Sunday, July 27

Week 160 - Investment Strategies for Low Incomes

Situation: We all know that credit is a revolving door and that it’s difficult to use credit and still pay it off. Equity behaves in a similar manner. Some portion of equity will accumulate while some (hopefully less) gets distributed and used. Many households and businesses strive to become knee-deep in both credit and equity. But for households living below the poverty line these issues of credit and equity are beyond daily life. How to move the ball ahead? The heads of low income households have no choice but to become better-than-average money managers. Why? Because equity eventually has to exceed credit. 

What does “equity” mean? Equity is a resource that is fungible, meaning it can be turned into dollars. If you have title to a car, that title represents equity. If you “own” a home that you put 20% down on, and have paid off an additional 30% of the original cost through paying your mortgage, you have no equity and no liability, meaning you would likely “break even” upon selling the house, after allowing for transaction costs, taxes and inflation. Equity takes many forms, education being the most important. But all forms of equity have to end up with a positive dollar value after accounting for transaction costs, insurance, taxes and inflation. Otherwise, the household is pulled deeper into poverty through the spiral created by the use of credit and the payment of interest on borrowed monies. 

After education, the next most important equity-builder is a support network that will help you convert that new degree into a higher-paying job with full benefits. In other words, and this is important, friends and family represent equity through the job contacts they can provide. Also, learn to go online and maintain your “profile” at LinkedIn because that is the “go-to” site for employers looking to fill a vacancy in their workforce.

How else might a household living under the poverty line build equity? A home mortgage used to be the favorite route but most all of us have learned by now that houses gain value no faster than inflation, have volatile market values, and can entail expensive maintenance. Many other ways of producing equity have been tried. For instance, the lottery has been tried but it has average returns of only 37 cents per dollar invested. Gold bullion has been tried and it does indeed beat inflation, by 3.4%/yr since 1968 vs. 5.4%/yr for the S&P 500 Index. However, gold bullion beats inflation by only 1%/yr over longer time periods, undergoes sudden shifts in value, is expensive to store, has to be insured, provides no income, and profits from its sale are taxed at the highest rate. 

This means that we have to drill down deeper to find a reasonable way for you to build equity after landing a good job. Home ownership can build equity if you a) invest the lowest down payment needed to qualify for a “conforming” 30-year mortgage, and b) don’t sell the house until after the mortgage is paid off. A government agency will insure that conforming mortgage, and after 10 yrs the mortgage payment will mostly go toward equity. In the meantime, you won’t pay taxes on income that goes toward interest. While the value of the house will merely track inflation for those 30 yrs, you will have invested only a 5-20% down to end up with 100% ownership. Then you get to live the rest of your life rent-free. The equity in your home is called "rent-equivalent income" by government accountants. Much of that gain represents a “gift” from your Uncle Sam. This is because of banking and insurance subsidies paid out by the federal government to produce stability in those market sectors, as well as “tax expenditures” (the official term for allowing you to avoid paying taxes on income used to pay mortgage interest). You are rewarded for your perseverance in paying off your mortgage, while the government benefits from the stability and character you bring to the neighborhood. 

What other choices are there? Treasury Notes and Bonds were once thought of as a way to build equity but this is not the truth and never has been. They’re just seat belts in the car called “life.” Historically they have beaten inflation by 1-2%/yr. That may sound good on the surface but income tax must be paid on both interest and capital gains. The only subsidy that Uncle Sam awards is freedom from having to pay state or local taxes on interest. Transaction costs are zero if you buy at the government website, and Savings Bonds come with an IRA-like feature, namely, no taxes on accrued interest over the life of the bond. Inflation a protected Savings Bonds (ISBs) are an exceptional value, in that you slowly build equity if they're held for more than 5 yrs because transaction and inflation costs are zero; federal tax on accrued interest is paid upon redemption but that cost is typically covered by the basic interest rate.

Now we have 3 ways for a household living below the poverty line to build equity: 1) have a family member obtain enough additional education to land a better job, 2) start building a Rainy Day Fund with ISBs (see Week 119, Week 117 and Week 151), and 3) start paying down a 30-yr mortgage. You notice that we haven’t talked about stock purchases. But paying into an IRA that includes stocks is a smarter next move (after landing a better job and starting a Rainy Day Fund) than becoming a homeowner. 

We’ll start by looking at the lowest-cost and most conservative mutual fund available that places ⅔ in bonds and ⅓ in stocks, which would be the Vanguard Wellesley Income Fund (VWINX, Line 23 in the Table). It requires an initial purchase of $3,000 but you can start by duplicating it online. Assign ⅔ to ISBs and ⅓ to stocks purchased as a dividend reinvestment plan (DRIP), see Column K in the Table, with an up-front investment ranging from $10 to $500, and minimum amounts required for additional investments ranging from $10 to $100. For tax purposes, you can declare that any DRIP you own is part of an IRA. 

What’s not to like? Well, I’m sure you know that precious few stocks make suitable investments for a household trying to dig out of poverty, and those will require watching. We’ve come up with a list of 12, to help you get started (see Table): Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), General Mills (GIS), Chubb (CB), International Business Machines (IBM) and VF Corporation (VFC), plus 5 regulated electric utilities: Wisconsin Energy (WEC), Consolidated Edison (ED), NextEra Energy (NEE), Xcel Energy (XEL) and Southern Company (SO). Those are the 12 top companies on our list of 17 “hedge stocks” (see Week 150). 

This week’s Table shows those 12 stocks at the top. They’re likely to build equity at a rate of ~10%/yr (see Column C), which translates to ~6.5%/yr after deducting the 3.2%/yr rate of inflation that has prevailed for the past 101 years. The IRS taxes your dividends and capital gains at a reduced rate. However, DRIPs have an expense ratio (transaction costs divided by account value) of 1-2%/yr (vs. 0.25%/yr for VWINX and 0%/yr for Treasury Notes and Savings Bonds purchased at treasurydirect). NOTE: For this week’s Table only, red highlights denote underperformance relative to VWINX instead of VBINX. Why? Because higher risk factors (see Columns E, I, and J) make VBINX unsuitable as a benchmark (or savings goal) for families trying to dig out of poverty. Higher risk is also why such families should avoid investing in the lottery, gold coins, or a home mortgage. After taking on the expense of higher education (and building a Rainy Day Fund with ISBs), they need to start an IRA.

Bottom Line: Furthering one’s education is the best investment for anyone living below the poverty line. We think the next best move is to make online purchases of inflation-protected Savings Bonds at treasurydirect and DRIPs in selected stocks (declared for tax purposes as IRAs) at computershare. Both can be done by spending as little as $25 at a time, but starting a DRIP requires an initial investment of $10 to $500. Our preferred IRA option for such a family is to regularly invest in the Vanguard Wellesley Income Fund (VWINX), which requires an initial investment of $3000. 

Risk Rating: 3

Full Disclosure of current purchase plans relative to items in the Table: I dollar-average into DRIPs for WMT, JNJ, IBM, and NEE.

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Sunday, July 20

Week 159 - Focus on “Compound Interest:” A Watch List of 77 Companies

Situation: If you’ve been reading this blog for long, you’re familiar with what we think is the “best” way for small investors to save for retirement, namely, the Vanguard Balanced Index Fund (VBINX), a low-cost hedged version of the S&P 500 Index. Recently, Warren Buffett went on the record and advised retail investors to use low-cost Vanguard index funds. His suggestion is to invest 90% of your retirement account in the Vanguard 500 Index Fund (VFINX) and the remaining 10% in the Vanguard Short-Term Treasury Fund (VFISX). Unfortunately, neither of these two approaches will pay you much of a dividend, and what dividend yield there is (plus its growth rate), barely keeps pace with inflation. In retirement, portions of those index funds would need to be sold every so often for you to fully benefit from that type of savings plan. From a budgeting standpoint, it makes more sense to receive income regularly from stocks (via dividend checks sent to you) while preserving the principal (your initial investment). 

If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146). 

This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.

The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.

Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).  

The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.

Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.

Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.

Risk Rating: 4

Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.

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Sunday, July 13

Week 158 - The Barron’s 500 List Screened for Durable Competitive Advantage

Situation: “It was the best of times, it was the worst of times…” That’s how investors will come to regard the current macroeconomic situation. The “best of times” because both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) are making new, inflation-adjusted highs. The “worst of times” because every major economy on the planet is locked in a grinding, low-grade borderline deflation because of unsustainably high interest payments on overall debt, owned by individuals, corporations and governments. How can the “retail” investor play this moment? What kind of asset allocation do YOU want to be sitting on? If you have enough income to open a new position, what should you bet on? A stock, a bond, cash-equivalents, gold, a home mortgage (instead of renting), commodity futures, or whole life insurance?

Here in the US, stock indices are loudly declaring a primary upward trend, which Dow Theory says will be sustained until either the DJIA or DJTA drops below a previously important low. That would mean a drop of more than 60%. Such an occurrence seems unlikely, short of World War III or a global pandemic. Central Banks are going to keep interest rates low for as long as it takes that “free money” to pump investment up enough for growth in productivity and employment to bring down per-capita debt. During that period, stock market returns over rolling 5-yr periods are unlikely to beat 10%/yr, even here in the US, which is the one place where deflation no longer remains a looming threat (see Week 143).

Given that stock investments are the best known way to beat inflation while having enough income to take advantage of compound interest (see Week 157), you’ll keep buying stocks unless overpricing becomes widespread, meaning you can no longer find a high-quality yet reasonably priced stock. Once the price/earnings ratio for the S&P 500 reaches 20, as it did recently, it doesn’t make much sense to buy stock unless you know how to ferret out the few remaining high-quality bargains. Let’s do that now.

First, we’ll apply Warren Buffett’s method to find out which companies have a “Durable Competitive Advantage” (see Week 135, and “DCA” in Column K of this week’s Table). This method computes a simple trendline for growth in Tangible Book Value (TBV, see Column L) over the past decade. If that rate is higher than 7%/yr, and TBV has no more than two down years, then the company has a Durable Competitive Advantage. The problem is that not many CEOs align TBV growth with earnings growth. They’d rather spend that money on a merger or acquisition. That’s particularly true for companies in defensive industries, where the risk of bankruptcy is nil, and they can do this because their products are essential. 

Next we want to know if the company’s stock price has become higher than its trendline for earnings growth can justify. To address that issue, Warren Buffett takes companies with a Durable Competitive Advantage and subjects them to a stress test, which we call the Buffett Buy Analysis (see “BBA” at Column M in the Table). The trendline for earnings over the past decade is extended out for a decade in the future. That dollar amount of earnings is multiplied by the lowest P/E ratio seen over the past decade to project a price 10 yrs from now. If the company pays a dividend, the current amount of that dividend is multiplied by 10 and added to the earnings projected for 10 yrs from now. (Mr. Buffett’s idea here is that the economy will be in the doldrums for the next 10 yrs such that the company will be unable to raise its dividend. However, companies that are able to maintain dividends will be rewarded with a higher stock price.) Those companies that have a Durable Competitive Advantage, but are projected by their BBA to grow their stock price slower than 7%/yr over the next decade, are rejected. In other words, their current price is so high that expected growth has already been “discounted” by enthusiastic buyers.

By applying this analysis to the 500 companies in the Barron’s 500 List, which are the largest companies (by revenue) on the New York and Toronto stock exchanges, we are left with just 26 companies to consider (see Table). Of these, only Ross Stores (ROST), Monsanto (MON), TJX Companies (TJX) and Franklin Resources (BEN) are found in the “universe” of 63 companies we consider to be worthwhile candidates for your retirement portfolio (see the Table for Week 122). None appear on our 29-stock Master List (see Week 146). In other words, all 26 companies in this week’s Table are chancy investments that have to be backed dollar-for-dollar with Savings Bonds or 10-yr Treasury Notes. As Warren Buffett recently stated: “If you’re not a professional, you are thus an amateur.” So cover your bets.

Bottom Line: Be careful how you deploy new money into this overheated market. The 26 stocks we’ve found are worthwhile bargains for you to consider but come with considerable price volatility (see Columns D and I in the Table). Even knowing that these stocks are not overpriced at the time of this writing (6/1/14), you still need to know whether the “story” supporting that stock price remains intact. If the story is broken, then the stock is overpriced. Researching THAT detail requires more attention than you’ll have time for on weekends. But start slowly, with an easy assignment. Analyze the 3 “blue chip” stocks on the list that are part of the Dow Jones Industrial Average: Cisco Systems (CSCO), Travelers (TRV), and JP Morgan Chase (JPM). Each is a dominant player in its industry, and it is those industries (finance and information technology) where professionals earn their greatest rewards by deciding on the right entry point for buying the stock as well as the right exit point.

Risk Rating: 7

Full Disclosure: I own shares of MON, CF, ACN, and TJX.

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Sunday, July 6

Week 157 - Capitalism is a Two-Trick Pony. Learn Both Tricks.

Situation: Sometimes, people with similar socioeconomic advantages become wealthy while others don’t. Sometimes, politicians like to say “the wealthy” have learned to acquire “unearned income” from compound interest, which is correct. Whether or not the acquisition of that skill constitutes real work is debatable. Compound interest is one of the pillars of capitalism, but it can’t work its considerable magic unless a family or business chooses to divert 10-15% of its disposable income away from consumption and toward long-term investments, specifically those that spin off dividends that grow annually and are reinvested to “compound” the benefit. The other pillar of capitalism is accrual accounting, which is the discipline of paying recurring expenses in real time by identifying and encumbering a specific part of current income. That leaves only non-recurring capital expenditures to be “financed”, which is usually accomplished by selling assets, borrowing money, or issuing stock.

Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)

The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses. 

For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary. 

The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.

Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.

Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).

Bottom Line: Maximize your use of compound interest and accrual accounting.  By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree. 

Risk Rating: 3

Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at

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