Why Abbott Looks Cheap

The pharmaceutical juggernaut Abbott Laboratories looks reasonably cheap these days. Its shares have been going down for the past few weeks and it's a good buying opportunity in my opinion. Here's why.

Consistent Dividend Growth

Abbott has grown dividends consistently for over 25 years. It's part of the Dividend Aristocrats index maintained by S&P. Not only that, but ABT has grown dividends an annualized 9.33% over the last 11 years. On average, the year-over-year dividend growth has also been around the same ballpark, 9.45% (the average and the annualized 11-year return can differ in case most of the growth was in one or just a few years as opposed to consistent over time. When they match, it's a sign the growth has been sustained over time).

Consistent Earnings Growth

A consistent dividend growth needs to be accompanied by a consistent earnings growth too or the dividend is not sustainable. Over the same last 11 years, ABT has had an annualized earnings growth of 9.31%, which comes in very close to its annualized dividend growth. This means that dividend growth is supported by earnings growth directly, which is a good sign. It means the company is passing through all of its extra earnings back to shareholders via dividend increases.

Some people prefer to see earnings growth slightly surpass dividend growth to be on the safe side. But by doing so, it means the company is increasing its cash reserves and I would want to understand why. It could mean an acquisition is coming up or the company is expecting to have higher expenses going forward (patent disputes, lawsuits, etc). So, higher earnings growth per se is neither good or bad, but must be understood. In the case of Abbott, for the past 11 years earnings and dividend growth have matched, which can only mean the company is growing smoothly and not becoming lopsided in anyway, neither increasing cash reserves nor depleting it, hence a very good sign in my opinion.

Consistent Sales Growth

Just because earnings growth have been consistent during this time does not necessarily mean the company is actually generating more cash since earnings can be so easily manipulated. However, 11 years is a long time, especially when the earnings can be seen in form of dividends during this time (it's a lot harder to fake real cash in your pocket than it is on an income statement). Nonetheless, let's see how Abbott fares in sales growth, which is a more direct way of assessing where growth is coming from.

For the past 10 years, sales have grown an annualized 8%. This is only slightly less than the 9% earnings growth, which indicates that for the most part sales have kept pace with earnings. It also indicates that the company has been aggressive at cutting costs at a rate of 1% per year. In the long run I'd expect earnings and dividend growth to slow down to catch up to sales growth. Still, 8% is a good growth rate to have.

Dividend Yield is Moderately High

At a price of approximately $45.50 and with an annual dividend of $1.76, ABT sports a dividend yield of 3.8%, which is pretty decent in today's market. When factoring in a 8-9% growth, it means investors can expect a return of 11-13% on their investment going forward, minus inflation and plus any share price appreciation.

Implied Price using Dividend Discount Model

Treating a share of ABT as a bond and investing in it just for the dividend using the Dividend Discount Model, I came up with a price range for ABT of between $59 and $44. This means that ABT is undervalued at the time of writing. My assumptions were a 10-11% discount and 7% dividend growth, which, given the track record of sales growth of 8% is still a little conservative.

Other Considerations

Other things to consider before investing: why is ABT going down in the past several weeks? No single news piece accounts for this decline, but a more thorough investigation is warranted.

One a price-to-earnings basis, ABT looks fairly valued with a tailing P/E of about 15. However, its forward P/E is only 10, since ABT expects to earn between $4.54 and $4.64 per share in 2011.

Conclusion

All things considered, ABT looks cheap to me. I'm buying shares of Abbott (ABT) at the time of writing. Please do your own analysis before buying.

Disclosures: I own shares of ABT at the time of writing.

S&P 500 Fair Value: What to Expect in 2011

About two years ago I posted my mathematical assessment of the market's fair value. It's still a widely-referenced article. Given your interest and my own curiosity as I prepare my investment route for 2011, I thought I'd repeat that study using more recent data.

But this time, I'll use both a dividend discount model and an earnings growth model.

S&P 500 Fair Value from a Dividend Perspective

Using the Dividend Discount Model here's a quick summary of the market today and what is in store for 2011, if history helps.

If we treat a stock as a bond and nothing else, we're expecting to get in the future our model for dividends  that we got in the past, plus some growth. This is one of the most conservative ways I know to value a stock and hence why I'm using it here to value the index.

Here are the numbers:

1. All-Time Dividend Growth. Since 1960, the S&P 500 has grown dividends an average of 5.04% per year (note: variance is large, meaning some years this number is much higher, others much lower).
2. 10-Year Dividend Growth. The last 10 years have seen a lower dividend growth, just 3.58% annually.
3. Today's Fair Value. Assuming a 5% growth ad infinitum a 7.5% discount rate based on an estimated dividend for 2011 of $24.28, today's fair value is 971, meaning the market is overvalued by 33%.

Modeled value vs. real value for S&P 500 using DDM.

S&P 500 Fair Value from an Earnings Perspective

Earnings provide another way to assess the fair value of an index. By looking at historical growth and current earning yield, we can put a fair price on the index. However, earnings are a secondary measure of what one can get out of an index, since not all earnings flow to the investor as dividends. 

While earnings can give us a good feel for how the market is doing, it can't tell us what the companies will do with their earnings nor how they will return them to us investors. Dividends can be cut, but earnings are flakier, given that they're not usually thought as belonging to shareholders, which is a shame, but quite true of most companies.

Here are the numbers:

1. All-Time Earnings Growth. Since 1960, S&P 500 earnings have grown an annualized 6.81%.
2. 10-Year Earnings Growth. For the trailing 10 years, earnings have grown 4.07%.
3. Today's Fair Value. Assuming 2011 earnings of 87.84 and applying a P/E multiple of 15, the S&P would be valued at 1318 today, meaning the market is undervalued by 1.7%.

Modeled value vs real value for S&P 500 using earnings.

Conclusion

Whether you choose to believe the DDM is more accurate or the earnings approach is more accurate, both currently indicate that the S&P is anywhere from fairly-valued all to the way to grossly overvalued.

However, this numerical assessment assumes a smooth continuation of history without taking into account all that is going on with the economy, international affairs and expectations of inflation/deflation.  Use this to help you make informed decisions, but do not rely entirely on it.

The source of raw data is still here (no affiliation with the authors or their institutions).

Disclosures: I own SPY and many other whole market-tracking indices at the time of writing.

Portfolio Returns for 2010

2010 is now history and it's time to update my portfolio returns to check on my progress so far.

In 2010, my US portfolio, which excludes real estate and foreign accounts, returned (including dividends) approximately 11.3%. Comparing with the S&P 500, which returned (including dividends) approximately 15.1%, my returns are not great.

But my results don't bother me at all, because my portfolio has less risk than the S&P and does better than the S&P in down years. Let's see why. But first, let me define risk.

Risk

I don't consider risk to be equal to beta or the Sharpe ratio. That's because I don't mind price swings (which increase beta) as long as I believe that in the long run, my buying power will be maintained or increased versus inflation.

In other words, I consider risk to be the degree with which I may lose principal, either via loss of capital (due to bankruptcy, long-term loses in the underlying companies, etc) or inflation.

With that, let's dissect my portfolio a bit to understand where I trailed the market and why I should not worry about it.

Portfolio Drag

Looking at my holdings and the weights they play on my overall allocation, I found out that the main reason for underperformance in 2010 was due to my bias towards large value companies. These are mainly blue chips that pay steadily-growing dividends such as HD, WMT and JNJ.

Let's look at a couple of those:

Johnson & Johnson (JNJ). The BandAid maker opened the year at $64.41 and closed it at $61.55, hence returning -4% in share price appreciation. When adding the 3.2% dividend, JNJ's total return was a negative 0.8%.

Walmart (WMT). The world's largest retailer opened the year at $53.45 and closed it at merely $54.09, thus returning 1.19% in share price. When adding its dividend of 2.2%, WMT's total return was 3.39%.

Home Depot (HD). The home-improvement retailer opened the year at $28.93 and closed at $30.21, thus returning 4.4% in share price. Adding its 3.3% dividend, HD's total return was 7.7%.

Therefore, my over-reliance on these big names caused my portfolio to lag behind the larger market.

However, as I've mentioned before, I believe my capital will be preserved better if I stay with these stocks for the long-run, as opposed to rotating in and out growth or "story" stocks throughout the year.

Goals, Restated

For the largest part of my portfolio, my goal is on dividend growth and capital preservation. As such, I believe these companies will continue doing the job. All three have been increasing dividends over the years (HD did pause for a while though, but I believe they will resume soon) and as long as my capital is safe with them, I will reap the benefits of the increasing dividends over time.

To recap my investing approach: When I invest, I look for companies with a history of sustainable dividend growth. Then I factor in this growth and current share price to determine a price I should pay now that will yield at least 11-12% dividend return over many years, with a margin of safety of between 10 and 15% (depending on various fundamental and historical factors).

For this reason, I'm quite happy with my returns so far. I will lag the S&P in good years, but I will do better in the down years (like I did in 2008).

Disclosures: I own every stock mentioned above at the time of writing.

Building a Strong Dividend Growth Portfolio

When it comes to indexing I usually have two views: it's a great tool if one doesn't have the time or inclination to analyze stocks, but it's also a wide catch-all net that brings in the tuna along with the catfish.

So, what should a time-constrained investor do if one doesn't want to invest in the entire market or a sector at once and get the chaff along with the wheat? Answer: Buy the strongest dividend payers from selected industries. And to find out who these dividend payers are one can do their own detailed analysis or read this blog.

Selected pharmaceutical index

The list below is a non-diversified list of strong pharmaceutical companies that have a history of paying dividends. Not all are cheap, but the point of indexing a sector is to get the benefit of the industry as a whole without having to guess or investigate which company has the best pipeline, the best strategy or the best cash position to go after acquisitions.

If one believes, like I do, in the future of the pharmaceutical industry -- which is home to great companies, many international, and robust dividend payers -- then buying the strongest companies is a wise strategy.

Dividend yield-based weighting

Should one buy an equal-weighted index of these companies? Well, first, if by equal-weight one means same number of shares, the answer is no. Share price is too dependent on number of shares, which is arbitrary and as such this index would be arbitrary as well. If one buys an equal number of dollars per company, that's a more suitable strategy but it would still assume that all companies are equivalent, which is not a good assumption.

A better way to index is to use a dividend yield-based indexing: buy more dollars worth of companies with higher dividend yields. This approach has two benefits: 1) one buys more of the higher-dividend companies which in turn boosts the yield of the portfolio and 2) higher yielding companies in the same industry are typically considered cheaper than peers since the yield is higher because the price is lower, so one ends up buying more of the cheaper companies.

However, this pure yield-based approach also has drawbacks: 1) high yielding companies can be cheaper for a reason, and a thorough investigation of these reasons defeats the purpose of this lazy indexing approach; and 2) high current yields could mean the companies have little growth ahead of them and as such the dividend may not keep up with inflation or growth elsewhere.

So, what's the alternative?

Dividend growth-based index

Factoring in current dividend yield as well as dividend growth should provide a much better index because current yield plus dividend growth equals total dividend returns. So, this indexing method is equivalent to saying "buy more of the companies that will return more money to you in form of dividends".

Of course, dividend growth involves making predictions about future dividends. However, armed with fundamental analysis and a long history of dividend growth one can make informed assumptions about future growth and thus minimize the risk of making a bad call.

With this, here's my dividend growth-based index of pharmaceutical companies based on 10-year historical growth rates and current yield and their respective weights.

Ticker	10-yr div. growth	Curr yield	Curr Price	P/E	Weight
NVS	13.74%	3.93%	49.55	12.07	2.36
JNJ	12.84%	3.57%	60.54	12.72	2.19
LLY	7.86%	5.57%	35.17	9.07	1.8
ABT	9.26%	3.66%	48.03	14.08	1.73
PFE	7.87%	4.87%	14.77	11.89	1.7
GSK	5.53%	5.28%	34.84	10.2	1.45
BMY	3.73%	5.00%	25.6	14.71	1.17
MRK	3.29%	4.19%	36.3	7.57	1

Putting it all together

The "weight" column in the table above indicates a dollar multiplier for each ticker. That means one should buy 2.36 times more Novartis (NVS) than Merck (MRK).

If one has a budget of $10,000 to allocate to this index, and rounding the number of shares to their nearest whole number, one should buy $1783.8 (36 shares) worth of NVS and only $762.3 (21 shares) of MRK.

The final portfolio worth approximately $10,000 in today's prices would look like this:

	Shares	Cost $
NVS	36	1783
JNJ	27	1634
LLY	38	1336
ABT	27	1296
PFE	86	1270
GSK	31	1080
BMY	34	870
MRK	21	762
	Total	$10,031

Of course, one should only follow this approach if one doesn't have time to do a thorough due-diligence fundamental analysis and after consulting with their financial advisor.

Disclosures: Long JNJ at the time of writing.