Sunday, September 28

Week 169 - Barron’s 500 “Industrials” That Are Dividend Achievers With Good Credit Ratings

Situation: There is increasing evidence that the US economy is moving away from the deflationary effects brought about by chronic trade deficits. This translates most directly into a recovery of the manufacturing sector, which we’re already starting to see. But emerging markets are the driver of industrial equipment sales, and those markets remain in a state of flux). Let’s take a closer look at what S&P classifies as “industrial” companies, since 11% of the S&P 500 Index consists of stocks issued by companies in that industry. 

We’ve taken the Barron’s 500 List and pulled out the 16 “industrial” companies that are Dividend Achievers with good S&P bond ratings (Table). Of those 16 companies, 12 are manufacturers. Five are either defense companies, such as Lockheed-Martin (LMT), Northrop Grumman (NOC), and General Dynamics (GD), or they manufacture and service equipment for the aerospace industry, i.e., United Technologies (UTX) and Parker-Hannifin (PH). Two build agriculture, construction and mining equipment, Deere (DE) and Caterpillar (CAT). The 5 remaining companies are niche operators, Stanley Black & Decker (SWK), Illinois Tool Works (ITW), 3M (MMM), Dover (DOV) and Emerson Electric (EMR).

What about the other 4, the ones that don’t build stuff? Well, that’s the same story you’ve heard since the California Gold Rush days, namely that gold miners didn’t make nearly as much money as their suppliers, who made a lot. Industrial companies that supply and distribute parts (WW Grainger, GWW), transport manufactured goods (Norfolk Southern, NSC) or clean up messes (Waste Management, WM and Republic Services, RSC) do quite well.

Bottom Line: The US trade balance looks to be improving, which means our manufacturing sector is seeing an uptrend in exports. These “industrial” companies endured a hard decade to start the 21st century but are now in recovery mode, steady but slow.

Risk Rating: 6

Full Disclosure: I own shares of UTX, DE and MMM.

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Sunday, September 21

Week 168 - Food-related Dividend Achievers With Good Credit Ratings

Situation: We’ve blogged often about the value to be gained from investing in food-related stocks (see Week 152 and Week 161). But there’s a problem. Many of those companies have market values in the mid-cap range and don’t have sterling credit ratings. This poses a problem because elsewhere in this blog we stress the importance of relying on large-cap companies with good credit ratings for your retirement portfolio. We also emphasize the importance of selecting the stocks to include in that portfolio from the list of 239 Dividend Achievers. That way you’ll have dividend income in retirement that grows faster than inflation.

This week we’ve bundled those ideas together to come up with a list of 14 companies (Table) for you to consider for your retirement portfolio. All 3 branches of the food supply chain are represented: production, processing, and distribution. The smallest company to meet our criteria is McCormick (MKC), a spice processor with a market capitalization of $8.6 Billion. As a group, stock in these companies rewarded investors with approximately a 12% total return/yr since the inflation-corrected S&P 500 Index peaked on 9/1/00, and lost 20% over the 18-month Lehman Panic period (Table). This compares well with our “Risk Off” benchmark, the Vanguard Wellesley Income Fund (VWINX), which returned 7.5%/yr since 9/1/00 and lost 16% during the Lehman Panic. Of course, the S&P 500 Index fund (VFINX) did much worse, returning 4% and losing 46.5%.

Bottom Line: You’ll get a lot better “bang for your buck” (and sleep better as well) if you have 3 or 4 food-related stocks in your retirement portfolio. Those have remarkably strong returns, and prices that don’t drop much when the market crashes. After all, everyone needs to eat!

Risk Rating: 4

Full Disclosure: I dollar-average into WMT and also own shares in MCD, HRL, MON, MKC, PEP, GIS, DE and KO.

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Sunday, September 14

Week 167 - Have Commodity-Related Stocks Hedged Against the Lack of Real Growth in the S&P 500 Index?

Situation: The S&P 500 Index made its all-time inflation-adjusted high on 9/1/00. Fourteen years is a long time for the stock market to be in the tank, even though the main hedging tool (10-yr US Treasury Notes) has been effective. After adjusting for 2.4%/yr inflation since 9/1/00, the Vanguard Intermediate-Term Treasury Fund (VFITX) has returned 3.3%/yr vs. 1.3%/yr for the Vanguard 500 Index fund (VFINX) with dividends reinvested, as of 8/16/14. Robert Shiller maintains a long-term series for both 10-yr US Treasury Notes and the S&P 500 Index. After adjusting for inflation, returns were 1.5%/yr for 10-yr Notes vs. -0.2%/yr for the S&P 500 Index (1.6%/yr with dividends reinvested). Without adjusting for inflation, 10-yr T-Notes were up 3.9%/yr and the S&P 500 Index was up 2.1%/yr (4.0%/yr with dividends reinvested). 

The general explanation for this 14-yr period of low 2.4% inflation is that it results from the lack of real growth in economies around the world, and this lack of growth can be associated with two global recessions that have occurred. Most observers think that a growing reliance on borrowed funds has been a major contributor to those recessions, i.e., interest payments were shackling growth. This culminated in the credit crisis of 2007-08. The problem is slowly being corrected through deleveraging, including government action to reduce spending and raise taxes. 

When central banks lower interest rates to stimulate growth during a recession, the currency is said to be weakened or debased. (The official term is financial repression, see Week 76 and Week 79.) This will correct itself when the economy recovers, i.e., central bankers will reverse their policy by withdrawing the excess reserves that they had been pushing into the banking system. During the period of currency debasement, the prices paid for “hard assets” naturally drift upward. (Think of the “bubble” that formed in US housing prices when the Federal Reserve kept interest rates too low for too long after the “” recession (March 2001 through November 2001.) 

What does this information mean for readers of this blog? Do we need to protect our retirement savings during periods of “financial repression” by investing in real estate, gold, commodity-related stocks, or commodity futures? All of these have real economic utility and are therefore bound to go up in price when the value of the dollar is falling. These are also inherently volatile investments, so we need to think long and hard before making that leap. They’ll start to lose that pricing power when the Federal Reserve starts to wind down its policy of financial repression. (Look at what has happened to the price of gold. It fell 35% between the summer of 2011 and the summer of 2013.)  

Let’s take a closer look at how commodity-related stocks have responded. Those stocks typically pay dividends and are easily traded, which are advantages not shared by other hard assets. On 9/10/13, we published an index of 15 commodity-related stocks (see Week 115). It showed that commodity-related stocks did indeed enjoy pricing power between 1992 and 2013, returning 14.5%/yr while the return for gold bullion was 13.7%/yr, twice the return on Vanguard’s S&P 500 Index fund (VFINX). 

Now that another year has passed, let’s see how the unwinding of financial repression has impacted those results. The accompanying Table shows that both gold bullion and commodity-related stocks haven’t done as well as the S&P 500 Index fund (VFINX) over the past 5 yrs but are still ahead since 9/1/00. One of our benchmarks for this week is the T Rowe Price New Era Fund (PRNEX), a low-cost, low-risk natural resources mutual fund. Red highlights denote metrics that underperform our main benchmark, the Vanguard Balanced Index Fund (VBINX).

Bottom Line: Commodity-related stocks and gold bullion are volatile assets, but worth owning during periods of financial repression. You just need to think about switching to an S&P 500 Index fund the moment you think the Federal Reserve is starting to wind down its policy of “printing money” to “prime the pump.” Most financial professionals can’t time that trade correctly, so you’ll do better by simply owning shares in one or two of the highest quality commodity-related companies for the long term, taking care to pick companies with dividend growth that outpaces inflation (see Column H in the Table). Chevron (CVX), Exxon Mobil (XOM), Canadian National Railway (CNI), and Monsanto (MON) look like suitable candidates for long-term dollar-averaging. But there are others to consider (see Week 163), such as Archer Daniels Midland (ADM). 

Risk Rating for the 15 stocks in the Table: 7

Full Disclosure: I dollar-average into a DRIP for XOM, and also own shares of CVX, CNI, POT, BBL, DD and MON.

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Sunday, September 7

Week 166 - “Risk-On/Risk-Off” Investing in Response to Global Economic Patterns

Situation: Most of us take more risks with our investments when the world looks to be in good shape economically, and fewer risks when it doesn’t. For example, throughout 2008 investors were risk-averse and tended to sell their losing positions. It was a “Risk-Off” year by all accounts, and that selling did great damage to the retirement savings of roughly a billion people worldwide. The freed-up funds mostly went into US Treasury Bonds and German Bunds, lowering interest rates enough to leave investors in those bonds with no inflation-adjusted income for years. You see the problem, don’t you? Investors should have continued trading stocks in 2008 instead of holding a “fire sale.” The result of all this selling was that stocks became increasingly underpriced relative to their value, as assessed by time-tested methods of fundamental analysis. But where were the buyers? They showed up two years later.

We all need to take a deep breath and agree that our “animal spirits” sometimes lead us to take unreasonable risks when global economic patterns look rosey. I’ve done it, you’ve done it. The cure? Develop a consistent “Risk-Off” investment regimen, and stick with it through good times and bad. The only alternative is to panic when things look bad, and that means selling stocks at a loss. Remember, Warren Buffett's #1 Rule is to "never lose money."

What, exactly, is a consistent Risk-Off investment regimen? Warren Buffett has often said he looks for established companies in boring industries, companies that have built their brand through generations of managers. He likes Procter & Gamble, Coca-Cola, Wal-Mart Stores, Johnson & Johnson, IBM, Heinz, Mars, Wells Fargo, American Express, and Exxon Mobil. In 2008, he sold Johnson & Johnson stock only because he wanted to help out some floundering companies like General Electric and Goldman Sachs, but he otherwise continued to invest in a disciplined manner (e.g. moving to buy the Burlington Northern Santa Fe railroad). Once he buys a stock or company, he does so with the intention of never selling it. Exceptions are rare: 1) To free up money for younger associates to invest, he has done some selective selling; and, 2) he’s done some trading while learning to invest in the energy industry. The point is that he’s the quintessential “Risk Off” investor, and a model for us all to follow.

Where do we go to find a tidy list of old and mostly boring companies that stock analysts tend to yawn at (or just plain overlook)? Here at ITR, we go our “stockpickers secret fishing hole” (see Week 68 and Week 105), which is my name for the Dow Jones Composite Index of 65 companies (30 industrials, 15 utilities, and 20 transportation companies). Railroads and electrical utilities are highlighted there, for example, and have been among the best-performing sub-industries over the last few years (see Week 148). But few, if any, stock brokers are going to try and interest you in buying those. Why? Because they’re government-regulated “and regulators might get it wrong.” Regulation in these stocks is necessary for two reasons: 1) the companies are monopolies; 2) prices for their services need to be set high enough for the companies to afford massive fixed costs and still make a profit. In this week’s Table, you’ll find 11 electric utilities and 3 railroads because those companies prosper in good times and bad. 

We’ve screened the 65 companies in the Dow Jones Composite Index, excluding those that a) don’t have long-term trading data, or b) have insufficient revenues to make it onto the Barron’s 500 List. We came up with 37 companies that either showed a higher rank by Barron’s criteria in 2014 than in 2013, or were ranked in the top 2/3rds for both years. The benchmark we use for “Risk Off” investing is the Vanguard Wellesley Income Fund (VWINX), which is 60% bonds/40% stocks. The benchmark we use for “Risk On” investing is the Vanguard Balanced Index Fund (VBINX), which is 40% bonds/60% stocks. VWINX has a low 5-yr Beta of 0.5, whereas, VBINX has a 5-yr Beta of 0.92, which is almost as high as the S&P 500 Index’s 5-yr Beta that is set at 1.0. This wide discrepancy is mainly because bonds have 70-80% less risk than stocks. Red highlights in the Table denote underperformance vs. VBINX.

NOTE: Our screening starts with the Barron’s 500 List of the largest companies (by revenue) on the New York and Toronto stock exchanges. That list is published each year in May and gives letter grades to each company in 3 areas: median three-year cash-flow-based return on investment (ROIC); the one-year change in that measure relative to the three-year median; and adjusted sales growth in the latest fiscal year. Those letter grades are equal-weighted and the combined grade determines the company’s rank for the year.

If you look at total returns for those 37 companies (Table), 20 outperformed VWINX in all 3 time periods (past 22, 10, and 5 yrs) but only 4 of those stocks lost less money for investors than VWINX did during the Lehman Panic: MCD, JBHT, SO, NEE. This was in spite of the fact that aggregate returns of the 37 companies not only beat VWINX at all 3 time periods but also beat the lowest-cost S&P 500 Index fund (VFINX) in all 3 time periods! So, picking safe stocks is trickier than picking a mutual fund that has built-in safety features. The only reason to pick stocks is to have a source of retirement income that outgrows inflation: Note that Dividend Growth values in Column I of the Table are typically 3-4 times greater than the rate of inflation. You have to “pick and track”. No mutual fund will do that for you.

When we look across the 3 market cycles since the 7/90-4/91 recession, we find that a bond-heavy balanced fund (VWINX) protects its investors from most of the stock market losses incurred during each recession. VWINX lost money in only 3 of the last 22 yrs: 1994 (-6.2%), 1999 (-3.6%), and 2008 (-9.1%), whereas, the S&P 500 Index lost money in 6 yrs, including a 33% loss in 2008. The protection that comes from high-quality bonds is what allows VWINX to grow from a point of preserved value at the beginning of recovery from each recession, instead of wasting months (or years) to make up for lost value.

Bottom Line: Stock-picking is the best way to have some retirement income that beats inflation (see Week 159), but it’s not the best way for a “retail investor” to accumulate wealth. We’ve found 37 stocks that (as a group) handily outperformed the S&P 500 Index after holding periods of 22, 10, and 5 yrs. But only 4 of those stocks could beat a bond-heavy balanced fund (VWINX) in all 3 time periods while losing less than the 16% that VWINX lost during the 18-month Lehman Panic. Two are regulated utilities (SO and NEE), the third is a trucking company (JBHT), and the fourth is a downscale restaurant chain (MCD) that thrives on recessions. So, if you didn’t start investing in those 4 companies 22 yrs ago, and kept adding money along the way, you’d have been better off investing in VWINX. Our standard stock-heavy benchmark, the Vanguard Balanced Index Fund (VBINX), only beat VWINX in the most recent 5-yr period because a severe recession has led to a strong bull market in stocks. Conclusion: We all need to learn how to become “Risk Off” investors by making a plan for investing a certain amount each month, then sticking to it through thick and thin.

Risk Ranking for the aggregate of 37 stocks: 6

Full Disclosure: I dollar-average each month into DRIPs for JNJ, NKE, PG, NEE, WMT, and MSFT, and also own shares of IBM, KO, UTX, MMM, MCD, and DD.

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