Sunday, March 25

Week 38 - Italy: A Story About a Country with Insufficient Return on Assets

Situation: Two days after the second bailout of Greece, a news article appeared on the front page of the NY Times (2/22/12): “For Greece, a Bailout; for Europe, Perhaps an Illusion.” The article ended by parsing Italy’s sovereign debt, which has reached an awesome #3 on The Hit Parade of the World’s Largest Debtors. It currently stands at 120% of Gross Domestic Product (GDP). ‘Italy is essentially in a sovereign debt trap,’ said Richard Batty, global investment strategist at Standard Life Investments. For Italy’s debt to be sustainable, the country’s economy must grow at a nominal [i.e., not inflation-corrected] rate of 5% a year, or the interest rate on its 10-yr bond must be 3.6%, Mr. Batty estimates. During Europe’s most recent boom period (2002-07) Italy’s nominal GDP grew at an average rate of only 3.6% and its 10-yr bond has a yield of 5% (even with a big rally this year). Mr. Batty is pointing out that a country must grow its economy at least as fast as the rate of interest it pays on outstanding debts.

Mission: Explain to our readers why Return on Assets (ROA), which for a country is approximately equal to nominal GDP, has to equal or exceed the interest rate on that country’s debt. If it doesn’t, the country’s debts can only continue to grow relative to nominal GDP. When private investors lose confidence in a country’s bonds, that country’s treasury will be forced to offer a higher rate of interest on new bonds to attract a different class of private investor, one interested in “junk bonds”. Those new investors then buy insurance, or Credit Default Swaps (CDS), that pay if the country defaults. The country has entered a “debt trap” because soon most of its tax revenues will go toward paying interest on its debt; default becomes unavoidable.

A country’s assets start with its birth-rate. Add to that the educational system that produces the nation’s workforce. Add increased efficiency in delivering a technologically sound education and the result is higher output/hr from the average worker, i.e. a gain in productivity. The growth rate of the workforce added to the growth rate of productivity equals nominal GDP. If productivity declines because of competition from other countries, GDP stalls-out or falls. Mature economies have a demographic problem because the death-rate becomes higher than the birth-rate. This problem can be solved by importing workers with valuable skill sets to boost productivity. Growth of productivity is also slowed by “friction”. There are many examples of friction, particularly professions with high barriers to entry that lock out new workers and prevent new technologies from taking hold, and/or education systems that fail to provide students with relevant skill sets.

To summarize: Italy’s nominal GDP (workforce gains + productivity gains) grows at only 3.6%/yr in good times. Italy has been paying for growth in its workforce and gains in productivity by borrowing money at an interest rate of ~5%. What this means is that Italy can only emerge from its debt trap by growing GDP faster. It can accomplish this by importing more skilled workers and removing friction from its productivity machine. There is no chance that investors will accept a lower interest rate on Italy’s 10-yr bond until that happens. But once it happens interest rates will drop below the rate of growth in nominal GDP, provided the Italian government uses the increase in revenue to pay down debt.

Bottom Line: Return on Assets (ROA) is an accounting ratio that carries a powerful and immutable impact. Not only countries but every family and business must respect its message: Grow revenues at least as fast as the interest rate on your outstanding debt (or don’t borrow money). But one country’s fiscal & monetary situation does not necessarily resonate with another’s. The US economy, for example, has strong growth when emerging from periods of slack because friction is less of a problem here than in almost any other country. Debt/GDP currently is 0.9-1.0 but is likely to fall below 0.85 over the next 3 years--assuming that nominal GDP growth continues to trend at 5-6%/yr and interest rates on 10 yr Treasury Notes continue to trend at 2-3%. The Federal Reserve has promised to continue its policy of Financial Repression through 2014, so those low interest rates “are baked into the cake.” How does this affect you the investor? It means you have been given a strong incentive to take on some risk. Invest in the US economy: borrow for college, start a family, buy a house, open a business, take more interest in stocks. Now is your time.

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Sunday, March 18

Week 37 - Hedging Your Bets

Situation: We have noticed a common misunderstanding on the part of both novice and seasoned investors: Too frequently a “hedge” for an investment is expected to make money for the investor, at least enough to cover trading costs and inflation. However, Merriam-Webster’s Collegiate Dictionary (11th ed) defines a hedge otherwise: “to protect oneself from losing or failing by a counterbalancing action.” A hedge may serve its purpose yet still be very expensive. But it can’t be so expensive as to obviate the purpose of acquiring it. An investment is designed to show a profit after costs for transactions, inflation, & taxes are paid. Hedges are not.

So let’s consider ITR’s favorite hedge (next to Savings Bonds). It was discussed in the Goldilocks Allocation blog (Week 3): 10-yr US Treasury Notes. Lately our fave has been getting a lot of bad press since it currently pays 2%, while the Consumer Price Index sets the rate of inflation at almost 3%. This situation is upside-down and quite uncommon in our country’s history. It has occurred because the Federal Reserve has adopted a policy of driving interest rates so low that people choose to make risky investments in the economy. This policy is known as “Financial Repression.” In other words, you can do better today by using your money for higher risk situations than by purchasing US Treasury bonds. If you have spare cash it is better to become an entrepreneur, buy stock, or buy something expensive (i.e., because inflation is expected to return soon). The last time the Federal Reserve adopted a policy of Financial Repression was in 1949. These monetary actions also have the not inconvenient feature of making it very cheap for the US Treasury to borrow money. An economics professor will tell you that such a policy risks producing the opposite outcome (i.e., hyperinflation) at some point in the not too distant future. That didn’t happen in 1949 for the singular reason that there was a great amount of “excess slack” in the economy due to the ending of World War II. Chairman Bernanke at the Federal Reserve has said that excess slack also characterizes our present economy, thus he is not very worried about hyperinflation.

In the present (unusual) situation, owning US Treasury Notes & Bonds does not appear to be useful as a hedge against collapsing stock prices. However, in August 2008 and August 2011 it was very useful. In August 2008, a new 30-yr T-Bond paid 4.5% interest. Now a new T-Bond pays 3% interest. That means the T-Bond you bought in August 2008 has gained 50% in value. If you paid $1000 for that bond, you could get ~$1500 for it now. While 10-yr T-Notes don’t go up as much during a recession, they also don’t go down as much when risky investments like stocks soar in value. But the important point is to build up a store of T-Notes over time because in a Bear Market for stocks those T-Notes are worth a lot more money than you paid for them. And here’s another important point--only a fool tries to predict the direction interest rates will move. That means that you would be wise to bite the bullet and make a regular quarterly payment into your hedge, whatever it may be. We favor T-Notes & inflation-protected Savings Bonds (ISBs). Others favor T-Bonds, while the rich who have no fear of losing their shirt freely invest in raw commodities (gold bricks, oil sitting in tankers moored off the coast of Singapore, etc.). 

Let’s take a look at how 10-yr US Treasury Notes function as a hedge--by taking the very long view. Since 1953, the AVERAGE interest rate on those Notes has been 6.2% according to Jack Hough (WSJ, 3/3/12 “Where to Find the Bargains”). Inflation has been 3.7% over that 59-year period as per the Consumer Price Index. If treasurydirect had been available in January 1953 and you had made a cost-free $100 investment in a 10-yr US Treasury Note paying 6.2% interest, you would have received $3,378 in interest over the next 59 yrs. This assumes that the note was “rolled over” every 10 yrs into a new Note paying the same interest. 

Now, consider that if the US Treasury had a dividend re-investment plan (DRIP) to go along with the $100 investment in bonds, every bi-annual interest payment of $3.10 would have become a re-investment--in a fractional share of a new Treasury Note paying 6.2%. Let’s say you continued spending $100 every January on the same investment and it continued to pay the same average 6.2%/yr. Those annual $100 investments would have produced $51,964 of interest payments over 59 years (total return = 5.2%/yr). You would have paid ~$15,000 in Federal tax (no state or local tax) and lost ~$37,000 to inflation. So where does our T-Note investment stand?? This hedge would have cost you nothing and profited you nothing after accounting for all costs (transaction fees, inflation, and taxes). 

Since we don’t have US Treasury Notes that pay 6.2% today, it’s hard to get cozy with the information in the above paragraph. We just have to take a deep breath and understand:
   a) Financial Repression is temporary;
   b) Interest rate cycles have very long durations (our current cycle peaked in 1982), so data has to be averaged across an entire cycle to have any meaning; 
   c) Dollar-cost averaging T-Notes over your adult life will allow you to capture the benefits and terrors of the cycle you’re living. It’s important to get in the habit of maintaining about 5% of your assets in the form of T-Notes purchased regularly at treasurydirect in multiples of $100.

Remember, when the stock market tanks the value of T-Notes increases dramatically. Two recent examples of this increase in value were a) after Lehman Brothers went belly-up, and b) in the past few months when it looked like the European Union might fall apart. There is no rational replacement for T-Notes and T-Bonds as a hedge against a Bear Market in stocks. Raw commodities could do the trick but they’re expensive to store and insure, and carry real risk. Commodities can lose 50% of value very quickly if a recession turns into a depression. When that happens, only T-Notes and T-Bonds will soar upward in value. By that point, newly purchased T-Notes/Bonds will be paying very low interest so you can’t be late to the party! Take a lesson from the biblical Joseph!! Remember him? The guy who stuck valuable grain in a storehouse knowing that in the next drought cycle it would be worth a bundle.

Bottom Line: A well-chosen hedge not only serves its purpose (conservation of assets) but will cost you nothing over the long-term. By dollar-cost averaging, your investment in 10-yr Treasury Notes probably won’t lose or gain any money over an interest rate cycle. But in a Bear Market your accumulated T-Notes will likely be worth at least 10% more than you paid for them. As we’ve seen recently, Bear Markets are associated with high unemployment--another painful reason why those T-Notes might come in handy.

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Sunday, March 11

Week 36 - Really Simple Savings

Situation: Many of us make a New Year’s Resolution to start saving for retirement, but then it all seems too daunting and another year rolls by. There are just too many bills and not enough money to set aside. The goal for this week’s blog is to offer guidance for starting a new retirement plan using small steps. Let’s discuss what you can accomplish with $300/mo.

Step 1:  Find companies on the 2012 Master List (Week 27) that have:
   a) less than 45% of total capitalization from long-term debt, and
   b) a “durable competitive advantage” - meaning no more than two down years in tangible book value (TBV) over the past decade, and a TBV growth rate of at least 6%/yr.

There are 11 such companies: JNJ, MDT, BDX, HRL, WAG, WMT, NEE, NSC, TROW, XOM, LOW

As a pool, these 11 companies represent a safe investment but we will filter further.

Step 2: Let’s narrow these 11 stocks to only those companies that generate enough free cash flow to cover dividend payouts by a factor of at least two (FCF/div = 2 or better), and have long-term debt/capitalization of no more than 30%. We do that because volatility in a stock’s price is usually a reflection of problems with debt and/or cash flow. That leaves 6 stocks: JNJ, HRL, WAG, LOW, TROW, and XOM. To these we’ll add NEE, even though it falls shy of our requirements, because it is an electric utility and the State of Florida guarantees its debts and profit margin.

Step 3: Choose one Core Holding (from XOM, LOW, TROW) and one Lifeboat Stock (from JNJ, HRL, WAG) in addition to the regulated utility (NEE). 

We have chosen one Lifeboat Stock balanced with one Core Holding because Lifeboat Stocks do well in a down market but rarely out-perform in an up market, whereas, Core Holdings tend to out-perform in an up market but do poorly in a down market (see Week 22 and Week 23). Having one of each in our portfolio internally hedges some of the risk of loss inheritant in stock ownership.

Step 4: Choose DRIPs that charge no more than $1 per purchase in order to keep our expenses low. For this 3-stock example, we’ll go with XOM, JNJ, and NEE.

Now let’s make a virtual investment (see attached Table) of $50/mo in JNJ and $50/mo in XOM via DRIPs using, which has low expenses. And we will hedge the risk inherent in owning those stocks by purchasing $100/mo (or $300/qtr) of inflation-protected ISB Savings Bond from The investment in NEE is already hedged because bankruptcy of a regulated electric utility is not a material risk. So we’ll invest $100/mo in NEE via a DRIP from without buying an equal amount of ISBs. The XOM and NEE DRIPs carry no costs. If you mail in $150/qtr for the DRIP in JNJ, there is no transaction charge, whereas, you would be charged $1 for each automatic monthly withdrawal of $50 from your checking account. In other words, regular purchases of ISBs and the 3 stocks are cost-free. 

To facilitate our calculations, we’ll say we mailed in $150 at the first of each quarter for both XOM and JNJ, $300 for NEE, and $300 for an ISB: a total of $900. The start date will be 7/1/02, when the Bear Market from the dot-com recession and 9/11 attacks bottomed. We’ll use Vanguard’s S&P 500 Index fund for comparison (VFINX). The result for VFINX is that $300/qtr thru 1/31/12 ($11,700 total) grew to $14,848, for a total return of 4.6%/yr. Investing $300/qtr in ISBs ($11,700 total) grew to $14,278 (3.9%/yr). Overall, the $35,100 invested in our combination of 3 DRIPs and ISBs grew to $50,295 after 9.6 yrs, for a total return of 6.7%/yr. By looking closely at the Table, you’ll see that the 3 DRIPs beat VFINX by 3.3%/yr AND lost 57% less in the Bear Market. 

Bottom Line: Really Simple Savings beat inflation by 4.4%/yr and beat the Vanguard S&P 500 Index Fund (VFINX) by 2.1%/yr. This was accomplished over the most difficult 10-yr period faced by stock investors since the Great Depression, with only a 20% loss during the Bear Market (vs. a 48% loss for VFINX).

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Sunday, March 4

Week 35 - Electric utilities, railroads, and gas pipelines

Situation: Electric power-plants are the most essential node in the infrastructure of any nation’s economy. In most countries, coal and natural gas are the main “feed-stocks” for power-plants. Notable exceptions are France and Japan where nuclear power also plays a major role. In any given week, raw goods (coal, lumber, grain, etc.) account for most cargo being moved by railroad cars, with coal dominating. This results in the fortunes of many railroads being tied to coal; some (e.g. NSC) own extensive coal-producing properties. It’s not uncommon for coal-fired power-plants to also hook into natural gas pipelines to fuel gas burners that can be turned on quickly to provide “peaking power.” The use of natural gas to provide baseline electricity is growing, even though it costs more than coal. Some of the reasons for this migration are that natural gas requires a smaller & cleaner plant with fewer workers, emits 55% less carbon dioxide, and has no need for smokestack “scrubbers” that remove toxic pollutants. Natural gas has also become remarkably cheaper through improved technology--horizontal drilling combined with hydrofracking. 

Taken together, these three industries (electric utilities, railroads for hauling coal, and pipelines that carry natural gas) form an economic triad that is characterized by interdependency and high fixed costs. Profitable operation is difficult to achieve because electricity prices are heavily regulated, and projects to build or modernize power-plants depend on the availability of cheap long-term loans. Over the years, governmental bodies have come forward to build a regime of subsidies, tax breaks, and debt guarantees that allow this triad to function. For investors, this should be good news because there is little likelihood of bankruptcy or even back-to-back losing years. This frees up cash, since the investor no longer has need of an off-setting position in risk-free bonds. However, investors do need to take more trouble to understand the economics. The payoff is a low risk:reward ratio.

Unfortunately for investors seeking company information, the financial press finds stories about these stocks to be either too boring or too technical to cover. The good news is that our ITR blog readers have already read a number of interesting things about one railroad and one utility, Norfolk Southern (NSC) and NextEra Energy (NEE), that shows each to be a potent and reliable money maker. Prior blogs (Week 10, Week 20 and Week 26) introduced issues related to production, transportation and marketing of commodities.

In the process of combing through data on utilities, railroads and gas pipeline companies, we’ve found two more companies that are on the verge of meeting current ITR requirements for inclusion on the Master List (Week 27): Wisconsin Energy (WEC) would be qualified but for having 9 yrs of dividend increases instead of the required 10. Plains All American (PAA), a gas pipeline company, has a BBB credit rating but the ITR requirement is a BBB+ rating. In addition, we find 6 other companies that have a “durable competitive advantage” on Buffett’s Buy Analysis (Week 30). This distinction makes these 6 worth tracking, in part because their growth over the next 10 yrs can be estimated with some degree of precision. The group includes 3 regulated electric utilities, which have projected growth rates of 1.6-5.7%/yr: Sempra Energy (SRE), Southern Company (SO), and NSTAR (NST). The other 3 companies are railroads, which have projected growth rates of 8.5-13.4%/yr: Union Pacific (UNP), CSX Railroad (CSX), and Canadian National (CNI). 

With so much interdependence found between railroads, regulated electric utilities, and gas pipeline companies, one is reminded of  a 3-legged stool. What would happen if the stool lost a leg? An article in the New York Times on 2/19/12 by Elisabeth Rosenthal compared projections for energy use by type in the US through 2035. Coal and natural gas use are approximately the same in terms of energy (BTUs consumed) at present but going forward natural gas use will grow 1.2%/yr vs. only 0.3%/yr for coal. By 2035, half again as much natural gas will be produced than coal. All other sources of energy (wind & solar power, oil for fuels, and nuclear power) together will not quite equal natural gas production. But 25-30% of energy use will still be coming from coal, even though wind & solar will have grown to provide 15-20% of power requirements. For power-plants, the takeaway is that coal use won’t change much but gas use will grow 50% by 2035.

Bottom Line: We will begin to separately track each of these 3 stable industries and file periodic reports for our readers. For now, the bottom line is that this economic triad of railroads, electric utilities and gas pipeline companies is going to grow in importance and the separate industries will become even more intertwined.

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