Risk-averse
Investors today are very nervous, and their confidence strained at best. Consequently, they are more focused on safety than they are on return. Money has been pouring into bonds and other fixed income vehicles at record rates. Unfortunately, interest rates are at all-time lows and fixed income offers little or no return. Investors, as they are coming to grips with this realization, are looking desperately for places to invest that are safe, yet offer decent returns.
Many investors are turning to dividend paying blue-chip stocks. Generally, we believe this is a good long-term strategy for several reasons. First of all, many blue-chip companies are currently available at discounts to historical normal valuations. Therefore, current dividend yield is higher than normal, and in many cases equal to or greater than rates on quality bonds.
Furthermore, many of these blue chips have long histories of increasing their dividends every year. In contrast to fixed income, this strategy offers investors a potential raise in pay each year along with some capital appreciation potential.
When evaluating these opportunities regarding dividend paying stocks, we believe it is imperative for investors to be realistic with their evaluations. Investors need to understand the important principles behind risk/reward ratios.
It is almost a universal truth that in order to generate higher returns you must also be willing to take more risk. But more risk does not necessarily mean high risk. In some cases, more risk may possibly only mean slightly more. Understanding that there are graduated levels of risk allows for more level-headed and reasoned investing decisions.
The lost decade
Much has been written and discussed regarding the so-called lost decade for equity returns. In our opinion, not enough has been written or discussed regarding the real cause of the lost decade. Volumes have been offered about bubbles and excesses of all assorted shapes and sizes. There is certainly some truth to be found with most of these reasons. However, our research indicates that overvaluation, built upon irrational exuberance was the greatest contributor to the lost decade.
We've written in the past about the dangers of bringing emotions into the investment process. Investing needs to be done rationally with the emotional response kept in check. We believe that one of the best ways to accomplish this is by investing by the numbers. In other words, investors need to calculate the returns that expected cash flows represent, and then run those calculations to their logical conclusions. Years ago we developed our EDMP Inc. F.A.S.T. Graphs™ to facilitate the easy accomplishment of these necessary mathematical investment tasks.
When evaluating either the stock market in general, or individual stocks specifically, the mathematically calculated returns underpinning each brings great clarity. Figure 1A below will look at the S&P 500 going back to calendar year 1998, or just a few years preceding the so-called lost decade for equities. We would like for the reader to focus on the level of excessive and increasing overvaluation that peaked in calendar year 2000.
The orange line with white triangles in Figure 1A approximately represents the historical normal price earnings ratio of 15 for the S&P 500 (the actual PE for the orange line is 15.4). As the chart clearly depicts, the black price line was significantly above the orange value line in 1998 and continued higher before it finally peaked in calendar year 2000.
Figure 1A S&P 14yr. EPS Growth Correlated to Price
Figure 1B below calculates the performance associated with Figure 1A. Due to excessive overvaluation, returns on the S&P 500 since 1998 have been extremely weak at 2.6%. If we had run this graph only since calendar year 2000, because of even worse overvaluation existing at that time, we would discover that $100,000 invested in the S&P 500 would actually shrink to just over $75,000 today. Ergo, the lost decade that everyone frets about so much. We started in 1998 for reasons that will become obvious later in this article. Take note of the red S&P 500 performance figures shown below at 1.0% without dividends and 2.6% with dividends, which are also repeated in the four company charts which follow.
Figure 1B S&P 14yr. Historical Performance
The Difference Sound Valuation Makes
Figures 2A and B through 5A and B below look at growing businesses with a moderate but growing dividend yield. In contrast to the general stock market as measured by the S&P 500, these growing businesses were trading at reasonable valuations in 1998. The difference in return that these quality growing businesses were capable of generating is shown in stark contrast to the general market.
Recognize that this occurred during the same economic environment over the exact same time frame. The primary differences are more attractive valuation and above-average earnings growth rates. Note that each of these companies historically grew earnings faster than the S&P 500 and that three of the four are currently valued at PE ratios much lower than the S&P 500 today. Only United Technologies (UTX) is trading at PE ratio that is equal to the S&P 500.
Therefore, it should be logically apparent that the S&P 500 started the period highly overvalued and ended in value. Each of the companies, in contrast, started the period in value, and ended the period undervalued. We are going to let following four sets of price- and earnings- correlated graphs speak for themselves.
However, for clarity sake we offer the following keys to interpreting these fundamentals-at-a-glance, “tools to think with” earnings and price correlated graphs. The orange line with white triangles represents a fair value calculated price earnings ratio based on widely accepted formulas for valuing a business. The number printed in orange ink to the right of the graph represents the fair value PE for each company.
Note how the black price line closely tracks and correlates to earnings. When the price line is above the orange line, overvaluation exists; when touching the orange line, the stock is in fair value; and when the black line is below the orange line, the stock is undervalued. The light blue shaded area represents dividends that are paid out of the green shaded area which represent earnings. The dividends are merely stacked on top the earnings for visual perspective.
Figure 2A UTX 14yr. EPS Growth Correlated to Price
Figure 2B UTX 14yr. Historical Performance
Figure 3A TEVA 14yr. EPS Growth Correlated to Price
Figure 3B TEVA 14yr. Historical Performance
Figure 4A IBM 14yr. EPS Growth Correlated to Price
Figure 4B IBM 14yr. Historical Performance
Figure 5A AFL 14yr. EPS Growth Correlated to Price
Figure 5B AFL 14yr. Historical Performance
Important Takeaways
There are many important takeaways to be gleaned from the above graphic presentation. First of all, well-run individual companies can, and do, generate rates of return that can be significantly different from the general stock market. Also, there are many companies that have their own growth drivers that are independent of general economic conditions. The four companies mentioned in this article are just a few of the numerous examples that could be presented.
The importance of valuation is also clearly evidenced by the above graphs. Just as growth rates can vary under the same economic scenario, valuations can vary as well. It is our experience that in every market, whether bull or bear, there will always exist fairly valued, overvalued, and undervalued companies. It's up to the scrutinizing investor to ferret them out. The benefits and rewards for doing so can be great.
Conclusions
Although it is certainly prudent for investors to be cognizant and aware of general economic conditions, it is equally as prudent for investors to base investment decisions on more specific information. More importantly, we believe it is imperative to keep the emotion out of the equation. Neither fear nor greed has ever served investors well, in our experience.
Many nervous investors are making mistakes that are rooted in irrational emotional responses. As an example, investors are buying into fixed income today when interest rates are at all-time lows. The future prices of current low-interest bonds are sure to fall in the long run as interest rates rise in the future. The focus on current income without looking at future valuation or appreciation is an area where we believe caution should be exercised.
Prudent investors are getting their emotions in check and are turning to dividend paying blue-chip stocks. With many companies trading at discounts to historical normal valuations and current dividend yields being competitive to bonds, we believe the prudent investor can find, and are finding, favorable alternatives to fixed income.
Disclosure: Long UTX,TEVA, AFL at the time of writing.
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.
