Sunday, January 1

Week 287 - Learn To Earn 9%/yr From Stocks Long-term

Situation: It is not difficult to pick 6 defensive stocks that will earn 6%/yr long-term (see Week 269). But try to pick 6 diversified stocks that will earn 9%/yr long-term without scaring you half to death. That is an order of magnitude more difficult but can be accomplished. Along the way, you’ll learn how not to “leave money on the table.

Mission: Produce a spreadsheet that incorporates key tactics for picking stocks, limiting the sample to stocks in the S&P 100 Index that 1) had total returns/yr of at least 9% over the past 16 and 25 yr stretches; 2) had total returns/yr of at least 0% during the Housing Crisis (4/07-10/11); 3) have at least a market yield (currently 1.9%); 4) have had dividend growth of at least 9%/yr over the past 5 yrs; 5) have had trendline (“least squares” method) price growth of at least 9%/yr over the past 25 yrs; 6) have a clean Balance Sheet, meaning that long-term debt is no greater than 1/3rd of total assets, the company has Tangible Book Value (barring temporary short-term indebtedness to complete an acquisition), and the company is able to pay dividends from Free Cash Flow; 7) the S&P rating on the company’s long-term debt is no lower than A-; 8) the S&P rating on the company’s stock is no lower than B+/M.  

Execution: We find 6 companies that satisfy all requirements (see Table).

Administration: For efficacy, the key tools we use are to 1) select from a pool of “mega-cap” companies, specifically those in the S&P 100 Index because it has an important safety feature: efficient “price discovery” based on the requirement that listed companies actively trade put and call options at the Chicago Board Options Exchange (CBOE); 2) demonstrate that Net Present Value is a positive number when using a 9% Discount Rate and 10-yr Holding Period. For safety, our key tools are to 1) calculate 3 ratios for determining whether or not the company has a clean balance sheet, and 2) select from companies that have a market yield or better. 

Bottom Line: Stock-picking at this level requires research time, focus, money, and enough discipline to avoid the two great dangers that Warren Buffett has identified: “I’ve seen more people fail because of liquor and leverage — leverage being borrowed money.” Getting a 9%/yr return over time is mainly about amortizing risk through diversification, which can be accomplished more safely and efficiently by dollar-averaging into a “Mid Cap Blend” index fund, like the SPDR MidCap 400 Index ETF (MDY), or Berkshire Hathaway (BRK-B) which is an agglomeration of 100 mostly Mid Cap companies. During the Housing Crisis (4/07-10/11), MDY and BRK-B had total returns/yr of -0.7% and -0.3%, respectively (see Column D in the Table).

Caveat: By “shooting for the moon” like this, you will hone your stock-picking skills but also lose a lot of money from time to time (at least on paper). In other words, you would be fully committing to market risk. So, start by regularly investing small amounts in MDY and BRK-B. Then pause to reassess. Move on to Blue Chip companies (i.e., the 30 companies in the Dow Jones Industrial Index) that carry low risk and almost meet our criteria, such as Procter & Gamble (PG at Line 11 in the Table), which only grows dividends 5.0%/yr. PG clears our other hurdles and has a positive NPV at the 9% discount rate (see Column Y in the Table). 

Risk Rating: 6 (where 10-yr Treasuries = 1, the S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into UNP, PG, and NEE, and also own shares of AAPL, HON, CAT, and MMM.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 17 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 (no dividends collected in 10th year), Initial Cost = average 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 5-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline (“least squares”) CAGR found at Column K ( Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table. The ETF for that index is MDY at Line 16.

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