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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