Situation: For retiree savings accounts, most of the financial advisors that I follow prefer that half be allocated to bonds and the rest to stocks that reliably pay an above-market dividend. There is a convenient, low-cost way to anchor one’s portfolio in that direction, which is to invest in VWINX -- Vanguard’s Wellesley Income Fund. The managers allocate almost 60% to bonds and the rest to stocks that have been selected from the FTSE High Dividend Yield Index. Vanguard markets the U.S. version with the stock ticker of VYM. The ~400 stocks in VYM are selected from the Russell 1000 Index of large-capitalization companies (IWB).
As a prospective retiree, you’ll want a balanced portfolio--one with approximately a 50:50 balance between stocks and bonds. The transaction costs for buying a corporate bond are high so you’ll want a mutual fund with a mix of government bonds and corporates. For stocks, you have the option of picking your own while keeping transaction costs (expense ratio) at ~2%/yr. But the expense ratio is much lower if you leave stock picking to professional managers (or computers) and opt for a mutual fund or Exchange-Traded Fund (ETF). The easy way to start is with VWINX, which has an expense ratio of 0.23%, and a 10-yr total return of 9.7%/yr. That’s 60% bonds, so supplement it with a stock mutual fund, stock ETF, or stocks of your own choosing. The Fidelity Balanced Fund (FBALX) is also weighted 60:40 in favor of bonds, also has a 10-yr total return of 9.7%/yr, but has a higher expense ratio of 0.53%. VWINX lost 9.8% in 2008 while FBALX lost 31.3%. That difference occurs because stock managers at VWINX are required to confine their selections to the ~400 companies in the FTSE High Dividend Yield Index while managers at FBLAX opted for a wide range of stocks typifying the S&P 500 Index. In other words, VWINX lost much less in the 2008 stock market crash because it held bond-like stocks. For a detailed analysis that compares VWINX to other balanced funds, read this Seeking Alpha article.
Mission: Use our Standard Spreadsheet to analyze companies in VWINX that have: 1) an S&P bond rating of A- or better, 2) a S&P stock rating of B+/M or better, 3) the 16+ year trading record needed for quantitative analysis by the BMW Method, and 4) are found in the current list of companies in the Vanguard High Dividend Yield Index.
Execution: see the 26 companies in this week’s Table.
Administration: We have emphasized the safety features inherent in confining stock selections to companies in the S&P 100 Index. The managers of VWINX apparently agree, given that 17 of their 26 selections (see Column AK in the Table) are in that index.
Bottom Line: We offer this view of stocks picked by managers at VWINX because that fund serves as a beacon for retirees. It has had only 5 down years in the past 40, and was down only 9.8% in the Great Recession of 2008. Since inception on 7/1/1970, it has returned 9.7%/yr.
Risk Rating: 4, where 10-year US Treasury Notes = 1; S&P 500 Index = 5; gold bullion = 10.
Full Disclosure: I dollar-average into PFE, NEE, INTC, PG, JPM, JNJ and CAT, and also own shares of CSCO, DUK, KO, PEP, TRV, MMM, BLK and XOM.
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Showing posts with label equity. Show all posts
Showing posts with label equity. Show all posts
Sunday, December 29
Sunday, August 21
Week 7 - Risk
Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;
(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and
(c) the S&P downgrade
have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Sunday, August 7
Week 5 - Master List of Companies Meeting the ITR Criteria
Goal: To pin down which companies in the S&P 500 Index conform to the ITR selection criteria and detail the benefits and risks of owning stock in each over the past decade.
click here to open the Master List Spreadsheet
Legend for the ITR Master List:
click here to open the Master List Spreadsheet
Legend for the ITR Master List:
Large S&P 500 Companies (n = 19): Stocks selected from the S&P 100 Index. Most of these are multinationals that derive 40-70% of sales from foreign countries.
Smaller S&P 500 Companies (n = 15): Stocks selected from the 400 smaller companies in the S&P 500 Index. Such companies typically have a focused business plan and a less hierarchical management style. These companies have fewer institutional impediments to innovation and can be more nimble in responding to market stresses caused by competition, obsolescence, and recession.
Ticker: Company symbol used for stock trading purposes. (Click on the ticker to view the "Investor Relations" page at the company's website.)
2000-10 TR: Annualized gross Total Return (reinvestment of dividends plus price appreciation) for a stock purchased at close of business (COB) 12/29/00 then sold at COB 12/31/10 (see discussion in Week 4 blog). Our benchmark, SPY, had an annualized gross total return of 1.3% for that 10 yr period. Returns are even lower when costs are subtracted - to calculate net total returns: trading commissions and fees amount to ~2% for each BUY or SELL order placed through a stock broker; inflation averaged 2.4%/yr over that 10 yr period (Inflation_Calculator); and tax rates on dividends and capital gains are set at 15%. To reiterate: fees, capital gains taxes, taxes on dividends, and inflation are not accounted for in calculating the gross Total Return (in Column 3).
Dividend: Current quarterly pay-out per share multiplied by 4 and divided by the recent stock price (expressed as %).
Ann Div Incr: consecutive annual dividend increases.
Stk Rating: "A" is S&P's highest stock rating, with relative benefit sometimes qualified with a "+" or "–" sign; L, M, and H denote a separate assessment of risk: low, medium, or high. Risk in this case represents the extent to which the stock’s value is likely to be impaired or improved during a bear or bull market, respectively.
Bnd Rating: Most companies are financed by both bonds and stocks. Bond ratings denote the risk of bankruptcy. AAA is S&P's highest bond rating, currently held by only 4 companies (ExxonMobil, Johnson & Johnson, Microsoft, and Automatic Data Processing). BBB- is the lowest “investment-grade” rating. BB+ and lower ratings are reserved for “junk status” bonds (also termed "high yield" bonds), which have odds of default greater than 1 in 20.
S&P Industries: S&P has 10 industry categories. Only the telecommunications industry is not represented on our Master List. It is obviously difficult to pigeonhole the major revenue source for a multinational company. Nonetheless, S&P analysts make an effort to do so because the fluctuation of stock prices and dividend payouts depend somewhat on the company's key industry, it is either moving into a new industry or has become an outlier in its historic industry.5 yr Beta: The variance of a stock’s price relative to the S&P 500 Index (Beta = 1.00) calculated each trading day over a 5 yr period and then averaged. For example, a Beta of 0.83 for 3M means that the price of 3M went up or down 83% as much as the S&P 500 Index over the 5 yrs before the current month. Barron’s Dictionary of Finance and Investment Terms (1998, Fifth Edition, Barron’s Educational Series, Inc.) ends its definition with this sentence: “A conservative investor whose main concern is preservation of capital should focus on stocks with low betas, whereas, one willing to take high risks in an effort to earn high rewards should look for high-beta.
Debt/Equity: Total debt divided by shareholder’s equity (total assets minus total liabilities). The Debt/Equity ratio for the S&P 500 Index is ~1.25. “Blue Chip” companies normally top out at 0.85 but may temporarily go higher to expand in support of strong revenues.
Bottom Line: 34 companies meet the ITR criteria for profitable long-term investment with acceptable risk. Of those 34, five (XOM, PG, MKC, NEE, UTX) stand out for providing steady returns (Mean Gross Total Return = 8.8%/yr) and good payouts (Mean Dividend = 2.8%) while maintaining a low S&P Risk Rating. Those 5 companies also issue bonds that carry an S&P rating of "A" (or better), and have very low price variance vs. S&P 500 Index (Average Beta of 0.53 vs. 1.00). For comparison, the annualized Total Return of the S&P 500 Index clunked along at 1.3% over the past decade, and it currently pays a dividend of 1.9%.
click here to continue to Week 6
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