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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