Situation: You would like a “safe and effective” way to own stocks and match total returns for the S&P 500 Index over time. There is no such way, if you define a “safe” stock portfolio as one with long-term price volatility that compares favorably with that of the S&P 500 Index. See, for example, red highlights in Column M of any of our Tables. Those denote unsafe stocks. You have to choose whether to prioritize safe or effective. Since insider trading is illegal, the only way you can beat the S&P 500 Index is by embracing more risk.
“The 2 and 8 Club” is our program for success using more risk (see Week 327). Those 16 large companies are all in the S&P 100 Index, whose members are required to have efficient price discovery through robust trading in put and call options on the Chicago Board of Options Exchange. Companies in The 2 and 8 Club are required to pay a predictably growing above-market dividend, i.e., yield over 2%/yr and dividend growth of over 8%/yr (over the past 5 yrs). They also have to have S&P bond ratings of A- or better and S&P stock ratings of B+/M or better. Finally, there need to be 16+ years of trading records to enable statistical analysis by the BMW Method.
Why do we measure growth using 5 years of dividends instead of 5 years of earnings? Earnings have to be reported by using Generally Accepted Accounting Principles (GAAP). Those are a mish-mash of offsets that can be manipulated by CEOs. So, earnings can look good when they really aren’t. Dividend growth is a product of steady growth in free cash flow, which is Operating Earnings minus Capital Expenditures to grow the company through additions to property, plant, and equipment. Boards of Directors must approve the dividend checks that are sent out to shareholders, which is money that might instead have remained with the company. Remember what Warren Buffett says: “Writing a check separates a commitment from a conversation.”
Mission:
1) Enlarge the pool of companies by extending The 2 and 8 Club concept beyond the S&P 100 Index to embrace qualified companies in the Barron’s 500 Index.
2) Add a column in the Table to show Market Capitalization for each company relative to Market Capitalization of all companies in the Table. Rank companies by Market Capitalization.
Execution: see Table.
Administration: Rules for extending the list of qualified companies (beyond the original 16 found in the S&P 100 Index) are as follows:
1. Include S&P 100 Companies that are in the reference data set, i.e., the FTSE High Dividend Yield Index but have seen either a recent price accumulation that takes their dividend yield under 2%/yr or slightly less than 8%/yr dividend growth. There are two such companies: Raytheon (RTN) and Coca-Cola (KO).
2. Include companies in both the reference data set (FTSE High Dividend Yield Index) and the current Barron’s 500 List. That produces 6 additional companies: WEC Energy Group (WEC), Automatic Data Processing (ADP), Air Products & Chemicals (APD), VF (VFC), Archer Daniels Midland (ADM) and Travelers (TRV).
Bottom Line: The extended version of “The 2 and 8 Club” has 24 companies (see Table), with relative Market Capitalizations being shown in Column AC. Past performance of the aggregate is remarkably high, e.g. see Columns E and K, while risk (in proportion to that outperformance) is acceptable (see Columns I and M). You, of course, want to capture some of that outperformance going forward. To do so, you’ll need to focus on buying stock in the companies most responsible, i.e., those with the largest market capitalization, such as Microsoft (MSFT) and JP Morgan Chase (JPM).
Risk Rating: 6 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)
Full Disclosure: I dollar-average into NEE, KO, JPM, MSFT and IBM. I also own shares of MMM, CAT, TRV, AMGN, and TXN.
"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
Showing posts with label depreciation. Show all posts
Showing posts with label depreciation. Show all posts
Sunday, October 22
Sunday, March 30
Week 143 - Deflation Remains a Looming Threat
Situation: We’re not out of the woods yet. The Lehman Panic (2008) reached into every corner of the world. The Chairman of the Federal Reserve (Ben Bernanke) immediately recognized it to be an existential threat on the scale of the Great Depression. Being a lifelong student of that event, he knew our government would have to mobilize extensive fiscal and monetary resources quickly to prevent a deflation that was already underway. Otherwise, we'd be in the same predicament as Japan by having an interminable recession. Economic activity of all kinds decreases during deflation, since people soon come to realize that whatever they want to buy now will be cheaper if they wait until next year.
Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.
Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).
Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.
Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower.
Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force.
Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.
But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013.
You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.
Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).
Risk Rating: 5 (things could go either way).
Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.
Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).
Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.
Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower.
Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force.
Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.
But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013.
You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.
Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).
Risk Rating: 5 (things could go either way).
Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, July 10
Week 1 - An Introduction to Our Blog
Who benefits from reading our ITR blog every week?
That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.
That would be the recently burned, casual investor - let's say a career woman who thought of herself as being risk averse (until the recent crash). She doesn't hold an MBA or work in a bank but does find investing to be a fascinating and useful hobby. She expects an asset will pay her rental income, interest, or a dividend, so she cannot be called a speculator. She may have owned a capital appreciation stock mutual fund but probably learned her lesson in the recent downturn. You would find her in a casino only to use the bathroom, or have a meal washed down with iced tea, and on a brokerage office Risk Questionnaire, she will score as a solid "growth & income investor". Her investment style is probably "capital preservation", where her main strategy is to protect her core investment monies.
The ITR target investor is one who finds the information provided about stock mutual funds to be inadequate. While bond mutual funds describe investment style in terms of both the credit risk and average time to maturity (risk of loss in value of long-term bonds due to inflation), similar information can be difficult to ascertain with stock mutual funds. Even when a company issues bonds, as most do, it is difficult to access that information. This is probably because many companies issue bonds that carry high credit risk and have long maturation periods. Standard & Poor's (S&P) rates each company's common stock and bond portfolio but that information is not required in a stock mutual fund prospectus. Managers of stock mutual funds like to invest in riskier stocks because in a “bull market” those stocks make the fund perform better than the relevant benchmark index. This is good for advertising because it suggests that the fund manager is a brilliant stock picker. But such is not the case: in a “bear market”, losses will be greater than for the benchmark. This is why the large majority of stock mutual funds lost more in 2008 than the standard benchmark – the S&P 500 Index, which lost a whopping 37%. And that 37% loss is just too great for our ITR reader. Having been burned, she will now shy away from stock mutual funds and wants to learn to invest directly in company stocks on her own.
This is best achieved by using a company's Dividend Re-Investment Plan (DRIP). Using a DRIP keeps trading costs low (you don't pay fees to a broker) and allows you to capture the power of compound interest through automatic re-investment of dividends. A monthly electronic purchase plan results in “dollar-cost averaging”, giving a certainty of buying cheaply during market down-turns. This type of an investment strategy lets our ITR investor develop a portfolio of 5-10 stocks with dividend re-investment, just as a bond mutual fund manager reinvests interest payments.
Now the problem for our investor becomes one of concentration: holding fewer than 50 stocks in a portfolio exposes the portfolio to market risk. There are two things that offer protection. One is to confine purchases to stocks that carry S&P Quality Ratings of A- or above, and the second is to choose only those companies that have increased dividends annually for at least 10 years. Stock in dividend-paying companies has been shown to hold up better in market downturns, thus some "insurance" is obtained by choosing stocks that yield more than an S&P 500 Index Fund (an example is SPY, an exchange-traded fund; current yield 1.8%).
Stock market risk can also be reduced (or hedged) using two other tools: diversification of holdings across industries, and by investing in other markets: foreign stocks, bonds (both US and foreign), rental properties and commodities markets. Problems arise though: commodity futures contracts pay no interest or dividends, and charges are steep, making these instruments suitable only for short-term investing by expert traders. Rental properties also carry significant charges. Unless one owns a Class A apartment building in a growing town, rental income isn't going to help in a stock market crash because occupancy will likely fall. Risks from owning a single apartment building can be diffused by owning a real estate investment trust (REIT) that invests in a number of Class A apartment buildings in different regions of the country, but value will still fall in a difficult economy. Thus, REITs are not a useful asset for someone who emphasizes capital preservation.
Let's take a closer look at companies that produce, package, transport, and market commodities. Some of these have S&P Quality Ratings of A- or better, yield as much or more than SPY, and have increased that payout annually for at least 10 years. (Whoa! Now our investor is tuned in . . .) These companies have found a way to develop raw commodities and consistently produce reliable streams of cash flow for reinvestment (after dividends are paid to stockholders and interest to bondholders). The major traditional commodities with a regulated "futures" market include corn, soybeans, wheat, live cattle, lean hogs, cocoa, coffee, sugar, gold, silver, copper, crude oil, heating oil and natural gas. There are 6 companies meeting our criteria that manage these feedstocks as their primary line of business. A future blog will identify and discuss these companies. All 6 had a 10-year total return of at least 7.7%/year, whereas, the median total return of a Fortune 500 company over that period was 6.7%/year (Fortune Magazine, May 23, 201, volume 163, no. 7, pp F2-F32) and the total return for the S&P 500 Index was 1.3%/year (moneychimp.com). However, commodity producers like these 6 companies suffer during stock market pull-backs, such as the one we've just experienced. A future ITR blog will discuss how to manage this risk.
Commodity markets are priced in dollars and globally sourced, which is the main support for their investment value. Therefore investments that are tied to a commodity represent a hedge against dollar depreciation. For that reason alone, it is worthwhile to buy stock in companies that can pass changes in valuation along to end-users. Future installments of our blog will address other key inputs to the economy that behave similarly, such as electricity.
Bottom Line: Our weekly ITR blog will provide you with tools that allow you to become your own fund manager. We know it’s a complicated undertaking and difficult for new investors to feel comfortable with these concepts. Each week we will post our take on the topics we’ve introduced to you and provide further analysis and tools for you to use in managing your portfolio.
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