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.

Dividend Discount Model in Action -- LLY Stock Analysis

Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.

For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.

LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.

Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.

If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.

LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.

LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.

Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.

Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.



Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.

Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.

Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.

Disclosures: No shares of LLY held at the time of writing.

Don't Confuse Price for Value

Philip Fisher was a great investor. Despite his focus on growth, he was well aware that the more you pay the less you keep, and hence the smaller your returns will be. Fisher also warned his readers that price and value are not equal and that just because a stock's price has been stable for a long time does not mean that a) it's correct nor b) that it can't change when events change or the market's mood swings.

Here's a paragraph from his book Common Stocks and Uncommon Profits that I find extremely important and possibly one of the main "hidden" lessons in the book:

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 38 to a high of 43, there is an almost irresistible tendency to attribute true value to this price level. Consequently, when, after the financial community has become thoroughly accustomed to this being the "value" of the stock, the appraisal changes and the stock, say, sinks to 24, all sorts of buyers who should know better rush in to buy. They jump to the conclusion that the stock must now be cheap. Yet if the fundamentals are bad enough, it may still be very high at 24. Conversely, as such stock rises to, say, 50 or 60 or 70, the urge to sell and take a profit now that the stock is "high" becomes irresistible to many people. Giving in to this urge can be very costly.

Fisher goes on to explain that fortunes are made when stocks are let go many times higher than what the investor paid for the stock, precisely because he bought them when they were undervalued or fairly valued and growing. He also added:

The only true test of whether a stock is "cheap" or "high" is not its current price in relation to some former price, no matter how accustomed we may have become to that former price, but whether the company's fundamentals are significantly more or less favorable than the current financial-community appraisal of that stock.

This rings true with value investors and growth investors as an investor is he or she who makes intelligent decisions about investments, and does not speculate on market events that have no bearing on the true value of a company.

The danger of getting too hooked up on price is so high that Fisher introduced its "influence" as follows:

This influence is one of the most subtle and dangerous in the entire field of investment and one against which even the most sophisticated investors must constantly be on guard.

Know the value of what you own.

Alternative valuation methods are harmful to one's pocket

Ben Graham taught us to look for discounts to net current asset value in order to protect against large declines in stock prices. Net current assets are current assets (cash and equivalents) minus current liabilities (all debts to be paid within a year).

But despite this method being proven to provide good results with minimal downside, people still choose to dream up their own convoluted valuation methods for investment.

Consider for example the use of the "eyeballs" metric at the peak of the dot-com bubble. Firms with no income were being appraised based on the number of people visiting these companies' web sites. That can barely show potential for future revenue, and it says nothing about real earning power nor what matters, profit-making.

While "eyeballs" seems ridiculous in hindsight, it wasn't questioned by many back then.

Other unproven valuation metrics are created all the time. Consider for example "economic goodwill". It states that the difference between market capitalization (share price times number of shares outstanding) and net tangible book value is the amount of "additional value that the market has assigned to a company, based on intangible assets, such as quality of management, growth prospects and efficiency of operations, that don't appear on a balance sheet".

The theory was that the lower this amount compared to the average of return on assets, return on equity, debt-to-equity ratio, and percentage growth of earnings divided by percentage growth of revenue, the cheaper a company would be.

This one study from 2000 thus picked the 10 most undervalued companies back then based on this metric, as shown below. The number in parenthesis is the return on their market price from 2000 until now.

American Power Conversion (-100% -- delisted)
Computer Associates (-74%)
Intel (-77%)
Microsoft (-58%)
Pomeroy (-81%)
Symantec (+63%)
Tellabs (-92%)
Verisign (-92%)
Viant (-100% -- delisted)
Xilinx (-78%)

To be sure, no valuation shortcut is infallible. Ben Graham never said the net current assets method can prevent loss. It can't, since the future is and will always be unknown. But if anything, it provides the best protection one can get short of clairvoyance.

People should be happy to buy dollar bills for fifty cents. Anything else is speculation.

S&P 500 Fair Value

Estimating the fair value of a stock is an exercise in predicting the future. Estimating the fair value of an entire index, such as the S&P 500 is not any easier. Luckily for us, it doesn't involve estimating the future of 500 companies simultaneously. We can treat the entire index as a single company (sort of like a conglomerate, with multiple divisions).

Many people like to predict future earnings and then apply a multiple (such as the P/E multiple) or forecast free cash flow year over year, apply a discount rate and add up the values. Others, like me, prefer to value a stock using the stream of dividends it will provide in the future, using the Dividend Discount Model (DDM).

Whatever method one uses, it boils down to three things:

1. Predicting future growth g (of earnings, cash flow, dividends)
2. Setting an appropriate discount rate r
3. Applying the appropriate model.

In this case, I will use:

1. A dividend growth rate inline with smoothed historical rates.
2. Use a discount rate that provides a reasonable historical fit, which a priori should be between 7 and 20% (another option is to use the risk-free rate of return, such as that of treasury bonds, but I don't like that option for various reasons that I won't discuss right now)
3. Use the Dividend Discount Model (DDM)
   

The DDM states that value = dividend / (discount rate r - growth rate g)

So, what is a good historical dividend growth rate? Let's look at the past to estimate that. The raw data can be found here.

Since 1960, the dividend rate has grown on average at 5.68% over the years.

The discount rate has varied a lot as investors took more or less risk depending on their perception at the time of risk, inflation and future growth. Fitting the DDM over the years to get a good approximation yields a 7.5% rate of discount (see the figure). This is the return rate an investor should demand for exposing his money to market risk. 7.5% seems appropriate as a long-term rate, even if it seems low right now, since times won't always be bad in the future, nor will they necessarily be good, like they were in the late 90's, when investors were demanding very little rates of return (even negative!).

Now, all we need is a starting point for the dividend the S&P500 index will pay an investor this year. Well, let's make an educated guess. In 2008, the dividend was $28. Since then, many companies have cut their dividends, suspended them or gone bankrupt. Very few have raised their dividends. If we assume a 15% drop in dividends for 2009, the fair value of the S&P 500 should be 681, not the current 870.

See the figure above for a plot of the estimated fair value versus the real value since 1960 (2009 numbers are measured year-to-date and estimated are year-end).

Can it fall more? Of course. Can it go up more from here? Sure. The best bet is to buy companies that are undervalued based on the Dividend Discount Model and for which future prospects look solid.

As for the S&P 500, I wouldn't bet on a continued rally from here.