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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