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.

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