North Star

A LETTER FROM THE INVESTMENT POLICY COMMITTEE |

ON FRIDAY, AUGUST 3rd, 1492, a fleet of three ships crewed by 90
men set sail from Palos de la Frontera, Spain. They were on a mission to find a new world. None of them knew how big the ocean was; no man had ever gone before them to show the way. There were no modern tools to guide them. They had no maps, only a vast open ocean. And the stars. There are 9,096 visible stars in the sky. As the Earth rotates, those stars all move in the night sky. All except one.

The star Polaris lies in a near-direct line with the Earth’s axis right above the North Pole. While every other star in the sky moves, the North Star does not. It is a constant; it can sometimes be the only constant for sailors.

When all else failed, Christopher Columbus and his crew had the North Star to guide them. 

The Financial ‘Seas’

Navigating the 2021 investment environment may feel a bit like embarking on discovering a new world. There is no map telling you where to go, no historical precedent to guide you. Interest rates have been close to 0% for years; how do you generate income for retirement? The government has never stimulated the economy to this degree; will that lead to inflation? Politics are as divisive as ever; will the social unrest continue in the next few years?

These are the endless waves crashing around you. Like Columbus, you need a ‘North Star’ to guide your investments where you want to go.

What Are the Characteristics of a Good North Star?

• It should be measurable. You can’t know whether you’re getting anywhere if you can’t measure where you are.
  
  
• Your North Star gives you direction, keeping you on track.
  
  
• A North Star must be stable; it is constant, never changing.
  
  
• Finally, it must be compelling to you. You must believe it is taking you in the right direction even when setbacks happen (and they will).

Let’s work our way through some North Star candidates.

Candidate #1: Market Value

My focus is to increase the market value of my portfolio. I must be going in the right direction if my accounts are growing. If not, I should make changes.

HOW DOES MARKET VALUE STAND UP AS A NORTH STAR?

It is the most measurable of any candidate on our list. You can find an updated dollar amount online 24 hours a day, 365 days a year.

The total value of your portfolio is compelling. We measure everything in our financial lives by market value.

When those numbers increase, we get a surge of positive feelings. When they decrease, we feel upset, disappointed, even fearful.

Market value passes our first two criteria; unfortunately, it fails the
final two.

Stocks have declined by 40% or more once every 25 years or so.¹ Market value is unstable; if that is where you’re looking, you better pack extra Dramamine.

The most dangerous part about market value is how deceptive its direction can be. From February to March 2020, the Dow Jones Industrial Average fell by nearly 37%². If prices were your North Star, they would be telling you to sell your stocks and change directions. The time your portfolio’s market value was at the bottom was the best time to buy, not sell.

HOW CAN I GROW MY PORTFOLIO WITHOUT MARKET VALUE TO GUIDE ME?

What if the goal of your investment strategy is to grow the value of your account? How will that happen if you aren’t paying attention to it?

Suppose you are going deep-sea fishing tomorrow. Your goal is to catch at least ten fish. How are you going to do that? You can hire a guide, wake up early, take your motion sickness medicine, and fish with the right bait. All those things will put you in a position to catch fish. Yet, the result is still out of your control.

You can’t force the fish to bite, nor can you force your account to go up. You don’t fill the livewell by looking at it; you fill it by putting bait on your hook and casting it into the water. In the same way, you don’t increase your portfolio’s market value by staring at it all day. That’s wasted time, at best, and more likely than not to point you in the wrong direction.

If looking at market value isn’t the best way to direct your portfolio, what is? Focus on the things that drive stock prices in the first place. Here is where we can start to find the best candidates for our North Star.

Candidate #2: Earnings

My focus is to increase the earnings per share of the stocks I own each year. I must be going in the right direction if earnings are growing. If not, I should make changes.

A share of stock is a small piece of ownership in a business. The primary purpose of a company is to earn a profit. So, it makes sense that we should focus on growing the total earnings of our portfolio year after year. How does this stack up as a North Star?

Earnings are measurable. All public companies report earnings according to Generally Accepted Accounting Principles. Those figures are available on any financial website.

Earnings are also compelling. Without profits, a company would not be able to pay dividends or reinvest in new growth projects. Growing earnings also generally lead to increasing stock prices. Focusing on growing the portfolio’s earnings is an improvement over looking at market value, but there are still some issues.

Earnings lack stability. In recessions, they decline almost as much as stock prices. During the COVID-19 recession, earnings for the S&P 500 dropped over 30% from top to bottom.³ That’s not quite as far as prices fell, but it’s close.

Earnings can also fail to provide direction. The most obvious failure
is through accounting fraud. The most infamous example is Enron  (2001), but there have been many other examples. In early 2020, Luckin Coffee (LKNCY) dropped 97% after regulators disclosed a massive accounting scandal. Earnings can also be ‘managed’ to hit Wall Street’s expectations.

Earnings are a useful metric. We look at them regularly to assess how our companies are doing. But, they are more appropriate as an additional tool in the toolbox. Our true North Star needs to be stronger than that.

Candidate #3: Dividend Income

My focus is to build a portfolio that pays as much dividend income as
possible. If dividends keep getting paid, I do not need my stock prices to go up. I’ll just live on the income year after year.

A popular strategy in today’s low interest rate environment is to buy
stocks with the highest dividend yields. How does maximizing dividend income stack up as a North Star?

Dividend income is measurable.

You can find dividend payments on your account statement as the checks come in each month.

Dividend income is also quite compelling. A $1 dividend is a lot more tangible than a $1 price increase.

And, while dividends do not provide perfect stability, they provide a more constant ‘horizon’ on which to focus. In 2020, companies in the S&P 500 decreased their dividends by less than 4%. That is more stable than the 30% decline in earnings and the 40% decline in stock prices.

Dividends also provide better direction than earnings. Cash dividends are a lot more difficult to fake; either you have the money or don’t. The Board of Directors authorizes dividend payments.

They take a long-term view of the company’s financials and pay out only what they don’t think they will need. Still, companies can create the illusion of dividends in two ways:

• They could pay out more dividends than they earn.
  A company that pays out more than 100% of its earnings is, in effect, borrowing money from future years to pay dividends now. Not only is this unsustainable, but it prevents them from reinvesting into the long-term health of their business.
  
  
• They can work some financial wizardry.
  Companies that don’t have enough earnings to cover their dividends in a given year can either (1) pay out of their built-up reserves (their ‘emergency fund’), (2) sell assets, (3) borrow money or (4) sell the stock, which dilutes their existing shareholders; in essence, they take from the left hand to give to the right. Focusing on maximizing dividend income is better than focusing on price. Still, there is one thing missing to make dividends a true North Star: future growth.
  
  

Candidate #4: Maximize Dividends in 10 years

My focus is to earn as much dividend income as possible ten years from now. Not only will this result in my income going up over time, but my stock prices will (eventually) follow.

Looking at future dividends shifts our mindset from maximizing income today to maximizing it over a lifetime. In most cases, this is at least a decade or longer.

The point is not to ignore today’s dividend; it is a valuable and essential part of the analysis. The current dividend still acts as a yardstick to measure our progress, provides stability during difficult times, and is a compelling cash flow source.

The main advantage of looking at dividend income in 10 years vs. current dividend income is the direction that it provides. If we steer our financial ship towards the stocks that are likely to maximize our income in 2030, we focus our attention on what is most likely to drive long-term price increases.

Case Study: Home Depot (HD)

Let’s take a look at an example: Home Depot (HD). What is its 10-
year dividend outlook?

The simplest way to forecast dividend growth would be to look in the past and project that forward. Over the last ten years, Home Depot has increased its dividend from $1.04 to $6 per share—a 19.2% annual growth rate. That’s a good starting point, but can lead to either overly optimistic or pessimistic assumptions. In this case, we think it unlikely that Home Depot can maintain that pace.

To fine-tune the forecast, let’s take a brief look at the underlying drivers of dividend growth and what they might be in the future:

• Home Depot sold $125 billion in merchandise in 2020. Sales growth has averaged around 7.3% per year over the last decade.⁴ Let’s assume this pace slows a bit each year to around 3.7% in 2030. If that’s the case, Home Depot’s sales would be under $207 billion.
  
  
• Now, how much of that $207 billion could they convert to profits? Home Depot’s margins had expanded from 9.5% in 2012 to 14.3% last year.⁵ Margins are more likely to decline than keep rising, so we’ll assume they come down to around 12.6%. That would mean operating cash flows of over $26 billion in 2030.
  
  
• Home Depot could pay the entire $26 billion as a dividend, but they need some money to reinvest into their business. Historically, they have reinvested about 17% of cash flows.⁶ So, let’s say $4.5 billion goes towards opening new stores or other worthy growth projects.
  
  
• The remaining $21.5 billion is free to pay dividends and repurchase shares. Home Depot is currently paying out 34% of its cash flow as a dividend.⁷ We expect that to creep higher over the next decade to around 43%. That would mean about $11.3 billion paid out as dividends in 2030.
  
  
• Home Depot has been buying back its stock. If they continue, we would expect the share count will decline from around 1.1 million shares today to approximately 0.8 million in 2030. In other words, current shareholders will own about 30% more of the business than they hold today.  

Using our 2030 estimates of $11.3 billion in total dividends and 800,000 shares outstanding, we anticipate Home Depot’s dividend in 2030 to be $14.22 per share. That would be a 10.1% annual increase from today.

Compared to its current price, Home Depot’s 10-year dividend yield would be about 5.5%. Through that lens, we would consider the stock quite attractive relative to even higher-yielding stocks. Compared with the 10-year U.S. Treasury at 1.75%, it’s very attractive. So far, we’ve only touched on Home Depot’s dividend income. Let’s see what might happen to their stock price.

What About Stock Price?

If you owned a farm that went from generating $10,000 in profits to $20,000, what do you think would happen to that farm’s value? You
might expect that the value would double (or something close to it) as
well. 

Home Depot is like a ‘farm’ that is growing its payout year after year. If you collect $10,000 in dividends from them today, which increases to $23,700, what do you think will happen to the market value? We can’t know for sure, but we can create some possible outcomes. The chart in the next column uses our dividend estimates above, combined with Home Depot’s historical dividend yields. We’ve constructed a ‘worst case’ scenario (red line), a ‘best case’ (green line), and an ‘average’ scenario (yellow line). The grey line shows where Home Depot is currently trading.⁸

Let’s start with the ‘worst case’ scenario. If Home Depot were to grow its dividend to $14.22 with the exact yield it had in 2009 (4.3%), the stock price would be $331.

If you own the stock the entire decade, our forecast suggests you would also collect about $98 per share in dividend income. Thus, our pessimistic total return⁹ would be about 3.8% per year.

Moving away from our worst-case scenario, we’ll use Home Depot’s long-term average dividend yield of 2.9%. If the dividend were $14.22, the stock price would go up to $490. Decade-long owners of Home Depot would earn about 7.1% per year.

Finally, in an optimistic scenario, Home Depot’s price would increase so that the dividend yield in 10 years was 1.5%. The total return under this scenario would be 13.5% per year.

Closing

What does 2021 have in store? If 2020 is any indication, no one has any idea. Fortunately, it’s not important to predict the details. Over the long run, it won’t make much of a difference whether this year’s inflation was 2% or 5%. Your 2030 self won’t care about this month’s Fed meeting. Your 2030 self might care about politics, but what happened in 2021 will be a distant memory. What will matter is that 2021 was the year when you stopped paying attention to the crashing waves. And, in doing so, you found a North Star to steer your portfolio even in the worst storms.

[1] Guggenheim Investments (2021). Putting Market Pullbacks in Perspective.
[2] From 2/12/2020 to 3/23/2020. DIA Interactive Stock Chart. Yahoo Finance. Accessed 29 Mar. 2021
[3] S&P 500 Earnings. https://www.multpl.com/s-p-500-
earnings. Accessed 29 Mar. 2021[4] DCM calculations. Source: Morningstar.
[5] Using cash flow from operations divided by 12-month sales. Source: Morningstar.
[6] Looking at capital expenditures divided by Cash Flow from Operations. Source: Morningstar.
[7] Data source: Morningstar
[8] At the time of writing, Home Depot’s stock price was at $295 per share. Source: Morningstar.
[9] Total return includes both price gains (or losses) and dividend payments

This report was prepared by Donaldson Capital Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information in these materials are from sources Donaldson Capital Management, LLC deems reliable, however we do not attest to their accuracy.

An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance to certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Past performance is not a guarantee of future results. The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation by Donaldson Capital Management, LLC.

S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalizationweighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.