Sunday, December 30

Week 78 - Master List Update (Q1 2013)

Situation: The time has come to provide sober guidance about saving for retirement. For most people, mutual funds are the best route to take and we’ve listed our 5 favorites in the accompanying Table. We remind you that you should not have more than 20% of your assets in a single fund, or 5% in a single stock. As noted in our Week 3 blog (see Goldilocks Allocations), it is also important to balance your stock investments 1:1 with bonds. Our 5 mutual funds do that when you have 20% of your retirement savings in each.

Whew! Now for the fun stuff, which is to generate a list of stock picks that meet our investment criteria. Previously, we’ve agonized over company fundamentals like efficiency (ROIC), long-term debt, and having enough free cash flow to pay for dividend increases (FCF/div). In this blog, we’re going to let you do that for yourself by using red warning flags in the 3 right hand columns of the Table (courtesy of data from the WSJ). This way, you’ll see the entire “universe of data” we analyze, starting with the 199 companies at the Buyupside website called Dividend Achievers. Those companies have had 10 or more consecutive years of dividend increases. We’ve added Occidental Petroleum (OXY) which will qualify come January first.

Next, we eliminate any company with a dividend yield less than the 15-yr moving average for the S&P 500 Index (1.8%). Then we eliminate any company that doesn’t have an S&P stock rating of A/M or better AND an S&P bond rating of BBB+ or better.

The remaining 49 companies can be split into two groups, those whose stocks lost less than 65% as much as the S&P 500 Index during the Lehman Panic AND had a 5-yr Beta of less than 0.65. Those 19 companies are less risky that the others, and make up the first group at the top of the Table. The 30 remaining companies are in the second group, and the 5 mutual funds (mentioned above) compose the third group.

Which of the top 19 stocks are particularly attractive to the risk-averse investor? We think those are the ones that pay a higher dividend than most others AND grow that dividend faster. I use a 3:7:10:50 standard for finding those good "income" stocks. By this I mean there is at least a 3% dividend yield, at least a 7% dividend growth rate, at least a 10% ROIC (5% for a regulated utility), and less than 50% capitalization from bonds. Six in the top 19 meet that standard: JNJ, ABT, PEP, PG, NEE, MCD. However, we eliminate Abbott Labs (ABT) because it is breaking up into two companies, so we’re down to 5.

Those readers who are over 55 and have little in the way of retirement savings should pay attention to these 5 reliable income producing stocks. We’ll aggregate the data from those, to augment our guidance for late-stage investors (see Retirement on a Shoestring Week 14 & Week 15). These 5 stocks are so bond-like that you needn't bother hedging them with an equal investment in bonds or bond funds. But you do need to “dollar-average” equally into all 5 DRIPs. We'll call this group "Stand Alone Stocks" and put their aggregate data at the bottom of the Table for comparison with aggregate data for the 5 mutual funds we mentioned.

Bottom Line: Recent academic studies show that returns from less risky (more bond-like) stocks are as great as returns from more risky stocks. Read this recent analysis by Mark Hulbert to open your eyes to the importance of holding such stocks in your portfolio.

Risk Rating: 4.

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Sunday, December 23

Week 77 - Low-risk Stocks in Food-related Companies

Situation: Currently, the stock market is overpriced according to the indicator with the greatest predictive value: The 10-yr cyclically adjusted price-earnings ratio (CAPE). It presently stands at 21.86, whereas CAPE has averaged 16 over the past 130 yrs. Partly this elevation is due to the Federal Reserve feeding $2 Trillion into the economy over the past 4 yrs. The Federal Reserve has just announced it will keep doing so at the rate of $85 Billion per month, i.e., purchasing $40 Billion in mortgage-backed securities and $45 Billion in US Treasury Notes (see Week 76 for a discussion of Financial Repression). That money gives banks and other corporations the ability to obtain cash at ~zero cost relative to the rate of inflation. However, that cash cannot be converted into loans/jobs/factories until the economy recovers enough to justify such investment. The result? Stock prices go up but earnings barely increase at all.

The other reason stock prices are going up faster than earnings is that sentiment has improved. Traders think the economy will gradually regain its full strength. Remember that stocks are priced to reflect expected corporate earnings 6 to 9 months from now. Under the current circumstances, what should you do? When all asset classes are overpriced because of Financial Repression, the best plan is to invest more in companies that will benefit from shortages in supplies when demand finally increases. The most critical looming shortages look to be food-related, given that per-capita food production hasn’t kept up with demand for more than 10 yrs. Grain yields have reached a plateau worldwide but a larger percentage of grain is going for animal feed and automobile fuel every day. Meanwhile, world population grows by 220,000 every day (Brown, Lester R.: Full Planet, Empty Plates, Norton, New York, 2012, 144 pp).

Our mission is to find food-related stocks that won’t follow the roller-coaster of grain prices but will reflect the coming ~5%/yr growth in grocery store prices. Here at ITR, we have come to define such “low-risk” stocks (see Week 76) as those having:
   a) dividend yield at least as great as the 15-yr moving average for the dividend yield of the S&P 500 Index (1.8%);
   b) annual dividend growth over the past 5 yrs of at least 6%/yr;
   c) price loss during the 18-month Lehman Panic (10/07 to 4/09) of no more than 30% (vs. 46% for the S&P 500 Index);
   d) 5-yr Beta of less than 0.65, meaning the stock price goes down less than 65% as far as the S&P 500 Index in a bear market;
   e) less than 50% of total capitalization is from long-term loans;
   f) dividends have been raised for at least 10 consecutive yrs.

We have come up with 10 stocks by using those metrics (Table). Only 6 are food & beverage production per se (HRL, LANC, MKC, SJM, PEP, KO) but the other 4 play important supporting roles: McDonald’s (MCD), Wal*Mart (WMT), CH Robinson (CHRW, the leading worldwide distributor of fresh vegetables labeled The Fresh 1), and Aqua America (WTR, the largest regulated North American water utility).

Bottom Line: Look at looming shortages. Oil was the #1 looming shortage until drillers in the US started using advanced technologies from Schlumberger (SLB) to drill horizontally and break up oil-containing rock formations by injecting a sand slurry under high pressure (hydrofracking). Now food is the #1 looming shortage, due to a water shortage that compounds a host of other shortages (tillable land, fertilizer, modern agricultural infrastructure, crop protection chemicals, drought-resistant seeds, affordable energy). To make matters worse, there are 3 billion more people having the wherewithal to buy meat, milk and eggs for their families than there were 20 yrs ago. However, animal protein requires 4 times as much grain to produce than does the simple consumption of that same grain for human nourishment (instead of using it for animal feed). Finally, over 10% of corn and sugar cane production worldwide is now being diverted from food supplies for use as automobile fuel. You can see that problems abound with food production. There are solutions for each problem but those will require time to phase in, and full support of a new generation of politicians who see fit to appropriate the necessary resources.

Risk Rating: 3.

Sunday, December 16

Week 76 - Hedging Stocks vs. Financial Repression

Situation: As of 12/7/12, a “risk-free” 10-yr US Treasury Notes yields 1.63%. This is vs. the 4.12% paid just 5 yrs ago. Meanwhile, the Consumer Price Index (inflation) has grown at a rate of 2.2% over the past 5 years vs. 2.9% over the 5 years ending in 12/07. This means that a 10 yr Treasury Note purchased on 12/07/07 paid 1.2% more than inflation, whereas, a 10 yr Treasury Note purchased on 12/07/12 paid 0.6% less than inflation. That 1.8% “trim” is called Financial Repression. It occured as the Federal Reserve gradually took two trillion dollars worth of Treasury Bonds and Notes out of circulation, thereby increasing the price (and lowering the yield) of remaining Bonds and Notes. This drives down the “yield curve” and the net result is that investors become willing to take greater risks with their money to escape the losses due to inflation that result from sitting on cash in the form of Treasury Bills and Notes. Investors are denied a “safe harbor” for part of their investments and are being pushed into using that money to expand factories, provide new services, buy homes and hold more stocks.

The idea is to boost the economy while reducing the amount of interest the US Government pays on its debt. Wikipedia defines Financial Repression as “any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.” It is a disguised form of inflation, since all asset classes eventually come to be priced higher (by that same 1.8% noted above) vs. historic valuations relative to inflation. Some leading economists have concluded that Financial Repression is a form of taxation (cf. Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different. Princeton University Press, 2008, p. 143).

You may think that these monetary policies will soon end and the economy will recover enough to grow at its usual 3%/yr faster than inflation. Well, the last time the Federal Reserve employed Financial Repression it lasted from 1945 to 1980. When used by central banks of other countries, it has averaged 20 yrs in duration (Carmen Reinhart and Belen Sbrancia, National Bureau of Economic Research working paper, 2011). Over the last 35 years, Sweden’s use was the briefest at 6 yrs (1984-1990).

What is our goal for today’s blog? How do we defeat Financial Repression in order to save for our retirement. That is a tall order, given that every asset class is valued relative to US 10-yr Treasury Notes. Hedge funds, however, are designed to respond to asset class impairment. In response to the Lehman Panic, many hedge fund traders hopped into gold, oil, and emerging market stocks. Then they tried high yield (and emerging market) bonds and high yield stocks. All of those predictably became overpriced. Thus, hedge funds haven’t fared all that well over the past year or two. Now they’re taking a closer look at dividend-growing companies in “defensive” industries, namely, healthcare, consumer staples, and utilities, even though stock in those companies has also become high-priced. 

In this week’s blog we take that approach and simply ask, which stocks fit our definition of a Hedge Fund (see Week 46)? That would be a stock that has beat the S&P 500 Index over the past 10 & 5 yrs, and fallen less than 65% compared to the S&P 500 Index during the Lehman Panic (10/07-4/09). That means we’ll have to stick to looking at stocks with a 5-yr Beta of 0.64 or less. And, since the S&P 500 Index had only a 1% total return for the past 5 yrs, we’ll only look at stocks with a 5-yr total return at least as great as that for “risk-free” money, which is 2.8% (i.e., the average rate of interest on 10-yr US Treasury Notes over the past 5 yrs). Because this blog is about saving for retirement by reinvesting dividend income, we’ll only look at stocks with a dividend yield of at least 1.8% (i.e., the 15-yr moving average for S&P 500 dividend yields). And, since there’s not much point in starting with a dividend-paying stock that doesn’t meet the “business case” for investment (see Week 68), we’ll exclude stocks that have a 5-yr dividend growth rate of less than 6%/yr. Finally, we’ll check financials on the WSJ website and exclude any that:
   a) have a return on invested capital (ROIC) less than the weighted average cost of capital (WACC), 
   b) are capitalized mainly by long-term loans, or 
   c) didn’t have enough free cash flow (FCF) last year to pay at least half of this year’s dividends.

In this analysis, we have turned up only 10 companies (Table). As expected, most come from one of the 3 “defensive” industries: ABT (Healthcare), WEC, NEE (Utilities), and MKC, HRL, GIS (consumer staples) but each of the remaining 4 (MCD, CHRW, CB, IBM) come from one of the other 7 S&P industry classifications. It will come as no surprise that all 10 companies have an S&P stock rating of A-/M or better, and an S&P bond rating of BBB+ or better. 

We compare these 10 stocks with our two favorite benchmarks (see Week 3):
   a) a 50:50 split between low-cost mutual funds tracking the S&P 500 Index (e.g. VFIAX) and the Barclays Capital Aggregate Bond Index (e.g. PRCIX); and
   b) the only mutual fund that is balanced ~50:50 between stocks and bonds, low-risk, low-cost and performs like a good hedge fund: Vanguard Wellesley Income Fund (VWINX). For you, the safest, cheapest, and least time-consuming way to save for retirement is to employ one of those benchmarks. 

Bottom Line: Hedge funds seek to beat the S&P 500 Index during bull markets but fall less during bear markets. We set out to see which stocks perform like an above-average hedge fund (i.e., fell less than 65% during the Lehman Panic while beating the market) by using the most rigid criteria. We find that such safe & effective stocks are rare, and don’t necessarily hide out in the 3 “defensive” industries (healthcare, consumer staples, utilities). In other words, we had to look at all 114 stocks in Zack’s database that meet our key criteria (capitalization of at least $8 Billion, dividend yield of at least 1.8%, 5 yr dividend growth rate of at least 6%, and ROIC of at least 9.5%). 

Risk Rating: 3. In other words, ownership of these stocks doesn’t have to be hedged with ownership of an equivalent amount of 10-yr US Treasury Notes and/or their untaxed equivalent (Savings Bonds) or a investment-grade bond fund like PRCIX. They’re internally hedged, much like the two utility stocks (WEC, NEE) but for more complex reasons having to do with competitive advantage (a topic we’ll explore in future blogs).

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Sunday, December 9

Week 75 - S&P 100 Companies without Red Flags

Situation: We all know that President Harry Truman preferred one-handed economists because he found the phrase “on the other hand” to be so exasperating. And, increasingly, the tables that accompany our blogs are sprinkled with red flags. So this week we’ll publish a Table that doesn’t look like it has the measles!

You’ve already heard that we favor large companies with multiple product lines ringing up sales. Why? Because that creates internal support, meaning that when sales crump in one line the company has the resources and talent needed to fill that hole. Anyone who has played on a good sports team or fought in a good military unit understands that concept. But stock traders don’t (or won’t) embrace it because the company then becomes too difficult to value “by the sum of its parts.” This means the stock’s price will lag behind its earnings growth. But you don’t care because you use a “buy and hold” investment strategy.

Accordingly, we’ve screened companies in the S&P 100 Index for the following traits (Table):
a) Dividend yield greater than or equal to 1.8%;
b) 10 yr annualized total return greater than or equal to 5%;
c) Losses during the Lehman Panic less than those for the S&P 500 Index;
d) Finance Value (b plus c) that beats the S&P 500 Index;
e) 5 yr annualized total return of at least 2.9% (i.e., the “risk-free” rate determined by averaging the interest rate of 10 yr US Treasury Notes over the past 5 yrs);
f) 5 yr dividend growth rate of at least 4%;
g) Return on Invested Capital (ROIC) of at least 10% over the trailing 12 months;
h) Long-term debt that is less than half the company’s total capitalization;
i) Last year’s free cash flow (FCF) is sufficient to fund this year’s dividends.

Our screen turned up 10 companies. Note that 6 of the 10 are from the Stockpickers Secret Fishing Hole (Week 29 & Week 68), which is the 65-stock Dow Jones Composite Index (DCA). Excluding regulated utilities (which have too much debt and too little free cash flow to pass our screen), there are 32 DCA companies in the S&P 100 Index. So the chance of a DCA company passing our screen is 19% (6 divided by 32) vs. 5.9% (4 divided by 68) for a non-DCA company.

Bottom Line: You can win by staying away from companies that are inefficient (low ROIC), have high LT debt, or pay dividends with retained earnings and borrowed money instead of using free cash flow. There is no bad news in our screen. If your portfolio contained these stocks throughout the past 10 yrs and you kept buying more during the Lehman Panic, then you’re a smart “vulture investor."

Risk Ranking: 6 (see Week 72).

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Sunday, December 2

Week 74 -Food Production Companies in the Russell 1000 Index

Situation: Last week we looked at a snapshot of food-related companies--those listed on the Omaha World-Herald 150 Index. This week we take on food production companies, screening the 150+ stocks in the Dow Jones US Food Production Index to drill down on the 18 largest companies, namely those listed in the Russell 1000 Index. The point is to set aside (for now) those companies that are peripheral to food production (railroads, farm equipment manufacturers, grocery stores, restaurants, bottlers, grain brokers, futures exchanges) and focus on the companies that produce food from animal protein and cereal grains. In the Table, you’ll see two companies that aren’t in the Russell 1000 Index: 
   a) Lancaster Colony (LANC) which is now large enough to appear in the next revision of that Index; 
   b) Syngenta (SYT) a Swiss company that competes directly with Monsanto (MON) to market crop protection (CP) materials and genetically-engineered seeds. SYT holds the number one position globally in CP materials with 19-20% of the market.

Of the 20 companies listed in the Table, only Hormel Foods (HRL)  and LANC are free of red-flagged items (i.e., “let the buyer beware”). But 7 more companies have been remarkably profitable over the past 5 & 10 yrs, and lost no more than 65% as much as the Russell 1000 Index during the Lehman Panic. Those 9 companies meet the “business case” for investment (see Week 71) by having at least the 7.18%/yr growth rate that is needed to double your investment within 10 yrs, as well as a combined dividend yield and dividend growth rate of at least 7.18%/yr: SYT, GIS, FLO, HRL, HNZ, HSY, SJM, LANC, MKC. This is a remarkable accomplishment for any company given that half of the last 10 yrs has seen the business world consumed by the Lehman Panic and its after effects.

Bottom Line: Food production will increase because the high prices that food products now command will justify cultivation of even marginal farm lands. Droughts will lead to more irrigation, while technology continues to improve drip irrigation methods to reduce evaporation and runoff. Higher food prices are inevitable after a drought and are occurring already but companies such as Tyson Foods (TSN) are finding that there is no loss of revenue when those costs are passed on to the consumer, as reported by the WSJ

In summary, food production companies are already quite profitable and stable investments but the future appears even brighter. A reasonable approach is to create your own specialty fund by taking capitalization-weighted positions in all 4 of the companies in the accompanying Table that have a “business case” for investment and are free of red flags with respect to return on investment, long-term debt and cash flow (Columns K, L & M in the Table): LANC, SYT, HRL, GIS.

Risk Rating of this blog: 6 (see Week 72).

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Sunday, November 25

Week 73 - "Food is the New Oil and Land the New Gold"

Situation: Today's title is a quote from Lester R. Brown’s new book (“Full Planet Empty Plates,” ISBN-10: 0393344150) and puts a fine point on why the ITR blog is now being written from Hastings, Nebraska. Planet Earth's reality is that ~220,000 people are born each day. There are also ~3 Billion people who have acquired upward mobility and expectations of a better life. The problem is how will we double food production to feed the planet as it sprints to a population of 7.5 Billion with a growth rate of 3%/yr. Meanwhile, droughts will probably be more frequent, and energy sources and concerns will continue to grow. In the world’s biggest breadbasket, the Great Plains of the US, almost a third of its corn crop is currently being diverted to make ethanol-blended gasoline.

In our breakdown of companies, we have classified “food-related companies” as what we have called defensive or “Lifeboat Stock” type investments (see Week 50). However, food-producing companies are dicey investments because weather plays such a large and unpredictable role in month-to-month pricing of food commodities (wheat, rice, corn, soybeans, oats) and animal feed. Where does that leave an investor who wants to put her hard-earned money toward solving the food problem? Which stocks should she consider buying as a responsible investment? Let’s start by looking at the 18 food-related companies (Table) as presented in The World-Herald 150, a stock index published in the Omaha World-Herald newspaper. That list is a good place to start because of Omaha’s central location on the Great Plains, and because the University of Nebraska is the focal point of agricultural research and policy in the US.

Looking at the Table, it is clear that food-related stocks as a group consistently outperform. In terms of Finance Value (Reward minus Risk in Col E, Table), all but one of the 18 companies outperformed the S&P 500 Index (VFIAX). But there’s a lot of variability. We’ve red-flagged items of concern and only one company is free of those concerns, Hormel Foods (HRL). But 6 more performed almost as well (i.e., beat VFIAX over the past 5 and 10 yrs while falling less than 2/3rds as much during the Lehman Panic). Those companies are PepsiCo (PEP), Aqua America (WTR), Kellogg (K), Smucker (SJM), Hershey (HSY), and Coca-Cola (KO).

Bottom Line: Food-related companies are going to become more compelling for investors as food shortages become more common due to population growth, affluence growth, urban sprawl, increasing energy costs and drought. Food production is a risky endeavor, so stock prices will fluctuate even more as production costs rise. This can be turned to the investor’s advantage by dollar-cost averaging (investing a little each month), owning several such stocks, and avoiding stocks issued by companies that carry significant debt (e.g. LT-debt that exceeds a third of Total Capitalization). As with any commodity, the investor is better off holding stock in a company that buys the raw commodity and turns it into something consumers want to buy than she would be investing directly in the raw commodity. However, the introduction 10 yrs ago of an Exchange Traded Fund (ETF) that buys gold bars (GLD) has shown that investors will buy a raw commodity and have someone store it for later sale. Result: now you can buy an ETF for corn futures (CORN). Its price is volatile but has grown 29% over the past 2 yrs vs. 13% for the S&P 500 Index.

The ITR Risk Rating: The risk rating for this blog is 8 on a scale that sets maximum performance orientation at 10 and maximum safety orientation at 1. [For example, a blog about oil & gas exploration and production companies like Apache (APA) and Suncor (SU) would have a risk rating of 10 and a blog about inflation-protected US Savings Bonds (ISB) would have a risk rating of 1.]

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Sunday, November 18

Week 72 - So You Want a Small Portfolio of Only 6 Stocks?

Situation: Stocks are risky, 4-5 times riskier than bonds. To capture the value of owning stocks directly vs. owning a stock mutual fund, you need to distribute the risk by owning stock in a number of companies. Academic studies recommend positions in at least 20 companies representing at least 5 industries. But if you’re just starting out, you’ll want to own only a few stocks. Well, there’s a way to do that: pick stocks to overemphasize safety and underemphasize performance. Instead of buying the 1/3rd Lifeboat Stocks and 2/3rds Core Holdings that we recommended (see Week 3), reverse that ratio for a small portfolio of 6 picks and go with companies that have the best credit ratings.

We first identify those that have a AAA credit rating (which is better than US Treasury Bonds with have a AA- credit rating). That AAA credit rating means the risk of bankruptcy is negligible: S&P can identify no concerns or issues that might herald a risk of bankruptcy. We’ve found there are only 4 such companies: Exxon Mobil (XOM), Automatic Data Processing (ADP), Johnson & Johnson (JNJ) and Microsoft (MSFT). To get you to our goal of 6 stocks, we’ll add the next safest company (in our opinion): Wal*Mart (WMT), with a AA credit rating. Then we’ll add the safest utility (in our opinion) that has its bonds guaranteed by a state government: NextEra Energy (NEE), with an A- credit rating.

Given the size of your portfolio, you can’t afford to be concerned about performance. Nonetheless, the 6 companies we’ve identified have performed as well (in the aggregate) as the least costly S&P 500 Index Fund (VFIAX, in the attached Table). More importantly, this “safe” portfolio of 6 stocks was harmed much less than VFIAX by the Lehman Panic.

But now you’ll want to know how these 6 stocks have performed compared to bonds, which we’ve recommended you own in a 1:1 ratio with stocks (Week 3). Bonds did better, as represented in the table by the T Rowe Price New Income Fund (PRCIX). You’d have also done better by avoiding those 6 stocks and holding the lowest cost balanced fund that has at least 50% of its asset value in bonds: the Vanguard Wellesley Income Fund (VWINX, in the Table).

Bottom Line: Owning individual stocks is a time-consuming hobby because you’ll soon realize that you need a baker’s dozen of dividend growers before you’ll sleep well. But there is a way to start with a portfolio of only 6 stocks where the gains are likely to be about as good as the S&P 500 Index and the pains are much less. But a more economical use of your resources would be to hold a low-cost bond-heavy balanced fund like VWINX, and you’ll probably make at least as much money going forward.

In future weekly posts, we’ll distinguish between blogs that feature ideas for investment performance vs. those that feature ideas for safety. In our closing statements, we’ll include a ratings scale of 0 to 10. An number between 7 to 10 will be for discussions that emphasize performance, while 1 to 3 will be for those that emphasize safety. Bear in mind that out-performance cannot be achieved without sacrificing safety but out-performance yields a bigger nest egg for retirement.

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Sunday, November 11

Week 71 - The “Business Case” for S&P 500 Companies

Situation: All of us would like our stock investments to perform better than the S&P 500 Index and we’re heartily disappointed by mutual funds that supposedly track that Index. Realistically, that goal is almost impossible to reach, according to a host of academic studies. Here at ITR, we modify that goal. We find that reducing risk by shooting for safety first and performance second is a better long-term investment strategy. In this week’s blog, we examine whether there is a way to have both safety and performance share top billing.

The Pursuit of Safety:  We screened the 500 companies in the S&P 500 Index to identify those that had less than a 30% drop in total returns during the 18-month Lehman Panic (vs. the 45% drop for the overall S&P 500 Index). Then we eliminated companies that

   a) are primarily capitalized with borrowed money,
   b) lack returns on invested capital (ROIC) that comfortably exceed the weighted average cost of capital (WACC), and
   c) fail to maintain a tangible book value (TBV).

The Pursuit of Performance:  Working with the remaining companies, we used the buyupside website to screen out those companies that did not show a total return in excess of 7%/yr over the past 5 and 10 yrs. Next we required our remaining companies to pass a Buffett Buy Analysis (see Week 30) by projecting a total return over the next 10 yrs in excess of 7%/yr. (We choose 7% as the cut-off because that growth rate will double your invested dollars over 10 yrs, which is the common requirement for a “business case” that justifies investing in the first place).

At the end of this exercise, we turned up 14 companies (see the attached Table), a convincing demonstration of just how hard it is to beat the S&P 500 Index without taking on a lot of risk. We added 3 more companies to our list, those that almost make the cut. The shortcoming of these 3 is that they’re from industries where profits are limited by government regulation (utilities & railroads): Union Pacific Railroad (UNP), NextEra Energy (NEE), and Wisconsin Energy (WEC). We also list one company that is on our Master List (MMM, see Week 65) that closely tracks the major indices with respect to both safety and performance. 3M is classified as a conglomerate because it operates in many industries and is also known for keeping up with the times. It is innovative and draws most of its sales from international markets. We also list a mutual fund (MDLOX) marketed by BlackRock, a hedge fund specialist. MDLOX has performed in line with above-average hedge funds but has the shortcoming of being expensive to own (e.g. it has a 5.25% front-end load) though still cheaper than a hedge fund proper. Hedge funds emphasize fixed-income investments (bonds), international stocks & bonds, and bet against weak-appearing stocks. That’s both complicated and expensive but hedge funds do indeed lose less money during market panics. You’ll notice from the Table that a straightforward bond-heavy balanced fund like VWINX performs just as well as MDLOX while being much cheaper to own.

Bottom Line: For your stock investments, stick to low-cost S&P 500 Index funds like VFIAX and low-cost balanced funds like VWINX (Table). The only reason for picking your own stocks is that you want to lose money while learning a time-consuming though informative hobby. To minimize those initial losses, stick with companies that grow nice dividends and are highly rated like those in our Master List (see Week 65). You’ll notice that when you push for stocks that perform the way a businessman likes by doubling his money over 10 yrs (Table), only 4 out of 17 companies meet that standard and also appear on our Master List (see Week 65): Hormel Foods (HRL), Chevron (CVX), NextEra Energy (NEE), and Wisconsin Energy (WEC). Therefore, the other 13 stocks are speculative.

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Sunday, November 4

Week 70 - The “Business Case” for Electric Utilities

Situation: You’d like to invest in something that’s as safe as 10-yr US Treasury Notes but pays more than the 1.8% interest you’ll get from owning those. While stocks are 4-5 times as risky (Riskmetrics), companies that need government subsidies to fund huge and ongoing fixed costs are allowed to issue stocks that are then safer than average due to government backing. State-regulated electric utilities are an example. Bankruptcy can’t happen, and Return on Equity is set by the state’s public utility commission (usually in a range of 9-12%). In other words, downside risk is eliminated at the expense of upside returns. Most states also allow their electric utilities to operate an unregulated subsidiary. NextEra Energy (NEE), for example, has a subsidiary that is the top generator of electricity from wind and solar farms in the US, and Dominion Resources (D) has a subsidiary that stores natural gas, the largest such facility in the US.

To filter out less-efficient utilities, we’ve used several accounting tools to assess whether the utility meets a “business case” for sound management, i.e., is likely to double the investor’s investment over the next 10 yrs (for a Total Return of 7.2%/yr). That’s a high bar for regulated utilities to reach, since the goals of public utility commissions are to a) prevent the state’s taxpayers from having to bail out the utility, and b) prevent the utility’s shareholders from reaping windfall profits. In other words, state-regulated electric utilities can neither be a “cost center” nor a “profit center.” The terms “business case” and “profit center” have approximately the same definition so you see the problem. Our job is simple: find the utilities that are so efficient as to almost be profit centers. And we apologize that the attached Table is overly complex but a number of metrics have to be used to assess companies that are on the edge of true profitability.

Bottom Line: Risk is the bane of an investor’s existence (see Week 7 on Risk). So let us find companies that governments have to subsidize and see what investors have to give up in return. To start, let us pick companies that are going to produce the same amount of product in good times as well as bad times, because that eliminates the risk of a business fall-off during recessions. In other words, if windfall profits aren’t possible at least we can stop worrying about more than one risk. By investing in state-regulated electric utilities, we get to stop worrying about the risk of bankruptcy and about the risk of recession. (It’s not quite that simple, since state public utility commissions try not to raise electricity rates during recessions.) The Table shows you 3 good investing choices: NextEra Energy (NEE), Wisconsin Electric (WEC), and Southern Company (SO). We threw in the Vanguard Index 500 Admiral Fund (VFIAX) so that you could compare utility returns to the lowest-cost stock fund that has all 500 of the largest companies.

Sunday, October 28

Week 69 - Making a Business Case for the “Steady Eddies”

Situation: In Week 62, we introduced yet another strategy, which we dubbed “The Steady Eddies”, to help you prepare for retirement without fearing that your nest egg will crack open and leak its contents during the first year of your retirement. Steady Eddies are Lifeboat Stocks (see Week 23) except without the life jackets that make Lifeboat Stocks so attractive (like an emphasis on state-regulated utilites).

Once again, we screen Zack’s database of 6,000+ world stocks for companies that meet the following basic criteria:
   (a) dividend 2% or better
   (b) dividend growth 3% or better
   (c) ROI 10% or better
   (d) 5-yr average ROI 10% or better. 

Next, we check the Buyupside database and eliminate companies with a greater than 30% drop in total return during the Lehman Panic, and also eliminate companies without 5 and 10 yr total returns of at least 7%. Next, we use our favorite tools to screen out volatility, inefficiecy, and risk by requiring, respectively: 5-yr beta of 0.7 or less, ROIC of 12% or more, and long-term debt of no more than 50% total capitalization.

After these analyses, we were left with 10 companies that qualify for inclusion in this week’s special list for sound long-term investment potential. If we include all 5 companies with 5-yr Betas higher than 0.7 (red-flagged in the Table), our list grows to 15 companies. All 15 have a DDG (dividend + 5-yr dividend growth) of greater than 7%.

The purpose of our blog this week is to determine which of the Steady Eddies have a “business case” for investment. By this, we mean that you’re likely to double your money in 10 yrs (i.e., realize total returns of 7.2%/yr). We’ve turned up 15 companies but the question we know you'll be asking is: "Which of those are currently underpriced?" After all, you don’t want to “buy high and sell low.” The answer turns out to be that it doesn’t matter much over the long run if you dollar-cost average (i.e., purchase a little stock each month using a dividend reinvestment plan). 

The only method we know for calculating whether a stock is currently underpriced or overpriced is the Buffett Buy Analysis (BBA, explained in Week 30): 1) determine whether the company has grown its tangible book value (TBV) steadily over the past 10 yrs; 2) project the trendline of Core Earnings for the past 8-9 yrs into the future for 10 yrs; 3) assume the economy is going to be bleak (P/E sinks to the lowest value seen in the past 10 yrs and the company can’t raise its dividend). That gives you a projected stock price which you can compare to the current price.

If the projected growth rate is higher than TBV growth rate over the past 10 yrs, the stock is probably underpriced at present (Table). The data needed to run these numbers are available from S&P, but only for large companies (LANC and FLO aren’t big enough). When we examine the remaining 13 companies, we find that 6 don’t qualify for analysis, either because they’ve spent some of their TBV or they’ve had more than 3 down yrs in TBV growth. Upon calculating the BBA for the remaining 7, however, we find that HD and BMY are overpriced, HRL is fairly priced, and the remaining 4 are underpriced. That gives you 5 stocks to reflect upon as potential purchases: HRL, MCD, CVX, ADP and UNP

Bottom Line: Don’t take chances with your retirement money. If you lose 50% on an investment, you have to achieve returns of 100% just to get back to where you started. That’s why “smart money” people favor fixed income investing, as exemplified in the attached Table by investing in PRCIX and VWINX. On the other hand, stock investments make an interesting hobby (and you’ll learn much about how the world works). Just make sure you have a dozen or so companies in your portfolio and you don’t get carried away, i.e., have at least 50% of your wealth in utilities (Week 50), bonds (Week 67), Rainy Day Funds (Week 15) and your domicile. Speaking as a doctor, a retiree and an investor, my most practical advice for the run-up to retirement is: Go to the dentist often. Don’t get a divorce. If your doctor prescribes a blood pressure medication, de-stress your life by selling the stocks. Invest the proceeds in a bond-heavy mix of VWINX, PRCIX, VFAIX, and ISBs (inflation-protected US Savings Bonds). And pay off your mortgage.

Sunday, October 21

Week 68 - Stockpickers Secret Fishing Hole (Making the “Business Case”)

Situation: The Dow Jones Composite Average (DCA) contains 65 stocks, all picked by a small committee headed by the Managing Editor of the WSJ. Of those 65 stocks, there are 
   a) 30 in the Dow Jones Industrial Average (DJIA), 
   b) 20 in the Dow Jones Transportation Average (DJTA), and 
   c) 15 in the Dow Jones Utility Average (DJUA). 
We call it the Stockpickers Secret Fishing Hole because the DCA usually out-performs the S&P 500 Index and always has a higher dividend yield. The problem is to know which companies to regularly invest in over the long term. In this week's blog, we walk you through a method for selecting companies that make a "business case" for long-term investment. The term “business case” means that you are likely to double your money in 10 years. That would be a 7.18% Annual Return.

First Step (current reward): Does the dividend yield plus the 5-yr dividend growth rate equal or exceed 7.2%?  

Second Step (current risk): Is long-term debt less than 50% of total capitalization?

Third Step (past reward): Did the company have annualized total returns over the past 5 yrs of at least 7.2%? 

Fourth Step (past risk): Did the company's total return fall less than 30% during the “bear market” between October 2007, and April 2009? (In case you're a recent arrival to this planet, ask any homeowner what a 30% loss on a major investment feels like. Then you'll understand our key reason for drawing the line there.)

The attached Table names the 8 companies that remain after applying these 4 tests: 5 are from the DJIA (WMT, MCD, TRV, KO, CVX); one from the DJTA (UNP), and two from the DJUA (SO, DUK). For comparison, findings on key mutual funds (PRCIX, VWINX, MDLOX, VFIAX) and other major DJIA companies (JNJ, XOM, PG) are shown, as well as the only major gold mining stock (NEM) that comes close to meeting our criteria for a “business case.” 

Note that bond-heavy mutual funds (PRCIX, MDLOX, VWINX) in the Table show an increase in total return during the recession (Col E), even though the underlying bonds pay a lower interest rate (cf. Col C showing that the sum of the current payout rate and the 5-yr decline in payout rate gives a low or negative number).

Bottom Line: We all know the past 5 yrs have been rough for investors. Nonetheless, some old standbys have continued making good money and are likely to keep doing so: WMT, MCD, KO, CVX and UNP. Any experienced investor has heard of these 5 companies and isn’t surprised to learn that they make money through thick and thin times. But who among us holds more shares in these "no brainers" today than he or she did 5 yrs ago? I can answer "yes" for owning only three (MCD, KO, CVX). In other words, we make investing appear more difficult than it really is. We get thrown off by the "noise" in the system: namely the "talking heads"--TV and newspaper pundits. Those same pundits can also be faulted for failing to highlight the importance of holding stock in regulated utilities like Duke Energy and Southern Company. Remember this point: regulated electric utilities can’t go bankrupt and are guaranteed ~10% ROE (Return on Equity) by state utility commissions.

Sunday, October 14

Week 67 - Bonds and Bond Funds

Situation: To quote from a NY Times editorial on 9/16/12 ("The Road to Retirement"): "More saving is clearly needed, along with ways to protect retirement savings from devastating downturns. The question is how." That quote serves as both the Central Thought for the ITR website and introduces our blog this week. 

Protecting retirement savings from an economic downturn amounts to setting up fixed income hedges against that possibility. One way to do that is to invest in hybrid stocks that are actually bonds in disguise (i.e., regulated utilities). Another way is to invest in a bond mutual fund wherein the manager can choose between a variety of offerings, including foreign bonds, e.g. T. Rowe Price New Income Fund (PRCIX). And for a third suggestion, we continue to recommend that our readers regularly add inflation-protected US Savings Bonds (ISBs) to their Rainy Day Funds (see Week 15).

By investing regularly in stocks, you'll capture part of the profits made in a growing economy but at what cost? The cost is the possibility of losing all of the dollars you've carefully invested in a company's stock should that company declare bankruptcy. And, in the event of a market collapse, all of your stocks will fall in value until the market recovers. If you happen to retire when the market is collapsing, you'll be loathe to sell at a loss but could find you have no choice. 

Bond investing captures an unchanging stream of income from money you've rented out, money that will be returned to you on a date certain. Should the "rentee" declare bankruptcy in the meantime, you'll still receive your share of the remaining assets. In short, stock investing requires you to accept uncertainty; bond investing doesn't. Inflation, however, decreases the purchasing power of any interest income you've earned from bonds and bond funds. This is not as important as you might fear if you reinvest your interest income and regularly add to your portfolio of bonds and bond funds.

Using bonds to buffer a temporary stock market loss is a simple way to maintain what you've obtained. All of us now know the value of doing so: After 5 years, the stock market is still short of its October 2007 high while bond investors have enjoyed annualized total returns of 7% (PRCIX).

A note of importance: The US Treasury has increased the money supply since 2007 to lower federal borrowing costs and make US exports cheaper on foreign markets. The term to describe this is “financial repression.” To accomplish this, the Federal Reserve expands its balance sheet through multi-trillion dollar purchases of US government bonds on the open market. This has driven the price of 10-yr Treasury Notes so high that interest on the Notes has fallen to the current inflation rate. That means there is now a risk of loss to investors in these Notes should inflation pick up: 10-yr Treasuries may no longer be the “zero risk” investment they once were. 

Bottom Line: Stocks in general are 4-5 times as risky as bonds (Riskmetrics). That riskiness can be dialed back if you select stocks that have been issued by companies with low debt and a history of growing dividends. Nonetheless, you'll still need to keep at least half your retirement money in bonds and utility stocks to buffer market downturns.

Sunday, October 7

Week 66 - Growing Perpetuity Index (Update)

Situation: In one of our first blogs (Week 4), we created the Growing Perpetuity Index (GPI). This was composed of 12 companies that are listed in the 65-stock Dow Jones Composite Average (DCA) and meet 4 criteria:
   a) dividend yield no less than the yield for the exchange-traded fund (ETF) that mimics the S&P 500 Index (SPY);
   b) 10 or more consecutive years of annual dividend increases;
   c) S&P stock rating of A- or better;
   d) S&P bond rating of BBB+ or better.
Those 12 companies are listed at the top of the accompanying Table, ranked in order of Finance Value (reward minus risk).

This week’s update shows that GPI stocks are outliers, meaning that all 12 companies fell less in value during the Lehman Panic than the S&P 500 Index did and therefore were wiser bets for you to have financed. Taken together, GPI stocks outperformed all but the best hedge funds (see Week 46). Results for a mutual fund (Blackrock Global Allocation Fund-MDLOX) that is issued by a leading hedge fund company serve as a proxy for that industry and are included in the Table for comparison. We also include results for the only mutual fund (VWINX) that allocates assets between stocks and bonds like our Goldilocks Allocation does (Week 3). We also include a leading bond mutual fund (PRCIX) and 4 additional stocks in the Dow Jones Composite Average that either meet our 4 criteria (see above) or soon will (CHRW, SO, MSFT and UNP). 

Bottom Line: There’s no shortage of safe and effective stocks for the long-term investor to own, as long as she owns several. Examples include McDonald’s (MCD), NextEra Energy (NEE), Procter & Gamble (PG), ExxonMobil (XOM), Southern Company (SO), CH Robinson Worldwide (CHRW), Chevron (CVX), and IBM. If you add $$ electronically each month to dividend reinvestment plans (DRIPs) for each of these stocks, you can stop worrying about market swings--you’ll come out right as long as you keep your nerve. But remember to balance your stock investments (other than utilities like SO and NEE) 50:50 with bond investments (e.g. PRCIX), for reasons we’ve discussed previously (see Week 3).

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Sunday, September 30

Week 65 - 2012 Master List (3Q Update)

Situation: Stock market fluctuations continue but since 2009 the 250 day moving average (S&P 500 Index) has kept moving higher without a break. Why? We need to remember that this trend line is forecasting conditions 6-9 months down the road. Similarly, when the Federal Open Market Committee (chaired by Ben Bernanke) moves interest rates up or down the effect appears 6-9 months later.

Our ITR Master List (see Week 5) is based on fundamentals that long-term investors use in making stock purchase or sale decisions. That means we need to update our list quarterly. Our requirements for including a company in the Master List have become more stringent, given that the economy is struggling with slow growth and there is little prospect of a breakout in either direction. Unfortunately, it’s a “Muddle Through Economy." To make the list, we currently require companies to have:
   a) at least an A- S&P rating for both debt and equity issues;
   b) to have increased their dividend for at least 10 yrs in a row;
   c)  to have a dividend yield that is equal to or greater than the S&P 500 Index's (currently 1.9%).

In addition, companies (other than regulated utilities) have to meet certain standards pertaining to investment efficiency, dividend coverage, and long-term debt. In other words, ROIC (Return On Invested Capital) has to be 12% or greater, Free Cash Flow (as reported by the WSJ) must be sufficient to pay the entire dividend, and long-term debt has to be no greater than 35% of total capitalization. The attached Table lists 20 companies that presently meet those standards. Three have been dropped since the last Master List update (see Week 52) and no new companies have been added.

Bottom Line: This is not a good time to take a chance on a risky stock, so stick to the fundamentals. Take a look at the Table and think about starting a DRIP in one or two of the companies that have been struggling, and are therefore under-priced. Look for those that have a Durable Competitive Advantage (see Week 42), and projected 10-yr growth that exceeds the past 9 yrs of growth in Tangible Book Value (indicating an under-priced stock): Becton Dickinson (BDX), Chevron (CVX), ExxonMobil (XOM), 3M (MMM), and Medtronic (MDT). Then do your homework. Spend time reading articles in the responsible business press. For example, the kind of information you need on Medtronic is found in a lead story in Barron’s.

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Sunday, September 23

Week 64 - Food Production Companies

Situation: All investors are interested in gaining information about the Next Big Thing that will drive movement in the markets. We think that could be food production because 
   a) there’s not going to be enough land under cultivation to feed 9 Billion people by 2050; and
   b) the land that is under cultivation will produce less food given there are more droughts such as those we’ve been experiencing. 

Food production has many moving parts, most of which are in a continual state of flux and difficult to document. Weather, technology (“The Green Revolution”), soil erosion due to flooding and wind, global warming, population growth, availability of fuel for power grids and farm machinery, irrigation requirements for water, estate taxes that break up family farms, diseases that affect plants and animals, internet access to regulated futures exchanges and weather forecasting websites, diversion of food grains to fuel production, transportation of food to markets, and financing needed to purchase farm machinery, farm land, seeds, insecticides, veterinarian services, futures contracts, and well digging equipment. All of these listed items change from season to season and year to year, and impact market prices.

This last item listed above (financing for farmers) is of particular interest to us as investors but is, unfortunately, “flying under the radar.” That is, stocks and bonds aren’t issued by finance firms to successful farms for listing on public exchanges where fair prices can be arrived at through active trading. Family farms are about as amenable to high finance as family homes, and we have witnessed the results of what happened when bonds were created from thousands of mortgages: prices were inflated. So, “high finance” for a farmer = belonging to a farmer’s co-operative. These local/regional organizations pool money from several or many farmers to invest in farm necessities and market farm products. Farmers (i.e., the co-op members) share in the proceeds. If you buy gas at a Cenex station or enjoy Land O’Lakes butter, you’re paying into a farmer’s co-operative. The 100 largest co-operatives in the US earn over $200 Billion a year in revenue. The largest is CHS Inc. (Cenex), based in Minnesota, with sales of over $40 Billion/yr and profits of over $1.5 Billion/yr. They do pretty much all things “Ag” and in most every location, including operating their own oil refineries (Laurel, MT & McPherson, KS). Land O’Lakes is the second biggest co-operative, handling 12 Billion pounds of milk annually and operating the Purina Mills animal feed business.

Current estimates are that 1.3-1.6 Million more acres have to be brought under cultivation using Green Technology before there will be enough food to support a world population of 9 Billion by 2050. That will be even more difficult in the face of global warming. I decided to get a ringside seat to observe this fight against nature: I moved from Cleveland, OH, to Hastings, NE, last spring. I expected to have to wait a few years before a humdinger of a drought got everyone’s attention but soon found my timing was perfect. Our editorial office will remain in Baltimore, MD.

Bottom Line: Investors need to think about how large populations are fed, and then move beyond buying stock in McDonalds. The accompanying Table shows how the 25 food production companies in the S&P 500 Index are doing, i.e., not very well for the most part. People need food but many are out of work and unable to spend much on food.In addition, the costs of food production are soaring. The result is that companies attempt to pass along those increased costs by raising prices only to see people respond by buying less. Some companies have done well: Monsanto, Hormel Foods, General Mills, Potash, Flowserve, and FMC are sound enterprises that are relatively low-risk. However, this is widely known so their stock is somewhat overpriced. Higher risk names that are also sound enterprises include Caterpillar, Deere, Mosaic, and Dupont. Their stock is either fairly priced or underpriced. 

For the seasoned investor, who knows fixed income investments are where the smart money hides out, there’s the Cenex preferred stock issue (CHSCP) paying 6.25% as of 9/12. Cenex is an $84 Billion company that shows strong continual growth due to its worldwide reputation in the food game. It’s a farmer’s co-operative so stock is not issued and it isn’t regulated by the SEC. What is known is that the company’s book value has grown at a rate of 9.65%/yr over the past 5 yrs. Bankruptcy is not even a remote possibility, yet it pays twice the interest of a US Treasury bond. Why? Because investors know nothing about farmer’s co-operatives and aren’t going to know anything until headlines appear in The WSJ such as: “Why isn’t there enough food?” and “Can Farmer’s Cooperatives be Capitalized Better?”

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