Sunday, October 25

Week 225 - How are the 20 Largest AgriBusiness Companies Doing?

Situation: Commodities have fallen steadily in value since the Lehman Panic. A recent further decline is related to a slowing in the pace of modernization in China, where 40% of commodity production had gone for the past 20 yrs. This has greatly compounded the problem because the rapid pace of modernization there had required remarkable growth in the production of all commodities. Now that China’s infrastructure buildout is largely complete, those upgraded mining and exploration assets in Australia, Brazil, Chile, and South Africa have been idled, and over a dozen billion dollar projects have been aborted. But those aren’t the only commodities out there. What about agricultural products? Demand for soybeans and cereal grains (e.g. barley, corn, oats, rice, rye, wheat, sorghum) is different because close to 20 million people emerge from poverty each year and are able to afford better food, which translates into a protein intake of at least 60 gm/d. The volumes of food involved in meeting that increased demand make it necessary to combine the “green revolution” with “factory farms.” That combination has come to be called “AgriBusiness.” AgriBusiness is focused on efficiently getting water to soil that has been prepared to support the germination of designer seeds through “agronomy.” Agronomy is shorthand for the scientific use of fertilizers, insecticides, and fungicides to optimize plant growth around weather patterns and irrigation systems that meet water needs.  

Mission: Assemble data on stocks representing the 20 largest AgriBusiness companies, and compare their aggregate performance with broad commodity indices--as well as narrower indices that reflect the performance of farming, mining, and energy companies.

Execution: AgriBusiness companies are high risk investments, and each has only a small piece of the pie. In order to compete against one another, each has to maintain a market for its goods and services in dozens of countries. Only 4 of the 20 identified AgriBusinesses are stable enough to warrant inclusion in a retirement portfolio by even the most basic criteria (see Table). These criteria are 1) Dividend Achiever status, 2) an S&P bond rating of at least BBB+, and 3) an S&P stock rating of at least B+/M. The 4 companies that make the cut are: Monsanto (MON), Deere (DE), Hormel Foods (HRL), and Archer Daniels Midland (ADM).

Bottom Line: If you think your portfolio requires exposure to commodities, then you’re in for a rough ride. But “long cycle” investments such as commodities can be quite rewarding if held for two or more market cycles. The safest approach is to own stock in a few of the larger AgriBusiness companies, as opposed to owning stock in mining or energy companies (see Week 221). This week’s blog takes a closer look at those agricultural producers. Be aware, however, that overproduction to meet China’s needs over the past decade has expanded agricultural production capacity along with that for oil, natural gas, coal, iron ore, bauxite, and copper. This is being reversed now that China’s “buildout” has begun to plateau.  

Risk Rating: 8

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

Note: Metrics in the Table that are 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, October 18

Week 224 - Growing Perpetuity Index, v2.0

Situation: We started publishing this weekly blog over 4 years ago, believing that investors can safely profit by dollar-averaging online into stocks of strong companies. To simplify matters, we defined strong companies as those in the 65-stock Dow Jones Composite Average (^DJA) with a record of increasing their dividend each year for at least the past 10 yrs. S&P calls such companies Dividend Achievers, and there are 28 in the ^DJA. We call ^DJA the “Stockpicker’s Secret Fishing Hole” because it outperforms the S&P 500 Index (^GSPC) over two or more market cycles (compare Lines 30 and 32 in Column C of the Table) but contains only 1/8th as many stocks. 

Mission: For v1.0 of the Growing Perpetuity Index, we set up 4 criteria to find the highest quality companies in the ^DJA (see Week 4). Each selected company had to fit the following criteria:
   a) has a dividend yield that is no less than the yield for the S&P 500 Index (VFINX);
   b) is a Dividend Achiever;
   c) has an S&P stock rating of A-/M or better;
   d) has an S&P bond rating of BBB+ or better.
There were 14 companies that met our criteria. We wanted a Growing Perpetuity Index of no more than 12 stocks, so Southern Company (SO) and Caterpillar (CAT) were excluded from v1.0 (see Week 4).

Execution: In the 4 years since that blog was published, two additional companies have come to meet our criteria: Microsoft (MSFT) and a railroad, CSX (CSX). Now we’re setting up version 2.0 of the Growing Perpetuity Index to include all 16 qualifying companies (see Table).

Bottom Line: A perpetuity is a bond that never matures (i.e., it pays interest indefinitely). A growing perpetuity is a bond that pays more interest each year. Our Growing Perpetuity Index does that. It is a unique reference tool for retirement planning, a safe and effective tactic to have a source of income (quarterly dividend checks) that will grow faster than inflation (see Column H in the Table). Inflation has grown 2.1%/yr since the S&P 500 Index peaked on 9/1/00 (see Column C in the Table), but dividends for v2.0 of the Growing Perpetuity Index have grown ~5 times faster (see Line 18 under Column H). Looking at price appreciation over the past 20 yrs using the BMW Method, the aggregate of 16 stocks (see Line 18 under Column L) has appreciated 3 times faster than the S&P 500 Index (see Line 32 in the Table). All 16 companies have outperformed the S&P 500 Index over the past 20 yrs (see Column L in the Table). However, outperformance always comes with greater risk: The BMW Method’s analysis of price performance over the past 20 yrs predicts that the extent of loss for those 16 companies in a future bear market will be 10% greater than for the S&P 500 Index (compare Lines 18 and 32 in Column N of the Table).  

Risk Rating: 4

Full Disclosure: I dollar-average into JNJ, NEE, WMT, MSFT and XOM, and also own shares of MCD, IBM, KO, UTX, and MMM.

Note: Metrics highlighted in red indicate underperformance relative to our benchmark (VBINX); metrics are current for the Sunday of publication.

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Sunday, October 11

Week 223 - Pricing Power

Situation: Stock-picking does not appear to be difficult. There is but one task (estimate earnings growth for ~30 companies) and one scorecard (growth of the S&P 500 Index). The long-term price appreciation for each company’s stock is a simple function of earnings growth and short-term interest rates. The most efficient way to boost earnings is to raise prices, if it won't hurt sales. This can be done by convincing customers that a company’s product or service is superior to the competition’s. In that scenario, pricing power = brand power. Alternatively, a company’s managers can engage in “restraint of trade” practices. In that scenario, pricing power = monopoly power (which is illegal). But pricing power is such a strong driver of earnings growth that company managers will try to skirt the legalities “to get a leg up on the competition.” Companies discover pricing power when “Mr. Market” decides that one of its “brands” is superior to others like it. In other words, consumers may decide to pay more dearly for a particular product or service just because it is perceived as “cool.” 

Mission: Determine which companies have brands that are strong enough to explain earnings growth “surprises.” In other words, which companies have the kind of stock price appreciation that comes from pricing power related to growing brand value, instead of pricing power related to “restraint of trade” practices. 

Execution: We'll start with the list of brand values in the recently published “Global 500 2015.”  Many of those brands denote whole companies but others denote separate product lines within a company. There are 87 US brands in that list with a higher dollar value in 2015 than in 2014. For analysis purposes, we’re only interested in companies (or the parent companies) having a publicly traded stock that has been around for at least 16 yrs and has a pricing pattern that roughly tracks that of the S&P 500 Index, as analyzed by the BMW Method. We find that 53 of those 87 companies meet those criteria and have revenues great enough to warrant inclusion in the Barron’s 500 List. Given that our stock-picking scorecard is the S&P 500 Index, we excluded the 6 companies that have had lower price appreciation over the past 16 yrs than the S&P 500 Index. Those are: Southwest Airlines (LUV), Sprint (S), Morgan Stanley (MS), Time Warner (TWX), Intel (INTC), Cisco Systems (CSCO). That leaves us with 47. An additional 17 were deleted because of having an S&P bond rating below BBB+ and/or an S&P stock rating below B+/M. This leaves us with 30 stocks to consider (see Table).

You want to have a stock-picking strategy that beats the S&P 500 Index. Failing that, you need to sell your stocks and dollar-average the proceeds into the lowest-cost S&P 500 Index fund (VFINX at Line 39 in the Table) or its bond-hedged version (VBINX at Line 37 in the Table). Over the past 20 and 30 yr periods, only 6 stocks have been able to track the S&P 500 Index and outperform it with less risk of loss in a future bear market, per the BMW Method. Those 6 stocks are Abbott Laboratories (ABT), Air Products and Chemicals (APD), 3M (MMM) and 3 utilities: American Electric Power (AEP), DTE Energy (DTE), and NextEra Energy (NEE). In other words, it is almost impossible to beat the S&P 500 Index unless you take on more risk (in the hope that price appreciation will outweigh the additional risk). 

Bottom Line: We have found 30 companies that beat the S&P 500 Index over the past 16 yrs (see Table). All 30 have improving brand values. The pricing power conferred by that improvement likely contributed to the earnings growth that has driven their stock prices higher. Investors are justified in thinking that pricing power is a “necessary but not sufficient” explanation for the outperformance of these stocks. A stock-picking strategy founded on improvement in brand values may be the best strategy available to retail investors, i.e., those who work outside the finance industry.

Risk Rating: 7

Full Disclosure: I dollar-average into NKE, UNP, JPM, WMT and MSFT, and also own shares of KO, PEP and MCK.

Note: Red highlights in the Table denote underperformance vs. the bond-hedged S&P 500 Index (VBINX); metrics in the Table are current for the Sunday of publication.

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Sunday, October 4

Week 222 - Food and Agriculture Companies: Brand Performance

Situation: How can we know whether a company is a “growth story”? Here at ITR, we depend on the fundamental performance of “metrics” from the previous 3 yrs, and the readout showing whether or not the company is moving ahead in terms of those metrics. The Barron’s 500 List provides that information, and also allows us to compare different companies within an industry. Usually, those findings correlate with the trend in “Tangible Book Value” or TBV, which Warren Buffett uses to identify companies with a Durable Competitive Advantage (see Week 158). Barron’s 500 data is more useful than TBV because it marks trends in Cash Flow and Return on Invested Capital (ROIC) regardless of a company’s degree of indebtedness, whereas, TBV is minimal or negative if a company is capitalized mainly by loans (which is unfortunately the case with most companies). 

Another key metric is Intangible Book Value. That’s the amount of money a company pays over and above TBV when it buys another company. Accountants book that asset as “Goodwill.” Intangible Book Value represents the dollar value of a company’s brand. It is difficult to place a dollar value on a brand unless a company is sold. But the information is so important that there are now 3 companies that compile the marketing data needed to make “best estimates.” One of those companies is Brand Finance, which recently came out with its 2015 ranking of the 500 most valuable brands worldwide. 

Here at ITR, we’re particularly interested in Food and Agriculture companies. Let’s see how those brands have performed, paying particular attention to companies that represent (or harbor) the top 7 growing brands: Coca-Cola (KO), PepsiCo (PEP), Nestle (NSRGY), Danone (DANOY), Diageo (DEO), Tyson Foods (TSN), and Kraft Heinz (KHC). This requires two spreadsheets. Table #1 ranks growing brands at the top of the table and declining brands at the bottom, assigning dollar values to each. Column D lists the parent company of each brand. Table #2 provides investment information for each of those 18 companies.

As an investor, you’re looking to find GARP (Growth at a Reasonable Price). Turning to Table #2, we see that all 18 companies beat the S&P 500 Index over the past 15 yrs (see Column C) and 16 yrs. 16-yr performance is measured by using statistical BMW Method data that is summarized in Columns L-N. So, growth is a foregone conclusion for these commodity-related stocks. That leaves two issues: 1) the price you pay for the stock relative to its operating earnings (EV/EBITDA in Column K); 2) the risk of loss that you take on by owning the stock (see Column D and Column N). Looking at the top 7 stocks with growing brands in Table #1, we see in Column K of Table #2 that Tyson Foods (TSN) is the only one that is not currently overpriced. With respect to the risk of loss, we see in Columns D & N of Table #2 that all except Coca-Cola (KO) and Pepsi (PEP) are overly risky, or carry currency risk because of not being priced in US dollars. For example, Nestle stock is priced in the world’s strongest currency: Swiss Francs.

Bottom Line: The value that comes from owning Food and Agriculture stocks ultimately depends on price trends for food commodities. That means these stocks will show greater price variance than the S&P 500 Index. However, food is a necessity and at least 10 million people a year emerge from poverty and can then afford to consume a 60 gm/d protein diet. So, we’re looking at risky investments that are remarkably rewarding if held over 2-3 market cycles; you have to be a “risk-on” investor to benefit from owning these stocks. The only exceptions are PepsiCo (PEP) and Coca-Cola (KO), which are sufficiently stable to be included in a retirement portfolio .

Risk Rating: 6/7

Full Disclosure: I own stock in KO, PEP, and DE.

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

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