"Bank" on IQ Trends

06/03/2005 12:00 am EST

Focus:

Kelley Wright

Managing Editor, Investment Quality Trends

According to the Hulbert Financial Digest, IQ Trends ranks near the top of the five-, ten-, and 15-year categories among all newsletters. Here, Kelley Wright describes the strategy behind the successful track record and highlights a trio of favorite banking bets.

"Originally developed by Geraldine Weiss in 1965, our strategy is called the dividend yield theory. We focus on finding quality and value in any market. Despite the difficulties and frustrations of investing, we believe that the stock market is the best place for your long-term investment capital, assuming that you can ride out the hills and valleys of the market, can recognize and appreciate good value, and have the courage to buy good stocks when they are undervalued, the patience to hold them for however long it takes for the price to move upwards, and the wisdom to sell when the price of the stock becomes overvalued.

"So how does one recognize value in the stock market? According to Charles Dow, values are determined by the return to the investor. We agree. The concept on which IQ Trends is based geared to that most basic of all investment fundamentals- getting a return on your investment dollar from a cash dividend. Yes, every investor hopes for capital gains, but the only return on which the investor in the stock market can rely on with a reasonable degree of confidence is the dividend. Thus, it is dividend yield, which most accurately and reliably identifies value in the market.

"Thus, our strategy concept is based on the simple premise that decisions to buy or sell a stock at a certain price is tied to the underlying value of dividends as expressed by the dividend yield. The approach is so basic to investing that it's frequently overlooked by investors who are seeking more complicated methods to achieve financial security. Yet when this concept is applied to high quality dividend paying stocks, it can help the investor to 1) minimize the downside risk in the stock market 2) maximize upside potential for capital gains and 3) maximize growth of dividend income, which allows investors to keep pace with inflation. And finally, it helps an investor know when a stock is overvalued and should be sold.

"We follow specific criteria to select blue-chip stocks, which comprise our universe of investments. There are over 12,000 domestic companies that are publicly traded. You have to have some means-some method-in order to filter out those best suited for purchase. So we pour the domestic marketplace through this filter and we end up with about 400 companies. These are 400 of the best quality corporation in America. These are companies that have excellent management, that have gone through multiple business cycles, that know their product, that know their customers, they know their markets, and know how to execute. In other words, they suit up, they show up, and they deliver- and they do it year in and year out.

"What are our criteria? We demand that a company pays dividends for 25 years straight. That's why most of the 12,000 don't qualify when we look at long-term charts-25 and 30s- for these companies, to find the repetitive pattern between the stock price and the dividend yield. These patterns show that stocks historically reach a low in price (where the yield is high) at which point they start to rise. And at some later point (when the yield is low), the stock rolls over and money starts to exit. And eventually, the stock will cycle all the way back down to where its price is low and yield is high. And at that point, we consider it undervalued. These high quality dividend paying companies tend to show this pattern time after time after time. Money flows into a stock when the yield is high enough. And the investor says, wow, I can't pass that up. And when the price is high and the yield is too low, investors will look for stocks that are more attractive.

"From looking at long-term patterns, it can be observed that dividend paying stocks fluctuate over time within an historic range of low yield (establishing a plateau of overvalue) and high yield (establishing a valley of undervalue). The plateaus and valleys identify areas in which stocks should be sold or bought. Each stock has its own profile of undervalued and overvalued. It has its own distinct characteristics of high and low yield and must be studied individually. Our methodology is like a DNA print and each company has its own profile. You can't say that all companies are undervalued when their yield is at X. Or all companies are overvalued when their yields are at Y. They're all individual companies that have their own cycles. That's why we prepare tables that show the under and overvaluation levels of the 400 stocks that we cover as blue-chip issues.

"You may wonder why dividends should bear a relationship to the price of the stock and how does that relationship serve to measure value. Dividends, unlike earnings, are real money. Dividends are not just figures on a balance sheet. Dividends cannot be faked. There are some very creative CFOs that do marvelous things with balance sheets! But one thing they can't change is the dividend. Earnings are subject to such terms as depreciation, cash flow, inventory adjustments, and reserves. A skillful accountant can make good earnings appear not so good, and vice versa. But the bottom line is this: dividends tell the truth. Meanwhile, here is a trio of banking stocks that are ranked as buys based on our strategy:

"For some time Citigroup (C NYSE) has been among the top of our recommended companies. The financial giant has roots extending back to 1812 when the doors to the original City Bank of New York were opened for business. Citi's present form dates to the 1998 merger of Traveler's Group and Citicorp. The company also operates vast credit card operations. Its global investment bank maintains operations in over 100 different countries and territories throughout the world. Services are best recognized through the company's SmithBarney name. Earlier this year we featured Citigroup after it marked its 20th consecutive year of dividend increase, raising its dividend by 10% to $1.76. The company remains a key area of value in the financial sector. Its many dividend increases have raised its undervalue prices steadily above its current trading range. Based on its new annual dividend, the company has an approximate 280% upside potential. The very low downside risk, combined with an excellent record of dividend increase and an almost 4.0% yield should insure that Citigroup remains a profitable proposition for the long-term.

"MAF Bancorp (MAFB NASDAQ) can date its history back to 1922, when operating as MidAmerica, it served residents in various immigrant communities throughout Chicago. Over its history, the bank expanded into a number of other businesses including an insurance agency and a residential real estate developer. Much of its recent expansion has been the result of its acquisitions activities in Illinois and Wisconsin. MAF Developments was founded in 1975 to serve as a real estate developer. Since its founding, the company has successfully completed construction of 18 subdivisions. At a recent price of $40, MAFB is undervalued with a yield of 2.3%. From current levels the company has 130% upside potential. As a smaller bank, the company remains well-poised to compete against many of its larger and more cumbersome competitors. Shareholders received news of a 10% dividend increase last January, another sign of financial strength. Shares will remain at undervalued up to a price of $51.

"With mergers and acquisitions constantly changing the face of the banking industry, investors are being left with fewer choices for investment. One company so far overlooked by takeover bids is Popular (BPOP MNASDAQ). The company is based in Puerto Rico and has roots dating back to 1893. It also has branches in New York, Illinois, California, New Jersey, Florida, and Texas. At a recent price of $23, Popular is just slightly above 10% from undervalue. From current levels the company has 74% upside potential to an overvalue price of $40, low yield of 1.6%. Particular appeal comes from the company's unique exposure to the Spanish-speaking markets of the United States. The company's excellent record of dividend increase, also makes further returns in the form of dividend yield a very likely possibility. The shares will continue to represent historic levels of value at prices of $23 and below." 

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