Streetwise

Lauren Rudd

Sunday, October 24, 2010

Do Not Let Volatility Dissuade You

Back when the Dow Jones industrial average finally broke through the 10,000 level there appeared a series of articles touting the attractiveness of bonds over stocks. The logic being that the Dow had crossed the 10,000 level more than 20 times since 1999 and therefore doing so one more time was no reason for excitement.

I do not take umbrage with the statistical data regarding the Dow’s volatility. And it is likely there will be similar articles that point out how many times the Dow has oscillated above and below the 11,000 level. However, I do take exception with the idea that bonds are some sort of an investing panacea. They are not.

Yes, the allocation within your portfolio between bonds, stocks and cash is critical and academic studies have shown that it can account for 90 percent of your investment success. So how you select an optimum mix? It requires an analysis of a myriad of economic factors and at the moment the economy is in a state of flux. For better or worse, a clearer picture will emerge after the upcoming elections.

Furthermore, achieving gains in a bond portfolio requires that you capture a bond’s capital appreciation that most often accrues from a decline in interest rates, not likely in today’s environment. Besides, that is not the strategy employed by most investors. Rather they are looking for the steady interest income and often hold bonds to maturity.

Asset allocation aside, the performance of an index, such as the Dow, has little or nothing to do with the performance of your portfolio or with performance of a particular stock, other than some meaningless day-to-day price volatility. Any company that demonstrates an annual rise in both profitability and dividend yield will be rewarded by Wall Street, the reward being a higher share price.

Is it difficult to find those companies? Start with the Dividend Achievers Handbook that I wrote about a couple of weeks ago. For example, listed in the book is Badger Meter (BMI), a company I have discussed here for the past two years. The company has been increasing dividends for 17 years and has a 10-year compounded annual dividend growth rate of 9.84 percent.

Established in 1905, Badger (no relation to the nocturnal carnivorous mammal with the same name) manufactures a variety of measuring devices, including drive-by utility meters that make in-person meter readings a thing of the past.

A year ago, my revised earnings estimate for 2009 was $1.85, up from a previous $1.75, with a 12-month target price on the stock of $44, as compared to a price back then of $38. Earnings for 2009 were a bit lighter than I expected, coming in at $1.79 per share as was the share price performance, with the shares recently closing at $42.09. Nonetheless, you still had a capital gain of 10.08 percent.

Furthermore, the company’s potential is still there based on its performance year-to-date. Looking at the third quarter ended September 30, net sales were a record $75.7 million, a 24.5 percent increase over the same period a year ago.

Earnings from continuing operations were a record $9.02 million, a 29.5 percent increase, while net earnings were also $9.02 million, a 37.1 decrease from a year ago. The primary reason was the increase in commodity costs. As a result Badger is considering a round of price increases across it product line.

Earnings per share from continuing operations for the third quarter were a record $0.60, a 27.7 percent increase over a year ago, while earnings per share were also $0.60, a 37.5 percent decrease from a year ago.

The intrinsic value of the shares, using a discounted earnings model with a 5-year average growth rate of 14 percent and a 15 percent discount rate, is $59. A more conservative free cash flow to the firm model produces an intrinsic value $57. My earnings estimate for this calendar year is $1.85 per share and $2.11 per share for 2011, with a 12-month target price on the shares of $48, for a 14 percent gain. There is also an indicated dividend yield of 1.30 percent.