Sunday, February 24

Week 86 - Low-risk Dividend Achievers vs. a Balanced Index Fund

Situation: The stocks we are calling “The Dividend Achievers” in the accompanying Table look like they can mint money. But for how many years will any one of these 26 “internally hedged” companies continue to have the pricing power and good management that make such outperformance possible? Pricing power comes from having a competitive advantage AND a product that is in demand but a tad short in supply. As an example, let’s take food products in the US. These stocks are expected to show price inflation that is 1% greater than the the overall Consumer Price Index for the next 2-3 yrs. Why is that? Because worldwide demand is growing while supply is constrained due to unpredictable events such as soil erosion, a dwindling availability of water, and an increase in temperatures to a range that is suboptimal for grain. The point is that there is always a reason for outperformance, and pricing power is usually the key to finding it. Pricing power is fungible . . . it won’t last. 

Where should a recent college graduate invest to secure her retirement 40 yrs from now? Readers of our blog know we favor defensive industries (consumer staples like food and housewares, utilities, health care) because people keep spending for those goods and services even during a recession. For example, look at this week's Table: 18 out of the 26 companies are in defensive sectors. 

Using our previously defined criteria (see Week 76), these 18 companies are internally hedged. By this we mean that their stock a) fell less than 65% as far as the S&P 500 Index during the Lehman Panic, b) has a 5-yr Beta less than 0.65 (meaning it will do as well in the next panic), and c) beat Vanguard's S&P 500 Index fund (VFINX) for the past 20 yrs. All of our best stock picks are on that list. Those paying a miniscule dividend now are likely to pay more in the future. None need to be backed 1:1 by an inflation-protected US Savings Bond or similar AAA credit.

But the tricky part is choosing which 5 or 6 of those stocks you want for your dividend reinvestment plans (DRIPs). If you're a "one-stop shopper", you won't take the time. In that case, we recommend the Vanguard Wellesley Income Fund (VWINX). 

For the rest of us, how should we pick stocks from this list of low-risk Dividend Achievers? These companies have a long history of annually increasing their payout so you can project future cash flows from that rate of increase. Simply add the current dividend yield (Column F, Table) to the historical rate of dividend increases (Column G) found on the Buyupside website. This produces the number in Column H, which is your projected rate of total return: 5.7% in the case of VWINX. Vanguard Wellesley Fund has done better than that over the past 20 yrs (Column I) because of capital gains realized upon the sale of bonds. How does that explain the outperformance? It happens because interest rates have steadily declined over the past 30 yrs, therefore, the bonds gained in value and a capital gain was realized when the bonds were sold. That also explains why utility stocks have outperformed (NEE, SO, WTR, UGI, SJI), since utilities are often capitalized with the help of bonds backed by a state government. When interest rates are low, cheap financing translates into a high return on invested capital (ROIC) to provide handsome annual increases in dividend payouts. To learn more about the rationale behind the above-method for arriving at the net present value of a stock, read The Four Pillars of Investing by William Bernstein (McGraw Hill, New York, 2002, ISBN 0-07-138529-0), the only book you need to read as a part-time investor.

For stocks other than utilities, deviations of the 20-yr total returns (Column J) from the discounted cash flow model (Column I) have more complex explanations. Here at ITR, we like to see agreement between predicted and actual returns. Good examples of this include the S&P 500 Index (VFINX), the average of 26 "hedge" stocks (Line 28, Table), Ross Stores (ROST), Family Dollar Stores (FDO), Hormel Foods (HRL), Chubb (CB), Abbott Laboratories (ABT), IBM and Procter & Gamble (PG). Predictable returns denote a stable competitive advantage. To gradually build a position in such stocks is sound investing, not gambling.

But all of these investment choices carry the risk of “pilot error", however small. We humans aren’t always rational allocators of capital but computers can be programmed to do an acceptable job. If you have $10 Million and take it to Goldman Sachs for them to invest on your behalf, they'll probably turn the task over to a computer. On June 20, 1996 Vanguard set up a Balanced Index Fund (VBINX) that has had an annualized total return since then of 7.2%/yr vs. 6.9%/yr for VFINX. The VBINX computer allocates 60% of your money to a total US stock market index and 40% to Barclay’s Capital US Float Adjusted Bond Index. The expense ratio is very low (0.25%), and there are no loads or other costs apart from requiring you to start your account  with a check for $3000. Turnover is relatively low, even though the computer rebalances the 60/40 allocation daily.

So what is the point to this? The point is that once programmed, computers have less pilot error in decision making. Why a 60/40 split? Because that's what was in vogue when the fund was launched. Here at ITR, we prefer a 50/50 split but with a computer doing the stock picking and rebalancing it’s reasonable to take the extra risk of carrying more stocks. After all, we break our 50/50 rule whenever we can find an internally hedged stock. The Table lists all 26 hedge stocks we know of that are A-rated, have 10+ yrs of dividend growth, and have been publically traded for 20+ yrs.

Bottom Line: 40 yrs is a long time to save for retirement and a lot can change. Let's assume that you are not interested in making an avocation of investing but want to keep your money somewhat insulated from human error and management fees. And, you also want it to grow with the economy. Then maybe a balanced index fund is your best choice. For a very long investment horizon, such as a Roth IRA that will keep paying tax-free returns long after you die, a balanced index fund is arguably the only choice. 

Risk Rating: 2.

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

Sunday, February 17

Week 85 - 15 Low-risk Food-related Stocks vs. Gold

Situation: Food-related companies have been outperforming every other category of stocks (aside from gold bullion ETFs and pipeline companies) for the past 10 yrs. For most food-related companies, that performance comes with relatively little risk using 3 measures that characterize a group of above-average performing hedge funds (see Week 46):
   a) Losses during the Lehman Panic less than 65% as great as losses for the S&P 500 Index;
   b) 5-yr Beta less than 0.65;
   c) returns that beat the S&P 500 Index over extended periods. 

Unfortunately, the fees levied by most hedge funds (e.g. 20% of any outperformance vs. the S&P 500 Index) will absorb a large share of your earnings, so you might as well have invested in the lowest-cost S&P 500 Index Fund with the longest history (VFINX). There are less costly substitutes for hedge funds that offer the 3 hedge fund characteristics mentioned above and they are: Warren Buffett's Berkshire Hathaway (BRK-B) which is a hedge fund disguised as an insurance company, Vanguard Wellesley Income Fund (VWINX) which is a bond-heavy balanced fund that behaves like a hedge fund, USAA Precious Metals and Minerals Fund (USAGX), and Royal Gold (RGLD) which is a US company and Dividend Achiever that invests in royalties from precious metals and minerals mining operations worldwide.

Surprisingly, there are a number of food-related companies that have better prospects going forward than either bonds or gold. We have identified 15 of these companies (Table) that have delivered strong returns over the past 20 yrs and satisfy the above 3 requirements for a hedge fund. To date, bonds and gold have been the main hedges that back the risky bets favored by managers of hedge funds (e.g. emerging market stocks). The shifting prospects of regional and global food demand relative to weather-induced shortages give pricing power to food-related companies--just as the coming wave of retiring baby boomers gives pricing power to gold. [This is because the government has not yet come up with a way to keep its current pension and health care programs solvent.] 

Many investors have shied away from stocks and moved into bonds. This has been at least partially due to the Recession (circa 2000) being followed closely by the even worse Lehman Panic (2008). I can’t blame them, given that the annualized total return on Vanguard’s S&P 500 Index Fund (VFINX) over the past 15 yrs is 4.5% vs. a 7.6% return for 20-yr US Treasury Bonds held in an exchange-traded fund (TLT). But don’t start transferring your funds just yet because bonds aren’t looking so good now. Interest rates are low because all bonds are linked to US Treasuries and the Federal Reserve has been on an unprecedented bond-buying binge since 2009. The US Government had a crummy balance sheet before the Lehman Panic, and now its debt is more than 4 times its annual income from taxes. And it continues to use borrowed money to pay over 20% of its bills.

Investors are shell-shocked from what happened to their stocks during the the recent recessions, and now they’re becoming frightened by the prospect of hyperinflation that will wipe out their bonds. So where do they invest their shrunken wealth? They put it into gold, which has worked well, at least so far. But gold is costly to buy, has to be insured, and produces no income. Those costs are reasonable during low inflation but will bite during high inflation.

We’ve explained why gold is a reasonable asset to own during a Financial Repression (when large-scale bond purchases are made by a central bank to restart economic growth). But we also noted in those blogs (see Week 79) that it would be unreasonable to continue owning gold after Financial Repression ends. Exactly when will that be? On February 5, 2013, the Congressional Budget Office (CBO) released a report explaining that tax revenues are now increasing due to an improving economy, and increased tax rates on high income households. In the meantime, the deficit is shrinking because spending on unemployment insurance and other “safety net” programs is decreasing and troops are returning home. But the CBO spokesperson, Douglas Elmendorf, said the budget gap would begin to worsen later this decade: “The number of people eligible for Social Security retirement benefits will be 40% higher in 10 years than in 2012.” 

How should investors prepare for that? One way would be to diversify your investments and hedge against the possibility that Congress will act to restore the government’s balance sheet to health, as occurred during the Clinton administration. An investor can do that by moving money into assets that are low risk (i.e., have the 3 hedge fund characteristics discussed earlier), are cheap to own, produce income, and have performed almost as well as gold. Such stocks would be in pipeline companies (an upcoming weekly blog topic) and food-related companies (see Table). Gold bullion has returned 8.4%/yr for the past 20 yrs vs. 10.8%/yr for the 15 food-related companies in the Table. However, the 3 low-cost “hedge” funds mentioned above (BRK-B, RGLD & USAGX) have all outperformed gold bullion, and RGLD has even outperformed the average food stock in our Table. [Note: BRK-B is a newer share class priced 1/1500th as much as the legacy share class (BRK-A) referenced in the Table.]

Bottom Line: The US economy is on the mend, and fears of hyperinflation will wane as people come to realize that interest rates can only go up a few percentage points in a slow-growth economy (“the new normal"). On the other hand, the increase in Social Security recipients will cause such a severe strain on the US government’s balance sheet in 10 yrs that hyperinflation could occur if current fiscal policies remain in place and China stops increasing its purchases of US Treasury Bonds. We think the possibility exists that interest rates could fluctuate in a frightening manner until Congress comes up with a way to meet our obligations without depending on the kindness of others. The average investor will want to protect herself with the next best thing to bonds and gold, preferably stock in stable companies that pay a good and growing dividend--which becomes something to spend in retirement. Food-related companies are among the safest and best-positioned to respond to population growth and the reduction in poverty, whether or not global warming proves to be a calamity.

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

Risk Rating: 4.

Sunday, February 10

Week 84 - Dividend Achievers that focus on International Sales

Situation: Last week we started a conversation about growth that is anchored around the concept of Opportunity Risk (see Week 83). The idea is that no one saving for retirement, no family saving for college, no company saving to build a broader competitive advantage, or government saving to build a broader comparative advantage can avoid RISK, since stagnation is the only alternative. They all have to consider Opportunity Risk, i.e., the risk that an expenditure will unnecessarily go toward supporting stagnation rather than growth. 

Last week we talked about investing in the smaller (i.e., faster growing) companies that aren't in the S&P 500 Index. This week we’ll turn our attention to companies that capture most of their revenues from faster growing countries. Same as last week, we’ll confine our attention to Dividend Achievers--companies that have increased their dividend annually for at least 10 yrs. We’ve come up with 27 companies, all having an S&P “A” rating of both their stock and bond issues (see Table). The 17 companies in the upper part of the Table lost less than 65% as much as the S&P 500 Index during the Lehman Panic; companies that lost more are red-flagged with respect to Risk (Column D) and take their place in the lower part of the Table. Why less than 65%? Because a group of above-average hedge funds lost slightly less than 65% as much as the S&P 500 Index during the Lehman Panic (see Week 46).

Of those 17 companies in the upper part of the Table, 9 are “hedge" companies (see Week 82). In other words, they have a 5-yr Beta of less than 0.65 (indicating that even today they’d likely lose less than 65% as much as the S&P 500 Index in a bear market) AND beat the S&P 500 Index over the past 15 yrs: 

        McDonald’s (MCD)
        Hormel Foods (HRL)
        Abbott Laboratories (ABT)
        International Business Machines (IBM)
        Colgate-Palmolive (CL)
        Johnson & Johnson (JNJ)
        Kimberly-Clark (KMB)
        PepsiCo (PEP)
        Procter & Gamble (PG)

Investment in any of these 9 stocks doesn’t need to be backed 1:1 by a high-grade bond like an inflation-protected US Savings Bond. Do be careful to pick several rather than rely on just one because even the best stocks eventually become overpriced and have to "correct" (witness Apple’s fall from grace).        

In the benchmarks at the bottom section of the Table we’ve included one of the best mutual funds focusing on international stocks (ARTIX). This table is a handy illustration of how stock selection can be used to beat mutual funds. Mutual fund managers drum up business by taking outsize risks. This results in good performance over the long haul but comes at the expense of terrible losses during bear markets. You don’t want that (or you wouldn’t be reading this blog).

Bottom Line: Companies that focus on sales from international markets are smart: they’ll grow earnings faster than the average S&P 500 company (which gets only 40% of its sales from outside the US). But it’s a hard row to hoe, so you will have to be very selective.

Risk Rating: 6.

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

Sunday, February 3

Week 83 - Low-Risk Small- and Mid-Cap Dividend Achievers

Situation: “Opportunity risk” is a phrase used by investors to denote the last consideration they check off their list before parting with hard-earned money. Spending on any investment means there will be less money available to support an even better opportunity. “Opportunity risk” is a reminder to all of us not to avoid making the chancy investments that eventually produce growth. We define these chancy investments as small & mid-cap stocks, emerging market stocks & bonds, oil & gas exploration and production companies, pipeline companies, diversified engineering companies that support infrastructure development, and food producers that support the growing world population. There is also opportunity risk for governments when they shy away from expensive but rewarding infrastructure projects that are so essential for GDP growth, like 10 gigabit/sec internet connectivity for every home and office.

Smaller companies can grow rapidly but usually have more cash flow problems and less resilience than large companies, often taking on too much debt. But even without troublesome debt and cash flow problems their stocks are often volatile. This is because investors hop on the bandwagon expecting that growth to get even more exciting but it inevitably slows. These “momentum investors” then sell at a loss, even though growth remains impressive. Apple stock (AAPL) is a current example of how the bandwagon works, and shows that even the largest companies can fall prey.

Companies that offer a good and growing dividend can usually avoid large price swings, so we have consulted the buyupside list of 199 Dividend Achievers (companies that have raised dividends annually for 10+ yrs), excluding those in the S&P 500 Index. We also require that stocks on our list meet our definition of a hedge stock (see Week 82):
        a) a 15-yr annualized total return that beats the S&P 500 Index (VFINX);
        b) a Lehman Panic (10/07-4/09) total return that is less than 65% as bad as the 45.6% loss in the S&P 500 Index;
        c) a 5-yr Beta of less than 0.65.

Our survey has turned up 28 companies (see attached Table) but only 7 are free of red flags in metrics for efficiency (ROIC), debt (LT debt/total capitalization), and cash flow (FCF/div). Those 7 companies include two food producers (LANC & SAFM), two property & casualty insurers (HCC & WRB), one company that sells cleaning products (CHD), one that builds pipelines and collects tolls for oil & gas transportation (PAA), and one that provides conventional electricity (MGEE). Close study of the table will show that all 28 companies have remarkably strong and steady profitability. 

Bottom Line: These days economic growth is constrained, so investors need to carefully take on more risk to adequately prepare for retirement. The “new normal” is a term you’ve seen by now, used to describe globally weak economic growth (due to vast amounts of debt that have to be serviced or repaid). The “new normal” clearly sums up present reality. What is less clear is that the financiers who came up with the term also think it sums up future reality. Why? Because the underlying reasons are long-term: a) governments, companies and families have borrowed too much in the expectation that the heady growth of the 1990s will come back and pay off those loans. b) But GDP growth at those 90s rates is unlikely to return because commodity prices (for oil, iron, copper, corn, soybeans, etc.) are likely to grow faster than “core inflation” when over a hundred million people/yr are emerging from poverty and wanting a better life. 

Let’s take oil as an example. Think about the expense and risk of a) drilling in deep water, b) hydro-fracking for oil and gas that is locked in deeply buried shale deposits, c) bulldozing and boiling tar sands into bitumen, and d) drilling under the Arctic Ocean. Then remember that oil is the main up-front cost for running a modern economy. When energy is cheap, GDP growth is readily achieved: the growth rates for both GDP and the price of oil have been the same since 1960 at 3.1%/yr (adjusted for inflation). But oil was cheap for only the first half of that 52-yr stretch (its been tripling in price every 10 yrs for the last half). You can see the problem, and its not going to go away until cheaper and cleaner energy substitutes are developed. The only near-term solution is conservation (driven by heavy taxation of electricity, vehicles, and fuels), such as Denmark has been doing for decades.

Risk Rating: 6.

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