R  I  V  E  R   P  O  I  N  T 

R  E  P  O  R  T

 

 

  September 2006

 

Blue Chips Approach Record High

 

The Dow Jones Industrial Average is on the verge of hitting an all-time high. The Dow closed the month of September at 11,679, just 43 points shy of the record set in early 2000.  We believe the Dow will surpass the old mark before year-end.  However, October has historically proven to be a very volatile month and with the recent advance it would be logical to assume that a pullback could occur before reaching a new high.  In 1995, we saw a similar economic pattern where the Fed stopped raising interest rates, the economy slowed, and the Dow rose over 30% the following year.

 

The driving force for the recent advance in stocks is a combination of falling energy prices coupled with the expectation that the Federal Reserve has succeeded in slowing economic growth without a recession ensuing. Energy prices have fallen as a direct result of weak demand and heavy supply while concerns about the Middle East have eased. Natural gas prices have fallen to their lowest level since 2002 and oil is down almost 20% to $63 a barrel from a high of $78. Although prices could reverse course if tension in the Middle East escalates, we believe oil prices will more than likely continue to ease further over the balance of the year. At RiverPoint, we began reducing our overweight position in clients’ portfolios in the energy sector last year and remain cautious on the group as earnings growth will likely slow over the next twelve months.

 

3rd Quarter Earnings Season Starts

 

Companies will begin reporting earnings for the third quarter over the next several weeks. Economists are expecting another robust earnings season with low double-digit growth. If they are correct in their expectations, it would mark the 13th straight quarter of double-digit earnings increases. As earnings continue to advance, stock prices should follow suit. Over the last few years, stocks prices have lagged earnings growth triggering lower valuations and causing stocks to look more attractive than they have in a decade.

 

A few companies recently reporting earnings include Oracle, Diageo and FedEx.  Oracle reported a 24% jump in earnings and the stock jumped 10% in one day. If this is any indication of what is in store for other companies, we should expect a fourth quarter rally.  Impressively, Oracle’s President, Charles Philips, seems to have been successful in changing the arrogant culture at Oracle to one of high quality service and customer care. For example, CFO’s now receive quarterly calls from Oracle focused on the operation of their systems.  In the past, the calls pertained to generating new sales rather than servicing customers’ existing systems.   

 

FedEx reported a very impressive 40% jump in profit driven by strong demand for ground and international shipments. They also raised their 2007 earnings outlook and stated they have received clearance to begin more flights to China on a weekly basis.

 

Diageo, the world’s largest distributor of alcoholic beverages, reported a 21% increase in earnings driven by solid U.S. sales of leading brands such as Smirnoff Vodka, Johnnie Walker Scotch and numerous other high quality brands. Diageo also increased its share buyback program.

 

Similar reports are expected from a number of other companies such as United Technologies, Bank of America, Cincinnati Financial, Midland Insurance, United Healthcare and Johnson & Johnson to name but a few.

 

What is a P/E ratio?

 

In the financial industry there are many ways to assess whether a stock’s price looks relatively expensive or not. Some of these common financial measures include a stock’s P/E ratio (price to earnings), P/S ratio (price to sales), P/B ratio (price to book), D/C ratio (debt to capital), ROE (return on equity) or W/C (working capital).

 

A P/E ratio is the price of a stock divided by the company’s earnings. For example, Procter & Gamble’s stock price is approximately $62 a share. P&G’s estimated earnings for the period ended June 30, 2007 is $3.00. Thus, its P/E ratio is $62/$3.00 or 20.7. This means that P&G trades at 20.7 times its estimated earnings. One measure of determining the stock’s attractiveness is to compare this ratio with P&G’s historical P/E ratio which is 21.6. In this case, P&G shares would be slightly undervalued relative to their historical P/E ratio. If P&G’s historical average P/E ratio of 21.6 is multiplied by $3.00 in estimated earnings, “fair value” would be approximately $65 versus the current price of $62.

 

On an ongoing basis, the RiverPoint investment committee screens a universe of over 1,000 stocks on various valuation measures as the first step in seeking stocks with attractive valuations. Once attractively valued stocks are identified, our research analysts conduct fundamental research designed to assess the company’s ability to sustain its competitive advantage, maintain its growth rate, and generate sufficient cash flow.  

 

However, historical valuations may not be relevant for valuing companies with a decelerating growth rate. In that case, other financial metrics may be more appropriate. Home Depot is a good example of a company where historical valuation measures may no longer be suitable.  In Home Depot’s case, a more appropriate measure might be the stock’s P/E ratio relative to its future growth rate. With a P/E ratio of 11.2 the stock trades at less than 1x, or .9%, of its growth rate of 13%.  This would be considered a very attractive valuation. Stocks with a P/E ratio of 1 to 1.5x their growth rate would generally be considered cheap while those with a P/E ratio over 2x their growth rate would be expensive.

 

At RiverPoint, once we have identified a list of companies with attractive valuations, our analysts then compare each company to its industry peers and the broader market. Companies with the most attractive valuations that are financially sound and fundamentally strong are then considered for inclusion in our clients’ portfolios.  The following is a list of a few companies that fit this profile:

 

 

 

 

 

Company

P/E Ratio on

2007 Est.

Earnings

 

Historical Avg.

P/E Ratio

 

Discount to

Fair Value

Estimated

Long-term Growth Rate

Financial

Strength

Rating (S&P)

 

 

 

 

 

 

Biomet

15.5x

24.8x

60%

15%

         A

Cincinnati Financial

15.3x

18.7x

22%

10%

         A-

FedEx

14.3x

17.6x

23%

15%

         B+

General Electric

15.7x

21.7x

38%

10%

         A+

Home Depot

11.2x

26.6x

137%

13%

         A+

Ingersoll Rand

9.8x

13.9x

42%

12%

         A

Johnson & Johnson

16.2x

22.5x

38%

10%

         A+

3M

14.9x

20.9x

40%

11%

         A

United Healthcare

14.4x

19.3x

34%

17%

         A+

 

Source:  Baseline

 

 

 

 

          Market Summary

 

9/30/06

 

YTD Price Change

 

Dow Jones Industrial Average

11,679

 9.0%

Nasdaq Composite

  2,258

 2.4%

Standard & Poor’s 500 Index

  1,336

 7.0%

 

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.