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.

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