Sunday, October 26

Week 173 - Why Vanguard?

Situation: Warren Buffett, in his Annual Report to Berkshire Hathaway investors this spring, included a “letter” to his relatives. It recommended that they structure investments in their “trusts” as follows: 90% in the Vanguard index fund dedicated to the S&P 500 Index (VFINX) or the index fund dedicated to the total US stock market (VTSMX), and 10% in the Vanguard managed fund dedicated to short-term US Treasury Notes (VFISX). His main concern was to minimize their investment costs while tracking stock market returns.

Our readers aren’t as rich as his relatives. So, we suggest that you back your stock investments 1:1 with US Treasury Notes & Bonds, other AAA-rated bonds, Savings Bonds, or the Vanguard Intermediate-term Treasury Fund (VFITX). In other words, the most prudent long-term investment balances large-capitalization US stocks with risk-free AAA bonds. And by “long-term”, we mean that you intend to hold your investment for at least 20 yrs in anticipation of using it for retirement purposes. Our benchmark for “Risk-On” investors is the Vanguard Balanced Index Fund (VBINX), which is composed 60% of a capitalization-weighted index of the total US stock market and 40% of an investment-grade US bond index (mainly US Treasuries). For “Risk-Off” investors, our benchmark is Vanguard’s Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks. “Risk-Off” investors are those who have moved closer to drawing on retirement income and have less investment time available to recover from market fluctuations.

When calculating your 1:1 stock:bond balance, remember to include the present value of your Social Security account, which would be $164,000 if you were to qualify today for a beginning payout of $2000/mo and were to receive monthly payouts for the next 11 yrs, assuming a discount rate of 5.6%. That discount rate is the sum of the “risk-free” rate (2.6% interest on a 10-yr Treasury Note) and “risk” (i.e., inflation, as reflected in a 3.0%/yr estimated annual cost-of-living adjustment). Total payments would amount to almost $305,000 over 11 yrs, with a monthly payment of $2636 in the 11th yr.

We need to draw attention now to the costs that are associated with investment accounts. How important are those costs? Well, the standard rule of thumb for business accountants is to note any cost as being “material” if it represents more than 5% of revenues or earnings. Upon noting said cost, the accountant will delve deeper to determine whether it is justified. Using that guideline, let’s look at the past 100 yrs of returns from owning 10-yr Treasury Notes and reinvesting interest payments vs. owning shares of the S&P 500 Index and re-investing dividend payments. Over that 100 yr period of time, the key facts  are:

        1) Inflation averaged 3.22%/yr;

        2) Total returns on 10-yr Treasury Notes averaged 5.05%/yr (1.83% after inflation);

        3) Total returns on the S&P 500 Index averaged 10.16%/yr (6.94% after inflation);

        4) Total after inflation returns for our recommended 50:50 allocation averaged 4.39%/yr;

        5) Therefore, transaction costs (expenses) become material when the expense ratio reaches 0.22%/yr, which would bring the after inflation total return down to 4.17%/yr; 

        6) The relevant Vanguard funds are VFITX (intermediate-term Treasuries) with an expense ratio of 0.20%/yr, and VFINX (S&P 500 Index) with an expense ratio of 0.17%. Both of those expense ratios are less than 0.22%/yr, so transaction costs are immaterial. 

Vanguard index funds were invented by John Bogle to provide retail investors with market-tracking investments that have immaterial transaction costs. (The only remaining costs are taxes and inflation.) The issue that concerns Mr. Bogle is that the average retail investor has an expense ratio of 2.2%/yr, which is 10 times too much! That is the reason why Warren Buffett thinks so many investors are being disappointed. Half of their after-inflation returns are being eaten up by costs, 90% of which can be eliminated by sticking to Vanguard index funds. 

Treasury Notes don't provide interest payouts that grow faster than inflation, but Vanguard's S&P 500 index fund (VFINX) has grown its dividend payout 4.7%/yr since 1980, which is 1.5%/yr faster than inflation over that 34-yr period. However, those payouts bounce around a lot because ~150 companies don’t pay a dividend. Only about 150 increase their dividend annually. 

Now you have the explanation why the purpose of this blog is to interest you in buying stock monthly (online) in selected companies that have increased their payout for at least 10 yrs at a rate 3-4 times faster than inflation. Some of those companies charge no transaction costs for automatic monthly investments (see Week 162). Examples include NextEra Energy (NEE), Abbott Laboratories (ABT), and ExxonMobil (XOM) for shares purchased through computershare.

Bottom Line: Here at ITR, we stress two things: minimizing transaction costs and maximizing retirement income. For this week’s Table, we’ve used our “Risk-On” benchmark (VBINX) supplemented with Vanguard’s intermediate-term Treasury fund (VFITX) to construct a 50:50 stock:bond fund, i.e., 75% VBINX and 25% VFITX. By having 25% invested in a Treasury bond fund, you’ll have an investment that goes up in value during a recession, and also provide a way to pay for unforeseen emergencies that often crop up during a recession. Alternatively, you can invest in the Vanguard Wellesley Income Fund, or a 50:50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Intermediate-term Treasury Fund (VFITX). All 3 of these options are worry-free and track the markets in a manner that gives you protection from a crash in the stock market. Plus, you don’t have to fiddle with picking stocks and the added complexity they bring to paying taxes.

Risk Rating: 4.

Full Disclosure: I invest monthly in inflation-protected Savings Bonds at and in NEE and ABT.

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Sunday, October 19

Week 172 - Core Holdings for an Overpriced Market

Situation: The stock market is currently overpriced when assessed by several criteria. Economists, including the Nobel Laureate Robert J. Shiller, are trying to figure out why this is so. As a small investor, all you need to know is that the stocks in your portfolio that have a price/earnings (P/E) ratio higher than 20 are in a danger zone. In other words, your total return from that investment is less than 5% unless earnings improve. On a risk-adjusted basis, you’d do better parking any newly available funds in US Savings Bonds

Even though stocks are overpriced, advantages remain for you to accumulate more for your portfolio. That is because you will receive growing dividends in retirement, however, to purchase more it is best to stick to dollar-cost averaging. Invest a little each month into an online Dividend Reinvestment Plan (DRIP). That way, you automatically smooth out the fluctuations in price. The bigger problem right now is that people prefer to cut back on investments in growth stocks when the market is overpriced. That’s not a good investment strategy, and we explain why below. 

Bonds, and hard assets like gold and real estate, just don’t have the growth horizon that stocks currently have. Trouble will come for stocks from only 3 broad categories:
  1. if interest rates and inflation spike upward (unlikely);
  2. if companies stop growing earnings almost 10%/yr (unlikely);
  3. if economic indicators herald a recession in a major economy (somewhat likely for the EuroZone and China). 
Because stocks remain the asset of choice, they are becoming overpriced. In particular, the buyers of bond-like stocks (i.e., those that have historically had a good total return and increase their dividend ~10% year after year) are crowding out the sellers. Prices for strong and stable “defensive” stocks, like Abbott Laboratories (ABT) and Colgate-Palmolive (CL), drift higher than what their earnings can justify. 

Does this really matter? Yes it does because timid investors see that price action and come off the sidelines to buy stock. Eventually, there’s almost no one left who wants to buy an overpriced stock and the market develops cracks. Buyers will only emerge when prices have fallen far enough for fundamental measures of value to justify the purchase. By that time, a lot of investors are underwater and are selling their Savings Bonds to fund cash-flow emergencies. The important point here is that a bear market can happen when the economy is doing just fine, as we saw on October 19, 1987. The Dow Jones Industrial Average fell 22.6% that day for no apparent reason other than “the big guys were selling their stock” because the market had gone up 44% in the previous 6 months.

For this week’s Table, we’ve listed all of the Dividend Achievers in the Barron’s 500 List that have an S&P bond rating of BBB+ or better and an S&P stock rating of A-/M or better. (That “M” in the denominator denotes medium risk, whereas, “L” denotes low risk.) To focus on growth companies we’ve excluded companies in the 4 “defensive” industries: healthcare, utilities, communication services, and consumer staples. The remaining 6 S&P industries are where we look for our “Core Holdings” (high-quality growth companies, see Week 102). Those industries represent 66% of the capitalization of the S&P 500 Index. Quite simply, your stock portfolio can’t capture market returns unless 2/3rds of it is in stocks issued by companies in those 6 industries: materials, energy, financial, industrial, consumer discretionary, and information technology. Even though those stocks will scare you when the market swoons, don’t sell unless the company’s “story” is broken. 

Most of the stocks in the Table are fully valued at present, i.e., have elevated P/E ratios (Column J) because investors expect those companies to have strong earnings growth over the next year. You don’t know what the future will bring, so look for companies that don’t have a P/E over 20. Try to spend your research time on the few companies that have hardly any metrics highlighted in red, which denotes underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX). 

Note: Companies that don’t have a Finance Value (Column E in the Table) higher than that for VBINX were excluded, as were companies that pay a dividend that amounts to more than 55% of their earnings (the “payout ratio,” Column I Table). Finally, companies that had a lower Barron’s 500 rank in 2014 than in 2013 were excluded, unless they ranked in the top 2/3rds both years (see Columns L&M Table).
Bottom Line: There are still some bargains to be found among growth stocks. The 17 companies in the Table meet our criteria for Core Holdings, but most are overpriced (average P/E = 22). Their investors have already enjoyed a strong run (Column F Table), and many will be looking to take profits. But there are 6 companies on the list that still offer good value relative to risk: ROST, QCOM, CB, IBM, LMT, GPC.

Risk Rating: 6

Full Disclosure: I dollar-average into NKE and IBM.

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Sunday, October 12

Week 171 - Thinking of Owning Farmland As An Investment?

Situation: Here on the Great Plains, owning farmland is the Great Game. Throughout the midwest, 60% of the land being farmed is rented. With corn prices down 50% from their 2012 peak, fixed rents are having to be renegotiated to reflect the falloff in farm incomes. “Custom financing” is becoming more prevalent, meaning that instead of a fixed rent the landlord gets half, 40% or 1/3rd of the revenue generated from crop sales at the end of the growing season. The tenant farmer pays all expenses other than property tax and insurance. 

Over very long time periods, farmland appears to be a better asset class to own than stocks. For example, farmland in southwest Iowa (Audubon County) that sold for $266/acre in 1963 was worth $9466/acre in 2013 for a price return of 7.4%/yr. Compare that to 6.6%/yr for the S&P 500 Index. You also need to consider that both asset classes produce income (rents or dividends) and are hammered by inflation, which averaged 4.2%/yr across that 50-yr interval. Farmland rents stay close to 5% of land value, bringing total return to 12.4%/yr. Reinvesting dividends on the S&P 500 Index over the past 50 yrs brings total return to 9.9%/yr. Accounting for inflation, those numbers drop to 8.2%/yr and 5.7%/yr. Farmland prices also show less volatility than stock prices, so farmland looks to be the hands-down winner!

Prime farmland in Eastern Nebraska or Western Iowa currently costs ~$9600/ac and is sold in quarter section (160 acre) parcels. You’ll need a big mortgage for that $1,536,000 price tag, even if you can come up with the $307,200 down payment. But unless you are yourself a farmer, this is not as wise an investment as it appears to be. Why? Like investing in gold, it predates and is outside the built-in benefits of capitalism: There’s no accrual accounting or compounding of interest (see Week 157). More importantly, you'll lose money when crop prices collapse like they did in 2013 and have continued to do this year.

For both tenant and landlord, the Great Game is to bet on the weather cycle as opposed to the economic cycle. The farmer can always tune in to a local AM radio station that will provide instant pricing for “futures” on farm commodities. As he’s driving his tractor, he can trade futures on the Chicago Mercantile Exchange (CME) by using his smartphone. When prices spike upward, farmers (and their landlords) can reap windfall profits if they act quickly. When prices spike downwards, the crop insurance that is built into every US Farm Bill will likely prevent efficient farmers from having to “cash out.” Farmers also have the option of buying grain bins to store their crop until the market recovers. And, most farmers “hedge” 20-30% of their crop against the risk that prices will fall, agreeing to sell at a pre-set price when the growing season ends by entering into a futures contract on the CME.

Farmers are gamblers, as are those among their landlords who take a cut of crop sales in lieu of a fixed rent. More often than not, their gambles pay off. Why? Because planet-wide protein production can’t keep up with the demand created by population growth and rising incomes, and weather-related crises are out of sync with economic crises. Now you know why Omaha came through the Great Recession better than any other American city.

For our readers, we’d better stress that owning farmland is another way to gamble on a commodity (see Week 163). Yes, big profits can occur but they’re a hit-or-miss thing with long dry spells punctuated by some bad years, such as 2014. That being said, the prudent move is to take the time-proven route to commodity profits, which is to invest in companies that service the producer (e.g. farmer) rather than the commodity itself (e.g. farmland and crop futures). In this case, it means investing in stock issued by companies that provide inputs (and outputs such as railroads) to “production agriculture.” Then add a couple of food-processing companies. Why? Because those companies supply food to grocery stores and can pass commodity costs on to the consumer.

How then might you make a farmland investment that benefits from the insights of capitalism (accrual accounting and compound interest)? That would be through dollar-cost averaging your stock purchases then reinvesting your dividends. We find only 10 companies that meet our criteria for inclusion in a retirement portfolio (Table). Our benchmark is the Vanguard Balanced Index Fund (VBINX) at Line 17 in the Table; red highlights denote metrics that underperform VBINX. Our criteria are:

        1) the company is an S&P Dividend Achiever, i.e., one that has raised its dividend annually for at least the past 10 yrs;
        2) the company has an S&P bond rating of BBB+ or higher;
        3) the company has an S&P stock rating of B+/M or higher;
        4) the company’s stock has a dividend yield of 1.4% or higher.

Now let’s see how those 10 stocks have done over the past 14 yrs as opposed to returns on owning farmland in Audubon County, Iowa, the benchmark we used above. Farmland values have grown 12.4%/yr and inflation has been 2.4%/yr. Adding 5%/yr in rental income and subtracting 2.4%/yr inflation leaves 15%/yr. For our 10 stocks, total return is close to 15%/yr, which makes after-inflation return ~12.5%/yr.

Bottom Line: Farmland has been the most stable and rewarding asset class to own for many decades, if not centuries. But is that extra 2.5%/yr (compared to Ag-related stocks over the past 14 yrs or the S&P 500 Index over the past 50 yrs) worth all the trouble and disappointments of being a tenant farmer's landlord? Property taxes are high, and slow to reset; fixed rents leave you with insufficient funds (after paying interest on the mortgage) to pay property taxes. But, if you have the patience of Job, live near the land you'd be renting, and want to gamble a million dollars, it probably is worth the trouble and disappointments. But to come out ahead you’ll need to have your tenant farmer pay you a revenue-based “custom” rent instead of a fixed rent. That saves him from having to pay you any rent at all in bad years like this one, so try to get him to settle for a 50:50 split of revenues (from crop sales at the end of the growing season).

Risk Rating: 8

Full Disclosure: I own shares of MON, HRL, GIS, MKC, PEP, and DE.

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Sunday, October 5

Week 170 - Growing Perpetuity Index (UPDATED)

Situation: Our blog (Invest Tune Retire) grew from the idea that owning “buy-and-hold” stocks only makes sense if you a) plan on using dividends from those stocks to supplement your retirement income, and b) pick the right stocks. The goal is to receive dividend checks during retirement that grow faster than inflation (see Column H in our Table). We began writing our blog using an unchanging index of a dozen stocks that would bring this idea into focus. To have a catchy name for that index, we borrowed a finance term that is used to describe a rare type of bond that pays out more interest year after year, called a growing perpetuity.

To pick stocks for our Growing Perpetuity Index (see Week 4), we turned to the Dow Jones Composite Index of 65 stocks, which includes the 30-stock Dow Jones Industrial Average (DJIA), the 20-stock Dow Jones Transportation Average and the 15-stock Dow Jones Utility Average. To qualify, stocks were required to: 

1) have a dividend yield no less than that for the exchange-traded fund (ETF) that mimics the S&P 500 Index (SPY);
2) be an S&P “Dividend Achiever” with 10+ years of annual dividend increases;
3) have an S&P stock rating of A- or better;
4) have an S&P bond rating of BBB+ or better.

We turned up 14 stocks but chose to limit our list to 12. Two utilities qualified, NextEra Energy (NEE) and Southern Company (SO), but we decided to include only one. We kept NEE because it is the dominant player in renewable energy (wind and solar). One transportation stock qualified, Norfolk Southern (NSC). There were 11 that qualified from the DJIA, so we needed to exclude one. Caterpillar (CAT) was excluded because the company had not raised the dividend for 24 months during the Great Recession, even though S&P still granted it Dividend Achiever status. After more than 3 yrs, the same 14 are the only companies that continue to qualify. Red highlights in the Table denote underperformance relative to our benchmark, Vanguard Balanced Index Fund (VBINX). For comparison purposes, the Table includes a section for stocks in the Barron’s 500 List that meet our criteria but aren’t in the Growing Perpetuity Index.

Bottom Line: It is not easy to identify high quality, buy-and-hold stocks that pay good and growing dividends. The 65-stock Dow Jones Composite Index has 14 such stocks by our criteria, the same number as in July of 2011 (see Week 4). We use 12 of those stocks to make up our Growing Perpetuity Index (see Table) but there are 28 more in the Barron’s 500 List that meet our criteria, including Microsoft which becomes a Dividend Achiever later this year. In both the list of 12 Growing Perpetuity Index stocks and the list of 28 similar stocks, the majority are S&P Dividend Aristocrats (see Column P in the Table), meaning that there has been a dividend increase approximately every year for at least the past 25 yrs. That’s the best sign that you’ve picked the right stock for your retirement portfolio (see Week 146).

Risk Rating for the Growing Perpetuity Index: 4

Full Disclosure: I dollar-average into XOM, WMT, JNJ, MSFT, ABT, PG, and NEE.

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