Sunday, July 31

Week 4 - Introducing the ITR Growing Perpetuity Index

Goal: To compose a value stock index that tracks the S&P 500 Index over two market cycles but with greater total returns and less risk. In the ITR Mission and Goals statement we define these companies as composing what we call the ITR Growing Perpetuity Index (GPI).

  • Companies selected for the GPI must: 
    • be members of the 65-stock Dow Jones Composite Index;
    • have a dividend yield greater than or equal to the yield for SPY (the exchange-traded fund that mimics the S&P 500 index);
    • have increased their dividend for 10+ years;
    • issue stock that has an S&P Quality Rating of A- or higher;
    • issue bonds that have an S&P Bond Rating of BBB+ or higher.
  • Currently, we find there are 12 companies that meet our criteria and thereby make up ITR's GPI:
    • ExxonMobil (XOM)
    • WalMart (WMT)
    • Procter & Gamble (PG)
    • Chevron (CHV)
    • Johnson & Johnson (JNJ)
    • Coca-Cola (KO)
    • McDonalds (MCD)
    • IBM (IBM)
    • United Technologies (UTX)
    • 3M (MMM)
    • NextEra Energy (NEE)
    • Norfolk Southern (NSC)
  • We used two benchmarks to test the validity of our selection method. One is the longest-running exchange-traded fund that mimics the S&P 500 Index (SPY). The other is the S&P 500 Index mutual fund that carries the lowest expense ratio (0.06%): Vanguard 500 Index Admiral (VFIAX). SPY is traded like any other stock on the New York Stock Exchange (NYSE), whereas, VFIAX is a no-load mutual fund that requires an initial investment of $100,000 and cannot be traded.
  • We need two market cycles to show that stocks selected for the GPI really do outperform SPY. SPY started trading on January 29, 1993, and for the first time it became possible to make "apples to apples" comparisons, i.e., purchase the Index and simultaneously purchase a stock. SPY "went live" two years and 4 months after the (250-day moving average of the) S&P 500 Index hit bottom due to the 1990-92 recession. The next bottom occurred in June '03 and the last in October '09, completing two market cycles. January 31, 2012 will be the two market cycle anniversary for SPY since it began trading exactly 19 years earlier.
  • To specifically compare the total return of a GPI stock to SPY, we calculate the total return from an investment of $200/month from 2/1/93 until the present day. Our virtual purchases follow the rules for a DRIP account using the ING website (ShareBuilder): namely, a $4 commission is charged for stock purchases but dividends are re-invested for free. For the 18 years from 1993 to 2011, we find that the total return for SPY was 5.1%/yr, whereas, the total return for each of the selected 12 stocks in the GPI was greater. For example, the total return for WalMart (WMT) was 7.3%/yr, for Coca-Cola (KO) was 5.4%/yr, and for NextEra Energy (NEE) was 7.6%/yr.
  • We are developing a methodology for anticipating when a Dow Jones Composite Index company is soon going to meet all 5 criteria for membership in the GPI. For example, it became clear in 2007 that Wal*Mart’s Chief Financial Officer (CFO) intended to rapidly increase dividend payouts such that WMT would soon have a yield greater than that of the S&P 500 Index. Given that WMT already met the other 4 criteria for inclusion in the GPI, we could have predicted that WMT would be added to the GPI by 2010.
  • Similarly, we are developing a methodology for anticipating when it will soon be necessary to remove a company from membership in the GPI. For example, the 2008 Panic negatively impacted 4 companies that already met all 5 criteria for the GPI – Caterpillar (CAT), Home Depot (HD), Pfizer (PFE), and General Electric (GE). Those companies were soon forced to withdraw plans to raise their dividend; PFE and GE eventually cut their dividend.
  • One of our goals is to highlight companies outside the Dow Jones Composite Index that otherwise meet criteria for inclusion in the GPI. Approximately 20 such companies exist in the S&P 500 Index. Some of these strong performers will eventually replace companies now in the Dow Jones Composite Index, and thereby become members of the ITR GPI. In our blog next week, we will introduce you to the ITR Master List of those companies in the S&P 500 Index.
Bottom line: Here’s 12 stocks that can be comfortably added to a very long term DRIP investment portfolio.

Click here to move to Week 5

Sunday, July 24

Week 3 - Goldilocks Allocations

Goal: To introduce asset allocation choices (the main drivers of investment returns) that minimize the risk of temporary loss while maintaining strong returns over two market cycles.

The internet makes it possible for investors to simply point and click their way to a balanced portfolio and cut out paying the middle man. This is important in the maintenance of a balanced portfolio for several reasons. First, it is less expensive—management fees are eliminated and commissions are reduced to less than a dollar a share. Second, use of an intermediary agent, such as a mutual fund portfolio manager, introduces what are called agency issues. Agents carry additional costs besides fund management fees: your investment can be allocated in ways that subject your funds to excessive risk of loss, and you will know nothing about it until it is too late. You own the cash you entrust to financial intermediaries but they are not required to act in your best interest. For example, the manager of a mutual fund may select risky stocks in an attempt to out-perform the relevant benchmark. This fund could achieve that during an “up market” but would surely underperform during a “down market” because stock market “risk” is what statisticians call “variance”: it cuts both ways. Risk, with respect to stocks, translates into the risk of bankruptcy for that company. For example, a stock that is unable to pay a dividend and is issued by a company that is deeply in debt is risky—its expenses exceed its earnings. The price of that stock will vary depending on whether the economy is strong enough for its products to be sold at a profit. Its price swings will be exaggerated because the chance it will have to declare bankruptcy is about the same as the chance it will earn enough to pay its debts. Another example is that of companies that are publicly owned but mainly operated by employees who are not shareholders (Berkshire Hathaway and Microsoft being notable exceptions). Those employees are being paid to act as the owner’s agents but they will probably act first to secure their own jobs and enhance their own remuneration.

An individual investor can best minimize the conflict between her needs and agency issues by eliminating this middleman, diversifying her holdings, and investing in companies that value shareholders by paying a reasonable dividend (25-50% of earnings) that increases every year. Direct ownership of stocks is done through Dividend Re-Investment Plans (DRIPs). Almost every S&P 500 company has a DRIP; some companies even waive all expenses. Computershare (computershare) services the largest number of DRIPs. The US Treasury issues the largest number of investment-grade bonds (treasurydirect) and also waives all commissions.

Changes in the macro economy (such as recession and inflation) are externalities that we try to anticipate through asset allocation decisions. For example, commodity-related stocks keep step with inflation and consumer-staples stocks retain value during a recession. Our ITR asset allocation plan is designed to weather these storms without sacrificing upside potential.

In future blogs, we will explore the ITR Investment Strategy:
  • Use do-it-yourself point-and-click investment in assets that generate dividends or interest (computershare);
  • Use a 50:50 balance of stocks and bonds;
  • Select stocks that yield as much or more than the S&P 500 Index (SPY);
  • Select stock in companies that have increased annual dividends for at least 10 years;
  • Avoid derivatives (assets linked to other assets) except for a global allocation stock fund and two bond mutual funds;
  • Stock allocations: 50% industrial & commodity-related, 33% defensive (consumer staples and health care related), and 17% in a global allocation mutual fund;
  • Bond allocations: 17% in 10-year US Treasury notes (treasurydirect); 33% in an international bond mutual fund, and 50% in a diversified investment-grade bond mutual fund. A future blog will provide detailed information about purchasing no-load bond funds online.

Bottom Line: Conserve assets, minimize expenses, and maintain what you’ve obtained. Forget about the big kill but instead seek a portfolio similar to one which investors call a “Goldilocks Economy”— not too hot and not too cold.

Click here to move to Week 4

Sunday, July 17

Week 2 - Underlying Principles for the ITR Investment Strategy

GOAL: to introduce you to the theory and tools behind the ITR blog. [If you haven’t already visited our “Mission & Goals” tab, you might want to read those before continuing.]

Tool #1:  Dollar Cost Averaging

How it works:  A fixed dollar amount is invested into a DRIP every month or quarter. The reason this is important is because “dollar cost averaging” ensures that a larger number of shares are purchased during periods when the stock price is depressed. This is counter-intuitive: the price is falling and your investment keeps falling in value. But it is obvious that you can buy more shares than usual at these cheap prices, and (here’s the really important part) the number of shares in your DRIP account determines the size of your quarterly dividend. This dividend is then automatically re-invested: you are using your “pay-out” to buy more shares. During a bear market, it is important to remember that the market slump is exaggerated by negative investor sentiment. The same applies to bull markets: Whatever the fundamental reason is for rising stock prices, the over-enthusiasm of stock traders makes the price go even higher. Market sentiment is said to account for 30% of pricing in the short term but 0% in the long term. A DRIP investor with a $100/month automatic purchase plan will need to possess a strong stomach to keep watching the stock price fall. But her $100/month will purchase an ever-increasing numbers of shares while the market is falling. What appears to be a fool’s errand in the short run becomes a very smart strategy in the long-term.

Tool #2: Compound Interest

How it works: You start the ball rolling by purchasing some shares for your DRIP. After that, dividends are going to be paid on those shares and that money will automatically purchase more shares. Those shares will pay a dividend 3 months later and that money will automatically purchase more shares. In other words, dividends are paid on dividends. This is a mathematical formula for achieving wealth over time. Even if you have to stop contributing your dollars to the DRIP during a period of financial hardship, you will continue to receive dividends and those will be used to buy even more shares. The total return of the S&P 500 Index is a product of price appreciation and dividend re-investment: 40% of the 9.9%/year growth of the S&P 500 Index since 1925 ( has been due to re-investment of dividends.

Tool #3: Reversion to the Mean

How it works: When you follow the price of a company’s stock over a number of market cycles (2-3) and compare those prices to the earnings posted by the company, what you will find is that the price of the stock will tend to revert to a mean value of approximately 15 times earnings. So when we find a stock that is selling for more than 20 times earnings, we know it’s over-priced. Conversely, when we find a stock that is priced at 10 times earnings, we consider it to be a bargain. What is “the Mean”? It’s approximately 15 times earnings for ALL assets!! As an example: a house is purchased for 10 times its annual rent, making it a reasonable investment. Then later on, someone offers to buy it for 20 times rent-equivalent income. That would be a really good deal since its price is eventually going to drift back to 15 times rent-equivalent income. This “drift” is called reversion to the mean. It is a basic tenant for buying and selling investments, i.e., buy low, sell high (and we didn’t even charge extra for that little gem!). Another example: the US Treasury offers 10% interest on a 30 year bond but later on the Treasury may pay only 5% interest on a new 30 year bond. That would be a good time to sell the first bond. It’s worth a lot more than what you paid for it because it’s still paying 10% interest whereas the prevailing rate is 5%. Our third and final example: You purchased a stock for 10 times earnings and later it appreciates to 20 times earnings. This is a good time to sell because reversion to the mean is eventually going to take this stock’s price back to 15 times earnings (and you don’t want to be holding it when that happens).

Tool #4: Benchmarking

How it works: This gives us a yardstick for comparing different kinds of businesses and allows selection of stocks that meet our value criteria. Our benchmark is the S&P 500 Index; more specifically, we will use the investible form of that index (SPY) that can be bought or sold like a stock. The S&P Index includes the 500 largest publicly traded US companies. It is “capitalization-weighted”, meaning that the contribution of each stock reflects the value of all that company’s stock. The S&P 500 Index is also non-selective, meaning that all 500 of the largest publicly traded companies in the country are included. Other broad-based indexes use different methodologies. The Dow Jones Indexes, for example, are price-weighted (closing prices are totaled at the end of each trading day) and selective (the Managing Editor of The Wall Street Journal picks the stocks): Dow Jones Industrial Index has 30 stocks, Dow Jones Transportation Index has 15 stocks, and Dow Jones Utility Index has 20 stocks; these are combined in the Dow Jones Composite Index (from which we will select the stocks that will comprise the ITR “Growing Perpetuity Index” that will be introduced in an upcoming weekly blog). Dow Jones Indexes are unscientific but nonetheless represent the Gold Standard of Indexing. Why? Well, they’ve been around longer than the S&P indexes (1884 vs. 1926) and their total returns beat comparable S&P indexes. For example, there are 12 companies in the 65-company Dow Jones Composite Index that meet our value criteria vs. fewer than 35 companies in the S&P 500 Index.

BOTTOM LINE: ITR will use value-investing principles to help our readers select stocks for regular purchase in a DRIP account. We also use a buy-and-hold approach that requires discipline and patience. The main criticism, really, is that our approach to investing is like watching paint dry: it’s very boring. So we’ll try to get our readers to think of boring as a synonym for investing, and interesting as a synonym for gambling.

Click here to move to Week 3

Sunday, July 10

Week 1 - An Introduction to Our Blog

Who benefits from reading our ITR blog every week?

That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.

The ITR target investor is one who finds the information provided about stock mutual funds to be inadequate. While bond mutual funds describe investment style in terms of both the credit risk and average time to maturity (risk of loss in value of long-term bonds due to inflation), similar information can be difficult to ascertain with stock mutual funds. Even when a company issues bonds, as most do, it is difficult to access that information. This is probably because many companies issue bonds that carry high credit risk and have long maturation periods. Standard & Poor's (S&P) rates each company's common stock and bond portfolio but that information is not required in a stock mutual fund prospectus. Managers of stock mutual funds like to invest in riskier stocks because in a “bull market” those stocks make the fund perform better than the relevant benchmark index. This is good for advertising because it suggests that the fund manager is a brilliant stock picker. But such is not the case: in a “bear market”, losses will be greater than for the benchmark. This is why the large majority of stock mutual funds lost more in 2008 than the standard benchmark – the S&P 500 Index, which lost a whopping 37%. And that 37% loss is just too great for our ITR reader. Having been burned, she will now shy away from stock mutual funds and wants to learn to invest directly in company stocks on her own.

This is best achieved by using a company's Dividend Re-Investment Plan (DRIP). Using a DRIP keeps trading costs low (you don't pay fees to a broker) and allows you to capture the power of compound interest through automatic re-investment of dividends. A monthly electronic purchase plan results in “dollar-cost averaging”, giving a certainty of buying cheaply during market down-turns. This type of an investment strategy lets our ITR investor develop a portfolio of 5-10 stocks with dividend re-investment, just as a bond mutual fund manager reinvests interest payments.

Now the problem for our investor becomes one of concentration: holding fewer than 50 stocks in a portfolio exposes the portfolio to market risk. There are two things that offer protection. One is to confine purchases to stocks that carry S&P Quality Ratings of A- or above, and the second is to choose only those companies that have increased dividends annually for at least 10 years. Stock in dividend-paying companies has been shown to hold up better in market downturns, thus some "insurance" is obtained by choosing stocks that yield more than an S&P 500 Index Fund (an example is SPY, an exchange-traded fund; current yield 1.8%).

Stock market risk can also be reduced (or hedged) using two other tools: diversification of holdings across industries, and by investing in other markets: foreign stocks, bonds (both US and foreign), rental properties and commodities markets. Problems arise though: commodity futures contracts pay no interest or dividends, and charges are steep, making these instruments suitable only for short-term investing by expert traders. Rental properties also carry significant charges. Unless one owns a Class A apartment building in a growing town, rental income isn't going to help in a stock market crash because occupancy will likely fall. Risks from owning a single apartment building can be diffused by owning a real estate investment trust (REIT) that invests in a number of Class A apartment buildings in different regions of the country, but value will still fall in a difficult economy. Thus, REITs are not a useful asset for someone who emphasizes capital preservation.

Let's take a closer look at companies that produce, package, transport, and market commodities. Some of these have S&P Quality Ratings of A- or better, yield as much or more than SPY, and have increased that payout annually for at least 10 years. (Whoa! Now our investor is tuned in . . .) These companies have found a way to develop raw commodities and consistently produce reliable streams of cash flow for reinvestment (after dividends are paid to stockholders and interest to bondholders). The major traditional commodities with a regulated "futures" market include corn, soybeans, wheat, live cattle, lean hogs, cocoa, coffee, sugar, gold, silver, copper, crude oil, heating oil and natural gas. There are 6 companies meeting our criteria that manage these feedstocks as their primary line of business. A future blog will identify and discuss these companies. All 6 had a 10-year total return of at least 7.7%/year, whereas, the median total return of a Fortune 500 company over that period was 6.7%/year (Fortune Magazine, May 23, 201, volume 163, no. 7, pp F2-F32) and the total return for the S&P 500 Index was 1.3%/year ( However, commodity producers like these 6 companies suffer during stock market pull-backs, such as the one we've just experienced. A future ITR blog will discuss how to manage this risk.

Commodity markets are priced in dollars and globally sourced, which is the main support for their investment value. Therefore investments that are tied to a commodity represent a hedge against dollar depreciation. For that reason alone, it is worthwhile to buy stock in companies that can pass changes in valuation along to end-users. Future installments of our blog will address other key inputs to the economy that behave similarly, such as electricity.

Bottom Line:  Our weekly ITR blog will provide you with tools that allow you to become your own fund manager. We know it’s a complicated undertaking and difficult for new investors to feel comfortable with these concepts. Each week we will post our take on the topics we’ve introduced to you and provide further analysis and tools for you to use in managing your portfolio.

Click this link to move to Week 2