Month 110 - Buy Low! 12 A-rated Haven Stocks in the S&P 100 Index that aren’t overpriced - August 2020

Situation: There’s no mystery to saving for retirement. A good working game plan is to divert 15-20% of your monthly income to the purchase of stocks and government bonds, and then keep those assets in a 60:40 balance of stocks:bonds. You can also use any bond substitutes (e.g. gold, T-bills, and utility stock ETFs) that typically hold their value in a stock market crash. Mainly use stock index ETFs for your retirement savings but also buy stock in companies that tend to have an above-market dividend yield. Those “shareholder-friendly payouts” happen because the company has good collateral: Liabilities are protected by Tangible Book Value and a cushion of Cash Equivalents. In other words, avoid stocks issued by companies that have become over-indebted. 

Think of the bonds in your portfolio as the collateral that backs your stocks. So, a good way to start saving for retirement is to over-emphasize collateral-thinking: Dollar-average into the low-cost Vanguard Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks picked from the Vanguard High Dividend Yield Index Fund ETF (VYM). VWINX has lost money in only 7 of the past 50 years, those losses always being less than 10%. Since its inception on 7/1/1970, VWINX has returned 9.7%/yr vs. 10.8%/yr for the S&P 500 Index with dividends reinvested.

The harder task is to stop putting additional money into stocks that have become overpriced. To do that you have to know how to calculate the Graham Number. Benjamin Graham wrote the first edition of The Intelligent Investor almost 100 years ago. It is hard to read because he uses numbers to express almost every pearl of knowledge. The “Graham Number” is simply the rational market price for any stock at any given moment, calculated as the square root of: 15 times earnings for the Trailing Twelve Months (TTM) multiplied by 1.5 times Book Value for the most recent quarter (mrq) multiplied by 22.5 (i.e., 1.5 times 15). So, the Graham Number is nothing more than what the stock’s price would be if it were to reflect a P/E of 15 and a Book Value of 1.5.  The purpose of doing this calculation on your stocks is to know their underlying worth. Benjamin Graham also explained why the 7-year P/E should not exceed 25, assuming that a single year’s P/E (TTM) should not exceed 20, which is an earnings yield of 5%/yr: In a normal inflationary environment, a company’s earnings are likely to grow 3% to 3.5% per year. After 7 years, a CAGR (Compound Annual Growth Rate) of 3.2%/yr takes a P/E of 20 to 25.

My definition of an Overpriced Stock is one that a) has a market price (50-day Moving Average) that is more than 2.5 times the Graham Number and b) has a 7-year P/E that is more than 30. Looking at the 30-stock Dow Jones Industrial Average (DJIA), I see that 5 A-rated stocks are overpriced (see Column AC-AH in Comparisons section of Table):

     Microsoft (MSFT), 

     Apple (AAPL), 

     Nike (NKE), 

     Coca-Cola (KO) and 

     Procter & Gamble (PG). 

Stocks get overpriced because they become popular with investors, leading to a Crowded Trade. Assuming that your goal is to Buy Low, why would you continue to add money to any of these 5 stocks that you already own? You would only do so because you harbor a Positive Sentiment regarding their future prospects, In other words, you would be making a speculative investment (“gambling”). To avoid gambling and instead employ a “risk-off” approach to buying individual stocks, you’ll need clear definitions for A-rated stocks and for Haven stocks to supplement the numbers-based system used above to avoid Overpriced stocks. You’ll also want to favor stocks issued by large companies, since those typically have multiple product lines and unencumbered lines of credit.

Mission: Define “A-rated stocks” and “Haven stocks”. Analyze A-rated Haven stocks in the S&P 100 Index that aren’t overpriced by using our Standard Spreadsheet.

Execution: see Table.

Administration: A-rated stocks are those that have a) an above market dividend yield (see portfolio of Vanguard High Dividend Yield Index Fund ETF - VYM), b) positive Book Value, c) positive earnings (TTM), d) an S&P rating on the company’s bonds that is A- or better, e) an S&P rating on the company’s stock that is B+/M or better, and f) a 20+ year trading history. 

Haven Stocks are A-rated stocks issued by companies that aren’t encumbered with risk factors that are likely to threaten the company’s solvency during a recession. So, companies in the Real Estate Industry (i.e., REITs) and companies in the Financial Services Industry (i.e., banks) are excluded, as are companies with negative Tangible Book Value if Total Debt is more than 2.5 times EBITDA (TTM) or Total Debt is more than 2.0 times Shareholder Equity. 

Bottom Line: With the S&P 500 Index being priced at 29 times TTM earnings (see SPY at Line 28 and Column K in the Table), the stock market is overpriced relative to its long-term P/E of 15-16. But its 50-day Moving Average price is still less than 2.5 times its Graham Number (i.e., 2.1), and its 7-yr P/E is still less than 30 (i.e., 28), per Columns AC and AE at Line 28 in the Table. Using our example of the DJIA, the timely thing to do would be to avoid buying more shares of the overpriced A-rated stocks (MSFT, NKE, PG, KO, AAPL) but to continue buying more shares of SPY. This strategy allows you to retain exposure to volatility in stocks that are Overpriced (because of their future prospects) while using diversification to reduce your risk of serious loss.

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

Full Disclosure: I dollar-average into NEE, INTC, WMT, JNJ, CAT, and also own shares of MRK, CSCO, TGT, DUK, SO, MMM. From late February through April 2020, I added shares of 6 new companies to my brokerage account--Comcast (CMCSA), Costco Wholesale (COST), Home Depot (HD), Merck (MRK), Disney (DIS) and Target (TGT), while selling shares of Norfolk Southern (NSC) and United Parcel Service (UPS). Regarding the 5 overpriced but A-rated stocks in the DJIA, I’ve stopped dollar-averaging into KO but continue to dollar-average into MSFT, NKE and PG because I expect those companies to continue to dominate their competitors. I have no plans to sell the shares of KO and AAPL that I already own.

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

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Week 382 - Steady Eddies

Situation: Some high-quality companies don’t pay good and growing dividends, don’t have high sustainability (ESG) scores, and aren’t blue chips, but do hold up well in bear markets. In theory, a hedge fund will take long positions in such companies (until retail investors take notice and the shares become overpriced). After reading this preamble, you’ll have figured out that we’re mostly talking about utilities. But that’s OK. You can still dollar-average into the non-utilities and do well, even though they’re often overpriced.

Mission: Run our Standard Spreadsheet on companies with A- or better S&P bond ratings and B+/L or better S&P stock ratings. Exclude companies in popular categories: “The 2 and 8 Club” (see Week 380), Blue Chips (see Week 379), the Dow Jones Industrial Average (see Week 378), and Sustainability Leaders (see Week 377). Also exclude companies that don’t do well in Bear Markets (see Column D in any of our Tables).

Execution: see Table.

Administration: This is a work in progress. The 7 examples in the Table are well-known to me; no doubt there are others in the S&P Index. 

Bottom Line: A smart investor knows that a Bear Market in a particular S&P industry will usually begin with little or no warning. By the time she starts to think about selling shares, it’s too late. Some kind of insurance will have to be in place before that happens. Warren Buffett’s well-known recommendation is that you dollar-average your stock investments and back those up with a short-term investment-grade bond fund. (He also recommends that you avoid the two habits that in his experience are likely to derail investors: drinking alcohol and borrowing money.) Here we add a third option, which is to find stocks that “fly under the radar” and hold up well in a Bear Market.

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

Full Disclosure: I own shares of HRL.

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Week 370 - Ways To Win At Stock-picking #1: Dollar-cost Average Into 10 Of The 30 DJIA Companies

Situation: You’re troubled by the dominance of the S&P 500 Index. After all, it is a derivative and you wonder whether it is really the safest and most effective way to build retirement savings. Your biggest concern is that it is a capitalization-weighted index, which is a design that favors momentum investing: Mid-Cap companies that garner investor enthusiasm become included in the S&P 500 Index because their stock is appreciating; Mid-Cap companies that have managed to be included in the S&P 500 Index investors are in danger of being excluded because investors have lost their enthusiasm and the stock’s price is falling. Many investors buy/sell shares in a company’s stock because of that trend in sentiment. Fundamental sources of value (revenue, earnings, and cash flow) often have little to do with their enthusiasm, or the fact that it has evaporated. Articles in the business press may carry greater weight, and those articles may be influenced by analyses introduced by short sellers, who are betting on a fall in price, or hedge fund traders with long positions, who are betting on a rise in price. In other words, most retail investors are paying attention to market sentiment when buying or selling shares, not due diligence that comes from a careful study of a company’s prospects and Balance Sheet. 

Your second biggest concern is likely to be that few S&P 500 companies have a good credit rating backing their debts. In other words, they’re paying too high a rate of interest on the bonds they’ve issued, or the bank loans they’ve taken out. The company’s Net Tangible Book Value is therefore likely to be drifting deeper into negative territory because of interest expenses, part of which are no longer tax deductible due to changes in U.S. tax law.

Both of these problems fall by the wayside if you invest in the 30 companies that make up the Dow Jones Industrial Average, either separately or together in the price-weighted Dow Jones Industrial Average Index (DIA at Line 18 in the Table). Investing in the “Dow” may be a little smarter for retirement savers than investing in the S&P 500 Index (SPY at Line 16 in the Table) for two reasons: 1) DIA has a dividend yield that is ~10% greater; 2) DIA pays dividends monthly, whereas, SPY pays dividends quarterly. A higher dividend yield means that your original investment is returned to you more quickly, which translates as a higher net present value, if other factors (e.g. dividend growth and long-term price appreciation) are not materially different.

Mission: Use our Standard Spreadsheet to illustrate how I dollar-cost average into stocks issued by 10 DJIA companies.

Execution: see Table.

Administration: It has been necessary to use 3 separate Dividend Re-Investment Plans (DRIPs) to dollar-cost average into the 10 DJIA stocks I’ve chosen (see Column AE in the Table). Those DRIPs automatically extract $100 each month for each of the 10 stocks; transaction costs average $18.68/yr (see Column AD), which includes automatic reinvestment of dividends. The expense ratio is 1.56% for each year’s investments, but expenses relative to Net Asset Value fall to less than 0.01% after 10-20 years.

Bottom Line: This week’s blog compares my long-standing pick of 10 Dow stocks (for an automatic monthly investment of $100 each using an online DRIP) to investing $1500/qtr in the entire 30-stock index (DIA) using a regional broker-dealer, which is something I’ve just started doing to facilitate comparison going forward. (You’ll see each year’s total returns in future blogs published the first week of July.)  

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

Full Disclosure: If one of the 10 stocks I’ve chosen is dropped from the Dow Jones Industrial Average (DJIA), I’ll sell those shares and use those dollars to start a DRIP with shares issued by another DJIA company.

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

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Week 364 - Ethanol Producers

Situation: “Market research analysts at Technavio have predicted that the global bio-fuels market will grow steadily at a CAGR of almost 6% by 2020”. But arguments against blending ethanol with gasoline are building. In 2016, 15.2 billion gallons were produced at 214 plants, with Archer Daniels Midland (ADM), Valero Energy (VLO) and Green Plains Renewable Energy (GPRE) being the main publicly-traded producers. For example, those 3 companies operate 4 ethanol plants in Nebraska that together produced 2.2 billion gallons, representing 31% of the state’s crop. Not only is fuel a big business for the agriculture sector, but the by-product (“distillers grains”) is a rich source of animal feed. For every ton of ethanol produced, there are 0.24 tons of distillers grains. 

You need to think of ethanol plants as a permanent feature of the Corn Belt, i.e., the 11 states of the Upper Midwest. Government subsidies for ethanol plants in Europe and the United States aren’t going away, for two important reasons. Ethanol is a renewable fuel, and adding it to gasoline makes tailpipe emissions less damaging to the atmosphere. Furthermore, ethanol plants represent the only stable market for the dominant farm product of those 11 states (North Dakota, South Dakota, Nebraska, Kansas, Minnesota, Iowa, Missouri, Wisconsin, Illinois, Indiana, and Ohio). But, before you buy shares in one of the 6 companies we highlight here, you need to understand a number of factors that impact the feedstocks and ultimate markets served by those plants. Start by reading this summary prepared for Green Plains (GPRE) investors.

Mission: Analyze the 6 publicly-traded US companies in the ethanol business, using our Standard Spreadsheet.

Execution: see Table.

Administration: Ethanol plants have changed the lives of farmers in the Corn Belt from being a speculator to being a professional businessman. Iowa, the state that produces the most corn, almost exclusively grows #2 field corn  destined for ethanol plants. 20% of that corn becomes “distillers grains”, and dry distillers grains are shelf-stable and greatly valued as animal feed all over the world. So, that’s a stable and global market. And, ethanol is increasingly being shipped out of the US, either separately or blended with gasoline. For example, China recently adopted the same 10% ethanol content requirement for gasoline that the US has been using. That is seen as an export opportunity for US ethanol plants.

Bottom Line: Corn Belt = ethanol plants. That’s the equation you need to remember. It’s all based on #2 field corn. The #1 sweet corn that we like to eat is rarely grown in the Corn Belt. A state outside the Corn Belt (Washington) is the leading producer. But it’s only been 11 years since the Bush Administration pushed Congress to blend 10% ethanol with gasoline. Yes, hundreds of ethanol plants were built as a result but the economics of running those plants is only now being sorted out. If you invest in any those, you’re a speculator by definition. 

Addendum: Here’s the definition of a red line for “speculation” given in the May 28, 2018 Bloomberg Businessweek on page 8: “...a conservative threshold for volatility, typically lower than that of the broader market for relevant assets…” Column M in all of our tables lists the 16-year volatility of each company (with the required trading record) and highlights in red those that have a greater volatility than the Dow Jones Industrial Average (DIA). Of the 6 companies in this week’s Table, even Archer Daniels Midland (ADM), the longest-established (and highest rated by S&P) company, has a volatility well above that of DIA.

Risk Rating: 8 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10) 

Full Disclosure: I dollar-average into Archer Daniels Midland (ADM), which is a member of “The 2 and 8 Club” (Extended Version; see Week 362).

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Week 358 - Hedge the Crash With Low-Beta Dividend Achievers

Situation: It’s really tough to own stocks when the market crumps. Yes, you can follow Warren Buffett’s advice and tough it out with dollar-cost averaging. His other main idea, which is to buy great businesses at a fair price, may be useful someday down the road. He hasn’t been able to find any in this overpriced market, and neither will you. But after the market crashes, you’ll both be glad you kept a hefty dollop of cash in reserve to serve that very purpose. 

But what about hedging against the crash? That’s what hedge funds are supposed to do. Why can’t you and I do it? It’s not that simple. Hedging means that your portfolio pulls ahead in a Bear Market but lags on a Bull Market. Given that the market is historically up 3 years out of 4, you see the problem with hedging. But looking deeper, volatility is what you want to hedge against. You can do that year in and year out by adopting the “School Solution”: overweight low-beta stocks in your portfolio at all times. 

By hedging against volatility, your portfolio won’t necessarily fall behind in a Bull Market. Having less volatility only means that your gains will be less than those for the S&P 500 Index in a Bull Market, AND your losses will be less in a Bear Market. It doesn’t mean you’ll underperform that Index long-term. Why? Because trending stocks become overbought in a Bull Market. But you’re underweighting those high-beta Financial Services and Information Technology stocks! Half of the market capitalization in the S&P 500 Index is currently in those two industries, vs. the long-term average of 30%. Owning high-beta stocks will make you richer faster, but you’ll have to do daily research so that you know when to BUY and when to SELL. My approach to those two industries is to dollar-average into Microsoft (MSFT), International Business Machines (IBM) and JP Morgan Chase (JPM). And keep dollar-averaging no matter what.

Mission: Run our Standard Spreadsheet to identify low-beta stocks of high quality: 
   1. S&P Bond Ratings of A- or better (Column T in the Table);
   2. S&P Stock Ratings of B+/M or better (Column U in the Table);
   3. 5-Yr Beta of less than 0.7 (Column I in the Table);
   4. Lower statistical risk of loss than the S&P 500 Index (Column M in the Table);
   5. Higher Finance Value than the S&P 500 Index (Column E in the Table)
   6. Dividend Achiever status (Column AC in the Table).

Execution: see Table.

Bottom Line: Try not to be a momentum investor. The exciting stories that underlie every Bull Market create a crowded trade for stocks issued by Financial Services and Information Technology companies. To usefully deploy the cash that’s rolling into their coffers, those companies will try to innovate and deploy new services and equipment sooner than planned. Things will get messy, bordering on chaos. Parts of the “story” will collapse, or end in court. Current examples abound. So, we’re back to the Tortoise and Hare story because it will be trotted out at the end of every market cycle. Will you channel the Hare, or will you channel the Tortoise?

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

Full Disclosure: I dollar-average into NEE, PEP and NKE, and also own shares of KO and JNJ.

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

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

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

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

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

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

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

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

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

Full Disclosure: I own shares of TJX.

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Week 212 - How Great is “Buy-and-Hold” Investing? Here’s a 30-yr Study.

Situation: One of Warren Buffett’s goals is to identify good companies, buy the stock, and hold it forever. Very few market commentators or analysts would agree with him on that point, and Warren Buffett himself is quick to close out a position if he detects an unanticipated change in its prospects. For his already wealthy friends and family, he suggests they put 90% of their new investment dollars in a Vanguard S&P 500 Index fund like VFINX. Here at ITR, we suggest that you combine two low-cost routes:
   1) add regularly to VFINX or its bond-hedged version, the Vanguard Balanced Index Fund (VBINX);
   2) add regularly to dividend reinvestment plans (DRIPs), making direct stock purchases online at computershare for example.
The idea is to favor stocks that have grown dividends at more than double the rate of inflation for at least past the 10 yrs (i.e., Dividend Achievers, see Week 205). If you’re 50 and expect to live to 80, that means you’ll have a 30-yr holding period for stocks that hopefully won’t have an unanticipated change in their prospects. 

Mission: See how well today’s Dividend Achievers did over the past 30 yrs compared to VFINX.

Execution: In addition to picking from the larger companies in the Dividend Achiever list, i.e., those that also appear on the 2015 Barron’s 500 List, we’ll draw data from our favorite databases: the BMW Method’s 30-yr statistical record for price appreciation, and the Buyupside total return stock calculator. 

We’re looking for stocks with price appreciation that beat the S&P 500 Index (^GSPC) over the past 30 yrs, and also had total returns that beat VFINX. To address risk, we’re looking for stocks that 1) have a statistical risk of future bear market losses that is less than that predicted for ^GSPC, and 2) lost less than VFINX in the Lehman Panic. We’ve excluded some stocks that pass those tests for the following reasons: 1) If their price variance hasn’t tracked ^GSPC’s, and 2) if their dividend hasn’t grown faster than the 5.2% rate at which the dividend for VFINX grew. Finally, companies with an S&P bond rating lower than BBB+ or an S&P stock rating lower than A-/M were excluded.

We’ve turned up 11 stocks (see Table). So, you can take a buy-and-hold approach to stock-picking without sacrificing returns and still benefit from dividend growth that beats VFINX. But risk remains a sticking point. While we’ve gone to great lengths to isolate a set of stocks with long-term risk that is less than that for ^GSPC and its total return version (VFINX), in the short-term we’re including stocks that have 5-yr Beta values greater than the S&P 500 Index (i.e., 1.00), and stocks that are overpriced relative to earnings, i.e., those with a P/E higher than VFINX (i.e., 20). Either will produce greater price appreciation in a bull market and greater price loss in a bear market. In other words, stocks with above-market 5-yr Betas and P/Es are destined to have above-market volatility over the near-term. If we were to eliminate such stocks there would be none left. If we did the same evaluation but limited the holding period to 25 yrs (see Week 199), only two stocks had a P/E that was equal to or less than the market’s and a 5-yr Beta that was less than or equal to 0.9. Those stocks are Baxter International (BAX) and Illinois Tool Works (ITW). By limiting the holding period to 16 yrs (as you’ll see in an upcoming blog), only 3 companies survive the screen: Wal-Mart Stores (WMT), Union Pacific (UNP), and DTE Energy (DTE).

Bottom Line: Buy-and-hold stock-picking isn’t a logical option compared to picking a low-cost S&P 500 index fund like VFINX. As we were taught in business school, the only lawful way to beat the S&P 500 Index is to take on more risk. But stock-picking can work in your favor over the long term, if you’re willing to dollar-cost average. In other words, you can use dollar-cost averaging to defeat near-term risk by riding out bear markets, if you continue to add fixed dollar amounts to your DRIPs while stocks are cheap. 

Risk Rating: 5

Full Disclosure: I dollar-average into ABT and also own shares of MCD, GIS, BDX, MMM, and UTX.

Note: For this week only, the metrics in the Table that are highlighted in red indicate underperformance relative to the Vanguard 500 Index Fund (VFINX), not the Vanguard Balanced Index Fund (VBINX) as in our previous blogs. That is because VBINX wasn’t launched until 1992. Metrics are current as of the Sunday of publication.

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Week 210 - Fortune 500 Agronomy and Food Production Companies

Situation: We like food and agriculture related investments because companies in that sector respond to global (not just US) demand. Those companies also respond to farm commodity prices, which are influenced as much by the weather as by macroeconomic factors (e.g. interest rates, labor costs, and GDP). Holding stocks in that sector gives you a non-correlated asset, i.e., one that is out-of-sync with the US economy. This is a good thing because it helps to balance your portfolio in tough times. In addition, since food is an essential good, companies in this sector retain pricing power during recessions. This strategy for insulating your portfolio against the ups and downs of the S&P 500 Index differs from other hedging strategies because long-term rates of return typically outperform the S&P 500 Index instead of underperforming it (as would occur for example by using Treasury bonds as a hedge). That outperformance comes with added volatility because the food and agriculture sector is even more complex than the energy sector. That said, you’ll need a way to categorize and evaluate the key players. 

Mission: Categorize and evaluate companies in the food and agriculture sector, starting with the chemical companies that address the agronomy needs of farmers, and food production companies.

Execution: First we’ll break down the “roles and missions” of companies in each sub-sector by using the analogy of a 4-legged stool. We start with the Fortune 500 List, which ranks companies by revenue and comes with features that help us to categorize and evaluate companies in all sub-sectors of the US economy. This year’s updated list was recently published and includes data on 1000 companies (ranked by revenue). There are a variety of tools for the investor to use, such as the year-over-year (YOY) change in each company’s revenue and earnings. There are also alphabetical lists of companies in every sub-sector. Food and agriculture related sub-sectors include: apparel, chemical, beverages, construction and farm machinery, energy, food consumer products, food production, food services, food and drug stores, forest and paper products, industrial machinery, motor vehicles and parts, packaging & containers, tobacco, food wholesalers, and grocery wholesalers.

The 4-legged stool has 2 legs that are on the buy side and 2 on the sell side. The buy side includes the companies in sub-sectors that help a farmer grow crops and raise animals then find someone who will buy those farm commodities. One buy side leg is for “hardware” (e.g. tractors) and the other is for “software” (e.g. fertilizer). The 2 legs on the sell side are companies in sub-sectors that either make intermediate products for sale to wholesalers, or further process farm commodities for marketing directly to consumers (e.g. a leather goods company). For this week’s blog, we’ll look at one sub-sector on the buy side (chemical companies that serve the agronomy needs of farmers) and one on the sell side (the “food production” sub-sector, as opposed to “food consumer products” that is the other leg of the sell side). 

In constructing this week’s Table, we have compared the Fortune 500 List to the Barron’s 500 List, which assigns a grade-point average to each company based on 3 key operational metrics that are related to growth in earnings and revenue over the past 3 yrs (see Week 205). We’ve screened out companies that have S&P bond ratings lower than BBB+ and S&P stock ratings lower than B+/M.

There are 12 stocks that meet our criteria, 6 from the Chemical industry and 6 from the Food Production industry (see Column T in the Table). Four companies have 30-yr stock price records that have been analyzed statistically by the BMW Method (see Lines U-W of the Table): Archer Daniels Midland (ADM), Seaboard (SEB), Dow Chemical (DOW), and duPont (DD). Column U of the Table shows that all 4 beat the price-only S&P 500 Index (^GSPC at Line 22) over that 30-yr interval, returning an average of 9.9%/yr vs. 7.0%/yr for ^GSPC. Each of the 4 carries a statistical risk of loss in a future Bear Market that is equal to or greater than that for the S&P 500 Index (see column W in the Table). The average predicted loss for those 4 stocks is 48% vs. 42% for ^GSPC. During the 18-month Lehman Panic (see Column D in the Table), those 4 had an average total return of -48.5% vs. -46.5% for the lowest-cost S&P 500 Index Fund (VFINX at Line 21 of the Table). 

Heightened risk is a common feature of commodity-related companies, partly because managers have to plan on selling products worldwide. For example, the US-based companies listed in the Table have to compete with similar companies based in Europe, including Bayer AG (BAYZF), BASF SE (BASFY) and Syngenta AG (SYT). All 3 of those companies actively market their products to farmers and farm cooperatives here in south-central Nebraska where I live. And Syngenta has a large seed production and research facility here. “The world is getting smaller” and companies that need to compete globally are finding that they have to consider merging. Several in the food and agriculture sector have already entered into co-marketing agreements. Monsanto, the world’s largest seed producer, is currently offering to buy Syngenta, the world’s largest pesticide producer.

Bottom Line: There are only two ways to beat the S&P 500 Index. One method is to trade on insider information (try that and you’ll go to jail). The second is to trade in stocks that carry more risk than the S&P 500 Index. The most productive risk plays address global rather than regional opportunities. Riskier stocks that beat the S&P 500 index long-term are typically issued by companies having business plans that are relatively immune to the macroeconomic forces (like US interest rates and GDP cycles) that drive the S&P 500 Index. Such a company’s prospects are instead driven by global, non-macroeconomic events (e.g. weather cycles). Most of those business plans are linked to a commodity “supercycle”. Your best bet is to study companies that use an essential commodity for their main feedstock. That way the market for their products will be driven by global growth in middle-class consumers as well as non-macroeconomic events. This logic takes you to considering companies that supply farmers with seeds and pesticides, as well as companies that produce protein-rich food. 

NOTE: The risk-adjusted returns you’ll enjoy from this method of investing are no greater than from an S&P 500 Index fund. The main reason to add commodity-related stocks to your portfolio is the benefit that comes from owning non-correlated assets over several market cycles (e.g. 30 yrs), which is to reduce your portfolio’s S&P 500 Index-related volatility without sacrificing returns.  

Risk Rating: 7.

Full Disclosure: I own stock in CF, MON and DD.

Note: Metrics in the Table that are highlighted in red denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund. Metrics are current as of the Sunday of publication.

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Week 208 - Stockpickers Secret Fishing Hole: Dividend Achievers with Improving Fundamentals

Situation: The 65-stock Dow Jones Composite Average (DJCA) typically outperforms the S&P 500 Index by about 1%/yr. It is composed of 30 Blue Chips, 20 Transports and 15 Utilities picked by the Managing Editor of the Wall Street Journal. The DJCA is a haven for "value" investors because the companies are long-standing members of mature industries and typically have predictable earnings. We call it the Stockpickers Secret Fishing Hole because total returns over 20 yrs are 1% greater than for the S&P 500 Index while bear market losses are 5% lower (see Table). Of the 65 companies, 29 are S&P Dividend Achievers (i.e., companies that have raised their dividend annually for at least the past 10 yrs, see Week 205). Now that the 2015 Barron’s 500 List has come out, we can check on Dividend Achievers and see which have improved their operations over the last 3 yrs.

Mission: Review the 2015 Barron's 500 List of the largest companies on the New York and Toronto stock exchanges to determine which of the 29 Dividend Achievers have moved up in rank compared to 2014. 

Execution: Barron’s uses 3 equally-weighted metrics to determine a company’s rank:   
   1) median 3-yr return on investment (ROIC),
   2) the most recent year’s ROIC relative to the 3-yr median, and
   3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank, and the highest rank is given a “1.” All 29 Dividend Achievers have high enough revenues to be included in the 2015 Barron’s 500 List. However, only 9 have a higher rank than in 2014 and only 5 of those have an S&P bond rating of BBB+ or higher and an S&P stock rating of B+/M or higher (see Table). One is a Blue Chip, Nike (NKE), meaning it is in the Dow Jones Industrial Average. Two companies are in the Dow Jones Utility Average, namely, Southern Company (SO) and NextEra Energy (NEE). Two companies are in the Dow Jones Transportation Average: Norfolk Southern Railroad (NSC) and Expeditors International of Washington (EXPD). 

Bottom Line: We occasionally revisit the Stockpickers Secret Fishing Hole to see if there’s a stock worth catching. Currently there are 5 but only two of those (NKE and NEE) look like “better bets” than the bond-hedged S&P 500 Index, i.e., the Vanguard Balanced Index Fund (VBINX).

Risk Rating: 5

Full Disclosure: I dollar-average into NKE and NEE.

NOTE: metrics highlighted in red indicate underperformance vs. VBINX. Metrics are current as of the Sunday of publication.

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Week 205 - Barron’s 500 Dividend Achievers with Improving Fundamentals

Situation: We recommend Vanguard Group mutual funds for retirement investing. Specifically, their S&P 500 index fund (VFINX) hedged 50:50 with their investment-grade intermediate-term bond index fund (VBIIX). That investment has paid ~7.7%/yr over the past 20 yrs (5.4%/yr after correcting for inflation of 2.3%/yr). Similar index funds are among the options available in almost any 401(k) plan. Why are Index funds better than “managed” funds? Because they can’t zig when the economy zags. However, Vanguard Group also markets managed funds that have performed well. One such fund that we like is Vanguard Wellesley Income Fund (VWINX) which is 55% bonds, 45% stocks, and handily beat a group of above-average hedge funds during the Lehman Panic. It has returned 8.4%/yr over the past 20 yrs. The benchmark we like to use is the Vanguard Balanced Index Fund (VBINX) which is 60% stocks, 40% bonds, and has returned ~8.2%/yr over the past 20 yrs. There’s just one problem: After you retire, these 3 choices for your retirement years don’t produce a lot of income from dividends and interest. You’ll be lucky if those quarterly payments keep up with inflation. In other words, you’ll have to sell shares periodically to maintain your spending power. That is bound to make you wonder whether or not you’ll outlive your nest egg.

Mission: Come up with a list of companies that have improving fundamentals and a 10+ yr history of increasing their dividend annually (companies that S&P labels Dividend Achievers, see Week 168). We’re looking for well-run companies that have grown their dividend more than twice as fast as inflation over the past 20 yrs, meaning 5%/yr or better.

Execution: To find companies with improving fundamentals, we depend on the Barron’s 500 List, published each year in May. In a now-standard fashion, the 2015 list gives a letter grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
   1) median 3-yr return on investment (ROIC),
   2) the most recent year’s ROIC relative to the 3-yr median, and
   3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank, and the highest rank is given a “1.” 

To find companies that have grown their dividend annually for at least the past 10 yrs, we refer to the holdings of PFM, which is an Exchange-Traded Fund that invests in every company on Standard & Poor’s list of Dividend Achievers.

To construct this week’s Table, we combine the two lists. Any company with a 2015 Barron’s 500 rank that is higher than its 2014 Barron’s 500 rank we consider to have “improving fundamentals.” If such a company is also a Dividend Achiever, it will appear in our Table, with certain notable exceptions. A company is excluded if its S&P bond rating is lower than BBB+ or its S&P stock rating is lower than B+/M. A company that has a 20-yr dividend growth rate less than 5%/yr is excluded. Companies with fewer than 20 yrs of being listed on either the New York or Toronto stock exchange are excluded.

Additional data is provided in Columns K and L of the Table referencing the BMW Method (see Week 199), where Standard Deviations of trendline price appreciation over the past 20 yrs are listed, as well as the extent of loss that would be incurred if prices fell by 2 Standard Deviations. 

Bottom Line: We’ve found 20 Dividend Achievers that have exhibited improving fundamentals over the past 3 yrs (see Table), as assessed by three metrics used to assemble the 2015 Barron’s 500 List. Their average dividend growth rate over the past 20 yrs beats inflation by ~10%/yr (see Column H in the Table). The top 9 companies in the Table outperformed our key benchmark, the Vanguard Balanced Index Fund (VBINX). VBINX is a version of the S&P 500 Index that is hedged 40% with investment-grade bonds. There is an online Dividend Reinvestment Plan (DRIP) or Direct Purchase Plan (DPP) available for all 9 of those stocks (see Column O of the Table), available either through computershare or Wells Fargo. 

Risk Rating: 4

Full Disclosure: I dollar-average into NKE and NEE, and also own shares of ITW, PEP, BDX, and INTC.

NOTE: metrics are brought current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark VBINX at Line 29 in the Table.

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Week 199 - Stocks with 25 years of Below-market Variance and Above-market Returns

Situation: Investing in stock and bond index funds have to be part of your retirement savings plan, since fees and transaction costs are negligible at the main vendor (Vanguard). In retirement, you can sell parts of those holdings as needed but the smarter move is to simply spend the dividends. However, those payouts don’t keep up with inflation most years. That’s why we recommend, as a supplemental plan, investing in high-quality buy-and-hold stocks through a dividend reinvestment plan (DRIP) with the intention of spending those dividends in retirement. Dozens of such stocks are available for direct purchase online through DRIP vendors like Computershare and Wells Fargo. However, there are two obvious problems: 1) automatic monthly investments in small dollar amounts can be costly; and 2) selection bias, i.e., you can only acquire large positions in approximately 10 stocks during a typical 25-yr accumulation period, and those will have to be stocks with a long history of growing dividends faster than inflation. The trick is to avoid stocks with more volatility than the S&P 500 Index and/or a history of lower returns.

This week’s blog builds on our Week 193 blog, where we introduced the concept of using several variance metrics over a 25-yr period to define volatility, then find stocks that have less volatility than the S&P 500 Index (^GSPC), as well as a higher CAGR (Compound Annual Growth Rate). You'll also want stocks with a better dividend growth rate than the Vanguard 500 Index Fund (VFINX), which hasn't kept up with inflation. 

In that Week 193 blog, we looked at stocks on the Barron’s 500 List and came up with only 15 (which had to be revised down to 10 to exclude/include after closer examination). To broaden our reach, we’ve now looked at all 650 stocks in the BMW Method dataset for 25-yr price variance in CAGRs. Only those that track ^GSPC (which has returned to trendline since the Lehman Panic) are of interest to us this week. Why? Because stocks that show recent performance that is one or two Standard Deviations above or below trend reflect an emergence of greater variance than ^GSPC. That may be for good reasons or bad, but our goal in this blog is to find stocks with growth trends that align with market fluctuations (^GSPC), then find the few that have lower price variance along with greater price appreciation. Otherwise, why bother? (Just invest in VFINX and make more money at lower cost and less risk.)

In the Table, you’ll see our results from screening all 650 stocks having 25 yrs of price variance data. Only 15 meet our criteria, i.e., have a CAGR that exceeds that for ^GSPC but with a lower price variance, which we define as your percent loss at 2 Standard Deviations below CAGR. That is, roughly every 20 yrs you can expect to lose value by the percentage listed in Column U of the Table. For example, if the Vanguard Total Bond Market Index Fund (VBMFX) were to sustain a price drop of 2 Standard Deviations (which it did 3 yrs ago), investors would lose 10% vs. a 40.6% loss for ^GSPC. In other words, stocks are 4.1 times riskier to own than bonds over the most recent 25 yr holding period.

To be sure those projections are current, we exclude stocks that haven’t returned to their pre-Lehman Panic trendline along with ^GSPC, and those that have a 5-yr Beta which is higher than that for the hedged S&P 500 Index (VBINX), which is 0.91. We have also excluded stocks that lost more than 46.5% (with dividends reinvested) during the 18-month Lehman Panic, which is the amount lost by VFINX. Other criteria are that the company's S&P bond rating be no lower than BBB+ and its S&P stock rating be no lower than B+/M. Also, the stock must have moved to new highs since the Lehman Panic.

We’re looking for Unicorns, i.e., stocks that have done better than the S&P 500 Index while being less risky. These same 15 stocks are unlikely to keep performing like that over the next 25 yrs, but the exercise is instructive. Why? Because it has taught you to stick with VFINX or its hedged version (VBINX), if you can’t pick stocks like these consistently AND keep track of both the “story” and the earnings projections that support their pricing. Nine of the 15 are Dividend Achievers, and a different group of 9 have high enough revenues to appear on the Barron’s 500 List. Those 11 stocks are the ones you’ll want to research before starting a new DRIP.

Business schools teach that there are only two ways to beat the market: 
   1) take on more risk, which means higher costs because you’ll be trading more frequently; 
   2) trade on insider information, which is illegal unless you own the entire company (Warren Buffett's preferred strategy).

Bottom Line: This week’s Table has 15 stocks that have defied gravity for the past 25 yrs, i.e., outperformed the market while incurring less risk. And, they’ve grown dividends faster (see Column H in the Table) than the 25-yr inflation rate of 2.3%. Seven of those 15 companies are in the Consumer Staples industry.

You can "whittle away" risk, as we've done here, but it’s just another hedging strategy based on past performance. All such plays are intended to insulate your portfolio from a stock market crash. But they also limit your portfolio's upside potential. Historically, the S&P 500 Index has been found to move higher 55% of the time. By hedging, you're trading a smoother ride for lower performance. Sometimes you’ll find a smoother ride with better performance, as shown in this week’s Table. But for how long will that continue? 

Risk Rating: 4

Full Disclosure: I own shares of MKC, PEP, ITW, and PG.

NOTE: Metrics in the Table are current as of the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, which is the Vanguard Balanced Index Fund (VBINX).

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

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).

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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