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May 26, 2004
Wish List Watch: The Dividend Elite Are Nearing Attractive Price Levels

A handful of Watch List companies are trading either below or near our target price levels.  According, some discussion on Watch List companies is warranted at this time. 

Higher Interest Rates – Lower Stock Prices

If you ignore the momentum forces at work in the markets, the logical conclusion is that the markets decline either because 1) the corporate fundamentals deteriorate, and/or 2) shareholders sell because they discover what they believe to be a better use for their capital. In the case of Dimon Incorporated number 1 explains why the company’s share price has collapsed in recent days (DMN previously expected earnings for an abbreviated fiscal 2004 to come in at negative 8-12 cents and on Monday the company lowered its target to a negative 29-31 cent loss).  However, in the case of TCLP and NWN – two entities that have not materially downgraded their financial outlooks but have nonetheless seen sharp share price declines -- shareholders seem to have simply found a better use for their money.




While it is obvious that higher interest rates have played a role in pushing down TCLP and NWN shares, what is less obvious is when to start buying shares for the long-term.

How To Value the Dividend Elite

When it comes to value investing one school of thought is to intently study/purchase those companies with PEG ratios below 1. However, payout kingpins TCLP and NWN – which are both slow growing entities – fail this test miserably. As for other valuation tests – namely P/B – TCLP and NWN are not exactly screaming undervaluation (remember that TCLP doesn’t have to consolidate its equity interest in NBP because it doesn’t own more than 50%).

Suffice it to say, running basic valuation tests on attractive dividend paying companies can lead to conflicting outlooks.  For example, Altria’s tangible book value is an appalling negative $12.8 billion, the company’s current yield is nearly 6%!, and MO’s P/E and PEG are an attractive 10 and 1 respectively.  Combine these confusing statistics with the company’s court unknowns and any outlook under the sun can shine through.

Before giving up hope, the investor should remember that people around the world smoke and are likely to continue smoking in the future.  Which leads us to the first stress test for a potential dividend investment: 1) Corporate Longevity: Whether or not a company is likely to continuing doing business tomorrow.

After discovering corporate longevity the next item to consider is 2) Dividend Posture: Whether or not a company is likely to sustain/raise dividend payouts tomorrow. Mergent’s is an excellent resource to start with (Spring 2004 Dividend Achievers), and common sense also plays a role (i.e. although utility companies face the unpredictability of deregulation many also have a history of 100+ years of dividends). However, here is where balance sheet and cash flow analysis becomes more important: Companies with strong cash flows that rarely have to reinvent themselves are the most attractive, and the balance sheet leveraging trend (discovered by an analysis of working capital and related debt/asset trends) is important because it could impact future cash flows/dividends.

Lastly, and perhaps most importantly in today’s marketplace, the investor must consider 3) Investment Alternatives: Whether or not a ‘risky’ company offers as a solid a potential return versus ‘safe’ government bonds.  Despite the fact that the 30-year Treasury yield used to be the benchmark preferred by Wall Street ‘Fed modelers’, today the 10-year is the most trusted instrument for yield comparisons.  Thus, one of the better ways to measure potential dividend investments is to compare dividend yield to the 10-year treasury. 

In short, wherein corporate longevity is assured, a history of dividends combined with a strong cash flows/balance sheet statement is found, and the dividend yield is comparable to bonds, the company is usually worth owning.

Incidentally, the cash cow that is Altria passes number 3 with flying colors, and is likely a good candidate to pass stress test number 1 (the negatives against big tobacco are increases in government taxes, lawsuits, fewer smokers, and increased competitiveness from heaper brands)
However, despite an impressive history of paying dividends MO’s dividend posture is uncertain given court/balance sheet risks.  

After Completing Stress Tests Momentum Forces Worth Considering

One of the most dramatic examples of how momentum infects the markets can be seen in utility stocks.  In less than 3-years the average yield on XLU (an ETF basket of utility stocks) went from being less than half of the yield on the 10-year to a higher yield than the 10-year.



Deteriorating fundamentals in utility stocks help to partially explain why utility stocks declined (and utility dividend yields rose).  Moreover, given that the yield on the 10-year was higher than the yield on XLU until the third quarter of 2002, the argument could be made that investors sold XLU because they found a better use for their money. However, seemingly the only thing that explains the fact that XLU was yielding more than the 10-year from 3Q-2002 to 2Q-2003 is that momentum forces drove prices to undervalued levels (and/or XLU dividend yields to unsustainable highs).

Point being, momentum in the markets creates bubbles (i.e. Nasdaq 5,000), but momentum also, from time to time, creates opportunities.

So when will the next buying opportunity emerge?

XLU - originally covered in early 2003 – was not added to the Wish List. Nevertheless, the chart below is the type of basic chart that previously made companies like LDR and BWL attractive investments.  To be sure, LDR and BWL are models of corporate longevity, each company has a history of paying dividends and had a strong set of financials, and – at the time of purchase – each company’s yield was comparable to the 10-year T-Yield.


With the final criterion for potential dividend investments being ‘Investment Alternatives’ the outlook for dividend stocks is hazy at best. Quite frankly, with rate hikes already priced into the markets the expected Fed rate hike next month is not likely to have a major impact on interest (market) rates.  Rather, thanks to rising commodity prices and higher interest rates the Fed may end up hiking interest rates just as the US economy begins to signal that it is cooling off. Should the economy cool off purchasing dividend companies soon would likely prove worthwhile (i.e. if interest rates do not move higher an NWN is worth owning today).

Alternatively, and ominously, a strong case can be made for another spike higher in interest rates. Under this scenario few dividend investments would immediately prosper.


-- Tax implications aside, TCLP yields more than the 10-year, and competition in the pipeline business does not arrive overnight (a degree of corporate longevity is assured). In short, should the outlook for NBP become more predictable buy TCLP on weakness.


-- After a steep sell off DMN is yielding more than 5%, and the company’s working capital is positive (but barely positive when you back out inventories).  To form a more rounded opinion on the company more information is required (the company will release results on June 10). Quite frankly, new issues - beyond currency translations and US capacity adjustments - have arisen this week. 

Finally, NWN - with a yield that is comparable to but not higher than the 10-year yield – is an attractive dividend investment.  The stock has failed to slide much below $28 a share during its current sell off, but, hopefully, another momentum drive lower will bring shares below this mark.  At $27.50 NWN would yield 4.72%, or roughly the same as the 10-year yield.