Sunday, February 22

Week 190 - Consumer Staples Companies in the Barron’s 500 List

Situation: Consumer Staples . . . sounds boring, doesn’t it? Here’s why you need to pay attention to this industry. That’s where you’ll find the companies that make all those things we couldn’t make it through the day without: “stuff” we need like food, toothpaste, personal hygiene products, cleaning products and kitchen paraphernalia. Some of us regularly use coffee, tobacco, alcohol, sports equipment, or beauty aids; those also come under Consumer Staples. Demand for these products is inelastic, due to their relative insensitivity to the ups and downs of the economy, i.e., the same numbers of units will be sold whether the price is up or down. If the manufacturer’s cost of production goes up, those costs will be passed on to the consumer without affecting the volume of sales. This degree of “pricing power” is rarely encountered in the other 9 S&P industries. You might think Consumer Staples companies have a license to print money but don’t be fooled. Competition is intense. These companies need to have large worldwide marketing budgets to grow sales, even for familiar brands like Procter & Gamble’s beauty products such as Pantene shampoo.

Here at ITR, we think you should pay close attention to all companies that have large revenues and multiple product lines. Why? Because such companies have strong brands, flexibility to adjust product lines during recessions, and committed customers. The downside is that large companies selling “essential goods” (i.e., Consumer Staples companies) don’t have to fear bankruptcy, thus leading their Chief Financial Officers to conclude that there is little to be gained from building up Tangible Book Value.

In constructing this week’s Table, we’ve examined all of the companies in the Barron’s 500 List, meaning the 500 largest companies by revenue that are listed on the New York and Toronto stock exchanges. Then we’ve eliminated companies that lack the usual indicators of long-term value, namely an S&P bond rating of BBB+ or better and an S&P stock rating of B+/M or better. Those ratings indicate a history of rewarding investors without burdening them with undue risk. Of the 20 companies that survived our cuts, 14 are Dividend Achievers (see Column R in the Table). 

As a group, these stocks appear overpriced when you compare the trailing P/E ratio with the S&P 500 Index’s (see Column J in the Table). However, other measures of value indicate that the group is no more overpriced than the S&P 500 Index. EV/EBITDA in Column K averages 12, whereas our estimate for overvaluation is any number above 13. And, the 20-yr log-linear price trend in Column M shows prices that currently average one standard deviation above trend (i.e., the same 1SD elevation as the S&P 500 Index). Two of the higher-quality companies have pricing that is on trend, Wal-Mart Stores (WMT) and JM Smucker (SJM). Those two companies, plus Hormel Foods (HRL) and PepsiCo (PEP) are on our list of Lifeboat Stocks (see Week 174). A final point: 12 of the 20 companies listed in the Table are food-related, which tells us they’re growth companies, given that tens of millions of people per year emerge from poverty in East Asia and adopt middle-class tastes for food.

Bottom Line: Consumer Staples are where you’ll find rewarding stocks that still allow you to sleep through the night.

Risk Rating: 4

Full Disclosure: I dollar-average into WMT and also own shares of HRL, GIS, KO, PEP, and PG.

Note: Metrics highlighted in red indicate underperformance relative to our benchmark (VBINX); values in the Table are current for the Sunday of publication.

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Sunday, February 15

Week 189 - Buffett Buy Analysis of Barron’s 500 List

Situation: What factors underlie pricing for the S&P 500 Index? Is it the capital gains of the collective companies? Is it dividends? Is it stable and/or predictable interest rates? And how much do random fluctuations in the appetite of investors affect prices? With the appearance of big main-frame computers in the 1980s, academicians could start to model these questions. It turns out that only two things matter to S&P 500 Index pricing, earnings and short-term interest rates. That predicts the market may be headed for a fall, given the current expectation that the Federal Reserve will start raising short-term interest rates later this year.

In that event, you’ll want to know which stocks are best positioned to weather such a storm. I know of no other way to answer the question than to subject the 500 stocks in the Barron’s 500 List to the Buffett Buy Analysis (see Week 183 and Week 30 for details). The “BBA” is only useful if the company has been growing its wealth (Tangible Book Value) steadily over the previous decade. By “growing its wealth”, Mr. Buffett means TBV is rising at a rate over ~9%/yr. (We’ll settle for 7%.) By “steadily”, Mr. Buffett means that TBV fell no more than two yrs over the past decade. The BBA is simply an extension for 10 more yrs of the rate at which core earnings grew over the past 10 yrs. That estimates the company’s earnings for 2024, which are multiplied by the lowest P/E seen during the past decade to arrive at the expected stock price in 2024. But if the company pays a yearly dividend, that amount is multiplied by 10 and added. The expected price in 2024 is compared to the current price to give the average total return/yr over the next 10 yrs (BBA) by using a Compound Annual Growth Rate (CAGR) calculator. You’ll find the key numbers in Columns N through R of this week’s Table

Sadly, there were only 16 companies with a BBA higher than ~7%/yr. For the most part, that is because prices have been driven up by short-term interest rates that have been under 1% for almost 6 yrs, thus making it cheap for investors to borrow money and invest it in stocks. Those currently elevated stock prices lower the CAGR that prices can achieve over the next 10 yrs.

What can we conclude from the 16 companies that passed the BBA test? For starters, two are railroads, Union Pacific (UNP) and CSX. Those industrial companies are joined by two more: Fluor (FLR) and Expeditors International of Washington (EXPD). Five additional companies are in the information technology sector: Apple (AAPL), Google (GOOGL), Oracle (ORCL), QUALCOMM (QCOM), and Cognizant Technology Solutions (CTSH). Three are Consumer Discretionary stocks: Ross Stores (ROST), Dick’s Sporting Goods (DKS), and Starbucks (SBUX). Two are oil exploration companies: Cameron International (CAM) and National Oilwell Varco (NOV). Two are financial services companies: JP Morgan Chase (JPM) and Travelers (TRV). In summary, 5 of the 10 S&P industry sectors failed to make an appearance (Consumer Staples, Healthcare, Utilities, Communication Services, and Materials), suggesting that those will be contributing little to growth.

Bottom Line: There are some bumps coming for the stock market. Prices have been inflated by cheap money and the lack of competition from bonds. Lifeboat Stocks (see Week 174) are particularly overpriced so you’ll need to maintain a program for investing in growth industries. In this week’s Table, there are 16 growth stocks that get passing grades from the Buffett Buy Analysis.

Risk Rating: 6

Full Disclosure: I dollar-average into JPM, and also own shares of QCOM. 

NOTE: Metrics highlighted in red denote underperformance relative to our benchmark, VBINX; metrics are brought current as of the Sunday of publication.

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Sunday, February 8

Week 188 - Markets Fall, Markets Rise. You’ll Need a Safety Net.

Situation: For almost 6 yrs, the stock market has risen steadily on the back of Federal Reserve policies that make investing in bonds seem foolish. That’s fun for awhile, especially if you’re a stock-picker. But it won’t be fun for much longer. “Defensive stocks” -- the best of which we refer to as “Lifeboat Stocks” (see Week 174) -- are now overpriced (except for WalMart). In addition, the Federal Reserve is likely to raise interest rates in 2015. That will encourage investors to take some money out of stocks and put it into bonds, rebalancing those competing assets. In such an event, you'll be likely to face two issues: 1) There may be a stock market pullback heralded by key infrastructure stocks, as appears to be happening already; 2) defensive stocks will get hurt as much as growth stocks because they’re more overpriced. That means you’ll want to dollar-average into growth stocks, i.e., stable, long-term outperformers selling at a reasonable price. To help you find those, we’ve subjected the entire Barron’s 500 List to the Buffett Buy Analysis (see Week 30 and Week 183).

Because of overpricing throughout the stock market, our list of companies for you to consider is rather short. It contains only 16 names and, as expected, none are from defensive industries (consumer staples, healthcare, utilities, and telecommunication services). You’ll see the entire list in next week’s blog but there are only 3 Dividend Achievers among the 16: Ross Stores (ROST), QUALCOMM (QCOM), and Expeditors International (EXPD). We’re particularly interested in those companies, since their record of raising dividends annually for at least the past 10 yrs makes their stock valuable in retirement as a way to beat inflation.

For this week’s Table, we’ve taken those 3 companies and added 4 more that I dollar-average into and call “Cornerstone Stocks.” Those 4 are WalMart Stores (WMT), ExxonMobil (XOM), Microsoft (MSFT), and NextEra Energy (NEE). You should pick 4 of your own to dollar-average into. 

Bottom Line: These 7 stocks are likely to mitigate your losses in a bear market and perform better than our benchmark (VBINX) in a bull market. As a group, they’ll form a Safety Net for your portfolio. However, only two are Hedge Stocks (see Week 182), WMT and NEE, so you’ll need to balance your investment in any of the other 5 companies with Treasury Notes, Savings Bonds, or a low-cost intermediate-term bond index fund like VBIIX (which is entered 5 times in the Table to represent this balancing).

Risk Rating: 4

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

NOTE: Metrics highlighted in red denote underperformance relative to our benchmark, VBINX.

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Sunday, February 1

Week 187 - Barron’s 500 List: Utilities With Good Credit

Situation: Utility stocks work a lot like bonds, since most utilities are ~60% capitalized with bonds backed by a state government. Being monopolies, both consumers and investors are protected by state and federal regulation. The Dow Jones Utility Average (DJUA) consists of 15 stocks that have been selected by a committee chaired by the managing editor of The Wall Street Journal. Since 1928, the DJUA has served as a technical indicator for stock-market health. This is due to the fact that stocks (particularly utilities) perform best in a low interest-rate environment. In the 72 yrs since the DJUA bottomed in 1942 (just before the Battle of Midway), it has risen at a rate of 5.7%/yr (without reinvestment of dividends) vs. 7.9%/yr for the S&P 500 Index without reinvestment of dividends, compared to 5.6%/yr for 10-yr Treasury Notes with reinvestment of interest payments.

Since January of '04, an exchange-traded fund that tracks the DJUA (IDU in the Table) has been available. With dividends reinvested, it has grown 2%/yr faster over the past 11 yrs than the lowest-cost S&P 500 Index fund with dividends reinvested (VFINX in the Table). And, it accomplished this feat with lower risk (see Column D and Column I in the Table). However, part of that performance is unsustainable because the Federal Reserve has kept overnight interest rates (for interbank loans) below 0.2% since November of '08. That policy is projected to end in 6 months and, once it does, utility stocks will gradually return to normal valuations relative to operating earnings. But utility stocks will always be somewhat like bonds in that they’ll represent “portfolio insurance” against stock market crashes.

For this week’s Table, we’ve examined all of the utility stocks in Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges. The Barron’s 500 List is helpful because companies are ranked both by their combined scores on sales growth and cash-flow based Return On Invested Capital (ROIC). For the Table, we have excluded any companies with an S&P bond rating less than BBB+ or an S&P stock rating of less than B+/M, leaving us with 9 stocks. Six are dividend achievers (Col P in the Table) and 5 are in the DJUA (Col T in the Table). Four are on both lists (NEE, ED, SO, D). A good way to get started investing in utilities is to pick two of those 4 stocks, then use dollar-cost averaging to build a “utility position” that eventually amounts to 4% of your retirement portfolio. There is probably no better investment to have in a low interest-rate environment. In a market crash, they’ll serve you almost as well as a corporate bond fund like the Vanguard Intermediate-term Corporate Bond Index Fund (VFICX at Line 15 in the Table). And a crash can’t be that far off, given the inflation in financial assets since '08 when the Federal Reserve began its policy of Financial Repression. For further explanation of Financial Repression, see Week 76 and Week 79.

Caveat Emptor: Utility stocks are presently over-priced. In the Table, this is seen most clearly for the utilities involved in natural gas storage and distribution (SRE and D): see the metrics for P/E (Col J) and EV/EBITDA (Col K). When running the Buffett Buy Analysis (see Week 30) in Cols U through Y, we see that those same companies have lost much of their future value to investors (see Col Y) because of overvaluation (see Col J and Col K).

The utility industry is evolving. It has been my good fortune to serve on the Board of Directors of a private power company for the past 15 yrs that provides heat, electricity, and air conditioning to an urban institution. The changes have been remarkable, as we’ve gone from depending on a coal-fired power-plant that only employed natural gas for “peaking power” to a natural gas-fired cogeneration plant, supplemented by solar, wind, and hydroelectric power. This is the future, happening now.

Bottom Line: High-quality utility stocks are safe and effective investments to include in your retirement portfolio. As a group, the 9 listed in our Table have returned ~12%/yr since '03 while losing less than 20% during the 18-month Lehman Panic. The index fund that reflects the Dow Jones Utility Average (IDU) did almost as well, gaining ~10%/yr while losing 35% during the Lehman Panic. This record beats the lowest-cost S&P 500 Index fund (VFINX), which only gained ~8%/yr while losing over 46% during the Lehman Panic. The rewards from owning utility stocks outweigh the risks, even in times of financial crisis. The question is: How much longer will the current low interest-rate environment (that has been so beneficial to debt-laden utility companies) persist? I would say we’re closer to the end than the beginning 6 yrs ago. Once interest rates start rising, you’ll see prices hold up better in utilities that have adopted a low “carbon footprint.” Likely beneficiaries include Dominion Resources (D) because of its dominant position major in natural gas storage & distribution, and NextEra Energy (NEE) because of its dominant position in wind and solar power.

Risk Rating: 4

Full Disclosure: I dollar-average into NEE and also own shares of D.

NOTE: metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).

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