Sunday, March 15

Week 193 - Barron’s 500 Companies with 25 years of Below-Market Variance in Stock Price Appreciation

Situation: Now that US stock and bond markets appear to be fully valued, it is time to pause and reflect. The metric we refer to as Finance Value is derived by subtracting risk from reward. But what is reward and what is risk? Reward is stock-price appreciation (plus appreciation due to reinvested dividend payments) over the long term. Let’s call it the 25 yr period that for most people is the most active time of saving for retirement. Risk can be summed up by a term from statistics: variance. 

As defined at the Investopedia website, variance is “a measurement of the spread between numbers in a data set. The variance measures how far each number in the set is from the mean. Variance is calculated by taking the differences between each number in the set and the mean, squaring the differences (to make them positive), and dividing the sum of the squares by the number of values in the set . . . Since variance measures the variability (volatility) from an average or mean, and volatility is a measure of risk, the variance statistic can help determine the risk an investor might take on when purchasing a specific security.” What does this mean in practical terms? Variance tells us how closely a company skirts the edge of oblivion (bankruptcy). The quickest way to track variance is to always check out the S&P credit report.

The S&P 500 Index has 4-5 times the level of variance that is found in an investment grade bond index. If stocks represent more than 25% of your retirement savings, you'll feel pain from a stock market crash. (Stocks can go down a lot just when you need the money.) The solution is to overweight bonds in your portfolio, or buy shares of a mutual fund that will do that for you (e.g. VWINX at Line 20 in the Table). However, few people who haven’t been to business school can embrace that idea of overweighting bonds. Why? Because it is much more entertaining to own stocks, and the incentives are greater. Those incentives include 1) greater returns over the very long term; 2) greater transparency of valuation metrics; 3) a narrower spread between bid and ask prices; 4) dividend payments that track earnings vs. interest payments that are fixed; 5) earnings growth that usually stays ahead of inflation, whereas, bonds lose value with inflation. Bondholders, however, benefit from two distinct advantages: 1) the return of principal upon maturity of the bond, whereas, stocks merely provide a return on principal; 2) in the event of bankruptcy, bondholders get money from the sale of assets but stockholders get nothing. 

We'll look at several measures of risk over a 25-yr time period, to see if we can come up with a few stocks in the Barron’s 500 List that are less risky than the S&P 500 Index by every one of those measures. 

We’ll start with the “BMW Method” to examine variance in CAGR (compound average growth rate) for stock prices over the past 25 yrs. This analysis will tell us the rate of price appreciation arrived at from the “least squares” calculation defined above for daily prices over 25 yrs. Applying the "least squares" test creates a trendline for the logarithm of daily prices. The BMW Method data set has 25-yr log-linear plots for the stocks of 560 companies, revised forward at the first of each month. At the BMW website, you’ll find that each regression line (of price over time) has two parallel lines above it and two parallel lines below it. Those represent one or two Standard Deviations (1SD or 2SD) from the rate of price appreciation. For example, the S&P 500 Index (^GSPC) has a 25-yr price appreciation of 6.4%/yr and the -1SD CAGR is 20% less (5.2%/yr).
In the Table, we list the 25-year rate of price appreciation in Column Q and the Standard Deviation (plus or minus 1SD or 2SD) in Column R. Most stocks, and the S&P 500 Index, are currently “on trend.” We’ve excluded companies whose current stock prices are 1SD or 2SD off trend, since that represents the volatility we’re trying to avoid. We’ve also excluded stocks that have a 5-yr Beta greater than the 5-yr Beta for the hedged S&P 500 Index (VBINX at Line 22 in the Table), as well as stocks with a 25-yr growth rate that has greater variance than the S&P 500 Index. Stocks that haven’t exceeded their best price in last bull market, which ended in October of 2007, are also excluded. In addition to these variance criteria, we’ve excluded companies that lost more than the 46.5% that the lowest-cost S&P 500 Index fund (VFINX at Line 24 in the Table) lost during the 18-month Lehman Panic. And, we’ve excluded companies with S&P bond ratings below BBB+ and/or S&P stock ratings below B+/M. 

Only 15 companies remain (Table). Its not surprising that 11 of those are Dividend Aristocrats, i.e., companies that have been growing their dividends annually for at least 25 years (see Column V in the Table).

Now let’s look at valuation metrics like P/E and EV/EBITDA (Columns J and K in the Table). And, we’ll add a new twist: PEGY (Column N), which is P/E divided by two metrics: estimated 5-yr rate of Growth in earnings (Column L) and dividend Yield (Column G). Recall that any P/E higher than 20 suggests that the stock is overpriced, since earnings yield then falls below 5%. Similarly, any company with an Enterprise Value that is more than 13 times higher than year-over-year operating earnings is overpriced (in our opinion). For PEGY, we think any number over 2.0 suggests that the stock is overpriced while any number under 1.2 suggests that the stock is underpriced. Taking these 3 metrics together (P/E, EV/EBITDA, and PEGY), which of the 15 stocks flunk all 3 tests? There are 4: CLX, CL, KO, HSY. The only stocks that are not overpriced by any of those 3 metrics are: McDonald’s (MCD), Microsoft (MSFT) and Comcast (CMCSA).

Bottom Line: This week we’ve tried to take the sting out of the stock market by finding stocks that have a 25-yr history of being less risky than the S&P 500 Index by every one of several volatility tests. We found 15, and 12 of those companies happen to be “defensive” stocks as defined by Standard & Poors (i.e., companies in the Consumer Staples, Healthcare, Utilities, and Communication Services industries). Then we looked at valuations, finding that 4 of the 15 are pricey by 3 metrics: P/E, EV/EBITDA, and PEGY. Those 6 are balanced by 5 stocks that aren't pricey (McDonald’s, Microsoft and Comcast).

Risk Rating: 4

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

NOTE: Metrics in the Table are brought current as of the Sunday of publication; red highlights denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).

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