Sunday, November 29

Week 230 - Bet with the House

Situation: Government regulation now limits pricing power in 3 sub-industries: electric utilities, long-distance railroad and truck transportation, and money-center banks. First it was electric utilities, then railroads and trucking. The purpose of this regulation was to ensure that these companies with high fixed costs would be able to maintain their networks. That meant customers had to be charged enough to keep Return on Equity at around 10%. Railroads and electric utilities are essentially monopolies, so regulators also prevent them from overcharging. Then the Great Recession came along, and the few investment banking firms that had existed prior to the Lehman Panic couldn’t remain solvent. To gain access to Federal protection, they applied to become commercial banks. That had the down-side of welcoming Federal auditors into their offices on a full-time basis. When the “other shoe dropped” (The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010), legislation imposed additional regulation on the riskier (and more lucrative) financial products that money center banks prefer to promote. The danger is that these interconnected megabanks would simultaneously lose a great deal of money, i.e., precipitate a global economic crisis. Dodd-Frank calls those banks “SIFIs” or “Systemically Important Financial Institutions." The point is that most of the levers controlling finance are no longer located near Wall Street. They’re in Washington. So, there may be more safety in investing with companies in those 3 sub-industries that fall under Federal protection. Think of them as government protected companies.

Mission: We take the gambler’s saying seriously, i.e., “when possible, bet with the house.” The House is now the US Treasury, which has controlled short-term interest rates through the Federal Open Market Committee since the Banking Act of 1933. That’s one key variable that controls stock prices. The other key variable is earnings growth, which is supposed to be a function of the private economy. But, pricing power of 3 sub-industries is now under oversight of the US Treasury or government agencies answerable to the US Treasury. To “bet with the house” we need to assess a sample of companies in those 3 sub-industries.

Execution: We look at the 65-stock Dow Jones Composite Index (^DJA) to find a representative sample of companies. This week’s Table has every company in those 3 sub-industries that is large enough to appear in the 2015 Barron’s 500 List, as long as it has an S&P bond rating of BBB+ or better and an S&P stock rating of B+/M.

Bottom Line: These 11 companies operate under close government regulation. As a group, they have done well compared to the lowest-cost S&P 500 Index fund (compare Lines 13, 22 and 26 under Columns C, E and N in the Table). This outperformance apparently comes with no additional risk (see the same Lines under Columns D, I and O in the Table), So, betting with the House looks like a good idea. Specifically, this 11-stock sample performs better than the 65-stock Dow Jones Composite Index (compare Lines 13, 20 and 25 in Columns C through F of the Table) which, in turn, performs better than VFINX (the lowest-cost S&P 500 Index fund at Line 22 of the Table).

Risk Rating: 6

Full Disclosure: I dollar-average into NEE, UNP and JPM.

Note: Metrics are current for the Sunday of publication; metrics in red denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).

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Sunday, November 22

Week 229 - Stocks with 5-30 Years of Risk vs. Reward Data That Beat the S&P 500 Index

Situation: In last week’s blog (see Week 228), we turned up 6 “unicorns” (stocks with above-market returns and below market risk) over 5-16 yr holding periods. This week we’ve extended the holding period out to 30 yrs. Once again we turned up 6 unicorns (see Table) but 3 of those weren’t on last week’s list. In other words, only 3 companies in the 2015 Barron’s 500 List have outperformed the S&P 500 Index over 5, 16 and 30 yr periods while presenting the investor with a less risk than the S&P 500 Index. Those companies are Kimberly-Clark (KMB), NextEra Energy (NEE), and DTE Energy (DTE). Aside from investing in such minimally risky “defensive” stocks, you would do better by investing in the broad diversification of a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund (VFINX). Or, you can seek higher returns by taking on more risk!

Mission: Develop a logical plan to have your stock portfolio outperform the S&P 500 Index by taking on more risk.

Execution: Academic studies of this problem have shown that you have two options:
1) pick stocks issued by 40+ large-capitalization companies that represent all 10 S&P industries, while avoiding those with long-term debt (see Week 158);
2) pick a low-cost stock index fund that represents the next most risky layer of the market, i.e., mid-capitalization companies covered by the S&P 400 Index. There is an exchange-traded fund that will do that for you, the SPDR MidCap 400 ETF Trust (MDY at Line 16 in the Table).

Bottom Line: If you want to beat the S&P 500 Index, you’ll have to take on more risk. Why? Because there are only 3 stocks that have had better risk-adjusted performance than the S&P 500 Index over the past 5, 16 and 30 yrs (KMB, NEE, DTE). That’s not enough! Academic studies have shown that you need to diversify your holdings across all 10 S&P industries in order to spread out risk that occurs in downturns. This means you need to hold upwards of 40 stocks in your portfolio to avoid “concentration” risk. Or, you can pick a mid-capitalization stock index fund (e.g. MDY) and save yourself a lot of trouble. Over the past 5-yr holding period, that choice would have given you better returns than the Vanguard S&P 500 Index fund (VFINX) but with a greater risk of loss (compare Lines 15 and 16 at Columns C, D and I of the Table). Over a 30-yr holding period (with regular additions through dollar-cost averaging), the returns are again greater for the Mid-Cap fund (see Lines 19 & 20 at Column M in the Table) but the risk of loss is significantly lower (see Column O at Lines 19 & 20 in the Table). This is a logical way to beat the S&P 500 Index without taking on more risk. Holding periods of 16, 20 and 25 yrs will also do that for you, per the BMW Method. Why does a Mid-Cap stock index carry less long-term risk than the S&P 500 Index? Because smaller companies have less access to long-term financing through bond sales. In other words, Mid-Cap companies have choppier earnings growth than S&P 500 companies, and are still establishing their brands. So, they are less able to attract a syndicate of banks that will back the issuance of a long-term bond with an interest rate that is lower than the company’s ROA (Return on Assets). Having no long-term debt means there is little chance of a company going bankrupt (or being acquired by another company for less than book value).

Risk Rating: 6 (because MDY will always have a higher 5-yr Beta than VFINX, which has a Risk Rating of 5, as will any broadly diversified collection of 40+ stocks).

Full Disclosure: I dollar-average into NEE.

Note: Metrics are brought current for the Sunday of publication; metrics highlighted in red denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).

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Sunday, November 15

Week 228 - Barron’s 500 Stocks with 5-16 Yrs of Below-Market Volatility and Above-Market Returns

Situation: You don’t want to lose sleep worrying about your stock portfolio, but you also don’t want to depend entirely on index funds for retirement planning. Most readers of this blog have decided to supplement their retirement income with dividend checks that grow 2-5 times faster than inflation. The stockpicker’s goal is to get risk-adjusted returns that meet or beat S&P 500 Index returns. That takes a lot of time and requires understanding how markets work, meaning a steep learning curve extending over 10 or more years. And, it is almost impossible to find stocks that will perform for you at the high level over the long term (as this week’s blog makes clear). To get that result you would need to become a short-term trader of stocks that are not widely followed by analysts (Google “Peter Lynch” to see what I mean). If you’re not willing to become that kind of trader, then a better choice is to invest in the lowest-cost S&P 500 Index fund, the Vanguard 500 Index Fund (VFINX), or its bond-hedged version, the Vanguard Balanced Index Fund (VBINX). Or, accept that fact that few of your long-term stock picks are going to have total returns that out-perform the S&P 500 Index on a risk-adjusted basis over 2-3 market cycles.

Mission: Find stocks that have better risk-adjusted returns than the S&P 500 Index over 2-3 market cycles. Start by looking at the largest companies in the US and Canada using the Barron’s 500 List to gain information about key fundamentals. Specifically, we want to find those that have had below-market volatility over the past 5 and 16 years and returns that have beat the S&P 500 Index over the past 5 and 16 years. Eliminate any stocks that have S&P bond ratings lower than BBB+ or S&P stock ratings lower than B+/M.

Execution: We have been able to identify only 6 stocks that satisfy our criteria (see Table). If you have been reading our blog regularly, you’ll know that we call such stocks unicorns. Four of these 6 unicorn stocks pay an above-market dividend, and the other one (Nike) increases its dividend more by than 20% a year. Our list has turned up “bond substitutes” of high quality but all bond substitutes are in great demand. Why? Because the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has eliminated the ability of banks to trade bonds for their own account. In other words, the principal market for bonds has dried up. It is going to be a long time before bonds again become a place where you can park money in anticipation of interest payments that more than compensate for inflation. 

And now, a word about the method we use to find unicorns in the Barron’s 500 List. To find companies with Below-market volatility over the past 5 yrs, we use 5-yr Beta, and at 16 yrs we use the predicted loss that would be incurred if the stock’s price dropped 2 Standard Deviations below trendline, per the BMW Method. To find companies with above-market returns at 5-yrs, and since the S&P 500 Index peaked on 9/1/00, we use the Buyupside total return stock calculator. To assess the past 16 years of price appreciation, we use the BMW Method. All comparisons are to either the S&P 500 Index or the lowest-cost stock mutual fund that mimics that index (VFINX). 

Bottom Line: We’re looking for “unicorn” stocks and found 6 (see Table). The method we use will probably never turn up more than 10 stocks, given that outperformance is almost always accompanied by greater volatility. The problem for you, the reader, is that we’ve used historical data. In other words, there’s no way of knowing whether these 6 stocks will continue to outperform while exhibiting below-market volatility.

Risk Rating: 4 

Full Disclosure: I dollar-average into NKE, UNP and NEE.

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, November 8

Week 227 - Established Companies with a Durable Competitive Advantage and Improving Fundamentals

Situation: Government and corporate credit woes are building up around the world, instead of receding. We’ve pointed out in several blogs that the root cause of the Great Recession was overuse of credit. We’ve also pointed out that the world had apparently learned its lesson and was gradually deleveraging. That trend stopped in 2014 and a reversal is now underway. Why did deleveraging stop? Because the Federal Reserve maintained its “free money” policy too long. How should we respond? Stocks are widely understood to have been inflated in value as a result of that Federal Reserve policy, since low interest rates made bonds an unattractive alternative. Until the Federal Reserve actually raises rates to traditional levels relative to inflation, that leaves you with the same two investment choices you’ve had for the past 5 years: risky stocks vs. “bond-like” stocks. Bond-like stocks are issued by established companies, have an above-market dividend yield, and have a history of growing dividends twice as fast as inflation. To pick the best bond-like stocks during this period of global economic uncertainty, focus on companies that have what Warren Buffett calls a “Durable Competitive Advantage”, particularly those with improving fundamentals.

Mission: Make a list of Barron’s 500 companies that have trading records extending back at least 16 yrs and have a Barron’s rank this year that is higher than last year’s rank, i.e., companies with improving fundamentals. Determine which have a Durable Competitive Advantage (see Week 30). That means Tangible Book Value (TBV) has grown at least 7-10% a year for the past 10 yrs, and there have been no more than two down years. If TBV is positive in any given year, that means tangible assets exceed liabilities. Most companies have a negative TBV because of being capitalized mainly by loans. That exposes the company to the risk of insolvency during periods when loans are difficult to renew, unless the company agrees to pay an interest rate that exceeds the company’s rate of return on assets. By focusing on TBV, we bypass such companies. Next, we eliminate companies with below-market dividend yields, or dividend growth that is less than twice the inflation rate. Finally, we calculate the Buffett Buy Analysis for each company that remains. 

Execution: This week’s Table lays out metrics that fit the mission. Calculation of the Buffett Buy Analysis (see Columns S thru Z in the Table) requires some explanation. It is a “discounted cash flow” method wherein earnings growth over the past 10 yrs (Column T) is projected 10 yrs into the future (Column U), then multiplied by the lowest P/E seen over the past 10 yrs (Column V). That gives a conservative estimate of the stock’s price 10 yrs from now, unless a dividend is paid. If a dividend is paid, there is a conservative assumption that the dividend won’t be increased any time in the next 10 yrs. The current annual dividend is multiplied by 10 (Column W) and added to the price estimate dictated by the projected growth in earnings (Column X). To conduct a Buffett Buy Analysis, we start with the current price (see Column Y) and calculate the Compound Annual Growth Rate (CAGR) over the next 10 yrs that would be needed to arrive at the predicted price (see Column X) 10 yrs from now. The result is given in Column Z. That CAGR is the Buffett Buy Analysis (BBA). That rate of stock price appreciation should be in line with the rate of TBV appreciation rate over the past 10 yrs (see Column R). It will be lower if the stock is currently overpriced, since the “runway” to reach the projected price 10 yrs from now is shorter.

Bottom Line: By taking an objective approach to stock-picking, we’ve managed to eliminate 99% of the companies on the Barron’s 500 List (see Table). Partly that’s because the market has become overpriced, since the Federal Reserve’s easy money policy takes attention away from owning bonds, and partly because those same policies have made money so cheap that most companies have come to rely more heavily on debt financing than they normally would. Debt financing is also cheaper because interest payments are tax-deductible. The 5 companies in this week’s Table offer objective value: 1) growing TBV; 2) improving fundamentals. They all have returns that have far exceeded S&P 500 Index’s returns since that index peaked on 9/1/00 (see Columns C and L in the Table), and none are currently overpriced (see Column K). The main caveat for owning such bond-like stocks is that their price is likely to drop for a period after the Federal Reserve starts raising interest rates, because new bonds pay more interest than old bonds.   

Risk Rating: 5

Full Disclosure: I dollar-average into NEE, and also own shares of CMI and ADM.

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

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Sunday, November 1

Week 226 - Grocery and Drug Stores, Restaurants and Their Suppliers

Situation: Food-related businesses supply an “essential good.” In the US, families spend approximately 10% of their income on food. Today’s blog is the last of a 4-part series covering food-related companies in the 2015 Fortune 500 list, which ranks 1000 companies by revenue and provides specific information about each company’s relation to the marketplace. Week 210 covered Agronomy and Food Production Companies; Week 218 covered Food Consumer Products, and Week 219 covered Agricultural Production Equipment. 

Mission: Provide details related to investment metrics for companies at the final stop in the food supply chain. Those companies are grocery and drug stores, restaurants, and specialized trucking companies serving those establishments. Our second focus is to reach conclusions about the benefits and risks that stockpickers need to consider when buying stock in these companies, particularly as a long-term holding for a retirement portfolio.

Execution: The prosperity of any company is determined, in part, by input costs. For food-related companies, the key inputs are cereal grains and soybeans, whether used to make food directly or indirectly (by feeding animals). Prices paid for those raw materials will depend on the economics of production at farms and ranches worldwide. As with other commodities, the up-front “fixed costs” of food production are very high. That large investment will be capitalized mainly with borrowed money. Therefore, a farmer faces major uncertainties on two fronts: interest rates and the weather. When interest rates are low and weather is optimal in major food-producing regions, there will be an overabundance of food commodities and prices will fall 30-50%. That leaves farmers with little or no money after servicing mortgages on their land and equipment, and buying seed and fertilizer for next year’s crop.

Bottom Line: Food-related businesses are speculative enterprises. Of the 13 in this week’s Table, only one can be considered suitable for inclusion in a retirement portfolio: Sysco (SYY). That is a trucking company which delivers food (in various stages of readiness for consumption) to grocery stores, restaurants, and institutions.

Risk Rating: 6

Full Disclosure: I own stock in McDonald’s (MCD).

Note: Metrics highlighted in red denote underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX). Metrics are brought current for the Sunday of publication.

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