Sunday, February 26

Week 34 - The New Gold Standard

Situation: Gold has been a top-performing asset in recent years. When currencies are weak and interest rates low, some investors shift assets into gold because they become afraid of losing even more money. This can make sense if deflation doesn’t intervene and collapse commodity prices across the board. Gold prices often rise when stocks are down but gold is expensive to own. In addition to buy/sell commissions, there are ongoing fees for insurance and storage. Gold pays no dividends or interest, so interest rates also have to be low to justify these expenses. And, the higher the price that gold rises to the larger will be the investment that gold mining companies make in exploration and production. Within a few years, the resulting increase in supply might outstrip demand. In today’s market, the price of gold is almost 3 times the cost of production, causing played-out mines to be re-opened for another run using newer mining technologies.

The dilemma we’re discussing in this week’s blog is common: When investors face market pressures like those seen in the past few years, should they bail out of stocks in favor of owning commodities such as gold? We propose that the answer is to continue making a monthly investment in companies on the 2012 Master List (Week 27) that fulfill two criteria:
   a) have less than 45% of total capitalization from long-term debt (except regulated utilities);

   b) have a “durable competitive advantage” as defined by Warren Buffett (Week 30), which we define as no more than two down yrs in tangible book value (TBV) over the past decade, and a TBV growth rate of at least 6%/yr.

We find that 11 out of 30 companies on the 2012 Master List meet those conditions:

You’ll note that 5 of these companies are also part of the group of 11 companies representing the Dow Jones Composite Average, which we’ve dubbed the "Stock-pickers Secret Fishing Hole" (Week 29). We’ll focus on these 5 companies to make our point (see attached Table). 

The Table shows that gold has increased in price at the amazing rate of almost 20%/yr since July of 2002, when the stock market was bottoming after the 9/11 attack. By November of 2004, those gains led to introduction of the first exchange-traded fund (ETF) that allowed investors to purchase fractional shares of gold bars (GLD). A competing gold ETF was introduced 2 months later (IAU). Nonetheless, many “gold bugs” chose to stick with owning shares in gold mining companies because, historically, gold prices are volatile and can remain depressed for decades. Owning shares of a large gold mine can present less risk, i.e., the mine holds ~1,000,000oz of readily extractable gold reserves with a known cost of production (currently ~$600/oz vs. the market price of over $1,700/oz). It’s unlikely that a major gold-mining company like Newmont Mining (NEM) or American Barrick (ABX) would fail to make money in any given year. Both pay a good dividend and show price appreciation that tracks the NYSE Arca Gold Miners Index (GDX).

The total return for Newmont Mining (NEM), as shown in the Table, is 7.2%/yr for the last ten years using quarterly additions to a dividend re-investment plan (DRIP). This compares favorably to the most popular S&P 500 Index Fund (VFINX), which had a total return of 4.6%/yr. But NEM did much better during the credit crunch from 10/07 to 4/09, gaining 1% in value while VFINX lost 48%. This matters a lot to those of us who save for retirement by contributing to mutual funds through 401(k) plans as our main strategy. We took a big hit and won’t soon forget the sinking feeling we had every 3 months reading our 401(k) statements!

Now let’s turn to the 5 stocks we found in our favorite fishing hole, the ones with a “durable competitive advantage”: XOM, WMT, JNJ, NSC, and NEE. How did they do compared to NEM and VFINX? Taken together, these DRIPs had a total return of 8.65%/yr but lost 15.8% during the credit crunch (Table). This performance easily beat the S&P 500 index fund, and beat Newmont Mining in terms of annualized total return. But during those 6 quarters after Lehman Brothers went bankrupt, NEM was the place to have parked some money because it gained 1% in value. 

So which is better? Investing in a top-tier gold mining company for a return of 7.2%/yr and little risk of loss during a credit crunch (as long as a deflation doesn't take hold), or investing in 5 top-tier dividend growers for a return of 8.65%/yr and a temporary 15.8% price loss in a credit crunch? Bear in mind that all top-tier gold mining stocks exhibit considerable volatility and none have ever garnered an A rating from S&P. But over the most recent 30 yr period NEM did manage to almost hold its own against VFINX in terms of total return, albeit with long periods of depressed prices, particularly in the 1990s when the stock market was booming. That discordance is called "non-correlated price action" by traders and is considered a good thing. Why? Because the non-correlated asset goes up in value when the stock market goes down. Long term US Treasury bonds are another non-correlated asset that does well in a bear market. Dollar cost-averaging into these at over 15+ years can be expected to beat inflation by 1.8%/yr, whereas gold only beats inflation if you know when to buy and when to sell.

Bottom Line: After an awful decade for stocks and a great decade for gold, we find that a basket of 5 Buffett-style growth stocks still managed to outperform a typical top-tier gold mining stock by almost 1.5%/yr.

Note added in post-script: The importance of gold as a guarantor of sovereign debt continues to grow, as evidenced in the second bailout of Greece by the European Union (concluded in Brussels on Feb 20), "Greece's lenders will have the right to seize the gold reserves in the Bank of Greece..." (New York Times, 2/22/12, article by Rachel Donadio on p. A11).

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Sunday, February 19

Week 33 - Rainy Day Fund in Retirement

Situation: It’s expected that retirement savings will be gradually depleted in retirement. But how do you deal with the unforeseen and unexpected expenditures that can upset an ongoing financial plan and derail your retirement savings?

This situation requires a backup plan--we need a “Super Hero” to step in and help. In an earlier blog (Week 15), we explained the importance of having a Rainy Day Fund and described the type of investments we would use to create such a fund. We can’t emphasize enough the importance of keeping contributions to the Rainy Day Fund on track throughout our prime working years; our 30s, 40s, 50s and right up into retirement.

The Rainy Day Fund that we suggest you establish is equally divided between Lifeboat Stocks and inflation-protected Savings Bonds, or “ISBs” (see Week 15). What this will achieve is that, by 10 yrs into your retirement, at least 50% of your stock holdings will be in Lifeboat Stocks (Weeks 8 & Week 23) instead of the 33% called for in our Goldilocks Allocation retirement savings portfolio (Week 3). This is important because Lifeboat Stocks are also termed “defensive”, meaning they don’t collapse in value during a bear market. Think about it. Having a bear market hit you two years into retirement might mean you’ll have to return to the workforce whether you like it or not.
Looking at the 2012 Master List (Week 27), we find 13 stocks representing “defensive” industries (health care, consumer staples, communication, employment services, utilities):
             ABT, KO, JNJ, MDT, PEP, PG, WAG
             WMT, ADP, BDX, HRL, MKC, and NEE.

And this is good because we can use these 13 stocks as candidates for our Lifeboat Stock designation (as defined in Week 25). Presently 12 of these 13 companies are relatively free of concerns. [The exception is ADP which has been bid up to a price (P/E=20) not justified by its low return on assets (ROA=3.6).] Seven of the remaining 12 are “Buffett Buys” from Week 30 (HRL, JNJ, MDT, WAG, BDX, WMT, NEE) but the remaining 5 also warrant Lifeboat Stock designation (ABT, KO, PEP, PG, MKC).

If used as 10+ yr DRIP investments with regular purchases in fixed amounts, any of these 12 stocks will more likely than not have a total return beating an S&P 500 Index fund AND show less depreciation during a bear market.

Since 7/1/02, for example, only MDT and WAG failed to do as well or better (in terms of regular DRIP investments) than the Vanguard S&P 500 Index Fund (VFINX); PG and JNJ DRIPs returned the same as VFINX (4.6%/yr). That’s 8 wins, 2 losses and 2 ties. With respect to price depreciation during the credit crunch from 10/07 to 4/09, all 12 of these stocks held up better than VFINX, which fell 47.6% vs. 21.6% for the 12 Lifeboat Stocks. Wow. Those ranged from an 18.8% gain (WMT) to a 48.9% loss (MDT).

To give you a concrete idea of what you accomplish by investing in Lifeboat Stocks to create a Rainy Day Fund, I will use my own Rainy Day Fund as an example. I created my fund on 7/1/02 using a quarterly investment of $630. I split this into $300/qtr for ISBs and $330/qtr for Coca-Cola (KO) in a dividend re-investment plan. As of 1/31/12, the $11,700 that I spent buying ISBs had grown to $14,278.34 (3.9%/yr) and the $12,928.55 that I spent on KO had grown to $18,476.95 (6.7%/yr). The result is that my Rainy Day Fund returned 5.4%/yr. For the sake of comparison, if we use a virtual $11,700 investment made in VFINX (Vanguard’s S&P 500 Index Fund) over this same period of time, it would have grown to be $14,847.98 (4.64%/yr). Inflation (Consumer Price Index) grew at a rate of 2.3%/yr. Therefore, my Rainy Day Fund had an after-inflation return of 3.1%/yr. This is a typical after-inflation return for a generic 50:50 stock:bond investment since 1970--after pricing in the tax benefits from owning Savings Bonds (Week 15).

Bottom Line: Every retiree would be smart to not only have a Rainy Day Fund going into retirement but continue adding the usual amounts after retiring. This could be the only unencumbered asset remaining in her portfolio to meet unexpected emergencies. It’s a real Super Hero that can step in and save the day!

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Sunday, February 12

Week 32- Growing Perpetuity Index Performance for 2011

Situation: The past year was a chaotic one for stock-pickers. Loss of the highest S&P rating for long-term US Treasury bonds in combination with Congress’ near inability to raise the debt ceiling in time to avoid a default on those bonds resulted in a sharp drop in the S&P 500 Index in early August. For the year of 2011, the S&P 500 Index remained unchanged in terms of price appreciation (but don’t forget that the 2% payout in dividends brings the total return up to 2%).

Mission: It’s time for an accounting of 2011 performance for our
GPI (Growing Perpetuity Index - see Week 4). We’ll do number-crunching every January, so READ NO FURTHER IF NUMBERS AREN’T YOUR THING! Just know (here’s the “sub-basement bottom line” for you) that someone who invested in DRIP accounts for all 12 stocks in the GPI had a total return of 11% for 2011, and that growth estimates for the next 10 yrs also come in at a total return of 11%.

We think that’s awesome, and frankly, it’s the reason we’re writing this blog.

So let’s assume that one of our readers invested in each of the 12 GPI stocks beginning January 3, 2011, using a dividend re-investment plan (DRIP) and made an electronic purchase of $100 the first trading day of each month (see Table 1). The results by year end were pretty good with the GPI returning 11.9%. Only two stocks (MMM & UTX) turned out to be losers. Three stocks (XOM, WMT, and JNJ) were not only winners but receive props for both beating the S&P 500 Index over the past 2 yrs and showing low risk (see Week 25 -- Master List Risk). For comparison, we examined a similar $1200/mo virtual investment in a DRIP for our benchmark, SPY (the Exchange-Traded Fund that mimics the S&P 500 Index). It had a negative return (-0.49%) for 2011. So the time and trouble of DRIP investing paid off, for this year.

But what about future prospects for our reader who is running those 12 DRIPs - assuming she makes no additional investments and lets her current DRIPs ride? How big of a nest egg would accumulate over the next 10 yrs? To answer that question, we’ll use Warren Buffett’s method (Week 30) for projecting 10 yr total returns (see Table 2). His method begins by establishing which companies have grown tangible book value steadily for  the past ~10 yrs. Among the 12 GPI stocks, 6 meet this qualification (CVX, XOM, MCD, NSC, WMT, and NEE). Of the remaining 6 stocks (PG, KO, MMM, JNJ, IBM, and UTX), his company (Berkshire Hathaway) has large holdings of 4 (PG, KO, JNJ, and IBM). It’s safe to assume that Warren Buffett would not own those stocks without a good reason. Book value might have been impaired for a reason, such as a decision to leave offshore earnings overseas (Week 30). The remaining two companies (UTX & MMM) also have large offshore earnings. Taking Warren Buffett’s method for projecting future growth in gains that will be realized by investors, we find that an average rate of 11.08%/yr (over the next 10 yrs) is projected for the 12-stock GPI (see Table 2).

Bottom Line: By investing the sum of $100/mo in each of the 12 DRIPs included on the list of GPI stocks, a return of 11.91% would have been realized for 2011. This is to be compared to a loss of 0.49% for investing the same $1200/mo in SPY. AND using Warren Buffett’s method for projecting 10-yr total returns suggests that an 11%/yr growth rate is likely to continue.

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Sunday, February 5

Week 31 - Master List Stocks Have Great Long-Term Returns but What About Safety?

Situation: All 30 stocks in the ITR 2012 Master List (Week 27) have 15-year total returns that handily beat the S&P 500 Index, and all but one (KO) beat the Index in terms of price appreciation. (Go team!!) But stocks also carry the unhappy possibility of a company filing for bankruptcy, and thus leaving shareholders with nothing. That is the one key thing that separates stocks from bonds: Bondholders get all the assets remaining after a company files for bankruptcy. And this brings us to an important issue: There is no such thing as a “safe stock”. We think of it this way: there are 3 kinds of stocks: 1) risky stocks, 2) temporarily safe stocks, and 3) relatively safe stocks. Here at ITR we have a system for winnowing out risky stocks but (until this week’s blog post) we hadn’t developed a system for identifying the least risky, i.e., relatively safe stocks. This is important--we’re not just splitting hairs! For example, Kodak would definitely have been near the top of our 1972 Master List if we’d been picking value stocks back then. But Kodak recently filed for Chapter 11; anyone holding that stock over the past 40 yrs didn’t make money in the long-term and had to watch the price fall gradually while hoping for a chance to sell. Of course, such an investor would have been better off to sell at a loss when the company stopped increasing its dividend annually. That investor would have been well served by a "label and column" in the 1972 Master List announcing that Kodak was a stock that is temporarily safe.

This week we’ll distinguish between temporarily safe stocks which might later perform like Kodak, and relatively safe stocks. We’ll use a simple tool that does the job for most stocks,  which is to identify stocks with what Warren Buffett calls a durable competitive advantage: “A long-term or durable competitive advantage in a stable industry is what we seek in a business.” Such companies a) produce a product or service that has predictable value in the marketplace, and b) have been in the game long enough that they’re unlikely to be displaced by competitors. The main factor he uses to identify such companies is a steady increase in book value (preferably tangible book value) over ~10 yrs

When we use the most recent 10 yrs of S&P data to evaluate 9 yrs of growth in tangible book value for each of the stocks on our 2012 Master List (Week 27), we find that 5 had no down years (XOM, LOW, OXY, WMT, NEE) and 8 that had only one down year (CVX, MCD, NSC, WAG, BDX, CB, HRL, TROW). These 13 are relatively safe for long-term investment. You can set aside $26,000, call your broker, and buy $2,000 worth of stock in those 13 companies (and don’t forget to set up automatic reinvestment of dividends). Then you can do the Rip van Winkle thing for 20 years. Upon waking up, your nest egg will have out-performed a similar $26,000 invested in the S&P 500 exchange-traded fund (SPY) over the same period, and probably by a wide margin. Why? Because over the past 10 yrs those 13 stocks averaged a 12% growth rate in tangible book value vs. ~3% for the S&P 500 Index.

One problem though--Warren Buffett’s method is not useful for evaluating future growth of many consumer staples & health care companies that earn 50% or more of their revenues outside the US. Such companies often have no tangible book value. Why is that? Because their Boards of Directors don’t want to pay taxes twice--first to the host nation’s treasury and then, after repatriating the profits, to the US Treasury. So those companies choose to leave profits in the host nation as captive retained earnings, to be used for expanding operations in that country. The company may then have to borrow the money needed to pay shareholder dividends. This impairs book value but given the stability of worldwide cash flow, the possibility of bankruptcy is considered to be so remote that the chance is worth taking. Wal-Mart is an exception: Even though it increases tangible book value annually without fail (at a rate of 11% per year), overseas earnings are repatriated as needed to pay dividends. Here at ITR, we prefer to think that stock in a company without tangible book value is no better than a temporarily safe investment

Bottom Line: No stock is a “safe bet”. If you want to make a safe investment in one of the companies on our 2012 Master List (Week 27), buy that company’s bonds. But 13 of those 30 stocks qualify as relatively safe by meeting Warren Buffett’s criterion for a company with a “durable competitive advantage”: steady growth in tangible book value over ~10 yrs. Eleven of our Master List companies have been steadily growing their tangible book value at a rate of at least 8%/year (CVX, XOM, OXY, LOW, WAG, WMT, BDX, CB, NEE, HRL, TROW) and 4 of those have no red-flagged risk factors (2yr Bollinger Bands, 5yr Beta, long-term debt/capitalization, and FCF/div): XOM, WAG, BDX, and WMT. As a group, those 4 are a “safe bet.”

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