Month 109 - 6 High-yield A-rated Non-financial Growth Stocks in the Dow Jones Industrial Average - July 2020

Situation: The purpose of a retirement portfolio is to accumulate wealth during working years and distribute that wealth during sunset years. The laws of finance that govern accumulation are “reversion to the mean” and “compound interest”. The closest we have to a law of finance that governs distribution is “the 4% rule”. 

If we dollar-cost average our purchase of shares on a monthly schedule during the accumulation period, we’ll never overpay over a given market cycle, i.e., we’ll “buy low” as often as we’ll “buy high” as reversion to the mean works its magic. If we automatically reinvest quarterly dividend payouts, this quarter’s dividend will pay a dividend on last quarter’s dividend as “compound interest” works its magic. During retirement, we’ll spend 4% of our total asset value, as calculated on December 31st of the year just ended, in the coming year. 

A-rated high-yield growth stocks in the Dow Jones Industrial Average (DJIA) have a dividend yield of ~3%/yr. So, if you’ve been dollar-averaging into those stocks you’ll occasionally want to sell shares in one of those stocks to meet next year’s spending goal. But given the stability of those reliable and growing payouts, I’d suggest that you look elsewhere to make up the projected shortfall. Why? Well, look at the spreadsheet of this month’s 8 DJIA growth stocks. If you own shares in all eight companies, you’re likely to enjoy a dividend yield of more than a 3%/yr for years to come. 

Mission: Find A-rated non-financial growth stocks in the DJIA that have an above-market dividend yield; analyze those by using our Standard Spreadsheet.

Execution: see Table.

Administration: A-rated means that S&P assigns the company’s bonds a rating of A- or higher, and assigns the company’s common stock a rating of B+/M or higher. It also means that debt levels are reasonable. So, in a setting of negative Tangible Book Value it is unreasonable for a company to be capitalized more than 50% with debt or to have total debts greater than 2.5 times EBITDA. Exclude financial stocks and stocks that have been traded on public exchanges for less than 20 years. Select only from DJIA stocks that are held in both of these portfolios: Vanguard High Dividend Yield ETF (VYM) and iShares Russell Top 200 Growth ETF (IWY).

Bottom Line: Market volatility is the key concern for investors who plan to maintain their lifestyle during retirement. So, you might as well make money off it. That means automatically buy low (through dollar-cost averaging) whenever the market collapses, and automatically take advantage of mean regression while you’re at it. In other words, use dollar-averaging to buy shares in high-yielding companies for nothing by using a DRIP (dividend reinvestment plan), where dividends pay dividends on previously reinvested dividends. 

Risk Rating: 5 (where 10-yr US Treasury Notes = 1, S&P 500 Index ETFs = 5, and gold = 10).

Full Disclosure: I dollar-average into PG, JNJ and CAT, and also own shares of MRK, CSCO and MMM

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Month 108 - 14 Buy-and-Hold Stocks in both the Dow Jones Composite Index and the S&P 100 Index - June 2020

Situation: If you’re a stock picker, you’ll need Buy-and-Hold stocks that are suitable for retirement but you’ll also need to know how to “buy low.” The job of an investor, according to Joel Greenblatt (CEO of Gotham Capital), “is to figure out what a business is worth and pay a lot less”. Those two words (buy low) separate investors from savers. 

The objective way to “buy low” is to listen to Warren Buffett and dollar-cost average a fixed amount each month into shares of large, well managed, and long-established companies with clean Balance Sheets. You do this by using an online Dividend Re-Investment Plan (DRIP). When the price of that stock falls during a Bear Market, you’ll automatically BUY LOW and acquire more shares per month than usual. 

The subjective way to “buy low” is to resort to labor-intensive Fundamental Analysis, which uses a bespoke set of metrics to repeatedly examine stocks in each sub-industry and decide which are bargain-priced. My requirements for a company to be “A-rated” and join my Watch List of “large and well-managed companies with clean Balance Sheets” can be seen in the Tables for each month’s blog. For example, a large company is one in the S&P 100 Index. A well-managed company is one picked by the Managing Editor of The Wall Street Journal for inclusion in the 65-stock Dow Jones Composite Index. A clean Balance Sheet is one earning an S&P Bond Rating of A- (or better), with positive Book Value for the most recent quarter (mrq). I also require that Tangible Book Value (TBV) be a positive number but a negative TBV is acceptable if the company is mainly capitalized by Common Stock and its Total Debt is no greater than 2.5X EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) for the Trailing Twelve Months (TTM). The companies I analyze are listed in both the iShares Russell Top 200 Value ETF (IWX) and the Vanguard High Dividend Yield Index ETF (VYM). I interpret “long-established” to mean a 20+ year history of being traded on a public stock exchange.

Mission: Using our Standard Spreadsheet, analyze A-rated stocks that are in both the 65-stock Dow Jones Composite Average and the S&P 100 Index.

Execution: see Table. Columns AP and AQ give annual costs and the vendor URL for each dividend reinvestment plan (DRIP). 

Administration: The idea behind owning “value” stocks is to lose less during Bear Markets. The idea behind owning “growth” stocks is to earn more during Bull Markets. Column AO shows how much the price of each stock changed in 2008. Column D shows how much the price of each stock changed in 2018 (when the S&P 500 Index lost 19.9% in the 4th quarter). These 14 stocks lost 5% less than the S&P 500 ETF (SPY) in 2018, and 17.3% less in 2008. An additional benefit of owning shares in these “value” companies that pay above-market dividends is that 7 are also listed in the iShares Russell Top 200 Growth ETF (IWY): MRK, KO, PG, JNJ, CAT, MMM, IBM. You can have “the best of both worlds” by owning those. 

Bottom Line: The secret of stock picking is to have a short Watch List because you’ll need to practice due diligence: follow the evolution of each company’s “story” and the effectiveness of its managers. This takes time and money: online subscriptions to The Wall Street Journal, Barron’s, Bloomberg Businessweek, and The New York Times don’t come cheap. Neither do online DRIPs: For example, the average expense ratio in the first year of using a DRIP to buy into these 14 companies is 1.56% (see Column AP in the Table: $18.76/$1200 = 1.56%). And, you’ll get a bigger bill from your accountant if you decide to sell a DRIP, besides spending more time yourself to get the paperwork ready. For example, you’ll have to list the “cost basis” for each of the 16 purchases you made each year (12 monthly purchases plus 4 purchases to reinvest quarterly dividends) of each stock so your accountant can calculate capital gains.

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

Full Disclosure: I dollar-average into PFE, NEE, INTC, KO, PG, WMT, JPM, JNJ, CAT and IBM, and also own shares of MRK, DUK, SO and MMM. 

NOTE: Aside from dollar-cost averaging, there is second objective way to buy low: make “one-off” purchases of any of these 14 stocks that appear on the “Dogs of the Dow” list, which is updated every New Year’s Day. For example, the 10 dogs on this year’s list include: International Business Machines (IBM), Pfizer (PFE), 3M (MMM), and Coca-Cola (KO).

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Month 106 - A-rated Value Stocks in the S&P 100 Index - April 2020

Situation: Growth at a reasonable price (GARP) is often mentioned as an investing goal because value underlies the decision to buy. Warren Buffett is the king of value investing and has over $80 Billion in cash (his “elephant gun”) that he’d like to spend. We’re in a Bear Market fueled by the adverse economic consequences of the COVID-19 pandemic. So, he’ll soon spend that cash pile to buy a large company. Let’s look at his options, considering the ways he has prioritized purchases in the past. Firstly, he likes large and long-established companies. Why large companies? Because those have multiple product lines, one of which is usually designed to help the company maintain a stream of revenue during a recession. In addition, those companies are large enough to have the marketing power needed to maintain and grow their brands. 

Mission: Let’s see which choices look attractive among A-rated “haven stocks” in the S&P 100 Index (see Month 104). Remember: These companies reliably pay an above-market dividend, so they’re found in the Vanguard High Dividend Yield Index (VYM), and they’re also listed in the iShares Russell Top 200 Value ETF (IWX). Warren Buffett places high store in companies that don’t overuse debt and also retain Tangible Book Value, so we’ll exclude companies with negative Tangible Book Value that also have a total debt load greater than 2.5 times EBITDA (Earnings Before Interest, Tax, Depreciation & Amortization) or have sold long-term bonds to build more than 50% of their market capitalization. Finally, the company's stock price has to meet both of our two value criteria: 1) Share price isn't more than twice the Graham Number; 2) share price isn't more than 25 times average 7-yr earnings per share. 

Execution: (see Table).

Administration: These 9 companies include 4 from the two most deeply cyclical industries: banks and semiconductor manufacturers. Berkshire Hathaway’s portfolio already includes the 3 banks on the list, i.e., JPMorgan Chase (JPM), U.S. Bancorp (USB), and Wells Fargo (WFC) but doesn’t include the semiconductor manufacturer, Intel (INTC). Berkshire Hathaway is at heart an insurance company, so Warren Buffett always needs to diversify away from the Financial Services industry. There are only 4 non-financial companies on the list: Intel (INTC), Cisco Systems (CSCO), Pfizer (PFE), and Target (TGT), and only TGT is within the price range that Mr. Buffett is looking to spend ($80 to $100 Billion). 

Bottom Line: Target (TGT) appears to be the most attractive company to add to Berkshire’s stable, given that it is priced right and Mr. Buffett already has experience owning companies in the Consumer Discretionary industry.. 

Risk Rating: 7 (where 10-yr U.S. Treasury Notes = 1, S&P 500 Index = 5, and gold = 10).

Full Disclosure: I dollar-average into INTC and JPM, and also own shares of PFE, CSCO, TGT, USB, BLK and WFC.

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Week 251 - A-rated S&P 500 Dividend Achievers with a Durable Competitive Advantage

Situation: Stock markets are more fragile than most people realize. For example, the S&P 500 Index has a Return on Assets or ROA of ~3% while its Weighted Average Cost of Capital or WACC is ~8%. Although the deficiency in ROA vs. WACC is unsustainable, that’s thought to be OK because the economy is still recovering from the Great Recession, i.e., the return on assets will reach parity with the cost of assets. As long as that doesn’t happen, company managers will hesitate before investing yet more capital in property, plant, equipment, and labor. Instead, they’ll be more likely to return money to investors via a buy back of stock or by raising the dividend. That has been common practice since the Great Recession, and is one reason why the stock market has a P/E ratio that is higher than its historical average.

Stock markets have only one fuel, and that is peoples’ savings, including the savings of corporations now that the US Supreme Court has decided that a corporation is essentially “a person” with the same First Amendment rights. Savings are more constrained than ever because the level of indebtedness of countries, corporations, states, cities, and small businesses has not decreased since the Great Recession. Only household debt has managed to recover somewhat. The “great unwind” has yet to occur. Deleveraging is not a priority for governments or corporations because interest rates are so low that it seems foolish not to borrow money. Until deleveraging happens, the ROA for the most important asset (educated citizens) will not be much greater than the cost of creating that asset. Why? Because the cost of servicing debt eats into savings needed for investment.

Given the above warning, you need to look for stock in companies that are responsibly managed and clearly profitable. These would be firms that have high operating margins most of the time (e.g. Nike), or moderate but stable operating margins all of the time (e.g. Wal-Mart Stores). What is an “operating margin” (see Column M in the Table)? It is an unambiguous measure of profitability, expressed as a ratio: EBIT/Total Revenue, where EBIT = Earnings Before Interest and Taxes. “Total Revenue” is the first line of an Income Statement and “Earnings Before Interest And Taxes” is usually at line 13. See this Income Statement of 3M Corporation as an example.  

Mission: Screen the S&P 500 Index for companies that have the following quality markers: 1) high S&P bond ratings (A- or higher) and stock ratings (A-/M or higher); 2) are designated as a Dividend Achiever by S&P, indicating annual dividend increases for at least the past 10 yrs; 3) have a Durable Competitive Advantage or DCA (see Columns P through T in the Table), as defined by Warren Buffett (see Week 241).

Execution: Given the turbulent nature of the stock market over the past decade, there are only 9 companies that meet our requirements (see Table). All of those companies have an Operating Margin greater than the WACC (see Column N of the Table). But some of the companies have a current problem selling their goods and services that pushes their ROA lower than their WACC (compare Column O to Column N in the Table). Exxon Mobil (XOM) at Line 10 in the Table is a prime example.

Bottom Line: It is particularly difficult to save for retirement when Central Banks are busy lowering the interest rate on bonds, a move that is meant to entice people to invest in stocks, start a new business, build a factory, create an app, buy a home or get a better education. For retirement planning, you need to put ~50% of your savings into dividend-paying stocks and the remainder into US Treasuries. To get adequate diversification, your stocks need to represent all 10 S&P industries. To get adequate quality, you need to have stringent criteria like those above. Only 6 S&P industries have contributed the 9 stocks that meet our stringent criteria: Consumer Staples (WMT), HealthCare (JNJ and ABT), Utilities (NEE), Consumer Discretionary (TJX, ROST, NKE), Information Technology (MSFT) and Energy (XOM). You can check out our recent blogs on defensive industries (Week 247) and growth industries (Week 248) for help picking stocks to cover the other 4 S&P industries (Basic Materials, Communication Services, Industrials, and Financials).

Risk Rating: 5

Full Disclosure: I dollar-average into WMT, JNJ, NEE, NKE, MSFT and XOM, and also own shares of ABT, TJX and ROST.

NOTE: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, VBINX at Line 16 in the Table. Total returns/Yr in Column C, and the CAGR for stock prices in Column U, are for performance over the past 20 years. That period is chosen because it covers approximately 3 market cycles, i.e., there have been 15 recessions in the past 90 years for an average of 6 years between each.

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Week 184 - Barron’s 500 List: Production Agriculture Companies

Situation: Agriculture stocks potentially offer investors above-average rewards, given that 1) food is an “essential good” and 2) middle-class consumers in Asia continue to grow in numbers and demand more protein in their diets. Companies that supply farmers with equipment, seeds, insecticides, feed, and fertilizer depend on the weather cycle and population growth for their pricing power, instead of the economic cycle. Valuations on those production agriculture companies tend to track farmland values, which have been growing 14-15%/yr for the past 14 yrs vs. 4-5%/yr for the S&P 500 Index with dividends reinvested.

The problem for investors is that there are many Production Agriculture companies and most are in the mid-cap range or have less-than-investment-grade credit ratings. For this week’s blog, we’ll stick to analyzing those that appear on the Barron’s 500 List with S&P investment-grade bond ratings and S&P stock ratings of at least B+/H.

That leaves only 9 companies (see Table). Some have P/E values higher than the S&P 500 Index, which has been hovering around 20. To see whether this should be a concern, we looked at each company’s Enterprise Value relative to Operating Earnings, i.e., EV/EBITDA (see Column K in the Table). Any value over 13 suggests that the stock is overpriced. None fell into that category.

Bottom Line: We’ve come up with 9 Production Agriculture stocks that are appropriate for inclusion in a retirement portfolio. When you pick one or two to accumulate over time with dollar-cost averaging, you’ll receive dividend cheques in retirement that are likely to grow twice as fast as inflation (see Column H in the Table).

Risk Rating: 7

Full Disclosure: I own shares of MON, DE, CF, CMI, HRL, and DD.

NOTE: Metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance relative to our benchmark, the Vanguard Balanced Index Fund.

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Week 182 - Our Current List of Hedge Stocks

Situation: It has been 32 weeks since we published our list of Hedge Stocks (see Week 150). That list of 17 companies grows shorter due to market volatility and overvaluation. Even so, the idea of owning stock in a company that is relatively immune from “shorting” by hedge funds remains worthwhile. Why? Because the 10-yr Treasury Notes that professional investors typically use to immunize their portfolio against short sales will continue to pay a lower-than-inflation rate of interest, as long as the Federal Reserve continues its policy of “financial repression” (see Week 79). That means any high-quality bond will have a historically low interest rate, limiting its utility as a portfolio protector. In this environment, stocks that have none of the features that attract hedge fund traders gain added value because it is unlikely that such stocks will plummet in a bear market. That means Hedge Stocks don’t need to be backed by high-quality bonds or low-risk bond funds.

Initially, the stocks we were looking for had these features (see Week 150):
        a) low volatility (5-yr Beta less than 0.7);
        b) a P/E of 22 or less;
        c) higher returns over both the past 5 and 14 yrs than our benchmark (VBINX);
        d) higher Finance Value than VBINX (see Column E in our Tables);
        e) an S&P rating of BBB+ or better on the company’s bonds.

With experience, we’ve decided to modify those criteria. One change is that we’ll only consider companies large enough to appear on the Barron’s 500 List, which is published each year in May. That gives us a way to evaluate fundamental metrics year-over-year: “median three-year cash-flow-based return on investment; the one-year change in that measure, relative to the three-year median; and adjusted sales growth in the latest fiscal year.” Another change is that we’ll only consider companies which either appear in the top 2/3rds of that list (i.e., rank in the top 333) for the two most recent years or have a higher ranking in the most recent year. The third change is to measure valuation by EV/EBITDA (Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation, and Amortization) instead of by P/E (stock price divided by the past 4 quarters of earnings). EV/EBITDA is the market value of all the stock and bond issues that are used to capitalize the company, divided by operating earnings. The use of cash, which is gained from operating earnings plus the issuance of stocks and bonds, is not addressed by EV/EBITDA. We have set the upper limit for valuation of a Hedge Stock at an EV/EBITDA of 13, instead of at a P/E of 22. Finally, to exclude under-analyzed companies, we’ll require an S&P stock rating of at least B+/M.

Bottom Line: Of the 17 companies in our last list of Hedge Stocks (see Week 150), only 9 remain: WMT, MCD, ED, SO, GIS, NEE, XEL, PEP, KMB (see Table). Three companies have been added: Altria Group (MO), Archer-Daniels-Midland (ADM), and Lockheed Martin (LMT). As it happens, all 12 companies are Dividend Achievers. That should tell you something.

Risk Rating: 4

Full Disclosure: I dollar-average into WMT and NEE, and also own shares of MCD, GIS and PEP.

NOTE: Metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance relative to our benchmark (VBINX).

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Week 181 - Bond Substitutes

Situation: Our long-term investment philosophy balances the risks of stock ownership by hedging those purchases with bonds, bond substitutes, or non-correlated assets. The idea is to have an investment that is capable of ameliorating a 20+% drop in the S&P 500 Index. Otherwise, it could take 2-6 yrs for your retirement portfolio to recover from a Bear Market. If you’re over 50, that doesn’t leave enough time for you to make up for the loss and still have an adequate retirement income. The best hedges are US Treasuries because those go up a lot in price when stock prices plunge. However, most retail investors currently avoid US Treasuries. Why? Because their interest rate is likely to remain low while the Federal Reserve cautiously emerges from “financial repression” (see Week 76 and Week 79). Financial Repression will probably remain with us as long as world debt is more than twice world GDP, and that is currently at a record high of 212%. This means that you need to learn about other ways to protect your retirement portfolio, starting with bond substitutes.

Conservatively managed stock/bond mutual funds, like the Vanguard Wellesley Income Fund (VWINX, at Line 28 in the Table), often substitute short-term bets on corporate bonds for longer term bets on US Treasuries. This has helped to maintain remarkably stable and strong returns for that asset class. VWINX has grown ~7.5% over the past 14 yrs and ~10%/yr over the past 5 yrs. You can separately invest in a corporate bond mutual fund at low cost. We like the Vanguard Intermediate-Term Investment-Grade Bond Fund (VFICX at Line 7 in the Table), which is itself hedged with US Treasuries as needed. See the Morningstar report for more information. VFICX has returned over 6%/yr long-term (e.g. since the S&P 500 Index peaked on 9/2000) as well as over the past 5 yrs. Note that the lowest cost S&P 500 Index fund (VFINX at Line 32 in the Table) has returned only ~4%/yr since 9/2000 with dividends reinvested. Without those gains from dividend reinvestment, it hasn’t even kept up with inflation! You get the point: A low-cost, investment-grade, intermediate-term, managed corporate bond fund is the Gold Standard hedge against stock market crashes.

Now let’s look at other options, like gold (see Week 175) and hedge stocks (see Week 150). Gold did well in the Lehman Panic but has terrible volatility (see Line 20 in the Table), and is still looking for the bottom in its current bear market. (Gold bullion has been falling in price at a rate of ~1.4%/mo for more than 3 yrs now.) An easier option is to pick stocks that hedge-fund managers are unlikely to sell short (see Week 150). The 17 stocks we’ve listed in that blog don’t need to be backed with bonds, since they’re unlikely to lose much money in a stock market crash. 

This week, we’ll look at a variation on that theme and screen the 20 stocks we’re aware of that lost less during the Lehman Panic than their long-term rate of return. In other words, they carry a positive number for Finance Value (see Column E in any of our tables). Five of those 20 companies appear on our list of Hedge Stocks (see Week 150): Wal-Mart Stores (WMT), McDonald’s (MCD), and 3 utilities:  Wisconsin Energy (WEC), Consolidated Edison (ED), and Southern (SO). We’ll call those Bond Substitutes. In the Table, we group those with corporate and international bond funds in a category called TREASURY BOND SUBSTITUTES.

Ten of the 20 stocks didn’t meet our criteria for stability, one requirement of which is to have a current price that is less than 10 times Tangible Book Value (TBV - see Column R in the Table). Another is to have an Enterprise Value (EV) that is less than 15 times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EV/EBITDA represents operating earnings relative to the market value of the stocks and bonds that capitalize a company (see column K in the Table). Now we have 5 companies that are hedge stocks (WMT, MCD, WEC, ED, SO) plus an additional 5 that are stable growers but have metrics that could make them attractive for hedge fund traders to “short.” Those 5 are Ross Stores (ROST), JB Hunt Transportation (JBHT), Hormel Foods (HRL), Occidental Petroleum (OXY), and QUALCOMM (QCOM). In the Table, they’re grouped with gold as LESS ATTRACTIVE T-BOND SUBSTITUTES. 

Upon applying the Buffett Buy Analysis (BBA in Column T; see Week 30), only WEC, ROST, QCOM look worthwhile for investment in this overheated market. Caveat Emptor: If you like these stocks, you’ll first need to assess the “story” that supports each company’s prospects for the future. Why? To determine if you want to buy into that story. You might decide the story is “broken” (or about to be), in which case you’ll look for something better to purchase with your retirement funds.

Bottom Line: We’ve introduced the thorny topic of “bond substitutes.” Gold is one such substitute. Stocks with a history of price stability in hard times are another (if they pay a dividend that persistently outgrows inflation). 

Risk Rating: 4

Full Disclosure: I own some Treasury Notes as well as shares of RPIBX, HRL, and MCD. I also dollar-average into WMT each month.

NOTE: Metrics in the Table are current as of the Sunday of publication.

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Week 180 - Reasonably Priced S&P 100 Stocks

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.

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Week 158 - The Barron’s 500 List Screened for Durable Competitive Advantage

Situation: “It was the best of times, it was the worst of times…” That’s how investors will come to regard the current macroeconomic situation. The “best of times” because both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) are making new, inflation-adjusted highs. The “worst of times” because every major economy on the planet is locked in a grinding, low-grade borderline deflation because of unsustainably high interest payments on overall debt, owned by individuals, corporations and governments. How can the “retail” investor play this moment? What kind of asset allocation do YOU want to be sitting on? If you have enough income to open a new position, what should you bet on? A stock, a bond, cash-equivalents, gold, a home mortgage (instead of renting), commodity futures, or whole life insurance?

Here in the US, stock indices are loudly declaring a primary upward trend, which Dow Theory says will be sustained until either the DJIA or DJTA drops below a previously important low. That would mean a drop of more than 60%. Such an occurrence seems unlikely, short of World War III or a global pandemic. Central Banks are going to keep interest rates low for as long as it takes that “free money” to pump investment up enough for growth in productivity and employment to bring down per-capita debt. During that period, stock market returns over rolling 5-yr periods are unlikely to beat 10%/yr, even here in the US, which is the one place where deflation no longer remains a looming threat (see Week 143).

Given that stock investments are the best known way to beat inflation while having enough income to take advantage of compound interest (see Week 157), you’ll keep buying stocks unless overpricing becomes widespread, meaning you can no longer find a high-quality yet reasonably priced stock. Once the price/earnings ratio for the S&P 500 reaches 20, as it did recently, it doesn’t make much sense to buy stock unless you know how to ferret out the few remaining high-quality bargains. Let’s do that now.

First, we’ll apply Warren Buffett’s method to find out which companies have a “Durable Competitive Advantage” (see Week 135, and “DCA” in Column K of this week’s Table). This method computes a simple trendline for growth in Tangible Book Value (TBV, see Column L) over the past decade. If that rate is higher than 7%/yr, and TBV has no more than two down years, then the company has a Durable Competitive Advantage. The problem is that not many CEOs align TBV growth with earnings growth. They’d rather spend that money on a merger or acquisition. That’s particularly true for companies in defensive industries, where the risk of bankruptcy is nil, and they can do this because their products are essential. 

Next we want to know if the company’s stock price has become higher than its trendline for earnings growth can justify. To address that issue, Warren Buffett takes companies with a Durable Competitive Advantage and subjects them to a stress test, which we call the Buffett Buy Analysis (see “BBA” at Column M in the Table). The trendline for earnings over the past decade is extended out for a decade in the future. That dollar amount of earnings is multiplied by the lowest P/E ratio seen over the past decade to project a price 10 yrs from now. If the company pays a dividend, the current amount of that dividend is multiplied by 10 and added to the earnings projected for 10 yrs from now. (Mr. Buffett’s idea here is that the economy will be in the doldrums for the next 10 yrs such that the company will be unable to raise its dividend. However, companies that are able to maintain dividends will be rewarded with a higher stock price.) Those companies that have a Durable Competitive Advantage, but are projected by their BBA to grow their stock price slower than 7%/yr over the next decade, are rejected. In other words, their current price is so high that expected growth has already been “discounted” by enthusiastic buyers.

By applying this analysis to the 500 companies in the Barron’s 500 List, which are the largest companies (by revenue) on the New York and Toronto stock exchanges, we are left with just 26 companies to consider (see Table). Of these, only Ross Stores (ROST), Monsanto (MON), TJX Companies (TJX) and Franklin Resources (BEN) are found in the “universe” of 63 companies we consider to be worthwhile candidates for your retirement portfolio (see the Table for Week 122). None appear on our 29-stock Master List (see Week 146). In other words, all 26 companies in this week’s Table are chancy investments that have to be backed dollar-for-dollar with Savings Bonds or 10-yr Treasury Notes. As Warren Buffett recently stated: “If you’re not a professional, you are thus an amateur.” So cover your bets.

Bottom Line: Be careful how you deploy new money into this overheated market. The 26 stocks we’ve found are worthwhile bargains for you to consider but come with considerable price volatility (see Columns D and I in the Table). Even knowing that these stocks are not overpriced at the time of this writing (6/1/14), you still need to know whether the “story” supporting that stock price remains intact. If the story is broken, then the stock is overpriced. Researching THAT detail requires more attention than you’ll have time for on weekends. But start slowly, with an easy assignment. Analyze the 3 “blue chip” stocks on the list that are part of the Dow Jones Industrial Average: Cisco Systems (CSCO), Travelers (TRV), and JP Morgan Chase (JPM). Each is a dominant player in its industry, and it is those industries (finance and information technology) where professionals earn their greatest rewards by deciding on the right entry point for buying the stock as well as the right exit point.

Risk Rating: 7

Full Disclosure: I own shares of MON, CF, ACN, and TJX.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

Week 17 - Value vs. Growth

Situation: ITR investors need to know the broad outline of a company’s business plan, so they will not be surprised by price swings in bull and bear markets.

Goal: Orient ITR investors to important accounting ratios that will help them characterize a stock.

To some extent, all of the stocks that are covered in ITR blogs can be called “value” stocks because the companies pay dividends, and those dividends are bigger than the market yield. Growth stocks produce a total return mainly through price appreciation, whereas, value stocks produce a total return mainly through sizable dividend payouts. 

Growth companies tend to be priced high relative to earnings and book value, and the total (enterprise) value of the company tends to be high relative to operating earnings (EBITDA) and sales (Revenue). The updated Master List (Week 16) has a column for each of these 4 accounting ratios. Higher ratios represent stock prices that have been “bid up” in expectation of continued growth for both the price of that stock and the economy. That is speculation, whereas, the payment of a dividend is real.

Growth companies like Colgate-Palmolive (CL), Coca-Cola (KO), McCormick (MKC), Automatic Data Processing (ADP), and T. Rowe Price (TROW) pay a modest dividend and have 3-4 elevated accounting ratios. At the opposite end of the spectrum are value companies that pay a substantial dividend and have 0-1 elevated accounting ratios: Sysco (SYY), Pepsico (PEP), Kimberly-Clark (KMB), NextEra Energy (NEE), and Chevron (CVX). “Defensive” industries (utilities, health-care, consumer staples) are the usual source of value stocks. However, you’ll notice that here we have an energy stock (CVX) but no health-care stock. (ABT and JNJ yield over 3% but aren’t cheap.) NEE is partly an energy stock, since only half is a regulated utility (Florida Power & Light); the other half is a wholesaler of wind & solar electricity (NextEra Energy Resources). The fact that NEE and CVX are value stocks tells us that energy production & distribution can be purchased very reasonably. On the other hand, pharmaceutical companies, are unreasonably expensive. Both conditions are likely to reverse because energy companies will be able to raise prices as the economy recovers, whereas, pharmaceutical companies will be constrained by the Affordable Care Act.  

Bottom Line: When the economy recovers, value stocks won’t have much lost ground to recover.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

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:

(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>