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.

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

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

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.

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

Month 101 - Moving the Needle: A-rated S&P 100 Companies in “The 2 and 8 Club” - November 2019

Situation: You’re now in your 50s. The “sunset years” loom ahead. While you have the advantage of being a more experienced investor, you’re losing time and may retire short of where you need to be. Even now, you need to have a “nest egg” at least 6 times your current salary. Your retirement account is likely to be 60% in stocks but that allocation falls to 50% by the time you retire. You’ll need to hold safer but more effective stocks. “The 2 and 8 Club” is one way to do that: buy stocks that carry both a higher dividend yield and a faster rate of dividend growth compared to the S&P 500 Index (SPY), i.e., stocks that yield at least 2%/yr and grow dividends at least 8%/yr. For safety, confine your picks to stocks issued by “mega-cap” companies in the S&P 100 Index. Why those? Because they’re large enough to have multiple product lines, i.e., they’re more able to respond to diverse market conditions. And, they’re required to have active hedging positions at the Chicago Board Options Exchange. Those “put and call” stock options are side-bets made by professional traders, which makes “price discovery” for the underlying stocks more rational. 

Mission: Use our standard spreadsheet to analyze companies in the S&P 100 Index that a) issue debt rated at least A- by S&P, b) issue stock rated B+/M or better by S&P,  c) are listed in the U.S. version of the FTSE High Dividend Yield Index--marketed by Vanguard Group as VYM, d) have the 16+ year trading record that is needed for quantitative analysis by the BMW Method, and e) have grown their dividend at least 8%/yr for the past 5 years. 

Execution: see the 13 companies at the top of this week’s Table.

Administration: Let’s explain the Basic Quality Screen (see Column AH in the Table). The idea is to give readers a quick take on which stocks are worthwhile to consider as a new BUY. The maximum score is 4. Overpriced stocks (see Column AF) are penalized half a point. Reading from left to right across the spreadsheet, the first opportunity to score a point is found in Column K. Stocks that have a 16-yr price appreciation that is more than 1/3rd the risk of ownership (Column M) score one point. A negative value in Column S for Tangible Book Value (highlighted in purple) results in a loss of one point if the debt load is either greater than 2.5 times EBITDA (Column R) or LT-debt represents more than 50% of the company’s total capitalization (Column Q). In Columns U and V, all 13 companies earn 2 points because their S&P ratings meet the requirement of being at least A- for the company’s debt and B+/M for the company’s stock. In Column Z, one point is earned if the stock appears likely to meet our Required Rate of Return over the next 10 years, which is 10%/yr, i.e., the dollar value is not highlighted in purple.

Bottom Line: As you approach retirement, look more closely at the stocks and ETFs in your portfolio. Those equities will need to be half your retirement savings. Where possible, choose stocks issued by large companies that offer higher dividend yields and faster dividend growth than the S&P 500 Index. Five of this week’s stocks are worth researching for possible purchase because of being rated 3 or 4 on our Basic Quality Screen (see Column AH): CSCO, JPM, USB, CAT and BLK.   

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 NEE, JPM, USB, CAT and IBM, and also own shares of AMGN, CSCO, PEP, BLK and MMM.

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

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

Month 100 - The Clubhouse Turn: A-rated Companies in the 65-Stock Dow Jones Composite Index - October 2019

Situation: Last month, we came up with 10 stocks that are “safe and effective” bets for the neophyte stock-picker. Our starting point was the S&P 100 Index of the largest publicly-traded companies that benefit from price discovery through a robust market in stock options. Very large companies have the built-in safety feature of multiple product lines, which provide management with internal options for responding to an economic crisis. I excluded companies with less-than-stellar S&P ratings on the stocks and bonds they have issued, as well as companies trading for fewer than 16 years. I have also excluded companies with volatile stocks--those with a 3-yr Beta that is higher than 0.75--as well as companies that are not listed in both of the “value” sub-indices (VYM and IWD) for the Russell 1000 Index. 

This month I’ve dialed back on those safety requirements by including stocks that likely carry more reward at the expense of greater risk. My assumption is that the stock-picker has accumulated 10+ years of experience and now needs to face up to the responsibility of carefully investing for retirement. The “savings race” has reached The Clubhouse Turn but she still needs guideposts for selecting safe and effective stocks.

Mission: Run our Standard Spreadsheet on only the companies in the 65-stock Dow Jones Composite Average that have either issued bonds rated at least  A- by S&P or carry no long-term debt on their balance sheet. (Those 65 companies are picked by a committee chaired by the Managing Editor of the Wall Street Journal.)

Execution: see Table.  

Administration: Five companies that met the above criteria had to be excluded because they lack information we need for analysis: a full 16+ years of trading records (V, AWK) or an S&P stock rating of at least B+/M (CVX, DD, MRK). One company, PepsiCo (PEP) has been added to the BACKGROUND section because it is the only company among last month’s list of 10 Starter Stocks that isn’t in the Dow Jones Composite Index.

Bottom Line: A mid-career stock-picker who doesn’t have a degree in accounting or business administration is at a disadvantage. It would be in her best interest to narrow her choices to the gold standard of stock-picker lists, which is the 65-stock Dow Jones Composite Index, then further narrow her choices to companies that issue bonds rated A- or better by S&P and have at least a 16 year trading record for their stock. That leaves 28 companies to research. The goal, of course, is to find stocks that have outperformed the S&P 500 Index over the past 5 and 10 years while losing less value than the Index did in its worst year of the past 10. In other words, I’m suggesting that she should focus her research on the 9 companies that have no red highlights in Columns C through F of the Table: Microsoft (MSFT), UnitedHealth (UNH), Nike (NKE), Boeing (BA), Intel (INTC), Union Pacific (UNP), Disney (DIS), NextEra Energy (NEE), and American Electric Power (AEP).   

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 MSFT, NKE, BA, UNP, NEE, JPM, INTC, KO, WMT, JNJ, PG, CAT and IBM, and also own shares of AAPL, CSCO, PFE, TRV, DUK, UPS, SO, MMM and XOM. So, I am invested in 22 of the 28 companies. It is difficult to follow that many companies, but it is nonetheless essential: Academic studies suggest that a stock-picker needs to be invested in at least 30 companies to have a good chance of matching market returns (see Columns C, F, and K in the Table) while enjoying less risk that the portfolio will lose value (see Columns D, I, and M of the Table).

APPENDIX: “Investment” is a nice word for the deployment of capital. As with any other capital expenditure, its effectiveness (profit margin) is what accountants call Operating Margin, which is Operating Income divided by Sales Revenue. Sales Revenue comes to the stock investor from dividends and the liquidation of shares. Operating Income is Earnings Before Interest and Taxes (EBIT) “after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.” 

As an investor who buys stocks, your variable costs of production are transaction costs (fees and commissions paid for purchase and sale of shares) plus rent/utilities/supplies for your “home office” and the cost of your business services (e.g. subscriptions to business magazines, newspapers, and websites). For money used to purchase stocks, EBIT is Gross Income (Sales Revenue after subtracting the variable costs of production) minus Depreciation (which is inflation).

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

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

Month 99 - Starter Stocks - September 2019

Situation: When I started investing, I picked up the phrase “stocks for widows and orphans.” Typically, Probate Court will assign fiduciary responsibility for investments made on behalf of a widow or orphan to lawyer. I later became acquainted with one of those and learned that she expected after-inflation returns from low-risk stocks to be well over 5%/yr. But she hadn’t fully considered transaction fees, taxes, or the need to balance stocks 50-50 with 10-yr US Treasury Notes (to hedge against what could be a catastrophic loss for a widow or orphan). And, few stocks make suitable long-term holdings in a portfolio that is supposed to be immune to gambling. Given that a stock broker’s main talent is to wisely supervise gambling, a broker is likely to welcome the prospect of building a portfolio of “boring” stocks that will have little turnover.

Many young but upwardly mobile “salary workers” face the same problem that lawyer is facing: how to invest wisely without gambling. I have 4 children who are trying to grapple with this problem; none have gained lasting satisfaction from consulting investment advisors. And, they don’t much like my advice, which is to research the problem and find their own solution, which is called DIY investing. But, they already have the most important asset: which is to be disinclined to gamble.

Starter Stocks, like those for widows and orphans, are usually (but not always) boring. Consumer Staples are most likely to be Starter Stocks, and Utilities are close behind. But then you’ll find that technology-related companies start to pop up from Health Care and Information Technology industries. 

Mission: Use our Standard Spreadsheet to screen out companies that are missing from either of the two key value indexes, which are the iShares Russell 1000 Value Index ETF -- IWD and the income-oriented variant of the Russell 1000 Index that was created as the FTSE High Dividend Yield Index but is marketed in the US as the Vanguard High Dividend Yield ETF -- VYM. Companies that issue bonds having an S&P rating lower than A- are also excluded, as are companies that issue stocks having an S&P rating lower than B+/M. Stocks must have a 16+ year trading record, to allow quantitative analysis by the BMW Method.

Administration: Most of the strategies that are likely to give high returns from owning stocks in a bull market also carry a high risk of loss in a bear market. So, when the market falls 25% those stocks might fall 50%. That means a 100% gain would have to occur over ensuing years just to get back to where the stock was priced when the last bull market ended. Banking and Finance faculty at business schools teach that this strategy is the only legal way to beat the market. In other words, reversion to the mean growth rate is sacrosanct. One way for an investor to hedge against such volatility is to pick stocks that go up or down less than 75% as much as the S&P 500 Index. In other words, exclude stocks with a 3-yr Beta that is higher than 0.75. Another way is to pick stocks issued by very large companies, namely those found in the S&P 100 Index. To be included in that index, companies are required to have an active market in put and call options at the Chicago Board Options Exchange, which means that “price discovery” for the underlying stock is efficient and relatively well insulated from “momentum” investors who are trading on the basis of fleeting rumors or sentiment. The other advantage of very large companies is that they have multiple product lines, at least one of which is expected to produce an attractively priced product during a recession. Integrated oil companies, for example, maintain a fleet of refineries that would be paying less for their feedstock (oil) during a recession--thereby allowing the company to make a nice profit from selling gasoline at a lower price than the customer had been used to paying. 

Bottom Line: The problem with screening for “Starter Stocks” is that you’ll pull up some that are broadly thought of as desirable. Both gamblers and non-gamblers will bid up such stocks but forget to sell them when shares become overpriced. Given that most Starter Stocks (see Table) are found in channels of the economy that are already saturated (i.e., companies can grow their revenues no faster than GDP grows), there is little reason to hold overpriced stocks in expectation that earnings will explode upward. For example, the stocks issued by all four of the Consumer Staples companies on our list (KO, PG, PEP, WMT) are overpriced (see Columns AB to AD in our Table). You’ll have to figure out when to buy (or sell) overpriced shares of such high-value stocks. A common strategy is to buy more shares when the price drops 5-10% below its usual range. This is called the buy the dip strategy. 

The easiest (and probably best) way to be certain of buying shares when they’re bargain-priced is to do it automatically. Sign up for a dividend reinvestment plan (DRIP) that takes a fixed amount of money out of your checking account on a specific date each month to buy more shares. That strategy is called dollar-cost averaging, and is the strategy that Warren Buffett favors to build a position in stocks that are often overpriced.

How well do our 10 Starter Stocks (at Line 10 in the Table) perform vs. the underlying ETFs -- VYM and IWD (at Lines 19 and 20)? Answer: quite a bit better (see Columns E, F and K).

Risk Rating: 6 (where 10-yr US Treasuries = 1, S&P 500 Index = 5, gold = 10)

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

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

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

Month 97 - Members of "The 2 and 8 Club" in the Russell 1000 Index - July 2019

Situation: The idea here is to “beat the market” by making selective purchases of individual stocks. This is a delusion, given that the odds are less than 1 in 20 that a professional trader will (over any 10-year period) beat VOO--the ticker for the lowest cost S&P 500 Index Fund, which has an Expense Ratio of 0.03%. VOO is marketed by Vanguard. 

Since you have to actively trade stocks to even come close to beating VOO, trading costs will relentlessly keep you from beating the market. Those costs include brokerage fees, commissions, research time & expense, and capital gains taxes. So, this month’s blog is about an interesting game, like tennis or marriage: When you lose, you’re a fool if you take it personally.  

Mission: Run our Standard Spreadsheet for high-quality stocks in the Russell 1000 Index that have a good and growing dividend. High quality means an S&P bond rating of A- or better. A good dividend is one that gets the stock into the Vanguard High Dividend Yield Index Fund (VYM). A growing dividend is one that has been 8.0%/yr (or better) over the past 5 years.

Execution: see Table.

Bottom Line: You’re toast. It isn’t going to happen. But you’ll come close to beating the market if you avoid making abstract considerations and instead follow concrete markers, such as avoiding stocks with a dividend yield plus dividend growth rate of less than 10%. And, find a way to quickly decide whether a stock is overpriced. For example, you can ask your broker if Morningstar rates the stock as being “overvalued”. Or, you can calculate the Graham Number on your smartphone. The Graham Number is what the stock’s price would be at 15 times Earnings Per Share for the trailing 12 months (TTM), multiplied Book Value for the most recent quarter (mrq). This is a power function (15 times 1.5 equals 22.5). So, you have to multiply those numbers (for the stock in question) by 22.5 before taking the square root, which is the stock’s rational price. If the stock is selling for more than 2.5 times the Graham Number, it is overpriced (see the numbers highlighted in purple at Column AB of the Table). In other words, many investors want to own the stock but relatively few owners want to sell it. You should wait for this fever to break before buying shares.

Risk Rating: 6 (where a 10-year US Treasury Note = 1, S&P 500 Index = 5, and gold = 10)

Full Disclosure: I dollar-average into NEE, JPM, CAT and IBM, and also own shares of CSCO, AMGN, TRV, CMI, MMM and BLK.

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

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

Week 389 - Bond ETFs

Situation: You want to balance your stock portfolio with safe bonds. Right? Well, here’s a news flash: You need to start thinking about balancing your bond portfolio with safe stocks. Why? Because the world is gorging itself on debt--households, municipalities, states, nations, and corporations most of all. Yes, this is understandable because the Great Recession was so disabling that central banks everywhere dropped interest rates lower than the rate of inflation. It was free money, so people borrowed the stuff and invested it. Just as the central bankers had intended. Economic activity gradually returned to normal almost everywhere, now that 10 years have passed since Lehman Brothers declared bankruptcy on September 15, 2008. But the Federal Open Market Committee is removing the punch bowl from the party and raising short-term interest rates by a quarter percent 3-4 times a year. Bondholders are stocking up on Advil due to interest rate risk (duration), meaning that for each 1% rise in short-term interest rates there is a material reduction in the value of an existing bond that is worse for long-term than short-term bonds. 

If a company is struggling and has to refinance a maturing issue of long-term debt, it will have to pay a materially higher rate of interest vs. that paid to holders of the expiring bond. This may impact the credit rating of its existing bonds, driving it closer to insolvency. General Electric (GE) is an especially vivid example of how this works. A few short years ago, GE had an S&P rating of AAA for its bonds. That rating is now BBB+ and falling fast. Larry Culp, the CEO, is desperately selling off core divisions of the company in an attempt to avert bankruptcy. 

Mission: Use appropriate columns of our Standard Spreadsheet to evaluate the leading bond ETFs, and compare those to the S&P 500 Index ETF (SPY) as well as a stock with an S&P Bond Rating of AA or better.

Execution: see Table. 

Bottom Line: To offset the risks in your stock portfolio (bankruptcy, market crashes and sensitivity to fluctuation of interest rates), you need a bond portfolio. Why? Because high quality bonds rise in value during stock market crashes and/or recessions, have much less credit risk, and usually less interest rate risk. Stock prices are more sensitive to short-term interest rates than any but the longest-dated bonds, e.g. 30-Yr US Treasury Bonds. Stock indexes like the S&P 500 Index (SPY) have average S&P Bond Ratings of BBB to BBB+, compared to AA+ for 30-Yr Treasuries. To cover those risks, you’ll need a bond fund that has low-medium interest rate risk and high credit quality. BND and IEF are examples (see Table). BIV differs only in having medium credit quality per Morningstar. TLT has high credit quality but also has high interest rate sensitivity. TLT can be compared to a stock with high credit quality and high interest rate sensitivity, e.g. Pfizer (PFE; see Table). The main thing to remember is that stock market crashes are invariably accompanied by a booming bond market (flight to safety). That’s a good thing because governments will have to take on a lot more debt to finance social programs like unemployment insurance.

Risk Rating: 1 for BND and IEF (where 10-Yr Treasuries = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: I own bond funds that approximate BIV and TLT.

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

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

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.

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

Week 365 - “Dogs of the Dow” (Mid-Year Review)

Situation: The 10 highest-yielding stocks in the Dow Jones Industrial Average are called The Dogs of the Dow (see Week 305 and Week 346). The only time-tested formula for beating an index fund (specifically the Dow Jones Industrial Average) is based on investing equal dollar amounts in each Dog at the start of the year. That would have worked in 6 of the past 8 years. Why? Because those are high quality stocks that have suffered a price decline and are likely to recover within ~2 years, which would lower their dividend yield and release them from the “Dog pen.” 

Mission: Predict which Dogs will emerge from the Dog pen by the end of 2018, using our Standard Spreadsheet.

Execution: see Table.

Administration: For various reasons, the 2018 Dogs are unlikely to post greater total returns this year than the Dow Jones Industrial Average (DIA). But we can still try to play the game by predicting which of this year’s Dogs will be missing from next year’s Dog pen. Those will probably come from those posting lower dividend yields at the mid-year point (see Column G in the Table): Coca-Cola (KO), Cisco Systems (CSCO), General Electric (GE), Merck (MRK) and Chevron (CVX).

Bottom Line: Given current trends, Cisco Systems (CSCO) and Chevron (CVX) are likely to be released from the Dog pen at the end of the year.

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

Full Disclosure: I dollar-average into KO, PG, XOM and IBM, and also own shares of CSCO.

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

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

Week 364 - Ethanol Producers

Situation: “Market research analysts at Technavio have predicted that the global bio-fuels market will grow steadily at a CAGR of almost 6% by 2020”. But arguments against blending ethanol with gasoline are building. In 2016, 15.2 billion gallons were produced at 214 plants, with Archer Daniels Midland (ADM), Valero Energy (VLO) and Green Plains Renewable Energy (GPRE) being the main publicly-traded producers. For example, those 3 companies operate 4 ethanol plants in Nebraska that together produced 2.2 billion gallons, representing 31% of the state’s crop. Not only is fuel a big business for the agriculture sector, but the by-product (“distillers grains”) is a rich source of animal feed. For every ton of ethanol produced, there are 0.24 tons of distillers grains. 

You need to think of ethanol plants as a permanent feature of the Corn Belt, i.e., the 11 states of the Upper Midwest. Government subsidies for ethanol plants in Europe and the United States aren’t going away, for two important reasons. Ethanol is a renewable fuel, and adding it to gasoline makes tailpipe emissions less damaging to the atmosphere. Furthermore, ethanol plants represent the only stable market for the dominant farm product of those 11 states (North Dakota, South Dakota, Nebraska, Kansas, Minnesota, Iowa, Missouri, Wisconsin, Illinois, Indiana, and Ohio). But, before you buy shares in one of the 6 companies we highlight here, you need to understand a number of factors that impact the feedstocks and ultimate markets served by those plants. Start by reading this summary prepared for Green Plains (GPRE) investors.

Mission: Analyze the 6 publicly-traded US companies in the ethanol business, using our Standard Spreadsheet.

Execution: see Table.

Administration: Ethanol plants have changed the lives of farmers in the Corn Belt from being a speculator to being a professional businessman. Iowa, the state that produces the most corn, almost exclusively grows #2 field corn  destined for ethanol plants. 20% of that corn becomes “distillers grains”, and dry distillers grains are shelf-stable and greatly valued as animal feed all over the world. So, that’s a stable and global market. And, ethanol is increasingly being shipped out of the US, either separately or blended with gasoline. For example, China recently adopted the same 10% ethanol content requirement for gasoline that the US has been using. That is seen as an export opportunity for US ethanol plants.

Bottom Line: Corn Belt = ethanol plants. That’s the equation you need to remember. It’s all based on #2 field corn. The #1 sweet corn that we like to eat is rarely grown in the Corn Belt. A state outside the Corn Belt (Washington) is the leading producer. But it’s only been 11 years since the Bush Administration pushed Congress to blend 10% ethanol with gasoline. Yes, hundreds of ethanol plants were built as a result but the economics of running those plants is only now being sorted out. If you invest in any those, you’re a speculator by definition. 

Addendum: Here’s the definition of a red line for “speculation” given in the May 28, 2018 Bloomberg Businessweek on page 8: “...a conservative threshold for volatility, typically lower than that of the broader market for relevant assets…” Column M in all of our tables lists the 16-year volatility of each company (with the required trading record) and highlights in red those that have a greater volatility than the Dow Jones Industrial Average (DIA). Of the 6 companies in this week’s Table, even Archer Daniels Midland (ADM), the longest-established (and highest rated by S&P) company, has a volatility well above that of DIA.

Risk Rating: 8 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10) 

Full Disclosure: I dollar-average into Archer Daniels Midland (ADM), which is a member of “The 2 and 8 Club” (Extended Version; see Week 362).

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

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

Week 360 - “The 2 and 8 Club” (Extended Version)

Situation: Market turmoil is turning stock and bond index funds into a “crowded trade.” Both are momentum investments, and both remain overvalued. Neither offsets the risk of the other. This is a good time to take some chips off the table and bulk-up your Rainy Day Fund. More importantly, it is a time to revisit the fundamentals of sound investing. For example, stop making “one-off” stock investments. Those are usually speculative. But follow Warren Buffett’s lead and continue to invest in strong companies by dollar-cost averaging. Those are “forever” investments that will likely prove worthwhile, through bear markets as well as bull markets, as long as you stay the course.

But how do we find “strong” companies? Experienced traders mainly offer 5 qualifiers: Look for 1) large and 2) well-established companies that have 3) strong Balance Sheets, and pay a 4) good and 5) growing dividend. We have converted those into numbers on a spreadsheet, and call it “The 2 and 8 Club.” We start by looking at the companies in the S&P 100 Index because those are required to have a robust market in Put and Call options (which facilitate Price Discovery). Approximately 20 of the 100 earn membership in our Club. Approximately 10 more companies on the Barron’s 500 List meet our requirements, allowing us to create an ~30 stock list (the Extended Version).

Mission: Produce a spreadsheet of the ~30 companies in the Extended Version of “The 2 and 8 Club.”

Execution: see Table.

Administration: What are our criteria for meeting each of the 5 qualitative objectives?

Large companies
Those are the 500 on the Barron’s 500 List published each May (see Columns N & O in our Tables).

Well-established companies
Those are the companies on the Barron’s 500 List that are also on the 16-Yr list of companies that are quantitatively evaluated each week by using the BMW Method. See Columns K-M in our Tables.

Strong Balance Sheet
Companies must have an S&P Bond Rating of BBB+ or higher (Column T in our Tables). For more granularity on this topic, we provide key metrics: Long-Term Debt as a percent of Total Assets (Column P), Operating Cash Flow as a percent of Current Liabilities (Column Q), Tangible Book Value per Share as a percent of Share Price (Column R), Dividend Payout as a percent of Free Cash Flow (Column S), Weighted Average Cost of Capital vs. Return on Invested Capital (Columns Z and AA). Values in those 6 columns that we think of as sub-par are highlighted in purple.

Good Dividend
Companies must be listed in the FTSE High Dividend Yield Index (US version). Those are the ~400 companies in the Russell 1000 Index that are judged by The Financial Times editors to have a dividend yield that is reliably above the market yield of approximately 2% (see Column G). The most convenient investment vehicle for that is the Vanguard High Dividend Yield ETF (VYM). The list is updated monthly, and you can access holdings here.

Growing Dividend
We require companies to have increased their dividend payout at least 8%/yr over the past 5 years (see Column H), as determined by calculating the Compound Annual Growth Rate (CAGR) for the most recent 4 quarters of regular dividend payouts vs. the same 4 quarters 5 years ago.

As a sanity check, we require that companies have historic returns relative to risk that is within reason for the retail investor, i.e., an S&P Stock Rating of at least B+/M (see Column U). 

Finally, there are two important caveats that you need to keep in mind: 1) No one invests solely on the basis of numbers. The story behind a company’s stock has to be examined by using multiple online sources, and revisited at least monthly. 2) Every investor needs a Watch List to help her get started with each month’s research. “The 2 and 8 Club” is our Watch List. 

Bottom Line: If you’re a downhill ski racer, your goal is to get to the Bottom Line safely and quickly. “Safely” is accomplished by setting up a few gates with line judges, and allowing you to “shadow” the course the night before. “Quickly” is assessed by using a stopwatch, combined with a video camera trained on the finish line. In other words, the activity is standardized to allow comparison with other racers and place limits on sanity. Stock picking isn’t much different. You need a starting place, a process governed by sanity checks, and a way to judge your performance. “The 2 and 8 Club” satisfies those basic needs. It will help give you a chance to outperform an S&P 500 Index enough to pay for the additional transaction costs and capital gains taxes that you’ll incur.

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

Full Disclosure: I dollar-average into MSFT, NEE, PEP, JPM, CAT and IBM, and also own shares of TRV, MMM, CSCO and CMI.

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

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

Week 306 - A-rated Dividend Achievers That Have Outperformed The S&P 500 For 25 Years At Lower Risk

Situation: Some companies have served investors well over the past 25 yrs, compared to an investment in the Vanguard 500 Index Fund (VFINX). If we define “gambling in the stock market” as a statistical probability of losing more than you would from VFINX in any given market calamity, we find that 10 of those outperforming companies aren’t gambles. As long as those companies retain their management culture, as well as their competitive advantages, they’ll continue to outperform at less risk vs. the S&P 500 Index. 

Mission: Subject those 10 companies to our standard spreadsheet analysis, except that in calculating Net Present Value we’ll use the rate of price appreciation over the past 25 yrs instead of 16 yrs, i.e., the BMW Method.

Execution: see Table.

Administration: Our conditions for inclusion are that companies must meet a high standard of quality. S&P ratings for both their stock and bond issues cannot be lower than A-. Balance Sheets must be clean, meaning that Long-Term Debt cannot constitute more than a 1/3rd of total assets, Tangible Book Value cannot be negative (we grant a little leeway in the event of a recent acquisition), and dividends have to be paid from Free Cash Flow (FCF). Companies must have annual revenues that are high enough to warrant inclusion in the Barron’s 500 List of large US and Canadian companies. 

Bottom Line: These 10 companies represent 6 of the 10 S&P Industries (see Column Z in the Table). Each stock’s predicted risk of loss (at 2 Standard Deviations below trendline price appreciation per the BMW Method) is less than the S&P 500 Index’s projected loss (see Column M in the Table). All 10 have positive NPVs at a 9% Discount Rate, suggesting that you’re likely to realize at least a 9%/yr total return over a 10 year Holding Period, whereas VFINX has a negative NPV (see Column Y in the Table). Hormel Foods (HRL) and NextEra Energy (NEE) have the highest NPVs.

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

Full Disclosure: I dollar-average into NEE, and own shares of TRV, ABT, MMM, and HRL.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote under-performance vs. VBINX at Line 18 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 = average 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 3-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning shares in a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table. The ETF for that index is MDY at Line 17. For bonds, Discount Rate = Interest Rate.


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

Week 296 - Testing Our Stock-picking Algorithm

Situation: The “normal” way to invest in stocks is to play the Market as a whole. Typically, that means dollar-cost averaging into index funds such as those offered by Vanguard Group (VFINX, VEXMX, VTSMX, VGTSX) or SPDR State Street Global Advisors (SPY, MDY, DGT). That way, transaction costs are minimized and you can’t miss out on market moves. Or, you can try to beat the Market by building (and managing) a portfolio composed of many stocks representing all 10 S&P Industries. There’s no shortage of books on the subject but one will suffice: “The Four Pillars of Investing: Lessons for Building a Winning Portfolio” by William J. Bernstein, 2002, McGraw-Hill. There you’ll find a mathematical exercise proving that the only logical way to do well from investing in stocks is to focus on dividend growth. 

Mission: Lay out an algorithm for stock selection.

Execution: Start with companies that have grown their dividend annually for 10 or more years, i.e., S&P Dividend Achievers. Select the ones that have grown their dividend faster than our benchmark S&P 500 index fund, VFINX, over the past 10 years, which is 6.8%/yr. Narrow that list down to those companies large enough to be on the Barron’s 500 List. Why? Because large companies a) have multiple product lines, and b) their stock has enough activity on the CBOE (Chicago Board Options Exchange) to facilitate price discovery. Remove any companies that don’t have an S&P Bond Rating of at least A- and an S&P Stock Rating of at least A-/M. Remove any companies that don’t have a 16-yr trading record that has been analyzed statistically by the BMW Method. Exclude companies that rely on long-term debt for more than 1/3rd of total capitalization, or couldn't meet dividend payments from free cash flow (FCF) in the two most recent quarters. Also exclude companies that are over-reliant on short-term debt, i.e., have more than 5% negative Tangible Book Value.

Administration: There are 27 companies that pass the above screen. By using the BMW Method, we have separated those into a group of 16 that has no greater chance of loss in a future Bear Market than the S&P 500 Index (see Column M of the Table under “Non-Gambling”), and a group of 11 that has a greater chance of loss (see red highlights in Column M under “Gambling”). If you do choose to invest in one of the Gambling companies, watch price-action because you’ll likely want to SELL at some point. In Columns N-P we provide data on 3 ratios that assess the overall health of Financial Statements.

Bottom Line: The purpose of stock-picking is to Beat the Market. It is very difficult, expensive, and time-consuming to do so over more than one Market Cycle. We have laid out a system for picking stocks, and back-tested it. It has a Failure Rate of 4%. In other words, 25 of the 26 stocks beat the S&P 500 Index over the past 16 years (see Column K in the Table). Just to be clear, we recommend that you dollar-average into index funds (see BENCHMARKS section of Table), and/or Berkshire Hathaway B-shares (where you would be building a position in over 100 large and mid-cap companies). 

Of the 16 stocks we designate as non-gambling investments, most carry market multiples (or lower) for EV/EBITDA: GWW, UNP, CNI, WEC, APD, NEE, TRV, WMT, TGT. Those stocks are attractive for purchase if no issues arise from your further research, such as reading the Morningstar evaluation.

Risk Rating is 7 for the stock selection system outlined above. Why is that? Because of Selection Bias (https://en.wikipedia.org/wiki/Selection_bias) and Transaction Costs (http://www.investopedia.com/terms/t/transactioncosts.asp).

Full Disclosure: I dollar-average into UNP, NKE, JNJ, PG, NEE and MSFT, and also own shares of CNI, MMM, WMT, HRL, TRV, MKC, ROST, TJX, GD and CAT.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 40 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 (no dividends collected in 10th year), Initial Cost = average 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 5-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 45 in the Table. The ETF for that index is MDY at Line 39.

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