Sunday, April 29

Week 43 - Finance Value of Master List Stocks

Situation: In last week’s blog (Week 42), we introduced the idea that an asset worth financing requires the exercise of due diligence prior to purchase: Finance Value = Reward - Risk. When you start accumulating a stock, you are making a prospective purchase, i.e., you purchase the hope of a future profit. In our experience, we have found only one way to apply real numbers to estimate whether a solid “business case” exists for making that bet. That is to conduct a Buffett Buy Analysis (BBA), which requires earnings data extending back 9-10 yrs. That calculation is explained in our Week 30 blog and gives a projected growth rate over the next 10 yrs. To have confidence in that number, you also need to know whether the company has what Warren Buffett calls a Durable Competitive Advantage. That assessment requires Tangible Book Value data going back 9-10 yrs. If Tangible Book Value grew steadily at an average rate of over 7%/yr, the company has a Durable Competitive Advantage. If the BBA also projects growth of over 7%/yr, then the basic requirement for a good business case has been met: the investment doubles in value over 10 yrs, which calculates out to be a total return of 7.18%/yr. If you know how the stock did for the last 10 yrs (retrospective reward), and how it did for the worst months of the last bear market (retrospective risk), you’ll be able to come up with its retrospective Finance Value (reward minus risk). The prospective reward is BBA and your confidence about realizing that reward lies in whether or not the company has a Durable Competitive Advantage. As for assessing prospective risk, you’ll have to rely on current risk metrics (LT debt/total capitalization, FCF/div, and ROIC) as explained in the Week 42 blog.

This week, we will look at ITR Master List stocks (Week 39) that look good “across the board.” We will also examine IBM, a former Master List stock that has risen so much in price that its dividend yield is only 1.7%, i.e., lower than the Master List cutoff point of 2.0%. We provide updates on IBM because it is a permanent member of our 12-stock Growing Perpetuity Index (Week 32). We’ll also examine bond mutual funds to highlight why we recommend those as hedges (low risk combined with respectable returns).

Turning to the ITR Master List (Week 39), we can populate our spreadsheet (see Table) with the same key data as last week. The Table shows companies in a descending order of recent finance value (reward minus risk). Bear in mind that BBA often cannot be applied for defensive stocks--those in our Lifeboat Stock category--because many of those companies do not see a need to maintain reserves in the form of Tangible Book Value (see blog from Week 30). Therefore, we cannot determine whether the company has a Durable Competitive Advantage (i.e., the ability to relentlessly increase Tangible Book Value at +7%/yr). However, the BBA can still be calculated. Since Warren Buffett places great weight on estimating a company’s Durable Competitive Advantage, and he is CEO of Berkshire Hathaway Corp, you can read how he guesstimates Durable Competitive Advantage for such companies (Berkshire Hathaway owns hundreds of millions of shares of two: Procter & Gamble and Coca-Cola).

Looking at the Table, we see that all 3 utility stocks in the ITR Master List stand out (NEE, SO, WEC), as do all 3 energy producers (XOM, CVX, OXY). CH Robinson Worldwide (CHRW) has always been a strong performer so it carries a high P/E. The company policy eschews the use of debt, and it is the leading logistics company in a world where commerce is relentlessly globalizing. You wouldn’t be overpaying given the very high ROIC, which reflects how rapidly their business is expanding. McDonald’s is another crowd-pleaser, since it supplies food at affordable prices in developing countries with large populations just emerging from poverty. Wal*Mart (WMT) also sells food and essentials to the developing world at very low prices. Amazingly, its stock climbed 16% during the worst 18 months of the Great Recession! Hormel Foods (HRL) and McCormick (MKC) are other high quality defensive stocks that provide food staples at low prices.

Bottom Line: Look before you leap. When you become a part-time financier by purchasing stock in a company it puts you at risk of losing all you have wagered. Know whether or not there is a business case for making that investment in the first place, then periodically check to see if it remains true. Professional investors can be counted on to “short” any stock from time to time, which drives down the price. This tempts non-professional investors to sell. If you’ve made a sound decision to buy that stock, you can ride out these periods. If you are dollar-cost averaging your purchases in a DRIP, you even want the short-sellers to do their thing because you’ll be buying more shares each month. The shares are literally “on sale”!

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