Grantham: High-quality stocks still relatively cheap

It’s always interesting to read Jeremy Grantham’s latest thoughts on the market. In his just published Q4 2009 letter (embedded below) he reiterates his view that the market, as represented by the S&P 500, is worth only 850 and that any advance from current levels will make it “seriously overpriced.”

Still, he says, the high-quality component of the market is still relatively cheap. Presumably this represents the types of stocks that his firm’s portfolio is overweighted in, so out of curiosity I looked around for a list of Grantham’s top portfolio holdings (as of Q3 2009) and came up with names like Abbott Labs (ABT), Johnson & Johnson (JNJ), IBM (IBM), Chevron (CVX), Microsoft (MSFT), Pepsico (PEP), Pfizer (PFE), Wal-Mart Stores (WMT) and so on.

Of course whenever I look at a stock as a potential investment I always have its dividend in mind – not just the dividend yield, but also the company’s record of growing its dividend over time. And in that respect, thirteen of the fifteen stocks listed as Grantham’s top holdings pay a dividend, and many have an excellent record of dividend growth.

That dividend growth could come in handy if Grantham’s prediction – repeated yet again in this letter – of “seven lean years ahead” comes to pass. Grantham’s full comments can be seen below:

GMO January

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10 Ben Graham dividend stocks for the enterprising investor

A recent post at ModernGraham – a site devoted to the study of the security analysis methods of value investing pioneer Benjamin Graham – highlights “10 Dividend Companies for the Enterprising Investor”. These are the top 10 dividend stocks in the site’s database with the highest dividend yield that are considered suitable for “enterprising” – as opposed to more defensive – investors.

The list includes some surprisingly familiar names like Pfizer, Philip Morris and DuPont, as well as more obscure companies like National Presto Industries and Psychemedics Corporation. Since I’m always looking for good dividend stock ideas – especially those that might be found at bargain prices – I didn’t waste any time checking out these suggestions.

The first thing I did was to create a spreadsheet with all ten dividend stocks that includes their relative current valuations (based on an average fair value derived using several different valuation methods, including Graham’s) and dividend growth history rating from (where three stars represent five years of consecutive dividend increases, four stars are ten, and five stars are 20):

The immediate takeaway is that while none of the companies listed has a stellar dividend growth record (Pfizer used to, and Philip Morris doesn’t have sufficient history), most do appear to be currently undervalued – with the caveat that in some cases the valuation is based on very limited data due to a short or volatile earnings history and/or lack of analyst coverage. With that in mind, I decided to take a closer look at the individual stocks:

B&G Foods [[BGS]] – B&G Foods sells and distributes shelf-stable food products like pickles, peppers and hot sauces under a variety of brand names that are likely to be familiar to grocery shoppers. Shares of its Class A common stock only began trading on the NYSE in 2007, so its price history is somewhat limited:

Trading at about $8 and yielding 8.5%, BGS appears to remain in an intermediate-term uptrend from its October 2008 lows. A more neutral to negative outlook would be warranted on a drop below $7 to $7-1/2.

Currently the company’s dividend payout exceeds its earnings and is a very high percentage of its free cash flow, bringing into question how sustainable the dividend is and/or to what extent it will be return of capital. Valuation wise, BGS appears to be currently trading at about fair value.

I like the company’s products (in fact some of their pickles and chopped peppers are sitting in my refrigerator as I write this). I just wish I liked their balance sheet as much. I’m not too tempted to buy the stock here, but might get interested if it drops closer to book value (about $5) in the coming weeks/months.

Bristol-Myers Squibb [[BMY]] – As with some other drug companies, this pharmaceutical giant has seen its shares unable to make any significant headway in recent years due to a combination of stagnant earnings, future product pipeline concerns, and potential legislation:

Trading at about $23 and yielding 5.5%, BMY has been trading with an upward bias with the market since bottoming a year ago, but would still have to be said to be presenting a somewhat neutral intermediate-term picture. A break-out above the $23-1/2 to $24 level would suggest a more clearly positive outlook, while a drop below $20-$21 would have negative implications.

From a valuation perspective BMY appears somewhat attractive here trading 16% below its average calculated fair value of $27. And it’s currently the only stock on the ModernGraham dividend list that has a positive valuation on all three Ockham Research measures that compare three criteria – price/sales, price/cash earnings and dividend yield – to recent historical values for the stock.

While BMY doesn’t have a history of raising its dividend every year (and thus the 0 stars rating from it has consistently paid a dividend over the years and grown it over time. Further, the dividend appears safe. If I didn’t already have a position in BMY (I’m short some put options – see here for details), I’d be giving it a serious look.

DuPont [[DD]] – The third largest U.S. chemical maker, DuPont is involved in everything from agriculture, industrial coatings, materials and electronics. Its stock was hit hard during the recent financial crisis, but is now up 100% from its March lows:

Currently trading at about $33 and yielding 5%, DD is in a clear intermediate-term uptrend. A drop below the $28-$30 level would change this picture to something more neutral/negative.

Like BGS (above), DD’s dividend payout appears to currently exceed its recent earnings, although it’s still below the company’s free cash flow. While this is usually a warning sign, the company has maintained its dividend so far during the recent economic turmoil, contrary to some predictions, so maybe this bodes well going forward.

From a valuation perspective, DD is one of the few stocks on this list that’s currently trading at or above its calculated average fair value, making it somewhat less appealing here. However I’ll be keeping an eye on it for a possible future buying opportunity at lower prices.

International Shipholding [[ISH]] – This company charters vessels to commercial and governmental customers for the transport of cars, trucks and larger vehicles, as well as other materials. Its stock has certainly been on a tear lately, reflecting increased profits and a relatively healthy balance sheet:

Currently trading at about $35 and yielding almost 6%, ISH is in a very strong intermediate-term uptrend that would probably require a drop below the $28-$29 level before being called into question. That said, it’s reasonable to wonder about the stock’s valuation at this point.

While ISH is still trading below its average calculated fair value, it should be noted that this estimate is based on little data, one piece of which – the stock’s long-term linear regression trendline – is actually far below the current price, at about $17. Another factor to consider is the nature of the company’s business, which is typically subject to cyclical ups and downs, making it harder to assign a fair value going forward.

The dividends too of such companies tend to rise and fall with the companies’ fortunes, and can’t be counted on for consistency (in fact Yahoo Finance shows no dividend payout at all for ISH between May 2001 and November 2008). Such pass-through dividends can be okay from my perspective (I have positions in a couple of shippers), but it suggests the best time to buy these type of stocks is when the stock price – and dividend – are in the doldrums. I’m staying away for now.

Merck [[MRK]] – Another giant pharmaceutical company and another troubled – and it can be argued undervalued – stock (see BMY above):

Trading at about $33 and yielding over 4.5%, MRK is in a clear intermediate-term uptrend that probably won’t be in jeopardy unless the stock drops below about $28-$29. Like BMY, MRK has a long history of paying a dividend, although it hasn’t been raised in years – but it appears safe.

Valuation analysis is made somewhat uncertain with the company’s recent acquisition of Schering-Plough (and talk of further acquisitions) but like BMY and PFE, MRK does appear to be still undervalued at current levels. I currently have positions in several other drug companies (PFE, BMY and GSK) so am not looking to add more in this sector right now, but I’ll continue to follow MRK for opportunities in the future.

National Presto Industries [[NPK]] – National Presto Industries makes housewares/small appliances like pressure cookers, can openers and electric knives; defense products such as ammo and cartridges; and absorbent products like diapers. The company’s good recent earnings growth (despite the recession) and a clean balance sheet are reflected in a stock price that is trading at all-time highs:

Trading at about $90 and yielding 5% (based on its single annual dividend payment made earlier this year), the shares of NPK are clearly in a strong intermediate-term uptrend. A break below about $81-$82 would suggest a more neutral outlook.

Valuation analysis does indicate that – despite the run-up in the stock – NPK may still be somewhat undervalued here. However it should be noted that this is based on fairly sparse data (NPK is not widely followed) and valuation estimates ranging from as low as the mid $40s up to over $200.

NPK appears to have paid a dividend consistently for 65 straight years so far, according to a company press release, with the payout at varying levels – presumably reflecting the company’s earnings/prospects at the time. This year’s dividend was the highest ever, consisting of a regular dividend of $1 and then an extra $4.55!

All in all this is an intriguing stock. I’m going to be keeping an eye on it for a possible buying opportunity at a lower price down the road.

Olin Corp. [[OLN]] – Olin Corporation is a manufacturer that concentrates in two business segments: chlor alkali products (which are used to make bleach, water purification and swimming pool chemicals, among other things) and Winchester-brand ammunition. While its stock has recovered somewhat from its lows earlier this year, it still seems to be reflecting the chemical industry’s recent woes:

Trading at about $16 and yielding 5%, OLN remains in an intermediate-term uptrend from its March lows. A drop below the $14 level would suggest a more neutral/negative outlook.

According to valuation analysis, OLN is one of the more undervalued of the listed dividend stocks, although fair value estimates range from as low as $9 to over $60. In terms of dividend history the dividend has been very stable – which is to say it hasn’t changed now for 10 years. So OLN isn’t a place to look for dividend growth, but its current dividend payout appears to be sustainable so far.

All in all, I’m going to be watching this more closely as a potential buy candidate in the coming weeks/months.

Pfizer [[PFE]] – The world’s largest research-based pharmaceuticals firm has had its share of problems in recent years, with a prolonged period of flat revenue and prospects of a major fall-off in 2011. While the company’s acquisition of Wyeth attempts to address this, the acquisition and the 50% dividend cut that accompanied it have not been exactly applauded by investors:

Currently trading at $17 and yielding 3.8%, shares of PFE have been in a steady intermediate-term uptrend since bottoming in March. The picture would change to something more neutral/negative on a drop below $15-1/2 to $16.

While all the drug companies appear undervalued to one degree or another, PFE appears to be trading at the greatest discount. This may be offset by its lower yield and uncertainties over the Wyeth integration. Still, ModernGraham notes that PFE is one of the few stocks on the list (the other is MRK) that would be considered suitable for both enterprising and defensive investors.

Before its dividend cut, Pfizer was a Dividend Aristocrat. That history, combined with the company’s now much more comfortable payout ratio, suggests that its dividend going forward should be safe and perhaps will begin a new growth path. Note: I currently have some longer-term bullish options positions in PFE.

Philip Morris International [[PM]] – Philip Morris sells cigarettes and other tobacco products outside of the U.S. and as such is seen as having faster growth prospects than some of its domestic counterparts. PM’s stock price history is limited, reflecting the company’s spin off from Altria Group in 2008:

Trading at about $49 and yielding 4.7%, PM remains in an intermediate-term uptrend from its March lows. A move back to the low to mid $40s wouldn’t be surprising within this context, but a drop below $43 or so would suggest a more neutral/negative outlook.

From a valuation perspective PM appears to be about fairly valued to even somewhat overvalued here, suggesting patience may be rewarded with a better buying opportunity at some point further down the road. In terms of dividend growth, PM has too little history in this regard to really get excited about, but so far so good as it has raised its dividend twice so far in its short history.

I already own PM in my IRA, but would otherwise certainly be looking to initiate a position the next time an opportunity presented itself.

Psychemedics Corp. [[PMD]] – This small-cap company is the world’s largest provider of hair testing services for the detection of abused substances. Its stock price chart appears to reflect a history of somewhat erratic earnings, as well as more recent revenue weakness due to the current economic downturn:

Trading at $5.5 and yielding about 8.7% (based on a projection of its latest announced dividend amount), PMD’s technical picture appears somewhat neutral on an intermediate-term basis. A drop below $4.5-$5 would be more clearly negative, although given the stock’s currently extreme oversold condition it could perhaps be viewed as a further long-term buying opportunity for those who might be so inclined.

While the valuation summary suggests PMD may be significantly undervalued here based on the average of its fair value estimates, it should be noted that this is based on sparse data with individual estimates ranging from as low as $1 up to $14 – a consequence of the company’s volatile earnings and the lack of analyst coverage. That said, the company appears profitable and claims a strong balance sheet.

PMD has paid a dividend consistently for 53 consecutive quarters. At the same time, it appears to have cut its dividend on several occasions, most recently this past August. And, based on current earnings and cash flow, I would question if the latest, lower dividend payout ($0.48 annually) can be sustained.

All in all I’m going to pass on this for now. But I might be tempted to establish a small position if it were to drop back down to the $3 level at some point.

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Cramer vs. Cramer on Lockheed Martin – A “Buy” or “Sell! Sell! Sell!”?

A while back I posted an example of how money managers can be hazardous to your financial health. Now Jim Cramer, host of CNBC’s Mad Money, has provided us with a more recent example of how blindly following financial “experts” can prove costly (and confusing).

In this case it involves his recommendation(s) on Lockheed Martin [[LMT]], a dividend stock I highlighted positively recently (see “3 dividend stocks with high free cash flow“). Apparently, according to equity research firm Ockham Research, Cramer was also positive on the stock early last month, giving a caller on his show the following advice:

“Lockheed Martin is a buy. Now, a lot of people were disappointed by the last quarter, I say get a life. This is a company generating a gigantic amount of cash. It’s not expensive. It’s very well run. And as far as I’m concerned, this is the best bargain in the defense group. LMT, Lockheed Martin, pull the trigger right now.”

Not long afterward the company disappointed analysts by forecasting slightly lower-than-expected 2010 earnings – not great news, but nothing that suggested any significant change in the company’s underlying long-term fundamentals. In reaction, the stock sold off in the following days – from about $75 down to the upper $60s.

To a value investor, the lower stock price would appear to make it an even better bargain. To Cramer? Apparently not so much. According to Ockham Research, here’s what he told viewers just two weeks after recommending LMT as “the best bargain in the defense group”:

“The day after Lockheed disappointed, Northrop Grumman came out with a solid beat and a really nice outlook. The difference is stark. Lockheed seems to be losing programs left and right. Northrop Grumman won $10 billion of contracts in the third quarter…

In the past Northrop Grumman has been among the worst of the defense contractors, a company plagued by pension problems and crummy execution. Amazingly now it’s Lockheed Martin with the pension problem and Northrop Grumman indicated it made a last sizable pension contribution for a while…

Cheaper, faster growth, same yield. I think Northrop Grumman is the better stock and the better company.”

Okay, so it’s no secret that Cramer’s show is more about entertainment and trading performance than education and long-term investing. So, what’s the real story on Lockheed Martin’s valuation?

To find out, I did some valuation analysis using the latest earnings data and analyst estimates comparing LMT to several of its counterparts in the defense sector – Northrop Grumman [[NOC]], General Dynamics [[GD]], Boeing [[BA]] and Raytheon [[RTN]].

I used several different valuation methods and then averaged the results to arrive at an average “fair value” for each stock to compare to its current market price (11/4/09), and the results are shown below:

Clearly, based on these results, at the present time most of the defense sector appears undervalued, with Lockheed Martin being the best value. NOC and RTN are almost as cheap, but LMT appears to have a better record of dividend growth.

In addition, looking ahead, analysts’ expectations of future earnings growth are still the highest – at about 11% – for Lockheed Martin, compared to about 9.5% or lower for the others. And don’t forget about the company’s high free cash flow – it goes a long way toward ensuring a sustainable dividend payout.

Of course all this doesn’t mean LMT won’t trade lower in the weeks and months ahead. But it does suggest that the “cheaper” and “faster growth” choice remains LMT – not NOC.

Note: I’m currently short some March put options against LMT at a lower strike, meaning I’m willing to buy the stock (have it “put” to me) if it trades below the strike price between now and when the options expire.

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Shiller, Grantham: “Market is overvalued (again)”

Two astute market observers – Robert Shiller and Jeremy Grantham – recently weighed in with their take on the market after its 60% run-up from the March lows and came to the same conclusion: it’s once again overvalued.

Not massively, mind you, but enough to cause concern. While neither is predicting another crash – at least not immediately – both are far less optimistic about the market’s prospects now than when they looked at it earlier this year.

Grantham expressed his views in his Q3 2009 letter (also see below for embedded document). In it he says that while the good news is we haven’t fallen into another Great Depression, this doesn’t mean everything is fine either, and “it still seems a safe bet that seven lean years await us.”

Looking at the market, Grantham estimates the S&P 500’s fair value to be about 860, which means at current levels (about 1035) the market is overpriced by over 20%. Although he’s not looking for it to make new lows, he expects to see it fall below fair value again, and that sometime before the end of next year it will drop “painfully” (at least by 15%) from current levels.

That being said, Grantham is currently now only modestly underweighted in equities, having recently taken some “chips off the table.” The reduction would have been greater except for the fact that he’s still able to find some groups of equities that he considers close to fair value, with U.S. high-quality blue-chip stocks being particular standouts in that regard.

Grantham notes that they’ve remained relatively cheap while investors chase after “junk and other risky assets.” Quality stocks, he says, have proven to be the one “free lunch” for investors over the long run, and his seven-year forecast shows them outperforming the S&P 500 by a significant margin.

While Grantham doesn’t mention dividends specifically, it goes without saying that most quality U.S. stocks pay dividends, and that these undoubtedly account for more than a small degree of the group’s relative attractiveness. For some high-quality U.S. dividend stock suggestions, see the previous post which attempts to find the best values among top U.S. dividend stocks at current market levels.

Grantham’s full comments can be seen below:
GMO – Q3 Oct 09 letter – Grantham

Robert Shiller expressed his views in a recent Tech Ticker video interview (3:15):

Like Grantham, Shiller sees the market as currently overvalued, with his P/E10 ratio up to almost 20, compared to an historical average of about 15. That doesn’t mean you should be completely out of the market he says – historically, “even when it’s been this high [the market’s] done all right.”

However, “given the economic situation” he remains worried about the stock market and sees “some irrational exuberance still in the system.” As a result, he says, he doesn’t feel the current bull market (in stocks and housing) can be trusted to continue.

For more on Shiller’s P/E10 valuation model, you can download a spreadsheet with the latest P/E10 data from Shiller’s website. You can also use an online P/E10-based stock returns predictor at Early Retirement Planning Insights to see how various market P/E10 values affect S&P 500 returns at 10 to 60 years into the future.

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The top U.S. dividend stocks: Which are the best values now?

A recent post at the dividend investing blog Dividends Value lists the author’s choices for the 10 Best U.S. Dividend Stocks. Not surprisingly these include such stellar dividend payers as Johnson & Johnson, Procter & Gamble, 3M and Abbott Laboratories to name a few, as well as four honorable mentions.

The post goes on to make an important point: most of these otherwise excellent dividend stocks “are not good buys today.” This shouldn’t come as a surprise given how far (and how quickly) the market has recovered from its lows earlier this year – in general, it’s a lot tougher to find stocks selling below their “fair values” today than it was just a few months ago. Dividend yields too are a lot lower than they were.

Still, there are bound to be some relative bargains still to be had, especially if the market accommodates with a pullback in the weeks/months ahead. So I ran some analysis on all 14 of the dividend stocks mentioned to try to come up with a rough idea of their current “fair” values (see spreadsheet below) and to find out which, if any, might still be reasonably priced:*

The “fair” values listed in the spreadsheet were obtained using several valuation methods:

Simple DCF Fair Value: This value is arrived at using a basic discounted cash flow calculator.

iStockResearch Fair Value: This value is based on the proprietary stock valuation model available at iStockResearch, which is also based on DCF but with additional inputs.

Graham Forward Intrinsic Value: This is based on the forward intrinsic value formula from The Graham Investor.

PEG Value: This value is based on the PEG Ratio (price/earnings to growth ratio), where the PEG Value is the price where the PEG Ratio equals one (considered a “fair” value level), using future earnings estimates.

Very-Long-Term Linear Regression Trendline Value: This is the current value of the very-long-term (25 years or more) linear regression trendline of the stock price history, which could be seen as representing the long-term “mean” value of the stock price action.

Average Fair Value: This is simply the mathematical average of the above five “fair value” results for each stock.

Ockham Research Valuation: This isn’t a numeric value, but a positive/negative/neutral valuation based on three criteria – price/sales, price/cash earnings and dividend yield – relative to recent historical values for the stock.

Bottom line
The spreadsheet column under the heading “% Above/Below Average FV” basically sums it all up by comparing the current stock price of each of the 14 listed dividend stocks with its averaged “fair value.” If a stock is trading above its fair value, the percentage by which it’s doing so is shown in red; if it’s trading below fair value, the percentage amount is shown in green.

At the time of this posting (10/11/09), only three of the stocks are currently showing as undervalued – Automatic Data Processing, Sysco Corp. and Wal-Mart Stores – but not by much. None are trading more than 5% below their average fair value.

On the other hand, five of the stocks are trading well above (10%+) their fair values, including McDonalds, Nucor, 3M and Coca-Cola. The most “expensive” stocks on the list, according to the valuations, are Nucor and (surprisingly) Coca-Cola, each of which is shown as currently being about 35% above fair value (although the latter at least has a positive Ockham Research valuation).

I’m currently short some cash-secured put options on several of these dividend stocks, including Abbott Laboratories, Emerson Electric and Procter & Gamble, meaning I’m willing to have shares of these stocks be “put” to me at somewhat lower prices. I’ve been looking to establish similar positions in several other stocks on this list and will likely do so on any decent market pullback.

* Note: I’ve updated the spreadsheet to reflect changes/updates in reported earnings and analysts’ estimates since the original post.

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