Sunday, May 31

Week 204 - 2015 Barron’s 500 List: Commodity Producers with Improving Fundamentals

Situation: Commodities are priced in dollars but those prices reflect worldwide supply and demand, not US economic forces. To further complicate matters, agricultural commodities are priced to reflect regional climate events. The 2012 US drought was so severe that China decided to decrease its reliance on the US for corn and instead ramp up domestic production and source more corn from Argentina and Ukraine. This highlights how population growth is the main driver for commodity production, whether it is basic materials needed to expand infrastructure, energy for electricity production and transportation, or meat and grain for grocery stores. The problem for commodity producers is the necessity for a large up-front investment, whether for oil and gas exploration, mining operations, or the web of technology and infrastructure that brings the “green revolution” to farming. Such investments typically involve large expenditures for property, plant, equipment, powerplants, internet access, storage facilities, paved roads, pipelines, and railroads. In turn, those high initial costs drive research and development into innovations that promise to reduce up-front costs. The result is affordable food, construction methods, fuel, and electricity. Once in place, production efficiencies tend to overshoot; supplies exceed demand for a period, as we see happening now with oil and natural gas production. 

Investors in commodity-related companies always face a roller-coaster ride, one that is often out-of-phase with regional economic cycles. As a result, commodity-linked investments tend to follow supercycles. Their “non-correlation” with GDP serves to benefit investors. This week’s blog is occasioned by the just-published Barron’s 500 List for 2015. That list gives a grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
   1) median 3-yr return on investment (ROIC),
   2) change in the most recent year’s ROIC relative to the 3-yr median, and
   3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank. There are 60 commodity producers; half were up in rank, half were down. We’re interested only in the companies that were up, since there’s no easy way to know why a company was down or when its rank will stop falling. And, since most of our readers are looking for retirement investments, we’re not interested in companies that have an S&P bond rating lower than BBB+ or an S&P stock rating lower than B+/M. Taken together, those restrictions remove all but 7 of the 60 companies from consideration (see Table).

These 7 stocks are different from those we usually think of as prudent for retirees. Notably, the average 5-yr Beta is high, and most are down one Standard Deviation from their 16-yr trendline in price appreciation (see Column M), whereas, recent pricing for the S&P 500 Index (^GSPC) is up two Standard Deviations. While we do like to invest in commodity-related stocks because of their out-of-sync behavior, extremes are a little un-nerving. 

It gets worse. In Column N of the Table, the downside risk comes into sharp focus. That’s where the BMW Method (see Week 193, Week 199 and Week 201) is used to predict your loss by incorporating 16 yrs of weekly variance in price trends. For example, a 47% loss is predicted for our group of 7 stocks in the next Bear Market, whereas, the S&P 500 Index is predicted to sustain a 32% loss. You’ll find this information in the BMW Method Log Chart for each stock. Start by using the S&P 500 Index as an example. Find ^GSPC at the bottom of the 16-yr series, click on it, and look for “*2RMS” in the upper left-hand corner. Subtract that RF number (0.68) from 100 to get the predicted 32% loss at 2 Standard Deviations below the price trendline. That degree of price variance is projected to occur every 19-20 yrs.

This price variance is important to be aware of because a high degree of price variance over time means the party can end quickly. When a commodity-producing company’s Tangible Book Value for the past decade gives it a Durable Competitive Advantage (see Column R and Week 158), there’s little likelihood that its earnings will grow more than 7%/yr over the next decade (see Column S), which we estimate by using the Buffett Buy Analysis (see Week 189). Only one stock passed that test, National Oilwell Varco (NOV). In other words, the very impressive returns achieved by this select group of 7 stocks (see Columns C, F and L in the Table) come with a very impressive risk of loss. 

Several academic studies have shown that the only way to legally “beat the market” is to take on a commensurately greater risk of loss. One example analyzed Jim Cramer’s success at picking stocks for CNBC’s “Mad Money” TV show. To make a long story short, you need to understand that over a 20-yr period you’ll probably be further ahead (on a risk-adjusted basis) by investing in a low-cost S&P 500 Index Fund (VFINX at Line 16 in the Table) than by investing in any combination of commodity-related companies. 

Think about it. Commodity-related companies depend on the infrastructure and sustainability needs of fast growing countries like China, Brazil, India, Nigeria and Russia. Such a heavy reliance on commodities in countries with such large populations will be reflected in the success of mutual funds that focus on international stocks or natural resource stocks. The Vanguard Total International Stock Index fund (VGTSX at Line 18 in the Table) and T Rowe Price New Era Fund (PRNEX at Line 17 in the Table), respectively, are good low-cost examples. Are either of those mutual funds a better (i.e., risk-adjusted) place to put your retirement savings than VFINX? No. The reason is that investing in commodities is a hedging strategy. Any effort to smooth out (hedge) returns does exactly that. It protects you from Bear Market losses while reducing your Bull Market gains. Stocks go up 55% of the time, so over the long term a hedging strategy will underperform the market.   

Bottom Line: Here at ITR, we like to call attention to investments that don’t track the S&P 500 Index. By having a few investments that are out-of-sync with the economic cycle, you may be able to limit the damage to your portfolio from a market crash. Our favorite non-correlated asset is the 10-yr US Treasury Note (when held to maturity), which you can obtain for zero cost. Our next favorite is stock in one or two commodity production companies, especially those where revenues reflect changes in the weather cycle. In particular, companies that supply farmers with tractors, center-pivot irrigation systems, diesel engines to power such equipment, fertilizer, herbicides, fungicides and ways to efficiently get crops and cattle to markets. 

Risk Rating: 7

Full Disclosure: I own stock in CMI.

Note: metrics highlighted in red denote underperformance vs. our key benchmark (VBINX); metrics are current for the Sunday of publication.

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Sunday, May 24

Week 203 - Rainy Day Fund Updated

Situation: Since the Lehman Panic, leading nations have tightened and coordinated regulatory oversight of the financial sector. The largest banks are now fewer in number yet control more assets. Paradoxically, the US Federal Reserve has less freedom to manage a credit crisis, thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act. While money-center banks are required to have more equity behind every loan, Congress has used the Lehman Panic to set rules that may make future credit crises harder to tamp down. (With global debt per capita still growing, the next one can’t be far off.)

When those happen, there’s a 50:50 chance that the ranks of the unemployed will double, your children will have difficulty finding work to match their education, and you will want to stay employed past retirement age. Here at ITR, we encourage you to have a Rainy Day Fund big enough to cover your basic needs for 18 months. Interest rates may remain low for awhile, so we recommend you choose more bond-like investments than previously recommended in setting up a Rainy Day Fund (see Week 162). Here are your choices (see Table):

   Inflation-protected US Savings Bonds (;
   3-month US Treasury Bills (;
   FDIC-insured Savings Accounts and Certificates of Deposit;
   Vanguard Money-Market Reserve Fund (VMMXX);
   10-yr US Treasury Notes (;
   iShares 1-3 yr Treasury Bond Fund (SHY);
   iShares 3-7 yr Treasury Bond Fund (IEI);
   iShares 7-10 yr Treasury Bond Fund (IEF);
   Gold bullion;
   Vanguard Short-Term Treasury Bond Fund (VFISX);
   Vanguard Interm-Term Bond Index Fund (VBIIX);
   Shares of Wal-Mart Stores (WMT), the only S&P 100 company whose stock grew more than 5% in value during the Lehman Panic;
   Shares of Johnson & Johnson (JNJ), the only AAA-rated company whose stock fell less than 20% during the Lehman Panic.

Among these 13 choices, 10-yr T-Notes are my favorite. Why? Because the bank where you have the checking account that accepts the electronic interest payments from the T-Notes you bought through TreasuryDirect will be happy to loan you money at a very low interest rate, if your FICO credit score is over 800. In other words, you'll have the best collateral and the lowest repayment risk. You’ll likely be granted an immediate loan in the same amount as the T-Notes in your TreasuryDirect account. You’ll only need to sign over future principal and interest payments until you’ve paid off the loan. The next best choice is to build up an FDIC-insured Savings Account at that same bank (or hold a lot of 3-month Treasury Bills in your TreasuryDirect account). 

You can invest in WMT and JNJ online at computershare, where it costs $1.00/mo to dollar-average your investment in each of those stocks. Columns J-L in the Table include the relevant BMW Method metrics (see Week 199 and Week 201) for both of those stocks, VBIIX, gold and the S&P 500 Index (^GSPC).

We recommend that you pick six of the 13 options listed above, assigning each to cover 3 months worth of your household expenses. Four of those options are insured against loss of principal: Treasury Bills, Treasury Notes, inflation-protected US Savings Bonds (ISBs), and Savings Accounts at an FDIC-insured bank. Use all 4 of those if you’re risk-averse. Inflation-protected US Savings Bonds are the most prudent and convenient choice for a Rainy Day Fund because those protect you against the ravages of inflation, and cost nothing (treasurydirect): Whenever you need money, just return to that website and pick the bonds you wish to redeem. The money will show up in your checking account the next business day. As with an IRA, interest payments that you’ve accrued over the years will be taxed as income. If you cash an ISB before 5 yrs have passed, you’ll forfeit one interest payment.

Bottom Line: Learn to pay your credit cards off every month, and set up automatic monthly purchases of inflation-protected Savings Bonds.

Risk Rating: 2

Full Disclosure: I dollar-average into WMT, JNJ, ISBs, and 10-yr Treasury Notes.

NOTE: In the Table, metrics that underperform our key benchmark (VBINX) are highlighted in red; metrics are brought current for the Sunday of publication.

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Sunday, May 17

Week 202 - Dividend Achievers with Growing Brand Recognition

Situation: Brand recognition is the secret sauce of a company's competitive advantage. It doesn't show up in core earnings or tangible book value, but does contribute powerfully to the markup in price (above market) that an acquiring company must offer before it can hope to succeed in a completing a merger or acquisition. The acquiring company books the markup (what it paid for the brand) as "goodwill" and recognizes it as an intangible asset.

Several organizations attempt to assign a dollar value to brands, and issue annual rankings. Brand Finance is one such organization, and just came out with its 2015 rankings for the “Global 500”. Their #1 Brand for both 2014 and 2015 is Apple, a brand they currently value at $128 Billion. We have looked through their list, finding that 20 Dividend Achievers improved their rank in 2015 vs. 2014 (see Columns K-M in the Table). You’ll remember that "Dividend Achievers" is what S&P calls companies that have increased their dividend annually for at least the past 10yrs. Some of the companies listed in the Table have more than one ranked brand, in which case we’ve presented metrics for the brand that improved the most. 

The Table also contains data from the BMW Method website for the past 16yrs (see Columns P-R). By scanning across the spreadsheet, you’ll see that Wal-Mart Stores (WMT), Nike (NKE) and PepsiCo (PEP) look like good choices for investment. We suggest that you dollar-cost average your investments and do it online. Direct Stock Purchase Plans that incorporate a Dividend ReInvestment Plan (DRIP) are available for each of those stocks.

Bottom Line: It is difficult to measure brand recognition but much depends on it. For example, a stock’s price will often change 5-10% over a short period of time because of a change in how its brand is being perceived (i.e., Monsanto). That is why Peter Lynch encouraged people to “invest in what you know” and liked to talk about the stock tips he’d gleaned from listening to comments his wife Carolyn made after shopping. Peter Lynch ran Magellan Fund at Fidelity Investments from 1977 to 1990, achieving a Total Return of 29.2%/yr. I only became successful at investing after reading his book “One Up on Wall Street” in 1990. 

Risk Rating: 5

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

NOTE: Metrics that underperform our key benchmark (VBINX) are highlighted in red; metrics are brought current for the Sunday of publication.

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Sunday, May 10

Week 201 - Barron’s 500 Companies with 16 years of Below-market Variance and Above-market Returns

Situation: You should invest in the lowest-cost S&P 500 Index fund (VFINX) unless your stock picks have a history of doing better while taking on less risk. Why? Because stock-picking takes up a lot of your time and costs more money than buying shares in an index fund. For investing in smaller capitalization stocks or foreign stocks, don’t even consider any option other than low-cost index funds. Those are the rules so what are the exceptions? There’s really only one, and that is to pick from large capitalization stocks have a history of granting annual dividend increases that more than compensate for inflation. The trick is to find a low-cost dividend reinvestment plan (DRIP) to dollar-average your monthly purchases. After you retire, have those dividends sent to your mailbox and enjoy the one source of retirement income that grows faster than inflation.

Mission: Identify large-capitalization stocks that have below-market variance and above-market returns while paying a dividend that grows more than twice as fast as inflation.

Execution: In our Week 193 and Week 199 blogs, we have presented a system for assessing price variance at multiple points over 25 yrs. The BMW Method provides monthly updates of 16-yr, 20-yr, 25-yr, 30-yr, 35-yr and 40-yr variance, which are “least squares” calculations based on the logarithm of weekly prices for over 500 stocks (fewer at 30, 35 and 40yr intervals). The graphs give a trendline (CAGR at Column S in the Table) with adjacent lines at one and two Standard Deviations from the trendline. The spread between the base trendline and the -2SD trendline is the percent loss you can expect once every 20 yrs (see Column U in the Table). In constructing the Table, a stock that follows a track one Standard Deviation away from the S&P 500 Index (^GSPC) over recent months is at variance with ^GSPC and has therefore been excluded (see Column T in the Table). To further assess variance exceeding that for the S&P 500 Index, we look at Total Return during the Lehman Panic (see Column D in the Table), and at the 5-yr Beta (see Column I in the Table). S&P ratings are used to exclude companies that issue bonds with a rating lower than BBB+ and stocks with a rating lower than B+/M.

Using this information, we’ve come up with 14 companies, all but one of which is a Dividend Achiever (see Column R in the Table). You’ll remember that "Dividend Achiever" is S&P’s term for a company that increases its dividend annually for at least the past 10 yrs. That one exception on our list is Campbell Soup (CPB), and S&P will soon designate it a Dividend Achiever. Several columns in the Table point to the outperformance of these 14 stocks, as well as documenting less volatility than the S&P 500 Index. What is their key to success? Column L (estimated 5-yr earnings growth/yr) offers the key: 3/4ths of these companies are expected to grow earnings slower than the average company in the S&P 500 Index. By itself, that speaks volumes about why these companies outperform with less risk. Their earnings growth is relentless, with only minor hiccoughs. When earnings balk, a stock’s price will usually fall and it may take years to recover (certainly many months). IBM is a case in point. It recently sold off a couple of slow-growth divisions and re-tasked a couple of others, taking an earnings hit. The stock price fell 20% as soon as these moves were announced, and it has stayed at that level for more than 6 months. Is the company worse off or better off as a result of those structural adjustments? Warren Buffett decided that it is better off and bought more shares of IBM for Berkshire Hathaway.

Bottom Line: Companies that rarely disappoint on earnings enjoy steady growth in their stock price. Mature companies with stable earnings growth can outperform the S&P 500 Index, even with earnings growth that is predictably less than for the average S&P 500 company. We’ve only found 14 companies that have better growth with less risk, but those “diamonds in the rough” are worth close examination as prospective investments for your retirement portfolio.

Risk Rating: 4

Full Disclosure: I dollar-average into WMT, NKE, NEE and JNJ, and also own shares of GIS, PEP and ITW.

NOTE: Metrics in the Table that underperform our key benchmark (VBINX) are highlighted in red. All metrics are brought current for the Sunday of publication.

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Sunday, May 3

Week 200 - Agronomy Companies on the Barron’s 500 List

Situation: I know, you’re already bored. But we really have to talk about commodity-related stocks occasionally because those are the high-risk, high-reward, high-cost stocks that anchor the world economy. Their prices usually reflect a megacycle that lasts for decades, starting with supply shortages (relative to demand) and ending with overproduction that persistently exceeds demand for a time (e.g. today’s oil & gas markets). The pricing of such stocks correlates with global demand, not with the typical 5-7 yr economic cycle of individual countries or regions. Some commodities are so adept at reflecting the global economic cycle as to earn special respect, like “Doctor Copper”. You’ll want to own two or three of these “non-correlated” stocks that dampen the ups and downs of the economic cycle. In particular, consider production agriculture companies because those have special advantages: 1) Their profits are driven more by the weather cycle than the economic cycle; 2) ten million people per year enter the middle class in Asia and Africa who can finally afford to consume the 60 grams/day of protein that is required for good health and a long life.

Livestock has been the best-performing commodity sector over the past year. Let’s think about what goes into livestock production: grain, hay, and soybeans are the most important inputs. (Four pounds of feed is needed to make one pound of Grade A meat.) Production of those crops requires certain inputs: tractors and combines (see Week 197), irrigation equipment (see Week 129), and this week’s topic about the tools of an agronomist (seeds, fertilizer, insecticides, herbicides, and fungicides). Agronomists work “on call” for individual farmers (or a farmer's cooperative) to address issues of plant genetics & physiology, soil science, and meteorology. Think of them as general practitioners overseeing the crop. Increasingly, this role is played by “seed analysts” from one of the major seed production companies (Monsanto, Syngenta, Bayer or Dupont). Seed analysts also look for farmers who will allow part of their fields to be used for plant research.

This week’s Table has all of the large, publicly-held agronomy companies in the United States and Canada. Stocks in these companies are not suitable for inclusion in a retirement portfolio. But several are suitable for a portfolio of non-correlated assets, i.e., those where prices don’t follow the economic cycle. The pricing of agronomy companies is mainly driven by weather cycles, and the worldwide growth rate for workers who are paid enough to provide their families with an adequate protein intake.

Bottom Line: You need to have a few investments that don’t track the S&P 500 Index, so-called "non-correlated assets." Inflation-protected Savings Bonds epitomize this concept, and you should have a Rainy-Day Fund that is mainly invested in those or Treasury Bills (see Week 162). But there are other, more rewarding non-correlated investments. Most are commodity-related and come with a lot more risk. We like large companies that focus on the needs of farmers and ranchers. This week's Table has 8 of those.

Risk Rating: 7

Full Disclosure: I own stock in MON, CF, and DD.

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

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