Sunday, September 25

Week 12 - AAA stocks and bonds

Situation: Investors have been casting about for “gold standard” investments, i.e., portfolio assets that won’t suddenly collapse in value. This role can be filled through the purchase of AAA bonds issued for sale by four companies, and from several foreign countries.

Goal: To outline investments that add security to your portfolio.

Lately we’ve heard much about AAA bond ratings. And as much as we’d like to find a counterpart among stocks, there isn’t any such equivalent AAA stock. The closest one can come is to own stock in Johnson & Johnson (JNJ). In our previous post entitled Risk (Week 7), we described six ways to assess the risk associated with owning stock in a particular company. Only JNJ came up clean on all six measures. Another endorsement for JNJ came after the Panic of 2008, when a Roundtable Discussion in the 1/12/09 issue of Barron’s focused on the difficulty companies had borrowing money after Lehman Brothers defaulted on September 15, 2008: “Is it going to be harder to borrow money to buy businesses?” Mario Gabelli’s answer was that “it won’t be harder for Johnson and Johnson...” (Barron's 2009 Roundtable, Part One -- Hang on Tight!). The reason JNJ is immune to Creditor’s Disease is that it uses debt sparingly and surrounds itself with a wide “moat”, meaning that for many years it has implemented a strategy that prevents competitors, suppliers, and buyers from defeating its business plan. Johnson & Johnson has the highest-rated or next highest-rated products in most corners of the fragmented health-care market, including pharmaceuticals, medical equipment, over-the-counter drugs, and health-care supplies.  

Four companies issue bonds that are rated AAA by S&P:
   Microsoft (MSFT)
   Exxon Mobil (XOM)
   Johnson & Johnson (JNJ)
   Automatic Data Processing (ADP)

However, Automatic Data Products’ long-term debt is only 0.7% of total equity because its business plan rarely generates enough return on assets to exceed the interest rate it would have to pay for borrowed monies. This means that ADP issues few bonds. Microsoft, a dying monopoly, has tens of billions in cash looking to be used in preparation “for that day”. Since it possesses such a mighty reserve, Microsoft also issues few bonds. Exxon Mobil’s total bond issue amounts to only 10% of equity. Johnson & Johnson issues more bonds, up to 30% of equity. The bonds of all 4 companies are reasonable and safe investments. However, individual investors are at a major disadvantage unless they already possess a lot of wealthy. You have to be able to buy these bonds in multiples of $25,000 or you pay unreasonable transaction costs, which negate the purpose for buying the bonds in the first place. 

The United States no longer has an unambiguous AAA rating on it’s long-term bonds but several countries outside the troubled Eurozone do issue such bonds:  Australia, Canada, Denmark, Norway, Singapore, Sweden, Switzerland, Liechtenstein, the United Kingdom, and Hong Kong. For Americans, Canada is the first place to shop for AAA sovereign credits. Fixed-income analysts also have a high opinion of those issued by Norway, Australia, and Singapore. For investors with limited capital, it is not reasonable to try owning sovereign credits other than those issued by the US Treasury, which are available cost-free in $100 lots at While 30-yr Treasury bonds have been downgraded by S&P to AA+, shorter duration issues retain the AAA rating: 10-yr Treasury notes represent a safe and rewarding investment for those who are prudent and employ dollar-cost averaging and re-invest interest payments. More importantly, 30-yr Treasury bonds are likely to regain their AAA rating soon. Why? Because fiscal policy (controlled by Congress) and monetary policy (controlled by the Federal Reserve Board) no longer promote deeper indebtedness as a means of “jump starting” the economy. In other words, “strong dollar” policies have replaced “weak dollar” policies. We alone, among major economies, are stopping the expansion of government and central bank balance sheets. 

Bottom Line: For investors looking to buy corporate bonds rated AAA by S&P, choices are pretty much limited to those issued by Johnson & Johnson and Exxon Mobil. Sovereign bonds of Australia, Norway, Singapore and Canada are also safe investments, as well as 10-yr US Treasury notes. While stocks in general are 4-5 times more risky than investment-grade bonds, the bonds issued by Johnson & Johnson, Exxon Mobil, and Automatic Data Processing are remarkably stable and worthwhile investments because they pay a high and growing dividend and carry no risk of bankruptcy, hence the AAA bond rating.

<to continue to Week 13 click here>

Sunday, September 18

Week -11 Summary - Punters and Bolters (we’re neither)

Situation: There are many styles of investing, and “buy and hold” is currently out of style. Here at ITR, we propose that the modest but relatively stable returns from buy-and-hold investing can be optimized by a) limiting our stock investments to those that are of high quality and have provided a total return that beats the S&P 500 Index over two market cycles, b) emphasizing the centrality of bonds, c) cutting transaction costs, and d) buying stocks and bonds when they’re cheap. These goals can be met with dollar cost averaging by using online dividend re-investment plans (DRIPs) and no-load mutual funds.
Goal: Summarize ITR’s investment philosophy.
We focused on Risk in the Week 7 blog, and the conclusion was pretty straightforward: risk comes from borrowing money to buy things. The government helps homeowners and corporations borrow money by making interest payments non-taxable. Both homeowners and corporations enjoy a greater return on investment by borrowing part of the capital needed to buy homes and expand facilities. These policies act to lower interest rates and accelerate economic growth but all debts eventually have to be repaid. Let’s start with your present situation (if not yours, then your neighbor’s).
What happened to your retirement savings? For many of us, our savings consisted mainly of our home equity - the same equity that we refinanced to pay the college tuition of our kids, or pay off credit cards, etc. Likely as not, your home equity is now a negative number since home equity equals market value minus the mortgage balance.
What caused your home equity to collapse? Owning real estate has historically been the riskiest sector in any economy. Values can change dramatically in both directions, and will follow the boom and bust cycle of the construction industry which, in turn, follows the boom and bust cycle of interest rates - often set unrealistically low by the Federal Open Market Committee. Twenty years ago, our government (aided and abetted by bankers and financiers) began to encourage home ownership by whatever means necessary. This compounded the risk inherent in home ownership by allowing mortgages to be obtained without evidence the loan could be repaid (Gretchen Morgenson and Joshua Rosner: Reckless Endangerment, Times Books, New York, 2011). Other governments, such as Canada’s, continued to restrict home ownership to those with adequate finances to make a down payment and an earnings horizon that is likely to fund repayment of the loan. The Canadian government did not have to bail out it’s banks during The Great Credit Bust of 2008. Canada did not have a credit bust, nor did Canadian homeowners default on their mortgages at an increased rate.
How is my home going to recover it’s value? That will happen when enough babies are born, enough vacant and run-down homes are bulldozed, and enough foreclosed homes are sold. Then, a growing demand for housing will encounter a dwindling supply of suitable houses or apartments, and prices will rise accordingly.
Our view at ITR is that the decision of where to live is a personal choice based on utility, and that it is better to take a less personal and risky approach to saving for retirement. We recommend sticking to stocks & bonds, where a great deal of historical data illuminates the choices you’ll make. Unfortunately, some people try to find the same kind of personal gratification from owning stocks & bonds that they seek in owning a home. Personal gratification of the short-term kind is also known as an adrenaline rush. This rush is addicting and leads to “short-termism”. When dealing with stocks & bonds, a short term mentality leads to a high turnover rate: Half or more of the positions in a stock portfolio are different at the end of each year than at the beginning. With respect to managed mutual funds, where turnover rates often exceed 30%, portfolio managers try to predict a company’s future prospects but then change their mind and sell a holding they label “dead money” to pursue something more promising. In Great Britain, the term that is applied to such speculators is “punter”. A related term is “bolter”, denoting one who engages in poorly considered asset sales. Either action may be based on rumors, since insider information is one way to beat the market. The point is that either behavior may exist to provide the next adrenaline rush, which can become habit forming and spread to things (“starter home”) and people (“starter wife”).
With stocks, the ITR goal is to offer a long-term path to improve on the performance of the S&P 500 Stock Index while incurring less volatility. Bonds (including international bonds) are used as a hedge against stock market over-valuations and currency risk. Our recommendation is to make careful but small purchases of each stock regularly in a DRIP, and to continue this for at least 10 years. It is a good idea to pick at least 5 DRIPs. (For example, this writer dollar-averages into IBM, KO, XOM, NEE, and JNJ.) Over time, you will expend the same amount of money when stocks are over-priced as under-priced. The key point is that such a program forces you to buy stocks when almost no one else is buying. Many studies have shown that the greatest risk faced by the individual investor is that she will stop buying stocks during a recession, and stop buying bonds when the economy is booming and stocks are soaring. Even worse, she may decide to sell stocks during a recession in order to buy into bonds (which are overpriced at that point), i.e., unless she is firmly committed to dollar-cost-averaging she will “buy high and sell low”.
Investors today have an added advantage in being able to use a computer-based “point-and-click” method of acquiring stocks and bonds. This approach takes on the importance of being a “best kept secret” in investment strategy because it allows small investors to keep their buying and selling fees to a minimum. Witness the myriad ways that mutual fund managers are using to deplete earnings from pension funds by levying mysterious and ill-explained fees or paying commissions for a high turnover rate! Being your own fund manager allows those expenses to be recouped and added back in to your investment. You’re only going to sell a stock if a) you retire, or b) the reasons you bought it no longer apply (i.e., it falls off the Master List).
Bottom Line: A 50:50 stock:bond portfolio is a safe and effective way to save for retirement, particularly when a) the internet is employed to lower costs, and b) purchases are made regularly through automatic electronic withdrawals from your checking account so as to be certain of catching financial assets when they’re “on sale”. Variance and risk are further reduced if your stock selections are confined to high-quality companies with a history of a) carrying less debt than equity, and b) increasing dividends annually.    
The stock market has been particularly volatile for the past several weeks, providing a test of sorts for our quality-based stock-picking thesis. As of 9/10/11, 8 of the 34 companies on our Master List have out-performed the S&P 500 Index (in terms of price) over the past month, 3 months, 6 months, yr-to-date, two yrs, and 5 yrs: CVX, KO, CL, MCD, PG, MKC, VFC, and GWW. We know of only one mutual fund that has managed the same feat, VWINX (the bond-heavy Vanguard Wellesley Income Fund).

<to continue to Week 12 click here>

Sunday, September 11

Week 10 - Commodity-related Stocks

Situation: Industrial and/or agricultural commodities represent the necessary feedstocks (i.e., inputs) for producing the items that are sold by many companies. The “spot price” for a commodity can vary widely, often driven by scarcity. Other influencing factors include production bottlenecks, transportation problems, weather, war, and changes in currency valuation that the commodity is priced in - usually the US dollar. For many commodities, prices are set for future sale through “futures contracts” using formal clearinghouses and regulated futures exchanges. For other commodities, an informal “forward contract” between parties is arranged through a bank. Additional companies have sprung up around production and/or transportation of key commodities, and have learned to factor in the many problems entailed. These are the types of companies we will examine for investment value this week.

Goal: To orient the investor to the few commodity-related companies that meet ITR’s investment criteria.

Such commodity-related companies are a key category of stock ownership. Why? Because most commodities are priced in US dollars (but produced elsewhere), which becomes a major factor driving total return for those stocks. Owning stock in such a company gives the investor insurance against devaluation of the dollar (currently running +5% per yr).  Another reason is that economic activity is, in large part, a function of commodity consumption. For example, you may have heard the term “Dr. Copper” thrown around by market pundits on TV shows. It simply means that a change in the price of copper foretells a change in GDP of countries that require large amounts of copper to expand their infrastructure. So the most credible “weatherman” for predicting the economic climate in China, for instance, is the price of copper from mines in Northern Australia and Indonesia.

Futures exchanges trade the most common raw commodities (e.g. oil, natural gas, corn, wheat, copper, gold). Roughly half of the companies in these markets process and/or transport raw commodities. The others are end-users or speculators who bet on price changes. ExxonMobil (XOM), Chevron (CVX), and Occidental Petroleum (OXY) are commodity-related stocks that meet our investment criteria. Two foreign stocks BHP Billiton (BHP, an Australian mining company) and Total SA (TOT, an integrated oil company in France) also appear to meet our criteria. Neither has been assigned a quality rating by S&P but both have total returns, large and growing dividends, and bond ratings consistent with our criteria (see the ITR Mission & Goals).

Two other economic sectors contain some companies that are commodity-related:
(a) railroads and other shipping companies
(b) electric utilities
Most of the bulk cargo carried by freight trains and river barges is either a commodity or a commodity chemical. One of the railroads, Norfolk Southern (NSC), meets our quality criteria.

Some electric utilities source energy directly from their own wind farms and solar arrays instead of relying 100% on outside energy sources, such as natural gas, coal, and processed uranium. Wattage obtained from wind or solar is undependable and difficult to store (batteries aren’t yet big enough), so excess power is promptly sold to other power companies on the grid: A modern electric utility consists of a state-regulated monopoly alongside an unregulated subsidiary that markets electricity to the highest bidder anywhere in the US. The leading electric utility in North America in sourcing energy from wind and solar is NextEra Energy (NEE) and it meets the ITR quality criteria.

Finally, there are two companies that produce and transport various industrial gases, Praxair (PX) and Air Products (APD). Their products are vital to a wide range of industrial processes and are in almost constant demand. These gases are marketed through forward contracts on a custom basis, much like an unregulated commodity.

Bottom Line: We have introduced 9 companies that produce, transport or market commodities as their key business and also meet the ITR investment criteria:
  • Exxon Mobile (XOM)
  • Chevron (CVX)
  • Occidental Petroleum (OXY)
  • BHP Billiton (BHP)
  • Total SA (TOT)
  • Norfolk Southern Railroad (NSC)
  • NextEra Energy (NEE)
  • Praxair (PX)
  • Air Products (APD)

Sunday, September 4

Week 9 - Bonds

Situation: Stock prices reflect earnings expectations but are also influenced by market forces (“a rising tide lifts all boats”). Bond prices reflect the of risk of bankruptcy but are also influenced by market forces (the prospect of inflation or deflation). When a company declares bankruptcy, it’s stock price falls to zero but it’s bond price falls by only 20-30% since bondholders stand to benefit from the sale of assets. Accordingly, investment-grade corporate bonds are only 20-25% as risky as is the parent company’s stock.

Goal: To convince our readers than a 50% asset allocation to bonds is a reasonable and appropriate hedge against unsettling fluctuations in their stock holdings.

Over long time periods, annualized total returns for the S&P 500 Index exceed inflation by 4-7% vs. 2-3% for investment-grade bond indices. Studies comparing bond and stock indices back to 1802 show that  bonds outperform stocks 29% of time in rolling 10-yr periods. <click here for a related story in Smartmoney> We are currently ending a 20-yr period in which bonds have out-performed stocks. This is an extremely rare “Black Swan” event.

This week we are adding an investment-grade bond fund managed by T. Rowe Price (New Income Fund - PRCIX) to the ITR Table of Lifeboat Stocks from Week 8. This table compares the 18.5 yr total returns of 5 Lifeboat Stocks to SPY, and to inflation. Returns for PRCIX exceed those for SPY but are less than those for Lifeboat Stocks. While PRCIX is not an index fund, it’s performance closely tracks the benchmark bond index: Barclays Capital U.S. Aggregate Index. While stocks in general have performed poorly due to back-to-back recessions, bonds (and Lifeboat Stocks) are somewhat immune and keep returning value that beats inflation.

A simple way to demonstrate how bonds can stabilize an investment portfolio is to compare SPY to US Savings Bonds. Over the 12.25 yr period that ended August 26, 2011, a one-time $500 investment in SPY (on 1/29/93) grew to $549.37 using dividend reinvestment (0.77%/yr). In contrast, a $500 investment in an inflation-protected US Savings Bond grew to $1014.20 (5.94%/yr). Adding the two together shows that $1000 grew to $1563.57 (3.72%/yr), which still beats inflation of 2.53%/yr by 1.19%.

At first glance, this appears to be a skewed example because the investment in SPY was made on 6/1/99 when the stock market was clearly overvalued (the “” bubble was in full flower). People were enthusiastic about buying stocks but unenthusiastic about buying bonds, particularly those with inflation protection, since the government was paying down its debt and no one believed inflation was a threat. The US Treasury had to offer unusually high interest rates to entice investors to purchase its inflation-protected offerings.

Now if we compare this to the opposite case, an investment in SPY when investors were avoiding stocks (after a recession that had cost them money): $500 invested in SPY on 1/29/93 grew to $1849.05 by 8/26/11 using dividend reinvestment (7.29%/yr). At the same time (1/93), a $500 investment in an EE Savings Bond (guaranteed to double in value after 20 yrs) grew to $1315.20 (5.34%/yr) over the same 18.6 year period. As expected, stocks outperformed bonds in this example because of market timing. That is, SPY was bought when it was on sale because investors preferred bonds. Add the two $500 investments together and $1000 grew to $3164.25 (6.40%/yr). The combined return again beats inflation (which was 2.50%/yr), this time by 3.9%/yr. To summarize, we have shown that even when a 50:50 investment in stocks & bonds is made under conditions that are very favorable to one but not the other, returns for the combination are stable and beat inflation over time. Thus, bonds in a portfolio act like ballast in a ship.

In the Week 3 Goldilocks Allocation blog we recommended a 50% allocation to bonds, divided as follows: 50% in an investment-grade bond fund like PRCIX, 33% in an investment-grade international bond fund like T. Rowe Price’s RPIBX (to counteract the falling dollar), and 17% in 10-yr US Treasury notes. These two no-load bond funds can be purchased over the internet like a point-and-click DRIP, using automatic electronic withdrawals from your bank account on a regular basis. Purchase of treasury notes is similar except that an order has to be placed each time through

Until recently, 10-yr Treasury Notes were considered to be the optimum risk-free investment. Then Standard & Poor’s pointed out that the US Treasury may have to restructure it’s long-term debt in the not-too-distant future. Why is that? Well, the Federal government is breaking some rules of financial prudence, i.e., running budget deficits that far exceed GDP growth, and running debts that exceed 60% of GDP. The cardinal rules for government finance were established in the Maastricht Treaty (2/7/92), which codified requirements for European countries wanting to use the Euro as currency. A country had to first demonstrate that it’s annual budget deficits did not exceed the nominal rate of GDP growth (i.e., GDP before adjusting for inflation) and that it’s government debt did not exceed 60% of GDP: A country with nominal GDP growth of as little as 3%/yr may be able pay off that degree of debt over time (Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different; Eight Centuries of Financial Folly”, Princeton Univ. Press, Princeton, 2009). However, a debt that exceeds 90% of GDP becomes impossible for a slow-growth country to pay off without having to restructure (i.e., default). Currently, the US budget deficit is 12.7% of GDP and its debt is 99% of GDP. This is why S&P has downgraded US Treasury notes and bonds from AAA to AA+. You are probably asking for a compelling reason why you need to invest in these debt instruments! The answer is that there are advantages to holding some bonds until their principal (your original cost) is returned to you. And the only notes/bonds that are both widely-available and carry little risk are those issued by the US Treasury. For example, China recently bought $100 billion worth of US Treasury bonds and notes.

Inflation will cause a bond mutual fund to fall in value, along with the prices of the underlying bonds. This is because a newly issued bond pays more interest than an older bond (issued before inflation took off). To limit that loss, bond fund managers will trade long-dated bonds for short-dated bonds as inflation develops. If you own treasury notes, your solution is simply to wait a few years: Your original investment will be returned to your bank account and, by holding onto the note, you will continue collecting interest, helping to pay for new notes that pay more interest. The point is that there are advantages to owning individual bonds as well as bond funds.

Bottom Line: Bonds are an investor’s best friend, especially in a deflationary environment (i.e., during a recession). Even if there is rapid inflation, the loss of value in a managed bond fund is less than the loss of value in an indexed bond fund, since managers are free to shorten maturities thereby limiting losses due to long-dated bonds, whereas long-dated bonds have to be left alone in an indexed fund. Even with inflation caused by a strong economy, losses to an indexed bond fund are less than the losses incurred by an indexed stock fund at the opposite end of the economic cycle, i.e., during a recession.

<click here to move to Week 10>