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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