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Believe It: Apple Is A Value Stock And Dividends Are King

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John Buckingham is the CEO and Chief Investment Officer of Al Frank Asset Management, and the editor of The Prudent Speculator, a monthly investing newsletter. Recently, he sat down with Steve Forbes to talk about Al Frank's strategy, investor psychology and why he loves dividend-paying stocks. Video and a transcript of the first half of their conversation follows.

[forbesvid id="fvn/inidaily/john-buckingham-prudent-speculator-al-frank-asset-mgmt" showid="80"]Steve Forbes: John, thank you for coming by. In the name of full disclosure, Forbes publishes The Prudent Speculator, a newsletter that comes out each month, where you have specific recommendations and also some punditry and words of advice to your readers. You also manage money for clients and two mutual funds, the Al Frank Fund and the Al Frank Dividend Fund?

John Buckingham: Correct.

Forbes: And about $100 million [in the mutual funds]. The rest of your clients about $400, $450 million?

Buckingham:Correct.

Forbes: And no white hair yet. Very good.

Buckingham: I'm getting some.

Forbes: Going back to Al Frank, a real person. You cut your eye teeth with him. How would you describe your approach to investing? It's not quite contrarian, not quite traditional value investing. You have your own metrics – algorithms as we call them. Please define them.

Buckingham:Sure. Well, I learned at the foot of the master, Al Frank, who was a self-taught investor. Al set out to learn what worked on Wall Street, and what he found is that companies trading at inexpensive valuations – low P/E ratios, low price-to-sales ratios, low price-to-book value ratios – those companies historically outperformed. And importantly these days, companies that pay dividends have historically outperformed.

My strategy is pretty much very similar to what Al would do, trying to find bargains. The amazing thing is, though, what we do is what people do in their every day life. You search for a deal. We just try to find the deal in the stock market supermarket, as opposed to going to the local grocery story.

Forbes: That gets to psychology, but you can define it as if you look for stocks on sale.

Buckingham: Right. Absolutely. Well, companies that are trading at inexpensive valuations. Over time stocks are seldom priced at fair value. They're either cheap or they're expensive. Our job is to try to exploit those pricing anomalies and try to buy low and sell high.  It's not always easy.

Forbes: Now, your universe is the Russell 3000?

Buckingham: Yeah, we screen on 3000 companies – that algorithm that you mentioned. We're always trying to find companies that fall into our parameters with our initial quantitative screens.

Forbes: ADRs as well?

Buckingham: Absolutely ADRs. We like to look overseas. We have about 200 stocks in our universe that we'll look at. You need to have sufficient volume and need to get financial information and so forth on them. But once we've got that quantitative review, then we'll go ahead and do a qualitative review.

Forbes: Now, define qualitative review, because that's where people think, "Okay, then the emotions start kicking in.”

Buckingham: That's exactly something you have to guard against. What we're trying to make sure is that stocks aren't cheap for a reason, because many companies are inexpensively priced but their earnings may be heading off a cliff.  They may have balance sheet difficulties. They may have obsolete products. They may have competitive challenges.  It's our job to do our homework and crunch those additional metrics.

But at the end of the day it's still a human being who has to make those decisions. So it's not a black box, by any stretch of the imagination, even though we certainly rely on a lot of technology to help us get to the right pond, as I like to say, so that we can conduct our fishing expedition with hopefully a little more success.

Forbes: Now, the performance certainly of the newsletter has been pretty good.

Buckingham: We've done well over the long haul, certainly. The newsletter was launched in 1977, and the annualized return on our model portfolios is somewhere in the 17%-18% range, which obviously is good. In interest of fair disclosure, of course, the last few years – especially in 2008, we could all do without 2008 – and even last year was a tough year for stock pickers. So, you're not always not going to be able to top the charts. But we're obviously focused on long term.

Forbes: Stay on that for a moment. Last year the averages were okay, but you make the point the average stock sucked.

Buckingham: Well, to put it mildly, yes. There were far more declining stocks than advancing stocks on both the New York Stock Exchange and on the NASDAQ. Last year was not a good year for the average stock. It was an okay year for the indexes – the Dow Jones Industrial Average being up 8% on a total return basis, S&P 500 up a percent or two, and even our benchmark, the Russell 3000 up a percent.

But the average mutual fund manager out there lost money to the tune of 3% or 4% last year. It doesn't sound that bad when you think about all the volatility and all the things we had to face last year, but it wasn't a great year. But still, if our newsletter portfolio's down a few percent we'll take it, compared to where we were, say, in August of last year when we were pushing bear market numbers for the full year.

Forbes: Why is that? How can the averages supposedly measure the market better than stocks in the market?

Buckingham: Well, it's simple arithmetic in that the averages are capitalization-weighted. So if a handful of large cap stocks do very well and the rest of the troops, if you will – the generals do well but the soldiers don't, you could have a situation where the overall market doesn't do well but the averages do. So far in 2012 we've seen the same kind of thing in reverse, because the average stock this year is doing better than the benchmarks. Most of the fund managers are outperforming the benchmark this year, whereas last year they were underperforming.

Forbes: Now, in terms of picking value stocks, what isn't a value stock these days?

Buckingham: Well, it's an interesting question because the line between value and growth these days is sort of blurred. Because a lot of growth type companies we own.

Forbes: Such as?

Buckingham: Well, we own Apple Computer. You can make a strong case today that Apple is actually a value stock even though it's growing like crazy. You have a fantastic balance sheet loaded with cash, you have a P/E ratio on an ex-cash better in the 10 or 11 range. Apple's attractively priced on that level.

But, of course, then you focus on things like price-to-book value where it's somewhat expensive. Even on a price-to-sales basis, there are many other stocks that are cheaper out there. The question that you ask, though, is how do you differentiate between value and growth. And again, we try to take our initial screens, focusing on only the stocks that are the least expensive relative to their peers and then relative to the overall market.

Then we get to do our qualitative work. And there are a lot of very nice companies that are attractively priced today. Whether you want to put them in a value box or a growth box, technically speaking we're not as concerned about. What we want to do is buy good companies that we think will appreciate in price over the long haul, and we'll let the Morningstars of the world decide which box they go into.

Forbes: Now, dealing with human emotions, psychological, you write a lot about that. You've made the point, as others have made, that the stock market's the only place in the world where if something's going up in price people want it, and if it's going down in price they don't want it. Whereas, when you go to the supermarket, if it's gone up in price you go elsewhere for a bargain.

Buckingham: Exactly.

Forbes: Why is that?

Buckingham: Well, it's human nature. Fear and greed will drive all investment decisions. I like to say there's a pendulum that swings back and forth. We swung way too far on the greed side in the tech bubble and then we swung way to side on the fear side in 2008/2009 when we were sort of discounting Great Recession II or Great Depression even, and we didn't really have such a severe economic downturn to justify that. The emotional part of investing is something that's always there. What we try to do is to focus on market history. Stocks have delivered the best long term return, relative to T-bonds and bills and inflation.

Forbes: What about people like Gary Schilling that say since 1981 bonds have done better than equities?

Buckingham: Well, it depends what you're invested in, Steve. With our returns at 17%, 18% a year, that's better than what bonds have done. Certainly that's why I think stock picking matters, because you can't just buy an index and sit with it forever. Indexes are going to, at least from my perspective, contain many stocks that are not attractively priced.

I think you can be buying under-valued stocks independent of where the overall market might be – keeping in mind, of course, that if everything is expensive then it's your job to obviously have more cash in your portfolio. But these days I think everything is more on the cheap side than expensive, especially given where we are on interest rates.

The fact that interest rates are at such low levels is a sign of that fear. I mean, people are willing to pay to get one basis point, .01% on a money market fund. And that's where a lot of money is parked. Or, they're going to shovel money into U.S. Treasuries, where a 10 year treasury yield is microscopic as well – 2% or so. Those just aren't attractive yields or returns from where I sit, especially when the dividend yields on stocks are so attractive.

Forbes: Was it just the trauma of 2008 that, as you put it, people focus on return of principal instead of return on principal?

Buckingham:Well, I think it's a combination of things. You had  what happened in the tech bubble bursting, right?

Forbes: Right.

Buckingham:And you had 9/11 which obviously caused market break. You had 2002, which was an awful year. You already had a slowdown going on in 2008 in terms of corporate profits and the economy, and then it was exacerbated by the financial mess. Absolutely it's a combination of things. When you see the kind of volatility we've seen with – and this is an important part, with the 24/7 media coverage – the fact that you can look at your smartphone and see what your portfolio's doing at any given second. That's a good thing from an informational standpoint, but it's not a good thing for the emotional part of investing.

Then you throw in what happened, also, with most asset classes all going down in 2008 and 2009, including the value of your house, the value of your art, the value of your fixed income investments. Unless they were in Treasuries they went down. You had a combination of factors that really scared the bejesus, if you will, out of everybody.

It takes time for those wounds to heal. You'll see the investors poking their head up out of the foxhole a little bit now, but despite the rally we've seen off the October lows, we don't see any signs of greed really emanating out there from the average investor.

Forbes: So this isn't, in your mind, a suspicious rally? The volume is low, as you point out. Mutual funds, equity funds still aren't taking in very much, compared to bond funds.

Buckingham:Right. I'm being a contrarian when it comes to the overall market. I like it when there are a lot of skeptics out there. I like it when there's not a lot of enthusiasm towards equities. That makes me feel better that equities are going to do well going forward.

I'm really focused on a lot of those kinds of factors. Today, with mutual fund flows actually being negative, out of equities into bonds, people are still shoveling money into bonds, that's a positive from where I sit. Even though the average investor is now sitting here saying, "Hmm, I just missed out on an 8%, 9%, 10% rally and I'm sitting here getting nothing in my money market or very little with my fixed income investments. Maybe it's time to tiptoe into stocks." That's why I'm focusing more on dividend payers and even in the larger cap space, because I think that's the next stop for investors, as they come out of their foxholes.

Forbes: Even though the small stocks have done well this year?

Buckingham:Yeah, even though small cap stocks have done well. And of course we have those as well. But I don't think that the big money, the real money, the pension fund money, the hedge funds – the hedge funds are still very much skeptical of this rally. I just don't see the real money coming into equities yet. And when it does, I really think it's going to focus on the blue chips stocks, because of course they're still going to be very scared and they want to make sure they have that liquidity to be able to get out if something blows up in Europe or there's some other traumatic event. There's going to be itchy trigger fingers out there and I think that large cap stocks provide a level of safety for those kinds of investors.

Forbes: Dividends, even though we haven't seen a big flood of money, it seems like everyone says, "Go with the big ones.” J&J yields more for the first time since 1950's. You'll find tons of stocks where the dividend yield is more than the eight or five year, ten year bond. Do you feel uncomfortable that others are echoing you?

Buckingham: I want to be the guy at the party that nobody wants to talk to. Believe me. I do have a little bit of discomfort over the fact that a lot of folks are talking about dividend-paying stocks. But I think they're talking about them for one reason and one reason only. In their mind it’s, "Well, you get a yield, you get income and that income is greater than what I'm going to get on a fixed income investment."

What we've done in our analysis and looking back at market history in our own studies, is found that dividend paying stocks have actually delivered better returns over the long haul than non-dividend paying stocks. And believe it or not, they've done so with lower volatility.

I think there are additional reasons, over and above what the masses are doing, as far as dividends go. I think the theme of dividends has legs. Again, I think that most companies these days are paying dividends. I mean, heck we're going to be talking about Apple maybe coming out with a dividend. Microsoft, Cisco, all of the big names are pretty much paying dividends. It's in vogue. If you look at the S&P 500 last year, you had over half of the companies raise the dividend or initiate a dividend. Dividends are here to stay, so to speak.

One final point on the subject is that if you look, again, back at market history, 25% to 40% of total return over the long haul has come from dividend income and dividends reinvested.

Yes, there's still capital appreciation in there, but you don't want to ignore dividends. I think you do so at your peril. I don't think it's a crowded trade, even though a lot of people are talking about it, because I just don't see the mutual fund flows – I don't see people shoveling money at stocks.

I see them nibbling. And of course, in the first part of the year you have flows from retirement contributions. I think one other point that people might have missed is that you have rebalances that are going on among asset allocators, because last year fixed income investments did well and most equity investments did poorly, so a lot of folks are selling down some of their fixed income and putting it into equities. That has played a role, I think, in the rally that we've seen thus far this year. But I do not think that the dividend theme is overbought, so to speak.