Sunday, February 28

Week 243 - S&P 500 HealthCare Companies

Situation: Obamacare has been a boost for the healthcare industry, bringing 10 million new health insurance clients into the system. And, the Federal Reserve’s main monetary policy since the Lehman Panic, called “quantitative easing,” invested $4.2T (that’s Trillion) in government bonds to bring interest rates down to historic lows. That got people to stop investing in bonds and instead expand their businesses, build manufacturing plants, buy cars, refinance homes, advertise their services, or simply buy stocks. It worked, and investment dollars favored the HealthCare industry. The only “fly in the ointment” is that stocks have become overpriced because bonds are no longer able to compete on a total-return basis. The Federal Reserve is now trying to reverse its “easy money policy” because the economy no longer needs life support. However, this will sink the stock market for a while, including healthcare stocks. But those of you who are building a retirement portfolio can hardly avoid the obvious benefits of owning healthcare stocks, which are a growing client base and an aging population. And that’s just in the United States. Looking internationally, there are almost 20 million people emerging from poverty each year and now able to invest in their health! 

Mission: You’ll need to know which stocks you might want to drop and which you might eventually profit from owning (and should probably continue to dollar-average into). So we need to come up with a list of the highest quality HealthCare stocks. We’ll use our standard spreadsheet to highlight both the past rewards of ownership and the likely risks of continued ownership. We’ll start with the list of healthcare stocks in the S&P 500 Index, deleting any with insufficient revenues to appear on the 2015 Barron’s 500 List. We’ll also delete any stocks that haven’t been trading long enough to appear on the 16-yr BMW Method list. Finally, we’ll delete any companies that don’t have S&P bond ratings of at least BBB+ and S&P stock ratings of at least B+/M. 

Execution: The above exercise leaves us with 20 companies to consider, only 5 of which are S&P Dividend Achievers (denoting 10+ years of annual dividend increases). Those 4 companies are: Johnson & Johnson (JNJ), Abbott Laboratories (ABT), Becton Dickinson (BDX), Medtronic (MDT) and Stryker (SYK). The other 15 are speculative investments to varying degrees (see Columns D, I, J, K, and O in the Table). The benchmark mutual fund, Vanguard HealthCare Fund (VGHCX), shows stronger risk-adjusted performance than the aggregate of 20 stocks (compare Line 22 to Line 25 in the Table). Its outperformance has been remarkable for decades.

Bottom Line: HealthCare stocks have become a “crowded trade.” If you’ve held several of the 20 stocks on our list over the past decade, you’re likely happy with your choices. The HealthCare industry will likely continue to do well given the demographic trends in the US and internationally with bigger percentages of people becoming insured, entering their sunset years and emerging from poverty. Just keep in mind that the value of these stocks is technology-driven, and a price-appreciation graph for technology-driven stocks will continue to look like a roller-coaster (see Column O in the Table). Only 3 of these stocks have a steady and strong trend of price-appreciation: Johnson & Johnson (JNJ), Abbott Laboratories (ABT), and Becton Dickinson (BDX). If you want to venture beyond these safe havens, the safest and most rewarding move looks to be the mutual fund that represents this industry so well: Vanguard HealthCare Fund (VGHCX) at Line 24 in the Table.

Risk Rating: 6

Full Disclosure: I dollar-average into ABT and also own stock in JNJ, BDX, and MCK.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark at Line 27 in the Table. Total Returns in Column C of the Table date to 9/1/2000 because that marks the peak of the S&P 500 Index before the “” recession. There have been two peaks since, in 2007 and 2015, so we’re entering the third market cycle since 2000.

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Sunday, February 21

Week 242 - Dairy Products

Situation: Now that almost 20 million people a year move out of poverty worldwide, the demand for protein is much greater than it was 10 yrs ago when that trend got rolling. Why? Because it is expensive to have 60 grams of protein in the daily adult male diet, as recommended by nutritionists. For example, a standard source for meeting daily protein needs is an 8 oz cup of whole milk. It contains 8 grams of protein. You’d have to drink 1.875 quarts a day if that were your only source, which would cost you $2.10/day if you lived in Mumbai, India. (The standard definition of “extreme poverty” is to be living on an income of less than $1.25/day.) Even in the affluent United States, people are demanding more protein in their diets because of new attention being given to the quality of foodstuffs. (It turns out that most of us haven’t been consuming our 60 grams of protein a day.) The most convenient source of protein is milk but demand for milk has been falling for decades. For example, here in the US we drank 19.9 million pounds of conventional whole milk in 2000 but only 11.4 million pounds in 2015. This falloff in demand has led to more creative ways of processing milk (to interest consumers in buying it), Greek yogurt being the most recent “crowd pleaser.” But there is still more milk being produced from our dairy herds than is being processed, which results in a trend toward smaller herds and lower prices. Since 1995, the price of conventional whole milk has risen 1.4% (vs. 2.1%/yr for the Consumer Price Index), but in recent years has tracked inflation.

Mission: Find out how publicly-traded companies and farmers cooperatives make money by processing less milk each year and selling it at prices that barely keep up with inflation.

Execution: The short answer is that they don’t. Less processing = less income. Dean Foods (DF) is the only nationwide company that relies on revenue from selling conventional milk, having recently spun off its division for producing organic milk and soy milk (to Whitewave Foods Company) and its division for producing yogurt (to Schreiber Foods). Line 11 in the Table makes clear that Dean Foods has been struggling, even though its stock price has managed to ride along with the stock market bubble. The other 7 companies in the Table also process milk but their milk-related sales generally represent less than 10% of their income.

Administration: Let’s look at how these 8 companies make money from milk.

   General Mills (GIS) sells Yoplait yogurt.
   Unilever plc (UL) sells Ben and Jerry’s ice cream and frozen yogurt.
   Nestle S.A. (NSRGY) sells Carnation milk, Nestle chocolate milk, Nesquik chocolate milk, Coffee-Mate, Dreyers ice cream, Haagen-Dazs ice cream, and a variety of yogurt brands.
    Coca-Cola (KO) has partnered since 2012 with Select Milk Producers (a nationwide farmers cooperative) to create a company called Fairlife LLC that filters milk into its separate components (water, butterfat, protein, vitamins & minerals, lactose). Those are recombined into a product (Fairlife) that has less than half the sugar (zero lactose) and twice the protein of conventional milk.
    Kroger (KR) has opened a new plant in Denver (Mountain View Foods) to process conventional and organic fresh milk for its King Soopers label, giving it a total of 17 plants in the US for processing “non-GMO milk.”
   Danone (DANOY) sells Dannon yogurt and Dannon Oikos Greek-style yogurt.
   Hain Celestial (HAIN) sells Greek Gods yogurt (my favorite).
   Dean Foods (DF) has co-marketing arrangements with 30 dairy cooperatives, including the largest (Land O’Lakes Dairy), for distributing milk products nationwide including butter and cheese. 
Bottom Line: Milk is a commodity, meaning there are high fixed costs for ramping up production in response to a shortage--to have an efficient and robust supply chain. Then a global recession occurs and people rethink their need for that now-expensive commodity; substitution occurs and the supply chain has to be truncated. “Rinse and repeat.” The 4 companies at the top of our Table take the smart route, depending little on milk products to support a sustainable earnings trend. The 4 companies at the bottom have made a greater commitment (total in the case of Dean Foods), so their earnings are at the mercy of the milk production cycle.

Risk Rating: 7

Full Disclosure: I own shares of KO and GIS.

Note: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark at Line 14 in the Table. Total Returns in Column C of the Table date to 9/1/2000 because that turning point marks the peak of the S&P 500 Index before the “” recession. There have been two peaks since then, in 2007 and 2015, so we are now entering the third market cycle since 2000.

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Sunday, February 14

Week 241 - S&P 100 Companies With a Durable Competitive Advantage

Situation: The Federal Reserve has committed to gradually raising interest rates, which will depress the prices of bond-like stocks as well as legacy bonds. There is a 50:50 chance that the Federal Reserve will have to backtrack at some point, given that the global financial system remains in recovery mode following the Lehman Panic of 2008. The European Central Bank, for example, continues to gradually lower interest rates below zero at its Deposit Facility. This leaves us investors to focus on owning stocks issued by the largest and most credit-worthy companies. Why? Because we’ll want to minimize the risk of owning stocks (bankruptcy) until interest rate fluctuations stabilize at a plateau where bond ownership has approximately the same risk-adjusted returns as stock ownership.

Mission: Develop a spreadsheet of “mega-cap” companies (i.e., those in the S&P 100 Index) whose stock appreciation is anchored by steady appreciation in Tangible Book Value (TBV). That means meeting Warren Buffett’s criteria for having a Durable Competitive Advantage (see Week 238). Eliminate any company that does not pay a dividend or have high S&P quality ratings, i.e., an A- or better rating for its bonds and B+/M or better rating for its common stock.

Execution: We have come up with 11 stocks that meet those criteria (see Table). Returns for the aggregate have been more than twice the returns for the lowest-cost S&P 500 Index Fund (VFINX) over the past two market cycles (see Columns C and L in the Table), but that result has come with a materially greater risk of loss in a future bear market (see Column N in the Table).

Bottom Line: Over the foreseeable future, you should think about owning stocks in mega-cap companies with strong credit, especially those that steadily grow their Tangible Book Value by 7%/yr or more (and have had no more than down 3 yrs in the past decade). In other words, look for companies that have what Warren Buffett calls a Durable Competitive Advantage. However, by using this strategy long-term you probably won’t beat a low-cost S&P 500 Index fund like VFINX (on either a risk- or cost-adjusted basis) unless you’re very good at picking from among the 11 stocks in the Table and keep studying those companies closely.

Risk Rating: 5

Full Disclosure: I dollar-average into 6 of these stocks online (NKE, MSFT, WMT, XOM and JPM).

Note: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX). Total returns in Column C of the Table date to 9/1/2000, because that was the last S&P 500 Index peak before the peak on 10/9/2007. The past 15+ year time span provides returns over more than two market cycles (given that a even more recent peak occurred on 7/20/2015).

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Sunday, February 7

Week 240 - Does Your Retirement Fund Need to Look Like a Rainy Day Fund?

Situation: Warren Buffett suggests that investors follow certain guidelines, such as “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” If you read this blog regularly, I’m guessing you’re partly a gambler like the rest of us. Warren is just asking us to engage that superego (which we all possess) and be prudent while building a nest egg. Some money is for gambling, the rest has to look a lot like a Rainy Day Fund (see Week 203) and be suitable for weathering an unforeseen financial calamity. Retirement or unanticipated medical expenses could prove to be such a calamity. To prevent that, you’ll need to construct a retirement portfolio that is weighted with stocks that behave in a bond-like manner, and Treasury Notes. (Growth stocks, with their greater risk of loss, could do long-term damage to your retirement portfolio if the market were to crash soon after you retire.) Think about it. When we were young, financial advisors stressed the importance of owning growth stocks because we’d have time to recover from a crash and still come out ahead compared to owning Treasury Notes and bond-like stocks. But retirement planning uses the opposite logic. You don’t have time on your side, particularly if you’ve reached age 55 and your retirement savings amount to less than 4 times your income. 

The problem: Almost half of the US’s soon-to-be-retired population has no access to a workplace retirement plan, and retirement savings for that age group only average $1000. If you, or someone you know, is in that cohort, then the least risky and lowest cost way to start digging out of that hole is to set up a “MyRA” online. That will help you save up to $15,000 in US Treasury issues by investing as little as $2.00 a time. “Interest earned is at the same rate as investments in the Government Securities Fund, which earned 2.31% in 2014 and an average annual return of 3.19% over the ten-year period ending December 2014.” During that 10-yr period, inflation averaged 2.04% you would have cleared a 1.15%/yr profit if MyRA accounts had been available then. Before MyRA accounts became available, only Federal employees had access to the Government Securities Fund. It pays the aggregate interest rate for all outstanding government securities that have more than 4 yrs remaining to maturity. There is no better way to reliably clear a profit net of inflation, net of transaction costs (zero in this case), and net of taxes (zero if you convert to a Roth IRA after investing the initial $15,000). Free money no strings attached.

Mission: Come up with a safe mix of assets for a Rainy Day Fund, i.e., a mix that has little chance of losing money in a financial crisis yet has a high chance of making a profit in each market cycle after allowing for expenses (inflation, taxes, and transaction costs). This is difficult to accomplish, as you might have noticed from reading our previous blogs on the subject (see Week 28, Week 33, Week 44, Week 112, Week 119, Week 151, Week 162, Week 188, Week 203). Our benchmark for Rainy Day Funds is the Vanguard Wellesley Income Fund (VWINX) at Line 15 in the Table, which is 60% bonds and 40% stocks. Its annual return has exceeded expenses (inflation, taxes and transaction costs) in 21 of the past 25 yrs while averaging 8.8%/yr, which beats inflation by 6.5%/yr.

Execution: No single investment (other than a MyRA) will protect you from losing money after inflation, taxes and transaction costs, but US Treasury Notes come close. Over the past 5 yrs, 10-yr Treasury Notes have paid 4.0%/yr if interest payments are reinvested in new 10-yr Notes (you can buy those cost-free in amounts of as little as $100 at Inflation took 1.2% and taxes took another 1.4%, leaving you with a 1.4%/yr profit. Why invest for the sake of a 1.4% return? Well, you need a safe place for some of your money. You don’t know when you’ll need it but you know that day will come. Wouldn’t a bond mutual fund be better? Those fluctuate a lot in value when interest rates change, going down when rates go up (and going up when rates go down), whereas, all of your principal investment is certain to be returned when a Treasury Note matures. Why not buy corporate bonds? Those carry high transaction costs and can’t beat comparably dated Treasury issues on a risk-adjusted basis. Why is that? Because all fixed-income investments are priced off Treasuries. A corporate bond is marketed to pay the investor a high enough interest rate to compensate for its risk of default. The risk-adjusted return of a 10-yr corporate bond is the same as the risk-adjusted return of a 10-yr Treasury Note issued the same month of the same year. You might as well point-and-click at to get all your bonds, since transaction costs are zero, taxes are less, and inflation-protected options are available. The simplest way to invest in 10-yr Treasury Notes is to schedule monthly purchases of Inflation-Protected Savings Bonds (ISBs) online. You can point-and-click to sell those anytime. Proceeds go into your checking account the following business day, at which point you become liable for Federal Income Tax on the accrued interest. (You have no liability for state or local taxes.) If you cash an ISB before holding it for 5 yrs, you’ll miss out on one interest payment.

What about owning “safe” stocks? There isn’t such a thing but you can justify owning stock in selected “utilities” and “communication services” companies for even a minimal-risk Rainy Day Fund. The utilities industry has 3 different types of companies: fossil-fuel based providers of electricity, natural-gas based providers of space heating, and renewable energy based electricity providers that use nuclear, solar, or wind energy. I invest in NextEra Energy (NEE) as the renewable-energy electricity provider because it is the leader in using renewable and non-polluting sources of intermittent and unreliable power (wind and solar). But to continuously and reliably provide power from a renewable and non-polluting source, there is only one option: nuclear power. The severity and momentum of global warming is such that nuclear will have to become a much bigger power source than it is at present. There is only one electric utility in the US that both specializes in delivering nuclear power and has a large fleet of such units: Exelon (EXC). Picking a natural gas utility is tricky though. There are no large utilities dedicated to providing natural gas for space heating, partly because the price of natural gas varies so much. Second best is to choose a company that diversifies equally into natural gas and electricity markets. I like Dominion Resources (D), which has an extensive pipeline network for natural gas and “operates the largest North American interstate gas storage system.” Finally, you need to choose a “communications services” company. I like AT&T (T).

Bottom Line: If you’re “late to the game,” your Retirement Fund needs to look like a minimal-risk Rainy Day Fund. The emphasis here is to avoid loss, not to get rich. We’re really looking at a version of “The Tortoise and Hare” story whenever we design a Rainy Day Fund. Given enough time (2-3 market cycles), the slow and steady growth of a Rainy Day Fund composed 40% of low-risk stocks and 60% of 10-yr Treasuries will benefit from the near-absence of losses during stock market crashes. Eventually, its “price return” will eclipse the S&P 500 Index (compare Lines 12 and 20 at Column K in the Table), and do so at less risk (compare Lines 12 and 20 at Column M in the Table). But take good care of your health during those sunset years because 2-3 market cycles is a long time.

Risk Rating: 3

Full Disclosure: I dollar-average into 10-yr T-Notes, NEE, D, T, and EXC at the ratios indicated in the Table.

Note: Metrics in the Table are current as of the Sunday of publication; metrics highlighted in red denote underperformance relative to the Vanguard Balanced Index Fund (VBINX), our key benchmark. Returns in Column C of the Table date to September 28, 1992, because that is when VBINX was first traded.

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