Sunday, March 31

Week 91 - A Capitalization-weighted Index of 10 Key Food Stocks

Situation: Investors are always on the lookout for a “safe haven” for investments that will beat inflation during good times and bad. Why? Because they’re afraid that the value of the dollar will fall relative to other major currencies such as occurs when the government runs a budget deficit that is greater than the growth rate of the economy (~3%/yr). Since the US budget is currently in such a position, investors are afraid that inflation is just around the corner. The standard solution to this problem is to choose commodity-related investments because commodities are priced on world markets. Any instance of “currency debasement” will make commodities priced in that currency more expensive. The most sought after commodities are oil & gas, copper, grain (e.g. rice, wheat, corn, soybeans) and gold, and spot prices of all exhibit marked volatility. As a result, 10-yr US Treasury Notes have historically been the safest of safe havens. To make matters worse, even though a government does a great deal of deficit spending in order to correct an economic downturn, that spending does not guarantee that its currency will become debased (i.e., devalued relative to other currencies). Adam Smith pointed out long ago that when one country is more efficient at creating a product than a second country, the second country will have to accept the fact that country #1 has a “comparative advantage.” As long as the US government is #1 in managing its economy, heavy deficit spending during an economic downturn will not debase the US dollar.

Undoubtedly, some investors will decide that the US government doesn’t handle its economy as well as other major governments handle theirs. Those investors will conclude that 10-yr US Treasury Notes are no longer a “zero risk” investment for beating inflation over time, and will tend to see gold as a substitute. Indeed, gold has outperformed 10-yr Treasury Notes since 2000, when the US government began the first of two cycles of deficit spending in an attempt to reverse two recessions. 

Why is gold considered to be a substitute safe haven? Because it will more reliably beat inflation over the very long term than will 10-yr Treasury Notes. Since 1972, when the US came off the Gold Standard, the value of gold has grown 8%/yr vs. 4.5%/yr for inflation and 6.5%/yr for 10-yr Treasury Notes. But now that the US government’s deficit spending is down to 7% of GDP and headed lower (after peaking at 9.5% of GDP in the second quarter of 2009), investors might think about looking beyond gold for ways to more safely beat inflation. Inflation-protected 10-yr Treasury Notes or Savings Bonds (ISBs) should be their first consideration, given the very low standard deviation (volatility).

Among commodities, the government predicts that grains will beat inflation by 1-2% over the coming years--along with the necessary inputs: farm equipment, seeds, fertilizer, animal feed, crop protection products and land. In this week’s blog, we’ve set up a capitalization-weighted index of 10 key food-related stocks (Table) and compare these to gold bullion, the largest oil & gas company (Exxon Mobil), the largest copper producer (Freeport-McMoRan), the S&P 500 Index, Vanguard’s Balanced Index Fund (VBINX), Vanguard’s intermediate-term US Treasury Funds (VFIUX, VIPSX), and the largest hedge fund issuing its own stock (Berkshire Hathaway). From the Table, it is clear that our Food Index outperforms all of those.

Bottom Line: Gold is a bubble-maker that is best avoided: From January 1977 to January 1980, the price of gold surged 482% to a high of $850/oz. In January 1981, it was $578/oz and by January of 1982 it was $376/oz. Our current situation looks like we are in another gold bubble, one that peaked on 9/5/11 (per the afternoon London Gold Fixing) at $1895/oz. Gold's peak-to-peak growth rate is 2.6%/yr, i.e., less than the 3.3% inflation over those 31+ yrs. All commodities form bubbles in the face of scarcity, and scarcity leads to higher production, but gold is not a necessity and its industrial uses consume only 10% of its production. Food, however, is a necessity and twice as much per year will be needed by 2050. There are no substitutes for food and starvation is not an option. Global grain reserves have been falling 4%/yr since 2000. That is why spot prices for grain commodities have been growing faster than core inflation and will continue doing so. Those price increases are being passed along to the consumer because food products have almost no price elasticity (e.g. people may buy less meat and substitute a cheaper protein-rich product like Greek yogurt, but they’re unlikely to opt for eating less animal protein). 

Risk Rating for the food index is 3.

Full Disclosure: I have shares in KO, PEP, DD, MKC, GIS, HRL, and FLS.

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Sunday, March 24

Week 90 - Pipelines

Situation: Pipelines are another sector of critical infrastructure that the government "builds out" by making tax expenditures. In order to tempt investors into funding the massive up-front costs of laying a new pipeline, the IRS offers these “tax breaks” as an incentive. Pipeline operators get direct support from the Internal Revenue Service (IRS) in the form of a letter stating that no corporate taxes need be paid as long as at least 85% of any profits are returned to shareholders--who also get a tax break (see below). The pipeline company, which is structured as a Limited Partnership that receives initial funding from a General Partner, has to issue bonds if it wants to further expand its pipeline network. Those bonds aren't backed by the government. That's the catch. All of the pipeline companies have to expand their networks (given the ever-growing demand) but also have to maintain an investment-grade rating on their bonds to obtain low-cost financing. They all "push the edge of the envelope" and issue as much debt as the 3 rating agencies (S&P, Moody's, and Fitch) will allow before the rating is dropped to "junk" status. If you’re still reading, you’ve probably figured out that a pipeline company is set up much like a real estate investment trust (REIT).

The fixed costs of a pipeline can be depreciated in 20 yrs even though the pipeline itself has a much longer life. That means “distributions” (i.e., each investor’s share of operating profits minus interest, capital expenditures and payments to the General Partner) are mostly tax-deferred. Investors receive a K-1 tax form each year noting that taxes owed on their share of the return on invested capital (ROIC) are only about 20%. The remaining 80% represents non-taxable depreciation which reduces the investor’s cost basis to zero over time. After that point, distributions are taxed at the going rate for capital gains. When the stock is sold, any gain that is realized (because of price appreciation) is taxed as income. Considering the unusual structure of this investment, it is a great way for you to grow your wealth. Granted, there are tax headaches, e.g. some pipeline routes cross states that require a tax form to be filed.

The current energy boom that has been touched off by “hydrofracking” and horizontal drilling has ignited ~$10 Billion/yr of investment in pipelines that will continue for ~25 yrs. Once a pipeline is built, the fees charged for transporting oil and gas are relatively inelastic, i.e., changes in the price of natural gas or oil have little influence on pricing.
The Table lists 10 Limited Partnerships that represent the spectrum of over 70 such companies. In the past, total returns (distribution rate + rate of growth in the distribution rate) have averaged 13-14%/yr. The Table calls those distributions “dividends” because that is how most investors think of them. But if you’ve read this far, you know that distributions are quite different from dividends. Just remember this: payouts are high and grow smoothly but price appreciation is slow and bumpy. You’ll build your after-tax wealth from the quarterly distributions, not from selling the stock (when you’ll have to pay full income tax on any profits). You’ll need a good accountant to do your taxes.

Bottom Line: Do you want to make real money (after inflation, transaction costs and taxes)? Then look at investing in MLPs (Master Limited Partnerships). Those are mainly pipeline companies that have great economics once the pipeline is built and long-term contracts are in place. There are two main problems you run into: 1) Your accountant will have to file more tax forms; 2) These companies carry a lot of debt and that debt is rated just one or two notches above junk. So you’ll have to do some digging and find companies that have good management. Then keep track of the company’s business plans. We think Kinder Morgan Enterprise Partners (KMP) has exemplary management, and S&P gives Enterprise Products Partners (EPD) an A-rating (the others haven’t yet been assigned a rating).

Risk Rating: 8.

Full Disclosure: I have no stock in an MLP but do have stock in one of the General Partners: Kinder Morgan (KMI).

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Sunday, March 17

Week 89 - Great Expectations from Dividend Aristocrats

Situation: Standard & Poors has made a point of highlighting any company that has raised its dividend annually over the past 25+ years by calling it a “Dividend Aristocrat.” Some of those stocks have a low dividend yield because the stock price rises faster than the dividend. Sherwin-Williams (SHW) is an example. Other companies raise their dividend faster than the stock price increases so as to keep attracting investors during a period when the company is struggling. Nucor (NUE) is an example. Nonetheless, all 40 Dividend Aristocrats in this week’s Table managed to continue increasing dividends during the Lehman Panic and currently have a dividend yield that is equal to or greater than that of the S&P 500 Index (VFINX). However, companies have not been screened for S&P stock ratings on the assumption that they’re all headed in that direction or have already arrived!

Most of us don’t have time to become knowledgeable about all 40 of these fine companies, so we need a couple of methods for selecting those that are best for our investment purposes:

Method #1: Focus on low-risk companies. Here at ITR, we define those as the companies that held up well during the Lehman Panic by losing less that 65% as much as the S&P 500 Index fund (VFINX), i.e., they lost no more than 29.6% of their value over that 18-month period (29.6% being 65% of the 45.6% lost by VFINX). We put those companies in the upper half of the Table

Method #2: Focus on companies that have a 20-yr total return that is at least as great as the total return one would expect from dividends paid. In other words, adding the current dividend yield to the average rate of dividend growth over the past 20 yrs is the expected total return, since dividends reflect earnings. The only way a stock can appreciate faster than its earnings/dividends grow is for stock traders to conclude that the company has improved its competitive advantage. Looking at the top half of the Table, we see that those companies are: Hormel Foods (HRL), Consolidated Edison (ED), Chubb (CB), Colgate-Palmolive (CL), Becton Dickinson (BDX), VF Corporation (VFC), Chevron (CVX) and Exxon Mobil (XOM).

Bottom Line: For a low-risk company that has increased its dividend payout for 25 yrs in a row, you can calculate your expected total return over the next 20 yrs by adding the current dividend yield to its historic rate of dividend growth--obtained by going to this Buyupside website. To obtain more information on the validity of this method, read “The Four Pillars of Investing” by William J. Bernstein (McGraw-Hill, 2002, New York, ISBN 0-07-138529-0). See Chapter 2, where he derives the “Gordon Equation...(Market Return = Dividend Yield + Dividend Growth).”

Risk Rating: 3

Full Disclosure: I own stock in HRL, BDX, CVX and XOM, and plan to buy stock in VFC.

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Sunday, March 10

Week 88 - Biofuels

Situation: Grain reserves around the world have been falling at an average rate of 4%/yr for more than 10 yrs. This is not a good thing. Prices have doubled over that period and demand still remains strong for 3 reasons: a) there are ~220,000 more mouths to feed each day, b) more than 10,000,000 workers emerge from poverty each year, and c) grain is increasingly diverted from the food chain to make biofuels. (This also appears to have reduced per capita oil consumption by almost 2%/yr.)

It took just a few years for biofuel production to become a major industry in a number of countries. Brazil is the leader with 90% of the cars sold there equipped to run on 100% ethanol made from sugar cane. When the price of sugar on the world market is high, Brazil sells its sugar overseas instead of using it to make ethanol; car tanks are then filled up with gasoline. Brazil currently has enough sugar production to fuel its cars and sell ethanol abroad, e.g. to US refiners for $0.20 less than the US wholesale price for corn ethanol. How is that possible? Because it is so much cheaper to make ethanol from sugar cane than from corn kernels.

Okay so where is this discussion headed? The current goal is to find a commercially successful way to make ethanol from grass and wood chips, so-called cellulosic ethanol. We're not there yet but we can make diesel fuel on a competitive scale from algae and vegetable oil. This week's blog looks at companies that invest in biofuel production and have stock that has been publicly traded for at least 6 yrs (Table).

BP is the biofuels leader, and it currently is in court because of a horrific deepwater oil rig explosion that killed 11 workers. But neither bad publicity nor big fines will cripple this company because it has many strengths, not least of which is its long-standing commitment to renewable energy. If you want to make only one investment in biofuels, BP remains your best bet. The only other investment-grade companies subspecializing in biofuels are duPont (DD) and Valero (VLO). Valero owns 10 ethanol plants and duPont is developing biobutanol as a substitute for ethanol--one that doesn’t need to be made from grain. Biobutanol research is almost at the point where it can be made in a cost-effective manner from ethanol, glycerol (a byproduct of biodiesel production), cellulose, solar energy or algae. 100% butanol is a suitable fuel for motor vehicles and can be transported in gasoline pipelines, whereas, ethanol is too water-soluble to pull off either feat. REX American Resources is also worth a look, since it does manage to beat the S&P 500 Index (VFINX) in terms of Finance Value (Column E in the Table). REX owns ethanol plants and specializes in selling animal feed made from the distiller's grains, which are the major by-product of ethanol production. For small-capitalization companies that didn’t make it into our Table, we refer you to the Exchange-Traded Fund specializing in those (PBW, see line 10 in the Table).

BP is expanding production of bioethanol from sugar cane in Brazil. Recently, it announced that one plant will be doubled in size to process 5 million tons of sugar cane annually, enough to make 120 million gallons of ethanol. BP has taken the lead in research on cellulosic ethanol production by setting up a Biofuels Global Technology Center in San Diego after buying cellulosic ethanol assets from Verenium. As part of that effort, BP operates a 1.4 million gallon/yr cellulosic demonstration facility in Jennings, LA. Together with duPont (DD), BP has made a major push toward establishing biobutanol as a fuel of the future (because of the important advantages butanol has over ethanol). That joint venture is called Butamax Advanced Biofuels. For this work, MIT’s Technology Review magazine (December 2010) named duPont as one of the 50 most innovative companies in the world.

Bottom Line: Biofuel production isn't a mature industry. BP, duPont (DD), and Valero (VLO) are the only companies with investment-grade stock offerings. But more will come.

Risk Rating: 9.

Full Disclosure: I have stock in duPont (DD).

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Sunday, March 3

Week 87 - Stocks for Retirees

Situation: Here’s a dilemma that faces all retirees: You can’t “play” the stock market anymore because you don’t have time to “wait out” a downturn in the economy. A recession is bound to carry down your economically sensitive stocks with it.

To have a sound investment strategy, you should still maintain a 1:1 ratio of stocks to bonds (including savings bonds and certificates of deposit). You'll have to allocate most of the stock portion to low-risk mutual funds, like the balanced funds from Vanguard (VWINX & VBINX). But you can still put some money in large-capitalization stocks that behave like a hedge fund, i.e., those that a) lost less than 65% as much as the S&P 500 Index during the Lehman Panic, b) continue to maintain a 5-yr Beta less than 0.65, and c) beat the S&P 500 Index over the past 20 yrs (for a discussion of this, see Week 76). For additional safety, you also need to stick with buying stock in only the largest companies, namely, those found in the S&P 100 Index that are capitalized with A-rated stock. For added safety, stick to companies that are Dividend Achievers, i.e., increased their dividend 10+ yrs.

Our analysis finds there are only 10 such companies (Table). We added General Mills (GIS), since it has increased dividends for 9 yrs and is large enough for the S&P 100 Index. We also have added NextEra Energy (NEE), a Dividend Achiever that is also large enough. Ten of these companies are from the 3 defensive industries (consumer staples, health care, utilities) that we draw on for our Lifeboat Stocks category (Week 50). The remaining two are IBM and McDonald's (MCD).

When we find a low-risk A-rated stock issued by a company in one of the 7 non-defensive industries, and it has a dividend yield as great as the S&P 500 Index, we call it a Core Holding (Week 22). Those stocks are hard to find but that’s where you’re most likely to double your money in 10 yrs. In our Goldilocks Allocation (Week 3), we encourage you to strive for balancing your stocks at a ratio of two dollars in Core Holdings for every dollar in Lifeboat Stocks. For the 10 stocks in the Table, using that strategy would result in 1/3rd in MCD, 1/3rd in IBM and 1/3rd in one of the 9 Lifeboat Stocks like Wal-Mart Stores (WMT). Bear in mind that all 12 are “hedge” stocks so you won’t need to backstop them with savings bonds as long as you invest consistently in small portions by putting $300/qtr into a dividend reinvestment plan (DRIP) for each.

Bottom Line: You need to continue saving after you retire, and half of your savings need to be in stocks. Why? Because you'll probably be living a long time and your expenses might surprise you: Stocks are necessary to keep up with inflation. To guesstimate your future expenses, keep an eye on what it costs to send a student to a private college for a year. (In 2010, it was $32,617 for tuition, room & board according to the National Center for Education Statistics.) Then multiply that number by however many years you have left before reaching 90. Shocking, isn’t it?? Re-do the calculation each year.

Risk Rating: 2.

Full disclosure: I am retired and personally maintain DRIPs in 10 of the 12 stocks highlighted above: MCD, WMT, GIS, NEE, ABT, IBM, JNJ, KO, PEP and PG.

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