Sunday, April 26

Week 199 - Stocks with 25 years of Below-market Variance and Above-market Returns

Situation: Investing in stock and bond index funds have to be part of your retirement savings plan, since fees and transaction costs are negligible at the main vendor (Vanguard). In retirement, you can sell parts of those holdings as needed but the smarter move is to simply spend the dividends. However, those payouts don’t keep up with inflation most years. That’s why we recommend, as a supplemental plan, investing in high-quality buy-and-hold stocks through a dividend reinvestment plan (DRIP) with the intention of spending those dividends in retirement. Dozens of such stocks are available for direct purchase online through DRIP vendors like Computershare and Wells Fargo. However, there are two obvious problems: 1) automatic monthly investments in small dollar amounts can be costly; and 2) selection bias, i.e., you can only acquire large positions in approximately 10 stocks during a typical 25-yr accumulation period, and those will have to be stocks with a long history of growing dividends faster than inflation. The trick is to avoid stocks with more volatility than the S&P 500 Index and/or a history of lower returns.

This week’s blog builds on our Week 193 blog, where we introduced the concept of using several variance metrics over a 25-yr period to define volatility, then find stocks that have less volatility than the S&P 500 Index (^GSPC), as well as a higher CAGR (Compound Annual Growth Rate). You'll also want stocks with a better dividend growth rate than the Vanguard 500 Index Fund (VFINX), which hasn't kept up with inflation. 

In that Week 193 blog, we looked at stocks on the Barron’s 500 List and came up with only 15 (which had to be revised down to 10 to exclude/include after closer examination). To broaden our reach, we’ve now looked at all 650 stocks in the BMW Method dataset for 25-yr price variance in CAGRs. Only those that track ^GSPC (which has returned to trendline since the Lehman Panic) are of interest to us this week. Why? Because stocks that show recent performance that is one or two Standard Deviations above or below trend reflect an emergence of greater variance than ^GSPC. That may be for good reasons or bad, but our goal in this blog is to find stocks with growth trends that align with market fluctuations (^GSPC), then find the few that have lower price variance along with greater price appreciation. Otherwise, why bother? (Just invest in VFINX and make more money at lower cost and less risk.)

In the Table, you’ll see our results from screening all 650 stocks having 25 yrs of price variance data. Only 15 meet our criteria, i.e., have a CAGR that exceeds that for ^GSPC but with a lower price variance, which we define as your percent loss at 2 Standard Deviations below CAGR. That is, roughly every 20 yrs you can expect to lose value by the percentage listed in Column U of the Table. For example, if the Vanguard Total Bond Market Index Fund (VBMFX) were to sustain a price drop of 2 Standard Deviations (which it did 3 yrs ago), investors would lose 10% vs. a 40.6% loss for ^GSPC. In other words, stocks are 4.1 times riskier to own than bonds over the most recent 25 yr holding period.

To be sure those projections are current, we exclude stocks that haven’t returned to their pre-Lehman Panic trendline along with ^GSPC, and those that have a 5-yr Beta which is higher than that for the hedged S&P 500 Index (VBINX), which is 0.91. We have also excluded stocks that lost more than 46.5% (with dividends reinvested) during the 18-month Lehman Panic, which is the amount lost by VFINX. Other criteria are that the company's S&P bond rating be no lower than BBB+ and its S&P stock rating be no lower than B+/M. Also, the stock must have moved to new highs since the Lehman Panic.

We’re looking for Unicorns, i.e., stocks that have done better than the S&P 500 Index while being less risky. These same 15 stocks are unlikely to keep performing like that over the next 25 yrs, but the exercise is instructive. Why? Because it has taught you to stick with VFINX or its hedged version (VBINX), if you can’t pick stocks like these consistently AND keep track of both the “story” and the earnings projections that support their pricing. Nine of the 15 are Dividend Achievers, and a different group of 9 have high enough revenues to appear on the Barron’s 500 List. Those 11 stocks are the ones you’ll want to research before starting a new DRIP.

Business schools teach that there are only two ways to beat the market: 
   1) take on more risk, which means higher costs because you’ll be trading more frequently; 
   2) trade on insider information, which is illegal unless you own the entire company (Warren Buffett's preferred strategy).

Bottom Line: This week’s Table has 15 stocks that have defied gravity for the past 25 yrs, i.e., outperformed the market while incurring less risk. And, they’ve grown dividends faster (see Column H in the Table) than the 25-yr inflation rate of 2.3%. Seven of those 15 companies are in the Consumer Staples industry.

You can "whittle away" risk, as we've done here, but it’s just another hedging strategy based on past performance. All such plays are intended to insulate your portfolio from a stock market crash. But they also limit your portfolio's upside potential. Historically, the S&P 500 Index has been found to move higher 55% of the time. By hedging, you're trading a smoother ride for lower performance. Sometimes you’ll find a smoother ride with better performance, as shown in this week’s Table. But for how long will that continue? 

Risk Rating: 4

Full Disclosure: I own shares of MKC, PEP, ITW, and PG.

NOTE: Metrics in the Table are current as of the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, which is the Vanguard Balanced Index Fund (VBINX).

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Sunday, April 19

Week 198 - Food Processors

Situation: Food and agriculture stocks should be good investments. Food is an “essential good” and its availability is tied as closely to weather trends as to macroeconomic trends. (Farmland is the most rewarding asset to own on a risk-adjusted basis.) But the companies that actually process grain and meat for sale in grocery stores don’t do so well. Why? Because food processing, to be efficient, has to be done at large regional plants. That means packaged food has to be transported over long distances, often in refrigerated vehicles, which is expensive. Locally-owned companies and farmer’s cooperatives have the competitive advantage (see Week 177 and Week 178). But some publicly-traded companies have been able to centralize food processing by purchasing raw food commodities in large volumes, then using refrigerated railcars and ships to distribute the packaged food over long distances. Another strategy has been to produce organic foods, coffee, chocolate, specialty beverages and other upscale food offerings that have high pricing power in combination with low price elasticity. People will pay top dollar for their favorite treat, even if it comes from a country they’ve never heard of and couldn’t find on a map. Ivory Coast for example, where cocoa for half the world’s chocolate is grown.

There are 17 Food Processors in the Barron’s 500 List but two are missing from the Table because their company’s bonds are “junk-rated” (S&P bond rating below BBB-). Six of the 15 are Dividend Achievers (see Column P in the Table), and 3 more Dividend Achievers have been added that don’t have revenues high enough to be included in the Barron’s 500 List. We’ve also included the biggest Food Processor on the planet: Nestle (NSRGY), based in Switzerland. We’ve also included two additional international companies: Unilever plc (UL) and Danone (DANOY). You’ll note that 9 of these 21 companies were highlighted in Week 191’s list of 14 “Key Food and Agriculture Companies.” That list focused on the most valued players along the entire food chain. This week’s list drills down on the food processing sector, i.e., companies take over after crops and meat animals leave the farm.    

To evaluate the risk of owning stocks in any of the 21 companies listed in the Table, look at 4 metrics: losses during the 18-month Lehman Panic (Column D in the Table); 5-yr Beta (Column I); S&P bond rating (Column N); and the S&P stock rating (Column O), where the lower letter indicates risk, and H is high, M is medium, L is low. Be aware that stocks of defensive companies like Food Processors are ~10% overpriced (see Column J in the Table). However, operating earnings relative to enterprise value (Column K in the Table) are still within the normal range. Valuation shouldn’t pose a problem for the long-term investor who picks stocks of quality companies and practices dollar-cost averaging

This week’s blog refreshes our previous blog on the same subject (see Week 161), removing two companies that carry a poor credit rating and one that was bought out by another company on the list. Those 3 losses have been replaced by 4 new companies to the list: Archer-Daniels-Midland (ADM), which is involved in food production and the distribution of food commodities but also does some food processing; Seaboard (SEB), which is involved in hog production and pork processing; Ingredion (INGR), formerly known as Corn Products International; and Unilever plc (UL).

Bottom Line: You need to pay attention to Food Processors when planning for retirement. Foods are “essential goods” that have inelastic prices. In other words, if raw commodities (wheat, rice, soybeans, corn, pork bellies, chicken wings, packaged beef, etc.) rise in cost, the company passes those costs on to the consumer without fear that sales will drop. The market for food is not saturated, as many investors think. Instead, it grows reliably: Every year, ~10 million people in East Asia move up from poverty and can finally afford an adequate protein intake (60+ grams a day). Another benefit is that the value chain for food depends on the weather cycle as much as the economic cycle. By owning stock in food companies, you are holding, in part, a non-correlated asset-, i.e., one that is not tied closely to the economic cycle. Such assets tend to be relatively unaffected by recessions. 

Risk Rating: 4

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

NOTE: red highlights in the Table denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX); metrics in the Table are current as of the Sunday of publication.

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Sunday, April 12

Week 197 - Farm Tractors

Situation: You’ve no doubt noticed that we prefer to blog about food and agriculture. And we’ve told you why, several times. But even though such companies enjoy certain advantages, and the relatively strong and stable earnings that come from those advantages, their stocks still don’t fit into retirement portfolios very well. You’ll need to be selective, and be willing to trade stocks as opposed to forgetting about them (confident that they’ll keep doing well over the long term). For example, fertilizer companies produce a commodity and may depend on an expensive commodity like natural gas to make fertilizer. But commodity markets, always and everywhere, are a font of volatility. Companies can go out of business if they depend on a commodity and haven’t hedged its future cost. Farmers also have to do that, to be sure they’ll get the right price for their grain at the end of the growing season. 

So, we have to look at the inputs to food production as well as outputs which, in a stepwise process, result in packaged food on the grocery store shelf. You have to break down the economic value of each participant. This week we’ll look at farm tractors, one of the main inputs to agriculture. In future weeks we’ll look at others: farmland rents, harvesters (combines), seed, animal feed, irrigation systems, insecticides, herbicides, fungicides, farm labor, and property taxes. A key point to remember is that farmers won’t spend any more money on these inputs than they have to unless they made out very well at the end of the last growing season. In other words, they sold their crop or their animals into a market characterized by scarcity of those items: prices were high. Those shortages only happen when farm production has fallen precipitously in one of the world’s important producing countries (Australia, Brazil, Argentina, Ukraine, China, India, Canada, or the US). When crops are abundant in all those places, prices fall to a point where farmers are doing well to break even. Those farmers will not be replacing their old tractor soon. That’s why these stocks have such a high beta (see Column I in the Table). They also performed poorly in the Great Recession (see Column D in the Table), but farmers’ lack of interest in buying tractors was for reasons external to the prices they received for farm commodities (which held up well). 

Tractors are sold worldwide by several companies but farmers in different parts of the world prefer certain tractor brands over others. Deere (DE) is the leading tractor producer and a big name in the US and South America, but AGCO tractors(the 3rd leading producer) are the first choice in parts of Europe and Asia. Case-International Harvester (CNHI) tractors run second. And, tractors have many uses so there need to be companies that provide the various accessories; Tractor Supply (TSCO) has done well in that area. As the standard tractors become more complex (i.e., digitized) they’ve become more expensive (sometimes costing $300,000 or more). That leaves a market for smaller and simpler tractors; Kubota (KUBTY) has done well in that area. You’ll see financial metrics for all these brands in this week’s Table. Caterpillar (CAT) is also on the list, even though it no longer makes farm tractors, because it produces tractor-like construction equipment (end-loader/backhoes for example) that are useful on large farms. 

Bottom Line: If you want to invest in production agriculture, you’ll need to first consider buying stock in one of the companies that make farm tractors. Warren Buffett has caught on to the value of making such an investment, recently buying $1.7B more stock in Deere (DE). Indeed, several of our favorite valuation measures (see Columns G through S in the Table) make DE look like the best choice of group. You can read more about the unique value of production agriculture investments by checking out our previous blogs on the topic (see Week 165 and Week 184).

Risk Rating: 6

Full Disclosure: I own shares of DE.

NOTE: In the Table, the metrics highlighted in red denote underperformance relative to our key benchmark, Vanguard Balanced Index Fund (VBINX). All metrics are current as of the Sunday of publication.

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Sunday, April 5

Week 196 - Stockpicker's Secret Fishing Hole: 20-yr Returns

Situation: We started this blog 4 years ago because we saw an inconsistency in the way people plan for retirement. The same inconsistency affects the way most investors buy stocks. They’re looking for exotic investments, often in foreign and small-cap companies (or mutual funds that target such companies). Why? Because the S&P 500 Index has imploded twice on them since 2000. So, they choose to ignore the 800 pound gorilla in the room (large, well-established US companies), particularly the boring companies like utilities and transports. In other words, they ignore the very companies that make up the 65-stock Dow Jones Composite Average (DJCA). This makes no sense, given that the DJCA outperforms the S&P 500 Index long-term, and does so with less volatility. So, we started our blog with the Growing Perpetuity Index (stocks in the DJCA that are Dividend Achievers) and have highlighted the DJCA by calling it the Stockpicker’s Secret Fishing Hole (see Week 68).  

But we’ve never made a comprehensive assessment of all 65 companies. This week’s blog tries to do that. Eight of the companies have been excluded because they are either too small to be in the Barron’s 500 List or don’t have total return records extending out to 20 yrs; 21 more were excluded because of being unsuitable for retirement portfolios (i.e., they had an S&P credit rating less than BBB+ and/or an S&P stock rating less than B+/M). Three of the remaining 36 were excluded because of having greater price volatility (variance) than the S&P 500 Index over the past 20 yrs. 

Not surprisingly, the 33 companies in this week’s Table have outperformed the DJCA over the past 20 yrs (compare Line 35 to Line 44 in the Table under Column C). And, the DJCA had a 20-yr total return that beat the S&P 500 Index by more than 10% (compare Line 44 to Line 45). The problem is that you’ve heard of many of those 33 companies and often use their products. So, there’s nothing mysterious or exotic about investing in those companies; none are the “diamond in the rough” you can talk up at cocktail parties. Your stockbroker understands human nature, so she won’t be talking up those names either. 

Let’s go down the list and see which stocks have outperformed the S&P 500 Index over both the past 5 and 20 yr periods. There’s JB Hunt Transport Services (the most commonly encountered trucks on the interstate), NextEra Energy (you know wind and solar power are growth industries but maybe you didn’t know NextEra is the leader), Nike (no one can be surprised by its continuing outperformance), and Travelers (any insurance company that knows how to price risk is a good investment). There’s 3M and the 3 railroads (Union Pacific, Norfolk Southern, and CSX), as well as Walt Disney and Home Depot. (You probably aren’t surprised to learn that all 6 of those are perennial money-makers.) UnitedHealth Group is the leading purveyor of health insurance (maybe you didn’t know that). Boeing and American Express round out the list of companies you already expected to continue raking in the cash. I had a stockbroker who didn’t mention any of those companies to me in over 30 years, although he did recommend others on the list: United Technologies, Cisco Systems, Intel, Caterpillar, ExxonMobil and Johnson & Johnson. 

Bottom Line: You have little time to research stocks, so focus your attention on a shorter list than the S&P 500. Try the 65-stock Dow Jones Composite Average (DJCA), which also happens to outperform the S&P 500 over the long term. All 65 stocks are picked by a committee headed by the Managing Editor of the Wall Street Journal. We’ve trimmed the list down to 33 that can fit into a retirement portfolio. Take particular note of the 19 that are S&P Dividend Achievers (i.e., companies that have increased their dividends annually for at least the past 10 yrs). Eleven of those have a Finance Value (see Column E in the Table) that beats the Finance Value for our key benchmark, VBINX, which is the Vanguard Balanced Index Fund: WMT, MCD, ED, SO, NEE, NKE, IBM, JNJ, KO, XOM, CVX. Inflation has been 2.1%/yr over the past 20 years, and the average 20-yr dividend growth rate of those 11 stocks has been 11.6%/yr (see Column H in the Table). If your retirement portfolio were to contain equal dollar amounts in each of those 11 stocks, your dividend checks would be growing 9-10% faster than inflation, every year. Think about it.

Risk Rating: 5

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

NOTE: Red highlights in the table denote underperformance vs. our key benchmark, VBINX. Values in the table are current as of the Sunday of publication.

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