Sunday, October 27

Month 100 - The Clubhouse Turn: A-rated Companies in the 65-Stock Dow Jones Composite Index - October 2019

Situation: Last month, we came up with 10 stocks that are “safe and effective” bets for the neophyte stock-picker. Our starting point was the S&P 100 Index of the largest publicly-traded companies that benefit from price discovery through a robust market in stock options. Very large companies have the built-in safety feature of multiple product lines, which provide management with internal options for responding to an economic crisis. I excluded companies with less-than-stellar S&P ratings on the stocks and bonds they have issued, as well as companies trading for fewer than 16 years. I have also excluded companies with volatile stocks--those with a 3-yr Beta that is higher than 0.75--as well as companies that are not listed in both of the “value” sub-indices (VYM and IWD) for the Russell 1000 Index

This month I’ve dialed back on those safety requirements by including stocks that likely carry more reward at the expense of greater risk. My assumption is that the stock-picker has accumulated 10+ years of experience and now needs to face up to the responsibility of carefully investing for retirement. The “savings race” has reached The Clubhouse Turn but she still needs guideposts for selecting safe and effective stocks.

Mission: Run our Standard Spreadsheet on only the companies in the 65-stock Dow Jones Composite Average that have either issued bonds rated at least  A- by S&P or carry no long-term debt on their balance sheet. (Those 65 companies are picked by a committee chaired by the Managing Editor of the Wall Street Journal.)

Execution: see Table.  

Administration: Five companies that met the above criteria had to be excluded because they lack information we need for analysis: a full 16+ years of trading records (V, AWK) or an S&P stock rating of at least B+/M (CVX, DD, MRK). One company, PepsiCo (PEP) has been added to the BACKGROUND section because it is the only company among last month’s list of 10 Starter Stocks that isn’t in the Dow Jones Composite Index.

Bottom Line: A mid-career stock-picker who doesn’t have a degree in accounting or business administration is at a disadvantage. It would be in her best interest to narrow her choices to the gold standard of stock-picker lists, which is the 65-stock Dow Jones Composite Index, then further narrow her choices to companies that issue bonds rated A- or better by S&P and have at least a 16 year trading record for their stock. That leaves 28 companies to research. The goal, of course, is to find stocks that have outperformed the S&P 500 Index over the past 5 and 10 years while losing less value than the Index did in its worst year of the past 10. In other words, I’m suggesting that she should focus her research on the 9 companies that have no red highlights in Columns C through F of the Table: Microsoft (MSFT), UnitedHealth (UNH), Nike (NKE), Boeing (BA), Intel (INTC), Union Pacific (UNP), Disney (DIS), NextEra Energy (NEE), and American Electric Power (AEP).   

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

Full Disclosure: I dollar-average into MSFT, NKE, BA, UNP, NEE, JPM, INTC, KO, WMT, JNJ, PG, CAT and IBM, and also own shares of AAPL, CSCO, PFE, TRV, DUK, UPS, SO, MMM and XOM. So, I am invested in 22 of the 28 companies. It is difficult to follow that many companies, but it is nonetheless essential: Academic studies suggest that a stock-picker needs to be invested in at least 30 companies to have a good chance of matching market returns (see Columns C, F, and K in the Table) while enjoying less risk that the portfolio will lose value (see Columns D, I, and M of the Table).

APPENDIX: “Investment” is a nice word for the deployment of capital. As with any other capital expenditure, its effectiveness (profit margin) is what accountants call Operating Margin, which is Operating Income divided by Sales Revenue. Sales Revenue comes to the stock investor from dividends and the liquidation of shares. Operating Income is Earnings Before Interest and Taxes (EBIT) “after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.” 

As an investor who buys stocks, your variable costs of production are transaction costs (fees and commissions paid for purchase and sale of shares) plus rent/utilities/supplies for your “home office” and the cost of your business services (e.g. subscriptions to business magazines, newspapers, and websites). For money used to purchase stocks, EBIT is Gross Income (Sales Revenue after subtracting the variable costs of production) minus Depreciation (which is inflation).

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

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Sunday, September 29

Month 99 - Starter Stocks - September 2019

Situation: When I started investing, I picked up the phrase “stocks for widows and orphans.” Typically, Probate Court will assign fiduciary responsibility for investments made on behalf of a widow or orphan to lawyer. I later became acquainted with one of those and learned that she expected after-inflation returns from low-risk stocks to be well over 5%/yr. But she hadn’t fully considered transaction fees, taxes, or the need to balance stocks 50-50 with 10-yr US Treasury Notes (to hedge against what could be a catastrophic loss for a widow or orphan). And, few stocks make suitable long-term holdings in a portfolio that is supposed to be immune to gambling. Given that a stock broker’s main talent is to wisely supervise gambling, a broker is likely to welcome the prospect of building a portfolio of “boring” stocks that will have little turnover.

Many young but upwardly mobile “salary workers” face the same problem that lawyer is facing: how to invest wisely without gambling. I have 4 children who are trying to grapple with this problem; none have gained lasting satisfaction from consulting investment advisors. And, they don’t much like my advice, which is to research the problem and find their own solution, which is called DIY investing. But, they already have the most important asset: which is to be disinclined to gamble.

Starter Stocks, like those for widows and orphans, are usually (but not always) boring. Consumer Staples are most likely to be Starter Stocks, and Utilities are close behind. But then you’ll find that technology-related companies start to pop up from Health Care and Information Technology industries. 

Mission: Use our Standard Spreadsheet to screen out companies that are missing from either of the two key value indexes, which are the iShares Russell 1000 Value Index ETF -- IWD and the income-oriented variant of the Russell 1000 Index that was created as the FTSE High Dividend Yield Index but is marketed in the US as the Vanguard High Dividend Yield ETF -- VYM. Companies that issue bonds having an S&P rating lower than A- are also excluded, as are companies that issue stocks having an S&P rating lower than B+/M. Stocks must have a 16+ year trading record, to allow quantitative analysis by the BMW Method.

Administration: Most of the strategies that are likely to give high returns from owning stocks in a bull market also carry a high risk of loss in a bear market. So, when the market falls 25% those stocks might fall 50%. That means a 100% gain would have to occur over ensuing years just to get back to where the stock was priced when the last bull market ended. Banking and Finance faculty at business schools teach that this strategy is the only legal way to beat the market. In other words, reversion to the mean growth rate is sacrosanct. One way for an investor to hedge against such volatility is to pick stocks that go up or down less than 75% as much as the S&P 500 Index. In other words, exclude stocks with a 3-yr Beta that is higher than 0.75. Another way is to pick stocks issued by very large companies, namely those found in the S&P 100 Index. To be included in that index, companies are required to have an active market in put and call options at the Chicago Board Options Exchange, which means that “price discovery” for the underlying stock is efficient and relatively well insulated from “momentum” investors who are trading on the basis of fleeting rumors or sentiment. The other advantage of very large companies is that they have multiple product lines, at least one of which is expected to produce an attractively priced product during a recession. Integrated oil companies, for example, maintain a fleet of refineries that would be paying less for their feedstock (oil) during a recession--thereby allowing the company to make a nice profit from selling gasoline at a lower price than the customer had been used to paying. 

Bottom Line: The problem with screening for “Starter Stocks” is that you’ll pull up some that are broadly thought of as desirable. Both gamblers and non-gamblers will bid up such stocks but forget to sell them when shares become overpriced. Given that most Starter Stocks (see Table) are found in channels of the economy that are already saturated (i.e., companies can grow their revenues no faster than GDP grows), there is little reason to hold overpriced stocks in expectation that earnings will explode upward. For example, the stocks issued by all four of the Consumer Staples companies on our list (KO, PG, PEP, WMT) are overpriced (see Columns AB to AD in our Table). You’ll have to figure out when to buy (or sell) overpriced shares of such high-value stocks. A common strategy is to buy more shares when the price drops 5-10% below its usual range. This is called the buy the dip strategy. 

The easiest (and probably best) way to be certain of buying shares when they’re bargain-priced is to do it automatically. Sign up for a dividend reinvestment plan (DRIP) that takes a fixed amount of money out of your checking account on a specific date each month to buy more shares. That strategy is called dollar-cost averaging, and is the strategy that Warren Buffett favors to build a position in stocks that are often overpriced.

How well do our 10 Starter Stocks (at Line 10 in the Table) perform vs. the underlying ETFs -- VYM and IWD (at Lines 19 and 20)? Answer: quite a bit better (see Columns E, F and K).

Risk Rating: 6 (where 10-yr US Treasuries = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: I dollar-average into NEE, KO, PG, INTC, WMT and JNJ, and also own shares of PFE, DUK, SO and PEP.

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

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