Situation: The S&P 500 Index represents the largest public companies in the US and uses a “scientific weighting”, where the greater the value of a company’s stock the higher the degree of representation for that company in the Index. We have watched the S&P 500 decline 14% in value over the 12 yr period from 1/3/2000 through 12/30/2011 meanwhile the “unscientific” Dow Jones indexes have increased in value:
the DJIA (30 industrial stocks) increased 6.2%,
the DJTA (15 transportation stocks) increased 69%,
the DJUA (20 utility stocks) increased 64%, and
the DJA (composite of those 65 stocks) increased 32%.
Ask any fisherman. The place to fish a river is the hole with the biggest fish. The place to fish for stocks is the smallest index that has the most valuable companies: the 65-stock DJA.
To find stocks in the DJA that are close to meeting our 6 criteria (discussed in Week 27) but aren’t quite there yet, we’ve tightened our risk screen to exclude stocks with a 2yr Bollinger Band variance exceeding 3 standard deviations and/or a 5yr Beta exceeding 0.95. That leads us into this week’s blog discussion and a spreadsheet of 9 stock picks. Six of these picks are on the 2012 Master List (see Week 27): KO, XOM, JNJ, NEE, PG, and WMT. The new “fish” are AT&T (T), Intel (INTC), and Travelers Insurance (TRV). You will recall that when we defined the ITR Growing Perpetuity Index (Week 4), we said it is composed of companies in the DJA that meet ITR’s investment criteria. The 3 new companies we identify this week (T, INTC and TRV) are all likely to be added to the GPI over the next 3 years.
Among non-DJA stocks on the 2012 Master List, only Abbott Laboratories (ABT), PepsiCo (PEP), Automatic Data Processing (ADP), and Becton-Dickinson (BDX) meet the low-risk standards that we have used to develop this week’s spreadsheet. In a very difficult 12-year period for stock owners, even these 13 low-risk stocks had tough sledding. Seven beat the 32% price increase for the DJA over that period: XOM (113%), NEE (187%), JNJ (41%), ABT (60%), PEP (88%), BDX (186%) and TRV (78%) but two stocks turned in an even worse performance than the gut-wrenching 14% loss posted by the S&P 500 Index: T (-38%) and INTC (-71%). The 4 “Steady Eddies” were PG (24%), WMT (-13%), KO (21%), and ADP (1%).
It’s worth noting that while the DJA was increasing at a rate of 2.4%/yr over that 12 year period, the Consumer Price Index increased 2.6% and inflation-protected ISB Savings Bonds increased 6.0% (doubling in value). This further illustrates why we recommend that you hedge stocks with an equal investment in bonds. Our point of balancing stock and bond investments 50:50 was emphasized to perfection in a recent Wall Street Journal article titled The Rally That Wouldn’t Die! (1/14/2012): “Since 1981, long-term Treasury bonds (average maturity of 20 yrs) have returned 11.03% annually, 0.05 percentage points better than the Standard & Poor’s 500-stock index.”
Bottom Line: Large, established companies are the best place to look for stocks that have lasting value and lower risk. We’ll continue fishing the Dow Jones Indexes for quality and dependability.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Showing posts with label B-Bands. Show all posts
Showing posts with label B-Bands. Show all posts
Sunday, January 22
Sunday, January 8
Week 27 - 2012 Master List
Situation: We update the ITR Master List at the end of each quarter to keep it current with new developments. Companies that no longer meet our investing criteria are removed from the list and new companies that meet our criteria are added to the list. This week's blog includes an updated spreadsheet <click here>.
For the first quarter of 2012, we decided to add two new criteria that will assist our readers in measuring the amount of risk that a company incorporates in its business plan. The new criteria are:
a) free cash flow (Week 25 blog - Master List Risk) must be at least 1.7 times the dividend payout, i.e., FCF/div equals or exceeds 1.7;
b) long-term financing with debt cannot exceed 45% of total capitalization, i.e., LT Debt/Total Capitalization is 45% or less.
With the addition of these two metrics, we are now using 6 criteria to evaluate the investment potential of a company. The original 4 criteria were:
1) an S&P stock rating of at least A-;
2) S&P bond rating of at least BBB+;
3) dividend yield at least as great as the S&P 500 Index’s yield; and
4) annual dividend increases for at least the last 10 yrs.
Our new assessment resulted in the removal of several companies from the ITR Master List. CL, LLTC, TGT & KMB were eliminated because LT debt/capitalization was greater than 45%; APD, KMB & SYY were eliminated because FCF/div was less than 1.7. A regulated utility, NEE, did not meet the new standards: it has FCF/div of 1.1 and LT debt/capitalization of 51%, however, it was not eliminated because these risk factors are mitigated by the State of Florida; i.e., debt is guaranteed as is return on investment.
As noted in the Week 25 blog that specifically addresses Risk, there are 3 factors that need to be tracked:
volatility,
long-term debt, and
cash flow problems.
Debt and inadequate free cash flow are the main sources of price volatility but there are other sources. One is speculation based on the high quality of the company’s brand. Coca-Cola, IBM, and General Electric have all seen periods when their stock price is unaccountably high for this reason. Investors buy a “blue chip stock” without digging through its Annual Report. In the updated ITR Master List, we are red-flagging stocks with a price higher than 3.5 times book value (see attached spreadsheet) to warn our readers. The volatility that then remains is cyclical, i.e., the price of railroads, financial and industrial stocks can become cheap during a recession then have a blazing recovery when the recession ends. Therefore, we use two factors to detect volatility:
1) 2yr Bollinger Bands and
2) 5yr Beta.
2yr Bollinger Bands evaluate recent volatility. We set the limit at 4 Standard Deviations away from the 2yr price fluctuation of the S&P 500 Index (go to Yahoo Finance, select "S&P 500 Index" or GSPC and select “interactive” under Charts (left column). Then select "2yr time period" and click on the tab at the top of the graph for “technical indicators” and select "Bollinger Bands" at dev=4.
5yr Beta evaluates volatility relative to the S&P 500 Index over a 5yr period: a value of 1.0 means volatility is identical to the Index’s, 0.5 means it's half as volatile, and 2.0 means twice as volatile. When a Master List stock is red-flagged for both of these volatility metrics, any buyer should expect a roller-coaster ride. Three such stocks are found on the 2012 Master List: EMR, NSC, and AFL.
Two new companies have been analyzed and found to meet our specific criteria for inclusion to the Master List: Chubb (CB), which markets insurance to corporations and high net-worth individuals; Genuine Parts (GPC), which sells automobile parts and business equipment through NAPA outlets. VF Corporation (VFC), a multinational clothing manufacturer, was returned to the list as a result of increasing its dividend.
We see from the spreadsheet that 4 Lifeboat Stocks from Week 23 (ABT, BDX, JNJ, and WAG) and one Core Holding from Week 22 (XOM) have no red flags. In other words, these 5 companies are priced at a reasonable multiple of book value, grow fast enough to continue raising dividends at a rate of ~10%/yr, and have mild price volatility relative to the S&P 500 Index.
Bottom Line: We identify 30 companies whose operations and management factors meet our conservative investment criteria. Five of these companies are currently free of concerns and therefore suitable for a DRIP portfolio composed of 7 or 8 stocks (but also keep in mind that smaller portfolios are risky due to lack of diversification).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
For the first quarter of 2012, we decided to add two new criteria that will assist our readers in measuring the amount of risk that a company incorporates in its business plan. The new criteria are:
a) free cash flow (Week 25 blog - Master List Risk) must be at least 1.7 times the dividend payout, i.e., FCF/div equals or exceeds 1.7;
b) long-term financing with debt cannot exceed 45% of total capitalization, i.e., LT Debt/Total Capitalization is 45% or less.
With the addition of these two metrics, we are now using 6 criteria to evaluate the investment potential of a company. The original 4 criteria were:
1) an S&P stock rating of at least A-;
2) S&P bond rating of at least BBB+;
3) dividend yield at least as great as the S&P 500 Index’s yield; and
4) annual dividend increases for at least the last 10 yrs.
Our new assessment resulted in the removal of several companies from the ITR Master List. CL, LLTC, TGT & KMB were eliminated because LT debt/capitalization was greater than 45%; APD, KMB & SYY were eliminated because FCF/div was less than 1.7. A regulated utility, NEE, did not meet the new standards: it has FCF/div of 1.1 and LT debt/capitalization of 51%, however, it was not eliminated because these risk factors are mitigated by the State of Florida; i.e., debt is guaranteed as is return on investment.
As noted in the Week 25 blog that specifically addresses Risk, there are 3 factors that need to be tracked:
volatility,
long-term debt, and
cash flow problems.
Debt and inadequate free cash flow are the main sources of price volatility but there are other sources. One is speculation based on the high quality of the company’s brand. Coca-Cola, IBM, and General Electric have all seen periods when their stock price is unaccountably high for this reason. Investors buy a “blue chip stock” without digging through its Annual Report. In the updated ITR Master List, we are red-flagging stocks with a price higher than 3.5 times book value (see attached spreadsheet) to warn our readers. The volatility that then remains is cyclical, i.e., the price of railroads, financial and industrial stocks can become cheap during a recession then have a blazing recovery when the recession ends. Therefore, we use two factors to detect volatility:
1) 2yr Bollinger Bands and
2) 5yr Beta.
2yr Bollinger Bands evaluate recent volatility. We set the limit at 4 Standard Deviations away from the 2yr price fluctuation of the S&P 500 Index (go to Yahoo Finance, select "S&P 500 Index" or GSPC and select “interactive” under Charts (left column). Then select "2yr time period" and click on the tab at the top of the graph for “technical indicators” and select "Bollinger Bands" at dev=4.
5yr Beta evaluates volatility relative to the S&P 500 Index over a 5yr period: a value of 1.0 means volatility is identical to the Index’s, 0.5 means it's half as volatile, and 2.0 means twice as volatile. When a Master List stock is red-flagged for both of these volatility metrics, any buyer should expect a roller-coaster ride. Three such stocks are found on the 2012 Master List: EMR, NSC, and AFL.
Two new companies have been analyzed and found to meet our specific criteria for inclusion to the Master List: Chubb (CB), which markets insurance to corporations and high net-worth individuals; Genuine Parts (GPC), which sells automobile parts and business equipment through NAPA outlets. VF Corporation (VFC), a multinational clothing manufacturer, was returned to the list as a result of increasing its dividend.
We see from the spreadsheet that 4 Lifeboat Stocks from Week 23 (ABT, BDX, JNJ, and WAG) and one Core Holding from Week 22 (XOM) have no red flags. In other words, these 5 companies are priced at a reasonable multiple of book value, grow fast enough to continue raising dividends at a rate of ~10%/yr, and have mild price volatility relative to the S&P 500 Index.
Bottom Line: We identify 30 companies whose operations and management factors meet our conservative investment criteria. Five of these companies are currently free of concerns and therefore suitable for a DRIP portfolio composed of 7 or 8 stocks (but also keep in mind that smaller portfolios are risky due to lack of diversification).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 25
Week 25 - Master List Risk
Situation: Risk is headline news again!! Consumers and corporations alike are taking on less risk these days but governments are still struggling. This is because governments are singularly able to increase spending during a recession. The central banks of the US and China spent heavily in early months of the recent recession and are now able to switch gears and think about repairing their lopsided balance sheets. European central banks, on the other hand, aren’t as dynamic and those economies now face a drawn-out recession. US corporations have cut borrowing (the S&P 500 Index Debt/Equity ratio has fallen from 1.6 to 1.2 over the past 3 yrs). US consumers have trimmed household debt and are still avoiding taking on new risks like real estate or stock purchases.
Put simply, our key question for this week’s blog is: How should the ITR investor measure the risk of investing in stocks? And a follow-on question: When is it smart to purchase a risky stock that has tumbled in value? Let’s dispense with the second question first. “Big money” is made in two ways, one of which is legal (taking on risk) and the second illegal (making trading decisions based on inside information). One of the effects of risk is to magnify volatility so that the stock will outperform in a rising market; but the downside amounts to a “near death experience” in a falling market. Experienced traders don’t consider buying stock in a “fallen angel” until after it has recovered ~40% of its lost value, and such a recovery can sometimes take years. The ITR DRIP investor isn’t going to want to be caught holding one of those stocks on the eve of retirement.
Now to address the first question: how is risk measured? In evaluating a company, “risk” is about volatility, debt, and cash flow that might not be enough pay a dividend. Price volatility can be assessed from the interactive graph function at Yahoo Finance by picking a stock index and charting it’s Bollinger Bands (BB) over the most recent two year (499 day) time span, setting the standard deviation at 4. To have a BB reference index that weights utilities and transportation companies better than the S&P 500 Index, we like to use the Dow Jones Composite Index (DJA) as our reference index for volatility. The Dow Jones Utility Index is a good metric for the performance of companies that provide essential goods, and the Dow Jones Transportation Index reflects “the pulse of the economy” better than the S&P 500 Index. The Dow Jones Composite Index will outperform the S&P 500 Index over extended periods of time. Why? Because it over-weights “boring transports and utilities.”
For the remaining two risk metrics (debt and cash flow), we use accounting data that can be found at both Yahoo Finance and the online Wall Street Journal (wsj.com). Long-term (LT) debt that is more than 1/3rd of total capitalization is a red flag. Free cash flow (FCF) is our most important risk metric because it’s the source of dividend growth: FCF is red-flagged when it’s less than two times the current dividend payout. How is FCF measured? By going to the Statement of Cash Flows. Start with “net cash flow from operations”, i.e., the bottom line of the first part of a Cash Flow Statement. Then subtract from that number the first item (capital expenditures) of the second part - called “cash flow from investments”. Divide that number by the first item (dividends paid to holders of common stock) of the third part, which is called “cash flows from financing.” An FCF/div greater than 2 indicates that the company can comfortably pay its usual dividend and consider raising its dividend. Wikipedia gives two examples under the topic of “cash flow statement”; the second example (XYZ co. LTD) can be used to follow the guidance above. This company is unlike those on our Master List, in that it has negative cash flow from operations and yet pays a large dividend. FCF/div = -0.65. The accompanying table shows the 4 numbers from the Cash Flow Statement that are used to determine FCF/div for each company.
In the accompanying table <click here>, we provide risk metrics (2yr BB volatility score, LT debt/cap, and FCF/div from the most recent annual report) for each stock in the ITR Revised Master List (Week 16). We also note the current dividend and the average rate of dividend growth over the past 10 years. Our risk analysis shows that 10 of these companies are well-managed from the standpoint of risk: JNJ, ABT, BDX, WAG, MKC, ADP, XOM, MMM, GD, and TROW.
Bottom Line: Know what you’re buying. Rather than attempting to hit the ball out of the park by picking stocks poised to reap windfall profits from a bull market, a sounder approach is to get on base with a walk or single. Leave the home run attempts to the gamblers while you carefully build your retirement portfolio using sound, well thought-out decisions.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Put simply, our key question for this week’s blog is: How should the ITR investor measure the risk of investing in stocks? And a follow-on question: When is it smart to purchase a risky stock that has tumbled in value? Let’s dispense with the second question first. “Big money” is made in two ways, one of which is legal (taking on risk) and the second illegal (making trading decisions based on inside information). One of the effects of risk is to magnify volatility so that the stock will outperform in a rising market; but the downside amounts to a “near death experience” in a falling market. Experienced traders don’t consider buying stock in a “fallen angel” until after it has recovered ~40% of its lost value, and such a recovery can sometimes take years. The ITR DRIP investor isn’t going to want to be caught holding one of those stocks on the eve of retirement.
Now to address the first question: how is risk measured? In evaluating a company, “risk” is about volatility, debt, and cash flow that might not be enough pay a dividend. Price volatility can be assessed from the interactive graph function at Yahoo Finance by picking a stock index and charting it’s Bollinger Bands (BB) over the most recent two year (499 day) time span, setting the standard deviation at 4. To have a BB reference index that weights utilities and transportation companies better than the S&P 500 Index, we like to use the Dow Jones Composite Index (DJA) as our reference index for volatility. The Dow Jones Utility Index is a good metric for the performance of companies that provide essential goods, and the Dow Jones Transportation Index reflects “the pulse of the economy” better than the S&P 500 Index. The Dow Jones Composite Index will outperform the S&P 500 Index over extended periods of time. Why? Because it over-weights “boring transports and utilities.”
For the remaining two risk metrics (debt and cash flow), we use accounting data that can be found at both Yahoo Finance and the online Wall Street Journal (wsj.com). Long-term (LT) debt that is more than 1/3rd of total capitalization is a red flag. Free cash flow (FCF) is our most important risk metric because it’s the source of dividend growth: FCF is red-flagged when it’s less than two times the current dividend payout. How is FCF measured? By going to the Statement of Cash Flows. Start with “net cash flow from operations”, i.e., the bottom line of the first part of a Cash Flow Statement. Then subtract from that number the first item (capital expenditures) of the second part - called “cash flow from investments”. Divide that number by the first item (dividends paid to holders of common stock) of the third part, which is called “cash flows from financing.” An FCF/div greater than 2 indicates that the company can comfortably pay its usual dividend and consider raising its dividend. Wikipedia gives two examples under the topic of “cash flow statement”; the second example (XYZ co. LTD) can be used to follow the guidance above. This company is unlike those on our Master List, in that it has negative cash flow from operations and yet pays a large dividend. FCF/div = -0.65. The accompanying table shows the 4 numbers from the Cash Flow Statement that are used to determine FCF/div for each company.
In the accompanying table <click here>, we provide risk metrics (2yr BB volatility score, LT debt/cap, and FCF/div from the most recent annual report) for each stock in the ITR Revised Master List (Week 16). We also note the current dividend and the average rate of dividend growth over the past 10 years. Our risk analysis shows that 10 of these companies are well-managed from the standpoint of risk: JNJ, ABT, BDX, WAG, MKC, ADP, XOM, MMM, GD, and TROW.
Bottom Line: Know what you’re buying. Rather than attempting to hit the ball out of the park by picking stocks poised to reap windfall profits from a bull market, a sounder approach is to get on base with a walk or single. Leave the home run attempts to the gamblers while you carefully build your retirement portfolio using sound, well thought-out decisions.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, August 21
Week 7 - Risk
Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;
(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and
(c) the S&P downgrade
have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
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