Sunday, April 28

Week 95 - Hedge Stock Picks for 2013

Situation: In several of our blogs over the past year, we’ve tried to identify stocks that behave like an above-average hedge fund (using a definition based on information provided by Warren Buffett at the May 2012 Annual Meeting of Berkshire Hathaway--see Week 30). A qualifying stock would need to beat the S&P 500 Index over the past 10 yrs while losing less than 65% as much as the S&P 500 Index lost during the Lehman Panic, and would need to maintain a 5-yr Beta of 0.65 or less to show that it would be likely do as well during the next financial panic. In this week’s blog, we merge those standards with ITR’s long-standing requirement that stocks used as a base for retirement planning be 
   a) Dividend Achievers, meaning they have consecutive annual dividend increases for at least the past 10 yrs
   b) have a dividend yield close to or better than the 15-yr moving average for the dividend yield on the S&P 500 Index (1.8%); 
   c) have an S&P stock rating of A- or better and an S&P bond rating of BBB+ or better;
   d) have no more than 50% of total capitalization coming from long-term debt; 
   e) have positive free cash flow (FCF) in the most recent year according to The WSJ;
   f) have a return on invested capital (ROIC) sufficient to cover the cost of capital (at least 8% for non-financial companies).

General Mills (GIS), which will be added to the 201-stock Dividend Achievers List published by S&P early next year, has been made a part of our list too. 

Since we began blogging about hedge stocks (see Week 76, Week 77, Week 82, Week 93), there are 11 stocks that consistently keep qualifying (Table). This list is important to you, the investor, for the simple reason that you don’t need to back up ownership of these stocks with an equal investment in Treasury Notes (or inflation-protected Savings Bonds). That precaution is necessary when purchasing other stocks in case the next financial panic happens soon after you retire when you’ll be particularly loathe to sell stocks that are repressed in value. Then you can sell bonds instead, which will be up in value.

We have only one concern about the hedge stocks in our Table, which is an increasing tendency for those companies to borrow money in order to keep raising their dividend annually. This trend started in 2005 when Procter & Gamble borrowed money to pay the part of its growing dividend that free cash flow (FCF) couldn’t fund. This was done to avoid bringing overseas earnings back to the US, which would result in a 30% tax (on top of taxes already paid to foreign countries). This increasingly affects the companies in our list of hedge stocks, since most are mainly expanding overseas. Only 6 of the 11 companies have money left in FCF after paying their dividend. Those “Retained Earnings” are the best way to grow the company, since they come at no cost. Eventually, the tax policy of the US Government will have to stop penalizing companies for overseas operations.

Bottom Line: Even though there are only a few stocks that qualify as “hedge stocks”, it is important for you to set up DRIPs in one or two of these and add money regularly through automatic deductions from your checking account. That’s not only a good way to prepare for retirement but it’s also the best way to hedge against the risk of hyperinflation. 

Risk Rating for the aggregate of 11 companies: 3.

Full disclosure: I have DRIPs in MKC, MCD, ABT, KO and IBM.

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

Sunday, April 21

Week 94 - There are 42 S&P 500 Companies with a Durable Competitive Advantage

Situation: Every year around this time we get a flood of data about the previous year’s stock performance. Our Week 59 blog introduced you to a way of defining stable growth that is likely to last: we identified 90 companies in the S&P 500 Index that almost met Warren Buffett’s definition of a Durable Competitive Advantage (DCA) and had similarly strong projected growth numbers for the next 10 yrs using the Buffett Buy Analysis (BBA). Now we’ve re-checked the numbers on all 500 companies using a more rigorous definition of DCA and BBA and come up with 42 companies (Table). 

Since this is a list of growth companies (only 11 pay at least a 1.8% dividend), it is important to rank these companies in terms of Retained Earnings (the engine of growth). That’s the money remaining in Free Cash Flow (FCF) after dividends have been paid: internally generated cash that is the cheapest way for a company to fund its future growth. Raising cash externally is more problematic and expensive. There are only 3 options: issue more stock, issue more bonds, or lobby a government entity for tax expenditures (either a tax break or a low-interest loan).

What is a Durable Competitive Advantage? It’s 10% or greater growth/yr in Tangible Book Value over the past decade, with no more than two down years.

What is Tangible Book Value? It’s assets that have a price and can be readily sold, like real estate and equipment. Intangible assets, such as the value of a brand name, are not included.

What is the Buffett Buy Analysis? It’s the projected rate of total return for the company’s stock over the next 10 yrs, assuming that the economy is in recession. BBA is calculated (see Week 59) by taking the trendline for growth in the past decade’s “core earnings” (as defined by S&P) and extending that trendline 10 yrs into the future. At the end of 10 yrs, the stock’s price (relative to earnings projected by the trendline) is calculated on the basis of the lowest Price/Earnings (P/E) multiple recorded in the past 10 yrs. Furthermore, it is assumed that the company will be unable to raise its dividend.

How do Retained Earnings affect future growth? Obviously, there would be more money in the Retained Earnings (RE) column of a company’s balance sheet if the company hadn’t decided to pay dividends--because all of its Free Cash Flow (FCF) would be “retained” to fund new initiatives. To an accountant, that means the company has the ability to continue growing at whatever rate its Return on Equity (ROE) happens to be. Problem is, the Chief Financial Officers of US companies have learned that it’s a lot easier to sell stock to “buy and hold” investors if they pay a dividend that is at least large enough to counter inflation. That usually means there is very little (if any) Free Cash Flow left to put into the Retained Earnings column at the end of the year. That’s why accountants treat dividends like a Closeout Sale, i.e., the company is being liquidated piecemeal.

Now you’re getting the point: companies that retain earnings are good bets, even though their stock prices are often volatile. It is that volatility makes almost all of the companies in the Table unsuitable for retirement savings: While it is popular to own stock in a fast-growing company, fast growth never lasts. Even the company’s managers don’t know when to stop spending vast sums of money in support of fast growth, so how would you know when to sell the stock? The other problem is that growth investors are fickle--follow herd instincts. They find it tiresome to analyze a problem with management’s vision or execution that is (perhaps temporarily) hurting the stock’s price. For example, Apple (AAPL - see Table) certainly has several more years of fast growth lying ahead but it is no longer popular to own the stock. Many of its investors have sold at a loss and are looking elsewhere for their fix.

Bottom Line: So why did I go to all the trouble of cranking numbers (from WSJ and S&P) on 500 companies for this week’s blog? Because the exercise is useful for turning up a few new names worth closer attention from an investor who is saving for retirement. This year we’ve uncovered 4 such companies: Kohl’s (KSS), Ross Stores (ROST), Kroger (KR) and Exxon Mobil (XOM). You already know that XOM is one of our favorite stocks--being both a Master List selection (Week 92) and a Growing Perpetuity Index selection (Week 66). But the other 3 are new names on our horizon and bear watching.

Risk Rating for the aggregate of 42 stocks: 7.

Full Disclosure: I have stock in XOM and FLS.

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

Sunday, April 14

Week 93 - Which investments are "safe havens?"

Situation: The business press seems to have settled on the year 2008 as a marker for risk. What those reporters mean to say is that if your favorite investment didn't lose money in 2008, it wasn't risky. We agree with that assessment since it’s hard to argue otherwise, but would like to pair it with a longer term measure of risk. “Dead money risk” comes to mind, which means your favorite investment doesn’t make money for a number of years. For example, March 24th is the 13th anniversary of when the S&P 500 Index first rose above 1550. It fell with the blowout but recovered back to 1550+ on October 9, 2007. Then it fell again with the Lehman Panic and has just now recovered to 1550+ again.  What this means in terms of “nominal dollars” is that if you had invested money in an S&P 500 Index fund (e.g. VFINX) on March 24, 2000 that has been “dead money” for 13 yrs. What this means in terms of “real dollars” (i.e., inflation-adjusted) is that your investment has fallen 35% in value, since the Consumer Price Index (CPI) rose 35% in the interim. If you had reinvested your VFINX dividends, your total return would have kept up with the CPI for no loss, no gain. Therefore, our definition of a "safe haven” is an investment that made money since 3/24/00 AND made money in 2008 (Table).

That leaves us with only 9 S&P 500 companies that pay a dividend of at least 1.2%/yr from the list of 201 Dividend Achievers (plus GIS, which is starting its 10th consecutive year of annual dividend increases and will be accorded Dividend Achiever status in 2014). Five of these companies are in our Stockpickers Secret Fishing Hole (see Week 68), i.e., they’re part of the 65-stock Dow Jones Composite Average: MCD, WMT, XOM, CHRW and SO. Four companies are part of a category we call Lifeboat Stocks, i.e., they’re among the best “value” stocks representing “defensive” industries (see Week 23), i.e., the utilities, consumer staples and healthcare industries that are known for maintaining their revenues during a recession: WMT, GIS, CHD and SO. The remaining 5 companies are part of a category we call Core Holdings (Week 22): MCD, CHRW, ROST, FDO, SHW. Core Holdings are the best “value” stocks from “cyclical” industries, i.e., the industries that are sensitive to economic cycles. That’s where you'll make most of your money, provided that you use a strategy of adding a little money at a time (monthly or quarterly) to a dividend reinvestment plan (DRIP). We recommend that you have $2 in Core Holdings for every $1 in Lifeboat Stocks.

Bottom Line: Folks, we’re here to tell you that you can’t "play the market." Since 1900, a Bear Market has happened about every 5 yrs. That means the S&P 500 Index fell at least 20% over approximately 20 months. Then a Bull Market started and it took roughly 20 months for stocks to recover from that loss and get back to their previous high. The Bull Market then continues to reach a new high over the next ~20 months. If you weren't fully invested in stocks during the first 10 business days after the Bear Market ended, your gains from having money in the new Bull Market would have been reduced by ~20%. Lesson learned: While stocks are historically the best asset class for building a retirement nest egg, those stock holdings will represent "dead money" 2/3rds of the time. The payoff is only going to happen about a third of the time, and you have no way of telling just when that will be (except that academic studies have shown that the best time to be in stocks is when it seems insane to do so). So keep only half your retirement savings in stocks and the other half in bonds (which only become dead money during hyperinflation). If you don't want to pick your own stocks and bonds, then invest in a low-cost balanced fund (like the Vanguard Wellesley Income Fund) which does it all for you.

Risk Rating for the aggregate of 9 stocks: 3.

Full Disclosure: I own stock in MCD, WMT, CHRW and GIS.

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

Sunday, April 7

Week 92 - Quarterly Update of Master List - Q1 2013

Situation: In assembling The ITR Master List for stocks, we need to be detail-oriented and non-speculative (see Week 43, Week 52, Week 65 and Week 78 for review). Otherwise, you might as well invest in the lowest-cost S&P 500 Index fund (VFINX). Why? Because its total return can’t be beat on a long-term, risk-adjusted basis. But that degree of risk (as we know from 2008 when the Index lost 37.22%) could wipe out a large chunk of your savings just as you’re beginning retirement. So, if you’ve been a steady reader of this blog we know you’re striving to accumulate stocks and mutual funds that will do almost as well as VFINX but with half the risk.

Here at ITR, we dial back the inherent risk of stocks by looking for companies that
1) pay a dividend of at least the 15-yr moving average for the S&P 500 Index (1.8%);
2) have increased dividends annually for at least 10 yrs;
3) have increased dividends at least as fast the S&P 500 Index (6.5%/yr);
4) have an S&P A-rating on their common stock;
5) are less than 50% capitalized by long-term debt;
6) have a return on invested capital (ROIC) sufficient to cover their cost of capital, which is at least 8%/yr for companies other than banks;
7) have positive free cash flow per The WSJ.

Our database is the S&P Dividend Achievers, the 201 companies that have increased their dividend annually for at least the past 10 yrs (plus those into their 10th year of raising dividends). In our Table this week, we show only the 16 stocks that lost less than 65% as much as VFINX during the 18-month Lehman Panic. We’ve added our favorite balanced fund for comparison, the Vanguard Wellesley Income Fund (VWINX).

Bottom Line: Just remember to invest a little at a time on a regular basis, which is most easily done by using a dividend reinvestment plan (DRIP). And maintain at least half a dozen DRIPs.

Risk Rating for the aggregate of 16 stocks: 4.

Full Disclosure: I own small amounts of stock in MCD, WMT, HRL, MKC, KO, JNJ, PEP, XOM, CVX, BDX, CHRW and PG--to get the annual reports e-mailed to me as soon as possible, and to “eat my own cooking.”

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