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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