Week 316 - 2017 Barron’s 500 List: A-rated “Defensive” Companies That Moved Up In Rank During The Commodity Recession

Situation: A stock-picker can’t beat the market, given that transaction costs and tax inefficiencies reduce returns by 1-3%/yr compared to the lowest-cost S&P 500 Index fund  (VFINX), which returns 7-8%/yr. To effectively compete with that, stock picks would need to return 9%/yr. That’s one of the reasons why we use a discount rate of 9% when calculating Net Present Value. 

In business school, I was taught that there are only two ways to beat the market: Plan A is to trade on “insider information” (patently illegal); Plan B is to take outsize risks (i.e., run a portfolio where the capitalization-weighted 5-Yr Beta is greater than 1.0). Those of us who are employed full time in Financial Services may become good stock-pickers because we know a particular industry very well, the result being that we overweight our picks in that industry. In other words, we’re engaged in a legal form of insider trading. For example, doctors and dentists are often savvy traders of health-care stocks. 

The stock-picker who had the longest run beating the S&P 500 Index was Peter Lynch, who managed Fidelity’s Magellan Fund from 1977 through 1990. He relied on diversification, running ~1000 stocks with the help of a dozen analysts, but focussed on retail stocks. He claimed that the insights his wife shared with him after a day of shopping were pivotal to his success. You get the point: Invest in what you know.

But what about Plan B (risk taking)? Like Plan A, that approach requires you to run a portfolio concentrated in particular industries. But unlike Plan A, those stocks have to be in boring “Defensive” industries, i.e., the ones where sales grow only as fast as the population grows (Consumer Staples, Healthcare, Communication Services, and Utilities). By overweighting defensive industries, you insulate your portfolio. When the market crashes, those industries tend to keep on growing their earnings. Than means you’re following Warren Buffett’s Rule #1: Never Lose Money.

Mission: Analyze the recent Commodity Recession (see Column D at Line 26 in the Table), which was almost severe enough to keep both GDP and the S&P 500 Index from growing. 

Execution: see Table.

Administration: Commodities are a key driver of the economy, so the Commodity Recession gave us a rare opportunity to see which companies out-perform without that key driver. You’ll need some background information. Of the 22 commodity futures contracts that compose the Bloomberg Commodity Index, the 5 classified as “Energy” are strongest, with a combined weight of 30.57% (Natural Gas, Brent Crude Oil, West Texas Intermediate Crude Oil, Ultra-Low Sulfur Diesel, and Unleaded Gasoline). When those are down ~20%, the S&P 500 Index will barely rise even though GDP might keep going up. Whether we like it or not, the prices of petroleum products will be the best predictors of the stock market for the next 10+ yrs. To be successful, a stock-picker has to anticipate the ups and downs in prices for energy commodities, and be positioned to reap good returns from stocks of A-rated S&P 500 companies that maintain or improve their valuation metrics during a commodity recession. 

Key metrics relate to cash-flow based ROIC, specifically the most recent year vs. the 3-Yr median, as well as sales growth for the most recent year. The Barron’s 500 List (published each May) ranks the largest 500 companies on the New York and Toronto stock exchanges in terms of those 3 metrics. We’re interested in knowing the names of ALL the A-ranked S&P 500 companies that moved up in rank. Most of those will be in “Defensive” industries. The few that are in “Growth” industries either have a business plan that allows them to be “hardy perennials,” or enjoy a special situation that allows them to take advantage of a Commodity Recession. This week we cover “Defensive” industries. Next week we’ll cover the few “Growth” industry out-performers.    

Bottom Line: The costs associated with owning the Vanguard 500 Index Fund (VFINX) are nil, whereas, the costs of owning (and trading) stock in a few dozen companies are substantial. And, the capital gains taxes that you’ll pay each year for trading those stocks are erratic and immediate vs. what you’ll pay upon eventually selling your VFINX shares. Your stock portfolio has to outperform the S&P 500 Index by 2-3%/yr to equal the returns you’d realize from owning VFINX shares. Invest smart, by knowing that the market goes down eventually and doing something about it ahead of time. Either stick to industries you know, or hedge by overweighting the stocks of companies in “Defensive Industries.” The 14 shown in the Table are a good place to start your research. Pay close attention to Columns P-S because even these companies can swoon in a market crash if they have messy Balance Sheets (messiness is highlighted in purple).

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

Full Disclosure: I dollar-average into JNJ and KO, and also own shares of HRL and WMT.

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

Week 195 - The Tortoise and the Hare

Situation: Our blog offers a variety of ways to invest for retirement. Priority is placed on assets having returns that are almost certain to exceed inflation and transaction costs over any given 5-yr period. We also restrict ourselves to highlighting stock/bond combinations that lost no more than 15% during the Lehman Panic (10/07-4/09). Yes, losing 15% over 18 months is painful but its less painful than the 19.3% loss sustained by the lowest-cost 50:50 combination of Vanguard stock and bond index funds (see Line 18 in the Table). We comb through the  Barron's 500 List to find those stocks that return the most money long-term while taking on the least risk (or “volatility” in stock prices over various time periods). Our goal is to find the investor’s unicorn, namely, “net-net-net” combinations that are likely to make money net of transaction costs, net of inflation, and net of taxes (see Week 112).

What's wrong with that? A real estate developer sitting next to me on a ski lift once had this response to my idea of helping people build a low-risk retirement portfolio: "People don't care about saving for retirement! Look at the choices they make." He was right. Our formula for investing has about as much appeal as bland baby food. Think about it. Our favorite bond is the inflation-protected Savings Bond, our favorite stocks are Wal-Mart and McDonald’s, and our favorite mutual fund is the bond-heavy Vanguard Wellesley Income Fund!

Now that we’ve admitted the humor of our situation, let’s compare those 4 choices to 4 similarly high-quality but “swifter” bonds, stocks, and mutual funds. We’ll call our approach “tortoise” and the swifter approach “hare” in honor of Aesop’s Fable (see Table). For a swift mutual fund, we’ll go with MDLOX, the Blackrock Global Allocation Fund. MDLOX is run by a hedge fund company and had a better record during the Lehman Panic than most of the better hedge funds. For a swift bond, we’ll go with CHS Convertible Preferred stock (CHSCP), issued by the largest farmer’s cooperative in the US. For a couple of swift stocks, we’ll go with Biogen Idec (BIIB), a biotech stock, and Dover (DOV), an innovative manufacturing company. These 4 choices are not random but are instead designed to cast an aggressive approach to investing in the best light.

As you can see from the Table, the hare investments come out ahead, mitigating losses during the Lehman Panic with strong performances both before and after that deep recession. If you take a close look, you’ll know which investment style you favor for building a retirement portfolio. Admittedly, our ITR blog doesn’t give readers who like the hare’s style as many meaty articles to read as those who like the tortoise’s style. Why? Because after you pass age 60 there is very little chance you’ll be able to rebuild a retirement portfolio that takes a +20% loss during a deep recession. And, the anxiety factor is much greater for aggressive investors because their transaction costs are higher than with automated online investing, partly because of the need to make frequent trading decisions and partly because many of the stocks that catch your interest can only be obtained through a stockbroker. For example, transaction costs for a $10,000 investment in MDLOX are ~6 times greater than for VWINX over a 10 yr holding period. 

Bottom Line: There is nothing exciting about building a prudent retirement portfolio. Your goal is to have stable returns that exceed transaction costs, inflation and taxes. Inflation-protected US Savings Bonds are the only investment that will accomplish that with near certainty. Why? Because transaction costs are zero, inflation costs are zero, and taxes on accrued interest are only paid when you cash in the bond. But Savings Bonds won’t help you much with retirement expenses. So, you’ll need to take on more risk by adding stocks to your portfolio. You’ll want to minimize that risk by keeping transaction costs low (through online dividend reinvestment plans), taking a buy-and-hold approach to stock ownership, and confining your stock selections to those that have a long history of annual dividend increases that beat inflation. If you are interested in making a hobby of investing, and have enough disposable income, you can take a more aggressive approach to stock ownership by setting up a second, non-retirement portfolio. For that you’ll need to find a stockbroker.

Risk Rating for tortoise: 3; Risk Rating for hare: 6.

Full Disclosure: I dollar-average into inflation-protected Savings Bonds and WMT, and also own shares of MCD for dividend reinvestment.

NOTE: metrics that underperform our key benchmark (VBINX) are highlighted in red; metrics are current as of the Sunday of publication.

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

Week 132 - What kind of returns can you expect after taxes and inflation?

Situation: Here you are, constantly worrying about whether you’ll have enough retirement income. Here at ITR, we want to give you as many options to consider as possible, along with pluses and minuses for each. Since true profit is the net of “gains” minus “expenses” it’s very important to consider what various retirement options are costing you, in real time. These costs are something that mutual fund managers and TV "experts" are loath to discuss, to say nothing of those infamous hedge funds. 

In this week’s blog, we want to boil this down to your likely “take home pay” for Plan A vs. Plan B vs. Plan C. We can start right up front by subtracting rates for taxes (25%) and inflation (2.4%) from Total Returns over the past 10 and 17 yr periods. Then we can subtract transaction costs, which better be a lot less than the 2%/yr spent by the average retail investor if you've been following our style of investing.

Plan A is the “plain vanilla” plan consisting of 50% in the lowest-cost S&P 500 Index fund (VFINX) and 50% in the lowest-cost intermediate-term investment-grade bond index fund (VBIIX). Looking at the Table, 17-yr returns for Plan A averaged 7%/yr and 10-yr returns averaged 6.1%/yr. (Note: you would have had to do some rebalancing every few years in order to maintain a 50:50 ratio.) The transaction costs or “expense ratio” for this plan are incorporated in the returns for each of the mutual funds, ~0.25%/yr. Subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 2.9%/yr over the past 17 yrs, or 2.1%/yr over the past 10 yrs.

Plan B is the "balanced fund" plan, consisting of 100% in either the Vanguard Balanced Index Fund (VBINX, a computer-run fund kept at 60% stocks and 40% bonds) or the Vanguard Wellesley Income Fund (VWINX, a managed fund kept at ~60% bonds and ~40% stocks). Looking at the Table, 17-yr returns for VBINX averaged 7.4% and 10-yr returns averaged 6.8%. As in Plan A,transaction costs for these Vanguard funds are ~0.25%/yr. For VBINX, subtracting 25% for taxes and 2.4% for inflation leaves you gaining an average of 3.2% after 17 yrs and 2.7%/yr after 10 yrs. For VWINX, returns, net of all 3 costs are 3.7% after 17 yrs and 2.7% after 10 yrs.

Plan C is the do-it-yourself plan consisting 50% of Plan A and 50% of 8 large-capitalization “hedge stocks” (see Week 126). Turning to the Table, we see that those hedge stocks returned an average of 9.9%/yr over the most recent 17 yrs and 10.2%/yr over the most recent 10 yrs. The expense ratio (Column O) for building those DRIPs at computershare is 0.9%/yr. After subtracting 25% for taxes and 2.4% for inflation, average returns come to 5.0%/yr after 17 yrs and 5.3%/yr after 10 yrs; then subtract 0.9%/yr for transaction costs and you’re left with 4.1% and 4.4%. Combining those net returns 50:50 with the net returns from Plan A leaves you gaining 3.5%/yr after 17 yrs and 3.2%/yr after 10 yrs for Plan C.

In terms of reward, Plan C is superior but VWINX is a close second. In terms of risk, the three plans also differ. For example, note the losses sustained during the 18-month Lehman Panic (Column D in the Table): 20.3% for Plan A; 28% (VBINX) and 16% (VWINX) for Plan B; 16.2% for Plan C. Risk is also reflected by the 5-yr Beta values (Column I): 0.5 for Plan A; 0.94 for VBINX and 0.58 for VWINX in Plan B; 0.45 for Plan C. Note: Returns are as of 12/31/2013; red highlights denote metrics that underperform VBINX.

In terms of risk, Plan C is superior but VWINX is a close second. Plan C also fits well with your workplace retirement plan, since almost all such plans offer an investment-grade bond fund and a stock index fund as options from which to choose. Then you can use your IRA for investing in the hedge stocks.

Bottom Line: All 3 of these plans are conservative, in that they’re designed to conserve your resources through any but the worst of financial calamities (nuclear war, global pandemic). For example, all but one of the 8 hedge stocks in Plan C is a “Lifeboat Stock” (see Week 106). Risk has been avoided except in the case of the computer-run balanced fund (VBINX), which is 60% stocks. Over the past 5 yrs of remarkable growth in the stock market, that part of Plan B has outperformed the other options (see Column G). VBINX is our benchmark, referenced in every blog, because it is not subject to human error and is largely hedged anyway, given its 40% bond index component. Daily rebalancing prevents any momentum in either stocks or bonds from skewing the fund in either direction.

The most important message that we’d like to leave with you is that transaction costs need to be accounted for, and avoided where possible. Warren Buffett has made this clear on several occasions. For example, at the 2004 Annual Meeting of Berkshire Hathaway shareholders he said, when asked about the best way to invest for retirement:

 “Among the various propositions offered to you, if you invested in a very low cost index fund -- where you don't put the money in at one time, but average in over 10 years -- you'll do better than 90% of people who start investing at the same time."

Risk Rating: 4

Full Disclosure: I own stock in all 8 of the companies at the top part of the Table.

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

Week 112 - Net-Net-Net Investing Revisited

Situation: The S&P 500 Index has recovered from the Lehman Panic, and now relies for its value on the assumption that GDP will soon be growing at 3%/yr. A lot of “ifs” are involved, mainly from the fact that almost 50% of revenues for S&P 500 companies are being earned outside the US. From here on, it’s going to be more difficult to make money from stocks, net of costs, net of inflation, and net of taxes. That’s what we all are after, right? You don’t like the roller coaster (years of double-digit returns followed by years of double-digit losses) or you wouldn’t be reading this blog. And you think this bull (market) is on its last legs, don’t you? (Even though reasoned analysis says otherwise: read this link). Nonetheless, there is a 50:50 chance that the stock market will undergo a correction in the next few months. So this is a good time to revisit the issue of net-net-net investing. Is there a way to come out ahead, that is, to make a nice profit after transaction costs, inflation, and taxes most years and only lose a little in the other years? Academic studies suggest that’s hard to do: you’re an above-average investor if you make 0.5% profit/yr over an extended period. So let’s consider the options.

At the top of this week’s Table we have 10 stocks that have beaten the Vanguard Balanced Index Fund for the last 13 yrs, while maintaining low 5-yr Betas, high dividend growth rates, and strong recent returns. However, as a group those stocks still lost 3.6% during the 18 month period of the Lehman Panic starting late in 2007 and ending in the spring of 2009 (Column D, Table). Coca-Cola (KO), for example, lost almost 16%. All 10 stocks have lost money for their investors during one or more years over the past 13 (Column K, Table). Berkshire Hathaway B shares lost money for 5 of those 13 years (and 28.8% during the Lehman Panic), while arguably being the best hedge fund available to retail investors (see Week 101). In other words, even the most conservative stocks still give their shareholders a roller-coaster ride. Just a less bumpy one. Those who can hold on will do well, but what about those who have just retired and need to cash out some of their stock portfolio?

Can bonds give stable returns? Well, yes. Those who make their living in finance know enough to mainly invest in bonds for that very reason. They also know to buy individual bonds in face amounts of at least $25,000 to reduce transaction costs, then hold those bonds to maturity--at which point they’re almost certain to get their $25,000 back. Bond mutual funds are a different animal, very different. Why? Because bond mutual funds fluctuate in value depending on inflation/deflation expectations, interest rates, the risk of default, and economic crises. Buying a bond and holding it to maturity negates those concerns, especially if its an inflation-protected bond (e.g., you might recover $30,000 at maturity instead of $25,000).

Nonetheless, there is one short-intermediate term investment-grade bond index fund that appears worthwhile, the Vanguard Intermediate-term Bond Index Fund (VBIIX). It is invested in US Government bonds, US corporate bonds, and international bonds, with maturities ranging from 5 to 10 yrs (Table). Its strengths lie in high credit quality, being globally all-inclusive, and having a prudent risk cut-off point (10 yrs). But there will be occasional years when even VBIIX loses money. It lost 2.9% in 1999 but hasn’t had a down year since, which makes it a top candidate for net-net-net investing.

Sometimes there are years when both bonds and stocks lose money. It’s called stagflation and last occurred in the early 90s. For example, the managed balanced fund we like, Vanguard Wellesley Income Fund (VWINX) which is 60% bonds and 40% stocks, lost 4% in 1994. The managed bond fund we like, T Rowe Price New Income Fund (PRCIX), lost 1.9% that same year. And, you need to be aware that both funds lost money in 2008 (Column K, Table).

If you own a bond and hold it to maturity, you can’t lose money on that investment. But, how much buying power has that $25,000 lost over 10 yrs? That leads us into a discussion of the “zero-risk” investment. This investment is focused on the purchase of inflation-protected 10-yr US Treasury Notes that are held to maturity. You can go into treasurydirect and buy US Treasury Notes in multiples of $100 in less than a minute (if you’ve already registered your computer and checking account) at zero cost. Most maturities come with an inflation-protected version. That means the US Treasury automatically increases your principal to reflect up-revisions of the CPI (Consumer Price Index). Your principal is not decreased in the event of a down-revision in CPI, i.e., in a period of deflation. You also receive a fixed interest payment every May and November. The up-revisions to your principal, and the payments of interest, are taxed. You’ll be out 25-30% of those gains but that represents your only reduction in cash flow. Note that when your principal is returned to your checking account after 10 yrs of being used by the government, its buying power is guaranteed to be the same as 10 yrs earlier. Because of interest payments, you’ll realize a gain (profit) every year, one that is net of transaction costs (zero), net of inflation (compensated), and net of 25-30% the government takes back in taxes. What’s the trick? Well, there are two: 1) you need to hold the Notes to maturity because interest-rate fluctuations in the overall bond market influence the day-to-day market value of any bond; 2) you’ll need to employ dollar-cost averaging by making regular quarterly purchases, since the fixed rate of interest on each Inflation-Protected Treasury Note will vary because it has to be set at a level that will allow the Note to attract sufficient buyers.

An alternative method is to buy Inflation-protected US Savings Bonds (ISBs) on a regular basis. However, these are only available in limited amounts, $6000/yr, and are based on Treasury Notes with 5-7 yr maturities (so their fixed interest rate is less than that for Inflation-protected 10-yr Notes). Interest payments are also less than for a 5-7 yr Note because of the built-in tax-advantage: Savings Bonds aren’t taxed until cashed out.  Another alternative is to invest in the mutual fund (VIPSX in the Table) that invests in Inflation-protected Treasury Notes & corporate bonds with maturities of 7-20 yrs. That fund started on June 29, 2000, so total returns/yr (Column C of our Table) date to then to show valid comparisons between inflation-protected securities and other investments. Red highlighted values denote under-performance vs. VBINX.

Bottom Line: There is one way to make a profit, every year, from investing: regular online purchases (using a fixed amount of dollars) of Inflation-protected 10-yr US Treasury Notes. If you are starting young, it is best to hold those in a self-directed Roth IRA (to eliminate taxes). What’s the catch? You won’t make much money this way but the key here is that you won’t be losing money either. It is the antithesis of gambling.

Risk Rating: 1

Full Disclosure: I invest quarterly in 10-yr Inflation-Protected US Treasury Notes, and monthly in DRIPs for half the stocks at the top of the Table: WMT, NEE, ABT, JNJ, and KO.

News Flash: Nobody makes much money from investing unless her day job is finance-related or she’s had decades of experience combined with careful study of the markets AND international business trends. (Otherwise everybody would do it.) Even then, there’s a “fly in the ointment” which is the time you take away from your family and friends, and lost opportunities for recreation and exercise. Time is money, so in the end you have to ask yourself: Have I been running a cost center or a profit center? But even if you decide it’s been a cost center, you’ll have had a very interesting avocation.

Note: earlier discussions of this topic occurred at Week 28 and Week 44.

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

Week 44 - Getting Started with Net-Net-Net Investing

Situation: When one initiates a long-term investment plan, there are 3 cost-centers that must be confronted:

   a) the fees & commissions levied on purchases

   b) the taxes levied on profits

   c) inflation 

Net-Net-Net Investing is all about what you are left with at the end of the day: net of fees & commissions, net of taxes, and net of inflation. In other words, it is your true profit, and that is the true profit that fund managers seldom discuss. The costs mentioned will ultimately determine whether your portfolio is a “profit-center” or “cost-center.” Some dividend re-investment plans (DRIPs) have no costs for startup, re-investing the dividend or automatic electronic purchases (e.g. XOM, NEE, PG). Neither do purchases of US Savings Bonds or US Treasury Notes, when purchased using treasurydirect. 

You probably know that profits from the sale of stock and dividends earned, are taxed at a lower rate than income. This is because you have already paid taxes as a co-owner of the company. When you cash out a Savings bond, you will be taxed for interest earned as though it were ordinary income but you won’t pay taxes during the accrual period--as interest is reinvested and accumulates. Savings Bonds, therefore, act like a standard IRA as regards taxes. Inflation, however, is hard to beat. But you can buy inflation-tracking investments such as inflation-protected Savings Bonds (ISBs) and stocks. There are also bond mutual funds that exclusively purchase inflation-protected investment-grade bonds, VIPSX for example, which was highlighted in blue (see the Table with Week 43) as being a good “hedge”.

Where to start today’s discussion? We suggest reading the ITR Goldilocks Allocation (Week 3) where you’ll see an equal investment is apportioned between stocks (in the form of DRIPs) and bonds (as no-load intermediate-term investment-grade mutual funds and 10-yr Treasury Notes). Inflation is the main risk of owning bond mutual funds. To protect yourself, it is best to purchase the Vanguard Inflation-protected treasury fund (VIPSX). An even better solution is to own ISBs, since those have built-in tax savings and track inflation even more closely than an inflation-protected bond fund. For the 50% allocation to DRIPs, the Goldilocks Allocation assigns 25% to Core Holdings, 16.6% to Lifeboat Stocks, and 8.3% to international stocks. (For a review of Core Holdings and Lifeboat Stocks see Week 22 & Week 23). International stocks and mutual funds are tricky to own--many risk factors come into play that don’t affect domestic stocks. Fortunately, some US-based companies gain more than 70% of their revenue outside the US. Three of our Master List companies (Week 39) stand out in that regard: McDonald’s (MCD), CH Robinson Worldwide (CHRW), and 3M (MMM).

Which company stocks should you consider first? Those are the companies with excellent metrics  “across the board” (found in the top half of the Table for Week 43). As a Core Holding, ExxonMobil is hard to beat (XOM). Others worth considering are its competitors, Chevron  (CVX) and Occidental Petroleum (OXY). Canadian National Railroad (CNI), IBM, and Chubb (CB) are others. Lifeboat Stocks with “across-the-board” appeal include Hormel Foods (HRL), McCormick (MKC), Becton Dickinson (BDX), as well as the 3 electric utilities (NEE, SO, WEC). 

Using data that we laid out in that Table, we’ll examine the results of a virtual investment of $300/mo - with $150/mo into ISBs, $75/mo into XOM, $50/mo into BDX, and $25/mo into MCD. All 3 DRIPs are available at computershare. Costs for set-up and automatic investments into XOM and BDX are negligible. However, the MCD drip carries significant transaction costs: it is better to mail in a single check for $300 each year, from which $6.00 will be deducted.

Results from an investment as described above over the past 9.75 yrs (Week 43 Table) are as follows:

   ISBs have returned 4.7%/yr

   Stocks in the ratio indicated by the Goldilocks Allocation (3 parts XOM, 2 parts BDX, 1 part MCD) returned 12.1%/yr on average (but also experienced price depreciation of 24.8% over the worst 18-months of the Great Recession).

Our virtual investment in stocks and bonds together returned 8.4%/yr. That compares favorably with the high-quality, low-cost Vanguard Wellesley Income Fund, which returned 5.6%. In terms of Finance Value (Week 42, Week 43), which compares total return to losses over that 18-month period, our 3 stocks comes in at -11.7% vs. -38% for the S&P 500 Index Fund. Our way of calculating Finance Value is to put a number on risk (i.e., price loss/gain during a bear market) and subtract/add that number to the long-term total return (cf. Table Week 43). This is an arbitrary but nonetheless quantitative and generalizable way of comparing one investment to another in terms of past performance. It’s a way of answering the inevitable question: Sure, your company earned real money for its shareholders over the past 10 yrs but how close did it come to declaring bankruptcy or needing a Private Equity fund to bail it out?

Bottom Line: What is the actual take-home pay from your accumulated investments? Let’s imagine you did as well as the S&P 500 Index since 7/1/02 (total return = 6%), which would mean you’re a very good investor. Then subtract 2.5% for inflation (i.e., growth in the Consumer Price Index). Also subtract one-fourth (1.5%) for taxes. Now you’re down to 2% but nevertheless still ahead. Unfortunately, 2% also happens to be the amount that private investors have been found to spend on average for the fees & commissions levied by fund managers and stock/bond brokers. In other words, you had no take-home pay. Some fees are even as high as 4%. Now look again at our stock and bond example as given above. Stocks and bonds (50:50 allocation) returned 8.4%/yr. After taking out 2.1% for taxes and 2.5% for inflation we’re left with 3.6% for costs and profit. What were the costs? Well, purchasing Savings Bonds costs you nothing, neither did XOM & BDX purchases via DRIPs. McDonald’s stock cost you $6 out of the $3600 you spent annually on stocks and bonds (i.e., total costs = 0.17%/yr). This means your annualized return net of inflation, taxes, and costs (i.e., your take home pay) comes to (3.60% - 0.17%) or 3.43%/yr. Dude, looking good.

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