Situation: In Q2 of 2014, the trade-weighted index of 19 Futures Contracts for raw commodities peaked (DJCI; see Yahoo Finance), as did the SPDR Energy Select Sector ETF (XLE; see Yahoo Finance). Both hit bottom in early Q1 of 2016. That should have been the end of the Bear Market but prices have not risen much since then. On the plus side, both ETFs tested their early 2016 bottom in Q3 of 2017 and failed to reach it, suggesting that prices for both are in a new (albeit weak) uptrend.
Interestingly, the SPDR Gold Shares ETF (GLD; see Yahoo Finance) has traced a similar track, peaking in Q1 of 2014, bottoming at the beginning of Q1 2016, and failing a test of that low point late in 2016. Other metrics also suggest that the Bear Market has ended. For example, recently posted earnings for Exxon Mobil (XOM) in Q3 of 2018 were robust enough to have reached a level last reached in Q3 of 2014.
Mission: Use our Standard Spreadsheet to track key investment metrics for companies that buy and/or extract raw commodities for processing, transport those by using 18-wheel tractor-trailers or railroads, or manufacture the diesel powered and natural-gas powered heavy equipment tractors that are used to mine and harvest raw commodities. Confine attention to companies that have at least a BBB+ S&P rating on their bonds and at least a B+/M rating on their common stocks, as well as the 16+ year trading record on the NYSE that is needed for long-term quantitative analysis by the BMW Method.
Execution: see Table.
Bottom Line: Near-month futures prices for commodities have come down off a supercycle that blossomed in 1999, and are now back to approximately where they started. This represents a classic “reversion to the mean”, likely due to supply constraints growing out of the somewhat rapid buildout of China’s economy. We’re not at the end of a 4-Yr Bear Market. Instead, we’re in the long tail of a remarkably strong 2-decade commodities Bull Market. It is important to note that commodity production is changing away from fossil fuels. However, petroleum products still represent more than 30% of trade-weighted commodity production. Going forward, the composition of that production will shift toward environmentally cleaner transportation fuels. Gasoline and diesel will yield dominance to CNG (compressed natural gas) and hydrogen (sourced from natural gas). This will mirror the shift toward clean electrical energy that has replaced coal with natural gas during the build-out of wind and solar sources, along with the necessary enhancements to electricity storage and transmission.
Risk Rating: 8 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10)
Full Disclosure: I dollar-average into CAT, XOM, R and UNP, and also own shares of NSC, BRK-B and CMI.
"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 electrical. Show all posts
Showing posts with label electrical. Show all posts
Sunday, December 9
Sunday, September 2
Week 374 - Bet With The House By Picking Companies In The 2 And 8 Club
Situation: In the U.S., capital-intensive industries with strategic importance are tightly regulated (see Week 230). Electric power grids and railroad networks are expensive to install, maintain and upgrade but those chores are absorbed by shareholders in private companies. Regulatory bodies grant these companies monopoly-like pricing power, oversee safety practices, and set rates high enough to pay for maintenance and upgrades.
Since the Great Recession, international Money Center banks have also come under intense regulation to meet Basel III requirements for sustainability and reduce systemic risks. A more specific definition now replaces Money Center Bank, which is Systemically Important Financial Institution (SIFI).
Looked at from the shareholder’s point of view, companies in these three industries have enough government regulation (and monopoly-like pricing power) that bankruptcy is no longer a material risk. One downside risk is that the US market for their goods and services is largely saturated. So, significant growth in the “bottom line” requires innovation and international outreach that will be overseen by government regulators.
Mission: Use our Standard Spreadsheet to highlight members of “The 2 and 8 Club” that are in the Electric Utilities, SIFI banking, and Railroad industries.
Execution: see Table.
Bottom Line: The safest tactic in gambling is to “bet with the house” whenever you can. Politicians are now in effective control of three industries: Electric utilities, railroads, and international Money Center banks (now called Systemically Important Financial Institutions or SIFIs). These industries are not in danger of being “nationalized” because politicians would much prefer that shareholders (as opposed to taxpayers) put up the large amounts of capital needed to keep these industries safe and effective.
Risk Rating: 6 (where US Treasury Notes = 1, S&P 500 Index =5, and gold bullion = 10)
Full Disclosure: I dollar-average into NEE and JPM.
"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
Since the Great Recession, international Money Center banks have also come under intense regulation to meet Basel III requirements for sustainability and reduce systemic risks. A more specific definition now replaces Money Center Bank, which is Systemically Important Financial Institution (SIFI).
Looked at from the shareholder’s point of view, companies in these three industries have enough government regulation (and monopoly-like pricing power) that bankruptcy is no longer a material risk. One downside risk is that the US market for their goods and services is largely saturated. So, significant growth in the “bottom line” requires innovation and international outreach that will be overseen by government regulators.
Mission: Use our Standard Spreadsheet to highlight members of “The 2 and 8 Club” that are in the Electric Utilities, SIFI banking, and Railroad industries.
Execution: see Table.
Bottom Line: The safest tactic in gambling is to “bet with the house” whenever you can. Politicians are now in effective control of three industries: Electric utilities, railroads, and international Money Center banks (now called Systemically Important Financial Institutions or SIFIs). These industries are not in danger of being “nationalized” because politicians would much prefer that shareholders (as opposed to taxpayers) put up the large amounts of capital needed to keep these industries safe and effective.
Risk Rating: 6 (where US Treasury Notes = 1, S&P 500 Index =5, and gold bullion = 10)
Full Disclosure: I dollar-average into NEE and JPM.
"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
Sunday, September 3
Week 322 - Global Buildout of Combined Heat & Power (CHP) Systems
Situation: Cogeneration of heat and power is a method that has long been used to capture waste energy remaining in the heat generated to produce electric power. That residual heat is used to generate steam--to heat nearby buildings. However, the Rural Electrification Act of 1936 subsidized the buildout of large, centrally located Regular Electric Generation Facilities (REGFs) to bring all homes onto the national power grid. That subsidy aborted the buildout CHP systems. Nonetheless, CHP systems accounted for 9% of US electric power generation in 2008. Worldwide, the growth of CHP systems is predicted to be 4.38%/yr from 2014 to 2024.
CHP systems are becoming more commonplace in urban areas, now that natural gas is replacing coal as the cheapest energy source. The idea is to add a heat exchanger that will generate steam from exhaust gases produced by newly installed electricity-generating gas turbines. This means that “energy wasted” is reduced to 20% from the 55% loss that is typical of REGFs. Unlike having a central station to generate electricity for wide use, CHP requires the station to be near heating and cooling application sites (https://energy.gov/eere/amo/combined-heat-and-power-basics). Most large applications are at industrial sites, typically oil refineries. But small applications used to heat or cool nearby buildings are also ideal. For example, the University of Cincinnati built a gas turbine powered CHP plant in 2004 with a capacity of 47,700 KW. The Department of Energy has identified a potential for over 290,000 sites in the US with more than 240GW of estimated output. That’s double the installed capacity of wind and solar power in the US.
Mission: Analyze 12 Electric Utilities that support electric grid connections to CHP power plants, including the 3 US companies highlighted in a recent study: “Some of the major players identified across the Global CHP system market for data centers include ENER-G, Korea Electric Power Corporation, National Grid plc, Exelon Corporation, NextEra Energy, Inc., Chubu Electric Power Company, American Electric Power Company, Inc. and others.
Execution: see Table.
Administration: Our best example of a CHP system is the one supporting the Phillips 66 (PSX) facility in Linden, NJ: “Linden Cogen Plant Gas Power Plant NJ USA” is owned by PSEG Power LLC, a division of Public Service Enterprise Group (PEG - see Table). The main purpose of this 1566 MW power plant is to provide Cogen-mode steam to the adjacent Bayway (Phillips 66) Refinery. It provides power to that refinery, and connects to the electrical grid operated by Consolidated Edison (ED) which provides power to the New York City and New Jersey markets.
Bottom Line: There are large up-front costs for building a cogeneration plant, but these pale in comparison to the long-term savings. But “the devil is in the details.” Plant engineers tend to focus on the avoided natural gas costs while assuming that the reliability benefit is approximately the same as for a Regular Electric Generation Facility. But it isn’t. Operating hours are lower and have a larger standard deviation. The key requirement for deciding to build a CHP plant is that it will provide steam for heating (and cooling) nearby buildings.
Risk Rating (for aggregate of 12 utilities): 4, where a 10-Yr T-Note = 1, S&P 500 Index = 5, and gold = 10.
Full Disclosure: I dollar-average into NextEra Energy (NEE).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
CHP systems are becoming more commonplace in urban areas, now that natural gas is replacing coal as the cheapest energy source. The idea is to add a heat exchanger that will generate steam from exhaust gases produced by newly installed electricity-generating gas turbines. This means that “energy wasted” is reduced to 20% from the 55% loss that is typical of REGFs. Unlike having a central station to generate electricity for wide use, CHP requires the station to be near heating and cooling application sites (https://energy.gov/eere/amo/combined-heat-and-power-basics). Most large applications are at industrial sites, typically oil refineries. But small applications used to heat or cool nearby buildings are also ideal. For example, the University of Cincinnati built a gas turbine powered CHP plant in 2004 with a capacity of 47,700 KW. The Department of Energy has identified a potential for over 290,000 sites in the US with more than 240GW of estimated output. That’s double the installed capacity of wind and solar power in the US.
Mission: Analyze 12 Electric Utilities that support electric grid connections to CHP power plants, including the 3 US companies highlighted in a recent study: “Some of the major players identified across the Global CHP system market for data centers include ENER-G, Korea Electric Power Corporation, National Grid plc, Exelon Corporation, NextEra Energy, Inc., Chubu Electric Power Company, American Electric Power Company, Inc. and others.
Execution: see Table.
Administration: Our best example of a CHP system is the one supporting the Phillips 66 (PSX) facility in Linden, NJ: “Linden Cogen Plant Gas Power Plant NJ USA” is owned by PSEG Power LLC, a division of Public Service Enterprise Group (PEG - see Table). The main purpose of this 1566 MW power plant is to provide Cogen-mode steam to the adjacent Bayway (Phillips 66) Refinery. It provides power to that refinery, and connects to the electrical grid operated by Consolidated Edison (ED) which provides power to the New York City and New Jersey markets.
Bottom Line: There are large up-front costs for building a cogeneration plant, but these pale in comparison to the long-term savings. But “the devil is in the details.” Plant engineers tend to focus on the avoided natural gas costs while assuming that the reliability benefit is approximately the same as for a Regular Electric Generation Facility. But it isn’t. Operating hours are lower and have a larger standard deviation. The key requirement for deciding to build a CHP plant is that it will provide steam for heating (and cooling) nearby buildings.
Risk Rating (for aggregate of 12 utilities): 4, where a 10-Yr T-Note = 1, S&P 500 Index = 5, and gold = 10.
Full Disclosure: I dollar-average into NextEra Energy (NEE).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, November 29
Week 230 - Bet with the House
Situation: Government regulation now limits pricing power in 3 sub-industries: electric utilities, long-distance railroad and truck transportation, and money-center banks. First it was electric utilities, then railroads and trucking. The purpose of this regulation was to ensure that these companies with high fixed costs would be able to maintain their networks. That meant customers had to be charged enough to keep Return on Equity at around 10%. Railroads and electric utilities are essentially monopolies, so regulators also prevent them from overcharging. Then the Great Recession came along, and the few investment banking firms that had existed prior to the Lehman Panic couldn’t remain solvent. To gain access to Federal protection, they applied to become commercial banks. That had the down-side of welcoming Federal auditors into their offices on a full-time basis. When the “other shoe dropped” (The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010), legislation imposed additional regulation on the riskier (and more lucrative) financial products that money center banks prefer to promote. The danger is that these interconnected megabanks would simultaneously lose a great deal of money, i.e., precipitate a global economic crisis. Dodd-Frank calls those banks “SIFIs” or “Systemically Important Financial Institutions." The point is that most of the levers controlling finance are no longer located near Wall Street. They’re in Washington. So, there may be more safety in investing with companies in those 3 sub-industries that fall under Federal protection. Think of them as government protected companies.
Mission: We take the gambler’s saying seriously, i.e., “when possible, bet with the house.” The House is now the US Treasury, which has controlled short-term interest rates through the Federal Open Market Committee since the Banking Act of 1933. That’s one key variable that controls stock prices. The other key variable is earnings growth, which is supposed to be a function of the private economy. But, pricing power of 3 sub-industries is now under oversight of the US Treasury or government agencies answerable to the US Treasury. To “bet with the house” we need to assess a sample of companies in those 3 sub-industries.
Execution: We look at the 65-stock Dow Jones Composite Index (^DJA) to find a representative sample of companies. This week’s Table has every company in those 3 sub-industries that is large enough to appear in the 2015 Barron’s 500 List, as long as it has an S&P bond rating of BBB+ or better and an S&P stock rating of B+/M.
Bottom Line: These 11 companies operate under close government regulation. As a group, they have done well compared to the lowest-cost S&P 500 Index fund (compare Lines 13, 22 and 26 under Columns C, E and N in the Table). This outperformance apparently comes with no additional risk (see the same Lines under Columns D, I and O in the Table), So, betting with the House looks like a good idea. Specifically, this 11-stock sample performs better than the 65-stock Dow Jones Composite Index (compare Lines 13, 20 and 25 in Columns C through F of the Table) which, in turn, performs better than VFINX (the lowest-cost S&P 500 Index fund at Line 22 of the Table).
Risk Rating: 6
Full Disclosure: I dollar-average into NEE, UNP and JPM.
Note: Metrics are current for the Sunday of publication; metrics in red denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: We take the gambler’s saying seriously, i.e., “when possible, bet with the house.” The House is now the US Treasury, which has controlled short-term interest rates through the Federal Open Market Committee since the Banking Act of 1933. That’s one key variable that controls stock prices. The other key variable is earnings growth, which is supposed to be a function of the private economy. But, pricing power of 3 sub-industries is now under oversight of the US Treasury or government agencies answerable to the US Treasury. To “bet with the house” we need to assess a sample of companies in those 3 sub-industries.
Execution: We look at the 65-stock Dow Jones Composite Index (^DJA) to find a representative sample of companies. This week’s Table has every company in those 3 sub-industries that is large enough to appear in the 2015 Barron’s 500 List, as long as it has an S&P bond rating of BBB+ or better and an S&P stock rating of B+/M.
Bottom Line: These 11 companies operate under close government regulation. As a group, they have done well compared to the lowest-cost S&P 500 Index fund (compare Lines 13, 22 and 26 under Columns C, E and N in the Table). This outperformance apparently comes with no additional risk (see the same Lines under Columns D, I and O in the Table), So, betting with the House looks like a good idea. Specifically, this 11-stock sample performs better than the 65-stock Dow Jones Composite Index (compare Lines 13, 20 and 25 in Columns C through F of the Table) which, in turn, performs better than VFINX (the lowest-cost S&P 500 Index fund at Line 22 of the Table).
Risk Rating: 6
Full Disclosure: I dollar-average into NEE, UNP and JPM.
Note: Metrics are current for the Sunday of publication; metrics in red denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, May 31
Week 204 - 2015 Barron’s 500 List: Commodity Producers with Improving Fundamentals
Situation: Commodities are priced in dollars but those prices reflect worldwide supply and demand, not US economic forces. To further complicate matters, agricultural commodities are priced to reflect regional climate events. The 2012 US drought was so severe that China decided to decrease its reliance on the US for corn and instead ramp up domestic production and source more corn from Argentina and Ukraine. This highlights how population growth is the main driver for commodity production, whether it is basic materials needed to expand infrastructure, energy for electricity production and transportation, or meat and grain for grocery stores. The problem for commodity producers is the necessity for a large up-front investment, whether for oil and gas exploration, mining operations, or the web of technology and infrastructure that brings the “green revolution” to farming. Such investments typically involve large expenditures for property, plant, equipment, powerplants, internet access, storage facilities, paved roads, pipelines, and railroads. In turn, those high initial costs drive research and development into innovations that promise to reduce up-front costs. The result is affordable food, construction methods, fuel, and electricity. Once in place, production efficiencies tend to overshoot; supplies exceed demand for a period, as we see happening now with oil and natural gas production.
Investors in commodity-related companies always face a roller-coaster ride, one that is often out-of-phase with regional economic cycles. As a result, commodity-linked investments tend to follow supercycles. Their “non-correlation” with GDP serves to benefit investors. This week’s blog is occasioned by the just-published Barron’s 500 List for 2015. That list gives a grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
1) median 3-yr return on investment (ROIC),
2) change in the most recent year’s ROIC relative to the 3-yr median, and
3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank. There are 60 commodity producers; half were up in rank, half were down. We’re interested only in the companies that were up, since there’s no easy way to know why a company was down or when its rank will stop falling. And, since most of our readers are looking for retirement investments, we’re not interested in companies that have an S&P bond rating lower than BBB+ or an S&P stock rating lower than B+/M. Taken together, those restrictions remove all but 7 of the 60 companies from consideration (see Table).
These 7 stocks are different from those we usually think of as prudent for retirees. Notably, the average 5-yr Beta is high, and most are down one Standard Deviation from their 16-yr trendline in price appreciation (see Column M), whereas, recent pricing for the S&P 500 Index (^GSPC) is up two Standard Deviations. While we do like to invest in commodity-related stocks because of their out-of-sync behavior, extremes are a little un-nerving.
It gets worse. In Column N of the Table, the downside risk comes into sharp focus. That’s where the BMW Method (see Week 193, Week 199 and Week 201) is used to predict your loss by incorporating 16 yrs of weekly variance in price trends. For example, a 47% loss is predicted for our group of 7 stocks in the next Bear Market, whereas, the S&P 500 Index is predicted to sustain a 32% loss. You’ll find this information in the BMW Method Log Chart for each stock. Start by using the S&P 500 Index as an example. Find ^GSPC at the bottom of the 16-yr series, click on it, and look for “*2RMS” in the upper left-hand corner. Subtract that RF number (0.68) from 100 to get the predicted 32% loss at 2 Standard Deviations below the price trendline. That degree of price variance is projected to occur every 19-20 yrs.
This price variance is important to be aware of because a high degree of price variance over time means the party can end quickly. When a commodity-producing company’s Tangible Book Value for the past decade gives it a Durable Competitive Advantage (see Column R and Week 158), there’s little likelihood that its earnings will grow more than 7%/yr over the next decade (see Column S), which we estimate by using the Buffett Buy Analysis (see Week 189). Only one stock passed that test, National Oilwell Varco (NOV). In other words, the very impressive returns achieved by this select group of 7 stocks (see Columns C, F and L in the Table) come with a very impressive risk of loss.
Several academic studies have shown that the only way to legally “beat the market” is to take on a commensurately greater risk of loss. One example analyzed Jim Cramer’s success at picking stocks for CNBC’s “Mad Money” TV show. To make a long story short, you need to understand that over a 20-yr period you’ll probably be further ahead (on a risk-adjusted basis) by investing in a low-cost S&P 500 Index Fund (VFINX at Line 16 in the Table) than by investing in any combination of commodity-related companies.
Think about it. Commodity-related companies depend on the infrastructure and sustainability needs of fast growing countries like China, Brazil, India, Nigeria and Russia. Such a heavy reliance on commodities in countries with such large populations will be reflected in the success of mutual funds that focus on international stocks or natural resource stocks. The Vanguard Total International Stock Index fund (VGTSX at Line 18 in the Table) and T Rowe Price New Era Fund (PRNEX at Line 17 in the Table), respectively, are good low-cost examples. Are either of those mutual funds a better (i.e., risk-adjusted) place to put your retirement savings than VFINX? No. The reason is that investing in commodities is a hedging strategy. Any effort to smooth out (hedge) returns does exactly that. It protects you from Bear Market losses while reducing your Bull Market gains. Stocks go up 55% of the time, so over the long term a hedging strategy will underperform the market.
Bottom Line: Here at ITR, we like to call attention to investments that don’t track the S&P 500 Index. By having a few investments that are out-of-sync with the economic cycle, you may be able to limit the damage to your portfolio from a market crash. Our favorite non-correlated asset is the 10-yr US Treasury Note (when held to maturity), which you can obtain for zero cost. Our next favorite is stock in one or two commodity production companies, especially those where revenues reflect changes in the weather cycle. In particular, companies that supply farmers with tractors, center-pivot irrigation systems, diesel engines to power such equipment, fertilizer, herbicides, fungicides and ways to efficiently get crops and cattle to markets.
Risk Rating: 7
Full Disclosure: I own stock in CMI.
Note: metrics highlighted in red denote underperformance vs. our key benchmark (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
Investors in commodity-related companies always face a roller-coaster ride, one that is often out-of-phase with regional economic cycles. As a result, commodity-linked investments tend to follow supercycles. Their “non-correlation” with GDP serves to benefit investors. This week’s blog is occasioned by the just-published Barron’s 500 List for 2015. That list gives a grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
1) median 3-yr return on investment (ROIC),
2) change in the most recent year’s ROIC relative to the 3-yr median, and
3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank. There are 60 commodity producers; half were up in rank, half were down. We’re interested only in the companies that were up, since there’s no easy way to know why a company was down or when its rank will stop falling. And, since most of our readers are looking for retirement investments, we’re not interested in companies that have an S&P bond rating lower than BBB+ or an S&P stock rating lower than B+/M. Taken together, those restrictions remove all but 7 of the 60 companies from consideration (see Table).
These 7 stocks are different from those we usually think of as prudent for retirees. Notably, the average 5-yr Beta is high, and most are down one Standard Deviation from their 16-yr trendline in price appreciation (see Column M), whereas, recent pricing for the S&P 500 Index (^GSPC) is up two Standard Deviations. While we do like to invest in commodity-related stocks because of their out-of-sync behavior, extremes are a little un-nerving.
It gets worse. In Column N of the Table, the downside risk comes into sharp focus. That’s where the BMW Method (see Week 193, Week 199 and Week 201) is used to predict your loss by incorporating 16 yrs of weekly variance in price trends. For example, a 47% loss is predicted for our group of 7 stocks in the next Bear Market, whereas, the S&P 500 Index is predicted to sustain a 32% loss. You’ll find this information in the BMW Method Log Chart for each stock. Start by using the S&P 500 Index as an example. Find ^GSPC at the bottom of the 16-yr series, click on it, and look for “*2RMS” in the upper left-hand corner. Subtract that RF number (0.68) from 100 to get the predicted 32% loss at 2 Standard Deviations below the price trendline. That degree of price variance is projected to occur every 19-20 yrs.
This price variance is important to be aware of because a high degree of price variance over time means the party can end quickly. When a commodity-producing company’s Tangible Book Value for the past decade gives it a Durable Competitive Advantage (see Column R and Week 158), there’s little likelihood that its earnings will grow more than 7%/yr over the next decade (see Column S), which we estimate by using the Buffett Buy Analysis (see Week 189). Only one stock passed that test, National Oilwell Varco (NOV). In other words, the very impressive returns achieved by this select group of 7 stocks (see Columns C, F and L in the Table) come with a very impressive risk of loss.
Several academic studies have shown that the only way to legally “beat the market” is to take on a commensurately greater risk of loss. One example analyzed Jim Cramer’s success at picking stocks for CNBC’s “Mad Money” TV show. To make a long story short, you need to understand that over a 20-yr period you’ll probably be further ahead (on a risk-adjusted basis) by investing in a low-cost S&P 500 Index Fund (VFINX at Line 16 in the Table) than by investing in any combination of commodity-related companies.
Think about it. Commodity-related companies depend on the infrastructure and sustainability needs of fast growing countries like China, Brazil, India, Nigeria and Russia. Such a heavy reliance on commodities in countries with such large populations will be reflected in the success of mutual funds that focus on international stocks or natural resource stocks. The Vanguard Total International Stock Index fund (VGTSX at Line 18 in the Table) and T Rowe Price New Era Fund (PRNEX at Line 17 in the Table), respectively, are good low-cost examples. Are either of those mutual funds a better (i.e., risk-adjusted) place to put your retirement savings than VFINX? No. The reason is that investing in commodities is a hedging strategy. Any effort to smooth out (hedge) returns does exactly that. It protects you from Bear Market losses while reducing your Bull Market gains. Stocks go up 55% of the time, so over the long term a hedging strategy will underperform the market.
Bottom Line: Here at ITR, we like to call attention to investments that don’t track the S&P 500 Index. By having a few investments that are out-of-sync with the economic cycle, you may be able to limit the damage to your portfolio from a market crash. Our favorite non-correlated asset is the 10-yr US Treasury Note (when held to maturity), which you can obtain for zero cost. Our next favorite is stock in one or two commodity production companies, especially those where revenues reflect changes in the weather cycle. In particular, companies that supply farmers with tractors, center-pivot irrigation systems, diesel engines to power such equipment, fertilizer, herbicides, fungicides and ways to efficiently get crops and cattle to markets.
Risk Rating: 7
Full Disclosure: I own stock in CMI.
Note: metrics highlighted in red denote underperformance vs. our key benchmark (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, February 1
Week 187 - Barron’s 500 List: Utilities With Good Credit
Situation: Utility stocks work a lot like bonds, since most utilities are ~60% capitalized with bonds backed by a state government. Being monopolies, both consumers and investors are protected by state and federal regulation. The Dow Jones Utility Average (DJUA) consists of 15 stocks that have been selected by a committee chaired by the managing editor of The Wall Street Journal. Since 1928, the DJUA has served as a technical indicator for stock-market health. This is due to the fact that stocks (particularly utilities) perform best in a low interest-rate environment. In the 72 yrs since the DJUA bottomed in 1942 (just before the Battle of Midway), it has risen at a rate of 5.7%/yr (without reinvestment of dividends) vs. 7.9%/yr for the S&P 500 Index without reinvestment of dividends, compared to 5.6%/yr for 10-yr Treasury Notes with reinvestment of interest payments.
Since January of '04, an exchange-traded fund that tracks the DJUA (IDU in the Table) has been available. With dividends reinvested, it has grown 2%/yr faster over the past 11 yrs than the lowest-cost S&P 500 Index fund with dividends reinvested (VFINX in the Table). And, it accomplished this feat with lower risk (see Column D and Column I in the Table). However, part of that performance is unsustainable because the Federal Reserve has kept overnight interest rates (for interbank loans) below 0.2% since November of '08. That policy is projected to end in 6 months and, once it does, utility stocks will gradually return to normal valuations relative to operating earnings. But utility stocks will always be somewhat like bonds in that they’ll represent “portfolio insurance” against stock market crashes.
For this week’s Table, we’ve examined all of the utility stocks in Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges. The Barron’s 500 List is helpful because companies are ranked both by their combined scores on sales growth and cash-flow based Return On Invested Capital (ROIC). For the Table, we have excluded any companies with an S&P bond rating less than BBB+ or an S&P stock rating of less than B+/M, leaving us with 9 stocks. Six are dividend achievers (Col P in the Table) and 5 are in the DJUA (Col T in the Table). Four are on both lists (NEE, ED, SO, D). A good way to get started investing in utilities is to pick two of those 4 stocks, then use dollar-cost averaging to build a “utility position” that eventually amounts to 4% of your retirement portfolio. There is probably no better investment to have in a low interest-rate environment. In a market crash, they’ll serve you almost as well as a corporate bond fund like the Vanguard Intermediate-term Corporate Bond Index Fund (VFICX at Line 15 in the Table). And a crash can’t be that far off, given the inflation in financial assets since '08 when the Federal Reserve began its policy of Financial Repression. For further explanation of Financial Repression, see Week 76 and Week 79.
Caveat Emptor: Utility stocks are presently over-priced. In the Table, this is seen most clearly for the utilities involved in natural gas storage and distribution (SRE and D): see the metrics for P/E (Col J) and EV/EBITDA (Col K). When running the Buffett Buy Analysis (see Week 30) in Cols U through Y, we see that those same companies have lost much of their future value to investors (see Col Y) because of overvaluation (see Col J and Col K).
The utility industry is evolving. It has been my good fortune to serve on the Board of Directors of a private power company for the past 15 yrs that provides heat, electricity, and air conditioning to an urban institution. The changes have been remarkable, as we’ve gone from depending on a coal-fired power-plant that only employed natural gas for “peaking power” to a natural gas-fired cogeneration plant, supplemented by solar, wind, and hydroelectric power. This is the future, happening now.
Bottom Line: High-quality utility stocks are safe and effective investments to include in your retirement portfolio. As a group, the 9 listed in our Table have returned ~12%/yr since '03 while losing less than 20% during the 18-month Lehman Panic. The index fund that reflects the Dow Jones Utility Average (IDU) did almost as well, gaining ~10%/yr while losing 35% during the Lehman Panic. This record beats the lowest-cost S&P 500 Index fund (VFINX), which only gained ~8%/yr while losing over 46% during the Lehman Panic. The rewards from owning utility stocks outweigh the risks, even in times of financial crisis. The question is: How much longer will the current low interest-rate environment (that has been so beneficial to debt-laden utility companies) persist? I would say we’re closer to the end than the beginning 6 yrs ago. Once interest rates start rising, you’ll see prices hold up better in utilities that have adopted a low “carbon footprint.” Likely beneficiaries include Dominion Resources (D) because of its dominant position major in natural gas storage & distribution, and NextEra Energy (NEE) because of its dominant position in wind and solar power.
Risk Rating: 4
Full Disclosure: I dollar-average into NEE and also own shares of D.
NOTE: metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Since January of '04, an exchange-traded fund that tracks the DJUA (IDU in the Table) has been available. With dividends reinvested, it has grown 2%/yr faster over the past 11 yrs than the lowest-cost S&P 500 Index fund with dividends reinvested (VFINX in the Table). And, it accomplished this feat with lower risk (see Column D and Column I in the Table). However, part of that performance is unsustainable because the Federal Reserve has kept overnight interest rates (for interbank loans) below 0.2% since November of '08. That policy is projected to end in 6 months and, once it does, utility stocks will gradually return to normal valuations relative to operating earnings. But utility stocks will always be somewhat like bonds in that they’ll represent “portfolio insurance” against stock market crashes.
For this week’s Table, we’ve examined all of the utility stocks in Barron’s 500 List of the largest companies by revenue that are listed on the New York or Toronto stock exchanges. The Barron’s 500 List is helpful because companies are ranked both by their combined scores on sales growth and cash-flow based Return On Invested Capital (ROIC). For the Table, we have excluded any companies with an S&P bond rating less than BBB+ or an S&P stock rating of less than B+/M, leaving us with 9 stocks. Six are dividend achievers (Col P in the Table) and 5 are in the DJUA (Col T in the Table). Four are on both lists (NEE, ED, SO, D). A good way to get started investing in utilities is to pick two of those 4 stocks, then use dollar-cost averaging to build a “utility position” that eventually amounts to 4% of your retirement portfolio. There is probably no better investment to have in a low interest-rate environment. In a market crash, they’ll serve you almost as well as a corporate bond fund like the Vanguard Intermediate-term Corporate Bond Index Fund (VFICX at Line 15 in the Table). And a crash can’t be that far off, given the inflation in financial assets since '08 when the Federal Reserve began its policy of Financial Repression. For further explanation of Financial Repression, see Week 76 and Week 79.
Caveat Emptor: Utility stocks are presently over-priced. In the Table, this is seen most clearly for the utilities involved in natural gas storage and distribution (SRE and D): see the metrics for P/E (Col J) and EV/EBITDA (Col K). When running the Buffett Buy Analysis (see Week 30) in Cols U through Y, we see that those same companies have lost much of their future value to investors (see Col Y) because of overvaluation (see Col J and Col K).
The utility industry is evolving. It has been my good fortune to serve on the Board of Directors of a private power company for the past 15 yrs that provides heat, electricity, and air conditioning to an urban institution. The changes have been remarkable, as we’ve gone from depending on a coal-fired power-plant that only employed natural gas for “peaking power” to a natural gas-fired cogeneration plant, supplemented by solar, wind, and hydroelectric power. This is the future, happening now.
Bottom Line: High-quality utility stocks are safe and effective investments to include in your retirement portfolio. As a group, the 9 listed in our Table have returned ~12%/yr since '03 while losing less than 20% during the 18-month Lehman Panic. The index fund that reflects the Dow Jones Utility Average (IDU) did almost as well, gaining ~10%/yr while losing 35% during the Lehman Panic. This record beats the lowest-cost S&P 500 Index fund (VFINX), which only gained ~8%/yr while losing over 46% during the Lehman Panic. The rewards from owning utility stocks outweigh the risks, even in times of financial crisis. The question is: How much longer will the current low interest-rate environment (that has been so beneficial to debt-laden utility companies) persist? I would say we’re closer to the end than the beginning 6 yrs ago. Once interest rates start rising, you’ll see prices hold up better in utilities that have adopted a low “carbon footprint.” Likely beneficiaries include Dominion Resources (D) because of its dominant position major in natural gas storage & distribution, and NextEra Energy (NEE) because of its dominant position in wind and solar power.
Risk Rating: 4
Full Disclosure: I dollar-average into NEE and also own shares of D.
NOTE: metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance vs. our key benchmark (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 4
Week 183 - Buffett Buy Analysis of Oil and Natural Gas Companies
Situation: Oil and natural gas companies account for 8% of US GDP. Their stock prices mainly reflect 3 factors: 1) the pricing of front-month futures contracts, 2) the amount of proven and economically recoverable reserves in the ground, and 3) the expected rate of growth in the world’s appetite for oil. All of those numbers will fall if there is a recession in one of the world’s major economies. Europe is now on the brink of entering its third recession in 10 yrs (triggered by the crisis in Ukraine), which is one reason why the price of oil fell 40% between June and December. But there are two other reasons to consider.
The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!
The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.
Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.
Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks.
Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).
How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).
The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table.
Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio:
1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX);
2) the stock is an S&P Dividend Achiever;
3) the company’s bonds have at least a BBB+ rating from S&P;
4) the stock has at least a B+/M rating from S&P;
5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and
6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years.
Risk Rating: 6
Full Disclosure: I dollar-average into XOM and also own shares of CVX.
Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!
The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.
Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.
Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks.
Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).
How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).
The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table.
Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio:
1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX);
2) the stock is an S&P Dividend Achiever;
3) the company’s bonds have at least a BBB+ rating from S&P;
4) the stock has at least a B+/M rating from S&P;
5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and
6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years.
Risk Rating: 6
Full Disclosure: I dollar-average into XOM and also own shares of CVX.
Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, September 7
Week 166 - “Risk-On/Risk-Off” Investing in Response to Global Economic Patterns
Situation: Most of us take more risks with our investments when the world looks to be in good shape economically, and fewer risks when it doesn’t. For example, throughout 2008 investors were risk-averse and tended to sell their losing positions. It was a “Risk-Off” year by all accounts, and that selling did great damage to the retirement savings of roughly a billion people worldwide. The freed-up funds mostly went into US Treasury Bonds and German Bunds, lowering interest rates enough to leave investors in those bonds with no inflation-adjusted income for years. You see the problem, don’t you? Investors should have continued trading stocks in 2008 instead of holding a “fire sale.” The result of all this selling was that stocks became increasingly underpriced relative to their value, as assessed by time-tested methods of fundamental analysis. But where were the buyers? They showed up two years later.
We all need to take a deep breath and agree that our “animal spirits” sometimes lead us to take unreasonable risks when global economic patterns look rosey. I’ve done it, you’ve done it. The cure? Develop a consistent “Risk-Off” investment regimen, and stick with it through good times and bad. The only alternative is to panic when things look bad, and that means selling stocks at a loss. Remember, Warren Buffett's #1 Rule is to "never lose money."
What, exactly, is a consistent Risk-Off investment regimen? Warren Buffett has often said he looks for established companies in boring industries, companies that have built their brand through generations of managers. He likes Procter & Gamble, Coca-Cola, Wal-Mart Stores, Johnson & Johnson, IBM, Heinz, Mars, Wells Fargo, American Express, and Exxon Mobil. In 2008, he sold Johnson & Johnson stock only because he wanted to help out some floundering companies like General Electric and Goldman Sachs, but he otherwise continued to invest in a disciplined manner (e.g. moving to buy the Burlington Northern Santa Fe railroad). Once he buys a stock or company, he does so with the intention of never selling it. Exceptions are rare: 1) To free up money for younger associates to invest, he has done some selective selling; and, 2) he’s done some trading while learning to invest in the energy industry. The point is that he’s the quintessential “Risk Off” investor, and a model for us all to follow.
Where do we go to find a tidy list of old and mostly boring companies that stock analysts tend to yawn at (or just plain overlook)? Here at ITR, we go our “stockpickers secret fishing hole” (see Week 68 and Week 105), which is my name for the Dow Jones Composite Index of 65 companies (30 industrials, 15 utilities, and 20 transportation companies). Railroads and electrical utilities are highlighted there, for example, and have been among the best-performing sub-industries over the last few years (see Week 148). But few, if any, stock brokers are going to try and interest you in buying those. Why? Because they’re government-regulated “and regulators might get it wrong.” Regulation in these stocks is necessary for two reasons: 1) the companies are monopolies; 2) prices for their services need to be set high enough for the companies to afford massive fixed costs and still make a profit. In this week’s Table, you’ll find 11 electric utilities and 3 railroads because those companies prosper in good times and bad.
We’ve screened the 65 companies in the Dow Jones Composite Index, excluding those that a) don’t have long-term trading data, or b) have insufficient revenues to make it onto the Barron’s 500 List. We came up with 37 companies that either showed a higher rank by Barron’s criteria in 2014 than in 2013, or were ranked in the top 2/3rds for both years. The benchmark we use for “Risk Off” investing is the Vanguard Wellesley Income Fund (VWINX), which is 60% bonds/40% stocks. The benchmark we use for “Risk On” investing is the Vanguard Balanced Index Fund (VBINX), which is 40% bonds/60% stocks. VWINX has a low 5-yr Beta of 0.5, whereas, VBINX has a 5-yr Beta of 0.92, which is almost as high as the S&P 500 Index’s 5-yr Beta that is set at 1.0. This wide discrepancy is mainly because bonds have 70-80% less risk than stocks. Red highlights in the Table denote underperformance vs. VBINX.
NOTE: Our screening starts with the Barron’s 500 List of the largest companies (by revenue) on the New York and Toronto stock exchanges. That list is published each year in May and gives letter grades to each company in 3 areas: median three-year cash-flow-based return on investment (ROIC); the one-year change in that measure relative to the three-year median; and adjusted sales growth in the latest fiscal year. Those letter grades are equal-weighted and the combined grade determines the company’s rank for the year.
If you look at total returns for those 37 companies (Table), 20 outperformed VWINX in all 3 time periods (past 22, 10, and 5 yrs) but only 4 of those stocks lost less money for investors than VWINX did during the Lehman Panic: MCD, JBHT, SO, NEE. This was in spite of the fact that aggregate returns of the 37 companies not only beat VWINX at all 3 time periods but also beat the lowest-cost S&P 500 Index fund (VFINX) in all 3 time periods! So, picking safe stocks is trickier than picking a mutual fund that has built-in safety features. The only reason to pick stocks is to have a source of retirement income that outgrows inflation: Note that Dividend Growth values in Column I of the Table are typically 3-4 times greater than the rate of inflation. You have to “pick and track”. No mutual fund will do that for you.
When we look across the 3 market cycles since the 7/90-4/91 recession, we find that a bond-heavy balanced fund (VWINX) protects its investors from most of the stock market losses incurred during each recession. VWINX lost money in only 3 of the last 22 yrs: 1994 (-6.2%), 1999 (-3.6%), and 2008 (-9.1%), whereas, the S&P 500 Index lost money in 6 yrs, including a 33% loss in 2008. The protection that comes from high-quality bonds is what allows VWINX to grow from a point of preserved value at the beginning of recovery from each recession, instead of wasting months (or years) to make up for lost value.
Bottom Line: Stock-picking is the best way to have some retirement income that beats inflation (see Week 159), but it’s not the best way for a “retail investor” to accumulate wealth. We’ve found 37 stocks that (as a group) handily outperformed the S&P 500 Index after holding periods of 22, 10, and 5 yrs. But only 4 of those stocks could beat a bond-heavy balanced fund (VWINX) in all 3 time periods while losing less than the 16% that VWINX lost during the 18-month Lehman Panic. Two are regulated utilities (SO and NEE), the third is a trucking company (JBHT), and the fourth is a downscale restaurant chain (MCD) that thrives on recessions. So, if you didn’t start investing in those 4 companies 22 yrs ago, and kept adding money along the way, you’d have been better off investing in VWINX. Our standard stock-heavy benchmark, the Vanguard Balanced Index Fund (VBINX), only beat VWINX in the most recent 5-yr period because a severe recession has led to a strong bull market in stocks. Conclusion: We all need to learn how to become “Risk Off” investors by making a plan for investing a certain amount each month, then sticking to it through thick and thin.
Risk Ranking for the aggregate of 37 stocks: 6
Full Disclosure: I dollar-average each month into DRIPs for JNJ, NKE, PG, NEE, WMT, and MSFT, and also own shares of IBM, KO, UTX, MMM, MCD, and DD.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
We all need to take a deep breath and agree that our “animal spirits” sometimes lead us to take unreasonable risks when global economic patterns look rosey. I’ve done it, you’ve done it. The cure? Develop a consistent “Risk-Off” investment regimen, and stick with it through good times and bad. The only alternative is to panic when things look bad, and that means selling stocks at a loss. Remember, Warren Buffett's #1 Rule is to "never lose money."
What, exactly, is a consistent Risk-Off investment regimen? Warren Buffett has often said he looks for established companies in boring industries, companies that have built their brand through generations of managers. He likes Procter & Gamble, Coca-Cola, Wal-Mart Stores, Johnson & Johnson, IBM, Heinz, Mars, Wells Fargo, American Express, and Exxon Mobil. In 2008, he sold Johnson & Johnson stock only because he wanted to help out some floundering companies like General Electric and Goldman Sachs, but he otherwise continued to invest in a disciplined manner (e.g. moving to buy the Burlington Northern Santa Fe railroad). Once he buys a stock or company, he does so with the intention of never selling it. Exceptions are rare: 1) To free up money for younger associates to invest, he has done some selective selling; and, 2) he’s done some trading while learning to invest in the energy industry. The point is that he’s the quintessential “Risk Off” investor, and a model for us all to follow.
Where do we go to find a tidy list of old and mostly boring companies that stock analysts tend to yawn at (or just plain overlook)? Here at ITR, we go our “stockpickers secret fishing hole” (see Week 68 and Week 105), which is my name for the Dow Jones Composite Index of 65 companies (30 industrials, 15 utilities, and 20 transportation companies). Railroads and electrical utilities are highlighted there, for example, and have been among the best-performing sub-industries over the last few years (see Week 148). But few, if any, stock brokers are going to try and interest you in buying those. Why? Because they’re government-regulated “and regulators might get it wrong.” Regulation in these stocks is necessary for two reasons: 1) the companies are monopolies; 2) prices for their services need to be set high enough for the companies to afford massive fixed costs and still make a profit. In this week’s Table, you’ll find 11 electric utilities and 3 railroads because those companies prosper in good times and bad.
We’ve screened the 65 companies in the Dow Jones Composite Index, excluding those that a) don’t have long-term trading data, or b) have insufficient revenues to make it onto the Barron’s 500 List. We came up with 37 companies that either showed a higher rank by Barron’s criteria in 2014 than in 2013, or were ranked in the top 2/3rds for both years. The benchmark we use for “Risk Off” investing is the Vanguard Wellesley Income Fund (VWINX), which is 60% bonds/40% stocks. The benchmark we use for “Risk On” investing is the Vanguard Balanced Index Fund (VBINX), which is 40% bonds/60% stocks. VWINX has a low 5-yr Beta of 0.5, whereas, VBINX has a 5-yr Beta of 0.92, which is almost as high as the S&P 500 Index’s 5-yr Beta that is set at 1.0. This wide discrepancy is mainly because bonds have 70-80% less risk than stocks. Red highlights in the Table denote underperformance vs. VBINX.
NOTE: Our screening starts with the Barron’s 500 List of the largest companies (by revenue) on the New York and Toronto stock exchanges. That list is published each year in May and gives letter grades to each company in 3 areas: median three-year cash-flow-based return on investment (ROIC); the one-year change in that measure relative to the three-year median; and adjusted sales growth in the latest fiscal year. Those letter grades are equal-weighted and the combined grade determines the company’s rank for the year.
If you look at total returns for those 37 companies (Table), 20 outperformed VWINX in all 3 time periods (past 22, 10, and 5 yrs) but only 4 of those stocks lost less money for investors than VWINX did during the Lehman Panic: MCD, JBHT, SO, NEE. This was in spite of the fact that aggregate returns of the 37 companies not only beat VWINX at all 3 time periods but also beat the lowest-cost S&P 500 Index fund (VFINX) in all 3 time periods! So, picking safe stocks is trickier than picking a mutual fund that has built-in safety features. The only reason to pick stocks is to have a source of retirement income that outgrows inflation: Note that Dividend Growth values in Column I of the Table are typically 3-4 times greater than the rate of inflation. You have to “pick and track”. No mutual fund will do that for you.
When we look across the 3 market cycles since the 7/90-4/91 recession, we find that a bond-heavy balanced fund (VWINX) protects its investors from most of the stock market losses incurred during each recession. VWINX lost money in only 3 of the last 22 yrs: 1994 (-6.2%), 1999 (-3.6%), and 2008 (-9.1%), whereas, the S&P 500 Index lost money in 6 yrs, including a 33% loss in 2008. The protection that comes from high-quality bonds is what allows VWINX to grow from a point of preserved value at the beginning of recovery from each recession, instead of wasting months (or years) to make up for lost value.
Bottom Line: Stock-picking is the best way to have some retirement income that beats inflation (see Week 159), but it’s not the best way for a “retail investor” to accumulate wealth. We’ve found 37 stocks that (as a group) handily outperformed the S&P 500 Index after holding periods of 22, 10, and 5 yrs. But only 4 of those stocks could beat a bond-heavy balanced fund (VWINX) in all 3 time periods while losing less than the 16% that VWINX lost during the 18-month Lehman Panic. Two are regulated utilities (SO and NEE), the third is a trucking company (JBHT), and the fourth is a downscale restaurant chain (MCD) that thrives on recessions. So, if you didn’t start investing in those 4 companies 22 yrs ago, and kept adding money along the way, you’d have been better off investing in VWINX. Our standard stock-heavy benchmark, the Vanguard Balanced Index Fund (VBINX), only beat VWINX in the most recent 5-yr period because a severe recession has led to a strong bull market in stocks. Conclusion: We all need to learn how to become “Risk Off” investors by making a plan for investing a certain amount each month, then sticking to it through thick and thin.
Risk Ranking for the aggregate of 37 stocks: 6
Full Disclosure: I dollar-average each month into DRIPs for JNJ, NKE, PG, NEE, WMT, and MSFT, and also own shares of IBM, KO, UTX, MMM, MCD, and DD.
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