Streetwise

Lauren Rudd

Sunday, June 1, 2014

Wall Street Can Act Like a Small Child

Yes, I know the financial markets can be trying. 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. This was well illustrated not long ago when the Street essentially misinterpreted the comments by Fed Chair Janet Yellen in her testimony to Congress last March.

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. 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.

Having your portfolio exceed the performance of one or more of the major equity indexes is known as relative performance. Yet, what really counts is absolute performance. In other words, you want a certain minimum repeating annual return over and above your original investment. Outperforming a negative index number with a less of a negative number is not an acceptable result.

To accomplish that performance goal you need to select companies that you know and understand and whose future you, yourself, can foresee. Please note I said that you can foresee. I have deliberately left out letting a mutual fund manager decide your future, receiving “help” from your friendly stock broker, or tips from Uncle Joe. They rarely work.

Instead, you want to train yourself to stay focused on finding companies that are outgunning their competition as they generate better-than-average earnings growth. Ultimately, a stock's performance is tied to earnings.

Furthermore, any company you are thinking of investing in must generate sufficient amounts of cash such that after paying its bills each month and meeting other obligations, it creates a cash surplus.

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.

No methodology would be complete without mentioning dividends. You want to look for firms that have consistently raised their dividend. My suggestion is 8 to 10 consecutive years of increases. Rising dividends are a sign of a company's financial health and its confidence in being able to generate ever higher earnings going forward.

It has been shown that over a period of 30 years, stocks with rising dividends 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. 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 my more than four decades 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. One company you might consider is United Technologies (UTX). A year ago my earnings estimate was $5.95 per share with a projected share price of $110. So how did the company do? Earnings came in at $6.21 per share and the shares recently closed at $116.25.

The Company has been raising dividends for 20 years. Its intrinsic value using a discounted earnings approach is $121. A more conservative discounted free cash flow to the firm model generates an intrinsic value of $125.

My earnings estimate for 2014 is $6.80 per shares with a projected 12-month share price of $136. In addition there is an indicated dividend yield of 2.00 percent, for a projected total return of 19.2 percent.