Sunday, December 25

Week 25 - Master List Risk

Situation: Risk is headline news again!! Consumers and corporations alike are taking on less risk these days but governments are still struggling. This is because governments are singularly able to increase spending during a recession. The central banks of the US and China spent heavily in early months of the recent recession and are now able to switch gears and think about repairing their lopsided balance sheets. European central banks, on the other hand, aren’t as dynamic and those economies now face a drawn-out recession. US corporations have cut borrowing (the S&P 500 Index Debt/Equity ratio has fallen from 1.6 to 1.2 over the past 3 yrs). US consumers have trimmed household debt and are still avoiding taking on new risks like real estate or stock purchases.

Put simply, our key question for this week’s blog is: How should the ITR investor measure the risk of investing in stocks? And a follow-on question:  When is it smart to purchase a risky stock that has tumbled in value? Let’s dispense with the second question first. “Big money” is made in two ways, one of which is legal (taking on risk) and the second illegal (making trading decisions based on inside information). One of the effects of risk is to magnify volatility so that the stock will outperform in a rising market; but the downside amounts to a “near death experience” in a falling market. Experienced traders don’t consider buying stock in a “fallen angel” until after it has recovered ~40% of its lost value, and such a recovery can sometimes take years. The ITR DRIP investor isn’t going to want to be caught holding one of those stocks on the eve of retirement.

Now to address the first question: how is risk measured? In evaluating a company, “risk” is about volatility, debt, and cash flow that might not be enough pay a dividend. Price volatility can be assessed from the interactive graph function at Yahoo Finance by picking a stock index and charting it’s Bollinger Bands (BB) over the most recent two year (499 day) time span, setting the standard deviation at 4. To have a BB reference index that weights utilities and transportation companies better than the S&P 500 Index, we like to use the Dow Jones Composite Index (DJA) as our reference index for volatility. The Dow Jones Utility Index is a good metric for the performance of companies that provide essential goods, and the Dow Jones Transportation Index reflects “the pulse of the economy” better than the S&P 500 Index. The Dow Jones Composite Index will outperform the S&P 500 Index over extended periods of time. Why? Because it over-weights “boring transports and utilities.”

For the remaining two risk metrics (debt and cash flow), we use accounting data that can be found at both Yahoo Finance and the online Wall Street Journal ( Long-term (LT) debt that is more than 1/3rd of total capitalization is a red flag. Free cash flow (FCF) is our most important risk metric because it’s the source of dividend growth: FCF is red-flagged when it’s less than two times the current dividend payout. How is FCF measured? By going to the Statement of Cash Flows. Start with “net cash flow from operations”, i.e., the bottom line of the first part of a Cash Flow Statement. Then subtract from that number the first item (capital expenditures) of the second part - called “cash flow from investments”. Divide that number by the first item (dividends paid to holders of common stock) of the third part, which is called “cash flows from financing.” An FCF/div greater than 2 indicates that the company can comfortably pay its usual dividend and consider raising its dividend. Wikipedia gives two examples under the topic of “cash flow statement”; the second example (XYZ co. LTD) can be used to follow the guidance above. This company is unlike those on our Master List, in that it has negative cash flow from operations and yet pays a large dividend. FCF/div = -0.65. The accompanying table shows the 4 numbers from the Cash Flow Statement that are used to determine FCF/div for each company.

In the accompanying table <click here>, we provide risk metrics (2yr BB volatility score, LT debt/cap, and FCF/div from the most recent annual report) for each stock in the ITR Revised Master List (Week 16). We also note the current dividend and the average rate of dividend growth over the past 10 years. Our risk analysis shows that 10 of these companies are well-managed from the standpoint of risk: JNJ, ABT, BDX, WAG, MKC, ADP, XOM, MMM, GD, and TROW.

Bottom Line: Know what you’re buying. Rather than attempting to hit the ball out of the park by picking stocks poised to reap windfall profits from a bull market, a sounder approach is to get on base with a walk or single. Leave the home run attempts to the gamblers while you carefully build your retirement portfolio using sound, well thought-out decisions.

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Sunday, December 18

Week 24 - Equity Summary

Situation: In the previous two blogs, we used virtual investments of $900/mo (beginning on 2/3/97) in representative Core Holdings (XOM, MMM, UTX, NSC) and Lifeboat Stocks (JNJ, WMT, NEE) to illustrate how we’d set up the equity half of a personal portfolio. Of our virtual dollars, two-thirds were invested in Core Holdings ($150/mo in each of 4 stocks, or $600/mo) and one-third in Lifeboat Stocks ($100/mo in each of 3 stocks, or $300/mo). This distribution reflects the ITR Goldilocks Allocation strategy (Week 3).

This week’s blog demonstrates the outcome of making 179 consecutive monthly purchases into those 7 DRIPs, ending on 12/1/11. <see attached spreadsheet> While the total investment was $161,100, the total return was a healthy $324,036 (TR = 7.74%/yr). The benchmark we are using is SPY, the Exchange Traded Fund the mimics the S&P 500 Index. SPY had a total return of 2.55%/yr based on 179 consecutive monthly purchases of $200 (commission of $4 per purchase). The total investment in SPY was $35,800, which then grew to $43,975. Inflation over that same 15 yr period was 2.32%/yr, as measured by the Consumer Price Index. In other words, our 7-stocks beat inflation by 5.42%/yr and beat the market by 5.19%/yr. In a future blog, we will provide a Credit Summary which will detail the outcome from investing $900/mo in bond funds as per a Goldilocks Allocation.

Summary: Do-It-Yourself (DIY) investing has obvious cost savings compared with going through an intermediary, such as a mutual fund manager. More to the point, it requires an investor to take personal responsibility for acquiring a working knowledge of investments and performing a modicum of research using the web. The goal is to “maintain what you’ve obtained” instead of participating in a market panic by selling your shares. Markets are moved more by fear than greed, such as the fear of a “margin call”. Many investors rely on help from borrowed money, i.e., by investing borrowed dollars and using the purchased stock as collateral for the loan. A “margin call” occurs when the broker requests additional capital (cash) from the investor to back an investment that has lost value. That is, the original loan is no longer backed with adequate collateral. As a DRIP investor on auto-pilot, however, you welcome a market panic because you are buying more shares than usual with your monthly investment. So, when should you sell a DRIP chosen from stocks in our Master List? We know of only 4 conditions that would trigger that:

   a) you need the money to retire;
   b) the company has gone 18 months without raising its dividend;
   c) the company has gone 18 months without having a dividend yield higher than the yield on the S&P 500 Index;
   d) the company has resorted to issuing bonds rated lower than BBB+ by S&P.

Bottom Line: Our ITR blog is for value investors who aren’t interested in buying stock with borrowed money or selling stock in a falling market. These are called "Rip van Winkle" investors, in honor of the off-hand comment from an investment guru that he’d have done better by not touching his portfolio for 10 or 20 years.

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Sunday, December 11

Week 23 - Lifeboat Stocks Revisited

Situation: In an earlier blog (Week 8), we defined Lifeboat Stocks as high-quality companies in defensive sectors of the economy (utilities, consumer essentials, health care). And by high quality we mean companies that have: low debt, a good credit rating, a dividend over 2%, and at least 10 yrs of annual dividend increases. In a later blog (Week 17), we introduced the use of accounting ratios to determine whether a company’s stock can be classified as fitting the category of “growth” or “value” and explained why we favored value. In this week’s blog, we will try to explain how some companies that qualify as a Lifeboat Stock (i.e., good credit rating and paying dividends with annual increases) can still carry considerable debt.

When a buyer makes a 20% down payment on a $200,000 house, then sells that house a year later for $240,000 (net of costs), that buyer’s out-of-pocket expenditure of $40,000 becomes $80,000. In accounting terms we would say that the Return on Equity (ROE) was 100%. Taxes will need to be paid on the $40,000 capital gain unless the gain is invested in another house but taxes are not due on monies used to pay interest on the mortgage. A US corporation works in a similar way, except that a business loan’s principal is not repaid, as in our mortgage example, until at the loan’s termination date. Boards of Directors, like homeowners, find this arrangement attractive because they can use someone else’s money to grow equity, tax-free. 

When a company provides something that is fundamentally essential (i.e., electricity, pharmaceuticals,payroll services or diapers) there is an even greater temptation to use borrowed money, and that is because that company is unlikely to lose money during a recession. It can still make the owed interest payments on schedule. And, as is the case with homeowners, the cheapest form of debt is long-term (LT) debt after considering all risks. Typically, a company will “roll over” the Principal payment due at the maturity of its loan by taking out a new LT loan in the same amount. However, if there is a credit crunch when the company needs to do so, there will undoubtedly be higher interest to be paid, or possibly a need to issue more stock to finance the Principal payment. A company could also be going through a lean period when it’s Return on Assets (ROA) is less than the interest rate it will have to pay on its new loan. In other words, it won’t be able to get a loan it can afford. What this means is that the company will be paying an interest rate that is higher than it’s ROA, which means the company is in the process of going bankrupt. It will have to pay a much higher interest rate to compensate a creditor for issuing a “junk bond”. Incidentally, this principal also applies to countries, as we are witnessing with the European Union.

The attached <spreadsheet> examines all of the ITR Lifeboat Stock candidates in terms of LT debt/capitalization, ROE, ROA, and P/BV, or the ratio of Price to Book Value (assets minus liabilities). Debt is subtracted from the value of the company's assets, which are owned by shareholders, but a company that efficiently uses borrowed money to increase its revenue will also show an increase in assets that is proportional to the increase in its liabilities. BV will remain stable and the share price will remain a reasonable multiple of BV. If BV falls because the value of its assets no longer cover its liabilities, then P/BV will soon reach double digits. To qualify as an ITR Lifeboat Stock, we are looking for companies with P/BV of less than or equal to 3.5, ROA greater than 8% (indicating ample ability to afford interest payments), ROE greater than the S&P 500 Index ROE (currently 16.5%), and LT debt/capitalization less than or equal to 35%. 

ABT, JNJ, MDT, BDX, ADPWAG, and WMT meet our criteria and are classified as Lifeboat Stocks. In addition, NEE, SO and MDU are utilities with government-backed credit and otherwise meet our requirements for being a Lifeboat Stock. The other companies on the spreadsheet do not meet those requirements. Taking one company from each of the main S&P Industries from which Lifeboat Stocks are drawn (consumer staples, health care, utilities), we’ll make a virtual investment of $100/mo in each DRIP (WMT, JNJ, and NEE) starting 2/3/97. Commissions are $1 per month for WMT and JNJ; NEE has no commission. Total returns were 5%/yr for WMT, 4.85%/yr for JNJ, and 7.78%/yr for NEE. This compares to 2.55%/yr for SPY (commission for monthly DRIP investment = $4). Spreadsheet information will be provided in next week’s Summary blog. 

Bottom Line: Lifeboat stocks provide some of the ballast that helps to preserve your portfolio during market turmoil; bonds provide the rest.

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Sunday, December 4

Week 22 - Core Holdings

Situation: Seasoned investors will try to strike an investment balance between equities (ownership rights that yield dividends or rent) and credits (loans that pay interest). They also attempt to balance their core holdings with “hedges” that are designed to mitigate potential losses. We introduced an ITR Goldilocks Allocation (Week 3 blog) that is designed to protect against bear markets by investing 67% of the entire portfolio in Lifeboat Stocks (see Week 8 blog) and high grade bonds. The remaining 33% is risk capital--core “cyclical” stocks that rise or fall with world markets.

Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.

On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.

For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGTWMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:

   3 energy stocks (XOM, CVX, OXY)
   3 manufacturers (GD, EMR, UTX)
   1 conglomerate (MMM)
   1 railroad (NSC)

We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.

The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).

Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.

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Sunday, November 27

Week 21 - Recent Performance of Growing Perpetuity Index

Situation: A new business cycle started on Oct 1, 2009 (when the S&P 500 Index 250-day moving average started moving up). We’re 8.5 quarters into the new cycle, long enough to assess total returns for the 12 companies in our Growing Perpetuity Index (Week 4).

We’ll examine the outcome from investing $100 at the start of each quarter to buy XOM, WMT, PG, CVX, IBM, JNJ, KO, MCD, UTX, MMM, NSC, NEE and re-invest dividends received from each. We’ll also assume those investments are cost-free, to allow us to compare our investment with the essentially cost-free Vanguard Admiral S&P 500 Index Fund (VFIAX) that is used by Warren Buffett as the benchmark for all asset classes. We will assess raw returns, unadjusted for management expenses, trading commissions, inflation, or taxes. The Vanguard fund has an expense ratio of merely 0.06%/yr because it requires a large initial investment of $10,000. We will also compare those returns with two balanced funds we have assessed previously, i.e., the Blackrock Global Allocation A (MDLOX) and Vanguard Wellesley Fund (VWINX).

Calculating our results as of 11/15/11, the attached <spreadsheet> is a summary of returns. Only 4 stocks under-performed the S&P 500 Index (PG, JNJ, MMM, and NEE) but all 4 showed positive returns for the ~2 yr period we examined. A total of $10,800 was invested ($900 in each of the 12 stocks), which grew to $12,797 representing a total return of 16.0%/yr (vs. 9.32%/yr for VFIAX and 2.73%/yr for the Consumer Price Index). That out-performance is not surprising given that the Growing Perpetuity Index includes iconic brands that are long-term dividend growers and typically yield more than the S&P 500 Index. Moving forward, we have no way of knowing which of the 12 will disappoint but we do know from back-testing that it is unlikely to be these same 4 stocks. For example, during the decade prior to the recent recession the under-performers were Coca-Cola (KO), Norfolk Southern (NSC), and 3M (MMM). After the recession ended, KO and NSC became strong performers. The performance of MMM is likely to improve if more international markets, like Japan’s, emerge from recession. Therefore, the ITR investment recommendation we will make is that you should regularly invest the same amount in every stock of the Growing Perpetuity Index, even if it only happens once a year. If that’s not practical, we encourage you to research the companies in the ITR Master List and purchase at least 4 DRIPs. Keep in mind that new companies will move onto the list (while others may be removed) on a quarterly basis, whereas the 65 companies in the Dow Jones Combined Average (from which the Growing Perpetuity Index companies are selected) rarely change. If your first 4 DRIPs are XOM, WMT, MCD, and IBM, you will have a solid investment.

Of the funds we mentioned earlier, one (MDLOX) under-performed the S&P 500 Index while the other (VWINX) more than kept up. Treasury notes (VFIUX) also did well.

Bottom Line: Investing regularly in as many of the Growing Perpetuity Index stocks as possible is almost certainly a way to “beat the market”. But a low-cost, bond-centric balanced fund like VWINX will also allow you keep up with the market without all the fuss and worry.

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Sunday, November 20

Week 20 - Mining & Drilling for Key Commodities: Oil & Gas

Situation: The key commodities extracted from the ground (oil, natural gas, copper and gold) are heavily traded on regulated futures exchanges. Open interest amounts to almost $100 billion but many more contracts trade “over the counter”, i.e., removed from the prying eyes of competitors and regulatory agencies. Some of the companies that find and extract commodities also refine, transport, and/or sell their product. Other companies provide additional services and equipment.

Goal: Orient the ITR investor to dividend-paying companies that produce (or support the production of) key commodities.

This week’s blog takes the ITR investor beyond the Master List into cyclical companies that take more chances with more up-front money. Why? Because these companies supply us with essential commodities. High fixed costs characterize every company that extracts materials from the earth by mining or drilling. When commodity prices are high, new companies are tempted to enter the fray, which then drives prices down. The companies that survive the melee can’t afford to continue innovating and expanding; production remains flat or declines until the economy re-expands enough for the survivors to “pick up the slack”. Most companies that dig commodities out of the ground are dependent on investors who are willing to lose everything in the hope of a big return. If it’s a young company that hasn’t had a chance to expand into safer sidelines (refining, transporting, merchandising), it will likely fail. However, these “junior miners” have enormous upside potential and therefore attract investors who want to gamble.

To analyze companies that mine gold & copper, or drill for oil & gas, it is helpful to focus on a particular geological province that attracts a typical grouping of companies. The Western United States is rich in such provinces with the current favorite being the shale formations that mainly yield natural gas. The recoverable oil & gas in these formations is 3 times that known to be present in Saudi Arabia. 

To take a closer look, we will focus our attention first on natural gas plays west of the continental divide. Drilling activities there have expanded rapidly for two reasons: new discoveries and technological breakthroughs that allow formerly marginal geology to be drilled anew. Drilling has increased dramatically since the advent of horizontal drilling and hydraulic fracturing (“fracking”). The Piceance Basin in NW Colorado is the most active recent find but production is rapidly expanding in the well-mapped Green River Basin in SW Wyoming and NE Utah.

The accompanying spreadsheet <click here to open> provides information about 9 companies active in exploration and production (E&P), plus 4 others that provide services and equipment (CAT, NOV, BHI, and SLB). The 6 pure E&P companies are riskiest (APC, NBL, EOG, DVN, ECA, COG) but the 3 companies with refineries (XOM, CVX, and RDS-B) do well through thick and thin, with significant fluctuations in share price because of being tightly tied to the economic cycle. The 4 servicing companies show the fastest earnings growth in each business cycle but with even more marked fluctuations in share price. This pattern (of mining & drilling suppliers reaping the most profit) has held true since as far back as the 1849 California Gold Rush.

All 13 companies pay dividends and are followed by S&P.  XOM, ECA, CVX, and NBL are active in Piceance Basin; DVN, RDS, COG, EOG, APC, APC, and CVX are active in Green River Basin. The drilling activity is hard to miss if you’re driving along I-70 in Colorado between the towns of Rifle and Grand Junction. You’ll see many oil service trucks plus the roadside buildup of servicing depots (e.g. near DeBeque). Driving I-80 west of Rawlins, Wyoming, is even more revealing because there is little else to see. An entire city (Wamsutter) has been built for oil workers where only a single gas station existed 15 years ago. Driving through that barren stretch at night is otherworldly because of lights and mists around drilling rigs that are hard to see by daylight.

The big problem with investing in E&P companies is that there always seems to be a wide variation in the quality of management and a shortage of skilled workers. These problems are related because good workers tend to follow good managers. If you’re investing in Exxon (XOM), Chevron (CVX), Shell (RDS-A) or Schlumberger (SLB), that problem has likely been solved. Here at ITR, we’ve been trying to get a handle on the others. We’ll keep you informed of our progress looking at shale plays.

Bottom Line: Drillers have to make a large up-front investment in order to make a lot of money several years down the road (living with a big “maybe”). Most drilling companies are small and don’t last long but do start strong by using money from impatient investors who are attracted to the potential for great rewards. The drillers that do succeed typically look for sidelines with more stable revenues, i.e., lay pipelines, refine petroleum & develop commodity chemicals, transport those products, and open service stations to fuel planes, ships, trucks, and cars.

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Sunday, November 13

Week 19 - Really Simple Savings

Situation: Many investors want to spend about as much time planning for retirement as they would spend planning for a vacation. They can’t afford to be “dollared to death” by fees and commissions. At the same time, they need a balanced portfolio which means that the “balancer” (or hedge) will increase in value when the stock market tanks.

Goal: Find a straightforward way for a 50 yr old investor to begin to seriously plan for retirement at age 65, without an exorbitant outlay of time or money to set up the portfolio.

Most probably this type of investor doesn’t follow the markets or invest each month in separate DRIP accounts. And we would also guess that $500/mo is the most our investor will commit to setting aside. These caveats leave a Roth IRA composed of no-load mutual funds as the best investment option. The reason is because a Roth IRA is unique among retirement investment options due to its tax-free status with no taxes levied on withdrawals ever, even for the unused money that goes to heirs.

Half the monthly money allotted by our investor ($250/mo) should be used to purchase shares of an S&P 500 Index Fund. The other half should be invested in an intermediate-term US Treasury Fund (i.e., a fund that essentially buys 10-yr Treasury Notes and holds those to collect interest until the principal is returned). Why these two particular choices? Related to stock purchases, this type of investor cannot assume the risk of under-performing compared to the market. Related to bond purchases (i.e., the hedge), this type of investor needs to be in the safest possible market. That would be the asset that the entire world wants to own when financial markets collapse: US Treasury Notes.

All “no-load” mutual fund companies offer both S&P 500 and T-Note funds with low expense ratios. We’ll use T Rowe Price funds to calculate outcomes for monthly purchases made from 2/3/97 through 11/1/11 (14.8 yrs). PREIX is the S&P 500 Index Fund and PRTIX is the intermediate-term US Treasury Fund. Investing $250/mo in each would result in $52,975 in the stock fund (total return = 2.2%/yr) and $69,853 in the bond fund (total return = 5.3%/yr) for a compound annual growth rate (CAGR) of 3.9%/yr (1.5%/yr after inflation). Our investor’s out-of-pocket investment over this time would have been $86,500 and total value would be $122,828. The S&P 500 fund paid out $472 in dividends over the past 6 months and the T-Note fund paid $783 in interest (i.e., the two together currently yield a little over 2%). Since the beginning of good record-keeping practices (1926), the CAGR after inflation is 2.3% for T-Notes and 6.7% for the S&P 500 Index without factoring in expenses. The rule-of-thumb for advising investors (as to what they can expect for planning purposes) is 2% and 4%, respectively. So a 50:50 combination is expected to yield 3%/yr. However, that overlooks the fact that the CAGR drifts upward when leverage (or borrowed money) is used to fuel investments. The opposite occurs with de-leveraging. In other words, when governments/companies/individuals borrow money to make improvements in their investments, those investments grow in value at a more rapid rate than if revenues alone are used to make improvements. When that borrowed money is returned to the lender, revenues are depleted so severely that little is left for “growth” (just google “Italy” for a timely example).

Saving for retirement doesn’t have to be complicated but it does have to be sincere. If you religiously set aside $500/mo beginning at age 50, you’ll have around $125,000 at age 65 in the example above. After retiring, you can spend the $200+/mo of dividends and interest and leave the principal intact. That would allow your spending power to keep up with inflation and your heirs will be titillated. Or you can cash out the funds and purchase an annuity that pays ~$800/mo but won’t keep up with inflation or leave anything for heirs.

Bottom Line: This 50:50 Stock/Bond example is a benchmark for a simple, safe and cheap Roth IRA plan. Interestingly, the initial $500 invested on 2/3/97 held its value throughout two bear markets, though it did fall back to parity ($500) at the depths of the last bear market on 3/9/09. We’ll use that feature to help gauge the safety of other Roth IRA strategies.

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Sunday, November 6

Week 18 - Hardy Perennials

Situation: Some companies manage to perform well through thick and thin.There are lessons to be learned by looking at price performance over the short, intermediate, and long term. Stocks that yield more than the S&P 500 Index provide more of their total return from dividends than price appreciation, but a consistent price appreciation is indicative of dividend payouts that will keep increasing. It can also act as a tip-off to where the economy might be headed. 

Goal: Find common characteristics among the companies that compose the updated ITR Master List and have outperformed the S&P 500 Index over the last 3 mo, 1 yr, 5 yr and 15 yr intervals.

These 11 stocks fit the above criteria and made our cut:

In a previous blog, we discussed what we called Lifeboat Stocks which are companies that sell consumer necessities and carry low debt. This blog's particular group of ITR stock picks has prices that tend to track the S&P 500 Index during bull markets but hold up better during bear markets. Interestingly, of these 11 stocks we find that 5 (MKC, ADP, ABT, NEE, and WMT) are also Lifeboat Stocks. What does this tell us? Quite simply put, that the past 15 years have been dominated by bear markets. 

The remaining 6 stocks (CVX, XOM, OXY, MCD, CL, and NSC) represent “core holdings” that tend to track the ups and downs of the S&P 500 Index. In order to outperform in hard times, these 6 companies would also have to be producing, transporting, or selling essentials. And this does appear to be the case: gasoline stations, electricity, and fast food restaurants have become necessities in our modern society. Each of these 6 companies also faces strong competition, so their out-performance has to be rooted and grounded in management’s focus on innovation and execution

Hardy perennials are flowering plants that take root and then continue to sprout and grow on a yearly basis. This requires a root system that is adapted to surviving sometimes severe weather, often with less than ideal soil conditions. Gardeners come to think of hardy perennials as being not that much different from weeds in that they can be difficult to eradicate and highly adaptable. We will revisit companies that continue to behave like “hardy perennials”.

Bottom Line: We are living through some tough times. The strongest companies remain those that focus on meeting the average consumer’s basic needs.

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Sunday, October 30

Week 17 - Value vs. Growth

Situation: ITR investors need to know the broad outline of a company’s business plan, so they will not be surprised by price swings in bull and bear markets.

Goal: Orient ITR investors to important accounting ratios that will help them characterize a stock.

To some extent, all of the stocks that are covered in ITR blogs can be called “value” stocks because the companies pay dividends, and those dividends are bigger than the market yield. Growth stocks produce a total return mainly through price appreciation, whereas, value stocks produce a total return mainly through sizable dividend payouts. 

Growth companies tend to be priced high relative to earnings and book value, and the total (enterprise) value of the company tends to be high relative to operating earnings (EBITDA) and sales (Revenue). The updated Master List (Week 16) has a column for each of these 4 accounting ratios. Higher ratios represent stock prices that have been “bid up” in expectation of continued growth for both the price of that stock and the economy. That is speculation, whereas, the payment of a dividend is real.

Growth companies like Colgate-Palmolive (CL), Coca-Cola (KO), McCormick (MKC), Automatic Data Processing (ADP), and T. Rowe Price (TROW) pay a modest dividend and have 3-4 elevated accounting ratios. At the opposite end of the spectrum are value companies that pay a substantial dividend and have 0-1 elevated accounting ratios: Sysco (SYY), Pepsico (PEP), Kimberly-Clark (KMB), NextEra Energy (NEE), and Chevron (CVX). “Defensive” industries (utilities, health-care, consumer staples) are the usual source of value stocks. However, you’ll notice that here we have an energy stock (CVX) but no health-care stock. (ABT and JNJ yield over 3% but aren’t cheap.) NEE is partly an energy stock, since only half is a regulated utility (Florida Power & Light); the other half is a wholesaler of wind & solar electricity (NextEra Energy Resources). The fact that NEE and CVX are value stocks tells us that energy production & distribution can be purchased very reasonably. On the other hand, pharmaceutical companies, are unreasonably expensive. Both conditions are likely to reverse because energy companies will be able to raise prices as the economy recovers, whereas, pharmaceutical companies will be constrained by the Affordable Care Act.  

Bottom Line: When the economy recovers, value stocks won’t have much lost ground to recover.

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Sunday, October 23

Week 16 - Revised Master List (Fall 2011)

Situation: It has been 3 months since we published the ITR Master List (Week 5), and it’s been quite a ride. The S&P 500 Index fell 11%. When prices fall, the dividend yield increases even though the dividend amount remains unchanged. So the yield on the Index went from 1.8% to 2.2% (which is more than an 11% increase because over 50 companies also increased their dividend). We thought this week’s blog would be a good time to update our Master List and discuss changes that have occurred.

Goal: Explain changes to the ITR Master List.

<Click here> to view the updated Master List spreadsheet. There are four new columns that have been added: P/E, Price/Book, EV/EBITDA, and EV/Revenue. These have been added to help explain the difference between what is considered a “growth stock” vs. those that are “value stocks” (which will be the subject of next week’s blog).

After reviewing the numbers, we decided that six companies had to be removed from the Master List because their yields were below 2.2% and no longer exceeded the S&P 500 Index. These companies are:

[In addition, ITT was also removed because it was broken into 3 companies as of 10/11.]

Three months ago, all six of these companies had a yield near the cutoff of 1.8% but since then have not fallen in price as much as the S&P 500 Index (11%). IBM and VFC actually increased in price during that market correction. So the yields of these six companies didn’t rise along with that of the Index. In other words, all six enjoy better earnings prospects than the Index as a whole. We expect that promise in growth potential will be reflected in forthcoming dividend increases, which makes it likely they will be returned to our Master List at some point over the next two years.

As some companies have been removed, five new companies have been added to the Master List because they now exceed the S&P 500 Index:

Medtronic (MDT) is in the health care industry and produces surgical equipment; S&P rates its stock at A/M and bonds at AA-. Walgreens (WAG) is a consumer staples company classified as a drug retailer; S&P rates its stock at A+/L and bonds at A. Linear Technology Corporation (LLTC) is in the information technology industry producing integrated circuits; S&P rates it’s stock at A/M but doesn’t offer a bond rating since the company has been retiring debt rapidly. T. Rowe Price (TROW) is in the financial services industry specializing in asset management; S&P rates its stock at A-/M but doesn’t offer a bond rating because the company carries no debt. Dover (DOV) produces industrial machinery such as elevators; S&P rates its stock at A/H and bonds at A.

Bottom Line: The Master List needs to be updated quarterly to remain useful as a planning and investment guide.

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Sunday, October 16

Week 15 - Retirement on a Shoestring: The Rainy Day Fund

Situation: A middle-income worker reaches age 50 without a pension, 401(k), or 403(b) plan. She’ll need to put aside the maximum amount allowed ($6,000/yr) into a Roth IRA. In addition, it would be smart to start a “Rainy Day Fund” (~$1,200/yr) to protect the Roth IRA from being depleted in the event of illness or unemployment. 

Goal: Determine how much money would be in the proposed Roth IRA and Rainy Day Funds (started at age 50) upon approaching a retirement age of 65, using the lowest expenses and least risky investments. 

Everyone needs to have a Rainy Day Fund as the first line of defense for economic well being. It needs to be readily available without paying significant penalty fees for early withdrawal (aside from taxes due). Such a fund should contain enough to pay 6 months of basic expenses. Most people use a savings account but here at ITR we advocate for something a little more remunerative. Consider a fund that balances stocks and bonds 50:50.

On the bond side, the Inflation-protected Savings Bond (ISB) is hard to beat. It is the benchmark for “net net net investing” (i.e., total return after expenses, inflation, and taxes). An ISB has no up-front expenses (and you know from our prior blogs that is a big point). To purchase yours, go to Treasurydirect and set up electronic withdrawals from your bank account. ISBs pay a fixed rate of interest but also add principal in direct proportion to inflation. There are no taxes on an ISB until you cash it in, typically at a time of minimal tax liability, ideally, after retirement. Invest at least $50/mo until you have enough ISBs to cover 3 months of living expenses. A small fee is assessed if you withdrawal your money prior to 5 years after purchase (you pay 3 months worth of interest income).

To cover the remaining 3 months of expenses, invest at least $50/mo in a Lifeboat Stock with a low beta and high dividend. Abbott Laboratories (ABT) meets those requirements and setting up your DRIP using Computershare is user-friendly. There are no fees for an automatic investment plan of as little as $10/mo. [There is one significant inconvenience: the initial shares need to be purchased through a stock broker and transferred electronically to Abbott Laboratories for registration in your name.] Other DRIPs to consider include Johnson & Johnson (JNJ), Procter & Gamble (PG), and Wal*Mart (WMT). Most of those DRIPs charge ~$1/mo but do not require you to register shares through a stock broker.

Once you have your Rainy Day Fund and Roth IRA (review Week 14) on autopilot, you will breathe a little easier. Now you can take an active interest in the rest of your retirement preparations, namely, paying off your obligations which for most people is a mortgage. This will leave you well positioned for starting a reverse mortgage at age 65. We also recommend taking an active approach to keeping your job skills tuned up by taking one evening class per semester at a local community college. This allows the maximum level of flexibility for remaining competitive in your current job, or finding a new job if that (unhappy) situation should arise.

We have attached a Spreadsheet summarizing the investment options mentioned for establishing a Roth IRA (Week 14) and a Rainy Day Fund. ISBs did not become available until 1999, so the history of transactions is shorter than what we’ve used in other examples. But if the total return for that shortened period (3.33%/yr) were to be applied for the same 14.7 yr period as our other examples, the total amount invested would be $8,850 (same as for ABT) and the ending value would be $11,587 instead of the $9,241 listed in the spreadsheet. That would bring the total ending value for the Rainy Day Fund to $24,966 after 14.7 yrs (total return = 4.16%/yr). Since the ending value for the proposed Roth IRA is $155,955, the total savings for retirement equals $180,921. That money could be used, for example, to purchase a fixed annuity paying over $1,000/mo beginning at age 65 in today’s dollars. Alternatively, you could just cease paying the $7,200/yr and draw the annual dividend and interest income from that $180,921 (i.e., $6,107/yr, or $509/mo). That payout would continue to grow ~4%/yr faster than inflation while leaving the principal untouched. Taxes would only be due on expenditures from the Rainy Day Fund. Social Security would likely add >$2,000/mo to your retirement income, which amount is partly taxable but also keeps up with inflation. 

Let’s face it, $2,600+ a month doesn’t go very far even if it is protected from inflation and taxes. This is why setting up a reverse mortgage and continuing to work will become important options to have available for fine-tuning your retirement income.

Bottom Line: Retirement is perilous. Plan ahead. It’s later than you think.

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Sunday, October 9

Week 14 - Retirement on a Shoestring: The Roth IRA

Situation: Many people spend their careers working at jobs that offer slim retirement benefits. Consider this: a year of retirement will cost you about as much as a year of private college. Unlike a child’s college expenses, retirement doesn’t end after 4 years! Many people are now in a situation with big problems looming on the retirement horizon. Those with little money set aside for retirement have only 4 ways to supplement Social Security income (excluding extortion):
   1) convert home equity to a reverse mortgage,
   2) raid their “Rainy Day Fund”,
   3) remain employed for more years,
   4) set up a Roth IRA.

Goal: Explain to a 50 yr old how to start a retirement plan based around a Roth IRA.

Okay, you’ve reached the age of 50 with little by way of retirement savings, and you know you need a sound retirement plan. One thing that Congress got right was to provide middle income workers with a special kind of IRA, called a Roth IRA. With standard IRAs, you receive an annual tax deduction for monies invested but as those monies are spent in retirement you will pay taxes as with ordinary income. A Roth IRA, however, uses monies that are already taxed so that the monies spent in retirement are tax-free. From an accountant’s point of view, a Roth IRA is a bonanza! It shows the lengths to which Congress will go to entice people to save for retirement. 

We want a benchmark to use for the IRA recommendations we’ll be making and have picked the Vanguard Wellesley Fund (VWINX), a bond-centric no-load balanced fund that channels our Goldilocks Allocation to some degree. VWINX had been perking along for several decades without much attention but now investors are taking notice. The reason is that during the recession it posted one of the best records among balanced funds. VWINX has done rather well: investing $200 a month since 2/1/97 would have yielded $57,497 by 10/7/11 for a total return of 5.67%/yr (pretty sweet). This compares favorably to the same investment in the S&P 500 Index, SPY, which would have yielded $40,349 for a total return of 1.69%/yr (not so sweet). The top-performing balanced fund during the recession (MDLOX, the Blackrock Global Allocation Fund that we highlighted in Week 13) yielded $61,233 for a total return of 6.31%/yr (also rocking the house). During that 14.7 year period, inflation averaged 2.5%/yr according to the BLS

After age 50, you can pay $6,000/yr into a Roth IRA. We set up a $3,000 allocation to stocks and picked a model portfolio of 3 “low beta” DRIPs. These were chosen because they carry no investment costs if purchased through Computershare. [Please note: the same purchases could be made using Sharebuilder at an accumulated expense of $144/yr, which cuts 0.5%/yr off your total return.] We selected XOM ($75/mo), BDX ($75/mo), and NEE ($100/mo). Over 14.7 yrs (ending 10/7/11), the $75/mo invested in XOM ($13,275) returned $24,592 for a total return of 7%/yr; the $75/mo invested in BDX ($13,275) returned $25,286 for a total return of 7.28%/yr; and the $100/mo invested in NEE ($17,700) returned $34,860 for a total return of 7.61%/yr. All together, $250/mo was invested in 3 DRIPs ($44,250) and returned $84,738 for a total return of 7.33%/yr. This beats SPY by more than 5.6% a yr. It also beats inflation by more than 4.8%/yr. Other DRIP combinations can be selected and may show even better results.

For the bond side of our demonstration Roth IRA ($3,000), we’ll track $250/mo invested in the diversified T. Rowe Price investment-grade fund, PRCIX. For the 14.7 years ending 10/7/11, that monthly investment would have totaled $44250 and yielded $69,984 for a total return of 5.38%/yr. It is a no-load fund, so we have now constructed a no-load Roth IRA fund balanced 50:50 between stocks and bonds. Our fund is composed of 4 assets and carries no investment costs: XOM, BDX, NEE, and PRCIX. Our benchmark balanced fund (VWINX) is also a no-load fund. In addition, we’ll show what would happen if you invested $6000/yr in MDLOX (Blackrock Global Allocation A), which is also a balanced fund but carries a front-end load of 5.25%. That is, you’d be paying $26.25 in fees with each month’s $500 investment. [While there are other share classes that have a lower initial cost, this is compensated by a higher expense ratio. For long-term investors, the A class shares (MDLOX) are the most economical.] Our model balanced fund composed of 3 stocks and one bond fund yielded $154,633 over 14.7 years on a total investment of $88,500, for a total return of 6.42%/yr. This compares well to the 6.31% total return for MDLOX and 5.67% for VWINX. So our key point is that even the best-performing managed stock fund can be bested by regular purchase and dividend reinvestment using DRIPs in combination with a diversified bond fund, without paying any upfront fees or commissions.

In next week’s blog, we’ll provide a spreadsheet of our proposed Roth IRA and also outline a proposed “Rainy Day Fund”. We’ll include appropriate benchmarks and update the spreadsheet periodically, and model additional DRIP choices from the Master List. In an upcoming edition of “The Incubator”, we’ll discuss the process for incorporating DRIPs into a Roth IRA plan.

Bottom Line: If you’re earning less than $100,000/yr and don’t have a pension plan or 401(k) plan through your employer, it’s time to start a Roth IRA. Don’t delay - the pain only increases!!

<click here to continue to Week 15>

Sunday, October 2

Week 13 - Foreign Stocks and Bonds

Situation: The ending of the Cold War in 1989 and the widespread use of the internet  launched the “global village” in earnest. The US economy now contributes only 25% of the world’s GDP.
Goal: Explain the benefits received when half of an investor’s assets are deployed outside the United States.
In an earlier blog, we defined the ITR Goldilocks Allocation which recommended 1/6th of an investors stock holdings be in foreign investments. A contributing point of fact is that 50% of sales made by S&P 500 companies occur outside the 50 states. Therefore, 2/3rds of recommended stock holdings are drawing part of their revenue from outside the US. Why not recommend an allocation that equals the 75% of world GDP found outside the US? There are 3 key reasons:
   (1) expenses are higher for the international mutual funds that must buy and sell stocks on foreign exchanges and hedge the currency risk
   (2) there is more political uncertainty
   (3) there is less transparency because of less stringent accounting and reporting rules

And then there is this remarkable statistic: several studies report that the coefficient of correlation of international stock indices with the S&P 500 Index is ~0.80. What this means is that economies around the world are strongly tied to the US economy and will move in sync with the US economy. Therefore, there is little risk that the companies on our Master List will fail to benefit from a strong bull market occurring in any country where they sell goods and/or services. Ownership of stock in high quality multinational companies that are based in the US is an indirect means of investing in foreign markets. Many of the Master List companies are heavily invested in Brazil, Russia, India, and China (known by the acronym BRIC), which are large countries that dominate “emerging market” growth.
Broadly diversified bond funds like PRCIX now include some bonds issued by foreign governments and corporations; such funds compose half of the ITR recommended bond allocation. When added to our 1/3rd recommendation for international bond funds like RPIBX, almost 40% of ITR’s recommended bond holdings are outside the US. Why not recommend 75%? Here, the argument is less rational. High quality foreign bonds outperform high quality US bonds by 1-2% because the value of the US dollar has been falling for the past decade. That means you will have to form an opinion about the future value of the US dollar before deciding how much to invest offshore. Recently, the fiscal and monetary policies of the US were redirected to clean up balance sheets at the US Treasury and Federal Reserve. This means the value of the dollar may gradually rise relative to a trade-weighted basket of other currencies. Here at ITR, we are concerned with retirement income and recommend sticking with “the devil we know”, namely, mutual funds and stocks denominated in US dollars - the currency we’ll be spending in retirement.  The type of international bond fund that we are recommending does little investing in emerging markets because such bonds typically carry a high level of risk. But on the stock side of the ITR asset allocation model it is important to capture growth, which is best accomplished by investing in emerging markets.
You may have counted the 1/6ths and noticed that we haven’t yet recommended a safe place to park the last 1/6th of stock holdings targeted to countries where growth is happening. That’s because almost all of the diversified international mutual funds lost more than the S&P 500 Index during the last big downturn, and weren’t beating it by much even before that downturn. Over the past 5 yrs, the S&P 500 Index is more than 1%/yr ahead of foreign indices. And, here at ITR we have only been able to identify two foreign companies that appear to meet ITR’s investment criteria (see Mission & Goals): Total SA (France’s integrated oil company) and BHP Billiton (the Australian mining company).
A generic solution to this problem is to recommend that you resort to a “flexible portfolio” mutual fund, one that can invest in anything anywhere. Few such funds have a long track record but those that do have weathered the recent unpleasantness better than any other category of stock funds. An ITR assessment finds that the flexible portfolio fund with the best track record over the past 15 yrs is Blackrock Global Allocation (MDLOX). It lost only 22% during the “bear market” between 10/9/07 and 3/9/09 vs. the spectacular 43% loss for the S&P 500 Index. As of 9/29/11, its 14.7 yr total return is 7.0%/yr vs. 2.0%/yr for the S&P 500 Index exchange-traded fund (SPY). Those returns are net of expenses (like commissions and front-end loads assessed for making our typical monthly investment of $200) but include the effect of free dividend reinvestment. MDLOX’s out-performance is because of it’s investment model:  a) a significant allocation to bonds, combined with b) stock investments in multinational companies based in developed countries, e.g. IBM, XOM, CVX, JNJ, and Apple (AAPL). To purchase MDLOX shares, use the same financial services company that you used to purchase bond funds (e.g. Fidelity Investments or T. Rowe Price).
But let’s be honest. MDLOX is expensive (management fees of ~2%/yr, regardless of share class), it doesn’t focus on emerging markets, and it depends on interest payments from bonds to maintain cash flow. Emerging market countries grow fast because of jobs in export and commodity businesses that result in dramatic increases in the standard of living. Every year, almost a hundred million people emerge from poverty. Now, those countries are fast becoming consumer-based economies. This is happening not only in the large BRIC countries but also in Turkey, Saudi Arabia, South Korea, Singapore, Chile, and Argentina. This trend has been present for some time, and certain companies have made it their business to market to those new consumers. For example, instead of making a $200/month investment in one of the examples discussed above (SPY or MDLOX), you could be investing in McDonald’s (MCD) where the 14.7 yr total return (net of the $1.50 commission on each purchase you make through Computershare) is 12.1%/yr. Now that’s a lot better than the 2.0% realized for SPY or the 7.0% for MDLOX!! How can “Mickey D” maintain such an outstanding performance through the bear markets of 1998, 2001-2, and 2008-9? Because for more than 20 years it’s business plan has focused on rapid expansion in emerging markets, capitalizing on the fact that 30% of income for those households goes for food vs. 8% here in the US (T. Rowe Price Report, issue 112, summer of 2011, p. 8).
Bottom Line: The US economy is still “the tail that wags the dog” but the dog (economies outside the US) is growing faster than the tail. Half of your assets need to reflect that growth.

<to continue to Week 14 click here>