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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