Sunday, July 3

Week 261 - Growing Perpetuity Index v2.1

Situation: Our blog started 5 years ago with the idea that saving for retirement could be more efficient if savers were to “dollar-average” $50-200 online each month into stocks. The purchases would be spread out over several companies in different sectors of the market, i.e., companies that pay a good and growing dividend. The saver’s accountants would declare to the IRS that those savings constitute an IRA. This week’s blog revisits our initial strategy, examines its performance, and looks for ways to enhance the way we measure performance. 

By using the 65-stock Dow Jones Composite Average or ^DJA, we picked an initial 12 stocks and called those the Growing Perpetuity Index (see Week 4). ^DJA is not only a shorter list than the S&P 500 Index (^GSPC) but also outperforms ^GSPC over the long term (compare Lines 32 and 33 at Column C in the Table). Our strategy was to exclude stocks that don’t pay at least a market dividend (currently 2.0%/yr), and those issued by companies that don’t have S&P ratings of at least BBB+ for their bonds and B+/M for their common stock. Most importantly, the companies needed to have a record of increasing their dividend annually for 10 or more years. S&P calls those companies Dividend Achievers.

Mission: List all companies that currently qualify for inclusion in the Growing Perpetuity Index (see Table), and highlight important metrics for the investor to consider. Five years ago, we found 14 companies and eliminated two to reach our goal of having only a dozen. At Week 224 there were 16 qualifiers; we gave up the idea having a dozen favorites and called the 16-stock portfolio Growing Perpetuity Index v2.0. Now, 19 companies meet our criteria, and we’ve added one (Union Pacific) that will soon be designated a Dividend Achiever. You get to choose from the 20 stocks in Growing Perpetuity Index v2.1. 

Execution: Highlighting “important metrics for the investor to consider” has become “the tail that wags the dog.” For example, we’ve come around to the idea that Net Present Value (NPV) needs to be calculated for every stock appearing in our tables. Explaining that math trick can start with pretending that you bought one of the stocks having a $0.00 transaction cost online, e.g. 50 shares of Exxon Mobil (XOM) at $100/Sh. If you’re looking for that $5000.00 investment to have a 9%/yr rate of price appreciation over a 10 year holding period, you’ll sell those 50 shares for $11835.00 ($236.72/Sh). The calculated Present Value of Expected Cash Flows on that price return works out to be $5000, meaning Net Present Value will be $0.00 because you spent $5000 of Present Value to buy it. 

You get the point: The discount rate (9%/yr) is like the inflation rate but instead reduces your return because of the Time Value of Money. For example, the impact of that 9%/yr “discount” on each dollar of dividends paid out 10 yrs from now is to leave you with a NPV of 39 cents. The dividend growth you expect is also 9%/yr, which (if realized) would also generate an NPV of $0.00. (A detailed explanation of the inputs to the NPV calculation can be found at Week 256). 

The amount of the dividend is important in the NPV calculation. Why? Because large dividend cash flows may be paid out in the early years, when the discount rate has less impact. XOM pays a high 3.3% dividend, which turns out to give it a positive NPV even though other factors work against its having a positive NPV. Those factors are 1) the NPV calculation includes transaction costs of 2.5% at both the front and back end, 2) the dividend growth rate is only 8.0%/yr, and 3) the price appreciation rate is only 7.9%/yr (see Columns G, H, M and Y at Line 16 in the Table). After buying XOM, almost 20% of its purchase price is returned to you as dividends within 5 yrs. 

Administration: Market returns have but two sources: asset allocation and security selection. We recommend bond-like stocks for retirement planning, backed 2:1 with 10-yr US Treasury Notes that are purchased online to avoid transaction costs. Diversification to gain exposure to foreign markets or small-mid capitalization companies is not necessary because the average company in the Table gains 40% of revenues outside the US and several of the companies (JNJ, MSFT, IBM, PG, KO, XOM, UTX, MMM) buy up small companies almost every year.

That leaves “security selection” as the key source of returns. This is the hard part, since you aren’t going to buy all 20 stocks. But it’s really a 2-part problem, given that transaction costs may outweigh selection bias as a source of poor returns for the average investor. So, let’s look at those costs as a fraction of the asset’s purchase price, the so-called expense ratio. For automatic purchases of $100/mo online, the average expense ratio for the 20 stocks we highlight this week is 1.4% (see Column AB in the Table). Note: 8 of those 20 stocks carry zero or minimal transaction costs.

When buying stocks through a discount broker, the expense ratio is typically 2.5%. Index funds purchased through the Vanguard Group have expense ratios of 0.25% or less, which is the main reason Warren Buffett recommends that his friends and relatives buy the Vanguard 500 Index Fund (VFINX at Line 28 in the Table) instead of trying to pick stocks.

Selection bias is an important problem for investors holding fewer than 40 stocks. We try to help you by emphasizing the importance of diversification, e.g. having stocks in all 10 of the S&P industries (see Week 236). Mostly, you need to emphasize quality when picking stocks (see our rationale above for making this week’s selections). Then see how to get the most value from the stocks you like by running NPV calculations before you buy (c.f. Columns U through Y in the Table). Also, pay attention to the Graham Number in Column T and compare it to the Stock Price in Column U. The Graham Number is what the price of the stock would be at 15X earnings and 1.5X book value.  

Bottom Line: We have refreshed our Growing Perpetuity Index. Now it is v2.1 and composed of 20 companies which, in the aggregate, handily outperform our benchmarks. We find that only 3 companies have a lower “finance value” than VFINX using our method of calculating performance: 16-yr total return minus the loss incurred in the 2011 market correction (see Column 5 of the Table). Those companies are 3M (MMM), CSX Railroad, and Caterpillar (CAT). In terms of NPV, all 20 companies outperformed the benchmarks (see Column Y in the Table). Those benchmarks include VFINX, Berkshire Hathaway (BRK-A), and the SPDR MidCap 400 ETF (MDY). 

Risk Rating is 6, where Treasuries = 1 and gold = 10.

Full Disclosure: I dollar-average into XOM, JNJ, MSFT, NEE, PG, and UNP. I also own shares of MCD, MMM, IBM, KO, and WMT.

NOTE: Metrics are current for the Sunday of publication. Metrics highlighted in red denote underperformance vs. VBINX (Vanguard Balanced Index Fund at Line 26 in the Table), which is our key benchmark.

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