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Archive for February, 2010

Beating the TSX (BTSX) is a portfolio published yearly by David Stanley in Canadian MoneySaver (an online subscription can be purchased for ~$20/yr, it’s well worth it). The portfolio applies a Dogs of the Dow strategy to the TSX. Specifically, it tracks the Dow Jones TSX 60 index and extracts the 10 companies with the highest dividend yield. The returns are impressive: the BTSX has achieved a compound annual growth rate (CAGR) of 10.2% from 1987 to 2010 as compared to the TSX Total Return Index which has returned 7.9% over the same period (see Investing by the Decade, David Stanley, Canadian MoneySaver February 2010).

Beating the Beating the TSX (BBTSX) portfolio is my attempt to improve on the BTSX’s performance, while still keeping the methodology simple.  In short, I hope to show that consistently better returns can be made by incorporating corporate share buybacks into the high dividend yield strategy employed by the BTSX.

Companies return value to shareholders through share buybacks or via dividends. There is debate as to which method of rewarding investors is favourable. When a company repurchases shares, earnings by the company become divisible by fewer shares and thus the value of each individual share is increased.   Dividend purists like to get paid in cash, however share buyback has the advantage of being more tax efficient since there is no distribution to be taxed. Both methods have merit, and it is reasonable to include companies who reward shareholders with buybacks as well as dividends to a screen like the Dogs of the Dow.

Indeed, in his book Your Next Great Stock, author Jack Hough devotes a chapter to the New Dogs Screen which combines share buybacks and dividend payout to a screen of the Dow.  Simply, he uses a measure called Net Payout Ratio rather than dividend yield to sort stocks. Net Payout Ratio is the sum of funds spent on dividends and share repurchases minus any money taken in from share issuance, then divided by the market cap of the company. Sorting the Dow stocks according to this measure and then choosing the 10 companies with the highest net payout ratio is the New Dogs of the Dow strategy. Hough points to a study that compares the performance of Dogs of the Dow to the New Dogs screen over a 22 year period (1983-2005).  The comparison shows that the Dogs returned 16.2% over the time period while the New Dogs significantly outperform with a return of 19.1%.

Further support for this hypothesis can be found in What Works On Wall Street by James P. O’Shaughnessy.  Although not a light read, this book provides excellent analysis of a number of investing strategies and incorporates  measures such as the Sharpe Ratio (see here for a definition) to determine the performance of each strategy in risk adjusted terms .  Most specific to my purpose, O’Shaughnessy provides a comprehensive study on the performance of dividend yield strategies compared to Net Payout Ratio strategies.   In the first edition of the book (1996), O’Shaughnessy concludes that one of the best strategies in risk adjusted terms is the Cornerstone Value strategy. This strategy is a variation of the Dogs of the Dow which picks the top 50 stocks by dividend yield from a universe of Market Leaders (see What Works on Wall Street for a definition of this index). However, interestingly, in the latest version of the book(2005), O’Shaughnessy adjusts the Cornerstone Value strategy to include share buybacks and concludes that this strategy not only outperforms the original Cornerstone Value strategy in both real and risk adjusted terms, but indeed, outperforms all strategies analyzed in risk adjusted terms. Between December 1952 and December 2003 the average annual compound return for the Cornerstone Value method was 15.78% with a Sharpe Ratio of .65 while the Cornerstone Value method adjusted for shareholder buyback yielded a return of 17.09% with a Sharpe Ratio of .73.

The Beating the Beating TSX portfolio is my attempt to factor in share buybacks to the Beating the TSX portfolio. Here is my BBTSX portfolio as calculated for February 25 2009:

Rank Name Symbol Net Payout Ratio
1 Husky Energy Inc. HSE 5.19%
2 Sun Life Financial Inc. SLF 4.42%
3 EnCana Corp. ECA 3.97%
4 Shaw Communications Inc. SJR.B 3.85%
5 Imperial Oil Ltd. IMO 3.72%
6 Thomson Reuters Corp. TRI 2.96%
7 Canadian Imperial Bank of Commerce CM 2.93%
8 Canadian Oil Sands Trust COS.UN 2.75%
9 Enbridge Inc. ENB 2.24%
10 Bank of Nova Scotia BNS 2.02%

I have used Jack Hough’s methodology as described in Your Next Great Stock and taken data from MSNMoney.com. One of my favourite characteristics of this portfolio is that it penalizes companies that dilute shareholder value by issuing shares. For example, Bank of Montreal (BMO) paid out $1.312 billion in dividends in 2009 but raised $1.662 billion in share issuance which results in a negative payout ratio. A straight dividend analysis would reward BMO for maintaining its dividend however, factoring in share buybacks penalizes BMO for maintaining its dividend at the cost of massive share dilution (here is a link to the company’s Cash Flow statement).

I plan to update the portfolio in the third week of May which is traditionally when David Stanley publishes the latest Beating the TSX portfolio and track my performance against that portfolio.

One final technical note, the BBTSX portfolio provided here is based on the Dow Jones Canadian 40 Country Titan Index since that is the index that the BTSX portfolio used for its latest update. That index has since been changed to include 60 stocks and is now the Dow Jones Canadian 60 Country Titan Index. The BTSX now tracks that index, and I will do the same in May when I publish my updated portfolio.

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In the last post, I took a look at 3 companies in the healthcare industry to determine if they are the kind of business I would consider investing in. All three passed my initial screen, suggesting that they have wide moats and should continue to increase cash flow and generate high returns on equity into the future. This week I will use a discounted cash flow (DCF) analysis to determine a fair price for these businesses.

A DCF analysis requires the following 4 parameters:

Free Cash Flow (FCF) Growth Rate: an estimate of the rate at which free cash flow will grow over the next 5 years

Discount Rate:  the rate used to discount future cash flows

Long Run Growth Rate: the rate at which cash flows are expected to grow in the very long-term

Margin of Safety: rate at which the projected fair value is discounted

For a more detailed description of the DCF process refer to The Five Rules for Successful Stock Investing.

Given the difficulty of forecasting and the inherent error that forecasts are subject to, a DCF analysis is really only useful for firms that operate a stable business where there can be some confidence that past performance will be an indication of future results. This explains why Warren Buffet applies it to wide moat companies with a long operating history. As discussed in the previous article, BDX, JNJ and SYK have impressive operating histories and pass Dorsey’s tests for ROE, and FCF/Sales indicating that these businesses have wide defensible moats.

Let’s start with the FCF growth rate, I will use the 5 year consensus analysis earnings forecast published on msnmoney for my calculation:

5 year projected earnings growth rate as of (13/2/2010)

Symbol 5 year growth rate
BDX 11.40%
JNJ 7.60%
SYK 11.70%

When considering the discount rate, Dorsey typically assigns a discount rate of 9% for stable companies that represent very low risk, 10.5% for an average company and 13-15% for riskier firms. I have assigned a discount rate of 9% for JNJ and BDX to reflect the stable, non-cyclical nature of their business and 9.5% to Stryker to account for the fact that this business specializes in devices and instruments associated with more elective surgeries and therefore may be more influenced by the business cycle. All the companies have been assigned a low discount rate to reflect the stable nature of their businesses and their past history of consistent returns.

With respect to the long run growth rate, I will use a value of 3%. Dorsey uses this value since it mirrors the long run US GDP growth rate. I considered using a value of 4% to reflect my belief that developed world demographics and the developing world’s desire to increase healthcare expenditures means that the healthcare sector will outperform other sectors of the economy over the long-term. I will provide DCF analysis using both values.

Finally, I will use a margin of safety rate of 30% to discount my fair value. According to Dorsey, Morningstar uses a margin of safety of 20% for stable companies, and 30-40% for less stable companies with inconsistent earnings history or which operate within a cyclical industry. It would be reasonable to use a 20% discount rate for these companies given their previously mentioned characteristics, however I have chosen to use 30% to offset the fact that I am using analyst consensus growth estimates which tend to be overly optimistic. Below, the parameters necessary for a DCF calculation are summarized:

BDX JNJ SYK
Discount Rate 9.00% 9.00% 9.50%
FCF Annual Increase 11.40% 7.60% 11.70%
Perpetuity Growth Rate 3.00%/4.00% 3.00%/4.00% 3.00%/4.00%
Current FCF 1125.70 12636.00 1204.20
Next Year FCF 1254.03 13596.34 1345.09
Shares Outstanding 246.00 2754.34 396.40
Margin of Safety 30% 30% 30%

Table 4 illustrates the 10 year FCF growth forecasts for the DCF analysis. I use a 5 year forecast to calculate the perpetuity values, rather than the 10 year forecast used in The Five Rules for Successful Stock Investing. Ultimately, this should render a more conservative estimate.   The results are as follows:

BDX JNJ SYK
5 year FCF Forecast $1,733.66 $18,163.94 $2,093.94
Perpetuity Value 3% $29,761.13 $311,814.35 $33,180.91
Perpetuity Value 4% $36,060.09 $379,083 $39,594.50
Discounted 3% $19,342.69 $202,657.93 $21,077.44
Discounter 4% $23,436.58 $246,377.90 $25,151.50
Total Equity Value 3% $24,738.91 $263,323.29 $27,471.21
Total Equity Value 4% $28,832.80 $307,164.80 $31,545.30
Per share value 3% $100.56 $95.60 $69.30
Per share value 4% $117.21 $111.52 $79.58
Margin of Safety Price 3% $70.40 $66.92 $48.51
Margin of Safety Price 4% $82.04 $78.06 $55.71

Changing the Perpetuity Growth Rate by 1% has a significant effect on the Margin of Safety Price  Only JNJ is currently trading below its margin of safety price calculated with a 3% Perpetuity Growth Rate, however all 3 companies are currently trading below their Margin of Safety Price calculated at a 4% Perpetuity Growth Rate.  Not surprisingly, the performance of these companies has not gone unnoticed by a famous investor who also likes to concentrate on cash flow and ROE.  Warren Buffet has been a long time holder of JNJ with recent purchases between $50.47 – $56.60 and has also recently taken a position in BDX purchasing it between $60.88 – 70.94 (see GuruFocus).

Full disclosure – long JNJ, SYK.

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Previously I took a look at the Canadian Telco and cable sector to determine whether the largest operators in that space met my requirements for investment. My analysis pointed to an inconsistent 10 year record that precludes investment for now.

This week I will take a look at the healthcare space by analyzing 3 of my favourite companies: Becton Dickinson and Company (BDX), Johnson & Johnson (JNJ), and Stryker (SYK). BDX is the world’s largest manufacturer and supplier of needles and syringes. JNJ is a giant in the health care space with diverse operations ranging from pharmaceuticals, medical devices and consumer staples. SYK is a manufacturer of devices and equipment for orthopaedic surgeries.

Table 1 and 2 illustrate the 10 year history of free cash flow and return on equity for all 3 companies. Applying Dorsey’s screen of a consistent 10 year history of FCF/Sales ratio of 5% or better and ROE above 15% illustrates the quality of these companies.

FCF/Sales Ratio and ROE

Symbol 5 year FCF/Sales average 10 year FCF/Sales

average

5 year ROE average 10 year ROE average
BDX 8.96% 11.79% 23.19% 21.46%
JNJ 19.94% 19.38% 28.17% 28.08%
SYK 14.32% 12.99% 20.73% 23.14%

These numbers handily exceed Dorsey’s requirements. Table 2 shows the financial leverage employed. The current leverage ratio for JNJ and SYK is 1.82, 1.31 respectively, both well below the 3 to 4 range that Dorsey considers a red flag. BDX has maintained a higher level of financial leverage (currently 3.6) which is a concern, however the non-cyclical nature of their business should ensure debt obligations are met.  BDX has a credit rating of AA- from S&P.

Lastly, let’s take a look at dividend history. Table 3 illustrates the 10 year dividend history of the companies. All 3 have a perfect record of increasing dividends yearly.  Indeed, JNJ and BDX are dividend aristocrats with a record of 46 and 36 consecutive years of dividend increases respectively. The payout ratio has remained in a steady range for all companies with JNJ the most generous, returning an average of 40% of its earnings to shareholders. Lastly, dividends have been increasing at a healthy rate for all companies with SYK specifically posting a very healthy 5 year increase rate of 49%.  As well, given that the company has close to 3 billion dollars in cash, it seems reasonable to expect further large dividend increases in the future.

The above analysis suggests that all 3 companies have wide economic moats that should protect their businesses long into the future. To paraphrase Buffett, these are great companies, the next question is, are they trading at a fair price? Next time I will try to answer that question by using the discounted cash flow method outlined by Dorsey in The Five Rules for Successful Stock Investing.

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