Sunday, April 27

Week 147 - Food & Fuel Costs since 1969 vs. Gold, Treasuries, and Stocks

Situation: As an investor, there are several categories (or “classes”) of assets that you can choose for investment. These include: stocks, stock options, bonds, gold, real estate, annuities, life insurance, and commodity futures & options. New sales pitches for each particular asset class are made available with remarkable frequency. However, you will seldom hear or read much about the downside of owning those types of assets. In truth, investing in each asset class supports a different purpose from the others. Aside from stock ownership, if you build a position in an asset class you’re usually engaging in what is referred to as “forced savings.” Why? Because transaction costs, inflation, and taxes will probably eat up all the profit. Home ownership is perhaps the best example of forced savings because the Federal Government makes sure that you’ll come out ahead if you persevere. This is accomplished over the life of a “conforming” 30-yr mortgage. The “price appreciation” of your home is unlikely to beat inflation (recall that over 40% of the Consumer Price Index reflects housing costs) but you will benefit from forced savings (paying the mortgage each month). Why? Because a bank bought 80% of the house with its initial loan, and the Federal Government then guaranteed that mortgage while granting you a big tax break on interest payments. You end up with all the equity, even though others assumed most of the risk. If you bought the house when you were 30, you’ll get to live there mortgage-free and rent-free after you turn 60. If you live to 75, that’s a 45-yr period of building equity in real estate. 

Now let’s examine how other investment choices played out play out over the same 45 year period (see Table). First of all, no bank is going to loan you 80% of the money you need to buy stocks or gold, so cross that right off the list. Nor is the Federal Government going to waive taxes on the interest you pay for any money that a bank loans you. You might get an 80% loan to buy Treasury Notes but you would most likely need to post those Notes as collateral. Even at that, the interest you pay on the loan will likely consume the interest you earn from the Notes. You also can get a 50% loan from your stockbroker to buy stocks but you’ll pay twice as much interest as you would buying Treasury Notes but are you sure you’ll make twice as much?  

What about buying gold? Gold looks attractive to own because it is a currency that can’t lose value (i.e., there’s just enough gold mined each year to keep ounces/person stable). But gold pays no interest, it has high transaction costs, it must be insured, and your capital gains will be taxed the same as ordinary income when you sell it. Gold does go up in value during times of inflation but your transaction and insurance costs will also increase. At that point, you really notice that you’re earning zero income from holding gold. In a deflation, gold falls in value and not by a trivial amount. It’s decrease will be at approximately the same rate as any other commodity. Being a stable-value currency, gold will naturally fall in value whenever the dollar rises in value. From all of this, we conclude that gold is nice to own during a recession (when transaction and insurance costs are low) but the moment the economy starts to turn around you’ll want to sell it. This will also be the same moment when gold begins to fall rapidly in value. Unfortunately, that sudden drop in the price of gold is also the first clear sign that the economy has turned the corner.

Let’s examine Treasury Notes and Bonds next. This asset class is yet another story when compared to the others. It is the only asset class that rises in value during a bad recession or persistent deflation, but with one exception. That exception is ownership of stock in food purveyors like McDonald’s or Wal-Mart; those stocks will also rise. But when the economy does turn the corner and start expanding, interest rates will rise and bond prices will fall. 

Stocks are the asset you want to hold in an expanding economy. Stocks will even keep up with the rare event of hyperinflation. The problem, however, with stock ownership is found in the Beta statistic. The Beta statistic is pegged to the price quote for the S&P 500 Index, which always has a Beta of 1. What this means is that if a stock climbs in value faster than the S&P 500 Index, it will have a Beta higher than 1. But that also means it will fall faster than the S&P 500 Index in a bear market, and to about the same degree. So, you’ll have to judge your stock purchases from the 3- or 5-yr Beta and keep the 5-yr Beta for your stock portfolio under 0.7 (Warren Buffett’s recommendation).

The Table has total returns for 18 stocks obtained from a screen of Dividend Achievers (10+ yrs dividend growth) among the 65 companies in the Dow Jones Composite Average that have data going back to ~1970 on the Buyupside website. Performance of the S&P 500 Index is given for comparison, as is a 60/40 mix of the S&P 500 Index and Treasury Notes. Stocks clearly outperformed Treasury Notes and Gold over that long-term period and over the past 5 yrs. Gold still managed to beat inflation over both periods, keeping its reputation as an inflation-fighter (before accounting for the costs of ownership). Treasury Notes are vulnerable to the “Financial Repression” that central banks worldwide use to drive down interest rates during a bad recession. That makes any T-Notes (or especially T-Bonds) that you already own very valuable if you want to sell them. But the downside is that any new Notes that you buy during a Financial Repression will pay very little interest. NOTE: metrics in the Table that underperform the mix of 60% stocks and 40% T-Notes (line 19) are highlighted in red. 

Bottom Line: Buy stock in 10 or more companies as your main long-term investing strategy. Our recommendation is that you make your purchases online and in small increments using a dividend reinvestment plan (DRIP). That keeps costs down and allows you to benefit from dollar-cost averaging. Try to pick stocks with a 5-yr Beta under 0.9, and keep the aggregate 5-yr Beta of your stock portfolio under 0.7 (that being yet another pearl of wisdom from the Oracle of Omaha, Warren Buffett). Since you’ll retire someday, stick to stock in companies that have a long history of growing their dividend. The advantage to this strategy is that you’ll have a retirement asset (quarterly dividend checks arriving in the mail) that grows quite a bit faster than inflation (see Column H in the Table).

Risk Rating for the aggregate of 18 stocks listed in the Table: 5

Full Disclosure of my current investment activity relative to assets listed in the Table: I dollar average into inflation-protected 10-yr US Treasury Notes, as well as DRIPs for WMT, JNJ, IBM, KO, XOM, and PG.

Post questions and comments in the box below or send email to:

Sunday, April 20

Week 146 - Spring 2014 Master List

Situation: You’d like to have a list of solid stocks to consult for your “personal” retirement plan. That’s the investment plan you're keeping outside of your “workplace” plan. We think you should focus on dividend-paying stocks issued by companies with a long history of increasing their dividend annually. Why? Because the rate those dividends increase at will exceed the rate of inflation (see Column H in the Table). That means the “personal” part of your retirement income will mainly consist of quarterly dividend checks that arrive in the mail, which differs from the “workplace” part of your income because it doesn’t get eaten up by inflation. 

Mission: Come up with a list of stocks that are safe multi-decade investments.

Execution: We’ll start with the list of 54 companies in our “universe” (see Week 122). That list initially held 51 companies but we’ve found 3 more. There are 3 criteria that stocks must meet to be included in the list: 1) be a Dividend Achiever (see with 10 or more consecutive years of dividend increases; 2) be cited in the Barron’s 500 List for outstanding growth in cash-flow based return on invested capital over the past 3 yrs and growth in revenues over the past year; 3) have an S&P credit rating of “A-” or better (see Standard and Poors).

We’ve improved on that list by removing companies that aren’t Dividend Aristocrats (see, i.e., those with 25 or more years of dividend increases, and companies that don’t perform as well as Warren Buffett’s newly-released savings plan for retail investors (see line 45 in the Table): "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions, or individuals -- who employ high-fee managers." What’s that? He writes a letter each year to investors in Berkshire Hathaway as though it were a letter to "non-financially literate" friends who have Berkshire Hathaway stock in their “trusts.” In this year’s letter (part of which is quoted above), he advises readers to simply invest in two of the Vanguard mutual funds, allocating 90% to the Vanguard 500 Index Fund (VFINX in the Tableand 10% to a short-intermediate term bond index fund. (We use IEF in the  Table because he subsequently indicated that the bond fund should exclusively invest in US Treasury issues). He also likes Berkshire Hathaway stock (BRK-A in the Table) but that doesn’t pay dividends, meaning that you’d have to periodically sell some shares to help meet your retirement expenses. 

We have 28 companies left (see Table). Fourteen are in “defensive” industries (utilities, telecommunications, consumer staples, and healthcare); we call those “Lifeboat Stocks” because they don’t sink in bad weather. Five are in the two highest risk industries (Energy and Materials), and the remaining 9 are in “growth” industries (finance, information technology, consumer discretionary, and industrial products). As always, red highlights denote metrics that underperform our favorite benchmark, the Vanguard Balanced Index fund (VBINX), which is essentially a well-hedged (40% bonds) S&P 500 Index fund. Like Warren Buffett, we think you can dispense with investment advisors and simply pick from Vanguard’s index funds. We differ in thinking you should be 40% invested in a general bond index rather than 10% invested in a short-term bond index. But there’s a very high likelihood you’ll make more money in the long run by taking his advice over ours. If, however, you start your retirement during a recession you might find that the 10% you’ve invested in a short-intermediate term bond index (IEF) doesn’t last very long, and you might have to sell some of your stock index fund (VFINX) at a loss to get by.

Bottom Line: Which of the 28 companies should you pick for your personal retirement plan? Well, 3 are what we call “hedge stocks” (see Week 140): MCD, KO and JNJ. Those are good choices because they don’t need to be backed by an equivalent investment in 10-yr US Treasury Notes or Savings Bonds (, both being available in inflation-protected versions. (You can also use the IEF index fund noted above but that doesn’t guarantee return of your initial investment.) We suggest, along with most investment advisers, that you strive for broad diversification. That means start with one stock from each of the 10 S&P industries. Aside from the 3 industries already represented by MCD (consumer discretionary), KO (consumer staples) and JNJ (healthcare), you’ll want to consider ED (utilities), T (telecommunications), CB (financials), GWW (industrials), ADP (information technology), XOM (energy) and NUE (materials). 

Risk Rating: 4.

Full Disclosure of current investment activity relative to stocks in the Table: I dollar-average into Dividend Reinvestment Plans at for XOM, KO, JNJ, ABT, WMT and PG.

Post questions and comments in the box below or send email to:

Sunday, April 13

Week 145 - Commodity Plays for Long-term Investment

Situation: You know that demographers expect the world’s population to reach 9 billion within 40 yrs. This will require a build-out of infrastructure that will severely tax commodity production in order to provide needed transportation fuels, electrical power, building materials, food, and water. Conservation of resources has to be a central theme, and will be achieved by taxation, cap & trade schemes, and oppressive regulations. Nonetheless, commodity producers will enjoy pricing power for their goods. As a savvy investor, you probably would like your investments to benefit in some small way from that bounty. But you also know better than to speculate in “futures” for raw commodities. The next best choice is to own stock in companies that produce and fabricate commodities for sale, or package such goods into products that are useful to consumers. Transportation companies sit right in the middle of all that, with railroads being the most consistently profitable.

Those of us who are “buy-and-hold investors” are hoping to ease retirement with quarterly dividend checks that grow faster than inflation. Here at ITR, our mission this week is to guide you into commodity-related stocks that have less volatility than commodity futures, AND are issued by investor-friendly companies. Such companies have a dividend history that combines a reasonable payout with annual increases. 

In developing this week’s Table, we’ve only considered companies that are in both the S&P 500 Index and the 2013 Barron’s 500 list. You’ll recall that the Barron’s 500 list rank orders companies by a) recent sales growth, and b) 3-yr growth in cash-flow based return on invested capital. We’ve excluded companies with a dividend yield of less than 1.5%.

There are 20 commodity-related companies for you to consider (Table). Twelve are food-related, which should tell you something. Thirteen are Dividend Achievers (Column N); those have 10 or more consecutive years of dividend increases. We excluded any companies that have a Finance Value (Column E) less than our benchmark, which is a hedged S&P 500 Index fund: Vanguard Balanced Index Fund (VBINX). But some other company metrics also perform less well than VBINX; those metrics are highlighted in red.  

Bottom Line: Raw commodities fluctuate widely in price, given the large investment and long lead times that companies face to supply the market during “good” years. Those companies will only invest in expansion if commodity reserves have fallen for years and demand is growing. That market signal prompts investment by a number of producers who are in close competition. So, pent-up demand followed by growing production eventually results in a “supply glut.” The fortunes of every company along the supply chain will rise and fall accordingly, with the exception of food companies. Why are food companies the exception? Because food is a necessity. Such companies are classified by S&P in the least-volatile industry (Consumer Staples), whereas, mining and drilling companies are in the most volatile industries (Energy; Materials).

Risk Rating: 5.

Full Disclosure of current investment activity relative to the Table: I dollar-average into XOM.

Post questions and comments in the box below or send email to:

Sunday, April 6

Week 144 - An All-stock Savings Plan with no Transaction Costs after Initial Set-up

Situation: Here at ITR, we recommend that you plan for retirement by using workplace savings plans supplemented with an IRA composed of online dividend reinvestment plans (DRIPs), i.e., stock in companies that reliably grow their dividends. (Your accountant needs to declare to the IRS that those DRIPs are IRA investments, and you need to stay within the annual limits for IRA investments.) The reasons behind using DRIPs are to minimize cost and risk, since those are the factors that most often trip up investors by eating up returns. This week’s blog takes that idea to its logical conclusion by presenting DRIPs that have no ongoing costs after initial set-up. In other words, the company is paying all of the transaction costs as a way to retain your loyalty. But you might ask, “How does that help me reduce the inherent risk of owning stocks?” That’s the compelling part of the story, because the few companies that are willing to cover your expenses happen to be some of the same companies that we routinely highlight for reducing investor risk over the decades. 

What’s not to like? Well, there are very few such companies. We’re aware of only eight (see Table). The DRIPs for all but 3 of those are serviced by computershare with the 3 exceptions being Hormel Foods (HRL), 3M (MMM), and General Mills (GIS), which are serviced by Wells Fargo. Navigating those websites to discover the option that saves you from paying ongoing costs can be a little tricky. For example, it costs a dollar a month to purchase JNJ shares automatically by having the investment dollars taken from your checking account, but if you go into the website to make a purchase each month, it’s free. 

You’ll notice that 3 of the 8 companies are from the “consumer staples” industry (HRL, GIS, PG). For this reason, we have added an exchange-traded fund (ETF) for that industry to our BENCHMARKS for comparison: VDC. Why do companies in the consumer staples industry do so well? After all, these mature companies have long produced boring products that offer little opportunity for innovation. Where have you heard this before? Oh, yeah! That’s the kind of company Warren Buffett likes. In other words, companies that sell "essential goods" don’t have much to worry about during a recession, and quickly recover from their small losses when the recession ends.

Bottom Line: Company CEOs tend to overlook costs during a bull market but then find they have to rigorously control costs in order to survive a bad recession. Many more of their employees will have to be laid off than would have been the case if those CEOs had rigorously controlled costs during good times. It’s a problem of human nature, not capitalism. We all feel expansive when our savings grow expansively, viewing costs as a small fraction of our gains. But as investors, costs are the only expense we can control (we certainly do not control inflation or taxes). Why not minimize transaction costs and management fees to the extent possible? After all, the average investor gives up over 2% of the net asset value of her holdings each year to those charges. Let’s take a hypothetical example: You’re 70 yrs old now and at age 20 you invested $5,000. If your assets were under management, those assets were documented to have had an average growth rate of 7%/yr over the next 50 yrs. Accordingly, you should have $150,000 to spend. But wait, there’s only $58,500 in that account because you paid an average of 2%/yr for each of those 50 yrs in transaction costs and management fees. Inflation averaged 4.1%/yr, so now you’re left with only 0.9%/yr in real gains (7 - 2 - 4.1 = 0.9). And that isn’t even accounting for taxes. Instead, we suggest that you try online DRIPs that have no ongoing transaction costs or management fees, and charge minimal fees for initial set-up and final sale.     

Risk Rating: 5, unless investment in each of the riskier items (XOM and MMM) is offset with an equal investment in inflation-protected Treasury Notes or Savings Bonds at treasurydirect, which brings the risk rating down to 3. 

Full disclosure of my current investment activity as related to companies in the Table: monthly additions to DRIPs in XOM, PG, JNJ, ABT, and NEE.

Post questions and comments in the box below or send email to: