Readings for the New Year

Following are several links to articles discussing the relationship of dividend growth to earnings growth.

• Surprise! Higher Dividends = Higher Earnings Growth (pdf), by Robert D Arnott and Clifford S. Asness.

• As noted below, the article concludes future earnings growth is highest for the firms that have high current payout ratios. The article does offer the caution that an investor needs to determine if a company with a high payout ratio can maintain the dividend at the current high rate.
  

• "We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come."
  

• Estimating the Long-Term Return on Stocks by John P. Hussman, Ph. D.

• The article provides an analysis similar to the yield to maturity (YTM) calculation for bonds. The Hussman article contains a formula an investor can use to determine YTM for stock investments.

  "...For stocks, the "yield-to-maturity" comes from two components: income plus capital gain. The income component is simply the dividend yield. Assume initially that the dividend yield is held constant over time...If the dividend yield (Dividend/Price) is constant, then by definition, prices must grow at exactly the same rate as dividends grow. By definition, when the dividend yield is unchanged between the date you buy stocks and the date you sell them, your total return equals the dividend yield (income) plus the growth rate of dividends (capital gain)."

• High Dividend Stocks: Bonds with Price Appreciation? This article is Chapter 2 of the book Investment Fables by Aswath Damodaran, Ph. D., a professor at New York University.
  

Dividend Aristocrat Performance as of 12.29.2006

Following is a summary of the S&P Dividend Aristocrat's performance as of 12.29.2006. For the 4-week period, the Aristocrats outperformed the US domestic indices except for the Dow Jones Industrial Average.

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Potential Dow Dogs for 2007

Following is a table for the potential Dogs of the Dow for 2007.

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Source: Dogs of the Dow

The performance for the 2006 Dogs of the Dow can be found at this link. Note, the performance does not include dividends

Bullish Sentiment Jumps

The American Association of Individual Investors sentiment indicator saw a larger jump in bullishness for the 12.28.2006 reporting period. This is a contrarian indicator; thus indicating the market might be getting a little extended. Certainly not hard to believe since the Dow is hitting new highs.

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Source: American Association of Individual Investors

Pre-Election Year Stock Market Performance

Below is a chart from Chart of the Day detailing historical performance of the Dow in a pre-election year. As the chart shows, the market tends to be the strongest in the first half of the pre-election year.

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Source: Chart of the Day

Dogs of the Aristocrats

An often cited investment strategy is the Dogs of the Dow. This strategy involves investing an equal dollar amount, on the first business day of a given year, in the top ten yielding Dow stocks as of the last business day of the prior year.

I thought it might be interesting to look at the top yielding stocks from S&P's Dividend Aristocrats. I have done no back testing of returns for this strategy, but below, I have listed the top yielding Aristocrats as of 1/26/2006. The stocks highlighted in yellow are in the running for inclusion in the Dow Dogs for 2007:

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Financial Savings Targets

A key aspect in developing ones investment plan is establishing a financial plan to ensure goals and objectives are being achieved on an ongoing basis. An important component of the plan is the development of specific asset value targets to be achieved on an annual basis.

An article recently published in the Journal of Financial Planning, Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement describes a process to determine what level of investment assets may be required in order to retire in comfort.

The article contains the following executive summary:

• "Investors commonly use stock ratios such as the price to earnings, price to book, and dividend yield to assess the financial health of a company because the ratios concisely benchmark a company's financial status.

• Clients and their financial advisors have no comparable ratios that would allow investors to conduct a similar analysis of their personal financial circumstances. This article establishes a set of personal financial ratios that individuals can use to analyze their financial standing. Just as stock ratios are primarily based on a company's earnings, the personal financial ratios are based on an individual's income. There are three ratios: savings to income, debt to income, and savings rate to income.

• The ratios are derived from a series of assumptions including household budgets, post-retirement income replacement, rates of return, and retirement distribution rates.

• The ratios are designed to serve as a road map so that investors can compare their individual ratios against the benchmarks to determine whether they are on track to retire by age 65. The ratios serve as a practical tool for advisors to help convey to their clients the fundamental relationship between one's income, debt, and savings rate, and how those relationships must change over time."

The article concludes by stating, "...ratios also provide households with a practical tool for analyzing their personal finances and the progress they are making toward financial independence." The article provides a process an investor can go through in determining appropriate levels of retirement savings needed at various stages in their lifecycle.

Source:
Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement
By: Charles J. Farrell, J.D., LL.M.
January, 2006
http://www.fpanet.org/journal/articles/2006_Issues/jfp0106-art6.cfm

Investing New Year Resolutions for 2007

As the new year approaches, many individuals will provide their best guesstimate on what will unfold for the markets and the economy in 2007. The one resolution I believe many investors should adopt is that of committing to gain a better understanding of their investments and why they choose to invest in particular companies. Over the course of the next week, I intend to highlight material on different investment and wealth management topics, such as financial planning, etc.

A quote in the recent newsletter from Investment Quality Trends:

"To some market valuations are hostile. To others, market valuations offer opportunity. We will leave the discussion about the market valuations to others because we don't know how to value markets; we do know how to value stocks."

To facilitate staying on track with this type of resolution, following are links to posts and/or articles that might enhance ones investment understanding as we enter the year 2007.

• Taking the Spin Out of Earnings Announcements. This article from the CFA Institute and featured on the American Association of Individual Investors website covers nine key points to consider when analyzing corporate earnings announcements.

• 10 Common Trading Errors. This list is featured on The Big Picture website and is a summary from a Fidelity article.

• For the new investor, Starting an Investment Program with Dollar Cost Averaging.

  "The first step is always the hardest. And individual investors taking their first steps in an investment program must also confront a sea of stock market uncertainty. Some plunge headlong into the market with all their savings. Others barely wet their feet before heading back to the safe shores of their money market funds. The problem, however, with these two all-or-nothing approaches is one of timing—the risk of entering the market at a high point in the market cycle...."

• Read a book featuring details on some of the more successful market investors.

• The Intelligent Investor by Benjamin Graham. Ben Graham is often called the "Father of Value Investing" and the "Dean of Wall Street". Warren Buffett often cites Ben Graham material. Warren Buffett studied under Ben Graham at Columbia University and Warren Buffett was the only student to ever get an A+ in a Benjamin Graham class.

• The Future for Investors by Jeremy Siegel. The Future for Investors reveals new strategies that take advantage of the dramatic changes and opportunities that will appear in world markets. He finds new technologies, expanding industries, and fast growing countries that stockholders relentlessly seek in the market often leads to poor returns. In fact growth itself can be an investment trap, luring investors into overpriced stocks and overly competitive industries. The book challenges conventional wisdom and provides a framework for picking stocks that will be long run winners.

• The Essays of Warren Buffett by Warren E. Buffett, Lawrence A. Cunningham. The Wall Street Journal, July 6, 2000, Front Page, "Cunningham's Buffett Essays ranked #3 on JP Morgan's 10-book list of "Summer Must-Reads for Millionaires"
  

Standard and Poor's New Dividend Aristocrats for 2007: Update

Following is S&P's rational for the changes to the Dividend Aristocrats portfolio.

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Source: Standard and Poor's

Dividend Aristocrats Outperform for the Week

On a market weighted basis, S&P's Dividend Aristocrats outperform for the week ending 12.22.2006.

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State Street Raises Dividend...But

Yesterday, State Street (STT) announced a YOY increased in its quarterly dividend of 10.5%. Details of the increase are noted below.

The 10.5% increase is lower than the company's historical increases. The company's rate of dividend growth has steadily declined from 19% in 2001 to the current 10%. Keep in mind though, STT is a company that increases its dividend every third quarter. This slowing of the dividend growth rate indicates an investor should research to see if the company's board is signaling a slow down in STT's earnings growth.

Year over Year Percentage Change

Bullish Sentiment Declines in the Period Ending 12.20.2006

In the American Association of Individual Investors sentiment survey release this week, bullish sentiment declined and bearishness increased a full 4.5 percentage points. The bullish trend in this contrarian indicator has been down since bullishness hit a high of 54.2% in the October 19th measurement period. If bullish sentiment falls to a level like July 20th, this would be one indication the equity markets may rally.

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Source: American Association of Individual Investors

S&P 500 Index Changes and Impact on Price of Stocks

Standard and Poor's made the following change to the S&P 500 Index on 12/19/2006. The stock chart shows the impact on the stock trading volume and resultant impact on the company's stock price upon being added to the S&P 500 Index.

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Following are the index changes that go into effect on 12/29/2006.

Spectra is the midstream gas business of Duke (DUK). The Spectra spin off is slated to close by 1.2.2007.

Dividend Aristocrats Performance 12.19.2006

NASDAQ Index lands in bottom third of performance ranking of Dividend Aristocrats Also include 1-month industry returns.

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Source: MSN Money

Thai Government Relaxes Investment Restrictions

This afternoon the Thai government retracted (earlier post) their announcement that they would restrict the flow of foreign funds in equity investments. The Thai government restrictions would remain on bonds and commercial paper though.

In the afternoon email alert from the Online Edition of the Wall Street Journal, Tim Annett stated,

"Ironically, a successful military coup this September against Prime Minister Thaksin Shinawatra lured some investors back to the nation's stock market in the belief that the Thai economy and political system might stabilize following a stretch of cronyism and mismanagement. This week's decision, the first big economic-policy move by the military-led government, seems certain to shake investor confidence in the new leaders. And the fact that the decision was so readily overturned after the market meltdown probably won't do much to strengthen the government's economic credibility, either, since it may reveal a lack of conviction at best or a lack of expertise at worst."

This is the type of activity that can contribute to market disruptions longer term. Time will tell.

Source:
Thai Take-Out
Tim Annett
The Wall Street Journal Online ($)
December 19, 2006, 12:41pm
http://online.wsj.com/article/SB116653266791254472-search.html?KEYWORDS=annett&COLLECTION=wsjie/6month

Pfizer Increases Dividend 21%

Pfizer (PFE) announced a 21% YOY increase in its first quarter 2007 dividend. This places the projected yield on the new dividend at 4.5%. Pfizer's highest yield historically had been about 4%.

Emerging Market Thailand Imposes Restrictions on Foreign Investors

The emerging markets declined overnight on Thailand's currency control announcement. These controls will negatively impact foreign investors. These are the type of unforeseen market events that can create stock market corrections. Higher quality dividend paying stocks should be a safe haven today relative to other markets.

Thai Stocks Tank on New Investment Rules

BANGKOK, Thailand (AP) - Thai stocks plummeted 15 percent Tuesday after the country's central bank introduced new controls on foreign investment, rattling markets throughout the region in the most dramatic turmoil since the 1997 Asian financial crisis.

Investors dumped stocks in Hong Kong, India, Indonesia and Malaysia amid concerns that the plunge might to spread through the region and trigger the kind of slump that wracked Asia nearly 10 years ago.

The Stock Exchange of Thailand's benchmark SET Index plunged as much 19.5 percent before recovering some to close at 622.14, down 14.8 percent.

It was the market's biggest drop ever, the stock exchange said. The hardest hit sectors were banking, energy and telecommunications.

The plunge came after the Bank of Thailand late Monday announced its toughest measures yet to clamp down on speculative inflows that have lifted the Thai currency, the baht, to a nine-year high of 35.09 to the U.S. dollar Monday. On Tuesday, the baht weakened to 35.93 per dollar.

Starting Tuesday, all banks are required to hold in reserve for one year 30 percent of capital inflows that aren't trade- or services-related, or repatriation of Thai residents' investments abroad, the bank said. Also, foreign investors must pay a 10 percent penalty unless they keep funds in the country for a year.

Effectively, the central bank's new rules mean that if a foreign investor allocated the equivalent of 100 million baht to the Thai bond market, the investor could only buy 70 million baht of bonds, while the remainder would be withheld by the central bank, earning no interest. If the investor wanted to withdraw the money in less than a year, only two-thirds of the amount withheld would be returned.

"Foreign investors are nervous about the measure introduced by the central bank," said Sukhbir Kanijoh, an analyst with Kasikorn Securities in Bangkok.

"Many are also worried that more measures will be introduced to curb the strengthening baht that will make the Thai market even less attractive," he said. "Selling is heavy and selling orders will likely continue throughout tomorrow, unless there is a revision to the measure."

But David Cohen, chief of Asian economic forecasting for Action Economics in Singapore, said the events in Thailand are fundamentally different from the events surrounding the 1997-98 Asian financial crisis.

The big problem 10 years ago was currency weakness; now, it's currency strength.

"I would emphasize the contrast to the situation in '97 and '98. The measures the Bank of Thailand felt obliged to impose were to resist the appreciation of their currency," Cohen said.

Ben Kwong, chief operating officer at KGI Asia in Hong Kong, also said regional economies are now "relatively healthy" compared with the situation in 1997.

"The situation is different now. Many regional economies have achieved more balanced accounts and currencies are likely to go up, not down," he said.

Thailand's measures "aim to change the rules of the game and were a blow to foreign investors' confidence. The big market reaction is understandable," he said. "But there shouldn't be any long-term effects on Hong Kong."

The Stock Exchange of Thailand on Tuesday called for the central bank to review its decision to impose new rules aimed at weakening the baht, saying the move prompted foreign investors to dump Thai shares.

Eli Lilly Dividend Analysis

Lilly (LLY) announced a 6.2% YOY increase in its quarterly dividend today. The 5-year average payout ratio averages 51%. The payout ratio has trended higher during this period, with a low payout of 41%in 2002.

As noted in past posts, the dividend growth rate is a factor that receives a lot of weight in analyzing the potential growth prospects of a company. A dividend growth stock's long run return tends to match its dividend growth rate, all else being equal. Is Lilly's 6.2% increase an indication of slower growth for LLY? Following are two tables detailing some company financial information:

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LLY has continued to use cash through September 2006 with cash and short term investments totaling approximately $3.6B. So the question becomes is sufficient information available that warrants selling or purchasing the stock?

Additional key factors:

• high dividend yield over last 15-years equals 5% in mid 1994.
• low dividend yield over past 15-years equals .9% at the end of 1998.
• stocks appears to be making a bottom in the low $50's.
  

• Lilly has a fairly strong drug pipeline: Prasugrel (anti-platelet agent), an inhaled insulin drug, long acting version of Byetta (diabetes), and a cancer drug.
• FDA requiring additional Phase III study for the diabetic drug Arxxant
  

T. Rowe Price Raises Dividend 21%

Last week T. Rowe Price (TROW) raised its quarterly dividend 21%. This dividend action is the 20th consecutive year the company has raised its quarterly dividend.

One technical factor to review when purchasing dividend growth stocks is the company's current yield relative to the historical yield for the stock. The 15-year range of the yield for TROW is a high yield of 2.6% and a low yield of .8%. The new yield on the new quarterly dividend is 1.5%.

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Modern Portfolio Theory and Concentrated Investments

An often cited aspect to investing is the construction of an investment portfolio under the discipline of Modern Portfolio Theory or MPT. Yahoo Finance provides a layman's description of MPT:

"You can divide the history of investing in the United States into two periods: before and after 1952. That was the year that an economics student at the University of Chicago named Harry Markowitz published his doctoral thesis. His work was the beginning of what is now known as Modern Portfolio Theory. How important was Markowitz's paper? He received a Nobel Prize in economics in 1990 because of his research and its long-lasting effect on how investors approach investing today.

Markowitz starts out with the assumption that all investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns.

Rather than look at risk on an individual security level, Markowitz proposes that you measure the risk of an entire portfolio. When considering a security for your portfolio, don't base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.

Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called "correlation," and it measures how much you can expect different securities or asset classes to change in price relative to each other.

For instance, high fuel prices might be good for oil companies, but bad for airlines who need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You'll get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies.

When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return."

With an investment approach that attempts to construct an investment portfolio with the goal of generating the best "risk adjusted" return, investors need to realize, this may not be the portfolio that generates the highest absolute return.

In a paper by Ed Easterling at Crestmont Research, he notes,

"Over the past several decades, the financial community has also realized that the theories of market efficiency, an important assumption for MPT and CAPM, may not be as strict as originally hypothesized. Financial markets are an efficiency process, rather than an efficient condition. In other words, markets function to find the right prices over time, but don’t always reflect all of the information all of the time..."

Additionally, Mr. Easterling's article makes the observation,

"...diversification in a portfolio applies to risks, not securities. Other than not being familiar with the investment alternatives, what other rational reason would explain why investors concentrate their portfolios into two major risks when so many options are available?"

At the time of Harry Markowitz's MPT study, an investor essentially had the choice of investing in stocks, bonds or cash. Today, an investor has many more investment choices, be it good or bad.

So, since MPT diversification applies to risk and not securities, it is possible that concentrated investment portfolios, in and of themselves, may not be a poor investment decision. On the other hand, today, the volatility of the markets is greater than what has been experienced in the past. This greater volatility is compounded in down markets as noted in the chart below.

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Copyright 2006, Crestmont Research, (www.CrestmontResearch.com)

Because volatility is greater in down markets, one way to potentially minimize the downside of an equity portfolio is to invest in securities that tend to hold their value better in down markets. As noted in prior posts, studies by Standard & Poor's indicate higher quality dividend paying stocks have historically held up better in down markets. This is important because negative returns have the most detrimental impact on long run returns as noted below:

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Source: Crestmont Research

As detailed in the lower right-hand portion of the above chart, each of the six portfolios have the same average rate of return; however, the portfolio that had no negative return periods has the highest compound rate of return.

In conclusion, it is important to remember minimizing risk is really the focus of constructing an investment portfolio. Concentrated investments in individual securities can result in poor returns if their investment characteristics indicate they are more volatile. For example, Black & Decker lost nearly 10% or $8+ in value yesterday. Conversely, utilizing a dividend growth investment discipline to select ones investments may lead to lower downside equity returns; hence, long run outperformance of your investment portfolio.