Sunday, September 27

Week 221 - Status of Commodity-Related Barron’s 500 Companies

Situation: Since 2009, China has contributed twice as much to world economic growth as the US. China has also purchased ~40% of all commodities sold worldwide. One commodity in particular, copper, is used as a measure of the health of commodity demand in emerging markets because it plays an important role in building electrical grids. Copper has recently reached new lows. China is slowing down its investment machine mainly because its total debt load has reached 300% of GDP. To put China’s woes in context for the US economy, the CEOs of several corporations have recently provided specific examples of how China’s economic decline impacts their businesses

What does this mean for investors? Basically, for the next one or two years, traders of all asset classes will be in a “risk-off” mode while governments, corporations, and individuals struggle to bring down their debt loads and develop ideas for growth. This cautionary stance will coincide with a bottoming of commodity prices as demand recovers while supplies moderate. The global “oil glut” is a special case, only marginally related to falling demand in China. Instead, it is due to a global “price war” triggered by an oversupply of oil related to improvements in technology, namely horizontal drilling into oil-rich shale deposits combined with hydraulic fracturing. And, oil prices may have further to fall.

Mission: Assess the effect on commodity-related companies of oversupply of commodities. Do this by evaluating all 56 such companies in the 2015 Barron’s 500 List that have at least 16 yrs of trading records.

Execution: This week’s spreadsheet (see Table) shows the carnage. Note the abundance of red highlights denoting underperformance relative to our key benchmark (VBINX at Line 73). Let’s start with a “thought experiment.” You’re looking for GARP (growth at a reasonable price), which will allow you to take advantage of sharply falling stock prices (see Column F in the Table). Let’s start by listing the companies that have moved up in rank compared to the 2014 Barron’s 500 List. Those are the ones with green highlights in Columns P and Q of the Table. Then pick those stocks that aren’t overpriced, i.e., the ones with an EV/EBITDA that is no greater than the EV/EBITDA for the S&P 500 Index (which is an EV/EBITDA of 11).

There are 10 candidates in the “oil & gas” group: HES, DVN, TSO, CAM, CHK, NOV, VLO, HAL, WFT, NBR. Two of those have been labelled “potentially underpriced” per the BMW Method (see Week 193): CHK and NOV (see Column O in the Table). There are 5 more candidates in the “basic materials” group: NUE, SCCO, CMC, X, AA and 6 candidates in the agriculture production group (ADM, POT, MOS, TSN, DOW, PPC). POT is another “potentially underpriced” stock. That totals 21 stocks. However, three of those failed to outperform the S&P 500 Index over the past 16 yrs (per the BMW Method: NBR, AA, PPC (see Column L in the Table). Eliminating those leaves 18 candidates. 

So far, so good. Most of the 18 have fallen hard in recent quarters and now have prices that are 1-2 Standard Deviations below trendline (see Column M in the Table). The BMW Method sorts out “risk” statistically by predicting the extent of loss below trendline that you can expect in a bear market (see Column N in the Table). The abundance of red highlights in that Column denotes stocks predicted to exhibit a greater loss below trendline than the S&P 500 Index faces, which is 32%. Every one of the 18 candidate stocks is highlighted in red, so they’re all unsuitable for a retirement portfolio. But what if you’re a speculator and willing to accept a loss of 40%? That’s a 25% greater loss than you’d suffer by owning an S&P 500 Index fund like VFINX. Even allowing for the added extra risk, only one of the 18 qualifies (ADM at Line 54 in the Table).

Given that commodity-related companies compose at least 10% of a balanced stock (or stock mutual fund) portfolio, we’ll need to dig deeper. For example, 23 of 56 such stocks listed in the Table are already in a bear market (see Column M), i.e., down 2 Standard Deviations (2SD) below their 16-yr trendline. Three of those companies have raised their dividend annually for at least the past 10 yrs (see a list of such Dividend Achievers in Column R of the Table) and have a statistical risk of loss in a bear market that is less than that for the S&P 500 Index (see Column N in the Table): CVX, XOM, PX. The odds that you’d lose money by starting to dollar-average into those stocks now are low.

Another approach is to dollar-average into low-cost mutual funds that reflect commodity investment, including emerging market index funds. There are 3 listed in the Benchmark section of the Table: 1) GSG, the exchange-traded fund for collateralized commodity futures; 2) PRNEX, the T Rowe Price New Era Fund that invests in natural resource stocks, and 3) VEIEX, the Vanguard index fund for emerging markets.

Bottom Line: The global economy faces a difficult period now that China’s fast growth phase has ended. Commodity-related assets are the first to crash, and that means commodity markets and commodity-related companies will be the first to recover. We’ve evaluated 56 commodity-related companies in the 2015 Barron’s 500 List to come up with 4 that are candidates for speculative investment: Archer Daniels Midland (ADM), Exxon Mobil (XOM), Chevron (CVX), and Praxair (PX).

Risk Rating: 8

Full Disclosure: Commodity-related stocks are “long-cycle” investments that I tend to favor, particularly those that are related to agricultural production. I dollar-average into XOM and also own shares of CVX, AA, HRL, ADM, DE, and DD.

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

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Sunday, September 20

Week 220 - Diversification Among Core Assets

Situation: Individual stocks are not a core asset unless you’ve created your own diversified mutual fund (i.e., 40+ stocks covering all 10 S&P Industries). The reason why individual stocks are considered a liability and not a core asset is because competition (aided by unforeseen technological advancements) can doom the prospects of any one company. There are 5 Core Assets, and your investment portfolio will need representation from some of each:
   1) diversified US stock mutual funds, especially index funds like VFINX and VEXMX (see the Table).
   2) Bonds, mainly US Treasuries but also intermediate-term investment-grade bond index funds like VBIIX (see the Table).
   3) Commodity-related investments. The relevant index fund is a “broad basket” collateralized futures ETF composed of iShares S&P GSCI Commodity Indexed Trust (GSG in the Table).
   4) Real estate. Most of us already have too much invested in real estate (i.e., the equity in our homes). The relevant REIT index fund is VGSIX in the Table.
   5) Cash-equivalents such as Savings Bonds, a Savings Account at an FDIC-insured bank, a short-term Treasury fund like VFISX (see the Table) or 3-6 month Treasury Bills purchased for zero cost at treasurydirect.

Mission: Set up a reasonable asset allocation, i.e., one that has worked well for me, using index funds as examples. This allocation needs to meet the standards of an acceptable personal retirement investment fund, and it does. However, opinions vary across a large spectrum. At one extreme, we have Warren Buffett who recommends that his relatives rely on a low-cost S&P 500 Index fund for 90% of their asset allocation, with the other 10% being invested in a short-term US Treasury fund. However, most investment advisors stress the importance of balancing among the 5 Core Assets listed above. In other words, hedge your bet on stocks even though the S&P 500 is well known to have outperformed all other asset classes over all rolling 20-yr periods on record. Warren Buffett takes a dim view of hedging strategies and continues to make bets that the S&P 500 Index will outperform international indexes as well as an esteemed group of hedge funds. The main reason for you to hedge your bets is that you’re not as rich as Warren Buffett’s relatives and could be financially devastated by a crash in the S&P 500 Index (if that’s where 90% of your retirement assets reside). So, hedging is a form of insurance and you’ll be glad you have it. (I never feel bad about dollar-averaging 30% of my new investment dollars into 10-yr Treasuries and Inflation-Protected Savings Bonds.) 

What lies at the other end of the spectrum of advice being offered by investment advisors? Well, if you include accountants and business school professors as “advisors” you’ll find a sizeable minority who recommend that most of your retirement savings be in US Treasury Notes and Bonds having as average of ~5 yrs remaining until maturity. You can do that yourself simply by dollar-averaging into 10-yr Treasury Notes through the zero-cost Treasury website. When I was living in New York City (while going to medical school), I had a personal accountant who made that exact recommendation when I asked for his views on asset allocation. I had great respect for him as a wise and prudent man but thought his recommendation bordered on the absurd. Then, a few years ago, I went to business school and started hearing the same view again, first from an accountant in my study group and then from a professor of Banking and Finance. Finally, I read Henry Paulson’s book about his experiences as US Treasury Secretary, titled “On the Brink.” Prior to that posting, he’d been the CEO of Goldman Sachs. In the book he mentions that his personal savings are limited to bonds. In other words, the message you’re hearing at this end of the spectrum is that bonds are backed by the assets of the institution issuing them, whereas, stocks are backed by nothing other than a faith in future earnings.

Execution: We recommend that you balance stock and fixed-income investments 50:50. Real Estate Investment Trusts (REITs) are a hybrid between stocks and bonds but (when assembled into and REIT) they’re essentially a type of bond called a “growing perpetuity” and I allocate 15% there. Cash equivalents are also bonds and I allocate 5% to those. Then I allocate 15% to intermediate-term bond index funds and 15% to Treasury bonds and notes, which brings me up to 50% allocated to fixed-income. For stocks, I allocate 30% to S&P 500 stocks (which represent 75% of the US market) and 10% to smaller capitalization stock mutual funds. Commodity-related stocks represent 10% of my portfolio, though the recent underperformance of many “long cycle” investments has caused many advisors (including me) to cut back to 5%. In summary, you now have a formula for allocating 50% to stocks and 50% to bonds or bond hybrids (see Table).  

Bottom Line: Core assets are vital to your financial well being. There are 5 categories, and this week’s Table gives index fund examples using an allocation that has worked well for me. By mixing 5 core assets you create your own hedge fund, the idea being to match returns of the S&P 500 Index over time while taking on less risk of a serious loss. Note: risk-adjusted returns for index funds in the commodity-linked and smaller capitalization stock categories typically underperform actively managed mutual funds. 

Risk Rating: 5

Full Disclosure: I dollar-average into 10-yr Treasury Notes, and have VFINX-like and VEXMX-like investments in my 401(k).

Note: Metrics highlighted in red denote underperformance relative to VBINX. Metrics are current for the Sunday of publication.

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Sunday, September 13

Week 219 - Agricultural Production Equipment

Situation: Investing in commodities, or commodity-related companies, is a good way to lose money fast if you invest in the commodity when the commodity “supercycle” is ending. Agricultural commodity-related companies are the least risky way to invest in the commodity “supercycle.” Why? Because food is a necessity and, 10 million people a year emerge from poverty and will earn enough income to increase their dietary protein to the required 60 gm/d minimum. For example, investors in General Mills (GIS) and Deere (DE) have enjoyed a 30-yr total return that beat the S&P 500 Index while having a statistically lower risk of loss in a bear market. For all types of commodities (e.g. gold, oil, iron ore, cereal grains), suppliers of equipment typically make more money than those (e.g. farmers) who produce the raw commodity. In the United States, this phenomenon first became common knowledge during the California Gold Rush of 1849. So, this week’s blog is about companies that supply equipment to farmers. 

Mission: Examine key metrics for all the agricultural equipment suppliers among the 1000 largest US companies by revenue, i.e., those in the 2015 Fortune 500 list with its supplemental material on the next largest 500.

Execution: The 2015 Fortune 500 list has 11 companies that make agricultural production equipment (see Table); 6 of those companies are also in the 2015 Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges: Tractor Supply (TSCO), Cummins (CMI), Deere (DE), AGCO (AGCO), Caterpillar (CAT), Terex (TEX). For comparison purposes, the benchmarks at the bottom of this week’s Table include commodity-production companies involved in oil & gas exploration, gold & copper mining, metals production, and meat production, as well as indices for prices of 24 commodities (GSG) and gold/silver prices (^XAU). 

The story, as you can see from the Table, is a depressing one. We’re near the end of the latest commodity “supercycle.” And, we won’t know if the supercycle has ended until developing nations can again afford to build out their infrastructure. There are some hints that the next supercycle is emerging, e.g., improved performance by several large companies in the metals and mining sector (see Week 217). But much depends on China, where 40% of the world’s appetite for commodities resides. Demand there continues to fall, and the government’s penchant for manipulating the stock market could forestall any recovery in confidence that would be sufficient to increase the demand for commodities. 

But we should be advised of the prospects for each of the 11 companies identified in the Table. Perhaps there is one positioned to herald a new dawn. Five of the companies make, service and/or equip farm tractors, skid loaders, backhoes, end-loaders, and combines. Those five are: Deere (DE), AGCO Corp (AGCO), Tractor Supply (TSCO), Caterpillar (CAT), Terex (TEX). Trimble Navigation (TRMB) makes computerized equipment to outfit tractors for "precision agriculture" dependent on GPS, whether for planting seeds or guiding sprayers of fertilizer, insecticides, herbicides, and fungicides. Valmont (VAL) makes center-pivot irrigation systems that use well water pumped by electric or diesel motors. Flowserve (FLS) is a major supplier of pumps, and Cummins (CMI) is a major supplier of diesel motors. Fastenal (FAST) supplies building materials and has outlets throughout the Midwest and Great Plains. Toro (TTC) supplies the latest generation of plant watering systems, which is a metered drip irrigation that depends on a grid of buried "tapes"; Deere (DE) also provides a drip irrigation system. 

As elsewhere, technology seems to be the game-changer. Drip irrigation systems use 40% less water than center-pivot systems which, in turn, use 40% less water than flood irrigation. Precision guidance of tractors from space (via GPS), combined with soil monitoring and interpretation via a wireless hookup to centers run by Monsanto (MON) and duPont (DE), means that the right amounts of water, fertilizer, insecticides, herbicides, and fungicides will be deployed to nurture the right kinds of seeds for each variety of soil in a farmer’s acreage--all combined with computerized weather analysis in real time (based on satellite interpretation of local rainfall patterns combined with meteorological prediction). This is called the Agronomy Revolution, and it’s where the future lies. The problem is that it has doubled the prices that farmers have to pay for new tractors with their attached gizmos. Typically, we would expect farmers to have trouble affording all of this “new paint” unless something had increased crop prices enough to give them a feeling of wealth. That happened with the drought of 2012, and conveniently during the Great Recession because Congress had mandated a surge in ethanol production.

The problem for you, as an investor, is that there is no company in the Table (including those named under Benchmarks) whose stock meets our requirements to be a candidate for inclusion in your retirement portfolio. Those requirements are a) the company is an S&P Dividend Achiever, having raised its dividend annually for at least the past 10 yrs; b) the company is large enough to appear on the 2015 Barron’s 500 List; c) the company’s stock has beat the S&P 500 Index for the past 16 yrs without incurring as great a risk of loss in a future bear market, per the BMW Method; d) the company’s bonds have an S&P rating no lower than BBB+ and its stock has an S&P rating no lower than B+/M, and e) the stock lost less money during the Lehman Panic than our key benchmark, the Vanguard Balanced Index Fund (VBINX). The only commodity-related companies we’re aware of that meet those requirements are Chevron (CVX) and Exxon Mobil (XOM). However, Chevron has gone 18 months without raising its dividend (because of negative cash flow related to a 60% drop in oil prices over the past year).

Bottom Line: Commodities, and commodity-related companies, are at a historic low point in valuation. Even the companies that supply farmers and ranchers with equipment are limping along. Deere (DE) has the best 30-yr record but remains a speculative investment, given that it’s stock lost more than the lowest-cost S&P 500 Index fund (VFINX) during the 18-month Lehman Panic period (see Column D in the Table). But Deere is also the company best positioned to benefit from the Agronomy Revolution that is bringing us the next big step up in agricultural productivity. The devil’s advocate will ask the obvious question: “If these stocks are all at historic lows, doesn’t that suggest that now is the time to buy?” That game has a name: Catch the Falling Knife. Which is fine, given that great rewards only go to those who take great risks. Professional investors often pass through a phase where they try their skill at catching the knife as it falls, after which they give up trying. From that point on, they studiously avoid buying any asset while it is falling in price.

Risk Rating: 7

Full Disclosure: I have FLS, CMI, and DE stock.

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

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Sunday, September 6

Week 218 - Food Consumer Products

Situation: This week’s blog is the second of a 4-part series covering companies in food-related categories on the 2015 Fortune 500 List, which has been expanded in recent years to include the 1000 largest US companies by revenue. The first installment (see Week 210) explained the methodology and looked at “agronomy and food production companies.” With the exception of Tyson Foods, the products of those companies are rarely seen on grocery store shelves. This week, we confine our attention to companies whose sole purpose is to put food and beverages on grocery store and convenience store shelves. Fortune 500 calls these "food consumer products" companies.

Mission: Identify stocks of “food consumer products” that might be suitable for inclusion in a retirement portfolio.

Execution: To start, we identified the Fortune 500 “food and consumer products” companies that also appear on the Barron’s 500 Lists for 2014 and 2015. Those rank the 500 largest companies traded on the Toronto and New York stock exchanges by revenue. Rankings “compare companies on the basis of three equally weighted measures: (1) median three-year cash-flow-based return on investment; (2) the one-year change in that measure, relative to the three-year median; (3) sales growth in the latest fiscal year.” Companies without trading records going back to the S&P 500 Index peak on 9/1/2000 have been excluded. There are 11 matches, 6 of which are companies that have increased their dividend annually for at least the past 10 yrs (see Column S in the Table). Four of those “Dividend Achievers” are suitable candidates for inclusion in your retirement portfolio, based on a) having lost less than our key benchmark (VBINX) during the Lehman Panic, b) beating the S&P 500 Index over the past 16 yrs and carrying less statistical risk of loss in a future “bear market” per the BMW Method, and c) having an S&P Bond Rating no lower than BBB+ and an S&P Stock Rating no lower than B+/M. Those 4 are Hormel Foods (HRL), General Mills (GIS), PepsiCo (PEP), and Coca-Cola (KO).

Bottom Line: We’re looking for stocks that perform well during good times and bad. That comes down to looking for companies with strong brands and pricing power. One of the best ways for a company to have pricing power is for its goods to enjoy “inelastic demand.” In other words, there is steady demand regardless of fluctuations in the economy; sales volume “changes little with a large movement in price”. Nothing does that better than food, even though the key input for food production is a raw commodity like wheat or rice, where spot prices can change dramatically. But food processors are able to pass any increased costs on to the consumer because food is a necessity that will be purchased regardless of price increases. In the accompanying Table, we have 11 companies for you to consider.

Risk Rating: 4

Full Disclosure: I have stock in HRL, GIS, PEP, and KO.

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