Sunday, November 20

Week 281 - Investing for Capital Gains

Situation: Don’t leave money on the table. That means don’t accept a lower rate of return when you could get a higher rate of return by investing in the same asset class while taking the same risk. 

This week we’ll focus on A-rated companies with over 9%/yr long-term growth in both Dividend and Price. Investing for Capital Gains starts with avoiding stocks that grow their dividends slower than 9%/yr. Why? Because you’ll soon find that 80% of the worthwhile companies are S&P Dividend Achievers, companies that have raised their dividend each year for at least the past 10+ years. Your benchmark is the S&P 400 MidCap Index, or its ETF (MDY). That index has a long-term growth rate of 9-10%/yr, which is higher than the growth rate for the S&P 500 Index while having a lower risk of loss (see Columns K & M at Lines 32 & 33 in the Table). 

Mission: Make a spreadsheet of Dividend Achievers that have 1) grown their dividend at least 9%/yr over the past 10 yrs, and 2) have demonstrated price appreciation of at least 9%/yr over the past 25 yrs. We define price appreciation statistically, i.e., as the trendline derived from a “least squares” calculation of Standard Deviation for weekly price points . We exclude companies that have either an S&P stock rating lower than A-/M or an S&P bond rating lower than A-. We also exclude companies having a) Long-Term debt that amounts to more than 1/3rd of total assets (see Column N of the Table), b) insufficient revenue to be on the Barron’s 500 List published 4/30/16, c) insufficient Free Cash Flow in the most recent two quarters to fund their dividend (see Column O of the Table), and d) negative Tangible Book Value (see Column P in the Table). We also exclude any companies with a Weighted Average Cost of Capital (WACC) that exceeds their Return on Invested Capital (ROIC), as shown in Columns AB & AC of the Table. In other words, all of the companies listed have a clean Balance Sheet.

Execution: We find that 17 companies meet our requirements. Some have performed poorly under stress, i.e., during the 4.5 year Housing Crisis (e.g. the 5 stocks highlighted in red in Column D), or have a history of price volatility that predicts a greater loss in the next Bear Market than the S&P 500 Index (e.g. the 7 stocks highlighted in red in Column M not already highlighted in Column D). You might want to pay more attention to the 5 companies that had neither problem, namely, GWW, HRL, WEC, PH, APD

Administration: Picking large-capitalization stocks for your retirement portfolio is fraught with risks, no matter how high you set the quality bar. Why? Because those companies typically have multiple product lines and strong brands, which allows them to borrow lots of money at low cost. Managers are incentivized to do this because their performance is often measured by Return on Equity (ROE). The more they use borrowed money, the higher ROE goes because returns go up while equity remains unchanged. Mid-Capitalization companies don’t yet have multiple product lines or strong brands, so their managers can’t borrow as much money. For those same reasons, it is rarely prudent to own stock in a Mid-Cap company, unless its Tangible Book Value is remarkably high. But a large aggregate of Mid-Cap companies (e.g. the S&P 400 MidCap Index) makes an excellent investment because there is little risk posed by long-term debt.

Owning individual stocks in a 401(k) through a mutual fund costs at least 1.59% more per year than owning index funds. Your costs, as an individual who likes to pick her own stocks, are at least 2%/yr more. Why would you do that? For starters, index funds are inefficient in ways that cost you almost 1%/yr. We all know another reason, which is that you can invest in Berkshire Hathaway (e.g. low-cost “B shares”) and beat the lowest-cost S&P 500 Index fund long-term while incurring less risk (compare Lines 23 & 28 in the Table). You can say the same about a few other companies, such as Johnson & Johnson at Line 22 in the Table. The cost of dollar-averaging $200/mo into JNJ stock online is 0.5%/yr. 

I think the best reason to go with stock-picking is that a majority of companies in the S&P 500 Index have messy Balance Sheets and weak brands. If you confine your picks to companies with strong Balance Sheets and strong brands, as shown in Columns N through R in the Table, you will minimize losses in a downturn, as shown in Column D of the Table. Not losing money is the secret of making money. As Warren Buffett says, "Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1."

Bottom Line: Investing requires a disciplined approach to goals. When capital appreciation is the goal, you’ll want to use a benchmark that achieves that goal with the least risk. We think the S&P 400 MidCap Index is appropriate, given that it has 20% less risk of loss than the S&P 500 Index and 10% greater price appreciation. By using the S&P 400 MidCap Index as our benchmark, we arrive at a 9% discount rate for the Net Present Value (NPV) calculation (see Appendix to Week 256). If your growth stock selections generate a negative NPV, you’d be better off investing in MDY, the SPDR Exchange-Traded Fund that tracks the S&P 400 MidCap Index. This week’s Table has 17 Dividend Achievers with positive NPVs after being “handicapped” by the 9% discount rate. Those are worthwhile dividend-growing stocks for your retirement portfolio, as evidenced by how well their price held up during the Housing Crisis (see Column D in the Table).

Risk Rating: 6 (where 1 = 10-yr US Treasury Notes and 10 = gold bullion).

Full Disclosure: I dollar-average into MSFT, NKE, and UNP. I also own shares of ROST, TJX, HRL, WMT, and MMM.

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