Month 111 - Nine A-rated non-Financial GARP Stocks in the S&P 100 Index - September 2020

Situation: “Growth at a reasonable price (GARP)" is an equity investment strategy that seeks to combine tenets of both growth investing and value investing to select individual stocks.” Different analysts use different metrics (and management assessments) to guesstimate favorable returns. Peter Lynch originated the concept and highlighted the usefulness of one ratio: Price/Earnings:Growth, commonly referred to as PEG. “Earnings” reference Earnings per Share (EPS) for the Trailing Twelve Month (TTM) period. “Growth” references an estimate of growth in EPS over the next 5 years. Yahoo Finance publishes the PEG ratio for each public company under Valuation Measures (see Column AH in the Table). The PEG ratio is kept up to date by Thomson Reuters. Peter Lynch is arguably the greatest stock-picker of all time. My interest in investing started through reading his books, which are practical down-to-earth primers. So, his reliance on PEG carries some gravitas. The basic idea is that a stock’s price ought to approximate the rate at which the company’s earnings grow (PEG = 1.0). That rarely happens in the real world but some companies come close (see Column AH in the Table).  

Mission: Look at the 23 A-rated non-financial high-yielding stocks in the S&P 100 Index and highlight the 9 that have 5-yr PEG numbers no higher than 2.5. 

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 bond rating of A- or better, 

            e) an S&P stock rating of B+/M or better, and 

            f) a 20+ year trading history. 

Bottom Line: Merck (MRK), Target (TGT), Intel (INTC), Comcast (CMCSA), and Lockheed Martin (LMT) have the overall highest quality among stocks on this list (see Column AL in the Table). INTC and CMCSA are also Value Stocks, meaning that their price (50-day moving average) is less than twice their Graham Number (see Column AC) and their 7-year P/E is no higher than 25 (see Column AE). 

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 MRK, PFE and INTC, and also own shares of TGT and CMCSA. 

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

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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.

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Week 390 - REITs That Qualify For "The 2 and 8 Club"

Situation: Membership in “The 2 and 8 Club” is based on the FTSE High Dividend Yield Index, which consists of the ~400 companies in the FTSE Russell 1000 Index that reliably pay an above-market dividend. Real Estate Investment Trusts (REITs) are excluded from the FTSE High Dividend Yield Index because their dividend payouts are variable, being fixed by law at 95% of gross income. But those payouts are usually higher than the yield on an S&P 500 ETF (e.g. SPY), which is ~2%. We are curious as to whether any REITs meet the 5 basic requirements for membership in “The 2 and 8 Club”, and find that there are 4 (see Table). However, REITs are typically “small cap stocks.” Only one of the four in our Table is a large enough company to be included in the FTSE Russell 1000 Index (Simon Property Group; SPG).

Mission: Populate our Standard Spreadsheet for REITs. Select only those that meet the 5 basic requirements for membership in “The 2 and 8 Club”:
   1) above-market dividend yield;
   2) 5-Yr dividend growth of at least 8.0%/yr;
   3) a 16+ year trading record that is analyzed weekly for quantitative metrics by the BMW Method;
   4) an S&P Bond Rating of BBB+ or higher;
   5) an S&P Stock Rating of B+/M or higher.
Add a column for FFO (Funds From Operations; see Column P in the Table), which is a ratio that the REIT Industry substitutes for P/E. 

Execution: see Table.

Bottom Line: Pricing for REITs is negatively correlated with rising interest rates but not as much as you might suspect. This is likely because the dividend yield for most REITs remains above the interest rate on a 10-Yr US Treasury Note. Pricing is more sensitive to the likelihood that the REIT will have enough FCF (Free Cash Flow) to fund dividend payouts (see Column R in the Table). Overall, it is hard to argue against the idea that high-quality REITs are a good “bond substitute.” 

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

Full Disclosure: I dollar-average into SPG and own shares of KIM.

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

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Week 379 - Are “Blue Chip” Stocks Overvalued?

Situation: There are two subjective issues that we need to quantify for “buy and hold” investors: 1) Define a “blue chip” stock. 2) Define an “overvalued” stock. 

Our previous effort to define a “blue chip” stock in quantitative terms (see Week 361) left room for subjective interpretation and was more complicated than necessary. Here’s the new and improved definition: Any US-based company in the S&P 100 Index whose stock has been tracked by modern quantitative methods for 30+ years, and enjoys an S&P rating of B+/M or better. The very important final requirement is that the company issues bonds carrying an S&P rating of A- or better. 

In last week’s blog, we introduced two different quantitative methods for deciding whether or not a stock is overvalued: 1) the Graham Number, which sets an optimal price by using Book Value for the most recent quarter (mrq) and Earnings Per Share for the trailing 12 months (TTM); 2) the 7-Yr P/E, which removes aberrations that are introduced by “blowout earnings” or the negative impact on earnings that is often introduced by “mergers and acquisitions” and “company restructurings.” Either metric can be misleading if used alone, but that problem is largely negated when both are used together. 

Mission: Set up our Standard Spreadsheet for the 40 companies that meet criteria. Show the Graham Number in Columns X and the 7-Yr P/E in Column Z.

Execution: see Table.

Administration: In our original blog about Blue Chip stocks (Week 361), we thought the definition needed to require that companies pay a good and growing dividend. However, there are no objective reasons why a company’s stock will be of more value if profits are paid out piecemeal to investors rather than entirely in the form of capital gains. That’s one of the things you learn in business school from professors of Banking and Finance. Accounting professors also point out that a dividend is a mini-liquidation, as well as a second round of taxation on the company’s profits. There are subjective reasons to prefer companies that pay a good and growing dividend, like building brand value (an intangible asset) and showing that the company is “shareholder friendly.” Dividends also reduce risk by returning some of the original investment quickly with inflation-protected dollars.

Bottom Line: In the aggregate, these company’s shares are overpriced but not to an unreasonable degree (see Columns X-Z in the Table). However, only 8 are bargain-priced: Altria Group (MO), Comcast (CMCSA), Berkshire Hathaway (BRK-B), JP Morgan Chase (JPM), Bank of New York Mellon (BK), Wells Fargo (WFB), US Bancorp (USB), and Exxon Mobil (XOM). You’ll note that all 8 face challenges that will cause investors to pause before snapping up shares. 

Shares in 9 companies are overpriced by both metrics (Graham Number and 7-Yr P/E): Home Depot (HD), UnitedHealth (UNH), Lowe’s (LOW), Costco Wholesale (COST), Microsoft (MSFT), Texas Instruments (TXN), Raytheon (RTN), Honeywell International (HON), and Caterpillar (CAT). You’ll need to think about taking profits in those, if you’re a share-owner.

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, NEE, KO, JNJ, JPM, UNP, PG, WMT, CAT, XOM, and IBM. I also own shares of COST, MMM, BRK-B, and INTC.

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

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Week 377 - Russell 1000 Non-financial Companies With High Sustainability and S&P Ratings

Situation: You’d like information about the durability of your investments. Sustainability is the jargon term that investment professionals have assigned to this topic. The problem is to quantify it by rating the 3 main components: Environment, Social, and Governance (ESG). The Yahoo Finance website now has a heading for sustainability that attempts to do exactly that. The editors of Barron’s also have a recent article looking more closely at the “100 Most Sustainable Companies”, with date suggesting that these may outperform the S&P 500 Index. We’d like to know which of those have also been examined by S&P. Specifically, which of those 100 Most Sustainable Companies have issued bonds that S&P has rated A or better?

Mission: Use our Standard Spreadsheet to analyze all of the Barron’s “100 Most Sustainable Companies” that are on the Russell 1000 List, selecting only the non-financial companies that have an S&P bond rating of A or better, and an S&P stock rating of B+/M or better. To identify stocks that are possibly overpriced, include columns for “Graham Numbers” and “7-Yr P/E”.

Execution: see Table.

Bottom Line: 18 companies meet criteria, 14 of which already appear on our two major lists: “The 2 and 8 Club” (see Week 360); “Blue Chips” (see Week 361). The new companies are Stanley Black & Decker (SWK), WW Grainger (GWW), Colgate-Palmolive (CL) and Deere (DE).

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 and PG, and also own shares of CSCO and CMI.

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

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Week 265 - How Do We Create Quality Time in Our Sunset Years?

     “For last year's words belong to last year's language
      And next year's words await another voice.
      And to make an end is to make a beginning."
                                           Little Gidding, by T.S. Eliot

Situation: After your career of gainful employment ends, you’ll need to make a new beginning. New beginnings are comparatively rare over the course of our lives, and frequently the changes made amount to nothing more than defenses thrown up to improve our situational control. Retirement is an excellent opportunity to examine such habits, as some may no longer have utility. But beware. People who have looked at personality adjustments in retirement suggest that whatever little monster lives inside us won't remain so little after we retire and dial back those defenses. Academic studies, however, reveal no universal trends. There’s just a complex tableau of effects. That said, we all know that our working life frequently required us to whittle ourselves into a machine of a person. That’s what we’ve been doing. And now we’re going to un-whittle, whether we want to or not. Prepare for that day by investing in yourself. Drop the job-related defenses without losing sight of the need we all have for routine and purpose. Build new routines that have a new purpose.

Mission: Retirement, like marriage, purports to be about quality-of-life. Both are influenced by two important factors: our health and our ability to pay. Opportunity becomes a function of maintaining our body and our balance sheet. 

Step #1 is to craft a retirement identity, now that your Facebook Page isn’t being monitored by your employer. Each of us needs to understand that there will be a new twist to the way we answer key questions: “Deep down, who am I? How do I get a life?” There will be moments of grieving over the loss of friends, particularly the loss of your best friend (yourself). Elisabeth Kubler-Ross has taught us that grieving happens in identifiable stages: denial, anger, bargaining, depression, and acceptance. These steps “can occur in any order.” From my decades employed as a doctor (neurosurgeon), I think that 95% of us will exhibit Kubler-Ross symptoms during retirement. Often, the trigger is not the loss of livelihood but the loss of personhood, which was gained through the roles and missions of our job. But psychotherapists say that explanation is too simplistic. They suggest instead that the vacuity of our interpersonal relationships away from work brings on a sense of loss that can no longer be covered up by work.

Step #2 is to take care of our bodies. This is a two-part problem because the things we do to damage our health often function to allay our feelings of stress: smoking, drinking, and continuing to eat after our appetite has been satisfied. And, stress is a contributing cause of most illnesses. Almost all of us have found ways to de-stress as often as necessary. (Prohibition failed for a reason.) Psychologists say the healthy way to do this is to take frequent 3 or 4 day vacations instead of the annual multi-week expedition. Of course, psychologists who say this are “arguing against interest” because part of their business comes from people overwhelmed by relationships that blew up during Christmas and annual vacations.

Step #3 is to fund your retirement. The trick here is not to gamble. Gambling mainly comes in two forms. Borrowing money is most common way people gamble. So don’t borrow money for anything other than a mortgage on your principal residence. The other form is to make risky investments. What is risk? Taking a risk is to bet on an uncertain outcome. In finance, “risk-on” means to have confidence in a future stream of earnings growth (for a stock) or the full repayment of principal on time (for a bond). “Risk-off” means confidence has evaporated; the investor will usually want to close out her position, perhaps at a loss. We caution you to make bond-like investments that are highly rated by S&P. With a highly-rated bond, the borrower almost always returns the original investment to the lender on time. With a highly-rated stock, bond-like features, such as good and growing dividends or a low debt/equity ratio, will often prevent the stock’s price from falling in a recession. Start your career as a stock-picker with the list of Dividend Achievers. For those of us who don’t have time to make a hobby of stock-picking, the way to avoid gambling is to invest in either a bond-heavy mutual fund like Vanguard Wellesley Income Fund (VWINX), or a stock-heavy index fund like Vanguard Balanced Index Fund (VBINX). 

In this week’s Table (Columns N-P), we introduce a third way to avoid gambling on stocks: avoid those that don’t exhibit reversion to the mean. In other words, confine your selections to stocks that are priced close to their 30-yr trendline. To demonstrate, we’ve picked 10 Dividend Achievers at the BMW Method 30-yr website, using Coca-Cola (KO) as the limit for risk of loss (Column P in the Table) and extent of leverage (Columns AC and AD in the Table), and the S&P 500 Index (^GSPC) as the limit for loss during the correction of 2011 (Column D in the Table). Companies with a Return on Invested Capital (ROIC) that is less than the Weighted Average Cost of Capital (WACC) are excluded (Columns AA-AB), as are companies with a negative book value, which makes it impossible to calculate the Graham Number (Column U). 

Execution: How might one craft a retirement identity? Start by coming up with a plan for preventing or minimizing Kubler-Ross symptoms. Or better yet, how about just facing them? The plan has to separately address distinct parts of your being, i.e., mental health, physical health, renewal through travel and recreation, and substitution. Why substitution? Because you’ll need to substitute for your work persona through the gradual and planned development of your natural personality, untethered to the habits necessitated by your working life. While it is impossible to detach entirely from ingrained habits, we all know that many of our co-workers (40% of all workers in one large study) report to work simply to make money and have health insurance. They were not there to either sustain or nourish their personality. Karl Marx was right about “alienation.” If you spent your working years as one of those unfortunates, retirement is a chance to recover, dial back your stress level and grow a little. But if you identified strongly with your workplace persona, you’ll need to remain somewhat tethered, perhaps by becoming “historian” of your trade association. 

How might one improve health? Given that many of our poor health habits exist because of work-related stress, experiment with dialing back unhealthy habits.

How might one plus-up retirement savings without gambling? We all know you can’t retire while you have debts. If that’s you, make sure you can migrate to a part-time job soon after retiring from your full-time job. Once your debts have been paid off, do the math and see if you can maintain your lifestyle by using income from Social Security, pensions & annuities, and your retirement portfolio. If there’s still not enough, you’ll have to continue with part-time work or dial back your lifestyle. But behavior is hard to change, so you’ll be tempted instead to borrow money, gamble, or borrow money to gamble. Don’t. There are no short-cuts. It’s too late in the game for you to invest in anything with an uncertain payoff. The only investments that can help you now are to be found at treasurydirect. You’ll have to keep working, dial back your lifestyle, or sponge off friends and relatives. If you are disabled, apply to the appropriate government agency for assistance.  

Administration: 
Mental Health: Here you’ll need to reach out. Start by paying closer attention to your network of friends and relatives. Technology also helps by providing vicarious relationships through your laptop: Facebook, movies, and feature presentations viewable with 360 degree “virtual reality” headsets. And remember, New York museums and Broadway plays are popular with tourists for a reason. Find a way to avail yourself of live theater or a museum visit at least once a year.

Physical Health: The trick here is 30 minutes of exercise a day (e.g. brisk walking), and eating a balanced diet that includes green vegetables, fruit, nuts and coffee (or some other antioxidant). If you live alone, there’s a good chance you’re not getting enough protein and Vitamin D. So, take a supplement like “Ensure Enlive” (Abbott Laboratories) each day. Finally, the need for extra sleep is easily forgotten. It may be hard to understand the importance of sleeping each night until rested, but “you’ll know it when you see it”.

Travel and Recreation: “Get a life!” That’s what we say to boring people who appear to have no excitement in their lives. But many senior citizens lack the wherewithal to travel, or even take up a renewing pastime. Fortunately, the internet makes it easy to find affinity groups and charitable organizations that will help you avoid becoming a “shut-in.”  

Substitution: learn routines for a new purpose in life, one that suits you. Here you’ll need a little professional help from someone who knows how to select and evaluate a psychological test that addresses someone like you. You’d best do this at least 3 yrs before you retire, since you may need to reacquire lost skills or encourage new skills. 

Bottom Line: Half of us will need to continue working in our sunset years. During the run-up to retirement, we’ll have to learn a new career/vocation/hobby, one that is less stressful and time-consuming. Those of us who don’t fear outliving our retirement assets will have a similar task, but will also have the luxury of free associating a plan for new routines that match a new purpose in life. Both groups soon realize they’ll have to pay a lot more attention to physical health than anticipated. That will lead to paying closer attention to mental health, which creates a positive feedback loop that stabilizes physical health. For example, we continue to eat after our appetite has been satisfied mainly because it decreases stress. By learning more about the sources of stress in our lives, and taking remedial action, we’ll find that losing weight is not so difficult. So, the key part of our makeover is to de-stress, which is most easily accomplished through frequent 3-4 day periods of Travel and Recreation. Academic studies also suggest that to de-stress we’ll need to nurture more friendships.

Risk Rating: 5 (US Treasuries = 1; gold = 10)

Full Disclosure: I dollar-average into NKE, JNJ, and T, and also own shares of ROST and KO. 

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 16 in the Table. NPV inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = the moving average for price over the past 50 days (corrected for transaction costs of 2.5%), Dividend Growth Rate is Dividend CAGR for the past 16 years, Price Growth Rate is Price CAGR for the past 30 years, and Price Return in the 10th year is corrected for transaction costs of 2.5%. The calculation template is found at (http://www.investopedia.com/calculator/netpresentvalue.aspx).

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Week 263 - “Bond-like” Stocks That Fly Under The Radar

Situation: The stock market is overpriced, which is the obvious outcome of “quantitative easing” and ultra-low interest rates. US Treasury bonds and notes carry an interest rate that is close to the projected inflation rate over their holding period. Stocks, in spite of their added risk, are the only path to portfolio growth. For that reason, the business news increasingly talks up “bond-like” stocks. 

Mission: In last week’s blog, we set up criteria for defining “bond-like” stocks, starting with the requirement that they be Dividend Achievers, i.e., the dividend has been increased annually for at least the past 10 yrs. Now we’ll use those same criteria to highlight “below the radar” stocks, e.g. those issued by companies that don’t have sufficient revenue to be included in the 2016 Barron’s 500 List.

Execution: We exclude any Dividend Achiever from consideration if one or more of the following conditions apply:

1. Revenues are insufficient to warrant inclusion in the 2016 Barron’s 500 List;
2. S&P bond rating is less than BBB+ or (in the absence of a rating) debt/equity is less than or equal to one;
3. S&P stock rating is less than B+/M or S&P assigns a denominator of “H” to the rating (indicating high risk of loss);
4. WACC exceeds ROIC;
5. Finance Value (Column E in our Tables) falls more than for the Vanguard 500 Index Fund (VFINX);
6. Dividend yield is less than for VFINX;
7. 16-yr CAGR is less than for the S&P 500 Index (^GSPC);
8. Dividend yield + 16-yr CAGR is less than 11.4%. NOTE: This metric has predictive value for Net Present Value (NPV) and is highlighted in yellow at Column Q in the Table.
9. Predicted loss to the investor at 2 standard deviations below 16-yr price CAGR is more than 36% (see Column P in the Table).

Bottom Line: We’ve found a dozen Dividend Achievers that appear attractive for long-term investment, even though most reside in the S&P 400 MidCap Index. Not surprisingly, 7 of the 12 are utility stocks. But the strongest stock of the group is Tanger Factory Outlet Centers (SKT), a real estate investment trust.

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

Full Disclosure: I own shares of Lincoln Electric (LECO).

Note: Metrics are current for the Sunday of publication. Metrics highlighted in red denote underperformance relative to our key benchmark (VBINX at Line 25 in the Table). NPV inputs are listed and justified in the Appendix for Week 256. 

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Week 163 - How To Bet On Commodity-related Stocks While The Children Are Watching

Situation: We all need to know how to drink responsibly, drive responsibly, eat responsibly, and flirt responsibly. But how, exactly, are we to gamble responsibly? If you’re a regular follower of our website, I’m sure you’ve gambled on something at some time in your life. This is behavior that is what John Maynard Keynes blamed on “animal spirits.” Here at ITR, we try to take the gambling out of investing because we think you’ll get a more comfortable retirement that way. 

Now we need a way to gauge whether or not we’re gambling on “hot” stocks. I travel a lot, researching the blog and trying to learn how people like to invest. I hear amazing statements. While riding up a ski lift last winter in Vail, I heard a real estate developer say "People aren't interested in saving for retirement. Look at the choices they make!" He knew what interests most people the most, i.e., moving to a house that better reflects the status they want to project, and he’d made a lot of money feeding that interest. 

More and more though, I’m struck by how carefully children monitor adult behavior. They quickly come to understand how a family gets to be “house poor” by living beyond both its means and its needs. And they’re less sure than ever about what lessons to take away from observing adults. A child will naturally look for someone to model her behavior on, anyone really, whose behavior suggests that he or she has character--a sense of responsibility and respect toward people in their home, their neighborhood, and the larger community. The word I hear them use is “dishonest”, to sum up places and people that don’t do that. 

This week’s blog is about learning to invest in traditionally risky stocks without gambling. We recommend doing this by looking at companies in the riskiest industries. i.e., energy and basic materials. Both are “commodity-related” industries and their stock values show the greatest variance. 5-yr Beta values are typically 50% higher than the S&P 500 Index, and losses during the Lehman Panic were typically 20% greater. A few simple rules will get us there, starting with all 68 such companies in the Barron’s 500 List that have long-term total return records:

        1) Exclude companies with S&P bond ratings of BBB- or lower, since S&P typically uses the BBB rating to designate a company that is doing OK at the moment but gambling with its life. Bear Stearns, for example, had its debt downgraded from “A” to “BBB” on March 13, 2008 just three day before J.P. Morgan Chase purchased it for $2.00/Share with assistance and encouragement from the Federal Reserve.

        2) Exclude companies that had lower scores for 2013 vs. 2012 on the Barron’s 500 List (see Week 158), unless scores for both years were in the top 300.

        3) Assign the “Not Gambling” label to companies that have S&P bond ratings of A- or better, and BBB+ if the company is a Dividend Achiever.

4) Assign the “Gambling” label to the remaining companies.

5) As a final “belt and suspenders” action, move any companies out of the “Not Gambling” category that lost more than the 28% that VBINX lost during the 18-month Lehman Panic period. 

This week’s Table shows the results. There are 7 “Not Gambling” and 19 “Gambling” stocks to choose from. For comparison, the BENCHMARKS section includes PRNEX (T Rowe Price New Era Fund), which is the lowest-cost mutual fund dedicated to the energy and basic materials industries. As always, red highlights denote underperformance relative to our key benchmark, The Vanguard Balanced Index Fund (VBINX). 

Bottom Line: You don’t have to gamble to own commodity-related stocks. Just do the above screen then take more time than usual to research the “story” supporting each company’s stock price. Pick a stock, start a DRIP (e.g. at computershare), and automatically invest $25-200/mo in the company of your choice. When the price swoons, keep investing as long as the “story” holds.

Risk Rating: 7

Full Disclosure: I own shares of MON.

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

Week 7 - Risk

Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.

In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:

(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;

(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and

(c) the S&P downgrade

have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.

Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.

<click this link to view the Risk Table>

S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and 
e) rivalry among existing firms.

S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.

LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.

TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.

BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).

RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.

MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.

Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.

Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%)  for the ITR Growing Perpetuity Index.

What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.


<click here to move to Week 8>