Sunday, May 6

Week 44 - Getting Started with Net-Net-Net Investing

Situation: When one initiates a long-term investment plan, there are 3 cost-centers that must be confronted:
   a) the fees & commissions levied on purchases
   b) the taxes levied on profits
   c) inflation 
Net-Net-Net Investing is all about what you are left with at the end of the day: net of fees & commissions, net of taxes, and net of inflation. In other words, it is your true profit, and that is the true profit that fund managers seldom discuss. The costs mentioned will ultimately determine whether your portfolio is a “profit-center” or “cost-center.” Some dividend re-investment plans (DRIPs) have no costs for startup, re-investing the dividend or automatic electronic purchases (e.g. XOM, NEE, PG). Neither do purchases of US Savings Bonds or US Treasury Notes, when purchased using treasurydirect

You probably know that profits from the sale of stock and dividends earned, are taxed at a lower rate than income. This is because you have already paid taxes as a co-owner of the company. When you cash out a Savings bond, you will be taxed for interest earned as though it were ordinary income but you won’t pay taxes during the accrual period--as interest is reinvested and accumulates. Savings Bonds, therefore, act like a standard IRA as regards taxes. Inflation, however, is hard to beat. But you can buy inflation-tracking investments such as inflation-protected Savings Bonds (ISBs) and stocks. There are also bond mutual funds that exclusively purchase inflation-protected investment-grade bonds, VIPSX for example, which was highlighted in blue (see the Table with Week 43) as being a good “hedge”.

Where to start today’s discussion? We suggest reading the ITR Goldilocks Allocation (Week 3) where you’ll see an equal investment is apportioned between stocks (in the form of DRIPs) and bonds (as no-load intermediate-term investment-grade mutual funds and 10-yr Treasury Notes). Inflation is the main risk of owning bond mutual funds. To protect yourself, it is best to purchase the Vanguard Inflation-protected treasury fund (VIPSX). An even better solution is to own ISBs, since those have built-in tax savings and track inflation even more closely than an inflation-protected bond fund. For the 50% allocation to DRIPs, the Goldilocks Allocation assigns 25% to Core Holdings, 16.6% to Lifeboat Stocks, and 8.3% to international stocks. (For a review of Core Holdings and Lifeboat Stocks see Week 22 & Week 23). International stocks and mutual funds are tricky to own--many risk factors come into play that don’t affect domestic stocks. Fortunately, some US-based companies gain more than 70% of their revenue outside the US. Three of our Master List companies (Week 39) stand out in that regard: McDonald’s (MCD), CH Robinson Worldwide (CHRW), and 3M (MMM).

Which company stocks should you consider first? Those are the companies with excellent metrics  “across the board” (found in the top half of the Table for Week 43). As a Core Holding, ExxonMobil is hard to beat (XOM). Others worth considering are its competitors, Chevron  (CVX) and Occidental Petroleum (OXY). Canadian National Railroad (CNI), IBM, and Chubb (CB) are others. Lifeboat Stocks with “across-the-board” appeal include Hormel Foods (HRL), McCormick (MKC), Becton Dickinson (BDX), as well as the 3 electric utilities (NEE, SO, WEC). 

Using data that we laid out in that Table, we’ll examine the results of a virtual investment of $300/mo - with $150/mo into ISBs, $75/mo into XOM, $50/mo into BDX, and $25/mo into MCD. All 3 DRIPs are available at computershare. Costs for set-up and automatic investments into XOM and BDX are negligible. However, the MCD drip carries significant transaction costs: it is better to mail in a single check for $300 each year, from which $6.00 will be deducted.

Results from an investment as described above over the past 9.75 yrs (Week 43 Table) are as follows:
   ISBs have returned 4.7%/yr
   Stocks in the ratio indicated by the Goldilocks Allocation (3 parts XOM, 2 parts BDX, 1 part MCD) returned 12.1%/yr on average (but also experienced price depreciation of 24.8% over the worst 18-months of the Great Recession).

Our virtual investment in stocks and bonds together returned 8.4%/yr. That compares favorably with the high-quality, low-cost Vanguard Wellesley Income Fund, which returned 5.6%. In terms of Finance Value (Week 42, Week 43), which compares total return to losses over that 18-month period, our 3 stocks comes in at -11.7% vs. -38% for the S&P 500 Index Fund. Our way of calculating Finance Value is to put a number on risk (i.e., price loss/gain during a bear market) and subtract/add that number to the long-term total return (cf. Table Week 43). This is an arbitrary but nonetheless quantitative and generalizable way of comparing one investment to another in terms of past performance. It’s a way of answering the inevitable question: Sure, your company earned real money for its shareholders over the past 10 yrs but how close did it come to declaring bankruptcy or needing a Private Equity fund to bail it out?

Bottom Line: What is the actual take-home pay from your accumulated investments? Let’s imagine you did as well as the S&P 500 Index since 7/1/02 (total return = 6%), which would mean you’re a very good investor. Then subtract 2.5% for inflation (i.e., growth in the Consumer Price Index). Also subtract one-fourth (1.5%) for taxes. Now you’re down to 2% but nevertheless still ahead. Unfortunately, 2% also happens to be the amount that private investors have been found to spend on average for the fees & commissions levied by fund managers and stock/bond brokers. In other words, you had no take-home pay. Some fees are even as high as 4%. Now look again at our stock and bond example as given above. Stocks and bonds (50:50 allocation) returned 8.4%/yr. After taking out 2.1% for taxes and 2.5% for inflation we’re left with 3.6% for costs and profit. What were the costs? Well, purchasing Savings Bonds costs you nothing, neither did XOM & BDX purchases via DRIPs. McDonald’s stock cost you $6 out of the $3600 you spent annually on stocks and bonds (i.e., total costs = 0.17%/yr). This means your annualized return net of inflation, taxes, and costs (i.e., your take home pay) comes to (3.60% - 0.17%) or 3.43%/yr. Dude, looking good.

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