Archive for July, 2014

5-Yr Projection of Mean Reversion for S&P 500 Price, GAAP Earnings and Dividends

Monday, July 28th, 2014

One approach to seeking fair value, or simply what is most likely, over the intermediate-term to long-term is the assumption of mean reversion.  That approach basically assumes that long-term means act a bit like gravity or a magnetic attraction that pulls on prices, earnings or dividends to return to the mean growth level.

It may take a lot of patience for that approach, and if there is a permanent structural change in markets, the former mean may not continue to serve as gravitational or magnetic attraction.   On the other hand structural changes are few and far between, making mean reversion a pretty good bet more often that not.

So, lets discover the long-term means for S&P 500 prices, GAAP earnings and dividends; and then apply those means to make reasonable 5-year projections of those dimensions into the future.

Let’s use the S&P monthly data available from Professor Shiller at Yale (you can download the data for yourself to do various studies on your own).  That data begins in the 1800’s using precursors to the S&P 500, such as the Dow Industrials and other data, but we will confine our study to actual S&P 500 data from its inception in 1957 (more than 57 years of data).


The long-term compound growth rate of the price of the S&P 500 is 6.88%.  Continuing that growth curve out 5 years comes up with a future  price projection in the vicinity of 2700.  That is around 36% to 37% above the current level.



The long-term compound growth rate of the GAAP earnings for the S&P 500 is 5.90%.  Continuing that growth out 5 years comes up with a future earnings level projection in the vicinity of $115 per index share. That is around 14% above the most recent 2-month trailing earnings levels.



The long-term compound growth rate of dividends for the S&P 500 is 5.37%.  Continuing that growth out 5 years comes up with a future earnings level projection in the vicinity of $45 per index share.  That is around 20% above the most recent 12-month  trailing dividend level.



Now let’s look at the growth trends since the effective beginning of the internet era in 1995, and also use the long-term growth factors from that beginning to see where that ends up.

In 1995, HTML had been around for a few years, and eventually it included ways to add images, not just text. That image capability was added and expanded to browser capability when Mark Andreesen released the Netscape browser in November 1994.  The internet rapidly transformed from a Geeky academic and military technology, to a personal and commercial technology.  It has been disruptive and transformative in business and for stocks ever since.

Keep in mind that if January of 1995 was particularly high or low relative to fair value, the projection would be comparably high or low.  For reference and to make your own judgment about that, here are the multiples at as of December 30, 1994:

  • GAAP earnings yield 5.95% (P/E ratio 18.81)
  • Dividend yield 2.90%
  • Moody’s long-term Baa corporate bonds 9.1%
  • 30-yr Treasuries 7.89%
  • 10-yr Treasuries 7.81%
  • 5-year Treasuries 7.81%
  • 2-yr Treasures 7.69%
  • 3-mo Treasuries 5.6%

The yield curve was essentially flat, while today it is steep. and the Fed was not such an intrusive player.


These charts have two 5-year projections.  The black dotted plot is a simple exponential trendline on the data from the beginning of 1995 projected out 5 years.  The red solid line is a projection from the beginning of 1995 at the long-term growth rate of the price of the S&P 500.

The exponential trend line is heavily influenced by the extremes of the dot-com bubble, while the long-term growth rate projection is impacted by the degree of “normalcy” of the starting point multiple.

The exponential projection suggests there is little if any price growth in the 5-year future of the S&P 500.  The long-term growth rate applied to the internet era suggests a price level 5 years out in the vicinity of 2900, or about 31% to 32% cumulative price change over the next 5 years.

At a minimum, the explosive growth of the past few years driven by both earnings recovery from the deep 2008 crisis, and by P/E multiple expansion.  Those forces are behind us, not in front of us.


There are many optimists among the analyst community, and there are long-term optimists who expect a correction, but there is a much more limited number of outright long-term pessimists.

Two prominent pessimists are Bill Gross of PIMCO and Jeremy Grantham of GMO.

  • PIMCO, as you may know, is predicting stock price appreciation in the 3% to 5% range over the next several years.
  • GMO is another important voice expressing concerns. Their quarterly asset class 7-year forecast is for negative 1.7% rate of return for US large-cap stocks (essentially the S&P 500), negative 5.2% return for small-cap stocks (essentially the Russell 2000), and positive 2.8% for high quality stocks. They see positive 3.6% returns for emerging market stocks,

As to High Quality Stocks, we suspect for the most part GMO was thinking about large-cap stocks that have not participated fully in this momentum market, and which are particularly strong otherwise – such as with consistent but modest revenue and dividend growth, low leverage and strong Balance Sheets, and wide business moats.  See our post of high quality stocks.)


The exponential trendline from the beginning of 1995 suggests earnings are already too high by about $10 per index share ($100 versus a 5-year projection of about $90).  Let’s hope that is not a good forecast, because the absolute level of earning and the associated negative growth rate would probably crush the stock market.

We do have historically high profit margins, historically low corporate borrowing costs, stagnant wages, above historical earnings growth rates, above average P/E multiples, and stock market capitalization that is at an historically high ratio to US GDP.  Those are key fundamental risk factors that should be evaluated.

The long-tern earnings growth rate applied to the earnings at the beginning of 1995 projected out 5 years, suggests earnings of about $122 per index share, or about 21% above current levels.

Standard & Poor‘s forecasts 2014 GAAP earnings of $119.87 (basically the 5-yr projection level at the long-term growth rate); and $136.39 for 2015.  The 3-year period leading up to the end of 2015 would have a compound earnings growth rate of 16.39% (about 2.5 times the long-term earnings growth rate).  They may be right, but if they are way wrong, there will be major market problems.



The exponential 5-year projection for S&P 500 dividends goes to about $40 per index share (about a cumulative 7% growth).  The long-term dividend growth rate applied from the beginning of 1995 suggests a 5-year projected cumulative growth of about 22% to about $46 per index share.


On balance, we have a greater faith in the growth of dividends than in the growth of either earnings or index price.  We also share GMO’s prediction that high quality stocks will do better over the next few years than large-caps in general.  Additionally, our client basis is at or near the end of the accumulation stage of their financial lives, where assets cannot be replaced easily or at all from new wages or business profits.  That means asset preservation is key, further pushing us in the direction of dividend and high quality bias within the stocks allocation, along with some amount of allocation to partially market neutral assets, such as long/short funds or positions.


Smart Money vs Dumb Money Sentiment Shows Strong Divergence Of Opinion

Friday, July 25th, 2014

There is a lot of talk about correction or melt-up.  Opinions are divided, and both can occur with either occurring first.

Corrections (10% declines) are inevitable within a Bull market, but when is not possible to predict.  Often times they are primed to happen due to valuation, or weakening operating performance, but triggered by an outside event of some sort.  We have had some big geopolitical events recently that have not had much impact.

The most important event in some people’s minds is a change in Fed interest rate policy (do note that stocks have done well in rising rate environments up to about 5% to 6% Treasury 10-year yield). The initial surprise of a directional change in interest rates, however, could cause some immediate negative stock reaction depending on what is done, and how much is done with rates.

In an attempt to gauge sentiment, surveys are constantly conducted, but opinions are not as reliable as investors putting their money on the line.

One way to dissect sentiment, is to separate the decisions of institutional investors (presumably smarter and/or more logic based decisions) versus retail investors (presumably not as smart and/or more emotional decisions). The best indicator of the view of those two groups is to see the ratio of Put buying (protective) to Call buying (gain seeking) of each.

Institutional investors dominate the options market for indexes (such as the S&P 100), while retail investors dominate the options market for individual stocks.

This chart shows the ratio of Puts to Calls (the “Put/Call Ratio”) for the S&P 100 index and for individual stocks as a whole.

Smart vs Dump OR Logical vs Emotional


No indicator is perfect, nor should any be taken as a sole indicator, but this particular sentiment indicators suggests that professional investors are more in the camp that says a correction is due, while retail investors (who have been piling in lately) are more in the melt-up came (or at least “I’ve got to catch up camp”)

The clear opposite direction of change in the two Put/Call ratios shows the divergence of views between professional and retail investors.

This does not mean Bear market, but simply that a correction is viewed as likely (if not needed to wash out weak hands) in the minds of institutional investors.

We believe the longer term factors for the stock market are still positive, if less extreme that when we came out of the depths of 2009.



Move Toward High Quality Stocks For Late Stage Bull Market (27 stock selections)

Tuesday, July 15th, 2014

A basic investment concept is to that high quality stocks fare better in down markets than low quality stocks, and therefore in late stages of a Bull market with generally fully valued stocks, tilting equity allocations toward high quality is prudent.

Accordingly, we set out to identify high quality stocks.  We know that sources such as S&P and ValueLine render quality ratings, but they are each a “black box” to a great extent, and we wanted to test quality using some other criteria as well.

We made the assumption that high quality could be identified by:

  • trading liquidity
  • strong balance sheets
  • revenue growth
  • long unbroken strings of dividend payment and increase
  • wide moats against competition.

With those conceptual criteria in mind, we applied these specific filter criteria to all stocks traded in the United States:

  • Wright’s investment grade rating minimum “BBB4” (see ratings description) for liquidity, financial strength, profitability and growth, based on 32 factors (577 passed filter)
  • Member David Fish’s Dividend Champions, Challenger or Contenders (“CCC”) – stocks that paid and increased dividends each year for at least 5 years; some did for decades (543 passed filter)
  • Morningstar “Wide Moat” designation (258 passed filter)
  • Revenue growth over each of 5, 3 and 1 years at least 3% (1796 passed filter)
  • Dividend growth over each of 5, 3, and 1 years at least 3% (657 passed filter)
  • Four part Balance Sheet  filter (1454 passed filter)

Four part Balance Sheet filter:

  • Tangible equity increased at minimum 3% annualized rate from 5th prior fiscal year to most recent completed fiscal year
  • Total Liabilities/Tangible Assets not more than that ratio 5  fiscal years ago
  • Current Ratio >= 0.9
  • Quick Ratio >=0.7

To understand the size of the universe we filtered, consider these sources with more than a combined 8,500 stocks:

  • NYSE has 4,668 listings (almost entirely stocks)
  • NASDAQ has 2,735 stocks
  • NYSE/AMEX has 425 listings
  • OTC BB has 836 stocks

From that universe, when we applied all of the criteria simultaneously, only 9 stocks passed, which we called our highest quality scenario.

We cross-referenced our list with quality ratings from S&P and from ValueLine, and found agreement.  The difference is that our list is much shorter than their lists.  Our criteria are more restrictive than those for S&P and ValueLine, resulting in the limited number of selections.

Highest Quality Scenario (9 stocks):

Pass All Filter Criteria

GGG Graco Inc. Capital Goods
GWW W.W. Grainger, Inc. Consumer Cyclical
MMM 3M Co Capital Goods
MON Monsanto Company Basic Materials
MSFT Microsoft Corporation Technology
QCOM QUALCOMM, Inc. Technology
SXL Sunoco Logistics Partners L.P. Energy
TIF Tiffany & Co. Services
UNP Union Pacific Corporation Transportation

If we did not apply the Balance Sheet criteria, but applied all of the others, 18 stocks  in addition to the highest quality 9 passed the filter.  These 18 stocks also substantially agree with quality ratings from S&P and ValueLine.

Best Performing Scenario (18 stocks):

Pass all criteria except Balance Sheet

ABC AmerisourceBergen Corp. Health Care
ADP Automatic Data Processing Services
BAX Baxter International Inc. Health Care
BEN Franklin Resources, Inc. Financial
BF-B Brown-Forman Corporation Consumer Non-Cyclical
CHRW C.H. Robinson Worldwide, Inc. Transportation
CLB Core Laboratories N.V. Energy
COST Costco Wholesale Corporation Services
EFX Equifax Inc. Services
EV Eaton Vance Corp Financial
FAST Fastenal Company Capital Goods
FDS FactSet Research Systems Inc. Technology
JKHY Jack Henry & Associates, Inc. Technology
MCK McKesson Corporation Health Care
NKE Nike Inc Consumer Cyclical
OKS Oneok Partners LP Utilities
SYK Stryker Corporation Health Care
TROW T. Rowe Price Group Inc Financial

If we required only the Wright’s investment grade rating, the Dividend CCC membership, and the Morningstar Wide Moat, there were an additional 38 stocks, for a total of 65 out of over 8,500 that passed some level of our high quality screen. A few of the stocks in this last group had only average quality ratings from either S&P or ValueLine, but most were high quality by those two independent sources as well.

Of those last 38, there were 17 that passed 1 or more of the additional criteria; and 21 that passed only the three minimum criteria — however, those 3 minimum criteria are quite important and powerful as they reduced over 8,500 stocks to merely 65.

Let’s look into the 27 stocks in the top group of 9 and second group of 18 high quality stocks.

If the 27 stocks were purchased in equal weights 10 years ago (as of June 30, 2014) and then rebalanced monthly — as might be done in a tax exempt or tax deferred account, but probably not in a taxable account — this chart compares the level of value accumulation of the S&P 500 versus the value accumulation by the 27 high quality stocks.


Basically, the blew the doors off of the S&P 500.  A criticism of this backtest is the benefit of hindsight.  Stocks that have only paid and increased dividends for 5 to 9 years as of today, would not have been selected 10 years ago based on the filter criteria, and their revenue and growth over the past 5, 3 and 1 years may not resemble those stats 10 years ago.

Let’s look at that in a more granular way to see recent periods where the filter is more likely to have selected these stocks.

This histogram shows how a monthly rebalanced, equal weight portfolio would have done versus the S&P 500 on a quarter-by-quarter basis.


Over the past 3, 2 and 1 years, the 27 stocks would have outperformed, but during this recent melt-up they generated less alpha than in prior periods.  Our hypothesis is that in a correction or worse, they would be better relative performers.

Let’s look now at their risk adjusted returns through the lens of Sharpe Ratios.


They have higher volatility than the S&P 500 as an equal weighted group, but superior risk adjusted returns.  The higher volatility, which is not major in significance, may be the result of a less diversified portfolio than the S&P 500.

Before, we move on to a look at the performance of the different subgroups of the 65 filter survivors, here is a high level view of the 27 by market-cap, style, and economic sensitivity.


They are large-cap and mid-cap, growth or value/growth blend by style; with a balance of cyclical, defensive and moderately economically sensitive stocks.  The standout data point is that small-caps didn’t produce any survivors.

Now let’s look at different filter survivor sub-groups.

Referring to the selection process as scenarios, we have identified 5 slices of the survivors:

  • Scenario I: Dividend CCC, Wright investment grade and Morningstar Wide Moat only (23 stocks)
  • Scenario II:  Scenario I criteria plus Balance Sheet criteria (15 stocks)
  • Scenario III: Scenario I criteria plus revenue and dividend growth criteria (18 stocks)
  • Scenario IV: Scenario I plus revenue and dividend growth and Balance Sheet criteria (9 stocks)
  • Scenario V: All stocks in Scenarios I-IV (65 stocks)

This first table calculates the “price only” IRR of each scenario of equal weighted stocks in  “buy and hold” portfolios (no rebalancing this time).

Scenario IV (all criteria met) is the superior price performer in all periods including 10, 7, 5, 3, 1 years and 6 months year-to-date 2014.

Scenario III (revenue and growth requirement, but not Balance Sheet) came in second and  outperformed the S&P 500  for 10, 7, 5 and 3 years; but fell behind the S&P 500 over that 1-year and 6-month periods.  In that 1-year and 6-month periods, Scenario II (Balance Sheet requirement, but not revenue or dividend growth) pulled into second place, beating the S&P 500.

Is the slight rotation from growth focus to Balance Sheet focus related to a concern about the impact of expected interest rate rises?


As an alternative way to examine the same price-only IRR data, this table presents the return spread between the Scenarios and the S&P 500.


Here is a table of 7-year and 5-year annualized growth of sales, reported earnings per share and dividends.

In this case, Scenario III (the revenue and dividend growth factors) understandably have somewhat stronger growth characteristics.  There has been a huge earnings recovery in the S&P 500, but that includes the effect of coming out of a large earnings hole.  The high quality stocks have lower 5-year earnings growth, because they did not have the earnings hole experienced by the S&P 500 in its entirety.


Looking at valuation (as of June 30, 2014), the high quality stocks have higher valuation multiples, but when we get to the PEG ratio (forward P/E divided by estimated 5-year forward earnings growth rate), the valuations for Scenarios II, III and IV are  in the reasonable range (basically 1x to 2x).

Scenario I (Dividend CCC, Wright’s investment grade, and Morningstar Wide Moat alone, is expensive  with a PEG of 3.63x (lacks sufficient growth).


These two tables present valuation data for the 9 and 18 stocks discussed above.




If you are interested in the current technical condition, potentially for deciding when to enter one or more of the stocks, you might want to be aware of opinions such as those from BarChart or

Not all of these are in good technical shape, but from a fundamental perspective most of these are probably a pretty good go-to list for high quality.

Here are links to each with technical ratings (change the symbol on the linked pages for the security you want to see):


Disclosure:  We own 13 of the 27 stocks in this blog post and may buy more.





Best and Worst ETFs by 3-yr Net Capture Ratios

Thursday, July 10th, 2014

Attractive funds have higher upside capture ratios than downside capture ratios, which are measures of participation in monthly up and down periods of the fund versus its primary benchmark index.

Upside and downside capture ratios are a complement to other risk/reward measures such as the Sharpe Ratio and the Sortino Ratio. All such measures are retrospective and are not alone sufficient for the necessary forward view of an prospective investment or existing holding, but they should be considered in the total data mix.

Here is a look at the best and worst ETFs for net capture ratio (upside ratio minus downside ratio) for those ETFs that have at least $100 million in assets and 10 years of history.  The 10 year history filter was to attempt to eliminate possible effects of new funds outperforming older funds due to smaller size.  As funds increase in size they are forced to become more like their benchmark in composition, moving toward a zero net capture ratio.




The best fund was IBB (biotech) and the worst fund was TLT (long-term Treasuries).

The top 10 funds consisted of healthcare, consumer cyclicals and utilities (all participating more in benchmark up moves and less in benchmark down moves).  The bottom 10 consisted mostly of bond funds and emerging market funds.

Upside and downside capture ratios are calculated by comparing the fund performance to its primary benchmark index.  Each month for the primary index is measured as either up or down, then the price movement of the fund is compared to the price movement of the benchmark.  For example if the primary benchmark rises by 1% in a month and the fund rises by 1.1%, then the upside capture ratio is 110%; and if the primary benchmark declines by 1% in a month, but the fund declines by 0.9%, then the downside capture ratio is 90%.  In that example, the net capture ratio (calculated by us, not by Morningstar, would be positive 20% [ 110% less 90%].

The primary benchmarks used by Morningstar in calculating capture ratios are:

  • S&P 500 index for U.S. stock funds,
  • Dow Jones Moderate Portfolio Index for balanced funds,
  • MSCI EAFE index for International Stock funds,
  • Barclays Aggregate Bond index for taxable-bond funds,
  • Barclays Municipal Bond index for municipal bonds

To visualize the capture ratios, here are monthly charts for IBB and TLT, in each case their price divided by the price of an ETF representing their primary benchmark from the list above:



Here are links for each of the best and worst ETFs to 3-yr weekly charts at similar the two above (the free site only goes out 3 years and does not provide monthly intervals):

Best Net Capture Ratios:

Worst Net Capture Ratio:

We do not currently own any of the listed ETFs.


9 Dividend Stocks Passing a Difficult Filter

Wednesday, July 9th, 2014

You may find something of interest for yourself in this group of filtered dividend stocks.

We quantitatively filtered through David Fish’s Dividend Champions, Contenders, and Challengers list (“CCC list”) of 543 stocks that have paid and increased dividend for at least 5 years (some for several decades) to find those that may be currently most attractive.

Only 9 (less than 2%) passed our filters.

Here are the stocks, and then how we got them:

Baxter International Inc BAX Medical Instruments & Supplies
CMS Energy Corp CMS Utilities – Regulated Electric
DTE Energy Holding Co DTE Utilities – Regulated Electric
Energy Transfer Equity LP ETE Oil & Gas Midstream
Genuine Parts Co GPC Specialty Retail
Microchip Technology Inc MCHP Semiconductors
ONEOK Partners LP OKS Oil & Gas Midstream
Simon Property Group Inc SPG REIT – Retail
Western Gas Partners, LP WES Oil & Gas Midstream

Prior to this review, we owned BAX, GPC, OKS and ETE.  We don’t expect to invest in the others at this time. We find utilities as a category to be overvalued.

We used three different database tools to do the filter.

Filter Level 1 (258 of 543 of CCC stocks passed level 1):

[used yesterday’s end-of-day data]

  • minimum dollar volume per minute $25,000
  • price above 200-day simple moving average
  • linear regression slope of 200-day average positive
  • current 200-day average above level 10 days ago
  • price less than 2 (63-day) standard deviations above 200-day average

Filter Level 2 (showing successive reduction of the 258):

[used today’s end-of -day data]

  • Yield >= 2.5% (100 passed)
  • Consensus target price >= 1.05 times price (42 passed)
  • PEG ratio <3x (24 passed)
  • 50-day average > 200-day average (15 passed)

Filter Level 3 (showing successive reduction of the 15):

[used today’s end-of-day data]

  • 1-yr revenue growth rate >zero
  • 3-yr revenue growth rate > zero
  • 5-yr dividend growth rate >= 3%

Then we checked with the Wright’s ratings for Liquidity, Financial Strength, Profitability and Growth [explanation of rating scale here] and the Moody’s credit rating.

These are important types of data for dividend investors seeking long-term holdings.

We’d like to see investment grade for dividend stocks.  For Wright’s we would like to see BBB4 or better, and Baa or better from Moody’s.

Wright’s Moody’s
GPC AAB10 n/a

Next we looked up the year ahead rating for price behavior as rendered by ThomsonReuters StarMine through Fidelity (where over 7 is Bullish and 3 or less is Bearish).  We don’t put great stock these ratings, but is does feel moderately soothing to know if analysts look favorably.

BAX 8.5
CMS 9.1
DTE 6.8
ETE 4.7
GPC 5.8
MCHP 8.7
OKS 4.2
SPG 3.8
WES 0.8

The we looked up the short-term technical rating of the 9 stocks as rendered by and  The BarChart data is self-evident in its meaning.  The StockCharts data is strong technically at 70 and above, and weak at 30 and below.

Technical ratings can be useful when deciding when to enter a position.

BarChart StockCharts
BAX 88% BUY 59.9
CMS 8% BUY 61.9
DTE 8% SELL 60.9
ETE 56% BUY n/a
GPC 80% BUY 51.6
MCHP 88% BUY 63.4
OKS 24% BUY 63.4
SPG 16% BUY 70.0
WES 32% BUY 86.0

Here is how those 9 stocks did versus the S&P 500 over the trailing 1 year: