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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