Strategies that bear results

Strategies that bear results 
July 18, 2012


Barbara Drury asks four fund managers where to look for stocks that offer good dividend income and growth.

Buy in gloom and sell in boom is sharemarket advice that has been proved right over and again. There is no doubt that investors are gloomy; the question is, are we gloomy enough yet?

''The problem is that no one will ring a bell and tell you it's time to get back into the market,'' the chief executive of Lincoln Indicators, Elio D'Amato, says.

''You only make money in stocks by buying low and selling high. If you want your investments to perform over the long run you need exposure to growth in up-and-coming companies.''

That's a difficult message to sell when Australian shares fell 11.1 per cent in the year to June 30. Size and quality were no defence, with only five of the top 20 stocks posting gains. After a year such as that, it is a brave investor who shifts money from the safety of a bank deposit into the uncertainty of shares.

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But the tradeoff between risk and reward is slowly shifting as the yields on term deposits fall along with official interest rates.

Where investors were able to get a guaranteed return of 6 per cent on a one-year term deposit 12 months ago, the going rate has dipped to less than 5 per cent and is expected to fall further.

Yields on 10-year government bonds are skirting 3 per cent, down from more than 5 per cent two years ago.

By comparison, the dividend yield on the local sharemarket is close to 5 per cent and it is possible to construct a quality portfolio including the banks and Telstra with a dividend yield of about 7 per cent; more including franking credits. This widening gap between the risk-free return from cash and bonds and the priced-for-risk return from shares is getting more tempting, but investors should not expect miracles.

The Australian market looks cheap at the moment at 10.8 times earnings compared with a historic price-earnings ratio of 14.5. But experts warn that growth will remain elusive while the world is deleveraging, Europe remains in crisis, US growth is anaemic and China is slowing.

''At the moment markets are so sceptical they don't believe anything people tell them and they don't believe growth till they see it. That's where the opportunities are,'' the head of Australian equities at Fidelity, Paul Taylor, says.

A dividend strategy focused on the big end of the market is a rational response to the current investment climate, but if you want a bit of growth with your income you need to cast your net wider.

ROB TUCKER, S.G. Hiscock

The SGH20 portfolio manager, Rob Tucker, says it is difficult to beat the overall market return if you only invest in the top 20 stocks. In the SGH20 fund (seeking the best 20 investment ideas from the top 300 stocks) CSL is one of only three top-20 stocks. ''We think we can add value where stocks are under-researched and undervalued,'' he says.

He says dividend growth might stall in the next 12 months, posing a trap for investors in so-called defensive sectors such as utilities. These utilities face regulatory resets - where their regulated return is lowered to match the change in the risk-free rate (10-year bond).

This means dividend payments are likely to be lower for these stocks over the next two years to three years.

''It's important not to buy shares just for yield,'' Tucker says. ''You can't have all your money in telcos, banks and utilities; you need to diversify.

''Equities are still growth assets, so we focus heavily on free cash-flow growth, which should support dividend growth on a three- to five-year view.''

Tucker looks for stocks with a strong economic moat such as the pricing power that comes from a strong brand or patent and high barriers to entry into their market. The fund currently has a bias towards healthcare stocks that are well positioned to benefit from the higher spending of an ageing population.

Tucker says Ramsay Health Care is in a good position to help the government solve the shortage of hospital beds and looks set to deliver 13 per cent compound dividend growth during the next three years. It currently sits on a dividend yield of 2.4 per cent.

Blood plasma group CSL is a solid performer with a global franchise and a pipeline of new products that should help the group grow organically. It has low debt and generates good free cash flow to fund acquisitions or share buybacks. Engineering consultancy WorleyParsons offers exposure to the mining services sector, which has been heavily sold recently. Tucker says Worley is one of the top global players in its field and is well positioned in the oil and gas sector. He expects the pipeline of capital spending in the LNG and shale oil industries will be robust during the next five years, providing longer-term growth. In the meantime, investors get a 3.8 per cent dividend yield.

Cardno is a professional infrastructure and environmental services company. Because it invests in professional employees it is not capital-intensive and generates good free cash flow, not to mention a dividend yield of 5.1 per cent, with an estimated 15 per cent dividend growth rate over the next two years.

Treasury Wine Estates is a turnaround story with minimal capital investment over the next three years. Tucker says the value of the company's wine inventories is not reflected in the balance sheet and is currently undervalued by the market.

He says the brand-conscious Asian market should provide a good five-year growth story for its premium Penfolds labels.

GEORGE BOUBOURAS, UBS Wealth Management

The head of investment strategy at UBS Wealth Management, George Boubouras, recommends a combination of quality cyclical stocks leveraged to growth in sectors such as mining, energy and consumer discretionary, with defensive stocks such as utilities, telcos and healthcare with cash flows that can deliver sustainable dividends. 

''Investors need to be able to sleep at night,'' he says. ''If you are not sleeping, you are in the wrong portfolio.''

Boubouras acknowledges that popular dividend stocks are expensive but says investors are prepared to pay for the certainty of dividends.

''Volatility is not going away and the market still faces challenges,'' he says. ''Earnings growth and good-quality dividends is all I'm aiming for in the current environment.''

He recommends accumulating Telstra shares on any price dips for its quality dividends from strong cash flow business models.

Westfield offers investors exposure to its quality global options and dividend-focused domestic business with a dividend yield of more than 5 per cent.

''One can search for higher yields but, as always when chasing a dividend, search for certainty of delivery,'' he says.

For a more defensive stance, AGL Energy has the largest retail customer base in the country, which Boubouras says offers the most defensive exposure to the utilities sector, plus a dividend yield of more than 4 per cent. Transurban is a quality infrastructure asset with predictable cash flows from toll roads in Sydney and Melbourne providing a dividend yield of more than 5 per cent.

Boubouras says Coca-Cola Amatil is currently expensive. However, he says the business generally trades at a premium to the overall market because of the certainty of its earnings and its reliable 4 per cent dividend yield.

PAUL TAYLOR, Fidelity Worldwide Investment

Despite the slow growth outlook, Taylor says some sectors and stocks will grow faster than others. He is investing in high-quality companies with strong balance sheets and good growth prospects and/or a high and sustainable dividend yield.

''If you can find a dividend yield of 7 per cent and earnings growth of 3 per cent, that's quite a strong position in a low-growth world,'' he says.

Taylor says companies that deliver sustainable dividends will be bid up in this market but company strategy is vital. He says Sydney Airport is a good long-term investment because of its strong and sustainable dividend yield (currently 7.2 per cent) and structural growth. ''It is one of the few China consumption plays as Chinese become more important to our tourism market'', he says.

Insurer Suncorp Group is more of a turnaround story. Not only was it hammered by natural disasters including the Queensland floods but it was caught out in the financial crisis with bad loans to property developers.

''We think its problems are cyclical, not structural,'' Taylor says. ''We think it should be a 15 per cent ROE [return on equity] business, not a 0.75 per cent ROE business, so there is a lot of upside. It was one of the only insurers to pay out on flood insurance, which was good for the brand.''

Taylor also likes Goodman Group. While retail and office property are weak, industrial property has been a beneficiary of the internet because it creates more need for distribution hubs rather than retail space.

It currently offers a dividend yield of more than 5 per cent.

One of the themes of Taylor's portfolio in the current market is to focus on the essentials of life such as supermarkets, banks and energy while consumers shun discretionary spending.

He says Origin Energy has been marked down because of uncertainty surrounding its coal seam gas to LNG project in Queensland, cost blowouts and speculation that the company may need to raise equity.

''All that is already priced into the stock and as we get more clarity it will provide price upside'', he says. In the meantime you've got a good stable business with a dividend yield of 4 per cent.

ELIO D'AMATO, Lincoln Indicators

D'Amato is confident that shares will hold up in the second half-year, with companies supported by low interest rates, no inflation, falling oil prices and low wage growth. He urges investors to use this period of market weakness to weed out poor-performing companies and consider unloved stocks that are fundamentally good businesses.

Heavy share-price falls during the past few months have exposed some attractive valuations, especially in the unloved mining, energy and mining services sectors. He singles out copper and gold producer PanAust, Maverick Drilling and Exploration and global drilling and services company Boart Longyear, which all have strong forecast earnings per share growth but are trading at a discount of more than 30 per cent below Lincoln's valuation. Boart also has a forecast dividend yield of 4.89 per cent.

Similarly, iron ore heavyweight Fortescue is trading at a 27 per cent discount to Lincoln's valuation of $6.60 a share. D'Amato says the latest low inflation figure out of China adds weight to his belief that it is near the bottom of a cyclical downturn and iron ore will be leveraged to the recovery when it occurs.

''It's important to get on these trains before they leave the station,'' he says. ''Don't put all your money in at once but in three or four parcels over time.''

D'Amato says Corporate Travel Management, a global corporate travel operator, has the ability to continue to beat expectations with forecast earnings growth of 19.8 per cent a share. ''The market is always a risk/reward tradeoff. At the moment you can get a good yield investing in the banks rather than putting your money into one,'' he says.

Read more: http://www.theage.com.au/money/investing/strategies-that-bear-results-20120717-226wr.html#ixzz21VgO8T3T

How to Choose Dividend Stocks - Morningstar Video

Dividends and Total Returns

During the bull market, the pursuit of rapidly growing businesses
obscured the real nature of equity returns. But growth isn't all there
is to successful investing; it's just one piece of a larger puzzle.
Total return includes not only price appreciation, but income as well.


And what causes price appreciation? In strictly theoretical terms,
there's only one answer: anticipated dividends. Earnings are just a
proxy for dividend-paying power. And dividend potential is not solely
driven by growth of the underlying business--in fact, rapid growth in
certain capital-intensive businesses can actually be a drag on
dividend prospects.

Investors who focus only on sales or earnings growth--or even just
the appreciation of the stock price--stand to miss the big picture. In
fact, a company that isn't paying a healthy dividend may be setting
its shareholders up for an unfortunate fate.

In Jeremy Siegel's The Future for Investors, the market's top
professor analyzed the returns of the original S&P 500 companies
from the formation of the index in 1957 through the end of 2003.

What was the best-performing stock? Was it in color televisions
(remember Zenith)? Telecommunications (AT&T T)? Groundbreaking
pharmaceuticals (Syntex/Roche)? Surely, it must have been a
computer stock (IBM IBM)?

None of the above. The best of the best hails not from a hot, rapidly
growing industry, but instead from a field that was actually
surrendering customers the entire time: cigarette maker Philip
Morris, now known as Altria Group MO. Over Siegel's 46-year time
frame, Philip Morris posted total returns of an incredible 19.75% per
year.

What was the secret? Credit a one-two punch of high dividends and
profitable, moat-protected growth. Philip Morris made some
acquisitions over the years, which were generally successful--but the
overwhelming majority of its free cash flow was paid out as
dividends or used to repurchase shares. As Marlboro gained market
share and raised prices, Philip Morris grew the core business at a
decent (if uninspiring) rate over the years. But what if the company-
-listening to the fans of growth and the foes of taxes--attempted to
grow the entire business at 19.75% per year? At that rate it would
have subsumed the entire U.S. economy by now.

The lesson is that no business can grow faster than the economy
indefinitely, but that lack of growth doesn't cap investor returns.
Amazingly, by maximizing boring old dividends and share buybacks, a
low-growth business can turn out to be the highest total return
investment of all time. As Siegel makes abundantly clear, "growth
does not equal return." Only profitable growth--in businesses
protected by an economic moat--can do that.


http://news.morningstar.com/classroom2/course.asp?docId=145248&page=3&CN=COM

Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf57n9sb

Corporate Finance - Dividend Theories

Dividend Irrelevance TheoryMuch like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

Bird-in-the-Hand TheoryThe bird-in-the-hand theory, however, states that dividends are relevant. Remember that total return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner (Gordon/Litner) took this equation and assumed that k would decrease as a company's payout increased. As such, as a company increases its payout ratio, investors become concerned that the company's future capital gains will dissipate since the retained earnings that the company reinvests into the business will be less. 

Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital gains.

Tax-Preference TheoryTaxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. This is known as the "tax Preference theory". 

Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control. 

Capital gains are also not realized in an estate situation. For example, suppose an investor purchased a stock in a company 50 years ago. The investor held the stock until his or her death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation. 

The Dividend-Irrelevance Theory and Company ValuationIn the determination of the value of a company, dividends are often used. However, MM's dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. 

For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own. 

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory assumes that investors can affect their return on a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decision since they can simulate their own dividend policy.

How Any Shareholder Can Construct His or Her Own Dividend Policy.

Recall that the MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. As a result, a stockholder can construct his or her own dividend policy. 

• Suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations.
• Likewise, if, from an investor's perspective, a company's dividend is too small, an investor can sell some of the company's stock to replicate the cash flow the investor expected.

As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy since they can simulate their own.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-theories.asp#ixzz1yf1Ugmp6

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How to Choose Dividend Stocks - Morningstar

Investors In Common Stocks Must Get Valuation Right; Here’s How

By Chuck Carnevale

Mar 09, 2012 04:54AM GMT

Chuck Carnevale

 

The investment industry is replete with pundits and self-proclaimed experts espousing various principles and rules that allegedly are the best way to value a stock correctly. Unfortunately, and in most cases, these rules are stated as fact, but unfortunately very few facts are ever presented to back them up.  In other words, much of it is either opinion or gleaned from something they’ve read or been taught before.  But even as a young boy, I was never willing to accept dogma as fact without simultaneously being provided supporting evidence and a logical explanation as to the “why” that they work.

In fifth grade I was once sent to the principal’s office by my English teacher because I made her cry.  She cried because every time she would regurgitate a rule of grammar, punctuation or spelling, she expected me to accept it unconditionally, merely because she said so.  For example, she would say something like I before E except after C expecting me to simply accept this rule as fact. I, on the other hand, not meaning to be argumentative or disruptive, only inquisitive, would immediately raise my hand in class and ask a simple question-why? No matter what rule she would state, I would relentlessly raise my hand and ask okay, but why?  I was not willing to have the rule dictated to me; I needed to understand why it was the rule and why it was important.

Now that I am an adult, I have continued to embrace my inquisitive nature, and to this day I will not accept a dogmatic statement without understanding why.  On the other hand, when I can review supporting evidence that validates the rule and therefore understand its significance, relevance and validity, then and only then, through my understanding it, can I embrace it willingly and passionately.  Therefore, as an author of financial articles, I believe my readers should hold me to this same standard that I hold others to.  Consequently, this article is designed to illuminate the “why” behind widely accepted notions of valuing a business primarily based on earnings (discounting cash flows).

When Investing in a Business Earnings Determine Intrinsic Value

In his best-selling book One Up On Wall Street, famed portfolio manager Peter Lynch dedicated his entire 10th chapter to earnings and thus titled it –Earnings, Earnings, Earnings. In the chapter’s second paragraph he succinctly stated the importance of earnings as follows:

“There are many theories, but to me, it always comes down to earnings and assets.  Especially earnings.  Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that it will ever happen. But value always wins out-or at least in enough cases that it’s worthwhile to believe it.”

An important foundational principle behind this discussion is the idea that we are talking about investing as part owners of strong businesses, rather than trading stocks.  Business owners are rewarded through the profits the companies they own are capable of generating on their behalf. These rewards can come in the form of salaries and bonuses for active owners, and from increasing value or cash flow from dividends for passive shareholders. In either event, all these rewards are ultimately a function of the businesses’ earnings capability, at least in the longer run.  Therefore, we should realize that when you truly invest in a stock, you really are investing in its ability to earn more money for you in the future.

When I first read Peter Lynch’s famous book in 1990, I had already developed a strong belief in the importance of earnings regarding assessing the fair value of an operating business.  Therefore, the theory behind Peter Lynch’s wisdom already resonated deep within me.  However, as already stated, it was the facts behind the theory that interested me the most. In fact, I was so committed to the notion that earnings determine market price, that I developed my own stock graphing tool that allowed me to evaluate the true relationship between a company’s earnings and its stock price over time.

The following additional quotes from Chapter 10 of Peter Lynch’s book titled: Earnings, Earnings, Earnings, speak to the importance of valuing a business based on its earnings power:

“you can see the importance of earnings on any chart that has an earnings line running alongside the stock price….  On chart after chart the two lines will move in tandem, or if the stock price stays away from the earnings line, sooner or later it will come back to earnings.”

A few pages later, Peter offers us another nugget of wisdom on the earnings and price relationship, plus a little bit of investing advice thrown in:

“a quick way to tell if a stock is overpriced is to compare the price line to the earnings line……. If you bought familiar growth companies…… when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you would do pretty well.”


Now that we’ve reviewed some investing axioms and nuggets from Mr. Peter Lynch, let’s see if we can perform two extremely important tasks. 

• First and most importantly, let’s see if we can answer the more important question as to why earnings determine market price; not just that it does. 
• Next, let’s produce some evidence that verifies the veracity of Mr. Peter Lynch’s words. 

In order to accomplish both of these important tasks we will rely on visual representation, and mathematical proofs provided by F.A.S.T. Graphs™. 

How to Value a Company’s Earnings and Why

The essential point underpinning the thesis of this article, is that when you’re investing in a business you’re not actually buying the stock, you’re buying the company’s earnings power.  The stock is only the vessel that contains the earnings you are purchasing.  When buying earnings, the principles of value apply just like they do with any other product or service. The easiest way to understand this clearly, is to think in terms of the price you pay to buy $1 dollar’s worth of one company’s earnings versus $1 dollar’s worth of another company’s earnings.

In other words, let’s look at two companies to see what the price, and therefore, value, of $1 dollar’s worth of earnings are. However, before we do, let’s establish some doctrine that we are going to focus on. First and foremost, remember that we are going to buy $1 dollar’s worth of earnings for each of our two companies.  Now, we need to clearly understand that once either of those dollar’s worth of earnings are taken out of the business and put into our pockets, the value of each dollar’s worth of earnings is precisely the same. When separated from the business, a dollar is a dollar, and a dollar from one company will buy no more or no less than a dollar from another company.

However, we also have to deal with the fact that $1 dollar’s worth of each respective company has a different cost.  This then begs the question, why? 

• In other words, why would we pay more to buy company A’s dollar worth of earnings than we would to buy Company B’s dollar worth of earnings? 
• Since a dollar’s worth of each company’s earnings once received outside of the business is worth exactly the same, why would we pay more to buy one of the dollars than the other?

The reason, as we will develop more fully later, is that if we are long-term investors in businesses, we are actually buying future earnings, not current earnings. Therefore, the amount of earnings we accumulate in the future will be a function of the company’s earnings growth rate, and will determine what price we paid today to buy those future earnings of tomorrow. Let’s clarify this by examining the dynamics of our two example companies. We will start with history presented as evidence of what has actually already happened, and then we will move on to the future, which we believe is actually more relevant.

Our first example is Sherwin-Williams Co. (SHW), which has achieved a historical earnings growth rate of 9.6% since 1999. At the bottom of the graph you can see that earnings have grown from $1.81 per share in 1999, to an estimate of $5.67 per share for fiscal 2012 (see yellow highlighted earnings at the bottom of the graph).  This represents approximately a three-fold increase in earnings over the past 14 years. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $3 dollars. Another way to put this is that Sherwin-Williams’ future dollars in 2012 only cost one third as much as the original $1 dollars worth of earnings cost in 1999.

 SHW Chart 1

Our second example, CSX Corp. (CSX), grew earnings per share at the higher rate of 12.9% since calendar year 1999.  Therefore, earnings per share grew from $.26 a share in calendar year 1999 to $1.86 per share estimated for fiscal year-end 2012 (see yellow highlighted earnings at the bottom of the graph). This is approximately a seven-fold increase in earnings per share over this 14-year period. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $7 dollars. Consequently, shareholders that bought CSX in 1999 only paid 1/7th of the original price for calendar year 2012 earnings.  In other words, due to the company’s historical earnings growth rate, future earnings were significantly cheaper than original earnings. As we will discover next, herein lays the essence of fair value, or what others call intrinsic value of a business (common stock).

 CSX 1

Now let’s move to current time to examine what price we have to pay to buy $1 dollar’s worth of each of our example company’s earnings today, and attempt to calculate what $1 dollar’s worth of future earnings are actually costing us. The metric that establishes that price is the common PE ratio.  One of the definitions of the PE ratio is: The price you pay to buy $1 dollar’s worth of a company’s earnings.  Remember though, we are pricing $1 dollars worth of today’s earnings, even though in actuality what matters most is the price we’re paying to buy $1 dollars worth of future earnings.

In the case of Sherman-Williams (SHW), today we are asked to pay $20.90 (current PE ratio 20.9 see red circle at right of graph ) to buy our $1 dollar’s worth of current earnings.  As an aside, you can note from the graph that this is the highest valuation or price that you were asked to pay to buy a $1 dollar’s worth of Sherwin-Williams’ earnings since 1999.  In other words, Sherwin-Williams’ stock appears very expensive today based on historical earnings growth.

 SHW 2

In the case of our second example, CSX Corp. we discover that we are only being asked to pay $11.90 (current PE 11.9 see orange circle at right of graph) to buy $1 dollar’s worth of CSX Corp.’s current earnings. This is almost half the price we are being asked to pay to buy an equivalent $1 dollar’s worth of Sherwin-Williams Co.’s earnings. Therefore, the rational investor should ask this simple question:  Why should I be willing to pay almost twice as much to buy Sherwin-Williams’ earnings as I’m being asked to buy CSX’s earnings? The only logical answer would be because future earnings are expected to be much higher for Sherwin-Williams Co. than for CSX Corp. But in fact, this is not true, and as we will next illustrate, the real answer doesn’t make any mathematical sense.

 CSX 2

Utilizing the Estimated Earnings and Return Calculator we discover that the consensus (15 analysts reporting to Capital IQ) estimate earnings growth rate for Sherman-Williams at a very strong 13.1%. This calculates out that expected calendar year 2017 earnings of $10.64 will be approximately twice as large as 2011’s earnings of $4.95.  Therefore, we are, in theory at least, only paying approximately $10 today to buy a future $1 dollar’s worth of Sherwin-Williams’ 2017 earnings.  In other words, the PE ratio of the future earnings we are buying is approximately 10, or half of what we have to today pay for current earnings.

 SHW 3

Once again, utilizing the Estimated Earnings and Return Calculator we discover that the consensus (26 analysts reporting to Capital IQ) expect CSX Corp. to grow earnings at a very strong rate of 14%. This calculates out that CSX Corp.’s expected earnings in 2017 will also be approximately 2 times larger than today’s earnings of $3.63 in 2017 versus the original $1.67 in 2011.  To be clear, this means that the earnings growth rates in both of our sample companies are expected to be essentially the same or at least similar.

Most importantly, it also means that we are only paying a PE of 5.6 to buy CSX Corp.’s $1 dollar’s worth of future earnings (2017) versus paying a PE of 10 for Sherwin-Williams’ $1 dollar’s worth of future earnings (2017). As we’ve previously established, if we received $1 dollar’s worth of dividends from both companies, each would be able to buy no more or no less goods or services than the other.  So once again we ask the question; why would we want to pay twice as much to buy $1 dollar’s worth of Sherwin-Williams’ future earnings as we would to buy CSX Corp.’s? Logically, it makes no sense, yet many investors do it every day.

 CSX 3

In the two examples used in our analogy above, we identified two companies with somewhat similar historical growth rates, but more importantly with almost identical expectations for future growth.  Consequently, logic should dictate that both companies should be priced at approximately the same valuations.  The examples utilized, neither company has a real edge over the other company regarding earnings power. Therefore, why should the one, Sherwin-Williams Corp., have an edge in market price over the other, CSX Corp.? The straightforward answer; there is no rational reason.

It’s also important to recognize that the market does not always price common stocks according to their fair value.  In fact, at any moment in time, the market can be mispricing the value of common stocks by significant degrees.  This is why the venerable Ben Graham gave us his famous metaphor: “in the short run the market is a voting machine, but in the long run it’s a weighing machine.”  This is the same lesson that Peter Lynch offered in the above referenced quote where he talks about value eventually winning out.  Shrewd investors know how to calculate fair value, and therefore, are capable of avoiding what is often the obvious mistake of paying too much.  On the other hand, shrewd investors also recognize a bargain when they see one.
Furthermore, it should also be understood that there are valid reasons to pay more for one company than for another.  However, those reasons have to be mathematically sound and, therefore, make economic and prudent sense.  For example, thanks to the power of compounding; a company with a very high growth rate of 20% to 30% or more would obviously be worth more than a company only growing at 10% or 15%.

• The point is that the faster growing company would be capable of generating significantly more future earnings than the slower growing one.  
• Therefore, even though you pay more today to buy the faster grower, you can actually be buying future earnings cheaper, again, thanks to the power of compounding.

Summary and Conclusions

The moral of the story is simply that investors should be careful and willing to always run the numbers out to their logical conclusions. But, it all starts with knowing what you are buying (investing in) in the first place.  True investors, like Peter Lynch, and many of the other renowned investing greats such as Phil Fischer, Warren Buffett, etc., all invest as owners in businesses with a focus on the strength of the business behind the stocks they buy. Therefore, these investor greats are always buying the earnings power of the respective businesses they are investing in, relative to their goals and objectives.

These principles of valuation apply equally to growth stocks as they do dividend stocks.  When applied to growth stocks,

• investors need to understand that the more future earnings they can buy today at a good price, means more future earnings that the market can capitalize in the future.  
• Since this is their only source of return, the more future earnings they can amass the more value or return they can expect.  
• Fast growth does typically come at a higher price, but simultaneously it needs be understood that faster growth, if it occurs, also generates a bigger pile of future earnings. 
• And, as this article has illustrated, it’s the future earnings that ultimately drive fair value.

When applied to dividend paying stocks, the principle is just as valid, and maybe easier to see.  

• Since the company is going to pay dividends, the dividend investor is going to receive some of the company’s earnings in cash outside of the business.  
• As I illustrated above, when they go to spend $1 dollar’s worth of dividends from Company A versus $1 dollar’s worth of dividends from Company B, each $1 dollar’s worth of dividends will have the same value outside of the business.  
• Therefore, it only logically follows that both of those dollars should have the same value while they are still in the business.

Importantly, a few words on the differences between investing and speculating are perhaps in order. 

Active traders will not find any value in this discussion, because

• active traders usually don’t own a company long enough to think about earnings power at all.  
• Active traders are only really interested in momentum and volatility.  
• They are “the voting machine” segment of the market. 
• This is a primary reason why stocks can become improperly or unrealistically valued by Mr. Market, the voter; however, there are others reasons that we will leave to future discussions. 
• Additionally, to be a trader requires a continuous commitment to watching every little price tick of the market, which is beyond the interest of most people that are investing for their future economic benefit.

True investors are interested in 

• building long-term positions in great businesses bought at rational prices. 
• It is to this segment of the financial community that this article is geared to. 
• Frankly, we believe this is the largest segment of the market comprised of prudent investors that have other things to do with their time than watching the bouncing ball of often frivolous stock price movements.  
• These true investors need to understand the principles of valuation presented in this article if they are going to achieve their financial goals while simultaneously doing so at reasonable levels of risk.

Based on this discussion, of the two companies utilized as examples in this article, the principles of valuation would indicate that one is a buy and one is a sell. We believe that both of these companies are excellent candidates that when appropriately priced (valued) would make great additions to almost any long-term investors portfolio.  However, if the expected future growth rates are accurate, then Sherwin-Williams is clearly overpriced, while CSX Corp. looks like a great bargain today.  Of course, all prospective investors are encouraged to perform their own due diligence before taking any action.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

http://www.forexpros.com/analysis/investors-in-common-stocks-must-get-valuation-right;-here%E2%80%99s-how-116410

Divine Dividends

Dividends represent nothing more than the investor's share of earnings that will be received immediately (rather than through reinvestment and future growth of the stock).

Dividends are one of the quickest and healthiest ways that earnings can make their way into shareholders' pockets.

Graham argued that intelligent investors would rather have dividends in their pockets (even if investors use them to buy more of the same stock) than risk waiting for possible future growth.  Furthermore, he insisted, it is management's responsibility to pay dividends.

For long-term investors who follow a "buy and hold" strategy, dividends are the only way to collect on investment gains.

In addition to representing money in the bank, dividends are, to many investors, a reliable indicator of future growth.  

Values are determined roughly by earnings available for dividends.  This relation among earnings, dividends and values survives.

A long history of dividend payments and regular dividend increases also indicates a substantial company with limited risk.  

Additionally, a rise in the dividend is tangible confirmation of the confidence of management in good times ahead.  A cut in the dividend is a red flag indicating trouble on the track.

Not all corporate income need be paid in dividends.  Depending on the industry and how much capital is required to keep the business growing, the appropriate payout may be as much as 80% or as little as 50% of net earnings.  

When studying the dividend payout of a company, calculate both average earnings and average dividends over a 10-year period.  From those two averages you can determine the average payout.  

Earnings fluctuate, but dividends tend to remain stable or,  in the best companies, to rise gradually.


One way of determining if a stock is overvalued or undervalued is to compare its dividend yield with that of similar companies.

• Safety, growth, and other factors being equal, the stock with the highest dividend and the lowest share price is the best bargain.
• As a further check of value, investors should compare the stock's dividend yield with that of the whole stock market dividend yield.

Rationale for Withholding Dividends

If a company isn't paying dividends it should, like Berkshire Hathaway, be doing something profitable with its earnings.  

It is acceptable to withhold dividends for the following reasons:

• To strengthen the company's working capital
• To increase productive capacity
• To reduce debt.

Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons.  It is easier to keep the cash on hand to bail management out of bad times or bad decisions.  Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income.  Consequently, other investors get no income.

Dividends in Jeopardy

Dividends may be put in jeopardy in two ways:

• When a company's earnings per share is less than its dividend per share
• When debt is excessive.

A company's average earnings (over several years) should be sufficient to cover its average dividend.  Though earnings per share can fall below dividend per share from time to time with reserves making up the difference, the condition can persist for only so long.  

A company with substantial earnings rarely becomes insolvent because of bank loans.  But when a company is under pressure, lenders may require a suspension of dividends as a form of financial discipline.

Benjamin Graham and The Power of Growth Stocks

Benjamin Graham and the Power of Growth Stocks: Lost Growth Stock Strategies from the Father of Value Investing

by Frederick K. Martin CFA & Nick Hansen

Use a master's lost secret to pick growth companies bound for success In 1948, legendary Columbia University professor Benjamin Graham bought a major stake in the Government Employees Insurance Corporation. In a time when no one trusted the stock market, he championed value investing and helped introduce the world to intrinsic value. He had a powerful valuation formula. Now, in this groundbreaking book, long-term investing expert Fred Martin shows you how to use value-investing principles to analyze and pick winning growth-stock companies—just like Graham did when he acquired GEICO. Benjamin Graham and the Power of Growth Stocks is an advanced, hands-on guide for investors and executives who want to find the best growth stocks, develop a solid portfolio strategy, and execute trades for maximum profitability and limited risk. Through conversational explanations, real-world case studies, and pragmatic formulas, it shows you step-by-step how this enlightened trading philosophy is successful. The secret lies in Graham's valuation formula, which has been out of print since 1962—until now. By calculating the proper data, you can gain clarity of focus on an investment by putting on blinders to variables that are alluring but irrelevant. This one-stop guide to growing wealth shows you how to: Liberate your money from the needs of mutual funds and brokers Build a reasonable seven-year forecast for every company considered for your portfolio Estimate a company's future value in four easy steps Ensure long-term profits with an unblinking buy-and-hold strategy This complete guide shows you why Graham's game-changing formula works and how to use it to build a profitable portfolio. Additionally, you learn tips and proven techniques for unlocking the formula's full potential with disciplined research and emotional control to stick by your decisions through long periods of inactive trading. But even if your trading approach includes profiting from short-term volatility, you can still benefit from the valuation formula and process inside by using them to gain an advantageous perspective on stock prices. Find the companies that will grow you a fortune with Benjamin Graham and the Power of Growth Stocks.

http://www.lybrary.com/benjamin-graham-and-the-power-of-growth-stocks-lost-growth-stock-strategies-from-the-father-of-value-investing-p-125191.html

The 8 Rules I Use to Earn $124.29 in Dividends Per Day

By Paul Tracy This easy list of rules has helped grow my daily income from almost nothing to more than $100 per day. The 8 Rules I Use to Earn $124.29 in Dividends Per Day

I counted twice, just to be sure...  $41,513.18. That's the amount in "daily paychecks" -- more commonly known as dividends -- I've received from my investment portfolio in 2011. That total comes to $124.29 for each day of the year. Cash. Why am I telling you this? It's not to brag. I was born and raised in Wisconsin. The typical Midwestern mentality is so ingrained in me, I veryrarely talk about money. And I'm not one to show off, either. I drive a Nissan I bought six years ago. I get my hair cut at Supercuts. No, I'm telling you this because I honestly think what I've discovered is the single best way to invest, hands down. I'm talking, of course, about the "Daily Paycheck" strategy. If you've read Dividend Opportunities for even a couple of weeks, you're likely familiar with Amy Calistri and this strategy. Amy is the Chief Strategist behind our premium Daily Paycheck newsletter. Her goal is to build a portfolio that pays at least one dividend every day of the year. The idea for her advisory came from my personal "Daily Paycheck" experiment.  I've been following the strategy personally for a few years now. In that time, I've not only been able to build an investment portfolio that pays me more than 30 times a month, but the checks are getting bigger and bigger as time passes. What I like best is that it's the easiest way to invest you can imagine. Once you get started, it runs on autopilot. Of course, you'll make a few portfolio adjustments now and then, but you won't have to anxiously watch your holdings every day.  Now it's time to come clean. If you start this strategy tomorrow, it's unlikely you'll be earning $124 a day by the weekend. I've been fortunate to start with a healthy-sized portfolio. And as I said, I've enjoyed the benefits of implementing the "Daily Paycheck" strategy for a few years now, so my payments have grown much larger than when I started. But here's the good news... it doesn't matter. Whether you have $20,000 or $2 million, you can start your own "Daily Paycheck" portfolio today. The results are fully scaleable, and anyone can have success, as long as you follow eight simple rules Amy and I created to not only build our portfolios, but also manage risks... 1. Dividend payers beat non-dividend payers. According to Ned Davis Research, firms in the S&P 500 that raised dividends gained an average of 8.8% per year between 1972 and 2008. Those that cut dividends or never paid them produced zero return over this entire time span. 2. Higher yields beat lower yields. This is such a "no-brainer" that it doesn't require explanation. Clearly, a bigger dividend puts more cash in your pocket.  3. Reinvesting your checks beats cashing them. Reinvesting buys you more shares, which leads to larger dividend checks, which buy you even more shares, and so on (this is how my dividend checks have grown). 4. Small caps beat large caps. A 70-year study of different equity classes showed that $1,000 invested in small-cap stocks grew to $3,425,250. In large-cap stocks it grew to only $973,850.  5. International beats domestic. The average U.S. stock pays just 2.1%. That's peanuts compared to yields overseas. Stocks in New Zealand yield 4.9%... stocks in France yield 4.7%... in Germany 4.0%... and in the U.K. 3.9%. 6. Emerging markets beat developed. It's much easier for a small economy to post fast growth than a large one. And investors who know this benefit. Over the past 10 years, Vanguard's MSCI Emerging Markets ETF (NYSE: VWO) has gained an average of 10.7% per year. Stocks throughout the developed world, as measured by the MSCI EAFE Index, have been up an average of just 4.8% per year. 7. Tax-free beats taxable. Tax-free securities often put more cash in your pocket at the end of the day -- especially if you're in a high tax bracket. A muni fund yielding 6.0% pays you a tax-equivalent yield of 9.2% if you're in the 35% tax bracket.  8. Monthly payouts beat annual payout.  Getting paid monthly is not only more convenient -- you actually earn more. Thanks to compounding, a stock paying out 1% monthly yields far more than 12% -- it can actually pay you 12.68% if you reinvest. It's these eight rules I've followed to build a portfolio that has not only paid me $124 a day in 2011, but that is also seeing rising payments. In November, I earned 37 checks, at an average daily amount of $160.30.  I've been investing for the better part of two decades. During that time, I've tried just about every strategy and style you can imagine. And don't get me wrong -- you can make money any number of ways in the market.  But earning thousands of dollars each month consistently? I never experienced that until I implemented the "Daily Paycheck" strategy. Good Investing! Paul Tracy Co-Founder -- StreetAuthority, Dividend Opportunities P.S. -- My ultimate goal is to build a portfolio that pays me $10,000 a month. In November I pocketed $4,808.87, so I'm well on my way. To learn how easy it is to set up your own "Daily Paycheck" portfolio, be sure to read this memo. It has all the details on how to get started yourself. http://globaldividends.com/newsletter.asp?d=5715&utm_source=outbrain&utm_medium=referral&utm_campaign=do-ob-1011