Sunday, August 28

Week 8 - Lifeboat Stocks

Situation: Investors aren’t interested in losing money. So when they venture into direct ownership of stocks, they want to start by investing in companies that can sidestep risk.

Goal: Orient the investor to companies that (a) meet our investment criteria (Mission and Goals), (b) carry low debt (Week 7 - Risk), and (c) are in “defensive” industries that weather recessions, i.e., utilities, consumer staples, and health care (Week 6 - Summary).

Any buy-and-hold investment portfolio contains stock in companies that sell things consumers can’t avoid buying. Those companies don’t have to cut prices during a recession. People always buy toothpaste at the price they’re used to paying: there is no elasticity of demand. Even if the cost of making toothpaste goes up, passing those costs onto the buyer will not reduce demand. There is a Vanguard consumer staples Exchange Traded Fund, VDC, that illustrates this idea. When graphed vs. SPY, both increased together in price during the 2004-2007 economic expansion but VDC held up much better during the subsequent recession.

There are 9 companies producing consumer staples that meet the ITR investment criteria:
Procter & Gamble (PG)
Wal-Mart (WMT)
Coca Cola (KO)
Pepsico (PEP)
Kimberly-Clark (KMB)
Colgate-Palmolive (CL)
McCormick (MKC)
Sysco (SYY)
Hormel Foods (HRL)
However, PEP, CL, and KMB are burdened with debt, leaving only 6 companies that ITR has dubbed “Lifeboat Stocks” in the consumer staples industry - a safer haven for queasy investors following a stock market roller-coaster ride.

Health care companies are defensive in nature and also have pricing power but those stock prices are particularly sensitive to government regulation and patent expirations. Nonetheless, this industry has performed without peer. One reason is that pharmaceutical companies have to recognize research and development (R&D) expenses on their financial statements as an operating cost, which is then written off (or "amortized") annually. No other industry is so dependent on R&D: fixed costs (property, plant and equipment) usually dominate and these are amortized over decades. There are 3 health care companies meeting the ITR investment criteria that avoid being bloated with debt:
Johnson & Johnson (JNJ)
Abbott Laboratories (ABT)
Becton-Dickinson (BDX)

Public utility companies are defensive because electricity is a necessity, guaranteed and priced by the state. These monopolies have enormous fixed costs and are financed mainly with government-guaranteed debt. Only one company
NextEra Energy (NEE)
meets our investment criteria and carries a below normal debt load for that industry. NEE is actually two companies, one being Florida Power and Light and the other being Next Era Energy Resources - an unregulated electricity distributor that owns more wind and solar generating capacity than any of it’s North American counterparts.

Finally, there is an unusual information technology company that performs like a lifeboat stock:
Automatic Data Processing (ADP)
This, you may recall, is one of only 4 companies that carry a AAA bond rating. It has little long-term debt (0.7% of capitalization) because it’s business plan generates such a small return on assets that use of debt financing cannot be justified (unless interest rates are very low). ADP is used by other companies to outsource their routine business services. For example, it is the largest company in the world processing payrolls. ADP also accepts a variety of additional “human resources” assignments: e.g. tax filings and business-to-business (B2B) transactions, such as those between an employer and an automobile dealer. ADP will hold payroll funds for a short period of time, e.g., to make Social Security transactions, assign funds to 401(k) plans, etc., and during this period the funds are invested in ultra-short term bonds.

Interestingly, 8 of the 11 Lifeboat Stocks performed substantially better than SPY during the down-turns of October 2008 and August 2011: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE. And, all 8 measure up well with respect to the 6 risk parameters outlined in our Week 7 blog Risk.  As of 8/25/2011, 6 of these 11 have outperformed SPY over the most recent one month, 3 month, 6 month, one yr, two yr, and 5 yr intervals:  KO, BDX, ADP, HRL, and MKC.  

Bottom line: We have identified 11 Lifeboat Stocks:  PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE, HRL, SYS, and MKC. The total return from investing $200/mo in each (since January of 1993) exceeds the total return from investing $200/mo in SPY over that period. Five of these companies are in our Growing Perpetuity Index (KO, PG, WMT, JNJ, and NEE). The results from making a $200/mo investment in each of these 5 companies vs. SPY  are broken out in the accompanying Lifeboat Stocks Table. Their out-performance is unambiguous.

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