Sunday, October 23

Week 277 - Counter-cyclical Barron’s 500 Dividend Achievers

Situation: What’s the biggest problem with owning stocks? When JP Morgan was asked this question, he answered: “It will fluctuate.” Benjamin Graham was more specific, noting in Chapter 14 (Stock Selection for the Defensive Investor) of his famous book (The Intelligent Investor, 4th Revised Edition, Harper & Row, New York, 1973, p.195) that:
     “Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.” 

But a stock’s price will rise far higher when investors clamor to “get in on the story.” All too often, that story reflects the investment that the company’s managers have made in Public Relations (e.g. advertising) at the expense of investments that grow Tangible Book Value (e.g. property, plant, equipment, and software). As a result, the company’s stock price will falter whenever the macro-economic outlook is negative. 

Mission: This week we’ll build on Warren Buffett’s observation that “only when the tide goes out do you discover who’s been swimming naked.” That last happened with the 4.5 yr Housing Crisis, i.e., year-over-year house prices (for conforming new sales nationwide) turned negative in Q3 of 2007 and didn’t turn positive again until Q1 of 2012. Most companies were exposed as naked swimmers, and their stock prices soon fell to a level more consistent with Benjamin Graham’s formula (see above). But a few outperformed during that 4.5 yr period. Total Returns/Yr proved to be greater than Total Returns/Yr have been over the 26+ yr period since the Savings & Loan Crisis of 1990-91. Do those companies have anything in common? We’d like to know, since owning shares in 2 or 3 such companies would help protect our portfolios from the ravages of the next crisis.

Mission: Look for companies in the Barron’s 500 List that 1) outperformed in the Housing Crisis, 2) have improved revenues and cash flow over the past 3 yrs, 3) have high S&P ratings on their bond and stock issues, and 4) are Dividend Achievers.

Execution: (see Table)

Administration: The first 3 companies in our Table (ROST, TJX, MCD) represent the Consumer Discretionary industry and see thrifty consumers as “core” clientele. Their Business Plan is designed to outperform in a recession because people will have an ongoing need to purchase their products and services, and more people will have become thrifty-minded. Four companies at the bottom of the list (WEC, XEL, ES, ED) are regulated public utilities that play a similar role: everyone needs to turn on lights and recharge their cell phones every day. Somehow the money will be found to pay the utility bill. 

It is harder to explain how the remaining two companies, IBM and WW Grainger (GWW), made the list. When a company needs information technology maintenance or upgrades, IBM has always had the reputation of being a safe and effective recommendation for a company’s Chief Information Officer to make. A deep recession is exactly when such upgrades are in demand, given that the company has had to reduce staffing to avoid being bought out by a stronger competitor. Automation and global sourcing are the paramount strategies to deploy in a recession. Similarly, GWW is the leading supplier of maintenance, repair, and operating products to businesses. So, demand for at least some of their products will have remained steady.

Among the BENCHMARKS and Standard Indices in our Table, note that only two asset classes that outperformed their long-term trend during the Housing Crisis: bonds and gold. This will always be the case in a financial crisis.

In the aggregate, these 9 stocks have a 5-Yr Beta below 0.5 (see Column I in the Table) which suggests that there would be less risk of loss vs. the S&P 500 Index in a Bear Market. But statistical analysis of weekly prices over the past 25 yrs suggests otherwise (see Column M in the Table). Taking both metrics into consideration, we see that WEC Energy Group (WEC) and Consolidated Edison (ED) are the only low-risk investments. 

Bottom Line: The “common thread” of our 9 recession-proof companies is a combination of skilled management and having a product line that includes goods and services exhibiting near-zero elasticity. Companies like Ross Stores (ROST), TJX (TJX) and McDonald’s (MCD), which appeal to the budget-minded among us, will ride out almost any storm. Electric utilities that are well-managed, like WEC Energy Group (WEC), or serve upscale markets, like Denver (XEL), Boston (ES) and New York City (ED), will emerge unscathed from recession. Finally, there are companies like IBM and Grainger (GWW) that provide maintenance and information technology to a long roster of companies, and these often cannot be pushed into the next quarter.

Risk Rating: 5 (where Treasuries = 1, and gold = 10)

Full Disclosure: I own shares of ROST, TJX, MCD, and IBM.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 19 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = moving average for stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline CAGR found at Column K ( Use of such a long-term trendline CAGR instead of a shorter-term current CAGR emphasizes the predictive value of “reversion to the mean”. Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% is based on returns from a stock index of similar risk to owning a small number of large-cap stocks where selection bias is paramount. That stock index is the S&P MidCap 400 Index.

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