Situation: The purpose of a retirement portfolio is to accumulate wealth during working years and distribute that wealth during sunset years. The laws of finance that govern accumulation are “reversion to the mean” and “compound interest”. The closest we have to a law of finance that governs distribution is “the 4% rule”.
If we dollar-cost average our purchase of shares on a monthly schedule during the accumulation period, we’ll never overpay over a given market cycle, i.e., we’ll “buy low” as often as we’ll “buy high” as reversion to the mean works its magic. If we automatically reinvest quarterly dividend payouts, this quarter’s dividend will pay a dividend on last quarter’s dividend as “compound interest” works its magic. During retirement, we’ll spend 4% of our total asset value, as calculated on December 31st of the year just ended, in the coming year.
A-rated high-yield growth stocks in the Dow Jones Industrial Average (DJIA) have a dividend yield of ~3%/yr. So, if you’ve been dollar-averaging into those stocks you’ll occasionally want to sell shares in one of those stocks to meet next year’s spending goal. But given the stability of those reliable and growing payouts, I’d suggest that you look elsewhere to make up the projected shortfall. Why? Well, look at the spreadsheet of this month’s 8 DJIA growth stocks. If you own shares in all eight companies, you’re likely to enjoy a dividend yield of more than a 3%/yr for years to come.
Mission: Find A-rated non-financial growth stocks in the DJIA that have an above-market dividend yield; analyze those by using our Standard Spreadsheet.
Execution: see Table.
Administration: A-rated means that S&P assigns the company’s bonds a rating of A- or higher, and assigns the company’s common stock a rating of B+/M or higher. It also means that debt levels are reasonable. So, in a setting of negative Tangible Book Value it is unreasonable for a company to be capitalized more than 50% with debt or to have total debts greater than 2.5 times EBITDA. Exclude financial stocks and stocks that have been traded on public exchanges for less than 20 years. Select only from DJIA stocks that are held in both of these portfolios: Vanguard High Dividend Yield ETF (VYM) and iShares Russell Top 200 Growth ETF (IWY).
Bottom Line: Market volatility is the key concern for investors who plan to maintain their lifestyle during retirement. So, you might as well make money off it. That means automatically buy low (through dollar-cost averaging) whenever the market collapses, and automatically take advantage of mean regression while you’re at it. In other words, use dollar-averaging to buy shares in high-yielding companies for nothing by using a DRIP (dividend reinvestment plan), where dividends pay dividends on previously reinvested dividends.
Risk Rating: 5 (where 10-yr US Treasury Notes = 1, S&P 500 Index ETFs = 5, and gold = 10).
Full Disclosure: I dollar-average into PG, JNJ and CAT, and also own shares of MRK, CSCO 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
Showing posts with label compound interest. Show all posts
Showing posts with label compound interest. Show all posts
Sunday, July 26
Sunday, December 17
Week 337 - Agriculture-related Companies in “The 2 and 8 Club” (Extended Version)
Situation: We’ve narrowed our “universe” to large & established US companies that reliably pay a good & growing dividend, and called it The 2 and 8 Club. Why? Because “good ” means 2% or better and “growing” means 8% or better. We use a wash/rinse/repeat method to find those companies.
In the “wash” cycle, we collect companies that are listed at each of the 3 online spreadsheets we value: 1) The capitalization-weighted FTSE High Dividend Yield Index for US companies, which is simply the 400 companies in the Vanguard High Dividend Yield ETF. 2) The S&P 100 Index, which has the advantage of price discovery through the requirement that stocks in these large companies have active markets in Put and Call Options. 3) The BMW Method List of statistical data for stocks that have been traded on a public exchange for at least 16 years.
In the “rinse” cycle, we look up information online about each stock that passed through the wash: 1) We make sure bonds issued by that company have an S&P Rating of A- or better. 2) We make sure stocks issued by that company have an S&P Rating of B+/M or better (go to your broker’s website). 3) We make sure the company’s annual dividend payout has been growing 8% or faster over the past 5 years, i.e., we get a list of payouts from the relevant Yahoo Finance page then put the most recent year’s payout and the payout for 5 years ago into a Compound Annual Growth Rate calculator.
In the “repeat” cycle, we take the same steps 3 months later, then select stocks to add or delete by using a brokerage that charges you a flat fee of ~1% of Net Asset Value/yr. This allows you to trade without incurring transaction costs (including dividend reinvestment).
If you’re a glutton for punishment, you can extend your oversight beyond S&P 100 stocks to include those on the Barron’s 500 List, published each year in May, which has the advantage of ranking companies by using 3 cash flow metrics. Then you’ll be running the Extended Version of The 2 and 8 Club, which currently has 32 companies (see Table for Week 329). This week’s blog drills down on the 10 companies in the Extended Version that ultimately depend on feedstocks provided by farmers, to ultimately market foods & beverages, motor engine fuels, animal feed, cigarettes, cotton shirts, and plastics made from corn.
Mission: Set up a Standard Spreadsheet of those 10 companies.
Execution: see Table.
Administration: Farmers operate a capital-intensive business that requires large-scale production on ~1000 acres to justify the cost of chemicals and fertilizer plus the main cost, which is for the purchase and maintenance of equipment (e.g. combines, tractors, grain carts, center-pivot irrigation systems, sprayers, semi-tractors that haul 30 tons of grain, grain-drying bins, grain storage bins, and satellite navigation links needed for weather forecasting and precision agriculture). Their mobile powered equipment requires diesel fuel, and their grain-drying bins require natural gas or propane.
Archer-Daniels-Midland is the only pure Ag company on the list. ADM collects crops at railheads for further shipment and initial processing, and distributes products worldwide. Much of that distribution begins by loading grain onto barges in the Mississippi River.
Weather is the key variable. The software and hardware on weather satellites is IBM gear, and IBM owns The Weather Channel. GPS-based software is an important part of precision agriculture, and similarly depends on satellites running IBM equipment. Cummins (CMI) and Caterpillar (CAT) provide diesel engines, and ExxonMobil (XOM) is one of the largest sources of diesel fuel. CAT also makes skid-loaders and backhoe/end-loaders that some farmers use.
PepsiCo (PEP) and Coca-Cola (KO) process a variety of farm products (including milk, cheese, oranges, oats, coffee and tea) into dozens of branded foods and beverages that are found worldwide. Altria Group (MO) processes tobacco plants into cigarettes and smokeless tobacco for the US market. VF Corporation (VFC) is the largest company that fabricates clothing for a variety of markets, and depends on farmers to produce its main feedstock (cotton). Target (TGT) markets clothing, and Super Target stores offer a large variety of foods and beverages.
Bottom Line: Farm incomes have fallen 20%/yr over the last 3 years, but appear to have stabilized with this year’s harvest. Cost-cutting and scaling-up are the main survival strategies. Farms that are large enough to sustain a family are multi-million dollar enterprises that cultivate more than a square mile of ground. When farmers are forced to cut costs, suppliers are forced into being acquired by (or merged with) other companies. To further complicate matters, efficient transportation networks now circle the planet. The supply of crop commodities outstrips demand enough that the effects of drought or war in one place are mitigated by bumper crops in another place.
Risk Rating: 8 (where 10-yr Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10).
Full Disclosure: I dollar-cost average into KO, XOM, and IBM, and also own shares of CAT and MO.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
In the “wash” cycle, we collect companies that are listed at each of the 3 online spreadsheets we value: 1) The capitalization-weighted FTSE High Dividend Yield Index for US companies, which is simply the 400 companies in the Vanguard High Dividend Yield ETF. 2) The S&P 100 Index, which has the advantage of price discovery through the requirement that stocks in these large companies have active markets in Put and Call Options. 3) The BMW Method List of statistical data for stocks that have been traded on a public exchange for at least 16 years.
In the “rinse” cycle, we look up information online about each stock that passed through the wash: 1) We make sure bonds issued by that company have an S&P Rating of A- or better. 2) We make sure stocks issued by that company have an S&P Rating of B+/M or better (go to your broker’s website). 3) We make sure the company’s annual dividend payout has been growing 8% or faster over the past 5 years, i.e., we get a list of payouts from the relevant Yahoo Finance page then put the most recent year’s payout and the payout for 5 years ago into a Compound Annual Growth Rate calculator.
In the “repeat” cycle, we take the same steps 3 months later, then select stocks to add or delete by using a brokerage that charges you a flat fee of ~1% of Net Asset Value/yr. This allows you to trade without incurring transaction costs (including dividend reinvestment).
If you’re a glutton for punishment, you can extend your oversight beyond S&P 100 stocks to include those on the Barron’s 500 List, published each year in May, which has the advantage of ranking companies by using 3 cash flow metrics. Then you’ll be running the Extended Version of The 2 and 8 Club, which currently has 32 companies (see Table for Week 329). This week’s blog drills down on the 10 companies in the Extended Version that ultimately depend on feedstocks provided by farmers, to ultimately market foods & beverages, motor engine fuels, animal feed, cigarettes, cotton shirts, and plastics made from corn.
Mission: Set up a Standard Spreadsheet of those 10 companies.
Execution: see Table.
Administration: Farmers operate a capital-intensive business that requires large-scale production on ~1000 acres to justify the cost of chemicals and fertilizer plus the main cost, which is for the purchase and maintenance of equipment (e.g. combines, tractors, grain carts, center-pivot irrigation systems, sprayers, semi-tractors that haul 30 tons of grain, grain-drying bins, grain storage bins, and satellite navigation links needed for weather forecasting and precision agriculture). Their mobile powered equipment requires diesel fuel, and their grain-drying bins require natural gas or propane.
Archer-Daniels-Midland is the only pure Ag company on the list. ADM collects crops at railheads for further shipment and initial processing, and distributes products worldwide. Much of that distribution begins by loading grain onto barges in the Mississippi River.
Weather is the key variable. The software and hardware on weather satellites is IBM gear, and IBM owns The Weather Channel. GPS-based software is an important part of precision agriculture, and similarly depends on satellites running IBM equipment. Cummins (CMI) and Caterpillar (CAT) provide diesel engines, and ExxonMobil (XOM) is one of the largest sources of diesel fuel. CAT also makes skid-loaders and backhoe/end-loaders that some farmers use.
PepsiCo (PEP) and Coca-Cola (KO) process a variety of farm products (including milk, cheese, oranges, oats, coffee and tea) into dozens of branded foods and beverages that are found worldwide. Altria Group (MO) processes tobacco plants into cigarettes and smokeless tobacco for the US market. VF Corporation (VFC) is the largest company that fabricates clothing for a variety of markets, and depends on farmers to produce its main feedstock (cotton). Target (TGT) markets clothing, and Super Target stores offer a large variety of foods and beverages.
Bottom Line: Farm incomes have fallen 20%/yr over the last 3 years, but appear to have stabilized with this year’s harvest. Cost-cutting and scaling-up are the main survival strategies. Farms that are large enough to sustain a family are multi-million dollar enterprises that cultivate more than a square mile of ground. When farmers are forced to cut costs, suppliers are forced into being acquired by (or merged with) other companies. To further complicate matters, efficient transportation networks now circle the planet. The supply of crop commodities outstrips demand enough that the effects of drought or war in one place are mitigated by bumper crops in another place.
Risk Rating: 8 (where 10-yr Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10).
Full Disclosure: I dollar-cost average into KO, XOM, and IBM, and also own shares of CAT and MO.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, May 7
Week 305 - Dogs of the Dow
Situation: We all know that Compound Interest is the most powerful force in the investing universe but the second most powerful force is less well known: Reversion to the Mean. That’s the force that makes many of the poorly-performing stocks from the last business cycle look good in the next business cycle. How this “magic” works is through the decisions made by investors, who either don’t put more money into a good but overbought stock (thereby marking its “high”), or do put more money into that same stock after it has become oversold (thereby marking its “low”). In the case of large and well-established companies, this “now I like it/now I don’t” oscillation can evolve faster than the normal business cycle; but for commodity-related companies it will evolve slower. Investors are eager to know when a “low” has been reached for actively traded stocks, such as those in the 30-stock Dow Jones Industrial Average (DJIA). That’s why we have “The Dogs of the Dow,” a respected investment theory that identifies high-quality but temporarily struggling stocks by their attractive dividend yields. Most DJIA stocks pay an above-market dividend, which that may go up or remain unchanged but will almost never go down. If the stock drifts lower in price, investors will be alerted to this by its rising dividend yield. Why? Because they’re getting paid more to own the stock and will tell their friends.
“Proponents of the Dogs of the Dow strategy argue that blue-chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with a high dividend relative to stock price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low-yield companies.”
At the end of each year, “Dogs” are identified as the 10 highest-yielding stocks DJIA. “Dogs of the Dow Theory” instructs you to invest equal dollar amounts in each of those 10 stocks in the first week of January. You can be certain that some of those stocks will show remarkable price appreciation over the next 12 months, but most won’t. By following this Theory, your odds of beating the DJIA are better than even, but most investors think they can improve on the odds by “winnowing out” companies having a business plan that appears likely to remain ineffective longer than a year.
Mission: Subject the 2017 Dogs of the Dow to our spreadsheet-based analysis.
Execution: see Table. Metrics highlighted using purple mark issues that will reduce the chances of that stock outperforming the DJIA this year.
Bottom Line: A great deal of research backs up Dogs of the Dow Theory. And, it has more value that Dow Theory in generating an series of Buy Signals. If you learn nothing else from our blog, learn Dow Theory and use it to ignore market pundits.
The thing to understand about the Dogs of the Dow strategy is that you aren’t going to restructure your equity portfolio every January by seeking to own equal dollar amounts of all 10 Dogs. But the list is very useful when Dow Theory is generating "Buy" signals. On such occasions, find a way to winnow the list down to 4 or 5 stocks and buy shares in companies you don’t already own. The most popular method is to pick the 5 lowest-priced, which have come to be called “Small Dogs of the Dow”. This year’s Small Dogs are Coca-Cola (KO), Verizon Communications (VZ), Merck (MRK), Pfizer (PFE) and Cisco Systems (CSCO). Two of those stocks, VZ and MRK, have S&P ratings of B/M, i.e., a clear message to the retail investor that these are best avoided.
Of the remaining 3, Coca-Cola (KO) shares are likely to be the most “safe and effective” to own. Emerging markets are past the Great Recession and starting to grow, giving Coke an opportunity to capitalize on its dominant position in countries where the middle class is growing at 10%/yr.
CSCO is attractive for a different reason. Companies around the world are finally increasing their capital expenditures faster than GDP. Computers and software are the fastest-growing class of capital expenditures. Cisco Systems (CSCO) has been increasing its sales and earnings faster that expected, and the company has been aggressively raising its dividend (see Column H in the Table).
Returning to the full list of 10 companies, Boeing (BA) is the hands-down winner in terms of Net Present Value (see Column Y in the Table) and has no serious issues with its balance sheet (see Columns P-R). As noted above, companies are investing more in computer-managed equipment and nothing tops aircraft in that regard. For example, the Department of Defense and NASA spend over $20 Billion a year on Boeing equipment. One thing you can be sure of under President Trump is that he will ramp up expenditures on right-wing jobs programs like the military. IBM also will benefit from the above-noted increase in corporate spending on capital equipment.
Risk Rating: 6 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into both KO and IBM.
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 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 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 24 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
“Proponents of the Dogs of the Dow strategy argue that blue-chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with a high dividend relative to stock price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low-yield companies.”
At the end of each year, “Dogs” are identified as the 10 highest-yielding stocks DJIA. “Dogs of the Dow Theory” instructs you to invest equal dollar amounts in each of those 10 stocks in the first week of January. You can be certain that some of those stocks will show remarkable price appreciation over the next 12 months, but most won’t. By following this Theory, your odds of beating the DJIA are better than even, but most investors think they can improve on the odds by “winnowing out” companies having a business plan that appears likely to remain ineffective longer than a year.
Mission: Subject the 2017 Dogs of the Dow to our spreadsheet-based analysis.
Execution: see Table. Metrics highlighted using purple mark issues that will reduce the chances of that stock outperforming the DJIA this year.
Bottom Line: A great deal of research backs up Dogs of the Dow Theory. And, it has more value that Dow Theory in generating an series of Buy Signals. If you learn nothing else from our blog, learn Dow Theory and use it to ignore market pundits.
The thing to understand about the Dogs of the Dow strategy is that you aren’t going to restructure your equity portfolio every January by seeking to own equal dollar amounts of all 10 Dogs. But the list is very useful when Dow Theory is generating "Buy" signals. On such occasions, find a way to winnow the list down to 4 or 5 stocks and buy shares in companies you don’t already own. The most popular method is to pick the 5 lowest-priced, which have come to be called “Small Dogs of the Dow”. This year’s Small Dogs are Coca-Cola (KO), Verizon Communications (VZ), Merck (MRK), Pfizer (PFE) and Cisco Systems (CSCO). Two of those stocks, VZ and MRK, have S&P ratings of B/M, i.e., a clear message to the retail investor that these are best avoided.
Of the remaining 3, Coca-Cola (KO) shares are likely to be the most “safe and effective” to own. Emerging markets are past the Great Recession and starting to grow, giving Coke an opportunity to capitalize on its dominant position in countries where the middle class is growing at 10%/yr.
CSCO is attractive for a different reason. Companies around the world are finally increasing their capital expenditures faster than GDP. Computers and software are the fastest-growing class of capital expenditures. Cisco Systems (CSCO) has been increasing its sales and earnings faster that expected, and the company has been aggressively raising its dividend (see Column H in the Table).
Returning to the full list of 10 companies, Boeing (BA) is the hands-down winner in terms of Net Present Value (see Column Y in the Table) and has no serious issues with its balance sheet (see Columns P-R). As noted above, companies are investing more in computer-managed equipment and nothing tops aircraft in that regard. For example, the Department of Defense and NASA spend over $20 Billion a year on Boeing equipment. One thing you can be sure of under President Trump is that he will ramp up expenditures on right-wing jobs programs like the military. IBM also will benefit from the above-noted increase in corporate spending on capital equipment.
Risk Rating: 6 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into both KO and IBM.
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 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 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 24 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
Sunday, April 2
Week 300 - $185/week For A Low-cost Online Retirement Fund
Situation: Let’s say you make $64,000/yr but don’t have a workplace Retirement Plan. You still need to put 15% of your income (or $9,600/yr or $185/week) into a Retirement Plan. You can’t expect Social Security checks to replace more than 40% of your salary.The lowest cost self-directed plan would be composed of an IRA for stocks and Inflation-protected US Savings Bonds (ISBs) for bonds. We define costs as a) transaction costs, b) taxes, and c) inflation. The annual IRA contribution limit is $5,500/yr ($6,500/yr if you’re over 50). That doesn’t cover the $9,600/yr you need to shield from taxes, which is where ISBs come in handy. Those have a $10,000/yr contribution limit, work like an IRA to defer taxes, and carry the added benefit of shielding you from inflation.
Mission: Set up our standard spreadsheet (see Table) for $6000/yr of online stock purchases which go into an IRA, and $3600/yr of online bond purchases, which go into ISBs.
Execution: see Table, where the Vanguard Interm-Term Bond Index Fund (VBIIX) is a proxy for ISBs to facilitate comparison with stocks, which are neither inflation-protected nor tax-advantaged.
Administration:
Plan A: You can put $100/mo into each of 5 stocks purchased online through computershare, then have your accountant declare that account at computershare to be your IRA. This assumes you’re over 50 years old when you start this plan.
Plan B: You can put $500/mo into a Total Stock Market Index Fund (VTSMX) IRA marketed by the Vanguard Group. VTSMX carries an expense ratio of only 0.16%/yr vs. 0.58%/yr for stocks purchased through computershare (see Column P in the Table). NOTE: Plan B is the smarter option. Why? a) The expense ratio is lower. b) An index fund eliminates the considerable risk of selection bias.
With either Plan, $300/mo is put into ISBs with automatic online withdrawals from your checking account. Less money is put into bonds than into stocks because Social Security payments are made from a US Treasury Bond Fund. The interest payments on ISBs are based off the interest payments for 10-yr Treasury Notes corrected for the value of the tax deferral benefit and inflation correction benefit. Also, remember that ISBs have zero transaction costs and zero inflation risk; interest accrues biannually and cannot be taxed until the bond is redeemed. To better understand why you should confine your bond investments to 10-yr US Treasury Notes, read the fine print:
Caveat emptor: “The hard part of setting up a Retirement Plan is understanding the role of bonds. Those go up in value when stocks go down, so bonds need to form half of the assets meant to sustain you in retirement. Why do bonds go up in value when stocks go down? Because bankruptcy drops bond prices to the liquidation value of collateral, say 70 cents on the dollar, whereas bankruptcy drops stock prices to zero. The easy part to understand is that the risk that a bond will end up in bankruptcy court is specified by the interest rate: no investor will buy a bond that doesn’t pay enough interest to compensate for the risk being assumed. The zero-risk set point for interest rates everywhere is the 10-yr US Treasury Note. A commercial bond has to pay sufficiently more interest to draw in a buyer. On a risk-adjusted basis, all publicly-traded bonds pay the same rate of interest. Given that Treasuries are obtained online at zero cost, there is no reason to own any other type of fixed-income investment (unless you’re a bond trader).”
Bottom Line: Investment-grade bond and total stock market indexes have approximately the same inflation-adjusted total returns over multi-decade periods of ~3%/yr (e.g. see Lines 21 and 22 in the Table). Those returns remain roughly equivalent, otherwise investors would accumulate less money in one in order to favor the other.
Instead of using stock & bond indexes, you can have professionals pick stocks and bonds for you. This is tempting, since most stock and bonds make unattractive investments (because most companies have Balance Sheet problems or a weak Brand). That’s why an actively managed & balanced mutual fund like Vanguard Wellesley Income Fund (VWINX) outperforms a 50:50 mix of stock and bond index funds (compare Line 13 to Line 23 in the Table).
Or you can pick conservative bonds and stocks for yourself and keep transaction costs low by investing online (compare Line 10 to Lines 13 and 23 in the Table). NOTE: transaction costs in Column AB, which come to 0.58%/yr ($56/$9600).
Risk Rating: 4 (where 10-yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, KO, IBM, JNJ, NEE, and ISBs.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Set up our standard spreadsheet (see Table) for $6000/yr of online stock purchases which go into an IRA, and $3600/yr of online bond purchases, which go into ISBs.
Execution: see Table, where the Vanguard Interm-Term Bond Index Fund (VBIIX) is a proxy for ISBs to facilitate comparison with stocks, which are neither inflation-protected nor tax-advantaged.
Administration:
Plan A: You can put $100/mo into each of 5 stocks purchased online through computershare, then have your accountant declare that account at computershare to be your IRA. This assumes you’re over 50 years old when you start this plan.
Plan B: You can put $500/mo into a Total Stock Market Index Fund (VTSMX) IRA marketed by the Vanguard Group. VTSMX carries an expense ratio of only 0.16%/yr vs. 0.58%/yr for stocks purchased through computershare (see Column P in the Table). NOTE: Plan B is the smarter option. Why? a) The expense ratio is lower. b) An index fund eliminates the considerable risk of selection bias.
With either Plan, $300/mo is put into ISBs with automatic online withdrawals from your checking account. Less money is put into bonds than into stocks because Social Security payments are made from a US Treasury Bond Fund. The interest payments on ISBs are based off the interest payments for 10-yr Treasury Notes corrected for the value of the tax deferral benefit and inflation correction benefit. Also, remember that ISBs have zero transaction costs and zero inflation risk; interest accrues biannually and cannot be taxed until the bond is redeemed. To better understand why you should confine your bond investments to 10-yr US Treasury Notes, read the fine print:
Caveat emptor: “The hard part of setting up a Retirement Plan is understanding the role of bonds. Those go up in value when stocks go down, so bonds need to form half of the assets meant to sustain you in retirement. Why do bonds go up in value when stocks go down? Because bankruptcy drops bond prices to the liquidation value of collateral, say 70 cents on the dollar, whereas bankruptcy drops stock prices to zero. The easy part to understand is that the risk that a bond will end up in bankruptcy court is specified by the interest rate: no investor will buy a bond that doesn’t pay enough interest to compensate for the risk being assumed. The zero-risk set point for interest rates everywhere is the 10-yr US Treasury Note. A commercial bond has to pay sufficiently more interest to draw in a buyer. On a risk-adjusted basis, all publicly-traded bonds pay the same rate of interest. Given that Treasuries are obtained online at zero cost, there is no reason to own any other type of fixed-income investment (unless you’re a bond trader).”
Bottom Line: Investment-grade bond and total stock market indexes have approximately the same inflation-adjusted total returns over multi-decade periods of ~3%/yr (e.g. see Lines 21 and 22 in the Table). Those returns remain roughly equivalent, otherwise investors would accumulate less money in one in order to favor the other.
Instead of using stock & bond indexes, you can have professionals pick stocks and bonds for you. This is tempting, since most stock and bonds make unattractive investments (because most companies have Balance Sheet problems or a weak Brand). That’s why an actively managed & balanced mutual fund like Vanguard Wellesley Income Fund (VWINX) outperforms a 50:50 mix of stock and bond index funds (compare Line 13 to Line 23 in the Table).
Or you can pick conservative bonds and stocks for yourself and keep transaction costs low by investing online (compare Line 10 to Lines 13 and 23 in the Table). NOTE: transaction costs in Column AB, which come to 0.58%/yr ($56/$9600).
Risk Rating: 4 (where 10-yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, KO, IBM, JNJ, NEE, and ISBs.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, February 14
Week 241 - S&P 100 Companies With a Durable Competitive Advantage
Situation: The Federal Reserve has committed to gradually raising interest rates, which will depress the prices of bond-like stocks as well as legacy bonds. There is a 50:50 chance that the Federal Reserve will have to backtrack at some point, given that the global financial system remains in recovery mode following the Lehman Panic of 2008. The European Central Bank, for example, continues to gradually lower interest rates below zero at its Deposit Facility. This leaves us investors to focus on owning stocks issued by the largest and most credit-worthy companies. Why? Because we’ll want to minimize the risk of owning stocks (bankruptcy) until interest rate fluctuations stabilize at a plateau where bond ownership has approximately the same risk-adjusted returns as stock ownership.
Mission: Develop a spreadsheet of “mega-cap” companies (i.e., those in the S&P 100 Index) whose stock appreciation is anchored by steady appreciation in Tangible Book Value (TBV). That means meeting Warren Buffett’s criteria for having a Durable Competitive Advantage (see Week 238). Eliminate any company that does not pay a dividend or have high S&P quality ratings, i.e., an A- or better rating for its bonds and B+/M or better rating for its common stock.
Execution: We have come up with 11 stocks that meet those criteria (see Table). Returns for the aggregate have been more than twice the returns for the lowest-cost S&P 500 Index Fund (VFINX) over the past two market cycles (see Columns C and L in the Table), but that result has come with a materially greater risk of loss in a future bear market (see Column N in the Table).
Bottom Line: Over the foreseeable future, you should think about owning stocks in mega-cap companies with strong credit, especially those that steadily grow their Tangible Book Value by 7%/yr or more (and have had no more than down 3 yrs in the past decade). In other words, look for companies that have what Warren Buffett calls a Durable Competitive Advantage. However, by using this strategy long-term you probably won’t beat a low-cost S&P 500 Index fund like VFINX (on either a risk- or cost-adjusted basis) unless you’re very good at picking from among the 11 stocks in the Table and keep studying those companies closely.
Risk Rating: 5
Full Disclosure: I dollar-average into 6 of these stocks online (NKE, MSFT, WMT, XOM and JPM).
Note: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX). Total returns in Column C of the Table date to 9/1/2000, because that was the last S&P 500 Index peak before the peak on 10/9/2007. The past 15+ year time span provides returns over more than two market cycles (given that a even more recent peak occurred on 7/20/2015).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Develop a spreadsheet of “mega-cap” companies (i.e., those in the S&P 100 Index) whose stock appreciation is anchored by steady appreciation in Tangible Book Value (TBV). That means meeting Warren Buffett’s criteria for having a Durable Competitive Advantage (see Week 238). Eliminate any company that does not pay a dividend or have high S&P quality ratings, i.e., an A- or better rating for its bonds and B+/M or better rating for its common stock.
Execution: We have come up with 11 stocks that meet those criteria (see Table). Returns for the aggregate have been more than twice the returns for the lowest-cost S&P 500 Index Fund (VFINX) over the past two market cycles (see Columns C and L in the Table), but that result has come with a materially greater risk of loss in a future bear market (see Column N in the Table).
Bottom Line: Over the foreseeable future, you should think about owning stocks in mega-cap companies with strong credit, especially those that steadily grow their Tangible Book Value by 7%/yr or more (and have had no more than down 3 yrs in the past decade). In other words, look for companies that have what Warren Buffett calls a Durable Competitive Advantage. However, by using this strategy long-term you probably won’t beat a low-cost S&P 500 Index fund like VFINX (on either a risk- or cost-adjusted basis) unless you’re very good at picking from among the 11 stocks in the Table and keep studying those companies closely.
Risk Rating: 5
Full Disclosure: I dollar-average into 6 of these stocks online (NKE, MSFT, WMT, XOM and JPM).
Note: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX). Total returns in Column C of the Table date to 9/1/2000, because that was the last S&P 500 Index peak before the peak on 10/9/2007. The past 15+ year time span provides returns over more than two market cycles (given that a even more recent peak occurred on 7/20/2015).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, November 8
Week 227 - Established Companies with a Durable Competitive Advantage and Improving Fundamentals
Situation: Government and corporate credit woes are building up around the world, instead of receding. We’ve pointed out in several blogs that the root cause of the Great Recession was overuse of credit. We’ve also pointed out that the world had apparently learned its lesson and was gradually deleveraging. That trend stopped in 2014 and a reversal is now underway. Why did deleveraging stop? Because the Federal Reserve maintained its “free money” policy too long. How should we respond? Stocks are widely understood to have been inflated in value as a result of that Federal Reserve policy, since low interest rates made bonds an unattractive alternative. Until the Federal Reserve actually raises rates to traditional levels relative to inflation, that leaves you with the same two investment choices you’ve had for the past 5 years: risky stocks vs. “bond-like” stocks. Bond-like stocks are issued by established companies, have an above-market dividend yield, and have a history of growing dividends twice as fast as inflation. To pick the best bond-like stocks during this period of global economic uncertainty, focus on companies that have what Warren Buffett calls a “Durable Competitive Advantage”, particularly those with improving fundamentals.
Mission: Make a list of Barron’s 500 companies that have trading records extending back at least 16 yrs and have a Barron’s rank this year that is higher than last year’s rank, i.e., companies with improving fundamentals. Determine which have a Durable Competitive Advantage (see Week 30). That means Tangible Book Value (TBV) has grown at least 7-10% a year for the past 10 yrs, and there have been no more than two down years. If TBV is positive in any given year, that means tangible assets exceed liabilities. Most companies have a negative TBV because of being capitalized mainly by loans. That exposes the company to the risk of insolvency during periods when loans are difficult to renew, unless the company agrees to pay an interest rate that exceeds the company’s rate of return on assets. By focusing on TBV, we bypass such companies. Next, we eliminate companies with below-market dividend yields, or dividend growth that is less than twice the inflation rate. Finally, we calculate the Buffett Buy Analysis for each company that remains.
Execution: This week’s Table lays out metrics that fit the mission. Calculation of the Buffett Buy Analysis (see Columns S thru Z in the Table) requires some explanation. It is a “discounted cash flow” method wherein earnings growth over the past 10 yrs (Column T) is projected 10 yrs into the future (Column U), then multiplied by the lowest P/E seen over the past 10 yrs (Column V). That gives a conservative estimate of the stock’s price 10 yrs from now, unless a dividend is paid. If a dividend is paid, there is a conservative assumption that the dividend won’t be increased any time in the next 10 yrs. The current annual dividend is multiplied by 10 (Column W) and added to the price estimate dictated by the projected growth in earnings (Column X). To conduct a Buffett Buy Analysis, we start with the current price (see Column Y) and calculate the Compound Annual Growth Rate (CAGR) over the next 10 yrs that would be needed to arrive at the predicted price (see Column X) 10 yrs from now. The result is given in Column Z. That CAGR is the Buffett Buy Analysis (BBA). That rate of stock price appreciation should be in line with the rate of TBV appreciation rate over the past 10 yrs (see Column R). It will be lower if the stock is currently overpriced, since the “runway” to reach the projected price 10 yrs from now is shorter.
Bottom Line: By taking an objective approach to stock-picking, we’ve managed to eliminate 99% of the companies on the Barron’s 500 List (see Table). Partly that’s because the market has become overpriced, since the Federal Reserve’s easy money policy takes attention away from owning bonds, and partly because those same policies have made money so cheap that most companies have come to rely more heavily on debt financing than they normally would. Debt financing is also cheaper because interest payments are tax-deductible. The 5 companies in this week’s Table offer objective value: 1) growing TBV; 2) improving fundamentals. They all have returns that have far exceeded S&P 500 Index’s returns since that index peaked on 9/1/00 (see Columns C and L in the Table), and none are currently overpriced (see Column K). The main caveat for owning such bond-like stocks is that their price is likely to drop for a period after the Federal Reserve starts raising interest rates, because new bonds pay more interest than old bonds.
Risk Rating: 5
Full Disclosure: I dollar-average into NEE, and also own shares of CMI and ADM.
Note: Metrics in the Table that are highlighted in red denote underperformance relative to our main benchmark, the Vanguard Balanced Index Fund (VBINX). Metrics are current for the Sunday of publication.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Make a list of Barron’s 500 companies that have trading records extending back at least 16 yrs and have a Barron’s rank this year that is higher than last year’s rank, i.e., companies with improving fundamentals. Determine which have a Durable Competitive Advantage (see Week 30). That means Tangible Book Value (TBV) has grown at least 7-10% a year for the past 10 yrs, and there have been no more than two down years. If TBV is positive in any given year, that means tangible assets exceed liabilities. Most companies have a negative TBV because of being capitalized mainly by loans. That exposes the company to the risk of insolvency during periods when loans are difficult to renew, unless the company agrees to pay an interest rate that exceeds the company’s rate of return on assets. By focusing on TBV, we bypass such companies. Next, we eliminate companies with below-market dividend yields, or dividend growth that is less than twice the inflation rate. Finally, we calculate the Buffett Buy Analysis for each company that remains.
Execution: This week’s Table lays out metrics that fit the mission. Calculation of the Buffett Buy Analysis (see Columns S thru Z in the Table) requires some explanation. It is a “discounted cash flow” method wherein earnings growth over the past 10 yrs (Column T) is projected 10 yrs into the future (Column U), then multiplied by the lowest P/E seen over the past 10 yrs (Column V). That gives a conservative estimate of the stock’s price 10 yrs from now, unless a dividend is paid. If a dividend is paid, there is a conservative assumption that the dividend won’t be increased any time in the next 10 yrs. The current annual dividend is multiplied by 10 (Column W) and added to the price estimate dictated by the projected growth in earnings (Column X). To conduct a Buffett Buy Analysis, we start with the current price (see Column Y) and calculate the Compound Annual Growth Rate (CAGR) over the next 10 yrs that would be needed to arrive at the predicted price (see Column X) 10 yrs from now. The result is given in Column Z. That CAGR is the Buffett Buy Analysis (BBA). That rate of stock price appreciation should be in line with the rate of TBV appreciation rate over the past 10 yrs (see Column R). It will be lower if the stock is currently overpriced, since the “runway” to reach the projected price 10 yrs from now is shorter.
Bottom Line: By taking an objective approach to stock-picking, we’ve managed to eliminate 99% of the companies on the Barron’s 500 List (see Table). Partly that’s because the market has become overpriced, since the Federal Reserve’s easy money policy takes attention away from owning bonds, and partly because those same policies have made money so cheap that most companies have come to rely more heavily on debt financing than they normally would. Debt financing is also cheaper because interest payments are tax-deductible. The 5 companies in this week’s Table offer objective value: 1) growing TBV; 2) improving fundamentals. They all have returns that have far exceeded S&P 500 Index’s returns since that index peaked on 9/1/00 (see Columns C and L in the Table), and none are currently overpriced (see Column K). The main caveat for owning such bond-like stocks is that their price is likely to drop for a period after the Federal Reserve starts raising interest rates, because new bonds pay more interest than old bonds.
Risk Rating: 5
Full Disclosure: I dollar-average into NEE, and also own shares of CMI and ADM.
Note: Metrics in the Table that are highlighted in red denote underperformance relative to our main benchmark, the Vanguard Balanced Index Fund (VBINX). Metrics are current for the Sunday of publication.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, August 24
Week 164 - Our Approach To Picking Stocks For Retirement Income
Situation: What’s the plan? How big a part should ownership of individual stocks play in your retirement savings? How should you pick those? How should you sell those?
We suggest that you plan to depend on "compound interest" to build financial security for you and your heirs, not "capital appreciation" (which is always a gamble in the absence of dividend growth). With few exceptions (see Week 150), stocks need to be backed 1:1 with US Treasury bonds (or mortgage agency debt instruments). Pick stocks by following these guidelines:
First, you’ll need a way to find companies with improving fundamentals. For us, that information can be found on the annual Barron’s 500 List, which ranks the 500 largest companies (by revenue) that are listed on the New York and Toronto stock exchanges by using 3 equal-weighted criteria: sales growth over the most recent year, growth in cash-flow based return on invested capital (ROIC) over the past 3 yrs, and the most recent year’s ROIC divided by median ROIC over the past 3 yrs. We’re most interested in companies that move up in rank year-over-year but we also value those that consistently place in the upper 2/3rds of the Barron’s 500 List (see Week 159).
Second, you’ll need a way to determine whether or not a company’s management has a primary goal of benefitting all shareholders (as opposed to themselves). Has the company a) raised its dividend annually for at least the past 10 yrs, and b) maintained an S&P bond rating of BBB+ or better?
Third, does the stock appear to be undervalued relative to risk? For that point, we calculate Finance Value (long-term reward minus Lehman Panic losses) to be sure that it beats the Finance Value for the Vanguard Balanced Index Fund (VBINX), as well as looking to be sure that both the 5-yr Beta and P/E do as well as VBINX.
Fourth, is the company’s dividend growth rate plus its current dividend yield greater than 7%? That would suggest that the “business case” for making the investment (doubling one’s money in 10 yrs) applies.
Fifth, stay on top of the “story.” In other words, what’s supporting the stock price vis-a-vis reported 12-month earnings (P/E). If the P/E is outside the normal range of 10-20, you need to be concerned. The story might be broken (low P/E) or outdated (high P/E).
Sixth, what about a Plan B? Do alternative investments like real estate (owned for rental income), gold (owned for capital appreciation), or commodity futures (owned for gambling that the underlying commodity will change dramatically in price over the near term) make sense? We don’t think any of those alternatives have a low enough risk to justify inclusion in a retirement portfolio. That leaves our benchmark, The Vanguard Balanced Index Fund (VBINX), as the only alternative investment. This week’s Table shows the 17 companies that pass our filter. Red highlights denote underperformance relative to VBINX.
Selling stocks that you’ve chosen by using these guidelines shouldn't become an issue if you’ve set up a Dividend Reinvestment Plan (DRIP) and add a small fixed amount of money to it regularly. That will capture “reversion to the mean” pricing. You benefit from the additional shares that a fixed amount of money buys for you whenever the price is down. That said, you will have to sell if the stock fails to meet the above criteria for extended periods. But as long as the company keeps raising its dividend every year enough to beat inflation, there’s little need to worry. We encourage you to think of your DRIPs as a growing perpetuity, which is a type of bond that keeps paying more interest every year. You don't care about the stock's price as long as the company is committed to increasing its dividend every year regardless of economic conditions.
However, the guidance I’ve just given isn’t going to satisfy all of you, so let’s use a golf analogy. The ball has landed off the fairway, out in the weeds: That’s how you feel about the stock because it has fallen in value compared to what you’ve paid for it. You’ll need to exercise due diligence and study the “story” that has been supporting the stock’s price: Has the price fallen because the story is broken? Or has the price fallen because of macroeconomic events that have little impact on the company’s prospects and the story remains intact? Decide whether or not you’d like to continue buying the stock. That decision process takes time to gestate but if at the end of that time you decide you are no longer a buyer then you are a seller. Finally, you’ll need a “tickler,” some kind of alert that stockpickers use to keep from getting very far into the weeds. The one I like is “sell if you’re down more than 90 days.” So, check your positions every 3 months and do some thinking about the losers. But beware, once you become a trader you're returns will increasingly align with capital appreciation rather than dividend growth. You'll get more thrills, and more sinking feelings.
Bottom Line: We've found 17 stocks that meet our criteria as of this writing (7/18/14), given that the goal is to have dividend income during your retirement years that is likely to grow faster than inflation.
Risk Rating: 4
Full Disclosure of my current or planned purchases of stocks in the Table. I dollar-average into NEE, PG, WMT, and JNJ each month at computershare.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
We suggest that you plan to depend on "compound interest" to build financial security for you and your heirs, not "capital appreciation" (which is always a gamble in the absence of dividend growth). With few exceptions (see Week 150), stocks need to be backed 1:1 with US Treasury bonds (or mortgage agency debt instruments). Pick stocks by following these guidelines:
First, you’ll need a way to find companies with improving fundamentals. For us, that information can be found on the annual Barron’s 500 List, which ranks the 500 largest companies (by revenue) that are listed on the New York and Toronto stock exchanges by using 3 equal-weighted criteria: sales growth over the most recent year, growth in cash-flow based return on invested capital (ROIC) over the past 3 yrs, and the most recent year’s ROIC divided by median ROIC over the past 3 yrs. We’re most interested in companies that move up in rank year-over-year but we also value those that consistently place in the upper 2/3rds of the Barron’s 500 List (see Week 159).
Second, you’ll need a way to determine whether or not a company’s management has a primary goal of benefitting all shareholders (as opposed to themselves). Has the company a) raised its dividend annually for at least the past 10 yrs, and b) maintained an S&P bond rating of BBB+ or better?
Third, does the stock appear to be undervalued relative to risk? For that point, we calculate Finance Value (long-term reward minus Lehman Panic losses) to be sure that it beats the Finance Value for the Vanguard Balanced Index Fund (VBINX), as well as looking to be sure that both the 5-yr Beta and P/E do as well as VBINX.
Fourth, is the company’s dividend growth rate plus its current dividend yield greater than 7%? That would suggest that the “business case” for making the investment (doubling one’s money in 10 yrs) applies.
Fifth, stay on top of the “story.” In other words, what’s supporting the stock price vis-a-vis reported 12-month earnings (P/E). If the P/E is outside the normal range of 10-20, you need to be concerned. The story might be broken (low P/E) or outdated (high P/E).
Sixth, what about a Plan B? Do alternative investments like real estate (owned for rental income), gold (owned for capital appreciation), or commodity futures (owned for gambling that the underlying commodity will change dramatically in price over the near term) make sense? We don’t think any of those alternatives have a low enough risk to justify inclusion in a retirement portfolio. That leaves our benchmark, The Vanguard Balanced Index Fund (VBINX), as the only alternative investment. This week’s Table shows the 17 companies that pass our filter. Red highlights denote underperformance relative to VBINX.
Selling stocks that you’ve chosen by using these guidelines shouldn't become an issue if you’ve set up a Dividend Reinvestment Plan (DRIP) and add a small fixed amount of money to it regularly. That will capture “reversion to the mean” pricing. You benefit from the additional shares that a fixed amount of money buys for you whenever the price is down. That said, you will have to sell if the stock fails to meet the above criteria for extended periods. But as long as the company keeps raising its dividend every year enough to beat inflation, there’s little need to worry. We encourage you to think of your DRIPs as a growing perpetuity, which is a type of bond that keeps paying more interest every year. You don't care about the stock's price as long as the company is committed to increasing its dividend every year regardless of economic conditions.
However, the guidance I’ve just given isn’t going to satisfy all of you, so let’s use a golf analogy. The ball has landed off the fairway, out in the weeds: That’s how you feel about the stock because it has fallen in value compared to what you’ve paid for it. You’ll need to exercise due diligence and study the “story” that has been supporting the stock’s price: Has the price fallen because the story is broken? Or has the price fallen because of macroeconomic events that have little impact on the company’s prospects and the story remains intact? Decide whether or not you’d like to continue buying the stock. That decision process takes time to gestate but if at the end of that time you decide you are no longer a buyer then you are a seller. Finally, you’ll need a “tickler,” some kind of alert that stockpickers use to keep from getting very far into the weeds. The one I like is “sell if you’re down more than 90 days.” So, check your positions every 3 months and do some thinking about the losers. But beware, once you become a trader you're returns will increasingly align with capital appreciation rather than dividend growth. You'll get more thrills, and more sinking feelings.
Bottom Line: We've found 17 stocks that meet our criteria as of this writing (7/18/14), given that the goal is to have dividend income during your retirement years that is likely to grow faster than inflation.
Risk Rating: 4
Full Disclosure of my current or planned purchases of stocks in the Table. I dollar-average into NEE, PG, WMT, and JNJ each month at computershare.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, July 20
Week 159 - Focus on “Compound Interest:” A Watch List of 77 Companies
Situation: If you’ve been reading this blog for long, you’re familiar with what we think is the “best” way for small investors to save for retirement, namely, the Vanguard Balanced Index Fund (VBINX), a low-cost hedged version of the S&P 500 Index. Recently, Warren Buffett went on the record and advised retail investors to use low-cost Vanguard index funds. His suggestion is to invest 90% of your retirement account in the Vanguard 500 Index Fund (VFINX) and the remaining 10% in the Vanguard Short-Term Treasury Fund (VFISX). Unfortunately, neither of these two approaches will pay you much of a dividend, and what dividend yield there is (plus its growth rate), barely keeps pace with inflation. In retirement, portions of those index funds would need to be sold every so often for you to fully benefit from that type of savings plan. From a budgeting standpoint, it makes more sense to receive income regularly from stocks (via dividend checks sent to you) while preserving the principal (your initial investment).
If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146).
This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.
The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.
Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).
The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.
Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.
Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.
Risk Rating: 4
Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.
If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146).
This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.
The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.
Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).
The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.
Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.
Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.
Risk Rating: 4
Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, July 6
Week 157 - Capitalism is a Two-Trick Pony. Learn Both Tricks.
Situation: Sometimes, people with similar socioeconomic advantages become wealthy while others don’t. Sometimes, politicians like to say “the wealthy” have learned to acquire “unearned income” from compound interest, which is correct. Whether or not the acquisition of that skill constitutes real work is debatable. Compound interest is one of the pillars of capitalism, but it can’t work its considerable magic unless a family or business chooses to divert 10-15% of its disposable income away from consumption and toward long-term investments, specifically those that spin off dividends that grow annually and are reinvested to “compound” the benefit. The other pillar of capitalism is accrual accounting, which is the discipline of paying recurring expenses in real time by identifying and encumbering a specific part of current income. That leaves only non-recurring capital expenditures to be “financed”, which is usually accomplished by selling assets, borrowing money, or issuing stock.
Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)
The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses.
For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary.
The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.
Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.
Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Maximize your use of compound interest and accrual accounting. By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree.
Risk Rating: 3
Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at treasurydirect.gov, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at computershare.com.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)
The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses.
For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary.
The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.
Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.
Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Maximize your use of compound interest and accrual accounting. By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree.
Risk Rating: 3
Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at treasurydirect.gov, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at computershare.com.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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