Sunday, December 30

Week 78 - Master List Update (Q1 2013)

Situation: The time has come to provide sober guidance about saving for retirement. For most people, mutual funds are the best route to take and we’ve listed our 5 favorites in the accompanying Table. We remind you that you should not have more than 20% of your assets in a single fund, or 5% in a single stock. As noted in our Week 3 blog (see Goldilocks Allocations), it is also important to balance your stock investments 1:1 with bonds. Our 5 mutual funds do that when you have 20% of your retirement savings in each.

Whew! Now for the fun stuff, which is to generate a list of stock picks that meet our investment criteria. Previously, we’ve agonized over company fundamentals like efficiency (ROIC), long-term debt, and having enough free cash flow to pay for dividend increases (FCF/div). In this blog, we’re going to let you do that for yourself by using red warning flags in the 3 right hand columns of the Table (courtesy of data from the WSJ). This way, you’ll see the entire “universe of data” we analyze, starting with the 199 companies at the Buyupside website called Dividend Achievers. Those companies have had 10 or more consecutive years of dividend increases. We’ve added Occidental Petroleum (OXY) which will qualify come January first.

Next, we eliminate any company with a dividend yield less than the 15-yr moving average for the S&P 500 Index (1.8%). Then we eliminate any company that doesn’t have an S&P stock rating of A/M or better AND an S&P bond rating of BBB+ or better.

The remaining 49 companies can be split into two groups, those whose stocks lost less than 65% as much as the S&P 500 Index during the Lehman Panic AND had a 5-yr Beta of less than 0.65. Those 19 companies are less risky that the others, and make up the first group at the top of the Table. The 30 remaining companies are in the second group, and the 5 mutual funds (mentioned above) compose the third group.

Which of the top 19 stocks are particularly attractive to the risk-averse investor? We think those are the ones that pay a higher dividend than most others AND grow that dividend faster. I use a 3:7:10:50 standard for finding those good "income" stocks. By this I mean there is at least a 3% dividend yield, at least a 7% dividend growth rate, at least a 10% ROIC (5% for a regulated utility), and less than 50% capitalization from bonds. Six in the top 19 meet that standard: JNJ, ABT, PEP, PG, NEE, MCD. However, we eliminate Abbott Labs (ABT) because it is breaking up into two companies, so we’re down to 5.

Those readers who are over 55 and have little in the way of retirement savings should pay attention to these 5 reliable income producing stocks. We’ll aggregate the data from those, to augment our guidance for late-stage investors (see Retirement on a Shoestring Week 14 & Week 15). These 5 stocks are so bond-like that you needn't bother hedging them with an equal investment in bonds or bond funds. But you do need to “dollar-average” equally into all 5 DRIPs. We'll call this group "Stand Alone Stocks" and put their aggregate data at the bottom of the Table for comparison with aggregate data for the 5 mutual funds we mentioned.

Bottom Line: Recent academic studies show that returns from less risky (more bond-like) stocks are as great as returns from more risky stocks. Read this recent analysis by Mark Hulbert to open your eyes to the importance of holding such stocks in your portfolio.

Risk Rating: 4.

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Sunday, December 23

Week 77 - Low-risk Stocks in Food-related Companies

Situation: Currently, the stock market is overpriced according to the indicator with the greatest predictive value: The 10-yr cyclically adjusted price-earnings ratio (CAPE). It presently stands at 21.86, whereas CAPE has averaged 16 over the past 130 yrs. Partly this elevation is due to the Federal Reserve feeding $2 Trillion into the economy over the past 4 yrs. The Federal Reserve has just announced it will keep doing so at the rate of $85 Billion per month, i.e., purchasing $40 Billion in mortgage-backed securities and $45 Billion in US Treasury Notes (see Week 76 for a discussion of Financial Repression). That money gives banks and other corporations the ability to obtain cash at ~zero cost relative to the rate of inflation. However, that cash cannot be converted into loans/jobs/factories until the economy recovers enough to justify such investment. The result? Stock prices go up but earnings barely increase at all.

The other reason stock prices are going up faster than earnings is that sentiment has improved. Traders think the economy will gradually regain its full strength. Remember that stocks are priced to reflect expected corporate earnings 6 to 9 months from now. Under the current circumstances, what should you do? When all asset classes are overpriced because of Financial Repression, the best plan is to invest more in companies that will benefit from shortages in supplies when demand finally increases. The most critical looming shortages look to be food-related, given that per-capita food production hasn’t kept up with demand for more than 10 yrs. Grain yields have reached a plateau worldwide but a larger percentage of grain is going for animal feed and automobile fuel every day. Meanwhile, world population grows by 220,000 every day (Brown, Lester R.: Full Planet, Empty Plates, Norton, New York, 2012, 144 pp).

Our mission is to find food-related stocks that won’t follow the roller-coaster of grain prices but will reflect the coming ~5%/yr growth in grocery store prices. Here at ITR, we have come to define such “low-risk” stocks (see Week 76) as those having:
   a) dividend yield at least as great as the 15-yr moving average for the dividend yield of the S&P 500 Index (1.8%);
   b) annual dividend growth over the past 5 yrs of at least 6%/yr;
   c) price loss during the 18-month Lehman Panic (10/07 to 4/09) of no more than 30% (vs. 46% for the S&P 500 Index);
   d) 5-yr Beta of less than 0.65, meaning the stock price goes down less than 65% as far as the S&P 500 Index in a bear market;
   e) less than 50% of total capitalization is from long-term loans;
   f) dividends have been raised for at least 10 consecutive yrs.

We have come up with 10 stocks by using those metrics (Table). Only 6 are food & beverage production per se (HRL, LANC, MKC, SJM, PEP, KO) but the other 4 play important supporting roles: McDonald’s (MCD), Wal*Mart (WMT), CH Robinson (CHRW, the leading worldwide distributor of fresh vegetables labeled The Fresh 1), and Aqua America (WTR, the largest regulated North American water utility).

Bottom Line: Look at looming shortages. Oil was the #1 looming shortage until drillers in the US started using advanced technologies from Schlumberger (SLB) to drill horizontally and break up oil-containing rock formations by injecting a sand slurry under high pressure (hydrofracking). Now food is the #1 looming shortage, due to a water shortage that compounds a host of other shortages (tillable land, fertilizer, modern agricultural infrastructure, crop protection chemicals, drought-resistant seeds, affordable energy). To make matters worse, there are 3 billion more people having the wherewithal to buy meat, milk and eggs for their families than there were 20 yrs ago. However, animal protein requires 4 times as much grain to produce than does the simple consumption of that same grain for human nourishment (instead of using it for animal feed). Finally, over 10% of corn and sugar cane production worldwide is now being diverted from food supplies for use as automobile fuel. You can see that problems abound with food production. There are solutions for each problem but those will require time to phase in, and full support of a new generation of politicians who see fit to appropriate the necessary resources.

Risk Rating: 3.

Sunday, December 16

Week 76 - Hedging Stocks vs. Financial Repression

Situation: As of 12/7/12, a “risk-free” 10-yr US Treasury Notes yields 1.63%. This is vs. the 4.12% paid just 5 yrs ago. Meanwhile, the Consumer Price Index (inflation) has grown at a rate of 2.2% over the past 5 years vs. 2.9% over the 5 years ending in 12/07. This means that a 10 yr Treasury Note purchased on 12/07/07 paid 1.2% more than inflation, whereas, a 10 yr Treasury Note purchased on 12/07/12 paid 0.6% less than inflation. That 1.8% “trim” is called Financial Repression. It occured as the Federal Reserve gradually took two trillion dollars worth of Treasury Bonds and Notes out of circulation, thereby increasing the price (and lowering the yield) of remaining Bonds and Notes. This drives down the “yield curve” and the net result is that investors become willing to take greater risks with their money to escape the losses due to inflation that result from sitting on cash in the form of Treasury Bills and Notes. Investors are denied a “safe harbor” for part of their investments and are being pushed into using that money to expand factories, provide new services, buy homes and hold more stocks.

The idea is to boost the economy while reducing the amount of interest the US Government pays on its debt. Wikipedia defines Financial Repression as “any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.” It is a disguised form of inflation, since all asset classes eventually come to be priced higher (by that same 1.8% noted above) vs. historic valuations relative to inflation. Some leading economists have concluded that Financial Repression is a form of taxation (cf. Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different. Princeton University Press, 2008, p. 143).

You may think that these monetary policies will soon end and the economy will recover enough to grow at its usual 3%/yr faster than inflation. Well, the last time the Federal Reserve employed Financial Repression it lasted from 1945 to 1980. When used by central banks of other countries, it has averaged 20 yrs in duration (Carmen Reinhart and Belen Sbrancia, National Bureau of Economic Research working paper, 2011). Over the last 35 years, Sweden’s use was the briefest at 6 yrs (1984-1990).

What is our goal for today’s blog? How do we defeat Financial Repression in order to save for our retirement. That is a tall order, given that every asset class is valued relative to US 10-yr Treasury Notes. Hedge funds, however, are designed to respond to asset class impairment. In response to the Lehman Panic, many hedge fund traders hopped into gold, oil, and emerging market stocks. Then they tried high yield (and emerging market) bonds and high yield stocks. All of those predictably became overpriced. Thus, hedge funds haven’t fared all that well over the past year or two. Now they’re taking a closer look at dividend-growing companies in “defensive” industries, namely, healthcare, consumer staples, and utilities, even though stock in those companies has also become high-priced. 

In this week’s blog we take that approach and simply ask, which stocks fit our definition of a Hedge Fund (see Week 46)? That would be a stock that has beat the S&P 500 Index over the past 10 & 5 yrs, and fallen less than 65% compared to the S&P 500 Index during the Lehman Panic (10/07-4/09). That means we’ll have to stick to looking at stocks with a 5-yr Beta of 0.64 or less. And, since the S&P 500 Index had only a 1% total return for the past 5 yrs, we’ll only look at stocks with a 5-yr total return at least as great as that for “risk-free” money, which is 2.8% (i.e., the average rate of interest on 10-yr US Treasury Notes over the past 5 yrs). Because this blog is about saving for retirement by reinvesting dividend income, we’ll only look at stocks with a dividend yield of at least 1.8% (i.e., the 15-yr moving average for S&P 500 dividend yields). And, since there’s not much point in starting with a dividend-paying stock that doesn’t meet the “business case” for investment (see Week 68), we’ll exclude stocks that have a 5-yr dividend growth rate of less than 6%/yr. Finally, we’ll check financials on the WSJ website and exclude any that:
   a) have a return on invested capital (ROIC) less than the weighted average cost of capital (WACC), 
   b) are capitalized mainly by long-term loans, or 
   c) didn’t have enough free cash flow (FCF) last year to pay at least half of this year’s dividends.

In this analysis, we have turned up only 10 companies (Table). As expected, most come from one of the 3 “defensive” industries: ABT (Healthcare), WEC, NEE (Utilities), and MKC, HRL, GIS (consumer staples) but each of the remaining 4 (MCD, CHRW, CB, IBM) come from one of the other 7 S&P industry classifications. It will come as no surprise that all 10 companies have an S&P stock rating of A-/M or better, and an S&P bond rating of BBB+ or better. 

We compare these 10 stocks with our two favorite benchmarks (see Week 3):
   a) a 50:50 split between low-cost mutual funds tracking the S&P 500 Index (e.g. VFIAX) and the Barclays Capital Aggregate Bond Index (e.g. PRCIX); and
   b) the only mutual fund that is balanced ~50:50 between stocks and bonds, low-risk, low-cost and performs like a good hedge fund: Vanguard Wellesley Income Fund (VWINX). For you, the safest, cheapest, and least time-consuming way to save for retirement is to employ one of those benchmarks. 

Bottom Line: Hedge funds seek to beat the S&P 500 Index during bull markets but fall less during bear markets. We set out to see which stocks perform like an above-average hedge fund (i.e., fell less than 65% during the Lehman Panic while beating the market) by using the most rigid criteria. We find that such safe & effective stocks are rare, and don’t necessarily hide out in the 3 “defensive” industries (healthcare, consumer staples, utilities). In other words, we had to look at all 114 stocks in Zack’s database that meet our key criteria (capitalization of at least $8 Billion, dividend yield of at least 1.8%, 5 yr dividend growth rate of at least 6%, and ROIC of at least 9.5%). 

Risk Rating: 3. In other words, ownership of these stocks doesn’t have to be hedged with ownership of an equivalent amount of 10-yr US Treasury Notes and/or their untaxed equivalent (Savings Bonds) or a investment-grade bond fund like PRCIX. They’re internally hedged, much like the two utility stocks (WEC, NEE) but for more complex reasons having to do with competitive advantage (a topic we’ll explore in future blogs).

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Sunday, December 9

Week 75 - S&P 100 Companies without Red Flags

Situation: We all know that President Harry Truman preferred one-handed economists because he found the phrase “on the other hand” to be so exasperating. And, increasingly, the tables that accompany our blogs are sprinkled with red flags. So this week we’ll publish a Table that doesn’t look like it has the measles!

You’ve already heard that we favor large companies with multiple product lines ringing up sales. Why? Because that creates internal support, meaning that when sales crump in one line the company has the resources and talent needed to fill that hole. Anyone who has played on a good sports team or fought in a good military unit understands that concept. But stock traders don’t (or won’t) embrace it because the company then becomes too difficult to value “by the sum of its parts.” This means the stock’s price will lag behind its earnings growth. But you don’t care because you use a “buy and hold” investment strategy.

Accordingly, we’ve screened companies in the S&P 100 Index for the following traits (Table):
a) Dividend yield greater than or equal to 1.8%;
b) 10 yr annualized total return greater than or equal to 5%;
c) Losses during the Lehman Panic less than those for the S&P 500 Index;
d) Finance Value (b plus c) that beats the S&P 500 Index;
e) 5 yr annualized total return of at least 2.9% (i.e., the “risk-free” rate determined by averaging the interest rate of 10 yr US Treasury Notes over the past 5 yrs);
f) 5 yr dividend growth rate of at least 4%;
g) Return on Invested Capital (ROIC) of at least 10% over the trailing 12 months;
h) Long-term debt that is less than half the company’s total capitalization;
i) Last year’s free cash flow (FCF) is sufficient to fund this year’s dividends.

Our screen turned up 10 companies. Note that 6 of the 10 are from the Stockpickers Secret Fishing Hole (Week 29 & Week 68), which is the 65-stock Dow Jones Composite Index (DCA). Excluding regulated utilities (which have too much debt and too little free cash flow to pass our screen), there are 32 DCA companies in the S&P 100 Index. So the chance of a DCA company passing our screen is 19% (6 divided by 32) vs. 5.9% (4 divided by 68) for a non-DCA company.

Bottom Line: You can win by staying away from companies that are inefficient (low ROIC), have high LT debt, or pay dividends with retained earnings and borrowed money instead of using free cash flow. There is no bad news in our screen. If your portfolio contained these stocks throughout the past 10 yrs and you kept buying more during the Lehman Panic, then you’re a smart “vulture investor."

Risk Ranking: 6 (see Week 72).

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Sunday, December 2

Week 74 -Food Production Companies in the Russell 1000 Index

Situation: Last week we looked at a snapshot of food-related companies--those listed on the Omaha World-Herald 150 Index. This week we take on food production companies, screening the 150+ stocks in the Dow Jones US Food Production Index to drill down on the 18 largest companies, namely those listed in the Russell 1000 Index. The point is to set aside (for now) those companies that are peripheral to food production (railroads, farm equipment manufacturers, grocery stores, restaurants, bottlers, grain brokers, futures exchanges) and focus on the companies that produce food from animal protein and cereal grains. In the Table, you’ll see two companies that aren’t in the Russell 1000 Index: 
   a) Lancaster Colony (LANC) which is now large enough to appear in the next revision of that Index; 
   b) Syngenta (SYT) a Swiss company that competes directly with Monsanto (MON) to market crop protection (CP) materials and genetically-engineered seeds. SYT holds the number one position globally in CP materials with 19-20% of the market.

Of the 20 companies listed in the Table, only Hormel Foods (HRL)  and LANC are free of red-flagged items (i.e., “let the buyer beware”). But 7 more companies have been remarkably profitable over the past 5 & 10 yrs, and lost no more than 65% as much as the Russell 1000 Index during the Lehman Panic. Those 9 companies meet the “business case” for investment (see Week 71) by having at least the 7.18%/yr growth rate that is needed to double your investment within 10 yrs, as well as a combined dividend yield and dividend growth rate of at least 7.18%/yr: SYT, GIS, FLO, HRL, HNZ, HSY, SJM, LANC, MKC. This is a remarkable accomplishment for any company given that half of the last 10 yrs has seen the business world consumed by the Lehman Panic and its after effects.

Bottom Line: Food production will increase because the high prices that food products now command will justify cultivation of even marginal farm lands. Droughts will lead to more irrigation, while technology continues to improve drip irrigation methods to reduce evaporation and runoff. Higher food prices are inevitable after a drought and are occurring already but companies such as Tyson Foods (TSN) are finding that there is no loss of revenue when those costs are passed on to the consumer, as reported by the WSJ

In summary, food production companies are already quite profitable and stable investments but the future appears even brighter. A reasonable approach is to create your own specialty fund by taking capitalization-weighted positions in all 4 of the companies in the accompanying Table that have a “business case” for investment and are free of red flags with respect to return on investment, long-term debt and cash flow (Columns K, L & M in the Table): LANC, SYT, HRL, GIS.

Risk Rating of this blog: 6 (see Week 72).

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