Stuart Shaw, CFA

In July 2007, I put the Dow Industrials on Fast Track, and concluded that, “If the Dow were a stock, it failed my 3-category rule, and I would pass.” The Dow is down 7.4% from last July and 5.9% year-to-date at the time of this writing.

Fast Track is a screening tool that focuses on 10 key categories incorporating the balance sheet, cash flow, earnings, valuation, and how management and the Street feel about the stock under consideration. I get interested in doing more extensive research using the entire Company Stock Risk Profile research process if a stock fails no more than 3 categories.

The Dow on Fast Track is a bottoms-up quick study of the Index and its components, and may also uncover a few ideas that may be worth your time for in-depth research. Here’s the Dow on Fast Track today:

1. More cash has been showing up on balance sheets. Cash and cash equivalents and short-term investments totaled $400.8 billion for the Dow companies at the end of this year’s first quarter, as compared with $301.3 billion a year ago. Excluding the 4 financial stocks in the Index, these same numbers were $248.8 billion and $209.5 billion, respectively. Moreover, 26 companies had stable or growing cash and cash equivalents and short-term investments on their balance sheets, up from last year’s Fast Track total of 15.
2. Long-term debt as a percentage of total capital for the Dow companies averaged 33.6% at the end of this year’s first quarter, excluding General Motors, which had negative total capital. Last year, the average was 35.2%, and 32.6% without General Motors. Fast Track favors companies with debt to total capital of 20% or less. Nine companies had percentages below 20%, 1 less than last year’s Fast Track.
3. Despite a tough economic environment, most Dow companies have been posting healthy cash flow. In 2007, free cash flow (cash from operations less capital expenditures) for all 30 companies came in at $86.7 billion, down from $114.1 billion in 2006. However, excluding the financials, free cash flow was $235.7 billion, up from $160.4 billion in 2006. This year’s first quarter is starting out on an equally strong note (without the financials) at $54.5 billion, as compared with $32.1 billion a year earlier. Twenty-five companies had stable or growing free cash flow, 5 more companies than last year’s Fast Track results.
4. But there were more earnings disappointments. Fourteen companies reported earnings that were below Street estimates in at least 1 of the last 4 quarters, 6 more than last year’s Fast Track.
5. Street analysts have been cutting earnings estimates for 11 companies versus only 3 a year ago. Last year’s optimism may be waning.
6. Only 5 stocks passed Fast Track’s 2 valuation measures. Last year, 12 stocks passed.
7. While managements remain overwhelmingly net sellers, they were somewhat more positive about their companies’ stocks. There were 7 companies where insiders were net buyers in the last 6 months. Home Depot stands out with net purchases of 5.7 million shares. Last year’s Fast Track turned up only 1 stock, Coca-Cola, with net purchases.
8. The majority of Street analysts continue to like the Dow stocks. Sixty-seven percent of the analysts following 21 Dow stocks are recommending their purchase. The remaining 9 stocks have the buy support of 41% of those analysts covering them. Fast Track gives higher marks to these 9 stocks, which have more room for ratings upgrades.

The average of all 30 stocks failed 4.3 out of 10 categories, as compared with last year’s 4.5. If the Dow were a stock, I would pass again since it would have failed my 3-category rule.

But the Dow is comprised of individual stocks, and Fast Track uncovered 11 potential ideas that are worth a closer look: 3M (MMM), Altria (MO), American Express (AXP), Boeing (BA), Caterpillar (CAT), Coca-Cola (KO), Hewlett-Packard (HPQ), Johnson & Johnson (JNJ), Microsoft (MSFT), Pfizer (PFE), and Disney (DIS), all having passed my rule of failing no more than 3 categories. Altria, Coca-Cola and Hewlett-Packard each failed 2.

Fast Track is a research tool for quickly and easily screening stocks for ideas. The 11 stocks cited above may or may not be good ideas. So whatever screening tool you choose to use, always thoroughly research the stocks that pass your screen.

In 1997, the Federal Reserve offered a valuation measure for the stock market. The model compared the earnings yield for the S&P 500 to the yield on the 10-year U.S. Treasury note. The earnings yield is forward earnings divided by price, which is the reverse of the price / earnings ratio. According to the model, the market is overvalued when the earnings yield is below the Treasury note yield (negative differential), and undervalued when the earnings yield is above the Treasury note yield (positive differential).

In the 1988 – 2007 period, the highest negative differential (based on year-end figures) was 2.61% in 1999. The differential remained negative and the market dropped precipitously, bottoming in 2002 when the differential moved to a positive 2.40%. The subsequent trend was up. The differential reached a high of 2.64% in 2005, and has been positive since 2002.

Standard & Poor’s current estimate for S&P 500 2008 earnings per share is $89.44. Dividing $89.44 by the S&P 500 index of 1396.60 (at the time of this writing) gives an earnings yield of 6.40%. The 10-year Treasury note yield is 3.94%. The positive differential is 2.46%, which is the third highest behind 2005 and 2007’s 2.53%. Based on the Fed model, the market is undervalued.

We can get the S&P 500 earnings implied by the model by setting the earnings yield equal to the 10-year Treasury note yield and then multiplying the S&P 500 index by the 10-year Treasury note yield. Multiplying 1396.60 by 3.94% gives implied earnings of $55.03. This is $34.41 below the current Standard & Poor’s earnings estimate for this year, and is the highest negative differential from actual earnings in the 1988 – 2007 period. Unless Standard & Poor’s is way off the mark, the Fed model is suggesting that investors in the aggregate are far too negative about the outlook for corporate earnings.

Unlike oil, gold, and other such commodities, water is the one commodity we must have to live. And I don’t even think about it. I don’t have to. Clean water is delivered to my home and where I work. It’s always available, and it’s cheap. Will it always be this easy?

Living in Arizona, one of the fastest growing and driest states, I thought back to a discussion I heard on NPR about population migration. I remembered this startling prediction: the Southwest will be riddled with ghost towns when water runs out, and those looking back 50 years from now will be mystified as to why people ever wanted to live there. Last year 26% of the Southeast was covered by an “exceptional” drought – the National Weather Service’s worst drought category.

Consider these worldwide facts from the United Nations’ Human Development Report 2006:

1. Less than 1% of the world’s freshwater is easily accessible.
2. 1.2 billion people lack access to freshwater, and 2.6 billion are without adequate sanitation.

More people with higher living standards, pollution, and climate change may be pointing to water shortages down the road. A key example, China has 20% of the world’s population but only 7% of the water. Will China have enough water to support its rapidly growing urban population?

The water industry should be ripe with investment opportunities. I put together a group of 18 stocks, certainly not all-inclusive of ways to participate in the industry, to begin to find out:

York (YORW), Pennichuck (PNNW), Middlesex (MSEX), Connecticut (CTWS), Southwest (SWWC), Artesian (ARTNA), SJW (SJW), American States (AWR), Aqua America (WTR), and California (CWT) are all domestic water utilities.

Mueller Industries (MLI) - tubes and fittings used in water distribution systems.

Watts Water Technologies (WTS) – water safety and flow control products.

Nalco (NLC) - water treatment chemicals and services.

Flowserve (FLS) – flow control equipment.

Gorman-Rupp (GRC) – pumps and fluid control equipment.

Calgon Carbon (CCC) – products to purify water and air.

Veolia Environment (VE) – water treatment services based in France.

Consolidated Water (CWCO) – desalination plants and water distribution systems in the Caribbean.

I used Fast Track to get a quick study on the group and find potential buy ideas:

1. These are mostly small cap stocks, and they are not widely followed on the Street. Thirteen stocks have market capitalizations under $ 1 billion. Thirteen stocks are covered by 5 analysts or less, and 9 stocks by 3 analysts or less.
2. Financial leverage is high, with long-term debt to total capital averaging 40.9%, ranging from 0% for Gorman-Rupp to 74.1% for Nalco.
3. Free cash flow was negative at 10 companies in 2007, and 7 companies posted negative free cash flow in each of the last 5 years. These are all utilities.
4. Thirteen stocks had P/E’s below their high / low 5-year average. Only two stocks, Mueller and Watts, also had PEG ratios that were below both their industry and the S&P 500.
5. California Water was the only company where management was a net buyer of stock.
6. The Street is not particularly enamored with this group of stocks. There are 40 purchase recommendations out of a total of 86 ratings, so there’s room for ratings upgrades. Aqua America seems to be the darling of the group with 10 analysts following the stock and 9 recommending purchase.

Here’s my take:

1. I was disappointed to find that Flowserve was the only stock that passed my Fast Track screen, having failed no more than 3 categories. But Flowserve is really a play on oil and gas, which accounts for 41% of their business, as opposed to 6% for water.
2. Only 3 companies, Veolia, Flowserve and Calgon, did not report disappointing earnings in any of the last 4 quarters. But Street analysts have held their earnings estimates steady at 12 companies. Watts pre-announced an earnings disappointment for their March quarter, citing weak construction here, slowing economic activity in Europe, and even problems in China. While this could be unique to Watts, is it a harbinger of more disappointments at other companies?
3. No company in the group delivered consistent earnings growth in the last 5 years. This, and that Watts is a pure play on water makes me question whether the water industry’s growth story has really kicked in yet.

I’ve decided to stay on the sidelines for now.

Initial claims for unemployment benefits rose to a seasonally adjusted 407,000 for the week ended March 29. Claims over 400,000 are usually considered recession territory. The Labor Department just reported that nonfarm payrolls fell 80,000 in March bringing the unemployment rate to 5.1%. But the unemployment rate is a lagging economic indicator.

What may the market be telling us about the economy? I looked at the year-to-date performance of the Dow Jones Industries Indexes, and I found this:

Delivery Services + 6.70%
Railroads +13.16%
Transportation Services +25.07%
Trucking +14.95%
Home Construction +24.28%
Home Improvement Retailers +8.56%
Hotels +5.07%

The stock market is a discounting mechanism, and the strong performance of these economically sensitive industries may be telling us that a pickup in economic activity is up ahead.

I also thought that it may be informative to look at passenger traffic at McCarran International Airport in Las Vegas. Passenger traffic as compared to a year ago was up 3.4% in February and 0.2% year-to-date.

This also caught my attention. Research in Motion added 2.2 million subscribers and shipped 4.4 million smart phones in the quarter ended March 1.

So, more people are going to Las Vegas to vacation and gamble, and they are buying a lot of BlackBerrys. Is the economy really as bad as the headlines make it seem?

Study: Wall Street Analysts Still Exuberant in Their Earnings Projections
Researchers find that upward bias persists even after 2003 Global Analyst Research Settlement

“Previous studies suggest their stock recommendations do not perform well, and now we show that their long-term earnings per share growth rate forecasts are excessive and upwardly biased.” – from the study by J. Randall Woolridge and Patrick Cusatis, Penn State Smeal College of Business.

My observations:

First, let’s do our own research rather than depend on others to do it for us. We do not have to pay high fees to someone else to manage our money, particularly to brokers peddling flawed Street research.

Maybe we should get out of the forecasting business. Here’s what I would suggest.

1. Use trailing 12-months earnings per share from continuing operations and before extraordinary items in the denominator of the price/earnings ratio. If you feel you have to use an earnings estimate, use the lowest estimate among the analysts offering forecasts for a margin of safety.
2. Instead of using the Street’s consensus 5-year earnings forecast in the denominator of the PEG ratio (price/earnings divided by earnings growth rate), use a company’s internal or sustainable earnings growth rate calculated as follows: earnings retention ratio ((net income – dividends) / net income)) X return on equity.

The ideal stock probably does not exist. But if it did, I believe it would look like this: great fundamentals and outstanding value, which have gone undiscovered by investors. In my ongoing search for stock ideas, I try to come as close to my view of the ideal stock as possible. Here’s what I look for.

The company produces products and services that people need and use every day giving it staying power through economic cycles. Individuals and businesses forego what they do not need when economic times are tough.

An established leader, the company dominates its markets with strong brand names. It has the critical mass to be a low cost producer and a very effective competitor, with the marketing muscle to successfully capitalize on powerful brand identification.

Cash from operations and after capital expenditures (free cash flow) is strong and growing. Also, cash from operations is consistently higher than net income indicating quality earnings. A company reporting positive net income, but ongoing negative cash from operations will eventually crash and burn. Real cash is a company’s lifeblood. I want to invest in companies that generate cash to grow their businesses, pay me dividends and buy back stock.

The company has a fortress balance sheet, with lots of cash that is growing and little or no debt. Cash from operations is the principle source of growing cash on the balance sheet, suggesting a profitable and well-managed company.

Management has a large stake in the ownership of the company, and they are buying stock for themselves. Real owners are apt to make better decisions than managers who do not have their personal fortunes at stake.

Managements whose interests are aligned with shareholders run businesses for cash, build strong balance sheets, and have large personal stakes in the outcome.

Earnings have been beating Street estimates for the last several quarters. Underestimating the company’s operating performance, Street analysts are raising their earnings estimates as they try to catch up to what is really happening. Rising earnings estimates indicate positive change, a key element supporting a rising stock price.

The company has a demonstrated record of high profitability. Profitability measures how well management utilizes the company’s resources to produce value for shareholders. Profitability (net profit margin and return on equity and their components) is rising and outperforming the company’s industry as well as the average company as represented by the S&P 500. The quality of profitability is high. Return on equity is rising because of higher pretax margins and asset utilization as opposed to a lower tax rate and higher leverage or debt.

I want stocks that pay dividends. Real cash in my pocket, dividends are a clear reflection of management’s confidence in the future of their business. As one CEO so aptly stated: “Paying a reliable and attractive dividend from the cash we generate each year is one of the most direct and transparent means we have of delivering shareholder value.”

The company has no controversial issues surrounding it, which potentially can crush a stock. These may be issues of questionable accounting and management practices, antitrust matters, new competition, and litigation, to name a few.

The stock is off the beaten track, with no analyst coverage and little institutional ownership. Investors have yet to discover the idea, leaving plenty of room for positive change in perception, expectations and stock price.

The company is poised to show substantial positive change that is going unrecognized by investors. No one is watching, but a catalyst is going to jolt the Street with a positive surprise and change investor perception. Catalysts could be a new product, new management, the sale of underperforming businesses, a strengthening balance sheet, a major cost cutting initiative. Substantial positive change also could emanate from expected negative events that do not happen, e.g. Altria in 2000 at $20 discounting a potential bankruptcy due to litigation.

The stock is undervalued. I use the Company Stock Risk Profile™ valuation measures. Multifaceted in its approach, the Company Stock Risk Profile uses six valuation methods comprised of twelve measures to value stocks yielding a comprehensive result. The ideal stock would be undervalued on all twelve measures.

Recession or not, we all need to eat. The food industry should be one place I would expect to find solid balance sheets and consistent operating performance in an uncertain economic environment.

I screened 14 food, beverage and confectionary stocks using the Company Stock Risk Profile Fast Track. Here’s what I found.

The industry has a lot of financial leverage. Long-term debt as a percentage of total capital averaged 38.2% for all 14 companies. Only three companies were below 20%, which is the Company Stock Risk Profile’s definition of low long-term debt – Coca-Cola (KO), Pepsico (PEP) and Diamond Foods (DMND). Heinz (HNZ) and Hershey (HSY) were at the high end with 70.4% and 68.3%, respectively.

This is not a consistently cash rich industry. Free cash flow at as many as six companies was not stable and declining.

Eight companies reported disappointing earnings as compared with Street expectations in at least one quarter in the latest four quarters. Street analysts have lowered earnings estimates at only two companies. Are these analysts too optimistic?

Valuation is a mixed picture. Eleven stocks had P/E’s (using trailing 12-month earnings) below the average of the high and low P/E’s for the last five years. But based on the PEG ratio (forward P/E / Projected Earnings Growth Rate), 12 stocks were overvalued relative to the industry and/or the S&P 500.

Managements have not demonstrated enthusiasm for their stocks. Kraft was the only company where management had purchased their company’s stock.

The Street on balance likes this group. There were eight stocks where more than half the analysts following them were recommending buy. The Company Stock Risk Profile and Fast Track favor stocks where less than half the analysts are recommending purchase, leaving plenty of room for ratings upgrades.

There were only two stocks that had both low long-term debt and stable or growing free cash flow. They were Coca-Cola and Pepsico. And Coca-Cola was the only stock that failed only 3 of the 10 Fast Track categories, leading me to take a closer look.

Coca-Cola’s Company Stock Risk Profile rating turned out to be Medium Risk. While the company’s fundamentals are solid, two variables raised the stock’s Risk Profile. Failing 8 of 12 valuation measures, the stock is far from cheap. And the Street is extremely bullish with 14 of the 16 analysts following the stock recommending purchase. Admittedly, I passed on Coca-Cola in March 2005 when the stock was $43 based on valuation.

The stock I find most intriguing is Kraft (KFT). Although the stock failed 4 of the 10 Fast Track categories, I broke my 3-category rule and put the stock through the complete Company Stock Risk Profile research process. Kraft is a turnaround story, so I wasn’t surprised that the Risk Profile rating was Medium. Here’s what caught my interest:

1. Kraft is one of the world’s leading food and beverage companies with such well-known and established brands as Philadelphia cream cheese, Oscar Mayer, Post cereals, Nabisco, and Kraft.
2. Kraft has new management at the top. Irene Rosenfeld was appointed Chief Executive Officer in June 2006, and also became Chairman in March 2007 following Altria’s spin-off of Kraft. Rosenfeld is a 25 year industry veteran, and came back to Kraft from Pepsico’s Frito-Lay where she was Chairman and CEO since 2004.
3. The company generated cash flow from operations of $3.6 billion last year and, after capital expenditures, free cash flow of $2.3 billion.
4. Insiders purchased stock this past February.
5. Kraft has yet to gain support on the Street. Only 4 of the 18 analysts following the stock are recommending buy.
6. Warren Buffett’s Berkshire Hathaway owns 132.4 million shares or 8.6% of the outstanding shares.

There also are negative factors to consider: (1) Management’s strategy to accelerate growth and cut costs has yet to prove successful, although top line growth is beginning to pick up; and, (2) The shares are not a bargain, having failed 7 of 12 valuation measures.

Because most Street analysts probably have low expectations, Kraft is positioned to surprise on the upside if the implementation of management’s strategy continues to move in the right direction. But the stock doesn’t yet offer the value I require to be appropriately compensated for the risk inherent in a turnaround. Nevertheless, I believe Kraft has the potential to be an attractive buy idea, and I’m going to follow the stock closely.

Pension Plans Take Chance on Mortgages
By Jim Davenport, Associated Press Writer

Maybe this is an early sign that the mortgage market is beginning to stabilize. This also is an excellent example of contrarian thinking and investing.

See my post Move Out Ahead of the Crowd, October 1, 2006.

World economic collapse is imminent. 1929 is just around the corner. My stocks will never stop going down. I can’t take this anymore, and I’m getting out now. This is a new age for the economy and the stock market, and there’s no way stocks are going down. Everyone else has been making a lot of money in the stock market, and I’m not going to be left out. Feel familiar? These are examples of strong emotions that can push you into making bad investment decisions. However, these same emotions can be your allies, and a resource that you can use to take advantage of investment opportunities.

There are many angry investors who were caught up in the dot.com, telecommunications, and technology bubble and subsequent collapse, Enron included. Some people lost their life savings. This does not have to happen to you.

The stock market is like riding a wave up and down. Sometimes the wave can be dramatic and last a long time before it crashes or takes you up. While the market seems to extend itself, that is go beyond what seems reasonable, on the upside and downside, it always changes direction. While this may seem obvious, it takes a lot of emotional strength to fully embrace this fact when you’re feeling great and complacent when the market is soaring, and it seems that it will never end, or when you’re feeling fear and panic when the market is dropping rapidly, and it seems it will never stop falling.

Are you on the verge of selling all of your stocks because you cannot take the falling prices anymore causing you to panic? Or, are you about to buy stocks, possibly stocks with a high degree of risk, because you feel that all’s well with the stock market, and there’s no way anything can go wrong? Are these the extreme emotions that are really behind the investment decisions you are about to make? Are you about to sell at the bottom of the market or buy at the top because you are caught up in your emotions?

Get a pencil and paper and draw an elongated S shaped curve. Write Exuberance at the top and Fear and Panic at the bottom. These extreme emotions represent market tops and bottoms. To the right of this graph draw a vertical line and label it Risk. Write the word Highest at the top of the line and the word Lowest at the bottom. I call this the Exuberance / Fear and Panic Graphic.

You must understand risk within the context of your emotions. You are putting your money at the highest risk of losing it when you are the most comfortable and complacent about your holdings, when you are exuberant. Risk is at its lowest level just at the time when you are the most negative about the market’s outlook, when you are feeling fear and panic. Objectively recognizing your emotions, you can then turn your emotions and the graph upside down with Exuberance at the bottom and Fear and Panic at the top. Seeing risk with new clarity, you are able to make better investment decisions to protect your capital and take advantage of opportunity.

What action should you take when you are able to gather the emotional strength to turn the graph upside down? Be afraid of the market at the top of the graph. Turning exuberance into fear, sell your stocks and be entirely in cash. If you find yourself at the bottom of the graph, transform your fears into excitement about finding stocks to buy. Put cash to work towards being fully invested in stocks.

There are various methods of valuing markets, among them price / earnings ratios, dividend yields, earnings yields, sentiment indicators, and technical analysis or charting. These methods look outward. I’m proposing that you also should look inward at yourself with the aid of the Exuberance / Fear and Panic Graphic as another, albeit unconventional, approach.

A successful investor is objective, disciplined, and has a clear understanding of risk. The Exuberance / Fear and Panic Graphic helps you to objectively examine your emotions, attain the discipline not to get caught up in the wrong emotions at the wrong time, and to recognize the real risk inherent in your investment decisions.

As a shareholder / owner, never lose sight of the fact that management is working for you. Expect and demand that management grow the long-term value of your investment, or shareholder value. I define shareholder value as being a function of the stock price, dividend, and book value.

Everything that management does should be in support of a higher stock price. If management is doing a good job for shareholders / owners, or not, it ultimately will show up in the stock price. Growing quality earnings is the bottom line measurement of how well management is performing, and in the long-term earnings drives stock prices. Moreover, investors know all too well the impact of scandals, fraud, and ill conceived acquisitions, the result of management actions.

Top management might make better decisions if they are large stakeholders in their company. Management’s personal financial interests should be aligned with shareholders / owners. If management does not express confidence in the future of their company by being substantial owners and buying stock for themselves, why should you?

The company should share the profits and pay you a dividend, real cash in your pocket. Meaningful and growing dividends are a direct reflection of management’s confidence in the prospects of the business. They represent management’s commitment to the shareholders / owners.

Expect management to grow your equity in the business, or book value per share. Book value per share is the net worth (total assets minus total liabilities equals shareholders’ equity) of the business stated on a per share basis, part of which you own as a shareholder. In Berkshire Hathaway’s annual reports, Warren Buffet includes a table on the page facing his letter to shareholders titled Berkshire’s Corporate Performance, which compares the company’s annual percentage change in book value per share with the S&P 500.

I propose measuring shareholder value as follows:

Shareholder Value = $ Change in Stock Price + Dividends per Share Received + $ Change in Book Value per Share

% Change in Shareholder Value = (Shareholder Value / Beginning Stock Price) x 100

Compare stocks over at least a five-year period, preferably ten years if the data is available.