Sunday, June 29

Week 156 - The Buffett Plan vs. the Top 34 Stocks in Our 63-Stock Universe

Situation: Let’s face it. Here at ITR we recognize Warren Buffett as the “Oracle of Omaha” and endorse his maxims for the retail investor. But up to now, we haven’t explained exactly what those maxims are.

Investing in stocks takes time, and the ability to accept errors as you climb the learning curve. Small investors are in a tough place because they have neither the resources nor advanced knowledge of professionals. What words does Mr. Buffett have to offer us? Let’s look at the maxims: On 5/3/14, at the annual meeting of Berkshire Hathaway, an investor asked Mr. Buffett if she should buy Berkshire Hathaway stock, invest in an index fund, or hire a broker. Warren’s answer was: "We never recommend buying or selling Berkshire. 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 yrs) you'll do better than 90% of people who start investing at the same time." In response to another questioner, he said: "If you like spending 6-8 hours per week working on investments, do it. If you don't, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things." At another juncture, he said: "Just pick a broad index like the S&P 500. Don't put your money in all at once; do it over a period of time. I recommend John Bogle's books. Any investor in funds should read them. They have all you need to know." John C. Bogle is the founder and retired CEO of Vanguard Group. His most recent book is “Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.”

Before the Annual Meeting, Mr. Buffett sent out his usual letter to investors, taking care to address them as honest and willing beginners who have set up a Trust for their heirs: "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." Again, Warren bluntly points out to us that costs are the main issue. Avoid those, let a computer make all the decisions, and you’ll do fine.

Here at ITR, we take a slightly different approach for our one and only specific recommendation. Invest in a very low cost S&P 500 index fund but choose one that is hedged. So, the Vanguard Balanced Index Fund (VBINX) is our benchmark. Readers with neither the time nor the compulsivity needed to pick stocks should dollar-cost average into VBINX. It hedges against the risk that the S&P 500 Index will overshoot in either direction, up or down. You’re buffered against a stock market crash because it invests 40% of assets in a broad-based, high quality bond index. You’re buffered against the “opportunity risk” of not capturing the successes of a booming economy because it invests 60% of assets in a stock index that moderately expands beyond the S&P 500 companies to include international and smaller companies

The result? VBINX lost only 28% of its value during the 18-month Lehman Panic, whereas, the Vanguard 500 Index Fund (VFINX) lost 46.5%. And, by not losing as much during the last two recessions, VBINX has returned 5.0%/yr to investors since the S&P 500 Index reached its inflation-adjusted all-time high on 9/1/00, compared to the 3.4%/yr total return for VFINX (see Week 155). Like the Buffett Plan (Line 49 in the Table), VBINX has a 5-yr Beta of 0.9 (Column I). In other words, it has 90% of the volatility of the S&P 500 Index, meaning you’ll be in for a bumpy ride. Our recommendation is that you build a Rainy Day Fund and resupply it promptly after any withdrawal (see Week 119). To get a significantly less bumpy ride from a broad-based low-cost mutual fund, your best bet is to dollar-cost average into the bond-heavy, advisor-managed Vanguard Wellesley Income Fund (VWINX). It has a 5-yr Beta of 0.51 and lost only 16% during the Lehman Panic, while beating both VBINX and VFINX since 9/1/00 by returning 7.7%/yr (see Week 155). 

In this week’s Table, we compare results for VBINX and VFINX by going back 8 more years, to 9/1/92. We include results for the top 34 stocks in our 63-stock Universe (see Week 155), i.e., those with a Finance Value (Column E) that beats our benchmark (VBINX). The starting point for our analysis (9/1/92) was when the US economy was slowly emerging from the July 1990-March 1991 recession, similar to the current situation. This upturn hit its inflation-adjusted market peak on 9/1/00, and was followed by two recessions. In other words, this week we’re looking at total returns (Column C) from 3 complete market cycles vs. two and a half. 

In September of 1992, the US (and the world) was beginning to emerge from a recession triggered by the collapse of the Savings and Loan industry. Here is the Wikipedia summary of events: “On Black Monday of October 1987, a stock collapse of unprecedented size caused the Dow Jones Industrial Average to fall by 22.6%. This collapse, larger than that of 1929, was handled well by the economy, and the stock market began to quickly recover. But in North America, the lumbering savings and loans industry was beginning to collapse, leading to a savings and loan crisis that put the financial well-being of millions of Americans in jeopardy.” 

Over 3 market cycles, returns for the inflation-corrected S&P 500 Index fund (VFINX) should align with 135-yr returns of the inflation-corrected S&P 500 Index, and they do (see Lines 50 and 52 in the Table): 6.6%/yr for VFINX vs. 6.6%/yr for the inflation-corrected 135-yr returns for the S&P 500 Index. The Buffett Plan had inflation-corrected returns of 6.1%/yr since 1992 vs. 5.6%/yr for VBINX and 6%/yr for VWINX. The secret ingredient of these outstanding returns is the expense ratio, which in every case is less than 0.25%/yr whether you are investing a lot or a little.

Now for a word about inflation-adjusted returns for the top 34 stocks in our Universe (see Table). Sure, these were great over the past 22 yrs: ~8%/yr for defensive stocks and ~12%/yr for growth stocks. But to an accountant they don’t compare that well with the ~6% inflation-adjusted return for the hedged S&P 500 Index fund (VBINX). Why not? There are two reasons: 1) Nobody is going to be prescient or compulsive enough to hold similarly valued shares of all 16 defensive stocks and all 18 growth stocks, so an accountant would point out that sampling errors and selection bias are distorting any one investor’s portfolio (a big disadvantage compared to an index fund); 2) transaction costs are material, meaning that the long-term expense ratio of at least 1%/yr is more than 5% of long-term returns, even in our best-case scenario which assumes that our hypothetical investor builds her entire portfolio online by dollar-cost averaging into dividend reinvestment plans (DRIPs). You’d have to put in 6-8 hours a week and become quite skilled at stock-picking to beat VBINX by 2%/yr over two market cycles.

Bottom Line: Warren Buffett is right, of course, when he says that 90% of small investors will be better served by sticking to Vanguard index funds, particularly the lowest-cost S&P 500 fund (VFINX). The Buffett Plan (see Line 49 in the Table) beats our benchmark (VBINX) over the past 3 market cycles. However, our benchmark beats it on a risk-adjusted basis (see Columns E & I in the Table). And, a low-cost bond-heavy Vanguard mutual fund (VWINX) beats both on a risk-adjusted basis, as does Berkshire Hathaway (BRK-A). Top-performing stocks from our 63-stock Universe (see Table) do a lot better but come with a trifecta of impediments for the stock-picker, including: selection bias, sampling error, and transaction costs.

Risk Rating is 4 for VWINX, BRK-A, VBINX and The Buffett Plan if opportunity cost is included. There is no material difference between these 4 from an accounting point of view but you’ll sleep best with VWINX. Stocks with similar sleepytime advantages include MCD, JNJ and WMT, as well as 4 utility stocks (NEE, XEL, ED, SO).

Full Disclosure of current investment activity relative to items in the Table: I dollar-cost average into T-notes as well as DRIPs for JNJ, XOM, NKE, IBM, KO, NEE, WMT, and ABT.

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Sunday, June 22

Week 155 - 41 of the 63 Companies in Our “Universe” Have Improving Fundamentals

Situation: We can all agree by now that the stock market is overvalued, and will likely remain so until lost jobs are recovered. In the meantime, you need to continue building your retirement nest egg. As always, there is a need to diversify your holdings but now you have the added problem of buying into an overpriced market.

How do we help you find good value for the money you’ll be putting down? Central banks around the world have made bonds an unrewarding investment, which encourages investors to buy stock instead. That has worked to boost the world economy to an extent, and many companies have found a way to do well even though millions of workers remain unemployed. In this week’s blog, we highlight 41 companies typifying that improved outlook. We culled those from our “universe” of 63 companies (see the Table for Week 122). Those were chosen because they’re among the 500 largest companies by revenues in the US and Canada (the Barron’s 500 List) but also because they’re Dividend Achievers with 10+ years of dividend growth AND have strong balance sheets with an S&P bond rating of A- or better. To summarize, we cut the list of 239 Dividend Achievers down to 63 by screening for size (large) and safety. But how does that help us find QUALITY?

You’ll remember that the Barron’s 500 List has special value  because it ranks companies by a formula that has 3 inputs: 1) sales growth over one year, 2) cash-flow based ROIC (return on invested capital) growth over 3 yrs, and 3) average ROIC over 3 yrs. The just-published (5/5/14) 2014 edition of the Barron’s 500 List gives us the information we need. It assigns a rank for each company’s performance over the past year and compares that to its rank for the previous year (Columns M and N in the Table). The 41 companies in the Table are the ones from our “universe” of 63 that have either improved their rank over the past year or were in the top 200 for both years. Those 41 are where you want to focus your research because “the trend is your friend”, which is perhaps the most important maxim of stock trading.

The Table provides other information that you’ll find useful, such as the website for setting up a dividend reinvestment plan (DRIP) for each stock, where you can make automatic monthly contributions from your checking account (Column P, titled “DRIP vendor”). But you’ll be distressed by Column J (P/E), which shows just how good investors have been at moving money into companies because of the improving fundamentals that we highlight here, i.e., sales growth that efficiently converts into ROIC growth. 

You’ll want to take a keen interest in the few companies that don’t have their P/E (Column J) highlighted in red, because that means the investor pays less for a share in each dollar of earnings than she would by investing in shares of our benchmark--the Vanguard Balanced Index Fund (VBINX) on Line 53. And, of course, you’ll want to bypass companies with a Finance Value (Column E) highlighted in red, unless you’ve learned a great deal about them that justifies your placing a bet. Those two steps leave you with 9 tickers to consider: ED, XEL, JNJ, ROST, MCD, CB, IBM, LMT and ACE. That’s not bad--notice that 3 “blue chips” are still on the bargain shelf: Johnson & Johnson (JNJ), McDonald’s (MCD), and International Business Machines (IBM). Those 3 don’t excite the kind of speculation that sends P/E values to the roof, which makes them excellent choices for the DRIP investor (although IBM did get pricey in the runup to the “” crash of 2000). 

Bottom Line: When markets are overpriced, we need to select stocks carefully and build our positions slowly through “dollar-cost averaging”, by adding a fixed amount of money each month. By using online dividend reinvestment plans (DRIPs), you can add $50-100/mo while keeping transaction costs in the 1-2% range; dividend reinvestment is typically cost-free. Eventually, there will be a market correction (or even a bear market). Then you’ll be buying more shares with the fixed amount you invest each month. Over time, prices will revert to each stock’s long-term growth rate, so you needn’t worry about paying too much. Just keep the automatic monthly investments going when the market is down and appears to be headed even lower. (Sort of counter-intuitive, isn’t it??) Try to make regular additions to 10 DRIPs, one for each of the 10 S&P industries noted in Column O (see Week 149).

Risk Rating: 4

Full Disclosure of current investment activity relative to stocks in the Table: I make monthly additions to DRIPs for JNJ, IBM, NEE, and NKE.

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Sunday, June 15

Week 154 - Healthcare Companies

Situation: Stocks issued by healthcare companies are safe and rewarding investments. Why? Because healthcare goods and services are essential in good times and bad, and prices for those goods and services increase faster than the Consumer Price Index. Also, the healthcare sub-industry is a branch in the Consumer Staples industry, which is the least risky of the 10 S&P industries.

But the Affordable Care Act (ACA) has upended all that. Stocks issued by healthcare companies have become dice in a floating crap game. No one knows how many of the 40 million previously uninsured citizens will buy subsidized health insurance, nor do we know how much they will utilize the medical care system. But if 30-35 million do participate, there’s going to be a doubling of revenues in healthcare companies across the board--given that most of that demographic is chronically ill. That is why stock in healthcare companies is now being priced at imprudently high multiples of the past year’s earnings, with P/E ratios running in the 30s. Those stocks are priced as though the bonanza will happen next year. Common sense and math tell us that can’t happen. This means a lot of “hot money” has entered the market, and that hot money can be counted on to leave the market just as fast. You, the cautious long-term investor, will be left holding the bag of shares that may be worth less than you’d paid. However, long-term investment strategies, such as those we employ, caution you to not be too fast to sell those shares. Better earnings will lift their value over the next decade, and probably a lot.

For this week’s Table, we’ve pulled all the healthcare stocks out of two databases: the Dividend Achievers list, and our own Watch List (see Week 139). That exercise yielded 13 companies but we cut 3 because they had an S&P Bond Rating lower than A-. As always, red highlights denote underperformance vs. the Vanguard Balanced Index Fund (VBINX), which is our benchmark.

Bottom Line: This is not a good time to start a new position in healthcare stocks. But if you do, invest small amounts regularly through a Dividend Reinvestment Plan (DRIP). That way, you won’t be hung out to dry when the “smart money” investors sell. If you continue making regular purchases, you may find yourself buying stock in a fine company at illogically depressed prices. You’ll be accumulating much shares faster, and your dividends will grow quicker. Company earnings will still be on an upward path, and annual dividend increases will likely grow at a faster rate than before the ACA. Healthcare stocks will continue to be a good investment, just scarier. 

Risk Rating: 7

Full disclosure: I dollar average into DRIPs for JNJ and ABT, and also own shares of BDX.

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Sunday, June 8

Week 153 - Water Utilities

Situation: You know that water is the major component of food, and essential to life. But it is also a main ingredient for a lengthening list of modern-day wonders such as hydraulic fracturing (“fracking”), server farms, and extracting oil from tar sands. The price for a liter of water is rising faster than the price for a gallon of gasoline. Cities in the southwest US, where a drought is entering its 5th decade, struggle to provide enough drinking water to growing numbers of residents. Wichita Falls, Texas, has resorted to recycling toilet water; San Diego, CA, has resorted to recycling sea water. Water utilities produce an essential good that inflates faster than the Consumer Price Index. Other sub-industries sharing that distinction are food processing (see Week 152) and healthcare (see next week’s blog).

Farmers in the US have managed to sidestep the crisis by digging ever deeper wells and more of them to supply water to center-pivot irrigation systems. Those meter out groundwater to rotating sprinklers, which cuts water usage 40% compared to “flood irrigation” based on canals. But aquifers are being depleted, especially in Texas and California where farm production is in long-term decline.

For this week’s Table, we examine water utilities among the Dividend Achievers. Those utilities have increased dividends annually for the past 10 or more years but there are only 4 that make our list. So, we have had to cast a wider net--looking for future Dividend Achievers--and found a winner. American Water Works (AWK) has increased its dividend annually since the stock was listed in August of 2008. Along with Aqua America (WTR), AWK supplies water for “fracking” the Marcellus Shale, which extends from West Virginia up through Pennsylvania and eastern Ohio to southern New York State. For both companies, that is the fastest-growing part of their business.

Bottom Line: You’ll want to think hard about investing in a water utility. Why? Because the stock will hold its value during a recession but also reflect earnings outperformance during an expansion.

Risk Rating: 3.

Full Disclosure: I have stock in AWK.

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Sunday, June 1

Week 152 - Food Processors in the S&P 500 Index

Situation: How many people think that they know a way to beat the S&P 500 Index? We keep saying that it can’t be done, not even over as few as two market cycles. If you are one of the ones who have made it a goal to beat the S&P, why not aim for the consolation prize? Namely, take Warren Buffett’s advice and invest in the lowest-cost S&P 500 Index fund from Vanguard (VFINX). The next best choice after this would be to invest in food processors. Yes, I know. We’ve said that before, too.

The S&P 500 Index has 19 such companies (see Table). Those companies typically outperform the S&P 500 Index but are also valued 10% higher than the Index (see Column J in the Table). That is acceptable because food prices have been growing more than 10% faster than inflation for a long time, and the gap is growing: Over the next two years, the US Department of Agriculture expects food prices to increase 3-4%/yr while overall inflation is increasing ~2%/yr.

Bottom Line: “Concentrated” stock portfolios are never a good idea, but food processing companies are the exception that proves the rule, right now and forever. How can that be? Well, food and water are the most essential goods (we'll talk about water next week). So, its no surprise that food processing companies continue to grow earnings even during a recession (see Column D in the Table). Go ahead and overweight those companies in your portfolio. What does “overweight” mean? Food processing companies are in the Consumer Staples industry, which has a 12% weighting in the S&P 500 Index. Be aware that "Consumer Staples" include companies that produce housewares, diapers, and personal care items (Procter & Gamble, Colgate-Palmolive, Clorox, and Kimberly-Clark) as well as superstores (Wal-Mart, Costco, and Target). So, we’re suggesting that you invest up to 10% of your stock portfolio in food processing companies. Start by researching those that are Dividend Achievers (see Week 122) with S&P credit ratings of “A-” or higher, then favor those with low volatility (Column I in the Table) and high Finance Value (Column E in the Table). As of this writing (5/6/14), Hormel Foods (HRL), McCormick (MKC), Coca-Cola (KO), and PepsiCo (PEP) meet those 4 criteria. 

Risk Rating: 3.

Full Disclosure: I dollar-average into KO, and also own shares of HRL, GIS, MKC, and PEP.

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