Seeking Alpha

chowder's  Instablog

chowder
Send Message
My primary objective is income replacement! ... The objective is to start earning an income stream now, to replace the income that will be earned throughout the working years. I want that income to be reliable, predictable and increasing. The income stream will need to continue to grow to stay... More
My blog:
Market Strategies
  • It's All About The Fundamentals

    In the next few days, I will be making another purchase in the Project $3 Million Portfolio. I thought I'd share some insight into how I go about the process.

    I've had quite a few requests about my stock selection process, and although I don't mind sharing it, it is time consuming to take people through the process. So, I thought I would write it down here and simply link to it when asked again.

    The very first thing I look at is a company's financial strength ratings, their credit rating if you will. I look for companies that rate a 1 or 2 for Safety by Value Line, or a BBB+ rating by Morningstar if you don't have access to Value Line, and I look at S&P Capital IQ for Quality ratings of B+ or better.

    If a company doesn't meet the quality rating, or I can't confirm one, I go no further, unless I'm specifically looking for a speculation company.

    These companies I purchase are supposed to provide us with a lifetime of income and the best way to insure that is to own quality. Quality is job #1.

    I have a watch-list of 48 companies that pass the quality stage. These are the companies I monitor for opportunity.

    As I look over the watch-list, I have to see what I own and decide which sectors I want to go with. Here is the current portfolio weightings:

    Consumers ... 43.2%

    MLP's ... 14.5%

    Utilities ... 13.5%

    Industrials ... 8.1%

    REIT's ... 5.6%

    Healthcare ... 4.2%

    Business Services ... 4.1%

    Energy ... 3.8%

    Technology ... 3.1%

    Financials ... ZERO

    Since the portfolio is so heavily weighted in consumers, anything consumer related is out this time around. That would include WMT or TGT for example.

    I decided to focus on the sectors with weightings under 10%, to help build some balance as we go forward this year.

    In looking over my watch-list, it isn't valuations I look to first. I look for companies rated to beat the market over the next 6 to 12 months. Fidelity has a rating system called StarMine and the research firms in the system provide ratings from zero to ten to determine where the collective firms rate a company currently. Anything from 7.0 and up is a Bullish rating.

    The reason I want some momentum here is because I want the position to have a good chance of getting off to a good start. We're in a good economic and market environment right now where the tide is supposed to raise all boats. By getting off to a fast start, it provides peace of mind during market corrections.

    Out of 48 companies on the watch-list, and considering the sectors I was looking to invest in, only 3 companies passed the StarMine ratings test. They were MSFT... 9.0, IBM ... 9.5 and CSX ... 9.1 If I was willing to add consumer related, WMT rated out at 7.4.

    Once I have the list narrowed down, I then look to see who provides the best discounts to fair value. I use S&P Capital IQ for these ratings. According to S&P, MSFT is selling at an 18.8% discount. IBM is selling at a 30.7% discount to fair value, and CSX is overvalued by 4%. I like to see discounts of 15% or more, but will settle for less when I have to. I eliminated CSX from consideration until better valuations present themselves.

    The next step, since this is a dividend growth portfolio, is to determine the total dividend return when you combine yield to the dividend growth number, what is known as the Chowder Rule.

    I won't delve into the fundamentals until the quality ratings, discounts and dividend growth numbers are acceptable. I don't wish to dig deep and then find out the dividend growth is unacceptable.

    When you take the current yield and add it to the 5 year compounded annual growth, I want to see a number of 12% or better when the yield is 3% or higher, or a number of 15% or better when the yield is under 3% but above 2%.

    MSFT has a Chowder Rule number of 18.98%. IBM has a Chowder Rule number of 16.27%, so both companies qualify.

    I want to see where the company has a consecutive string of raising the dividend. I'll accept 5 years, but I prefer 10 or more. The more the better.

    IBM has a 17 year string and MSFT has a 7 year string. Both qualify.

    At this point I look at earnings. I look at the last 10 years and I want to see where earnings have increased at least in 7 of those 10 years.

    IBM has seen their earnings rise in 10 of the last 10 years. I really like this! MSFT has seen their earnings rise in 7 of the last 10 years. Both qualify.

    At this point, it isn't a matter of who has the better numbers, both companies qualify for the next step, where the final decision will be made.

    This is important! I don't go with the best yield and dividend growth. I go with the company with the better underlying fundamentals, and that's the next step.

    I look at current PE's vs historical PE's to help determine valuation.

    IBM's current PE is 11.1% and normal PE is 16.6%. MSFT's current PE is 13.3% and normal PE is 18.1%. Both are still looking good. But when I look at return on equity and return on invested capital, I see that IBM's numbers are on the rise and MSFT's numbers are on the decline.

    Estimated earnings growth, and I realize they are just estimates, show IBM at 10.2% and MSFT at 9.1%.

    When I look at all the firms that cover these companies, StarMine tracks their buy, sell or hold ratings for accuracy. I always look at the reports by the top two firms for accuracy on a company and these companies aren't tops with every company they cover.

    The top two firms for accuracy calls on IBM are Jefferson Research with an 84% accuracy rating and then comes Ford Equity Research with a 73% accuracy rating. Both companies have a Buy rating on IBM.

    The top two firms for accuracy calls on MSFT are the same two companies, so this makes this easier to decipher. Jefferson Research has an accuracy rating of 84% and has a Hold rating on MSFT. Ford Equity has a 73% accuracy rating and has a Strong Buy on MSFT.

    Since Jefferson Research is more accurate than any other firm with their calls on these two companies, I delved a little deeper into their research.

    IBM:

    Earnings Quality ... Strongest

    Cash Flow Quality ... Strongest

    Operations Efficiency ... Strongest

    Balance Sheet ... Strongest

    Valuation ... Least Risk

    MSFT:

    Earnings Quality ... Strongest

    Cash Flow Quality ... Strong

    Operation Efficiency ... Strong

    Balance Sheet ... Weakest

    Valuation ... Least Risk

    ....

    Both companies are still worthy of purchase, and some people may choose MSFT because of the higher yield and slightly better Chowder Rule number, but IBM presents the stronger fundamentals at this time, and it's those fundamentals that are going to drive the dividend growth.

    So, when the cash hits the account, I will be taking out a position in IBM the middle of next week.

    Jan 11 5:39 AM | Link | 107 Comments
  • The Chowder Rule

    I notice that a lot of people are now referring to The Chowder Rule. I thought that as long as people are going to use it as a criteria in their stock selection, I would explain how and where it came from.

    In order to understand the importance of The Chowder Rule, and how it relates to the stock selection process, one needs to understand the concept of dividend growth investing as I see it. One needs to understand what I was trying to accomplish and why. Once you understand this, you may be able to adjust the numbers to suite your needs, or accept it and apply it as it is.

    When I discovered dividend growth investing I was surprised that there wasn't a blue print to describe exactly what it was. I saw where people had various views or ideas of what dividend growth investing meant to them.

    One concept I came across stated that any company whose expected long-term dividend growth rate exceeded its current yield, was a dividend growth stock. I can see that as workable, but it appears to have limitations. One would have to abandon owning high quality companies with high yields, yet low dividend growth rates. One might get caught up with owning mostly low yielding companies with high dividend growth rates that are unsustainable.

    Keep in mind that there is usually a trade off between yield and dividend growth. My objective was to find a balance between the two.

    I do prefer a long history of dividend growth over a short one. I do prefer more dividend growth over less. With the threat of higher interest rates affecting high yield companies, it is also plausible that high dividend growth will slow, and low dividend growth will freeze or decline. So again, I'm looking for balance between the two.

    One of the problems with high dividend growth is that it eventually has to slow. So in my opinion, I am better off trying to balance a high yield vs high dividend growth.

    Another consideration about double digit dividend growth is the base from which it began. If a company started with a dividend of 2 cents, it wouldn't be difficult to grow at double digits and it wouldn't have much of an impact on the income stream either. Also, keep an eye on the payout ratio. Just make sure it isn't astronomically high in order to provide dividend growth. A company can't continue raising the payout ratio, so something has to give.

    One thought that had an impact in applying The Chowder Rule was a stock that yields 1% has to raise its dividend 20% to generate the same dollar increase in annual income that another stock yielding 4% can achieve with a mere 5% hike.

    Which growth rate is more realistically expected to be maintained over long time frames?

    Most of the principles and concepts I apply have been taken from the book, "The Single Best Investment" by Lowell Miller.

    According to Miller, the hidden key to the single best investment is dividend growth. The reason dividend growth is so important for long-term investors is because dividend growth is what drives the compounding machine in a way that is certain and inevitable. Dividend growth is an authoritative force that compels higher returns regardless of other factors affecting the stock market.

    An important point is that an instrument that produces income is valued based on the amount of income it produces. The more income it produces, the more valuable the asset.

    Keep in mind, you not only receive greater income as the years go by, you also get a rising stock price because the asset producing the income is worth more as the income it produces increases.

    Stop and think about it for a minute. When you look at the long dividend growth history of companies like KO, PG and JNJ, if share price didn't keep up with dividend growth, they would have yields of 10%, 15% or more -- and the market isn't going to allow that to happen.

    (The following paragraph is the essence of The Chowder Rule!)

    So in effect, you get a "double dip" when you invest in high yield stocks that have high rising dividends. You get the income that increases to meet or surpass inflation, and you get the effect of that rising income on the stock price, which is to force price higher.

    Dividend growth investing to me means that I am creating a compounding machine, not playing the market. Dividend growth is the energy that drives that machine.

    In the book, "What Works on Wall Street" by James O'Shaughnessey, he states ... "It's impossible to monkey with a dividend yield." The author found that high yield was a much more effective factor in stock price performance when what he calls "large" stocks are studied. Among large stocks, he found that the highest-yielding stocks out-performed the overall universe 91% of the time over all rolling ten year periods.

    Miller/Howard Investments revisited the issue of high yield and dividend growth with the help of Ford Investor Services, an institutional database and research organization based in San Diego. Using their data base going back to 1970, they found that high-yield stocks outperform the market over long periods on both an absolute and a risk-adjusted basis. The key is to own quality! ... (I hope you got that.)

    Once you understand the concept, the next step is to come up with a plan of action.

    This leads to a formula I adopted. I call it "The Success Formula That Never Fails."

    High Quality + High Current Yield + High Growth of Yield = High Total Return.

    High Quality is defined as having superior financial strength. A company must have a 1 or 2 rating for Safety with Value Line, or a BBB+ rating or better with S&P. Both of these Financial Strength ratings indicate investment grade quality. ... Anything that doesn't meet the High Quality definition is considered speculation and managed differently within the portfolio.

    High Current Yield is defined as a yield that is at least 50% above the yield offered by the S&P 500. Therefore, if the S&P 500 has a 2% yield, then 3% is the minimum number for purchase under the formula stated above.

    High Growth of Yield is defined as companies that raise their dividend at a rate of 5% or more.

    With the "Success Formula" in hand, I needed to come up with a way for it to support my long-term objectives.

    My long-term objective is to grow the portfolio at an 8% compounded annual growth rate (OTCPK:CAGR). I decided I would try to take advantage of total dividend return, current yield plus a 5 year CAGR to help support my long-term 8% CAGR objective. This total dividend return concept was dubbed The Chowder Rule by a Contributor on Seeking Alpha by the name of J.D. Welch.

    Since High Current Yield called for a 3% minimum yield, based on the 50% above the S&P 500 yield concept, Howard Miller's 5% annual dividend growth minimum, when added to the yield came out to 8%. That was exactly what my long-term goals were and I established those goals before I read Miller's book.

    I then decided I would place a "moat" around that 8% number as a margin of safety because I knew as price rises, yields come down and the original Chowder Rule number will as well.

    I thought I would go 50% higher and came up with a Chowder Rule number of 12% as a total return objective. ... If others want to adjust the number to meet their objectives, that's fine. As long as it supports what it is you are trying to do, you'll get no argument from me. ... Ha!

    Anyway, that 12% total dividend return number is now referred to as The Chowder Rule by many. So basically, if a stock has a 3% yield, I need a 5 year dividend growth rate of 9% to get my 12% number. If a stock has a 4% yield, I only need an 8% dividend growth rate.

    For example:

    CVX has a yield of 3.1% and a 5 year CAGR of 9.13%. When added together, I get a Chowder Rule number of 12.23%. ... It qualifies for purchase as long as the fundamentals and valuations meet your standards.

    As I delved deeper into the concept of dividend growth investing, I realized I needed to focus on the safety of the dividend first. As I researched, I found that a lot of companies with solid dividends weren't able to grow their business like a lot of other companies, so their dividend growth may not be as robust. Utility companies are a good example of this.

    Since my long-term goal is to achieve an 8% CAGR, I thought I would use that number for utility companies since it still supported my objective. I include telecom and MLP's under the utility umbrella. So for example, D has a yield of 3.4% and a 5 year CAGR of 6.99%, giving me a Chowder Rule number of 10.39%. It qualifies for purchase as long as the fundamentals and valuations meet your standards.

    I know there are those who wish to own companies with yields below 3%, yet have higher dividend growth. I'm not opposed to this, but keep in mind, the lower the yield, the more you must rely on capital appreciation to achieve High Total Return.

    I decided that if I'm willing to accept a yield below 3%, I must require a higher dividend growth rate. I needed a higher Chowder Rule number to serve as a margin of safety. I decided to use 15% for companies yielding less than 3%.

    So for example:

    DE has a yield of 2.4% and a 5 year CAGR of 13.84% for a Chowder Rule number of 16.24%. It qualifies for purchase as long as the fundamentals and valuations meet your standards.

    Again, these numbers were designed around my long-term objectives. If your goals are different, you can adjust the numbers any way you wish as long as they support your goal. Just keep in mind that the lower the yield, the more you must rely on price appreciation.

    I applied The Chowder Rule as a way to take the pressure off of price appreciation. I was looking for the "double dip" balance.

    Oct 30 6:42 AM | Link | 106 Comments
  • Basic Forms Of Risk

    In recent weeks the Dow Jones Industrials have continued to hit new all-time highs. According to the Wall Street Journal, the Dow has hit a new high 28 times this year.

    The higher the market goes, the more people worry about a market correction. Just how much more riskier are stocks now than other investing opportunities? I suppose it all depends on how one defines risk.

    Before I get into defining risk from my point of view, let me share some food for thought. It has been reported that Warren Buffett's Rule #1 is to not lose money. He is also reported as saying that one should not own a company that would cause us to sell on a 50% pullback.

    So which is it? Don't lose money or don't sell on a 50% pullback? ... I believe it all comes down to how you define risk. I think I understand how to not lose money and still be able to withstand a 50% pullback.

    I believe that risk takes two very basic forms and everything else is an offshoot of those basic forms of risk. They are referred to as "Shallow Risk" and "Deep Risk."

    I recently read an article in the Wall Street Journal by Jason Zweig, where he wrote about these basic forms of risk. According to Zweig, William Bernstein, an investment manager at Efficient Frontier Advisors, calls "Shallow Risk" as a temporary drop in an asset's market price. Key word being "temporary." Benjamin Graham, author of The Intelligent Investor, referred to a temporary loss as "quotational loss."

    "Shallow Risk" is as inevitable as the weather. You can't invest in anything other than cash without being hit by sharp falls in price. "Shallow" doesn't mean that the losses can't cut deep or last long ... only that they aren't permanent.

    "Deep Risk" on the other hand is a loss of capital that you won't recover for decades ... if ever. The four causes of deep risk are inflation, deflation, confiscation and devastation. These forces can make assets lose most of their value and never recover.

    Bernstein says that we should insure against deep risks based both on how likely and how severe they are. For example, if you live in a flood zone, you should insure against flood before anything else.

    As you break down the causes of deep risk, devastation would include war or anarchy. There isn't much that you can do about it. As far as I'm concerned, it is a risk I can ignore, other than not investing in countries with unsteady regimes or no law and order.

    Confiscation can be attributed to a surge in taxation, or a seizure by government as happened to bank deposits in Cyprus.

    For the most part, we can manage our assets for most taxes, but we must be aware that tax changes involve deep risk. A change to the tax laws regarding REIT's and MLP's would be a good example. So, we may want to keep those positions in proper perspective within our portfolio's.

    Deflation is the persistent drop in the value of assets and is very rare in modern history. It has hit Japan, but almost nowhere else in the past century, due to central banks that print money to drive up prices.

    If one is concerned about deflation though, the best place to put your money would be in long-term government bonds. You could also get foreign exposure via equities since deflation isn't likely to hit all nations at once.

    However, since bonds protect you from deflation, they expose you to inflation ... by far the likeliest source of deep risk.

    Bernstein said that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years. That is deep risk at its deepest. --- In my opinion, dividend growth is the best hedge against inflation. This does of course expose you to shallow risk.

    Most people who promote asset allocation would want us to have a globally diversified stock portfolio with some gold and natural resources companies, some treasuries, inflation protected securities and bonds. But holding stocks to insure against deep risk drives your shallow risk though the roof. While stocks should protect you against inflation in the long run, they are guaranteed to expose you to price drops in the shorter run. That could push you into the final frontier of deep risk ... your own behavior.

    Most investors can't survive the pain of plunging prices unless they have a surplus of cash, capital gains and courage. When you have plenty of each, you can hang on and endure price drops like we experienced during The Great Recession. I found that when you own quality blue chip type companies, that the risk I was taking on was in the shallow risk category. In other words, losses were temporary.

    If one sells quality in a declining market, one is thereby inflicting a permanent loss which comes under deep risk. In a lot of situations, it's your behavior that is more at risk than your holdings. Your behavior can turn shallow risk into deep risk in a heartbeat.

    This is why I continue to harp on owning quality blue chip companies. These companies have survived decades of adversity and continue to bounce back correction after correction. If the blue chip companies don't come back after a market correction, nothing will. If I can eliminate deep risk, I can handle shallow risk. After all, the loss from shallow risk is only temporary.

    Take the advice of Warren Buffett. Only own companies you would feel comfortable owning, and adding to, if they were to suffer a 50% pullback. That's how you meet Rule #1 ... don't lose money. Focus on best of breed!

    Aug 14 7:59 AM | Link | 15 Comments
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.