Sunday, November 16

Week 176 - Non-Speculative Stocks

Situation: Here at ITR, we “mine” data that are readily available on the internet. The idea is to use objective information to help retail investors avoid disappointment. The main problem, of course, is that American corporations tend to expand by borrowing the money needed. Why? Because interest payments aren’t taxable. Each year, the average company spends 5% more on expansion than it can afford to extract from its cash flow. That 5% has to be borrowed. Presumably, the company’s growth plan will bring in enough additional cash flow to pay back the loan. (Would that the world were so kind!) 

If a company keeps growing its long-term debt (instead of paying it down), investors will shy away and its stock price will plateau, or even fall. The company then has to create incentives that keep investors from abandoning it. For our investment purposes, we like the one where the company pays a nice dividend and grows it ~10%  each year. That incentive, however, requires even more cash flow. Now the company may have to borrow more money to remain true to strategy. This means the company will have to revise its business plan, e.g. get rid of underperforming divisions. (Even “blue chip” companies like Procter & Gamble face this dilemma.) Tangible Book Value may disappear as interest payments keep rising. The dividend payout (as a percent of earnings) will likely drift higher, and when it gets higher than 50-60% long-term investors start to bail out of their positions.

You get the point. Even the soundest of companies will eventually face an opportunity for expansion that cannot be afforded without borrowing money. That is why the US government has created an incentive to take out that loan by waiving taxes on the part of earnings that will be used to make interest payments. The government calculates that the expanded company will be able to pay more taxes soon, and everybody wins. In reality, the company is taking a gamble and the government is a partner in that gamble. Now you see why there are very few of what can truly be called “non-speculative” stocks. For this week’s blog, we’ll try anyway to identify some. By using the following screening metrics, we’ve come up with a short list of what we think are “buy-and-hold” companies:
   1. The company’s bonds have an S&P credit rating of A- or better.
   2. The company’s stock has an S&P rating of A-/M or better.
   3. The company is an S&P Dividend Achiever with at least 10 yrs of dividend growth.
   4. The company has a positive tangible book value (TBV), as calculated by S&P.
   5. The stock price is less than 7.5 x TBV.
   6. The company’s dividend payout is no more than 50% of earnings (65% for utilities).
   7. The company’s EV/EBITDA is no more than 14.
   8. The company’s stock investors lost less than 60% during the 18-month Lehman Panic.
   9. The company’s Finance Value (Col E in the Table) is better than -40%.

What’s EV/EBITDA? Its a time-proven way to get a better handle on stock valuation than P/E. EV stands for Enterprise Value, which is what a private equity firm would need to pay if it wanted to buy the company, meaning it would assume responsibility for the company’s debts and purchase all outstanding shares of its stock. EV is “neutral” with respect to capital structure: bonds and stocks are treated the same. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, i.e., operating earnings. EBITDA is “neutral” with respect to capital expenditures. They’re not included. Unlike P/E, EV/EBITDA can’t be fudged.

We’ve identified 13 companies (see Table) that meet all 9 requirements; they’re not overpriced. These companies learned to grow by investing retained earnings rather than borrowing more money. When retained earnings proved insufficient, they tended to issue more stock. Their managers and shareholders accepted the fact that they’ll be paying more taxes than if they’d borrowed the money. This means they’ve learned to delay some capital expenditures. In other words, opportunity risk has replaced credit risk. Metrics in the Table that have been highlighted in red to indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX). 

Stepping back for a moment, to reflect on our method for coming up with that list of 13 buy-and-hold stocks, you’ll note that we depend on measurements of past performance. In a history class, “the past is prologue” but not in Corporate America. The character of management personnel is determinative and difficult to measure, which is why we’ve used multiple metrics to steer you away from companies that are addicted to debt. Fortunately, we can sort out that issue objectively. The future prospects of a company’s sub-industry, however, is an even more important issue and it will require a subjective assessment. You’ll have to do that yourself by learning to evaluate the “story” that supports each company’s stock price. That story emerges from the Business Plan and is carefully designed to hold up even if the company’s competitors prove to be more nimble. But it won’t hold up when a technological breakthrough makes the entire sub-industry obsolescent. For example, the energy industry will be transitioning away from “fossil” fuels because those produce greenhouse gases that pollute the air and heat the atmosphere. Caveat Emptor.

Bottom Line: Company research certainly helps an investor make fewer mistakes. But currently most companies are on a downward path. They’re caught up in “mission creep” that is paid for with an ever-increasing use of debt. Until the US tax code stops incentivizing managers to take that path, stock-pickers will have trouble beating broad-based index funds. Why? Because the Wilshire 5000 Index and The Vanguard Total Stock Market Index Fund (VTSMX) include “startups” and small or mid-cap companies that are unable to qualify for a long-term loan with an acceptable interest rate, meaning a rate that is less than the company’s rate of return on assets (ROA).

Remember that the only reason to be a stock-picker is to nail down a stream of retirement income that grows 2-4 times faster than inflation (see Column H in the Table). There are no mutual funds (or other asset classes) that can do that for you. But you’ll get rich faster by sticking to a low-cost, broad-based mutual fund like VTSMX. And, of course, hedge the volatility risk of that investment with a low-cost, corporate/government bond fund like the Vanguard Intermediate-Term Investment-Grade Fund (VFICX). The “B shares” of Berkshire Hathaway (BRK-B) are another low-cost way to access the kind of diversification without reliance on debt that makes sense to us here at ITR.

Risk Rating: 4

Full Disclosure: I dollar-average into WMT and NEE, and also own shares of HRL, ABT, CVX, XOM, and LECO.

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