Sunday, November 24

Week 125 - Berkshire Hathaway’s Stock Portfolio

Situation: We have called Berkshire Hathaway a “hedge fund for the masses” (see Week 101). It has almost a hundred wholly-owned subsidiaries, but also has a common stock portfolio that currently represents 34% of its market capitalization. With respect to risk vs. reward, that portfolio behaves quite differently than the company as a whole (see Week 101). On November 14, 2013, Berkshire Hathaway filed Form 13F with the US Securities and Exchange Commission (SEC), as required. That 3rd quarter update details Berkshire Hathaway’s common stock portfolio as of 9/30/13. Over 40 companies are on the list but only 15 have a dollar value greater than 1% of the entire list’s value. Our analysis of these companies is in this week’s Table but excludes two on the list  because the stocks were issued too recently for analysis (Phillips 66; General Motors).

We like to follow Berkshire Hathaway closely because “financials” and “information technology” are the riskiest of the 10 S&P industries. Those industries are the growth engine of our economy, and who better to look to for guidance than Warren Buffett. If your portfolio doesn’t include any stocks issued by companies in those two categories of industries, it will underperform the S&P 500 Index by a significant margin. Remember, the oldest rule for investors is the greater the risk, the greater the reward. That doesn’t leave you getting much sleep at night, so we ask you just to remember that the greater the risk, the greater the volatility. Berkshire Hathaway is important because it is mainly an insurance company and that is the only sub-industry among financials that we find to be worthy of your attention as a retirement investor (see Week 101, Week 117, Week 122). The others are Chubb (CB), HCC Insurance Holdings (HCC), and WR Berkley (WRB). You may take the position that those companies have to pay out more for property damage due to weather-related events amplified by global warming. That’s true, but then those property and casualty insurers follow up by raising their premiums a lot higher. 

Berkshire Hathaway sailed through the Lehman Panic (Column D in Table) without losing as much as our benchmark stock/bond index fund (VBINX), while beating Vanguard’s S&P 500 Index fund in every rolling 5-yr period over the past 30+ yrs. However, that record may come to an end on December 31st (see Column F in the Table). This has all been accomplished with low volatility (current 5-yr Beta = 0.25) and below-average valuations (current P/E = 15). What’s not to like? Well, two things. One is that Warren Buffett has total executive control in managing Berkshire Hathaway, and he’s getting on in years. Another is that his style of governance (delegation of authority to subsidiary company CEOs) doesn’t measure up to current standards of “due diligence.” That means investors in Berkshire Hathaway need to know the moving parts of the company, and attend the annual meetings in Omaha (or at least read the annual reports). I’ve been doing that for years and have reached the conclusion that Berkshire Hathaway is in reality two companies. One is composed of the wholly owned subsidiaries; the other is composed of the common stock holdings.  

Looking at the Table, we see that the 13 largest stock holdings represent 87% of the common stock portfolio and 30% of Berkshire Hathaway’s market capitalization. Breaking down the dollar value of those stock holdings, we see that 44.4% is invested in four financial services companies (WFC, MCO, USB, AXP). American Express (AXP) and Wells Fargo (WFC) represent almost 39%! Taken together, those 13 companies performed better than the S&P 500 Index (VFINX) over the past 10 yrs (Column C) and almost as well over the past 5 yrs (Column F), yet with significantly less volatility (5-yr Beta = 0.82 vs. 1.00 for the S&P 500 Index; losses during the Lehman Panic were 35.7% vs. 46.5%). The 4 financial services companies have a 5-yr Beta of 1.02 and the two largest (WFC & AXP) have a 5-yr Beta of 0.94, whereas, a mutual fund that comes close to being an index fund for the financial services sector (PRISX in the Table) has a 5-yr Beta of 1.15. Now, bear in mind that Warren Buffett made these huge bets on AXP and WFC decades ago, apparently to achieve outperformance during bull markets at the expense of underperformance during bear markets. Note: red highlights in the Table denote values that underperform the benchmark stock/bond index fund (VBINX). 

Bottom Line: Over 45% of Berkshire Hathaway’s stock portfolio is invested in financial services companies, yet the portfolio has a 5-yr Beta that is 29% less than for a fund that is close to being a financial services index fund (PRISX). The portfolio differs from the remaining 66% of Berkshire Hathaway in being somewhat more risky in terms of 5-yr Beta and losses during the Lehman Panic. In fact, its stock portfolio has metrics that are similar to those for the S&P 500 Index Fund (VFINX) except better (Table). That outperformance is due to the 44% of the portfolio’s net asset value that is contributed by 4 financial services companies. The surprise is that the portfolio’s volatility is so much less than one would expect. To summarize, Berkshire Hathaway as a whole acts like a hedge fund in that it performs well when the market is down but tends to lag behind when the market is up (see Column F in the Table and our Week 101 blog). The stock portfolio is a crucial factor because it saves Berkshire Hathaway from lagging even more when the market is up, since those stocks tend to track the market whether it is moving up or moving down (see Columns C&F in the Table). That stock portfolio is helping Berkshire Hathaway exactly where it needs help and when it needs it.

Risk Rating: 4

Full Disclosure: I own stock in Berkshire Hathaway and make monthly additions to DRIPs in Wal-Mart Stores, Procter & Gamble, IBM, Exxon Mobil, and Coca-Cola.

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Sunday, November 17

Week 124 - Farm Equipment, Fertilizer and Seed Companies

Situation: You’ll soon tire of reading agricultural blogs that begin by projecting that the world’s population will grow to 9 Billion by 2050. What’s the catch? It’s that improved standards of living imply that there will be a doubling of food production by then. Most of the increase will be in the form of animal protein: meat, poultry, fish, shrimp, milk, and eggs. And we’ll also keep reminding you that it takes 4 pounds of grain to produce a pound of meat but only one pound of grain to produce a pound of shrimp. So, you’ll be seeing more about aquaculture too.

How do we double food production in 35 years? Well, let’s look back to the 60s and 70s when the “green revolution” doubled food production primarily through improvements in farm equipment, fertilizer, herbicides, pesticides, fungicides, and seeds. Improvements in logistics and water use were also important. To double food production yet again, we’ll have to double down on innovation in all of those areas. What’s the kicker? It’s that the price increases, which will arise from the inevitable shortages in raw food commodities, can be counted on to drive such innovation.

As an investor, you’ll want to look at companies that produce and/or market farm equipment, fertilizer, fungicides, herbicides, pesticides, and seeds. You already know that almost any commodity exhibits sharp price fluctuations over time. That is because the price has to rise high enough to justify the large, up-front, fixed costs that are needed to increase the supply of any commodity. This always looks like a worthwhile investment by the time it is made. But competition soon becomes fierce, which leads to a supply glut that drives prices down to the point where almost every producer loses money for awhile (or goes bankrupt). That’s very painful, so the financial backers all swear off making further investments to grow production. That’s why prices will have to rise to high levels before investment starts to increase again. Governments that depend on revenues from commodity producers go through the same whipsaw experience as investors.

This week’s blog focuses on companies that make it possible for farmers and ranchers to increase the production of food commodities. If you understood the preceding paragraph, you’ll know that these companies go through wrenching changes in their stock prices. Farm and ranch land values also depend on raw commodity prices, and fluctuate accordingly. Now you won’t be surprised when you check out this week’s Table. While every entry is a high quality Barron’s 500 stock, as noted in columns G & H of the Table, every entry also has a high 5-yr Beta (Column K in the Table). 

That degree of volatility is unsuitable for retirement portfolios. Monsanto (MON) is the only stock on the list that has both long-term Finance Value (Column E) and short-term Finance Value (Columns G and H), meaning that MON beat the market (VBINX) over the long-term (Column C), incurred lower losses during the Lehman Panic (Column D), and showed increasing sales and cash flows over the most recent 3 yrs (Columns G & H). But its volatility (Column K) and valuation (Column L) are both excessive--and have tended to remain so over the years.

Bottom Line: The “Green Revolution” in agriculture remains dependent on companies that make farm equipment, fertilizer, seeds, herbicides, fungicides, and insecticides. The imprudent use of any of these products will have important negative effects on the environment, which will require further innovation to manage effectively. The stock prices for these companies reflect, in part, how much money farmers made (or lost) at the end of the last growing season by using (or under-using) their products.

Risk Rating: 8

Full Disclosure: I have stock in DD, CAT, MON, and POT.

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Sunday, November 10

Week 123 - S&P Food and Beverage Index Companies

Situation: Food reserves are dwindling around the world. China has food shortages, and prices there are rising. Creeping desertification isn’t helping, nor is war in sub-Saharan Africa. Crop losses due to drought now occur every year somewhere in the world. The US Department of Agriculture projects that prices for food commodities will rise 1-2%/yr faster than inflation. However, for individual commodities (like corn) prices will increase one year only to fall the next year because of overplanting. Another factor is the increase in meat production, which is driven by the tens of millions of people that emerge from poverty each year. Going forward, the prices for food commodities will have to rise even more than in the past--to drive investment in technology and other types of innovation (including conservation). Otherwise, the goal of doubling food production by 2050 (to feed a world population of 9 Billion) won’t be met.

In light of these facts, investors have overbought the stocks of most companies that supply grocery stores. There are over 100 companies in the S&P Food & Beverage Index. We have winnowed the list down to those that have good recent records for growth (see Table). These 24 companies are the ones found in the 2013 Barron’s 500 list of companies with superior recent growth in sales and cash flow. Those 24 have an average price/earnings (P/E) ratio of 22 but worthwhile bargains remain (GIS, WMT, KR, PEP). If you are starting a long-term dividend reinvestment plan (DRIP), with automatic monthly additions, you need not be concerned about overvaluation because prices will revert to a mean P/E somewhere between 15 and 20 as the food business goes through its inevitable boom and bust phases. We suggest that you focus your research on the 9 companies that have both long-term Finance Value (Column E) and short-term Finance Value, i.e., an improving (or stable) rank in the Barron’s 500 Lists (Columns G and H): WMT, GIS, SJM, COST, HSY, KR, UNFI, CPB, KO.

Note: In our Table, red highlights denote inferior performance relative to our standard benchmark, which is the Vanguard Balanced Index Fund (VBINX). The numbers in the Table are brought current as of close of business (COB) the Friday before publication of the blog. Long-term total returns/yr go back to 10/9/02 (Column C) because that was the low point for our benchmark (VBINX) in the previous market cycle, i.e., the “ recession.” And remember, the stocks you accumulate in your retirement portfolio over your working years will generate quarterly dividend checks after you retire. So pay attention to Columns J & K in the Table. Those tell you a) how much income your accumulated shares will generate each year, and b) how much that income will increase each year. 

While it is true that the future prospects for most of these companies will change over time, that is less true for the 9 companies that are Dividend Achievers (Column N), i.e., those that have increased their dividends annually for at least the past 10 yrs. And 6 of those 9 are Dividend Aristocrats that have increased their dividends annually for at least the past 25 yrs (ADM, KO, HRL, PEP, SYY, WMT). Of those 6, Archer Daniels Midland (ADM) and Hormel Foods (HRL) are more involved in food production and therefore more influenced by fluctuations in commodity prices. Also remember that none of the companies that make farm equipment, sell fertilizer, or produce seeds are in the S&P Food and Beverage Index. The technological innovations needed for doubling food production by 2050 will mainly come from those production-enabling companies, and we’ll update you on those next week.

Bottom Line: Predictions indicate a looming food crisis that will be with us for decades. Prepare your portfolio for the rising food costs you’ll face in retirement by investing in the companies that supply your grocery store. 

Risk Rating: 5

Full Disclosure: I make monthly additions to DRIPs for KO and WMT, and also have stock in HRL, GIS, and PEP.

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Sunday, November 3

Week 122 - Our Universe of 51 Companies

Situation: Stock selection comes down to assessing safety vs. efficacy. “Safety” means the company has effective defenses against having short sales consume more than 10% of its publicly-traded stock in a bear market, and effective defenses against bankruptcy. “Efficacy” means the company has a time-proven business plan that generates earnings growth over time. The problem is that many metrics are used to capture these values (safety & efficacy), and they only look backwards, amounting what the military calls “fighting the last war.” Our blog has carried on this tradition, be-laboring our readers with numbers that capture important information about safety & efficacy in the past. Simplification is needed, along with metrics that point to the future.

Safety is about having a stable return that grows over time with few hiccups. The main "hiccup" we want to avert is a serious drop in stock price because management then has to take measures (such as selling assets) to avert bankruptcy. To alleviate concerns like that, we won't consider any companies in this blog that have an S&P bond rating less than -A (Column N in the Table). When we invest for retirement we’re ultimately looking for retirement income that grows enough to beat inflation handily, i.e., dividend checks that arrive each quarter and get bigger each year. Remember: annuities and pensions don’t grow. Social Security is the only cost-effective exception to that rule. (At present, it more than keeps up with inflation but there is talk of having it merely keep up with inflation.) Going forward, stock ownership is likely to be the only way for investors to have a steady stream of income that more than keeps up with inflation. So what is the best way to find such stocks? You need start with the list of 200+ Dividend Achievers. Why? Because those are the only companies that will keep paying you more, year after year, and have done so for at least the past 10 yrs. Companies with a long record of increasing dividends irrespective of recessions are safe for retirement investment. You’re only looking at two metrics after you retire: a) dividend yield of the stocks you own (Column G in the Table), and b) dividend growth of the stocks you own (Column H in the Table). Adding those together approximates your future total return. What’s the catch? You need to be a little choosy in picking from the Dividend Achiever list because 1-2% of the names on that list will disappear each year. In other words, the company has discontinued annual dividend increases. This happened to Pfizer, General Electric, and Home Depot during the Lehman Panic. So you’ll need to pay particular attention to the next paragraph.

Efficacy means growth, and growth ultimately comes down to increasing sales and cash flow over time. The editors of Barron’s provide an important service to investors by publishing a 500-stock list each May that ranks companies by performance in those two key areas during the most recent 3 yrs, along with noting the previous year’s rank. Any company listed there has superior growth prospects, given that it has been chosen from the more than 6500 that are listed on US exchanges, plus those listed on the Toronto Stock Exchange.

Now we can define a “universe” of worthwhile companies for our blog to follow, by listing all of the Dividend Achievers that appear in the 2013 Barron’s 500 list. It turns out that there are 51 (see Table). At the top, you’ll see 12 Lifeboat Stocks (Week 106). Those are the companies from defensive industries (utilities, consumer staples, healthcare, and communication services) that have a Finance Value (Reward minus Risk; see Column E of the Table) superior to that of our benchmark--the Vanguard Balanced Index Fund (VBINX, which is 60% stock index and 40% bond index). Next are 7 additional defensive companies that have a Finance Value less than VBINX. The third group is most important: those are companies in non-defensive industries (energy, materials, industrials, financials, consumer discretionary, and information technology) that have a superior Finance Value compared to VBINX (see Column E in the Table). Companies in those industries do particularly well in a growing economy so you can think of them as “growth” companies. That’s where 2/3rds of your stock assets need to be. We call the best such companies Core Holdings (Week 102). The fourth group is for growth companies that didn’t have a Finance Value superior to VBINX. Benchmarks are at the bottom. Metrics are current as of close of business on October 30, 2013. 

Bottom Line: Stock-picking is cumbersome but for future retirees it has a uniquely worthwhile feature. You’ll get substantial annual pay raises during your retirement (Column H of the Table). Over the past 20 yrs, dividend growth rates have far exceeded inflation for companies that have committed to annual dividend increases. All 51 of the companies in the Table have been growing dividends annually for over 10 yrs; S&P calls such companies “Dividend Achievers.” Those 51 include 34 companies that have been growing dividends annually for over 25 yrs; S&P calls such companies “Dividend Aristocrats” and there are only 54 names in that group. The Barron’s 500 List has given us a way to winnow down that list of safe companies for retirement investment (Dividend Achievers), so as to include only those that have demonstrated increasing sales and cash flow growth in recent years. 

Risk Rating: 4

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

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