Situation: The stock market is overpriced, and will remain so until bonds pay enough interest to compete with stocks toe-to-toe. I doubt that will happen in the next few years, given that inflation-adjusted 10-yr Treasury Notes are selling very well while paying only 0.42% interest, as of 11/1/14. (Full disclosure is needed here: I admit to being a recent buyer.) So, let’s identify and discuss the next best thing to bonds for stabilizing a retirement portfolio. Are there any large-capitalization US stocks left that are reasonably priced?
Good question, and a hard one to answer. The exchange-traded fund for the S&P 100 Index is OEF (Line 19 in the Table). As expected, it has similar metrics to VFINX, Vanguard’s S&P 500 Index fund (see Line 20). But there are interesting differences. OEF can be considered to be a tad less risky because it pays a little higher dividend, has a little lower 5-yr Beta, lost a little less during the Lehman Panic, and has a 15% lower P/E. With respect to the key metric for someone who is saving for retirement, it has 70% higher dividend growth (Column H in the Table). The S&P 100 Index is the place to look for a good retirement stock, particularly when the market is overvalued. Why? Because that’s typically a time when mid-cap and small-cap stocks are even more overvalued than usual.
How can you be sure a stock isn’t overpriced? The best comparison to make is to examine its price in regards to its Tangible Book Value (TBV). If price/TBV is less than 3, the stock isn’t overpriced. We set the cutoff point twice as high in our assessment, at ~6 (see Column O in the Table). Our reason for doing that is to ensure that we identify stocks that have true value. Next, we look at EV/EBITDA: Enterprise Value (market value of all the stocks and bonds used to capitalize the business) divided by Earnings Before Interest, Taxes, Depreciation, and Amortization (i.e., "operating earnings" to an accountant). Cash spent on new projects is not considered in EV/EBITDA, and neither is the cash spent to buy and service loans. EV/EBITDA can be very revealing. For example, Costco Wholesale (COST) has a P/E of almost 30 but its EV/EBITDA is less than half that (see Columns J and K in the Table).
Another helpful metric is Dividend Payout (Column L in the Table). If a company is sending more than half its profits to shareholders, it won’t have much Free Cash Flow left to produce and market more and/or better products. That means the company’s managers will probably need to borrow money to expand. Issuing more stock isn’t as attractive to them as issuing a bond or borrowing from a bank, since the revenue that will be used to pay interest on that loan isn’t taxable. Choice #1 (using Free Cash Flow to expand) increases TBV, whereas, Choice #2 (borrowing money to expand) reduces TBV.
Bottom Line: After all the number crunching, we find that there are 10 companies in the S&P 100 Index that are reasonably priced and carry high ratings from S&P on both their stock and bond issues.
Risk Rating: 6
Full Disclosure: I dollar-average into WMT and MSFT.
NOTE: Metrics in the Table are current as of the Sunday of Publication.
Post comments below, or email to: irv.mcquarrie@InvestTuneRetire.com
Showing posts with label 5 yr beta. Show all posts
Showing posts with label 5 yr beta. Show all posts
Sunday, December 14
Sunday, July 20
Week 159 - Focus on “Compound Interest:” A Watch List of 77 Companies
Situation: If you’ve been reading this blog for long, you’re familiar with what we think is the “best” way for small investors to save for retirement, namely, the Vanguard Balanced Index Fund (VBINX), a low-cost hedged version of the S&P 500 Index. Recently, Warren Buffett went on the record and advised retail investors to use low-cost Vanguard index funds. His suggestion is to invest 90% of your retirement account in the Vanguard 500 Index Fund (VFINX) and the remaining 10% in the Vanguard Short-Term Treasury Fund (VFISX). Unfortunately, neither of these two approaches will pay you much of a dividend, and what dividend yield there is (plus its growth rate), barely keeps pace with inflation. In retirement, portions of those index funds would need to be sold every so often for you to fully benefit from that type of savings plan. From a budgeting standpoint, it makes more sense to receive income regularly from stocks (via dividend checks sent to you) while preserving the principal (your initial investment).
If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146).
This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.
The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.
Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).
The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.
Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.
Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.
Risk Rating: 4
Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.
If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146).
This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.
The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.
Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).
The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.
Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.
Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.
Risk Rating: 4
Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, May 18
Week 150 - Our Current List of Hedge Stocks
Situation: Our favorite way to look at risk is to make a guesstimate of what would happen to retirement investments in a bear market. Recall that a bear market occurs when the S&P 500 Index falls more than 20% from its most recent peak. That’s a different question than calculating what happens to those investments in a recession. Why? Because bear markets, such as the one-day 22% collapse in 1987, don’t necessarily presage a recession. The famed economist Paul Samuelson once quipped that “the stock market has called 9 of the past 5 recessions.”
Some of the stocks in your portfolio need to be “downturn resistant” because, during a downturn, you are more likely to have financial difficulties and need to sell some assets to tide you over until better times. Perhaps you’ll have enough Treasury Notes and Savings Bonds for those to act as a safety net. If not, you'll need to either sell some stocks, or go deeper in debt. If you decide to sell some stocks, you’d rather not take a loss. The idea of having a few such Hedge Stocks is that those are unlikely to show much price depreciation in a market downturn. Even Warren Buffett, who counsels investors never to close out a good position, sold his entire large block of Johnson & Johnson shares going into the Lehman Panic. The proceeds were used to help assemble $26B in loans to six companies that badly needed capital (General Electric, Goldman Sachs, Bank of America, Dow Chemical, Swiss Re, and Mars Candy). His first loan of $5 Billion was to Goldman Sachs on 9/24/08--9 days after Lehman Brothers Holdings filed for bankruptcy. That heralded the Federal Government’s “bailout” of Wall Street banks in mid-October 2008, using almost half the $700B in “TARP” funds that was for a different purpose (i.e., to buy up mortgage-backed securities from the 7 surviving Wall Street banks). Warren’s timely display of confidence in Wall Street probably had more to do with averting another Great Depression than did the dollar amount of all the loans. Remember: Confidence in a company’s future is what impels investors to buy stock, not it’s balance sheet.
What else makes a company’s stock price go up or down? We need to examine that before we can understand the idea of a hedge stock. There are really only two factors to consider: 1) Is the stock over-priced? 2) Is the story broken (e.g. will the company collapse in a market panic)? “Overpriced” means that the 5-6%/yr rate of return realized by cautious investors throughout recorded history no longer applies. Note: that expected rate of return will stick close to the nominal rate of GDP growth, which in the USA has been 5-6% until recently. In other words, the price for a share of stock has to be less than 20 times the most recent 12 months of earnings per share to realize more than a 5% return. With lower returns, there is a valuation problem and hedge fund traders will be drawn to bet against (or short) the stock. You can easily find out if the P/E is over 20 by checking Yahoo Finance on your smartphone.
The second question is much harder to assess: Does the story that supports confidence in a company’s future stream of earnings still apply? Or is the story broken? This terminology dates to medieval Italy, where a banker would sit at a bench (banca) in the town square. If he ran out of money, the bench would be broken in front of him (banca rotta), later transliterated to “bankrupt.”
For any widely-held company, there is always a steady production of articles, blogs and TV commentators pointing to “factlets” suggesting that the story is broken. That’s how media outlets attract advertisers and readers (i.e., by creating anxiety). Quite simply, it is human nature to undermine a money-making story, particularly when you haven’t been a beneficiary.
This makes it important to do your own “story” research for stocks that you own or want to own. For hedge stocks, researching the story is a little easier because they’re never “barnburners.” There’s no chance they’ll light up the investment universe, except of course for the “bond gnomes” off in a corner who would happily loan money to such companies. In a bull market, hedge stocks struggle to keep up with the S&P 500 Index but over the long term they’ll probably make money for their shareholders because of being downturn-resistant. When the stock market cracks, these companies don’t. Thus, it turns out that hedge stocks are not that hard to research. Their history of performance is one of limited price fluctuations, whether the market is headed up or down.
We use the hedged S&P 500 Index as our benchmark and guide for finding hedge stocks. These stocks are buried in that hedged index (The Vanguard Balanced Index Fund or VBINX). It is hedged in both directions: You are insulated from a market crash by its 40% allocation to high-grade bonds. Likewise, you benefit from market exuberance because the 60% allocation to stocks references an index of the 1000 largest companies. In other words, riskier mid-cap company stocks are included. Their high 5-yr Betas pull VBINX’s 5-yr Beta up to 0.91 from 0.6, which is where you’d expect for an index composed of 60% S&P 500 stocks and 40% high-grade bonds. That "balanced fund" strategy works because VBINX sank only 60% as far as the S&P 500 Index during the Lehman Panic (Column D in the Table), and has performed 50% better since 9/1/00, which is when the S&P 500 Index reached its inflation-adjusted high.
We also look for other metrics that are likely to prevent a hedge fund trader from betting against a company’s stock. These include: a dividend yield of at least 1.5%, outperformance relative to VBINX over both the short-term (5 yrs) and long-term, a P/E no greater than 22 (for the last 4 quarters of reported earnings), a Finance Value (Column E in the Table) that beats VBINX, a 5-yr Beta under 0.7, and an S&P bond rating of at “A-” or better. Metrics that underperform VBINX are highlighted in red.
Bottom Line: The value of owning a hedge stock is that you don’t need to hedge your downside risk by making an equivalent investment in a 10-yr Treasury Note or an inflation-protected Savings Bond. But our screen of S&P 500 companies turns up only 15 hedge stocks, even after bending our standards a little (Table). Twelve of the 15 are in “defensive” industries--utilities, consumer staples, and healthcare. Those 12 are what we call “Lifeboat Stocks” (see Week 106). McDonald’s (MCD), VF Corporation (VFC), and IBM are the only exceptions. If the market were not currently going through an overpriced moment, more companies would qualify. Of course, after a market collapse our search will become easier but that will also be when everyone (aside from Warren Buffett) is averse to investing. He has put a fine point on it: “Only when the tide goes out do you discover who's been swimming naked.”
Risk Rating: 4.
Full disclosure: I dollar-average into DRIPs at computershare.com for WMT, NEE, IBM, JNJ, and KO.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Some of the stocks in your portfolio need to be “downturn resistant” because, during a downturn, you are more likely to have financial difficulties and need to sell some assets to tide you over until better times. Perhaps you’ll have enough Treasury Notes and Savings Bonds for those to act as a safety net. If not, you'll need to either sell some stocks, or go deeper in debt. If you decide to sell some stocks, you’d rather not take a loss. The idea of having a few such Hedge Stocks is that those are unlikely to show much price depreciation in a market downturn. Even Warren Buffett, who counsels investors never to close out a good position, sold his entire large block of Johnson & Johnson shares going into the Lehman Panic. The proceeds were used to help assemble $26B in loans to six companies that badly needed capital (General Electric, Goldman Sachs, Bank of America, Dow Chemical, Swiss Re, and Mars Candy). His first loan of $5 Billion was to Goldman Sachs on 9/24/08--9 days after Lehman Brothers Holdings filed for bankruptcy. That heralded the Federal Government’s “bailout” of Wall Street banks in mid-October 2008, using almost half the $700B in “TARP” funds that was for a different purpose (i.e., to buy up mortgage-backed securities from the 7 surviving Wall Street banks). Warren’s timely display of confidence in Wall Street probably had more to do with averting another Great Depression than did the dollar amount of all the loans. Remember: Confidence in a company’s future is what impels investors to buy stock, not it’s balance sheet.
What else makes a company’s stock price go up or down? We need to examine that before we can understand the idea of a hedge stock. There are really only two factors to consider: 1) Is the stock over-priced? 2) Is the story broken (e.g. will the company collapse in a market panic)? “Overpriced” means that the 5-6%/yr rate of return realized by cautious investors throughout recorded history no longer applies. Note: that expected rate of return will stick close to the nominal rate of GDP growth, which in the USA has been 5-6% until recently. In other words, the price for a share of stock has to be less than 20 times the most recent 12 months of earnings per share to realize more than a 5% return. With lower returns, there is a valuation problem and hedge fund traders will be drawn to bet against (or short) the stock. You can easily find out if the P/E is over 20 by checking Yahoo Finance on your smartphone.
The second question is much harder to assess: Does the story that supports confidence in a company’s future stream of earnings still apply? Or is the story broken? This terminology dates to medieval Italy, where a banker would sit at a bench (banca) in the town square. If he ran out of money, the bench would be broken in front of him (banca rotta), later transliterated to “bankrupt.”
For any widely-held company, there is always a steady production of articles, blogs and TV commentators pointing to “factlets” suggesting that the story is broken. That’s how media outlets attract advertisers and readers (i.e., by creating anxiety). Quite simply, it is human nature to undermine a money-making story, particularly when you haven’t been a beneficiary.
This makes it important to do your own “story” research for stocks that you own or want to own. For hedge stocks, researching the story is a little easier because they’re never “barnburners.” There’s no chance they’ll light up the investment universe, except of course for the “bond gnomes” off in a corner who would happily loan money to such companies. In a bull market, hedge stocks struggle to keep up with the S&P 500 Index but over the long term they’ll probably make money for their shareholders because of being downturn-resistant. When the stock market cracks, these companies don’t. Thus, it turns out that hedge stocks are not that hard to research. Their history of performance is one of limited price fluctuations, whether the market is headed up or down.
We use the hedged S&P 500 Index as our benchmark and guide for finding hedge stocks. These stocks are buried in that hedged index (The Vanguard Balanced Index Fund or VBINX). It is hedged in both directions: You are insulated from a market crash by its 40% allocation to high-grade bonds. Likewise, you benefit from market exuberance because the 60% allocation to stocks references an index of the 1000 largest companies. In other words, riskier mid-cap company stocks are included. Their high 5-yr Betas pull VBINX’s 5-yr Beta up to 0.91 from 0.6, which is where you’d expect for an index composed of 60% S&P 500 stocks and 40% high-grade bonds. That "balanced fund" strategy works because VBINX sank only 60% as far as the S&P 500 Index during the Lehman Panic (Column D in the Table), and has performed 50% better since 9/1/00, which is when the S&P 500 Index reached its inflation-adjusted high.
We also look for other metrics that are likely to prevent a hedge fund trader from betting against a company’s stock. These include: a dividend yield of at least 1.5%, outperformance relative to VBINX over both the short-term (5 yrs) and long-term, a P/E no greater than 22 (for the last 4 quarters of reported earnings), a Finance Value (Column E in the Table) that beats VBINX, a 5-yr Beta under 0.7, and an S&P bond rating of at “A-” or better. Metrics that underperform VBINX are highlighted in red.
Bottom Line: The value of owning a hedge stock is that you don’t need to hedge your downside risk by making an equivalent investment in a 10-yr Treasury Note or an inflation-protected Savings Bond. But our screen of S&P 500 companies turns up only 15 hedge stocks, even after bending our standards a little (Table). Twelve of the 15 are in “defensive” industries--utilities, consumer staples, and healthcare. Those 12 are what we call “Lifeboat Stocks” (see Week 106). McDonald’s (MCD), VF Corporation (VFC), and IBM are the only exceptions. If the market were not currently going through an overpriced moment, more companies would qualify. Of course, after a market collapse our search will become easier but that will also be when everyone (aside from Warren Buffett) is averse to investing. He has put a fine point on it: “Only when the tide goes out do you discover who's been swimming naked.”
Risk Rating: 4.
Full disclosure: I dollar-average into DRIPs at computershare.com for WMT, NEE, IBM, JNJ, and KO.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, April 27
Week 147 - Food & Fuel Costs since 1969 vs. Gold, Treasuries, and Stocks
Situation: As an investor, there are several categories (or “classes”) of assets that you can choose for investment. These include: stocks, stock options, bonds, gold, real estate, annuities, life insurance, and commodity futures & options. New sales pitches for each particular asset class are made available with remarkable frequency. However, you will seldom hear or read much about the downside of owning those types of assets. In truth, investing in each asset class supports a different purpose from the others. Aside from stock ownership, if you build a position in an asset class you’re usually engaging in what is referred to as “forced savings.” Why? Because transaction costs, inflation, and taxes will probably eat up all the profit. Home ownership is perhaps the best example of forced savings because the Federal Government makes sure that you’ll come out ahead if you persevere. This is accomplished over the life of a “conforming” 30-yr mortgage. The “price appreciation” of your home is unlikely to beat inflation (recall that over 40% of the Consumer Price Index reflects housing costs) but you will benefit from forced savings (paying the mortgage each month). Why? Because a bank bought 80% of the house with its initial loan, and the Federal Government then guaranteed that mortgage while granting you a big tax break on interest payments. You end up with all the equity, even though others assumed most of the risk. If you bought the house when you were 30, you’ll get to live there mortgage-free and rent-free after you turn 60. If you live to 75, that’s a 45-yr period of building equity in real estate.
Now let’s examine how other investment choices played out play out over the same 45 year period (see Table). First of all, no bank is going to loan you 80% of the money you need to buy stocks or gold, so cross that right off the list. Nor is the Federal Government going to waive taxes on the interest you pay for any money that a bank loans you. You might get an 80% loan to buy Treasury Notes but you would most likely need to post those Notes as collateral. Even at that, the interest you pay on the loan will likely consume the interest you earn from the Notes. You also can get a 50% loan from your stockbroker to buy stocks but you’ll pay twice as much interest as you would buying Treasury Notes but are you sure you’ll make twice as much?
What about buying gold? Gold looks attractive to own because it is a currency that can’t lose value (i.e., there’s just enough gold mined each year to keep ounces/person stable). But gold pays no interest, it has high transaction costs, it must be insured, and your capital gains will be taxed the same as ordinary income when you sell it. Gold does go up in value during times of inflation but your transaction and insurance costs will also increase. At that point, you really notice that you’re earning zero income from holding gold. In a deflation, gold falls in value and not by a trivial amount. It’s decrease will be at approximately the same rate as any other commodity. Being a stable-value currency, gold will naturally fall in value whenever the dollar rises in value. From all of this, we conclude that gold is nice to own during a recession (when transaction and insurance costs are low) but the moment the economy starts to turn around you’ll want to sell it. This will also be the same moment when gold begins to fall rapidly in value. Unfortunately, that sudden drop in the price of gold is also the first clear sign that the economy has turned the corner.
Let’s examine Treasury Notes and Bonds next. This asset class is yet another story when compared to the others. It is the only asset class that rises in value during a bad recession or persistent deflation, but with one exception. That exception is ownership of stock in food purveyors like McDonald’s or Wal-Mart; those stocks will also rise. But when the economy does turn the corner and start expanding, interest rates will rise and bond prices will fall.
Stocks are the asset you want to hold in an expanding economy. Stocks will even keep up with the rare event of hyperinflation. The problem, however, with stock ownership is found in the Beta statistic. The Beta statistic is pegged to the price quote for the S&P 500 Index, which always has a Beta of 1. What this means is that if a stock climbs in value faster than the S&P 500 Index, it will have a Beta higher than 1. But that also means it will fall faster than the S&P 500 Index in a bear market, and to about the same degree. So, you’ll have to judge your stock purchases from the 3- or 5-yr Beta and keep the 5-yr Beta for your stock portfolio under 0.7 (Warren Buffett’s recommendation).
The Table has total returns for 18 stocks obtained from a screen of Dividend Achievers (10+ yrs dividend growth) among the 65 companies in the Dow Jones Composite Average that have data going back to ~1970 on the Buyupside website. Performance of the S&P 500 Index is given for comparison, as is a 60/40 mix of the S&P 500 Index and Treasury Notes. Stocks clearly outperformed Treasury Notes and Gold over that long-term period and over the past 5 yrs. Gold still managed to beat inflation over both periods, keeping its reputation as an inflation-fighter (before accounting for the costs of ownership). Treasury Notes are vulnerable to the “Financial Repression” that central banks worldwide use to drive down interest rates during a bad recession. That makes any T-Notes (or especially T-Bonds) that you already own very valuable if you want to sell them. But the downside is that any new Notes that you buy during a Financial Repression will pay very little interest. NOTE: metrics in the Table that underperform the mix of 60% stocks and 40% T-Notes (line 19) are highlighted in red.
Bottom Line: Buy stock in 10 or more companies as your main long-term investing strategy. Our recommendation is that you make your purchases online and in small increments using a dividend reinvestment plan (DRIP). That keeps costs down and allows you to benefit from dollar-cost averaging. Try to pick stocks with a 5-yr Beta under 0.9, and keep the aggregate 5-yr Beta of your stock portfolio under 0.7 (that being yet another pearl of wisdom from the Oracle of Omaha, Warren Buffett). Since you’ll retire someday, stick to stock in companies that have a long history of growing their dividend. The advantage to this strategy is that you’ll have a retirement asset (quarterly dividend checks arriving in the mail) that grows quite a bit faster than inflation (see Column H in the Table).
Risk Rating for the aggregate of 18 stocks listed in the Table: 5
Full Disclosure of my current investment activity relative to assets listed in the Table: I dollar average into inflation-protected 10-yr US Treasury Notes, as well as DRIPs for WMT, JNJ, IBM, KO, XOM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Now let’s examine how other investment choices played out play out over the same 45 year period (see Table). First of all, no bank is going to loan you 80% of the money you need to buy stocks or gold, so cross that right off the list. Nor is the Federal Government going to waive taxes on the interest you pay for any money that a bank loans you. You might get an 80% loan to buy Treasury Notes but you would most likely need to post those Notes as collateral. Even at that, the interest you pay on the loan will likely consume the interest you earn from the Notes. You also can get a 50% loan from your stockbroker to buy stocks but you’ll pay twice as much interest as you would buying Treasury Notes but are you sure you’ll make twice as much?
What about buying gold? Gold looks attractive to own because it is a currency that can’t lose value (i.e., there’s just enough gold mined each year to keep ounces/person stable). But gold pays no interest, it has high transaction costs, it must be insured, and your capital gains will be taxed the same as ordinary income when you sell it. Gold does go up in value during times of inflation but your transaction and insurance costs will also increase. At that point, you really notice that you’re earning zero income from holding gold. In a deflation, gold falls in value and not by a trivial amount. It’s decrease will be at approximately the same rate as any other commodity. Being a stable-value currency, gold will naturally fall in value whenever the dollar rises in value. From all of this, we conclude that gold is nice to own during a recession (when transaction and insurance costs are low) but the moment the economy starts to turn around you’ll want to sell it. This will also be the same moment when gold begins to fall rapidly in value. Unfortunately, that sudden drop in the price of gold is also the first clear sign that the economy has turned the corner.
Let’s examine Treasury Notes and Bonds next. This asset class is yet another story when compared to the others. It is the only asset class that rises in value during a bad recession or persistent deflation, but with one exception. That exception is ownership of stock in food purveyors like McDonald’s or Wal-Mart; those stocks will also rise. But when the economy does turn the corner and start expanding, interest rates will rise and bond prices will fall.
Stocks are the asset you want to hold in an expanding economy. Stocks will even keep up with the rare event of hyperinflation. The problem, however, with stock ownership is found in the Beta statistic. The Beta statistic is pegged to the price quote for the S&P 500 Index, which always has a Beta of 1. What this means is that if a stock climbs in value faster than the S&P 500 Index, it will have a Beta higher than 1. But that also means it will fall faster than the S&P 500 Index in a bear market, and to about the same degree. So, you’ll have to judge your stock purchases from the 3- or 5-yr Beta and keep the 5-yr Beta for your stock portfolio under 0.7 (Warren Buffett’s recommendation).
The Table has total returns for 18 stocks obtained from a screen of Dividend Achievers (10+ yrs dividend growth) among the 65 companies in the Dow Jones Composite Average that have data going back to ~1970 on the Buyupside website. Performance of the S&P 500 Index is given for comparison, as is a 60/40 mix of the S&P 500 Index and Treasury Notes. Stocks clearly outperformed Treasury Notes and Gold over that long-term period and over the past 5 yrs. Gold still managed to beat inflation over both periods, keeping its reputation as an inflation-fighter (before accounting for the costs of ownership). Treasury Notes are vulnerable to the “Financial Repression” that central banks worldwide use to drive down interest rates during a bad recession. That makes any T-Notes (or especially T-Bonds) that you already own very valuable if you want to sell them. But the downside is that any new Notes that you buy during a Financial Repression will pay very little interest. NOTE: metrics in the Table that underperform the mix of 60% stocks and 40% T-Notes (line 19) are highlighted in red.
Bottom Line: Buy stock in 10 or more companies as your main long-term investing strategy. Our recommendation is that you make your purchases online and in small increments using a dividend reinvestment plan (DRIP). That keeps costs down and allows you to benefit from dollar-cost averaging. Try to pick stocks with a 5-yr Beta under 0.9, and keep the aggregate 5-yr Beta of your stock portfolio under 0.7 (that being yet another pearl of wisdom from the Oracle of Omaha, Warren Buffett). Since you’ll retire someday, stick to stock in companies that have a long history of growing their dividend. The advantage to this strategy is that you’ll have a retirement asset (quarterly dividend checks arriving in the mail) that grows quite a bit faster than inflation (see Column H in the Table).
Risk Rating for the aggregate of 18 stocks listed in the Table: 5
Full Disclosure of my current investment activity relative to assets listed in the Table: I dollar average into inflation-protected 10-yr US Treasury Notes, as well as DRIPs for WMT, JNJ, IBM, KO, XOM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, June 30
Week 104 - Capitalization-weighted Index of 20 Hedge Stocks
Situation: Yield-hungry investors dominate stock trading as well as bond trading, and we all know why. It is because the US Federal Reserve has driven Treasury bond yields to historically low levels. Bonds of any maturity issued anywhere in the world have greater risk than US Treasuries, so non-Treasuries offer a higher interest rate than an equivalent Treasury. That added risk is priced into those rates.
Buyers care little for the details. They just want to be paid enough interest to more than compensate for inflation. But they also know that high-yield bonds carry a significant risk of default, which makes them no less risky than stocks. Many investors have turned to stocks that a) grow dividends fast enough to more than keep up with inflation, and b) have other bond-like features like low volatility (i.e., low Beta). This blog has catered to those investors, until recently. But now this has become a “crowded trade”, and we are calling attention to its high cost for companies as well as investors. Many companies have tried to comply, but that means they lose the opportunity to grow their businesses at zero cost with Retained Earnings (RE). Instead, their free cash flow (FCF) is increasingly consumed by the need to grow their dividend--to attract buyers and boost the stock’s price. This type of “asset inflation” is exactly what Ben Bernanke had in mind when he had the Federal Reserve launch its bond-buying program 3 yrs ago. Unfortunately, several prominent companies have had to issue new stocks and bonds just to maintain the kind of growing dividend that investors expect.
Here at ITR, we played along with yield-hungry investors as long as we could. But the competitive advantage of any company is linked to the cost of money for capital improvements. If free money (RE) is used, there is no need to go through the expensive (and embarrassingly public) rigamarole of issuing new stocks and bonds. So we are now changing our focus to identify solid companies that consistently grow FCF and have some left after paying a dividend. Such companies tend to pay a small but growing dividend. If you own stock in one, and you’re a retiree who depends on dividend checks, you’ll have to learn to occasionally sell some of the shares you hold. For example, Sherwin-Williams (Table) had a 2% yield two yrs ago but has a 1% yield now. You’ll notice, however, that its growth rate has increased from 20%/yr over the past 13+ yrs to 30%/yr over the past 5 yrs, growth that is increasingly funded by RE.
With these thoughts in mind, we still have to identify bond-like stocks for you to consider owning in lieu of a high-yield corporate bond fund (i.e., a fund that holds bonds paying 6-8%/yr but those bonds have an S&P rating lower than BBB-). Instead of owning one of the top such funds, e.g. the USAA High Income Fund (USHYX in the Table), we suggest that you own bond-like stocks that behave like a good hedge fund (see Week 101).
Because low-Beta/high-yield stocks are the “in thing” to own (i.e., overpriced), we’ll need a screen that focuses instead on companies that have a recent record of beating out their competition without necessarily paying much of a dividend. We'll do that by depending first on the Barron’s 500 Table because it ranks companies with respect to recent growth in sales and cash flow. Then we apply our usual metrics to identify hedge stocks, i.e., stocks that a) beat the S&P 500 Index over the past 5 yrs and longer, e.g. since that Index reached its inflation-adjusted peak on 3/24/00; b) lost no more than 2/3rds as much as the S&P Index during the Lehman Panic; c) have a 5-yr Beta that’s no more than 2/3rds as high as the S&P Index 5-yr Beta; d) have an S&P stock rating of A- or better, and e) have an S&P bond rating of BBB+ or better. Except in the case of a regulated utility, we also require the company to be less than 50% capitalized by long-term bonds, have a positive FCF, and exhibit dividend growth that exceeds the 6.5%/yr dividend growth rate of the S&P 500 Index.
Our screen of the S&P 500 Index turns up 20 companies (Table). All 20 are dividend payers, and only two aren’t yet Dividend Achievers. The exceptions are Costco Wholesale (COST) and General Mills (GIS), both of which are less than a year away from reaching the required 10 yrs of consecutive dividend increases. Seven of the 20 companies pay less than the 2% yield for the lowest-cost S&P 500 Index fund (VFINX). Taken together, the 20 companies have returned 11.9% since 3/24/00 (as of close of business on 6/17/00), and 14.6% over the past 5 yrs. But much of that outperformance is achieved by the smaller and more nimble companies. To compensate for that unhelpful aberration, we’ve set up a capitalization-weighted index by valuing the total return of the largest company (WMT) over the past 13+ yrs at 20 times more than the total return for the smallest company (HRL). Column N of the Table lists the multiplication factors for the other 18 stocks, based on market capitalization. That adjustment brings aggregate total return over the past 13+ yrs down to 9.5% (vs. 11.9%).
If you're just getting started as a DRIP investor, you’ll want to start the drill (of adding small amounts automatically each month to stock) in companies that are gaining on their competition. Those are the companies that improved their Barron’s 500 rank in 2012 vs. 2011. The companies that failed to do so are red-flagged in Column G of the Table. Choosing among the remaining companies is simply a matter of starting with one of those having the best capitalization-weighted growth records: PG, JNJ, TJX, KO and COST. But remember, stock-picking requires scale. (Academic studies have shown that a buy-and-hold stock-picker needs 20 stocks to have a reasonable chance of losing less than the S&P 500 Index in a bear market but still manage to track that index in a bull market.)
Bottom Line: If you want to shy away from owning Treasuries while the Federal Reserve is driving yields lower than the rate of inflation, you’ll be better served by owning bond-like stocks than a high-yield bond fund. Trouble is, most investors have already made that switch so you’ll have to be selective as well as patient. Start by setting up DRIPs in “hedge stocks” that have been gaining on their competition. Then employ “dollar-cost averaging” by having the same amount withdrawn from your checking account each month for each DRIP.
Risk Rating: 5.
Full Disclosure: Each month, I electronically dollar-average into DRIPs for WMT, NEE, JNJ, IBM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Buyers care little for the details. They just want to be paid enough interest to more than compensate for inflation. But they also know that high-yield bonds carry a significant risk of default, which makes them no less risky than stocks. Many investors have turned to stocks that a) grow dividends fast enough to more than keep up with inflation, and b) have other bond-like features like low volatility (i.e., low Beta). This blog has catered to those investors, until recently. But now this has become a “crowded trade”, and we are calling attention to its high cost for companies as well as investors. Many companies have tried to comply, but that means they lose the opportunity to grow their businesses at zero cost with Retained Earnings (RE). Instead, their free cash flow (FCF) is increasingly consumed by the need to grow their dividend--to attract buyers and boost the stock’s price. This type of “asset inflation” is exactly what Ben Bernanke had in mind when he had the Federal Reserve launch its bond-buying program 3 yrs ago. Unfortunately, several prominent companies have had to issue new stocks and bonds just to maintain the kind of growing dividend that investors expect.
Here at ITR, we played along with yield-hungry investors as long as we could. But the competitive advantage of any company is linked to the cost of money for capital improvements. If free money (RE) is used, there is no need to go through the expensive (and embarrassingly public) rigamarole of issuing new stocks and bonds. So we are now changing our focus to identify solid companies that consistently grow FCF and have some left after paying a dividend. Such companies tend to pay a small but growing dividend. If you own stock in one, and you’re a retiree who depends on dividend checks, you’ll have to learn to occasionally sell some of the shares you hold. For example, Sherwin-Williams (Table) had a 2% yield two yrs ago but has a 1% yield now. You’ll notice, however, that its growth rate has increased from 20%/yr over the past 13+ yrs to 30%/yr over the past 5 yrs, growth that is increasingly funded by RE.
With these thoughts in mind, we still have to identify bond-like stocks for you to consider owning in lieu of a high-yield corporate bond fund (i.e., a fund that holds bonds paying 6-8%/yr but those bonds have an S&P rating lower than BBB-). Instead of owning one of the top such funds, e.g. the USAA High Income Fund (USHYX in the Table), we suggest that you own bond-like stocks that behave like a good hedge fund (see Week 101).
Because low-Beta/high-yield stocks are the “in thing” to own (i.e., overpriced), we’ll need a screen that focuses instead on companies that have a recent record of beating out their competition without necessarily paying much of a dividend. We'll do that by depending first on the Barron’s 500 Table because it ranks companies with respect to recent growth in sales and cash flow. Then we apply our usual metrics to identify hedge stocks, i.e., stocks that a) beat the S&P 500 Index over the past 5 yrs and longer, e.g. since that Index reached its inflation-adjusted peak on 3/24/00; b) lost no more than 2/3rds as much as the S&P Index during the Lehman Panic; c) have a 5-yr Beta that’s no more than 2/3rds as high as the S&P Index 5-yr Beta; d) have an S&P stock rating of A- or better, and e) have an S&P bond rating of BBB+ or better. Except in the case of a regulated utility, we also require the company to be less than 50% capitalized by long-term bonds, have a positive FCF, and exhibit dividend growth that exceeds the 6.5%/yr dividend growth rate of the S&P 500 Index.
Our screen of the S&P 500 Index turns up 20 companies (Table). All 20 are dividend payers, and only two aren’t yet Dividend Achievers. The exceptions are Costco Wholesale (COST) and General Mills (GIS), both of which are less than a year away from reaching the required 10 yrs of consecutive dividend increases. Seven of the 20 companies pay less than the 2% yield for the lowest-cost S&P 500 Index fund (VFINX). Taken together, the 20 companies have returned 11.9% since 3/24/00 (as of close of business on 6/17/00), and 14.6% over the past 5 yrs. But much of that outperformance is achieved by the smaller and more nimble companies. To compensate for that unhelpful aberration, we’ve set up a capitalization-weighted index by valuing the total return of the largest company (WMT) over the past 13+ yrs at 20 times more than the total return for the smallest company (HRL). Column N of the Table lists the multiplication factors for the other 18 stocks, based on market capitalization. That adjustment brings aggregate total return over the past 13+ yrs down to 9.5% (vs. 11.9%).
If you're just getting started as a DRIP investor, you’ll want to start the drill (of adding small amounts automatically each month to stock) in companies that are gaining on their competition. Those are the companies that improved their Barron’s 500 rank in 2012 vs. 2011. The companies that failed to do so are red-flagged in Column G of the Table. Choosing among the remaining companies is simply a matter of starting with one of those having the best capitalization-weighted growth records: PG, JNJ, TJX, KO and COST. But remember, stock-picking requires scale. (Academic studies have shown that a buy-and-hold stock-picker needs 20 stocks to have a reasonable chance of losing less than the S&P 500 Index in a bear market but still manage to track that index in a bull market.)
Bottom Line: If you want to shy away from owning Treasuries while the Federal Reserve is driving yields lower than the rate of inflation, you’ll be better served by owning bond-like stocks than a high-yield bond fund. Trouble is, most investors have already made that switch so you’ll have to be selective as well as patient. Start by setting up DRIPs in “hedge stocks” that have been gaining on their competition. Then employ “dollar-cost averaging” by having the same amount withdrawn from your checking account each month for each DRIP.
Risk Rating: 5.
Full Disclosure: Each month, I electronically dollar-average into DRIPs for WMT, NEE, JNJ, IBM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, May 19
Week 98 - Mutual Funds
Situation: Mutual fund managers invest your hard-earned money in assets traded on exchanges around the world. Those assets are assembled and sold to you on the basis of Net Asset Value (NAV) per share. Your money is being invested in a derivative product that is priced by assembling the prices of exchange-traded assets. Mutual funds are marketed on the basis of past performance and their current expense ratio (transaction costs/NAV).
Because the stock market is rising 2/3rds of the time, managers tend to assemble their mutual fund from stock in companies that outperform the S&P 500 Index during a “bull market” (i.e., have a 5-yr Beta greater than 1.00). That bias is eliminated in the case of an index fund where a computer does the managing (usually rebalancing the portfolio to maintain capitalization weighting). That means the “managed” mutual fund will perform worse than average 1/3rd of the time, i.e., during a “bear market.” Long-term performance graphs will look better though. But no one is interested in owning stocks that do worse than the indices during a bear market. You’ve been there, done that.
We encourage you to own a stock portfolio that is less risky than the S&P 500 Index, one with a capitalization-weighted 5-yr Beta of 0.65 or less. That means that in a bad year, like 2008 when the S&P 500 Index lost 37.4%, your stock portfolio would lose no more than 25%. Since that is a greater loss than anyone can stomach if over 55, bonds need to be added for safety, not profit. Remember: stocks are “dead money” 2/3rds of the time. This is because the first half of a bull market only makes up for losses incurred during the previous bear market. Investment-grade bonds allow you to bridge that “valley” because they pay interest twice a year at a fixed (or inflation-adjusted) rate until the bond matures and principal is returned to the investor. There are no “ifs” and you’ll even beat inflation by 1-2% over the long haul. The key problem for shareholders is that after a 25% loss, a 50% gain is needed just to break even. That's how math works.
Looking at Lehman Panic returns (Column D of this week's Table), if you had half your money in the lowest-cost investment-grade bond index fund (VBMFX) and half in the lowest-cost S&P 500 stock index fund (VFINX) your loss was only 19% instead of 45.6% for VFINX alone. If you had money in the lowest-cost bond-heavy balanced mutual fund (Vanguard Wellesley Income Fund or VWINX), your loss fell to 16% (Table).
But what about long-term growth? Over the past two market cycles (since the S&P 500 Index peak on March 24, 2000), the 50:50 stock:bond index combination has returned 4.1%/yr, which is 1.7% more than inflation. VWINX has returned 8.1%/yr because it is 60% bonds and 40% stocks. Remember, bonds keep paying interest the whole time that stocks are down in the “valley.” Bonds also rise in price during recessions, so managers of VWINX can sell those at a profit. If you’d held only the S&P 500 Index (VFINX), your returns would only have been 2.3%/yr meaning you’d have lost 0.1%/yr to inflation.
So what is the point we are making? If you like the convenience of mutual funds, play defense by holding a bond-heavy, actively-managed balanced fund like Vanguard’s Wellesley Income Fund (VWINX). It's a hedge fund in disguise, since it has a low 5-yr Beta (0.58) and outperforms the S&P 500 Index on rolling 5-yr periods. (The managers aren’t allowed to use the main tool of a hedge fund, which is short sales, a risky tactic that often backfires.)
What we’d all like to find is a low-cost stock mutual fund that has mediocre performance during bull markets but outstanding performance during bear markets, i.e., a hedge fund for the masses. For the foreseeable future, hedge funds will continue to be private investment contracts available to the wealthy. Why? Because the retail investor (you and me) won’t buy something that has a sales pitch of mediocre performance during a bull market. We’re thinking: Why invest my money in a fund that is limping along 2/3rds of the time? Hedge funds get around this by saying: “Well, we think we can beat the S&P 500 Index over the long term because of our superior performance during bear markets.” According to Warren Buffett (Week 46), that is impossible because of their high fees: a typical hedge fund keeps 20% of any money it makes for a client as well as charging her a 2% annual fee.
Hedge funds use various strategies (check Wikipedia for an excellent entry explaining these). The best hedge funds have been able to beat the S&P 500 Index over a 5-10 yr period while losing less than 65% as much during a bear market (Week 46). It is hard to know just when a bear market is going to transpire, so hedge funds tend to maintain a 5-yr Beta of 0.65 or less during the run-up to a bear market. It all gets pretty complicated but the better hedge funds tend to be stuffed with bonds and shorted stocks (i.e., betting against stocks). The bonds are often risky, paying several % more interest than a 10-yr Treasury Note, which is all right since a risky bond is less risky than a “safe” stock because the risk of default is less and the money recovered in a default is substantial (vs. the total loss that a shareholder must endure).
There is a very low cost mutual fund for Treasury Notes (VFITX in the Table). Or you can buy US Treasuries in amounts as small as $100. There’s no cost, just point-and-click (go to treasurydirect). The money will be withdrawn from your checking account and every 6 months an interest payment will be sent back. At the end of the bond’s term, your original investment is returned.
You’ll complain that “the current interest rate is lower than the rates for corporate bonds or bond funds.” Correct, because you’re buying a “zero-risk” product that will keep paying interest during a bear market and even during Armageddon assuming the U.S. Marine Corps still exists. The extra interest paid (called the “spread”) on non-Treasury bonds compensates you for their extra risk (i.e., the risk of default). It's still true that there is no free lunch.
In the end, you are best off selecting some low-risk DRIPs for your stocks and balancing those with Treasury Notes or Savings Bonds, which are the same as Treasury Notes except that interest accrues automatically and is lower because you’ll pay no tax on the accrued interest until you sell.
What is a low-risk DRIP? For safety’s sake we will use an extreme example and call it a virtual mutual fund (Table): the 8 Dividend Aristocrats that have not only increased their dividend annually for at least 25 yrs and are also “blue chips”, i.e., members of the 30-stock Dow Jones Industrial Average. These are: Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), Exxon Mobil (XOM), Chevron (CVX) and 3M (MMM). Four of those (WMT, MCD, JNJ, KO) are what we call “hedge stocks” because they fell less than 65% as far as the S&P 500 Index during the Lehman Panic, have beaten the S&P 500 Index over the past two market cycles, and have a 5-yr Beta of 0.65 or less. Those 4 stocks are enough like bonds that you don’t have to backstop their risk with an equal investment in Treasury Notes or Savings Bonds. The other 4 stocks (CVX, XOM, MMM, PG) include two (PG and XOM) that almost qualify as hedge stocks, have the highest S&P stock rating (A+/L, with the “L” denoting low risk), and have high credit ratings (AA- and AAA, respectively). There is no chance of either going bankrupt or falling as fast in value as the S&P 500 Index during a bear market, so you won't need Treasuries as a backstop.
To sum up: Your virtual mutual fund is 60% in 6 “safe” DRIPs, 20% in 2 riskier DRIPs (CVX and MMM), and 20% in a Treasury Note fund (VFITX) to backstop CVX and MMM. There are 10 units (8 DRIPs plus 2 units of VFITX). Assigning $50/mo to each results in an investment of $6,000/yr. Costs for investing $50/mo electronically from your checking account for WMT and JNJ are $1/mo. Costs are higher for KO, CVX, MMM and MCD, so annual or semiannual investments have to be made: one-off electronic transfers into those DRIPs. There are no costs for the XOM and PG DRIPs, or the $100 that goes into VFITX each month (aside from the expense ratio of 0.2%).
Your virtual mutual fund lost 10.3% during the 18-mo Lehman Panic bear market but returned an average of 8.6%/yr over the past 13+ yrs and beat both the S&P 500 Index and inflation by 6.2%/yr. The 5-yr Beta is 0.5, indicating that your virtual mutual fund is perfectly balanced between stock and bond risk.
Bottom Line: For the most part, stocks are a gamble but bonds aren’t. Make sure your retirement savings are balanced between stocks and bonds in terms of the aggregate 5-yr Beta, i.e., close to 0.5. You can design a balanced stock and bond portfolio by using DRIPs for the stock investments balanced with Treasury Notes, or a bond mutual fund that only holds Treasury Notes (VFITX). From a tax-savings standpoint, you’re better off using Inflation-protected Savings Bonds.
Risk Rating: 3.
Full Disclosure: I use this plan to supplement my workplace retirement savings.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Because the stock market is rising 2/3rds of the time, managers tend to assemble their mutual fund from stock in companies that outperform the S&P 500 Index during a “bull market” (i.e., have a 5-yr Beta greater than 1.00). That bias is eliminated in the case of an index fund where a computer does the managing (usually rebalancing the portfolio to maintain capitalization weighting). That means the “managed” mutual fund will perform worse than average 1/3rd of the time, i.e., during a “bear market.” Long-term performance graphs will look better though. But no one is interested in owning stocks that do worse than the indices during a bear market. You’ve been there, done that.
We encourage you to own a stock portfolio that is less risky than the S&P 500 Index, one with a capitalization-weighted 5-yr Beta of 0.65 or less. That means that in a bad year, like 2008 when the S&P 500 Index lost 37.4%, your stock portfolio would lose no more than 25%. Since that is a greater loss than anyone can stomach if over 55, bonds need to be added for safety, not profit. Remember: stocks are “dead money” 2/3rds of the time. This is because the first half of a bull market only makes up for losses incurred during the previous bear market. Investment-grade bonds allow you to bridge that “valley” because they pay interest twice a year at a fixed (or inflation-adjusted) rate until the bond matures and principal is returned to the investor. There are no “ifs” and you’ll even beat inflation by 1-2% over the long haul. The key problem for shareholders is that after a 25% loss, a 50% gain is needed just to break even. That's how math works.
Looking at Lehman Panic returns (Column D of this week's Table), if you had half your money in the lowest-cost investment-grade bond index fund (VBMFX) and half in the lowest-cost S&P 500 stock index fund (VFINX) your loss was only 19% instead of 45.6% for VFINX alone. If you had money in the lowest-cost bond-heavy balanced mutual fund (Vanguard Wellesley Income Fund or VWINX), your loss fell to 16% (Table).
But what about long-term growth? Over the past two market cycles (since the S&P 500 Index peak on March 24, 2000), the 50:50 stock:bond index combination has returned 4.1%/yr, which is 1.7% more than inflation. VWINX has returned 8.1%/yr because it is 60% bonds and 40% stocks. Remember, bonds keep paying interest the whole time that stocks are down in the “valley.” Bonds also rise in price during recessions, so managers of VWINX can sell those at a profit. If you’d held only the S&P 500 Index (VFINX), your returns would only have been 2.3%/yr meaning you’d have lost 0.1%/yr to inflation.
So what is the point we are making? If you like the convenience of mutual funds, play defense by holding a bond-heavy, actively-managed balanced fund like Vanguard’s Wellesley Income Fund (VWINX). It's a hedge fund in disguise, since it has a low 5-yr Beta (0.58) and outperforms the S&P 500 Index on rolling 5-yr periods. (The managers aren’t allowed to use the main tool of a hedge fund, which is short sales, a risky tactic that often backfires.)
What we’d all like to find is a low-cost stock mutual fund that has mediocre performance during bull markets but outstanding performance during bear markets, i.e., a hedge fund for the masses. For the foreseeable future, hedge funds will continue to be private investment contracts available to the wealthy. Why? Because the retail investor (you and me) won’t buy something that has a sales pitch of mediocre performance during a bull market. We’re thinking: Why invest my money in a fund that is limping along 2/3rds of the time? Hedge funds get around this by saying: “Well, we think we can beat the S&P 500 Index over the long term because of our superior performance during bear markets.” According to Warren Buffett (Week 46), that is impossible because of their high fees: a typical hedge fund keeps 20% of any money it makes for a client as well as charging her a 2% annual fee.
Hedge funds use various strategies (check Wikipedia for an excellent entry explaining these). The best hedge funds have been able to beat the S&P 500 Index over a 5-10 yr period while losing less than 65% as much during a bear market (Week 46). It is hard to know just when a bear market is going to transpire, so hedge funds tend to maintain a 5-yr Beta of 0.65 or less during the run-up to a bear market. It all gets pretty complicated but the better hedge funds tend to be stuffed with bonds and shorted stocks (i.e., betting against stocks). The bonds are often risky, paying several % more interest than a 10-yr Treasury Note, which is all right since a risky bond is less risky than a “safe” stock because the risk of default is less and the money recovered in a default is substantial (vs. the total loss that a shareholder must endure).
There is a very low cost mutual fund for Treasury Notes (VFITX in the Table). Or you can buy US Treasuries in amounts as small as $100. There’s no cost, just point-and-click (go to treasurydirect). The money will be withdrawn from your checking account and every 6 months an interest payment will be sent back. At the end of the bond’s term, your original investment is returned.
You’ll complain that “the current interest rate is lower than the rates for corporate bonds or bond funds.” Correct, because you’re buying a “zero-risk” product that will keep paying interest during a bear market and even during Armageddon assuming the U.S. Marine Corps still exists. The extra interest paid (called the “spread”) on non-Treasury bonds compensates you for their extra risk (i.e., the risk of default). It's still true that there is no free lunch.
In the end, you are best off selecting some low-risk DRIPs for your stocks and balancing those with Treasury Notes or Savings Bonds, which are the same as Treasury Notes except that interest accrues automatically and is lower because you’ll pay no tax on the accrued interest until you sell.
What is a low-risk DRIP? For safety’s sake we will use an extreme example and call it a virtual mutual fund (Table): the 8 Dividend Aristocrats that have not only increased their dividend annually for at least 25 yrs and are also “blue chips”, i.e., members of the 30-stock Dow Jones Industrial Average. These are: Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), Exxon Mobil (XOM), Chevron (CVX) and 3M (MMM). Four of those (WMT, MCD, JNJ, KO) are what we call “hedge stocks” because they fell less than 65% as far as the S&P 500 Index during the Lehman Panic, have beaten the S&P 500 Index over the past two market cycles, and have a 5-yr Beta of 0.65 or less. Those 4 stocks are enough like bonds that you don’t have to backstop their risk with an equal investment in Treasury Notes or Savings Bonds. The other 4 stocks (CVX, XOM, MMM, PG) include two (PG and XOM) that almost qualify as hedge stocks, have the highest S&P stock rating (A+/L, with the “L” denoting low risk), and have high credit ratings (AA- and AAA, respectively). There is no chance of either going bankrupt or falling as fast in value as the S&P 500 Index during a bear market, so you won't need Treasuries as a backstop.
To sum up: Your virtual mutual fund is 60% in 6 “safe” DRIPs, 20% in 2 riskier DRIPs (CVX and MMM), and 20% in a Treasury Note fund (VFITX) to backstop CVX and MMM. There are 10 units (8 DRIPs plus 2 units of VFITX). Assigning $50/mo to each results in an investment of $6,000/yr. Costs for investing $50/mo electronically from your checking account for WMT and JNJ are $1/mo. Costs are higher for KO, CVX, MMM and MCD, so annual or semiannual investments have to be made: one-off electronic transfers into those DRIPs. There are no costs for the XOM and PG DRIPs, or the $100 that goes into VFITX each month (aside from the expense ratio of 0.2%).
Your virtual mutual fund lost 10.3% during the 18-mo Lehman Panic bear market but returned an average of 8.6%/yr over the past 13+ yrs and beat both the S&P 500 Index and inflation by 6.2%/yr. The 5-yr Beta is 0.5, indicating that your virtual mutual fund is perfectly balanced between stock and bond risk.
Bottom Line: For the most part, stocks are a gamble but bonds aren’t. Make sure your retirement savings are balanced between stocks and bonds in terms of the aggregate 5-yr Beta, i.e., close to 0.5. You can design a balanced stock and bond portfolio by using DRIPs for the stock investments balanced with Treasury Notes, or a bond mutual fund that only holds Treasury Notes (VFITX). From a tax-savings standpoint, you’re better off using Inflation-protected Savings Bonds.
Risk Rating: 3.
Full Disclosure: I use this plan to supplement my workplace retirement savings.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, April 28
Week 95 - Hedge Stock Picks for 2013
Situation: In several of our blogs over the past year, we’ve tried to identify stocks that behave like an above-average hedge fund (using a definition based on information provided by Warren Buffett at the May 2012 Annual Meeting of Berkshire Hathaway--see Week 30). A qualifying stock would need to beat the S&P 500 Index over the past 10 yrs while losing less than 65% as much as the S&P 500 Index lost during the Lehman Panic, and would need to maintain a 5-yr Beta of 0.65 or less to show that it would be likely do as well during the next financial panic. In this week’s blog, we merge those standards with ITR’s long-standing requirement that stocks used as a base for retirement planning be
a) Dividend Achievers, meaning they have consecutive annual dividend increases for at least the past 10 yrs;
b) have a dividend yield close to or better than the 15-yr moving average for the dividend yield on the S&P 500 Index (1.8%);
c) have an S&P stock rating of A- or better and an S&P bond rating of BBB+ or better;
d) have no more than 50% of total capitalization coming from long-term debt;
e) have positive free cash flow (FCF) in the most recent year according to The WSJ;
f) have a return on invested capital (ROIC) sufficient to cover the cost of capital (at least 8% for non-financial companies).
General Mills (GIS), which will be added to the 201-stock Dividend Achievers List published by S&P early next year, has been made a part of our list too.
Since we began blogging about hedge stocks (see Week 76, Week 77, Week 82, Week 93), there are 11 stocks that consistently keep qualifying (Table). This list is important to you, the investor, for the simple reason that you don’t need to back up ownership of these stocks with an equal investment in Treasury Notes (or inflation-protected Savings Bonds). That precaution is necessary when purchasing other stocks in case the next financial panic happens soon after you retire when you’ll be particularly loathe to sell stocks that are repressed in value. Then you can sell bonds instead, which will be up in value.
We have only one concern about the hedge stocks in our Table, which is an increasing tendency for those companies to borrow money in order to keep raising their dividend annually. This trend started in 2005 when Procter & Gamble borrowed money to pay the part of its growing dividend that free cash flow (FCF) couldn’t fund. This was done to avoid bringing overseas earnings back to the US, which would result in a 30% tax (on top of taxes already paid to foreign countries). This increasingly affects the companies in our list of hedge stocks, since most are mainly expanding overseas. Only 6 of the 11 companies have money left in FCF after paying their dividend. Those “Retained Earnings” are the best way to grow the company, since they come at no cost. Eventually, the tax policy of the US Government will have to stop penalizing companies for overseas operations.
Bottom Line: Even though there are only a few stocks that qualify as “hedge stocks”, it is important for you to set up DRIPs in one or two of these and add money regularly through automatic deductions from your checking account. That’s not only a good way to prepare for retirement but it’s also the best way to hedge against the risk of hyperinflation.
Risk Rating for the aggregate of 11 companies: 3.
Full disclosure: I have DRIPs in MKC, MCD, ABT, KO and IBM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
a) Dividend Achievers, meaning they have consecutive annual dividend increases for at least the past 10 yrs;
b) have a dividend yield close to or better than the 15-yr moving average for the dividend yield on the S&P 500 Index (1.8%);
c) have an S&P stock rating of A- or better and an S&P bond rating of BBB+ or better;
d) have no more than 50% of total capitalization coming from long-term debt;
e) have positive free cash flow (FCF) in the most recent year according to The WSJ;
f) have a return on invested capital (ROIC) sufficient to cover the cost of capital (at least 8% for non-financial companies).
General Mills (GIS), which will be added to the 201-stock Dividend Achievers List published by S&P early next year, has been made a part of our list too.
Since we began blogging about hedge stocks (see Week 76, Week 77, Week 82, Week 93), there are 11 stocks that consistently keep qualifying (Table). This list is important to you, the investor, for the simple reason that you don’t need to back up ownership of these stocks with an equal investment in Treasury Notes (or inflation-protected Savings Bonds). That precaution is necessary when purchasing other stocks in case the next financial panic happens soon after you retire when you’ll be particularly loathe to sell stocks that are repressed in value. Then you can sell bonds instead, which will be up in value.
We have only one concern about the hedge stocks in our Table, which is an increasing tendency for those companies to borrow money in order to keep raising their dividend annually. This trend started in 2005 when Procter & Gamble borrowed money to pay the part of its growing dividend that free cash flow (FCF) couldn’t fund. This was done to avoid bringing overseas earnings back to the US, which would result in a 30% tax (on top of taxes already paid to foreign countries). This increasingly affects the companies in our list of hedge stocks, since most are mainly expanding overseas. Only 6 of the 11 companies have money left in FCF after paying their dividend. Those “Retained Earnings” are the best way to grow the company, since they come at no cost. Eventually, the tax policy of the US Government will have to stop penalizing companies for overseas operations.
Bottom Line: Even though there are only a few stocks that qualify as “hedge stocks”, it is important for you to set up DRIPs in one or two of these and add money regularly through automatic deductions from your checking account. That’s not only a good way to prepare for retirement but it’s also the best way to hedge against the risk of hyperinflation.
Risk Rating for the aggregate of 11 companies: 3.
Full disclosure: I have DRIPs in MKC, MCD, ABT, KO and IBM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 13
Week 80 - 2012 Total Return for the Growing Perpetuity Index
Situation: The US economy has improved but only enough for job growth to keep up with population growth. The stock market, on the other hand, is pointing to the likelihood that the rate of economic expansion (GDP) will soon double to more than 3%/yr. We’re in a bull market, which we define as the S&P 500 Index outperforming the “blue-chip” 65-stock Dow Jones Composite Index. During 2012, there was a wide gap between the two with the S&P 500 Index gaining 13% vs. 5% for the Dow Jones Composite Index. Those are price-only indices so dividends, which are ~30% greater for the blue-chip index, aren’t counted. Therein lies the problem! Fear of going over the “fiscal cliff” had investors pulling money out of stocks that pay good dividends. Those dividends would have been taxed approximately twice as much had we gone over the cliff. We didn’t and are predicting that 2013 will see a renewed interest in dividend-paying stocks.
It’s time to update our previously published Growing Perpetuity Index (GPI, see Week 66). The 12 companies in our GPI are the bluest of blue-chips, and had an average Total Return of only 3.8% (Table). For 5 and 10 yr periods, the GPI handily outperformed the S&P 500 Index, as well as the Vanguard Dividend Growth Fund, a more appropriate benchmark for the GPI (Table). We have separated those 12 stocks into two groups, 7 that are low risk and 5 that are high risk.
Warren Buffett has stated on several occasions that stocks having a 5-yr Beta greater than 0.7 are best avoided. And the better hedge funds generally have 5-yr betas of less than 0.7. Indeed, at the May 2012 annual meeting of Berkshire Hathaway, Mr. Buffett indicated that a group of 5 above-average hedge funds lost 35% less than the S&P 500 Index during the Lehman Panic (Week 46). In other words, those hedge funds had a 5-yr Beta of less than 0.65. That is why we have recently started breaking our blog tables into two groups: an upper group that lost less than 65% as much as the S&P 500 Index during the Lehman Panic and had a 5-yr Beta less than 0.65, vs. a lower group that doesn’t meet that standard (see Week 78).
Our GPI has 7 such companies in the top group (Table): Wal*Mart (WMT), McDonald’s (MCD), NextEra Energy (NEE), IBM (IBM), Johnson & Johnson (JNJ), Coca-Cola (KO) and Procter & Gamble (PG). Those 7 had an average total return of 8% in 2012. More importantly, the aggregate data for those 7 stocks (line 9 of the Table) is impressive. Only two other A-rated dividend-paying stocks in the S&P 500 Index can come close to matching that data set, namely, Darden Restaurants (DRI) and General Mills (GIS). Darden Restaurants’ credit rating is too low to warrant inclusion in our Master List (Week 78) and General Mills has only raised its dividend for 6 consecutive yrs, instead of the 10 required for inclusion in the Master List. A recent hit movie (“Moneyball” based on the 2003 book of the same name by Michael Lewis) dwelt on this point by showing that a baseball team composed of players that individually had a low market value could outperform richer teams if those players collectively had a high on-base percentage. This concept came earlier to the investment world, in the early 1980s, when Michael Milken showed that “fallen angels” (corporate bonds that had slipped below an investment-grade rating) could give good results if, as a group, key ratios were at an investment grade level.
The point here is that every company’s competitive advantage is a work in progress. Some years the pieces fall together nicely but other years see a potent competitor taking market share. Only by holding a number of well-chosen stocks can you pull ahead of the pack.
Bottom Line: If you’re within 15 yrs of retirement, confine your stock-picking to tickers with a 5 yr Beta of less than 0.65 that lost less than 65% as much as the S&P 500 Index during the Lehman Panic.
Risk Rating: 3.
It’s time to update our previously published Growing Perpetuity Index (GPI, see Week 66). The 12 companies in our GPI are the bluest of blue-chips, and had an average Total Return of only 3.8% (Table). For 5 and 10 yr periods, the GPI handily outperformed the S&P 500 Index, as well as the Vanguard Dividend Growth Fund, a more appropriate benchmark for the GPI (Table). We have separated those 12 stocks into two groups, 7 that are low risk and 5 that are high risk.
Warren Buffett has stated on several occasions that stocks having a 5-yr Beta greater than 0.7 are best avoided. And the better hedge funds generally have 5-yr betas of less than 0.7. Indeed, at the May 2012 annual meeting of Berkshire Hathaway, Mr. Buffett indicated that a group of 5 above-average hedge funds lost 35% less than the S&P 500 Index during the Lehman Panic (Week 46). In other words, those hedge funds had a 5-yr Beta of less than 0.65. That is why we have recently started breaking our blog tables into two groups: an upper group that lost less than 65% as much as the S&P 500 Index during the Lehman Panic and had a 5-yr Beta less than 0.65, vs. a lower group that doesn’t meet that standard (see Week 78).
Our GPI has 7 such companies in the top group (Table): Wal*Mart (WMT), McDonald’s (MCD), NextEra Energy (NEE), IBM (IBM), Johnson & Johnson (JNJ), Coca-Cola (KO) and Procter & Gamble (PG). Those 7 had an average total return of 8% in 2012. More importantly, the aggregate data for those 7 stocks (line 9 of the Table) is impressive. Only two other A-rated dividend-paying stocks in the S&P 500 Index can come close to matching that data set, namely, Darden Restaurants (DRI) and General Mills (GIS). Darden Restaurants’ credit rating is too low to warrant inclusion in our Master List (Week 78) and General Mills has only raised its dividend for 6 consecutive yrs, instead of the 10 required for inclusion in the Master List. A recent hit movie (“Moneyball” based on the 2003 book of the same name by Michael Lewis) dwelt on this point by showing that a baseball team composed of players that individually had a low market value could outperform richer teams if those players collectively had a high on-base percentage. This concept came earlier to the investment world, in the early 1980s, when Michael Milken showed that “fallen angels” (corporate bonds that had slipped below an investment-grade rating) could give good results if, as a group, key ratios were at an investment grade level.
The point here is that every company’s competitive advantage is a work in progress. Some years the pieces fall together nicely but other years see a potent competitor taking market share. Only by holding a number of well-chosen stocks can you pull ahead of the pack.
Bottom Line: If you’re within 15 yrs of retirement, confine your stock-picking to tickers with a 5 yr Beta of less than 0.65 that lost less than 65% as much as the S&P 500 Index during the Lehman Panic.
Risk Rating: 3.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 16
Week 76 - Hedging Stocks vs. Financial Repression
Situation: As of 12/7/12, a “risk-free” 10-yr US Treasury Notes yields 1.63%. This is vs. the 4.12% paid just 5 yrs ago. Meanwhile, the Consumer Price Index (inflation) has grown at a rate of 2.2% over the past 5 years vs. 2.9% over the 5 years ending in 12/07. This means that a 10 yr Treasury Note purchased on 12/07/07 paid 1.2% more than inflation, whereas, a 10 yr Treasury Note purchased on 12/07/12 paid 0.6% less than inflation. That 1.8% “trim” is called Financial Repression. It occured as the Federal Reserve gradually took two trillion dollars worth of Treasury Bonds and Notes out of circulation, thereby increasing the price (and lowering the yield) of remaining Bonds and Notes. This drives down the “yield curve” and the net result is that investors become willing to take greater risks with their money to escape the losses due to inflation that result from sitting on cash in the form of Treasury Bills and Notes. Investors are denied a “safe harbor” for part of their investments and are being pushed into using that money to expand factories, provide new services, buy homes and hold more stocks.
The idea is to boost the economy while reducing the amount of interest the US Government pays on its debt. Wikipedia defines Financial Repression as “any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.” It is a disguised form of inflation, since all asset classes eventually come to be priced higher (by that same 1.8% noted above) vs. historic valuations relative to inflation. Some leading economists have concluded that Financial Repression is a form of taxation (cf. Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different. Princeton University Press, 2008, p. 143).
You may think that these monetary policies will soon end and the economy will recover enough to grow at its usual 3%/yr faster than inflation. Well, the last time the Federal Reserve employed Financial Repression it lasted from 1945 to 1980. When used by central banks of other countries, it has averaged 20 yrs in duration (Carmen Reinhart and Belen Sbrancia, National Bureau of Economic Research working paper, 2011). Over the last 35 years, Sweden’s use was the briefest at 6 yrs (1984-1990).
What is our goal for today’s blog? How do we defeat Financial Repression in order to save for our retirement. That is a tall order, given that every asset class is valued relative to US 10-yr Treasury Notes. Hedge funds, however, are designed to respond to asset class impairment. In response to the Lehman Panic, many hedge fund traders hopped into gold, oil, and emerging market stocks. Then they tried high yield (and emerging market) bonds and high yield stocks. All of those predictably became overpriced. Thus, hedge funds haven’t fared all that well over the past year or two. Now they’re taking a closer look at dividend-growing companies in “defensive” industries, namely, healthcare, consumer staples, and utilities, even though stock in those companies has also become high-priced.
In this week’s blog we take that approach and simply ask, which stocks fit our definition of a Hedge Fund (see Week 46)? That would be a stock that has beat the S&P 500 Index over the past 10 & 5 yrs, and fallen less than 65% compared to the S&P 500 Index during the Lehman Panic (10/07-4/09). That means we’ll have to stick to looking at stocks with a 5-yr Beta of 0.64 or less. And, since the S&P 500 Index had only a 1% total return for the past 5 yrs, we’ll only look at stocks with a 5-yr total return at least as great as that for “risk-free” money, which is 2.8% (i.e., the average rate of interest on 10-yr US Treasury Notes over the past 5 yrs). Because this blog is about saving for retirement by reinvesting dividend income, we’ll only look at stocks with a dividend yield of at least 1.8% (i.e., the 15-yr moving average for S&P 500 dividend yields). And, since there’s not much point in starting with a dividend-paying stock that doesn’t meet the “business case” for investment (see Week 68), we’ll exclude stocks that have a 5-yr dividend growth rate of less than 6%/yr. Finally, we’ll check financials on the WSJ website and exclude any that:
a) have a return on invested capital (ROIC) less than the weighted average cost of capital (WACC),
b) are capitalized mainly by long-term loans, or
c) didn’t have enough free cash flow (FCF) last year to pay at least half of this year’s dividends.
In this analysis, we have turned up only 10 companies (Table). As expected, most come from one of the 3 “defensive” industries: ABT (Healthcare), WEC, NEE (Utilities), and MKC, HRL, GIS (consumer staples) but each of the remaining 4 (MCD, CHRW, CB, IBM) come from one of the other 7 S&P industry classifications. It will come as no surprise that all 10 companies have an S&P stock rating of A-/M or better, and an S&P bond rating of BBB+ or better.
We compare these 10 stocks with our two favorite benchmarks (see Week 3):
a) a 50:50 split between low-cost mutual funds tracking the S&P 500 Index (e.g. VFIAX) and the Barclays Capital Aggregate Bond Index (e.g. PRCIX); and
b) the only mutual fund that is balanced ~50:50 between stocks and bonds, low-risk, low-cost and performs like a good hedge fund: Vanguard Wellesley Income Fund (VWINX). For you, the safest, cheapest, and least time-consuming way to save for retirement is to employ one of those benchmarks.
Bottom Line: Hedge funds seek to beat the S&P 500 Index during bull markets but fall less during bear markets. We set out to see which stocks perform like an above-average hedge fund (i.e., fell less than 65% during the Lehman Panic while beating the market) by using the most rigid criteria. We find that such safe & effective stocks are rare, and don’t necessarily hide out in the 3 “defensive” industries (healthcare, consumer staples, utilities). In other words, we had to look at all 114 stocks in Zack’s database that meet our key criteria (capitalization of at least $8 Billion, dividend yield of at least 1.8%, 5 yr dividend growth rate of at least 6%, and ROIC of at least 9.5%).
Risk Rating: 3. In other words, ownership of these stocks doesn’t have to be hedged with ownership of an equivalent amount of 10-yr US Treasury Notes and/or their untaxed equivalent (Savings Bonds) or a investment-grade bond fund like PRCIX. They’re internally hedged, much like the two utility stocks (WEC, NEE) but for more complex reasons having to do with competitive advantage (a topic we’ll explore in future blogs).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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