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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