Most people would agree that it is difficult to put the cost of bailing out our financial system into real terms.  Including the recent Citi rescue, some estimates are as high as $4.6 trillion dollars in total costs.  So, we would be remiss in not sharing this shocking visual representation of the government bailout as it currently stands.  The chart needs little explanation to get its point across.  Jim Bianco of Bianco Research has crunched the numbers, compounding each of these historic government expenditures by the rate of inflation (using CPI) so we can compare apples to apples.

Its impossible to argue that this is a cheap solution to this crisis, but we hope this enormous effort has the desired effect.  However, it appears we have little choice in the matter now and a massive full-scale effort to re-ignite the economy is underway.  For better or for worse, here we go.

Some investors, shaken by the markets volatile and often violent downturns, are seeking the shelter of dividends to cushion the impact of market swings. On the surface that seems like a justifiable strategy with the dividend yield on the S&P 500 sitting around 3.8%–a 15 year high; heck, 30-year U.S. Treasuries are only yielding 3.6%.

Not so fast, the stock market’s best dividend yield in 15 years has more to do with the rapid decline in prices rather than substantially increased dividend payouts.  In November alone, 91 companies reduced or suspended their dividends–the most in any one month since May of 1958. This comes on the heels of 81 dividend cuts in October and 60 in September. This pace may not continue to accelerate the way that it has over the past three months but it does demonstrate that dividends are a management decision and are not a guaranteed stream of income, especially in tough economic times when business is cash strapped.  To be fair, 212 companies have increased dividends this year by a combined $18.4 billion, which is noteworthy but pales in comparison to the amount of cuts, which far outweigh the increases.  There is no doubt cash is king, now more than ever, as companies fear being unable to raise capital if necessary.

It is no surprise that the financial services industry has been the hardest hit in the current crisis. Credit markets have been all but frozen and investment banks are reconstituting their demolished business models. According to Standard & Poor’s, financial companies account for 15% of the stock market but pay out 21% of its dividends. Estimates are that the sub-prime mortgage debacle has cost the industry $972 billion with only $880 billion raised in response up until now. With formerly revered Wall Street firms failing and being subject to government rescue plans, those financial companies that remain standing are interested in self-preservation, which often means strengthening balance sheets by paying less to shareholders in the form of dividends. So far, dividend reductions by financial firms have accounted for $31 billion; in the previous five years, this sector has only reduced its dividends by a total of $3.1 billion. Not to mention the fact that TARP funding may come with a caveat that limits common stock dividends for a period of time; however, we prefer to look at what is observable instead of speculating on the actions of the Treasury Secretary of an administration in transition.

Firms like Citigroup (C) have all but suspended their dividend (three different reductions over the last year) after receiving $20 billion in government rescue. Bank of America (BAC) bucked its trend of increasing dividends for 30 straight years, halving the amount of those increases in one fell swoop. The New York Times (NYT) last week found it necessary to cut its dividend by 74%. All of these companies presently value preserving liquidity over paying out earnings to shareholders, which is a completely defendable notion as credit has been very tough to obtain. We would expect that this trend to continue until there is a significant improvement in the economy.  But it is not just the “blue chips” that are cutting dividends, as Standard and Poor’s Senior Index Analysts Howard Silverblatt explains,

“Financial issues accounted for about two-thirds of the dividend cuts and 93% of the dollar damage during the third quarter. Also, no longer is it just blue chip companies cutting dividends. Many of the issues are now much smaller, and more regional. The problem has trickled down.”

Most will remember from introductory finance classes that one common way to value stocks is to consider the stock price as a claim on future dividends. This Dividend Discount Model (DDM) is wonderful for teaching the basic tenets of finance, but it ignores companies that do not pay a dividend and is much too simplistic to put in to practice as we have learned from high growth stocks that shun paying dividends in favor of share buy-backs. For example, the DDM would imply that cutting the dividend is a bad thing for a stock and should decrease its expected price. However, the market has reacted favorably to some dividend cuts, notably when the investment community sees that preserving the capital that would have gone to fund those pay-outs as an essential requirement for a firm to remain well capitalized and to cushion itself in a challenging environment.

So, what does this mean? Essentially, dividend pay-outs are wonderful but they’re are more at risk now and in the months ahead than at any time in recent memory. Now is not the time to base an investment strategy solely on dividend yield. For investors who depend on income from their investments, this is a fine time to look for high-yielding stocks, but stick to stocks and industries that are unlikely to be forced to cut or eliminate their pay-outs in this rough environment. One key statistic that an income investor must pay attention to is the company’s payout ratio or the percentage of earnings per share that are paid out  to shareholders as dividends. When a company’s earnings are being compressed–as is commonplace right now–it will likely reduce its dividend in order to maintain its financial health. Furthermore, if a company has a substantial debt burden, it is a more likely candidate to either cut or eliminate dividends.

Of course, the old fundamental rule of investing is true: investing in companies with growing earnings and sales is wise as those companies will be in better position to maintain or even raise their dividend going forward. Such companies are more scarce in this recessionary environment, but they do exist.

Students of Economics 101 will remember the lesson of inferior goods, which are goods whose demand is inversely related to the consumer’s income or purchasing power. The classic example of this phenomenon is Spam, the canned meat product made by Hormel (HRL). You will not find a lot of people who eat Spam for the flavor or the nutrition, people eat Spam because it is a cheap alternative to fresher meat. So, in this economy where people are pinching their pennies in order to get the most value for their money, inferior goods are a growth industry. We have already noticed consumers trading down to Wal-Mart (WMT) for everything from groceries to clothing and dropping the high dollar retailers like Whole Foods (WFMI) and The Gap (GPS). In this post we will discuss two companies that are benefiting from the trading down in food: Hormel and Campbell Soup Co. (CPB).

To begin, let’s look at Campbell Soup, who reported earnings on Monday.  The results showed that CPB has grown sales 3%, which followed the summer quarter’s results (normally CPB’s weakest) were up a handsome 13%. Soup sales grew by an impressive 12% in the most recent quarter.  Unfortunately, Campbell’s had a very tough time converting those sales into cash earnings because of increased commodity costs related to corn and other basic inputs. Further dampening earnings, Campbell Soup ended up on the wrong side of commodity hedging amounting to a loss of $26 million.  The company also was pressured by a strengthening dollar as the company claims between 25 and 30 percent of sales from abroad.  Profits slipped 3.7% to $260 million, but on a per share basis the results were actually up slightly to $.71. The company is also in the process of rolling out some new brands of Soups including Select Harvest, which is in direct competition with Progresso Soup from General Mills (GIS).  The company has increased advertising budgets to get the word out on Select Harvest and to capitalize on the economic downturn.

Campbells has been largely unscathed in the negative market action of the last year.  At this point, CPB is down 11% which is remarkable considering the rest of the market. Furthermore, nearly all of that loss has occurred since Friday when the broad market was headed higher.  So, with this kind of inverse price action in relation to the market it is easy to understand why CPB has a beta coefficient of .19. Interestingly, shorting interest has increased in the last few months for Campbells.  We at Ockham Research have Campbell Soup rated Fairly Valued as of our last report on 11/22/08, but after the decline in price and mixed yet encouraging quarterly results, we may be inclined to go more positive in the near future.

As for Hormel, makers of Spam, chili and Jennie-O Turkey products, they announced earnings this morning for the fourth quarter and fiscal year.  The results contained some similarities to Campbell Soup in that sales were healthy as they grew 12% from $1.66 billion to $1.86 billion.  However, the company could not lift profits based on these gains, and earnings slipped 33% from $101.2 million ($.73 per share) to $67.8 million ($.50 per share). Commodity costs were again a major culprit, even though they have fallen from this summer’s record highs, commodities were still far more expensive than in the past.  Also, Hormel is feeling the same pain other investors are feeling right now as investments in an executive retirement fund fell sharply.

The company offered guidance for the fiscal year 2009 on the low end of estimates calling for earnings of $2.15-$2.25. The stock is trading down about 3% on the day, but you cannot blame that on Spam.  Spam is hardly Hormel’s only product, but the gelatinous mixture of spiced ham and pork invented during the Great Depression is again their most popular.  As an article from the New York Times (NYT) proclaims production of Spam is going full tilt.  Workers are working plenty of overtime and are only allowed vacation days on Thanksgiving and Christmas Day.

We have an Undervalued rating on Hormel right now as the company is priced below its historically normal valuation ranges. For example, Hormel in the past has had a price-to-cash flow between 9.55x and 12.92x but currently the stock is trading for just 8.1 times cash flow.  Another oft used valuation metrics is price-to-sales which for HRL over the last ten years has normally ranged between .66x and .89x, but it is currently only .56x.  The stock would need to appreciate into the mid thirties for these valuation metrics to return to within the normal ranges. So, if you believe that the market and the economy have further to decline, you may want to look at these food stocks as a delicious hedge against further weakness.

Yes, we recognize that we may be crazy to take a positive stance on Vulcan Materials Co (VMC) as we did several weeks back.  Vulcan announced a few days ago that they are cutting 38 jobs as they tighten the belt through this continued economic downturn.  Then, yesterday, Vulcan had a heck of a trading day with a $7.38 increase per share or roughly a jump of +18.4%.  Not a bad trading day, and it could demonstrate in some ways how the new administration’s plan in the White House to stimulate the economy could benefit a firm like Vulcan.

Vulcan is a construction material supply company.  Crushed stone, sand, gravel and similar materials are all the expertise of Vulcan, and the projects they produce are vital to any residential or commercial development.  Given the continued correction in housing and construction in general, it is possible that the downturn Vulcan has experienced since its peak in July of 2007 will continue.  Their net income for the third quarter of this year was only $59.1 million, compared with $135.4 million for the same period last year.

Tom Carroll, the director of business development and external affairs at Vulcan put it this way, saying, “When you see a downturn in those sectors [housing, etc], it obviously ends up reflecting on your business.”

We don’t disagree with Tom, but we do think that perhaps the message beginning to permeate through the market from the new Obama administration could signal a turn in Vulcan’s prospects.  Just yesterday, President-elect Obama outlined an aggressive stimulus plan to create jobs and stimulate the economy.  He very quickly outlined a list of items that he wants to enact including the creation of 2.5 million jobs, with spending specifically on roads, bridges, schools, and clean energy programs.  It’s that last part that could really open the door for Vulcan Materials.  As an active materials supplier in more than 20 states, this company has the expansive resources and product set to really benefit as spending on infrastructure grows.

Vulcan Materials currently receives a rating of Greatly Undervalued from Ockham.  We base that on our historical sales, cash, and dividend models for Vulcan.  If we just focus on the Cash Earnings analysis we can begin to understand that for VMC, the current level of Cash Earnings compared to its historical levels helps identify where VMC is in relation to what the investing community was willing to pay for this level of Cash Earnings in the past. Currently, Vulcan’s Price to Cash Earnings ratio is 5.35.  That is roughly 51% below where the average of the Price to Cash Earnings range would be for Vulcan over the last decade.  Now we’re not saying that a decline in the stock price wasn’t (or isn’t) justified, but if you look at our price chart and ratings history, we were pretty negative on VMC when it was far above these levels.  So we’re certainly not illogical about Vulcan, as many of our investment banking research brethren have been in the past.

The market continued its march downward and, even after a relatively large Friday rally, the S&P 500 still finished down 8.4%.  The price-to-peak earnings ratio has again reached another low at 9.0x.  Clearly, this valuation metric is closely following the market as we are no longer anywhere near peak earnings levels.  In fact, by our calculations earnings at present are just two-thirds of record earnings for the S&P 500, a level that was reached in the summer of 2007.  This is an extreme situation that does not occur often.

Many stocks are selling at or near book value.  Think about the significance of that for a moment.  Equity in the company is valued near what the company could sell its tangible assets (minus liabilities) for in a fire sale today.  Now, remember that stocks are a claim on future cash flows, and those cash flows in the current market are almost completely discounted.  We continue to believe that for long-term value investors, this is very enticing time to be cautiously investing in those stocks least affected by the credit and housing crises.  We think it is reasonable to assume that companies which have continued to improve fundamental metrics–such as sales and cash flow–are a good place to start.  Companies that have a lot of cash on hand (and little debt) will be in a great position to take advantage of the downturn either by protecting against a slowdown or by buying out competitors without the need for extensive financing.  Every company will be affected to some extent by nationwide deleveraging but stocks that can produce strong cash flow will be the quickest to recover.  Companies that fit this description include: Apple, Boeing, Google, and Microsoft.

The percentage of NYSE stocks selling above their 30-week moving average is again remarkably low at just 2.5%.  When market sentiment reaches extremes like we are now witnessing, you can bet that the situation will not persist and is due for a rebound.  That being said, we would never claim to be in the business of market timing because there are still many nasty turns that this market could take; over the weekend we witnessed another event that just a year or more ago would have been unthinkable as Citigroup required a government rescue package.  However, while the short-term market outlook is quite unclear, the market is much more predictable over the long-term.  We continue to believe that their are greatly undervalued stocks in this market that have been

unjustly dragged down in the wretched economic environment.

As you will notice from our asset allocation model we recommend that long-term value investors be bullish right now in this depressed market.  As any student of finance will tell you, the return on an investment is inextricably linked to the risk the investor is willing to take on.  Clearly, the stock market has plenty of risks associated with it, but its valuation is much less risky now than it was one year ago and the return that one can reasonably expect to make from the equity market is vastly improved over one year ago.  We had told our EIG readers that the stock market was overheated for the better part of early 2007 because the risks of entering an already-expensive market were not going to be compensated by the return that an investor could expect.  Well, now the tables have turned and we believe that investors can afford to take the current risk of the market because of the likelihood of improved long-term returns.  As we’ve stated before, investors must do their homework but should be on the lookout for companies that are solid financially and are nimbly navigating this economic environment for when the market turns around (as it always has) these stocks will be the first to benefit.