Month 112 - WATCH LIST: 28 A-rated Non-financial Companies in the iShares Top 200 Value ETF - October 2020

Situation: Savers eventually come to realize that they need to invest for income, to realize a positive return on investment (ROI). ROI is the most common profitability ratio.

    ROI is calculated by subtracting the initial value of the investment from the final value of the investment (which equals the net return), then dividing this new number (the net return) by the “cost of investment”, and, finally, multiplying by 100. For an asset in an investor’s portfolio, the “cost of investment” equals inflation + transaction costs.

Inflation is the only cost from owning Savings Bonds or an FDIC-insured savings account, there being no transaction costs. But savers typically incur a negative ROI because the interest rate credited to their account is almost always lower than the inflation rate, unless they bought Inflation-protected Savings Bonds.

The woke saver’s goal is to invest in assets that have low transaction costs but also have interest or dividend rates that cover inflation: stocks and bonds. An “investment-grade intermediate-term” bond fund, like the Vanguard Total Bond Market Index ETF (BND), is a suitable choice except during periods of hyperinflation. That’s because the value of bonds already held in the fund, referred to as “legacy” bonds, will fall when inflation is rising briskly. Why? Because the interest rate on legacy bonds will be lower than the rate of inflation. 

The dividend yield on stocks and stock ETFs could also lag behind rising inflation. However, the companies that pay those dividends usually grow their earnings and dividends faster during inflation, partly because the value of the dollar keeps falling. The investor’s ROI will likely remain positive, since it reflects growth in the stock’s price (from faster earnings growth) and growth in the dividend payout. 

Our saver, whom we now call an investor because she knows enough to seek out value (by looking to pay low transaction costs for apparently underpriced assets), will need to shop among different high-yielding assets to sustain ROI growth: 1) a bond-heavy “balanced” mutual fund like the Vanguard Wellesley Income Fund (VWINX), 2) a high-yielding stock index ETF like the Vanguard High Dividend Yield Index Fund (VYM), and 3) individual stocks selected from the VYM portfolio. 

Mission: Analyze stocks in the iShares Top 200 Value Index ETF (IWX) that are also in VYM’s portfolio and meet these 5 criteria: have a) at least a 20-year trading record, b) an S&P bond rating of A- or higher, c) an S&P stock rating of B+/M or higher, d) a positive Book Value for the most recent quarter (mrq), and e) positive earnings for the Trailing Twelve Months (TTM). These criteria narrow your choices to a manageable but high quality Watch List. If you don’t have time to follow all 28 companies, confine your attention to the 21 companies that are also in the S&P 100 Index (see Column AR in the Table) or the 16 companies that are also in the 65-stock Dow Jones Composite Average (see Column AS in the Table).

Execution: see Table.

Administration: For comparison purposes, I list the 9 Financial Services companies separately because the Federal Open Market Committee (FOMC) has promised to keep interest rates near zero through 2023. Financial Services companies profit from the “spread” between what they pay for money and what they make from that money. With interest rates for 15-year home mortgages moving lower than 2.5% and 5-year inflation rates moving higher than 1.8%, there is little profit potential on the horizon.

To calculate the annual ROI of a publicly-traded corporation, divide Earnings Before Interest and Taxes (EBIT line of Net Income statement) by Total Assets (at the bottom of the Balance Sheet statement). You want the most recent information available, which is ROI for the Trailing Twelve Months (TTM). That is similarly calculated using the 4 most recent quarterly Net Income and Balance Sheet statements (see Column AT in the Table). 

Bottom Line: You’ll need to focus on large-capitalization stocks in your retirement account that pay a good and growing dividend. Why? There are 4 reasons: Those companies have 1) multiple product & service lines that likely can be managed to allow the company to continue growing earnings during a recession; 2) multi-billion dollar credit lines are already in place, 3) banking relationships are already in place that make it possible for each company to issue new long-term bonds with low interest rates during a recession, and 4) these companies are what you need to invest in, if you want to achieve total returns that come close to those achieved by the gold standard that we all measure our investment returns against, which are the capitalization-weighted S&P 500 Index ETFs like SPY (see Line 47 in the Table), which large brokers like Fidelity offer at negligible cost. 

Possible BUYs among Value Stocks (i.e. those with green highlights in both Column AD and Column AF of the Table). There are 9 such stocks: Pfizer (PFE), Cisco Systems (CSCO), Intel (INTC), American Electric Power (AEP), Duke Energy (DUK), Comcast (CMCSA), Southern (SO), Eaton PLC (ETN) and International Business Machines (IBM). The “possible BUYs” need to    1) not be overburdened with debt (see red highlights in Columns S-U of the Table);

  2) have a PEG ratio no greater than 2.5 (Column AI), and

  3) have high Returns On Tangible Capital Employed (Column O) and Returns On Investment (Column AT).

Intel (INTC) and Cisco Systems are the only ones that have a Return On Investment (TTM) greater than 15% (see Column AT in the Table). Findings: PFE, CMCSA and IBM are overburdened with debt; AEP, DUK, SO, ETN and IBM have high PEG ratios. The only remaining companies, CSCO and INTC, do have high returns (Earnings Before Interest and Taxes) on Tangible Capital Employed and Total Assets (see Columns O and AT in the Table), and are therefore “possible BUYs.”

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

Full Disclosure: I dollar-average into MRK, PFE, INTC, PG, WMT, CAT, and also own shares of NEE, CSCO, TGT, DUK, KO, JNJ, CMCSA, SO, MMM IBM.

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

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

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

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

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

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

Execution: see Table.

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

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

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

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

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

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

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

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

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

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

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

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

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Week 386 - Retirement Savings Plan For The Self-Employed

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

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

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

Execution: see Table.

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

Risk Rating: 4

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

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Week 373 - 10 Dividend Achievers In Defensive Industries That Are Suitable For Long-term Dollar-cost Averaging

Situation: Which asset class do you favor? Stocks, bonds, real estate or commodities? On a risk-adjusted basis, none of those are likely to grow your savings faster than inflation over the near term. You might want to hold off making “risk-on” investments, unless you're a speculator, because markets are likely to fluctuate more than usual. If you think a “risk-off” approach is best, then you need to pick “defensive” stocks for monthly (or quarterly) investment of a fixed dollar amount (dollar-cost averaging). To minimize transaction costs, you’ll want to invest automatically in each stock through an online Dividend Re-Investment Plan (DRIP). 

Now you will be positioned to ride-out a Bear Market, knowing that you’re accumulating an unusually large amount of shares in those companies as their stocks fall in price. And, those prices won’t fall far enough to scare you because that group of stocks has an above-market dividend yield. So, you’ll stick with the program instead of selling out in a moment of panic.

Mission: Run our Standard Spreadsheet for high-quality stocks issued by companies in defensive industries, i.e., utilities, consumer staples, healthcare, and communication services.

Execution: see Table.

Administration: Companies that don’t have at least an A- S&P rating on their bonds and at least a B+/M rating on their stock are excluded, as are those that don’t have at least a 16-yr trading record suitable for quantitative analysis by using the BMW Method. Companies that aren’t large enough to be on the Barron’s 500 List are also excluded.

Bottom Line: We find that 10 companies meet our requirements. Companies in the Consumer Staples industry dominate the list: Hormel Foods (HRL), Costco Wholesale (COST), PepsiCo (PDP), Coca-Cola (KO), Procter & Gamble (PG), Walmart (WMT), and Archer Daniels Midland (ADM). As a group, these 10 companies have above-market dividend yields and dividend growth (see Columns G & H in the Table). Risk is below-market, as expressed by 5-Yr Beta and predicted loss in a Bear Market (see Columns I & M). 

Risk Rating: 4 for the group as a whole (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10).

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

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Week 368 - Are You A Baby Boomer (54 to 72 years old) With Only $25,000 In Retirement Savings?

Situation: Here in the United States, a third of you have less than $25,000 in Retirement Savings.

Mission: Assess options for a healthy married couple with a household income of $59,000/yr, whose breadwinner will retire when he or she reaches age 66 and the household starts receiving an initial Social Security check of $2,123/mo . Assume that they have $25,000 in retirement savings in an IRA, with an initial payout of $75/mo.

Execution: see Table.

Administration: The options for the couple to receive an income from their $25,000 IRA are unattractive. They’ll need a relatively safe way to come up with an income of 3-4%/yr from that $25,000, a way that grows the principal at least as fast as inflation (historically 3.1%/yr). That growth rate can be predicted from the 5-yr growth rate for the quarterly dividend. To have enough confidence in that stream of income, their only option is to find half a dozen high-quality stocks with low price variance (5-yr Beta less than 0.7) and secure dividends. 

They should be able to live reasonably well on $2,198/mo, given that the poverty line for a household of two is $1,372/mo. But let’s break it down: They’ll pay at least $900/mo for housing (rent, tenant’s insurance, and utilities), so they’re left with $1,300/mo to cover the consumer price index categories of food and beverages, apparel, transportation, medical care, recreation, education and communication, and other goods and services. “Other goods and services” include restaurant meals, delivery services, and cigarettes. Food will cost at least $250/mo. Now they’re down to ~$1,050/mo to cover clothing, car expenses, Medicare premium plus deductibles and co-payments, smartphones, meals out, vacations, delivery services, and cigarettes. Owning, maintaining, and operating a used car for 5,000 miles/yr will cost ~$625/mo, which leaves $425/mo for clothing, healthcare, smartphones, meals out, vacations, delivery services, and cigarettes. To avoid selling the car, one of them will need to find a part-time job. New clothes, dining out, and travel will be hard to fund. Out-of-pocket healthcare costs will go up, so they’ll need to save money by avoiding alcohol, tobacco, caffeine, and sweets. 

Bottom Line: When a couple is facing a retirement that will be funded only by the average Social Security payout at full retirement age ($25,476/yr), they won’t be living much above the Federal Poverty Level for a household of two ($16,460/yr). It they own a home, they’ll no longer be able to afford to maintain it and pay property taxes. So, they’ll need to sell it and invest the residual equity. Maintaining their car will barely be affordable. Having $25,000 in an IRA will help, but a third of couples in their situation will retire with an even smaller cushion. In our Table for this week, we show how $75/mo is the expected income from an IRA of $25,000 value that has an average dividend yield of 3.6%/yr.

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

Full Disclosure: I dollar-average into NEE, KO, and JNJ.

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Week 367 - Safe and Effective Stocks

Situation: The stock market is becalmed, waiting for wind to fill its sails. "Risk-On" investors seem to be out of ideas, except for a renewal of interest in the energy sector. The bond market is experiencing hard-to-predict volatility. Safe stocks that will grow your money effectively are hard to find. The formula for Net Present Value tells us that more value is found when your original investment is returned to you quickly. Therefore, an “effective” stock is one that pays a good and growing dividend. 

Mission: “Safe stocks” = an oxymoron. Basically, we’re looking for a group of high-quality stocks issued by companies in “defensive” industries (Utilities, HealthCare, Consumer Staples, and Communication Services). “Effective stocks” are those that a) pay an above-market dividend, b) grow that dividend at an above-market rate, and c) have an above-market 16-Yr CAGR. Our reference for the “market” is the Dow Jones Industrial Average ETF (DIA). 

Execution: see Table.

Administration: What are “high-quality” stocks? Those are either “Blue Chips” (see Week 361) or members of “The 2 and 8 Club” (see Week 327 and Week 348) plus its Extended Version (see Week 362). “Safe and effective” stocks are those that have no red highlights in Columns D, E, G, I, K, and M of the reference Tables. (Red highlights indicate underperformance vs. DIA.) In addition, we require that the company be a Dividend Achiever, and that its long-term bonds have an S&P rating of A- or better (see Column T).   

Bottom Line: We find that only 5 companies issue “safe and effective” stocks (see Table). Were you to own shares of similar value in all 5, you wouldn’t be gambling. In other words, your risk-adjusted returns would likely “beat the market” by 1-2%/yr over a market cycle. But your transaction costs would also be 1-2% higher vs. owning shares in the leading S&P 500 Index Fund (SPY).  

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

Full Disclosure: I dollar-average into NEE, KO, and JNJ.

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

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

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

Execution: see Table.

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

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

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

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

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

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

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

Execution: see Table.

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

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

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

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

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Week 356 - Defensive Companies in “The 2 and 8 Club” (Extended Version)

Situation: You don’t want to lose money but you’re starting to. That comes with having your savings in an overbought stock market. It’s time for a cautionary warning light to click on in your head. That would mean moving some money into cash equivalents and making sure that at least a third of your stock portfolio is in defensive stocks, i.e., utility, healthcare, consumer staples, and telecommunication services companies. And, review the stocks you’re dollar-averaging into. Be comfortable with the prospect of building up your share-count in those stocks throughout a market crash. 

Mission: Run our Standard Spreadsheet on defensive companies in “The 2 and 8 Club” (Extended Version).

Execution: see Table.

Administration: If their dividend growth rates continue to fall, Coca-Cola (KO) and Pfizer (PFE) will no longer be members of “The 2 and 8 Club.” Conversely, Hormel Foods (HRL at Line 13 in the Table) recently raised its dividend and now has a yield that is well above the yield for the S&P 500 Index. That means it will soon be included in the US version of the FTSE High Dividend Yield Index. HRL already meets the other requirements for membership in “The 2 and 8 Club.” So, it will become a member upon being listed in that Index. The ETF for that Index is VYM (the Vanguard High Dividend Yield ETF at Line 18 in the Table).

Bottom Line: There aren’t a lot of great defensive stocks, but the 8 included in “The 2 and 8 Club” are worth your close attention. Why? Because a set of trade policies are being promulgated by several countries that restrict the cross-border flow of goods and services. If those policies blossom into a tit-for-tat Trade War, Robert Shiller (Nobel Prize winning economist) thinks a recession would be triggered: “It’s just chaos,” he said on CNBC. “It will slow down development in the future if people think that this kind of thing is likely.” 

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

Full Disclosure: I dollar-average into NextEra Energy (NEE) and PepsiCo (PEP), and also own shares of Coca-Cola (KO) and Hormel Foods (HRL).

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Week 344 - “The 2 and 8 Club” Updated

Situation: Stock-pickers need a Watch List of companies to pick from, one that is short enough to allow buyers to make a timely decision to buy or sell. “The 2 and 8 Club” (see Week 327) currently has 21 members that we’ve picked from the S&P 100 Index. Although our Tables are filled with data, those numbers are necessary but not sufficient for investors to take action. There needs to be a story that explains why this or that company in “The 2 and 8 Club” is likely to outperform, given that the S&P 100 Index ETF (OEF) is even harder to beat than the S&P 500 Index ETF (SPY). For example, compare Line 29 in the Table to Line 31. 

“The story” will change as circumstances dictate. Each company’s Board of Directors will have to assess inevitable challenges to The Business Plan, then decide to either endorse the changes recommended by the CEO or replace the CEO. It isn’t easy. Looking at the past 35 yrs of statistical data, only 4 stocks in “The 2 and 8 Club” have outperformed the S&P 500 Index with no greater volatility: 
   Caterpillar (CAT),
   CVS Health (CVS),
   3M (MMM),
   NextEra Energy (NEE).

This suggests that the biggest and best companies are unlikely to grow their dividends faster than 8%/yr for more than two market cycles. Many will drop out of “The 2 and 8 Club” and be replaced by upstarts. To use “The 2 and 8 Club” as a Watch List, you need to be an active trader. That means tracking the performance of all S&P 100 companies that are found in the Vanguard High Dividend Yield Fund VYM, which is managed by Morningstar to represent all of the American companies listed in the FTSE All-World High Dividend Yield Index. Think of VYM as the ~400 companies in the Russell 1000 Index that a) pay an above-market dividend, and b) are unlikely to cut their dividend during a recession. 

Mission: Update “The 2 and 8 Club” (see Week 327).

Execution: see Table.

Administration: Over a market cycle, you can expect to make more money at less risk by investing in VYM than by investing in the largest S&P 500 Index ETF (SPY), i.e., compare Lines 28 and 31 in the Table. To create “The 2 and 8 Club”, we simply take the S&P 100 companies from VYM that a) have grown their dividend at least 8%/yr over the past 5 yrs, b) have a 16+ year trading record for statistical purposes, c) have an S&P bond rating of at least BBB+ (this is a change from our initial requirement of at least an A- rating), and d) have an S&P stock rating of at least B+/M.

Bottom Line: Successful stock-pickers are a tad compulsive, happy to toil alone at their hobby. (Warren Buffett couldn’t understand why his wife left him to become an artist living in San Francisco.) It helps to have a workable Watch List, one that has a high signal-to-noise ratio. We like the companies in the S&P 100 Index because they have a) multiple product lines, and b) efficient price discovery, i.e., are required to have active put and call options on the CBOE (Chicago Board Options Exchange). We also look for companies in the S&P 100 Index that have a high Net Present Value, which is difficult to achieve for companies that don’t pay a good and growing dividend. So, we require at least a 2% dividend and an 8% dividend growth rate for membership in our Watch List, accordingly named “The 2 and 8 Club”. 

Caveat Emptor: If you choose to pick stocks by using this algorithm, you’re a gambler (see red highlights in Columns I and M in the Table). In other words, you’re taking on more risk than you would by owning an S&P 500 Index fund like SPY. Yes, you’ll likely have higher returns but that will be accompanied by higher volatility. As a frequent trader, you’ll also be paying higher taxes and absorbing higher transaction costs.

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, JPM, MMM, IBM and NEE, and also own shares of CSCO, PEP, AMGN, MO, TXN, CAT and TGT.

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

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Week 332 - Defensive Companies in “The 2 and 8 Club”

Situation: The Dow Jones Industrial Average keeps making new highs, “confirmed” by new highs in the Dow Jones Transportation Average. According to Dow Theory, we are in a “primary” Bull Market. That is a period when investors should be paying off their debts and/or building up cash reserves. It is also a period when stocks in “growth” companies become overpriced, and stocks in “defensive” companies become reasonably priced (after having been overpriced). It’s a good time to research high-quality companies in “defensive” industries: Consumer Staples, Health Care, Utilities, and Communication Services. 

Mission: Develop our standard spreadsheet for companies in “The 2 and 8 Club” (see Week 327) that are in defensive industries (see Week 327), and add any companies that are close to qualifying.

Execution: (see Table)

Administration: We’ll use the Extended Version of “The 2 and 8 Club”, which simply matches companies on two lists: The Barron’s 500 List and the 400+ companies in the FTSE High Dividend Yield Index. The Barron’s 500 List is published annually in May, and ranks companies by their 1 & 3 year Cash Flows from Operations, as well as their past year’s Revenues. The FTSE High Dividend Yield Index lists US companies that pay more than a market yield (~2%) and are thought unlikely to reduce dividends during a Bear Market. Companies that appear on both lists but do not have a 5-Yr Compound Annual Growth Rate (CAGR) of at least 8% for their quarterly dividend payout are excluded, as are any companies that carry an S&P Rating lower than A- for their bonds or lower than B+/M for their stocks.

Note the inclusion of Costco Wholesale (COST) at Line 4 in the Table. Although it has an annual yield lower than the required 2% for its quarterly dividend, the company has also issued a supplementary dividend every other year for the past 5 years. In those years, the dividend yield exceeds 5%. In calculating Net Present Value (see Column Y in the Table), we have used adjusted values for Dividend Yield (5.4%) and 5-Yr Dividend Growth (2.1%) in an effort to present an assessment closer to reality. That boosts NPV 42% over what it would be had supplemental dividends been ignored.

Note the inclusion of Coca-Cola (KO) at Line 9 in the Table. Although it has a 5-year dividend CAGR of 7.7%, which is slightly lower than our 8% cut-off, KO is a “mega-capitalized” company that has a major influence on prospects for the Consumer Staples industry.  

Bottom Line: Experienced stock-pickers can usually look forward to a decent night’s sleep, if experience has taught them to overweight their portfolio in high-quality “defensive” stocks that pay a good and growing dividend. By restricting our Watch List to companies in “The 2 and 8 Club”, we’ve found that there are only 10 defensive stocks you need to consider during this opportune time, i.e, when valuations are lower for “defensive” stocks because “growth” stocks become the overcrowded trade in a primary Bull Market.

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

Full Disclosure: I dollar-cost average into KO and NEE, and also own shares of COST, AMGN, MO, and HRL.

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

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Week 326 - Investing for Income

Situation: Bonds or stocks? Which will give you a larger monthly check without disrupting your sleep? For stocks, the standard would be SPDR Dow Jones Industrial Average ETF (DIA), yielding 2.2%. For bonds, the standard would be iShares 20+ Year Treasury Bond ETF (TLT), yielding 2.5%. So far, so good. But what if you want more income than those “plain vanilla” options provide? For example, a bond index fund that wouldn’t be hit for a big loss if inflation were to spike upward? Then you would want to be an investment-grade intermediate-term index fund like the Vanguard Interm-Term Bond Fund (BIV). If you’re a stock-picker and want more yield, you’ll need to start with a close look at the 400+ stocks in the Russell 1000 Index that yield more than a market average 2%. There’s an exchange-traded index fund (ETF) that holds positions in all such stocks: The Vanguard High Dividend Yield ETF (VYM). Our Table for this week pulls out 8 Dividend Achievers that we think do the job. But remember, you’d have to hold positions in all 8 to minimize selection bias. Then, you’d have an investment that yields ~2.7% and is likely to grow those dividends ~9%/yr.

Mission: Find A-rated Dividend Achievers with a higher yield than DIA, a clean Balance Sheet, and less volatility over the past 20 years than the S&P 500 Index. 

Execution: We find 8 companies in the Russell 1000 Index that meet those criteria, except for minor Balance Sheet issues (see Table).

Bottom Line: Low-risk investments that yield more than 3% have almost disappeared. We find only two: WEC Energy Group (WEC) and Procter & Gamble (PG). Of course, there are some companies and government agencies that issue bonds paying a higher interest rate, but you’d have to invest $25,000 in each to avoid paying high up-front transaction costs. And, you’d need to have positions in several such bonds to minimize selection bias.  

Risk Rating: 3 (where 10-Yr US Treasury Note = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: For equities, I dollar-average into NEE, PG and JNJ, and also own shares of TRV, WMT and MMM. For bonds, I own shares of BIV.

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Week 317 - 2017 Barron’s 500 List: A-rated “Growth” Companies That Moved Up In Rank During The Commodity Recession

Situation: If you’re a stock-picker, your job description and mission is to beat the lowest-cost S&P 500 Index ETF (SPY) by ~3%/yr over 5 years. Why? To overcome the frictional costs of do-it-yourself investing, mainly transaction costs and erratic capital gains taxes. In last week’s blog, we highlighted hedging, i.e., over-weighting “defensive” stocks. This week we highlight growth, i.e., picking stocks that grow fast enough to compensate for the drag created by defensive stocks. You should do fine most years, if you invest in 15-20 companies from each category, follow their quarterly reports, and track industry trends. You’ll have to trade often, so find a way to keep trading costs down (~1% of Net Asset Value). 

Commodities anchor the economy, so the recent Commodity Recession (7/14-7/16) made it easy to see which companies are efficient, i.e., their “cash-flow-based return on investment” grew during that period. The Barron’s 500 List ranks companies by tracking that growth over the most recent 3 years.

Mission: Identify companies that moved up in rank last year. 

Execution: Eliminate companies that do not have S&P bond ratings of A- (or better) and S&P stock ratings of A-/M (or better). In the Table, emphasize Balance Sheet metrics (see Columns P-S). In the evaluation of Net Present Value (Columns V-Z), use a Discount Rate of 9%/yr and a Holding Period of 10 years. Assume that the investor pays the average transaction cost when buying or selling stock (2.5%). Highlight potential money-losing issues in purple.

Administration: This is where you come into the picture. You need to assemble information and make a choice. The Table has only 27 Columns of metrics, but it’s a start. Column Z (NPV) is a convenient summary of the combined effects of the current dividend, its rate of growth (using the past 4 years), and the approximate capital gain that would be realized upon selling the stock ten years from now (which is arrived at by extrapolating the 16-Yr CAGR in Column K). That NPV estimate is only as good as management’s ability to build the company’s Brand while maintaining a clean Balance Sheet. 

Bottom Line: The list has the names of only 9 companies. You’ll need to invest in more than 50 growth companies (to avoid Selection Bias). But these 9 are about as problem-free as any you’ll find. Why is it so difficult to identify reliably growing companies? Because growth never lasts. It has a beginning, a middle, and an end--when sales grow only as fast as the population in the company’s “catchment area.” Competition and innovation are huge factors. One cancels out the other over time.

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

Full Disclosure: I own shares of TJX.

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

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

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

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

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

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

Execution: see Table.

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

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

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

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

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

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