Sunday, January 31

Week 239 - The “Big 6” Agronomy Companies Are Starting To Merge

Situation: For the past 10 years, companies in the “Basic Materials and Energy” industries have made massive investments to support China’s infrastructure buildout. More than 10 million people a year in China moved from rural poverty to cities during that time. But now China’s government sees little need for more construction projects and manufacturing capacity. Labor costs have increased and more emphasis is being placed on satisfying the need for consumer goods. China is no longer an emerging market. Other countries in Southeast Asia are able to produce goods more cheaply and compete with China for market share. The problem now is that the worldwide supply chain for energy, basic materials, and food commodities is twice the size it was 10 yrs ago but the market for all those goods is only a little larger. Production can’t suddenly be cut in half which means that excess goods have to go into storage. There has never been a commodity crash as big as this. To make matters worse, the world has yet to shake off lingering effects of the Lehman Panic. People got by with less for so long that they’ve unlearned the habit of casual shopping. But food? Who guessed that consumers would even cut back on that? Many families in North America are losing interest in foods that aren’t healthy, farm goods that aren’t produced in an environmentally sensitive manner, and meat that isn’t produced with due consideration to every farm animal’s well being. That means the grocery store bill is larger every week for those families but they’re seeking out grocery stores that offer those products. “Factory Farming” is going out of style. 

Mission: Assemble growth-related metrics for the 6 largest companies that produce seeds, insecticides, herbicides and fungicides.

Execution: Dow Chemical (DOW) and duPont (DD) have decided to merge operations then spin off 3 companies. There will be one new company formed for agriculture, one for specialty chemicals, and and one for commodity chemicals. Syngenta (SYT) and Monsanto (MON) tried to merge, then broke off talks, and are now talking again. Bayer (BAYRY) and BASF (BASFY) have also held preliminary talks with potential partners. Let’s see what makes some of these 6 companies a target for purchase by other agronomy firms.

Administration: All of these companies are struggling. None of the US companies that S&P analyzes (MON, DD, DOW) has been able to grow Tangible Book Value (TBV) over the past 10 yrs, and stock prices average more than 20 times TBV (see Columns P-R in the Table). The main factor keeping these companies away from insolvency is the value of their strong brands. Risk metrics shown in the Table are very concerning, such as total return during the 2011 stock market correction (Column D), 5-yr Beta (Column I), and the BMW Method’s projection of price loss in a bear market compared to the 16-yr price trendline (Column O). On the other hand, the rewards to investors who bought any of these stocks at the market peak on September 1, 2000, have been quite satisfactory (see Columns C and M in the Table). Average dividend yield is ~3.4% and average dividend growth is 10.5% (see Columns G and H in the Table). The two weakest companies are duPont and Dow Chemical, so it is not surprising that those are the first to combine operations.

Bottom Line: Agronomy stocks aren’t for the faint of heart. You’d have to be a speculator who is able to weather volatility over at least two market cycles before reaping your reward. Now these stocks are on the bargain shelf, being forced to merge operations--which is just what an investor like Warren Buffett loves to see happening. Monsanto (MON) is the only one that might be a suitable stock to own for someone who is not a financial services professional. 

Risk Rating: 7

Full Disclosure: I dollar-average into MON and also own shares of DD.

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

Post questions and comments in the box below or send email to:

Sunday, January 24

Week 238 - Let’s Revisit The “Stockpicker’s Secret Fishing Hole”

Situation: Stock-picking is a good way to build a retirement portfolio, if you have enough time and enthusiasm. It requires that you delve into fundamental company practices far enough to select and follow a dozen or more stocks. But how do you start, and where should you focus your efforts? For sure, you’re not going to analyze all 500 stocks in the S&P 500 Index (^GSPC). But you can become familiar with the 65 stocks in the Dow Jones Composite Index (^DJA). We call it the Stockpicker’s Secret Fishing Hole because it often outperforms the S&P 500 Index. For example, price appreciation over the past two market cycles for ^DJA has been twice as great as for ^GSPC (see Column C at Lines 52 & 54 in the Table). ^DJA also benefits from being a “managed” index: its stocks are picked by a Wall Street Journal committee chaired by the Managing Editor.

Mission: Produce our standard spreadsheet for all ^DJA stocks that have revenues high enough to warrant inclusion in the Barron’s 500 List. Exclude any that have an S&P stock rating lower than B+/M, or an S&P bond rating lower than BBB+, and determine which of the remainder have a Durable Competitive Advantage (DCA). 

Execution: Of the 38 companies that meet mission criteria, 18 are suitable for long-term investment because much of their book value is in real (“tangible”) assets that track earnings growth. Warren Buffett says this confers a “Durable Competitive Advantage” if tangible assets have been growing at least 9% per year over the most recent decade, and if there have been no more than two down years (see The Warren Buffett Stock Portfolio by Mary Buffett and David Clark, Scribner, New York, 2011). Given that the Great Recession sharply reduced economic growth over the past decade, I’ve loosened that standard to 7%/yr with no more than 3 down years. 

The 18 companies listed below meet our requirements. All have a Price/Tangible Book Value ratio that is less than 10. In other words, real assets (as opposed to brand value or “goodwill”) represent at least 10% of the share price (see Columns T-V in the Table). I use this system, and dollar-average into the 7 stocks with bold typeface: 

        Public Service Enterprise Group
        NextEra Energy
        JB Hunt Transport Services
        Wal-Mart Stores
        American Express
        Union Pacific
        Expeditors International of Washington
        Cisco Systems
        JP Morgan Chase
        Goldman Sachs

Bottom Line: “High quality megacaps are the name of the game.” You’ll need a system for recognizing value and sustainability among those large capitalization companies. S&P charts for individual companies list the Tangible Book Value (TBV) for each of the past 10 yrs and are available through most brokerages, as well as S&P. By using a calculator for Compound Annual Growth Rate, you can arrive at each company’s Durable Competitive Advantage (growth in TBV). If the company has no TBV, its liabilities exceed the value of its real assets; you’ll need to delve into its Balance Sheet before deciding to assume that much risk. We’ve filtered through the 65-stock Dow Jones Composite Index and come up with 18 companies that look worthwhile, using our standard spreadsheet supplemented with calculations of their Durable Competitive Advantage.

Risk rating: 5

Full Disclosure: In addition to the 7 stocks above that I dollar-average into, I own shares of UTX, DD, MMM, INTC, KO, IBM, JNJ and MCD.

Note: Metrics in the Table are current for the Sunday of publication; those highlighted in red denote underperformance vs. our key benchmark (VBINX at Line 45 in the Table). Total returns/yr (in Column C of the Table) date to the penultimate S&P 500 Index peak that occurred on 9/1/2000.

Post questions and comments in the box below or send email to:

Sunday, January 17

Week 237 - Respect The KISS Rule

Situation: How do we save for retirement? After all, a typical adult is disinclined to reduce discretionary spending by the needed ~50% to plan for her future (and that’s assuming that a series of favorable events will transpire). To effectively save for retirement, most people have to make a game out of it. We substitute the discretionary entertainment value that comes from immediate consumption by instead watching our nest egg grow. The entertainment value we receive can be amplified by trying to be more clever than our neighbors and co-workers. With the help of a financial advisor, we play around with our retirement portfolios. But it doesn’t have to be that way. You can forget about entertainment and one-upping your friends. Just pick mutual funds that balance stocks and bonds. Or pick only one, such as the Vanguard Balanced Index Fund (VBINX), which serves as Jack Bogle’s only personal investment during most years. He’s the originator of index fund investing and founder of Vanguard Group. Jack Bogle respects the KISS rule: “Keep it simple, stupid.” But he has many critics in the community of investment advisors (as the above link makes clear). Their main criticism is that VBINX minimizes international investing and overlooks “core” assets like real estate investment trusts (REITs), small-cap stocks, and commodities.

Mission: Test a balanced portfolio of “core assets” consisting of US stocks, international stocks, US bonds, international bonds, REITs, and Commodities. In other words, combine the most diversified mutual funds for US stocks (VTSMX), US bonds (VBMFX), real estate investment trusts (VGSIX), commodity futures (QRAAX), international bonds (RPIBX), and international stocks (VGTSX). 

Execution: Since the S&P 500 Index peaked on 9/1/00 (see Table), total return/yr for these 6 core assets has come in at 3.6%/yr, matching the lowest-cost S&P 500 Index fund (VFINX). Broad diversification among core assets is meant to reduce the risk of an S&P 500 index fund without reducing returns. The 6 core assets we selected did achieve our objective. Risk measures were lower for this asset group (see Columns D and I in the Table). However, these core assets under-performed VFINX by a wide margin during the bull market of the past 5 years (see Column F in the Table). More importantly, their average expense ratio is 3 times higher at 0.52% (vs. 0.17% for VFINX). And, QRAAX has to be purchased through a broker. 

As a “rule of thumb” you want some assurance that your investment will meet the “business case” and double in value over the next 10 years, i.e., total return will increase by at least 7%/yr. If the dividend yield plus the dividend growth rate is at least 7%, that is likely to be the case (see Columns G and H in the Table where those instances are highlighted in green). Core assets, except for the real estate fund (VGSIX), do not meet that criterion.

Administration: Mutual funds also have “tail risks,” a term used to describe unlikely yet destabilizing events. Managed funds are sold on the basis of performance, which means managers tend to choose small- and mid-cap stocks that often perform remarkably well (meaning they have a high return on equity or ROE), due in part to being overcapitalized by loans and bonds that are “less than investment grade.” Of course, that indebtedness is ignored when calculating ROE. Index funds are also sold on the basis of performance and overly dependent on their smallest (i.e., riskiest) companies for that performance. Finally, mutual funds maintain minimal cash balances which can force them to sell their bonds or stocks at a loss during a bear market (i.e., conduct a “fire sale”). In other words, they have to immediately honor every investor’s request to have her money returned. None of these problems exist if you’re a shareowner. You get to decide how much risk you want to assume and whether or not to “ride out” a bear market, or even continue dollar-averaging into your favorite positions, so as to “vacuum up” shares that mutual funds are unloading at a loss.

By now you’re getting the point: part of your retirement portfolio has to be devoted to owning shares in a diversified group of strong companies that you’ve selected, so as to avoid the “buy high, sell low” roller coaster that mutual funds can’t avoid. They’re constrained by market forces and the inflows/outflows of investor’s cash. They’ll engage in “momentum investing” as they ride bull markets up, and “fire sales” as they ride bear markets down. By owning individual stocks, you choose whether to play along or not. Individual stocks also have their place in a retirement portfolio for another reason we often highlight. Many companies issue dividends that have increased 2-5 times faster than inflation for more than 10 years, whereas, distributions from stock mutual funds rarely keep up with inflation (see Column H in any of our Tables). That means you don’t have to cash out shares during retirement but instead can simply live off your income. For example, you can do quite well by investing in 5 stocks (that represent half the S&P industries) combined with owning 10-yr Treasury Notes in a 60% stock/40% Treasury Note ratio (see Line 14 in the Table). 

Bottom Line: Broad diversification among “core assets” will allow you to match the performance of the lowest-cost S&P 500 Index fund (VFINX) while incurring less risk, as long as you ignore transaction costs, advisory fees, and front-end brokerage charges. But professional money managers prefer to get you into “core assets” for the very reason that they live off advisory fees (as well as often gaining a piece of the income from transaction costs and brokerage relationships). Warren Buffett is right. You will beat 90% of professional investors by investing online through Vanguard Group--placing 90% of your savings in the lowest-cost S&P 500 Index fund (VFINX) and 10% in the lowest cost US government short-term bond index fund (VSBSX), as shown in Line 23 of the Table. The key benchmark we recommend to our readers is the Vanguard Balanced Index Fund (VBINX) at line 21 in the Table, which does even better than the Buffett Plan while incurring less risk. 

Risk Rating: 5

Full Disclosure: I own shares of MCD, JNJ, and KO, as well as dollar-average into T, NEE and Treasury Notes.

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

Post questions and comments in the box below or send email to:

Sunday, January 10

Week 236 - A 10-Stock Retirement Portfolio (One Stock For Each S&P Industry)

Situation: If you don’t want to depend entirely on index funds to fund your retirement, you’ll need a plan for buying stocks. One approach is to only choose stocks from defensive industries, i.e., Consumer Staples, HealthCare, Utilities and Communication Services (see Week 231). Another strategy would be to have all 10 S&P industries represented, which would make your portfolio more diversified. (Academic studies show that returns are higher from owning stocks that are diversified across industries.) 

Mission: Pick one stock from each of the 10 S&P industries, meaning the 4 defensive industries listed above, plus Industrials, Financial Services, Consumer Discretionary, Information Technology, Basic Materials, and Energy

Execution: To avoid “cherry-picking” from a list of currently impressive stocks, I’ll simply present the 10 stocks in the S&P 100 list that I dollar-average into (see Table). To be complete, 9 alternates from the S&P 100 Index are listed. 

Administration: Five of the stocks can be purchased online and without additional fees by making pre-programed monthly additions with automatic dividend reinvestment using computershare: Exxon Mobil (XOM), NextEra Energy (NEE), Abbott Laboratories (ABT), IBM (IBM) and Union Pacific (UNP). One exception is that IBM levies a 2% fee for reinvesting dividends. The remaining 5 stocks are available at reasonable cost, also from computershare: Monsanto (MON), JP Morgan (JPM), PepsiCo (PEP), AT&T (T), and Nike (NKE). 10-yr US Treasury Notes can be purchased at no cost at treasurydirect but automatic purchase is not available and you’ll need to point-and-click each purchase, as well as reinvest interest payments. Total transaction costs per year come to ~$137 if you invest $1200 (or $19,200/yr) in each of the 10 stocks and 6 Treasury bonds. This results in an expense ratio of 0.71% (see Column U in the Table).

Bottom Line: We’ve shown that you can dollar-average $100/mo into one stock for each S&P industry, and back that up with $600/mo in 10-yr US Treasury Notes, to achieve a total return/yr of ~7.0% dating back to the S&P 500 Index peak on 9/1/2000 (after subtracting transaction costs of 0.71%/yr). This beats our key benchmark (the Vanguard Balanced Index Fund, VBINX) by approximately 2.0%/yr without incurring additional volatility, according to standard measures (see Columns D, I, and O in the Table). However, you are responsible for the considerable risk of sampling bias, since you’ll be selecting only one stock to represent each of the 10 S&P industries. 

Risk Rating: 6

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

Post questions and comments in the box below or send email to:

Sunday, January 3

Week 235 - How Are Our 4 Key AgriBusiness Stocks Doing?

Situation: Ten weeks ago, we took a close look at the 20 largest AgriBusiness companies (see Week 225). We didn’t find much to love. When a commodity “supercycle” ends, it takes down all sectors, including oil & gas, mining, and agriculture. Nonetheless, we concluded that 4 AgriBusiness companies have strong enough balance sheets and wide enough marketing to “muddle through” this downturn. Each of the four firms we selected is a widely known and respected brand: Monsanto (MON), Hormel Foods (HRL), Archer Daniels Midland (ADM) and Deere (DE). Now that the commodity bear market has deepened, let’s look in on these companies to see how they’re holding up. 

Mission: Perform our standard spreadsheet analysis and make comparisons to relevant benchmarks (see Table).

Bottom Line: Hormel Foods (HRL) continues to outperform because of the “great meat rally.” Monsanto (MON) stock fell in price last year after a failed merger attempt with Syngenta (SYT) but is now recovering amid speculation that major agribusinesses will have to merge (given the imbalance between supply and demand for commodities). Indeed, duPont (DD) and Dow Chemical (DOW) have already agreed to do so. Archer Daniels Midland (ADM) and Deere (DE) are both in deepening bear markets due to a sharp fall in revenues. ADM coordinates agribusiness infrastructure worldwide but also gets ~10% of its revenues from ethanol production. That market is under pressure due to several factors, the most important being that a “blend wall” has been reached for blending gasoline that is 10% ethanol. No more ethanol is needed, and gasoline with 15% ethanol can’t be used in cars built before 2002. The blend wall became an issue because cars are increasingly fuel-efficient, and many car owners prefer not to use 10% ethanol. Deere (DE) manufactures heavy equipment for construction and mining in addition to the iconic green tractors and harvesters used in farming. All of those markets have collapsed now that China has largely completed its infrastructure buildout and is going through its own mini-recession. Another important market pressure is that consumers are getting fussier about how foodstuffs are produced and processed. These preferences are undermining the “factory farming” innovations that brought us cheap and abundant food, known as the “green revolution.” In summary, it looks like the AgriBusiness sector will remain under downward pressure for several more years.

Risk Rating: 8

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

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

Post questions and comments in the box below or send email to: