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).

Post questions and comments in the box below or send email to:

No comments:

Post a Comment

Thanks for visiting our blog! Leave comments and feedback here: