Sunday, July 26

Week 212 - How Great is “Buy-and-Hold” Investing? Here’s a 30-yr Study.

Situation: One of Warren Buffett’s goals is to identify good companies, buy the stock, and hold it forever. Very few market commentators or analysts would agree with him on that point, and Warren Buffett himself is quick to close out a position if he detects an unanticipated change in its prospects. For his already wealthy friends and family, he suggests they put 90% of their new investment dollars in a Vanguard S&P 500 Index fund like VFINX. Here at ITR, we suggest that you combine two low-cost routes:
   1) add regularly to VFINX or its bond-hedged version, the Vanguard Balanced Index Fund (VBINX);
   2) add regularly to dividend reinvestment plans (DRIPs), making direct stock purchases online at computershare for example.
The idea is to favor stocks that have grown dividends at more than double the rate of inflation for at least past the 10 yrs (i.e., Dividend Achievers, see Week 205). If you’re 50 and expect to live to 80, that means you’ll have a 30-yr holding period for stocks that hopefully won’t have an unanticipated change in their prospects. 

Mission: See how well today’s Dividend Achievers did over the past 30 yrs compared to VFINX.

Execution: In addition to picking from the larger companies in the Dividend Achiever list, i.e., those that also appear on the 2015 Barron’s 500 List, we’ll draw data from our favorite databases: the BMW Method’s 30-yr statistical record for price appreciation, and the Buyupside total return stock calculator. 

We’re looking for stocks with price appreciation that beat the S&P 500 Index (^GSPC) over the past 30 yrs, and also had total returns that beat VFINX. To address risk, we’re looking for stocks that 1) have a statistical risk of future bear market losses that is less than that predicted for ^GSPC, and 2) lost less than VFINX in the Lehman Panic. We’ve excluded some stocks that pass those tests for the following reasons: 1) If their price variance hasn’t tracked ^GSPC’s, and 2) if their dividend hasn’t grown faster than the 5.2% rate at which the dividend for VFINX grew. Finally, companies with an S&P bond rating lower than BBB+ or an S&P stock rating lower than A-/M were excluded.

We’ve turned up 11 stocks (see Table). So, you can take a buy-and-hold approach to stock-picking without sacrificing returns and still benefit from dividend growth that beats VFINX. But risk remains a sticking point. While we’ve gone to great lengths to isolate a set of stocks with long-term risk that is less than that for ^GSPC and its total return version (VFINX), in the short-term we’re including stocks that have 5-yr Beta values greater than the S&P 500 Index (i.e., 1.00), and stocks that are overpriced relative to earnings, i.e., those with a P/E higher than VFINX (i.e., 20). Either will produce greater price appreciation in a bull market and greater price loss in a bear market. In other words, stocks with above-market 5-yr Betas and P/Es are destined to have above-market volatility over the near-term. If we were to eliminate such stocks there would be none left. If we did the same evaluation but limited the holding period to 25 yrs (see Week 199), only two stocks had a P/E that was equal to or less than the market’s and a 5-yr Beta that was less than or equal to 0.9. Those stocks are Baxter International (BAX) and Illinois Tool Works (ITW). By limiting the holding period to 16 yrs (as you’ll see in an upcoming blog), only 3 companies survive the screen: Wal-Mart Stores (WMT), Union Pacific (UNP), and DTE Energy (DTE).

Bottom Line: Buy-and-hold stock-picking isn’t a logical option compared to picking a low-cost S&P 500 index fund like VFINX. As we were taught in business school, the only lawful way to beat the S&P 500 Index is to take on more risk. But stock-picking can work in your favor over the long term, if you’re willing to dollar-cost average. In other words, you can use dollar-cost averaging to defeat near-term risk by riding out bear markets, if you continue to add fixed dollar amounts to your DRIPs while stocks are cheap. 

Risk Rating: 5

Full Disclosure: I dollar-average into ABT and also own shares of MCD, GIS, BDX, MMM, and UTX.

Note: For this week only, the metrics in the Table that are highlighted in red indicate underperformance relative to the Vanguard 500 Index Fund (VFINX), not the Vanguard Balanced Index Fund (VBINX) as in our previous blogs. That is because VBINX wasn’t launched until 1992. Metrics are current as of the Sunday of publication.

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Sunday, July 19

Week 211 - Buffet Buy Analysis of 2015 Barron's 500 List

Situation: All investors need a system for projecting the future cash flows (dividends or earnings) of their investments. The one we employ can be found at Column H in any of our weekly tables. It’s labeled “Growth Based on Calculating the Log-linear Compound Annual Growth Rate (CAGR)” of dividend payouts over the past 10-30 yrs. Once a year we calculate the Buffett Buy Analysis (see Week 30) for the 500 stocks found on either the S&P 500 Index or the Barron’s 500 List. This week we’ve used the recently published Barron’s 500 List for 2015. It ranks companies by earnings and revenue growth over the past 3 yrs. 

Mission: Calculate the Buffett Buy Analysis (BBA) for each stock on the 2015 Barron’s 500 List, screening out the large number that haven’t shown at least a 7%/yr increase in Tangible Book Value (TBV) over the past decade and/or had more than two yrs when TBV fell. In other words, the BBA requires companies to have what Warren Buffett calls a Durable Competitive Advantage (DCA).  

Execution: The Table lists 13 companies with a projected return to investors of 7%/yr or more over the next decade. The BBA for each is displayed in Columns M-R of the Table. Companies with an S&P (or Moody’s) bond rating lower than BBB+ have been excluded, as have companies with an S&P stock rating lower than B+/M (see Columns K and L in the Table). 

In previous years of tallying companies that pass the BBA test (see Week 59, Week 94 and Week 158), we’ve found that the number of such companies has steadily declined. This year continues that trend. The reason is that the Bull Market continues to make investors optimistic, leading them to “crowd-fund” companies with persistent earnings growth. Briefly, this is how the BBA works: The trend in tangible earnings growth is projected out 10 yrs. That dollar amount is then multiplied by the lowest P/E over the past decade, and the current dividend x10 is added to give the stock’s price 10 yrs from now. Yes, you get the idea. A higher price paid for a company’s stock today means a slower growth rate (BBA) is needed to reach the calculated price 10 yrs from now. That growth rate (BBA) needs to exceed 7%/yr to meet the “business case” for investing, which is to double one’s investment over 10 yrs. 

That explains why there are fewer names on the list each year, but it doesn’t explain why certain names keep turning up year after year. That can only occur if investors either fail to see the value of those stocks or they’re too nervous to spend more money on them. Now we’ve narrowed the list down to only 13 remaining stocks (see Table), and only one of those hasn’t appeared on earlier lists: MasterCard (MA), which was previously excluded only because it hadn’t been traded for a full 10 yrs. To summarize: Week 59 had 90 companies that included Ross Stores, Apple, QUALCOMM, Union Pacific and Expeditors International. Week 94 had 42 companies that included Ross Stores, Apple, QUALCOMM, Expeditors International, Google and Starbucks. Week 158 had 22 companies that included Ross Stores, Apple, QUALCOMM, Union Pacific, Expeditors International, Google, Starbucks, TJX, Travelers, CSX, Fluor and Dick’s Sporting Goods. 

Bottom Line: If you don’t already have stock in one or two of these companies, think about taking time to look again at their merits. But be aware that the first step of the Buffett Buy Analysis (BBA) is to list the companies that have increased their Tangible Book Value (TBV) faster than 7%/yr over the past decade without their TBV having slowed in more than two of those years. That means the BBA test is only applied to companies that already have a high and stable rate of earnings growth. Those stocks often exhibit high price variance in good times, meaning they’ll also exhibit high price variance in bad times. Apple stock (AAPL) tells that story well (see Column D at Line 5 in the Table). For further confirmation of that point, look at the 5-yr Beta values in Column I of the Table. All of those are high except Union Pacific, which is a government-regulated monopoly. Now you know why the stocks on this week’s list (except MasterCard) have appeared on one or more of our BBA lists over the past 3 yrs, and that’s because they make investors nervous about adding more money. In spite of the obvious merits of these stocks, they haven’t yet become “crowded trades.” 

Risk Rating: 7

Full Disclosure: I have stock in QCOM, UNP, and TJX.

Note: Metrics in the Table that are highlighted in red indicate underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX). Metrics in the Table are current for the Sunday of publication.

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Sunday, July 12

Week 210 - Fortune 500 Agronomy and Food Production Companies

Situation: We like food and agriculture related investments because companies in that sector respond to global (not just US) demand. Those companies also respond to farm commodity prices, which are influenced as much by the weather as by macroeconomic factors (e.g. interest rates, labor costs, and GDP). Holding stocks in that sector gives you a non-correlated asset, i.e., one that is out-of-sync with the US economy. This is a good thing because it helps to balance your portfolio in tough times. In addition, since food is an essential good, companies in this sector retain pricing power during recessions. This strategy for insulating your portfolio against the ups and downs of the S&P 500 Index differs from other hedging strategies because long-term rates of return typically outperform the S&P 500 Index instead of underperforming it (as would occur for example by using Treasury bonds as a hedge). That outperformance comes with added volatility because the food and agriculture sector is even more complex than the energy sector. That said, you’ll need a way to categorize and evaluate the key players. 

Mission: Categorize and evaluate companies in the food and agriculture sector, starting with the chemical companies that address the agronomy needs of farmers, and food production companies.

Execution: First we’ll break down the “roles and missions” of companies in each sub-sector by using the analogy of a 4-legged stool. We start with the Fortune 500 List, which ranks companies by revenue and comes with features that help us to categorize and evaluate companies in all sub-sectors of the US economy. This year’s updated list was recently published and includes data on 1000 companies (ranked by revenue). There are a variety of tools for the investor to use, such as the year-over-year (YOY) change in each company’s revenue and earnings. There are also alphabetical lists of companies in every sub-sector. Food and agriculture related sub-sectors include: apparel, chemical, beverages, construction and farm machinery, energy, food consumer products, food production, food services, food and drug stores, forest and paper products, industrial machinery, motor vehicles and parts, packaging & containers, tobacco, food wholesalers, and grocery wholesalers.

The 4-legged stool has 2 legs that are on the buy side and 2 on the sell side. The buy side includes the companies in sub-sectors that help a farmer grow crops and raise animals then find someone who will buy those farm commodities. One buy side leg is for “hardware” (e.g. tractors) and the other is for “software” (e.g. fertilizer). The 2 legs on the sell side are companies in sub-sectors that either make intermediate products for sale to wholesalers, or further process farm commodities for marketing directly to consumers (e.g. a leather goods company). For this week’s blog, we’ll look at one sub-sector on the buy side (chemical companies that serve the agronomy needs of farmers) and one on the sell side (the “food production” sub-sector, as opposed to “food consumer products” that is the other leg of the sell side). 

In constructing this week’s Table, we have compared the Fortune 500 List to the Barron’s 500 List, which assigns a grade-point average to each company based on 3 key operational metrics that are related to growth in earnings and revenue over the past 3 yrs (see Week 205). We’ve screened out companies that have S&P bond ratings lower than BBB+ and S&P stock ratings lower than B+/M.

There are 12 stocks that meet our criteria, 6 from the Chemical industry and 6 from the Food Production industry (see Column T in the Table). Four companies have 30-yr stock price records that have been analyzed statistically by the BMW Method (see Lines U-W of the Table): Archer Daniels Midland (ADM), Seaboard (SEB), Dow Chemical (DOW), and duPont (DD). Column U of the Table shows that all 4 beat the price-only S&P 500 Index (^GSPC at Line 22) over that 30-yr interval, returning an average of 9.9%/yr vs. 7.0%/yr for ^GSPC. Each of the 4 carries a statistical risk of loss in a future Bear Market that is equal to or greater than that for the S&P 500 Index (see column W in the Table). The average predicted loss for those 4 stocks is 48% vs. 42% for ^GSPC. During the 18-month Lehman Panic (see Column D in the Table), those 4 had an average total return of -48.5% vs. -46.5% for the lowest-cost S&P 500 Index Fund (VFINX at Line 21 of the Table). 

Heightened risk is a common feature of commodity-related companies, partly because managers have to plan on selling products worldwide. For example, the US-based companies listed in the Table have to compete with similar companies based in Europe, including Bayer AG (BAYZF), BASF SE (BASFY) and Syngenta AG (SYT). All 3 of those companies actively market their products to farmers and farm cooperatives here in south-central Nebraska where I live. And Syngenta has a large seed production and research facility here. “The world is getting smaller” and companies that need to compete globally are finding that they have to consider merging. Several in the food and agriculture sector have already entered into co-marketing agreements. Monsanto, the world’s largest seed producer, is currently offering to buy Syngenta, the world’s largest pesticide producer.

Bottom Line: There are only two ways to beat the S&P 500 Index. One method is to trade on insider information (try that and you’ll go to jail). The second is to trade in stocks that carry more risk than the S&P 500 Index. The most productive risk plays address global rather than regional opportunities. Riskier stocks that beat the S&P 500 index long-term are typically issued by companies having business plans that are relatively immune to the macroeconomic forces (like US interest rates and GDP cycles) that drive the S&P 500 Index. Such a company’s prospects are instead driven by global, non-macroeconomic events (e.g. weather cycles). Most of those business plans are linked to a commodity “supercycle”. Your best bet is to study companies that use an essential commodity for their main feedstock. That way the market for their products will be driven by global growth in middle-class consumers as well as non-macroeconomic events. This logic takes you to considering companies that supply farmers with seeds and pesticides, as well as companies that produce protein-rich food. 

NOTE: The risk-adjusted returns you’ll enjoy from this method of investing are no greater than from an S&P 500 Index fund. The main reason to add commodity-related stocks to your portfolio is the benefit that comes from owning non-correlated assets over several market cycles (e.g. 30 yrs), which is to reduce your portfolio’s S&P 500 Index-related volatility without sacrificing returns.  

Risk Rating: 7.

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

Note: Metrics in the Table that are highlighted in red denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund. Metrics are current as of the Sunday of publication.

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Sunday, July 5

Week 209 - 2015 Master List

Situation: We scour the internet to find quantitative data that will help you invest for retirement. How you invest is your business but we think index funds are the way to go. Those have drawbacks (i.e., tracking only the US economy, amplifying “crowded trades” and generating dividends that don’t quite keep up with inflation). If you want to correct those shortcomings, you’ll need to dollar-average into at least a dozen buy-and-hold stocks.

Mission: Screen for buy-and-hold stocks.

Execution: We’ve found several tools that can keep your risk low, when used in tandem. Briefly, we screen out stocks that:
   1. lost more than the bond-hedged S&P 500 Index fund (VBINX) during the Lehman Panic (see Column D in any of our tables);
   2. didn't improve their rank in the 2015 Barron’s 500 List or rank in the top 250 for both 2014 and 2015;
   3. don’t meet several BMW Method criteria. Those criteria are based on using weekly stock prices over the past 20 yrs to establish a log-linear CAGR, and comparing that CAGR to that for the S&P 500 Index (^GSPC). We look for stocks with a higher CAGR than ^GSPC, stocks that track ^GSPC to within one Standard Deviation (1SD), and stocks with a predicted loss in a future Bear Market of under 40%, which would occur if prices fall by two Standard Deviations (-2SD);
   4. don’t have an S&P bond rating of at least A-;
   5. don’t have an S&P stock rating of at least A-/M.
Almost all stocks that clear those hurdles will turn out to be S&P Dividend Achievers, meaning that the dividend has been raised annually for at least the past 10 yrs.

Bottom Line: This week’s screen turns up 16 stocks that “beat the market” (see Table). Only 3 of those (Johnson & Johnson, Nike, and PepsiCo) are in the S&P 100 List of “mega-cap” companies. Why? Because the price performance of stock in such an unwieldy company is at a competitive disadvantage over long periods vs. stock in a smaller and more nimble company. Why do you need to screen out stocks that haven’t demonstrated an ability to beat the market? Because your money will go farther if you put it in the market, i.e., into the lowest-cost S&P 500 Index fund (Vanguard’s 500 Index Fund, VFINX) or a bond-hedged S&P 500 Index fund like the Vanguard Balanced Index Fund (VBINX). 

Risk Rating: 5

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

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

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