E, I prefer valuation metrics directly employ FCF. Lots of FCF alone does not suffice--the price that you pay for the FCF is really what matters. When using my 'quick and dirty' comparison of enterprise value:FCF perpetuity, I like to see ratios of 1.0 or less. The lower the ratio, the greater the potential discount I am getting. Stated another way, cheap valuations provide higher 'margin for error' in my decisions.

Once I have a list of candidates, I can do more in-depth assessment. I can also overlay my macro view on candidates to get a more complete picture of risk vs reward.

Currently, my screen whittles down the universe of stocks into a pretty small list.

References

Collins, J.C. & Porras, J.I. 1994. Built to last. New York: Harper Business.

Porter, M.E. 1980. Competitive strategy. New York: Free Press.

The CSCO Disco

Calling a bottom in Cisco (CSCO) has been a risky endeavor recently. Three times in the past year, CSCO has gapped lower after disappointing earnings reports.  Previous gaps lower have been followed by upward price movement to fill the gaps.

The most recent gap lower in Feb, however, was followed by further price weakness. After meandering lower for weeks, CSCO stormed some 5% higher--thought to be linked to an internal company memo issued yesterday by CEO John Chambers stating that the company had to make some changes.

Note the chunky volume on today's move higher. Note also the possibility of a 'double bottom at $17ish.

Perhaps this will turn out to be another false signal. But one factor that is providing tailwinds rather than headwinds at this level is valuation. CSCO generates $9-10 billion in free cash flow. As a perpetuity, $9 billion in annual cash amounts to $9 / .1 = $90 billion.

CSCO has $40 billion (!) in cash and $15 billion in debt. That's $40 - $15 = $25 billion in net cash. Market cap is currently $100 billion, meaning that enterprise value is $100 - $25 = $75 billion.

So the way I see it, I can currently buy a cash rich, high profit margin large cap stalwart with a dominant position in its sector and strong brand for about a 17% discount from list price. Is this discount warranted because CSCO is losing its edge like some market participants fear? I don't think so. CSCO operates in an industry that is attractive for profits. Moreover, it has a strong franchise and some of the most capable managers in industry.

My only reservation is my bearish macro view--which keeps me from getting really aggressive in a situation like this.  That said, I added to my position last week and will look to add more now that the technicals have perked up.

I'll be watching for pullbacks below $18.

position in CSCO

AAPL Losing Some Weight

Apple's (AAPL) weighting in the Nasdaq 100 Index (NDX) will be cut significantly on May 2. Currently 20% of the index, AAPL's weighting will fall to about 12%.

The weightings of Microsoft (MSFT) and Oracle (ORCL) will double as part of the adjustment.

The move is being done to rebalance the stock weightings to better reflect underlying market capitalizations. Currently in the NDX, AAPL's weighting is 6x higher than MSFT even though AAPL's market cap is only 46% higher currently.

Because there are index products based on the NDX such as the Powershares QQQ Trust (QQQQ), the shift will likely put near term selling pressure on AAPL and a bid underneath those stocks whose weighting will significantly increase.

position in MSFT

Core Positions

The 'core position' concept may be worth considering as we begin building the Haile Fund portfolio. Core positions provide strong exposure to asset classes or sectors being pursued by the investor. Usually, core positions are 'low maintenance' in that they do not require constant review and oversight. As such, time horizons associated with core positions are usually long term in nature.

When putting a portfolio together, I personally like to look for core positions early in the process. This is because core positions can serve to anchor my portolio in the asset classes that I am interested in. Once the portfolio is solidly anchored, then I can pursue other, more specialized (or speculative) positions that help tailor the overall asset class composition toward more specific views.

As an example, I would view the Rogers International Commodity Index fund (RJI) discussed yesterday as a potential core position in commodities because it provides broad, market weighted exposure to the sector. Once I have positioned a broad fund like RJI in my portfolio, then I can look for other, more specialized commodity investments, such as DBA (ags), JJC (copper), or GLD (gold), that better express my preferences toward specific commodities.

In equities, core positions are often reflected by large cap stocks that dominate attractive industries. Due to its size and influence in the tech sector, Apple (AAPL) can be considered a core equity position.

One problem I often encounter with acquiring core positions is that they are often overpriced (from where I sit, anyway). Two strategies that I use to cope with this problem are a) sit on my hands and patiently wait for the security to be put 'on sale' by the market (this happens more often that you might think), or b) take a small position now at the current price with plans to add more shares if/when price goes lower.

Recently, I have employed strategy b) to begin building core equity positions in my personal portolio (I have not owned stocks for quite some time). I have initiated small 'starter' positions in a few large cap tech and healthcare names such as Microsoft (MSFT) and Johnson & Johnson (JNJ). My work suggests that these names offer decent--but not great--value here. These starter positions give me initial exposure, while leaving the door open for using lower price to my advantage to build more meaningful core positions down the road.

Should stocks rip higher from here and never look back, at least I have some core exposure that will allow me to participate.

Anyway, you might find the core position concept useful as you search the investment landscape for ideas.

positions in GLD, JNJ, MSFT, RJI

Price to Earnings Ratios

The price to earnings ratio (P/E) is the most common valuation metric applied to stocks. The higher the P/E, the more expensive the stock.

P/E has many shortcomings. The 'E' represents net income as determined by accounting convention. Accounting earnings can be subject to considerable manipulation and often do not reflect the true cash earning power of an enterprise.

Another drawback is that the 'E' typically reflects a 12 month performance window. Company performance is sure to change over time, so basing valuation on a one year time frame can be short cited.

Moreover, Wall Street is notorious for using earnings estimated by analysts for the next 12 months when generating P/Es. Research suggests that analysts are overly optimistic when forecasting the future, meaning that the so called 'forward' P/Es provide an illusion of value that often disappears when P/Es are based on 'trailing' (i.e., trailing 12 month or TTM) performance.

Finally, P/Es often appear most attractive when business cycles have peaked. Cyclical expansions increase earnings. Higher earnings drive P/Es lower, and those lower P/Es can entice investors into thinking that they are buying stocks on the cheap just before cycles turn down. This missive from my friend Vitaliy suggests that we may be facing just such a situation currently.

That said, P/E can still be a useful valuation metric--particularly when employing aggregate P/E measures to assess overall market value. John Hussman is a sharp valuation guy who employs this approach. An example of his work can be found here.

After reading it, answer these questions: Where do we stand currently with respect to overall market P/E compared to history? What is the historical relationship between P/E and future stock returns? What does John Hussman forecast for 10 year market returns given current aggregate market P/E?

position in SPX

Tobin's q

Generally speaking, Tobin's q is the market value of an asset divided by the replacement value of an asset. While the devil can be in the details of accurately determining both the numerator and denominator, hopefully you can see that the higher the value of Tobin's q, the more expensive an asset is.

As such, Tobin's q represents one approach to securities valuation. Tobin's q for the broad stock market appears below.

What do current levels of Tobin's q suggest about the general value of stocks here--cheap, fair value, or expensive?

position in SPX

Buffett's Annual Letter

Each spring, Berkshire Hathaway (BRK.A, BRK.B) chairman and CEO Warren Buffett pens a letter to shareholders. It's been said that reading his archived letters provides more value that obtaining an MBA.

Not sure about that, but I do know that reading Buffett's annual letters always offers some insight--even if I don't always agree with Mr Buffett's point of view.

The most recent 2010 letter, along with previous years' archived letters, can be found here.

no positions

Market Cap and Enterprise Value

Last week we discussed the concepts of market capitalization and enterprise value, and how they can be used in valuation methods.

Here's some more on the subject using a pre meltdown example of General Motors (GM) as an example.

no positions