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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