Sunday, October 22

Week 329 - Capitalization-weighted Index of “The 2 and 8 Club”

Situation: You would like a “safe and effective” way to own stocks and match total returns for the S&P 500 Index over time. There is no such way, if you define a “safe” stock portfolio as one with long-term price volatility that compares favorably with that of the S&P 500 Index. See, for example, red highlights in Column M of any of our Tables. Those denote unsafe stocks. You have to choose whether to prioritize safe or effective. Since insider trading is illegal, the only way you can beat the S&P 500 Index is by embracing more risk. 

The 2 and 8 Club” is our program for success using more risk (see Week 327). Those 16 large companies are all in the S&P 100 Index, whose members are required to have efficient price discovery through robust trading in put and call options on the Chicago Board of Options Exchange. Companies in The 2 and 8 Club are required to pay a predictably growing above-market dividend, i.e., yield over 2%/yr and dividend growth of over 8%/yr (over the past 5 yrs). They also have to have S&P bond ratings of A- or better and S&P stock ratings of B+/M or better. Finally, there need to be 16+ years of trading records to enable statistical analysis by the BMW Method

Why do we measure growth using 5 years of dividends instead of 5 years of earnings? Earnings have to be reported by using Generally Accepted Accounting Principles (GAAP). Those are a mish-mash of offsets that can be manipulated by CEOs. So, earnings can look good when they really aren’t. Dividend growth is a product of steady growth in free cash flow, which is Operating Earnings minus Capital Expenditures to grow the company through additions to property, plant, and equipment. Boards of Directors must approve the dividend checks that are sent out to shareholders, which is money that might instead have remained with the company. Remember what Warren Buffett says: “Writing a check separates a commitment from a conversation.

1) Enlarge the pool of companies by extending The 2 and 8 Club concept beyond the S&P 100 Index to embrace qualified companies in the Barron’s 500 Index.
2) Add a column in the Table to show Market Capitalization for each company relative to Market Capitalization of all companies in the Table. Rank companies by Market Capitalization.

Execution: see Table.

Administration: Rules for extending the list of qualified companies (beyond the original 16 found in the S&P 100 Index) are as follows:
   1. Include S&P 100 Companies that are in the reference data set, i.e., the FTSE High Dividend Yield Index but have seen either a recent price accumulation that takes their dividend yield under 2%/yr or slightly less than 8%/yr dividend growth. There are two such companies: Raytheon (RTN) and Coca-Cola (KO).
   2. Include companies in both the reference data set (FTSE High Dividend Yield Index) and the current Barron’s 500 List. That produces 6 additional companies: WEC Energy Group (WEC), Automatic Data Processing (ADP), Air Products & Chemicals (APD), VF (VFC), Archer Daniels Midland (ADM) and Travelers (TRV). 

Bottom Line: The extended version of “The 2 and 8 Club” has 24 companies (see Table), with relative Market Capitalizations being shown in Column AC. Past performance of the aggregate is remarkably high, e.g. see Columns E and K, while risk (in proportion to that outperformance) is acceptable (see Columns I and M). You, of course, want to capture some of that outperformance going forward. To do so, you’ll need to focus on buying stock in the companies most responsible, i.e., those with the largest market capitalization, such as Microsoft (MSFT) and JP Morgan Chase (JPM).  

Risk Rating: 6 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)

Full Disclosure: I dollar-average into NEE, KO, JPM, MSFT and IBM. I also own shares of MMM, CAT, TRV, AMGN, and TXN.

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Sunday, October 15

Week 328 - Precision Agriculture

Situation: Production Agriculture has created its own problems. Worldwide supply has exceeded demand for years. In early 2017, the USDA projected that farm income would fall for a 4th straight year. But it hasn’t turned out to be that bad, since crop prices have coalesced near last year’s levels, and sales volumes have risen. Much of the oversupply results from technological improvements in farming, starting with the buildout of center-pivot irrigation in the 70s and 80s. Weather prediction started improving in the 1990s, and the National Oceanic and Atmospheric Administration (NOAA) now has a number of online tools available to farmers at no cost. 

To integrate weather information with soil characteristics on a given farm, we now have professional agronomists who provide specific advice on the use of seeds, fertilizer, water, insecticides, herbicides and fungicides. Agronomists are sometimes employed by equipment or seed vendors, who offer Wi-Fi connections that link information collected on tractors to agronomists. More often, Agronomists are employed on retainer by farmers. Many have university degrees, and others with less training work under supervision for an agronomy service, such as Servi-Tech, Inc

The application of Global Positioning Systems to agriculture began with patent approval in 1998. Increasingly, agronomists encourage farmers to adopt GPS-based services addressing their entire set of specific needs, a tactic called “Precision Agriculture.” For example, satellite imagery and soil sampling can be used for variable rate seeding and watering. Results at harvest time are analyzed using Wi-Fi linked to a crop-yield computer program on GPS equipped combines. Trimble, Inc. (TRMB) is a leader in this technology, and new combines are increasingly equipped with Trimble receivers.

Mission: Present a table of publicly-traded companies that provide precision agriculture equipment, and explain in the Administration section the specific offerings of each company in the Table.

Execution: see Table.


* Provides a variety of digital tools through strategic collaborations with 1) Lindsay Corporation (manufacturer of center-pivot irrigation systems) to match soil and seed characteristics with water needs; 2) Ag Connections to present a complete range of farm management software in a digital platform.  
* Recently purchased Blue River Technology, because it makes “tractor-towed robots that can analyze crops and apply fertilizer and pesticides plant-by-plant.
* Has started using its experience with thousands of corn seed varieties in various soil conditions in “self-teaching algorithm” to predict how a particular seed variety will perform after a farmer plants it. But the key to Monsanto’s emerging dominance of precision farming is due to a subsidiary: The Climate Corporation. It’s FieldView Platform is mounted on tractors and provides software for integration of various planting and harvesting inputs. 
* Has purchased Precision Planting LLC, which had been part of a Monsanto subsidiary--The Climate Corporation, and is licensed to retain connectivity with The Climate Corporation’s FieldView Platform.
* Has developed the AgSense software app for optimal GPS-managed control of variable center-pivot irrigation systems.
* Provides daily information and analytic tools essential for precision agriculture planning, augmented by its recent purchase of the Agrible news service.
* Precision agriculture is increasingly dependent on GPS systems and images of farmland generated by orbiting satellites. Detailed images of quarter sections of farmland are now available, using satellites designed to transmit different types of information with specific uses in farming. Agriculture research has been a specific mission of NASA since 2015. IBM owns “The Weather Channel” and has worked with NOAA since 1996 to improve weather forecasting at a “hyper-local” level. IBM provides most of the hardware and software that makes this possible, and has started applying this to precision agriculture, specifically in Brazil.
* Is a pioneer in field navigation equipment and tractor-mounted computers. Its product line has been successful with farmers and is being upgraded almost annually.

Bottom Line: Precision Agriculture is in its early years, but the consolidation phase is well underway. We’ve presented the leading publicly-traded companies above, along with investor information (see Table). These are powerful tools in the hands of the farmer, and will no doubt improve the efficiency and scope of crop production worldwide.

Risk Rating: 8 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: I dollar-average into MON and IBM, and also own shares of CAT and RAVN.

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Sunday, October 8

Week 327 - The 2 and 8 Club: A Strategy To Beat The S&P 500

Situation: You enjoy learning about economics through investing in specific companies but then you learn that you are “leaving money on the table.” How does that happen? Because Warren Buffett has explained to us that the Vanguard S&P 500 Admiral Fund (VFIAX) will beat professional stock-pickers 90% of the time. Why? Because a) it has an expense ratio of only 0.04%, b) it reaches all sectors of the economy, and c) capital gains taxes are negligible because there’s no point selling VFIAX shares before you retire. Instead, you can continue to dollar-average into your VFIAX account until you retire, regardless of market fluctuations.

But we can suggest a strategy for picking stocks without losing much money vs. VFIAX. Firstly, you’d need a watch list positioned in all 11 S&P sectors. Secondly, you’d need a fee-based trading account at your brokerage, one costing ~1%/yr of net asset value that allows you to buy and sell shares as needed without paying transaction costs. Alternatively, you can employ a Dividend Re-Investment Plan when transaction costs are lower. For example, computershare’s DRIP for NextEra Energy (NEE) carries no transaction costs. Thirdly, you’d need to have plan for picking stocks from your watch list, and the discipline to stick with that plan.

Our blog for this week has a workable plan that we call “The 2 and 8 Club.” It sticks to a watch list of the largest and most frequently traded companies, i.e., those in the S&P 100 Index. It picks companies that pay more than a market yield (~2%) by using the S&P 100 companies listed in the FTSE High Dividend Yield Index, which most investors in the US know as VYM, the Vanguard High Dividend Yield ETF. Not all high-yielding companies in the S&P 100 Index are found there because companies have to meet international standards of dividend predictability. 

Now you know the “2” part of The 2 and 8 Club, i.e., 2% market yield. The “8” part is a requirement that selected companies pay a dividend that has had a Compound Annual Growth Rate (CAGR) over the past 5 yrs of at least 8.0%/yr. Companies whose bonds are rated lower than A- by S&P are excluded, as are those whose stock is rated lower than B+/M.

Mission: List the current members of The 2 and 8 Club.

Execution: see Table.

Administration: To use this Plan, you simply keep track of the current members of The 2 and 8 Club, then dollar-average into half of those. Some will reach a point where they no longer qualify for membership. Chances are you will decide to stop investing in those companies but we suggest you consider replacing them with newly qualified companies. Each position is predicted to have at least a 10%/yr return (2+8=10), which is 3%/yr more than the long-term return for the S&P 500 Index. That 3% safety factor will likely be nibbled away by transaction costs of at least 1%/yr and capital gains taxes of at least 2%/yr.

Bottom Line: There are fewer than a dozen finance professionals in history with a record of beating the S&P 500 Index every year for more than 2 market cycles. So, a stock-picker like you or me is essentially a gambler. For example, 11 of the 16 companies in the Table that qualify for inclusion in The 2 and 8 Club have shown more extreme fluctuations in market price over the past 16 years than has the S&P 500 Index (see red highlights in Column M of the Table). As finance professors like to say, there are only two ways to beat the S&P 500 Index: 1) use insider information (which is illegal), or 2) have a portfolio that carries more risk of loss than the S&P 500 Index. 

But you’re more than a gambler. You’re participating in an experiential school that teaches you (through trial and error) how the economy operates, and you’re learning more about the behavior of groups (sociology) and the governance of countries (politics).

Risk Rating: 6 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, gold = 10).

Full Disclosure: I dollar-average into MSFT, IBM, MMM, CAT, JPM, AMGN, UNP and NEE.

NOTE: Candidates for The 2 and 8 Club are listed at the bottom of the Table. These are S&P 100 companies that have recently been paying an above-market (SPY) dividend yield and have grown that dividend faster than 8%/yr over the past 5 years, but are not yet included in the US version of the FTSE High Dividend Yield Index (

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Sunday, October 1

Week 326 - Investing for Income

Situation: Bonds or stocks? Which will give you a larger monthly check without disrupting your sleep? For stocks, the standard would be SPDR Dow Jones Industrial Average ETF (DIA), yielding 2.2%. For bonds, the standard would be iShares 20+ Year Treasury Bond ETF (TLT), yielding 2.5%. So far, so good. But what if you want more income than those “plain vanilla” options provide? For example, a bond index fund that wouldn’t be hit for a big loss if inflation were to spike upward? Then you would want to be an investment-grade intermediate-term index fund like the Vanguard Interm-Term Bond Fund (BIV). If you’re a stock-picker and want more yield, you’ll need to start with a close look at the 400+ stocks in the Russell 1000 Index that yield more than a market average 2%. There’s an exchange-traded index fund (ETF) that holds positions in all such stocks: The Vanguard High Dividend Yield ETF (VYM). Our Table for this week pulls out 8 Dividend Achievers that we think do the job. But remember, you’d have to hold positions in all 8 to minimize selection bias. Then, you’d have an investment that yields ~2.7% and is likely to grow those dividends ~9%/yr.

Mission: Find A-rated Dividend Achievers with a higher yield than DIA, a clean Balance Sheet, and less volatility over the past 20 years than the S&P 500 Index. 

Execution: We find 8 companies in the Russell 1000 Index that meet those criteria, except for minor Balance Sheet issues (see Table).

Bottom Line: Low-risk investments that yield more than 3% have almost disappeared. We find only two: WEC Energy Group (WEC) and Procter & Gamble (PG). Of course, there are some companies and government agencies that issue bonds paying a higher interest rate, but you’d have to invest $25,000 in each to avoid paying high up-front transaction costs. And, you’d need to have positions in several such bonds to minimize selection bias.  

Risk Rating: 3 (where 10-Yr US Treasury Note = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: For equities, I dollar-average into NEE, PG and JNJ, and also own shares of TRV, WMT and MMM. For bonds, I own shares of BIV.

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Sunday, September 24

Week 325 - Sans Artifice Is The Preferred Look

Situation: Objective reality is mercenary. Business deals are largely about “transferring risk to a less knowledgeable party.” We know better than to take these things personally, but we tire of the rat race and look forward to drinking with friends on the weekend. 

We often take risks ourselves, to recover from our mistakes (divorce, buying a “fixer-upper” in a changing neighborhood, not kicking adult children out to face the world, etc.). 

To avoid becoming alcoholics or gamblers, we must tend better to our personal relationships and try not to be an avatar of money. How does one do that? Three ways: One is about the way we invest, making wise choices. That would include having a large cash position, and a nest egg of stocks and bonds that aren’t gambles. Another is in the messages we give off, the optics and emojis we emanate. Finally, we must place a high value on family life, loyalty.

We all know how to give the impression that we’re about money, which is to “dress for the job you want”. At the opposite end of the spectrum, you’ll find people who are sans artifice but steady and reliable. They don’t armor themselves in upscale clothing, makeup, or scents. Men would then find themselves leaving the suit jacket, the sport coat, the tie, the permanent-press shirt, and the shiny shoes in the closet. And maybe think about replacing that expensive ride with a Prius Two or small Tesla. 

For women, it would mean falling out of bed in the morning to compose her ensemble, which may include clothing that doesn’t cover up tattoos, no makeup, and Skechers as the default choice in footwear. Once so-attired, openness toward whomever comes naturally, without giving a thought to talking up or down to that person. 

Let’s look at the money side. What does “having a large cash position” mean? It means you either hold Treasury Bills at (and dollar-average into 2-Yr Treasury Notes as well as Savings Bonds), or you hold a large cash balance at an FDIC-insured bank. 

Why is cash important? A recent Wall Street Journal article titled “Longer CFO Tenure is Good for Companies” has a good explanation. When faced with the Lehman Panic in 2008, the CFOs who kept their jobs used good people skills to hold on with successive CEOs but also went into the crisis with large cash positions on the company ledger. Not surprisingly, the companies that have these long-tenured CFOs tend to have unusually good stock performance. Simple message, isn’t it? Good people skills combined with a propensity to hold large cash positions. And, it doesn't depend on a lot of experience. Some of those CFOs were barely 30 years old when the Lehman Panic hit. It's a matter of values.

Mission: Assemble a list of A-rated Dividend Achievers that have Tangible Book Value and also have shown less volatility than the S&P 500 Index over the past 20 years.

Execution: see Table.

Bottom Line: This is a “tortoise and hare” blog, the Central Thought being to “live long and prosper.” Use little debt and maintain a large cash position, that’s the easy part. You just need to say “no” a few times, and walk the talk (meaning no artifice or excess in your habits). The hard part is hewing to family life. Believe it or not, that’s the best way to prevent high blood pressure. I know. I’m a doctor. (Try getting through a divorce without high blood pressure.) 

For equities, the 10 stocks in the Table have returned almost 12%/yr since the S&P 500 peak on 7/19/07 vs. ~7%/yr for the S&P 500 Index ETF (SPY). For cash, the iShares 1-3 Year Treasury Bond Index ETN (SHY) has returned 2.0%/yr (vs. inflation of 1.7%/yr).

Risk Rating: 4 (where 10-Yr US Treasury Note = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: For equities, I dollar-average into JNJ, PG and NEE, and also own shares of HRL, TRV, MMM, and WMT. For cash, I dollar-average into ISBs (Inflation-Protected Savings Bonds).

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Sunday, September 17

Week 324 - Farmland REITs; Contract Farming

Situation: Farmland prices have come down over the past 3 years, reflecting the drop in prices paid for farm commodities and the resulting loss of farm income. This year’s harvest may be a record-breaker, further aggravating the problem. In central Nebraska, cropland prices have fallen from almost $11,000/acre to less than $8000/acre, and rents have fallen from almost $500/acre to less than $250/acre. Now is not a good time to speculate in farmland, unless you’re knowledgeable about local agriculture. Even then, you’d need to employ two experts: a farmland broker and a farm management company. 

Why not simply buy shares in a farmland Real Estate Investment Trust (REIT)? Until 2013, those didn’t exist. Now there are two small ones: Farmland Partners (FPI) and Gladstone Capital (GLAD). “These REITs generate income by leasing land to tenant farmers. But rents can slump when crop prices are soft.” 

The problem for investors is that there is a lot of marketing hype about the enduring and recession-resistant benefits of owning a working farm through several market cycles. But derivative ownership shares, that is, in REITs and companies having large holdings of cropland rented to tenant farmers, tend to track spot prices for the crops being harvested. Those prices vary remarkably, depending on weather, logistical bottlenecks elsewhere on the planet, and technological innovation. Trends in farmland value are closely tracked by the US Department of Agriculture, confirming that cropland rents vary more than farmland prices. 

Moving on to ranch land valuations, we again see that rents are driven by commodity prices but to a larger degree. This is because meat processing companies closely control their supplier’s use of land and inputs, so as not to be driven out of business by unpredictable oversupply or undersupply events. For example, drought or disease can cause a collapse in herds or flocks.

Over the past 50 yrs, farmland has not been a significantly more rewarding asset than stocks. For example, farmland in southwest Iowa (Audubon County) that sold for $379/acre in 1967 is now worth ~$7200/acre, giving a price return of 6.1%/yr. Compare that to the 6.7%/yr price return for the S&P 500 Index. Both asset classes produce income (rents or dividends), with farmland rents being higher than dividends on the S&P 500 Index. Total return for each asset class has been impacted by inflation, which has averaged 4.1%/yr since 1967. Cropland rents have been little better than 3%, bringing total return to 5.6%/yr after inflation. Reinvesting dividends on the S&P 500 Index over the past 50 yrs also brings total return to 5.6%/yr after inflation. 

     A: Explain the 4 ways to invest in farmland (other than buying parcels of good cropland and renting those out): Those are to buy shares in 1) a farmland REIT; 2) a land trust that rents cropland to tenant farmers; 3) a seed producer that contracts for using part of a farmer’s land for research on different genetic strains; 4) a meat packer that contracts for conditions under which a farmer will produce broiler chickens, hogs, or beef cattle.
     B: Generate a spreadsheet with valuation metrics that illustrate the benefits and risks of owning shares in each publicly-traded companies in those 4 categories.  

Execution: see Table.

        Farmland REITs: Farmland Partners (FPI); Gladstone Land (LAND).
        Land Trusts: Texas Pacific Land Trust (TPL); Alexander & Baldwin (ALEX).
        Seed Producers: Monsanto (MON); Pioneer Hybrid (a subsidiary of duPont, DD); Syngenta AG (SYT). 
        Meat Packers: Hormel Foods (HRL); Tyson Foods (TSN); Sanderson Farms (SAFM); Pilgrim’s Pride (PPC); Seaboard (SEB); Leucadia National (LUK).

Bottom Line: Farm operations are high risk endeavors. An investor can only ameliorate those risks by learning to farm, and having the good fortune to have a significant equity position in several hundred acres of irrigated cropland. That will offer the scale (and financial underpinning) needed to efficiently deploy the equipment and agronomy tools needed for precision agriculture. For those who only want “a piece of the action,” there are 10 publicly-traded stocks issued by companies that either own farmland or control the way it is used (see Table). Aside from Hormel Foods (HRL), those are high-risk stocks. 

Risk Rating: 8 (where 10-Yr US Treasury Notes = 1; S&P 500 Index = 5; gold = 10)

Full Disclosure: I dollar-average into MON, and also own shares of HRL.

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Sunday, September 10

Week 323 - “Toto, I’ve A Feeling We’re Not In Kansas Any More.”

Situation: A storm has hit international relations. It’s not as though we haven’t been warned. In his 2014 book, “World Order,” Henry Kissinger mentions dark trends could undermine the principles of international governance, which were established by (and adhered to since) the Peace of Westphalia ended the Thirty Years War in 1648. Those principles are 1) the inviolability of national sovereignty, and 2) the self-determination of peoples free from religious intolerance. But Russia has recently annexed Crimea, and Great Britain’s vote to leave the European Union reflects growing religious intolerance. Here in America, we have echoed Brexit by electing Donald J. Trump to be our President. 

Investors abhor uncertainty and wonder whether they’ll continue to prosper in the absence of International Order. The issue is one of governance. Picture a tent with many people of various nationalities inside, debating ideas about how best to get along together. This metaphor worked for hundreds of years, even though a camel would occasionally stick its nose under a tent. Now countries and economic unions are having to grapple with anarchists seeking Jihad.

What does it all mean? Investors need a mental picture, one where cause and effect assume a pattern that allows us to anticipate how events on the world stage are likely to play out. Artists often arrive at formulations before events unfold. The disruption of Victorian Order that culminated in World War One is one example. The writings of Franz Kafka and paintings of Picasso spring to mind as heralds of Modernism. Similarly, Existentialists like Albert Camus and Jean Paul Sartre anticipated the Second World War and gave us The Theatre of the Absurd. The effect reached music with the 12-tone scale, choreography with ballets no longer anchored in stories, paintings lacking both content and message, and the “deconstruction” of classical poetry

The art world has evolved beyond Modernism to become Post-Modern, but more recently that has been replaced by Contemporary Art, which anticipates the crumbling of World Order we’re now seeing. Formerly, art was about feelings, music, and imagery; reasoned discourse was left out. In Contemporary Art, the intellect is finally engaged but still without reasoned discourse. The tent ropes have come loose. We are left to manage without Cliff’s Notes, religious precepts, party politics, or judicial constraint; mood-altering drugs are used to let light in as often as to keep it out. A piece of Contemporary Art (if we are open to it at all) might lead any one of us to see, hear, read, imagine, or think along a unique trajectory, then use that as a basis for free association. 

There are no guideposts, and the unhinging has been accelerated by the ready availability of computing power and networking via one’s cell phone. The artist typically has no interest in channeling the viewer or listener’s thoughts, feelings, or mental images. Why presume, given that each of us is unique? A poet might apply the words levitation, unmooring, kaleidoscopic, or ricochet to characterize the mental effects that the artist ignites in some people. If people join together, it might become participatory theater. Think of stadium performances by iconic figures like The Grateful Dead, Janis Joplin, or even Donald J. Trump. The traditional format used by the music industry is also “going down the tubes.” Few artists make an “album” any longer with a recording studio contract. It’s all small entrepreneurs selling a single song via the internet, using social media as advertising.

Prepare your portfolio. Think about limiting key retirement investments to US Treasury bonds and well-capitalized A-rated stocks that have a Durable Competitive Advantage (see Table). VYM is the Benchmark Index for Russell 1000 companies that pay at least a market dividend. “Durable Competitive Advantage” (see Column O in the Table) is a term that Warren Buffett coined to denote a 7% (or higher) rate of growth in a company’s Tangible Book Value (TBV) over the past 10 yrs, provided that TBV is down no more than 3 years (see Week 158 and Week 241).

Administration: The sky is not falling. Civilization won’t end, and neither will Westphalian Principles of Governance. Be patient but don’t take risks. Some good is bound to come from abandoning “received wisdom” or “group think.” Why? Because “received wisdom” gives rise to dogma, and dogma prevents innovation. Don’t worry about nuclear war. Sure, it could happen. Maybe there’s even a “material” risk (odds higher than one in twenty). That would amount to an existential crisis for many survivors. We’d all become more focussed on survival, so behavior would become more collegial. 

Bottom Line: Uncertainty is on the move. So, this is not a good time to speculate in financial assets. Hard assets like farmland are another matter (see next week’s blog).

Risk Rating: 6 (where 10-Yr T-Notes = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: I dollar-average into MSFT and NEE, and own shares of NKE, TJX, ACN, JPM, and TRV.

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Sunday, September 3

Week 322 - Global Buildout of Combined Heat & Power (CHP) Systems

Situation: Cogeneration of heat and power is a method that has long been used to capture waste energy remaining in the heat generated to produce electric power. That residual heat is used to generate steam--to heat nearby buildings. However, the Rural Electrification Act of 1936 subsidized the buildout of large, centrally located Regular Electric Generation Facilities (REGFs) to bring all homes onto the national power grid. That subsidy aborted the buildout CHP systems. Nonetheless, CHP systems accounted for 9% of US electric power generation in 2008. Worldwide, the growth of CHP systems is predicted to be 4.38%/yr from 2014 to 2024. 

CHP systems are becoming more commonplace in urban areas, now that natural gas is replacing coal as the cheapest energy source. The idea is to add a heat exchanger that will generate steam from exhaust gases produced by newly installed electricity-generating gas turbines. This means that “energy wasted” is reduced to 20% from the 55% loss that is typical of REGFs. Unlike having a central station to generate electricity for wide use, CHP requires the station to be near heating and cooling application sites ( Most large applications are at industrial sites, typically oil refineries. But small applications used to heat or cool nearby buildings are also ideal. For example, the University of Cincinnati built a gas turbine powered CHP plant in 2004 with a capacity of 47,700 KW. The Department of Energy has identified a potential for over 290,000 sites in the US with more than 240GW of estimated output. That’s double the installed capacity of wind and solar power in the US.

Mission: Analyze 12 Electric Utilities that support electric grid connections to CHP power plants, including the 3 US companies highlighted in a recent study: “Some of the major players identified across the Global CHP system market for data centers include ENER-G, Korea Electric Power Corporation, National Grid plc, Exelon Corporation, NextEra Energy, Inc., Chubu Electric Power Company, American Electric Power Company, Inc. and others.

Execution: see Table.

Administration: Our best example of a CHP system is the one supporting the Phillips 66 (PSX) facility in Linden, NJ: “Linden Cogen Plant Gas Power Plant NJ USA” is owned by PSEG Power LLC, a division of Public Service Enterprise Group (PEG - see Table). The main purpose of this 1566 MW power plant is to provide Cogen-mode steam to the adjacent Bayway (Phillips 66) Refinery. It provides power to that refinery, and connects to the electrical grid operated by Consolidated Edison (ED) which provides power to the New York City and New Jersey markets.

Bottom Line: There are large up-front costs for building a cogeneration plant, but these pale in comparison to the long-term savings. But “the devil is in the details.” Plant engineers tend to focus on the avoided natural gas costs while assuming that the reliability benefit is approximately the same as for a Regular Electric Generation Facility. But it isn’t. Operating hours are lower and have a larger standard deviation. The key requirement for deciding to build a CHP plant is that it will provide steam for heating (and cooling) nearby buildings.

Risk Rating (for aggregate of 12 utilities): 4, where a 10-Yr T-Note = 1, S&P 500 Index = 5, and gold = 10. 

Full Disclosure: I dollar-average into NextEra Energy (NEE).

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Sunday, August 27

Week 321 - Managing Risk in a Stock Portfolio

Situation: Risk is the likelihood that the market will move against your position. You can use statistics to estimate the frequency and severity of such a move. That analysis starts by calculating the trendline for weekly price changes over multi-year periods (e.g. 20 years) by using the BMW Method. Looking at the S&P 500 Index (^GSPC), we see that prices have appreciated 4.9%/yr. In the upper left corner of that display, the Return Factor (RF) denotes the 0.68% reduction (or gain) of price at 2 Standard Deviations from trendline, i.e., a 32% loss (or gain). It has happened twice in the past 20 years. Prices rose almost 32% from trendline in early 2000 and fell more than 32% from trendline in 2008. We consistently list that predicted loss/gain for each stock at Column M in our tables, using a red highlight that percent is greater than 2 Standard Deviations from the percent for ^GSPC. For the non-professional, owning shares in such a stock represents a gamble. 

Mission: Screen stocks by using the BMW Method for the 20 year holding period, selecting those that do not appear to be a gamble, i.e., deviate 32% or less from trendline. Exclude any that aren’t in the 2017 Barron’s 500 List. Also exclude any that can’t beat SPY (the SPDR S&P 500 Index ETF) in terms of total return/yr over the past 10 years (Column C in the Table) and price appreciation over the past 20 years. We also exclude companies that don’t have a Finance Value (Column E in the Table) that exceeds that for SPY. Over 90% of the stocks passing these screens are Dividend Achievers. We have excluded the two that aren’t.

Execution: see Table

Bottom Line: You’re goal is to beat the lowest-cost S&P 500 Index Fund (VFINX) while incurring less risk, but you can’t do that unless your total return over a multi-year period is 2-3%/yr greater. Why? Because an active trader incurs significant transaction costs and capital-gains taxes, neither of which materially affect returns from VFINX. You’ll need a plan. Start by diversifying your investments and taking Warren Buffett’s advice to dollar-cost average. To keep transaction costs low, you’ll have to “cut out the middleman” and resort to an online service like computershare. It is designed to facilitate dividend reinvestment and dollar-cost averaging. 

Given that a large element of risk is introduced by selection bias, you’ll want to ameliorate that risk by investing in at least 20 companies and taking care to pick companies that have less statistical risk than the S&P 500 Index. This week’s Table has 22 for you to consider. 

Risk Rating (for aggregate of 22 stocks): 5 (where a 10-Yr Treasury Note = 1, the S&P 500 Index = 5, and gold = 10)

Full Disclosure: I dollar-average into JNJ and NEE, and also own shares of HRL, MMM, CNI, and ABT.

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Sunday, August 20

Week 320 - Key Players In The Food Chain That Have Tangible Book Value

Situation: As a stock-picker, you need to invest some of your assets in mature industries. Those are the industries where sales growth is a function of population growth. Companies in those industries typically retain value during recessions. Food & beverage companies are the prime example.

Mission: Set up a spreadsheet of key players in the food chain. Exclude any that do not have positive net Tangible Book Value. Why? Because the SEC requires that before a company can issue stock for sale on a public exchange. Include S&P stock and bond ratings, as well as key Balance Sheet debt ratios. Determine whether Free Cash Flow (FCF) covered company dividend payments for the last two quarters. Determine whether the company is an efficient deployer of capital by comparing Weighted Average Cost of Capital (WACC) to Return on Invested Capital (ROIC). The latter number should be at least twice the former.

Execution: see Table.

Administration: You’re a stock-picker because you think you have a strategy for beating a broad market index fund (e.g. SPY). You’re unlikely to succeed unless you avoid paying Capital Gains taxes until after you drop into a lower tax bracket (i.e., retire). Try to stick with companies that issue A-rated bonds and stocks, and practice other risk-reducing measures (e.g. deploy capital efficiently, have a clean Balance Sheet, and build a strong brand). 

You’re also unlikely to succeed if you invest in a volatile stock, i.e., one where the price varies more widely than the price of the S&P 500 Index. We identify that 3 ways:
1) Stock price change vs. change in the S&P 500 Index is greater in response to withdrawal of a key market support, e.g. the cost of taking out a loan or buying a house goes up 20%, or spot prices for key commodities go down 20% (see Column D in any of our Tables);
2) 5-Yr Beta exceeds 1 (see Column I in any of our Tables);
3) 16-Yr stock price volatility is statistically greater than S&P 500 Index volatility per the BMW Method, which we highlight in red (see Column M of any of our Tables).

Bottom Line: We have uncovered only 2 “buy-and-hold” stocks: Costco Wholesale (COST) and Coca-Cola (KO). Consider investing in a sector fund, e.g. SPDR Consumer Staples Select Sector ETF (XLP).

Risk Rating: 7 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)

Full Disclosure: I dollar-average into KO and MON, and also own shares of HRL, COST, AGU, and WMT.

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Sunday, August 13

Week 319 - A-rated Russell 1000 Companies With Tangible Book Value That Pay A "Good and Growing" Dividend

Last week, we surveyed A-rated companies in the 65-stock Dow Jones Composite Index with positive Tangible Book Value. It turned out there are 9 such companies for your Watch List. These 9 stocks constitute the latest version of our Growing Perpetuity Index (see Week 261 for background). This week, we survey all other companies in the Russell 1000 Index that pay a “good and growing” dividend and meet those requirements. There are 11 such companies, bringing the total number to 20.

Our Benchmark for companies that pay a “good and growing” dividend is the Vanguard High Dividend Yield ETF (VYM at Line 16 in the Table). That fund represents a subset of the Russell 1000 Index of the largest publicly-traded US companies which pay at least as high a dividend yield as the average for the full set. As it happens, all of the companies in the subset that have A ratings from S&P on their bonds and stocks are Dividend Achievers

Bottom Line: Our blog is centered on the idea that stock-picking can be a safe and effective way to save for retirement. These 20 companies in the Russell 1000 Index (including the 9 from last week) represent our best effort to create a concise “Watch List” for stock-pickers. But be aware: A safer and more efficient approach is to invest in the Vanguard High Dividend Yield ETF (VYM). Then you won’t be forced (through painful experience) to learn about economics.

Risk Rating: 6 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)

Full Disclosure: I own shares of HRL.

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Sunday, August 6

Week 318 - Growing Perpetuity Index: A-Rated Dow Jones Composite Companies With Tangible Book Value that pay a “Good and Growing” Dividend

Situation: You need a way to save for retirement that is safe and effective. We agree with Warren Buffett’s approach which is to use a low-cost S&P 500 Index fund combined with a low-cost short-intermediate term US Treasury fund. If you’re wealthy, make the stock:bond mix 90:10. If not, move toward a 50:50 mix.

If you’re a stock-picker but fully employed outside the financial services industry, find a formula that won’t require a lot of your time for oversight and maintenance. The S&P 500 Index has too many stocks, so stick to analyzing the Dow Jones Composite Index. Those stocks have been picked by the Managing Editor of the Wall Street Journal. Start with the 20 companies in that 65-stock index that pay at least a “market dividend” and are Dividend Achievers, i.e., have raised their dividend annually for at least the past 10 years. We call that shortened version The Growing Perpetuity Index (see Week 261). It also excludes companies with less than a BBB+ S&P Bond Rating or  B+/M S&P Stock Rating. But companies with with ratings lower than A- tend to develop problems, as do companies with negative net Tangible Book Value. (The SEC requires that the sale of newly-issued shares on a US stock exchange not dilute a company’s net Tangible Book Value below zero.) 

Mission: Revise “The Growing Perpetuity Index” to exclude companies with negative Tangible Book Value, as well as companies with an S&P Bond Rating less than A- or an S&P Stock Rating less than A-/M.

Execution: We’re down to 9 companies (see Table).

Administration: Our Benchmark for companies that pay a “good and growing” dividend is the Vanguard High Dividend Yield ETF (VYM at Line 14 in the Table). That fund represents a subset of the Russell 1000 Index of the largest publicly-traded US companies which pay at least as high a dividend yield as the average for the full set. As it happens, all of the companies in the subset that have A ratings from S&P on their bonds and stocks are Dividend Achievers

In next week’s blog, we highlight the 11 companies in VYM that aren’t in the Dow Jones Composite Index. Then you’ll need to track only 20 companies on your adventure into stock-picking! But be aware: 30% of those 20 companies are boring utilities, meaning that clear-eyed stock-picking isn’t glamorous at all. It’s just making money by not losing money, which is Warren Buffett’s #1 Rule.

Bottom Line: Stock-picking becomes a problem for non-gamblers at the Go/No-Go point, i.e., after 5 years of trying, you need to think about giving up if you can’t beat the total return/yr for an S&P 500 Index fund (SPY or VFINX) by at least 2%/yr. This is because you need to cover your greater transaction costs and capital gains taxes that are being expensed out. We’re suggesting that you start with 9 “blue chip” stocks that have a reasonable likelihood of letting you stay in the game after a 5 year probation period. Of course, you’d be opening yourself up to selection bias because there is a greater risk of loss vs. investing in all 500 stocks. Academic studies have shown that you’d need to own shares in at least 50 companies to largely overcome that risk.

Risk Rating: 6 (10-Yr Treasury Note = 1, S&P 500 Index = 5, gold = 10).

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

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Sunday, July 30

Week 317 - 2017 Barron’s 500 List: A-rated “Growth” Companies That Moved Up In Rank During The Commodity Recession

Situation: If you’re a stock-picker, your job description and mission is to beat the lowest-cost S&P 500 Index ETF (SPY) by ~3%/yr over 5 years. Why? To overcome the frictional costs of do-it-yourself investing, mainly transaction costs and erratic capital gains taxes. In last week’s blog, we highlighted hedging, i.e., over-weighting “defensive” stocks. This week we highlight growth, i.e., picking stocks that grow fast enough to compensate for the drag created by defensive stocks. You should do fine most years, if you invest in 15-20 companies from each category, follow their quarterly reports, and track industry trends. You’ll have to trade often, so find a way to keep trading costs down (~1% of Net Asset Value). 

Commodities anchor the economy, so the recent Commodity Recession (7/14-7/16) made it easy to see which companies are efficient, i.e., their “cash-flow-based return on investment” grew during that period. The Barron’s 500 List ranks companies by tracking that growth over the most recent 3 years.

Mission: Identify companies that moved up in rank last year. 

Execution: Eliminate companies that do not have S&P bond ratings of A- (or better) and S&P stock ratings of A-/M (or better). In the Table, emphasize Balance Sheet metrics (see Columns P-S). In the evaluation of Net Present Value (Columns V-Z), use a Discount Rate of 9%/yr and a Holding Period of 10 years. Assume that the investor pays the average transaction cost when buying or selling stock (2.5%). Highlight potential money-losing issues in purple.

Administration: This is where you come into the picture. You need to assemble information and make a choice. The Table has only 27 Columns of metrics, but it’s a start. Column Z (NPV) is a convenient summary of the combined effects of the current dividend, its rate of growth (using the past 4 years), and the approximate capital gain that would be realized upon selling the stock ten years from now (which is arrived at by extrapolating the 16-Yr CAGR in Column K). That NPV estimate is only as good as management’s ability to build the company’s Brand while maintaining a clean Balance Sheet. 

Bottom Line: The list has the names of only 9 companies. You’ll need to invest in more than 50 growth companies (to avoid Selection Bias). But these 9 are about as problem-free as any you’ll find. Why is it so difficult to identify reliably growing companies? Because growth never lasts. It has a beginning, a middle, and an end--when sales grow only as fast as the population in the company’s “catchment area.” Competition and innovation are huge factors. One cancels out the other over time.

Risk Rating: 6 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)

Full Disclosure: I own shares of TJX.

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