Sunday, August 31

Week 165 - Production Agriculture Companies in the Barron’s 500 List

Situation: Regular readers of this blog have already been introduced to 2 key strategic facts about making investments in food-related companies: 1) food prices tend to rise 1-2% faster than general inflation because demand for protein increases faster than supply; 2) food-related commodities are what we call “countercyclical” because pricing is dictated by the weather, not global economic patterns. If you don’t want all your retirement savings tied to the economic cycle, a good alternative is to consider investing in businesses that supply farmers and help get their products to market. We’ve recently blogged (see Week 161) about companies that process farm products and distribute those items to grocery stores, hospitals, homes, hotels, restaurants, etc. Because food is essential, those companies can raise prices in response to a commodity shortage. But farmers lose money when they can’t deliver commodities because the weather won’t co-operate. In other words, production agriculture is at the mercy of the weather but the processing and distribution of food products is not.

Many companies support production by the farmer, not just the ubiquitous seed and fertilizer stores. There are suppliers of diesel engines that run center-pivot irrigation systems, tractors to plant seed and spread insecticides, fungicides and herbicides, combines to harvest grain, factories to package meat, others that produce ethanol and animal feed from corn, and companies that ship grain and meat overseas. The screen for this week’s Table includes all 15 Production Agriculture companies in the Barron’s 500 List. That list ranks the 500 largest companies (by revenue) on the New York and Toronto stock exchanges. The Barron’s rankings for 2014 and 2013 are in Columns G & H of the Table. Rankings reflect the letter grades for 3 metrics: growth in revenue over the past year, median 3-yr growth in cash-flow based return on invested capital (ROIC), and the past year’s growth in ROIC divided by median 3-yr ROIC. 

Most of the stocks in the Table are volatile in terms of both the 5-yr Beta (Column K) and losses during the 18-month Lehman Panic (Column D) when compared to our benchmark, which is the Vanguard Balanced Index Fund (VBINX). Monsanto (MON) and Archer Daniels Midland (ADM) appear to be the only companies where rewards outweigh risks enough for the stock to fit into a retirement portfolio. But long-term rewards for each of the 15 stocks (Column C) are far greater than for the lowest-cost S&P 500 Index fund (VFINX). Red highlights denote underperformance relative to our benchmark (VBINX).   

Bottom Line: The companies that serve the needs of farmers are at the mercy of the weather. If farmers don’t have money to spend on a) technologically-advanced farm implements, b) seeds engineered to resist drought and disease, and c) fertilizers to correct losses of essential elements from the soil (potassium, phosphorus, and nitrogen), those farmers aren’t going to be efficient producers this season. That means they’ll have less money to spend on such “productivity upgrades” next season, and the companies that supply those upgrades to farmers will make less money. When the weather makes a turn for the better, farmers will have excess cash and those vendors will do well going into the next season. And, when farm operations are productive that increase in supply will dampen price increases for items on grocery store shelves. In other words, the economic cycle tends to be moderated by the weather cycle: the two are out of sync. As investors, we need to have retirement money working for us in both cycles to smooth out our returns on investment.

Risk Rating: 7

Full disclosure: I have no plans to purchases shares in companies that are listed in the Table, but do own stock in MON, POT, CMI, DE, DD, and CAT.

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Sunday, August 24

Week 164 - Our Approach To Picking Stocks For Retirement Income

Situation: What’s the plan? How big a part should ownership of individual stocks play in your retirement savings? How should you pick those? How should you sell those?

We suggest that you plan to depend on "compound interest" to build financial security for you and your heirs, not "capital appreciation" (which is always a gamble in the absence of dividend growth). With few exceptions (see Week 150), stocks need to be backed 1:1 with US Treasury bonds (or mortgage agency debt instruments). Pick stocks by following these guidelines:

First, you’ll need a way to find companies with improving fundamentals. For us, that information can be found on the annual Barron’s 500 List, which ranks the 500 largest companies (by revenue) that are listed on the New York and Toronto stock exchanges by using 3 equal-weighted criteria: sales growth over the most recent year, growth in cash-flow based return on invested capital (ROIC) over the past 3 yrs, and the most recent year’s ROIC divided by median ROIC over the past 3 yrs. We’re most interested in companies that move up in rank year-over-year but we also value those that consistently place in the upper 2/3rds of the Barron’s 500 List (see Week 159). 

Second, you’ll need a way to determine whether or not a company’s management has a primary goal of benefitting all shareholders (as opposed to themselves). Has the company a) raised its dividend annually for at least the past 10 yrs, and b) maintained an S&P bond rating of BBB+ or better? 

Third, does the stock appear to be undervalued relative to risk? For that point, we calculate Finance Value (long-term reward minus Lehman Panic losses) to be sure that it beats the Finance Value for the Vanguard Balanced Index Fund (VBINX), as well as looking to be sure that both the 5-yr Beta and P/E do as well as VBINX.

Fourth, is the company’s dividend growth rate plus its current dividend yield greater than 7%? That would suggest that the “business case” for making the investment (doubling one’s money in 10 yrs) applies.

Fifth, stay on top of the “story.” In other words, what’s supporting the stock price vis-a-vis reported 12-month earnings (P/E). If the P/E is outside the normal range of 10-20, you need to be concerned. The story might be broken (low P/E) or outdated (high P/E).

Sixth, what about a Plan B? Do alternative investments like real estate (owned for rental income), gold (owned for capital appreciation), or commodity futures (owned for gambling that the underlying commodity will change dramatically in price over the near term) make sense? We don’t think any of those alternatives have a low enough risk to justify inclusion in a retirement portfolio. That leaves our benchmark, The Vanguard Balanced Index Fund (VBINX), as the only alternative investment. This week’s Table shows the 17 companies that pass our filter. Red highlights denote underperformance relative to VBINX

Selling stocks that you’ve chosen by using these guidelines shouldn't become an issue if you’ve set up a Dividend Reinvestment Plan (DRIP) and add a small fixed amount of money to it regularly. That will capture “reversion to the mean” pricing. You benefit from the additional shares that a fixed amount of money buys for you whenever the price is down. That said, you will have to sell if the stock fails to meet the above criteria for extended periods. But as long as the company keeps raising its dividend every year enough to beat inflation, there’s little need to worry. We encourage you to think of your DRIPs as a growing perpetuity, which is a type of bond that keeps paying more interest every year. You don't care about the stock's price as long as the company is committed to increasing its dividend every year regardless of economic conditions.

However, the guidance I’ve just given isn’t going to satisfy all of you, so let’s use a golf analogy. The ball has landed off the fairway, out in the weeds: That’s how you feel about the stock because it has fallen in value compared to what you’ve paid for it. You’ll need to exercise due diligence and study the “story” that has been supporting the stock’s price: Has the price fallen because the story is broken? Or has the price fallen because of macroeconomic events that have little impact on the company’s prospects and the story remains intact? Decide whether or not you’d like to continue buying the stock. That decision process takes time to gestate but if at the end of that time you decide you are no longer a buyer then you are a seller. Finally, you’ll need a “tickler,” some kind of alert that stockpickers use to keep from getting very far into the weeds. The one I like is “sell if you’re down more than 90 days.” So, check your positions every 3 months and do some thinking about the losers. But beware, once you become a trader you're returns will increasingly align with capital appreciation rather than dividend growth. You'll get more thrills, and more sinking feelings.

Bottom Line: We've found 17 stocks that meet our criteria as of this writing (7/18/14), given that the goal is to have dividend income during your retirement years that is likely to grow faster than inflation. 

Risk Rating: 4

Full Disclosure of my current or planned purchases of stocks in the Table. I dollar-average into NEE, PG, WMT, and JNJ each month at computershare.

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Sunday, August 17

Week 163 - How To Bet On Commodity-related Stocks While The Children Are Watching

Situation: We all need to know how to drink responsibly, drive responsibly, eat responsibly, and flirt responsibly. But how, exactly, are we to gamble responsibly? If you’re a regular follower of our website, I’m sure you’ve gambled on something at some time in your life. This is behavior that is what John Maynard Keynes blamed on “animal spirits.” Here at ITR, we try to take the gambling out of investing because we think you’ll get a more comfortable retirement that way. 

Now we need a way to gauge whether or not we’re gambling on “hot” stocks. I travel a lot, researching the blog and trying to learn how people like to invest. I hear amazing statements. While riding up a ski lift last winter in Vail, I heard a real estate developer say "People aren't interested in saving for retirement. Look at the choices they make!" He knew what interests most people the most, i.e., moving to a house that better reflects the status they want to project, and he’d made a lot of money feeding that interest. 

More and more though, I’m struck by how carefully children monitor adult behavior. They quickly come to understand how a family gets to be “house poor” by living beyond both its means and its needs. And they’re less sure than ever about what lessons to take away from observing adults. A child will naturally look for someone to model her behavior on, anyone really, whose behavior suggests that he or she has character--a sense of responsibility and respect toward people in their home, their neighborhood, and the larger community. The word I hear them use is “dishonest”, to sum up places and people that don’t do that. 

This week’s blog is about learning to invest in traditionally risky stocks without gambling. We recommend doing this by looking at companies in the riskiest industries. i.e., energy and basic materials. Both are “commodity-related” industries and their stock values show the greatest variance. 5-yr Beta values are typically 50% higher than the S&P 500 Index, and losses during the Lehman Panic were typically 20% greater. A few simple rules will get us there, starting with all 68 such companies in the Barron’s 500 List that have long-term total return records:

        1) Exclude companies with S&P bond ratings of BBB- or lower, since S&P typically uses the BBB rating to designate a company that is doing OK at the moment but gambling with its life. Bear Stearns, for example, had its debt downgraded from “A” to “BBB” on March 13, 2008 just three day before J.P. Morgan Chase purchased it for $2.00/Share with assistance and encouragement from the Federal Reserve.

        2) Exclude companies that had lower scores for 2013 vs. 2012 on the Barron’s 500 List (see Week 158), unless scores for both years were in the top 300.

        3) Assign the “Not Gambling” label to companies that have S&P bond ratings of A- or better, and BBB+ if the company is a Dividend Achiever.

4) Assign the “Gambling” label to the remaining companies.

5) As a final “belt and suspenders” action, move any companies out of the “Not Gambling” category that lost more than the 28% that VBINX lost during the 18-month Lehman Panic period. 

This week’s Table shows the results. There are 7 “Not Gambling” and 19 “Gambling” stocks to choose from. For comparison, the BENCHMARKS section includes PRNEX (T Rowe Price New Era Fund), which is the lowest-cost mutual fund dedicated to the energy and basic materials industries. As always, red highlights denote underperformance relative to our key benchmark, The Vanguard Balanced Index Fund (VBINX). 

Bottom Line: You don’t have to gamble to own commodity-related stocks. Just do the above screen then take more time than usual to research the “story” supporting each company’s stock price. Pick a stock, start a DRIP (e.g. at computershare), and automatically invest $25-200/mo in the company of your choice. When the price swoons, keep investing as long as the “story” holds.

Risk Rating: 7

Full Disclosure: I own shares of MON.

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Sunday, August 10

Week 162 - A “Rainy Day Fund” Using DRIPs That Don’t Have Transaction Costs

Situation: We all have occasions when we need to use our Rainy Day Fund to meet non-recurring capital expenditures. Afterward, we hope that our regular contributions will replenish it before we’re blind-sided again. That Fund needs to have some dividend-paying stocks in it, as well as inflation-protected Savings Bonds that can be cashed anytime without risk of loss (at treasurydirect). Why stocks? If chosen well, they’ll grow in value somewhat faster than Savings Bonds, as long as dividends are automatically reinvested. But when the market is down, you don’t want to sell those stocks at a loss. Instead, a better choice is to cash in some Savings Bonds. But the kind of “safe” stocks that are suitable for the Fund don’t grow very fast, so you need to 1) minimize expenses by using an online dividend reinvestment plan (DRIP), and 2) find DRIPs that are cost-free.

The trick is knowing which stocks to pick. This week’s Table has one stock for each of 4 essential industries: healthcare, consumer staples, utilities, and energy. Those 4 stocks are: Abbott Laboratories (ABT), Procter & Gamble (PG), NextEra Energy (NEE) and Exxon Mobil (XOM). In the next bear market, these should hold their value relatively well. DRIPs for all 4 can be obtained through computershare at essentially zero purchasing cost. There are no fees for either the initial set-up of automatic monthly purchases or for dividend reinvestment. Well, there is one exception to that bold statement. Procter & Gamble has a “processing fee” of two cents a share for purchases. The minimum amounts permitted for each automatic monthly investment are: $25 for ABT and inflation-protected Savings Bonds, $50 for XOM and PG, and $100 for NEE. If you make automatic $100 monthly purchases for each, your expense ratio for the year is going to be $0.24/$6000 = 0.004%, which we consider to be negligible. The Savings Bonds you’re accumulating through automatic monthly investment at treasurydirect are not only cost-free but come with tax advantages identical to those of an IRA (along with the same limits on annual purchases).

Bottom Line: Build a resilient and rewarding Rainy Day Fund. The one I’ve described here has the advantage of being cost-free. Peruse the Table for details, and note that red highlights denote underperformance vs. our favorite benchmark for retirement savings, which is the Vanguard Balanced Fund (VBINX). You’ll see that the Rainy Day Fund performs quite well (Columns C & F in the Table) and carries little risk (Columns D & I in the Table) compared to VBINX. However, the Rainy Day Fund won’t keep up with VBINX in a bull market because it designed for safety, not wealth-building.

Risk Rating: 3

Full Disclosure: This is the Rainy Day Fund that I currently employ.

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Sunday, August 3

Week 161 - Food Processors That Stock Grocery Store Shelves

Situation: I think we’ve all become a little bit leery of the current stock market. Market analysts keep anticipating GDP growth of 3% but the International Monetary Fund projects that GDP growth in the US is only going to be 1.6% for 2014, and Janet Yellen (the new Chairperson of the Federal Reserve) says that our economy won’t return to 3% GDP growth until 2016 at the earliest. Investors have responded by again sheltering in safe harbors like companies in the 4 “defensive” S&P Industries. Those would be: Consumer Staples, Healthcare, Utilities, and Communication Services. That means those stocks are overpriced according to their Price/Earnings ratio--price divided by earnings over the past 4 quarters (P/E) has moved into the danger zone. P/E ratios higher than 20 are considered too high because returns to the investor drop below 5%/yr. When returns from “defensive” stocks fall that far, professional investors will start to cut their risk profile by moving money into corporate bonds, e.g. Vanguard’s Intermediate-Term Investment-Grade Bond Fund (VFICX, see Table). 

This week, our task is to look at the safest sub-industry (after regulated utilities) within the 4 defensive industries: Food Processors. To get a clear picture, we’ve included all 20 of the publicly-traded companies that stock your grocery store’s shelves to a material degree and have  long-term trading records (see Table). The first column of data (Col C) tells the story. All 20 have total returns that equal or exceed that of our benchmark, the Vanguard Balanced Index Fund (VBINX, see Table), which has returned a little over 5%/yr since the most recent inflation-corrected peak in the S&P 500 Index occurred on 9/1/00. Because it’s hedged, VBINX performed better than the lowest-cost S&P 500 Index fund (VFINX in Table). Risk for the 20 aggregated food processors (Line 22 in the Table), as measured by both total return over the 18-month Lehman Panic panic period and 5-yr Beta (Columns D & J), was less than for VBINX even though total returns after both 14 yrs and 5 years were much greater (Columns C & F).

Now that we’ve got your attention, let’s “muddy the waters.” Look at the Table and note that only PEP, GIS, and SJM provide the investor with what she wants, which is to be at least as good as VBINX in terms of performance (Columns C, F, G, H, I) as well as safety (Columns D, J, K, M, N, O). The aggregated data on Line 22 look great but you’ll need stock-picking skills to capture those high returns at low risk. Remember: data points that underperform VBINX are highlighted in red. Column K (P/E) has an abundance of those, indicating that the market is pricey.

Bottom Line: Food Processors are a mother lode of opportunity for investors but that sub-industry is highly fragmented. Out of the 20 companies in the Table, only 5 are sizable: Nestle (NSRGY), Danone (DANOY), Mondelez International (MDLZ), Coca-Cola (KO) and PepsiCo (PEP). But size (Col L) and bond ratings (Col O) don’t matter much when a company is selling an essential product. The exception occurs when government regulation imposes price controls, as is the case with milk, e.g. Dean Foods (DF at Line 17 in the Table), which is the largest milk producer in the US. 

How should you prioritize your research into the “story” that supports the market value for each of these stocks? We suggest that you assign the same priority as the PowerShares Dividend Achievers Portfolio (PFM, Line 36 in the Table), an exchange-traded fund or ETF. That priority is: KO, PEP, GIS, HRL, SJM, MKC, FLO, LANC.

Risk Rating: 4

Full Disclosure: I don’t plan to purchase any stock listed in the Table, but do own shares of MKC, KO, HRL, GIS, and PEP.

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