Sunday, January 8

Week 288 - Don’t Leave Money On The Table

Situation: This phrase originated with poker players. It speaks volumes and quickly came to be adopted first by the financial community, and now the First Lady. It means that you need to become aware of all the available ways to meet your goals, then find a path forward that is most worthwhile and comes with the least risk of damaging your finances. Yes, that requires you to surf the web for hours and talk with experts. But if your daughter is college-bound, you’d better help her apply for available scholarships and teach her how to draw up a “term list” for available loans. Make an appointment with her high school guidance counselor, then visit colleges with her.

The risk:reward ratio for the stock market isn’t as good as the bond market’s, but the bond market is considerably more opaque to the retail investor, and can only teach you how to grow your money slowly. The transparency of publicly-traded corporate stocks, combined with their being the most rewarding asset class, means that stocks will have to dominate your retirement savings (if you start late). There is enough information available on the internet that you can try for a long-term return of 9% a year. How? By investing in A-rated stocks that have been appreciating that fast for the past 25 yrs. If you are afraid of owning stock in such companies, that’s understandable, given that most would lose more than an S&P 500 Index fund in a market crash (see Column N in the Table). You can likely achieve a 9%/yr return at less risk by doing something as simple as dollar-averaging into the S&P 400 MidCap Index ETF (MDY), or Berkshire Hathaway (BRK-B) which is an agglomeration of over 100 mostly Mid Cap companies. 

Mission: Apply the 9% rule to the Dow Jones Composite Index (65 stocks) and the S&P 100 Index.

Execution: The companies we look at have a 9% trendline rate of price appreciation, meaning a Compound Annual Growth Rate (CAGR) calculated by the “least squares” method from weekly price points over the past 25 yrs. Stocks with a recent price trend that is two standard deviations above or below the trendline price are excluded, since there is no way to confidently predict that prices will return to the trendline. All companies are required to have at least an A- credit rating from S&P and at least an A-/M stock rating. The ratio of long-term debt to total assets cannot exceed 33% (see Column N in the Table). Tangible book value per share must be no less than -6%, which is the rate for Procter & Gamble (see Column O in the Table). Dividends over the past 6 months must have been paid from free cash flow (Div/FCF as noted in Column P of the Table). 

Administration: The main competition that corporate stocks face comes from corporate bonds of similar risk, which are bonds rated at the lowest “investment grade” level, i.e., below Standard & Poor’s BBB+ rating or Moody’s Baa1 rating. But bonds (or bond funds) with that rating don’t pay even half the 9% you stand to gain from well-research stocks issued by the largest corporations. For example, the interest rate for the average Moody’s US Baa corporate bond on 11/15/16 was 4.36%. Paybacks to stock investors, in the form of dividends and/or share repurchases, tend to track that Baa rate. When you own such a bond, the interest payment is made every 6 months (i.e., 2.18% of the amount you invested) and that check will reliably show up in your mailbox until the bond matures. 

Contrast that to the situation for high quality stocks in our Table, which have appreciated in price at least 9%/yr over the past 25 yrs (see Column K in the Table). Those had total returns of only 2.4%/yr during the 4.5 year Housing Crisis (see Column D in the Table), even though their total returns averaged ~10%/yr over the past 16 yrs, a period that included two severe recessions (see Column C in the Table). You get the picture, which is that you’ll have to own stocks and endure volatility if you waited until age 50 to start putting 15%/yr of your salary into a retirement plan. But if you had started saving that much at age 30, you could have taken a middle road, one where you would stand to double your money every 10 yrs (i.e., get a 7.2%/yr return), and do so with less risk, by investing in a low-cost bond-heavy mutual fund like the Vanguard Wellesley Income Fund (VWINX), which returned 4.9%/yr during the 4.5 year Housing Crisis (see Line 21 in the Table).

Bottom Line: Get out your pencil sharpener and green eyeshade, because making money from stocks is a lot of trouble. To simplify that task, stick with stocks issued by the largest corporations. Or, if you lack the time or interest to become a closet financier, invest in index funds that are composed of stocks issued by smaller corporations. Why a Mid Cap index fund? Because to get the 9%/yr price appreciation that is typical of Mid Cap growth stocks, without incurring their much greater risk of bankruptcy, you’ll need to hold positions in hundreds.

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

Full Disclosure: I dollar-average into 6 stocks in the Table (UNP, NKE, JNJ, NEE, MSFT, PG), and own shares in 6 others (CAT, MMM, HON, GD, WMT, EMR). 

NOTE: Net Present Value serves a valuable purpose, in that the calculation brings together the effects of dividend yield, dividend growth, and capital appreciation--while deducting 9%/yr from the dollars contributed by each of those cash flows. A positive NPV number means you’re not leaving money on the table--as long as you’re unable to find a safer investment that more reliably pays 10%/yr long-term. NPV is a retrospective analysis. If dividend growth were to fall below the trendline established over the past 10 years, NPV would go down. If price appreciation were to fall below the trendline established over the past 25 years, NPV would go down. But if increases were to develop in either, the Net Present Value of an investment made today would increase. The trick is to confine your attention to companies that have a clean Balance Sheet (see Columns N-P in the Table). But you also need to try balancing your stock picks across all 10 S&P Industries--to avoid the considerable risk that comes from selection bias.

Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 24 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 = 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 10-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 29 in the Table. The ETF for that index is MDY at Line 23.

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