Sunday, June 30

Week 104 - Capitalization-weighted Index of 20 Hedge Stocks

Situation: Yield-hungry investors dominate stock trading as well as bond trading, and we all know why. It is because the US Federal Reserve has driven Treasury bond yields to historically low levels. Bonds of any maturity issued anywhere in the world have greater risk than US Treasuries, so non-Treasuries offer a higher interest rate than an equivalent Treasury. That added risk is priced into those rates. 

Buyers care little for the details. They just want to be paid enough interest to more than compensate for inflation. But they also know that high-yield bonds carry a significant risk of default, which makes them no less risky than stocks. Many investors have turned to stocks that a) grow dividends fast enough to more than keep up with inflation, and b) have other bond-like features like low volatility (i.e., low Beta). This blog has catered to those investors, until recently. But now this has become a “crowded trade”, and we are calling attention to its high cost for companies as well as investors. Many companies have tried to comply, but that means they lose the opportunity to grow their businesses at zero cost with Retained Earnings (RE). Instead, their free cash flow (FCF) is increasingly consumed by the need to grow their dividend--to attract buyers and boost the stock’s price. This type of “asset inflation” is exactly what Ben Bernanke had in mind when he had the Federal Reserve launch its bond-buying program 3 yrs ago. Unfortunately, several prominent companies have had to issue new stocks and bonds just to maintain the kind of growing dividend that investors expect. 

Here at ITR, we played along with yield-hungry investors as long as we could. But the competitive advantage of any company is linked to the cost of money for capital improvements. If free money (RE) is used, there is no need to go through the expensive (and embarrassingly public) rigamarole of issuing new stocks and bonds. So we are now changing our focus to identify solid companies that consistently grow FCF and have some left after paying a dividend. Such companies tend to pay a small but growing dividend. If you own stock in one, and you’re a retiree who depends on dividend checks, you’ll have to learn to occasionally sell some of the shares you hold. For example, Sherwin-Williams (Table) had a 2% yield two yrs ago but has a 1% yield now. You’ll notice, however, that its growth rate has increased from 20%/yr over the past 13+ yrs to 30%/yr over the past 5 yrs, growth that is increasingly funded by RE. 

With these thoughts in mind, we still have to identify bond-like stocks for you to consider owning in lieu of a high-yield corporate bond fund (i.e., a fund that holds bonds paying 6-8%/yr but those bonds have an S&P rating lower than BBB-). Instead of owning one of the top such funds, e.g. the USAA High Income Fund (USHYX in the Table), we suggest that you own bond-like stocks that behave like a good hedge fund (see Week 101).

Because low-Beta/high-yield stocks are the “in thing” to own (i.e., overpriced), we’ll need a screen that focuses instead on companies that have a recent record of beating out their competition without necessarily paying much of a dividend. We'll do that by depending first on the Barron’s 500 Table because it ranks companies with respect to recent growth in sales and cash flow. Then we apply our usual metrics to identify hedge stocks, i.e., stocks that a) beat the S&P 500 Index over the past 5 yrs and longer, e.g. since that Index reached its inflation-adjusted peak on 3/24/00; b) lost no more than 2/3rds as much as the S&P Index during the Lehman Panic; c) have a 5-yr Beta that’s no more than 2/3rds as high as the S&P Index 5-yr Beta; d) have an S&P stock rating of A- or better, and e) have an S&P bond rating of BBB+ or better. Except in the case of a regulated utility, we also require the company to be less than 50% capitalized by long-term bonds, have a positive FCF, and exhibit dividend growth that exceeds the 6.5%/yr dividend growth rate of the S&P 500 Index. 

Our screen of the S&P 500 Index turns up 20 companies (Table). All 20 are dividend payers, and only two aren’t yet Dividend Achievers. The exceptions are Costco Wholesale (COST) and General Mills (GIS), both of which are less than a year away from reaching the required 10 yrs of consecutive dividend increases. Seven of the 20 companies pay less than the 2% yield for the lowest-cost S&P 500 Index fund (VFINX). Taken together, the 20 companies have returned 11.9% since 3/24/00 (as of close of business on 6/17/00), and 14.6% over the past 5 yrs. But much of that outperformance is achieved by the smaller and more nimble companies. To compensate for that unhelpful aberration, we’ve set up a capitalization-weighted index by valuing the total return of the largest company (WMT) over the past 13+ yrs at 20 times more than the total return for the smallest company (HRL). Column N of the Table lists the multiplication factors for the other 18 stocks, based on market capitalization. That adjustment brings aggregate total return over the past 13+ yrs down to 9.5% (vs. 11.9%).

If you're just getting started as a DRIP investor, you’ll want to start the drill (of adding small amounts automatically each month to stock) in companies that are gaining on their competition. Those are the companies that improved their Barron’s 500 rank in 2012 vs. 2011. The companies that failed to do so are red-flagged in Column G of the Table. Choosing among the remaining companies is simply a matter of starting with one of those having the best capitalization-weighted growth records: PG, JNJ, TJX, KO and COST. But remember, stock-picking requires scale. (Academic studies have shown that a buy-and-hold stock-picker needs 20 stocks to have a reasonable chance of losing less than the S&P 500 Index in a bear market but still manage to track that index in a bull market.) 

Bottom Line: If you want to shy away from owning Treasuries while the Federal Reserve is driving yields lower than the rate of inflation, you’ll be better served by owning bond-like stocks than a high-yield bond fund. Trouble is, most investors have already made that switch so you’ll have to be selective as well as patient. Start by setting up DRIPs in “hedge stocks” that have been gaining on their competition. Then employ “dollar-cost averaging” by having the same amount withdrawn from your checking account each month for each DRIP.

Risk Rating: 5.

Full Disclosure: Each month, I electronically dollar-average into DRIPs for WMT, NEE, JNJ, IBM, and PG.

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

Sunday, June 23

Week 103 - Oil & Gas Producers in the 2013 Barron's 500 Index

Situation: Energy companies are currently in a slack period. Production is up due to improvements in extraction methods, while demand is down because of recession in Europe combined with sub-par growth elsewhere.

When we look at energy companies that have a) outperformed the S&P 500 Index since it peaked in inflation-adjusted terms on 3/24/2000, and b) lost less than 65% as much as that index during the Lehman Panic, we come up with 8 tickers (see Table): OXY, EOG, IMO, HES, CVX, APC, XOM and APA. In other words, those 8 companies meet our standard for long-term Finance Value. However, none meet our standard for recent finance value which is to have risen in Barron's 500 rank in the most recent year (2012). That means all 8 scored lower with respect to sales and/or 1-3 yr cash flow in 2012 than in 2011 (Table). Two of the companies (XOM & CVX) issue A-rated stocks and bonds per S&P and score well on tests (see Week 30) for Durable Competitive Advantage (Col J) and Buffett Buy Analysis (Col K).

Bottom Line: Oil and gas production will keep growing 1%/yr for decades. Companies in that business face growing challenges because the “low-hanging fruit” is gone and environmental concerns are growing. Drillers increasingly have to operate in hostile climates, the deep ocean, or both (Arctic Ocean). Governments used to subsidize exploration & production, and overlook the need for environmental protection, but those days are gone. Pipelines are the most efficient and safe way to move petroleum products on land, but railroads are preferred by the public. That choice drives up both costs and risks, which only adds to the price of fuel. The danger, for this century, isn’t that we’ll run out of petroleum products. It’s that we’ll no longer be able to afford them. Solar panels and wind farms will be sprouting everywhere possible. If you’re saving for retirement, electric utilities and railroads are a better way to invest in the energy infrastructure than oil companies.

Risk Rating: 8.

Full Disclosure: I own stock in OXY, CVX, and XOM.

Sunday, June 16

Week 102 - Core Holdings Revisited

Situation: The US economic recovery and Treasury yields are finally climbing in tandem. The current interest rate on 10-yr Treasury Notes almost exceeds the dividend yield of the S&P 500 Index, which will attract yield-hungry investors (who had been putting their money in high-yield stocks and bonds) back into Treasuries. 

This move is timely, as it puts a fine point on the importance of having 2/3rds of your stock allocation in what we call “Core Holdings." Those are high-quality companies within industries that are the engine of a growing economy (see Week 22). Those include energy, materials, consumer discretionary, financial, information technology, and industrial stocks. In recent years, our focus has been on the stocks of companies in defensive industries (healthcare, telecommunication services, consumer staples, and utilities) because of their higher dividends and lower volatility.

Most of the better companies in the Core Holdings category have modest dividend yields in the 1-2% range. That’s because the corporate strategy is to grow earnings during an economic recovery and then reinvest in their own growth at zero cost by using Retained Earnings (RE). That seems to be a wiser use of Free Cash Flow than paying dividends (which are difficult to fund during slack years), then issuing stocks or bonds at a cost of 8+%/yr to grow the company. The danger, of course, is that the CEO will instead use RE to make an acquisition that is not synergistic with that company’s Business Plan. History suggests such acquisitions seldom work out. By having to accept the discipline of paying a good and growing dividend, the CEO has less leeway to spend foolishly. To sum up, you'll have to pick carefully among companies that use RE to fund their growth.

You can calculate how much of a company’s historical Return on Equity (ROE) can be funded with Retained Earnings (Table). But frequently you will be given little insight into whether a successful company’s Business Plan will remain stable and transparent when RE swells to hundreds of millions of dollars or more. To sum up again: RE is the ultimate Competitive Advantage. It’s the one that makes capitalism work but it can be squandered. You, the investor, will be better off in the long run if you invest in Core Holdings that fund their own growth, for the most part, by using RE. 

For this week’s Table, we combine two lists: the recently updated 201-company Dividend Achievers, and the Barron’s 500 Table that was published 5/4/13. The former is for companies that have raised their dividend annually for at least the past 10 yrs. The latter is for companies that have increased sales and cash flow-based ROIC for the past year and cash flow-based ROIC for the past 3 yrs. We have identified the S&P 500 companies that are on both lists, then added any other S&P 500 companies have shown year-over-year improvement in their Barron’s rank. Companies that don’t have at least an A-/H S&P rating for their stock and a BBB+ rating for their bonds are discarded, as are any that lost more than 2/3rds as much as the S&P 500 Index lost during the Lehman Panic. As a final screen, only those companies that beat the S&P 500 Index by the following metrics were retained: total return since the inflation-adjusted S&P 500 peak on 3/24/00, dividend growth rate, 5-yr total return, and 5-yr Beta. 

Our analyses have identified 12 companies, all but one of which are among the Dividend Achievers. The exception, Travelers (TRV), is one year away from becoming a Dividend Achiever. In other words, the best growth companies pay at least a small dividend that grows annually. 

The companies on our list, aside from Nike (NKE), McDonald’s (MCD) and IBM, are companies you might not have heard of before. But if you’re a shopper, you’ll know that TJX, Sherwin-Williams (SHW), VF Corporation (VFC), and Ecolab (ECL) sell high-quality goods at attractive prices. The only growth industry that isn’t represented here is energy, so we’ve included Exxon Mobil (XOM) under the Benchmarks heading at the bottom of the Table. It is the only energy stock that comes close to meeting our criteria, and will be featured in next week’s blog about oil & gas producers and refiners. 

Remember, companies that develop useful products from raw materials will almost never have a 5-yr Beta less than 1.00 because commodity prices fluctuate too widely. That also means that even the best commodity-related companies will sometimes underperform the S&P 500 Index for years at a time. Having said that, XOM remains the premier Core Holding. You won't go wrong by setting up an automatic transfer of $50/mo from your checking account into the XOM DRIP at zero cost (see computershare).

Bottom Line: Grow your stock portfolio with the economy, even though you might wish you had bought some of those stocks when the economy was in recession.

Risk Rating: 7

Full Disclosure: I have stock in MCD, IBM, and XOM.

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

Sunday, June 9

Week 101 - Is Berkshire Hathaway becoming a hedge fund for the masses?

Situation: The idea of a hedge fund is difficult to sell, even to those who are already wealthy. Why? Because investors value outperformance during a bull market more than they value outperformance during a bear market. Lets face it: we humans have a high-Beta brain. We don’t like playing defense with our investments. We tend to view bonds as boring and the 4 defensive sectors of the stock market (utilities, telecommunications, consumer staples, and healthcare) are only interesting because their bond-like stream of reliable dividends tends to keep up with inflation. Hedge funds are another bond-like investment but with a twist. Their managers are typically betting against an overvalued stock or bond if they can find one. This is done through a “short sale.” That means borrowing the stock or bond then immediately selling it in expectation that it will fall in value. When the fall in price satisfies the hedge fund manager, the stock or bond is purchased and returned to its original owner. In essence, the hedge fund manager borrowed $10 worth of widgets, then sold those expecting to buy them back later for $5, and will pocket the $5 profit. Had the widgets gone up in value to say $1000, the hedge fund manager would still have had to buy them back for return to the original owner, and would have lost $1000 plus interest on the loan.

So two things are happening with a hedge fund: 1) a value is being placed on poorly understood assets; 2) any asset that appears overvalued will get “shorted” and any asset that appears undervalued will get purchased. There is one important thing, though, that isn’t happening which is one reason why hedge funds have a low Beta. Hedge fund managers don’t buy a risky asset with the plan of selling it before the risk becomes apparent to all and it falls in value. This means that hedge fund managers need the support of an expensive research staff to help discover poorly understood assets and determine whether those are over- or under-valued. That research expertise is why the already wealthy clients of a hedge fund are willing to pay big bucks, typically 2%/yr of assets under management plus 20% of any outperformance vs. the S&P 500 Index over a 3-4 yr period.

Where does that leave us “retail investors” who don’t have sufficient wealth to legally qualify as a hedge fund client? We are not in this game for sport. We are in the game because we don’t want to become a burden to our children during what is likely to be more than 25 yrs of retirement. Academic studies have shown that the average retail investor realizes only half of the performance that his or her asset allocation should warrant, for three reasons: 1) high transaction costs that come from using an intermediary; 2) borrowing money “on margin” to invest in stocks, and 3) behavioral factors (ignorance about how markets work and participating in the excitement of buying stocks during a bull market). 

Retail investors need to stop making the mistakes cited above and apply some of the lessons learned by hedge fund managers: a) avoid investing in “growth” stocks or mutual funds, which are typically those with a 5-yr Beta higher than 1.00 (the S&P 500 Index’s 5-yr Beta), and b) keep on the lookout for undervalued stocks, bonds, commodities, or real estate. It boils down to using the internet for trading and research.  

Are there any shortcuts that are less time-consuming? Perhaps a low-cost hedge fund-like investment for the masses? I would like to suggest that there are two: a) Berkshire Hathaway class B stock ($113.03/Sh at COB 5/29/13); b) the Vanguard Wellesley Income Fund ($25.32/Sh at COB 5/29/13). Both achieve the basic expectations of a hedge fund investor to perform better than the S&P 500 Index over two market cycles, to lose less than 65% as much as a low-cost S&P 500 Index fund (e.g. the Vanguard 500 Index Fund or VFINX) loses during bear markets, and to maintain low volatility (meaning a 5-yr Beta of 0.65 or less). 

This week’s Table has the details. It also shows how the 15 largest stock holdings of Berkshire Hathaway have performed much better than the S&P 500 Index over the past two market cycles (i.e., since the S&P 500 peak on 3/24/00) by returning 11.4%/yr vs, 2.4%/yr. On average, those 15 stocks (the mutual fund part of Berkshire Hathaway) perform much like VFINX with respect to 5-yr Beta (0.95 vs. 1.00), dividend yield (2.4% vs. 2%), and the extent of loss during the Lehman Panic (38.1% vs. the 46.5%) though you’ll notice that the 15 Berkshire Hathaway stocks did better on all 3 counts. You could point out that there are mutual funds you can buy, like the BlackRock Global Allocation A Fund (MDLOX), which achieve similar results with a 5-yr Beta of ~1.00. The special thing about Berkshire Hathaway is that it is an insurance conglomerate, and insurance companies typically have low 5-yr Betas because they have to maintain vast holdings of zero-risk funds (e.g. cash or US Treasury Notes) in the event of a calamity that triggers a large insurance payout. 

For Berkshire Hathaway, such zero-risk funds comprised 19% of its $427.5 Billion in assets at the end of 2012, and its insurance division accounted for 30% of earnings. It has the additional safety net of owning ~100 other businesses, most of which carry low risk. For example, railroads and gas/electric utilities comprised 29% of its assets in 2012 and 32% of its earnings. This explains why Berkshire Hathaway has a 5-yr Beta of only 0.25. Its stock holdings (mainly the 15 companies listed in the Table) accounted for only 20% of its assets and 15% of its earnings.

While perusing the BENCHMARKS section of the Table, you no doubt noted that there is an inverse correlation between cash/bond allocations and losses during the Lehman Panic. This should remind you that asset allocation has been proven to be the most important factor driving investment success. (The next most important factor is keeping costs low for both transactions and intermediaries.) While tax considerations are less important, you should fully fund any workplace retirement plan that you have (and a Roth IRA if you qualify), as well as regularly purchasing inflation-protected US Savings Bonds for your Rainy Day Fund (see Week 33). Taxes are never due on a Roth IRA, and are due on the others only when the monies are spent.

Bottom Line: The innovation we call a “hedge fund” contains valuable lessons for all investors. It teaches disciplines that can be added to the list of other types of under-utilized investment strategies such as dollar-cost averaging, rebalancing, reinvesting dividends and interest, and buy-and-hold investing. For example, BlackRock, Inc. started as a hedge fund and now has $4 Trillion under management (ah, yep you read that right). With a 5.25% up-front charge and a minimum investment of $1000, you can buy shares of their premier mutual fund called BlackRock Global Allocation A (MDLOX). It has the same volatility as the S&P 500 Index but otherwise incorporates their hedge fund philosophy. During bad times (such as the Lehman Panic), it lost half as much as the lowest-cost S&P 500 Index fund (VFINX). During better times (such as the last 13+ yrs taken as a whole), total returns averaged 8.3%/yr which was much better than the 2.4%/yr realized by investors in VFINX. Now for the kicker: The stock market has done well in recent years, with VFINX gaining 5.8%/yr over that past 5 yrs even though that period includes the worst part of the Lehman Panic. However, MDLOX has gained only 3.7%/yr over that period and only 2.6% so far this year. In other words, a good hedge fund will underperform (vs. the S&P 500) during bull markets and outperform during bear markets. Since stock markets have (over the past 100+ yrs) spent 2/3rds of their time either in a bear market or recovering from one, this is formula for success.

So think about investing in a poor man’s hedge fund like Berkshire Hathaway class B shares (BRK-B) or a low-cost bond-heavy balanced fund like Vanguard Wellesley Income Fund (VWINX). But you’ll say: “I’m worried about owning bonds because interest rates will rise when the Federal Reserve stops buying bonds at the rate of $85B per month.” Don’t be too concerned. Both the Federal Reserve and the managers of bond-heavy mutual funds have been (for the most part) buying only those bonds that mature in 7 yrs or less. Yes, those will decrease in market value when the Federal Reserve stops its bond-buying program (called Quantitative Easing 3) but they aren’t going to be sold at a loss. Instead, they’ll be kept off the market and held on the balance sheet until they mature. Supply and Demand for credit will remain balanced as the economy recovers, and more demand will bring more supply at more cost. That of course predicts a higher interest rate. But the market won’t be flooded with low-yielding bonds nobody wants to buy at their original price.

Risk Rating: 3.

Full Disclosure: I have stock in Berkshire Hathaway, and 4 of its top 15 non-insurance holdings (Table): WMT, IBM, KO, and PG.

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

Sunday, June 2

Week 100 - Agriculture-related Companies in the Barron’s 500 Table

Situation: Food production is a highly fragmented industry. Most food products are locally produced. People enjoy shopping for food at farmer’s markets but currently there is not enough dietary protein produced to keep up with global population growth. Last year’s drought in the US caused a spike in corn, soybean, and wheat prices, which then caused a spike in farmland values. The US Department of Agriculture projects a good harvest this summer but warns that food price inflation is likely to exceed average inflation by 1-2%/yr for the next few years. 

We sort companies by long-term Finance Value (Col E in the Tables we attach to each week’s blog), which is Reward (total return/yr over one or two market cycles) minus Risk (total return during the 18-month Lehman Panic). The blogs for this week and last week introduce a way to measure short-term Finance Value by using the annual Barron’s 500 Index. The recently released 2013 version gives equal weight to 3 metrics:
   a) sales growth for 2012, 
   b) median "cash-flow based" return on investment (ROIC) for the past 3 yrs, and 
   c) cash-flow based ROIC for 2012.
Our Table for this week shows each agriculture-related company’s Barrons rank in 2013 (Column F) vs. its rank in 2012 (Col G). If the company fell in rank (year-over-year), the 2012 rank in Column F is red-flagged. If the rank was higher in 2012 than in 2011, we consider that to be a timely endorsement of the company’s short-term Finance Value.

There are 27 agriculture-related companies in the 2013 Barron’s 500 Index. Based on long-term Finance Value (Col E), we place 16 of those companies in the “A” list at the top of this week’s Table. Ten of those have moved up in rank with respect to short-term Finance Value (Col F): Monsanto (MON), Altria Group (MO), General Mills (GIS), JM Smucker (SJM), Reynolds American (RAI), Hershey (HSY), Coca-Cola (KO), Agrium (AGU), Campbell Soup (CPB) and Kellogg (K). You’ll note that only 3 of these produce nutritious food: General Mills, Campbell Soup and Kellogg. The remainder, aside from a seed producer (Monsanto) and a fertilizer producer (Agrium), produce things we buy because they give us a buzz (tobacco, caffeine, sugar) or taste good (chocolate, salt).

Bottom Line: We identify 16 companies that have performed well with respect to sales and cash flow over the past 1-3 yrs and outperformed the S&P 500 Index over the past 13+ yrs (as well as during the Lehman Panic). These 16 companies had total returns averaging 15% over the past 13+ yrs vs. 2.4%/yr for the lowest cost S&P 500 Index fund (VFINX), and on average lost only 22.7% during the Lehman Panic (vs. 46.5% for VFINX). Ten of those 16 companies are moving up in Barron’s 500 rank, our measure of short-term Finance Value. Five of our “Top 10” companies are able to fund future growth by using Retained Earnings: Monsanto (MON), JM Smucker (SJM), Hershey (HSY), Agrium (AGU), and Campbell Soup (CPB).

Risk Rating: 4

Full disclosure: I have stock in KO, HRL, DD, CAT, and GIS.

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