Sunday, October 28

Week 69 - Making a Business Case for the “Steady Eddies”

Situation: In Week 62, we introduced yet another strategy, which we dubbed “The Steady Eddies”, to help you prepare for retirement without fearing that your nest egg will crack open and leak its contents during the first year of your retirement. Steady Eddies are Lifeboat Stocks (see Week 23) except without the life jackets that make Lifeboat Stocks so attractive (like an emphasis on state-regulated utilites).

Once again, we screen Zack’s database of 6,000+ world stocks for companies that meet the following basic criteria:
   (a) dividend 2% or better
   (b) dividend growth 3% or better
   (c) ROI 10% or better
   (d) 5-yr average ROI 10% or better. 

Next, we check the Buyupside database and eliminate companies with a greater than 30% drop in total return during the Lehman Panic, and also eliminate companies without 5 and 10 yr total returns of at least 7%. Next, we use our favorite tools to screen out volatility, inefficiecy, and risk by requiring, respectively: 5-yr beta of 0.7 or less, ROIC of 12% or more, and long-term debt of no more than 50% total capitalization.

After these analyses, we were left with 10 companies that qualify for inclusion in this week’s special list for sound long-term investment potential. If we include all 5 companies with 5-yr Betas higher than 0.7 (red-flagged in the Table), our list grows to 15 companies. All 15 have a DDG (dividend + 5-yr dividend growth) of greater than 7%.

The purpose of our blog this week is to determine which of the Steady Eddies have a “business case” for investment. By this, we mean that you’re likely to double your money in 10 yrs (i.e., realize total returns of 7.2%/yr). We’ve turned up 15 companies but the question we know you'll be asking is: "Which of those are currently underpriced?" After all, you don’t want to “buy high and sell low.” The answer turns out to be that it doesn’t matter much over the long run if you dollar-cost average (i.e., purchase a little stock each month using a dividend reinvestment plan). 

The only method we know for calculating whether a stock is currently underpriced or overpriced is the Buffett Buy Analysis (BBA, explained in Week 30): 1) determine whether the company has grown its tangible book value (TBV) steadily over the past 10 yrs; 2) project the trendline of Core Earnings for the past 8-9 yrs into the future for 10 yrs; 3) assume the economy is going to be bleak (P/E sinks to the lowest value seen in the past 10 yrs and the company can’t raise its dividend). That gives you a projected stock price which you can compare to the current price.

If the projected growth rate is higher than TBV growth rate over the past 10 yrs, the stock is probably underpriced at present (Table). The data needed to run these numbers are available from S&P, but only for large companies (LANC and FLO aren’t big enough). When we examine the remaining 13 companies, we find that 6 don’t qualify for analysis, either because they’ve spent some of their TBV or they’ve had more than 3 down yrs in TBV growth. Upon calculating the BBA for the remaining 7, however, we find that HD and BMY are overpriced, HRL is fairly priced, and the remaining 4 are underpriced. That gives you 5 stocks to reflect upon as potential purchases: HRL, MCD, CVX, ADP and UNP

Bottom Line: Don’t take chances with your retirement money. If you lose 50% on an investment, you have to achieve returns of 100% just to get back to where you started. That’s why “smart money” people favor fixed income investing, as exemplified in the attached Table by investing in PRCIX and VWINX. On the other hand, stock investments make an interesting hobby (and you’ll learn much about how the world works). Just make sure you have a dozen or so companies in your portfolio and you don’t get carried away, i.e., have at least 50% of your wealth in utilities (Week 50), bonds (Week 67), Rainy Day Funds (Week 15) and your domicile. Speaking as a doctor, a retiree and an investor, my most practical advice for the run-up to retirement is: Go to the dentist often. Don’t get a divorce. If your doctor prescribes a blood pressure medication, de-stress your life by selling the stocks. Invest the proceeds in a bond-heavy mix of VWINX, PRCIX, VFAIX, and ISBs (inflation-protected US Savings Bonds). And pay off your mortgage.

Sunday, October 21

Week 68 - Stockpickers Secret Fishing Hole (Making the “Business Case”)

Situation: The Dow Jones Composite Average (DCA) contains 65 stocks, all picked by a small committee headed by the Managing Editor of the WSJ. Of those 65 stocks, there are 
   a) 30 in the Dow Jones Industrial Average (DJIA), 
   b) 20 in the Dow Jones Transportation Average (DJTA), and 
   c) 15 in the Dow Jones Utility Average (DJUA). 
We call it the Stockpickers Secret Fishing Hole because the DCA usually out-performs the S&P 500 Index and always has a higher dividend yield. The problem is to know which companies to regularly invest in over the long term. In this week's blog, we walk you through a method for selecting companies that make a "business case" for long-term investment. The term “business case” means that you are likely to double your money in 10 years. That would be a 7.18% Annual Return.

First Step (current reward): Does the dividend yield plus the 5-yr dividend growth rate equal or exceed 7.2%?  

Second Step (current risk): Is long-term debt less than 50% of total capitalization?

Third Step (past reward): Did the company have annualized total returns over the past 5 yrs of at least 7.2%? 

Fourth Step (past risk): Did the company's total return fall less than 30% during the “bear market” between October 2007, and April 2009? (In case you're a recent arrival to this planet, ask any homeowner what a 30% loss on a major investment feels like. Then you'll understand our key reason for drawing the line there.)

The attached Table names the 8 companies that remain after applying these 4 tests: 5 are from the DJIA (WMT, MCD, TRV, KO, CVX); one from the DJTA (UNP), and two from the DJUA (SO, DUK). For comparison, findings on key mutual funds (PRCIX, VWINX, MDLOX, VFIAX) and other major DJIA companies (JNJ, XOM, PG) are shown, as well as the only major gold mining stock (NEM) that comes close to meeting our criteria for a “business case.” 

Note that bond-heavy mutual funds (PRCIX, MDLOX, VWINX) in the Table show an increase in total return during the recession (Col E), even though the underlying bonds pay a lower interest rate (cf. Col C showing that the sum of the current payout rate and the 5-yr decline in payout rate gives a low or negative number).

Bottom Line: We all know the past 5 yrs have been rough for investors. Nonetheless, some old standbys have continued making good money and are likely to keep doing so: WMT, MCD, KO, CVX and UNP. Any experienced investor has heard of these 5 companies and isn’t surprised to learn that they make money through thick and thin times. But who among us holds more shares in these "no brainers" today than he or she did 5 yrs ago? I can answer "yes" for owning only three (MCD, KO, CVX). In other words, we make investing appear more difficult than it really is. We get thrown off by the "noise" in the system: namely the "talking heads"--TV and newspaper pundits. Those same pundits can also be faulted for failing to highlight the importance of holding stock in regulated utilities like Duke Energy and Southern Company. Remember this point: regulated electric utilities can’t go bankrupt and are guaranteed ~10% ROE (Return on Equity) by state utility commissions.

Sunday, October 14

Week 67 - Bonds and Bond Funds

Situation: To quote from a NY Times editorial on 9/16/12 ("The Road to Retirement"): "More saving is clearly needed, along with ways to protect retirement savings from devastating downturns. The question is how." That quote serves as both the Central Thought for the ITR website and introduces our blog this week. 

Protecting retirement savings from an economic downturn amounts to setting up fixed income hedges against that possibility. One way to do that is to invest in hybrid stocks that are actually bonds in disguise (i.e., regulated utilities). Another way is to invest in a bond mutual fund wherein the manager can choose between a variety of offerings, including foreign bonds, e.g. T. Rowe Price New Income Fund (PRCIX). And for a third suggestion, we continue to recommend that our readers regularly add inflation-protected US Savings Bonds (ISBs) to their Rainy Day Funds (see Week 15).

By investing regularly in stocks, you'll capture part of the profits made in a growing economy but at what cost? The cost is the possibility of losing all of the dollars you've carefully invested in a company's stock should that company declare bankruptcy. And, in the event of a market collapse, all of your stocks will fall in value until the market recovers. If you happen to retire when the market is collapsing, you'll be loathe to sell at a loss but could find you have no choice. 

Bond investing captures an unchanging stream of income from money you've rented out, money that will be returned to you on a date certain. Should the "rentee" declare bankruptcy in the meantime, you'll still receive your share of the remaining assets. In short, stock investing requires you to accept uncertainty; bond investing doesn't. Inflation, however, decreases the purchasing power of any interest income you've earned from bonds and bond funds. This is not as important as you might fear if you reinvest your interest income and regularly add to your portfolio of bonds and bond funds.

Using bonds to buffer a temporary stock market loss is a simple way to maintain what you've obtained. All of us now know the value of doing so: After 5 years, the stock market is still short of its October 2007 high while bond investors have enjoyed annualized total returns of 7% (PRCIX).

A note of importance: The US Treasury has increased the money supply since 2007 to lower federal borrowing costs and make US exports cheaper on foreign markets. The term to describe this is “financial repression.” To accomplish this, the Federal Reserve expands its balance sheet through multi-trillion dollar purchases of US government bonds on the open market. This has driven the price of 10-yr Treasury Notes so high that interest on the Notes has fallen to the current inflation rate. That means there is now a risk of loss to investors in these Notes should inflation pick up: 10-yr Treasuries may no longer be the “zero risk” investment they once were. 

Bottom Line: Stocks in general are 4-5 times as risky as bonds (Riskmetrics). That riskiness can be dialed back if you select stocks that have been issued by companies with low debt and a history of growing dividends. Nonetheless, you'll still need to keep at least half your retirement money in bonds and utility stocks to buffer market downturns.

Sunday, October 7

Week 66 - Growing Perpetuity Index (Update)

Situation: In one of our first blogs (Week 4), we created the Growing Perpetuity Index (GPI). This was composed of 12 companies that are listed in the 65-stock Dow Jones Composite Average (DCA) and meet 4 criteria:
   a) dividend yield no less than the yield for the exchange-traded fund (ETF) that mimics the S&P 500 Index (SPY);
   b) 10 or more consecutive years of annual dividend increases;
   c) S&P stock rating of A- or better;
   d) S&P bond rating of BBB+ or better.
Those 12 companies are listed at the top of the accompanying Table, ranked in order of Finance Value (reward minus risk).

This week’s update shows that GPI stocks are outliers, meaning that all 12 companies fell less in value during the Lehman Panic than the S&P 500 Index did and therefore were wiser bets for you to have financed. Taken together, GPI stocks outperformed all but the best hedge funds (see Week 46). Results for a mutual fund (Blackrock Global Allocation Fund-MDLOX) that is issued by a leading hedge fund company serve as a proxy for that industry and are included in the Table for comparison. We also include results for the only mutual fund (VWINX) that allocates assets between stocks and bonds like our Goldilocks Allocation does (Week 3). We also include a leading bond mutual fund (PRCIX) and 4 additional stocks in the Dow Jones Composite Average that either meet our 4 criteria (see above) or soon will (CHRW, SO, MSFT and UNP). 

Bottom Line: There’s no shortage of safe and effective stocks for the long-term investor to own, as long as she owns several. Examples include McDonald’s (MCD), NextEra Energy (NEE), Procter & Gamble (PG), ExxonMobil (XOM), Southern Company (SO), CH Robinson Worldwide (CHRW), Chevron (CVX), and IBM. If you add $$ electronically each month to dividend reinvestment plans (DRIPs) for each of these stocks, you can stop worrying about market swings--you’ll come out right as long as you keep your nerve. But remember to balance your stock investments (other than utilities like SO and NEE) 50:50 with bond investments (e.g. PRCIX), for reasons we’ve discussed previously (see Week 3).

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