We believe that based on earnings, 2012 is starting out with the stock market undervalued. We believe in the long-term ownership of great businesses purchased at sound and attractive valuations. Consequently, we view the stock market as merely the store that we shop at in order to buy the businesses we want to own.
Furthermore, we do not rely on the market to set the price at which we are willing to buy or sell. Instead, we prefer to calculate the intrinsic value of the business based on the company’s earnings power. If the market price is at or below that level of valuation we will be a buyer, if not, we either look elsewhere or patiently wait for the True Worth™ valuation to manifest.
Conversely, if the market significantly overprices a company, even one that we like very much, we will sell to avoid long-term risk. Based on years of research and reviewing the earnings and price relationship on thousands of companies, we are confident that the proper value will inevitably be applied to a business by the market; it’s only a matter of time.
Shares of stock represent ownership in the business. In the long run, business success and shareholder returns will inevitably correlate. However, it is also an undeniable fact that the stock market can and will temporarily either over-price or under-price a business. And, it is also an undeniable fact that a company (business) derives its true value from its earnings power, in other words, the amount of cash flow it is capable of generating on its shareholders’ behalf.
Therefore, contrary to what many people are willing to accept, is the indisputable reality that the business results of the company behind the common stock you own is far more important to wealth creation, than what the stock market may be mispricing it at over a short period of time.
Mispricing happens when emotions erode rational thinking thereby manifesting either greed or fear. It is important that investors maintain a reasoned and rational approach and avoid the emotional response at all costs.
When reviewing the broader stock market in the context of market price versus intrinsic value, we emphatically state that the stock market is significantly undervaluing many best-of-breed American corporations. We believe this is primarily due to extreme pessimism that has been promulgated by the masters of the media.
Currently, when you review America’s best of breed companies from the perspective of operating results, i.e., earnings power, you will discover that in the aggregate, there are a large number of businesses that have performed extremely well in calendar year 2011.
Stated more simply, there are numerous businesses that grew at above-average rates during 2011, but alas, the stock market did not reward that growth according to what it should have. Therefore, based on price action, many of America’s best businesses had a down year. However, when you measure earnings power, the same companies generated significant business growth. In time, we contend that it is inevitable that these fine businesses will be rewarded according to their business achievements. Once again, it’s only a matter of time.
Even more importantly, we further contend that best-of-breed companies trading at such unrealistically low valuations, at least in our opinion, offer the best combination of low risk and future growth possible. The opportunity to invest in and own best-of-breed companies trading at unjustified low valuations is very rare. Common sense would dictate that it can only come when pessimism about our future is at its lowest.
Furthermore, we are also very confident that the majority of these companies are going to continue to generate above-average future earnings growth. As a result, we see a potential double-barreled explosion in the future stock price of many of these fine businesses.
First, we expect a PE expansion as the market inevitably values these companies at more normal PE ratios. Second, we expect that the majority of these companies will continue to grow their businesses (earnings) at above-average rates over the next several years.
The combination of these two factors could generate significant future rewards at low levels of risk. We feel that risk is reduced when valuations are too low to be reasonable, and could be reduced further with the proper level of diversification.
The Case for a Positive View of Stocks
The following list is comprised of Dividend Champion companies that are trading at historically low PE ratios based almost exclusively on negative investor sentiment. Our list is comprised exclusively from David Fish’s current list of 102 Dividend Champions, companies that have increased their dividends every year for at least 25 years. Amazingly, of the 102 names on this list, 43 of them were available at below normal, and therefore we feel, attractive valuations.
To be clear, there were another 45 or so names out of the 102 Dividend Champions that could have been included based on reasonable or fair valuation. Names like McCormick & Co. (MKC), McDonald’s Corp. (MCD), Hormel Foods Corp. (HRL), Sherwin Williams Co. (SHW), and RPM International (RPM) represent just a few of the high profile names that were excluded due to our strictest definition of intrinsic value. In other words, these names were not necessarily overvalued but just fully valued. Of the entire Dividend Champions list, we only rejected five that we considered either excessively overvalued or poor investments based on weak fundamentals.
43 Dividend Champions On Sale
We have organized this list in order from the highest five-year estimated annual total return to the lowest, based on the combination of consensus analyst estimates for growth and valuation. The first four columns in the table compare the current PE to the historically normal 15-year PE and the 15-year historical EPS growth rate to the 5-year estimated EPS growth rate. Then the current dividend yield is listed, and finally, the 5-year estimated annual total return calculation. The 5-year estimated annual total return is a calculation based on the company achieving the estimated EPS growth rate and then the stock trading at its earnings justified valuation.
More Reasons to be Positive About the Market
On top of low valuations, there are additional insights supporting a positive view for our economy and the stock market. John Bodnar, a financial planner/registered investment advisor in Florham Park, New Jersey, sent a letter to his clients, and with his permission we offer a few excerpts. What fascinated us was the following paragraph referencing an article in TIME magazine in 1992 that is eerily similar to even almost identical to the doom and gloom promoted by the media today:
“The U.S. economy remains almost comatose… the economy is staggering under many structural burdens, as opposed to familiar cyclical problems… The structural faults represent once in a lifetime dislocations that will take years to work out. Among them: job drought, debt hangover, the banking collapse, the real estate depression, the healthcare cost explosion, and the runaway federal deficit.”
All of these worries, which reflect almost