Sunday, April 24

Week 251 - A-rated S&P 500 Dividend Achievers with a Durable Competitive Advantage

Situation: Stock markets are more fragile than most people realize. For example, the S&P 500 Index has a Return on Assets or ROA of ~3% while its Weighted Average Cost of Capital or WACC is ~8%. Although the deficiency in ROA vs. WACC is unsustainable, that’s thought to be OK because the economy is still recovering from the Great Recession, i.e., the return on assets will reach parity with the cost of assets. As long as that doesn’t happen, company managers will hesitate before investing yet more capital in property, plant, equipment, and labor. Instead, they’ll be more likely to return money to investors via a buy back of stock or by raising the dividend. That has been common practice since the Great Recession, and is one reason why the stock market has a P/E ratio that is higher than its historical average.

Stock markets have only one fuel, and that is peoples’ savings, including the savings of corporations now that the US Supreme Court has decided that a corporation is essentially “a person” with the same First Amendment rights. Savings are more constrained than ever because the level of indebtedness of countries, corporations, states, cities, and small businesses has not decreased since the Great Recession. Only household debt has managed to recover somewhat. The “great unwind” has yet to occur. Deleveraging is not a priority for governments or corporations because interest rates are so low that it seems foolish not to borrow money. Until deleveraging happens, the ROA for the most important asset (educated citizens) will not be much greater than the cost of creating that asset. Why? Because the cost of servicing debt eats into savings needed for investment.

Given the above warning, you need to look for stock in companies that are responsibly managed and clearly profitable. These would be firms that have high operating margins most of the time (e.g. Nike), or moderate but stable operating margins all of the time (e.g. Wal-Mart Stores). What is an “operating margin” (see Column M in the Table)? It is an unambiguous measure of profitability, expressed as a ratio: EBIT/Total Revenue, where EBIT = Earnings Before Interest and Taxes. “Total Revenue” is the first line of an Income Statement and “Earnings Before Interest And Taxes” is usually at line 13. See this Income Statement of 3M Corporation as an example.  

Mission: Screen the S&P 500 Index for companies that have the following quality markers: 1) high S&P bond ratings (A- or higher) and stock ratings (A-/M or higher); 2) are designated as a Dividend Achiever by S&P, indicating annual dividend increases for at least the past 10 yrs; 3) have a Durable Competitive Advantage or DCA (see Columns P through T in the Table), as defined by Warren Buffett (see Week 241).

Execution: Given the turbulent nature of the stock market over the past decade, there are only 9 companies that meet our requirements (see Table). All of those companies have an Operating Margin greater than the WACC (see Column N of the Table). But some of the companies have a current problem selling their goods and services that pushes their ROA lower than their WACC (compare Column O to Column N in the Table). Exxon Mobil (XOM) at Line 10 in the Table is a prime example.

Bottom Line: It is particularly difficult to save for retirement when Central Banks are busy lowering the interest rate on bonds, a move that is meant to entice people to invest in stocks, start a new business, build a factory, create an app, buy a home or get a better education. For retirement planning, you need to put ~50% of your savings into dividend-paying stocks and the remainder into US Treasuries. To get adequate diversification, your stocks need to represent all 10 S&P industries. To get adequate quality, you need to have stringent criteria like those above. Only 6 S&P industries have contributed the 9 stocks that meet our stringent criteria: Consumer Staples (WMT), HealthCare (JNJ and ABT), Utilities (NEE), Consumer Discretionary (TJX, ROST, NKE), Information Technology (MSFT) and Energy (XOM). You can check out our recent blogs on defensive industries (Week 247) and growth industries (Week 248) for help picking stocks to cover the other 4 S&P industries (Basic Materials, Communication Services, Industrials, and Financials).

Risk Rating: 5

Full Disclosure: I dollar-average into WMT, JNJ, NEE, NKE, MSFT and XOM, and also own shares of ABT, TJX and ROST.

NOTE: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, VBINX at Line 16 in the Table. Total returns/Yr in Column C, and the CAGR for stock prices in Column U, are for performance over the past 20 years. That period is chosen because it covers approximately 3 market cycles, i.e., there have been 15 recessions in the past 90 years for an average of 6 years between each.

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Sunday, April 17

Week 250 - A Monthly Retirement Savings Plan With Automatic Online Additions

Situation: If you’re self-employed or work at a company that doesn’t sponsor a 401(k) or 403(b) retirement plan, you need to create your own. The “secret sauce” is payday deductions. Economists often say that the parts of your income you never see are the parts you stop thinking about. Pay stubs list those automatic withdrawals for taxes, social security, health insurance, and a tax-deferred retirement plan but you no longer care: You’re receiving “full benefits” which is why you took the job in the first place.

If you’re one of the 50% of US workers who doesn’t have a workplace retirement plan, you need to go to start an IRA funded with payday deductions. This can be done by visiting a bank, brokerage, credit union or by going online to a low-cost mutual fund site like Vanguard Group. You can also set up monthly automatic withdrawals from your checking account to invest in Dividend Re-Investment Plans (DRIPs). Your accountant will report to the IRS that those constitute your IRA. That works best if you backup those stock investments with bonds by using one of the US Treasury’s zero-cost IRA-like plans (Savings Bonds and MyRA), which have no transaction costs. At their website, you’ll see an option for automatic monthly withdrawals from your checking account.

Mission: Set up a spreadsheet that illustrates an automatic online retirement savings plan with monthly additions for each item.

Execution: If your net worth (excluding home & mortgage) is less than $1 Million, you needn’t bother with picking stocks and bonds. Just go to the Vanguard Group website and pick the Vanguard Wellesley Income Fund (VWINX at Line 25 in the Table), which is 45% stocks and 55% bonds. Make that your IRA and set up monthly withdrawals from your checking account. If you’re self-employed as an “S Corporation”, the IRS provides special tax-deferred retirement options geared to your situation. 

If you choose to pick your own dividend-paying stocks and back those with Treasuries, read on: 
I. Bonds
You’ll need to start by assigning 25% to 75% of your savings to US Treasury issues, with the percentage depending on your view of the economic climate. The only automatic monthly withdrawal plan offered by the US Treasury are for Savings Bonds and MyRA. Inflation-adjusted Savings Bonds (“I Bonds”) are your best choice if you might want to cash in some for emergencies. The total return on Savings Bonds is approximately the same as for 10-yr Treasury Notes that have been renewed every 10 yrs, once you consider the tax benefit from owning Savings Bonds. The biannual interest paid on Savings Bonds is accrued and cannot be taxed until after you cash the bonds, whereas, tax is due every year on the the biannual interest you receive from Treasury Notes.
II. Stocks
The remaining 25% to 75% of your retirement savings plan needs to reflect growth in the economy. There are 10 S&P industries in the economy and you’ll probably gain the most benefit if you pick a stock for each. No one can predict which industry will take the lead in a future growth spurt, and each of the 10 has taken the lead at some point in the past. To set up automatic online investments each month, you’ll need to pick stocks that pay a dividend. The two largest online DRIP vendors are Computershare and Shareowneronline.

Administration: This week’s Table is a spreadsheet for stocks I have picked (one for each S&P industry), combined with a 50% commitment to 10-yr Treasury Notes that serve as proxies for Savings Bonds. In the Table, we assume that $100/mo is invested in each stock online and $1000/mo is invested in Savings Bonds online. The total investment is $24,000/yr and the transaction costs come to $164/yr (see Column Z in the Table). The Expense Ratio (164/24000) is 0.68% for the first year. If the economy keeps growing, that $164/yr will become an increasingly smaller fraction of the asset value.

Bottom Line: Polls have shown that “planning for retirement” is the biggest financial worry Americans have after “out of control spending.” Partly this is because 50% of Americans work where there is no retirement plan. The secret to success from stashing away ~15% of your gross income in a 401(k) or 403(b) plan is that you never see the money unless you look at the paystub. If you want success from setting up a retirement plan without those 401(k) or 403(b) tools, you need to mimic them. Have the money disappear automatically from your paycheck or checking account. Sending that money to a “conservative allotment, low-cost balanced mutual fund” like The Vanguard Balanced Index Fund (VBINX in the Table) is a good way to begin solving the problem with an IRA. If you are self-employed as an S Corporation, you can set aside the entire 15% or more of your income in a tax-advantaged retirement plan. You can also pick dividend-paying stocks for your IRA, plus Inflation-protected Savings Bonds and MyRAs that are tax-advantaged like an IRA.

Risk Rating: 4

Full Disclosure: I use the plan summarized in the Table.

NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. The Vanguard Wellesley Income Fund or VWINX. Total Returns in Column C date to 9/1/2000, a peak in the S&P 500 Index.

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Sunday, April 10

Week 249 - Warren Buffett’s Interest In The Food And Agriculture Sector

NOTE: There is one fact and one assumption that contribute to our blog’s philosophy and approach to financial security. Market volatility is increasing (look at any chart of the S&P 500 Index over the past 90 yrs), which we assume is related to the fact that personal financial security is decreasing. The increase in market volatility is related to the upward drift in P/E, which is secondary to improvements in “information and communications technology.” The task of our blog is to help you choose and create your own “market” which will be less volatile than the S&P 500 Index. We also have the goal of helping you understand that your “personal financial security” has to mesh with your concept of “personal safety.” Accordingly, we recommend that your retirement savings be in a non-speculative category. That means over half is invested in 10-yr US Treasury Note equivalents and the rest in stocks of large US corporations. Here at ITR, we’ll consider the Vanguard Wellesley Income Fund (VWINX) to be our key benchmark going forward, replacing the Vanguard Balanced Index Fund (VBINX).  

Situation: Most investors now understand that the commodity “supercycle” is ending. China has largely finished building out its economy, which is close to 21st century standards along its Eastern seaboard. The country also has abundant stores of grain, iron ore, copper, bauxite, and petroleum. The world has had to expand commodity production to make this possible. Now that China has cooled off, the world has almost twice the ability to supply commodities than is needed to continue developing emerging markets. 

Food is the exception. While food storage facilities have been replenished, almost 20 million people a year continue to emerge from poverty. They can finally afford a protein intake of 60 grams a day for an adult male, as recommended by nutritionists. This will require agricultural logistics to continue expanding, albeit more slowly. 

As investors, we can’t help wondering how Warren Buffett views the ups and downs of commodity production, namely the implosion that began in the spring of 2011 and has now become a Bear Market for the Basic Materials and Energy industries. You can be certain Mr. Buffett figures to make money from buying stock in some of those bargain-priced companies: “Be fearful when others are greedy, and be greedy when others are fearful” is his motto

Mission: Track positions that Berkshire Hathaway has established in commodity production and processing since 2011, particularly in the Food and Agriculture sector.

Berkshire Hathaway purchased control of these Food & Agriculture companies prior to 2011:

  • See’s Candies, purchased for $25 Million in 1972;
  • Dairy Queen, purchased for $585 Million in 1997;
  • CTB (an agricultural equipment manufacturer, purchased for $180 Million in 2002;
  • The Pampered Chef (a kitchenware manufacturer), purchased for ~$900 Million in 2002.
Berkshire Hathaway began accumulating these Food & Agriculture stocks prior to 2011:

  • Coca-Cola (KO), 400,000,000 shares worth $17.4 Billion, purchases since 1988;
  • Wal-Mart Stores (WMT), 56,185,293 shares worth $3.7 Billion, purchases since 2005;
  • Dow Chemical (DOW), preferred shares worth $3 Billion, purchased in 2009.

Berkshire Hathaway has purchased these commodity-related companies since 2011:

  • Iscar (Israel toolmaker), purchased for $10 Billion in 2013;
  • HJ Heinz, purchased jointly with 3G Capital for $23 Billion in 2013;
  • NV Energy, purchased for $5.6 Billion in 2013;
  • Phillips Specialty Products, purchased for $1.4 Billion in 2013;
  • Kraft Foods Group, purchased jointly with 3G Capital for $50 Billion in 2015;
  • Precision Castparts, purchased for $32 Billion in 2015.
Berkshire Hathaway has been accumulating these commodity-related stocks since 2011: 

  • Phillips 66 (PSX), 75,550,000 shares (14% of business) worth ~$6.1B;
  • NOW (NOW), 1,825,569 shares (1.7% of business) worth ~$25M;
  • Suncor Energy (SU), 300,000,000 shares (21% of business) worth ~$7.2B;
  • Kinder Morgan (KMI), 26,533,525 shares (13% of business) worth ~$460M;
  • Kraft Heinz (KHC), 325,634,818 shares (27% of business) worth ~$24B; 
  • Deere (DE), 22,884,190 shares (7.2% of business) worth ~$1.8B;
  • Costco Wholesale (COST), 4,333,363 shares (1% of business) worth ~$650M;
  • Restaurant Brands Int’l (QSR), 8,438,225 shares (3.7% of business) worth ~$280M;
  • Mondelez International (MDLZ), 578,000 shares (0.4% of business) worth ~$23M.
Administration: Looking at Berkshire Hathaway’s commitment to commodity-related companies since 2011, most of the outright purchases and share holdings have been in Food and Agriculture sector. HJ Heinz and the Kraft Foods Group were taken private to form Kraft Heinz (KHC) with an Enterprise Value of $110B, which started trading on 7/6/2015. LG Capital and Berkshire Hathaway each own a little over 25% of KHC shares, the remaining 48% being owned by outside shareholders. LG Capital will operate the new company. Berkshire Hathaway now owns shares in 8 publicly-traded Food and Agriculture companies (see Table). Those shares are worth ~$51B, representing almost 39% of Berkshire Hathaway’s stock portfolio.

Bottom Line: Over the past 4 yrs, Warren Buffett has almost doubled Berkshire Hathaway’s commitment to the Food and Agriculture sector. Kraft Heinz (KHC) is second only to Wells Fargo (WFC) in the Berkshire Hathaway stock portfolio, and he has built a large position in Deere (DE) shares. Prior to 2012, Warren Buffett’s interest in this sector was confined to purchasing 4 small companies for $1.7B, maintaining a large position in Coca-Cola (KO), and building a position in WalMart (WMT). The combined value of KO and WMT shares is ~$21B, whereas, the combined value of KHC and DE shares is ~31B. 

Risk Rating: 7

Full Disclosure: I dollar-average into Wal-Mart Stores, and also own shares of Berkshire Hathaway, Deere, Coca-Cola, and duPont (which is merging with Dow Chemical).   
NOTE: Metrics in the Table are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. the Vanguard Wellesley Income Fund (VWINX). Total Returns in Column C date to 9/1/2000, a peak in the S&P 500 Index.

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Sunday, April 3

Week 248 - A-rated S&P 500 Growth Companies That Are Dividend Achievers And Have A Durable Competitive Advantage

Situation: Stocks are tricky investments to own, particularly “growth” stocks. How should you get started? You know by now that we believe the investor with less than a million dollars in net worth should focus on owning stock in S&P 500 companies. We particularly like those in the annual Barron’s 500 List of US and Canadian companies with the highest revenues. Stock prices reflect expected earnings growth. An easy way to find companies with steady earnings growth is to look for S&P’s Dividend Achievers, i.e., companies that have been increasing their dividend annually for at least the past 10 yrs. S&P also helps us by assigning each company in the S&P 500 Index to one of 10 industries, 6 of which are “growth” industries: Energy, Basic Materials, Financials, Industrials, Consumer Discretionary, and Information Technology

It helps to know how a company is capitalized. Does it mainly depend on selling common stock to attract investors, or does it prefer to float bond issues and sell preferred stock? If the answer is bonds and preferred stock, then the company’s book value will mainly reflect its brand value. (Accountants call that an “intangible” asset.) But if the answer is common stock, “tangible” assets may have more value than all the company’s liabilities. In other words, the company has what accountants call Tangible Book Value (TBV). If its stock price is no more than ~15 times TBV, it is undeniably solvent.

Mission: Develop a spreadsheet of growth companies in the Barron’s 500 List that are both Dividend Achievers and undeniably solvent. Focus on those with at least a 15 year trading history, taking care to exclude any with an S&P Bond Rating lower than A- or an S&P Stock Rating lower than A-/M. Then check to be sure TBV growth has at least doubled over the past decade and there haven’t been any more than 3 down years for TBV. In other words, the company meets Warren Buffett’s requirements for having a Durable Competitive Advantage (see Week 238).

Execution: There are only 5 companies that meet our criteria (see Table). In the aggregate, they’re no riskier than our key benchmark, VBINX at Line 12 in the Table. VBINX is essentially an S&P 500 Index fund that is 40% hedged with high quality bonds. Note in Column C of the Table that Total Returns over the past 2+ market cycles have been more than 3 times higher than the benchmark’s.

Bottom Line: If you’re new to stock picking, you’ve probably been confining your attention to “defensive” stocks, which are those issued by companies in the HealthCare, Utilities, Consumer Staples, and Communication Services industries. Your next step is to think about owning shares in “growth” stocks issued by companies in the Information Technology, Financial Services, Industrial, Consumer Discretionary, Basic Materials, and Energy industries. Those are riskier but have greater long-term returns. You can get help deciding which to own by screening for companies that a) grow their dividend reliably, b) have large revenues, c) have a Tangible Book Value (TBV), and d) meet Warren Buffett’s requirements for having a Durable Competitive Advantage (DCA): steady TBV growth that has at least doubled TBV over the past decade (i.e., growth of more than 7.1%/yr). We’ve run that screen and find that only 5 companies meet our requirements (see Table).

Risk Rating: 6

Full Disclosure: I dollar-average into NKE, MSFT and XOM, and also own shares of ROST and TJX.

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

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