Sunday, March 27

Week 247 - S&P 500 Dividend Achievers That Have Tangible Book Value And Are In Defensive Industries

Situation: When the stock market is shaky, an investor’s thoughts turn to safety. You need an algorithm. Which stocks do you want to stick with, and maybe buy more of, while they’re on sale? More importantly, how did you get in this jam in the first place? 

Mission: Come up with stocks likely to weather down markets without falling behind in up markets. Using a baseball term, we’re looking for a way to hit singles regularly.

Execution: Step #1 is to list all the Dividend Achievers (companies that have increased their dividend annually for at least the past 10 yrs) in “Defensive” S&P industries of the S&P 500 Index (Consumer Staples, HealthCare, Utilities, Communication Services). Step #2 is to eliminate companies that have no Tangible Book Value (TBV), meaning companies whose Liabilities have a higher dollar value than their Tangible Assets. Step #3 is to eliminate any that have an S&P Bond Rating lower than A- or an S&P Stock Rating lower than A-/M. Step #4 is to eliminate any that don’t have enough revenue to appear on the 2015 Barron’s 500 List. Step #5 is to eliminate any whose stocks haven’t been traded on a public exchange for more than 16 yrs.

Administration: There are 11 stocks that meet our requirements for reasonable and prudent investing (see Table), an algorithm for all seasons. But that begs the question: Why do so many of us avoid reasonable and prudent investing and instead “play” the market? After all, 95% of stock-pickers would do better (in the long run) simply by dollar-averaging into the bond-heavy Vanguard Wellesley Income Fund (compare VWINX at Line 16 in the Table to VFINX at Line 19). So, we’re not really picking stocks just to make money. We also need the outlet, a way to bring our “animal spirits” safely to life and hope to make our lives a little grander. The trick then is to analyze why we invest the way we do, and decide who we hope to impress. 

Bottom Line: “It will fluctuate.” That’s how JP Morgan answered a young man’s question about the stock market. But stocks of some companies fluctuate less. Those companies are in “defensive” industries: Consumer Staples, HealthCare, Utilities, and Communication Services. To avoid that sinking feeling in the pit of your stomach whenever the market swoons, pick A-rated stocks from among Dividend Achievers in those industries. Focus on companies that are valued as much for their real assets as their brand. 

Risk Rating: 4

Full Disclosure: I own shares of ABT, JNJ, NEE, HRL, KO, and WMT.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. Total Returns in Column C of the Table date to 9/1/2000, a peak of the S&P 500 Index.

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Sunday, March 20

Week 246 - Corn Belt Prosperity: Is It Gone?

Situation: The farming counties of the Corn Belt are in a recession due to the collapse in corn price per bushel, but the US economy is still growing. “In the past 50 years, every recession has seen the number of jobs in the economy decline by at least 1%. And jobs have never declined by that much outside of a recession. Today, the number of jobs in the U.S. has been growing briskly—up 292,000 in December and up 2.7 million over the past year. This is why many economists remain confident the U.S. can avoid recession.” That quotation from the Wall Street Journal summarizes the way we measure growth vs. contraction in the economy but jobs are a “lagging” indicator. The country is already on the brink of recession because of the “knock-on” effects of slow growth and high indebtedness in emerging market countries, mainly China. Their plight is made worse by our Federal Reserve’s policy of raising interest rates. The “capital flight” that has been happening in emerging market countries simply gets accelerated as the dollar gets stronger and as interest rates move higher. In other words, investors are pulling money out of emerging markets but those are the very markets where real growth is happening. A third of the revenue for S&P 500 Index companies comes from those countries. Earnings for the S&P 500 Index will fall as those countries head into recessions, triggered in part by our strong dollar. News Flash: almost all of the 45 major stock markets around the world are currently in a Bear Market.

Mission: Drill down on the Corn Belt centered in Illinois, Iowa, southern Minnesota and the eastern half of Nebraska, where 57% of US production occurs. That’s also where almost half of US ethanol plants are located. Cropland in those states has been falling steadily in price/acre for 3 years, and 2015 showed no hint of relief. The average price per acre in those 4 states in 2015 was $6418, which is 2.9% lower than in 2014. For Iowa, where 2015 values were $8200 per acre, prices were down 6.3%. But farm incomes have fallen 55% in the past two years, so it is only a matter of time before cropland values start to reflect that loss in productivity. 

Execution: Let’s see how large AgriBusiness companies based in North America are doing, specifically those that meet our quality standards: Monsanto (MON), Potash (POT), DuPont (DD), Dow Chemical (DOW) and Deere (DE). Looking at this week’s Table, we see that they mirror what’s happening to commodity producers everywhere, namely, too much supply is being generated just when demand is collapsing for a variety of reasons. 

Administration: What you can do, as an investor, is to remember that this is a very rewarding group of 5 stocks to own over 2-3 market cycles (see Column C in the Table). Mostly, you need to avoid taking action. Don’t go out and buy cropland, don’t sell any of these stocks that you already hold, and keep dollar-averaging into those that you do own long-term. The thing about commodity markets is that during bear markets producers either fail or barely survive. Production eventually falls enough that remaining companies have to struggle to catch up with demand (demand that is no longer being satisfied). It will not be difficult to ramp up operations at that point because stocks (and bonds) issued by commodity producers will be snapped up by investors. However, these capital expenditures won’t take effect for a while because so much investment has to be directed at replacing fixed assets and skilled labor lost during the downturn. But production eventually catches up to (and then exceeds) demand. That is why these are called long-cycle investments. Boom-bust-boom turnarounds typically span two or three stock market cycles.

Bottom Line: This commodity supercycle is finished. Most estimates show that global commodity-related production is approximately 150% of demand. Farm commodities are no different. Those produced in the US have to be marketed at too high a price in foreign countries, because of the “strong” dollar. That means farmers in Brazil, Argentina, the Ukraine, Australia and Canada have a competitive advantage over US farmers. The US-based AgriBusiness companies that have worldwide operations will recover faster than US farmers but a difficult decade lies ahead. In rural counties of the Corn Belt, prosperity is unlikely to recover soon.

Risk Rating: 8 (on a scale where gold-related investments are 10 and inflation-protected US Savings Bonds are 1).

Full Disclosure: I dollar-average into MON, and own stock in DD, ADM, and DE.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. 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, March 13

Week 245 - S&P 500 Utilities

Situation: Utilities are still getting upbeat press notices for bond-like stability that comes with almost twice the yield, and steady dividend growth. Investors want to invest in these stocks for a variety of reasons but are told they’ll go down in value as the Federal Reserve raises interest rates. These are slow-growth stocks that have to compete with bonds. When new bonds start paying higher interest, legacy bonds (and utility stocks) fall in price so that their yields can rise. But there are other considerations that will help these stocks rebound quickly.
   1) Utilities pay the lowest interest on their bonds because those are backed by a state government. 
   2) The state regulating authority will make sure consumers are charged enough for the utility to realize a 9-11% ROE (Return On Equity), which is necessary to maintain cash flow for maintenance and expansion.
   3) A utility’s dividend payments are a relatively small expense, not as great as its capital expenditures, energy purchases, and labor costs.
   4) Energy is getting a lot cheaper, i.e., coal, natural gas, wind, and solar power are all falling in cost per kilowatt-hour generated. 
   5) Labor costs continue to fall because of automation (software upgrades), and the closure of coal-fired power plants.
   6) Because of “green technology” we are moving to an era of networked sensors (the internet of things), more efficient lighting and wiring, better insulation, and the automated regulation of lighting, heating, ventilation, and air conditioning. In other words, Return on Invested Capital (ROIC) will continue improving through technology, whether or not interest rates rise.

Mission: Let’s take a look at how utility stocks in the S&P 500 Index are doing, now that the Federal Reserve has started raising rates. We’ll set up a spreadsheet that focuses on our quality criteria.

Execution: Start with companies that have revenues large enough to appear on the 2015 Barron’s 500 List, and those that have at least 16 yrs of trading data which allow the company’s weekly stock prices to be analyzed by the BMW Method. We eliminate any company having a S&P Bond Rating lower than BBB+ or an S&P Stock Rating lower than B+/M. Finally, we’ll run Warren Buffett’s method for arriving at Durable Competitive Advantage or DCA (see The Warren Buffett Stock Portfolio by Mary Buffett and David Clark, Scribner, New York, 2011). First we calculate the ratio of stock price divided by Tangible Book Value (TBV). Then we note how many years in the past decade TBV has fallen and calculate DCA, which is the rate of TBV growth over the past decade. 

Administration: We’ve come up with 9 companies. Some generate electricity, others distribute natural gas. But now that natural gas is replacing coal as the main feedstock at power plants, electric utilities are going into the gas utility business. Why? Because they want a guaranteed source of natural gas at the lowest possible price, an in-house supply. The latest example is Southern Company’s acquisition of AGL Resources. Others are building large solar and wind farms. Several have nuclear power plants, and Southern Company is building more. You get the point. Energy is the main feedstock for an electric utility; the company is most efficient if it owns its source of energy.

Bottom Line: Utility stocks make great investments for retirees. You don’t need to back them up with bonds because they’re already bond-like. You can easily make the retiree’s 4% annual withdrawal rate because they have dividend payouts close to 4%; many of those in the 3% range have dividend growth rates of 3-5%/yr, i.e., your utility stocks are yielding more than 4% within a few years of purchase. Spend the dividends and never sell the shares. If you don’t want to go to the trouble of picking stocks, just invest in the benchmark: Utilities Select Sector SPDR exchange-traded fund (XLU) at Line 15 in the Table.

Risk Rating: 4

Full Disclosure: I dollar-average monthly into NEE.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. 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, March 6

Week 244 - Will You Profit From Owning Stocks?

Situation: People used to say “yes” whenever asked that question. Now, the answer is more problematic. Let’s assume that “the past is prologue” and calculate how much you’d profit from the “best-case scenario.” If on August 9, 1999, you purchased 25 shares of the lowest cost S&P 500 Index fund online, the Vanguard 500 Index Fund (VFINX), for $120.07/Sh ($3001.75), and spent dividends along the way, then sold your 25 shares 16 yrs later on 8/7/2015 for $192.03/Sh ($4800.75), you would have averaged a 3.0%/yr price return. According to the Buyupside website, your total return averaged 4.9%/yr, which included price appreciation of 3.0%/yr, plus an average dividend yield of 1.9%/yr. 

Your initial $3001.75 investment has grown to $6400.00. Of that growth, $1599.25 is due to dividends and $4800.75 is due to capital appreciation, as noted above. But the annual 15% tax on dividends has reduced the value of those payouts to $1359.36, and the 20% capital gains tax has reduced your gain from selling 25 shares to $4440.95. That leaves you with $5800.31, for an after-tax return of 4.2%/yr. Now let’s account for the 2.2%/yr average rate of inflation over those 16 years, which brings your gain down to 2.0%/yr. Transaction costs of 0.2%/yr are folded into the share price, so you’re left with an average profit from your initial investment of 2.0%/yr net of costs. So far, so good. But consider this: The average retail investor spends 2.2%/yr on transaction costs vs. the 0.2%/yr that you’ve spent. Your entire 2.0%/yr profit came from choosing an investment run by computers. 

There was no one at Vanguard Group to call on the phone when the S&P 500 Index crashed twice. You flew solo. That’s the best-case scenario, disintermediation. But no one you’ll ever meet invests that way. Why? Because the ups and downs of the S&P 500 Index cannot be looked upon with equanimity by anyone other than a professional trader. Another reason is human nature. People can’t seem to make a plain vanilla investment that all available evidence says is the best investment on the planet. Instead, they’ll entertain themselves by trying to beat the S&P 500 Index. 

Then there’s the 4% rule to consider. That’s the maximum amount you can sell each year from a balanced retirement portfolio (50% bond, 50% stock), after adding a percentage to account for recent inflation, without running the risk that you’ll out-live your money. VFINX is 100% large-capitalization stocks and pays only a 2% dividend. You’d have to sell some shares every year to collect the other 2%. The market might be down a lot when you sell those shares, so it might be preferable to find a way to live off dividends and preserve your principal. 

Our benchmarks for retirement savings are the Vanguard Balanced Index Fund and the Vanguard Wellesley Income Fund at Lines 27 & 28 in this week’s Table. Both have payouts less than 3%/yr, and payouts over the past 16 yrs have fallen because interest rates have fallen and those funds are hedged with bonds. The only way to reach 4%/yr in dividend payouts is to own stock in companies that grow dividends faster than inflation. 

Mission: Find a source of retirement income that reliably grows at least twice as fast as inflation and gives you a chance to live off dividends without eroding principal. That means you’re looking to own stock in companies that S&P calls Dividend Aristocrats (because they’ve increased their dividend annually for at least the past 25 yrs). 

Execution: Which of the 51 Dividend Aristocrats meet our quality criteria for inclusion in a retirement portfolio, and have grown their dividend more than three times as fast as inflation over the past 16 yrs, i.e., at least 6.0%/yr? And which of those have revenues high enough to be in the 2015 Barron’s 500 List, and S&P ratings of BBB+ or better for bonds and B+/M or better for stocks. Of the 30 stocks that emerge from that screen, which fluctuate in price more than the S&P 500 Index? During the most recent market correction (4/1/11 through 9/30/11), 8 were more volatile so we’ve excluded those. Four others have a dividend yield that is lower than VFINX, so we’ve excluded those. That leaves 18 companies that meet all criteria; those grew their dividends more than 11%/yr over the past 16 yrs (see Column H in the Table).

Bottom Line: Yes, you can profit from owning shares in the lowest-cost S&P 500 Index fund (VFINX) over two market cycles. But you can do better by owning a basket of stocks issued by companies that have increased their dividend annually for at least the past 25 yrs. These are companies that S&P calls Dividend Aristocrats. We’ve found 18 such companies that meet our quality criteria, and all but 2 (Coca-Cola and Wal-Mart Stores) have outperformed the lowest-cost S&P 500 Index fund (VFINX) over the past 23 yrs. As a group, they have a dividend yield of ~3.0% and grew their dividends 5 times faster than inflation. They all meet the 4% rule for annual withdrawals from a retirement fund. In other words, dividend growth is so rapid that you’re getting at least a 4% dividend yield on your original investment within a few years, and dividend yield is likely to grow more than twice as fast as inflation. 

Risk Rating: 4

Full Disclosure: I dollar-average monthly into ABT and XOM (neither have transaction costs at, and also own shares of MCD, JNJ, KO, PEP, and WMT.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. VBINX, our key benchmark. Total Returns in Column C of the Table date to 9/28/1992 because that marks the onset of trading in VBINX.

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