Sunday, January 26

Week 134 - Food-related Stocks Found in Our Universe of 55 Companies

Situation: Yes, I know. You’d like to put a little zip into your retirement savings by investing in commodities. Here at ITR, retirement is our end-game so we eschew risk. That means we don’t talk about investing in raw commodities through futures or exchange-traded funds (ETFs) like CORN. Instead, we talk about investing in companies that turn those commodities into value-added products. Buying stock in production companies has two advantages over investing in raw commodities: 1) if the raw commodity is rising in price, that increased cost is passed on to the end-user; 2) if the raw commodity is falling in price, that reduction in CGS (cost of goods sold) serves to increase the profit margin. (However, in a competitive environment those savings are passed on to the end-user.) We look at  food-related companies in this week’s blog because we expect world food prices to grow 1-2%/yr faster than world GDP. Other commodity-related investments appear less attractive. For instance, companies that produce fossil fuels are likely to grow slower than world GDP, since growing atmospheric carbon dioxide now has to be mitigated by substituting carbon-neutral energy sources, such as solar, wind, nuclear, hydroelectric, and geothermal. Companies that mine minerals from the ground (or make products from those) are likely to grow with GDP, given the key roles that copper, iron, zinc, nickel, and aluminum play in the building of infrastructure. 

There are three types of companies that support food production. Those that: 
   a) provide inputs to the farm like seeds and fertilizer, 
   b) provide tools for the farmer to use, and 
   c) take farm commodities out to the food chain.

This week’s Table lists 12 stocks that cover all three items listed above. Inputs come from Monsanto (MON), tools come from Deere (DE) and Caterpillar (CAT). Farm products enter the food chain via rail and trucking companies like Canadian National Railway (CNI) and Sysco (SYY). In the United States, almost 40% of corn goes to ethanol producers like Archer Daniels Midland (ADM). Meats are produced by Hormel Foods (HRL); snack food and beverages are produced by Coca-Cola (KO) and PepsiCo (PEP). Much of the final distribution occurs through restaurants like McDonald’s (MCD) and hypermarkets like Wal-Mart Stores (WMT) and Target (TGT). We picked those 12 companies are from our “universe” of 55 high-quality companies (originally 51, see the updated Table for Week 122). “High-quality companies” means those that a) are found on the Barron’s 500 list of companies with the best growth in sales and cash flow over the past 3 yrs; b) have increased dividend payouts for 10 or more consecutive years, e.g. companies called Dividend Achievers by Standard & Poor’s, and c) have a Standard & Poor’s credit rating of A- or higher. Red highlights in the Table denote metrics that underperform our benchmark, Vanguard Balanced Index Fund (VBINX). The history of total returns in Column C goes back to 9/1/00 because that’s when the lowest-cost S&P 500 Index fund (VFINX) peaked before the “dot-com” recession. That Index of price performance remains “underwater” by inflation-adjusted accounting, but on a total return basis (price appreciation plus dividend reinvestment) it has beat inflation (bottom of Column C). 

Bottom Line: Looking at all 6 benchmarks in the Table, and comparing those to the average values for 12 companies in each column, you’ll see that that stock in those companies handily outperforms the benchmarks, in terms of both performance and safety.

Risk Rating: 6

Full Disclosure: I own stock in WMT, MCD, MON, HRL, CNI, KO, PEP, DE, and CAT.

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Sunday, January 19

Week 133 - Here’s a “Safety First” Retirement Plan With Expenses Under $7/yr

Situation: We all know that investing for retirement is problematic, uncertain, and expensive. We’ve all thought about what it would feel like to depend solely on Social Security for retirement income. And, we all know that the current level of government financing for Social Security is unsustainable due to the relentless growth in the numbers and longevity of retirees, combined with ever fewer workers per retiree contributing to fund the program. Anyone over 50 who doesn’t understand the effect this could have on her sunset years hasn’t been paying attention the past few decades.

Mission: Design a personal retirement plan to supplement Social Security and workplace retirement plans. The plan must minimize transaction costs, bankruptcy risk, and inflation/deflation risk to whatever extent possible.

Here’s how we suggest setting up such a plan. Stocks grow in value during inflation while bonds grow in value during recession. You’ll need both. If you dollar-average by investing small amounts of money 50:50 into bonds and stocks on a regular basis, your retirement savings will grow regardless of inflation and deflation. 

As an aside, Central Banks (such as our Federal Reserve) have so many ways to disguise and allay deflation that we only know they are doing so when interest rates fall to absurdly low levels. Pundits call it “printing money” but the technical term is Financial Repression (see Week 79). We’re in a period of financial repression now, meaning that money is so cheap for corporations and banks to obtain that prices for stocks and real estate rise faster than earnings or rents can justify. The Fed’s idea is to “jump start” the economy enough--by encouraging private investment with free money--that it will grow on its own. Once victory is declared and financial repression ends, the favor is returned. Stock and real estate prices will then slow their growth while earnings and rents catch up. Since free money will no longer be available, interest rates will rise to normal or temporarily inflated levels. When will financial repression end? Judging from precedent, that won’t be soon. To prevent deflation following World War II, it lasted from 1947 until 1980.

To eliminate the risk of bankruptcy, purchases for this plan are confined to stocks and bonds that have a AAA credit rating from Standard and Poor’s. When we checked the candidates, we found that 4 companies qualified, along with 10-yr US Treasury Notes. The stocks are Microsoft (MSFT), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Automatic Data Processing (ADP). Treasuries can be obtained at zero cost at treasurydirect; we recommend inflation-protected 10-yr Notes which are sold in January and July of each year. XOM and JNJ can be obtained at no cost through computershare, although you’ll be charged $1 for each JNJ purchase if you use automatic withdrawals from your checking account. (There is no charge for separate point-and-click JNJ purchases through computershare.) Purchases of MSFT shares through Microsoft’s online transfer agent are expensive, and there’s no online transfer agent for ADP. So, it is best to use a low-cost online broker for those. For example, you can use TD Ameritrade or Capital One. The cost per trade at those sites is currently $6.95.

JNJ is a hedge stock (see Week 126), so you don’t need to back up those purchases with an equal purchase of 10-yr Treasury Notes. That leaves 3 stocks (MSFT, XOM, ADP) to be balanced with Treasuries (or listed as 7 items in all, see the Table). For example, you could decide to invest $4,200/yr. That is, $600/yr per line item which is the same as $300/half, $150/qtr, or $50/mo. For XOM, automatic withdrawals from your checking account in the amount of $50/mo is both free and convenient using computershare. For zero-cost investments in JNJ and 10-yr Treasuries, go online every 6 months to invest $300 in JNJ at computershare and $900 in 10-yr Treasuries at treasurydirect. For lowest-cost investing ($6.95/yr) in ADP and MSFT, make alternate-year purchases of $1200 each through an online broker like Capital One or TD Ameritrade. In summary, T-Notes, JNJ and XOM are free; MSFT and ADP are purchased on alternate years for $6.95. Your out-of-pocket cost is $6.95/yr. This plan carries considerably less risk than VWINX, the safest low-cost balanced mutual fund (see Columns D and J in the Table), even though 10-yr returns are almost identical (Column F). Note: metrics in red indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX).

When you retire, change from automatic reinvestment of quarterly dividends to having the dividends mailed to you. For Treasuries, there is no automatic reinvestment of interest. You receive interest payments twice a year deposited into your checking account, and return of the principal amount ($900) after 10 yrs. When you retire, stop making any “rollover” purchases, which you may have scheduled for T-Notes that are maturing every 6 months. Then you simply receive the principal amount of maturing T-Notes in your checking account. Reinvest T-Note interest payments in inflation-protected Savings Bonds at treasurydirect and hold those for at least 5 yrs before cashing them in, at which time you’ll be taxed for the accumulated interest payments.

Bottom Line: It’s always a good idea to have a personal retirement savings account, even if you already contribute the maximum allowed amount to a company-sponsored retirement plan. Why? Because corporations can change or discontinue their employee retirement plans. And, the Federal government will no doubt be changing long-standing Social Security policies for future retirees. You can have a tax-advantaged aspect of your personal, point-and-click retirement savings account simply by having your accountant declare it to be an IRA, as long as the annual limit for contributions isn’t exceeded. 

To avoid gambling with your personal retirement savings plan, you’ll need to include investments with AAA credit ratings. That way you don’t have to worry about bankruptcy. And make sure you hedge against the risk of recession because anytime that stocks go down, T-Notes go up. Finally, don’t spend any money on transaction costs that you don’t absolutely have to spend.

Risk Rating: 3

Full Disclosure: I regularly buy 10-yr T-Notes, MSFT, JNJ, and XOM.

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Sunday, January 12

Week 132 - What kind of returns can you expect after taxes and inflation?

Situation: Here you are, constantly worrying about whether you’ll have enough retirement income. Here at ITR, we want to give you as many options to consider as possible, along with pluses and minuses for each. Since true profit is the net of “gains” minus “expenses” it’s very important to consider what various retirement options are costing you, in real time. These costs are something that mutual fund managers and TV "experts" are loath to discuss, to say nothing of those infamous hedge funds. 

In this week’s blog, we want to boil this down to your likely “take home pay” for Plan A vs. Plan B vs. Plan C. We can start right up front by subtracting rates for taxes (25%) and inflation (2.4%) from Total Returns over the past 10 and 17 yr periods. Then we can subtract transaction costs, which better be a lot less than the 2%/yr spent by the average retail investor if you've been following our style of investing.

Plan A is the “plain vanilla” plan consisting of 50% in the lowest-cost S&P 500 Index fund (VFINX) and 50% in the lowest-cost intermediate-term investment-grade bond index fund (VBIIX). Looking at the Table, 17-yr returns for Plan A averaged 7%/yr and 10-yr returns averaged 6.1%/yr. (Note: you would have had to do some rebalancing every few years in order to maintain a 50:50 ratio.) The transaction costs or “expense ratio” for this plan are incorporated in the returns for each of the mutual funds, ~0.25%/yr. Subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 2.9%/yr over the past 17 yrs, or 2.1%/yr over the past 10 yrs.

Plan B is the "balanced fund" plan, consisting of 100% in either the Vanguard Balanced Index Fund (VBINX, a computer-run fund kept at 60% stocks and 40% bonds) or the Vanguard Wellesley Income Fund (VWINX, a managed fund kept at ~60% bonds and ~40% stocks). Looking at the Table, 17-yr returns for VBINX averaged 7.4% and 10-yr returns averaged 6.8%. As in Plan A,transaction costs for these Vanguard funds are ~0.25%/yr. For VBINX, subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 3.2% after 17 yrs and 2.7%/yr after 10 yrs. For VWINX, returns, net of all 3 costs are 3.7% after 17 yrs and 2.7% after 10 yrs.

Plan C is the do-it-yourself plan consisting 50% of Plan A and 50% of 8 large-capitalization “hedge stocks” (see Week 126). Turning to the Table, we see that those hedge stocks returned an average of 9.9%/yr over the most recent 17 yrs and 10.2%/yr over the most recent 10 yrs. The expense ratio (Column O) for building those DRIPs at computershare is 0.9%/yr. After subtracting 25% for taxes and 2.4% for inflation, average returns come to 5.0%/yr after 17 yrs and 5.3%/yr after 10 yrs; then subtract 0.9%/yr for transaction costs and you’re left with 4.1% and 4.4%. Combining those net returns 50:50 with the net returns from Plan A leaves you gaining 3.5%/yr after 17 yrs and 3.2%/yr after 10 yrs for Plan C.

In terms of reward, Plan C is superior but VWINX is a close second. In terms of risk, the three plans also differ. For example, note the losses sustained during the 18-month Lehman Panic (Column D in the Table): 20.3% for Plan A; 28% (VBINX) and 16% (VWINX) for Plan B; 16.2% for Plan C. Risk is also reflected by the 5-yr Beta values (Column I): 0.5 for Plan A; 0.94 for VBINX and 0.58 for VWINX in Plan B; 0.45 for Plan C. Note: Returns are as of 12/31/2013; red highlights denote metrics that underperform VBINX.

In terms of risk, Plan C is superior but VWINX is a close second. Plan C also fits well with your workplace retirement plan, since almost all such plans offer an investment-grade bond fund and a stock index fund as options from which to choose. Then you can use your IRA for investing in the hedge stocks.

Bottom Line: All 3 of these plans are conservative, in that they’re designed to conserve your resources through any but the worst of financial calamities (nuclear war, global pandemic). For example, all but one of the 8 hedge stocks in Plan C is a “Lifeboat Stock” (see Week 106). Risk has been avoided except in the case of the computer-run balanced fund (VBINX), which is 60% stocks. Over the past 5 yrs of remarkable growth in the stock market, that part of Plan B has outperformed the other options (see Column G). VBINX is our benchmark, referenced in every blog, because it is not subject to human error and is largely hedged anyway, given its 40% bond index component. Daily rebalancing prevents any momentum in either stocks or bonds from skewing the fund in either direction.

The most important message that we’d like to leave with you is that transaction costs need to be accounted for, and avoided where possible. Warren Buffett has made this clear on several occasions. For example, at the 2004 Annual Meeting of Berkshire Hathaway shareholders he said, when asked about the best way to invest for retirement:

 “Among the various propositions offered to you, if you invested in a very low cost index fund -- where you don't put the money in at one time, but average in over 10 years -- you'll do better than 90% of people who start investing at the same time."

Risk Rating: 4

Full Disclosure: I own stock in all 8 of the companies at the top part of the Table.

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Sunday, January 5

Week 131 - Packaged Foods and Meats

Situation: It is currently our view that the market is overpriced. In such circumstances, many investors will consider low-volatility, high-return stocks in going forward with their investment plan. How do we know the market is overpriced? The P/E for the S&P 500 index is 20, meaning current return on the Vanguard 500 Index Fund (VFINX) is 5%. (It was also 20 on October 1, 1929, and began rising above 20 on October 1, 2007, to herald the Lehman Panic). 

However, the stock market discounts anticipated future earnings. That means the price of stocks today is based on earnings that are expected to occur over the next 12-18 months, which is why a company’s stock falls hard and fast when it’s quarterly earnings report shows lower than expected earnings. Companies that have predictably steady earnings growth, such as Coca-Cola (KO), exhibit little stock price volatility and often have a P/E higher than 20. In other words, investors know what KO earnings will be a year from now. That confidence in the future attracts investors to KO even though they know they’re paying too much and therefore cannot expect long-term total returns greater than ~10%. But when the market is overpriced investors are banking on a certain amount of growth in future earnings that is anything but certain. 

Our economy today is on the cusp of deflation which, if it were to occur, would cause a stock market crash. So, if you still want to buy stocks at these prices you’d better pick companies that can weather a recession. This means that you’re on the lookout for companies that sell products with low elasticity. These are products that consumers buy as frequently during a recession as in good times. That translates into low volatility in their stock’s price (low 5-yr Beta). No sub-industry is better than Packaged Foods & Meats in fitting that bill.

We have gone through the S&P Food & Beverage Select Industry Index and focused on the 18 companies in the Packaged Foods & Meats sub-industry with 
  a) stock records going back to the market peak on September 1, 2000, and 
  b) a market capitalization greater than one billion dollars (see Table).
As a group, these companies had 4 times the total return/yr of the S&P 500 Index (VFINX) over those 13+ yrs while losing only 21.5% during the 18-month Lehman Panic, which was a period when VFINX lost 46.5%. This gives us confidence that these same companies will be inclined to provide a solid performance in the event of another downturn. The average 5-yr Beta for these 18 companies is less than 0.5 vs. 1.0 for VFINX. Two of the companies, General Mills (GIS) and JM Smucker (SJM) have P/E values less than 20, good Finance Value (Column E in the Table), and stable or improving recent growth in sales and cash flow (Columns L & M). Both companies also have investment-grade bond ratings of BBB+ (Column O).

Bottom Line: Our view is that the market is overpriced and future prosperity of the world’s economies is open to question. Nonetheless, stocks are the asset class to focus on for growing your retirement nest egg. You have no choice but to continue dollar-averaging into stocks each month but you can choose which stocks you’ll buy. In this economic climate, you’ll of course focus on companies in “defensive” industries: healthcare, communications, utilities, and consumer staples--like housewares and food. Among consumer staples, the most defensive sub-industry is Packaged Foods & Meats. That means you’ll want to look at the 18 companies in that sub-industry that have the longest market history and the highest capitalization (Table). We find that two of those 18 have outstanding performance records combined with low risk: General Mills (GIS) and JM Smucker (SJM).

Risk Rating: 3

Full Disclosure: I have stock in HRL, GIS, PEP, and MKC.

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