Sunday, March 2

Week 139 - 2014 Watch List for the S&P 500 Index

Situation: Every stock-picker has a watch list, a convenient way to follow the growth and safety of companies that interest her. Two problems have to be addressed: how many companies to follow, and why those particular companies. We think our readers would appreciate it if we could strive to be comprehensive, and that is facilitated by cutting the number of metrics used to one that tracks with growth and one that tracks with safety.

Growth, we think, is best evaluated by the people who put out the Barron’s 500 List every May. They examine over 3,000 companies in terms of the trend in a) cash-flow based return on investment over the prior 3 yrs, and b) sales growth over the previous year. To winnow that list, we pick only the companies that have scored in the top 300 for the two most recent years. Then we exclude companies that didn’t start issuing stock until after 2000 (because there’s not enough data to determine long-term trends by using less time). Remember: We’re looking for companies that you can invest small amounts of money in each month by using a dividend reinvestment plan (DRIP), so that you can spend those stock dividends after you retire. One advantage of having a long-term horizon is that you don’t need to worry about overpaying or underpaying for those shares each month. Why? Because you’ll be “dollar-cost averaging.” That means your price per share shows “reversion to the mean” long-term rate of price appreciation; each stock develops its own “signature” rate after a decade or two of trading. 

Safety has many facets but for our Watch List we have to pick one metric that distills those factors. We’ll use the Standard & Poor’s credit rating for long-term company debt (Column N in our Table), and exclude any companies that have less than an A- rating. Most companies are willing to pay S&P to assign a rating, even if the company doesn’t currently issue long-term bonds (just in case it might want to someday). An A-rating from S&P is the finance industry’s "Good Housekeeping Seal of Approval."  

That leaves one problem unaddressed: Why should we create a Watch List. What’s the goal? Our goal always is to find well-managed companies that raise their dividend annually, since that growth rate translates into your annual dividend pay raise after you retire and start cashing those checks (see Column H in the Table). We’re also looking for companies that have a Durable Competitive Advantage (Column Q in the Table), referencing a method created by Warren Buffett (see Week 135). 

Finally, we’re looking for hedge stocks (see Week 117). Our definition for a hedge stock is evolving. At the moment, it is a stock that a) beats the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles), b) loses less than the 28% that VBINX lost during the 18-month Lehman Panic, c) has a 5-yr Beta that’s less than the 0.67 average for the hedge fund industry, d) pays at least a 1.5% dividend, and e) has a trailing P/E no higher than 20. Why all those requirements? Because each one acts to discourage a hedge fund trader from shorting the stock.

Bottom Line: Our Watch List has 69 companies (Table), most of which are risky. You see that from the extent of losses during the Lehman Panic (Column D) and the 5-yr Beta (Column I), where values that show underperformance relative to the benchmark (VBINX) are highlighted in red. But that’s to be expected when you screen for growth. Remember: There are only two known ways to beat the S&P 500 Index: Take on more risk, or trade on the basis of insider information. In this country (different from most countries in the world), you’ll land in jail if you trade on insider information (remember Martha Stewart?). That leaves taking on more risk, which is why Jim Cramer’s stock picks tend to beat the S&P 500 Index. In this week’s blog, we’ve helped you consider a growth company for inclusion in your stock portfolio by excluding any that don’t have at least an A- credit rating. In other words, even if the company’s stock fell a lot the company is still unlikely to wind up in bankruptcy court.

We’ve turned up 24 Dividend Achievers (Column O in the Table), which are companies that have raised their dividend annually for the past 10 or more years. Four more companies are soon to be Dividend Achievers because they’ve increased their dividend annually for 9 yrs: Microsoft (MSFT), Costco Wholesale (COST), Deere (DE) and BlackRock (BLK). There are 6 companies with a Durable Competitive Advantage (Column P) but only two of those are also Dividend Achievers: Ross Stores (ROST) and Wal-Mart Stores (WMT). We found only one hedge stock: Coca-Cola (KO).

Risk Rating: 7

Full Disclosure of active trading in these stocks: I dollar-average into DRIPs for WMT, MSFT, PG, KO, IBM, NKE, and ABT.

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1 comment:

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