THIS IS THE LAST WEEKLY ISSUE. FUTURE ISSUES WILL APPEAR MONTHLY.
Situation: “The 2 and 8 Club” is based on the FTSE High Dividend Yield Index, which represents the ~400 companies in the FTSE Russell 1000 Index that reliably have a dividend yield higher than S&P 500 Index. Accordingly, a complete membership list for “The 2 and 8 Club” requires screening all ~400 companies in the FTSE High Dividend Yield Index periodically to capture new members and remove members that no longer qualify. This week’s blog is the first complete screen.
Mission: Use our Standard Spreadsheet to analyze all members of “The 2 and 8 Club.”
Execution: see Table
Administration: The requirements for membership in “The 2 and 8 Club” are:
1) membership in the FTSE High Dividend Yield Index;
2) a 5-Yr dividend growth rate of at least 8%;
3) a 16+ year trading record that has been quantitatively analyzed by the BMW Method;
4) a BBB+ or better rating from S&P on the company’s bond issues;
5) a B+/M or better rating from S&P on the company’s common stock issues.
In addition, the company cannot become or remain a member if Book Value for the most recent quarter (mrq) is negative or Earnings per Share for the trailing 12 months (TTM) are negative. Finally, there has to be a reference index that is a barometer of current market conditions, i.e., has a dividend yield that fluctuates around 2% and a 5-Yr dividend growth rate that fluctuates around 8%. The Dow Jones Industrial Average ETF (DIA) is that reference index. In the event that the 5-Yr dividend growth rate for that reference index moves down 50 basis points to 7.5% for example, we would use that cut-off point for membership instead of 8%.
Bottom Line: There are 40 current members. Only 9 are in “defensive” S&P Industries (Utilities, Consumer Staples, and Health Care). At the other end of the risk scale, there are 12 banks (or bank-like companies) and 5 Information Technology companies; 13 of the 40 have Balance Sheet issues that are cause for concern (see Columns N-P). While the rewards of “The 2 and 8 Club” are attractive (see Columns C, K, and W), such out-performance is not going to be seen in a rising interest rate environment (see Column F in the Table). Why? Because the high dividend payouts (see Column G in the Table) become less appealing to investors when compared to the high interest payouts of Treasury bonds).
NOTE: This week’s Table will be updated at the end of each quarter.
Risk Rating: 6 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into JPM, NEE and IBM, and also own shares of TRV, CSCO, BLK, MMM, CMI and R.
Caveat Emptor: If a capitalization-weighted Index of these 40 stocks were used to create a new ETF, it would be 5-10% more risky (see Columns D, I, J, and M in the Table) than an S&P 500 Index ETF like SPY. But the dividend yield and 5-Yr dividend growth rates would be ~50% higher, which means the investor’s money is being returned quite a bit more rapidly. That will have the effect of reducing opportunity cost.
"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 financial repression. Show all posts
Showing posts with label financial repression. Show all posts
Sunday, December 30
Sunday, February 8
Week 188 - Markets Fall, Markets Rise. You’ll Need a Safety Net.
Situation: For almost 6 yrs, the stock market has risen steadily on the back of Federal Reserve policies that make investing in bonds seem foolish. That’s fun for awhile, especially if you’re a stock-picker. But it won’t be fun for much longer. “Defensive stocks” -- the best of which we refer to as “Lifeboat Stocks” (see Week 174) -- are now overpriced (except for WalMart). In addition, the Federal Reserve is likely to raise interest rates in 2015. That will encourage investors to take some money out of stocks and put it into bonds, rebalancing those competing assets. In such an event, you'll be likely to face two issues: 1) There may be a stock market pullback heralded by key infrastructure stocks, as appears to be happening already; 2) defensive stocks will get hurt as much as growth stocks because they’re more overpriced. That means you’ll want to dollar-average into growth stocks, i.e., stable, long-term outperformers selling at a reasonable price. To help you find those, we’ve subjected the entire Barron’s 500 List to the Buffett Buy Analysis (see Week 30 and Week 183).
Because of overpricing throughout the stock market, our list of companies for you to consider is rather short. It contains only 16 names and, as expected, none are from defensive industries (consumer staples, healthcare, utilities, and telecommunication services). You’ll see the entire list in next week’s blog but there are only 3 Dividend Achievers among the 16: Ross Stores (ROST), QUALCOMM (QCOM), and Expeditors International (EXPD). We’re particularly interested in those companies, since their record of raising dividends annually for at least the past 10 yrs makes their stock valuable in retirement as a way to beat inflation.
For this week’s Table, we’ve taken those 3 companies and added 4 more that I dollar-average into and call “Cornerstone Stocks.” Those 4 are WalMart Stores (WMT), ExxonMobil (XOM), Microsoft (MSFT), and NextEra Energy (NEE). You should pick 4 of your own to dollar-average into.
Bottom Line: These 7 stocks are likely to mitigate your losses in a bear market and perform better than our benchmark (VBINX) in a bull market. As a group, they’ll form a Safety Net for your portfolio. However, only two are Hedge Stocks (see Week 182), WMT and NEE, so you’ll need to balance your investment in any of the other 5 companies with Treasury Notes, Savings Bonds, or a low-cost intermediate-term bond index fund like VBIIX (which is entered 5 times in the Table to represent this balancing).
Risk Rating: 4
Full Disclosure: I dollar-average into WMT, XOM, MSFT and NEE.
NOTE: Metrics highlighted in red denote underperformance relative to our benchmark, VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Because of overpricing throughout the stock market, our list of companies for you to consider is rather short. It contains only 16 names and, as expected, none are from defensive industries (consumer staples, healthcare, utilities, and telecommunication services). You’ll see the entire list in next week’s blog but there are only 3 Dividend Achievers among the 16: Ross Stores (ROST), QUALCOMM (QCOM), and Expeditors International (EXPD). We’re particularly interested in those companies, since their record of raising dividends annually for at least the past 10 yrs makes their stock valuable in retirement as a way to beat inflation.
For this week’s Table, we’ve taken those 3 companies and added 4 more that I dollar-average into and call “Cornerstone Stocks.” Those 4 are WalMart Stores (WMT), ExxonMobil (XOM), Microsoft (MSFT), and NextEra Energy (NEE). You should pick 4 of your own to dollar-average into.
Bottom Line: These 7 stocks are likely to mitigate your losses in a bear market and perform better than our benchmark (VBINX) in a bull market. As a group, they’ll form a Safety Net for your portfolio. However, only two are Hedge Stocks (see Week 182), WMT and NEE, so you’ll need to balance your investment in any of the other 5 companies with Treasury Notes, Savings Bonds, or a low-cost intermediate-term bond index fund like VBIIX (which is entered 5 times in the Table to represent this balancing).
Risk Rating: 4
Full Disclosure: I dollar-average into WMT, XOM, MSFT and NEE.
NOTE: Metrics highlighted in red denote underperformance relative to our benchmark, VBINX.
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, December 28
Week 182 - Our Current List of Hedge Stocks
Situation: It has been 32 weeks since we published our list of Hedge Stocks (see Week 150). That list of 17 companies grows shorter due to market volatility and overvaluation. Even so, the idea of owning stock in a company that is relatively immune from “shorting” by hedge funds remains worthwhile. Why? Because the 10-yr Treasury Notes that professional investors typically use to immunize their portfolio against short sales will continue to pay a lower-than-inflation rate of interest, as long as the Federal Reserve continues its policy of “financial repression” (see Week 79). That means any high-quality bond will have a historically low interest rate, limiting its utility as a portfolio protector. In this environment, stocks that have none of the features that attract hedge fund traders gain added value because it is unlikely that such stocks will plummet in a bear market. That means Hedge Stocks don’t need to be backed by high-quality bonds or low-risk bond funds.
Initially, the stocks we were looking for had these features (see Week 150):
a) low volatility (5-yr Beta less than 0.7);
b) a P/E of 22 or less;
c) higher returns over both the past 5 and 14 yrs than our benchmark (VBINX);
d) higher Finance Value than VBINX (see Column E in our Tables);
e) an S&P rating of BBB+ or better on the company’s bonds.
With experience, we’ve decided to modify those criteria. One change is that we’ll only consider companies large enough to appear on the Barron’s 500 List, which is published each year in May. That gives us a way to evaluate fundamental metrics year-over-year: “median three-year cash-flow-based return on investment; the one-year change in that measure, relative to the three-year median; and adjusted sales growth in the latest fiscal year.” Another change is that we’ll only consider companies which either appear in the top 2/3rds of that list (i.e., rank in the top 333) for the two most recent years or have a higher ranking in the most recent year. The third change is to measure valuation by EV/EBITDA (Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation, and Amortization) instead of by P/E (stock price divided by the past 4 quarters of earnings). EV/EBITDA is the market value of all the stock and bond issues that are used to capitalize the company, divided by operating earnings. The use of cash, which is gained from operating earnings plus the issuance of stocks and bonds, is not addressed by EV/EBITDA. We have set the upper limit for valuation of a Hedge Stock at an EV/EBITDA of 13, instead of at a P/E of 22. Finally, to exclude under-analyzed companies, we’ll require an S&P stock rating of at least B+/M.
Bottom Line: Of the 17 companies in our last list of Hedge Stocks (see Week 150), only 9 remain: WMT, MCD, ED, SO, GIS, NEE, XEL, PEP, KMB (see Table). Three companies have been added: Altria Group (MO), Archer-Daniels-Midland (ADM), and Lockheed Martin (LMT). As it happens, all 12 companies are Dividend Achievers. That should tell you something.
Risk Rating: 4
Full Disclosure: I dollar-average into WMT and NEE, and also own shares of MCD, GIS and PEP.
NOTE: Metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance relative to our benchmark (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Initially, the stocks we were looking for had these features (see Week 150):
a) low volatility (5-yr Beta less than 0.7);
b) a P/E of 22 or less;
c) higher returns over both the past 5 and 14 yrs than our benchmark (VBINX);
d) higher Finance Value than VBINX (see Column E in our Tables);
e) an S&P rating of BBB+ or better on the company’s bonds.
With experience, we’ve decided to modify those criteria. One change is that we’ll only consider companies large enough to appear on the Barron’s 500 List, which is published each year in May. That gives us a way to evaluate fundamental metrics year-over-year: “median three-year cash-flow-based return on investment; the one-year change in that measure, relative to the three-year median; and adjusted sales growth in the latest fiscal year.” Another change is that we’ll only consider companies which either appear in the top 2/3rds of that list (i.e., rank in the top 333) for the two most recent years or have a higher ranking in the most recent year. The third change is to measure valuation by EV/EBITDA (Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation, and Amortization) instead of by P/E (stock price divided by the past 4 quarters of earnings). EV/EBITDA is the market value of all the stock and bond issues that are used to capitalize the company, divided by operating earnings. The use of cash, which is gained from operating earnings plus the issuance of stocks and bonds, is not addressed by EV/EBITDA. We have set the upper limit for valuation of a Hedge Stock at an EV/EBITDA of 13, instead of at a P/E of 22. Finally, to exclude under-analyzed companies, we’ll require an S&P stock rating of at least B+/M.
Bottom Line: Of the 17 companies in our last list of Hedge Stocks (see Week 150), only 9 remain: WMT, MCD, ED, SO, GIS, NEE, XEL, PEP, KMB (see Table). Three companies have been added: Altria Group (MO), Archer-Daniels-Midland (ADM), and Lockheed Martin (LMT). As it happens, all 12 companies are Dividend Achievers. That should tell you something.
Risk Rating: 4
Full Disclosure: I dollar-average into WMT and NEE, and also own shares of MCD, GIS and PEP.
NOTE: Metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance relative to our benchmark (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 21
Week 181 - Bond Substitutes
Situation: Our long-term investment philosophy balances the risks of stock ownership by hedging those purchases with bonds, bond substitutes, or non-correlated assets. The idea is to have an investment that is capable of ameliorating a 20+% drop in the S&P 500 Index. Otherwise, it could take 2-6 yrs for your retirement portfolio to recover from a Bear Market. If you’re over 50, that doesn’t leave enough time for you to make up for the loss and still have an adequate retirement income. The best hedges are US Treasuries because those go up a lot in price when stock prices plunge. However, most retail investors currently avoid US Treasuries. Why? Because their interest rate is likely to remain low while the Federal Reserve cautiously emerges from “financial repression” (see Week 76 and Week 79). Financial Repression will probably remain with us as long as world debt is more than twice world GDP, and that is currently at a record high of 212%. This means that you need to learn about other ways to protect your retirement portfolio, starting with bond substitutes.
Conservatively managed stock/bond mutual funds, like the Vanguard Wellesley Income Fund (VWINX, at Line 28 in the Table), often substitute short-term bets on corporate bonds for longer term bets on US Treasuries. This has helped to maintain remarkably stable and strong returns for that asset class. VWINX has grown ~7.5% over the past 14 yrs and ~10%/yr over the past 5 yrs. You can separately invest in a corporate bond mutual fund at low cost. We like the Vanguard Intermediate-Term Investment-Grade Bond Fund (VFICX at Line 7 in the Table), which is itself hedged with US Treasuries as needed. See the Morningstar report for more information. VFICX has returned over 6%/yr long-term (e.g. since the S&P 500 Index peaked on 9/2000) as well as over the past 5 yrs. Note that the lowest cost S&P 500 Index fund (VFINX at Line 32 in the Table) has returned only ~4%/yr since 9/2000 with dividends reinvested. Without those gains from dividend reinvestment, it hasn’t even kept up with inflation! You get the point: A low-cost, investment-grade, intermediate-term, managed corporate bond fund is the Gold Standard hedge against stock market crashes.
Now let’s look at other options, like gold (see Week 175) and hedge stocks (see Week 150). Gold did well in the Lehman Panic but has terrible volatility (see Line 20 in the Table), and is still looking for the bottom in its current bear market. (Gold bullion has been falling in price at a rate of ~1.4%/mo for more than 3 yrs now.) An easier option is to pick stocks that hedge-fund managers are unlikely to sell short (see Week 150). The 17 stocks we’ve listed in that blog don’t need to be backed with bonds, since they’re unlikely to lose much money in a stock market crash.
This week, we’ll look at a variation on that theme and screen the 20 stocks we’re aware of that lost less during the Lehman Panic than their long-term rate of return. In other words, they carry a positive number for Finance Value (see Column E in any of our tables). Five of those 20 companies appear on our list of Hedge Stocks (see Week 150): Wal-Mart Stores (WMT), McDonald’s (MCD), and 3 utilities: Wisconsin Energy (WEC), Consolidated Edison (ED), and Southern (SO). We’ll call those Bond Substitutes. In the Table, we group those with corporate and international bond funds in a category called TREASURY BOND SUBSTITUTES.
Ten of the 20 stocks didn’t meet our criteria for stability, one requirement of which is to have a current price that is less than 10 times Tangible Book Value (TBV - see Column R in the Table). Another is to have an Enterprise Value (EV) that is less than 15 times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EV/EBITDA represents operating earnings relative to the market value of the stocks and bonds that capitalize a company (see column K in the Table). Now we have 5 companies that are hedge stocks (WMT, MCD, WEC, ED, SO) plus an additional 5 that are stable growers but have metrics that could make them attractive for hedge fund traders to “short.” Those 5 are Ross Stores (ROST), JB Hunt Transportation (JBHT), Hormel Foods (HRL), Occidental Petroleum (OXY), and QUALCOMM (QCOM). In the Table, they’re grouped with gold as LESS ATTRACTIVE T-BOND SUBSTITUTES.
Upon applying the Buffett Buy Analysis (BBA in Column T; see Week 30), only WEC, ROST, QCOM look worthwhile for investment in this overheated market. Caveat Emptor: If you like these stocks, you’ll first need to assess the “story” that supports each company’s prospects for the future. Why? To determine if you want to buy into that story. You might decide the story is “broken” (or about to be), in which case you’ll look for something better to purchase with your retirement funds.
Bottom Line: We’ve introduced the thorny topic of “bond substitutes.” Gold is one such substitute. Stocks with a history of price stability in hard times are another (if they pay a dividend that persistently outgrows inflation).
Risk Rating: 4
Full Disclosure: I own some Treasury Notes as well as shares of RPIBX, HRL, and MCD. I also dollar-average into WMT each month.
NOTE: Metrics in the Table are current as of the Sunday of publication.
Please leave comments below, or email to: irv.mcquarrie@InvestTuneRetire.com
Conservatively managed stock/bond mutual funds, like the Vanguard Wellesley Income Fund (VWINX, at Line 28 in the Table), often substitute short-term bets on corporate bonds for longer term bets on US Treasuries. This has helped to maintain remarkably stable and strong returns for that asset class. VWINX has grown ~7.5% over the past 14 yrs and ~10%/yr over the past 5 yrs. You can separately invest in a corporate bond mutual fund at low cost. We like the Vanguard Intermediate-Term Investment-Grade Bond Fund (VFICX at Line 7 in the Table), which is itself hedged with US Treasuries as needed. See the Morningstar report for more information. VFICX has returned over 6%/yr long-term (e.g. since the S&P 500 Index peaked on 9/2000) as well as over the past 5 yrs. Note that the lowest cost S&P 500 Index fund (VFINX at Line 32 in the Table) has returned only ~4%/yr since 9/2000 with dividends reinvested. Without those gains from dividend reinvestment, it hasn’t even kept up with inflation! You get the point: A low-cost, investment-grade, intermediate-term, managed corporate bond fund is the Gold Standard hedge against stock market crashes.
Now let’s look at other options, like gold (see Week 175) and hedge stocks (see Week 150). Gold did well in the Lehman Panic but has terrible volatility (see Line 20 in the Table), and is still looking for the bottom in its current bear market. (Gold bullion has been falling in price at a rate of ~1.4%/mo for more than 3 yrs now.) An easier option is to pick stocks that hedge-fund managers are unlikely to sell short (see Week 150). The 17 stocks we’ve listed in that blog don’t need to be backed with bonds, since they’re unlikely to lose much money in a stock market crash.
This week, we’ll look at a variation on that theme and screen the 20 stocks we’re aware of that lost less during the Lehman Panic than their long-term rate of return. In other words, they carry a positive number for Finance Value (see Column E in any of our tables). Five of those 20 companies appear on our list of Hedge Stocks (see Week 150): Wal-Mart Stores (WMT), McDonald’s (MCD), and 3 utilities: Wisconsin Energy (WEC), Consolidated Edison (ED), and Southern (SO). We’ll call those Bond Substitutes. In the Table, we group those with corporate and international bond funds in a category called TREASURY BOND SUBSTITUTES.
Ten of the 20 stocks didn’t meet our criteria for stability, one requirement of which is to have a current price that is less than 10 times Tangible Book Value (TBV - see Column R in the Table). Another is to have an Enterprise Value (EV) that is less than 15 times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). EV/EBITDA represents operating earnings relative to the market value of the stocks and bonds that capitalize a company (see column K in the Table). Now we have 5 companies that are hedge stocks (WMT, MCD, WEC, ED, SO) plus an additional 5 that are stable growers but have metrics that could make them attractive for hedge fund traders to “short.” Those 5 are Ross Stores (ROST), JB Hunt Transportation (JBHT), Hormel Foods (HRL), Occidental Petroleum (OXY), and QUALCOMM (QCOM). In the Table, they’re grouped with gold as LESS ATTRACTIVE T-BOND SUBSTITUTES.
Upon applying the Buffett Buy Analysis (BBA in Column T; see Week 30), only WEC, ROST, QCOM look worthwhile for investment in this overheated market. Caveat Emptor: If you like these stocks, you’ll first need to assess the “story” that supports each company’s prospects for the future. Why? To determine if you want to buy into that story. You might decide the story is “broken” (or about to be), in which case you’ll look for something better to purchase with your retirement funds.
Bottom Line: We’ve introduced the thorny topic of “bond substitutes.” Gold is one such substitute. Stocks with a history of price stability in hard times are another (if they pay a dividend that persistently outgrows inflation).
Risk Rating: 4
Full Disclosure: I own some Treasury Notes as well as shares of RPIBX, HRL, and MCD. I also dollar-average into WMT each month.
NOTE: Metrics in the Table are current as of the Sunday of publication.
Please leave comments below, or email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, September 14
Week 167 - Have Commodity-Related Stocks Hedged Against the Lack of Real Growth in the S&P 500 Index?
Situation: The S&P 500 Index made its all-time inflation-adjusted high on 9/1/00. Fourteen years is a long time for the stock market to be in the tank, even though the main hedging tool (10-yr US Treasury Notes) has been effective. After adjusting for 2.4%/yr inflation since 9/1/00, the Vanguard Intermediate-Term Treasury Fund (VFITX) has returned 3.3%/yr vs. 1.3%/yr for the Vanguard 500 Index fund (VFINX) with dividends reinvested, as of 8/16/14. Robert Shiller maintains a long-term series for both 10-yr US Treasury Notes and the S&P 500 Index. After adjusting for inflation, returns were 1.5%/yr for 10-yr Notes vs. -0.2%/yr for the S&P 500 Index (1.6%/yr with dividends reinvested). Without adjusting for inflation, 10-yr T-Notes were up 3.9%/yr and the S&P 500 Index was up 2.1%/yr (4.0%/yr with dividends reinvested).
The general explanation for this 14-yr period of low 2.4% inflation is that it results from the lack of real growth in economies around the world, and this lack of growth can be associated with two global recessions that have occurred. Most observers think that a growing reliance on borrowed funds has been a major contributor to those recessions, i.e., interest payments were shackling growth. This culminated in the credit crisis of 2007-08. The problem is slowly being corrected through deleveraging, including government action to reduce spending and raise taxes.
When central banks lower interest rates to stimulate growth during a recession, the currency is said to be weakened or debased. (The official term is financial repression, see Week 76 and Week 79.) This will correct itself when the economy recovers, i.e., central bankers will reverse their policy by withdrawing the excess reserves that they had been pushing into the banking system. During the period of currency debasement, the prices paid for “hard assets” naturally drift upward. (Think of the “bubble” that formed in US housing prices when the Federal Reserve kept interest rates too low for too long after the “dot.com” recession (March 2001 through November 2001.)
What does this information mean for readers of this blog? Do we need to protect our retirement savings during periods of “financial repression” by investing in real estate, gold, commodity-related stocks, or commodity futures? All of these have real economic utility and are therefore bound to go up in price when the value of the dollar is falling. These are also inherently volatile investments, so we need to think long and hard before making that leap. They’ll start to lose that pricing power when the Federal Reserve starts to wind down its policy of financial repression. (Look at what has happened to the price of gold. It fell 35% between the summer of 2011 and the summer of 2013.)
Let’s take a closer look at how commodity-related stocks have responded. Those stocks typically pay dividends and are easily traded, which are advantages not shared by other hard assets. On 9/10/13, we published an index of 15 commodity-related stocks (see Week 115). It showed that commodity-related stocks did indeed enjoy pricing power between 1992 and 2013, returning 14.5%/yr while the return for gold bullion was 13.7%/yr, twice the return on Vanguard’s S&P 500 Index fund (VFINX).
Now that another year has passed, let’s see how the unwinding of financial repression has impacted those results. The accompanying Table shows that both gold bullion and commodity-related stocks haven’t done as well as the S&P 500 Index fund (VFINX) over the past 5 yrs but are still ahead since 9/1/00. One of our benchmarks for this week is the T Rowe Price New Era Fund (PRNEX), a low-cost, low-risk natural resources mutual fund. Red highlights denote metrics that underperform our main benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Commodity-related stocks and gold bullion are volatile assets, but worth owning during periods of financial repression. You just need to think about switching to an S&P 500 Index fund the moment you think the Federal Reserve is starting to wind down its policy of “printing money” to “prime the pump.” Most financial professionals can’t time that trade correctly, so you’ll do better by simply owning shares in one or two of the highest quality commodity-related companies for the long term, taking care to pick companies with dividend growth that outpaces inflation (see Column H in the Table). Chevron (CVX), Exxon Mobil (XOM), Canadian National Railway (CNI), and Monsanto (MON) look like suitable candidates for long-term dollar-averaging. But there are others to consider (see Week 163), such as Archer Daniels Midland (ADM).
Risk Rating for the 15 stocks in the Table: 7
Full Disclosure: I dollar-average into a DRIP for XOM, and also own shares of CVX, CNI, POT, BBL, DD and MON.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
The general explanation for this 14-yr period of low 2.4% inflation is that it results from the lack of real growth in economies around the world, and this lack of growth can be associated with two global recessions that have occurred. Most observers think that a growing reliance on borrowed funds has been a major contributor to those recessions, i.e., interest payments were shackling growth. This culminated in the credit crisis of 2007-08. The problem is slowly being corrected through deleveraging, including government action to reduce spending and raise taxes.
When central banks lower interest rates to stimulate growth during a recession, the currency is said to be weakened or debased. (The official term is financial repression, see Week 76 and Week 79.) This will correct itself when the economy recovers, i.e., central bankers will reverse their policy by withdrawing the excess reserves that they had been pushing into the banking system. During the period of currency debasement, the prices paid for “hard assets” naturally drift upward. (Think of the “bubble” that formed in US housing prices when the Federal Reserve kept interest rates too low for too long after the “dot.com” recession (March 2001 through November 2001.)
What does this information mean for readers of this blog? Do we need to protect our retirement savings during periods of “financial repression” by investing in real estate, gold, commodity-related stocks, or commodity futures? All of these have real economic utility and are therefore bound to go up in price when the value of the dollar is falling. These are also inherently volatile investments, so we need to think long and hard before making that leap. They’ll start to lose that pricing power when the Federal Reserve starts to wind down its policy of financial repression. (Look at what has happened to the price of gold. It fell 35% between the summer of 2011 and the summer of 2013.)
Let’s take a closer look at how commodity-related stocks have responded. Those stocks typically pay dividends and are easily traded, which are advantages not shared by other hard assets. On 9/10/13, we published an index of 15 commodity-related stocks (see Week 115). It showed that commodity-related stocks did indeed enjoy pricing power between 1992 and 2013, returning 14.5%/yr while the return for gold bullion was 13.7%/yr, twice the return on Vanguard’s S&P 500 Index fund (VFINX).
Now that another year has passed, let’s see how the unwinding of financial repression has impacted those results. The accompanying Table shows that both gold bullion and commodity-related stocks haven’t done as well as the S&P 500 Index fund (VFINX) over the past 5 yrs but are still ahead since 9/1/00. One of our benchmarks for this week is the T Rowe Price New Era Fund (PRNEX), a low-cost, low-risk natural resources mutual fund. Red highlights denote metrics that underperform our main benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Commodity-related stocks and gold bullion are volatile assets, but worth owning during periods of financial repression. You just need to think about switching to an S&P 500 Index fund the moment you think the Federal Reserve is starting to wind down its policy of “printing money” to “prime the pump.” Most financial professionals can’t time that trade correctly, so you’ll do better by simply owning shares in one or two of the highest quality commodity-related companies for the long term, taking care to pick companies with dividend growth that outpaces inflation (see Column H in the Table). Chevron (CVX), Exxon Mobil (XOM), Canadian National Railway (CNI), and Monsanto (MON) look like suitable candidates for long-term dollar-averaging. But there are others to consider (see Week 163), such as Archer Daniels Midland (ADM).
Risk Rating for the 15 stocks in the Table: 7
Full Disclosure: I dollar-average into a DRIP for XOM, and also own shares of CVX, CNI, POT, BBL, DD and MON.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 30
Week 143 - Deflation Remains a Looming Threat
Situation: We’re not out of the woods yet. The Lehman Panic (2008) reached into every corner of the world. The Chairman of the Federal Reserve (Ben Bernanke) immediately recognized it to be an existential threat on the scale of the Great Depression. Being a lifelong student of that event, he knew our government would have to mobilize extensive fiscal and monetary resources quickly to prevent a deflation that was already underway. Otherwise, we'd be in the same predicament as Japan by having an interminable recession. Economic activity of all kinds decreases during deflation, since people soon come to realize that whatever they want to buy now will be cheaper if they wait until next year.
Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.
Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).
Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.
Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower.
Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force.
Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.
But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013.
You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.
Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).
Risk Rating: 5 (things could go either way).
Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.
Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).
Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.
Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower.
Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force.
Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.
But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013.
You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.
Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).
Risk Rating: 5 (things could go either way).
Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 19
Week 133 - Here’s a “Safety First” Retirement Plan With Expenses Under $7/yr
Situation: We all know that investing for retirement is problematic, uncertain, and expensive. We’ve all thought about what it would feel like to depend solely on Social Security for retirement income. And, we all know that the current level of government financing for Social Security is unsustainable due to the relentless growth in the numbers and longevity of retirees, combined with ever fewer workers per retiree contributing to fund the program. Anyone over 50 who doesn’t understand the effect this could have on her sunset years hasn’t been paying attention the past few decades.
Mission: Design a personal retirement plan to supplement Social Security and workplace retirement plans. The plan must minimize transaction costs, bankruptcy risk, and inflation/deflation risk to whatever extent possible.
Here’s how we suggest setting up such a plan. Stocks grow in value during inflation while bonds grow in value during recession. You’ll need both. If you dollar-average by investing small amounts of money 50:50 into bonds and stocks on a regular basis, your retirement savings will grow regardless of inflation and deflation.
As an aside, Central Banks (such as our Federal Reserve) have so many ways to disguise and allay deflation that we only know they are doing so when interest rates fall to absurdly low levels. Pundits call it “printing money” but the technical term is Financial Repression (see Week 79). We’re in a period of financial repression now, meaning that money is so cheap for corporations and banks to obtain that prices for stocks and real estate rise faster than earnings or rents can justify. The Fed’s idea is to “jump start” the economy enough--by encouraging private investment with free money--that it will grow on its own. Once victory is declared and financial repression ends, the favor is returned. Stock and real estate prices will then slow their growth while earnings and rents catch up. Since free money will no longer be available, interest rates will rise to normal or temporarily inflated levels. When will financial repression end? Judging from precedent, that won’t be soon. To prevent deflation following World War II, it lasted from 1947 until 1980.
To eliminate the risk of bankruptcy, purchases for this plan are confined to stocks and bonds that have a AAA credit rating from Standard and Poor’s. When we checked the candidates, we found that 4 companies qualified, along with 10-yr US Treasury Notes. The stocks are Microsoft (MSFT), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Automatic Data Processing (ADP). Treasuries can be obtained at zero cost at treasurydirect; we recommend inflation-protected 10-yr Notes which are sold in January and July of each year. XOM and JNJ can be obtained at no cost through computershare, although you’ll be charged $1 for each JNJ purchase if you use automatic withdrawals from your checking account. (There is no charge for separate point-and-click JNJ purchases through computershare.) Purchases of MSFT shares through Microsoft’s online transfer agent are expensive, and there’s no online transfer agent for ADP. So, it is best to use a low-cost online broker for those. For example, you can use TD Ameritrade or Capital One. The cost per trade at those sites is currently $6.95.
JNJ is a hedge stock (see Week 126), so you don’t need to back up those purchases with an equal purchase of 10-yr Treasury Notes. That leaves 3 stocks (MSFT, XOM, ADP) to be balanced with Treasuries (or listed as 7 items in all, see the Table). For example, you could decide to invest $4,200/yr. That is, $600/yr per line item which is the same as $300/half, $150/qtr, or $50/mo. For XOM, automatic withdrawals from your checking account in the amount of $50/mo is both free and convenient using computershare. For zero-cost investments in JNJ and 10-yr Treasuries, go online every 6 months to invest $300 in JNJ at computershare and $900 in 10-yr Treasuries at treasurydirect. For lowest-cost investing ($6.95/yr) in ADP and MSFT, make alternate-year purchases of $1200 each through an online broker like Capital One or TD Ameritrade. In summary, T-Notes, JNJ and XOM are free; MSFT and ADP are purchased on alternate years for $6.95. Your out-of-pocket cost is $6.95/yr. This plan carries considerably less risk than VWINX, the safest low-cost balanced mutual fund (see Columns D and J in the Table), even though 10-yr returns are almost identical (Column F). Note: metrics in red indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX).
When you retire, change from automatic reinvestment of quarterly dividends to having the dividends mailed to you. For Treasuries, there is no automatic reinvestment of interest. You receive interest payments twice a year deposited into your checking account, and return of the principal amount ($900) after 10 yrs. When you retire, stop making any “rollover” purchases, which you may have scheduled for T-Notes that are maturing every 6 months. Then you simply receive the principal amount of maturing T-Notes in your checking account. Reinvest T-Note interest payments in inflation-protected Savings Bonds at treasurydirect and hold those for at least 5 yrs before cashing them in, at which time you’ll be taxed for the accumulated interest payments.
Bottom Line: It’s always a good idea to have a personal retirement savings account, even if you already contribute the maximum allowed amount to a company-sponsored retirement plan. Why? Because corporations can change or discontinue their employee retirement plans. And, the Federal government will no doubt be changing long-standing Social Security policies for future retirees. You can have a tax-advantaged aspect of your personal, point-and-click retirement savings account simply by having your accountant declare it to be an IRA, as long as the annual limit for contributions isn’t exceeded.
To avoid gambling with your personal retirement savings plan, you’ll need to include investments with AAA credit ratings. That way you don’t have to worry about bankruptcy. And make sure you hedge against the risk of recession because anytime that stocks go down, T-Notes go up. Finally, don’t spend any money on transaction costs that you don’t absolutely have to spend.
Risk Rating: 3
Full Disclosure: I regularly buy 10-yr T-Notes, MSFT, JNJ, and XOM.
Mission: Design a personal retirement plan to supplement Social Security and workplace retirement plans. The plan must minimize transaction costs, bankruptcy risk, and inflation/deflation risk to whatever extent possible.
Here’s how we suggest setting up such a plan. Stocks grow in value during inflation while bonds grow in value during recession. You’ll need both. If you dollar-average by investing small amounts of money 50:50 into bonds and stocks on a regular basis, your retirement savings will grow regardless of inflation and deflation.
As an aside, Central Banks (such as our Federal Reserve) have so many ways to disguise and allay deflation that we only know they are doing so when interest rates fall to absurdly low levels. Pundits call it “printing money” but the technical term is Financial Repression (see Week 79). We’re in a period of financial repression now, meaning that money is so cheap for corporations and banks to obtain that prices for stocks and real estate rise faster than earnings or rents can justify. The Fed’s idea is to “jump start” the economy enough--by encouraging private investment with free money--that it will grow on its own. Once victory is declared and financial repression ends, the favor is returned. Stock and real estate prices will then slow their growth while earnings and rents catch up. Since free money will no longer be available, interest rates will rise to normal or temporarily inflated levels. When will financial repression end? Judging from precedent, that won’t be soon. To prevent deflation following World War II, it lasted from 1947 until 1980.
To eliminate the risk of bankruptcy, purchases for this plan are confined to stocks and bonds that have a AAA credit rating from Standard and Poor’s. When we checked the candidates, we found that 4 companies qualified, along with 10-yr US Treasury Notes. The stocks are Microsoft (MSFT), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Automatic Data Processing (ADP). Treasuries can be obtained at zero cost at treasurydirect; we recommend inflation-protected 10-yr Notes which are sold in January and July of each year. XOM and JNJ can be obtained at no cost through computershare, although you’ll be charged $1 for each JNJ purchase if you use automatic withdrawals from your checking account. (There is no charge for separate point-and-click JNJ purchases through computershare.) Purchases of MSFT shares through Microsoft’s online transfer agent are expensive, and there’s no online transfer agent for ADP. So, it is best to use a low-cost online broker for those. For example, you can use TD Ameritrade or Capital One. The cost per trade at those sites is currently $6.95.
JNJ is a hedge stock (see Week 126), so you don’t need to back up those purchases with an equal purchase of 10-yr Treasury Notes. That leaves 3 stocks (MSFT, XOM, ADP) to be balanced with Treasuries (or listed as 7 items in all, see the Table). For example, you could decide to invest $4,200/yr. That is, $600/yr per line item which is the same as $300/half, $150/qtr, or $50/mo. For XOM, automatic withdrawals from your checking account in the amount of $50/mo is both free and convenient using computershare. For zero-cost investments in JNJ and 10-yr Treasuries, go online every 6 months to invest $300 in JNJ at computershare and $900 in 10-yr Treasuries at treasurydirect. For lowest-cost investing ($6.95/yr) in ADP and MSFT, make alternate-year purchases of $1200 each through an online broker like Capital One or TD Ameritrade. In summary, T-Notes, JNJ and XOM are free; MSFT and ADP are purchased on alternate years for $6.95. Your out-of-pocket cost is $6.95/yr. This plan carries considerably less risk than VWINX, the safest low-cost balanced mutual fund (see Columns D and J in the Table), even though 10-yr returns are almost identical (Column F). Note: metrics in red indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX).
When you retire, change from automatic reinvestment of quarterly dividends to having the dividends mailed to you. For Treasuries, there is no automatic reinvestment of interest. You receive interest payments twice a year deposited into your checking account, and return of the principal amount ($900) after 10 yrs. When you retire, stop making any “rollover” purchases, which you may have scheduled for T-Notes that are maturing every 6 months. Then you simply receive the principal amount of maturing T-Notes in your checking account. Reinvest T-Note interest payments in inflation-protected Savings Bonds at treasurydirect and hold those for at least 5 yrs before cashing them in, at which time you’ll be taxed for the accumulated interest payments.
Bottom Line: It’s always a good idea to have a personal retirement savings account, even if you already contribute the maximum allowed amount to a company-sponsored retirement plan. Why? Because corporations can change or discontinue their employee retirement plans. And, the Federal government will no doubt be changing long-standing Social Security policies for future retirees. You can have a tax-advantaged aspect of your personal, point-and-click retirement savings account simply by having your accountant declare it to be an IRA, as long as the annual limit for contributions isn’t exceeded.
To avoid gambling with your personal retirement savings plan, you’ll need to include investments with AAA credit ratings. That way you don’t have to worry about bankruptcy. And make sure you hedge against the risk of recession because anytime that stocks go down, T-Notes go up. Finally, don’t spend any money on transaction costs that you don’t absolutely have to spend.
Risk Rating: 3
Full Disclosure: I regularly buy 10-yr T-Notes, MSFT, JNJ, and XOM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 6
Week 79 - Gold vs. Financial Repression
Situation: Three weeks ago (see Week 76), we explained how Financial Repression forces investors to allocate more funds to stocks. This step has to be taken to counter (hedge) the main result of Financial Repression, which is to inflate values of all financial instruments by ~1.8%. In other words, you can’t come out ahead of inflation by putting your money in a historically safe place like Treasury Notes. You will have to put it in a less safe place, and that means investing in stocks (becoming a trader), local real estate (becoming a landlord), a small business (becoming an employer), or the education needed to land a better job. Our goal was to show you some stocks that are better (and arguably safer) places to put your money than Treasury Notes. By investing in those “hedge stocks” you would be doing something counter-intuitive, i.e., using stocks to hedge against bond losses.
Financial Repression is basically a tax on all your assets. The Federal Reserve levies that tax by removing Treasury Notes and mortgage-backed securities (MBS) from circulation, currently at a rate of $85 Billion/mo. Treasuries and MBS that remain on the market become so high in price that their interest rates may fall lower than the rate of inflation. This is done to drive mortgage interest so low that all of the expensive mortgages taken out in 2005-2008 can be refinanced to inexpensive mortgages, and new buyers looking for a home can get an affordable mortgage. In other words, a recession caused by a real estate crash can only be reversed by restoring home values.
We get that part of the equation but what about the other part--expansion of the Federal debt? What does Financial Repression do for the Federal Reserve and the banking system? Let’s focus on the big issue, the one driving investors into gold. Financial Repression makes it very cheap for overly indebted governments to borrow money. When the Federal Reserve drives down interest rates to reduce the cost of borrowing, investors (and even economists) will often conclude that Financial Repression represents debasement of the currency. That makes gold (a currency that cannot be debased) more expensive. Gold shouldn’t be an investment asset because it produces no income to offset its costs (commissions, storage fees, insurance, and a high tax rate on any capital gains). But when the Federal Reserve is giving away money at a cost to its balance sheet of $1.14 Billion/yr, TV commentators say “the Fed is printing money” and TV viewers go out and buy gold. The Fed isn’t printing more money. It is actually printing less than it was because relatively few people can put it to use unless the cost of borrowing is next to nothing. The Fed simply tilts the ebb and flow of money through the banking system toward more flow, thus allowing banks to make money available at very low interest rates. The goal is to reflate an economy that is under threat of deflation. (Up until recently, the main purchasers of that cheap money have been the Chief Financial Officers of solvent corporations who have figured they will be able to use it when demand for their products finally returns.)
When Financial Repression works and deflation is prevented, gold is a great asset to own because Financial Repression usually takes a long time to work its magic. But if deflation happens because Financial Repression is applied too late or too timidly, gold is a terrible asset to own. In 2008, when the Fed was still keeping interest rates high and the “bailout” had not yet kicked in, the exchange-traded fund (ETF) for large gold-mining stocks (GDX) fell in price from $56.87 (in 3/08) to $15.83 (in 10/08) for a 72% loss. Over that same 9 month period, a highly-regarded low-cost/no-load natural resources mutual fund (PRNEX) fell 51% and Vanguard’s lowest-cost S&P 500 fund (VFIAX) fell 35%. Investors who thought a 1930s-style depression was in the offing fled from gold. Once it became clear that a depression had been prevented by the prompt application of robust monetary and fiscal policies, investors returned to gold seeking to reap the benefits of Financial Repression. But most will disappear when and if the economy is reflated without incident. Why? Because, at that point, the Fed will be withdrawing money from circulation to prevent inflation and driving up interest rates. That will make the trading commissions, storage costs, insurance premiums, and capital gains taxes on gold unaffordable. Gold is only a reasonable long-term investment when the government is over-spending in its role as lender of last resort and driving up debt per capita. Once debt per capita is falling, the economy is okay: the currency isn’t being debased. Right now, debt per capita is increasing and the currency is being (temporarily?) debased. This means gold is a reasonable investment now provided that holding costs continue to remain low and gold isn’t overpriced.
In summary, you need to answer two questions before investing in gold:
1) Can you afford the holding costs?
2) Is gold overpriced?
Question #1 is easy to answer because you can own gold bullion through an exchange-traded fund (GLD) at a cost of less than 0.5%/yr after paying the trading commission. That expense ratio will increase when Financial Repression ends. In other words, storage fees and insurance premiums will rise in tandem with rising interest rates. Question #2 is harder to answer because no one knows quite how to price gold. It has some tangible value (industrial uses) and a lot of intangible value (jewelry), which is why profits from its sale are taxed at the highest rate as though it were a collectible similar to art.
Doing the math, we’ll start with best estimates. An ounce of gold has historically been said to have the same value as a very good suit of clothes. Most of us aren’t prepared to shell out $1600+ when we shop for a good suit. But financial reporters keep trying to pin down gold’s value by asking tailors how much they charge to make a very good suit from very good fabric. Tailors think that’s an easy question and over the past few years have answered ~$1000. Another way is to look up the prices of gold mining stocks (see the attached Table). Those reflect the cost of extracting & milling the mine’s most easily accessed ore in order to market its next ounce of gold: $1200/oz to $1300/oz.
What have we learned? At $1660 (the price of gold on 12/31/12), gold is overvalued and could fall out of favor with investors. Those are the very people who have been buying up half the annual production of gold over the past 5 yrs. Without the eagerness of those investors, the only tangible value gold has is the price paid for the 12% of annual production that is used for industrial applications--the rest being used for jewelry, which is another intangible like art. (Central Banks also buy and sell gold but don’t move the needle much from year to year.)
Let’s try harder to come up with gold’s value to an investor. An investor wants to own gold as a hedge against the hyperinflation that will arise if the currency is unremittingly debased. So an investor will want to know how efficiently decreases in the purchasing power of the dollar (inflation) have been compensated for by increases in the price of gold. To answer this question, we need a reliable way of measuring the true value of the dollar. Since gold, always and everywhere, is an easily transported medium of exchange, we need a benchmark that is available always and everywhere. In other words, we need a benchmark that measures the true value of every currency relative to the true value of every other currency. In business school, the choice of a reasonable benchmark by which to value different currencies is called arriving at purchasing power parity (PPP).
It sounds silly but that benchmark is the price of a Big Mac hamburger. Go out and buy an issue of a British business magazine called The Economist if you doubt whether this is the global way to measure PPP. McDonald’s has established restaurants in 190 countries so Big Macs are ubiquitous--always made the same way, always on the menu, and always marked up the same in local currency. It is easy to find the price of a Big Mac in the currency of any country on the planet (just Google it). So let’s establish PPP for gold in US dollars relative to a Big Mac. In 1975, the average price of gold was $161.25 and the average price of a Big Mac was $0.75. In 2012, the average price of gold was $1766 and the average price of a Big Mac was $4.33. So gold went up 10.95 times in price while Big Macs were going up 5.77 times. The Consumer Price Index (CPI) only went up 4.28 times over that 38 year period so McDonald’s is a strong brand that bestows considerable pricing power. If gold bullion had enjoyed the same pricing power as a Big Mac, it would have had an average price in 2012 of $930.41 (161.25 x 5.77), instead of $1766. Therefore, in 2012 the average price of an ounce of gold represented at least $836 (1766 minus 930) of intangible value vs. a Big Mac, which already has considerable intangible value vs. the CPI.
Let’s be clear about intangible value. When a company is bought by a private equity fund, the amount paid over and above tangible book value is called intangible book value. Intangible value is the price paid for the brand and the talent that went into building it: The pricing power of that brand is worth only what the buyer is willing to pay. Gold bullion is a great brand that currently enjoys enormous pricing power. Whenever you sell it at a profit, you’ll pay a lot of tax because the IRS is onto your game. The IRS considers the entire value of your gold to be intangible and therefore taxable as a work of art. You bought a votive object, plain and simple, then profited from its sale.
Bottom Line: In the event that the Federal Reserve and Congress are able to bring the country out of Financial Repression, which now seems likely to occur within 5 years, gold bullion is going to lose value. How much and how fast? Rationally, that depends on the rate at which the nation’s debt per capita decreases. The government’s debt will keep growing but not as fast as the population. Irrationally, you have to ask yourself what price investors will pay for gold after currency debasement has ended. This will depend on sentiment. If you are a gold bug, you’ll never sell. But if you’re not wedded to the gold coins buried in your backyard, you’ll sell and sell quickly because the price will be falling fast (herd instinct). If you own a well-chosen gold mining stock (Table), you’ll still take a hit but not from the IRS since gold mining stocks are taxed like any other corporate stock. You’ll just end up wishing you’d invested in the mining industry rather than gold mining per se, perhaps through a diversified mining stock like Rio Tinto (RIO) or a mining equipment stock like Caterpillar (CAT). Both are shown in the Table.
Risk Rating for gold mining stocks is a 10. No asset class fell faster or farther during the 9 months in 2008 when major economies appeared to be falling into a 1930s-style depression.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 23
Week 77 - Low-risk Stocks in Food-related Companies
Situation: Currently, the stock market is overpriced according to the indicator with the greatest predictive value: The 10-yr cyclically adjusted price-earnings ratio (CAPE). It presently stands at 21.86, whereas CAPE has averaged 16 over the past 130 yrs. Partly this elevation is due to the Federal Reserve feeding $2 Trillion into the economy over the past 4 yrs. The Federal Reserve has just announced it will keep doing so at the rate of $85 Billion per month, i.e., purchasing $40 Billion in mortgage-backed securities and $45 Billion in US Treasury Notes (see Week 76 for a discussion of Financial Repression). That money gives banks and other corporations the ability to obtain cash at ~zero cost relative to the rate of inflation. However, that cash cannot be converted into loans/jobs/factories until the economy recovers enough to justify such investment. The result? Stock prices go up but earnings barely increase at all.
The other reason stock prices are going up faster than earnings is that sentiment has improved. Traders think the economy will gradually regain its full strength. Remember that stocks are priced to reflect expected corporate earnings 6 to 9 months from now. Under the current circumstances, what should you do? When all asset classes are overpriced because of Financial Repression, the best plan is to invest more in companies that will benefit from shortages in supplies when demand finally increases. The most critical looming shortages look to be food-related, given that per-capita food production hasn’t kept up with demand for more than 10 yrs. Grain yields have reached a plateau worldwide but a larger percentage of grain is going for animal feed and automobile fuel every day. Meanwhile, world population grows by 220,000 every day (Brown, Lester R.: Full Planet, Empty Plates, Norton, New York, 2012, 144 pp).
Our mission is to find food-related stocks that won’t follow the roller-coaster of grain prices but will reflect the coming ~5%/yr growth in grocery store prices. Here at ITR, we have come to define such “low-risk” stocks (see Week 76) as those having:
a) dividend yield at least as great as the 15-yr moving average for the dividend yield of the S&P 500 Index (1.8%);
b) annual dividend growth over the past 5 yrs of at least 6%/yr;
c) price loss during the 18-month Lehman Panic (10/07 to 4/09) of no more than 30% (vs. 46% for the S&P 500 Index);
d) 5-yr Beta of less than 0.65, meaning the stock price goes down less than 65% as far as the S&P 500 Index in a bear market;
e) less than 50% of total capitalization is from long-term loans;
f) dividends have been raised for at least 10 consecutive yrs.
We have come up with 10 stocks by using those metrics (Table). Only 6 are food & beverage production per se (HRL, LANC, MKC, SJM, PEP, KO) but the other 4 play important supporting roles: McDonald’s (MCD), Wal*Mart (WMT), CH Robinson (CHRW, the leading worldwide distributor of fresh vegetables labeled The Fresh 1), and Aqua America (WTR, the largest regulated North American water utility).
Bottom Line: Look at looming shortages. Oil was the #1 looming shortage until drillers in the US started using advanced technologies from Schlumberger (SLB) to drill horizontally and break up oil-containing rock formations by injecting a sand slurry under high pressure (hydrofracking). Now food is the #1 looming shortage, due to a water shortage that compounds a host of other shortages (tillable land, fertilizer, modern agricultural infrastructure, crop protection chemicals, drought-resistant seeds, affordable energy). To make matters worse, there are 3 billion more people having the wherewithal to buy meat, milk and eggs for their families than there were 20 yrs ago. However, animal protein requires 4 times as much grain to produce than does the simple consumption of that same grain for human nourishment (instead of using it for animal feed). Finally, over 10% of corn and sugar cane production worldwide is now being diverted from food supplies for use as automobile fuel. You can see that problems abound with food production. There are solutions for each problem but those will require time to phase in, and full support of a new generation of politicians who see fit to appropriate the necessary resources.
Risk Rating: 3.
The other reason stock prices are going up faster than earnings is that sentiment has improved. Traders think the economy will gradually regain its full strength. Remember that stocks are priced to reflect expected corporate earnings 6 to 9 months from now. Under the current circumstances, what should you do? When all asset classes are overpriced because of Financial Repression, the best plan is to invest more in companies that will benefit from shortages in supplies when demand finally increases. The most critical looming shortages look to be food-related, given that per-capita food production hasn’t kept up with demand for more than 10 yrs. Grain yields have reached a plateau worldwide but a larger percentage of grain is going for animal feed and automobile fuel every day. Meanwhile, world population grows by 220,000 every day (Brown, Lester R.: Full Planet, Empty Plates, Norton, New York, 2012, 144 pp).
Our mission is to find food-related stocks that won’t follow the roller-coaster of grain prices but will reflect the coming ~5%/yr growth in grocery store prices. Here at ITR, we have come to define such “low-risk” stocks (see Week 76) as those having:
a) dividend yield at least as great as the 15-yr moving average for the dividend yield of the S&P 500 Index (1.8%);
b) annual dividend growth over the past 5 yrs of at least 6%/yr;
c) price loss during the 18-month Lehman Panic (10/07 to 4/09) of no more than 30% (vs. 46% for the S&P 500 Index);
d) 5-yr Beta of less than 0.65, meaning the stock price goes down less than 65% as far as the S&P 500 Index in a bear market;
e) less than 50% of total capitalization is from long-term loans;
f) dividends have been raised for at least 10 consecutive yrs.
We have come up with 10 stocks by using those metrics (Table). Only 6 are food & beverage production per se (HRL, LANC, MKC, SJM, PEP, KO) but the other 4 play important supporting roles: McDonald’s (MCD), Wal*Mart (WMT), CH Robinson (CHRW, the leading worldwide distributor of fresh vegetables labeled The Fresh 1), and Aqua America (WTR, the largest regulated North American water utility).
Bottom Line: Look at looming shortages. Oil was the #1 looming shortage until drillers in the US started using advanced technologies from Schlumberger (SLB) to drill horizontally and break up oil-containing rock formations by injecting a sand slurry under high pressure (hydrofracking). Now food is the #1 looming shortage, due to a water shortage that compounds a host of other shortages (tillable land, fertilizer, modern agricultural infrastructure, crop protection chemicals, drought-resistant seeds, affordable energy). To make matters worse, there are 3 billion more people having the wherewithal to buy meat, milk and eggs for their families than there were 20 yrs ago. However, animal protein requires 4 times as much grain to produce than does the simple consumption of that same grain for human nourishment (instead of using it for animal feed). Finally, over 10% of corn and sugar cane production worldwide is now being diverted from food supplies for use as automobile fuel. You can see that problems abound with food production. There are solutions for each problem but those will require time to phase in, and full support of a new generation of politicians who see fit to appropriate the necessary resources.
Risk Rating: 3.
Subscribe to:
Comments (Atom)