Sunday, August 26

Week 60 - The “Fiscal Cliff”

Situation: "The Fiscal Cliff": Political candidates on the stump, special interest groups, reporters and “talking heads” in the media love to bandy the term about. Hand-wringing and doomsday prophecies abound. How much of this should we (as long-term investors) be paying attention to? The fiscal cliff is supposed to occur because of legislative bills that have already been signed into law by Congress but which have not yet taken effect. The idea is that our present trajectory (under these pending bills) has the adult US population and the country’s economy bolting over a financial cliff en masse come January. “But wait,” you say, “it’s an election year and this smells suspiciously like Vote Getting Behavior!” Our view is that beyond its usefulness as a classical media scare, the fiscal cliff’s effect on investors will probably depend on their investing strategy, i.e., whether you’re investing for the short term or the long term.

Short term investor: The Fiscal Cliff isn’t good because it cuts the US 2013 GDP by 0.5-0.6%. That may not sound like much of a cut but the expected GDP is only 1.2% and would, therefore, be cut in half. Economists predict that this will be enough to stall the economic recovery and perhaps create a recession.

Long term investor: The Fiscal Cliff is good. You’ll feel skippy because government spending goes down and taxes go up. As a result, the government will spend only a little more than what it collects in taxes and fees instead of its current behavior of spending a lot more. In real terms, that means the US Treasury won’t be pushing so many dollars away from the private economy by continually floating larger and larger government bond issues to support the public economy. 

So just what is the Fiscal Cliff then in real terms? 
    a) Taxes on dividends and capital gains will revert to Clinton-era rates. That means capital gains are taxed at a 20% rate instead of at 15%. For middle income households, dividends are taxed at 28% instead of 15%.
    b) And then there’s the Alternative Minimum Tax (AMT) which will revert to its original form. Remember that? It forces everyone to pay some tax even if they’ve been successful in using “tax shelters” to prevent that. The AMT has to be corrected for inflation annually by separate legislation. If it’s not, many middle income households will be taxed at upper-middle income rates, meaning that dividends would then be taxed at a 31% rate.
    c) Take-home pay will fall because the special reduction of Social Security taxes (from 6.5% down to 4.5%) is going to expire.
    d) State unemployment benefits will no longer receive Federal extensions.
    e) The August 2, 2011, legislation that extended the Federal Debt Limit kicks in. Remember how that one came about? Congress couldn’t agree on how to limit spending so automatic cuts of $1.2 Trillion (apportioned 50% to defense spending and 50% to discretionary spending) over 10 yrs will kick in. That means Federal spending will be $120 Billion less in 2013. 

Bottom Line: No politician wants to be the one who cuts government spending and raises taxes. They know they’ll have a tough time getting re-elected because opponents will promise voters more. That means they are careful to inflict pain during the first year of a President’s term and then hope you’ll forget how it felt. By letting Bush-era tax cuts on dividends and capital gains expire as promised, and by having across-the-board cuts in defense and discretionary spending occur automatically and equally in every Government bureau, no politician can be personally blamed: Nobody’s fingerprints are on the legislation.

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Sunday, August 19

Week 59 - We counted and there are 90 companies in the S&P 500 Index with a Durable Competitive Advantage

Situation: Investing is a numbers game, even though valuations over the near term are somewhat influenced by fear and greed. In Week 54, we defined the calculations we use to arrive at what is called a “durable competitive advantage” (DCA) by Warren Buffet. The final step of the analysis generates what is called Buffett’s Buy Analysis (BBA) and gives a specific market price for a company’s stock 10 yrs from now. That price estimate is based on using today’s market price to project a 10 yr Total Return. If the stock is overpriced today, its projected Total Return will likely be less than the “business case”, in other words, less than 7.2%/yr which is the Annualized Total Return for an asset that doubles in value over 10 yrs.

Similarly, if the company’s Tangible Book Value hasn’t grown at least 7.2%/yr over the past 9-10 yrs (with no more than 3 down yrs), there isn’t any point in calculating the Buffett Buy Analysis. This is because a less than stellar past performance rarely gives way to an outstanding future performance. For our blog topic this week, we examined all 500 companies in the S&P 500 Index and found that 90 of those companies have a Durable Competitive Advantage. We’ve identified borderline companies as well (Table), by setting the cut-off point at 6.5% for both the past growth in Tangible Book Value (DCA - Column J) and the expected future growth in Total Return (BBA - Column K).

We’ve also provided additional information on the 90 companies that passed our math quiz. You’ll peruse this Table and think we’ve gone to a lot of trouble to highlight dozens of companies that rarely are mentioned on TV or in newspapers, and you’ll also notice that oil & gas producers are here in abundance. In addition, there are many companies that we are used to seeing highlighted for performance which don’t appear on the our list. Now why is that? Well, some (like Procter & Gamble) are so confident they’ll have a steady (and growing) stream of revenue that management sees no point in the company “saving for a rainy day.” Other companies are so well run (like Coca-Cola) that large numbers of investors have decided to overpay for the privilege of owning its shares. A company doesn’t really have to maintain Tangible Book Value if it has
   a) low debt;
   b) steady and reliable growth in Free Cash Flow; and
   c) never gets caught borrowing money to pay its quarterly dividend.
Many companies have “corner office” occupants who will say “Oh, that would be us!” if asked that question but don’t believe them. If a company doesn’t appear in our Table it is either breaking one of those three rules, or its stock is overpriced thus making its BBA less than 6.5%, or the company doesn’t have a long enough track record for our analysis. In the Table, you’ll again see red & blue highlighting. Red means performance as bad or worse than the S&P 500 Index. Blue means bear market losses of less than 65% those seen for the S&P 500 Index (Column D). Blue in Column E means Finance Value was as good or better than that of an above-average hedge fund (see Week 46). 

Bottom Line: Stock ownership has been receiving negative press lately. We find this to be strange given that bond ownership is merely a hedge that is unlikely to beat inflation even after government spending stabilizes. Partly, the bad stock ownership vibes are due to the dismal performance of the S&P 500 Index over the past 10+ yrs. Keep in mind though, that has been a period that has seen two recessions. This week we take a close, number-crunching look at all the stocks in the S&P 500 Index to see if stock ownership is really that bad for your financial health (i.e., cholesterol for your retirement portfolio). It takes a big table to encapsulate relevant information about all 90 stocks that have done well over the past 10 yrs and are likely to continue doing well, but at least we can cross the other 410 companies off our watch list for now. We ranked those 90 companies by their Finance Value (reward minus risk). We arrived at those numbers (for columns C & D in the Table) by going to the website. I’ve cross-checked their math many times and it’s spot-on. Of those 90 companies, 28 were “clean,” meaning that their 10+ yr Annualized Total Return was greater than the S&P 500 Index and their 18 month bear market losses were less than 65% of the S&P 500 Index losses. Six of those 28 companies are in the current iteration of our Master List (see Week 52): Occidental Petroleum (OXY), Hormel Foods (HRL), NextEra Energy (NEE), Becton Dickinson (BDX), Chevron (CVX), and ExxonMobil (XOM).

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Sunday, August 12

Week 58 - Dow Jones Transportation Index: Taking the Pulse of the US Economy

Situation: Every economist has a favorite series of data points that s/he uses to measure whether the economy is heading up or down. Usually these “metrics” track activity that is related to the transportation sector. This was part of the reason Warren Buffett bought a railroad, i.e. to know how many freight cars were loaded yesterday compared to last week and last month. An economist I enjoy following will even phone toll booth operators working on the turnpike. News reports frequently mention the Dow Jones Industrial Average (DJIA) as being “up” or “down” but those reports don’t tell you that stock traders put little store in that movement unless it is further confirmed by a similar move in the Dow Jones Transportation Average (DJTA) and a corresponding increase or decrease in trading volume. Our key point here is that the movement of goods is the fulcrum of the US economy. Inventory drawdowns can herald a strengthening economy, or imply that manufacturers don’t see much of a market for their goods. However, when inventory drawdowns happen because trucks are pulling up to warehouses and distribution centers, then leaving with deliverables, it’s an early sign the economy is growing again and manufacturers will soon need to replenish inventories.

Let’s take a closer look at the stocks in the DJTA (Table). As always, we use blue highlight in the Table to denote companies that outperform the S&P 500 Index (e.g. fall less than 2/3rds as far in a bear market) and red to denote companies that underperform the S&P 500 Index. Only 18 of the 20 DJTA companies are tracked by S&P; those have S&P data that we summarize in the Table. The transportation sector is deeply cyclical because the only thing that transportation companies do is move goods from point A to point B, which is exactly why we’re interested. In a deep recession, only essential goods are being moved:  fuel for electrical powerplants, basic foodstuffs, medicine, laundry detergent, toothpaste. You get the picture. 

A sound long-term investment strategy is to have a solid idea of when the economy is seriously flirting with recession or is about to recover from recession. At those times, the DJTA may start to change direction even before the DJIA. If the DJTA heads down, that suggests the economy is slowing and becomes a tip-off to shore up our holdings of Lifeboat Stocks (Week 50) and bond funds. If the DJTA heads up during a recession, you’d better think about owning stock in more cyclical companies, or what we like to call Core Holdings (Week 22). There are even a few companies in the DJTA that have learned how to make at least a little money during the depths of a recession: CH Robinson Worldwide (CHRW), Norfolk & Southern (NSC), and Union Pacific (UNP). 

Bottom Line: We think the game to watch is the Dow Jones Transportation Average vis-a-vis the Dow Jones Industrial Average and the volume of trading. And think about buying stock in one of these transportation-related companies too, even though the ride is certain to be bumpy.

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Sunday, August 5

Week 57 - Four Stocks and a Bond Fund

Situation: Much of the available information about investing is mind-numbing in its complexity and scariness. That is why most people turn the task of saving for retirement over to trusted professionals.  A really smart, fee-only advisor might recommend that you put 60% of your retirement savings in a no-load S&P 500 Index mutual fund (e.g. VFINX), 30% in a no-load managed intermediate-term, investment-grade bond fund (e.g. PRCIX), and 10% in a no-load, inflation-protected, short/intermediate-term US Treasury fund (e.g. VIPSX). If you had come into an inheritance in June of 2002 and invested it that way on July 1, 2002, your total return through July 19, 2012 would have been 5.8%/yr. However, you’d have lost almost 23% during the 2007-09 bear market (see attached Table). Had your advisor guided you to a no-load, conservative-allocation balanced fund like Vanguard Wellesley Income Fund (VWINX), you would have done even better with a total return of 7.1%/yr, However, you would have lost over 13% during the 18-month bear market (Table).

Let’s pretend that investing isn’t all that complex and you can do better on your own. And let’s assume you have maximized your contributions to your retirement plan at work, and would also like to put $500/mo into a Roth IRA--by using a $100/mo automatic withdrawal from your bank account into each of 5 dividend/interest re-investment plans (DRIPs). Your question then is “which 5 DRIPs make the most sense going forward from today?" In our Week 54 blog, we surveyed all 500 of the S&P 500 Index companies to determine which have a “durable competitive advantage.” We then matched those with the 60 S&P 500 companies that have the most honored brands globally. We came up with 14 matches, 3 of which are companies on our Master List (Week 52): ExxonMobil (XOM), Wal*Mart (WMT), and Microsoft (MSFT). If we chose those 3 as DRIP investments, we would still need a diversified bond fund and a second Lifeboat Stock (Week 50) besides WMT in order to minimize risk. Our best suggestion is to pick a stock from the Master List that is issued by a regulated electric utility, one that grows its dividend annually and has a durable competitive advantage (Week 54). We’ve selected NextEra Energy (NEE). For the bond fund, we like T Rowe Price’s New Income Fund (PRCIX). If you had enrolled in these 5 DRIPs on July 1, 2002 then made no further additions, your total return through July 19, 2012 would have been 7.6%/yr and your portfolio would have lost only 13% during the bear market (Table).

Bottom Line: Risks that are embedded in the major world economies and global marketplace really haven’t changed much since 2007. Careful selection of two Lifeboat Stocks (e.g. WMT & NEE) and two additional stocks (e.g. XOM & MSFT) from what we like to call Core Holdings (Week 22) will get you started, supplemented by a diversified bond fund that can invest internationally (e.g. PRCIX). Once you see how well this works, that experience will likely guide you to investing in additional DRIPs.

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