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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