Week 87 - Stocks for Retirees

Situation: Here’s a dilemma that faces all retirees: You can’t “play” the stock market anymore because you don’t have time to “wait out” a downturn in the economy. A recession is bound to carry down your economically sensitive stocks with it.

To have a sound investment strategy, you should still maintain a 1:1 ratio of stocks to bonds (including savings bonds and certificates of deposit). You'll have to allocate most of the stock portion to low-risk mutual funds, like the balanced funds from Vanguard (VWINX & VBINX). But you can still put some money in large-capitalization stocks that behave like a hedge fund, i.e., those that a) lost less than 65% as much as the S&P 500 Index during the Lehman Panic, b) continue to maintain a 5-yr Beta less than 0.65, and c) beat the S&P 500 Index over the past 20 yrs (for a discussion of this, see Week 76). For additional safety, you also need to stick with buying stock in only the largest companies, namely, those found in the S&P 100 Index that are capitalized with A-rated stock. For added safety, stick to companies that are Dividend Achievers, i.e., increased their dividend 10+ yrs.

Our analysis finds there are only 10 such companies (Table). We added General Mills (GIS), since it has increased dividends for 9 yrs and is large enough for the S&P 100 Index. We also have added NextEra Energy (NEE), a Dividend Achiever that is also large enough. Ten of these companies are from the 3 defensive industries (consumer staples, health care, utilities) that we draw on for our Lifeboat Stocks category (Week 50). The remaining two are IBM and McDonald's (MCD).

When we find a low-risk A-rated stock issued by a company in one of the 7 non-defensive industries, and it has a dividend yield as great as the S&P 500 Index, we call it a Core Holding (Week 22). Those stocks are hard to find but that’s where you’re most likely to double your money in 10 yrs. In our Goldilocks Allocation (Week 3), we encourage you to strive for balancing your stocks at a ratio of two dollars in Core Holdings for every dollar in Lifeboat Stocks. For the 10 stocks in the Table, using that strategy would result in 1/3rd in MCD, 1/3rd in IBM and 1/3rd in one of the 9 Lifeboat Stocks like Wal-Mart Stores (WMT). Bear in mind that all 12 are “hedge” stocks so you won’t need to backstop them with savings bonds as long as you invest consistently in small portions by putting $300/qtr into a dividend reinvestment plan (DRIP) for each.

Bottom Line: You need to continue saving after you retire, and half of your savings need to be in stocks. Why? Because you'll probably be living a long time and your expenses might surprise you: Stocks are necessary to keep up with inflation. To guesstimate your future expenses, keep an eye on what it costs to send a student to a private college for a year. (In 2010, it was $32,617 for tuition, room & board according to the National Center for Education Statistics.) Then multiply that number by however many years you have left before reaching 90. Shocking, isn’t it?? Re-do the calculation each year.

Risk Rating: 2.

Full disclosure: I am retired and personally maintain DRIPs in 10 of the 12 stocks highlighted above: MCD, WMT, GIS, NEE, ABT, IBM, JNJ, KO, PEP and PG.

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

Week 78 - Master List Update (Q1 2013)

Situation: The time has come to provide sober guidance about saving for retirement. For most people, mutual funds are the best route to take and we’ve listed our 5 favorites in the accompanying Table. We remind you that you should not have more than 20% of your assets in a single fund, or 5% in a single stock. As noted in our Week 3 blog (see Goldilocks Allocations), it is also important to balance your stock investments 1:1 with bonds. Our 5 mutual funds do that when you have 20% of your retirement savings in each.

Whew! Now for the fun stuff, which is to generate a list of stock picks that meet our investment criteria. Previously, we’ve agonized over company fundamentals like efficiency (ROIC), long-term debt, and having enough free cash flow to pay for dividend increases (FCF/div). In this blog, we’re going to let you do that for yourself by using red warning flags in the 3 right hand columns of the Table (courtesy of data from the WSJ). This way, you’ll see the entire “universe of data” we analyze, starting with the 199 companies at the Buyupside website called Dividend Achievers. Those companies have had 10 or more consecutive years of dividend increases. We’ve added Occidental Petroleum (OXY) which will qualify come January first.

Next, we eliminate any company with a dividend yield less than the 15-yr moving average for the S&P 500 Index (1.8%). Then we eliminate any company that doesn’t have an S&P stock rating of A/M or better AND an S&P bond rating of BBB+ or better.

The remaining 49 companies can be split into two groups, those whose stocks lost less than 65% as much as the S&P 500 Index during the Lehman Panic AND had a 5-yr Beta of less than 0.65. Those 19 companies are less risky that the others, and make up the first group at the top of the Table. The 30 remaining companies are in the second group, and the 5 mutual funds (mentioned above) compose the third group.

Which of the top 19 stocks are particularly attractive to the risk-averse investor? We think those are the ones that pay a higher dividend than most others AND grow that dividend faster. I use a 3:7:10:50 standard for finding those good "income" stocks. By this I mean there is at least a 3% dividend yield, at least a 7% dividend growth rate, at least a 10% ROIC (5% for a regulated utility), and less than 50% capitalization from bonds. Six in the top 19 meet that standard: JNJ, ABT, PEP, PG, NEE, MCD. However, we eliminate Abbott Labs (ABT) because it is breaking up into two companies, so we’re down to 5.

Those readers who are over 55 and have little in the way of retirement savings should pay attention to these 5 reliable income producing stocks. We’ll aggregate the data from those, to augment our guidance for late-stage investors (see Retirement on a Shoestring Week 14 & Week 15). These 5 stocks are so bond-like that you needn't bother hedging them with an equal investment in bonds or bond funds. But you do need to “dollar-average” equally into all 5 DRIPs. We'll call this group "Stand Alone Stocks" and put their aggregate data at the bottom of the Table for comparison with aggregate data for the 5 mutual funds we mentioned.

Bottom Line: Recent academic studies show that returns from less risky (more bond-like) stocks are as great as returns from more risky stocks. Read this recent analysis by Mark Hulbert to open your eyes to the importance of holding such stocks in your portfolio.

Risk Rating: 4.

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Week 76 - Hedging Stocks vs. Financial Repression

Situation: As of 12/7/12, a “risk-free” 10-yr US Treasury Notes yields 1.63%. This is vs. the 4.12% paid just 5 yrs ago. Meanwhile, the Consumer Price Index (inflation) has grown at a rate of 2.2% over the past 5 years vs. 2.9% over the 5 years ending in 12/07. This means that a 10 yr Treasury Note purchased on 12/07/07 paid 1.2% more than inflation, whereas, a 10 yr Treasury Note purchased on 12/07/12 paid 0.6% less than inflation. That 1.8% “trim” is called Financial Repression. It occured as the Federal Reserve gradually took two trillion dollars worth of Treasury Bonds and Notes out of circulation, thereby increasing the price (and lowering the yield) of remaining Bonds and Notes. This drives down the “yield curve” and the net result is that investors become willing to take greater risks with their money to escape the losses due to inflation that result from sitting on cash in the form of Treasury Bills and Notes. Investors are denied a “safe harbor” for part of their investments and are being pushed into using that money to expand factories, provide new services, buy homes and hold more stocks.

The idea is to boost the economy while reducing the amount of interest the US Government pays on its debt. Wikipedia defines Financial Repression as “any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.” It is a disguised form of inflation, since all asset classes eventually come to be priced higher (by that same 1.8% noted above) vs. historic valuations relative to inflation. Some leading economists have concluded that Financial Repression is a form of taxation (cf. Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different. Princeton University Press, 2008, p. 143).

You may think that these monetary policies will soon end and the economy will recover enough to grow at its usual 3%/yr faster than inflation. Well, the last time the Federal Reserve employed Financial Repression it lasted from 1945 to 1980. When used by central banks of other countries, it has averaged 20 yrs in duration (Carmen Reinhart and Belen Sbrancia, National Bureau of Economic Research working paper, 2011). Over the last 35 years, Sweden’s use was the briefest at 6 yrs (1984-1990).

What is our goal for today’s blog? How do we defeat Financial Repression in order to save for our retirement. That is a tall order, given that every asset class is valued relative to US 10-yr Treasury Notes. Hedge funds, however, are designed to respond to asset class impairment. In response to the Lehman Panic, many hedge fund traders hopped into gold, oil, and emerging market stocks. Then they tried high yield (and emerging market) bonds and high yield stocks. All of those predictably became overpriced. Thus, hedge funds haven’t fared all that well over the past year or two. Now they’re taking a closer look at dividend-growing companies in “defensive” industries, namely, healthcare, consumer staples, and utilities, even though stock in those companies has also become high-priced. 

In this week’s blog we take that approach and simply ask, which stocks fit our definition of a Hedge Fund (see Week 46)? That would be a stock that has beat the S&P 500 Index over the past 10 & 5 yrs, and fallen less than 65% compared to the S&P 500 Index during the Lehman Panic (10/07-4/09). That means we’ll have to stick to looking at stocks with a 5-yr Beta of 0.64 or less. And, since the S&P 500 Index had only a 1% total return for the past 5 yrs, we’ll only look at stocks with a 5-yr total return at least as great as that for “risk-free” money, which is 2.8% (i.e., the average rate of interest on 10-yr US Treasury Notes over the past 5 yrs). Because this blog is about saving for retirement by reinvesting dividend income, we’ll only look at stocks with a dividend yield of at least 1.8% (i.e., the 15-yr moving average for S&P 500 dividend yields). And, since there’s not much point in starting with a dividend-paying stock that doesn’t meet the “business case” for investment (see Week 68), we’ll exclude stocks that have a 5-yr dividend growth rate of less than 6%/yr. Finally, we’ll check financials on the WSJ website and exclude any that:
   a) have a return on invested capital (ROIC) less than the weighted average cost of capital (WACC), 
   b) are capitalized mainly by long-term loans, or 
   c) didn’t have enough free cash flow (FCF) last year to pay at least half of this year’s dividends.

In this analysis, we have turned up only 10 companies (Table). As expected, most come from one of the 3 “defensive” industries: ABT (Healthcare), WEC, NEE (Utilities), and MKC, HRL, GIS (consumer staples) but each of the remaining 4 (MCD, CHRW, CB, IBM) come from one of the other 7 S&P industry classifications. It will come as no surprise that all 10 companies have an S&P stock rating of A-/M or better, and an S&P bond rating of BBB+ or better. 

We compare these 10 stocks with our two favorite benchmarks (see Week 3):
   a) a 50:50 split between low-cost mutual funds tracking the S&P 500 Index (e.g. VFIAX) and the Barclays Capital Aggregate Bond Index (e.g. PRCIX); and
   b) the only mutual fund that is balanced ~50:50 between stocks and bonds, low-risk, low-cost and performs like a good hedge fund: Vanguard Wellesley Income Fund (VWINX). For you, the safest, cheapest, and least time-consuming way to save for retirement is to employ one of those benchmarks. 

Bottom Line: Hedge funds seek to beat the S&P 500 Index during bull markets but fall less during bear markets. We set out to see which stocks perform like an above-average hedge fund (i.e., fell less than 65% during the Lehman Panic while beating the market) by using the most rigid criteria. We find that such safe & effective stocks are rare, and don’t necessarily hide out in the 3 “defensive” industries (healthcare, consumer staples, utilities). In other words, we had to look at all 114 stocks in Zack’s database that meet our key criteria (capitalization of at least $8 Billion, dividend yield of at least 1.8%, 5 yr dividend growth rate of at least 6%, and ROIC of at least 9.5%). 


Risk Rating: 3. In other words, ownership of these stocks doesn’t have to be hedged with ownership of an equivalent amount of 10-yr US Treasury Notes and/or their untaxed equivalent (Savings Bonds) or a investment-grade bond fund like PRCIX. They’re internally hedged, much like the two utility stocks (WEC, NEE) but for more complex reasons having to do with competitive advantage (a topic we’ll explore in future blogs).

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

Week 72 - So You Want a Small Portfolio of Only 6 Stocks?

Situation: Stocks are risky, 4-5 times riskier than bonds. To capture the value of owning stocks directly vs. owning a stock mutual fund, you need to distribute the risk by owning stock in a number of companies. Academic studies recommend positions in at least 20 companies representing at least 5 industries. But if you’re just starting out, you’ll want to own only a few stocks. Well, there’s a way to do that: pick stocks to overemphasize safety and underemphasize performance. Instead of buying the 1/3rd Lifeboat Stocks and 2/3rds Core Holdings that we recommended (see Week 3), reverse that ratio for a small portfolio of 6 picks and go with companies that have the best credit ratings.

We first identify those that have a AAA credit rating (which is better than US Treasury Bonds with have a AA- credit rating). That AAA credit rating means the risk of bankruptcy is negligible: S&P can identify no concerns or issues that might herald a risk of bankruptcy. We’ve found there are only 4 such companies: Exxon Mobil (XOM), Automatic Data Processing (ADP), Johnson & Johnson (JNJ) and Microsoft (MSFT). To get you to our goal of 6 stocks, we’ll add the next safest company (in our opinion): Wal*Mart (WMT), with a AA credit rating. Then we’ll add the safest utility (in our opinion) that has its bonds guaranteed by a state government: NextEra Energy (NEE), with an A- credit rating.

Given the size of your portfolio, you can’t afford to be concerned about performance. Nonetheless, the 6 companies we’ve identified have performed as well (in the aggregate) as the least costly S&P 500 Index Fund (VFIAX, in the attached Table). More importantly, this “safe” portfolio of 6 stocks was harmed much less than VFIAX by the Lehman Panic.

But now you’ll want to know how these 6 stocks have performed compared to bonds, which we’ve recommended you own in a 1:1 ratio with stocks (Week 3). Bonds did better, as represented in the table by the T Rowe Price New Income Fund (PRCIX). You’d have also done better by avoiding those 6 stocks and holding the lowest cost balanced fund that has at least 50% of its asset value in bonds: the Vanguard Wellesley Income Fund (VWINX, in the Table).

Bottom Line: Owning individual stocks is a time-consuming hobby because you’ll soon realize that you need a baker’s dozen of dividend growers before you’ll sleep well. But there is a way to start with a portfolio of only 6 stocks where the gains are likely to be about as good as the S&P 500 Index and the pains are much less. But a more economical use of your resources would be to hold a low-cost bond-heavy balanced fund like VWINX, and you’ll probably make at least as much money going forward.

In future weekly posts, we’ll distinguish between blogs that feature ideas for investment performance vs. those that feature ideas for safety. In our closing statements, we’ll include a ratings scale of 0 to 10. An number between 7 to 10 will be for discussions that emphasize performance, while 1 to 3 will be for those that emphasize safety. Bear in mind that out-performance cannot be achieved without sacrificing safety but out-performance yields a bigger nest egg for retirement.

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

Week 63 - Bigger is often better

Situation: Large companies have advantages over smaller companies, advantages that can make the risk of bankruptcy negligible. These include multiple subsidiaries and penetration of international markets, which means some part of the big company is always making money and can support other portions of the business. Most large cap companies have over 100,000 employees, and can also support as many as another 100,000 in the supply chain. This means that very large companies are key players in the broader sense of supporting our economic system. That is why companies other than banks were bailed out by the US Government during the Lehman Panic in 2008-09, namely, GM, Chrysler, GE, AIG, Fannie Mae, and Freddie Mac. The very biggest companies won’t be allowed to go bankrupt. Therefore, the greatest risk to stock ownership (bankruptcy) is not a concern for investors. Fraud and mismanagement, however, do remain as concerns because large multinational companies are unwieldy. Nonetheless, the advantages of stock ownership in large companies outweigh the disadvantages, and everyone who is saving for retirement needs to periodically consider investing in one or more of these companies.

Looking at the Zacks database, we find 21 S&P 500 companies with both a market capitalization of over $120 Billion and a positive Return on Investment (ROI) over the past 5 yrs (Table). We omitted putting two companies, Google (GOOG) and Philip Morris International (PM), in the Table because they didn’t exist in 2002. That is when our calculation for “reward” (10+ yr Annualized Total Return) begins. The other 19 companies are in the Table. The Table also includes the lowest-cost S&P 500 Index fund available (VFIAX) and the only low cost mutual fund (VWINX) that has an asset allocation scheme similar to our Goldilocks Allocation (see Week 3). A variety of metrics are included in the Table for your reading pleasure. Red flags mean “buyer beware.”

Bottom Line: The largest companies tend to survive downturns better than their smaller brethren, so we’ve grouped those “megacaps” together for closer analysis using our favorite tools and metrics. Only the oil giants, ExxonMobil and Chevron, emerge with no cause for concern. But even those two companies, which are reliable & consistent money-makers, have to be watched closely by their shareholders. For example, one might question how management is preparing for the wider adoption of carbon-neutral legislation designed to save the planet from global warming.

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

Week 41 - Personal Savings Modules

Situation: Many of us who have retirement benefits through our jobs tend to not fully fund our plan, thus not receiving the full tax advantage of the retirement benefits, even though it would reduce our annual tax bill. And it gets worse! Some of us do fully fund our workplace retirement plan and that can STILL leave us with too few dollars for our sunset years. Is there a solution? Yes,we need to mimic our neighbors who don’t have a workplace retirement plan but instead use IRAs (including Roth IRAs), and US Savings Bonds to build Personal Savings Modules (PSMs).

This week’s blog assumes that IRAs are understood and in common use by our readers. In reality, fewer than 25% of job holders contribute to an IRA; fewer than half of those contributors are not paying the full amount allowed by law per year (for a related story click here). Since you’re reading this blog, we will assume you want a fully funded IRA at $5000/yr (in DRIPs) balanced with $5000/yr in Savings Bonds (which have the same tax benefits as an IRA). And let’s face another tough fact--chances are that if you are in the early stages of your career, you don’t have enough income to do this. This means we need a way to decide how much of your income can safely be siphoned off into retirement savings as you age.

We recommend investing 5% of gross income at age 25 and increasing this up to 20% by age 70. In other words, every 3 years add another 1% to your savings plan. If you’re 25 years old and making $20,000/yr, set aside $1000/yr (5%). By age 50, 14% needs to be diverted to your workplace retirement plan and PSMs. By retirement age (71), those savings plus Social Security will need to replace at least 70% of the income you were receiving through work.

The simplest and cheapest way to start a PSM is to go online and set up automatic monthly withdrawals from your bank account. A balanced mutual fund would be just the ticket--a “starter home” for your savings! The problem we immediately encounter is that all of them have irritatingly high costs, take on too much risk, or don’t invest enough in bonds. The only balanced fund that roughly mimics what we call a “Goldilocks Allocation” (see Week 3) is the Vanguard Wellesley Fund (VWINX). It has a very low expense ratio (0.25%) and no fees or commissions but it requires an initial purchase of $3000. For many of us, that is a stretch. The second best choice for a hybrid investment is to buy stock in a regulated public utility. ITR’s Master List (Week 39) suggests two: NextEra Energy (NEE) and Wisconsin Electric (WEC). Investing in either of these companies would give you a DRIP with rock bottom costs that can be managed by you from the website. For tax purposes, that DRIP then needs to be designated as part of your IRA.

For a follow-on PSM, we suggest that you stretch beyond relying on a single-asset and balance it with regular purchases of a Lifeboat Stock DRIP balanced by purchases of US Savings Bonds. The accompanying Table lists all the Lifeboat Stocks that are also on our Master List (Week 39). For your Savings Bonds, we recommend choosing traditional (EESB) Savings Bonds because those are guaranteed to pay at least 3.5%/yr if you hold them for 20 yrs. (Prior to that anniversary date, each EESB purchased pays approximately the same interest as a 5-yr Treasury Note that was purchased on that same date.) As an example, I constructed a PSM using a JNJ DRIP started 12 yrs ago using $100/mo, and balanced it with EESBs I started purchasing 20 yrs ago (~$50/mo). By 4/2/2012, the $12,200 paid into EESBs had grown to $27,068.44 (a 6.3%/yr increase) and the $14,200 that went to JNJ had grown to $18,867.80 (a 4.2%/yr increase). That’s an increase of 4.6%/yr for both together, which beats inflation by 2.1%/yr.

Should you be one of the lucky few who has a workplace retirement plan, contribute as much as you are allowed by law but avoid the exciting/expensive choices: emerging market mutual funds, high-yield bond funds or small capitalization stock funds. If you’re offered hedge funds, don’t take the bait (for fun, do a Google search on the terms “Warren Buffett” & “Hedge Funds”). Stick with “plain vanilla” choices: large-capitalization US stock funds and intermediate-term investment-grade bond funds. If your company wants you to stuff your retirement savings plan full of its own stock, don’t go there! No company is immune from bankruptcy. For example, Johns-Manville and over 10,000 other companies were bankrupted in the 1980s by asbestos-related lawsuits. Even though many of the lawsuits were later declared to be criminally fraudulent, by that time the companies were gone. Enron is another example with 6000 of its employees putting all of their retirement savings into its stock and losing every penny when the company collapsed. If you do choose to purchase company stock, limit those holdings to 5% of your total assets--the same limit you would place on any other single company’s stock.

What kind of assets, overall, are good for your retirement savings? To ride out the last market crash defensively with Lifeboat Stocks (see attached Table) as measured by the drop in each of those stocks between 10/1/07 and 4/1/09, the best DRIPs to have were: WEC, JNJ, ABT, BDX, WMT, HRL, and MKC. Those went down less than 20% (vs. 46% for VFINX, the Vanguard S&P 500 Index Fund). Wal*Mart stock even went up 19% (Table). Did your portfolio have any of those stocks going into the crash? Mine had only two (JNJ and MKC). A market crash of that magnitude usually means one thing: Investors are afraid of deflation. There are only two types of assets that do well then: 10-30 yr US Treasury Notes & Bonds, and stock in companies that sell food very cheap: McDonald’s and Wal*Mart. Unless you had those assets and some of the more resilient Lifeboat Stocks noted above, your portfolio probably took a beating. Even the most resilient balanced fund (VWINX) went down 24% over that 18-month period.

Bottom Line: If a crash occurred one month after you retired, would your portfolio be able to ride it out relatively unscathed??

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

Week 33 - Rainy Day Fund in Retirement

Situation: It’s expected that retirement savings will be gradually depleted in retirement. But how do you deal with the unforeseen and unexpected expenditures that can upset an ongoing financial plan and derail your retirement savings?

This situation requires a backup plan--we need a “Super Hero” to step in and help. In an earlier blog (Week 15), we explained the importance of having a Rainy Day Fund and described the type of investments we would use to create such a fund. We can’t emphasize enough the importance of keeping contributions to the Rainy Day Fund on track throughout our prime working years; our 30s, 40s, 50s and right up into retirement.

The Rainy Day Fund that we suggest you establish is equally divided between Lifeboat Stocks and inflation-protected Savings Bonds, or “ISBs” (see Week 15). What this will achieve is that, by 10 yrs into your retirement, at least 50% of your stock holdings will be in Lifeboat Stocks (Weeks 8 & Week 23) instead of the 33% called for in our Goldilocks Allocation retirement savings portfolio (Week 3). This is important because Lifeboat Stocks are also termed “defensive”, meaning they don’t collapse in value during a bear market. Think about it. Having a bear market hit you two years into retirement might mean you’ll have to return to the workforce whether you like it or not.

Looking at the 2012 Master List (Week 27), we find 13 stocks representing “defensive” industries (health care, consumer staples, communication, employment services, utilities):

             ABT, KO, JNJ, MDT, PEP, PG, WAG

             WMT, ADP, BDX, HRL, MKC, and NEE.

And this is good because we can use these 13 stocks as candidates for our Lifeboat Stock designation (as defined in Week 25). Presently 12 of these 13 companies are relatively free of concerns. [The exception is ADP which has been bid up to a price (P/E=20) not justified by its low return on assets (ROA=3.6).] Seven of the remaining 12 are “Buffett Buys” from Week 30 (HRL, JNJ, MDT, WAG, BDX, WMT, NEE) but the remaining 5 also warrant Lifeboat Stock designation (ABT, KO, PEP, PG, MKC).

If used as 10+ yr DRIP investments with regular purchases in fixed amounts, any of these 12 stocks will more likely than not have a total return beating an S&P 500 Index fund AND show less depreciation during a bear market.

Since 7/1/02, for example, only MDT and WAG failed to do as well or better (in terms of regular DRIP investments) than the Vanguard S&P 500 Index Fund (VFINX); PG and JNJ DRIPs returned the same as VFINX (4.6%/yr). That’s 8 wins, 2 losses and 2 ties. With respect to price depreciation during the credit crunch from 10/07 to 4/09, all 12 of these stocks held up better than VFINX, which fell 47.6% vs. 21.6% for the 12 Lifeboat Stocks. Wow. Those ranged from an 18.8% gain (WMT) to a 48.9% loss (MDT).

To give you a concrete idea of what you accomplish by investing in Lifeboat Stocks to create a Rainy Day Fund, I will use my own Rainy Day Fund as an example. I created my fund on 7/1/02 using a quarterly investment of $630. I split this into $300/qtr for ISBs and $330/qtr for Coca-Cola (KO) in a dividend re-investment plan. As of 1/31/12, the $11,700 that I spent buying ISBs had grown to $14,278.34 (3.9%/yr) and the $12,928.55 that I spent on KO had grown to $18,476.95 (6.7%/yr). The result is that my Rainy Day Fund returned 5.4%/yr. For the sake of comparison, if we use a virtual $11,700 investment made in VFINX (Vanguard’s S&P 500 Index Fund) over this same period of time, it would have grown to be $14,847.98 (4.64%/yr). Inflation (Consumer Price Index) grew at a rate of 2.3%/yr. Therefore, my Rainy Day Fund had an after-inflation return of 3.1%/yr. This is a typical after-inflation return for a generic 50:50 stock:bond investment since 1970--after pricing in the tax benefits from owning Savings Bonds (Week 15).

Bottom Line: Every retiree would be smart to not only have a Rainy Day Fund going into retirement but continue adding the usual amounts after retiring. This could be the only unencumbered asset remaining in her portfolio to meet unexpected emergencies. It’s a real Super Hero that can step in and save the day!

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

Week 28 - Net-Net-Net investing

Situation: Our ITR blog is focused on long-term savings that can be used for retirement, and without paying any more in fees than is necessary to achieve that goal. That means explaining how a newby investor can set aside 15% of income for at least 15 yrs and maintain a risk level that is less than 1 in 20 of losing her principal investment. In prior blogs, we discussed minimizing fees & commissions by using point-and-click investing but there are also fungible costs that cannot be avoided, namely, inflation and taxes. According to Webster's Collegiate Dictionary (11th Ed), fungible means “that one part or quantity may be replaced by another equal part or quantity in the satisfaction of an obligation”. In other words, someone else defines those obligations and those definitions can change over time. Here at ITR, we’ve factored the cost of inflation into the calculations presented in our spreadsheets but we haven’t said much about how to minimize it. And the only mention of taxes we’ve made has been to encourage you to use Roth IRAs, employer’s 401(a) & 403(b) plans, and savings bonds. Again, we haven’t said much about how to reduce the taxes due on your investment winnings.

Goal: a) Construct an investment portfolio consistent with our Goldilocks Allocation (Week 3) distribution while attempting to achieve a positive return net of fees, inflation, and taxes.
b) Assume that our investor is 50 yrs old with a gross taxable income of $96,000/yr.
c) Assume that our investor will spend $1200/mo on combined retirement and Rainy Day savings over a 15 yr period, resulting in an out-of-pocket expenditure of $216,000.

For the portfolio: We recommend allocating $6000/yr to a Roth IRA composed of dividend re-investment plans (DRIPs) in 5 stocks, $6000/yr to ISBs (inflation-protected savings bonds) and EESBs (standard savings bonds that guarantee a 3.5% return if held for 20 years), $1200/yr to a NextEra Energy (NEE) DRIP, and $1200/yr to a Rainy Day Fund composed 50:50 of a Johnson & Johnson (JNJ) DRIP and ISBs. Central to our strategy is to pay no taxes on the 50% of retirement savings in stocks (by assigning those DRIPs to a Roth IRA), and to delay paying federal taxes on the 50% in savings in bonds until retirement (there are no state or local taxes due on savings bonds). A Rainy Day Fund by definition needs to be accessible, so the stock portion of the fund will be taxable.

An investment of $1200/yr in stock of the regulated utility (NEE) is a “hybrid investment”, i.e., it doesn’t need to be hedged in the usual way with an equally weighted purchase of investment-grade bonds--because both the debt and the return on investment are guaranteed by a state government. These unusual features also help to offset the tax bill; you’re rewarded with a higher dividend (~4%) that helps pay taxes on those dividends. (Capital gains will be taxed upon sale but that isn’t until after you’ve retired and are in a lower tax bracket.)

Recommended Roth IRA stocks: We support the plan of investing 2/3rds of our sample portfolio’s monies in DRIPs chosen from among Core Holding stocks (e.g. XOM, CVX, PX, NSC, UTX). Care needs to be taken to include at least one company with heavy exposure to international markets (e.g. MCD, KO, MMM, BHP). The remaining 1/3rd of investment monies should be used to purchase DRIPs from among the Lifeboat Stocks (e.g. MKC, PG, ABT, JNJ, BDX, WMT, WAG).

In our virtual retirement portfolio, we’ll assign $125/mo to each of 4 Roth IRA DRIPs (XOM, KO, WMT, UTX), $250/mo to EESBs, $250/mo to ISBs, and $100/mo to the NEE DRIP (for a total of $1100 per month). For the Rainy Day Fund, we’ll assign $50/mo to ISBs and $50/mo to a JNJ DRIP. That brings the total monthly investment to $1200.

In a future blog, we’ll see how this portfolio holds up going forward and retrospectively. Will it provide a positive return after tallying and subtracting all expenses (fees & commissions, inflation, and taxes)? We’ll also look at the small number of academic studies that have been done on Net-Net-Net investing. Be warned--these studies are perhaps a little discouraging because any positive return is considered worthy of recognition! That’s mainly because it’s hard to spend less than 2%/yr on fees & commissions unless you “go it alone”. Another reason is that savings bonds are excluded from most asset allocation models because purchases are limited ($5000/yr for both ISBs and EESBs).

Bottom Line: Have you figured out what your “take home pay” is in real terms? It’s one thing to crow about winnings but quite another to add up all the losses incurred from such things as commissions & fees, taxes, and inflation. After those 3 expenses have been backed out of total annual gains, what remains is called “Net-Net-Net investing” and this is what real investing for profit is all about.

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

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

Week 22 - Core Holdings

Situation: Seasoned investors will try to strike an investment balance between equities (ownership rights that yield dividends or rent) and credits (loans that pay interest). They also attempt to balance their core holdings with “hedges” that are designed to mitigate potential losses. We introduced an ITR Goldilocks Allocation (Week 3 blog) that is designed to protect against bear markets by investing 67% of the entire portfolio in Lifeboat Stocks (see Week 8 blog) and high grade bonds. The remaining 33% is risk capital--core “cyclical” stocks that rise or fall with world markets.

Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.

On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.

For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGT, WMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:

   3 energy stocks (XOM, CVX, OXY)
   3 manufacturers (GD, EMR, UTX)
   1 conglomerate (MMM)
   1 railroad (NSC)

We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.

The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).

Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.

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

Week 13 - Foreign Stocks and Bonds

Situation: The ending of the Cold War in 1989 and the widespread use of the internet  launched the “global village” in earnest. The US economy now contributes only 25% of the world’s GDP.

Goal: Explain the benefits received when half of an investor’s assets are deployed outside the United States.

In an earlier blog, we defined the ITR Goldilocks Allocation which recommended 1/6th of an investors stock holdings be in foreign investments. A contributing point of fact is that 50% of sales made by S&P 500 companies occur outside the 50 states. Therefore, 2/3rds of recommended stock holdings are drawing part of their revenue from outside the US. Why not recommend an allocation that equals the 75% of world GDP found outside the US? There are 3 key reasons:
   (1) expenses are higher for the international mutual funds that must buy and sell stocks on foreign exchanges and hedge the currency risk
   (2) there is more political uncertainty
   (3) there is less transparency because of less stringent accounting and reporting rules

And then there is this remarkable statistic: several studies report that the coefficient of correlation of international stock indices with the S&P 500 Index is ~0.80. What this means is that economies around the world are strongly tied to the US economy and will move in sync with the US economy. Therefore, there is little risk that the companies on our Master List will fail to benefit from a strong bull market occurring in any country where they sell goods and/or services. Ownership of stock in high quality multinational companies that are based in the US is an indirect means of investing in foreign markets. Many of the Master List companies are heavily invested in Brazil, Russia, India, and China (known by the acronym BRIC), which are large countries that dominate “emerging market” growth.

Broadly diversified bond funds like PRCIX now include some bonds issued by foreign governments and corporations; such funds compose half of the ITR recommended bond allocation. When added to our 1/3rd recommendation for international bond funds like RPIBX, almost 40% of ITR’s recommended bond holdings are outside the US. Why not recommend 75%? Here, the argument is less rational. High quality foreign bonds outperform high quality US bonds by 1-2% because the value of the US dollar has been falling for the past decade. That means you will have to form an opinion about the future value of the US dollar before deciding how much to invest offshore. Recently, the fiscal and monetary policies of the US were redirected to clean up balance sheets at the US Treasury and Federal Reserve. This means the value of the dollar may gradually rise relative to a trade-weighted basket of other currencies. Here at ITR, we are concerned with retirement income and recommend sticking with “the devil we know”, namely, mutual funds and stocks denominated in US dollars - the currency we’ll be spending in retirement.  The type of international bond fund that we are recommending does little investing in emerging markets because such bonds typically carry a high level of risk. But on the stock side of the ITR asset allocation model it is important to capture growth, which is best accomplished by investing in emerging markets.

You may have counted the 1/6ths and noticed that we haven’t yet recommended a safe place to park the last 1/6th of stock holdings targeted to countries where growth is happening. That’s because almost all of the diversified international mutual funds lost more than the S&P 500 Index during the last big downturn, and weren’t beating it by much even before that downturn. Over the past 5 yrs, the S&P 500 Index is more than 1%/yr ahead of foreign indices. And, here at ITR we have only been able to identify two foreign companies that appear to meet ITR’s investment criteria (see Mission & Goals): Total SA (France’s integrated oil company) and BHP Billiton (the Australian mining company).

A generic solution to this problem is to recommend that you resort to a “flexible portfolio” mutual fund, one that can invest in anything anywhere. Few such funds have a long track record but those that do have weathered the recent unpleasantness better than any other category of stock funds. An ITR assessment finds that the flexible portfolio fund with the best track record over the past 15 yrs is Blackrock Global Allocation (MDLOX). It lost only 22% during the “bear market” between 10/9/07 and 3/9/09 vs. the spectacular 43% loss for the S&P 500 Index. As of 9/29/11, its 14.7 yr total return is 7.0%/yr vs. 2.0%/yr for the S&P 500 Index exchange-traded fund (SPY). Those returns are net of expenses (like commissions and front-end loads assessed for making our typical monthly investment of $200) but include the effect of free dividend reinvestment. MDLOX’s out-performance is because of it’s investment model:  a) a significant allocation to bonds, combined with b) stock investments in multinational companies based in developed countries, e.g. IBM, XOM, CVX, JNJ, and Apple (AAPL). To purchase MDLOX shares, use the same financial services company that you used to purchase bond funds (e.g. Fidelity Investments or T. Rowe Price).

But let’s be honest. MDLOX is expensive (management fees of ~2%/yr, regardless of share class), it doesn’t focus on emerging markets, and it depends on interest payments from bonds to maintain cash flow. Emerging market countries grow fast because of jobs in export and commodity businesses that result in dramatic increases in the standard of living. Every year, almost a hundred million people emerge from poverty. Now, those countries are fast becoming consumer-based economies. This is happening not only in the large BRIC countries but also in Turkey, Saudi Arabia, South Korea, Singapore, Chile, and Argentina. This trend has been present for some time, and certain companies have made it their business to market to those new consumers. For example, instead of making a $200/month investment in one of the examples discussed above (SPY or MDLOX), you could be investing in McDonald’s (MCD) where the 14.7 yr total return (net of the $1.50 commission on each purchase you make through Computershare) is 12.1%/yr. Now that’s a lot better than the 2.0% realized for SPY or the 7.0% for MDLOX!! How can “Mickey D” maintain such an outstanding performance through the bear markets of 1998, 2001-2, and 2008-9? Because for more than 20 years it’s business plan has focused on rapid expansion in emerging markets, capitalizing on the fact that 30% of income for those households goes for food vs. 8% here in the US (T. Rowe Price Report, issue 112, summer of 2011, p. 8).

Bottom Line: The US economy is still “the tail that wags the dog” but the dog (economies outside the US) is growing faster than the tail. Half of your assets need to reflect that growth.


<to continue to Week 14 click here>