Sunday, January 29

Week 30 - “Buffett Buy Analysis” of 13 Low-Risk Stocks

Situation: Last week we identified 13 stocks that appear to have high quality and low risk, based on retrospective factors (see Week 29). But what kind of future performance can we expect from these companies?

Mission: Adopt a methodology for evaluating a company’s future performance. So far we’ve only made one recommendation for a new retirement savings plan: establish a DRIP account for each of the 12 Growing Perpetuity Index stocks (Week 4) then contribute a fixed amount to each DRIP periodically for 10+ yrs. This savings approach takes full advantage of the power of dollar-cost-averaging to make up for the fact that half of those stocks carry volatility risk: CVX, MCD, UTX, MMM, NSC, and IBM. In our last blog (Week 29), we screened out stocks from the 2012 Master List (Week 27) that carry volatility risk. That left 10 companies for the risk-averse saver to consider. Then we found 3 more in the 65-stock Dow Jones Combined Index that come close to meeting criteria for inclusion on the 2012 Master List. This is useful info for the newby investor but what are the chances of losing money after investing in one of those?

There are mathematical ways to look at that. We’ve chosen Warren Buffett’s method, as described by two persons who’ve made a vocation out of parsing Warren’s methodology: Mary Buffett (who is the ex-wife of his son Peter) and David Clark (a finance & legal expert). Their recent book “The Warren Buffett Stock Portfolio” (Scribner, New York, 2011, 225 pp) explains why he doesn’t approve of the standard method, the one based on calculating a company’s “net present value” or NPV. He doesn’t approve because the “data inputs” are subjective (i.e., you tend to get the answer you’re looking for). In fact, one might speculate that the recent credit crisis grew (in part) from NPV calculations made at thousands of real estate brokerages around the country! Consciously or unconsciously, those brokers came up with numbers from which they (and their bosses) reaped substantial profit. 

Warren Buffett has often noted that the rate of growth of a real number (book value) is almost identical to the rate of growth of NPV calculated his way. So he uses the real number. This means there can be no argument about the rate and steadiness of a company’s growth. Where possible, he prefers to use tangible book value (i.e., that's what’s left after removing hard-to-value “assets” like goodwill). He’s always on the lookout for a company with a steady increase in book value, which suggests to him that it has a “durable competitive advantage” -from years of producing a product or service that has predictable value in the marketplace. After finding one, he uses the following method to calculate how much money he is likely to make each year (on average) over the next 10 yrs, if he purchases stock in that company.

   Step 1: calculate the growth rate for earnings per share, preferably core earnings, over the most recent ~10 yr period.
   Step 2: project that growth rate into the future, arriving at Earnings/Share 10 yrs from now.
   Step 3: take that number and multiply it by the lowest Price/Earnings ratio that the stock has had over the past ~10 yrs, thereby arriving at projected price per share 10 yrs from now (based on the assumption that the company will have to endure tough times, as reflected in the assignment of a historically low P/E ratio).
   Step 4: Add to that price the current annual dividend payment multiplied by 10 yrs (based on the assumption that the company will continue paying the current dividend for 10 yrs but will not be able to raise it).
   Step 5: Subtract the current share price, thereby arriving at the minimal projected total gain (his projected profit/share, 10 yrs after a one-time purchase).
   Step 6: convert that number to an annual rate of gain. 

Any rate of 8% or more suggests a probable winner. From running those calculations on our 13 low-risk companies, using the most objective inputs available, we come up with 10 yr growth rates in gain/share ranging from 1.16% to 16.9% (see attached Table). Only 5 of those companies (XOM, BDX, TRV, NEE, and WMT) showed a steady increase in tangible book value (or had only one down year) over the most recent 10 yrs of S&P data. And only two of those (BDX & WMT) had a projected rate of gain of 8% or better.

But some of the other companies are attractive nonetheless. Why? Either because of being a commodity producer--and therefore unlikely to have persistent sub-par growth without dividend increases for 10 yrs running (e.g. XOM & NEE), or because of being a company with widely valued brands and high barriers to entry of a new competitor (e.g. KO, PEP, INTC, PG, ABT, and JNJ). Those 8 companies are almost certain to continue raising dividends every year. Remember: Warren’s model is built on the assumption that there will be hard times going forward and companies will be unable to raise dividends. 

Bottom Line: Based on Warren Buffett’s model for projecting total returns, we see two likely winners going forward: BDX and WMT.

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Sunday, January 22

Week 29 - Stockpicker’s Secret Fishing Hole

Situation: The S&P 500 Index represents the largest public companies in the US and uses a “scientific weighting”, where the greater the value of a company’s stock the higher the degree of representation for that company in the Index. We have watched the S&P 500 decline 14% in value over the 12 yr period from 1/3/2000 through 12/30/2011 meanwhile the “unscientific” Dow Jones indexes have increased in value:
   the DJIA (30 industrial stocks) increased 6.2%,
   the DJTA (15 transportation stocks) increased 69%,
   the DJUA (20 utility stocks) increased 64%, and
   the DJA (composite of those 65 stocks) increased 32%.
Ask any fisherman. The place to fish a river is the hole with the biggest fish. The place to fish for stocks is the smallest index that has the most valuable companies: the 65-stock DJA.

To find stocks in the DJA that are close to meeting our 6 criteria (discussed in Week 27) but aren’t quite there yet, we’ve tightened our risk screen to exclude stocks with a 2yr Bollinger Band variance exceeding 3 standard deviations and/or a 5yr Beta exceeding 0.95. That leads us into this week’s blog discussion and a spreadsheet of 9 stock picks. Six of these picks are on the 2012 Master List (see Week 27): KO, XOM, JNJ, NEE, PG, and WMT. The new “fish” are AT&T (T), Intel (INTC), and Travelers Insurance (TRV). You will recall that when we defined the ITR Growing Perpetuity Index (Week 4), we said it is composed of companies in the DJA that meet ITR’s investment criteria. The 3 new companies we identify this week (T, INTC and TRV) are all likely to be added to the GPI over the next 3 years.

Among non-DJA stocks on the 2012 Master List, only Abbott Laboratories (ABT), PepsiCo (PEP), Automatic Data Processing (ADP), and Becton-Dickinson (BDX) meet the low-risk standards that we have used to develop this week’s spreadsheet. In a very difficult 12-year period for stock owners, even these 13 low-risk stocks had tough sledding. Seven beat the 32% price increase for the DJA over that period: XOM (113%), NEE (187%), JNJ (41%), ABT (60%), PEP (88%), BDX (186%) and TRV (78%) but two stocks turned in an even worse performance than the gut-wrenching 14% loss posted by the S&P 500 Index: T (-38%) and INTC (-71%). The 4 “Steady Eddies” were PG (24%), WMT (-13%), KO (21%), and ADP (1%).

It’s worth noting that while the DJA was increasing at a rate of 2.4%/yr over that 12 year period, the Consumer Price Index increased 2.6% and inflation-protected ISB Savings Bonds increased 6.0% (doubling in value). This further illustrates why we recommend that you hedge stocks with an equal investment in bonds. Our point of balancing stock and bond investments 50:50 was emphasized to perfection in a recent Wall Street Journal article titled The Rally That Wouldn’t Die! (1/14/2012): “Since 1981, long-term Treasury bonds (average maturity of 20 yrs) have returned 11.03% annually, 0.05 percentage points better than the Standard & Poor’s 500-stock index.”

Bottom Line: Large, established companies are the best place to look for stocks that have lasting value and lower risk. We’ll continue fishing the Dow Jones Indexes for quality and dependability.

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Sunday, January 15

Week 28 - Net-Net-Net investing

Situation: Our ITR blog is focused on long-term savings that can be used for retirement, and without paying any more in fees than is necessary to achieve that goal. That means explaining how a newby investor can set aside 15% of income for at least 15 yrs and maintain a risk level that is less than 1 in 20 of losing her principal investment. In prior blogs, we discussed minimizing fees & commissions by using point-and-click investing but there are also fungible costs that cannot be avoided, namely, inflation and taxes. According to Webster's Collegiate Dictionary (11th Ed), fungible means “that one part or quantity may be replaced by another equal part or quantity in the satisfaction of an obligation”. In other words, someone else defines those obligations and those definitions can change over time. Here at ITR, we’ve factored the cost of inflation into the calculations presented in our spreadsheets but we haven’t said much about how to minimize it. And the only mention of taxes we’ve made has been to encourage you to use Roth IRAs, employer’s 401(a) & 403(b) plans, and savings bonds. Again, we haven’t said much about how to reduce the taxes due on your investment winnings.

Goal: a) Construct an investment portfolio consistent with our Goldilocks Allocation (Week 3) distribution while attempting to achieve a positive return net of fees, inflation, and taxes.
b) Assume that our investor is 50 yrs old with a gross taxable income of $96,000/yr.
c) Assume that our investor will spend $1200/mo on combined retirement and Rainy Day savings over a 15 yr period, resulting in an out-of-pocket expenditure of $216,000.

For the portfolio: We recommend allocating $6000/yr to a Roth IRA composed of dividend re-investment plans (DRIPs) in 5 stocks, $6000/yr to ISBs (inflation-protected savings bonds) and EESBs (standard savings bonds that guarantee a 3.5% return if held for 20 years), $1200/yr to a NextEra Energy (NEE) DRIP, and $1200/yr to a Rainy Day Fund composed 50:50 of a Johnson & Johnson (JNJ) DRIP and ISBs. Central to our strategy is to pay no taxes on the 50% of retirement savings in stocks (by assigning those DRIPs to a Roth IRA), and to delay paying federal taxes on the 50% in savings in bonds until retirement (there are no state or local taxes due on savings bonds). A Rainy Day Fund by definition needs to be accessible, so the stock portion of the fund will be taxable.

An investment of $1200/yr in stock of the regulated utility (NEE) is a “hybrid investment”, i.e., it doesn’t need to be hedged in the usual way with an equally weighted purchase of investment-grade bonds--because both the debt and the return on investment are guaranteed by a state government. These unusual features also help to offset the tax bill; you’re rewarded with a higher dividend (~4%) that helps pay taxes on those dividends. (Capital gains will be taxed upon sale but that isn’t until after you’ve retired and are in a lower tax bracket.)

Recommended Roth IRA stocks: We support the plan of investing 2/3rds of our sample portfolio’s monies in DRIPs chosen from among Core Holding stocks (e.g. XOM, CVX, PX, NSC, UTX). Care needs to be taken to include at least one company with heavy exposure to international markets (e.g. MCD, KO, MMM, BHP). The remaining 1/3rd of investment monies should be used to purchase DRIPs from among the Lifeboat Stocks (e.g. MKC, PG, ABT, JNJ, BDX, WMT, WAG).

In our virtual retirement portfolio, we’ll assign $125/mo to each of 4 Roth IRA DRIPs (XOM, KO, WMT, UTX), $250/mo to EESBs, $250/mo to ISBs, and $100/mo to the NEE DRIP (for a total of $1100 per month). For the Rainy Day Fund, we’ll assign $50/mo to ISBs and $50/mo to a JNJ DRIP. That brings the total monthly investment to $1200.

In a future blog, we’ll see how this portfolio holds up going forward and retrospectively. Will it provide a positive return after tallying and subtracting all expenses (fees & commissions, inflation, and taxes)? We’ll also look at the small number of academic studies that have been done on Net-Net-Net investing. Be warned--these studies are perhaps a little discouraging because any positive return is considered worthy of recognition! That’s mainly because it’s hard to spend less than 2%/yr on fees & commissions unless you “go it alone”. Another reason is that savings bonds are excluded from most asset allocation models because purchases are limited ($5000/yr for both ISBs and EESBs).

Bottom Line: Have you figured out what your “take home pay” is in real terms? It’s one thing to crow about winnings but quite another to add up all the losses incurred from such things as commissions & fees, taxes, and inflation. After those 3 expenses have been backed out of total annual gains, what remains is called “Net-Net-Net investing” and this is what real investing for profit is all about.

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Sunday, January 8

Week 27 - 2012 Master List

Situation: We update the ITR Master List at the end of each quarter to keep it current with new developments. Companies that no longer meet our investing criteria are removed from the list and new companies that meet our criteria are added to the list. This week's blog includes an updated spreadsheet <click here>.

For the first quarter of 2012, we decided to add two new criteria that will assist our readers in measuring the amount of risk that a company incorporates in its business plan. The new criteria are:
   a) free cash flow (Week 25 blog - Master List Risk) must be at least 1.7 times the dividend payout, i.e., FCF/div equals or exceeds 1.7;
   b) long-term financing with debt cannot exceed 45% of total capitalization, i.e., LT Debt/Total Capitalization is 45% or less.

With the addition of these two metrics, we are now using 6 criteria to evaluate the investment potential of a company. The original 4 criteria were:
   1) an S&P stock rating of at least A-;
   2) S&P bond rating of at least BBB+;
   3) dividend yield at least as great as the S&P 500 Index’s yield; and
   4) annual dividend increases for at least the last 10 yrs.
Our new assessment resulted in the removal of several companies from the ITR Master List. CL, LLTC, TGT & KMB were eliminated because LT debt/capitalization was greater than 45%; APD, KMB & SYY were eliminated because FCF/div was less than 1.7. A regulated utility, NEE, did not meet the new standards: it has FCF/div of 1.1 and LT debt/capitalization of 51%, however, it was not eliminated because these risk factors are mitigated by the State of Florida; i.e., debt is guaranteed as is return on investment.

As noted in the Week 25 blog that specifically addresses Risk, there are 3 factors that need to be tracked:
   long-term debt, and
   cash flow problems.
Debt and inadequate free cash flow are the main sources of price volatility but there are other sources. One is speculation based on the high quality of the company’s brand. Coca-Cola, IBM, and General Electric have all seen periods when their stock price is unaccountably high for this reason. Investors buy a “blue chip stock” without digging through its Annual Report. In the updated ITR Master List, we are red-flagging stocks with a price higher than 3.5 times book value (see attached spreadsheet) to warn our readers. The volatility that then remains is cyclical, i.e., the price of railroads, financial and industrial stocks can become cheap during a recession then have a blazing recovery when the recession ends. Therefore, we use two factors to detect volatility:
   1) 2yr Bollinger Bands and
   2) 5yr Beta.
2yr Bollinger Bands evaluate recent volatility. We set the limit at 4 Standard Deviations away from the 2yr price fluctuation of the S&P 500 Index (go to Yahoo Finance, select "S&P 500 Index" or GSPC and select “interactive” under Charts (left column). Then select "2yr time period" and click on the tab at the top of the graph for “technical indicators” and select "Bollinger Bands" at dev=4.

5yr Beta evaluates volatility relative to the S&P 500 Index over a 5yr period: a value of 1.0 means volatility is identical to the Index’s, 0.5 means it's half as volatile, and 2.0 means twice as volatile. When a Master List stock is red-flagged for both of these volatility metrics, any buyer should expect a roller-coaster ride. Three such stocks are found on the 2012 Master List: EMR, NSC, and AFL.

Two new companies have been analyzed and found to meet our specific criteria for inclusion to the Master List: Chubb (CB), which markets insurance to corporations and high net-worth individuals; Genuine Parts (GPC), which sells automobile parts and business equipment through NAPA outlets. VF Corporation (VFC), a multinational clothing manufacturer, was returned to the list as a result of increasing its dividend.

We see from the spreadsheet that 4 Lifeboat Stocks from Week 23 (ABT, BDX, JNJ, and WAG) and one Core Holding from Week 22 (XOM) have no red flags. In other words, these 5 companies are priced at a reasonable multiple of book value, grow fast enough to continue raising dividends at a rate of ~10%/yr, and have mild price volatility relative to the S&P 500 Index.

Bottom Line: We identify 30 companies whose operations and management factors meet our conservative investment criteria. Five of these companies are currently free of concerns and therefore suitable for a DRIP portfolio composed of 7 or 8 stocks (but also keep in mind that smaller portfolios are risky due to lack of diversification).

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Sunday, January 1

Week 26 - Commodity Plays: Risk vs. Reward

Situation: We’ve found few companies that produce a commodity and meet the ITR criteria for safety and dividend growth, but those few are all oil & gas producers: ExxonMobil (XOM), Chevron (CVX), Occidental Petroleum (OXY). To be certain that our assessment doesn’t miss other oil & gas producers that are close to meeting our criteria, we took a closer look (Week 20) at a shale gas province in the Western US. All of the major players (other than Apache (APA) are active in that geological province. All of the major hard-rock miners are also active nearby, recovering large amounts of gold and copper: BHP Billiton (BHP), Rio Tinto (RIO), Freeport-McMoran Copper & Gold (FCX), Newmont Mining (NEM), Barrick Gold (ABX). The fastest-growing mining & drilling activity occurs in 4 contiguous states (Wyoming, Utah, Nevada, Colorado), so it’s not overly inconvenient to perform on-site assessments of management and operations. But first, let’s use the internet to examine these players from the standpoint of risk vs. reward

In last week’s blog (Week 25), we chose metrics for risk:
   price volatility on 2yr Bollinger Bands;
   FCF/div less than 2.0;
   LT debt more than 1/3rd total capital (bonds + stock). 

In this week’s blog, we add our 3 favorite growth metrics:
   Dividend yield greater than that for the S&P 500 Index;
   5yr average dividend growth of at least 8%/yr;
   Return on Invested Capital (ROIC) of at least 10%.

What is this new metric (ROIC)? It’s operating earnings divided by common & preferred stock + LT debt. ROIC is important because it tells us about the one piece of the company, operations, which should matter most to investors. AND, it assumes that all of the money provided by investors, whether from purchasing a stock or a bond, has a single purpose--to support operations! ROIC ignores the other parts of the company, i.e., those that deal with investment activities (e.g. using retained earnings to expand) and financing activities (e.g. buying back stock and retiring bonds).

The accompanying spreadsheet <click here> shows the S&P stock rating, S&P bond rating, the 3 “return” columns (dividend, 5yr dividend growth, ROIC), and the 3 “risk” columns (2yr Bollinger Bands, FCF/div, LT debt). Values that don’t meet our standard for investment (re: ratings, growth, or risk) are red-flagged. That is, a dividend rate of less than 2%, a 5yr dividend growth rate of less than 8%/yr, ROIC of less than 10%/yr, 2yr BB price volatility more than 4 standard deviations away from the Dow Jones Composite Index (DJA), FCF/div of less than 2.0, and LT debt greater than 33% of total capitalization.

Six companies had clean S&P ratings (XOM, CVX, OXY, MDU, APA, CAT), 3 companies were well-managed from the standpoint of risk (XOM, ABX, BHP), and 6 companies exhibited growth sufficient to support a dividend increase (XOM, CVX, OXY, COP, NEM, BHP).  S&P ratings are never complete for companies based outside the United States (e.g. SLB, RDS, BP, ECA, ABX, RIO, BHP), so it is difficult to make comparisons between US and non-US companies. But based on other sources of information, Royal Dutch Shell (RDS), BHP Billiton (BHP), Rio Tinto (RIO), and Schlumberger (SLB) come close to the S&P ratings we find acceptable. In summary, this analysis of risk vs. reward has uncovered only one commodity-producer (besides XOM, CVX, and OXY) that we would consider for long-term investment: BHP Billiton (BHP).

Bottom Line: Before making any speculative investment, it is necessary for a knowledgeable person to observe operations first hand and meet with management. Backward-looking accounting data are not very helpful when evaluating capital-intensive mining & drilling decisions, where a company’s growth prospects can ride on what a geologist says is “worth a look.”

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