Week 339 - HealthCare Companies in the Vanguard High Dividend Yield Index

Situation: American culture has increasingly disparate trends, but almost every adult is interested in occasionally partaking of a mood-altering substance. The cultural shift toward “Better Living Through Chemistry” now extends well beyond recreational drug use. Drugs are successfully being marketed for “wellness” without evidence-based research attesting to their efficacy. (These are medications that the FDA has approved for use in other conditions or diseases than those being touted in marketing materials.) As an example, WebMD has a list of 46 drugs and vitamins that are used to help prevent or treat Alzheimer’s Disease while noting that none have proof of efficacy.

Mission: Use our Standard Spreadsheet to list established HealthCare companies that pay a good and growing dividend.

Execution: see Table.

Administration: Eight of the 400 US companies in the FTSE Global High Dividend Yield Index are 1) in the S&P HealthCare Industry, 2) have trading records that extend for at least the 16 year period needed for statistical analysis by the BMW Method, and 3) are in the 2017 Barron’s 500 Index that ranks companies by using cash-flow based metrics.

Bottom Line: The main thing to remember about HealthCare companies is that their revenues will grow approximately three times faster than GDP, and (here’s the good part) growth is likely to continue during a recession when GDP is falling. In other words, some pharmaceuticals like anti-platelet drugs enjoy steady (inelastic) demand regardless of price. Investors also need to remember that prescription drugs have only 20 years of patent protection, and that clock starts ticking when clinical trials begin. Drug development is an expensive multi-year process which fails more often than it succeeds. Risk-adjusted returns on investment for these companies are no better than those for the aggregate of companies in the S&P 500 Index.

Risk Rating: 7 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-cost average into JNJ, and also own shares of ABT, PFE and AMGN.

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Week 183 - Buffett Buy Analysis of Oil and Natural Gas Companies

Situation: Oil and natural gas companies account for 8% of US GDP. Their stock prices mainly reflect 3 factors: 1) the pricing of front-month futures contracts, 2) the amount of proven and economically recoverable reserves in the ground, and 3) the expected rate of growth in the world’s appetite for oil. All of those numbers will fall if there is a recession in one of the world’s major economies. Europe is now on the brink of entering its third recession in 10 yrs (triggered by the crisis in Ukraine), which is one reason why the price of oil fell 40% between June and December. But there are two other reasons to consider. 

The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!

The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.

Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.

Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks. 

Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).

How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).

The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table. 

Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio: 
   1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX); 
   2) the stock is an S&P Dividend Achiever; 
   3) the company’s bonds have at least a BBB+ rating from S&P; 
   4) the stock has at least a B+/M rating from S&P;
   5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and 
   6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years. 

Risk Rating: 6

Full Disclosure: I dollar-average into XOM and also own shares of CVX.

Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.

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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.  

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Week 38 - Italy: A Story About a Country with Insufficient Return on Assets

Situation: Two days after the second bailout of Greece, a news article appeared on the front page of the NY Times (2/22/12): “For Greece, a Bailout; for Europe, Perhaps an Illusion.” The article ended by parsing Italy’s sovereign debt, which has reached an awesome #3 on The Hit Parade of the World’s Largest Debtors. It currently stands at 120% of Gross Domestic Product (GDP). ‘Italy is essentially in a sovereign debt trap,’ said Richard Batty, global investment strategist at Standard Life Investments. For Italy’s debt to be sustainable, the country’s economy must grow at a nominal [i.e., not inflation-corrected] rate of 5% a year, or the interest rate on its 10-yr bond must be 3.6%, Mr. Batty estimates. During Europe’s most recent boom period (2002-07) Italy’s nominal GDP grew at an average rate of only 3.6% and its 10-yr bond has a yield of 5% (even with a big rally this year). Mr. Batty is pointing out that a country must grow its economy at least as fast as the rate of interest it pays on outstanding debts.

Mission: Explain to our readers why Return on Assets (ROA), which for a country is approximately equal to nominal GDP, has to equal or exceed the interest rate on that country’s debt. If it doesn’t, the country’s debts can only continue to grow relative to nominal GDP. When private investors lose confidence in a country’s bonds, that country’s treasury will be forced to offer a higher rate of interest on new bonds to attract a different class of private investor, one interested in “junk bonds”. Those new investors then buy insurance, or Credit Default Swaps (CDS), that pay if the country defaults. The country has entered a “debt trap” because soon most of its tax revenues will go toward paying interest on its debt; default becomes unavoidable.

A country’s assets start with its birth-rate. Add to that the educational system that produces the nation’s workforce. Add increased efficiency in delivering a technologically sound education and the result is higher output/hr from the average worker, i.e. a gain in productivity. The growth rate of the workforce added to the growth rate of productivity equals nominal GDP. If productivity declines because of competition from other countries, GDP stalls-out or falls. Mature economies have a demographic problem because the death-rate becomes higher than the birth-rate. This problem can be solved by importing workers with valuable skill sets to boost productivity. Growth of productivity is also slowed by “friction”. There are many examples of friction, particularly professions with high barriers to entry that lock out new workers and prevent new technologies from taking hold, and/or education systems that fail to provide students with relevant skill sets.

To summarize: Italy’s nominal GDP (workforce gains + productivity gains) grows at only 3.6%/yr in good times. Italy has been paying for growth in its workforce and gains in productivity by borrowing money at an interest rate of ~5%. What this means is that Italy can only emerge from its debt trap by growing GDP faster. It can accomplish this by importing more skilled workers and removing friction from its productivity machine. There is no chance that investors will accept a lower interest rate on Italy’s 10-yr bond until that happens. But once it happens interest rates will drop below the rate of growth in nominal GDP, provided the Italian government uses the increase in revenue to pay down debt.

Bottom Line: Return on Assets (ROA) is an accounting ratio that carries a powerful and immutable impact. Not only countries but every family and business must respect its message: Grow revenues at least as fast as the interest rate on your outstanding debt (or don’t borrow money). But one country’s fiscal & monetary situation does not necessarily resonate with another’s. The US economy, for example, has strong growth when emerging from periods of slack because friction is less of a problem here than in almost any other country. Debt/GDP currently is 0.9-1.0 but is likely to fall below 0.85 over the next 3 years--assuming that nominal GDP growth continues to trend at 5-6%/yr and interest rates on 10 yr Treasury Notes continue to trend at 2-3%. The Federal Reserve has promised to continue its policy of Financial Repression through 2014, so those low interest rates “are baked into the cake.” How does this affect you the investor? It means you have been given a strong incentive to take on some risk. Invest in the US economy: borrow for college, start a family, buy a house, open a business, take more interest in stocks. Now is your time.

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