Sunday, May 26

Week 99 - Gold and Copper Miners

Situation: Commodities are having a bad year. People who regard gold as a currency, or a safe haven in times of market turmoil and recession, are finding that the US economy is recovering. The great fear that “inflation is just around the corner because the Fed keeps printing money” hasn’t materialized. The Federal Reserve’s preferred inflation indicator (personal consumption expenditures) continues to moderate and is now 1% (year-over-year). People who regard copper production as being so essential to infrastructure investment that they refer to it as “Dr. Copper” are again correct. 

Taken as a whole, the economies of the world are slowly emerging from a slack period. (Dr. Copper reflects that fact.) Yes, the US economy is growing at 2%/yr but European economies are shrinking 2%/yr and Asian economies are struggling to grow 4%/yr--somewhat slower than their former pace.

The great mining companies of Australia (BHP Billiton and Rio Tinto), which mainly export iron ore to China, are shelving their expansion plans (read this link). Whereas the production of most commodities couldn't keep up with demand just a few years ago, supplies now exceed demand. Spot prices continue to fall and production cutbacks are reported almost monthly. Copper production mainly gets warehoused. What to make of all this? Input costs are facilitating the production of finished goods instead of constraining production.

But investors know that infrastructure spending has to increase soon, given that the world’s population increases by 220,000 a day. They also know that governments will engage in deficit spending, and central bankers will engage in “easy money” policies, as long as sub-par growth crimps tax revenues. So gold and copper producers aren’t about to close up shop. Spot prices for gold and copper are simply in the downward phase of what economists like call “reversion to the mean.” The upward phase will resume when economic growth returns to Europe because that's where the bottleneck is located. The BRIC countries (Brazil, Russia, India, and China) are the engine of globalization; those countries cannot grow unless they export a growing volume of goods to Europe.

For this week’s Table, we’re using the recently released Barron’s 500 list as our guide. That list weights 3 items equally: 
   a) sales growth for 2012, 
   b) median "cash-flow based" return on investment (ROIC) for the past 3 years, and 
   c) cash-flow based ROIC for 2012. 
Here at ITR, we view those factors above all others in assessing current Finance Value.

All of the mining-related companies on that list are in the Table. We have also included two railroad companies that play key roles in North American commodity production--Canadian National (CNI) and Union Pacific (UNP)--as well as Caterpillar (CAT), which is the dominant manufacturer of mining equipment. Three gold producers also make the list: Goldcorp (GG), Barrick Gold (ABX), and Newmont Mining (NEM). In addition, the two largest copper producers are included: Freeport-McMoRan Copper & Gold (FCX) and Southern Copper (SCCO). Remember, where copper is found there will also be some gold (and vice-versa). Pure gold emerges as a by-product when copper is purified by electrolysis. 

Bottom Line: Commodity producers have large fixed costs, and that kind of investment only happens when a commodity becomes expensive because it is in short supply. This raises input costs, putting a brake on production and driving up the cost of finished products. Once production expands, however, the opposite happens. This “commodity cycle” typically last for ~15 yrs. For gold and copper, we’re at the end of one cycle and looking to start another when Europe emerges from recession. 

You, as someone who is saving for retirement, probably have a shorter horizon and shouldn’t be investing in commodity producers. The price swings are simply too great. But if you can’t resist the temptation, stick to a low-cost commodity mutual fund such as T. Rowe Price New Era fund (PRNEX in the Table). Better yet, invest in the lowest-volatility railroad stock (CNI) or the lowest-volatility oil stock (XOM).

Remember, the whole point of commodity investing is to participate in the long and strong up-periods of the commodity cycle. The problem is that the down-periods get recognized belatedly and suddenly. That means you probably won’t be able to sell in time to realize a good profit. You'll want to find a company that lives off commodities but also makes money during recessions. For example, railroads haul everyday essentials; integrated oil companies operate gas stations and produce petrochemicals that are used to make plastics.

Risk Rating: 9.

Full Disclosure: I have stock in CNI, XOM, and CAT.

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Sunday, May 19

Week 98 - Mutual Funds

Situation: Mutual fund managers invest your hard-earned money in assets traded on exchanges around the world. Those assets are assembled and sold to you on the basis of Net Asset Value (NAV) per share. Your money is being invested in a derivative product that is priced by assembling the prices of exchange-traded assets. Mutual funds are marketed on the basis of past performance and their current expense ratio (transaction costs/NAV).

Because the stock market is rising 2/3rds of the time, managers tend to assemble their mutual fund from stock in companies that outperform the S&P 500 Index during a “bull market” (i.e., have a 5-yr Beta greater than 1.00). That bias is eliminated in the case of an index fund where a computer does the managing (usually rebalancing the portfolio to maintain capitalization weighting). That means the “managed” mutual fund will perform worse than average 1/3rd of the time, i.e., during a “bear market.” Long-term performance graphs will look better though. But no one is interested in owning stocks that do worse than the indices during a bear market. You’ve been there, done that.  

We encourage you to own a stock portfolio that is less risky than the S&P 500 Index, one with a capitalization-weighted 5-yr Beta of 0.65 or less. That means that in a bad year, like 2008 when the S&P 500 Index lost 37.4%, your stock portfolio would lose no more than 25%. Since that is a greater loss than anyone can stomach if over 55, bonds need to be added for safety, not profit. Remember: stocks are “dead money” 2/3rds of the time. This is because the first half of a bull market only makes up for losses incurred during the previous bear market. Investment-grade bonds allow you to bridge that “valley” because they pay interest twice a year at a fixed (or inflation-adjusted) rate until the bond matures and principal is returned to the investor. There are no “ifs” and you’ll even beat inflation by 1-2% over the long haul. The key problem for shareholders is that after a 25% loss, a 50% gain is needed just to break even. That's how math works.

Looking at Lehman Panic returns (Column D of this week's Table), if you had half your money in the lowest-cost investment-grade bond index fund (VBMFX) and half in the lowest-cost S&P 500 stock index fund (VFINX) your loss was only 19% instead of 45.6% for VFINX alone. If you had money in the lowest-cost bond-heavy balanced mutual fund (Vanguard Wellesley Income Fund or VWINX), your loss fell to 16% (Table).

But what about long-term growth? Over the past two market cycles (since the S&P 500 Index peak on March 24, 2000), the 50:50 stock:bond index combination has returned 4.1%/yr, which is 1.7% more than inflation. VWINX has returned 8.1%/yr because it is 60% bonds and 40% stocks. Remember, bonds keep paying interest the whole time that stocks are down in the “valley.” Bonds also rise in price during recessions, so managers of VWINX can sell those at a profit. If you’d held only the S&P 500 Index (VFINX), your returns would only have been 2.3%/yr meaning you’d have lost 0.1%/yr to inflation.

So what is the point we are making? If you like the convenience of mutual funds, play defense by holding a bond-heavy, actively-managed balanced fund like Vanguard’s Wellesley Income Fund (VWINX). It's a hedge fund in disguise, since it has a low 5-yr Beta (0.58) and outperforms the S&P 500 Index on rolling 5-yr periods. (The managers aren’t allowed to use the main tool of a hedge fund, which is short sales, a risky tactic that often backfires.)

What we’d all like to find is a low-cost stock mutual fund that has mediocre performance during bull markets but outstanding performance during bear markets, i.e., a hedge fund for the masses. For the foreseeable future, hedge funds will continue to be private investment contracts available to the wealthy. Why? Because the retail investor (you and me) won’t buy something that has a sales pitch of mediocre performance during a bull market. We’re thinking: Why invest my money in a fund that is limping along 2/3rds of the time? Hedge funds get around this by saying: “Well, we think we can beat the S&P 500 Index over the long term because of our superior performance during bear markets.” According to Warren Buffett (Week 46), that is impossible because of their high fees: a typical hedge fund keeps 20% of any money it makes for a client as well as charging her a 2% annual fee.

Hedge funds use various strategies (check Wikipedia for an excellent entry explaining these). The best hedge funds have been able to beat the S&P 500 Index over a 5-10 yr period while losing less than 65% as much during a bear market (Week 46). It is hard to know just when a bear market is going to transpire, so hedge funds tend to maintain a 5-yr Beta of 0.65 or less during the run-up to a bear market. It all gets pretty complicated but the better hedge funds tend to be stuffed with bonds and shorted stocks (i.e., betting against stocks). The bonds are often risky, paying several % more interest than a 10-yr Treasury Note, which is all right since a risky bond is less risky than a “safe” stock because the risk of default is less and the money recovered in a default is substantial (vs. the total loss that a shareholder must endure).

There is a very low cost mutual fund for Treasury Notes (VFITX in the Table). Or you can buy US Treasuries in amounts as small as $100. There’s no cost, just point-and-click (go to treasurydirect). The money will be withdrawn from your checking account and every 6 months an interest payment will be sent back. At the end of the bond’s term, your original investment is returned.

You’ll complain that “the current interest rate is lower than the rates for corporate bonds or bond funds.” Correct, because you’re buying a “zero-risk” product that will keep paying interest during a bear market and even during Armageddon assuming the U.S. Marine Corps still exists. The extra interest paid (called the “spread”) on non-Treasury bonds compensates you for their extra risk (i.e., the risk of default). It's still true that there is no free lunch.

In the end, you are best off selecting some low-risk DRIPs for your stocks and balancing those with Treasury Notes or Savings Bonds, which are the same as Treasury Notes except that interest accrues automatically and is lower because you’ll pay no tax on the accrued interest until you sell.  

What is a low-risk DRIP? For safety’s sake we will use an extreme example and call it a virtual mutual fund (Table): the 8 Dividend Aristocrats that have not only increased their dividend annually for at least 25 yrs and are also “blue chips”, i.e., members of the 30-stock Dow Jones Industrial Average. These are: Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), Exxon Mobil (XOM), Chevron (CVX) and 3M (MMM). Four of those (WMT, MCD, JNJ, KO) are what we call “hedge stocks” because they fell less than 65% as far as the S&P 500 Index during the Lehman Panic, have beaten the S&P 500 Index over the past two market cycles, and have a 5-yr Beta of 0.65 or less. Those 4 stocks are enough like bonds that you don’t have to backstop their risk with an equal investment in Treasury Notes or Savings Bonds. The other 4 stocks (CVX, XOM, MMM, PG) include two (PG and XOM) that almost qualify as hedge stocks, have the highest S&P stock rating (A+/L, with the “L” denoting low risk), and have high credit ratings (AA- and AAA, respectively). There is no chance of either going bankrupt or falling as fast in value as the S&P 500 Index during a bear market, so you won't need Treasuries as a backstop.

To sum up: Your virtual mutual fund is 60% in 6 “safe” DRIPs, 20% in 2 riskier DRIPs (CVX and MMM), and 20% in a Treasury Note fund (VFITX) to backstop CVX and MMM. There are 10 units (8 DRIPs plus 2 units of VFITX). Assigning $50/mo to each results in an investment of $6,000/yr. Costs for investing  $50/mo electronically from your checking account for WMT and JNJ are $1/mo. Costs are higher for KO, CVX, MMM and MCD, so annual or semiannual investments have to be made: one-off electronic transfers into those DRIPs. There are no costs for the XOM and PG DRIPs, or the $100 that goes into VFITX each month (aside from the expense ratio of  0.2%).

Your virtual mutual fund lost 10.3% during the 18-mo Lehman Panic bear market but returned an average of 8.6%/yr over the past 13+ yrs and beat both the S&P 500 Index and inflation by 6.2%/yr. The 5-yr Beta is 0.5, indicating that your virtual mutual fund is perfectly balanced between stock and bond risk.

Bottom Line: For the most part, stocks are a gamble but bonds aren’t. Make sure your retirement savings are balanced between stocks and bonds in terms of the aggregate 5-yr Beta, i.e., close to 0.5. You can design a balanced stock and bond portfolio by using DRIPs for the stock investments balanced with Treasury Notes, or a bond mutual fund that only holds Treasury Notes (VFITX). From a tax-savings standpoint, you’re better off using Inflation-protected Savings Bonds.

Risk Rating: 3.

Full Disclosure: I use this plan to supplement my workplace retirement savings.

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Sunday, May 12

Week 97 - Capitalization-weighted Index of 11 High-quality Dividend Achievers

Situation: What is a high-quality stock? Here at ITR, we advocate a “buy and hold” strategy of stock selection, our goal being to set up a dividend reinvestment plan (DRIP) for each selection. We advocate that you start small and add a little each month, by having that amount withdrawn electronically from your checking account. That means you've got a lot at stake if you change your mind about a stock and liquidate your DRIP. Before starting down that path, you need to have a definition of “quality” (there are many to choose from) that will let you get into a stock and stay invested for the long term.

We’ve offered some tips in previous blogs (see Week 3, Week 50, Week 72, Week 87 and Week 93):
   a) plan to have at least 4 DRIPs;
   b) avoid companies with long-term debt that is worth more than the stock;
   c) avoid stocks that have a 5-yr Beta higher than the S&P 500 Index's (1.00);
   d) favor companies that have positive free cash flow (FCF).

Recently, we’ve seen that a number of fine companies with positive FCF don’t have enough FCF to pay their dividend. That means they’ll have no Retained Earnings (RE) with which to fund next year’s growth, and the company has to raise more cash (sell more stock, issue more bonds, or lobby government officials to make more tax expenditures). Companies get caught in this bind for 3 reasons: 1) The economy is still in the Intensive Care Unit (so to speak): Revenues can’t generate enough FCF to afford the dividend policy that the company has trained its investors to expect (e.g. annual raises sufficient to cover inflation). 2) That dividend policy needs to remain stable when there is a slack economy, since it is an effective way to keep investors in the stock market given the paltry income they get from bonds. 3) Foreign earnings are difficult to repatriate because 20-25% will have to be turned over to the Internal Revenue Service (i.e., the difference between low tax rates in developing countries and high tax rates in the United States). For that reason, most companies reinvest earnings in the same country that produced the earnings.

Here at ITR, "High quality” means simply that the company has Retained Earnings at the end of the year. That's the essence of capitalism. Rational investors favor investment-grade bonds, since return of their original investment is guaranteed. There are no guarantees that a stock will retain value. Remember, the Central Thought of business isn’t to make money . . . it's to redistribute the risk of losing money. A stock investor holds out hope that her chosen company will grow in value by deploying Retained Earnings. Most companies don’t have Retained Earnings; they have to expand by issuing stocks or bonds which costs at least 8%/yr.

The accompanying Table was constructed from a list (see invescopowershares) of 201 Dividend Achievers, i.e., companies that have increased their dividends annually for the past 10 or more yrs. Those companies were screened as follows:
   1) Any company’s stock that had a total return during the Lehman Panic period (10/07 thru 3/09) worse than -30% (vs. -46.5% the lowest cost S&P 500 Index fund--VFINX) was discarded .
   2) Any stock that has a history of growing dividends less rapidly than 5%/yr, which is the dividend growth rate for VFINX, was discarded. 
   3) Companies with a dividend yield less than 1% were discarded. 
   4) Companies that don’t have an S&P stock rating of at least A-, and an S&P bond rating of at least BBB+ were discarded. 

The remaining companies were checked against the Buyupside website for performance vs. VFINX over the past two market cycles, beginning with the peak that occurred on March 24, 2000. Since then, VFINX has grown at a rate of 2.3%/yr through the reinvestment of dividends--price performance has only been 0.3%/yr. None of the companies that remained after applying the above screens performed as badly as VFINX, so none had to be discarded. 

Then we used The WSJ to collect data on FCF, LT debt, ROIC, ROE and RE. Any company that didn’t have Retained Earnings in 2012 was discarded, as was any company that didn’t have an ROIC sufficient to pay ongoing costs of capitalization (at least 8%/yr). Companies where LT debt accounted for more than 50% of total capitalization were also discarded. 

We ended up with 11 companies remaining that were ranked by the market value of their stock. Appropriate multiples ($1-11) were used to arrive at a capitalization-weighted index that has paid 9.3%/yr over the past two market cycles (vs. 2.3%/yr for VFINX).

Bottom Line: Consider having your key DRIPs in the very few large companies that remain able to grow by reinvesting their Retained Earnings, namely, WMT, IBM, XOM and ABT. Add DRIPs for smaller companies when you’re able to do so without going into debt, neglecting your health, avoiding exercise, or skipping vacations.  

Risk Rating: 4.

Full Disclosure: I have DRIPs in WMT, IBM, XOM, and ABT. Automatic monthly additions for XOM and ABT carry no charges; there is a $1.05 charge for WMT and a $1.00 charge for IBM. I invest $280/mo in these 4 DRIPs, for an initial expense ratio of 0.73% ($2.05/$280).

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Sunday, May 5

Week 96 - Ten “A”-rated Utility Stocks are Dividend Achievers

Situation: Here at ITR we’re always on the lookout for “safe stocks." Yes, we know and agree that is an oxymoron but there are some stocks that are safe enough that they don’t have to be backed up with AAA bonds such as US Treasury Notes or Savings Bonds. Last week (Week 95), we came up with a list of 11 “hedge” stocks that met our test of “safe enough for investing.” This week we’ve come up with an additional 10 stocks of utility companies that are also “safe enough.” 

The problem with utility stocks is that they’re harder to analyze. When you go to The WSJ website and punch in a ticker, you’ll find that almost every utility stock has negative free cash flow at the end of the year, and is capitalized by bonds for the most part. Typically, its return on invested capital (ROIC) is so anemic that you’ll doubt if it even covers the cost of capital, let alone the cost of its dividend. So skip that website. Just rest assured that utilities enjoy tax expenditures and government backing in exchange for regulation of utility rates that customers pay. For example, electric utilities (e.g. SO, NEE, WEC, SCG in the Table) are regulated by a state government through its Public Utilities Commission (PUCO). That means its bonds are a) tax-free and/or pay low interest, and b) are backed by a state government. The PUCO sets return on equity (ROE) in the range of 10-12% by charging customers enough to maintain that ROE. That translastes into more than a 7%/yr total return for shareholders over time. 

The overriding idea is that while utilities have high fixed costs (i.e., are unlikely to be profitable) they are also a core function of the state. To attract investors to buy the stock and bond issues needed to meet those costs, the PUCO provides sweeteners such as those noted above. The stock owner also has the assurance that bankruptcy won’t occur.    

Bottom Line: Not all utilities are created equal, so be selective (Table). Nonetheless, the tax expenditures that support utilities are sufficiently robust that you can have a good risk-adjusted return simply by investing in a utilities mutual fund (e.g. XLU). But you're likely to do better by setting up a DRIP for one of the 10 utilities in the Table, e.g. if you add $100/mo electronically to a Computershare DRIP in NEE there are no transaction fees. 

The main caveat is that utilities are mostly capitalized with bonds, and a spike in interest rates would drive investors away.

Risk Rating: 4.

Full Disclosure: I maintain a DRIP in NEE.

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