Sunday, August 12

Week 371 - Know What You’re Buying: Graham Numbers for “The 2 and 8 Club”

Situation: Stock prices are a function of 3 variables: book value, earnings, and market sentiment. The first two numbers come from the company’s most recent quarterly report. Market sentiment drives the movement in buy and sell orders for a particular block of shares on a public exchange. In the days before electronic trading systems took over, traders would get together after work and make back-of-the-envelope calculations of future book values and earnings for stocks that interested them. This would give them an idea about the price at which the company’s stock would open the next morning. Benjamin Graham gave traders a starting point for those discussions on page 349, Chapter 14, of his book The Intelligent Investor (cf. the Revised Edition of 2003, annotated by Jason Zweig). There he makes clear that a rational price is the square root of 15 times earnings/share (EPS) and 1.5 times book value/share (BVPS), which is the square root of 22.5 X EPS x BVPS. For example, on June 18, 2018, JP Morgan Chase & Co. (JPM) closed at $108.17, with EPS of $6.35 and BVPS of $72.00. The Graham Number equals the square root of (22.5 X 6.35 X 72 = 10,287) or $101.42. Conclusion: JPM is 6.66% overvalued ($108.17/$101.42 = 1.0666).  

Mission: Run our Standard Spreadsheet for the 22 companies in “The 2 and 8 Club” to include Graham Numbers.

Execution: see Columns Z and AA in this week’s Table.

Bottom Line: The average company on this list is overvalued by a factor of three (see Column AA), reflecting the end-of-times for the second longest Bull Market since the Great Depression. You have to ask yourself why you still own shares of a stock that is priced more than 3 times its fundamental value. Those reasons will always reflect market sentiment unless you know of a specific reason why earnings and book value are going increase above trend, and you’re almost certain it will play out that way.

Risk Rating: 7 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into MSFT, NEE, JPM, CAT and IBM and also own shares of TRV, MMM, CSCO and CMI.

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

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Sunday, August 5

Week 370 - Ways To Win At Stock-picking #1: Dollar-cost Average Into 10 Of The 30 DJIA Companies

Situation: You’re troubled by the dominance of the S&P 500 Index. After all, it is a derivative and you wonder whether it is really the safest and most effective way to build retirement savings. Your biggest concern is that it is a capitalization-weighted index, which is a design that favors momentum investing: Mid-Cap companies that garner investor enthusiasm become included in the S&P 500 Index because their stock is appreciating; Mid-Cap companies that have managed to be included in the S&P 500 Index investors are in danger of being excluded because investors have lost their enthusiasm and the stock’s price is falling. Many investors buy/sell shares in a company’s stock because of that trend in sentiment. Fundamental sources of value (revenue, earnings, and cash flow) often have little to do with their enthusiasm, or the fact that it has evaporated. Articles in the business press may carry greater weight, and those articles may be influenced by analyses introduced by short sellers, who are betting on a fall in price, or hedge fund traders with long positions, who are betting on a rise in price. In other words, most retail investors are paying attention to market sentiment when buying or selling shares, not due diligence that comes from a careful study of a company’s prospects and Balance Sheet. 

Your second biggest concern is likely to be that few S&P 500 companies have a good credit rating backing their debts. In other words, they’re paying too high a rate of interest on the bonds they’ve issued, or the bank loans they’ve taken out. The company’s Net Tangible Book Value is therefore likely to be drifting deeper into negative territory because of interest expenses, part of which are no longer tax deductible due to changes in U.S. tax law.

Both of these problems fall by the wayside if you invest in the 30 companies that make up the Dow Jones Industrial Average, either separately or together in the price-weighted Dow Jones Industrial Average Index (DIA at Line 18 in the Table). Investing in the “Dow” may be a little smarter for retirement savers than investing in the S&P 500 Index (SPY at Line 16 in the Table) for two reasons: 1) DIA has a dividend yield that is ~10% greater; 2) DIA pays dividends monthly, whereas, SPY pays dividends quarterly. A higher dividend yield means that your original investment is returned to you more quickly, which translates as a higher net present value, if other factors (e.g. dividend growth and long-term price appreciation) are not materially different.

Mission: Use our Standard Spreadsheet to illustrate how I dollar-cost average into stocks issued by 10 DJIA companies.

Execution: see Table.

Administration: It has been necessary to use 3 separate Dividend Re-Investment Plans (DRIPs) to dollar-cost average into the 10 DJIA stocks I’ve chosen (see Column AE in the Table). Those DRIPs automatically extract $100 each month for each of the 10 stocks; transaction costs average $18.68/yr (see Column AD), which includes automatic reinvestment of dividends. The expense ratio is 1.56% for each year’s investments, but expenses relative to Net Asset Value fall to less than 0.01% after 10-20 years.

Bottom Line: This week’s blog compares my long-standing pick of 10 Dow stocks (for an automatic monthly investment of $100 each using an online DRIP) to investing $1500/qtr in the entire 30-stock index (DIA) using a regional broker-dealer, which is something I’ve just started doing to facilitate comparison going forward. (You’ll see each year’s total returns in future blogs published the first week of July.)  

Risk Rating: 6 (where U.S. Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10).

Full Disclosure: If one of the 10 stocks I’ve chosen is dropped from the Dow Jones Industrial Average (DJIA), I’ll sell those shares and use those dollars to start a DRIP with shares issued by another DJIA company.

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

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