Sunday, May 27

Week 360 - “The 2 and 8 Club” (Extended Version)

Situation: Market turmoil is turning stock and bond index funds into a “crowded trade.” Both are momentum investments, and both remain overvalued. Neither offsets the risk of the other. This is a good time to take some chips off the table and bulk-up your Rainy Day Fund. More importantly, it is a time to revisit the fundamentals of sound investing. For example, stop making “one-off” stock investments. Those are usually speculative. But follow Warren Buffett’s lead and continue to invest in strong companies by dollar-cost averaging. Those are “forever” investments that will likely prove worthwhile, through bear markets as well as bull markets, as long as you stay the course.

But how do we find “strong” companies? Experienced traders mainly offer 5 qualifiers: Look for 1) large and 2) well-established companies that have 3) strong Balance Sheets, and pay a 4) good and 5) growing dividend. We have converted those into numbers on a spreadsheet, and call it “The 2 and 8 Club.” We start by looking at the companies in the S&P 100 Index because those are required to have a robust market in Put and Call options (which facilitate Price Discovery). Approximately 20 of the 100 earn membership in our Club. Approximately 10 more companies on the Barron’s 500 List meet our requirements, allowing us to create an ~30 stock list (the Extended Version).

Mission: Produce a spreadsheet of the ~30 companies in the Extended Version of “The 2 and 8 Club.”

Execution: see Table.

Administration: What are our criteria for meeting each of the 5 qualitative objectives?

Large companies
Those are the 500 on the Barron’s 500 List published each May (see Columns N & O in our Tables).

Well-established companies
Those are the companies on the Barron’s 500 List that are also on the 16-Yr list of companies that are quantitatively evaluated each week by using the BMW Method. See Columns K-M in our Tables.

Strong Balance Sheet
Companies must have an S&P Bond Rating of BBB+ or higher (Column T in our Tables). For more granularity on this topic, we provide key metrics: Long-Term Debt as a percent of Total Assets (Column P), Operating Cash Flow as a percent of Current Liabilities (Column Q), Tangible Book Value per Share as a percent of Share Price (Column R), Dividend Payout as a percent of Free Cash Flow (Column S), Weighted Average Cost of Capital vs. Return on Invested Capital (Columns Z and AA). Values in those 6 columns that we think of as sub-par are highlighted in purple.

Good Dividend
Companies must be listed in the FTSE High Dividend Yield Index (US version). Those are the ~400 companies in the Russell 1000 Index that are judged by The Financial Times editors to have a dividend yield that is reliably above the market yield of approximately 2% (see Column G). The most convenient investment vehicle for that is the Vanguard High Dividend Yield ETF (VYM). The list is updated monthly, and you can access holdings here.

Growing Dividend
We require companies to have increased their dividend payout at least 8%/yr over the past 5 years (see Column H), as determined by calculating the Compound Annual Growth Rate (CAGR) for the most recent 4 quarters of regular dividend payouts vs. the same 4 quarters 5 years ago.

As a sanity check, we require that companies have historic returns relative to risk that is within reason for the retail investor, i.e., an S&P Stock Rating of at least B+/M (see Column U). 

Finally, there are two important caveats that you need to keep in mind: 1) No one invests solely on the basis of numbers. The story behind a company’s stock has to be examined by using multiple online sources, and revisited at least monthly. 2) Every investor needs a Watch List to help her get started with each month’s research. “The 2 and 8 Club” is our Watch List. 

Bottom Line: If you’re a downhill ski racer, your goal is to get to the Bottom Line safely and quickly. “Safely” is accomplished by setting up a few gates with line judges, and allowing you to “shadow” the course the night before. “Quickly” is assessed by using a stopwatch, combined with a video camera trained on the finish line. In other words, the activity is standardized to allow comparison with other racers and place limits on sanity. Stock picking isn’t much different. You need a starting place, a process governed by sanity checks, and a way to judge your performance. “The 2 and 8 Club” satisfies those basic needs. It will help give you a chance to outperform an S&P 500 Index enough to pay for the additional transaction costs and capital gains taxes that you’ll incur.

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

Full Disclosure: I dollar-average into MSFT, NEE, PEP, JPM, CAT and IBM, and also own shares of TRV, MMM, CSCO and CMI.

"The 2 and 8 Club" (CR) 2018 Invest Tune All rights reserved.

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