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Wednesday, January 9, 2008

* Sometimes Things Aren't As They Appear

This is the third and final post in a series that began on Monday. If you haven't read the earlier posts you may want to take a look at them here:

On Monday I posted a Stock Analysis on Citi Corp (C). Based on that quantitative analysis C was rated as a 5-Star Strong Buy, but I am avoiding this stock and will not buy it.

On Tuesday I posted a Stock Analysis on General Electric Company (GE). Based on that quantitative analysis GE was rated as a 0-Star Avoid stock, but last week I increased my position in GE.

What gives?

Sometimes things aren't as they appear!

A Quantitative Analysis inherently is driven by historical results. I never subjectively alter the inputs on my quantitative analyses posted on this site - they are what they are based on the historical results. This allows me to compare one company with another, knowing it is based on the companies historical performance. But what if something has happened that would change what the historical results are depicting? That is where the Qualitative Analysis comes into play.

By nature a Qualitative Analysis is more subjective and is the most difficult part of the overall evaluation process. The difference between Warren Buffet and me is his superior ability to perform qualitative analysis. Wikipedia describes it as follows: "Unlike quantitative research, qualitative research relies on reasons behind various aspects of behavior. Simply put, it investigates the why and how of decision making, as compared to what, where, and when of quantitative research." Let's look at the C and GE from a qualitative perspective.

Citi Corp (C):
As noted in the quantitative analysis, C has had an impressive past. However, from a qualitative standpoint we have to ask a few questions: How did they do what they did and will they be able to continue doing it in the future.

Historically, C through its financial services has generated substantial cash flow well beyond the operating needs of the business. C has chosen to return a portion of this cash flow to its shareholders in the form of dividends. Over the last 10 years its dividend growth rate has been an impressive 15%.

Now the more important question, will they be able to continue to perform the same way in the future? Obviously, there is not a definitive way to answer this question, but what observations can we make. I have watched C very closely over the past few months. I wanted to find a reason to buy it. However, as posts such as Financial Melt-down Continues and What's Up With Citi's (C) Payday Loan?, I could not find one. To the contrary, I became very concerned about their ability to sustain dividend growth into the future.

As shown in the quantitative analysis report, C's payout ratio had increased substantially in 2004 going from 32% to 49%. It then stayed in the mid-to high 40's in 2005 and 2006, while the dividend increase fell from a high of 57.1% in 2003 to around 10% in 2005 and 2006. This is much less than the 10-year average used in the quantitative analysis. Though a payout ratio of 49% and a dividend increase of 10% are not considered bad, both are moving in undesirable directions.

I decided to run an alternate scenario on C. Dropping the dividend and earnings growth rate to zero in 2008 and 2009 and then increasing to 10% thereafter, the DCF value for C dropped from $62.39 to $36.72. This is getting much closer to the $28.24 1/4/07 closing price. Are these revised assumptions reasonable? I don't know, but they are more reasonable than what quantitative analysis report was calculating based on historical information.

As a shareholder of C (I hold a small stake in my IRA), I hope they recover and perform well in the future. As a value play C may have be a good add. However, from a income perspective, current indications are a flat to lower dividend in the near-term, and that is what I base decisions on in my dividend income portfolio.

General Electric Company (GE):
GE is one of those boring predictable companies that finds its way into most every dividend investor's portfolio. GE is a well managed, well run company and has been that way for decades. When it falters, it always recovers and comes back stronger. I like owning GE because it offsets some of my more risky investments, but I will not buy it at just any price.

Until recently, not only was GE a 0-Star Avoid stock, it also had a negative NPV when compared to a money market account (MMA). I will not by a stock when its quantitative analysis indicates its income will under perform a MMA. No matter how stable a company is, it will not be safer than a federally insured MMA. So why did I buy GE?

Like C, GE has been able to generate substantial cash flow beyond the operating needs of the business and has returned this cash flow to its share holders in the form of dividends. However, at 8.7% its historical dividend growth rate is about half of C's. Its current payout ratio of 52% is only slightly higher than its 10-year average of 48%. Given GE's global and diverse earnings streams, I believe it will be able to maintain and grow its dividend in the near term and over the long term.

Since the quantitative analysis of GE is driven by historical results, I will not be able to fully update GE until they publish Q4/07 results. However, for my alternate scenario I held everything flat in 2007 with 2006 except I updated the 2007 dividend to actual. This change dropped the calculated premium from 32.8% to 15.2%, increased the NPV of the MMA Differential from $2,781/thousand to $4,019/thousand and dropped the years needed to reach the MMA earning level from 10 to 9.

As a long-term dividend investor, I am more focused on the dividend analytical data and earnings than I am on the relative price of the security, particularly when it is a security such as GE that I have little concern of having to sell in the future. For these true "blue-chip" stocks, my barrier to entry is lower. Ironically, even with a lower barrier to enter, it is often more difficult to find an entry point for true blue-chip companies since everyone is trying to get in. When the opportunity presents itself, I move quickly.

Conclusion:
In summary, the key take away is that the quantitative analyses that I post are not the final answer. Since a quantitative analysis focuses on past performance, it indicates as to whether or not the company has performed in a manner that would be a good fit in a dividend focused portfolio. If the answer to that question is yes, then you move to the next step of qualitative analysis. Here you look to answer the difficult questions of what will the company do in the future and will it be enough to warrant its purchase?

As I tell my kids, if it were easy they wouldn't call it a job and pay people to do it. Mr . Buffet, you have my utmost respect.

Full Disclosure: At the time of this writing, I own shares of C in my IRA and GE in my dividend portfolio.

What qualitative analysis do you perform before buying a stock?

This post is the last in a three part series. [Intro], [First Post], [Second Post]


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