Month 110 - Buy Low! 12 A-rated Haven Stocks in the S&P 100 Index that aren’t overpriced - August 2020

Situation: There’s no mystery to saving for retirement. A good working game plan is to divert 15-20% of your monthly income to the purchase of stocks and government bonds, and then keep those assets in a 60:40 balance of stocks:bonds. You can also use any bond substitutes (e.g. gold, T-bills, and utility stock ETFs) that typically hold their value in a stock market crash. Mainly use stock index ETFs for your retirement savings but also buy stock in companies that tend to have an above-market dividend yield. Those “shareholder-friendly payouts” happen because the company has good collateral: Liabilities are protected by Tangible Book Value and a cushion of Cash Equivalents. In other words, avoid stocks issued by companies that have become over-indebted. 

Think of the bonds in your portfolio as the collateral that backs your stocks. So, a good way to start saving for retirement is to over-emphasize collateral-thinking: Dollar-average into the low-cost Vanguard Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks picked from the Vanguard High Dividend Yield Index Fund ETF (VYM). VWINX has lost money in only 7 of the past 50 years, those losses always being less than 10%. Since its inception on 7/1/1970, VWINX has returned 9.7%/yr vs. 10.8%/yr for the S&P 500 Index with dividends reinvested.

The harder task is to stop putting additional money into stocks that have become overpriced. To do that you have to know how to calculate the Graham Number. Benjamin Graham wrote the first edition of The Intelligent Investor almost 100 years ago. It is hard to read because he uses numbers to express almost every pearl of knowledge. The “Graham Number” is simply the rational market price for any stock at any given moment, calculated as the square root of: 15 times earnings for the Trailing Twelve Months (TTM) multiplied by 1.5 times Book Value for the most recent quarter (mrq) multiplied by 22.5 (i.e., 1.5 times 15). So, the Graham Number is nothing more than what the stock’s price would be if it were to reflect a P/E of 15 and a Book Value of 1.5.  The purpose of doing this calculation on your stocks is to know their underlying worth. Benjamin Graham also explained why the 7-year P/E should not exceed 25, assuming that a single year’s P/E (TTM) should not exceed 20, which is an earnings yield of 5%/yr: In a normal inflationary environment, a company’s earnings are likely to grow 3% to 3.5% per year. After 7 years, a CAGR (Compound Annual Growth Rate) of 3.2%/yr takes a P/E of 20 to 25.

My definition of an Overpriced Stock is one that a) has a market price (50-day Moving Average) that is more than 2.5 times the Graham Number and b) has a 7-year P/E that is more than 30. Looking at the 30-stock Dow Jones Industrial Average (DJIA), I see that 5 A-rated stocks are overpriced (see Column AC-AH in Comparisons section of Table):

     Microsoft (MSFT), 

     Apple (AAPL), 

     Nike (NKE), 

     Coca-Cola (KO) and 

     Procter & Gamble (PG). 

Stocks get overpriced because they become popular with investors, leading to a Crowded Trade. Assuming that your goal is to Buy Low, why would you continue to add money to any of these 5 stocks that you already own? You would only do so because you harbor a Positive Sentiment regarding their future prospects, In other words, you would be making a speculative investment (“gambling”). To avoid gambling and instead employ a “risk-off” approach to buying individual stocks, you’ll need clear definitions for A-rated stocks and for Haven stocks to supplement the numbers-based system used above to avoid Overpriced stocks. You’ll also want to favor stocks issued by large companies, since those typically have multiple product lines and unencumbered lines of credit.

Mission: Define “A-rated stocks” and “Haven stocks”. Analyze A-rated Haven stocks in the S&P 100 Index that aren’t overpriced by using our Standard Spreadsheet.

Execution: see Table.

Administration: A-rated stocks are those that have a) an above market dividend yield (see portfolio of Vanguard High Dividend Yield Index Fund ETF - VYM), b) positive Book Value, c) positive earnings (TTM), d) an S&P rating on the company’s bonds that is A- or better, e) an S&P rating on the company’s stock that is B+/M or better, and f) a 20+ year trading history. 

Haven Stocks are A-rated stocks issued by companies that aren’t encumbered with risk factors that are likely to threaten the company’s solvency during a recession. So, companies in the Real Estate Industry (i.e., REITs) and companies in the Financial Services Industry (i.e., banks) are excluded, as are companies with negative Tangible Book Value if Total Debt is more than 2.5 times EBITDA (TTM) or Total Debt is more than 2.0 times Shareholder Equity. 

Bottom Line: With the S&P 500 Index being priced at 29 times TTM earnings (see SPY at Line 28 and Column K in the Table), the stock market is overpriced relative to its long-term P/E of 15-16. But its 50-day Moving Average price is still less than 2.5 times its Graham Number (i.e., 2.1), and its 7-yr P/E is still less than 30 (i.e., 28), per Columns AC and AE at Line 28 in the Table. Using our example of the DJIA, the timely thing to do would be to avoid buying more shares of the overpriced A-rated stocks (MSFT, NKE, PG, KO, AAPL) but to continue buying more shares of SPY. This strategy allows you to retain exposure to volatility in stocks that are Overpriced (because of their future prospects) while using diversification to reduce your risk of serious loss.

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

Full Disclosure: I dollar-average into NEE, INTC, WMT, JNJ, CAT, and also own shares of MRK, CSCO, TGT, DUK, SO, MMM. From late February through April 2020, I added shares of 6 new companies to my brokerage account--Comcast (CMCSA), Costco Wholesale (COST), Home Depot (HD), Merck (MRK), Disney (DIS) and Target (TGT), while selling shares of Norfolk Southern (NSC) and United Parcel Service (UPS). Regarding the 5 overpriced but A-rated stocks in the DJIA, I’ve stopped dollar-averaging into KO but continue to dollar-average into MSFT, NKE and PG because I expect those companies to continue to dominate their competitors. I have no plans to sell the shares of KO and AAPL that I already own.

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Month 104 - Retire with a Portfolio of Haven Stocks - February 2020

Situation: Once you retire, you’ll start to worry about outliving your nest egg, wondering when the next recession will start, and how bad it will be. If a market meltdown happens soon after you retire, and kicks off a long and deep recession, half of your retirement savings could go out the door.

You need to close that door ahead of time by focusing your portfolio on haven assets that you won’t sell under any circumstances. The problem is that haven assets are boring things, like Savings Bonds, 10-Yr US Treasury Notes, and stock in American Electric Power (AEP). On the opposite side of the coin are assets with moxie, like JPMorgan Chase (JPM), which are likely to lose a lot of value in a market crash. Why? Because buyers of moxie assets pile on, while sellers become relatively scarce. Market crashes can happen fast, especially those due to a credit crunch, so prices for moxie assets can fall too far too fast while their investors rush for the exit. “A run on the bank” is the apt analogy. The lesson is not to exclude moxie (i.e., growth stocks) from your retirement portfolio but to be careful not to overpay for those shares. That means you have to buy before the mania sets in. If your shares double in price but then fall 50% in the next market crash, you haven’t lost money. "For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments." -- Warren Buffett.

The trick is to know when the shares you own in an “excellent company” are overpriced. Once you’ve made that determination, stop buying more but continue reinvesting dividends. To be clear, haven stocks aren’t just high-yielding stocks or value stocks. Growth stocks can also qualify, if not overpriced. So let’s look at metrics that Benjamin Graham used to determine if a stock is overpriced. Remember, he was Warren Buffett’s favorite professor at Columbia University’s business school. Graham started by calculating what a stock’s price would be if it reflected ideal valuation, meaning a price 1.5 times Book Value and 15 times Earnings per Share (EPS). He called that price the “Graham Number,” and calculated it as follows: multiply Book Value per share for the most recent quarter (mrq) by Earnings Per Share for the trailing twelve months (ttm), then multiply that number by 22.5 (1.5 x 15 = 22.5). Then calculate the square root of that number on your calculator. A stock priced more than twice the Graham Number is overpriced.

Another number he thought helpful is the 7-yr P/E, which is the stock’s current price divided by average EPS for the last 7 years. Graham thought that number should be no more than 25 for a stock to be considered fairly priced. In other words, a company that historically has a P/E of ~20 (which Graham thought to be the upper limit of normal valuation) might grow its EPS for 7 years at a typical rate of 3.2%/yr. That would result in a 7-yr P/E of 25. The “danger zone” for a stock’s current price to be thought of as overpriced is 2.0 to 2.5 times the Graham Number and 26 to 31 times average EPS over the past 7 years. So, if one of those numbers is in the danger zone and the other exceeds the danger zone, don’t even think about buying it for your retirement portfolio (see Column AG in our Tables, where that degree of overpricing is denoted with a “yes”).

Mission: Use our Standard Spreadsheet to analyze stocks likely to survive a deep recession. I’ll do this by referencing companies that are named in both of the most conservative indexes: 1) FTSE High Dividend Yield Index (VYM, the U.S. version marketed by Vanguard Group); 2) iShares Russell Top 200 Value Index (IWX).

Execution: see Table.

Administration: Any company listed in both those indexes that issues debt rated lower than A- by S&P is excluded, as are any that issue common stocks rated lower than B+/M by S&P. Stocks that don’t have a 16+ year trading record are also excluded because the data is insufficient for statistical analysis of their weekly share prices by the BMW Method. Companies with a zero or negative Book Value in the most recent quarter (mrq) are also excluded, as are companies with negative EPS over the trailing 12 months (ttm).

Bottom Line: The idea behind owning Haven Stocks is that you’ll “live to fight another day” after enduring an economic crisis. During a Bull Market, some of those value stocks will lag behind the market’s performance. But during Bear Markets, they’ll fall less in value. If market crashes haven’t become extinct, value stocks will outperform both growth stocks and momentum stocks over the long term. Just remember: When you buy a stock for your retirement portfolio, it needs to pay an above-market dividend because a time will come when you’ll want to stop reinvesting that stream of dividends and start spending it.

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

Full Disclosure: I dollar-average into PFE, NEE, KO, INTC, PG, WMT, JPM, JNJ, USB, CAT, MMM, IBM, XOM, and also own shares of AMGN, DUK, AFL, SO, PEP, TRV, BLK, WFC.

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

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Week 386 - Retirement Savings Plan For The Self-Employed

Situation: Let’s follow the Kiss Rule (Keep It Simple, Stupid). There are many jobs that don’t offer a workplace retirement plan. For example, if you’re a long-haul truck driver and own your Class 8 tractor, i.e., you’re an “Owner/Operator”, you make over $100,000 per year but have high expenses. As an S corporation, you don’t pay taxes on the 15% of gross income that you try to set aside for retirement. 

How do you invest it? If you follow the KISS Rule, you’re best off putting all of it in Vanguard’s Wellesley Income Fund. That fund has an expense ratio of 0.22% and is half stocks and half bonds. The ~70 stocks are selected from the FTSE High Dividend Yield Index (i.e., the ~400 companies in the Russell 1000 Index that reliably pay an above-market dividend). You’ll recognize that Index as the same source we use to pick stocks for “The 2 and 8 Club”.

Mission: Run our Standard Spreadsheet using the 10 stocks that reliably pay good and growing dividends and are less likely to fall as much as the Dow Jones Industrial Average in a Bear Market. Compare that portfolio to the Vanguard Wellesley Income Fund (VWINX), the Vanguard High Dividend Yield Index ETF (VYM), and the SPDR S&P 500 Index ETF (SPY). 

Execution: see Table.

Bottom Line: If you’re self-employed (e.g. do seasonal work), you need a flexible retirement plan with low transaction costs. Safety is the main goal. Take no risks! If you want to pick your own stocks, all right. You can keep costs for that low by dollar-averaging but then your bonds have to be very low risk, i.e., US Savings Bonds.

Risk Rating: 4

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

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

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Week 366 - A Capitalization-weighted Watch List for Russell 1000 Companies

Situation: Every stock-picker needs to confine her attention to a manageable list of companies, called a “Watch List.” Here at ITR, the focus is on investing for retirement. So, our interest is in companies that have a higher dividend yield than the S&P 500 Index. Why? Because your original investment will be returned to you faster, which automatically gives your portfolio a higher “net present value” than a portfolio composed of companies that pay either no dividend or a small dividend. Once you’ve retired, you’ll switch from reinvesting dividends to spending dividends.

Mission: Assemble a Watch List composed of companies that are “Blue Chips” (see Week 361), companies that are in “The 2 and 8 Club” (see Week 344), and companies that are in the Extended Version of “The 2 and 8 Club” (see Week 362). 

Execution: see Table.

Bottom Line: If you’re saving for retirement and would like to pick some individual stocks to supplement your index funds, here is an effective and reasonably safe Watch List. However, the mutual funds that pick individual stocks haven’t done very well compared to benchmark index funds. So, your chances of doing well as a stock-picker also aren’t good. But index funds like the SPDR S&P 500 (SPY) expose you to significant downside risk. There is one conservatively managed mutual fund that we think is an excellent retirement investment, the Vanguard Wellesley Income Fund, which is mostly composed of bonds. Your risk of loss from owning VWINX is less than half that from owning SPY; the 10-Yr Total Return is 7.0%/yr vs. 9.0%/yr for SPY.

Risk Rating for our Watch List: 7 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10).

Full Disclosure: I dollar-average into MSFT, JPM, XOM, WMT, PG, KO, IBM, CAT and NEE, and also own shares of GOOGL, CSCO, MCD, MMM, TRV, CMI and ADM.

"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.

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Week 349 - Dividend Achievers with high Long-term Debt offset by a Strong Global Brand

Situation: Some highly indebted companies manage to pass through economic cycles with little difficulty, even though though they sometimes find it expensive to roll-over (refinance) their Long-Term Debt. This is a conundrum, given the impairment of their Balance Sheets (debt maturing in more than one year represents more than one third of their total assets). Think of having $200,000 left on your mortgage but your household assets (including equity in your home) are only worth $600,000. 

I try to avoid investing in such companies. When I do, I look for an excuse to sell. But there has to be a rational explanation for why these companies prosper, given the cost of servicing long-term debt. Two explanations come to mind: 
   1) These companies have a lower cost of capital, since so much of their capitalization is in the form of debt, where interest payments have not been taxed until recently. (The new tax law levies a 21% tax on interest payments that consume more than 30% of earnings.) 
   2) These companies have a strong Global Brand, which is an Intangible Asset that increases their acquisition value. That is, a strong Global Brand would increase the purchase price at least 5% above Tangible Book Value.
   3) These companies sell products that are remarkably “inelastic”, meaning that sales volumes are insensitive to price: “The price elasticity of supply measures how the amount of a good that a supplier wishes to supply changes in response to a change in price.[2] In a manner analogous to the price elasticity of demand, it captures the extent of horizontal movement along the supply curve relative to the extent of vertical movement [in price]. If the price elasticity of supply is zero the supply of a good supplied is ‘totally inelastic’ and the quantity supplied is fixed.” 

Mission: Analyze high-yielding Dividend Achievers (companies that have increased their dividend annually for at least the past 10 years). Select companies that have long-term Debt amounting to more than 33% of Total Assets, as shown in Column P of the Table. Reject companies that do not have a strong Global Brand. Also reject companies that do not have A ratings from S&P for both the bonds and common stocks that they have issued (see Columns T and U in the Table). Brand rankings are shown in Columns AB-AC of the Table. Examine a comparison group of companies in the Benchmark Section of the Table. 

Execution: see Table.

Bottom Line: The outperformance and low price volatility of these stocks, even during difficult market conditions (see Column D in the Table), cannot be explained by unique Tangible Assets such as strong Patent Protections or Tax Advantages. That leaves Brand Values (i.e., consumers prefer a brand they can trust) and Inelasticity (i.e., unit sales are not price sensitive) to account for the resiliency of their stock prices. That resiliency ultimately comes from pricing power. 

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

Full Disclosure: I dollar-average into Coca-Cola (KO), and also own shares of IBM and McDonald’s (MCD).

"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.

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Week 289 - Don't Leave Federal "Tax Expenditures" On The Table

Situation: There are 5 Federal government programs that can reduce your cost of living in retirement. You need to learn about these and take advantage of them whenever you are likely to benefit.

Program #1: The Social Security Act of 1935: You need to decide when to retire, because each year you delay results in an 8% larger Social Security check. You also need to brush up on other aspects of The Social Security Act that apply to you or your family. If you and your husband are divorced, and you’ve never remarried, you may still be eligible for some additional benefits. Check out the SSA website for answers to questions, and visit your nearest SSA office to get the help that you might need. 

Program #2: Social Security Act Amendments of 1965 (Medicare): When you enroll in Medicare at age 65, you’ll have the option of taking out private “MediGap” insurance, which is supervised by your state government, or enrolling in Part C, which is a private “Medicare Advantage” plan that is a Federally-managed and “capped” supplement encompassing Parts A and B of Medicare. 

Program #3: The Housing and Community Development Act of 1987 provides insurance for FHA Home Equity Conversion Mortgages (HECM), known as “reverse mortgages”. More than 3/4ths of the average retirees’ net worth is tied up in home equity, with other sources averaging ~$45,000 for Americans in the 65 to 69 year age group. By following the 4% Rule, the average American can only spend $150/mo of that “nest egg” to supplement her income from Social Security. To keep up with the myriad expenses of home ownership, she’ll have to decide whether to get a part-time job, sell her house, rent out part of it, or enter into a reverse mortgage. “Reverse mortgages are increasing in popularity with seniors who have equity in their homes and want to supplement their income. The only reverse mortgage insured by the U.S. Federal Government is called a Home Equity Conversion Mortgage or HECM, and is only available through an FHA approved lender.” But there is evidence that the average American is preparing better for retirement: As of 2015, those between the ages of 55 and 64 had saved an average of $104,000 according to the Government Accountability Office, which means $217/mo could be spent without eliminating that nest egg.

Program #4: The Cigar Excise Tax Extension Act of 1960 provides the legal framework for Real Estate Investment Trusts or REITs. This law does not create a tax expenditure (subsidy). Instead, it raises more revenue by creating an incentive for investors to move their money into real estate. That indirectly helps to reduce your cost of living at an extended care facility, when you can no longer live independently. Unless you are well off, you won’t be able to afford private long-term care insurance, and Federally subsidized long-term care insurance is only available to retired Federal employees. REITs are a partial solution, because they free real estate companies from paying Federal taxes, leaving investors with the obligation to pay that tax. REITs are similar to mutual funds except that they’re required to pay at least 90% of their income to investors, as dividends. Those dividends are attractive enough that REITs now have a large following among investors. Many “nursing homes” and extended care facilities are REITs. Retirees benefit from the capitalization structure of healthcare REITs, but investors who can tolerate a “roller-coaster ride” also come out ahead.

Program #5: The Food Stamp Act of 1964: Your next decision is whether or not to apply for food stamps. If you have no other source of income than Social Security, you are definitely eligible.

Mission: Set up a spreadsheet of ways an investor might invest in some of the public-private partnerships listed above, including health insurance companies that offer MediGap and Medicare Advantage plans. Pay particular attention to healthcare REITs.

Execution: see Table.

Bottom Line: Once you retire, your annual income will not keep up with inflation. With each passing year, you’ll become a little more watchful of spending and a little more likely to search out discounts. You’ll start to inquire about Federal programs that are particularly helpful to retirees, e.g. Food Stamps. We’ve listed 5 Federal programs that benefit retirees; you should become conversant in these before you retire. We have also listed 6 companies in the Table; 3 are healthcare REITs and 3 are large insurance companies with MediGap or Medicare Advantage plans. All 6 are high-risk high-reward businesses. 

Risk Rating: 7 (where US Treasuries = 10, the S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I don’t own shares in any of the 6 companies listed in the Table, but am looking to buy shares in the only “blue chip” (Dow Jones Industrial Average company): UnitedHealth Group (UNH).


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Week 286 - Should You Take Out A Reverse Mortgage?

Situation: Young couples are often advised to make payments each month on 1) a home mortgage, and 2) a “whole life” insurance policy. Homes are not good investments, and neither are “whole life” policies. They’re a form of compelled savings. If we later find ourselves unprepared for retirement, we may be guided to recoup those savings by “taking out” a reverse mortgage or “borrowing against” a whole life policy. The government joins the party by compelling us to save during our working years (under the Federal Insurance Contributions Act of 1935), and then guides us to recoup our “Social Security” savings in retirement. 

Mission: Look at the costs and benefits of reverse mortgages. NOTE: To obtain more detailed information, I suggest reading this article that appeared in USA Today on October 28.

Execution: “On the plus side, reverse mortgages are considered loan advances to you, not income you earned. Thus, the payments you receive are not taxable. Moreover, they usually don't affect your Social Security or Medicare benefits.” Emotional benefits play a role, given that 1) you get to keep living in your home without paying rent, and 2) your children get to inherit a house that retains considerable equity. And, reverse mortgages make a great Rainy Day Fund.

On the negative side, there is “opportunity cost”: You are giving up the opportunity to invest a large sum of your own money, if you sell the house and rent a place more suited to your needs. Transaction costs on the sale are the same as those for taking out a reverse mortgage (6%), which leaves 94% for you to invest. We provide an example (see Table) of how you might set up an online investment in bonds and stocks that pays out at least 2%/yr (after transaction costs) and grows those payments at least 2%/yr.  

Administration: The investment example has an asset allocation of 50% bonds/50% stocks. The bonds are “zero risk/zero cost” 10-Yr Treasury Notes accessed through the government website; that site also offers inflation-protected Treasury Notes. You can invest in KO, JNJ and WMT online but have to use a different website to invest in PG. Each pays a good and growing dividend, and had Total Returns/yr during the Housing Crisis that were better than those for our key benchmark, the Vanguard Balanced Index Fund (VBINX; see Column D in the Table). 

It is best to make these investments over time, starting with 40% of your proceeds then adding $100/mo to each of the 4 stocks and $1200/qtr to T-Notes. So, 60% of the proceeds from selling your house would initially go to an FDIC-insured savings account paying little interest. Part of that 60% will never be invested because it serves as your Rainy Day Fund. Nonetheless, you’ll be in a position to withdraw $9600/yr for electronic transfers to bond and stock accounts. Annual transaction costs come to ~$72/yr (see Column N in the Table).

Bottom Line: Reverse mortgages can be a good idea, if you’ve paid off your home mortgage and have almost no source of retirement income outside of Social Security. But inflation will always be with us, so it might be better to sell your house and move to a place that is not designed for raising children. Then, you can invest the proceeds from selling your house in a manner that costs you little and provides an opportunity to protect yourself from inflation.

Risk Rating: 4 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into PG and JNJ, as well as inflation-protected Savings Bonds (which are an IRA-like version of 10-Yr Treasury Notes). I also own shares of KO and WMT.

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Week 278 - Living From One Month To The Next On Social Security

Situation: 60℅ of Americans over age 65 are “overwhelmingly” dependent on Social Security and 20% are totally dependent (“Animal Spirits”, George A. Akerlof and Robert J. Shiller, Princeton University Press, Princeton and Oxford, 2009, p. 124). To maintain Social Security in its current form, with cost of living adjustments (COLA), would consume ~2℅ of the country's taxable income going forward. The average monthly benefit (July 2016) for a retired worker is $1350. Contrast this with the US “poverty threshold” of $1200/mo.

Mission: Outline constraints on the 20% who are totally dependent on Social Security and the 40% who have some savings but remain overwhelmingly dependent on Social Security. Create a spreadsheet of the types of assets held by the latter group.

Execution: To live independently on $1350/mo, an individual or couple would have to start retirement debt-free and remain so. If they are living rent and mortgage free in their home, they will not be able to afford the expenses (maintenance, property tax, utilities) unless they take in a renter. A car would also not be affordable due to expenses (insurance, tires, maintenance, registration). The discipline of sticking to a budget rules out the use of credit cards; a debit card and checking account are a better plan. They would need to use accrual accounting. That is, assign all $1350 of income each month to budgeted expense, including a savings account for non-recurring capital expenditures on new clothes, vacations, income taxes and medical/dental expenses. 

The 40% who find themselves overwhelmingly dependent on Social Security probably had no intention of ever owning stocks or stock mutual funds, preferring instead to use FDIC-insured savings accounts, Savings Bonds, whole life insurance, 1/10th ounce gold coins and a money market fund (or short-term bond fund) obtained from a broker. They are savers rather than investors and don’t want to place their savings at risk. They’d like to avoid losing money to inflation, and may be aware that the only zero-risk/zero-cost investments are 10-Yr Inflation-protected Treasury Notes and IRA-like Inflation-protected Savings Bonds obtained online. 

This cohort doesn’t want to gamble, which means they don’t want to invest in asset classes that always seem to fall in value during a recession. That restraint rules out stocks, corporate bonds, and REITs but not the equity in their own home. They may strive to own a home, but until the Housing Crisis they weren’t fully aware of the risk. Now they know that only Treasury Notes and gold can be counted on to rise in value during a financial crisis. 

Administration: see Table.

Bottom Line: Live small, stay out of debt, close any credit card accounts and keep track of every penny in an accrual accounting ledger.

Risk Rating: 3 (where Treasury Notes = 1 and gold = 10).

Full Disclosure: I dollar-average into Savings Bonds and hold Treasury Notes at www.treasurydirect.gov. I hold an intermediate-term US Treasury Bond Fund in a retirement account. 

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 13 in the Table.

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Week 277 - Counter-cyclical Barron’s 500 Dividend Achievers

Situation: What’s the biggest problem with owning stocks? When JP Morgan was asked this question, he answered: “It will fluctuate.” Benjamin Graham was more specific, noting in Chapter 14 (Stock Selection for the Defensive Investor) of his famous book (The Intelligent Investor, 4th Revised Edition, Harper & Row, New York, 1973, p.195) that:
     “Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.” 

But a stock’s price will rise far higher when investors clamor to “get in on the story.” All too often, that story reflects the investment that the company’s managers have made in Public Relations (e.g. advertising) at the expense of investments that grow Tangible Book Value (e.g. property, plant, equipment, and software). As a result, the company’s stock price will falter whenever the macro-economic outlook is negative. 

Mission: This week we’ll build on Warren Buffett’s observation that “only when the tide goes out do you discover who’s been swimming naked.” That last happened with the 4.5 yr Housing Crisis, i.e., year-over-year house prices (for conforming new sales nationwide) turned negative in Q3 of 2007 and didn’t turn positive again until Q1 of 2012. Most companies were exposed as naked swimmers, and their stock prices soon fell to a level more consistent with Benjamin Graham’s formula (see above). But a few outperformed during that 4.5 yr period. Total Returns/Yr proved to be greater than Total Returns/Yr have been over the 26+ yr period since the Savings & Loan Crisis of 1990-91. Do those companies have anything in common? We’d like to know, since owning shares in 2 or 3 such companies would help protect our portfolios from the ravages of the next crisis.

Mission: Look for companies in the Barron’s 500 List that 1) outperformed in the Housing Crisis, 2) have improved revenues and cash flow over the past 3 yrs, 3) have high S&P ratings on their bond and stock issues, and 4) are Dividend Achievers.

Execution: (see Table)

Administration: The first 3 companies in our Table (ROST, TJX, MCD) represent the Consumer Discretionary industry and see thrifty consumers as “core” clientele. Their Business Plan is designed to outperform in a recession because people will have an ongoing need to purchase their products and services, and more people will have become thrifty-minded. Four companies at the bottom of the list (WEC, XEL, ES, ED) are regulated public utilities that play a similar role: everyone needs to turn on lights and recharge their cell phones every day. Somehow the money will be found to pay the utility bill. 

It is harder to explain how the remaining two companies, IBM and WW Grainger (GWW), made the list. When a company needs information technology maintenance or upgrades, IBM has always had the reputation of being a safe and effective recommendation for a company’s Chief Information Officer to make. A deep recession is exactly when such upgrades are in demand, given that the company has had to reduce staffing to avoid being bought out by a stronger competitor. Automation and global sourcing are the paramount strategies to deploy in a recession. Similarly, GWW is the leading supplier of maintenance, repair, and operating products to businesses. So, demand for at least some of their products will have remained steady.

Among the BENCHMARKS and Standard Indices in our Table, note that only two asset classes that outperformed their long-term trend during the Housing Crisis: bonds and gold. This will always be the case in a financial crisis.

In the aggregate, these 9 stocks have a 5-Yr Beta below 0.5 (see Column I in the Table) which suggests that there would be less risk of loss vs. the S&P 500 Index in a Bear Market. But statistical analysis of weekly prices over the past 25 yrs suggests otherwise (see Column M in the Table). Taking both metrics into consideration, we see that WEC Energy Group (WEC) and Consolidated Edison (ED) are the only low-risk investments. 

Bottom Line: The “common thread” of our 9 recession-proof companies is a combination of skilled management and having a product line that includes goods and services exhibiting near-zero elasticity. Companies like Ross Stores (ROST), TJX (TJX) and McDonald’s (MCD), which appeal to the budget-minded among us, will ride out almost any storm. Electric utilities that are well-managed, like WEC Energy Group (WEC), or serve upscale markets, like Denver (XEL), Boston (ES) and New York City (ED), will emerge unscathed from recession. Finally, there are companies like IBM and Grainger (GWW) that provide maintenance and information technology to a long roster of companies, and these often cannot be pushed into the next quarter.

Risk Rating: 5 (where Treasuries = 1, and gold = 10)

Full Disclosure: I own shares of ROST, TJX, MCD, and IBM.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 19 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = moving average for stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Use of such a long-term trendline CAGR instead of a shorter-term current CAGR emphasizes the predictive value of “reversion to the mean”. Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% is based on returns from a stock index of similar risk to owning a small number of large-cap stocks where selection bias is paramount. That stock index is the S&P MidCap 400 Index.

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

Week 223 - Pricing Power

Situation: Stock-picking does not appear to be difficult. There is but one task (estimate earnings growth for ~30 companies) and one scorecard (growth of the S&P 500 Index). The long-term price appreciation for each company’s stock is a simple function of earnings growth and short-term interest rates. The most efficient way to boost earnings is to raise prices, if it won't hurt sales. This can be done by convincing customers that a company’s product or service is superior to the competition’s. In that scenario, pricing power = brand power. Alternatively, a company’s managers can engage in “restraint of trade” practices. In that scenario, pricing power = monopoly power (which is illegal). But pricing power is such a strong driver of earnings growth that company managers will try to skirt the legalities “to get a leg up on the competition.” Companies discover pricing power when “Mr. Market” decides that one of its “brands” is superior to others like it. In other words, consumers may decide to pay more dearly for a particular product or service just because it is perceived as “cool.” 

Mission: Determine which companies have brands that are strong enough to explain earnings growth “surprises.” In other words, which companies have the kind of stock price appreciation that comes from pricing power related to growing brand value, instead of pricing power related to “restraint of trade” practices. 

Execution: We'll start with the list of brand values in the recently published “Global 500 2015.”  Many of those brands denote whole companies but others denote separate product lines within a company. There are 87 US brands in that list with a higher dollar value in 2015 than in 2014. For analysis purposes, we’re only interested in companies (or the parent companies) having a publicly traded stock that has been around for at least 16 yrs and has a pricing pattern that roughly tracks that of the S&P 500 Index, as analyzed by the BMW Method. We find that 53 of those 87 companies meet those criteria and have revenues great enough to warrant inclusion in the Barron’s 500 List. Given that our stock-picking scorecard is the S&P 500 Index, we excluded the 6 companies that have had lower price appreciation over the past 16 yrs than the S&P 500 Index. Those are: Southwest Airlines (LUV), Sprint (S), Morgan Stanley (MS), Time Warner (TWX), Intel (INTC), Cisco Systems (CSCO). That leaves us with 47. An additional 17 were deleted because of having an S&P bond rating below BBB+ and/or an S&P stock rating below B+/M. This leaves us with 30 stocks to consider (see Table).

You want to have a stock-picking strategy that beats the S&P 500 Index. Failing that, you need to sell your stocks and dollar-average the proceeds into the lowest-cost S&P 500 Index fund (VFINX at Line 39 in the Table) or its bond-hedged version (VBINX at Line 37 in the Table). Over the past 20 and 30 yr periods, only 6 stocks have been able to track the S&P 500 Index and outperform it with less risk of loss in a future bear market, per the BMW Method. Those 6 stocks are Abbott Laboratories (ABT), Air Products and Chemicals (APD), 3M (MMM) and 3 utilities: American Electric Power (AEP), DTE Energy (DTE), and NextEra Energy (NEE). In other words, it is almost impossible to beat the S&P 500 Index unless you take on more risk (in the hope that price appreciation will outweigh the additional risk). 

Bottom Line: We have found 30 companies that beat the S&P 500 Index over the past 16 yrs (see Table). All 30 have improving brand values. The pricing power conferred by that improvement likely contributed to the earnings growth that has driven their stock prices higher. Investors are justified in thinking that pricing power is a “necessary but not sufficient” explanation for the outperformance of these stocks. A stock-picking strategy founded on improvement in brand values may be the best strategy available to retail investors, i.e., those who work outside the finance industry.

Risk Rating: 7

Full Disclosure: I dollar-average into NKE, UNP, JPM, WMT and MSFT, and also own shares of KO, PEP and MCK.

Note: Red highlights in the Table denote underperformance vs. the bond-hedged S&P 500 Index (VBINX); metrics in the Table are current for the Sunday of publication.

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

Week 192 - Navigating Retirement

Situation: The premise of our weekly blogs is that all of us are planning ahead in order to enjoy a healthy, productive retirement. That said, each of us needs financial resources that are adequate to fund our planned retirement. In other words, this blog is focused on Classical Economics, not Behavioral Economics. But for this week, we want to step “out of frame” and examine some issues that are better examined through the eyes of the Behavioral Economists. The key point is that retirees conduct their business while living with two problems that likely received insufficient attention prior to retirement. The first problem is that exiting from your day job can create a crisis related to identity. Second, retiring means we must face the illusion that we are immortal . . . and recognize that we are not. 

If you didn’t know it prior to retiring, certainly afterwards most people will admit that their day job was a complicated mixture of being “just a job” or livelihood, and being their personhood. In retirement (and job loss), we frequently have to construct another “personhood” to replace what has been lost. As a medical doctor, I know that patients with good mental health tend to beat the odds, e.g. after treatment for cancer. I also know that depression makes one more vulnerable to illness and injury, and that losing one’s job is at the top of the list for creating Reactive Depression (along with divorce and death of a family member). Being hit with any one of those three life events is considered by most doctors to be reason enough to seek counseling. Personally, I believe that beginning retirement is the kind of loss that should also be added to the above list. (You've lost your job!)

Why is that? Well, because fundamentally, having a satisfactory retirement isn’t really about finding enough money. It’s about freedom . . . peace of mind. We’ve “slain our dragons” and now it’s time to find a sense of accomplishment, peace of mind. How do we make this transition? It starts by remembering who you were when you came of age. Those who have always worked will probably be interested in finding another job after they retire.

Another important point is that you need to stay healthy. Your mental attitude (optimism and energy) depends on feeling well. The basic keys to good health are easy to remember and cheap to apply: 1) Eat more fresh vegetables, fruit and nuts but less red meat (and no desserts); 2) do cardiothoracic conditioning, something equivalent to two miles of brisk walking and 10 push-ups a day; 3) gradually get back to your high school graduation weight; 4) limit yourself to one cup of coffee a day and one drink a week; 5) don’t smoke cigarettes, puff cigars, or hang out with smokers; 6) get regular dental care to make sure you’re not developing a tooth abscess; 7) get a colonoscopy every 10 years; 8) take a nap most afternoons; 9) drink more water than you think you need (this is because as you get older, you won’t feel the thirst until you’re weak from dehydration). 

Your main enemy is hypertension, and it is certain to afflict you if you aren’t aggressive about getting daily exercise, minimizing caffeine intake, staying away from smokers, avoiding contentious people, and getting your BMI (body mass index) under 22. Buy a blood pressure measuring kit to use at home (and keep a daily log). And, as your age advances, gradually wean yourself from driving cars; walk instead. Don’t shovel snow (way too many people get heart attacks from doing that). If you develop any kind of sudden neurological dysfunction, call 911.

Bottom Line: Retirement isn’t what it’s cracked up to be in TV ads for ocean cruises, blood thinners and Viagra. At first you’ll be surprised when friends become disabled by old age, or just up and die. You’ll soon need to take a philosophical position on the subject of death, become more aware of who you are. By knowing your core values, you’ll be better able to make a list of who and what gives you peace of mind. Doing those activities and seeing those people will lower your blood pressure. And don’t forget to make some new friends. Your goal is to find a sense of freedom, which includes freedom from deadlines, obligations and supervision by anyone (other than your cardiologist). If people you know try to get you to march to their drummer instead of your drummer, find other people who share your values. You’ll live longer and better because you’ll have a life, and do things you want to do. Think less about return on invested capital and more about return of invested capital. As you get older, you’ll sleep better if you gradually wind down “growth” investments while maintaining “defensive” investments. So, the end result of this discussion is that we have prepared a Table for this week that has two bond examples plus 5 stocks worth preserving for the growing dividends they’ll spin off. We selected those 5 from our recent list of 10 Lifeboat Stocks (see Week 174). Our goal in presenting this Table is to provide you with a sample of sound dividend and interest paying investments that will give you a stable platform for your Golden Years.

Risk Rating: 3

Full Disclosure: I dollar-average into WMT and 10-yr inflation-protected T-Notes, and also own shares of JNJ, BDX and PEP.

Note: Metrics in the Table that underperform our 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 181 - Bond Substitutes

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

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

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

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

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

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

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

Risk Rating: 4

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

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

Please leave comments below, or email to: irv.mcquarrie@InvestTuneRetire.com