Sunday, July 3

Month 132 - Learn the Dow - July 2022

Situation: We’re experiencing a market crash, which means it is a bad time to be a risk-on growth investor. But it’s OK if you’re a risk-off value investor. Wall Street professionals used to be so risk-off that Henry Paulson, the Secretary of Treasury and former CEO of Goldman Sachs, had a personal investment account composed almost entirely of bonds. 

As a stock-picker, you need to pay attention to companies that Wall Street professionals think are representative of the US economy, such as the 30 companies in the Dow Jones Industrial Average (DJIA). Twenty-one of those are value companies, in that they reliably pay an above-market dividend yield. Value stocks are outperforming growth stocks this year by ~20%. However, growth has outperformed value in 18 of the last 28 years

Growth is about future production (difficult to measure), whereas, value is about current production (easy to measure). Growth stocks underperform value stocks when the path forward for growth is uncertain. If the Federal Open Market Committee (FOMC) concludes that the economy is overheated, it will raise short-term interest rates to dampen demand. That will pull investors away from growth companies. Why? Because the cash flows of growth companies are expected to accelerate in the future. Therefore, those flows are discounted at the “Risk-free Rate”, which is understood to be the rate of interest paid on a 10-yr US Treasury Note. That rate will go up whenever the FOMC starts to raise short-term interest rates. Growth stocks have more price volatility than value stocks because estimates for future earnings growth are to some extent a matter of speculation about what the FOMC is going to do about interest rates. 

The value of any stock depends on its price volatility relative to earnings growth. If the volatility statistic (5-yr Beta) is too high and earnings growth is too low, you might be better off investing in Risk-free Zero-cost 10-yr US Treasury Notes. To manage that risk, you need to know the Required Rate of Return (RRR). The RRR for a stock or business is calculated by using the Capital Asset Pricing Model or CAPM. RRR is the total return per year that must be achieved to eliminate the material risk that the Risk-free Rate (return on a 10-yr US Treasury Note) will prove a better investment. First you need to know the Market Return (MR), which is the total return over interval X of an S&P 500 Index ETF like SPY. Second, know the Risk-free Rate (RfR) for the Vanguard Intermediate-Term Treasury Fund (VFITX) over interval X. Third, know the 5-yr Beta for the stock in question. RRR = RfR + 5-yr Beta multiplied by (MR - RfR).

Mission: Use our Standard Spreadsheet to analyze DJIA companies.   

Execution: see Table.

Analysis: Warren Buffett’s favorite metric is addressed in Column V of the Table: Return on Tangible Capital Employed. He thinks anything higher than a 20% return for the last fiscal year (lfy) is a good number. Ten of the 30 companies meet that standard: MRK, MSFT, V, CSCO, PG, AAPL, AMGN, HD, JNJ and MMM. His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (see Column AQ) and is negatively impacted by the degree to which managers choose to capitalize their company by issuing long-term bonds instead of common stock (see Column Z). Twelve companies have a BUY rating from Morningstar (CRM, NKE, MSFT, CSCO, BA, DIS, HON, VZ, JPM, INTC, GS and MMM) and 15 companies have a Long-term Debt to Equity ratio that is less than 1.0 (CRM, NKE, UNH, MRK, MSFT, V, CSCO, PG, DIS, JNJ, INTC, CVX, WMT, TRV and GS). Mr. Buffett also states that a high Free Cash Flow Yield (Column L) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost. Twenty-six companies (CRM, NKE, UNH, MRK, MSFT, V, CSCO, PG, AAPL, MCD, AMGN, AXP, HD, DIS, HON, JNJ, KO, JPM, INTC, WBA, CVX, TRV, CAT, MMM, IBM and DOW) have Free Cash Flow left over after paying dividends. His third point (that the stock be available “at a sensible price”) is addressed by the 1 year and 3-5 year Forward PEG ratios (see Columns Q and R): Eight companies have PEGs under 2.0 at both time points (CRM, NKE, UNH, DIS, HON, CAT, MMM and IBM). In summary, 6 companies (CRM, NKE, MSFT, CSCO, DIS and MMM) are cited 4 times. 

Bottom Line: Value investing is about owning stock in companies that offer goods and services people need rather than want. Demand is inelastic to price because people keep buying in the same quantities ( People keep buying food, toothpaste and internet service; diabetics keep buying insulin; businesses keep contracting for kilowatt-hours of electricity, and governments keep buying defense goods. 

Risk Rating: 7

Full Disclosure: I dollar-average into NKE, MRK, MSFT, PG, JNJ, VZ, INTC and WMT, and also own shares of CRM, UNH, CSCO, MCD, BA, HD, HON, KO, JPM, CAT, MMM and IBM.

Note: Eleven stocks have a 16-yr Total Return (Column E) that is less than the Required Rate of Return (Column D): CSCO, BA, AXP, DIS, JPM, WBA, CVX, CAT, GS, MMM and IBM.

"The 2 and 8 Club" (CR) 2017 Invest Tune All rights reserved.

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