Sunday, December 29

Week 130 - Seeking Alpha? Here are 10 companies

Situation: More than just a technical term in statistics, “alpha” has come to have Unicorn-like significance for traders. Indeed, some investors think of alpha as the Holy Grail of investing. The non-mathematical definition of alpha carries little cachet. It refers to Annualized Total Return from an investment that is in excess of what can be accounted for by fluctuations in the mean value for that asset class, i.e., market-beating returns. It seems that alpha should be simple to achieve since, by definition, half of investments do better than average. For stocks issued by well-established companies, half would have superior returns. The problem is that many such beknighted companies fall out of that category with remarkable frequency, only to be replaced by others that also fall out with remarkable frequency. The result? You should follow Warren Buffett’s advice to retail investors, which is that you’re best off sticking to a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund (VFINX).

But the myth survives in the lay press that you and I can “beat the market” if we but pay a fee to the investment guru, brokerage, or hedge fund of the hour. Here at ITR, we say forget the fee and do-it-yourself online with dividend reinvestment plans (DRIPs). More importantly, we encourage you to forget the myth. It isn’t achievable anyway, for periods longer than 20 yrs, unless you are Warren Buffett, John Templeton, or Peter Lynch. But there are kernels of wisdom in the writings and quotations of those three luminaries, which you and I can use to our advantage: Don’t buy stock in good companies that make money rapidly in a bull market. Instead, look for good companies that lose money slowly in a bear market. That’s why every one of our tables has a Column D that states how much each company’s stock lost during the Lehman Panic. We don’t think companies that lost more than 28% over that 18 month period are worth your attention, since that is how much the hedged S&P 500 Index lost as measured by the Vanguard Balanced Index Fund (VBINX), vs. the 46.5% lost by the lowest cost S&P 500 Index fund (VFINX). Hedging is necessary. So, the idea is to stick to an index fund and seek your own alpha. To do that, you will need to pick DRIP stocks that have made more than VFINX while losing less than VBINX in the Lehman Panic. 

Let’s look for companies that beat VFINX for both the past 21 yrs (two and a half market cycles) and the past 5 yrs. We’ll pick those from our universe of 55 companies that have beaten that index since 2002 (see Week 122) and eliminate any company that lost more than the 28% loss sustained by VBINX during the Lehman Panic. Surprisingly, we find 10 companies that have pulled off the alpha feat (see Table). Half of those companies have names that are familiar to anyone who shops: Nike (NKE), TJX, Sherwin-Williams (SHW), Hormel Foods (HRL) and Colgate-Palmolive (CL). They are what they are, namely, unexciting but also able to post good profits year in and year out. Who doesn’t need the stuff they sell? Try going a year without toothpaste, meat, shoes, marked-down new clothes, and paint. In short, most of these companies don’t have great performance because they grow earnings rapidly in a bull market. Instead, it’s because their earnings hold up well in a bear market. Remember: when one of your stocks drops 50% in a recession it has to go up 100% just to get back where it was. In the meantime, 3 to 5 yrs have passed while you’ve had that “dead money” sitting in your brokerage account.

Bottom Line: It is possible to “beat the market” over a long period of time by owning stock in companies that have a strong, recession-proof brand.

Risk Rating: 4

Full Disclosure: I have stock in IBM, Nike (NKE), and Hormel Foods (HRL).

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Sunday, December 22

Week 129 - Crop irrigation equipment

Situation: The “Green Revolution” of the 1970s grew out of innovations in farm equipment, augmented by improvements in tillage techniques, fertilizers, insecticides, herbicides, and seeds (see Week 124). Possibly the most important innovation came soon afterward, when groundwater irrigation (from wells) began to replace surface water irrigation (from canals). That transition grew from the innovation of “center-pivot” sprinklers in the 1950s and 60s. Those sprinklers can water 136 acres (of the 160 acres in a quarter section of land) in a single rotation around the center pivot. That cuts the water requirement for growing corn by over 40%. Now another innovation is gaining acceptance, and that is buried drip irrigation systems which selectively irrigate the root zone and cut water requirements by another 40%.

At present, there are a billion acres of irrigated land worldwide. Nine million of those acres are in Nebraska, which is arguably the most productive region for agriculture on the planet. Nearly 8.5 million of those 9 million acres are irrigated by groundwater pumped to center pivots. This doubles productivity in a state that gets only 22 inches of rain a year. Dryland farming depends on rainfall and rainfall of less than 20 inches produces only 110 to 140 bushels of corn per acre, whereas, the yield with center-pivot irrigation is roughly doubled. 

Historically, dams have been the most important piece of irrigation equipment. The technology of storing water during the rainy season, for use during the dry season when crops are maturing, has until recently been the only way farmers could “ride out” a multi-year drought. Dams also protect fields and towns from flooding, recharge the aquifer, and provide recreation opportunities that bring in tourist dollars. The unfortunate aspect of the Green Revolution is that farmland has increased 10-fold in value, making it too expensive to buy up and flood with a new dam. (Eminent Domain cannot be used to seize land for the apparent purpose of enriching farmers.) Here in the US, the Army Corps of Engineers worked in the 1970s and 80s to map out all the best locations for placing dams but few have been built. That forces greater use of groundwater wells but also removes the best way to recharge the aquifers that support those wells, which is the reservoir behind a dam--combined with drainage canals that divert excess water (produced by floods) into holding basins. For further information on crop irrigation strategies visit the University of Nebraska at Lincoln website (

As an investor, we think you’ll want to know which listed companies provide irrigation equipment. There are two companies that make center-pivot sprinkler systems, Valmont Industries (VMI), which holds the original patent, and Lindsay Corporation (LNN). You’ll also want to know which listed companies make and install subsurface drip irrigation (SDI) systems. Again, there are two: John Deere (DE) and Toro (TTC). For groundwater irrigation systems, you’ll want to know which companies make the pumps and plumbing that bring well water to the surface and distribute it. Here there are 3 leaders: Xylem (XYL), a company that only recently started issuing stock, Flowserve (FLS), and Marmon Water, a subsidiary of Berkshire Hathaway (BRK-A). Diesel and propane powered generators supply power to groundwater pumps; Cummins (CMI) and Caterpillar (CAT) are the most prominent suppliers. 

The future of irrigation will be driven by data collected on crop moisture levels when tractors make a pass through a field. Trimble Navigation (TRMB) has software that uses satellite weather information to produce virtual data on rainfall at any GPS location specified by the farmer. Modern tractors have global positioning systems (GPS) that link to an onboard computer containing data from previous passes through the field. Software packages take over the chores of seeding the field, deciding how much and what kind of fertilizer to place where, and doing the same for insecticides, herbicides, and fungicides. In a new program called Field360, the data collected on John Deere (DE) tractors will be wirelessly downloaded to a local DuPont Pioneer (DD) field office for analysis. Information on crop moisture levels in different parts of the field will be made available to the farmer to use in programming sprinkler (or drip) irrigation systems. A similar system is being rolled out by Monsanto (MON) and another is available through Raven Industries (RAVN) that links to AGCO tractors. 

For this week’s Table, we have populated our basic spreadsheet with data for the companies cited above; total returns are impressive. There is, however, a problem for investors: the spreadsheet looks like it has the measles because red highlights are everywhere. Those indicate substandard performance vs. our benchmark (the bond-hedged S&P 500 Index - VBINX). This means that while the potential rewards from investing in irrigation equipment are high the risk is even higher. 

Bottom Line: Modern farming is increasingly about automation, and programmed with the help of GPS. This system is gradually reducing the overuse or underuse of inputs like fertilizer, insecticides, herbicides, fungicides, and now water. That automation is based in tractors and combines, standard pieces of farm equipment for generations, that now cost several hundred thousand dollars apiece. For example, at a cost of less than a thousand dollars a year that information can be transferred wirelessly in real time from Deere (DE) tractors to a DuPont Pioneer (DD) field office for analysis. In many parts of the world, water scarcity is the key factor limiting production farming. The new era of micromanagement via GPS promises to optimize water use by responding to known crop moisture levels and rainfall in different parts of a field. Further progress in optimizing water use will depend on large-scale financing for projects that collect and store rain and flood waters by using dams, diversion canals and holding basins. In agricultural areas afflicted with creeping desertification, such projects are the only known way to recharge the depleted aquifers that support groundwater irrigation.

The only stocks mentioned here that currently have good long- and short-term Finance Value, along with high S&P bond ratings, are Berkshire Hathaway (BRK-A) and Monsanto (MON).

Risk Rating: 7

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Full disclosure: I have stock in Deere, Flowserve, DuPont, Cummins, Caterpillar, and Berkshire Hathaway.

Sunday, December 15

Week 128 - Disintermediation Is Our Investment Philosophy

Situation: Every project needs a Central Thought or Point of Main Interest. Forty years of investing have taught me to take personal responsibility for controlling my costs, i.e., inflation, taxes, research, and commissions. At first, those seemed to be largely unavoidable. So, I didn't keep track of them. Finally, I realized I was losing money after subtracting what accountants call CGS (Cost of Goods Sold) from my gains, whether paper or actual. That brought me to DIY (Do It Yourself), using DRIPs for stock investing and treasurydirect for bond investing. I could cut out the middleman. There is a fancy name for doing that: disintermediation. My first small step was to dollar-average Savings Bond purchases through automatic withdrawals from my salary, starting in 1992. Two years later, I set up a DRIP for Exxon Mobil (XOM) and soon moved on DRIPs for McDonald's (MCD) and Procter & Gamble (PG). All 4 of those investments have beat inflation and implied taxes over the past two decades, and all but MCD remain free of transaction costs.

Let's break down the benefits of disintermediation. First, you regulate safety. Second, you decide how much to diversify your holdings. Third, you decide whether to emphasize income or growth. Fourth, you decide when to sell. We have suggestions for how you might manage those control levers:

#1 Safety: Start with 40% of your savings in 10-yr Treasury Notes (or Savings Bonds), 20% in hedge stocks (see Week 117), and 40% in other stocks chosen from our universe of 51 (see Week 122).

#2 Diversification: Bonds are priced around the world on the basis of their risk of default compared to the US 10-yr Treasury Note. That makes T-Notes the most obvious hedge for stocks, given that T-Note prices go up in any recession whereas stock prices fall. With stocks, you need to have a portfolio where all 10 S&P industries are represented. You'll need at least 12 different DRIPs; 4 of those need to represent the 4 defensive S&P industries (healthcare, consumer staples, utilities, and telecommunication services) and 4 need to be hedge stocks (see Week 117). For this week’s Table, we’ve picked the highest ranked stock in terms of long-term Finance Value (Column E in the Table) for each of the 10 S&P industries. That leaves non-defensive industries underrepresented so we’ve added the two highest capitalization stocks that remain: Nike (NKE) and Chevron (CVX).

#3 Income vs. Growth: A growing dividend is money in the bank, but a growing stock price is fungible. So look to own stock in growth companies that pay a growing dividend. Many growth companies, i.e., those in the 6 non-defensive S&P industries (energy, materials, information technology, consumer discretionary, industrials and financials), provide substantial and growing dividends even if their fortunes ebb during recessions.

#4 When to sell: If you're dollar-averaging into a DRIP, never sell as long as the dividend is being increased every year. When you retire, start spending (instead of reinvesting) that dividend.

Results of this plan: If you go to the Table and add two parts 10-yr T-Note returns to 3 parts 10-yr returns for our 12-stock list, then divide by 5, you’ll see that the total return/yr is approximately 35% better than the total return/yr for the S&P 500 Index (VFINX) but the risk measures (columns D and L) indicate greater safety.

Bottom Line: What’s not to like about point-and-click investing? Well, your choices have to be well-researched because selling a DRIP comes with tax headaches. You’ll also need to have nerves of steel in order to maintain fixed regular allocations into each DRIP during a bear market. Even though you’re getting more shares for each dollar allocated, you’ll really wish you weren’t shovelling more money into a falling market. I had to learn that lesson the hard way during the recession but shovelled on during the Great Recession. 

Risk Rating: 3

Full Disclosure: I make monthly additions to DRIPs in WMT, NKE, ABT, and IBM. I also have stock in MCD, CVX, MON, and OXY.

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Sunday, December 8

Week 127 - Barron’s 500 Industrial Companies That Are Also Dividend Achievers

Situation: The resumption of strong earnings growth in the industrial sector is a hallmark of recovery from a recession. Those companies do so poorly during a recession that their recovery is well publicized by the press. Retail investors take that to be a sign that they’d better “get on the bandwagon.” Professional investors view the resulting inflow of dollars as just one more worry in an already overheated market. They’re afraid that the additional rise in stock prices won’t be justified by the expected rise in corporate earnings. Message? Nobody wants to see another bubble but you need to prepare for one anyway--by hedging your bets.

Is it a good time to buy stock in one or two of the leading industrial companies? No, you’re too late. But there is never a bad time to start putting ~$60/mo into the stock of any well-researched company by using a Dividend Re-Investment Plan (DRIP). To research industrial companies, first try to understand why they’re doing so well. In a nutshell it is for two basic reasons, “on-shoring” and “fracking.” U.S. exports account for well over 40% of world trade, and those exports are growing. But a lot of the parts for those “widgets” are now being built in Asia. Most manufacturers started doing that 10 yrs ago out of sheer necessity. They had to compete on labor costs or go bankrupt. The downside is the cost (and delay) in moving those parts back to the US for final assembly: Think about moving a Boeing 777 wing from where it is made (Japan) to where the plane is assembled (Seattle). 

Now that wages have more than tripled in China but fallen here in the U.S., there is no longer an overwhelming labor cost advantage to globalization. In addition, one of the main inputs for manufacturing in general and chemicals in particular is natural gas, which has fallen 50% in price here at home but costs 4 times that much in Asia. Result? Companies are bringing production back home in a process called “on-shoring.” There has also been a new-found appreciation for the infrastructure that the U.S. already has in place, as opposed to the almost non-existent infrastructure in Asian locales where wages are still low (Myanmar and inland China). Paved roads, seaports, railroads, electrical wiring, and airports are essential tools of commerce. 

The icing on the cake is that wage growth here in the U.S. has either reversed or stagnated while productivity has kept growing through investment in communication services and information technology. U.S. workers were already the best at interacting with growing automation in the workplace. Then the Great Recession came along and forced companies to double down on robots and automation, producing a dramatic increase in worker productivity. Result? US manufacturing jobs have grown steadily since the third quarter of 2010. This has been the first sustained growth that has occurred since the third quarter of 1998 (U.S. Bureau of Labor Statistics). Message? Build it here. When all is said and done, no other country has a workforce with the talent, creativity, and productivity that is found here in the US.

This week’s Table has all 15 “industrials” found in the Barron’s 500 list of companies with the best records of recent cash flow and sales growth that have also increased dividends annually for at least the past 10 yrs. (Companies with an S&P credit rating of BBB+ or lower were excluded.) All 15 took a hit on earnings during the Lehman Panic but kept growing dividends anyway--out of confidence in the future. Twelve of the 15 showed growth or stability in their cash flow and sales, or maintained their rank in the top 200 on the Barron’s 500 list (see Columns F and G of the Table). Three of those 12 also have good long-term Finance Value (see Column E of the Table): CH Robinson Worldwide (CHRW), Grainger (GWW) and Canadian National Railroad (CNI).

Under BENCHMARKS in the Table, we have added two new features. First, we have included the Vanguard Dividend Growth stock mutual fund (VDIGX) because it prioritizes dividend growth ahead of dividend yield. It also differs from our preference for companies that have 10 or more years of dividend growth by accepting companies with only two years of dividend growth. Second, we have included the sector ETF for industrial stocks (XLI). Red highlights in the Table denote underperformance vs. our benchmark: We use the Vanguard Balanced Index fund (VBINX) that is composed 40% of an investment-grade bond index and 60% of a large-capitalization stock index. That fund lost only 28% during the Lehman Panic vs. 46.5% lost by the S&P 500 index fund (VFINX). We think that hedging against the inevitable bear market for stocks is a fundamental aspect of investing. That is why we have chosen a benchmark (VBINX) that fully hedges the S&P 500 Index fund (VFINX).

The Table also includes 4 columns (O, P, Q, and R) for the Buffett Buy Analysis (see Week 30 & Week 94). That analysis uses for its starting point the 9-yr growth rate for Tangible Book Value (TBV). If that is greater than the nominal rate of GDP growth (5-6%/yr), then the company is said to have a Durable Competitive Advantage (DCA) provided there were no more than 3 yrs in the past 10 when TBV fell. If the stock navigates past those hurdles, its total return over the next 10 yrs is calculated--giving the Buffett Buy Analysis (BBA). That calculation is based on extrapolating core earnings growth over the past 8 or 9 yrs and multiplying that by the worst P/E seen in the past 10 yrs. The current dividend X 10 is added on the assumption that economic conditions won’t allow the company to raise its dividend over the next 10 yrs. The resulting number is the predicted stock price 10 yrs from now; it is compared to the current stock price to arrive at the projected total return/yr over the next decade. If the stock is overpriced now, its BBA will be underwhelming compared to its record of growth in TBV.

Bottom Line: An industrial stock is risky to own because earnings either diminish greatly or disappear in a recession, which is reflected by the stock’s price. But that company is well-positioned to show robust earnings growth when the economy recovers. We find 3 companies that have both long and short term Finance Value (CHRW, GWW and CNI). Grainger (GWW) is too overpriced (P/E = 24) to expect high returns to continue but you might want to see a fuller explanation from Morningstar ( CH Robinson Worldwide (CHRW) has had problems acquiring a competitor in the truck-brokerage business, which has depressed its stock price. Apparently that problem has now been resolved, leading Morningstar to upgrade its recommendation to Buy. The third leader on our list, Canadian National (CNI), is thought to be overpriced by Morningstar but the P/E of 18 doesn’t seem that high to us--given that CNI is generally regarded as “the highest margin railroad by far,” to quote the Morningstar analyst. 

This week’s Table carries more data than usual because its always a nail-biting experience to commit money to stock in an industrial company. 

Risk Rating: 8

Full Disclosure: I own stock in UTX, MMM, CNI, and CAT.

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Sunday, December 1

Week 126 - There are 7 “Hedge Stocks” in the S&P 100 Index

Situation: Here at ITR, we like to focus your attention on stocks issued by really big companies. That’s because those companies have the resources and flexibility needed to ride out a bear market. You don’t get as much bang for the buck as you do with small or mid-cap stocks (e.g. those found in the S&P 400 Index) but the risk of damage to your retirement nest egg just when you need it the most (at the beginning of retirement) is much less. Our latest list of “hedge stocks” (see Week 117) had only 16 companies but 7 of those are found in the S&P 100 Index of companies with market capitalizations over ~$35B. 

We’ll look at the long and short term Finance Values of those seven. In addition, we’ll look at 3 more companies that are on the border for inclusion that august group: General Mills (GIS) and NextEra Energy (NEE) have ~$35B of market capitalization and are in our list of 16 hedge stocks; Procter & Gamble (PG) is already in the S&P 100 Index but fell just short of being a hedge stock. Why? Because during the Lehman Panic it lost slightly more than our benchmark, the Vanguard Balanced Index Fund (VBINX -- Column D in the Table). But PG is already used by investors around the world to hedge against the risk of their other investments, so we’ll sneak it into our list of S&P 100 hedge stocks.

These 10 stocks have superior long-term Finance Value (Column E in the Table), meaning that after subtracting losses during the Lehman Panic from long-term gains investors came out ahead of our benchmark (VBINX). We assess short-term Finance Value by referencing the Barron’s 500 list for 2013 vs. the 2012 list, to determine whether there has been recent growth in sales and cash flow (Columns L & M in the Table). Of the 3 companies that were in the top 200 in 2012 (ABT, MCD, GIS), only McDonald’s (MCD) slipped out of that group in 2013. Of the remaining 7 companies, only PepsiCo (PEP) had a significantly lower rank in 2013 than in 2012. That leaves us with 8 hedge stocks that have both long and short term Finance Value. Those are the ones you need to study closely. Then think about setting up a DRIP through computershare (which offers DRIPs for all 10).

What’s not to like? Let’s start with the fact that nobody really likes the idea of investing in a hedge fund or hedge stock, since those mainly make money for you by falling less during a bear market at the expense of rising less during a bull market like the one we’ve seen over the past 5 yrs (Column G). Half of those 10 companies failed to make as much money as our VBINX benchmark, which is itself hedged (40% invested in bonds). Returns for those laggards are highlighted in red, as are any other numbers in the Table denoting underperformance vs. VBINX. The S&P 500 Index (VFINX) did even better than VBINX, as you would expect in a bull market. 

Now you see what’s not to like. Taken together, the 10 stocks underperformed VBINX over the past 5 yrs (Line 14 at Column G in the Table) and did even worse vs. the S&P 500 Index fund (VFINX): Lines 25 & 26 at Column G in the Table. Think of hedge stocks as ballast, deep in the hold of the ship taking you to retirement. The ship goes slower because the ballast is heavy, but the ship will rock less in a big storm instead of foundering. To give that ship some zip faster after the storm, put a large dollop of our retirement savings in Core Holdings (see Week 102). Those are growth companies that have to be hedged with bonds, but they’ll outperform the S&P 500 Index in a bull market. Note that our list of 10 hedge stocks in the S&P 100 Index has only one Core Holding (MCD). The other 9 are Lifeboat Stocks (see Week 106). No surprise there!

Bottom Line: Hedge stocks don’t need to be backed up with bonds. They’ll carry you through a bear market by losing ~40% less than the S&P 500 Index. Some, like Wal-Mart (WMT) and McDonald’s (MCD), will even gain in value. Why? Because people shop for the cheapest food they can find after they’ve lost their job. Over the past 100+ yrs, market cycles have lasted about 5 yrs and bear markets have accounted for a third of that; bull markets account for 2/3rds. However, the first half of a bull market only serves to get the S&P 500 Index back where it was at the beginning of the bear market. Since the market only makes new highs a third of the time, it is possible for a company’s stock to beat the market by losing less the other 2/3rds of the time. That’s the whole premise behind a hedge fund or hedge stock. 

Large companies have a better chance of doing that than small companies, given that they have more product lines, pay lower interest on their loans, and maintain larger cash hoards relative to earnings. The 10 large capitalization stocks in the Table won’t, as a group, do as well as the S&P 500 Index in a bull market but they’ll serve you much better in a bear market. And we’ve had two of those since 3/24/00, when the market peaked just before the “ recession.” Over the 13.5 yrs since then, those 10 stocks have kept more than 7% ahead of inflation (Column C) while the S&P 500 Index still struggles to beat inflation by 1%. You get the point.

Risk Rating: 3

Full Disclosure: I regularly add to DRIPs in 6 of these companies (WMT, PG, KO, JNJ, ABT, NEE), and also own stock in MCD and GIS.

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Sunday, November 24

Week 125 - Berkshire Hathaway’s Stock Portfolio

Situation: We have called Berkshire Hathaway a “hedge fund for the masses” (see Week 101). It has almost a hundred wholly-owned subsidiaries, but also has a common stock portfolio that currently represents 34% of its market capitalization. With respect to risk vs. reward, that portfolio behaves quite differently than the company as a whole (see Week 101). On November 14, 2013, Berkshire Hathaway filed Form 13F with the US Securities and Exchange Commission (SEC), as required. That 3rd quarter update details Berkshire Hathaway’s common stock portfolio as of 9/30/13. Over 40 companies are on the list but only 15 have a dollar value greater than 1% of the entire list’s value. Our analysis of these companies is in this week’s Table but excludes two on the list  because the stocks were issued too recently for analysis (Phillips 66; General Motors).

We like to follow Berkshire Hathaway closely because “financials” and “information technology” are the riskiest of the 10 S&P industries. Those industries are the growth engine of our economy, and who better to look to for guidance than Warren Buffett. If your portfolio doesn’t include any stocks issued by companies in those two categories of industries, it will underperform the S&P 500 Index by a significant margin. Remember, the oldest rule for investors is the greater the risk, the greater the reward. That doesn’t leave you getting much sleep at night, so we ask you just to remember that the greater the risk, the greater the volatility. Berkshire Hathaway is important because it is mainly an insurance company and that is the only sub-industry among financials that we find to be worthy of your attention as a retirement investor (see Week 101, Week 117, Week 122). The others are Chubb (CB), HCC Insurance Holdings (HCC), and WR Berkley (WRB). You may take the position that those companies have to pay out more for property damage due to weather-related events amplified by global warming. That’s true, but then those property and casualty insurers follow up by raising their premiums a lot higher. 

Berkshire Hathaway sailed through the Lehman Panic (Column D in Table) without losing as much as our benchmark stock/bond index fund (VBINX), while beating Vanguard’s S&P 500 Index fund in every rolling 5-yr period over the past 30+ yrs. However, that record may come to an end on December 31st (see Column F in the Table). This has all been accomplished with low volatility (current 5-yr Beta = 0.25) and below-average valuations (current P/E = 15). What’s not to like? Well, two things. One is that Warren Buffett has total executive control in managing Berkshire Hathaway, and he’s getting on in years. Another is that his style of governance (delegation of authority to subsidiary company CEOs) doesn’t measure up to current standards of “due diligence.” That means investors in Berkshire Hathaway need to know the moving parts of the company, and attend the annual meetings in Omaha (or at least read the annual reports). I’ve been doing that for years and have reached the conclusion that Berkshire Hathaway is in reality two companies. One is composed of the wholly owned subsidiaries; the other is composed of the common stock holdings.  

Looking at the Table, we see that the 13 largest stock holdings represent 87% of the common stock portfolio and 30% of Berkshire Hathaway’s market capitalization. Breaking down the dollar value of those stock holdings, we see that 44.4% is invested in four financial services companies (WFC, MCO, USB, AXP). American Express (AXP) and Wells Fargo (WFC) represent almost 39%! Taken together, those 13 companies performed better than the S&P 500 Index (VFINX) over the past 10 yrs (Column C) and almost as well over the past 5 yrs (Column F), yet with significantly less volatility (5-yr Beta = 0.82 vs. 1.00 for the S&P 500 Index; losses during the Lehman Panic were 35.7% vs. 46.5%). The 4 financial services companies have a 5-yr Beta of 1.02 and the two largest (WFC & AXP) have a 5-yr Beta of 0.94, whereas, a mutual fund that comes close to being an index fund for the financial services sector (PRISX in the Table) has a 5-yr Beta of 1.15. Now, bear in mind that Warren Buffett made these huge bets on AXP and WFC decades ago, apparently to achieve outperformance during bull markets at the expense of underperformance during bear markets. Note: red highlights in the Table denote values that underperform the benchmark stock/bond index fund (VBINX). 

Bottom Line: Over 45% of Berkshire Hathaway’s stock portfolio is invested in financial services companies, yet the portfolio has a 5-yr Beta that is 29% less than for a fund that is close to being a financial services index fund (PRISX). The portfolio differs from the remaining 66% of Berkshire Hathaway in being somewhat more risky in terms of 5-yr Beta and losses during the Lehman Panic. In fact, its stock portfolio has metrics that are similar to those for the S&P 500 Index Fund (VFINX) except better (Table). That outperformance is due to the 44% of the portfolio’s net asset value that is contributed by 4 financial services companies. The surprise is that the portfolio’s volatility is so much less than one would expect. To summarize, Berkshire Hathaway as a whole acts like a hedge fund in that it performs well when the market is down but tends to lag behind when the market is up (see Column F in the Table and our Week 101 blog). The stock portfolio is a crucial factor because it saves Berkshire Hathaway from lagging even more when the market is up, since those stocks tend to track the market whether it is moving up or moving down (see Columns C&F in the Table). That stock portfolio is helping Berkshire Hathaway exactly where it needs help and when it needs it.

Risk Rating: 4

Full Disclosure: I own stock in Berkshire Hathaway and make monthly additions to DRIPs in Wal-Mart Stores, Procter & Gamble, IBM, Exxon Mobil, and Coca-Cola.

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Sunday, November 17

Week 124 - Farm Equipment, Fertilizer and Seed Companies

Situation: You’ll soon tire of reading agricultural blogs that begin by projecting that the world’s population will grow to 9 Billion by 2050. What’s the catch? It’s that improved standards of living imply that there will be a doubling of food production by then. Most of the increase will be in the form of animal protein: meat, poultry, fish, shrimp, milk, and eggs. And we’ll also keep reminding you that it takes 4 pounds of grain to produce a pound of meat but only one pound of grain to produce a pound of shrimp. So, you’ll be seeing more about aquaculture too.

How do we double food production in 35 years? Well, let’s look back to the 60s and 70s when the “green revolution” doubled food production primarily through improvements in farm equipment, fertilizer, herbicides, pesticides, fungicides, and seeds. Improvements in logistics and water use were also important. To double food production yet again, we’ll have to double down on innovation in all of those areas. What’s the kicker? It’s that the price increases, which will arise from the inevitable shortages in raw food commodities, can be counted on to drive such innovation.

As an investor, you’ll want to look at companies that produce and/or market farm equipment, fertilizer, fungicides, herbicides, pesticides, and seeds. You already know that almost any commodity exhibits sharp price fluctuations over time. That is because the price has to rise high enough to justify the large, up-front, fixed costs that are needed to increase the supply of any commodity. This always looks like a worthwhile investment by the time it is made. But competition soon becomes fierce, which leads to a supply glut that drives prices down to the point where almost every producer loses money for awhile (or goes bankrupt). That’s very painful, so the financial backers all swear off making further investments to grow production. That’s why prices will have to rise to high levels before investment starts to increase again. Governments that depend on revenues from commodity producers go through the same whipsaw experience as investors.

This week’s blog focuses on companies that make it possible for farmers and ranchers to increase the production of food commodities. If you understood the preceding paragraph, you’ll know that these companies go through wrenching changes in their stock prices. Farm and ranch land values also depend on raw commodity prices, and fluctuate accordingly. Now you won’t be surprised when you check out this week’s Table. While every entry is a high quality Barron’s 500 stock, as noted in columns G & H of the Table, every entry also has a high 5-yr Beta (Column K in the Table). 

That degree of volatility is unsuitable for retirement portfolios. Monsanto (MON) is the only stock on the list that has both long-term Finance Value (Column E) and short-term Finance Value (Columns G and H), meaning that MON beat the market (VBINX) over the long-term (Column C), incurred lower losses during the Lehman Panic (Column D), and showed increasing sales and cash flows over the most recent 3 yrs (Columns G & H). But its volatility (Column K) and valuation (Column L) are both excessive--and have tended to remain so over the years.

Bottom Line: The “Green Revolution” in agriculture remains dependent on companies that make farm equipment, fertilizer, seeds, herbicides, fungicides, and insecticides. The imprudent use of any of these products will have important negative effects on the environment, which will require further innovation to manage effectively. The stock prices for these companies reflect, in part, how much money farmers made (or lost) at the end of the last growing season by using (or under-using) their products.

Risk Rating: 8

Full Disclosure: I have stock in DD, CAT, MON, and POT.

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Sunday, November 10

Week 123 - S&P Food and Beverage Index Companies

Situation: Food reserves are dwindling around the world. China has food shortages, and prices there are rising. Creeping desertification isn’t helping, nor is war in sub-Saharan Africa. Crop losses due to drought now occur every year somewhere in the world. The US Department of Agriculture projects that prices for food commodities will rise 1-2%/yr faster than inflation. However, for individual commodities (like corn) prices will increase one year only to fall the next year because of overplanting. Another factor is the increase in meat production, which is driven by the tens of millions of people that emerge from poverty each year. Going forward, the prices for food commodities will have to rise even more than in the past--to drive investment in technology and other types of innovation (including conservation). Otherwise, the goal of doubling food production by 2050 (to feed a world population of 9 Billion) won’t be met.

In light of these facts, investors have overbought the stocks of most companies that supply grocery stores. There are over 100 companies in the S&P Food & Beverage Index. We have winnowed the list down to those that have good recent records for growth (see Table). These 24 companies are the ones found in the 2013 Barron’s 500 list of companies with superior recent growth in sales and cash flow. Those 24 have an average price/earnings (P/E) ratio of 22 but worthwhile bargains remain (GIS, WMT, KR, PEP). If you are starting a long-term dividend reinvestment plan (DRIP), with automatic monthly additions, you need not be concerned about overvaluation because prices will revert to a mean P/E somewhere between 15 and 20 as the food business goes through its inevitable boom and bust phases. We suggest that you focus your research on the 9 companies that have both long-term Finance Value (Column E) and short-term Finance Value, i.e., an improving (or stable) rank in the Barron’s 500 Lists (Columns G and H): WMT, GIS, SJM, COST, HSY, KR, UNFI, CPB, KO.

Note: In our Table, red highlights denote inferior performance relative to our standard benchmark, which is the Vanguard Balanced Index Fund (VBINX). The numbers in the Table are brought current as of close of business (COB) the Friday before publication of the blog. Long-term total returns/yr go back to 10/9/02 (Column C) because that was the low point for our benchmark (VBINX) in the previous market cycle, i.e., the “ recession.” And remember, the stocks you accumulate in your retirement portfolio over your working years will generate quarterly dividend checks after you retire. So pay attention to Columns J & K in the Table. Those tell you a) how much income your accumulated shares will generate each year, and b) how much that income will increase each year. 

While it is true that the future prospects for most of these companies will change over time, that is less true for the 9 companies that are Dividend Achievers (Column N), i.e., those that have increased their dividends annually for at least the past 10 yrs. And 6 of those 9 are Dividend Aristocrats that have increased their dividends annually for at least the past 25 yrs (ADM, KO, HRL, PEP, SYY, WMT). Of those 6, Archer Daniels Midland (ADM) and Hormel Foods (HRL) are more involved in food production and therefore more influenced by fluctuations in commodity prices. Also remember that none of the companies that make farm equipment, sell fertilizer, or produce seeds are in the S&P Food and Beverage Index. The technological innovations needed for doubling food production by 2050 will mainly come from those production-enabling companies, and we’ll update you on those next week.

Bottom Line: Predictions indicate a looming food crisis that will be with us for decades. Prepare your portfolio for the rising food costs you’ll face in retirement by investing in the companies that supply your grocery store. 

Risk Rating: 5

Full Disclosure: I make monthly additions to DRIPs for KO and WMT, and also have stock in HRL, GIS, and PEP.

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Sunday, November 3

Week 122 - Our Universe of 51 Companies

Situation: Stock selection comes down to assessing safety vs. efficacy. “Safety” means the company has effective defenses against having short sales consume more than 10% of its publicly-traded stock in a bear market, and effective defenses against bankruptcy. “Efficacy” means the company has a time-proven business plan that generates earnings growth over time. The problem is that many metrics are used to capture these values (safety & efficacy), and they only look backwards, amounting what the military calls “fighting the last war.” Our blog has carried on this tradition, be-laboring our readers with numbers that capture important information about safety & efficacy in the past. Simplification is needed, along with metrics that point to the future.

Safety is about having a stable return that grows over time with few hiccups. The main "hiccup" we want to avert is a serious drop in stock price because management then has to take measures (such as selling assets) to avert bankruptcy. To alleviate concerns like that, we won't consider any companies in this blog that have an S&P bond rating less than -A (Column N in the Table). When we invest for retirement we’re ultimately looking for retirement income that grows enough to beat inflation handily, i.e., dividend checks that arrive each quarter and get bigger each year. Remember: annuities and pensions don’t grow. Social Security is the only cost-effective exception to that rule. (At present, it more than keeps up with inflation but there is talk of having it merely keep up with inflation.) Going forward, stock ownership is likely to be the only way for investors to have a steady stream of income that more than keeps up with inflation. So what is the best way to find such stocks? You need start with the list of 200+ Dividend Achievers. Why? Because those are the only companies that will keep paying you more, year after year, and have done so for at least the past 10 yrs. Companies with a long record of increasing dividends irrespective of recessions are safe for retirement investment. You’re only looking at two metrics after you retire: a) dividend yield of the stocks you own (Column G in the Table), and b) dividend growth of the stocks you own (Column H in the Table). Adding those together approximates your future total return. What’s the catch? You need to be a little choosy in picking from the Dividend Achiever list because 1-2% of the names on that list will disappear each year. In other words, the company has discontinued annual dividend increases. This happened to Pfizer, General Electric, and Home Depot during the Lehman Panic. So you’ll need to pay particular attention to the next paragraph.

Efficacy means growth, and growth ultimately comes down to increasing sales and cash flow over time. The editors of Barron’s provide an important service to investors by publishing a 500-stock list each May that ranks companies by performance in those two key areas during the most recent 3 yrs, along with noting the previous year’s rank. Any company listed there has superior growth prospects, given that it has been chosen from the more than 6500 that are listed on US exchanges, plus those listed on the Toronto Stock Exchange.

Now we can define a “universe” of worthwhile companies for our blog to follow, by listing all of the Dividend Achievers that appear in the 2013 Barron’s 500 list. It turns out that there are 51 (see Table). At the top, you’ll see 12 Lifeboat Stocks (Week 106). Those are the companies from defensive industries (utilities, consumer staples, healthcare, and communication services) that have a Finance Value (Reward minus Risk; see Column E of the Table) superior to that of our benchmark--the Vanguard Balanced Index Fund (VBINX, which is 60% stock index and 40% bond index). Next are 7 additional defensive companies that have a Finance Value less than VBINX. The third group is most important: those are companies in non-defensive industries (energy, materials, industrials, financials, consumer discretionary, and information technology) that have a superior Finance Value compared to VBINX (see Column E in the Table). Companies in those industries do particularly well in a growing economy so you can think of them as “growth” companies. That’s where 2/3rds of your stock assets need to be. We call the best such companies Core Holdings (Week 102). The fourth group is for growth companies that didn’t have a Finance Value superior to VBINX. Benchmarks are at the bottom. Metrics are current as of close of business on October 30, 2013. 

Bottom Line: Stock-picking is cumbersome but for future retirees it has a uniquely worthwhile feature. You’ll get substantial annual pay raises during your retirement (Column H of the Table). Over the past 20 yrs, dividend growth rates have far exceeded inflation for companies that have committed to annual dividend increases. All 51 of the companies in the Table have been growing dividends annually for over 10 yrs; S&P calls such companies “Dividend Achievers.” Those 51 include 34 companies that have been growing dividends annually for over 25 yrs; S&P calls such companies “Dividend Aristocrats” and there are only 54 names in that group. The Barron’s 500 List has given us a way to winnow down that list of safe companies for retirement investment (Dividend Achievers), so as to include only those that have demonstrated increasing sales and cash flow growth in recent years. 

Risk Rating: 4

Full Disclosure: I make automatic monthly additions to DRIPs in ABT, JNJ, WMT, PG, KO, NEE, NKE, XOM, and IBM.

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Sunday, October 27

Week 121 - Water Utilities Among the Dividend Achievers

Situation: Globally, water use is growing twice as fast as the population. This represents more intensive water use than in the past. For example, a recent study out of Columbia University notes that withdrawals from US municipal water systems increased 130% since 1950 while the population was increasing by 99%. Is exponential growth in water use sustainable? Not as long as water remains so cheap. If you use withdrawals under a regime of improved conservation measures to estimate sustainable water use, how many people can be supported going forward and still allow rainfall and snowpack to halt the depletion of our aquifers? About 5 Billion, which is 2 Billion fewer people than we have now and half the population the planet will have by 2060. Can desalination of ocean water make up the difference? Yes, but it is energy-intensive, expensive, and polluting. The new desalination plant at San Diego County has cost more than a billion dollars to build. The water it produces will have to be priced at twice the current rate, i.e., at $1,000 for a family of four for one year instead of $500. And, the pace of building desalination plants in the Western Hemisphere is much too slow to address the problem. In the Eastern Hemisphere, a wider acknowledgement of the problem has led to appropriate investment in desalination plants but the pace needs to pick up.

Most experts expect the pricing of water to increase rapidly, given the rate of population growth and the fact that 70-80% of water has historically been used for agriculture. The water distribution problem is compounded by global warming, and the fact that a billion people already live in regions undergoing desertification where water must be imported. A global water crisis can be expected in the next 10-15 yrs, unless the construction of desalination plants (and the expansion of water allocation regimes) “scale-up” much faster than is currently envisaged. For example, farmers in California have long prevented the legislature from imposing an allocation regime for groundwater use (wells), and resist metering.

Water utilities often take the form of municipal or regional cooperatives, using a clean water source combined with rate-based financing of the distribution system. However, the use of fertilizer by farmers can introduce excess nitrates into these water systems, necessitating the construction of water treatment plants. That requires financing, which may include issuance of common stock. Water rights can be expensive, which also requires upfront financing. This week’s blog looks at 7 water utilities that have increased their dividends annually for at least the past 10 yrs (see Table). Note: all values in the Table are current as of October 26, 2013. Red highlights denote values that are inferior to benchmark (VBINX) values. The main “takeaway” from the Table is in Column J, where you see that 5 of the 7 companies already have unsustainably high valuations. In other words, investors are well aware that water is undervalued and are betting that the dividends paid by these companies will grow faster.

Bottom Line: There aren’t many solid growth industries but water utilities certainly represent one. Clean water is destined to become more valuable than oil in our lifetimes. All 7 of the water utilities in this week’s blog represent worthwhile investments in terms of long-term Finance Value (Column E of the Table). In terms of dividend growth plus dividend yield, Aqua America (WTR) stands out. It is also a large enough company to have a Standard & Poors stock rating (A/L).

Risk Rating: 3

Full Disclosure: I don’t own any shares issued by these companies.

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Sunday, October 20

Week 120 - $150/wk for a Retirement Fund

Situation: You’ve heard a lot about saving for retirement, and you’ve probably heard that Social Security plus your workplace retirement plan probably won’t get you to a comfortable retirement any more. Why? Because people only reduce their spending by 15% after they retire, which means you will need a private savings plan to make up for the lost income. This savings plan can take the form of an IRA, payments into a low-cost annuity, proceeds from the sale of your home (if you move to smaller quarters), or perhaps even gold you’ve hidden away, and other choices. But when retirement is more than 5 years in the future, stocks remain your best bet.

We recommend that you minimize costs by using a stock index fund backed by a bond index fund. The Vanguard Balanced Index Fund (VBINX) provides both in one package, allocated 60% to stocks and 40% to bonds (see Table). It is rebalanced daily, so you won’t get burned if a stock market bubble bursts. (Most of those stock gains would already have been converted to bonds as part of daily rebalancing, and bonds typically increase in value when stocks crash.) Or, you can choose a low-cost managed fund that uses an excess of bonds to balance both the inherent risk of stocks and the difficulty managers have of knowing when to move away from stocks and into bonds. The Vanguard Wellesley Income Fund (VWINX) has the best record. It is bond-heavy and therefore has less volatility than VBINX but performs about as well. The third low-cost option is to study the markets yourself and invest in stocks online at computershare, and in bonds at treasurydirect. This third option allows you to pick only the most stable stocks and bonds. That hedging strategy will serve you well, even though it has less exposure to growth themes.

Why do we harp on buying and selling costs? Aside from “impulse buying”, the main reason retail investors make only half as much as they should (based on whatever asset allocations they’ve chosen) is their failure to control costs. (Company CEOs are no different.) It’s a human failing to like toys and spend too much for those. But retirement is dead serious. You won’t like it if you haven’t prepared your body, mind, and pocketbook ahead of time.
Our blog this week details one example of a personal retirement fund (mine). I dollar-average into 6 stocks and one bond (see Table). There are two Lifeboat Stocks (Week 106): Procter & Gamble (PG) and NextEra Energy (NEE), and two Core Holdings (Week 102): International Business Machines (IBM) and Nike (NKE). The remaining two stocks are Exxon Mobil (XOM) and Microsoft (MSFT), both of which have AAA credit ratings to make up for the fact that they don’t quite meet our standards for designation as Core Holdings. 

In our Week 117 blog on hedge stocks, we identified 16 such stocks out of the 900 in the S&P 500 and S&P 400 mid-cap indexes. NextEra Energy (NEE) was one of those, meaning that an investment in NEE stock doesn’t need to be backed up with investment in a Treasury Note or a bond index fund. The “bonds” that I use to back up the $250 that I invest each month in the other 5 stocks are inflation-protected 10-yr US Treasury Notes ($750/qtr).

In the Table, we use red highlights to denote values that are lower than benchmark values (VBINX). All values are current through 10/18/13.

Bottom Line: Dividend Reinvestment Plans (DRIPs) take time to set up and sell but are on automatic pilot the rest of the time. Savings Bonds and Treasury Notes are even easier to manage (through treasurydirect), except that you have to remember to buy them. The key difficulty is deciding exactly which stocks you’d like to own for an extended period. If you want to eliminate that chore without incurring additional expense, it is best to take Warren Buffett’s advice and invest in low cost index funds. 

This week’s blog shows one example of how you can build retirement savings with DRIPs for stocks issued by 6 highly rated and stable companies, balanced with inflation-protected 10-yr Treasury Notes. You can have your accountant designate up to $6500/yr as a standard IRA or Roth IRA.

Risk Rating: 4

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