Sunday, May 25

Week 151 - “Lifeboat Stocks” for your Rainy Day Fund

Situation: Over time, you will spend a lot of the money that is stashed in your Rainy Day fund (see Week 33 and Week 119). Life has unique ways of generating unbudgeted capital expenses, which frequently require that you choose between two means of payment. Either use credit or use equity (i.e., your Rainy Day Fund). How can you cover those “pop-up” expenses and still avoid destroying your Rainy Day Fund? Remember, a key ingredient in a Rainy Day Fund is Inflation-protected US Savings Bonds (ISBs - see Week 33). Those actually grow 20-80% faster than inflation and offer several tax advantages. However, a quarter’s worth of interest is lost if you cash out an ISB before 5 years have passed. But, let’s face it: ISBs won’t allow you to spend much without depleting your Rainy Day Fund.

A remedy is to add what we like to call “Lifeboat Stocks” (see Week 8, Week 23, Week 50 and Week 106) to your Rainy Day Fund. Those stocks are issued by companies in “defensive” industries--utilities, healthcare, and consumer staples. The reason we make that recommendation is to get a higher total return while giving up only a little safety. That allows the effects of price appreciation and dividend reinvestment to replenish the Fund and keep it growing. The trick is deciding which companies to select for investment. There aren’t many companies that grow steadily and issue a stock that holds up well during downturns (bear markets and recessions) without becoming overpriced during upturns (like the current one). We can find only 12 companies that fit the bill, and 5 of those are electric utilities (see Table). Given that the stock issued by electric utility companies has many bond-like features, you might as well allocate the non-Savings Bond part of your Rainy Day Fund to a “balanced” mutual fund that has a lot of high-quality corporate and government bonds. We recommend the Vanguard Wellesley Income Fund (VWINX, Line 20 in the Table), which is 45% stocks and 55% bonds. Its annual expense ratio is only 0.25%/yr. But you’ll need to make an initial investment of $3,000 to get into the fund; then you can add as little as $100 at a time. So, a combination of 50% ISBs and 50% VWINX is a cheap and convenient way to have a continuously useful Rainy Day Fund.

But many of you want to invest in stocks because they’re interesting and offer a way to beat inflation and taxes, as long as you keep your transaction costs low and reinvest dividends. So, you’ll want to know how we picked the 12 stocks in the Table. Firstly, they had to have very good S&P credit ratings and be Dividend Achievers (S&P’s name for companies that have raised their dividends annually for 10 or more yrs). More importantly, they had to perform better than our benchmark (The Vanguard Balanced Index Fund, VBINX) over both the long term (10+ yrs) and short term (5 yrs) without losing as much as VBINX did during the 18-month Lehman Panic, which was 28%. But we bend those rules a little if there is outperformance in another area, like volatility (5-yr Beta) or valuation (P/E). Red highlights are used in the Table to denote underperformance relative to VBINX.

Bottom Line: A Rainy Day Fund won’t be of much use to you unless it includes stocks.

Risk Rating: 2.

Full Disclosure: For my Rainy Day Fund, I dollar-average into ISBs, WMT, JNJ, and NEE. It also contains shares of PEP and GIS, as well as standard US Savings Bonds--EESBs, which the US Treasury guarantee to at least double your money if you hold them for 20 yrs (total return = 3.5%/yr).

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Sunday, May 18

Week 150 - Our Current List of Hedge Stocks

Situation: Our favorite way to look at risk is to make a guesstimate of what would happen to retirement investments in a bear market. Recall that a bear market occurs when the S&P 500 Index falls more than 20% from its most recent peak. That’s a different question than calculating what happens to those investments in a recession. Why? Because bear markets, such as the one-day 22% collapse in 1987, don’t necessarily presage a recession. The famed economist Paul Samuelson once quipped that “the stock market has called 9 of the past 5 recessions.” 

Some of the stocks in your portfolio need to be “downturn resistant” because, during a downturn, you are more likely to have financial difficulties and need to sell some assets to tide you over until better times. Perhaps you’ll have enough Treasury Notes and Savings Bonds for those to act as a safety net. If not, you'll need to either sell some stocks, or go deeper in debt. If you decide to sell some stocks, you’d rather not take a loss. The idea of having a few such Hedge Stocks is that those are unlikely to show much price depreciation in a market downturn. Even Warren Buffett, who counsels investors never to close out a good position, sold his entire large block of Johnson & Johnson shares going into the Lehman Panic. The proceeds were used to help assemble $26B in loans to six companies that badly needed capital (General Electric, Goldman Sachs, Bank of America, Dow Chemical, Swiss Re, and Mars Candy). His first loan of $5 Billion was to Goldman Sachs on 9/24/08--9 days after Lehman Brothers Holdings filed for bankruptcy. That heralded the Federal Government’s “bailout” of Wall Street banks in mid-October 2008, using almost half the $700B in “TARP” funds that was for a different purpose (i.e., to buy up mortgage-backed securities from the 7 surviving Wall Street banks). Warren’s timely display of confidence in Wall Street probably had more to do with averting another Great Depression than did the dollar amount of all the loans. Remember: Confidence in a company’s future is what impels investors to buy stock, not it’s balance sheet.

What else makes a company’s stock price go up or down? We need to examine that before we can understand the idea of a hedge stock. There are really only two factors to consider: 1) Is the stock over-priced? 2) Is the story broken (e.g. will the company collapse in a market panic)? “Overpriced” means that the 5-6%/yr rate of return realized by cautious investors throughout recorded history no longer applies. Note: that expected rate of return will stick close to the nominal rate of GDP growth, which in the USA has been 5-6% until recently. In other words, the price for a share of stock has to be less than 20 times the most recent 12 months of earnings per share to realize more than a 5% return. With lower returns, there is a valuation problem and hedge fund traders will be drawn to bet against (or short) the stock. You can easily find out if the P/E is over 20 by checking Yahoo Finance on your smartphone.

The second question is much harder to assess: Does the story that supports confidence in a company’s future stream of earnings still apply? Or is the story broken? This terminology dates to medieval Italy, where a banker would sit at a bench (banca) in the town square. If he ran out of money, the bench would be broken in front of him (banca rotta), later transliterated to “bankrupt.”

For any widely-held company, there is always a steady production of articles, blogs and TV commentators pointing to “factlets” suggesting that the story is broken. That’s how media outlets attract advertisers and readers (i.e., by creating anxiety). Quite simply, it is human nature to undermine a money-making story, particularly when you haven’t been a beneficiary. 

This makes it important to do your own “story” research for stocks that you own or want to own. For hedge stocks, researching the story is a little easier because they’re never “barnburners.” There’s no chance they’ll light up the investment universe, except of course for the “bond gnomes” off in a corner who would happily loan money to such companies. In a bull market, hedge stocks struggle to keep up with the S&P 500 Index but over the long term they’ll probably make money for their shareholders because of being downturn-resistant. When the stock market cracks, these companies don’t. Thus, it turns out that hedge stocks are not that hard to research. Their history of performance is one of limited price fluctuations, whether the market is headed up or down. 

We use the hedged S&P 500 Index as our benchmark and guide for finding hedge stocks. These stocks are buried in that hedged index (The Vanguard Balanced Index Fund  or VBINX). It is hedged in both directions: You are insulated from a market crash by its 40% allocation to high-grade bonds. Likewise, you benefit from market exuberance because the 60% allocation to stocks references an index of the 1000 largest companies. In other words, riskier mid-cap company stocks are included. Their high 5-yr Betas pull VBINX’s 5-yr Beta up to 0.91 from 0.6, which is where you’d expect for an index composed of 60% S&P 500 stocks and 40% high-grade bonds. That "balanced fund" strategy works because VBINX sank only 60% as far as the S&P 500 Index during the Lehman Panic (Column D in the Table), and has performed 50% better since 9/1/00, which is when the S&P 500 Index reached its inflation-adjusted high.

We also look for other metrics that are likely to prevent a hedge fund trader from betting against a company’s stock. These include: a dividend yield of at least 1.5%, outperformance relative to VBINX over both the short-term (5 yrs) and long-term, a P/E no greater than 22 (for the last 4 quarters of reported earnings), a Finance Value (Column E in the Table) that beats VBINX, a 5-yr Beta under 0.7, and an S&P bond rating of at “A-” or better. Metrics that underperform VBINX are highlighted in red.

Bottom Line: The value of owning a hedge stock is that you don’t need to hedge your downside risk by making an equivalent investment in a 10-yr Treasury Note or an inflation-protected Savings Bond. But our screen of S&P 500 companies turns up only 15 hedge stocks, even after bending our standards a little (Table). Twelve of the 15 are in “defensive” industries--utilities, consumer staples, and healthcare. Those 12 are what we call “Lifeboat Stocks” (see Week 106). McDonald’s (MCD), VF Corporation (VFC), and IBM are the only exceptions. If the market were not currently going through an overpriced moment, more companies would qualify. Of course, after a market collapse our search will become easier but that will also be when everyone (aside from Warren Buffett) is averse to investing. He has put a fine point on it: “Only when the tide goes out do you discover who's been swimming naked.”

Risk Rating: 4.

Full disclosure: I dollar-average into DRIPs at for WMT, NEE, IBM, JNJ, and KO.

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Sunday, May 11

Week 149 - Stock Selection: Start with one for each S&P Industry

Situation: Investing looks like such a cool thing to do. It’s maybe even a way to make money without slacking at our day jobs, that is, by doing the necessary research on Sunday morning over coffee. I started that way 40 years ago, and then found out that the “fun stuff” doesn’t work. In other words, you can’t “guesstimate” where markets are headed. Why? Because the only way to build a base of investing knowledge is to study the past. Unfortunately, as Mark Twain said, “history never repeats itself.” In particular, you can’t estimate which of the 10 S&P industries is going to take the lead over the next few years. Sure, we’re sort of emerging from a recession by fits and starts. Typically, that would mean that the Consumer Discretionary industry would take the lead, followed by the Information Technology and Financial industries. But with the numbers for structural unemployment being up in the teens (when you include people who’ve given up looking for work), where will we get enough consumers to buy all that newly produced stuff? Structural unemployment takes a long time to wind down. Why? Because it is both expensive and time-consuming to retrain displaced workers to do the new types of jobs. It’s easier for companies to simply train workers in foreign countries, like India, where labor costs are lower.

But really, no one knows how the future will play out. Even something as straightforward as interest rates can’t be estimated going forward by examining historical data. In other words, the cost of money you will use to invest isn’t known: Will it go up or will it go down? What this means for the long-term investor is that we need to avoid speculation and simply place small but growing bets on all sectors of the economy. Here at ITR, we suggest that you start by building up positions in key stocks through small automatic monthly investments made online, using Dividend Re-Investment Plans (DRIPs). 

In this week’s Table, we’ve chosen one company for each S&P industry, namely the company that is highest ranking by Finance Value in the Universe of 63 companies that we’ve found to be acceptable for long-term accumulation (see Table for Week 122). If the company chosen for a particular industry doesn’t have a projected rate of return (dividend yield + dividend growth) that exceeds the market rate (6.8%: VFINX), we chose the company with next highest Finance Value. Similarly, if a company’s 5-yr Beta (measuring volatility) is more than 20% higher than the market rate of 1.00, we chose the company with the next highest Finance Value. Remember: each of the companies in the Table for Week 122 has all 3 of the characteristics that we value most highly: 1) Inclusion in the Barron’s 500 Table of companies that show steady growth in cash flow from operations, as well as recent growth in sales; 2) Inclusion in the S&P list of Dividend Achievers--that have grown dividends for 10 or more yrs; 3) a long-term S&P credit rating of “A-” or higher. 

And the winners are:
        Consumer Staples: Wal-Mart Stores (WMT);
        Healthcare: Abbott Laboratories (ABT);
        Utilities: Southern Company (SO);
        Telecommunication Services: AT&T (T);
        Consumer Discretionary: Ross Stores (ROST);
        Information Technology: International Business Machines (IBM);
        Industrial: WW Grainger (GWW);
        Financial: Chubb (CB);
        Materials: Monsanto (MON);
        Energy: Chevron (CVX).

Stock in most of those companies can be purchased online while starting a DRIP. However, to make an initial purchase in CB, ABT, ROST or GWW you’ll need an online broker such as TD Ameritrade or Merrill Edge, where trades cost $6.95, or a local discount broker such as Edward Jones, where a typical trade costs $54.90. Once you have accumulated a few shares, there are various online services like Computershare that allow you to use those shares to start a low-cost DRIP. 

Remember that red highlights in the Table denote underperformance relative to our key benchmark, the Vanguard Balanced Fund (VBINX). For example, AT&T (Line 11 in the Table) has a rate of growth since the market peak on 9/1/00 (Column C) that is approximately the same as the market’s rate (VFINX in Line 24) but somewhat slower than our benchmark’s rate (VBINX in Line 22). 

Bottom Line: Your investments need to be distributed across different sectors of the economy. If you live in the US, you can be well diversified without investing in foreign markets because US corporations are active in markets worldwide. What’s not to like about building a portfolio that reaches into every sector of the economy? Well, people at social gatherings will wander away if you start talking about investments. They’re seeking information about “hot stocks” and will soon realize that you’re an “old-stick-in-the-mud” who cares little about whether the stock market is up or down this month.

Risk Rating: 4.

Full Disclosure of my investing activity relative to stocks in the Table: I dollar-average into DRIPs for WMT, ABT, and IBM each month, and also own stock in Monsanto, Chevron, and Berkshire Hathaway.

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Sunday, May 4

Week 148 - Utilities and Railroads

Situation: We all know that it’s not a good idea to invest in a company that has high fixed costs AND variable costs that are both high and unpredictable (e.g. energy sources). Prominent examples of such companies are railroads and electric utilities. While those impediments to investing normally would make it difficult to attract financing at a reasonable cost, politicians recognize that rail transportation and electricity are essential public services. As a result, these industries have come to be tightly regulated. In return, company shareholders know they’ll get a return on equity that is 9% or greater, their bonds will have a degree of government backing, and rules against monopoly power will be waived. 

Importantly, Warren Buffett has come to see that the advantages of investing in rail transportation and electricity producers outweigh the disadvantages. Berkshire Hathaway now owns the largest railroad in the country (Burlington Northern Sante Fe), as well as what will soon be the largest electric utility (MidAmerican Energy). Both subsidiaries are growing at a remarkable pace, in large part because Mr. Buffett requires them to invest 100% of their free cash flow in expansion (i.e., no dividends are paid to the parent company). In Berkshire’s recently issued annual report, we see that a whopping 78% of its pre-tax earnings came from those two subsidiaries. We also see that Mr. Buffett considers them to be so similar that he groups their results together.  

To participate in the smoothly growing total returns that reward investors in the leading electric utility and railroad companies, you can simply invest in Berkshire Hathaway B shares (BRK-B), priced at around $125, or you can consider the 8 companies in this week’s Table. Those 8 companies were picked because of a) placement on Barron’s 500 list of companies with the best sales and cash flow growth, and b) having an “A-” or better S&P rating on their long-term debt. Six of the 8 are Dividend Achievers with 10 or more years of dividend growth. The two exceptions will become Dividend Achievers in a little less than one year (D) or a little less than 3 years (UNP). We list Canadian National Railway (CNI) as a Dividend Achiever even though S&P doesn’t list it (due to its being based outside the US) because its record of dividend growth qualifies it for inclusion.

Bottom Line: Don’t overlook electric utilities and railroads. Yes, both are heavily regulated by federal, state and local governments but politicians have learned not to interfere beyond making sure that these monopolies don’t harm, neglect, or take advantage of their customers. Total returns for the 8 companies in the Table are expected to grow at 12.4%/yr (Column G + Column H in the Table), consistent with having grown at 12.9%/yr over the past two market cycles, i.e., the time since the S&P 500 Index peaked at 1520.77 on 9/1/2000. Over that same period (ending in March 2014), the S&P 500 Index with dividends reinvested grew at a rate of only 3.6%/yr . The 8 stocks in the Table managed their far superior growth while losing only 18.8% during the 18-month Lehman Panic (Column D in the Table), whereas, the low cost Vanguard 500 Index Fund lost 46.5% (Line 20 in the Table). This stunning difference in long-term risk persists to the present day, given the current difference in the 5-yr Beta statistic: 0.36 vs. 1.00 (Column I in the Table). You decide.  

Risk Rating: 3. 

Full Disclosure: I happily own stock in NextEra Energy, Berkshire Hathaway, and Canadian National Railway.

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