Sunday, November 25

Week 73 - "Food is the New Oil and Land the New Gold"

Situation: Today's title is a quote from Lester R. Brown’s new book (“Full Planet Empty Plates,” ISBN-10: 0393344150) and puts a fine point on why the ITR blog is now being written from Hastings, Nebraska. Planet Earth's reality is that ~220,000 people are born each day. There are also ~3 Billion people who have acquired upward mobility and expectations of a better life. The problem is how will we double food production to feed the planet as it sprints to a population of 7.5 Billion with a growth rate of 3%/yr. Meanwhile, droughts will probably be more frequent, and energy sources and concerns will continue to grow. In the world’s biggest breadbasket, the Great Plains of the US, almost a third of its corn crop is currently being diverted to make ethanol-blended gasoline.

In our breakdown of companies, we have classified “food-related companies” as what we have called defensive or “Lifeboat Stock” type investments (see Week 50). However, food-producing companies are dicey investments because weather plays such a large and unpredictable role in month-to-month pricing of food commodities (wheat, rice, corn, soybeans, oats) and animal feed. Where does that leave an investor who wants to put her hard-earned money toward solving the food problem? Which stocks should she consider buying as a responsible investment? Let’s start by looking at the 18 food-related companies (Table) as presented in The World-Herald 150, a stock index published in the Omaha World-Herald newspaper. That list is a good place to start because of Omaha’s central location on the Great Plains, and because the University of Nebraska is the focal point of agricultural research and policy in the US.

Looking at the Table, it is clear that food-related stocks as a group consistently outperform. In terms of Finance Value (Reward minus Risk in Col E, Table), all but one of the 18 companies outperformed the S&P 500 Index (VFIAX). But there’s a lot of variability. We’ve red-flagged items of concern and only one company is free of those concerns, Hormel Foods (HRL). But 6 more performed almost as well (i.e., beat VFIAX over the past 5 and 10 yrs while falling less than 2/3rds as much during the Lehman Panic). Those companies are PepsiCo (PEP), Aqua America (WTR), Kellogg (K), Smucker (SJM), Hershey (HSY), and Coca-Cola (KO).

Bottom Line: Food-related companies are going to become more compelling for investors as food shortages become more common due to population growth, affluence growth, urban sprawl, increasing energy costs and drought. Food production is a risky endeavor, so stock prices will fluctuate even more as production costs rise. This can be turned to the investor’s advantage by dollar-cost averaging (investing a little each month), owning several such stocks, and avoiding stocks issued by companies that carry significant debt (e.g. LT-debt that exceeds a third of Total Capitalization). As with any commodity, the investor is better off holding stock in a company that buys the raw commodity and turns it into something consumers want to buy than she would be investing directly in the raw commodity. However, the introduction 10 yrs ago of an Exchange Traded Fund (ETF) that buys gold bars (GLD) has shown that investors will buy a raw commodity and have someone store it for later sale. Result: now you can buy an ETF for corn futures (CORN). Its price is volatile but has grown 29% over the past 2 yrs vs. 13% for the S&P 500 Index.

The ITR Risk Rating: The risk rating for this blog is 8 on a scale that sets maximum performance orientation at 10 and maximum safety orientation at 1. [For example, a blog about oil & gas exploration and production companies like Apache (APA) and Suncor (SU) would have a risk rating of 10 and a blog about inflation-protected US Savings Bonds (ISB) would have a risk rating of 1.]

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Sunday, November 18

Week 72 - So You Want a Small Portfolio of Only 6 Stocks?

Situation: Stocks are risky, 4-5 times riskier than bonds. To capture the value of owning stocks directly vs. owning a stock mutual fund, you need to distribute the risk by owning stock in a number of companies. Academic studies recommend positions in at least 20 companies representing at least 5 industries. But if you’re just starting out, you’ll want to own only a few stocks. Well, there’s a way to do that: pick stocks to overemphasize safety and underemphasize performance. Instead of buying the 1/3rd Lifeboat Stocks and 2/3rds Core Holdings that we recommended (see Week 3), reverse that ratio for a small portfolio of 6 picks and go with companies that have the best credit ratings.

We first identify those that have a AAA credit rating (which is better than US Treasury Bonds with have a AA- credit rating). That AAA credit rating means the risk of bankruptcy is negligible: S&P can identify no concerns or issues that might herald a risk of bankruptcy. We’ve found there are only 4 such companies: Exxon Mobil (XOM), Automatic Data Processing (ADP), Johnson & Johnson (JNJ) and Microsoft (MSFT). To get you to our goal of 6 stocks, we’ll add the next safest company (in our opinion): Wal*Mart (WMT), with a AA credit rating. Then we’ll add the safest utility (in our opinion) that has its bonds guaranteed by a state government: NextEra Energy (NEE), with an A- credit rating.

Given the size of your portfolio, you can’t afford to be concerned about performance. Nonetheless, the 6 companies we’ve identified have performed as well (in the aggregate) as the least costly S&P 500 Index Fund (VFIAX, in the attached Table). More importantly, this “safe” portfolio of 6 stocks was harmed much less than VFIAX by the Lehman Panic.

But now you’ll want to know how these 6 stocks have performed compared to bonds, which we’ve recommended you own in a 1:1 ratio with stocks (Week 3). Bonds did better, as represented in the table by the T Rowe Price New Income Fund (PRCIX). You’d have also done better by avoiding those 6 stocks and holding the lowest cost balanced fund that has at least 50% of its asset value in bonds: the Vanguard Wellesley Income Fund (VWINX, in the Table).

Bottom Line: Owning individual stocks is a time-consuming hobby because you’ll soon realize that you need a baker’s dozen of dividend growers before you’ll sleep well. But there is a way to start with a portfolio of only 6 stocks where the gains are likely to be about as good as the S&P 500 Index and the pains are much less. But a more economical use of your resources would be to hold a low-cost bond-heavy balanced fund like VWINX, and you’ll probably make at least as much money going forward.

In future weekly posts, we’ll distinguish between blogs that feature ideas for investment performance vs. those that feature ideas for safety. In our closing statements, we’ll include a ratings scale of 0 to 10. An number between 7 to 10 will be for discussions that emphasize performance, while 1 to 3 will be for those that emphasize safety. Bear in mind that out-performance cannot be achieved without sacrificing safety but out-performance yields a bigger nest egg for retirement.

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Sunday, November 11

Week 71 - The “Business Case” for S&P 500 Companies

Situation: All of us would like our stock investments to perform better than the S&P 500 Index and we’re heartily disappointed by mutual funds that supposedly track that Index. Realistically, that goal is almost impossible to reach, according to a host of academic studies. Here at ITR, we modify that goal. We find that reducing risk by shooting for safety first and performance second is a better long-term investment strategy. In this week’s blog, we examine whether there is a way to have both safety and performance share top billing.

The Pursuit of Safety:  We screened the 500 companies in the S&P 500 Index to identify those that had less than a 30% drop in total returns during the 18-month Lehman Panic (vs. the 45% drop for the overall S&P 500 Index). Then we eliminated companies that

   a) are primarily capitalized with borrowed money,
   b) lack returns on invested capital (ROIC) that comfortably exceed the weighted average cost of capital (WACC), and
   c) fail to maintain a tangible book value (TBV).

The Pursuit of Performance:  Working with the remaining companies, we used the buyupside website to screen out those companies that did not show a total return in excess of 7%/yr over the past 5 and 10 yrs. Next we required our remaining companies to pass a Buffett Buy Analysis (see Week 30) by projecting a total return over the next 10 yrs in excess of 7%/yr. (We choose 7% as the cut-off because that growth rate will double your invested dollars over 10 yrs, which is the common requirement for a “business case” that justifies investing in the first place).

At the end of this exercise, we turned up 14 companies (see the attached Table), a convincing demonstration of just how hard it is to beat the S&P 500 Index without taking on a lot of risk. We added 3 more companies to our list, those that almost make the cut. The shortcoming of these 3 is that they’re from industries where profits are limited by government regulation (utilities & railroads): Union Pacific Railroad (UNP), NextEra Energy (NEE), and Wisconsin Energy (WEC). We also list one company that is on our Master List (MMM, see Week 65) that closely tracks the major indices with respect to both safety and performance. 3M is classified as a conglomerate because it operates in many industries and is also known for keeping up with the times. It is innovative and draws most of its sales from international markets. We also list a mutual fund (MDLOX) marketed by BlackRock, a hedge fund specialist. MDLOX has performed in line with above-average hedge funds but has the shortcoming of being expensive to own (e.g. it has a 5.25% front-end load) though still cheaper than a hedge fund proper. Hedge funds emphasize fixed-income investments (bonds), international stocks & bonds, and bet against weak-appearing stocks. That’s both complicated and expensive but hedge funds do indeed lose less money during market panics. You’ll notice from the Table that a straightforward bond-heavy balanced fund like VWINX performs just as well as MDLOX while being much cheaper to own.

Bottom Line: For your stock investments, stick to low-cost S&P 500 Index funds like VFIAX and low-cost balanced funds like VWINX (Table). The only reason for picking your own stocks is that you want to lose money while learning a time-consuming though informative hobby. To minimize those initial losses, stick with companies that grow nice dividends and are highly rated like those in our Master List (see Week 65). You’ll notice that when you push for stocks that perform the way a businessman likes by doubling his money over 10 yrs (Table), only 4 out of 17 companies meet that standard and also appear on our Master List (see Week 65): Hormel Foods (HRL), Chevron (CVX), NextEra Energy (NEE), and Wisconsin Energy (WEC). Therefore, the other 13 stocks are speculative.

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Sunday, November 4

Week 70 - The “Business Case” for Electric Utilities

Situation: You’d like to invest in something that’s as safe as 10-yr US Treasury Notes but pays more than the 1.8% interest you’ll get from owning those. While stocks are 4-5 times as risky (Riskmetrics), companies that need government subsidies to fund huge and ongoing fixed costs are allowed to issue stocks that are then safer than average due to government backing. State-regulated electric utilities are an example. Bankruptcy can’t happen, and Return on Equity is set by the state’s public utility commission (usually in a range of 9-12%). In other words, downside risk is eliminated at the expense of upside returns. Most states also allow their electric utilities to operate an unregulated subsidiary. NextEra Energy (NEE), for example, has a subsidiary that is the top generator of electricity from wind and solar farms in the US, and Dominion Resources (D) has a subsidiary that stores natural gas, the largest such facility in the US.

To filter out less-efficient utilities, we’ve used several accounting tools to assess whether the utility meets a “business case” for sound management, i.e., is likely to double the investor’s investment over the next 10 yrs (for a Total Return of 7.2%/yr). That’s a high bar for regulated utilities to reach, since the goals of public utility commissions are to a) prevent the state’s taxpayers from having to bail out the utility, and b) prevent the utility’s shareholders from reaping windfall profits. In other words, state-regulated electric utilities can neither be a “cost center” nor a “profit center.” The terms “business case” and “profit center” have approximately the same definition so you see the problem. Our job is simple: find the utilities that are so efficient as to almost be profit centers. And we apologize that the attached Table is overly complex but a number of metrics have to be used to assess companies that are on the edge of true profitability.

Bottom Line: Risk is the bane of an investor’s existence (see Week 7 on Risk). So let us find companies that governments have to subsidize and see what investors have to give up in return. To start, let us pick companies that are going to produce the same amount of product in good times as well as bad times, because that eliminates the risk of a business fall-off during recessions. In other words, if windfall profits aren’t possible at least we can stop worrying about more than one risk. By investing in state-regulated electric utilities, we get to stop worrying about the risk of bankruptcy and about the risk of recession. (It’s not quite that simple, since state public utility commissions try not to raise electricity rates during recessions.) The Table shows you 3 good investing choices: NextEra Energy (NEE), Wisconsin Electric (WEC), and Southern Company (SO). We threw in the Vanguard Index 500 Admiral Fund (VFIAX) so that you could compare utility returns to the lowest-cost stock fund that has all 500 of the largest companies.