Streetwise

Lauren Rudd

Sunday, June 10, 2012

In Some Way You Are Dealing With a Childish Mentality

Yes, I know the financial markets have been trying of late. In many ways Wall Street is like a child that just will not take no for an answer. Each time a piece of economic or corporate data is released that somehow does not meet its desires; the Street throws a temper tantrum and you know what happens then.

Playing on the Street’s volatility, virtually every investment organization parrots the same party line, Utopia is just over the hill but only they know which hill. Yes, and I am in the business of selling bridges in Brooklyn.

Forget Utopia. You simply want to invest in companies with an intrinsic value well above their current share price and that have an excellent track record of performance in their particular field of endeavor. At the same time you want to monitor them on a quarterly basis to ensure an ongoing performance that meets your requirements. By doing so, you are likely to chalk up those positive absolute returns.

Exceeding the performance of one or more of the major equity indexes is relative performance. Yet, what really counts is absolute performance. In other words what you want and should expect is a certain minimum repeating annual return over and above your original investment. Forget the indexes.

Please note that I have said nothing about trading stocks, buying mutual funds, receiving “help” from your friendly stock broker, or tips from Uncle Joe. Rather you need to select companies that you know and understand and whose future you, yourself, can foresee.

You want to train yourself to stay focused on finding companies that are outgunning their competition as they generate better-than-average profit growth. After all, a stock's performance is ultimately tied to the underlying company's earnings potential.

Therefore, any company you're thinking of investing in must generate sufficient amounts of cash that after paying its bills each month and meeting other obligations, the company creates a surplus of cash.

This is known as "free cash flow," and is considered an indicator of safety because the funds can be used for growth, paying down debt or to cover unexpected contingencies.

The best-performing companies generate just under 6 percent of their market capitalization in cash each year. A company such as United Technologies (UTX) throws off more than 7.5 percent, thanks in part to its below-average debt and a steady stream of aerospace and defense contracts.

No methodology would be complete without mentioning dividends. Dividends are a cushion for periods such as we are seeing now when share prices slump. You want to look for firms that have consistently raised their dividend payouts. Rising dividends are a sign of a company's financial health and its confidence in being able to generate ever higher earnings going forward.

Ned Davis Research found that over the past 30 years, dividend growers have returned an average of 10.4 percent annually, compared with 9.4 percent gains for basic dividend payers and 1.5 percent for non-payers.

Unfortunately, regardless of how well you hone your skills, not every company you select is going to be a winner year after year. Nonetheless, if you are careful in your selection, your portfolio’s absolute return is likely to outperform not only the major indexes but also the vast majority of mutual funds. That conclusion is based on more than four decades (Ouch!) of Wall Street experience.

So by now you are probably saying to yourself that I should provide you with an example to spring board your efforts.  Great idea; an excellent example is United Technologies. The Company has been raising dividends for 18 years. Its intrinsic value using a discounted earnings approach is $111. A more conservative discounted free cash flow to the firm model generates an intrinsic value of $120. The shares recently closed at 73.64.

My earnings estimate for 2012 is $5.48 per share for a forward P/E of 13 based on the current share price, with a projected 12-month share price of $83 for a capital gain of 17 percent and a P/E of 15, as compared to today’s P/E of 12.35. In addition there is an indicated dividend yield of 2.7 percent, for a projected total return of nearly 20 percent.