Monday, November 7

Month 136 - Dow Jones Utility Average - November 2022

Situation: Electric utilities are currently upgrading their transmission and generation systems to accommodate wind and solar–power sources that have inconvenient locations and fluctuate with the weather. Surplus power at a regulated utility has to be sold to a private power grid or stored at a battery “farm.” When more power is needed than wind and solar can provide, an “on-demand” source is required because wind and solar sources “peak out.” Most public power stations have access to a natural gas pipeline and will tap into that to provide “peaking power.” Other sources can also be used, like coal, oil, nuclear, hydroelectric, geothermal, biomass, and the above-noted battery “farms” that are being built next to power plants that receive abundant supplies from wind and solar. Hydrogen fuel cells are a new development to provide peaking power, and will increasingly become the preferred option. Why? Because hydrogen can be made from the electrohydrolysis of water using clean sources like wind or solar, and its combustion emits no carbon dioxide. A hydrogen plant built next to a traditional power plant has a much smaller footprint than a battery farm (which covers 2-3 acres) and doesn’t degrade over time (which all batteries will do). Hydrogen can be transported by tanker trucks in cryogenic liquid form but hydrogen pipelines will eventually be built (to totally eliminate the need for natural gas). Air Products and Chemicals (APD) is the world’s largest producer of hydrogen  and is one of our A-rated companies (see the Benchmarks section in this week’s spreadsheet).

It is important to remember that electric utilities produce an essential good, and that the demand for electrical power grows faster than the population grows. Prices that consumers pay for electricity are regulated at the State level by public utility commissions (PUCs), which grant monopoly power to power companies in exchange for requiring them to maintain and upgrade their power grids. Stocks issued by regulated utilities have below-market price volatility because of those contracts (which ensure a profit margin of 9-11%). Regulated utilities typically pay above-market dividends and thereby attract savers looking to own a bond substitute.

Mission: Use our Standard Spreadsheet to analyze all 15 companies in the Dow Jones Utility Average.

Execution: see Table.

Analysis: Warren Buffett’s favorite metric is found in Column S of the Table (Return on Tangible Capital Employed). He thinks anything higher than a 20% return for the last fiscal year (lfy) is a good number. None of these companies meet that standard. His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (see Column AP), and is negatively impacted by the degree to which managers have capitalized the company by issuing long-term bonds (see Column Y). Five companies have a BUY rating from Morningstar (EXC, FE, PEG, D, EIX). Atmos Energy (ATO) is the only company with a Debt to Equity ratio lower than 1.0. Mr. Buffett also states that a high Free Cash Flow Yield (Column J) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost. However, electric utilities are upgrading transmission grids to accommodate wind and solar power. So, there is no Free Cash Flow available after paying dividends. His third point (that the stock be available “at a sensible price”) is addressed by the 1 year and 3-5 year Forward PEG ratios (see Columns N and O): AES is the only company that has a lower than 2.0 at both time points.

Five companies are A-rated (ATO, NEE, AEP, XEL, ED) in that they have met all 8 “value” criteria (see Appendix). 

Bottom Line: By owning stock in a regulated utility, you’d be profiting from an asset that is essentially risk-free. The Required Rate of Return (using the Capital Asset Pricing Model) for the Vanguard Utilities ETF (VPU) – with its 5-yr Beta of 0.47 – matches that of an S&P 500 Index ETF – with its 5-yr Beta of 1.00 – on a risk-adjusted basis. VPU’s RRR for the past 10 year holding period is 5.7%/yr but VPU actually returned 9.0%/yr vs. 11.5%/yr for the S&P 500 ETF (SPY). By taking 53% less risk you wouldn’t recover 53% less money than with SPY. You’d actually have recovered 22% less. Now you know why Warren Buffett encourages retail stock pickers to portfolio 5-yr Betas under 0.7.

Risk Rating: 4 (where 10-yr US Treasuries = 1, S&P 500 Index = 5, and gold bullion = 10). 

Full Disclosure: I dollar-average into NEE and AEP, and also own shares of ATO.

Appendix: To receive an A rating, we require the company to 1) be listed in the Vanguard High Dividend Yield ETF (VYM); 2) have the 16-yr trading history required for quantitative analysis by the BMW Method; 3) issue corporate bonds rated A- or better by S&P; 4) issue common stock rated B/M or better by S&P; 5) have shown earnings growth for the trailing twelve months; 6) have a positive Book Value for the most recent quarter; 7) have capitalization from issuance of corporate bonds that is no more than 2.5 times equity (capitalization from issuance of common stock), and 8) have a 10-yr Rate of Return (Column E in the Table) that exceeds the 10-yr Required Rate of Return (Column D in the Table).

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

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Sunday, October 2

Month 135 - 23 A-rated Non-financial Companies in the iShares Top 200 ETF - October 2022

Situation: One of the most actionable newsletters we’ve published came out 6 months ago: Month 129 - 26 A-rated Non-financial companies in the iShares Top 200 Index - April 2022. It describes how we arrive at a workable Watch List of companies. As such, this newsletter relates to the most important criticism we’ve received from our readers. Namely, that information in our most actionable newsletters isn’t tracked over time. 

Mission: To update last April’s newsletter every six months, starting this month. The overall goal of our newsletter is to present companies and ETFs that beat the S&P 500 Index over the Trailing Sixteen Year (TSY) period on a risk-adjusted basis. 

Execution: see Table of 23 Companies selected from the iShares Top 200 ETF (IWL).

Administration: We’ve upgraded our requirements to designate a company “A-rated” (see Appendix). Six of last April’s companies no longer meet requirements: Cisco Systems (CSCO), Intel (INTC), 3M (MMM), United Parcel Service (UPS), Eaton plc (ENT) and Comcast (CMCSA), but we’ve found 3 IWL companies that do meet requirements: American Electric Power (AEP), Archer Daniels Midland (ADM), and Honeywell International (HON). New requirements for the A-rated designation include having a 16-yr RRR, meaning a Required Rate of Return (see Column D of the Table) that is no less than the 16-yr Actual Rate of Return (Column E). RRR is calculated by using the Capital Asset Pricing Model which has 4 moving parts (see sample in Appendix).

Analysis: Warren Buffett’s favorite metric is found in Column T of the Table: Return on Tangible Capital Employed. He thinks a 20% return for the last fiscal year (lfy) is a good number. Nine companies meet this standard: LLY, MRK, PG, TXN, JNJ, PEP, LMT, ITW, QCOM.  His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (see Column AP) and is negatively impacted by the degree to which managers capitalize the company by issuing long-term bonds (see Column Y). Four companies have a BUY rating from Morningstar (APD, HON, PEP, QCOM), and 11 companies have a Long-term Debt to Equity ratio lower than 1.0: MRK, ADP, PFE, PG, ADM, TXN, APD, JNJ, WMT, RTX, GD. Mr. Buffett also states that a high Free Cash Flow Yield (Column L) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost. 17 companies meet that standard: LLY, MRK, ADP, WM, PFE, PG, ADM, TXN, KO, HON, JNJ, LMT, ITW, RTX, CAT, GD, QCOM. His third point (that the stock be available “at a sensible price”) is addressed by 1-yr and 3-year Forward PEG ratios (see Columns O and P): Only 4 companies (HON, RTX, GD, CAT) have PEGs under 2.0 for both intervals. Seven companies are cited 3 times (MRK, PG, HON, TXN, JNJ, RTX, QCOM).

Bottom Line: Stock-pickers need to track “fundamental” metrics over time for companies on their Watch Lists. 

Risk Rating: 7 (where 10-yr US Treasuries = 1, S&P 500 Index = 5, and gold bullion = 10). 

Full Disclosure: I dollar-average into MRK, NEE, AEP, PFE, PG, TXN, JNJ, PEP, LMT, WMT, RTX, CAT, and also own shares of APD, TGT, KO, HON, GD

Appendix: Requirements for A-rated designation are to 1) be listed in the Vanguard High Dividend Yield ETF (VYM); 2) have the 16-yr trading history required for quantitative analysis by the BMW Method; 3) issue corporate bonds rated A- or better by S&P; 4) issue common stock rated B/M or better by S&P; 5) have shown positive earnings growth for the trailing 12 months; 6) have shown positive Book Value for the most recent quarter; 7) have capitalization from issuance of corporate bonds that is no more than 2.5 times capitalization from issuance of common stock (equity), 8) have a 16-yr Rate of Return in Column E in the Table that is no less than the 16-yr Required Rate of Return or RRR in Column D in the Table, and 9) be domiciled in the United States.

Appendix: Calculation of RRR by using: a) Market Return (S&P 500 Index); b) Risk-free Return (10-yr US Treasury Note); c) Risk (5-yr Beta); d) Holding Period (we use 16 years so as to include a major recession). Procedure: subtract the 16-yr Risk-free Return (Vanguard Intermediate Term Treasury Fund with ticker VFITX) from the Market Return (16-yr SPDR S&P 500 ETF with ticker SPY) to get the market effect on pricing. Multiply the market effect on pricing by the 5-yr Beta to get the risk attached to that effect. Then add back the Risk-free Rate to get RRR. For example, the Vanguard Utilities ETF (VPU) has an RRR of 5.8%/yr because SPY minus VFITX for the 16-yr holding period is 6.0%/yr, and 6.0% times VPU’s 5-yr Beta of 0.47 is 2.8%. Adding back the 16-yr VFITX total return of 3.0%/yr gives VPU’s 16-yr RRR of 5.8%/yr. The actual 16-yr total return for VPU of 8.9%/yr is less than the actual 16-yr total return for SPY 9.0%/yr. But SPY has a 16-yr RRR of 9.0%/yr because the 5-yr Beta for the S&P 500 Index is fixed at 1.00 by convention. Stock traders think of RRR as the hurdle rate that must be achieved to equal the market’s return on a risk-adjusted basis.

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com