The Quality Doesn't Matter Phenomenon

Standard and Poors recently reported that 2005 was an upside-down year. Their research shows that, in general, the higher the quality of the company the poorer it performed in the year just past. In addition, the smaller the company the better it likely performed. Since when did quality not matter? S&P cited their own research that shows over the long run companies with the highest earnings and dividend quality ratings have outperformed lower quality companies by a wide margin.

But why would “quality” not matter -- especially in a time of increasing globalization, geopolitical risks, rising interest rates, and spiking oil prices? Coincidently, we spent an entire investment policy meeting on this very subject earlier this year. We did not have S&P’s statistics then, but we could see widespread evidence that small stocks were doing better than large stocks. Our conclusion was that the relative out-performance of smaller and less creditworthy companies was a function of the strength of the US economy. The primary reason for that conclusion was that our research showed a similar quality-doesn’t-matter occurrence in bonds; where the yield spread between AAA and junk-rated bonds was also well below normal. We concluded that even though many people (particularly the media) were not buying how strong the US economy was, that US stocks and bonds certainly were.

We started studying this quality-doesn’t-matter phenomenon because we have just been mystified as to why the outstanding business performances of many of the companies we own had largely been ignored. Our world is entirely contained within the so-called investment-grade universe of companies, and those companies were exhibiting three almost universal characteristics: 1. Earning growth that was much higher than the average of the last five years; 2. Dividend growth that was perhaps as good as we have ever seen; 3. Our valuation models were showing most of our companies were 15%-20% undervalued, using statistical relationships between dividend growth and price.

Actually, we were not complaining because these high quality companies were seldom on sale, and we have been nibbling all year, but the strong performance of companies that would never make it through our “quality door” gave us pause. S&P’s recent comments about quality and performance, combined with our own research showing the remarkable narrowing of the yield spread between AAA bonds and junk bonds, produced a kind of “what’s wrong with this picture” among the members of our investment policy committee. This resulted in the following line of thinking: What kind of environment causes riskier companies to perform much better than normal? Answer: when risks are perceived to be low. When are risks to companies low? Answer: when interest rates are low and the economy is strong and expanding. Are interest rates likely to stay low and will the economy continue to grow at near 4%? Answer: no and no.

If our line of thinking is correct, a change in the notion that quality-doesn’t-matter is at hand because we are absolutely convinced that the Federal Reserve’s goal is to slow economic growth to 3% from 4%, and they will drive interest rates wherever they deem necessary to accomplish their goal. A one percent slow down in the economy doesn’t sound like much, but remember it is one percent on 4%, or actually a 25% slowing. That magnitude of slowing will hurt many companies, and it will disproportionately hurt smaller more highly-leveraged companies whose business is mostly in the US; the very companies that the market is currently smitten with.

But doesn’t the slowing economy mean that all companies will suffer? The short and long answers are both “No.” There are three reasons: 1. The typical high quality company that is in our portfolios produces almost 50% of their earnings outside the US. Thus, the slowdown we see coming will be less pronounced among our companies. 2. While the US economy is slowing, economists we follow are forecasting that the rest of the world’s economic growth will be accelerating in 2006. 3. This means that not only will our companies be less affected by the slowing US economy the 50% of their earnings outside the US is likely to be accelerating, which would add to their appeal relative to small domestic companies.

Our research can find few instances where the current quality-does-not matter phenomenon lasted for an extended time. We can find even fewer occasions when quality has actually been a negative, as has been the case in the last 18 months. For these reasons, we believe the current situation cannot last and, indeed, there are signs that the worm is already turning. Since the first of the year, our portfolios have been outperforming the major indexes and, on a total return basis, they have already grown more in the first two and a half months than they did all of 2005. We will keep you informed of their progress in the coming months.

As we said earlier, dividend increases over the past twelve months may have been the best the Rising Income portfolio has ever produced, and we are sure that the portfolio’s dividend growth over the last three years is the best three-year period ever. Currently, there are 27 companies in our model portfolio, which have an average current dividend yield of 3.3%. The big news is that dividend growth over the last twelve months has been 11.6%, with Toyota, Nestle, United Technologies, and Colgate leading the way with dividend increases averaging well over 20%. Dividend increases over the last three years have averaged 10.4%, with Toyota, Cincinnati Financial, Wachovia, Wells Fargo, and United Technologies putting up 20% plus growth.

To compute the total dividend return over the past three years, we add the average dividend yield of 3.3% to the average growth of 10.4% to get 13.7%. During the last three years, the actual total return of the portfolio has been significantly less that this figure, and that is where the valuation gap occurs. Over the last 20 years, on average, the stocks in our portfolio have had a near 90% correlation between dividend growth and price growth. Our models currently indicate that the average stock in our portfolio is 15% undervalued. Our models also indicate that the greatest cause of the valuation gap is the portfolios’ performance over the last year. We believe this is a direct result of the quality-doesn’t-matter phenomenon we discussed earlier, but will change as earnings among smaller companies come up short.

The old saying that goes, “Eventually the cream rises to the top”. Old sayings become old because they are true. We own the cream of the crop. You know the rest.

Donaldson Capital's General Dividend Strategy: Part I

Rising dividends have power. But, their power is largely hidden because most people don’t know where to look for it. Understood properly, the hidden qualities of rising dividends can afford investors an unobstructed view beyond today’s fluctuating prices into the underlying values of an individual stock and the overall market. In this letter, we will identify some of these hidden qualities and how we use them for investment analysis and selection. Dividends are becoming a more familiar subject among investors, but judging from the articles we have read in the mainstream media, the public is still primarily interested in high dividend yield, with dividend growth running a distant second. It is natural that high dividend yield investing would get the most attention. It is easy to understand. The formula for current dividend yield is very straight forward:

For example, Bank of America (BAC) pays a dividend of $2.00 and is selling at $45.00 per share, producing a current dividend yield of 4.44%. Although a yield of 4.44% is attractive, particularly in a world where a 10-year US Treasury Bond yields just over 4.0%, our research shows conclusively that it is the combination of dividend yield and dividend growth that offers the greatest rewards. BAC is one of our favorite stocks, but we like it for important reasons beyond its current dividend yield. Indeed, if its current dividend yield were all we could expect over the next 10 years, we would buy the Treasury bond because it is backed by the full faith and credit of the US government, while BAC’s dividend is not guaranteed and could be cut to zero next week without violating any laws.

Quality Door

It is important to remember that dividends are not a legal obligation; they are paid at the sole discretion of the board of directors of the company. That is why, even though we invest only in stocks that pay dividends, our investment selection process does not start by going through the “Dividend Door.” That process starts through the “Quality Door.” By this we mean that all of our potential portfolio holdings must possess solid creditworthiness before we will even look at them from a dividend perspective. Indeed, the first question we ask about companies we are considering is -- would we loan them money? We expect to own most of the companies we buy for many years. Over time, some sort of bad news inevitably hits all companies. We want to be sure that the companies we own can take these hits and continue on without coming apart. The idea that you can jump in and out of stocks and avoid the hits is widespread among investors today and is simply not true. We can cite countless examples of where bad news has hit a company without warning, severely testing the financial and management resources of the organization for years, and never giving traders a prayer of getting their money back.

Most high-yield dividend stocks we see touted in the media can not pass through the quality door. We think they are an accident waiting to happen. The companies are using high dividends just to keep investors happy, but they are, essentially, liquidating their companies by paying out more than they can afford. When the inevitable bad news comes, their high dividend will be the first thing to go.

If we were to reduce our investment selection process to one sentence it would be:

We seek to own companies with unquestioned financial strength that pay a generous dividend and promise superior dividend growth in the future.

The word dividend comes from the French word, dividere, meaning, to cut. Dividends are literally your “cut” of the company’s profits, and herein lies the first hidden value of rising dividend investing: In selected companies, dividends go up almost every year. Indeed, in the last 45 years, the cumulative dividends of the Dow Jones Industrial Average (DJIA) have risen 37 times and fallen only 8 times. Few people are aware just how stable the dividends of some major companies really are. Another hidden value is that for the DJIA, the steadily rising dividends have not only represented nearly 40% of the DJIA's total investment return, they have also provided an important gauge for determining the value of the DJIA itself. We will elaborate on this idea later.

Yield at Cost

The current dividend yield of a stock whose dividend is stable is easily understood. You do not even need to know the formula because it is computed for you and shown in most financial publications for every stock. When you look at BAC in the paper or at an online financial site, it will look something like this:

Name>>>Price>>> High>>> Low>>> Volume>>> PE>>> Dividend Yield
BAC >>>>45 >>>>46.25>>> 44.15>>> 300,000 >12>>>> 2.00>>> 4.4

But, understanding the value of a rising dividend is much tougher and techniques to assist you in doing so are almost totally absent in today’s media. One approach we use to uncover this hidden value is the concept of “Yield at Cost.” Yield at Cost is the current dividend divided by your original purchase price. Yield at Cost is quite revealing once you understand how to use it. Let us show a Yield at Cost analysis for BAC.

Most investors look only at price. Some might look at PE or yield, but almost no one will look at the most important data on the line, dividend. Let’s say you bought BAC ten years ago. Table 1 on the next page shows that in 1995 you would have paid $14.53 per share for BAC. Dividing the current dividend of $2.00 by your original purchase price, we find that your Yield at Cost is 13.77%. This is a remarkable cash on cash return, yet no financial publication in the world can show it to you, because it is yours and yours alone.

Looking at Table 1, you will see that in 1995 BAC paid a dividend of $.52, which produced a dividend yield of 3.58%. Over the last 10 years, however, the company has raised its dividend every year and today pays $2.00, almost four times what it paid in 1995. Please note that BAC’s current yield, as would have been reported in the media, ranged between 2.25% and 4.44% (Column F). Your Yield at Cost, which Column G shows was rising every year, would have been completely hidden from you, unless you understood the concept. Let’s look at Table 1 to see other important features of dividend investing.

Please double click the table to enlarge it.



If you are like most people, who look only at price, you wake up every morning saying, “Should I sell my BAC and take my profit, or should I wait for another day when it might be higher?” Our guess is that most price-only investors who bought BAC in 1995 had a very tough time holding the stock in the late 1990s. The stock went flat from 1997 through 2002 (Column E), at a time when the investment world became inebriated with tech stocks. Yet, even though BAC’s price was going nowhere, its dividend and underlying value were increasing by double digits every year. BAC’s dividend went from $.69 in 1997 to a $1.22 in 2002. That is nearly an 80% increase in cash distributions and the price hardly moved. That alone should have been a warning that something was amiss with the market’s valuation mechanism. In hindsight, it is now clear that during this time something other than valuation was driving stock prices. That something was an irrational exhuberance for the thin air of high flying techs. Understanding that your Yield at Cost was rising every year, may have given you enough incentive not to go chasing tech stocks that were trading at 200 and 300 times earnings.

As shown in columns B and C, BAC’s earnings and dividends have had average annual growth of 9.1% and 14.4%, respectively. This is excellent growth, particularly in dividends. Column D shows that BAC’s dividend payout has averaged 39.4% of earnings per share. Column D also shows that the dividend payout ratio has been rising significantly – with dividends representing about 30% of earnings ten years ago and about 50% today. This is graphic evidence of a board of directors that is able and willing to return to its shareholders a fair cut of the profits. Column E shows that BAC has experienced price growth of 12% per year, which is similar to dividend growth, as is often the case with rising dividend stocks. To determine the average annual total return, we add the average annual dividend yield of 3.45% to the average annual price increase of 12% to arrive at 15.45%.

There is much good information on Table 1, but, as they say, the past results are no guarantee of the future, let us cite two points that tell us BAC’s prospects for the next ten years are sound.

1. Growing Earnings: It is not well understood that the US economy has been growing on average about 7% a year for the last 50 years. If you are a closet economist you will fuss and say that the economy has grown at only 3% a year. But both numbers are correct. The more widely accepted figure of 3% annual growth is adjusted for inflation, which has averaged 4% per year during this time, and measures real economic growth. But the 7% figure is also correct because it is the actual or gross rate of economic growth not adjusted for inflation. Since stock prices and other corporate financial data are not adjusted for inflation, an apples to apples comparison calls for us to use the 7% growth rate.

BAC is as close to being a nationwide banking operation as any financial institution we have in this country. If the US economy continues to expand at a gross rate of 7% per year, it is not a stretch of the imagination to predict that BAC will also grow earnings at least at 7% annually for the next decade.

2. Precedents for a Continued Rising Dividend: So, BAC has a bright future. That does not mean its dividends will keep pace with its earnings. How can we be sure that the company’s board of directors will continue to give us our cut? The short answer is we don’t know. We believe the best way to judge a company’s likelihood of being fair to its shareholders is to look for precedents from its past. In this case, we mean dividend decisions they made when things were tough. There is a powerful precedent-setting action contained in Table 1.

In 1998, BAC’s earnings fell nearly 20% versus the prior year. Remarkably, BAC, showing their unquestioned financial strength, raised their dividend by nearly 14%. We see three good things to take from their actions:

A. They correctly saw that the troubles of the time were temporary.

B. They did not make a token dividend increase; they raised their dividend at the same rate as they had been doing prior to the earnings weakness.

C. Their strategic actions prior to 1998 created a strong financial condition that allowed them to handle the rough spot with ease. (Thus, the importance of the “Quality Door.”)

Donaldson Capital Management has been using a dividend oriented investment approach since our founding. Dividend investing, a we practice it, is suited for those people who want their investments to be safe, to provide much higher than average cash flows, and over time to provide capital gains comparable to the blue chip averages with much less volatility.

Next time I will discuss the long-term statistical correlations between dividend growth and price growth. I think you will be surprised at the findings.

Blessings,

*All data shown here is taken from sources believed to reliable. DCM cannot guarantee their accuracy. Data may not total correctly due to rounding.