Sunday, January 27

Week 82 - 37 Dividend-Growing Hedge Stocks in the S&P 500 Index

Situation: Many of you have been interested in our Lifeboat Stocks category (see Week 8) and have followed the updates (see Week 23 & Week 50) we’ve posted. We’ve created this category of stocks in an attempt to take your interest off risky investments and provide a class of investment that will provide some security for doing as well as the overall market. In other words, Lifeboat Stocks are an introduction into a hedging strategy. Hedge Funds, you’ll remember from our blogs on the topic (see Week 46 & Week 76), seek to beat the S&P 500 Index over long time periods while sidestepping market downdrafts. They achieve this by having an overall low Beta--something lower than 0.65, and that means holding lots of bonds to backstop what could be chancy investments like stocks in emerging markets. 

But there are also stocks that behave in a bond-like manner. Of these, regulated utilities are the main group, with master limited partnerships (which operate oil and gas pipelines) being the second largest group. Both encompass government regulation alongside government subsidies, which act to tempt investors into financing upfront fixed costs that are huge. In other words, government regulation is accepted by investors because returns are stable and bankruptcy is not a concern. But there is also a third option for hedging, and that is what we call hedge stocks because they behave like hedge funds. There are 37 stocks in the S&P 500 Index that have beaten the index over the past 15 years, partly by falling less than 65% as far as the index during the Lehman Panic, and have a 5-yr Beta of less than 0.65 (Table). 

You might expect most of those stocks to be from the 3 “defensive” S&P industries that contribute our Lifeboat Stocks, namely: Utilities, Health Care, and Consumer Staples. And you would be right:

8 are utilities:  Southern (SO), NextEra Energy (NEE), Dominion Resources (D), PG&E (PCG), Consolidated Edison (ED), Sempra Energy (SRE), Xcel Energy (XEL), Wisconsin Energy (WEC).

4 are Health Care companies:  Abbott Laboratories (ABT), AmerisourceBergen (ABC), CR Bard (BCR), Johnson & Johnson (JNJ).

15 are Consumer Staples companies, subdivided into 4 groups. 
     7 food stocks:  PepsiCo (PEP), Hormel Foods (HRL), General Mills (GIS)
HJ Heinz (HNZ), Hershey (HSY), JM Smucker (SJM), McCormick (MKC).
     4 housewares stocks:  Procter & Gamble (PG), Colgate-Palmolive (CL), Kimberly-Clark (KMB), Clorox (CLX).
     2 broad discounters:  Wal-Mart Stores (WMT), Costco (COST).
     2 tobacco stocks:  Altria (MO), Lorillard (LO). 

Interestingly, that leaves 10 companies that are from the remaining 7 “non-defensive” S&P industries:

3 Consumer Discretionary:  Family Dollar Stores (FDO), McDonald’s (MCD), TJX Stores (TJX).
3 Materials:  Ecolab (ECL), Sherwin-Williams (SHW), Bemis (BMS).
2 Financial:  Chubb (CB), Progressive (PGR).
1 Industrial:  CH Robinson Worldwide (CHRW).
1 Technology:  International Business Machines (IBM). 

For comparison, the Table includes several benchmarks (in capital letters) ranked at their respective Finance Value: gold bullion, the largest gold mining stock (ABX), the largest hedge fund (BRK-A), 3 bond funds, and 3 stock funds. Red flags are used to denote concerns, or underperformance vs. the lowest cost S&P 500 Index fund with data extending over 15 years (VFINX).

Bottom Line: A single stock is at least 3 times riskier than a single investment-grade bond, so you need to own well-chosen stocks to come out ahead. The 37 stocks highlighted in the Table are special in that they don’t need to be backed with an equal investment in a safe bond (e.g. an inflation-protected US Savings Bond) as long as you pick several. If you’re only going to pick a few, then pick from the ten that compose our Master List (Week 78) and don’t have red flags in Columns I through L of the Master List Table: WMT, IBM, JNJ, PEP, MCD, ABT, NEE, CHRW, HRL, MKC (in order of stock market value).

Risk Rating: 3.

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Sunday, January 20

Week 81 - Core US Food and Beverage Companies

Situation: The worldwide food and beverage industry is very mature, very fragmented and very competitive. We need to sort companies into manageable groups to allow analysis of investment potential. We started with those based in the US and came up with a list of 20 noteworthy stocks (see the attached Table). Not all are in the business of producing food and beverages. We’ve included the largest seed company (Monsanto), the largest farm equipment company (John Deere), the largest trucking company dedicated to delivering food products and prepared meals (Sysco) and a freight forwarding company (CH Robinson Worldwide) that delivers its own line of vegetables (The Fresh 1) anywhere in the world that has an air freight terminal. We sorted these 20 companies into two groups of 10 in the Table. The upper group has 5-yr Beta values less than 0.65 and Total Returns during the 18 months of the Lehman Panic that fell less than 65% as far as the S&P 500 Index Total Returns. This leads us to think of those 10 companies as being “bond-like” and having such low risk that there’s no need to hedge an investment in these companies with an equal investment in 10-yr US Treasury Notes, or inflation-protected US Savings Bonds, or a high quality investment-grade intermediate-term bond fund (see Week 76 for more information on hedges). To find substantial risk factors associated with these stocks, you have to look deeper. We have identified what we consider to be some key risk factors and red-flagged values denoting higher risk (see Columns H-M in the Table). Only 3 stocks that have no red flags, and they are the ones with the highest Finance Value (Reward minus Risk: Column E), namely Hormel (HRL), CH Robinson (CHRW) and General Mills (GIS). You can think of these 3 companies as having little uncertainty related to earnings growth going forward. Bottom Line: Food is so essential that the top 10 companies (Table) rival regulated utilities for stability and dependable earnings growth, even though food companies don’t have government-guaranteed credit and return on equity. Risk Rating: 3.

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Sunday, January 13

Week 80 - 2012 Total Return for the Growing Perpetuity Index

Situation: The US economy has improved but only enough for job growth to keep up with population growth. The stock market, on the other hand, is pointing to the likelihood that the rate of economic expansion (GDP) will soon double to more than 3%/yr. We’re in a bull market, which we define as the S&P 500 Index outperforming the “blue-chip” 65-stock Dow Jones Composite Index. During 2012, there was a wide gap between the two with the S&P 500 Index gaining 13% vs. 5% for the Dow Jones Composite Index. Those are price-only indices so dividends, which are ~30% greater for the blue-chip index, aren’t counted. Therein lies the problem! Fear of going over the “fiscal cliff” had investors pulling money out of stocks that pay good dividends. Those dividends would have been taxed approximately twice as much had we gone over the cliff. We didn’t and are predicting that 2013 will see a renewed interest in dividend-paying stocks.

It’s time to update our previously published Growing Perpetuity Index (GPI, see Week 66). The 12 companies in our GPI  are the bluest of blue-chips, and had an average Total Return of only 3.8% (Table). For 5 and 10 yr periods, the GPI handily outperformed the S&P 500 Index, as well as the Vanguard Dividend Growth Fund, a more appropriate benchmark for the GPI (Table). We have separated those 12 stocks into two groups, 7 that are low risk and 5 that are high risk.

Warren Buffett has stated on several occasions that stocks having a 5-yr Beta greater than 0.7 are best avoided. And the better hedge funds generally have 5-yr betas of less than 0.7. Indeed, at the May 2012 annual meeting of Berkshire Hathaway, Mr. Buffett indicated that a group of 5 above-average hedge funds lost 35% less than the S&P 500 Index during the Lehman Panic (Week 46). In other words, those hedge funds had a 5-yr Beta of less than 0.65. That is why we have recently started breaking our blog tables into two groups: an upper group that lost less than 65% as much as the S&P 500 Index during the Lehman Panic and had a 5-yr Beta less than 0.65, vs. a lower group that doesn’t meet that standard (see Week 78).

Our GPI has 7 such companies in the top group (Table): Wal*Mart (WMT), McDonald’s (MCD), NextEra Energy (NEE), IBM (IBM), Johnson & Johnson (JNJ), Coca-Cola (KO) and Procter & Gamble (PG). Those 7 had an average total return of 8% in 2012. More importantly, the aggregate data for those 7 stocks (line 9 of the Table) is impressive. Only two other A-rated dividend-paying stocks in the S&P 500 Index can come close to matching that data set, namely, Darden Restaurants (DRI) and General Mills (GIS). Darden Restaurants’ credit rating is too low to warrant inclusion in our Master List (Week 78) and General Mills has only raised its dividend for 6 consecutive yrs, instead of the 10 required for inclusion in the Master List. A recent hit movie (“Moneyball” based on the 2003 book of the same name by Michael Lewis) dwelt on this point by showing that a baseball team composed of players that individually had a low market value could outperform richer teams if those players collectively had a high on-base percentage. This concept came earlier to the investment world, in the early 1980s, when Michael Milken showed that “fallen angels” (corporate bonds that had slipped below an investment-grade rating) could give good results if, as a group, key ratios were at an investment grade level.

The point here is that every company’s competitive advantage is a work in progress. Some years the pieces fall together nicely but other years see a potent competitor taking market share. Only by holding a number of well-chosen stocks can you pull ahead of the pack.

Bottom Line: If you’re within 15 yrs of retirement, confine your stock-picking to tickers with a 5 yr Beta of less than 0.65 that lost less than 65% as much as the S&P 500 Index during the Lehman Panic.

Risk Rating: 3.  

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Sunday, January 6

Week 79 - Gold vs. Financial Repression

Situation: Three weeks ago (see Week 76), we explained how Financial Repression forces investors to allocate more funds to stocks. This step has to be taken to counter (hedge) the main result of Financial Repression, which is to inflate values of all financial instruments by ~1.8%. In other words, you can’t come out ahead of inflation by putting your money in a historically safe place like Treasury Notes. You will have to put it in a less safe place, and that means investing in stocks (becoming a trader), local real estate (becoming a landlord), a small business (becoming an employer), or the education needed to land a better job. Our goal was to show you some stocks that are better (and arguably safer) places to put your money than Treasury Notes. By investing in those “hedge stocks” you would be doing something counter-intuitive, i.e., using stocks to hedge against bond losses. 

Financial Repression is basically a tax on all your assets. The Federal Reserve levies that tax by removing Treasury Notes and mortgage-backed securities (MBS) from circulation, currently at a rate of $85 Billion/mo. Treasuries and MBS that remain on the market become so high in price that their interest rates may fall lower than the rate of inflation. This is done to drive mortgage interest so low that all of the expensive mortgages taken out in 2005-2008 can be refinanced to inexpensive mortgages, and new buyers looking for a home can get an affordable mortgage. In other words, a recession caused by a real estate crash can only be reversed by restoring home values.

We get that part of the equation but what about the other part--expansion of the Federal debt? What does Financial Repression do for the Federal Reserve and the banking system? Let’s focus on the big issue, the one driving investors into gold. Financial Repression makes it very cheap for overly indebted governments to borrow money. When the Federal Reserve drives down interest rates to reduce the cost of borrowing, investors (and even economists) will often conclude that Financial Repression represents debasement of the currency. That makes gold (a currency that cannot be debased) more expensive. Gold shouldn’t be an investment asset because it produces no income to offset its costs (commissions, storage fees, insurance, and a high tax rate on any capital gains). But when the Federal Reserve is giving away money at a cost to its balance sheet of $1.14 Billion/yr, TV commentators say “the Fed is printing money” and TV viewers go out and buy gold. The Fed isn’t printing more money. It is actually printing less than it was because relatively few people can put it to use unless the cost of borrowing is next to nothing. The Fed simply tilts the ebb and flow of money through the banking system toward more flow, thus allowing banks to make money available at very low interest rates. The goal is to reflate an economy that is under threat of deflation. (Up until recently, the main purchasers of that cheap money have been the Chief Financial Officers of solvent corporations who have figured they will be able to use it when demand for their products finally returns.)

When Financial Repression works and deflation is prevented, gold is a great asset to own because Financial Repression usually takes a long time to work its magic. But if deflation happens because Financial Repression is applied too late or too timidly, gold is a terrible asset to own. In 2008, when the Fed was still keeping interest rates high and the “bailout” had not yet kicked in, the exchange-traded fund (ETF) for large gold-mining stocks (GDX) fell in price from $56.87 (in 3/08) to $15.83 (in 10/08) for a 72% loss. Over that same 9 month period, a highly-regarded low-cost/no-load natural resources mutual fund (PRNEX) fell 51% and Vanguard’s lowest-cost S&P 500 fund (VFIAX) fell 35%. Investors who thought a 1930s-style depression was in the offing fled from gold. Once it became clear that a depression had been prevented by the prompt application of robust monetary and fiscal policies, investors returned to gold seeking to reap the benefits of Financial Repression. But most will disappear when and if the economy is reflated without incident. Why? Because, at that point, the Fed will be withdrawing money from circulation to prevent inflation and driving up interest rates. That will make the trading commissions, storage costs, insurance premiums, and capital gains taxes on gold unaffordable. Gold is only a reasonable long-term investment when the government is over-spending in its role as lender of last resort and driving up debt per capita. Once debt per capita is falling, the economy is okay: the currency isn’t being debased. Right now, debt per capita is increasing and the currency is being (temporarily?) debased. This means gold is a reasonable investment now provided that holding costs continue to remain low and gold isn’t overpriced. 

In summary, you need to answer two questions before investing in gold: 
   1) Can you afford the holding costs? 
   2) Is gold overpriced? 
Question #1 is easy to answer because you can own gold bullion through an exchange-traded fund (GLD) at a cost of less than 0.5%/yr after paying the trading commission. That expense ratio will increase when Financial Repression ends. In other words, storage fees and insurance premiums will rise in tandem with rising interest rates. Question #2 is harder to answer because no one knows quite how to price gold. It has some tangible value (industrial uses) and a lot of intangible value (jewelry), which is why profits from its sale are taxed at the highest rate as though it were a collectible similar to art.

Doing the math, we’ll start with best estimates. An ounce of gold has historically been said to have the same value as a very good suit of clothes. Most of us aren’t prepared to shell out $1600+ when we shop for a good suit. But financial reporters keep trying to pin down gold’s value by asking tailors how much they charge to make a very good suit from very good fabric. Tailors think that’s an easy question and over the past few years have answered ~$1000. Another way is to look up the prices of gold mining stocks (see the attached Table). Those reflect the cost of extracting & milling the mine’s most easily accessed ore in order to market its next ounce of gold: $1200/oz to $1300/oz.

What have we learned? At $1660 (the price of gold on 12/31/12), gold is overvalued and could fall out of favor with investors. Those are the very people who have been buying up half the annual production of gold over the past 5 yrs. Without the eagerness of those investors, the only tangible value gold has is the price paid for the 12% of annual production that is used for industrial applications--the rest being used for jewelry, which is another intangible like art. (Central Banks also buy and sell gold but don’t move the needle much from year to year.)

Let’s try harder to come up with gold’s value to an investor. An investor wants to own gold as a hedge against the hyperinflation that will arise if the currency is unremittingly debased. So an investor will want to know how efficiently decreases in the purchasing power of the dollar (inflation) have been compensated for by increases in the price of gold. To answer this question, we need a reliable way of measuring the true value of the dollar. Since gold, always and everywhere, is an easily transported medium of exchange, we need a benchmark that is available always and everywhere. In other words, we need a benchmark that measures the true value of every currency relative to the true value of every other currency. In business school, the choice of a reasonable benchmark by which to value different currencies is called arriving at purchasing power parity (PPP). 

It sounds silly but that benchmark is the price of a Big Mac hamburger. Go out and buy an issue of a British business magazine called The Economist if you doubt whether this is the global way to measure PPP. McDonald’s has established restaurants in 190 countries so Big Macs are ubiquitous--always made the same way, always on the menu, and always marked up the same in local currency. It is easy to find the price of a Big Mac in the currency of any country on the planet (just Google it). So let’s establish PPP for gold in US dollars relative to a Big Mac. In 1975, the average price of gold was $161.25 and the average price of a Big Mac was $0.75. In 2012, the average price of gold was $1766 and the average price of a Big Mac was $4.33. So gold went up 10.95 times in price while Big Macs were going up 5.77 times. The Consumer Price Index (CPI) only went up 4.28 times over that 38 year period so McDonald’s is a strong brand that bestows considerable pricing power. If gold bullion had enjoyed the same pricing power as a Big Mac, it would have had an average price in 2012 of $930.41 (161.25 x 5.77), instead of $1766. Therefore, in 2012 the average price of an ounce of gold represented at least $836 (1766 minus 930) of intangible value vs. a Big Mac, which already has considerable intangible value vs. the CPI.

Let’s be clear about intangible value. When a company is bought by a private equity fund, the amount paid over and above tangible book value is called intangible book value. Intangible value is the price paid for the brand and the talent that went into building it: The pricing power of that brand is worth only what the buyer is willing to pay. Gold bullion is a great brand that currently enjoys enormous pricing power. Whenever you sell it at a profit, you’ll pay a lot of tax because the IRS is onto your game. The IRS considers the entire value of your gold to be intangible and therefore taxable as a work of art. You bought a votive object, plain and simple, then profited from its sale. 

Bottom Line: In the event that the Federal Reserve and Congress are able to bring the country out of Financial Repression, which now seems likely to occur within 5 years, gold bullion is going to lose value. How much and how fast? Rationally, that depends on the rate at which the nation’s debt per capita decreases. The government’s debt will keep growing but not as fast as the population. Irrationally, you have to ask yourself what price investors will pay for gold after currency debasement has ended. This will depend on sentiment. If you are a gold bug, you’ll never sell. But if you’re not wedded to the gold coins buried in your backyard, you’ll sell and sell quickly because the price will be falling fast (herd instinct). If you own a well-chosen gold mining stock (Table), you’ll still take a hit but not from the IRS since gold mining stocks are taxed like any other corporate stock. You’ll just end up wishing you’d invested in the mining industry rather than gold mining per se, perhaps through a diversified mining stock like Rio Tinto (RIO) or a mining equipment stock like Caterpillar (CAT). Both are shown in the Table.

Risk Rating for gold mining stocks is a 10. No asset class fell faster or farther during the 9 months in 2008 when major economies appeared to be falling into a 1930s-style depression.

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