Situation: In a bull market, most companies in most sectors of the economy show surprisingly strong earnings growth, with companies in the transportation sector leading the way. We know that most companies have embedded risk factors, so why are those companies able to participate in the bull market? The reason is that wobbly companies have been able to grow revenues because of having a good story. So, they’ve been able to set up a good line of credit from banks. In other words, their CEOs think the company will be able to “ride out the storm” by using borrowed money, all the while knowing that many shareholders will feel forced to sell rather than continue to watch the company’s share price collapse. As Warren Buffett says: “You don’t find out who’s been swimming naked until the tide goes out.” But risk is a numbers game (not a story game), so embedded risk factors can be identified in advance.
Mission: Screen the top 200 S&P 500 companies for embedded risk factors, leaving a select list of A-rated companies for analysis: Those are 1) listed at VYM (the Vanguard High Dividend Yield ETF composed of of companies that have a dividend yield higher than that for the S&P 500 Index); 2) have a common stock that has been traded on a U.S. Stock Exchange for 20+ years; 3) have at least an A- S&P credit rating on their corporate bond issues, 4) have at least a B/M S&P stock rating, 5) having a positive earnings per share (TTM), 6) having a positive book value (mrq), 7) have long-term debts valued at no more than 2.5 times equity, and total debts valued at no more than 2.5 times EBITDA (unless covered by collateral of positive Tangible Book Value), 8) have a 10-year actual rate of return that is greater than their 10-year required rate of return (RRR), 9) have a 5-year Beta that is lower than 1.00, 10) is listed in Vanguard’s Dividend Appreciation ETF (VIG) of stocks with 10+ years of annual dividend growth, which eliminates the top 25% of dividend yielders (i.e., those with yields that are perhaps unsustainable).
Analysis: Warren Buffett’s favorite metric is found in Column T of the Table: Return on Tangible Capital Employed. He thinks a 20% return (TTM) is a good number, and 4 stocks qualify: MRK, PEP, JNJ and PG. His second point (that the company is being “run by able and honest managers”) is addressed in Morningstar reports (Column AL) and negatively impacted by the extent to which managers capitalize the company by issuing long-term bonds (Column X). No stocks have a BUY rating from Morningstar but 10 companies have a Long-Term Debt to Equity ratio lower than 1.0 (MRK, TRV, GD, CB, ADP, WMT, JNJ, PG, ABT, CME). Mr. Buffett also thinks a high Free Cash Flow Yield (Column K) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost; 13 companies meet that standard (MRK, CAT, TRV, GD, CB, ADP, WMT, JNJ, NEE, PG, ABT, CME, TGT). His third point (that the stock be available at a sensible price) is addressed by 1-yr and 5-yr Forward PEG ratios (Columns O and P). Five companies have a PEG lower than 2.5 at both time intervals (MRK, TRV, GD, JNJ, TGT). Three companies are cited 3 times (MRK, JNJ, PG).
Bottom Line: When buying stocks, look for embedded risks. Then decide whether returns will likely pay you enough for taking those risks.
Risk Rating: 5 (where 10-yr US Treasury Notes = 1, S&P 500 Index = 5, and go
Full Disclosure: I dollar-average into MRK, CAT, PEP, WMT, JNJ, NEE, PG, CME, and also own shares of GD and ABT.
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