Sunday, September 30

Week 65 - 2012 Master List (3Q Update)

Situation: Stock market fluctuations continue but since 2009 the 250 day moving average (S&P 500 Index) has kept moving higher without a break. Why? We need to remember that this trend line is forecasting conditions 6-9 months down the road. Similarly, when the Federal Open Market Committee (chaired by Ben Bernanke) moves interest rates up or down the effect appears 6-9 months later.

Our ITR Master List (see Week 5) is based on fundamentals that long-term investors use in making stock purchase or sale decisions. That means we need to update our list quarterly. Our requirements for including a company in the Master List have become more stringent, given that the economy is struggling with slow growth and there is little prospect of a breakout in either direction. Unfortunately, it’s a “Muddle Through Economy." To make the list, we currently require companies to have:
   a) at least an A- S&P rating for both debt and equity issues;
   b) to have increased their dividend for at least 10 yrs in a row;
   c)  to have a dividend yield that is equal to or greater than the S&P 500 Index's (currently 1.9%).

In addition, companies (other than regulated utilities) have to meet certain standards pertaining to investment efficiency, dividend coverage, and long-term debt. In other words, ROIC (Return On Invested Capital) has to be 12% or greater, Free Cash Flow (as reported by the WSJ) must be sufficient to pay the entire dividend, and long-term debt has to be no greater than 35% of total capitalization. The attached Table lists 20 companies that presently meet those standards. Three have been dropped since the last Master List update (see Week 52) and no new companies have been added.

Bottom Line: This is not a good time to take a chance on a risky stock, so stick to the fundamentals. Take a look at the Table and think about starting a DRIP in one or two of the companies that have been struggling, and are therefore under-priced. Look for those that have a Durable Competitive Advantage (see Week 42), and projected 10-yr growth that exceeds the past 9 yrs of growth in Tangible Book Value (indicating an under-priced stock): Becton Dickinson (BDX), Chevron (CVX), ExxonMobil (XOM), 3M (MMM), and Medtronic (MDT). Then do your homework. Spend time reading articles in the responsible business press. For example, the kind of information you need on Medtronic is found in a lead story in Barron’s.

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Sunday, September 23

Week 64 - Food Production Companies

Situation: All investors are interested in gaining information about the Next Big Thing that will drive movement in the markets. We think that could be food production because 
   a) there’s not going to be enough land under cultivation to feed 9 Billion people by 2050; and
   b) the land that is under cultivation will produce less food given there are more droughts such as those we’ve been experiencing. 

Food production has many moving parts, most of which are in a continual state of flux and difficult to document. Weather, technology (“The Green Revolution”), soil erosion due to flooding and wind, global warming, population growth, availability of fuel for power grids and farm machinery, irrigation requirements for water, estate taxes that break up family farms, diseases that affect plants and animals, internet access to regulated futures exchanges and weather forecasting websites, diversion of food grains to fuel production, transportation of food to markets, and financing needed to purchase farm machinery, farm land, seeds, insecticides, veterinarian services, futures contracts, and well digging equipment. All of these listed items change from season to season and year to year, and impact market prices.

This last item listed above (financing for farmers) is of particular interest to us as investors but is, unfortunately, “flying under the radar.” That is, stocks and bonds aren’t issued by finance firms to successful farms for listing on public exchanges where fair prices can be arrived at through active trading. Family farms are about as amenable to high finance as family homes, and we have witnessed the results of what happened when bonds were created from thousands of mortgages: prices were inflated. So, “high finance” for a farmer = belonging to a farmer’s co-operative. These local/regional organizations pool money from several or many farmers to invest in farm necessities and market farm products. Farmers (i.e., the co-op members) share in the proceeds. If you buy gas at a Cenex station or enjoy Land O’Lakes butter, you’re paying into a farmer’s co-operative. The 100 largest co-operatives in the US earn over $200 Billion a year in revenue. The largest is CHS Inc. (Cenex), based in Minnesota, with sales of over $40 Billion/yr and profits of over $1.5 Billion/yr. They do pretty much all things “Ag” and in most every location, including operating their own oil refineries (Laurel, MT & McPherson, KS). Land O’Lakes is the second biggest co-operative, handling 12 Billion pounds of milk annually and operating the Purina Mills animal feed business.

Current estimates are that 1.3-1.6 Million more acres have to be brought under cultivation using Green Technology before there will be enough food to support a world population of 9 Billion by 2050. That will be even more difficult in the face of global warming. I decided to get a ringside seat to observe this fight against nature: I moved from Cleveland, OH, to Hastings, NE, last spring. I expected to have to wait a few years before a humdinger of a drought got everyone’s attention but soon found my timing was perfect. Our editorial office will remain in Baltimore, MD.

Bottom Line: Investors need to think about how large populations are fed, and then move beyond buying stock in McDonalds. The accompanying Table shows how the 25 food production companies in the S&P 500 Index are doing, i.e., not very well for the most part. People need food but many are out of work and unable to spend much on food.In addition, the costs of food production are soaring. The result is that companies attempt to pass along those increased costs by raising prices only to see people respond by buying less. Some companies have done well: Monsanto, Hormel Foods, General Mills, Potash, Flowserve, and FMC are sound enterprises that are relatively low-risk. However, this is widely known so their stock is somewhat overpriced. Higher risk names that are also sound enterprises include Caterpillar, Deere, Mosaic, and Dupont. Their stock is either fairly priced or underpriced. 

For the seasoned investor, who knows fixed income investments are where the smart money hides out, there’s the Cenex preferred stock issue (CHSCP) paying 6.25% as of 9/12. Cenex is an $84 Billion company that shows strong continual growth due to its worldwide reputation in the food game. It’s a farmer’s co-operative so stock is not issued and it isn’t regulated by the SEC. What is known is that the company’s book value has grown at a rate of 9.65%/yr over the past 5 yrs. Bankruptcy is not even a remote possibility, yet it pays twice the interest of a US Treasury bond. Why? Because investors know nothing about farmer’s co-operatives and aren’t going to know anything until headlines appear in The WSJ such as: “Why isn’t there enough food?” and “Can Farmer’s Cooperatives be Capitalized Better?”

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Sunday, September 16

Week 63 - Bigger is often better

Situation: Large companies have advantages over smaller companies, advantages that can make the risk of bankruptcy negligible. These include multiple subsidiaries and penetration of international markets, which means some part of the big company is always making money and can support other portions of the business. Most large cap companies have over 100,000 employees, and can also support as many as another 100,000 in the supply chain. This means that very large companies are key players in the broader sense of supporting our economic system. That is why companies other than banks were bailed out by the US Government during the Lehman Panic in 2008-09, namely, GM, Chrysler, GE, AIG, Fannie Mae, and Freddie Mac. The very biggest companies won’t be allowed to go bankrupt. Therefore, the greatest risk to stock ownership (bankruptcy) is not a concern for investors. Fraud and mismanagement, however, do remain as concerns because large multinational companies are unwieldy. Nonetheless, the advantages of stock ownership in large companies outweigh the disadvantages, and everyone who is saving for retirement needs to periodically consider investing in one or more of these companies.

Looking at the Zacks database, we find 21 S&P 500 companies with both a market capitalization of over $120 Billion and a positive Return on Investment (ROI) over the past 5 yrs (Table). We omitted putting two companies, Google (GOOG) and Philip Morris International (PM), in the Table because they didn’t exist in 2002. That is when our calculation for “reward” (10+ yr Annualized Total Return) begins. The other 19 companies are in the Table. The Table also includes the lowest-cost S&P 500 Index fund available (VFIAX) and the only low cost mutual fund (VWINX) that has an asset allocation scheme similar to our Goldilocks Allocation (see Week 3). A variety of metrics are included in the Table for your reading pleasure. Red flags mean “buyer beware.”

Bottom Line: The largest companies tend to survive downturns better than their smaller brethren, so we’ve grouped those “megacaps” together for closer analysis using our favorite tools and metrics. Only the oil giants, ExxonMobil and Chevron, emerge with no cause for concern. But even those two companies, which are reliable & consistent money-makers, have to be watched closely by their shareholders. For example, one might question how management is preparing for the wider adoption of carbon-neutral legislation designed to save the planet from global warming.

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Sunday, September 9

Week 62 - The Steady Eddies

Situation: The older we get, the less interested we are in trying to hit a home run with our stock picking. We’re more satisfied hitting some singles and doubles, and realize that this is a sounder investing strategy, i.e., beating the market a little at a time. Most importantly, we don’t ever want to experience again that sinking feeling we had in September of 2008 as we watched the market tank. Our goal has become to have our stocks and mutual funds keep up with the market when it rises but not when it’s falling. In previous blogs, we’ve called attention to “Lifeboat Stocks” (see Week 50) issued by highly regarded health-care and consumer staples companies. Our blog this week uncovers more such companies, “The Steady Eddies,” where ever they might be hiding. 

We began our search using the Zacks database of publicly traded world-wide stocks. Next, we selected for:
   a) dividend yield of 2% or more,
   b) 5 yr dividend growth rate of 3% or more,
   c) return on investment (ROI) of 10% or more,
   d) average 5 yr ROI of 10% or more.
That screen turned up 200 stocks.

Our next step was to examine how those companies have rewarded their investor-owners since the end of the dot-com bear market (7/02), and how they’ve hurt investor-owners during the 10/07 - 4/09 bear market. If that 10+ yr Total Return was less than 5%, i.e., the inflation rate (2.5%/yr) plus a real gain of 2.5%/yr, we rejected the stock because it hadn’t come close to keeping up with the S&P 500 Index, which gained 5.6%/yr. And, if the stock lost more than 30% during the 18-month bear market we rejected it (even though the S&P 500 Index lost 46%). Remember, the key feature of a Steady Eddy is that it falls less than the market. Finally, we pay attention to Warren Buffett and reject any companies that are capitalized predominantly by loans and any with a 5-yr Beta of more than 0.7. At the end of our analysis we had 15 companies (Table), all of which are familiar to risk-averse investors. What this means is that these stocks can only be had by paying a premium price. You will have to buy and hold these stocks for 10-15 yrs to realize their rather impressive ability to generate wealth through good times and bad. Two Vanguard mutual funds are also included for comparison purposes. None of the 15 companies were on our list of 90 companies that have a Durable Competitive Advantage (see Week 54) because the last step in calculating that advantage is to project the 10 yr total return (see Buffett Buy Analysis Week 30), which is anchored to the current price.

Bottom Line: We’ve satisfied our quest for a portfolio of safe stocks but there are a lot of fellow investors who like to throw money at these companies. Nonetheless, you’ll be rewarded for maintaining DRIPs (dividend reinvestment plans) in 5 of these companies and making regular small additions (dollar-cost averaging). The growth of your investment will be slow but steady, like watching paint dry. I’m certainly satisfied with the 5 companies that I chose long ago for my DRIPs: MCD, PG, KO, ABT, MKC. At one time I owned stock in 4 others that I bought through a brokerage but then I prematurely gave up on the investment and sold (see Table): GIS, NVS, PEP and KMB. The lesson I learned is to do careful research then take the trouble to set up a DRIP and build it up gradually through automatic additions taken from your checking account. It then takes more thought and effort to close out a position than a mere phone call to your broker.

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Sunday, September 2

Week 61 - Gold Miners

Situation: Owning gold appears to satisfy an emotional need for some investors. Until recently, most of the gold mined on a yearly basis was used to produce jewelry. Then in 2004 an exchange-traded fund (ETF) became available that allowed investors to own fractional shares of gold bars and pay low maintenance costs (GLD). An unexpected byproduct of this was to increase the level of speculation in gold, thus adding to supply constraints because production of gold rarely keeps up with demand.

So just what kind of investment is gold? Many terms are applied to answer that question. For example, “store of value, hard currency, safe harbor, hedge against inflation, easily transported wealth, hard asset, piggy bank, real money” are a few. The abundance of descriptors for the role that gold plays only goes to show how important gold is. For dispassionate readers of this blog, however, it’s just another counter-cyclical “hedge,” much like a US Treasury bond. The purpose of a hedge isn’t to increase your wealth. The purpose is to prevent a loss of principal, i.e., to protect your initial dollar outlay. The buyers are more interested in return of their investment than return on their investment. For this reason, they want a hedge that has a low or negative beta. The 5-yr beta for 12 gold mining stocks in the accompanying Table is -0.05 to 0.71 (with an average of 0.43--meaning those stocks go down only 4.3% when the S&P 500 Index goes down 10%). 

You may have asked: "How do I go about investing in gold?" The simplest way is to purchase shares of GLD or IAU (a second gold ETF). These are valued at one tenth (GLD) or one hundredth (IAU) the purchase price of an ounce of gold. Owning gold in one of these ETFs has an advantage over owning gold bars because transaction, storage and insurance costs are much lower. But keep in mind that you still get no dividend income and any capital gains will be taxed as income (because the IRS classifies gold as a collectible, like art). Another way to own gold is to take advantage of its scarcity in the earth’s crust, meaning that supply is likely to keep falling behind demand: You can buy stock in a gold mine. Then you’ll earn a dividend of ~1.7% (average yield for the 12 stocks in our Table) and get taxed half as much on your capital gains.

Our Table was constructed by screening a database of world stocks for 
   a) market capitalization greater than $2 Billion;
   b) Return on Investment (ROI) greater than 1%/yr;
   c) average 5-year ROI greater than 1%/yr.

Almost 2,000 names popped up and among those were 12 gold mining companies that we selected for closer examination (Table). For comparison, we show Annualized Total Returns spanning the ~8 yr period since the first exchange traded gold fund (GLD) became available, and compare those returns with those for the lowest cost S&P 500 Index fund (VFIAX). Four companies (AEM, BVN, IAG, GG) had Annualized Total Returns greater than 7% while losing less than 15% in the 2007-09 bear market, but only one of those has large gold reserves: Goldcorp (GG).

Bottom Line: Gold differs from other countercyclical hedges. Like US Treasury issues, it performs well during recessions. Unlike Treasuries, it performs badly during a depression but better during inflation. If you value these particular features, you can “double down” on your gold investment by owning stock in gold miners. Why? Because those companies own recoverable gold in the ground. Gold production has increased less than 1% a year for the past 13 yrs yet demand for gold (and therefore its price) has more than doubled. What’s the downside? The price of gold is volatile. Even though having it in your portfolio can mitigate stock market losses, you risk losing some of what you have invested in gold when the economy recovers. US Treasuries, on the other hand, will return every dollar you have invested. But what about the effect of inflation on gold vs. Treasuries? Gold wins while inflation is rising but usually doesn’t do as well over a complete economic cycle. US Treasury notes and bonds historically beat inflation by ~2%/yr whereas gold loses ~1%/yr.

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