Sunday, September 29

Week 117 - Hedge Stocks Revisited

Situation: Hedge Fund managers often bet against (short) shaky or overpriced stocks. That means borrowing thousands of shares of that stock and immediately selling those. While waiting for the shares to fall far enough in price to provide a profit to the hedge fund (after being bought back and returned to the owner), the hedge fund has to pay that owner interest on the loan and the value of any dividends that she would have received. There are over 10,000 hedge funds, so other hedge fund managers often see the same opportunity and “pile on.” That creates a self-fulfilling prophecy because the stock price will certainly fall from the selling pressure--presumably enough to “discover” the real value of the firm. That means prices for many stocks will crash in the early months of a recession, particularly stock in companies financed primarily by debt (which is most of the S&P 500 companies, since interest on that debt is tax-deductible). You and I, however, would like to avoid that downdraft in our portfolios by investing in stocks that are less likely to be shorted. Here at ITR, we call those “hedge stocks” (see Week 46, Week 76, Week 95 and Week 101).

By definition then, a hedge stock has few (if any) of the characteristics that would tempt a hedge fund manager to short the stock. That’s a long list but the main problems that attract “shorts” are: 
   1) more long-term debt than equity (because debt can’t always be refinanced cheap); 
   2) apparent overvaluation (price/earnings ratio higher than 20);
   3) 5-yr Beta higher than ~0.65 (i.e., volatility is necessary to make a short sale work);
   4) ROIC less than ~10% (suggesting managerial incompetence);
   5) negative free cash flow (suggesting excessive or untimely capital expenditures);
   6) little or no dividend payout (since dividends add costs to a short sale).

This week’s screen looks at all 900 stocks in both the large-cap S&P 500 Index and the medium-cap S&P 400 Index. We exclude any stocks that have: 
   a) a P/E greater than 21; 
   b) a dividend yield less than 1.5%;
   c) a 5-yr Beta greater than 0.65;
   d) a total return/yr (since the S&P 500 Index’s inflation-adjusted peak on 3/24/00) less than that for the Vanguard 500 Index Fund (VFINX);
   e) a loss in total return over the 18-month “Lehman Panic” period greater than 30.2%, which is 65% as much as the 46.5% that VFINX lost.

We also exclude companies (aside from utilities) that had problems in 2012 with free cash flow (FCF), long-term debt, and return on invested capital (ROIC). 

This screen yields only 16 companies (see Table). Not surprisingly, 12 of those 16 are from “defensive” S&P industries (consumer staples, healthcare, utilities, and communication services). In other words, those 12 are “Lifeboat Stocks” (see Week 106). Aside from the 4 Utilities companies (WEC, SO, NEE, WTR), there are 2 Healthcare companies (JNJ and ABT) and 6 Consumer Staples companies, all food-related (KO, PEP, GIS, SJM, LANC, WMT). The remaining 4 companies (CB, HCC, MCD, CHRW) are all we could find to represent the 6 “non-defensive” S&P industries (Energy, Materials, Industrial, Financials, Information Technology, and Consumer Discretionary). In other words, those 4 are “Core Holdings” (see Week 102): 2 Financial companies (CB and HCC), one Industrial company (CHRW), and one Consumer Discretionary company (MCD). Red highlights in the Table indicate inferior performance vs. our reference benchmark: the Vanguard Balanced Index Fund (VBINX). Data are current through 9/27/13.

While your investment in any of these 16 hedge stocks need not be backed up 1:1 with an investment in US Treasuries, the very brevity of the list (1.8% of the 900 companies) shows why we suggest that you insulate your stocks from market crashes by owning an equivalent amount of Treasuries or A-grade bond funds. (We think that inflation-protected US Savings Bonds, if held for more than 5 yrs, are the best option. Interest accrues automatically, and isn’t taxed until the bond is redeemed.) Much of the downdraft in stock prices that occurs during a market crash is due to hedge funds shorting stocks. Should you happen to retire just before one of those downdrafts occurs, you’ll be pleased to hold some stocks that didn’t get shorted. An interesting sidebar here is that Hedge Fund Research recently published its findings for the average total return of stock-related hedge funds in the first 6 months of 2013, which was 7.7%. Our 16 hedge stocks returned almost twice as much, 14.6% (Column F in the Table).

Bottom Line: “Price Discovery” is important and hedge funds do a fine job of this by shorting overpriced or shaky stocks before they get too overpriced. Our analysis this week shows that all but 16 of the S&P 500 and S&P 400 stocks have one or more characteristic that might trigger a short sale. When short sales include more than a few percent of a company’s outstanding shares, the downside volatility becomes exaggerated. You can either a) accept this volatility, or b) weight your portfolio toward stocks that are relatively immune. We’ve found 16 relatively immune stocks for you to consider.

Risk Rating: 3

Full Disclosure: I dollar-average into DRIPs for WMT, ABT, JNJ, KO, and NEE each month, and also own some stock in MCD, PEP, and GIS.

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Sunday, September 22

Week 116 - Is there an “Optimum Portfolio” for the retail investor?

Situation: There has always been this myth of the “optimum portfolio” but exactly whose interests are best served by such a portfolio? We’re all different, after all, and of many minds. You may know that the left brain rationalizes everything to make us look better than we are and the right brain spouts poetry, solves math problems, and creates art, music, novels, architecture (along with gambling and other addictions). Ah, did I just mention gambling? There’s our clue to the optimum portfoliio. Pretty much any investor will take a risk once in awhile but she also wants most of her money to be in a safe place. So there’s the dichotomy.

Here at ITR, we keep gambling corralled in a small corner, writing only occasional pieces about commodity-related investments. The idea there is that (with enough basic information) the average investor can look at how commodities are used and make an investment where future benefits are more than likely to offset the not inconsiderable risks.

In Week 3, we set out our ideas on asset allocation, namely by proposing a recipe that calls for 3 helpings of bonds, two helpings of Core Holdings (Week 102), and one helping of Lifeboat Stocks (Week 106). The accompanying Table breaks out our current choices in each category.

Starting with bonds, US Treasuries are the place to be because all other bonds go down in value during a financial crisis but Treasuries go up, a lot. Some companies that make or market essential products also shine: People will pay the price dictated by supply and demand rather than go without heat, light, water, baby formula, Band-Aids, Tylenol, pizza, trips to the nearest McDonald’s, clothes, shoes and cleaning materials. Previous necessities, like a new car every 3 years, cable TV, soda pop, beer, quick stops at Starbucks, an evening out for dinner and a movie, and holiday travel soon become “out of reach” for the unemployed.

All 27 companies in the Table are A-rated by S&P, and none are rated high risk. This means that the second letter in the S&P stock rating is either an “L” for low risk, or an “M” for medium risk. 

14 are in defensive industries (healthcare, consumer staples, utilities). 
The remaining 13 stocks represent Core Holdings:
   5 of those are in S&P’s “consumer discretionary” industry (ROST, FDO, MCD, TJX, NKE)
   2 are in the “materials” industry (SHW and SIAL)
   2 are in the “information technology” industry (IBM and ADP)
   2 are in the “financial” industry (CB and TRV)
   1 is in the “industrial” industry (JBHT) and 
   1 is in the “energy” industry (CVX).

The Table has red highlights for metrics that underperform the Vanguard Balanced Index Fund (VBINX), which is weighted 40% in a bond index and 60% in a stock index.

Bottom Line: Every portfolio is a form of personal expression. In providing a "guide" to help you construct an optimum portfolio, our first concern is to guide you away from foundering on the shoals in a storm.

Risk Rating: 5

Full disclosure: my trading positions on companies in the Table consist of monthly automatic electronic additions to DRIPs in WMT, NKE, ABT, JNJ, IBM, and NEE.

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Sunday, September 15

Week 115 - Capitalization-weighted Commodity Index (Updated)

Situation: Back in Week 49, we took a stab at creating a commodity index referencing stocks issued by key producers. It was intended to be a quick guide to the most volatile stocks in a favorable period, i.e., during rapid urbanization. To do that, the index needed to include companies that make the products most in demand and are marketed in all of the urbanizing regions. Our 8-company list came up short on both scores, so we’ve added 7 companies: duPont (DD), Occidental Petroleum (OXY), Potash (POT), Enbridge (ENB), Alcoa (AA), FMC (FMC), and BHP Billiton (BBL).

Mission: Create a capitalization-weighted index of 15 companies that have a primary focus on commodity extraction, production, packaging, or transportation. Demonstrate recent as well as long-term finance values, recent as well as long-term total returns, dividend information, debt, return on invested capital (ROIC), free cash flow per share (FCF/Sh), and multiple statistical presentations of recent and long-term volatility. In the Table showing these items, highlight any metric in red that fails to meet the standard of our recommended anchor investment: Vanguard Balanced Index Fund (VBINX). Include an appropriate benchmark, i.e., the lowest-cost no-load mutual fund that is most representative of natural resource stocks: T Rowe Price New Era Fund (PRNEX).

Execution: What does the Table tell us?
        A) Since the end of the “ recession” over 11 yrs ago, total returns are 14.3% vs. 6.9% for VBINX (Col C). But this has been at the expense of greater risk. Losses of 34.3% were accumulated during the Lehman Panic vs. overall market losses of 28% (Col D). Risk-adjusted returns (Col E) show that only 9 of the 15 companies have “Finance Value” vs. VBINX, i.e., are worth committing your funds over the long-term. But overall, our 15 companies had risk-adjusted returns on a par with VBINX
        B) How have those 9 better-performing companies been doing recently? There we look to the Barron’s 500 table for guidance, since it tells us recent trends in sales and cash flow. Only two of the 9 showed improvement in 2012 vs. 2011: Monsanto (MON) and Canadian National Railroad (CNI).
        C) What about dividends (Columns I-K)? Dividend yield is 2.6% vs. 1.9% for VBINX, and dividend growth is 9.5% vs. 2.2%; 9 of the 15 companies have increased their dividends annually for at least the past 10 consecutive yrs.
        D) Capitalization-weighted returns were a full 1.2% higher (Col N) than average returns (Col C), indicating that larger companies have an advantage over smaller companies. (The opposite holds true for almost all of the 10 S&P industries.) The companies with the most impact are BHP Billiton (BBL), Monsanto (MON), Occidental Petroleum (OXY), and Chevron (CVX).
        E) Risk is a different story (Columns P-S): Only 4 companies lost less than the balanced index fund (VBINX): FMC, Enbridge (ENB), Chevron (CVX), and Exxon Mobil (XOM). Only one of those (XOM) had a tighter range of annual returns over the past 11 yrs and only two (XOM & ENB) had better 5-yr Beta values. However, Enbridge (ENB) is a pipeline company funded primarily with long-term debt (62.3% of capitalization). That presents a risk of default should the company have to rollover a large maturing loan during a credit crunch.
       F) How efficient are these companies (Col T)? Using a standard of 12% return on invested capital (ROIC) we see that 10 of the 15 have efficient operations: MON, FMC, POT, CVX, XOM, CNI, BBL, SLB, CAT and DD. Exxon Mobil (XOM), as always, is the standout in this regard.
      G) How does our Index stack up compared to a large natural resources mutual fund with ~100 companies (PRNEX)? On average, Index returns are greater and losses are less.

Bottom Line: Let’s start by recalling that on a risk-adjusted basis you can’t beat the S&P 500 Index. Yes, I know, two guys have done that. Peter Lynch ran the Magellan Fund in the 70s and 80s and beat the S&P 500 Index for 22 consecutive years but he did that by including ~1000 companies and doing superhuman research on those companies (helped by a large staff). Warren Buffett couldn’t do it consistently by stock-picking so he turned to company-picking and now owns over 100. Though he hasn’t beat the S&P 500 Index every year, he has beat it for every rolling 5-yr period over the past 40+ yrs while taking less risk (current 5 yr Beta =0.25). Your only chance of beating the S&P 500 Index is to take more risk or buy stock using insider knowledge (which is illegal in the US).

The world is urbanizing at a rapid rate, so this is the time to bet on infrastructure. That means betting on commodity producers, and here’s a terrific article about commodity cycles to help you decide if that’s something you’re willing to tackle. Five of our 15 companies are in the 30-stock Dow-Jones Industrial Average (DJIA): CVX, XOM, CAT, DD and AA. You might want to start your research there, since the DJIA outperforms the S&P 500 Index most years (DIA in the Table).

Risk Rating: 9

Full Disclosure: I have significant holdings (over 100 shares) in XOM, CVX, and OXY.

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Sunday, September 8

Week 114 - Mid-2013 Master List

Situation: Every investor needs a short list of carefully-screened stocks to kick-start her own research. We try to do that by revising our ITR Master List quarterly (see Week 92 for discussion). The problem is the competition that we stockpickers face: well-hedged mutual funds like Vanguard Wellesley Income (VWINX) and BlackRock Global Allocation A (MDLOX), ETFs like Vanguard Consumer Staples (VDC), conglomerates like Berkshire Hathaway (BRK-B), and large corporations that get most of their revenues from diverse international markets, like 3M (MMM), Exxon Mobil (XOM), Procter & Gamble (PG), Coca-Cola (KO), Johnson & Johnson (JNJ), and McDonald’s (MCD). All of these have done as well or better than the S&P 500 Index: Let’s look at 9-yr Total Returns/yr since the same point in the last bull market (i.e., Aug, 2004), compared to the lowest-cost S&P 500 Index fund--the Vanguard 500 Index (VFINX) which has returned 7.4% through 8/13/2013):
        VWINX: 7.4%
        MDLOX: 8.5%
        VDC: 10.8%
        BRK-B: 8.4%
        MMM: 7.5%
        MCD: 19.3%
        XOM: 10.4%
        PG: 7.4%
        KO: 9.8%
        JNJ: 8.8%
All of the above stocks have their ups and downs but you’re not going to lose money by owning shares in any of them over an extended period of time. By equal-weighting your initial investment in all 10 stocks and then practicing dollar-cost averaging, you’re likely to succeed at net-net-net investing (turning a profit after transactions costs, inflation, and taxes, see Week 28 and Week 112) over the next 10 yrs. I’m not alone in this opinion. For example, Warren Buffett has sold several derivative contracts that pay if the S&P 500 Index doesn’t exceed ~1100 (it’s already ~1700) on a fixed date between 2019 and 2028. In the meantime, he collects big premiums on the contracts. But if he loses the bet, Berkshire Hathaway has to pay billions of dollars to the counterparties. (These are amounts that exceed the interim premium payments over 5-fold.) He thinks the main risk of loss has to do with nuclear war.

So where does that leave our new screen for ITR Master List stocks? Well, some of the above names keep popping up: Coca-Cola, McDonald’s, and Johnson & Johnson. To stay ahead of the game, we recently altered our approach, and the screen no longer excludes companies that have a dividend yield less than the Vanguard 500 Index Fund (VFINX). Why? Because dividends reduce free cash flow (FCF), which is free money that can be used to grow the company. The only alternative way for a company to expand is to issue more stocks and/or bonds, which is not only expensive but also lowers the stock price and can handicap innovation. Looking at the 18 stocks in the Table, you’ll see that 9 currently have a lower dividend yield than VFINX. Nonetheless, 15 are what S&P calls Dividend Achievers because they’ve increased dividends annually for the last 10 or more yrs. The exceptions are Costco Wholesale (COST), CVS Caremark (CVX), and AmerisourceBergen (ABC), all 3 of which are within 2 yrs of being designated Dividend Achievers.

To screen, we started with the Barron’s 500 table, where companies are ranked on the basis of recent growth in sales and cash flow. Then we excluded any company with a 3-yr Beta greater than the 3-yr Beta for Vanguard Balanced Index Fund (VBINX), which is 0.88, AND any that lost more than the 28% that VBINX lost during the Lehman Panic (10/07-4/09). We also excluded companies that couldn’t match or exceed VBINX in terms of Total Return/yr since 9/1/00 (the low point in the previous market cycle), AND over the past 5 yrs. Finally, companies that are mainly funded by loans and companies that have less than an A- rating from S&P were excluded. Of the remaining 18 companies, 12 (Table) are from one of the 4 “defensive” industries (see Table). Defensive industries are considered to be consumer staples, healthcare, utilities and communication services because their products have low elasticity (i.e., people pay up for their products even when the economy sucks). Therefore, those 12 defensive stocks, which were picked up by our screen, are what we like to call Lifeboat Stocks (see Week 106): WMT, UGI, HRL, GIS, SO, NEE, ABT, SJM, JNJ, ABC, CVS, KO. The 6 companies from non-defensive industries include 5 “consumer discretionary” companies: ROST, FDO, MCD, TJX, COST and one “materials” company (SHW). Four non-defensive industries have no representation in our ITR Master List, and those are: Energy, Industrials, Financials, and Information Technology. Why is that? Risk! All are latecomers to the party when the economy begins to emerge from recession, and their stocks tend to fall the furthest in value during the recession. It’s those industries that make you shy away from investing in an S&P 500 Index fund like VFINX. In other words, your natural instinct is to leave the party just as the punch is getting spiked.

Bottom Line: Our ITR Master List cues you to buy stock in companies that help build retirement savings without ruining your sleep. Coca-Cola (KO) is the most nervous-making company on our Mid-2013 ITR Master List. We know you can live at peace owning KO stock because Warren Buffett tells you so almost every time he’s on TV. All of the companies on the list are well-valued by investors so you need to set up a dividend reinvestment plan (DRIP) for each one you select. Why? They’re expensive now because future earnings have already been discounted in their share price. That means you’ll want to start with a small investment and keep adding that same amount on a regular basis, e.g. by setting up a DRIP with automated monthly withdrawals from your checking account. The advantage is that you’ll get to buy more shares using the same number of dollars when the price inevitably falls.  

Risk Rating: 4

Full Disclosure: I make monthly automatic additions to DRIPs in WMT, NEE, ABT, JNJ, and KO.

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Sunday, September 1

Week 113 - A Diversified Online Investment Plan with Zero Ongoing Costs

Situation: Many investors were shocked at how much their savings plan was damaged in 2008 (blown-up is the jargon term). This has built a wall of mistrust between investors and the professional financial advisors who are supposed to be assisting them. How do we move forward? I suggest that the financial services industry start by recommending “starter investment plans” that cost the investor little to set up and nothing going forward. Such a plan is likely to satisfy the investor even if there’s a market downturn. That’s how to build trust.

Along the way, the investor will naturally discover that she needs help with research. For example, by using Merrill Edge for a little online trading (at $6.95/trade) she’ll have full access to Standard and Poor’s research as well as Morningstar’s, AND phone access to a broker. Or, by using a low-cost nationwide brokerage, Edward Jones for example, she’ll have an in-person relationship with a local broker and receive up-to-date reports on a hundred or more companies each month.

Mission: To provide 3 investment plans that can be managed online at little cost, including one with zero costs. Include information about long-term and recent returns, losses or gains during the Lehman Panic, and both of the main sources of risk (debt and volatility).

Option #1 is to use an online balanced fund like the Vanguard Wellesley Income Fund (60% bonds) or the Vanguard Balanced Index Fund (40% bonds) as the anchor for the plan. Those funds require an initial investment of $3000 and a minimum $100 for each subsequent investment (such as automatic monthly payments from your checking account). Costs are very low, e.g. 10-yr costs for the initial $3000 investment total less than $100. Total Returns were 7% for each fund over the past 11 yrs thru 8/15/13 (see Table). Over the past 5 yrs, VWINX returned 8.6% and VBINX returned 7.2%. Neither fund leveraged (has debt). VBINX has a higher 5-yr Beta (0.94) than VWINX (0.58). Since 2001, the most that VWINX lost in a single year was 9.9% vs. 19.9% for VBINX (Column K in Table). During the 18-month Lehman Panic, VWINX lost 16% and VBINX lost 28% (Column D in the Table).
Option #2 is generic: half bond index and half stock index. Almost every 401(k) Plan has those choices. The goal here is to maintain 50% of your assets in a short to intermediate term global investment-grade bond index fund, like the Vanguard Intermediate-term Bond Index Fund (VBIIX), and 50% in a low-cost S&P 500 Index fund, like the Vanguard 500 Index Fund (VFINX). This combination had a total return of 6.5% over the past 11 yrs (Column C in Table), improving to 6.9% over the past 5 yrs (Column F in Table). Neither fund is leveraged but companies in the S&P 500 Index are ~40% financed by long-term loans. 5-yr Beta is 0.5; you can expect single-year losses up to 15.6%, based on experience since 2001 (Column K in Table). 
Option #3: Maintain one third of assets in Inflation-protected Savings Bonds (ISBs) obtained through treasurydirect at no cost for setup or ongoing purchases; maintain one third of assets in DRIPs for what we call hedge stocks (see Week 95) that also have no costs for setup or ongoing purchases (see Note below): NextEra Energy (NEE) and Johnson & Johnson (JNJ). The final third is for DRIPs in riskier stocks that again have no costs for setup and ongoing purchases: Exxon Mobil (XOM) and Procter & Gamble (PG). This stock/bond combination has returned 8.6% since 7/1/02 (Column C in Table) and 7.2% over the past 5 yrs (Column F). Long-term debt is 15.2% of total capital (Column N) but most of that is held by a regulated utility (NEE) backed by the State of Florida. The 5-yr Beta for Option #3 is 0.31, which is much lower than the other two options. Average single-year losses since 2001 were 6% (Column K), which is considerably less than the 14.5% and 15.6% losses that can be expected for Option #1 and Option #2, respectively. In summary, Option #3 appears to be the most rewarding and least risky.

Notes for Option #3: a) The JNJ DRIP charges $1.00 for automatic withdrawals from your checking account but there is no charge for one-time requests made as often as you like. b) Savings Bonds are not taxed until cashed out; that tax advantage, over time, adds a little over 1%/yr to total returns. c) For our presentation of Option #3 in the Table, we have substituted a reasonable proxy for ISBs, namely VBIIX, and entered it twice to denote its one third weighting relative to the two thirds weighting for the 4 stocks. d) For NEE to have zero ongoing costs for automatic monthly DRIP investments, a minimum of $100 has to be invested. e) If you choose ISBs for your bond investment, you’ll need to make that request each time using your registered computer and checking account. If you choose instead to use the similar Vanguard mutual fund (VBIIX), you’ll be able to set up automatic monthly investments but your initial investment has to be $3000 (as for the other Vanguard mutual funds listed in the Table) and the service is not free: it has a 0.2% expense ratio. f) There are no charges for setting up DRIPs at computershare on NEE, XOM, JNJ and PG, nor are there charges for dividend reinvestment. To summarize: If you have a $600 monthly investment plan ($200 for ISB, $100 each for NEE, XOM, JNJ and PG) there are zero costs both initially and going forward; all dividends and interest payments are reinvested automatically. If you choose to make automatic monthly investments for JNJ, instead of one-off investments, that will incur a $1.00/mo charge.

Bottom Line: In preparing for retirement, you need to make peace with the financial services industry. Yes, I know, they charged 2-4% of your net asset value each year to guide you to an asset allocation that collapsed in 2008, along with your dreams of a secure retirement. To make matters worse, your retirement plan will never recover from those losses even though those losses have been reversed by the amazing recovery of the stock market (assuming you didn’t sell any of your stock holdings during the Lehman Panic). Why? Because now you are 6 yrs closer to retirement and those recovered losses don’t buy as much now as in 2007. You could still be feeling like you’d been thrown off a horse. The best way to get back on that horse is to learn to take better care of yourself by owning the problem and using the internet more. Why is that an advantage over using a financial planner? For example, I think inflation-protected Savings Bonds are the best foundation for a savings plan but very few financial services professionals will even mention those. Neither will they guide you to the bond mutual fund that mimics Savings Bonds (VBIIX in the Table), even though its about the only short to intermediate-term bond fund that hasn’t lost money in any year since 1999. Why do they shy away from recommending that you put some of your money in a very safe place where returns still beat inflation handily (bottom of Column C in Table)? Because there’s no way for them or their friends to profit from that advice. Somehow, the idea of minimizing your out-of-pocket expenses (as a way to build trust) has never dawned on them. Almost any auto dealer, furniture salesman, or casino manager knows better these days. 

So, get started by having fun making a little money on your own. Then expand on that experience by using the financial services industry for institutional stock analyses.

Risk Rating: 4

Full Disclosure: I have been using Option #3 for a long time, as well as Option #2 for my 401(k).

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