Sunday, January 28

Week 343 - Raise Cash For The Crash

Situation: By now, you know that many are predicting that we are in the late stages of a bull market. Euphoria is the last stage, and in the present climate, one would expect that euphoria will begin happening as the new tax bill takes effect. Two or 3 years later, the stock market will over-correct to the downside and recession will likely soon follow. Now would be a good time for small investors to begin to protect themselves. One way to do that would be to “bulk up” on cash equivalents and Treasuries. The money you still have in equities will need to move in the direction of high-yielding Dividend Achiever type stocks. 

Why should we start making these changes now? Because the yield curve is flattening (see Appendix below), which is the best indicator that Financial Services professionals have to predict a market crash.

Mission: Draw up a portfolio of stocks and bonds that will carry you through a market crash relatively unscathed.

Execution: see Table.

Administration: There are 4 ways to raise cash for a crash.
   1) Have a Rainy Day Fund that covers 6 months of expenses and is inflation-protected. All of us resist maintaining this “Dead Money Account.” Why? Because it keeps taking money away from spending as our income increases. The trick is to make it painless by a) eliminating transaction costs, tax payments, and inflation risk, and b) paying into the Account automatically. Sounds great, but how? By going to the US Treasury website and directing that a transfer of $25+/mo be made from your checking account into an Inflation-Protected Savings Bond (ISB). Follow a First In/First Out (FIFO) policy when cashing-out your Rainy Day Fund, since you’ll lose an interest payment if you cash-out sooner than 5 years. Taxes are only due after you’ve drawn down the Account.

   2) Increase your Cash-Equivalents Allocation: dollar-average into 2-Yr Treasury Notes. Normally, this allocation is whatever cash cushion you like to maintain in your Savings, Checking, and Brokerage Accounts. But now isn’t a normal time. You need to plus-up those cash holdings and build a “backstop.” Why? Because there’s a material risk that your household will soon be living on less income (that is, a reduction upwards of 5%/yr). The easiest way to build a temporary backstop is to go back into and invest $1000 every 2 months in a 2-Yr Treasury Note. After 2 years, you’re done. You’ve allocated $12,000 that will start paying $1000 into your Checking Account every 2 months. Meantime, you can track the value of this investment through the ticker SHY (iShares 1-3 Year Treasury Bond ETF -- see Line 20 in the Table),  

   3) Reduce your Equity Allocation but retain Dividend Achievers with above-market yields. This week’s Table has suggestions that may assist you. Those stocks were chosen largely on the basis of a) high ratings from S&P, b) above-market yields, c) the likelihood of payouts continuing to increase in a recession, d) P/E ratios at or below market, and e) predicted losses in a bear market (see Column M in the Table) that are less than or equal to those predicted for the S&P 500 Index (at Line 20). When the crash hits, you will be tempted to sell these (your most crash-resistant stocks) because you’re afraid they’ll fall further. Don’t. Instead of reinvesting dividends, just have the dividend checks sent to your mailbox. If you aren’t a stock picker, simply invest in VYM (Vanguard High Dividend Yield ETF at Line 17 in Table) and XLU (SPDR Utilities Select Sector ETF at Line 14).

   4) Increase your Fixed-Income Allocation: dollar-average into 20+ Yr Treasury Bonds. In a Bear Market, you may need to raise cash by selling assets. You might want to sell assets that have temporarily spiked upward in value because stocks are crashing. Only one asset that will predictably do that for you: 20+ Year Treasury Bonds, which are already being bought up and flattening the yield curve (see Appendix below). These are the Treasuries you’ll be buying, and later turning around to sell. So, you’ll need to have a brokerage account that is fee-based (that is, you’re charged ~1% of Net Asset Value/yr in return for transaction costs being waived). Then dollar-average into TLT (iShares 20+ Year Treasury Bond ETF at Line 15 in the Table). Sell those when you think the stock market has bottomed, and spend the proceeds on stocks in that Fire Sale. 

Bottom Line: To avoid sleepless nights and migraine headaches, pull in your horns now. Stop gambling (but restart after the market collapses). Build up your Rainy Day Fund, and invest in cash equivalents, high-yielding high-quality stocks, and long-term Treasuries. When the crash hits, people will tell you to stop buying stocks altogether. Why do they say that? Because nobody can say for sure how long the market will keep going down. But Walmart (WMT) and McDonald’s (MCD) will be booming, even while layoffs in the Industrial Sector continue to make headlines. The End of the World isn’t happening. Get over it. Read the Wall Street Journal. When the Bear looks to be getting tired, call your stock broker and buy.  

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

Full Disclosure: I dollar-cost average into NEE and TGT, and also own shares of PEP, PFE, HRL, and MO. I am executing on the 4 suggestions above for raising cash.

APPENDIX: The yield curve is Flattening. What does that jargon term mean? Savvy investors are moving money out of growth stocks and into Long-Term Treasuries, even while the Federal Reserve is raising Short-Term interest rates. It doesn’t make sense. Long-Term rates would typically move up in tandem with Short-Term rates, provided the economy is truly gaining strength. 

You can follow that increase in Long-Term Treasury Bond prices (which move in the opposite direction of interest rates) by going to Yahoo Finance and entering TLT (for iShares 20+ Yr Treasury Bond ETF). Click on “chart” and select the 2 Year chart. Then on “indicator” and choose a 200-day moving average. That will show the steady upward movement in the price of those bonds—because buyers outnumber sellers. That results in a steady downward movement in the rate of interest being earned by new buyers, which flattens the yield curve. 

There are several explanations why Long-Term interest rates might fall even as Short-Term rates are rising: “the the simplest: markets are losing confidence in the Fed’s ability to raise [Short-Term] rates without inflation sagging.” You might want to learn more about the falling yield curve, so read on.

"The 2 and 8 Club" (CR) 2017 Invest Tune

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Sunday, January 21

Week 342 - Industrial Companies in “The 2 and 8 Club” (Extended Version)

Situation: There are many industrial companies that enjoy good earnings over long time intervals. But these earnings are yoked to the economic cycle and tend to be volatile. This unsettles investors. Companies in the Financial Services, Consumer Discretionary, and Information Technology industries face the same problem. However, those 4 industries are also responsible for most of the growth in the US stock market. Stockpickers have to either stare at ugly “paper losses” from time to time, or behave like retail investors and “buy high, sell low.” For the former group, which has absorbed losses, studies show that they’ll spend 4% less money on consumer goods than customary. But when the stock market is up a lot, they’ll spend 4% more. The mechanics of maintaining what you’ve obtained may be difficult to explain to your life partner, but your heirs will understand. The harder part (for your life partner) is to understand why you allocate more money to the stock market when its down but less when its up!  

The takeaway message from this is that money needs to be taken “off the table” when the market is frothy, and spent. With the current market, now would be a good time to start doing that. At every one of Berkshire Hathaway’s annual meetings that I’ve attended, Warren Buffett reprises his famous quote: “Be fearful when others are greedy and greedy when others are fearful”. In other words, allocate more of your income to the stock market when the economy is in a slump. Baron Rothschild put a fine point on it 202 years ago, when he profited mightily from the defeat of Napoleon at the Battle of Waterloo: “Buy when there’s blood in the streets, even if the blood is your own”. Caveat Emptor: The opposing argument, that “timing the market” never works, is widely respected.

Mission: If you want to at least keep up with the S&P 500 Index, you’ll have to focus much of your research on industrial stocks. So, here are 6 industrial stocks that 1) pay good & growing dividends, and 2) are highly rated by S&P and Morningstar. See our Week 329 blog for a detailed explanation of how we pick stocks from the Barron’s 500 List that have at least a 2% dividend yield and an 8%/yr dividend growth rate (over the previous 5 years). 

Execution: see Table.

Bottom Line: Industrial companies take advantage of a growing economy. However, their stock prices fluctuate more widely than most investors can tolerate. You have to be a bit of a gambler to become an enthusiast. Over the long term, you’ll grow to be happy with the rewards. Just don’t expect your risk-adjusted total returns to be any better than you’d realize from owning shares in an S&P 500 Index fund, unless your hobby is to analyze industrial companies. To do so, it helps if you decide that only a few companies are likely to reward the time you spend on their study. We think the 6 industrial companies in “The 2 and 8 Club” are worth your time (see Table).

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

Full Disclosure: I dollar-cost average into MMM, and also own shares of CMI and CAT.

"The 2 and 8 Club" (CR) 2017 Invest Tune

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Sunday, January 14

Week 341 - Companies in “The 2 and 8 Club” with Strong Global Brands

Situation: You’d like to own stocks that won’t give you heartburn when the market crashes. There are only two ways a company can predictably weather a recession better than others in its industry. By having 1) a clean Balance Sheet (see Columns P-S in any of our Tables) and/or 2) a strong Global Brand. During a recession, consumers will have less money to spend because they’re not making as much. They’ll cut back on frills but keep spending on necessities marketed by companies they respect. Economists call such spending inelastic, and also speak of those companies as having a strong brand. Accountants struggle to define brand value, even though it obviously runs to the billions of dollars for a number of companies, so they call it an intangible asset.  

Mission: Use our Standard Spreadsheet to analyze the 33 companies in the Extended Version of “The 2 and 8 Club” (see Week 329), selecting only those that have a Top 500 Global Brand.

Execution: see Table, where all 21 such companies are ranked by brand value in Column AC.

Administration: We need to know what fraction of sales for each company originate outside the United States. That information should be in every company’s Annual Report but is often missing. Perhaps the reason is that those companies often retain revenues in the country of origin (to avoid double taxation should revenues be repatriated to the USA). But we know that Microsoft, the largest company in this week’s Table, draws more than 60% of its revenues from outside the United States. Over the past 5 years, I have seen two articles estimating that 45-50% of all revenues for S&P 500 companies occur outside the United States.  

For you to attempt to own shares in a third or half of the 21 companies on our list (see Table), you’ll need to keep track of two variables: 1) Dividends (Yield & Growth rates), and 2) Global Brand value. Both will change over time. Brand values are easy to follow (see link above). But some companies will mature in their market and no longer be able to grow dividends faster than 8% a year. A company might cut its dividend, in which case it would no longer be listed in the US version of the FTSE Global High Dividend Yield Index. There will also be new members of “The 2 and 8 Club.”

To move in and out of positions as indicated by your research, you’ll have to become an active stock trader. Dollar-cost averaging is still a good idea, but you’ll likely find that an online Dividend Re-Investment Plan (DRIP) doesn’t have the flexibility you’ll require. A recent study of 13 broker-dealers offers detailed information about those that have the low transaction costs and attractive reward programs. Ally Financial (ALLY) is their top-ranked brand.

Bottom Line: There are only two ways a company can insulate itself from a looming recession: 1) maintain a Clean Balance Sheet, and 2) keep making money because of having a strong Global Brand. This week’s Table highlights 21 brand leaders, over half of which have clean Balance Sheets.

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

Full Disclosure: I dollar-cost average into MFST, MMM, IBM, KO and JPM, and also own shares of MO, TRV, PFE, CAT, and TXN.

"The 2 and 8 Club" (CR) 2017 Invest Tune

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Sunday, January 7

Week 340 - Financial Services Companies in “The 2 and 8 Club”

Situation: Ten years ago, you were probably burned in the recession by owning stocks (or bonds) served up by the Financial Services industry. OK, I’ll give you that. But now the industry is back on its feet and paying good dividends, and your job is to invest. “Once bitten, twice shy” can’t be your approach. Instead, you need to know a little about when to get in and when to get out. Why? Because it’s one of the two industries where you stand to make a lot of money--the other being Information Technology. You can’t be a stockpicker and keep up with the S&P 500 Index unless you invest ~15% of your stock portfolio in each of those.

The leading company in this space is Berkshire Hathaway, which is an insurance company that makes side bets by using income from premiums (while waiting for claims to be filed). This sounds easy but it all depends on the quality of those side bets and the amount of cash set aside to pay claims. Greed will doom that project, which is why Berkshire’s CEO (Warren Buffett) says “be fearful when others are greedy and greedy when others are fearful.” These days, he must think that others are being very greedy because he has set aside over $100 Billion in cash. But, with Berkshire Hathaway being an insurance company, recent hurricanes have already shrunk that pile of cash by $3 Billion.

Mission: Run our standard spreadsheet for Financial Services companies in “The 2 and 8 Club” (see Week 329). 

Execution: see Table

Administration: Let me use an example to explain why banks can be so profitable. Banks set a price on your use of their money. That interest rate has to appear attractive or you won’t sign up for a repayment plan. If the counterparty (loan officer) thinks the project is too risky, she can still make the loan at an attractive rate, provided that the collateral (e.g. your home) becomes bank property if you default on the loan and is worth enough to cover the bank’s risk. 

Let’s say you need money to dig a gold mine. Chances are, that won’t “pan out” and the bank will have to claim collateral, i.e., all or part of the tangible assets (land, equipment, and structures that you purchased with their money). But sometimes the mine “proves up” and you’ll want to expand it. The loan officer is happy to extend credit because now there is new collateral (gold). The bank will accept a royalty in lieu of repayment. If you are a stockholder in a bank that specializes in loaning money to gold (or silver) mining companies (see Week 307), your payoff is much greater than it would be from owning a mutual fund of gold mines, e.g. VanEck Vectors Gold Miners ETF (GDX). Go to Lines 19-21 in the Table and compare Royal Gold (RGLD, a company that finances gold mines through royalty agreements) with the total returns from owning a gold bullion ETF (GLD) or stock in GDX. You’ll see that RGLD is a reasonably good investment (indeed, it’s a Dividend Achiever), whereas, GLD and GDX are anything but.  

Bottom Line: The reality is that the hopes and dreams of people who are “cash short” can be fulfilled by borrowing money, and their risk of a crippling loss from various enterprises can be reduced by taking out insurance. The bank (or insurance company) wins, even if the borrower defaults on the loan (or is wiped out by a natural disaster). In fact, it often prefers that outcome. Over time, the bank’s Return on Equity (ROE) can be amazing, say 15-20%. But the bank may be funding those loans with too much borrowed money (e.g. more than 20-25 times the amount of cash equivalents and stock that is backing those loans). On the other hand, when ROE grows because the bank is able to sell the assets it acquires at a nice profit (or the insurance company is able to double its premiums on new contracts because recent disasters proved that premiums had been too low), the risk-adjusted returns for stockholders are very good.

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

Full Disclosure: I dollar-cost average into J. P. Morgan Chase (JPM), and also own shares of The Travelers Companies (TRV) and Berkshire Hathaway (BRK-B).

"The 2 and 8 Club" (CR) 2017 Invest Tune

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