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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