I remember the day quite well: April 22, 1980. My bride of 16 years (we recently celebrated 30 years of her putting up with me), Karen, was 8 months pregnant with our second child and to help induce labor, we decided to manually construct a new backyard fence. While nailing a nice piece of 1 x 8 cedar board, Karen noticed some soot falling from the sky. We were living on a north-facing hill in Lake Oswego, Oregon, a bit south of Portland, and were fortunate to have been considered “locals” during the previous eruption of Mt. St. Helens in the spring and summer of 1980. As we looked to the north, we could see a tall plume of volcanic ash about 55 miles off in the distance. Our daughter, Lindsay, was born a few days later.
My job at the time involved travel and I was very familiar with an aerial vantage point of the Cascade mountain range from 30,000 feet. To say it is impressive is a huge understatement. The downtown Portland office I maintained had an unobstructed view of Mt St, Helens off in the distance to the north and Mt Hood to the east. On a really clear day, I could see Mt Rainer off the western shoulder of Mt St Helens. Back then, this nifty feat could be accomplished in all northeast corner offices above the 7th floor in my building.
There I was - home, office and weekly travel - situated with a unique view and focus on the 1980 volcanic activity of Mt St Helens. While sporadic ash was sprinkling on us as we built the fence, the major eruption was to be a few weeks later, whacking 1290 feet off the top of the mountain and created enough ash and dust to cover the island of Manhattan to a depth of 28 stories.
Also, back then, running office football betting pools was an acceptable work-time activity. Unknown to most people, there was almost weekly eruptions of the mountain, from it first rumble on March 27th to the incredible blowout on May 18th that leveled all tress for 17 miles to the northeast, and into July. The regularity of volcanic activity provided fodder for those of us who yearned for the football season to return. The official office “Guess the Height of the Volcanic Plume” betting pool was born. I was a natural to get involved in its infancy, especially since I spent a large part of my day gazing out the window at the mountains.
Between my office perch on the 7th floor and Mt St Helens was a radio tower. This was before the days of satellite radio and high towers were commonplace. Early in the eruption cycle, I observed that plumes reaching the top of the radio tower were reported in the newspapers the next morning to be around 38,000 feet. Using the Boy Scout training from my youth, I was able to use this radio tower as my yardstick in making predictions for the ash and pumas plume pool. This yardstick gave me an edge over the other players and assisted me in being the most consistent winner. Of course, I kept this little advantage to myself until well into the eruption “season”.
Much like the Mt St Helens radio tower yardstick, I use a few fundamental yardsticks when evaluating stocks. Over time, my investing yardsticks provide a benchmark to compare stocks for relative value.
A major yardstick is next year’s PEG ratio. The concept of the PEG ratio is that stock prices are fairly valued at around one times long-term earnings growth rates. Next year’s PEG ratio is calculated by dividing the stock price by next year’s estimated earnings, divided by the estimated 3- to 5-year EPS growth rate ((price/05 EPS)/ 08-09 growth rate). For large cap issues, I look to buy when next year’s PEG ratio is less than 1.0 and for mid- small-caps, I look for ratios below 1.30. Historically slow growth industries, such as utilities and REITs, will have PEG ratios substantially higher. I especially like using the PEG ratio to compare companies within the same industry. As I am looking for undervalued stock prices, it is important to find the best value among industry players.
Another yardstick is dividend growth. I am more concerned with the growth of dividends during the previous 3-, 5- and 10-year time frames than I am with current dividend yield. I like to own companies that increase dividends greater than the inflation rate. If annual inflation is 2.5 percent, and a company raises its payout by 6.0 percent, investors are realizing a real rate of return in cash income of 3.5 percent, and a higher cash return on invested capital. My goal is to own companies that increase dividends by at least 6.0 percent a year. Lower dividend growth sometimes is offset by a higher initial dividend yield. This is the case with many utilities.
Compounding a growing dividend can have a positive impact on a portfolio. For example, an individual invest $1,000 in a $10 stock, buying 100 shares. The stock is not a stellar selection and proceeds to flat line for 20 years, never appreciating. However, the shareholder reinvests a 2.5 percent initial dividend that increases by 6.0 percent a year. After 20 years, the stock is still worth $10 a share, but the share count has increased as the growing dividend was reinvested. The investor now own 245 shares, worth $2,450. Annual income is calculated at $172, for a 17 percent annual cash return on your invested capital. Due to the benefits of reinvesting and compounding a growing dividend, this example provides a 20-year average annual return of 7.2 percent on the initial capital - with no capital appreciation.
Evaluating the S&P Equity Ranking for 10 year consistency in earnings and dividend growth is another yardstick I use. Standard and Poor’s offers an A+ to NR (not rated) ranking for companies with a minimum 10-year stock trading history. B+ is considered “average” and I look for companies with an A rating. These are companies that excel in the most important fundamental ratios – growth in earnings per share and growth in cash dividends to shareholders. The time frame of 10 years is sufficient to encompass most economic cycles, and matches the investment horizons of many long-term strategists.
Much like the ratio tower yardstick helped my predictions in the ash and pumas plume pool, these simple investing yardsticks assist me in reviewing stock prices and fundamental investment values.
By the way, every so often, my bride and I recall the “fence building with ash falling” Fisher remedy to induce child birth. We still have a five pound bag of Mt St Helens ash, collected from roof gutters and plant leaves, stashed in some box in one of the corners of the basement and it stands ready if needed sometime in the future. Karen and I have a basic difference of opinion as to which part of the remedy is most important: fence building or 1980 Mt St Helens volcanic ash – or neither.
George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr. Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.