Author Archives: NLObserver Team

Dexia: So What’s in a Name

In the last financial crisis, we came across a company named Cerberus Capital.  Those who started Cerberus Capital had to know the kind of connotation that would be invoked with a name based on a three-headed dog that guards the gates of the underworld from those who wished to escape.  For some, Cerberus Capital’s involvement in Chrysler and GMAC seemed inescapable for the U.S. government during their bailouts of the auto and banking industry. 

Currently, a Belgium bank named Dexia Group is attempting to find a way out of its financial problems.  Apparently, Dexia is holding an enormous amount of Greek debt that could possibly go bust.   Without a plan from France, Belgium and Luxembourg, Dexia threatens to bankrupt many towns and cities in France as well as depositors in Belgium and Luxembourg. 
Like Cerberus Capital, we wonder what is in the name.  So it should comes as no surprise when we looked up what the meaning of Dexia is.  Here are the Wikipedia definitions of what Dexia is:
Dexia is a genus of tachinid flies in the family Tachinidae. Most larvae are parasitoids of beetles (Scarabaeidae).”
Since the above definitions of Dexia was relatively obscure, we looked up what a parasitoid is.  Again, Wikipedia’s definition is as follows:
A parasitoid is an organism that spends a significant portion of its life history attached to or within a single host organism in a relationship that is in essence parasitic; unlike a true parasite, however, it ultimately sterilises or kills, and sometimes consumes, the host. Thus parasitoids are similar to typical parasites except in the more dire prognosis for the host.”
Cornell University’s Guide to Natural Enemies of North America defines parasitoids, in part, as:
Insect parasitoids have an immature life stage that develops on or within a single insect host, ultimately killing the host…”
We can only wonder if Dexia, the Belgium bank, will ultimately lead to killing the hosts, in this case France, Belgium, Luxembourg  or even the European Union as we know it.
More about Dexia from Bloomberg.com
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In the News: October 9, 2011

Europe on the Brink at The Atlantic
In Praise of Dumbphones at The Atlantic
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Nasdaq 100 Watch List: October 7, 2011

Below are the Nasdaq 100 companies that are within 10% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.

Symbol Name Price P/E EPS Yield P/B % from Low
ILMN Illumina, Inc. 27.18 31.39 0.87 0 4.25 0.00%
QGEN Qiagen N.V. 12.65 23 0.55 0 1.21 0.16%
BMC BMC Software, Inc. 36.98 14.61 2.53 0 4.39 1.01%
LIFE Life Technologies Corp. 36.82 18.95 1.94 0 1.56 4.31%
TEVA Teva Pharmaceutical 36.75 10.51 3.5 2.10% 1.41 5.00%
FSLR First Solar, Inc. 59.74 10.18 5.87 0 1.52 7.29%
PAYX Paychex, Inc. 27.11 18.44 1.47 4.70% 6.3 7.92%
VOD Vodafone Group Plc 26.25 11.22 2.34 7.30% 1.01 7.98%
URBN Urban Outfitters, Inc. 23.29 15.77 1.48 0 2.91 8.48%
GOOG Google Inc. 515.12 18.58 27.72 0 3.19 8.90%
NFLX Netflix, Inc. 117.21 29.74 3.94 0 19.38 8.90%
CTXS Citrix Systems, Inc. 54.94 31.09 1.77 0 3.93 9.42%
FISV Fiserv, Inc. 53.38 17.51 3.05 0 2.46 9.50%
VRSN VeriSign, Inc. 29.69 6.62 4.49 0 N/A 9.96%
HSIC Henry Schein, Inc. 61.09 16.25 3.76 0 2.21 9.97%
Watch List Summary
It appears that Illumina (ILMN) has come full circle since last appearing on our Nasdaq 100 Watch List on December 19, 2009 (found here).  At the time, Illumina (ILMN) traded at $27.88.  The stock rose as high as $79.40.  In our September 23, 2011 article (found here), as Illumina crept back onto our watch list at $41.67, we said, “while ILMN is still nearly 50% above the December 19, 2009 price, the possibility exists that all the gains that were made could disappear in short order.  Between our last posting and now, ILMN has managed to lose all of the gains that were accrued from December 2009.  We’re now actively accumulating shares of ILMN with the expectation that the share price will decline by approximately 50% from the current level.
Pharmaceutical Product Development (PPDI) has announced that they have accepted an all cash offer of $33.25 per share by the Carlyle Group and Hellman & Friedman (article here).  Pharmaceutical Product Development (PPDI) was on our September 11, 2009 watch list (found here).  Of the four companies on that list, only one has not been bought out.  Cephalon (CEPH), Genzyme (GENZ) and now Pharmaceutical Product Development Inc. (PPDI) have been acquired.  Although we’re not unaccustomed to stocks on either of our Dividend or Nasdaq 100 watch lists being bought, this is the first time that 75% of the companies on a single list were acquired by another institution.  We’d like to offer up the holdout, Stericycle (SRCL), to anyone willing to help us accomplish a grand slam.
Watch List Performance Review
The following is a performance review of the Nasdaq 100 Watch List from October 18, 2010:

  •  Apollo Group, Inc. (APOL): +16.79%
  • Urban Outfitters, Inc. (URBN): -24.87%
  • FLIR Systems, Inc. (FLIR): +0.50%
  • Intel Corporation (INTC): +15.37%
  • Adobe Systems (ADBE): -9.97%
  • Nasdaq 100 (NDX): +5.01%
The performance of the five companies on the Nasdaq 100 list from last year underperformed the Nasdaq 100 by -5.45%.  Only two stocks, Apollo Group (APOL) and Intel (INTC) managed to eke out gains in the last year.  Apollo Group was a considerable surprise to us since we believed that the stock should have been dropped from the Nasdaq 100 at the time of the annual re-ranking of the index in December 2010.
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Slittare: Italy’s credit rating

On February 18, 2009, we wrote an article titled “When Paper Has No Value.” In that article, we highlighted West Germany’s $2 billion bailout of Italy in 1974 that was backed by the value of Italy’s gold holdings. Regarding the use of gold as collateral we said the following:
No nation wants to actually resort to this feature first, because as one nation dips its toes in the water all subsequent nations will follow in its path at ever higher gold prices. It is only the last nation in the pool, with sizable gold reserves, that benefits the most from using gold as collateral. The first nation in the pool becomes the sacrificial lamb. Unfortunately, desperate times call for desperate measures.”
We couldn’t help but notice that Moody’s credit rating for Italy was downgraded three notches on October 4, 2011 (found here). There are three primary reasons given for the downgrade of Italy’s debt:
(1) The material increase in long-term funding risks for euro area sovereigns with high levels of public debt, such as Italy, as a result of the sustained and non-cyclical erosion of confidence in the wholesale finance environment for euro sovereigns, due to the current sovereign debt crisis.
(2) The increased downside risks to economic growth due to macroeconomic structural weaknesses and a weakening global outlook.
(3) The implementation risks and time needed to achieve the government's fiscal consolidation targets to reverse the adverse trend observed in the public debt, due to economic and political uncertainties.
In Italian, the word slittare means to slide or to be postponed. This was the term that was used to describe Italy’s economic woes that led to the loan using gold as collateral in 1974. Depending on its usage, slittare encapsulates the problems faced by Italy today. The increase in long-term debt is the postponement of the inevitable and the increased downside risk to economic growth points to a further slide. The third issue mentioned by Moody’s, implementation risk, only adds to why the first and second reasons will only grow.
Like it was in 1974, Germany is currently in the position of having to buttress European nations as the “lender of last resort.” We’re wondering which nation will be the first to pledge their gold reserves as collateral in exchange for a loan to avoid collapse. It will be desperate times when a nation pledges their gold reserves for the purpose of a loan. However, when this does occur, it will set the ball in motion that will inexorably create a floor in the price of gold.

The Coming Precious Metals Dividend War

On September 9, 2009 we wrote an article titled “Silver Should be the Focus.” In that article, we cautioned readers to “be mindful of the coming competitive dividend war between precious metal companies. I remember one, now defunct, gold company that paid out their dividend in actual gold. These are all gimmicks to lure investors in at a time when the rule of the day should be ‘head to the exits.’
The first salvos of the coming war to attract investors to precious metal stocks have be initiated.In April 2011, Newmont Mining (NEM) started what they deemed … the industry's first and only dividend policy linked directly to the realized gold price…"Naturally, this isn’t the first time that gold linked dividends has taken place, but it sells really well to those unfamiliar with gold stocks and their dividend policies.On September 19, 2011, Newmont Mining (NEM) announced a further enhancement of their “first ever” gold linked dividend policy with the following changes:

 

The enhanced policy will continue to link the quarterly dividend rate to changes in the gold price but will also provide an additional step up of 7.5 cents per share when the Company's realized gold price for a quarter exceeds $1,700 per ounce and a further step up of 2.5 cents per share (10 cents in total compared to the existing policy) when the Company's realized gold price for a quarter exceeds $2,000. At average realized gold prices below $1,700 per ounce, the current dividend policy remains unchanged. Newmont's quarterly gold price-linked dividend payments are based on the Company's average realized gold price for the preceding quarter.”
Not to be outdone, Hecla Mining (HL) announced on September 20, 2011 that they would have a dividend that is linked to the price of silver.Hecla’s silver-linked dividend policy is as follows:

 

The initial quarterly dividend under the policy is expected to be $0.03 per share of common stock ($0.12 per year), if Hecla's average realized silver price for the third quarter is $40.00 per ounce. All dividends, including those in the third quarter, would increase or decrease by $0.01 per share ($0.04 annually) for each $5.00 per ounce incremental increase or decrease in the average realized silver price in the preceding quarter.”
Newmont Mining (NEM) and Hecla Mining (HL) are soon to be joined by a crowded field of precious metal companies that are going to progressively up the ante.It will soon be indistinguishable as to who has the most sensible dividend policy and who has a compounding “money” losing machine.The race to offer attractive dividend payments has help from an unexpected source.
Unlike past precious metal bull markets, gold and silver stocks have stiff competition for investment capital in the form of gold and silver ETFs.In fact, more money is being plowed into the combined gold and silver ETFs than the stocks that have actual claims on getting the metal out of the ground.This presents a challenge for precious metal stocks that would normally issue shares in acquisition of other gold companies or expand their operations.In order to get the share price up, a competitive environment of dividend increases will lead many companies to ruin in an effort to attract new investors.
As described in our 2009 recommendation silver, one gold or silver company is going to “jump the shark” and make their dividend payments in the actual metal.When that time comes, it will be fair warning to protect your positions, though this may be indistinguishable to ebullient gold bugs at the time.
The single best dividend policy that we’ve seen among gold stocks, was held by Homestake Mining [HM] as describe in our October 31, 2010 profile of Homestake (found here).By 1933, Homestake had a 53-year history of continuous dividend payments.Not surprisingly, Homestake was among the 2% of gold stocks that rose in value from 1924 to 1932 due, in part, to their amazing dividend policy.
Because we’re in the early stages of a gold bull market, there is little attention being paid to the quality of the dividend policy.Gold and silver linked dividend policies appear advantageous when the price of the commodity is going up.However, such a policy can imperil a poorly managed company as the average price declines.
The most effective antidote to becoming collateral damage in the coming dividend war will be to buy the gold and silver stocks that are members of the Philadelphia Gold and Silver Stock Index or the Amex Gold Bug Index.Ironically, institutional support, by being the member of an index, will allow gold and silver stocks to survive hard times where others will unnecessarily falter.
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In the News: October 2, 2011

NLO Dividend Watch List: September 30, 2011

The problems in Europe continue to plague the markets globally.  The S&P 500 rallied mid-week when it seemed that the bailout of Greece is coming.  Seemingly good news couldn't hold the market up and thus the selling continued from Wednesday through Friday.  The S&P closed down 0.44% for the week while the blue-chip, the Dow Industrial index, was actually up 1.3%.  Upon initial review, it could have been a flight to "quality" within the realm of stocks.  However, as a result of the sell off, our list swelled and we included only those companies within 5% of the 52-week low below. 
Symbol
Name
Price
% Yr Low
P/E
EPS
Dividend
Yield
Payout
FNFG
First Niagara Financial Group Inc. 
9.15
0.00%
13.66
0.67
0.64
6.99%
96%
EMR
Emerson Electric Co.
41.31
0.00%
12.75
3.24
1.38
3.34%
43%
GTY
Getty Realty Corp.
14.42
0.00%
8.69
1.66
1.00
6.93%
60%
NFG
National Fuel Gas Co.
48.68
0.02%
15.65
3.11
1.42
2.92%
46%
MMM
3M Co
71.79
0.11%
12.19
5.89
2.20
3.06%
37%
AOS
AO Smith Corp.
32.03
0.28%
9.56
3.35
0.64
2.00%
19%
UMBF
UMB Financial Corp. 
32.08
0.38%
13.04
2.46
0.78
2.43%
32%
WFSL
Washington Federal, Inc. 
12.74
0.39%
14.81
0.86
0.24
1.88%
28%
AVP
Avon Products, Inc.
19.6
0.51%
11.46
1.71
0.92
4.69%
54%
ATR
AptarGroup Inc.
44.67
0.61%
16.98
2.63
0.88
1.97%
33%
XRAY
DENTSPLY International Inc. 
30.69
0.92%
16.07
1.91
0.20
0.65%
10%
BMI
Badger Meter, Inc.
28.93
0.94%
16.44
1.76
0.64
2.21%
36%
AVY
Avery Dennison Corp.
25.08
0.97%
9.02
2.78
1.00
3.99%
36%
DNB
Dun & Bradstreet Corp.
61.26
1.36%
11.92
5.14
1.44
2.35%
28%
ADM
Archer Daniels Midland Co.
24.81
1.60%
7.93
3.13
0.64
2.58%
20%
ALB
Albemarle Corp.
40.4
1.60%
9.35
4.32
0.66
1.63%
15%
SYY
Sysco Corp.
25.9
1.65%
13.21
1.96
1.04
4.02%
53%
CYN
City National Corp.
37.76
1.70%
12.50
3.02
0.80
2.12%
26%
CAT
Caterpillar Inc.
73.84
1.71%
12.20
6.05
1.84
2.49%
30%
JCI
Johnson Controls Inc  
26.37
1.78%
11.77
2.24
0.64
2.43%
29%
UGI
UGI Corp.
26.27
1.78%
11.52
2.28
1.04
3.96%
46%
ITW
Illinois Tool Works, Inc.
41.6
1.91%
10.98
3.79
1.44
3.46%
38%
BXS
BanCorp.South Inc.
8.78
1.97%
18.68
0.47
0.04
0.46%
9%
EOG
EOG Resources, Inc.
71.01
2.10%
44.66
1.59
0.64
0.90%
40%
BEN
Franklin Resources, Inc.
95.64
2.20%
11.41
8.38
1.00
1.05%
12%
SON
Sonoco Products Co.
28.23
2.21%
14.19
1.99
1.16
4.11%
58%
BDX
Becton, Dickinson and Co.
73.32
2.25%
12.32
5.95
1.64
2.24%
28%
CATO
Cato Corp.
22.56
2.36%
10.30
2.19
0.92
4.08%
42%
HP
Helmerich & Payne, Inc.
40.6
2.39%
11.12
3.65
0.28
0.69%
8%
UVV
Universal Corp.
35.86
2.40%
6.87
5.22
1.92
5.35%
37%
APD
Air Products & Chemicals, Inc.
76.37
2.40%
14.22
5.37
2.32
3.04%
43%
VNO
Vornado Realty Trust
74.62
2.43%
16.66
4.48
2.76
3.70%
62%
DOV
Dover Corp.
46.6
2.60%
10.20
4.57
1.26
2.70%
28%
MUR
Murphy Oil Corporation
44.16
2.62%
8.96
4.93
1.10
2.49%
22%
WAG
Walgreen Co.
32.89
2.78%
11.19
2.94
0.90
2.74%
31%
FULT
Fulton Financial Corp. 
7.65
2.82%
11.42
0.67
0.20
2.61%
30%
CTBI
Community Trust BanCorp., Inc. 
23.29
2.87%
9.95
2.34
1.24
5.32%
53%
NUE
Nucor Corp.
31.64
2.99%
21.38
1.48
1.45
4.58%
98%
SBSI
Southside Bancshares, Inc. 
18.01
3.00%
8.00
2.25
0.72
4.00%
32%
AROW
Arrow Financial Corp. 
22.25
3.00%
11.84
1.88
0.97
4.36%
52%
TRMK
Trustmark Corp. 
18.15
3.01%
10.93
1.66
0.92
5.07%
55%
BOH
Bank of Hawaii Corp.
36.4
3.12%
10.80
3.37
1.80
4.95%
53%
BMS
Bemis Co Inc
29.31
3.17%
14.58
2.01
0.96
3.28%
48%
MSEX
Middlesex Water Company 
17.07
3.20%
18.55
0.92
0.73
4.28%
79%
EXPD
Expeditors International of Washington
40.55
3.23%
23.17
1.75
0.50
1.23%
29%
GE
General Electric Co
15.22
3.40%
11.98
1.27
0.60
3.94%
47%
GS
Goldman Sachs Group, Inc.  
94.55
3.45%
9.27
10.20
1.40
1.48%
14%
ARE
Alexandria Real Estate Equities, Inc.
61.39
3.47%
21.47
2.86
1.88
3.06%
66%
PPG
PPG Industries, Inc.
70.66
3.50%
11.15
6.34
2.28
3.23%
36%
WBS
Webster Financial Corp.
15.3
3.52%
12.24
1.25
0.20
1.31%
16%
BRO
Brown & Brown, Inc.
17.8
3.55%
16.18
1.10
0.32
1.80%
29%
GBCI
Glacier BanCorp., Inc. 
9.37
3.65%
16.44
0.57
0.52
5.55%
91%
SWK
Stanley Black & Decker, Inc.
49.1
3.87%
13.68
3.59
1.64
3.34%
46%
MLM
Martin Marietta Materials, Inc.
63.22
3.98%
34.36
1.84
1.60
2.53%
87%
SUSQ
Susquehanna Bancshares, Inc. 
5.46
4.00%
21.00
0.26
0.08
1.47%
31%
BMO
Bank of Montreal
55.85
4.09%
11.24
4.97
2.71
4.85%
55%
CFR
Cullen/Frost Bankers, Inc.
45.86
4.13%
12.99
3.53
1.84
4.01%
52%
LNC
Lincoln National Corp.
15.63
4.20%
4.56
3.43
0.20
1.28%
6%
HIG
Hartford Financial Services Group Inc.  
16.14
4.26%
4.62
3.49
0.40
2.48%
11%
SJW
SJW Corp.
21.77
4.31%
16.37
1.33
0.69
3.17%
52%
NTRS
Northern Trust Corp. 
34.98
4.39%
13.88
2.52
1.12
3.20%
44%
TROW
T. Rowe Price Group, Inc. 
47.77
4.42%
16.76
2.85
1.24
2.60%
44%
WSFS
WSFS Financial Corp. 
31.57
4.43%
15.55
2.03
0.48
1.52%
24%
PBI
Pitney Bowes Inc  
18.8
4.44%
11.33
1.66
1.48
7.87%
89%
PEP
PepsiCo Inc.
61.9
4.47%
15.75
3.93
2.06
3.33%
52%
TRV
The Travelers Companies, Inc.
48.73
4.53%
9.21
5.29
1.64
3.37%
31%
CBSH
Commerce Bancshares, Inc. 
34.75
4.57%
12.32
2.82
0.92
2.65%
33%
PH
Parker Hannifin Corp.
63.13
4.59%
9.91
6.37
1.48
2.34%
23%
TDS
Telephone and Data Systems, Inc
21.25
4.68%
11.87
1.79
0.47
2.21%
26%
FRS
Frisch's Restaurants, Inc
19.4
4.70%
10.37
1.87
0.64
3.30%
34%
CBU
Community Bank System, Inc.
22.69
4.71%
11.64
1.95
1.04
4.58%
53%
UTX
United Technologies Corp.
70.36
4.83%
13.64
5.16
1.92
2.73%
37%
T
AT&T Inc
28.52
4.85%
8.29
3.44
1.72
6.03%
50%
PAYX
Paychex, Inc. 
26.37
4.98%
17.94
1.47
1.24
4.70%
84%
Watch List Summary
Topping our list this week is First Niagara Financial Group (FNFG).  According to Value Line, this New York regional bank typically trades at 15 times earnings.  The recent merger with NewAlliance Bancshares should fuel First Niagara's expansion and growth.  It appears that growth is being priced into the company as seen in the forward P/E ratio of 7.5.  If the company can grow 18% as predicted by the analysts, the dividend payout ratio should contract slightly.

Moving down the list, we have a well known bluechip company, 3M (MMM). IQTrends estimates that anytime 3M trades around a 3% dividend yield, it is undervalue. Currently, the yield sits slightly above its undervalued range at 3.06%.  Another gauge we can look to is Value Line Investment Survey, which shows a fair value at 12x cash flow. Using the 2012 estimate of $9 cash flow and 3M is fairly valued at $108.  At the  current price of $71, with a 3% yield, there appears to be a reasonable  margin of safety for long-term investors.

Another company to highlight this week is Avon Products (AVP). This cosmetics producer is extremely undervalued according to historical cash flow and dividend yield. At almost 5% dividend yield and a healthy payout ratio, we believe Avon is a stock one to pay attention to. The stock is undervalued at or around 3.7% dividend yield so the current 4.69% yield suggests that AVP has at least 25% upside. If based on AVP's cash flow we get a more bullish picture. Valueline shows Avon trades around 14x cash flow and with 2012 consensus at $2.80 per share, Avon's fair value appears to be at $39, a figure that is twice the current price.

After last appearing on our Dividend Watch List of September 16, 2011, Harleysville Group (HGIC) has increase by 119%.  On Friday September 23rd, it was reported by Bloomberg (article here) that Harleysville Group was rumored to be acquired by Nationwide Insurance.  On Thursday September 29th, it was officially announced that Nationwide Insurance would pay $60 a share for Harleysville Group.  Nationwide Insurance is paying 2 times book value in the transaction.  Harleysville Group was ranked 3rd on our list of top dividend stocks to consider on September 16th.
From the same list, three insurance related companies are worth considering.  First on the list is American National Insurance Company (ANAT) which “…operates in five segments: Life, Annuity, Health, Property and Casualty, and Corporate…” ANAT is selling at a book value of $139 a share while trading at $69.25 and sporting a P/E ratio of 11.5.  From 1992 to 2002, ANAT increased it’s dividend for each year.  However, since late 2002, ANAT has intermittently increased the annual dividend from $2.96 to the current level of $3.08.  The dividend yield is a healthy 4.40% with a reasonable payout ratio of 51%.
The next company was ranked 5th on our September 16th list and currently ranked 51st is Brown & Brown (BRO).  Brown & Brown is “…a diversified insurance agency, markets and sells insurance products and services primarily in the United States.”  BRO has a price/book ratio of 1.65 and an enterprise value of $2.51 billion.  Trading within 4% of the 52-week low, Brown & Brown has fallen by 34% from the high and is within 13% of the 2009 low.  BRO has increased the dividend every year since 1996.

Finally, Allstate (ALL) was ranked 9th on the list and has managed to fall off of our current list.  Prior to 2008, Allstate had increased the dividend for 14 years in a row.  However, the financial crisis took its toll on the company requiring a dividend cut of 51%.  Allstate recently increased the dividend in March of this year.  

Watch List Performance Review

In our ongoing review of the NLO Dividend Watch List, we have taken the top five stocks on our list from September 10, 2010 and have checked their performance one year later. The top five companies on that list can be seen in the table below.

Symbol Name 9/10/2010 9/9/2011
% change
INTC Intel Corp. 17.97 19.7 9.63%
WST West Pharmaceutical Services 33.65 37.78 12.27%
TR Tootsie Roll Industries Inc 23.87 23.67 -0.84%
OMI Owens & Minor, Inc. 26.44 27.72 4.84%
BEC Beckman Coulter, Inc. 45.71 83.47 82.61%
Avg.
21.70%
Dow Industrials 10,462.77 10,992.13 5.06%
Excluding Beckman Coulter (BEC), the remaining four stocks, on average, managed to exceed the Dow Jones Industrials throughout the year with a gain +6.48%. The average performance of all five stocks was 21.70% compared to the Industrials 5.06% in the same one year period of time.

Dow Theory: Bear Market Downside Target

On August 2, 2011, we received what is widely understood to be a Dow Theory bear market indication. According to Dow Theory, a bear market indication shall remain in place until counteracted by a bullish indication. The middle ground, where there is not a new bear market confirmation nor a new bull market signal, is generally considered a range or a “line.”

On August 9, 2011, we presented what we believed to be bear market rally targets according to Dow Theory. In the comment section of that same article, we revised the bear market rally targets based on the low of the Dow Industrials set on August 10, 2011.

The first bear market rally target, which seems next to impossible for the Dow Industrials to stay above, is 11,416.80. This level was only the first of five upside targets that would need to be breached for any prospect that a renewed cyclical bull market is in the works.

A confirmation of the bear market would be signaled if the Dow Industrials and Dow Transports were to fall below 10,719.94 and 4,149.94, respectively.

According to Dow Theory, we are still in a bear market and the early unconfirmed indications are that we may be headed to the 9,686.48 level.

Buffett Prepares His Exit

In a Market Watch article title “Buffett’s Berkshire Buyback Part of Exit Plan”, it was announced that Berkshire Hathaway (BRK-A) will buy back shares of its Class-A and Class-B shares. In the article, it was also mentioned that “the plan also essentially provides for ‘an unlimited and perpetual program.’” This suggests that the shares of Berkshire Hathaway will continuously be bought under specific conditions.
We’re in perfect agreement that the current plan to repurchase Berkshire Hathaway (BRK-B) stock along with the introduction of a select team of managers is part of the strategy to phase out Warren Buffett’s involvement in the company. However, we think that the most overlooked part of Buffett’s departure plan was the purchase of Burlington Northern Santa Fe (BNI).
For a long time, Warren Buffett has been outspoken against the ownership of airline shares due to “…significant capital to engender the growth, and then earns little or no money.” Therefore, it would seem out of character to purchase a company in an industry synonymous for many of the same attributes as airlines. However, the purchase of a railroad company has two significant advantages that are not afforded to most corporations in the United States.
First, a quirk in the rules for railroads allow them to not have to liquidate in bankruptcy, if that were to occur. After Buffett is gone, whoever is in charge can bumble with some derivative instruments that, for unforeseen reasons, blow up. If the blow up were large enough, it could trigger the need to file bankruptcy to get Berkshire Hathaway’s house in order. The clause in the Interstate Commerce Commission (ICC) and Bankruptcy Act allows for railroads not to liquidate if faced with bankruptcy proceedings. This protects Berkshire Hathaway from having to sell off valuable assets while the company re-emerges out of bankruptcy.
The second significant succession strategy of a railroad has to do with what is called “compulsory mergers.” This requirement allows the ICC and a railroad that has gone bankrupt to merge with another company on terms drawn up by the ICC, the bankrupt company and the acquiring company.
Since the railroad industry, like the airline industry, is synonymous for bankruptcy, BRK gets to take advantage of the "compulsory" mergers rule under section 77 of the Bankruptcy Act. This rule gives the ICC "...control over formulating a plan for the reorganization of an insolvent railroad."
Knowing that bankruptcy is only just around the corner in the next economic purge, Berkshire Hathaway can absorb other rails with absolute impunity. Even better, "...Section 5 of the Commerce Act, which governs mergers of solvent railroads, give the merging carriers primary control over the formulation of a merger plan." Could you imagine structuring your own deal of a merging rail that is going bankrupt?
There is a lot of precedent for these laws in the structuring of many railroads.  In fact,  Chicago, Burlington and Quincy Railroad and Northern Pacific Railway (independent companies before their merger) have had their days with aspects of these rules before merging. Because railroads go bankrupt often, there are many examples of how this works. In one "merger," an acquiring railroad "bought" $1.9 million of claims against the state of Florida at a cost of $5,000 from another railroad facing bankruptcy. In our examination of the topic, we have seen assets worth even more being given away for $0.00 as part of a compulsory merger. 
Because Buffett has been outspoken against the ownership of airline shares due to the general lack of profitability and high propensity to go bankrupt, it seems out of character to purchase a company in an industry synonymous for the same attributes. We believe that Buffett’s purchase of Burlington Northern Santa Fe (BNI) was a critical piece of the succession strategy laid down for the benefit of current and future shareholders of Berkshire Hathaway.

Citations:

  • Berkshire Hathaway 2007 Annual Report. Page 8. 2007 Report here 
  • Altman, Edward I. Predicting Railroad Bankruptcies in America. The Bell Journal of Economics and Management Science. Vol. 4, No. 1 (Spring, 1973), pp. 184-211.
  • The Yale Law Journal. "'Compulsory' Mergers under Section 77 of the Bankruptcy Act". Vol. 64, No. 2 (December 1954). page 282-292
  • Bedingfield, Robert, “Top Officer Quits at Penn Central in Cash Squeeze”, New York Times, June 9, 1970. page 1.
  • Schroeder, Alice. The Snowball. Bantam Books, New York. 2008.

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In the News: September 25, 2011

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Nasdaq 100 Watch List: September 23, 2011

Below are the Nasdaq 100 companies that are within 5% of their respective 52-week lows. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and rigorous due diligence.
Symbol Name Price P/E Div/Shr Yield P/B % from low
TEVA Teva Pharmaceutical 35.26 10.08 0.79 2.10% 1.33 0.74%
ESRX Express Scripts 38.71 15.86 0 0 10.55 0.91%
FISV Fiserv, Inc. 49.65 16.28 0 0 2.27 1.85%
NIHD NII Holdings, Inc. 29.73 12.08 0 0 1.36 2.02%
XRAY DENTSPLY 31.24 16.36 0.2 0.60% 2.13 2.49%
EXPD Expeditors Intl of Was 40.45 23.11 0.5 1.20% 4.52 2.98%
QGEN Qiagen N.V. 13.45 24.45 0 0 1.2 3.07%
VOD Vodafone Group P 25.08 10.72 1.92 7.60% 0.93 3.17%
PCAR PACCAR Inc. 34.06 17.29 0.72 2.00% 2.07 3.21%
NFLX Netflix, Inc. 129.36 32.82 0 0 20.22 3.47%
AMAT Applied Materials 10.59 7.3 0.32 2.90% 1.6 3.93%
URBN Urban Outfitters 23.41 15.85 0 0 2.76 3.95%
PAYX Paychex, Inc. 26.22 18.46 1.24 4.70% 6.27 4.38%
BMC BMC Software, Inc. 38.85 15.34 0 0 4.16 4.46%
RIMM Research In Motion 21.32 3.89 0 0 1.12 4.46%
JOYG Joy Global Inc. 65.01 11.84 0.7 1.00% 3.57 4.52%
INFY Infosys Limited 48.23 17.73 0.85 1.70% 4.33 4.58%
ILMN Illumina, Inc. 41.67 48.12 0 0 4.52 4.65%
VRSN VeriSign, Inc. 28.34 6.32 0 0 N/A 4.96%
Watch List Summary
The following are companies we are tracking from our watch list  this week. First up is Illumina (ILMN) which was last on our watch list on December 19, 2009. After being on our list, Illumina (ILMN) rose 172% at its peak on July 4, 2011. Already ILMN has lost -45.17% since the high in July. While ILMN is still nearly 50% above the December 19, 2009 price, the possibility exists that all the gains that were made could disappear in short order. As an example, anyone who bought ILMN after June 4, 2010 is confronted with a loss. ILMN has a market cap of $5.18B. Levered free cash flow at $146.48 million and enterprise value at $4.75 billion. The stock has lost -47.52% since the high on July 6th and is currently trading at 4.65% above its 52-week low.
Paychex (PAYX) was on our new low watch list on August 15, 2010 when it was within 2% of the 52-week low. Subsequently, Paychex (PAYX) rose 35.80% in 7 months. Employment being what it is, PAYX is trading in a wide range exhibiting a strong base at around $25. According to Value Line, PAYX is trading 30% below the historical fair value. PAYX has no debt and is likely to be an acquisition target if the stock remains at the current price or lower. Already PAYX has fallen 22% from the high set on March 9th bringing the market cap down to $9.49 billion. Prior to 2008, PAYX had a 19-year history of increasing the dividend. Since 2008, the annual dividend has remained at $1.24. PAYX would be purchased at any price below $25.50.
Netflix (NFLX) is going through significant turmoil as reflected in the stock price. Since the high of $298.73, NFLX has plummeted to $129.36 or down -56%. The financials on NFLX are a moving target making it difficult to fully determine the company’s true value. However, the business model is compelling and warrants considerable review. NFLX has a market cap of $6.8 billion and enterprise value of $6.65 billion. After applying Edson Gould’s 1/3 speed resistance line, NFLX will become worth considering at $99.58 and below. A detailed analysis of Gould's speed resistance line applied to NFLX can be found here.
Expeditors International of Washington (EXPD) has fallen to within 2.98% of the 52-week low. According to Yahoo!Finance, EXPD provides logistics services which involves consolidation or forwarding air and ocean freight. EXPD is a highly efficient organization and is trading at 2006 prices as if the company hasn’t averaged earnings of $1.32 in last 4 years compared to average earnings of $0.66 in the period from 2002 to 2005. According to Value Line Investment Survey, EXPD is estimated to have cash flow of $2 for 2011. Historically, EXPD has traded at 25 times cash flow which suggests that the stock should be selling at a fair value of $50. EXPD has increased their dividend every year for the last 18 years.
Watch List Performance Review
The performance of our watch list after one year is to remind us of the possible outcome of investing in the stocks on our list. It is hoped that we can gain greater insight in the investing process and refine that process as we go along. Below is the performance of the top five stocks on our Nasdaq 100 watch list from September 17, 2010.
Symbol Name 2010 2011 % change
PAYX Paychex, Inc. 25.95 26.22 1.04%
INTC Intel Corporation 18.81 22.16 17.81%
AMAT Applied Materials, Inc. 11.02 10.59 -3.90%
YHOO Yahoo! Inc. 13.89 14.71 5.90%
MXIM Maxim Integrated Products 16.91 23.89 41.28%
Avg. 12.43%
NDX Nasdaq 100 Index 1955.83 2206.86 12.83%

All of the top five stocks from last year achieved 25% returns by May 2011.  However, only Maxim Integrated (MXIM) was able to sustain it's price performance that was above the Nasdaq 100 throughout the year.  As a group, the top five fell short of the Nasdaq 100 by -0.40%.

Netflix and Speed Resistance Lines

In a February 9, 1970 Barron’s article titled “600 on the Dow?” William X. Scheinman provides an interesting chart of the Dow Industrials (DJI) that outlines what he believes to be the target level that the DJI would fall to before rebounding. This analysis included macro economic analysis that supported the reasons why the Dow was expected to go to 600.

What is most compelling in Scheinman’s analysis is the accuracy of the target level that the DJI was expected to reach. An element that leaves some unanswered questions is that Scheinman had predicted that the DJI would reach 600 within the same year that the article was written. Of course, The DJI didn’t reach 600 until 1974. This has to do with Scheinman’s cycle analysis which is separate and distinct from the topic which we will examine. Being aware of this inconsistency and leaving it aside for the time being, we’ve attempted to understand the rational and methodology of how Scheinman was able to arrive at 600 on the DJI when it was trading at 755.68.

Scheinman indicates that he obtained his method for accurately predicting the level of the DJI from Edson Gould. According to Scheinman, Gould used what is known as the 1/3 speed resistance line measurement to gauge price change and elapsed time which was purported to be two key determinants of crowd psychology in the market. Scheinman goes on to say:

“Resistance lines decline or ascend at one-third or two-thirds the rates of actual declines and advances between significant bottoms and tops. Resistance to advance or decline is frequently encountered at such trendlines; however, if the resistance line is decisively penetrated, the price-action often tends to accelerate in the direction of the penetration.”
In an example provided by Scheinman below, he plots the bull market of the DJI from 1949 to 1970. In that chart, we can see that the dashed line, the one-third speed resistance line, intersects with the 600 level on the DJI.

As far as we can tell, the 1/3 speed resistance line is calculated by dividing the peak of the market move by 3.  To be as conservative as possible, we’ve added the 1/3 speed resistance figure to the low of the first major decline in the bull run.  In this case, the first major low in the bull market from 1949 to 1966 was at the 1953 low of DJI 254.  The peak is indicated to be 1001 (1001/3=333.66).  Then we add 333.66 to 254 arriving at a figure of 587.66.  In order to account for the extremes, we assume that 1/3 the peak is the point at which the market finally settles.  In this case, 1/3 of the peak value is 333.66.  We feel that the conservative and extreme values help to establish a range which a market or stock that has had a near parabolic rise will finally settle at or near. 

According to our calculations for the market run from 1949 to 1966, 587.66 and 333.66 were the conservative and extreme downside targets for the market, respectively.  However, in the article, Scheinman says that the potential worst-case scenario level would be 597.61.  For the most part, Scheinman’s estimate was fairly accurate in terms of where the reversal in the market occurred.  The bottom in the stock market took place on December 9, 1974 at the 579.94 level.

In the chart of the Dow from 1945 to 1976 below, it should be noted that a large amount of “overshooting” of the 1/3 speed resistance line occurred when the low did take place in 1974 instead of 1970 as predicted by Scheinman.  In the case of the Dow, the index overshot the 1/3 speed resistance line in 1974 by 15%.  However, the price was well within the established, albeit wide, range of 587.66 to 333.66.

We decided to see how consistent the 1/3 speed resistance line would be if applied to three different situations.  First, we’ll review the bull market in the Dow Industrials (DJI) from 1982 to 2007. Next, we’ll run this model using the Philadelphia Gold and Silver Index (XAU) from the bear market bottom of 2001 to the present.  Finally, we’re going to see how this model works against Netflix (NFLX), a member of the Nasdaq 100, in a real-time example.

In the case of the bull market run from 1982 to 2007, we divided the peak of the market at 14,164 by 3 and arrived at 4721.33.  We then added 4721.33 to the first major low in the market after the beginning of the bull market which was in 1987 at 1738.74.  The sum of the two figures is 6460.07 for the conservative and 4721.33 for the extreme scenarios. 

When we review the actual bottom in the DJI in 2009 of 6547.05 we can see that the difference between the most conservative estimate and the 2009 low was off by 86.98 points.  There is no instance of the DJI overshooting the 1/3 speed resistance line.  Although coming within 1.5% of an estimated target seems exceptional, the real challenge becomes, would an investor commit money to an investment before the price level actually hits a projected target?  Once invested, could an investor stomach a further decline of 27% or more? [(6460.07-4721.33)/6460.07=26.92%]

In the case of the bull market run in the XAU Index, we divided the peak of the index at 206.37 in 2008 by 3 and arrived at 68.79.  We then added 68.79 to the first major low in the index after the beginning of the bull run, which was at 49.83 on November 19, 2001.  The sum of the two figures is 118.62.  When we contrast the difference between the two numbers, 118.62 and the actual low of 65.72, we see that conservative estimate was accomplished, however a further decline of 45% to below the extreme level was established instead.  Reasonably near the extreme end of the range, but who is willing to hold on after a 45% drop?
Finally, in reviewing the chart pattern of Netflix (NFLX), we have the peak of NFLX at $298.73.  The conservative estimate for the stock is that it would fall to $148 which has already taken place.  The extreme downside target would be $99.58.  Because of the nature of the rise, we believe that Netflix (NFLX) is slated to fall at least to the $99.58 level. 
If for any reason investors become interested in buying Netflix (NFLX), the ideal time to do it appears to be at a price at or below $99.58.  However, the difficulty may be that the sentiment that pushed the stock price to $298.73 would likely be just the opposite to push the price down.  Only time will tell whether Netflix is going to conform to technical patterns created by Edson Gould.
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In the News: September 18, 2011

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NLO Dividend Watch List: September 16, 2011

The market rallied everyday this week taking the Dow Jones Industrial Average above the 11,500 mark.  The S&P 500 is back above 1,200 level. In regards to Dow Theory, we believe that the bear market is still intact (see Dow Theory Bear Market stands).  Until both the Industrials and Dow Jones Transports can break above their intermediate high, we believe the market remains very vulnerable.

September 16, 2011 

Symbol Name Price % Yr Low P/E EPS (ttm) Dividend Yield Payout Ratio
ANAT American National Insurance 70.88 1.10% 11.74 6.04 3.08 4.35% 51%
TMP Tompkins Financial Corp. 36.51 2.41% 11.59 3.15 1.44 3.94% 46%
HGIC Harleysville Group Inc.  26.76 3.60% 15.12 1.77 1.52 5.68% 86%
SYY Sysco Corp. 27.4 3.71% 13.98 1.96 1.04 3.80% 53%
BRO Brown & Brown, Inc. 19.01 4.51% 17.28 1.10 0.32 1.68% 29%
PEP PepsiCo Inc. 62.05 4.73% 15.79 3.93 2.06 3.32% 52%
SFNC Simmons First National Corp.  21.8 5.47% 10.48 2.08 0.76 3.49% 37%
GBCI Glacier BanCorp., Inc.  10.64 5.56% 18.67 0.57 0.52 4.89% 91%
ALL Allstate Corp.   24.94 5.59% 23.75 1.05 0.84 3.37% 80%
GD General Dynamics Corp. 60.6 5.59% 8.64 7.01 1.88 3.10% 27%
SYBT S.Y. BanCorp., Inc.  19.4 5.66% 11.21 1.73 0.72 3.71% 42%
VLY Valley National BanCorp.  11.11 5.71% 13.23 0.84 0.69 6.21% 82%
CBSH Commerce Bancshares, Inc.  37.36 5.78% 13.25 2.82 0.92 2.46% 32%
CATO Cato Corp. 24.03 5.86% 10.97 2.19 0.92 3.83% 42%
MMM 3M Co 80.53 5.96% 13.67 5.89 2.20 2.73% 37%
CTBI Community Trust BanCorp., Inc.  24.65 6.02% 10.53 2.34 1.24 5.03% 53%
FRS Frisch's Restaurants, Inc 19.66 6.10% 10.51 1.87 0.64 3.26% 34%
BDX Becton, Dickinson and Co. 77.25 6.19% 12.98 5.95 1.64 2.12% 28%
BXS BanCorp.South Inc. 10.31 6.29% 21.94 0.47 0.04 0.39% 9%
T AT&T Inc 28.94 6.40% 8.41 3.44 1.72 5.94% 50%
CFR Cullen/Frost Bankers, Inc. 48.98 6.43% 13.88 3.53 1.84 3.76% 52%
NTRS Northern Trust Corp.  37 6.69% 14.68 2.52 1.12 3.03% 44%
DOV Dover Corp. 52.34 6.71% 11.45 4.57 1.26 2.41% 28%
SJW SJW Corp. 22.31 6.80% 16.77 1.33 0.69 3.09% 52%
BRK-A Berkshire Hathaway Inc. CL 'A' 107100 6.82% 14.36 7457.95 N/A N/A N/A
TR Tootsie Roll Industries Inc  24.89 7.01% 28.94 0.86 0.32 1.29% 37%
MDP Meredith Corp. 24.28 7.05% 8.73 2.78 1.02 4.20% 36%
MTB M & T Bank Corp. 74.15 7.11% 10.44 7.10 2.80 3.78% 39%
FNFG First Niagara Financial Group Inc.  10.46 7.28% 15.61 0.67 0.64 6.12% 96%
MATW Matthews International Corp.  31.25 7.35% 12.86 2.43 0.32 1.02% 13%
EOG EOG Resources, Inc. 90.16 7.44% 56.70 1.59 0.64 0.71% 40%
SWK Stanley Black & Decker, Inc. 56.73 7.59% 15.80 3.59 1.64 2.89% 46%
BOH Bank of Hawaii Corp. 40.13 7.62% 11.91 3.37 1.80 4.49% 53%
GS Goldman Sachs Group, Inc.   107.49 7.73% 10.54 10.20 1.40 1.30% 14%
ALB Albemarle Corp. 46.3 7.77% 10.72 4.32 0.66 1.43% 15%
PAYX Paychex, Inc.  27.08 7.80% 19.07 1.42 1.24 4.58% 87%
CYN City National Corp. 42.13 7.89% 13.95 3.02 0.80 1.90% 26%
PRK Park National Corp. 53.56 7.92% 12.06 4.44 3.76 7.02% 85%
ATNI Atlantic Tele-Network, Inc. 32.6 7.95% 31.65 1.03 0.88 2.70% 85%
FFIN First Financial Bankshares, Inc.  28.23 8.00% 13.70 2.06 0.96 3.40% 47%
CWT California Water Service 18.05 8.41% 18.61 0.97 0.62 3.43% 64%
WEYS Weyco Group, Inc.  22.81 8.41% 18.85 1.21 0.64 2.81% 53%
JCI Johnson Controls Inc   30.19 8.48% 13.48 2.24 0.64 2.12% 29%
THFF First Financial Corp. 28.75 8.49% 11.88 2.42 0.94 3.27% 39%
SHW Sherwin-Williams Co. 75.37 8.49% 16.53 4.56 1.46 1.94% 32%
TRV The Travelers Companies, Inc. 50.61 8.56% 9.57 5.29 1.64 3.24% 31%
BANF BancFirst Corp.  34.61 8.60% 12.49 2.77 1.08 3.12% 39%
EGN Energen Corp. 47.11 8.75% 12.30 3.83 0.54 1.15% 14%
TRMK Trustmark Corp.  20.24 8.88% 12.19 1.66 0.92 4.55% 55%
WMT Wal-Mart Stores, Inc. 52.65 8.98% 11.20 4.70 1.46 2.77% 31%
CB Chubb Corp.   60.39 9.03% 8.69 6.95 1.56 2.58% 22%
BMO Bank of Montreal 60.07 9.08% 11.55 5.20 2.82 4.69% 54%
AVP Avon Products, Inc. 22.1 9.14% 12.92 1.71 0.92 4.16% 54%
UMBF UMB Financial Corp.  36.79 9.17% 14.96 2.46 0.78 2.12% 32%
DNB Dun & Bradstreet Corp. 66.59 9.25% 12.96 5.14 1.44 2.16% 28%
FFIC Flushing Financial Corp.  11.20 9.27% 8.55 1.31 0.52 4.64% 40%
ASBC Associated Banc-Corp.  10.32 9.32% 32.25 0.32 0.04 0.39% 13%
ARE Alexandria Real Estate Equities, Inc. 68.56 9.57% 23.97 2.86 1.80 2.63% 63%
HNZ HJ Heinz Co. 51.52 9.66% 17.12 3.01 1.92 3.73% 64%
FUL HB Fuller Company 20.89 9.95% 12.90 1.62 0.30 1.44% 19%
SEIC SEI Investments Company  16.88 9.97% 13.84 1.22 0.24 1.42% 20%
BMS Bemis Co Inc 31.25 10.00% 15.55 2.01 0.96 3.07% 48%
GCI Gannett Co Inc 10 10.05% 4.73 2.13 0.32 3.18% 15%
ADM Archer Daniels Midland Co. 28.62 10.08% 9.14 3.13 0.64 2.24% 20%
AFL AFLAC Inc. 36.33 10.09% 9.56 3.80 1.20 3.30% 32%
CBU Community Bank System, Inc. 23.99 10.30% 12.30 1.95 1.04 4.34% 53%
AOS AO Smith Corp. 37.51 10.32% 11.20 3.35 0.64 1.71% 19%
CHFC Chemical Financial Corp.  16.74 10.42% 12.49 1.34 0.80 4.78% 60%
APD Air Products & Chemicals, Inc. 82.36 10.43% 15.34 5.37 2.32 2.82% 43%
EXPD Expeditors International of Washington, Inc.  44.33 10.44% 25.33 1.75 0.50 1.13% 29%
WFC Wells Fargo & Co. 24.95 10.50% 9.67 2.58 0.48 1.92% 19%
MUR Murphy Oil Corporation 52.21 10.52% 10.59 4.93 1.10 2.11% 22%
EMR Emerson Electric Co. 45.74 10.56% 14.12 3.24 1.38 3.02% 43%
UBSI United Bankshares, Inc.  21.52 10.70% 13.04 1.65 1.20 5.58% 73%
FII Federated Investors Inc 17.75 10.87% 11.02 1.61 0.96 5.41% 60%
GE General Electric Co 16.33 10.94% 12.86 1.27 0.60 3.67% 47%
STT State Street Corp. 34.43 10.96% 10.90 3.16 0.72 2.09% 23%
77 Companies

Watch List Summary
Topping our list this week is a life insurance company, American National (ANAT), which is selling at half of its book value.  With a 4.35% dividend yield and a conservative dividend payout ratio, ANAT should entice most patience investors to look into this company.  We've initiated a 5% position of this company in our portfolio.
Another company we like and have mentioned many times is Sysco (SYY).  We again bring back the concept of using dividend yield to gauge valuation.  Sysco historically is undervalued at 2% thus making it very attractive at current levels.  If the yield returns to the historical undervalued range, the potential upside would be 90%.  With a payout ratio sitting at 53%, the earnings could take a hit and the dividend is would still be safe. We've initiated a 5% position of this company in our portfolio.
Pepsi Co. (PEP) is another name we'd like to highlight.  The earnings predictability of Pepsi Co. is high and investors could possibly extract additional information on key metrics such as cash flow or dividend outlook.  According to its historical trend, anytime Pepsi trades above 2.2% dividend yield, the stock is considered undervalued.  The current yield of 3.32% could reward long-term investor with 50% upside in a fairly short period of time.

Top Five Performance Review

In our ongoing review of the NLO Dividend Watch List, we have taken the top five stocks in our database from September 17, 2010 (not published) and have checked their performance one year later. The top five companies on that list can be seen in the table below.



Symbol Name 2010 Price 2011 Price % change
WST West Pharmaceutical 33.43 40.07 19.86%
OMI Owens & Minor, Inc. 26.63 29.89 12.24%
WFSL Washington Federal, Inc.  14.59 14.99 2.74%
FUL HB Fuller Company 19.32 20.89 8.13%
CSL Carlisle Companies Inc. 29.31 37.15 26.75%
Average 13.94%
DJI Dow Jones Industrial 10,607.85 11,509.09 8.50%
SPX S&P 500 1,125.59 1,216.01 8.03%

Last year's top five outperformed the market by more than 5%.  The best performer was Carlisle (CSL) whose share have risen as high as 73% and that occurred within 7 months.  West Pharma (WST) rose as high as 40% in just 6 months.

Disclaimer:

On our current list, we excluded companies that have no earnings. Stocks that appear on our watch lists are not recommendations to buy. Instead, they are the starting point for doing your research and determining the best company to buy. Ideally, a stock that is purchased from this list is done after a considerable decline in the price and extensive due diligence. We suggest that readers use the March 2009 low (or the companies' most distressed level in the last 2 years) as the downside projection for investing. Our view is to embrace the worse case scenario prior to investing. A minimum of 50% decline or the November 2008 to March 2009 low, whichever is lower, would fit that description. It is important to place these companies on your own watch list so that when the opportunity arises, you can purchase them with a greater margin of safety. It is our expectation that, at the most, only 1/3 of the companies that are part of our list will outperform the market over a one-year period.



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A Contrarian Indicator That Says the Gold Run Isn’t Over…Yet

As the saying goes, “once something becomes mainstream the investment opportunity probably has passed.”  In some instances, the magazine cover is the most recognized way to tell if a concept, idea or person has gone mainstream.  But how do we know this is really the case?  Except for the anecdotal evidence that fits someone fancy or the less than anecdotal evidence that was published here, there has been little proof to demonstrate that such a contrarian indicator is reliable or accurate.
 
The recent rise in the price of gold has many wondering if we have reached the stage where, as an investment theme, it has gone mainstream.  Since July 1999, the average price of gold has risen from $255.81 to the most recent high of $1,900.  For any commodity price to rise so much, let alone the dramatic increase in the stocks represented in that industry, should warrant some cause for concern.
As a contrarian indicator, we could look at the many magazine covers out there to make our determination of whether gold has gone mainstream.  However, using such an indicator can take a lot of cover stories and a substantial amount of time before we eventually could consider ourselves correct.  The number of missed opportunities and inaccurate calls for a market top would be many.
However, with the advent of keyword searches and proprietary databases, we can look at the historical significance of all mentions of gold. We have chosen to use the Proquest Complete database covering Barron’s from May 1921 until the present.  Although this will likely include advertisements, we’re willing to believe that the increase in ads about gold would correspondingly increase when there is more interest in the precious metal.  Not surprisingly, advertisers spend more when they shouldn’t and spend less when they should spend more.
In the chart below we see, on a 10-year basis, the number of times that gold is mentioned in Barron’s from May 1921 until August 2011.  For reasons that shall be explained, the decade of the 1930’s and 1980’s were periods when the number of gold mentions peaked. 

Our observation is that the peak in the number of mentions on the topic of gold occurred after major turning points in the price of gold.  The bar chart below shows the decade of the 1930’s in greater detail.  The year of 1932 shows the most articles written on gold.  The decline in interest after 1932 reflects the herd mentality of diminished expectations for gold after England’s September 21,1931 departure from the gold standard.
The impact of England’s suspension of the gold standard led to a domino effect of countries abandoning the gold standard. Denmark, Norway and Sweden abandoned the standard by the end of the same month.  In October 1931, Finland was next to go off the gold standard.  Those that remained on the gold standard in Europe suffered huge losses due to the devaluation of their large holdings of British pounds in their treasury.  The belief at the time was that the currency would always be backed by the set price of gold.

However, after many countries departed from the gold standard, the price of gold stocks began to bottom.  With fewer articles on the topic of gold after 1932, the bull market in precious metal stocks was just beginning as demonstrated in the chart below of gold and silver stocks from 1924 to 1933. 
During the financial crisis from 1929 to 1932, it seems as if gold was popular in Barron’s until it was no longer being propped by governments through the use of a gold standard.  Once freely able to find a price, the process of gold stocks bottoming was inevitable.
After the peak in the price of gold in 1979/1980, Barron’s was again late in the most mentions of gold.  However, the period that followed the 1980’s peak in mentions of gold held at very high levels as the die-hard gold bugs were unwilling to accept the reality of the disinflationary environment that the world economy was entering.
In the chart below, we observed that a significant drop-off in mentions of gold after 1987 may have to do with the fact that gold stocks declined equally as much as the Dow in the same period of time.  Since the decline in gold stocks couldn’t offset the losses of stocks as anticipated, anyone who would have claimed that gold stocks were a refuge during a declining market had all the evidence to demonstrate that such a notion was foolhardy.

In light of the fact that we believe that we’re in a secular bull market in gold stocks, as indicated in our 2010 article (found here) or in our September 2009 article on silver being the best play on the rise of gold (article here), our expectation is that the number of mentions in gold need to match the levels of 1980 or 1932 before we’d be concerned that the lagging contrarian indicator of Barron’s mentions of gold has any relevance on future long-term price declines in the metal and gold stocks.
Because we believe that gold stocks act like perpetual options on the price of gold, we’d select the gold stocks from the Philadelphia Gold and Silver Stock Index (XAU).  The following are our top choices from the XAU index:
1. Freeport-McMoran (FCX)-  Freeport-McMoRan is within 10% of the 52-week low and has a dividend payout ratio of 17%.  The P/E ratio is at a modest level of 7 times earnings.  Value Line indicates that FCX is selling at least 35% below historical fair value.  Since 2004, FCX has traded up to its estimated fair value and then retrenched.  Investors in FCX should expect to sell at the $62 level and rotate into other relatively underpriced gold stocks at that time.
2. AngloGold Ashanti (AU)- At the end of last year (2010) AngloGold's total reserves amounted to 71.2 million ounces. The stock is within 15% of the 52-week low and has a dividend payout ratio of 13%.  The trailing P/E is 22 but they are expected to grow their earning next year, which brings their forward P/E to 9.5.  According to Value Line, AU is trading only 6% below its historical fair value.  Using the 5-year historical book value of 4 as a benchmark, the current book value of 3.8 suggests a 5% discount to the average.
3. Kinross Gold (KGC)- Kinross operates in hte Americas, Africa, and Russia.  At the end of 2010, its proven reserves were 62.4 million ounces of gold, 90.9 million ounces of silver, and 1.4 billion pounds of copper.  The stock is currently trading just 1.3x its book value.  If the 5-year history is any measure, the stock should rise 77% and trade at 2.3x book value.  The company continued to increase its dividend over the years.  Started in 2008, Kinross paid $0.08 per share and now it pays $0.10.  The current payout ratio of 10% along with current gold price implies that dividend increases maybe around the corner.
4.Gold Fields (GFI)- Gold Fields engages in acquisition, exploration, development, and production of gold.  At the end of 2010, their gold equivalent reserves stood at 78 million ounces.  The company's P/E of 40 is high and price-to-book ratio is fair.  While the current dividend yield of 1.7% appears to be high for a gold stock, that dividend is heavily dependent upon the profitability of their business. GFI's dividend policy is to pay out 50% of its cash earnings depending upon investment opportunities.
    

 5. Barrick Gold (ABX)-  According to Value Line investment survey, Barrick Gold is fairly valued at 10 times cashflow.  With an estimated 2011 cash flow of $6.10 per share, Barrick Gold (ABX) is selling 13.72% below fair value as of September 13, 2011.  Despite having a low dividend yield, Barrick has a sustainable dividend payout ratio of 12%, allowing for a substantial decline in earnings if necessary.

Our ranking of the gold stocks above is strictly based on those that are closest to the low and part of the Philadelphia Gold and Silver Stock Index (XAU).  Aggressive precious metal investors can also participate in the extremely popular SPDRGold Share (GLD) ETF or the highly volatile iShares Silver Trust (SLV) for greater potential gain and/or loss. 

We believe that a correction in gold stocks, beyond the trading range that has been established in the XAU since October 2010, is still on the horizon.  Therefore, we believe that these stocks and funds can be bought at lower prices.
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