Sunday, December 1

Week 126 - There are 7 “Hedge Stocks” in the S&P 100 Index

Situation: Here at ITR, we like to focus your attention on stocks issued by really big companies. That’s because those companies have the resources and flexibility needed to ride out a bear market. You don’t get as much bang for the buck as you do with small or mid-cap stocks (e.g. those found in the S&P 400 Index) but the risk of damage to your retirement nest egg just when you need it the most (at the beginning of retirement) is much less. Our latest list of “hedge stocks” (see Week 117) had only 16 companies but 7 of those are found in the S&P 100 Index of companies with market capitalizations over ~$35B. 

We’ll look at the long and short term Finance Values of those seven. In addition, we’ll look at 3 more companies that are on the border for inclusion that august group: General Mills (GIS) and NextEra Energy (NEE) have ~$35B of market capitalization and are in our list of 16 hedge stocks; Procter & Gamble (PG) is already in the S&P 100 Index but fell just short of being a hedge stock. Why? Because during the Lehman Panic it lost slightly more than our benchmark, the Vanguard Balanced Index Fund (VBINX -- Column D in the Table). But PG is already used by investors around the world to hedge against the risk of their other investments, so we’ll sneak it into our list of S&P 100 hedge stocks.

These 10 stocks have superior long-term Finance Value (Column E in the Table), meaning that after subtracting losses during the Lehman Panic from long-term gains investors came out ahead of our benchmark (VBINX). We assess short-term Finance Value by referencing the Barron’s 500 list for 2013 vs. the 2012 list, to determine whether there has been recent growth in sales and cash flow (Columns L & M in the Table). Of the 3 companies that were in the top 200 in 2012 (ABT, MCD, GIS), only McDonald’s (MCD) slipped out of that group in 2013. Of the remaining 7 companies, only PepsiCo (PEP) had a significantly lower rank in 2013 than in 2012. That leaves us with 8 hedge stocks that have both long and short term Finance Value. Those are the ones you need to study closely. Then think about setting up a DRIP through computershare (which offers DRIPs for all 10).

What’s not to like? Let’s start with the fact that nobody really likes the idea of investing in a hedge fund or hedge stock, since those mainly make money for you by falling less during a bear market at the expense of rising less during a bull market like the one we’ve seen over the past 5 yrs (Column G). Half of those 10 companies failed to make as much money as our VBINX benchmark, which is itself hedged (40% invested in bonds). Returns for those laggards are highlighted in red, as are any other numbers in the Table denoting underperformance vs. VBINX. The S&P 500 Index (VFINX) did even better than VBINX, as you would expect in a bull market. 

Now you see what’s not to like. Taken together, the 10 stocks underperformed VBINX over the past 5 yrs (Line 14 at Column G in the Table) and did even worse vs. the S&P 500 Index fund (VFINX): Lines 25 & 26 at Column G in the Table. Think of hedge stocks as ballast, deep in the hold of the ship taking you to retirement. The ship goes slower because the ballast is heavy, but the ship will rock less in a big storm instead of foundering. To give that ship some zip faster after the storm, put a large dollop of our retirement savings in Core Holdings (see Week 102). Those are growth companies that have to be hedged with bonds, but they’ll outperform the S&P 500 Index in a bull market. Note that our list of 10 hedge stocks in the S&P 100 Index has only one Core Holding (MCD). The other 9 are Lifeboat Stocks (see Week 106). No surprise there!

Bottom Line: Hedge stocks don’t need to be backed up with bonds. They’ll carry you through a bear market by losing ~40% less than the S&P 500 Index. Some, like Wal-Mart (WMT) and McDonald’s (MCD), will even gain in value. Why? Because people shop for the cheapest food they can find after they’ve lost their job. Over the past 100+ yrs, market cycles have lasted about 5 yrs and bear markets have accounted for a third of that; bull markets account for 2/3rds. However, the first half of a bull market only serves to get the S&P 500 Index back where it was at the beginning of the bear market. Since the market only makes new highs a third of the time, it is possible for a company’s stock to beat the market by losing less the other 2/3rds of the time. That’s the whole premise behind a hedge fund or hedge stock. 

Large companies have a better chance of doing that than small companies, given that they have more product lines, pay lower interest on their loans, and maintain larger cash hoards relative to earnings. The 10 large capitalization stocks in the Table won’t, as a group, do as well as the S&P 500 Index in a bull market but they’ll serve you much better in a bear market. And we’ve had two of those since 3/24/00, when the market peaked just before the “ recession.” Over the 13.5 yrs since then, those 10 stocks have kept more than 7% ahead of inflation (Column C) while the S&P 500 Index still struggles to beat inflation by 1%. You get the point.

Risk Rating: 3

Full Disclosure: I regularly add to DRIPs in 6 of these companies (WMT, PG, KO, JNJ, ABT, NEE), and also own stock in MCD and GIS.

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