Month 112 - WATCH LIST: 28 A-rated Non-financial Companies in the iShares Top 200 Value ETF - October 2020

Situation: Savers eventually come to realize that they need to invest for income, to realize a positive return on investment (ROI). ROI is the most common profitability ratio.

    ROI is calculated by subtracting the initial value of the investment from the final value of the investment (which equals the net return), then dividing this new number (the net return) by the “cost of investment”, and, finally, multiplying by 100. For an asset in an investor’s portfolio, the “cost of investment” equals inflation + transaction costs.

Inflation is the only cost from owning Savings Bonds or an FDIC-insured savings account, there being no transaction costs. But savers typically incur a negative ROI because the interest rate credited to their account is almost always lower than the inflation rate, unless they bought Inflation-protected Savings Bonds.

The woke saver’s goal is to invest in assets that have low transaction costs but also have interest or dividend rates that cover inflation: stocks and bonds. An “investment-grade intermediate-term” bond fund, like the Vanguard Total Bond Market Index ETF (BND), is a suitable choice except during periods of hyperinflation. That’s because the value of bonds already held in the fund, referred to as “legacy” bonds, will fall when inflation is rising briskly. Why? Because the interest rate on legacy bonds will be lower than the rate of inflation. 

The dividend yield on stocks and stock ETFs could also lag behind rising inflation. However, the companies that pay those dividends usually grow their earnings and dividends faster during inflation, partly because the value of the dollar keeps falling. The investor’s ROI will likely remain positive, since it reflects growth in the stock’s price (from faster earnings growth) and growth in the dividend payout. 

Our saver, whom we now call an investor because she knows enough to seek out value (by looking to pay low transaction costs for apparently underpriced assets), will need to shop among different high-yielding assets to sustain ROI growth: 1) a bond-heavy “balanced” mutual fund like the Vanguard Wellesley Income Fund (VWINX), 2) a high-yielding stock index ETF like the Vanguard High Dividend Yield Index Fund (VYM), and 3) individual stocks selected from the VYM portfolio. 

Mission: Analyze stocks in the iShares Top 200 Value Index ETF (IWX) that are also in VYM’s portfolio and meet these 5 criteria: have a) at least a 20-year trading record, b) an S&P bond rating of A- or higher, c) an S&P stock rating of B+/M or higher, d) a positive Book Value for the most recent quarter (mrq), and e) positive earnings for the Trailing Twelve Months (TTM). These criteria narrow your choices to a manageable but high quality Watch List. If you don’t have time to follow all 28 companies, confine your attention to the 21 companies that are also in the S&P 100 Index (see Column AR in the Table) or the 16 companies that are also in the 65-stock Dow Jones Composite Average (see Column AS in the Table).

Execution: see Table.

Administration: For comparison purposes, I list the 9 Financial Services companies separately because the Federal Open Market Committee (FOMC) has promised to keep interest rates near zero through 2023. Financial Services companies profit from the “spread” between what they pay for money and what they make from that money. With interest rates for 15-year home mortgages moving lower than 2.5% and 5-year inflation rates moving higher than 1.8%, there is little profit potential on the horizon.

To calculate the annual ROI of a publicly-traded corporation, divide Earnings Before Interest and Taxes (EBIT line of Net Income statement) by Total Assets (at the bottom of the Balance Sheet statement). You want the most recent information available, which is ROI for the Trailing Twelve Months (TTM). That is similarly calculated using the 4 most recent quarterly Net Income and Balance Sheet statements (see Column AT in the Table). 

Bottom Line: You’ll need to focus on large-capitalization stocks in your retirement account that pay a good and growing dividend. Why? There are 4 reasons: Those companies have 1) multiple product & service lines that likely can be managed to allow the company to continue growing earnings during a recession; 2) multi-billion dollar credit lines are already in place, 3) banking relationships are already in place that make it possible for each company to issue new long-term bonds with low interest rates during a recession, and 4) these companies are what you need to invest in, if you want to achieve total returns that come close to those achieved by the gold standard that we all measure our investment returns against, which are the capitalization-weighted S&P 500 Index ETFs like SPY (see Line 47 in the Table), which large brokers like Fidelity offer at negligible cost. 

Possible BUYs among Value Stocks (i.e. those with green highlights in both Column AD and Column AF of the Table). There are 9 such stocks: Pfizer (PFE), Cisco Systems (CSCO), Intel (INTC), American Electric Power (AEP), Duke Energy (DUK), Comcast (CMCSA), Southern (SO), Eaton PLC (ETN) and International Business Machines (IBM). The “possible BUYs” need to    1) not be overburdened with debt (see red highlights in Columns S-U of the Table);

  2) have a PEG ratio no greater than 2.5 (Column AI), and

  3) have high Returns On Tangible Capital Employed (Column O) and Returns On Investment (Column AT).

Intel (INTC) and Cisco Systems are the only ones that have a Return On Investment (TTM) greater than 15% (see Column AT in the Table). Findings: PFE, CMCSA and IBM are overburdened with debt; AEP, DUK, SO, ETN and IBM have high PEG ratios. The only remaining companies, CSCO and INTC, do have high returns (Earnings Before Interest and Taxes) on Tangible Capital Employed and Total Assets (see Columns O and AT in the Table), and are therefore “possible BUYs.”

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

Full Disclosure: I dollar-average into MRK, PFE, INTC, PG, WMT, CAT, and also own shares of NEE, CSCO, TGT, DUK, KO, JNJ, CMCSA, SO, MMM IBM.

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

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Month 96 - Watch List for S&P 100 Companies in the Vanguard High Dividend Yield Index - June 2019

Situation: All investors have an objective as well as a plan to reach that objective. I started with the objective of getting my children through college, then moved on to having a comfortable retirement. Direct stock ownership has been a key part of both plans. Why stocks? Because mutual funds are sold on the basis of long-term performance records, not safety from market crashes. But a small group of stocks are relatively safe because of being issued by a large company that reliably pays a good and growing dividend. The trick is to have a Watch List of 20-30 such companies and know “the story” behind each company.

Mission: Use our Standard Spreadsheet to evaluate companies in the S&P 100 Index that also appear in the FTSE High Dividend Yield Index, i.e., the ~400 companies in the FTSE Russell 1000 Index that reliably pay an above-market dividend. Our source document is the list of companies in VYM (the capitalization-weighted Vanguard High Dividend Yield ETF,
which is the US version of the FTSE High Dividend Yield Index.

Execution: see Table showing a spreadsheet with 36 columns of information for commons stocks issued by 27 US companies.

Administration: 54 companies are common to both indexes but 27 have been  excluded from our Watch List because an item of information needed to populate a cell in the spreadsheet is missing and/or the company's S&P ratings are too low to denote above-average safety. We require an A- bond rating or better and a B+/M stock rating or better.

A key requirement is to avoid overpaying for a stock. I’m a numbers guy, so I use two numbers to decide if a stock is overpriced (where “price” or P is defined as the 50-day moving average):
   1) the 7-yr P/E is greater than 30 (see Column AD in the Table. 
   2) the stock’s Graham Number, which is the square root of 22.5 times EPS (Earnings Per Share) multiplied by BV/Sh (Book Value Per Share), is greater than 250% of its price (see Column AB in the Table). 

If only one of those two numbers is over the limit, the stock is still overpriced if the other number is close to the limit (more than 25 or 200%, respectively).

Another key requirement is to know whether a company's stock is a worthwhile investment, given its current price. As a starting place, I’ve devised a Basic Quality Screen that has only 6 elements and a maximum score of 4 (see Table):
   1) If price appreciation over the past 16 years has been greater than 1/3rd the risk of short-term loss as determined by the BMW method, one point is added. In other words, 16-Yr price appreciation in Column K is greater than 1/3rd the risk in Column M.
   2) If Tangible Book Value in Column S is negative and either LT-debt represents more than 50% of Total Capital (Column O), or Total Debt is more than 250% of EBITDA (Column P), one point is subtracted. 
   3) If the S&P Bond Rating in Column U is A- or better, one point is added. 
   4) If the S&P Stock Rating in Column V is B+/M or better, one point is added. 
   5) If Net Present Value of dividend growth (based on trailing 5-Yr dividend growth in Column H) and cash-out value after a 10 year Holding Period (determined by extrapolation of trailing 16-Yr price appreciation in Column K) is a positive number when applying a Discount Rate of 10% (see Column Z), one point is added. 
   6) If the two markers of an overpriced stock noted above (see Columns AB and AD) indicate that the stock is indeed overpriced, half a point is subtracted.

The final SCORE is found in Column AJ.

Bottom Line: As expected, these 27 companies have not performed as well as SPY, the S&P 500 Index ETF (see Line 29 to Line 35 at Columns C through F in the Table). But these 27 companies pay a higher dividend (Column G) and have lower price volatility (see Columns I & M) than SPY. Estimates for Net Present Value after a 10 year holding period (assuming a continuation of the trailing 5 year dividend growth rate and the trailing 16 year price growth rate and trading costs of 2.5% at the time of purchase and sale) were higher than SPY (see Column Z).  

Conclusion: These 9 stocks appear to be over-priced (see Columns AB and AD): CSCO, KO, TXN, PEP, JNJ, LMT, MMM, CL and UPS. These 12 appear to be bargain-priced “value stocks” based on Book Value, Graham Number and average 7 year P/E (see Columns AA-AE): PFE, NEE, DUK, INTC, TGT, SO, JPM, CMCSA, USB, BLK, XOM and WFC. These 10 appear to be worthwhile investments because of having a score of either 3 or 4 on our Basic Quality Screen (see Column AJ): PFE, NEE, DUK, INTC, PG, SO, JPM, WMT, CAT, BLK.

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

Full Disclosure: I dollar-average into NEE, KO, INTC, PG, JNJ, JPM, WMT, CAT and IBM. I also own shares of PFE, CSCO, DUK, SO, PEP, MMM, BLK, UPS and XOM. Note that all but two (BLK and PEP) of those 18 are in the 65-stock Dow Jones Composite Average.

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

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Week 367 - Safe and Effective Stocks

Situation: The stock market is becalmed, waiting for wind to fill its sails. "Risk-On" investors seem to be out of ideas, except for a renewal of interest in the energy sector. The bond market is experiencing hard-to-predict volatility. Safe stocks that will grow your money effectively are hard to find. The formula for Net Present Value tells us that more value is found when your original investment is returned to you quickly. Therefore, an “effective” stock is one that pays a good and growing dividend. 

Mission: “Safe stocks” = an oxymoron. Basically, we’re looking for a group of high-quality stocks issued by companies in “defensive” industries (Utilities, HealthCare, Consumer Staples, and Communication Services). “Effective stocks” are those that a) pay an above-market dividend, b) grow that dividend at an above-market rate, and c) have an above-market 16-Yr CAGR. Our reference for the “market” is the Dow Jones Industrial Average ETF (DIA). 

Execution: see Table.

Administration: What are “high-quality” stocks? Those are either “Blue Chips” (see Week 361) or members of “The 2 and 8 Club” (see Week 327 and Week 348) plus its Extended Version (see Week 362). “Safe and effective” stocks are those that have no red highlights in Columns D, E, G, I, K, and M of the reference Tables. (Red highlights indicate underperformance vs. DIA.) In addition, we require that the company be a Dividend Achiever, and that its long-term bonds have an S&P rating of A- or better (see Column T).   

Bottom Line: We find that only 5 companies issue “safe and effective” stocks (see Table). Were you to own shares of similar value in all 5, you wouldn’t be gambling. In other words, your risk-adjusted returns would likely “beat the market” by 1-2%/yr over a market cycle. But your transaction costs would also be 1-2% higher vs. owning shares in the leading S&P 500 Index Fund (SPY).  

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

Full Disclosure: I dollar-average into NEE, KO, and JNJ.

"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.

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Week 366 - A Capitalization-weighted Watch List for Russell 1000 Companies

Situation: Every stock-picker needs to confine her attention to a manageable list of companies, called a “Watch List.” Here at ITR, the focus is on investing for retirement. So, our interest is in companies that have a higher dividend yield than the S&P 500 Index. Why? Because your original investment will be returned to you faster, which automatically gives your portfolio a higher “net present value” than a portfolio composed of companies that pay either no dividend or a small dividend. Once you’ve retired, you’ll switch from reinvesting dividends to spending dividends.

Mission: Assemble a Watch List composed of companies that are “Blue Chips” (see Week 361), companies that are in “The 2 and 8 Club” (see Week 344), and companies that are in the Extended Version of “The 2 and 8 Club” (see Week 362). 

Execution: see Table.

Bottom Line: If you’re saving for retirement and would like to pick some individual stocks to supplement your index funds, here is an effective and reasonably safe Watch List. However, the mutual funds that pick individual stocks haven’t done very well compared to benchmark index funds. So, your chances of doing well as a stock-picker also aren’t good. But index funds like the SPDR S&P 500 (SPY) expose you to significant downside risk. There is one conservatively managed mutual fund that we think is an excellent retirement investment, the Vanguard Wellesley Income Fund, which is mostly composed of bonds. Your risk of loss from owning VWINX is less than half that from owning SPY; the 10-Yr Total Return is 7.0%/yr vs. 9.0%/yr for SPY.

Risk Rating for our Watch List: 7 (where US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10).

Full Disclosure: I dollar-average into MSFT, JPM, XOM, WMT, PG, KO, IBM, CAT and NEE, and also own shares of GOOGL, CSCO, MCD, MMM, TRV, CMI and ADM.

"The 2 and 8 Club" (CR) 2018 Invest Tune Retire.com All rights reserved.

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Week 344 - “The 2 and 8 Club” Updated

Situation: Stock-pickers need a Watch List of companies to pick from, one that is short enough to allow buyers to make a timely decision to buy or sell. “The 2 and 8 Club” (see Week 327) currently has 21 members that we’ve picked from the S&P 100 Index. Although our Tables are filled with data, those numbers are necessary but not sufficient for investors to take action. There needs to be a story that explains why this or that company in “The 2 and 8 Club” is likely to outperform, given that the S&P 100 Index ETF (OEF) is even harder to beat than the S&P 500 Index ETF (SPY). For example, compare Line 29 in the Table to Line 31. 

“The story” will change as circumstances dictate. Each company’s Board of Directors will have to assess inevitable challenges to The Business Plan, then decide to either endorse the changes recommended by the CEO or replace the CEO. It isn’t easy. Looking at the past 35 yrs of statistical data, only 4 stocks in “The 2 and 8 Club” have outperformed the S&P 500 Index with no greater volatility: 
   Caterpillar (CAT),
   CVS Health (CVS),
   3M (MMM),
   NextEra Energy (NEE).

This suggests that the biggest and best companies are unlikely to grow their dividends faster than 8%/yr for more than two market cycles. Many will drop out of “The 2 and 8 Club” and be replaced by upstarts. To use “The 2 and 8 Club” as a Watch List, you need to be an active trader. That means tracking the performance of all S&P 100 companies that are found in the Vanguard High Dividend Yield Fund VYM, which is managed by Morningstar to represent all of the American companies listed in the FTSE All-World High Dividend Yield Index. Think of VYM as the ~400 companies in the Russell 1000 Index that a) pay an above-market dividend, and b) are unlikely to cut their dividend during a recession. 

Mission: Update “The 2 and 8 Club” (see Week 327).

Execution: see Table.

Administration: Over a market cycle, you can expect to make more money at less risk by investing in VYM than by investing in the largest S&P 500 Index ETF (SPY), i.e., compare Lines 28 and 31 in the Table. To create “The 2 and 8 Club”, we simply take the S&P 100 companies from VYM that a) have grown their dividend at least 8%/yr over the past 5 yrs, b) have a 16+ year trading record for statistical purposes, c) have an S&P bond rating of at least BBB+ (this is a change from our initial requirement of at least an A- rating), and d) have an S&P stock rating of at least B+/M.

Bottom Line: Successful stock-pickers are a tad compulsive, happy to toil alone at their hobby. (Warren Buffett couldn’t understand why his wife left him to become an artist living in San Francisco.) It helps to have a workable Watch List, one that has a high signal-to-noise ratio. We like the companies in the S&P 100 Index because they have a) multiple product lines, and b) efficient price discovery, i.e., are required to have active put and call options on the CBOE (Chicago Board Options Exchange). We also look for companies in the S&P 100 Index that have a high Net Present Value, which is difficult to achieve for companies that don’t pay a good and growing dividend. So, we require at least a 2% dividend and an 8% dividend growth rate for membership in our Watch List, accordingly named “The 2 and 8 Club”. 

Caveat Emptor: If you choose to pick stocks by using this algorithm, you’re a gambler (see red highlights in Columns I and M in the Table). In other words, you’re taking on more risk than you would by owning an S&P 500 Index fund like SPY. Yes, you’ll likely have higher returns but that will be accompanied by higher volatility. As a frequent trader, you’ll also be paying higher taxes and absorbing higher transaction costs.

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 MSFT, JPM, MMM, IBM and NEE, and also own shares of CSCO, PEP, AMGN, MO, TXN, CAT and TGT.

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

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Week 336 - Version 3.0 of The Growing Perpetuity Index Reflects “The 2 and 8 Club”

Situation: We started this blog six years ago with the idea to create a Growing Perpetuity Index as a way to save for retirement, by selecting from a workable “watch list” of high-quality stocks (see Week 21). We chose to base the index on companies in the 65-stock Dow Jones Composite Average (^DJA), and ended up selecting 12 from the 14 that had earned S&P’s designation of Dividend Achiever, i.e., companies that had raised their dividend annually for the previous 10 years or longer:
        Exxon Mobil
        Wal-Mart Stores
        Procter & Gamble
        Johnson & Johnson
        IBM
        Chevron
        Coca-Cola
        McDonald’s 
        United Technologies
        3M
        Norfolk Southern
        NextEra Energy

Our thought was that investors could select stocks from this index to safely dollar-cost average automatic online contributions into their Dividend Reinvestment Plan (DRIP). That would allow relatively safe and efficient growth in their retirement assets. Version 2.0 (see Week 224) added back the two companies that had been left out, Caterpillar (CAT) and Southern Company (SO), plus two newly qualified companies: Microsoft (MSFT) and CSX (CSX).

Now we’ll apply a lesson learned from running Net Present Value (NPV) calculations, namely that Discounted Cash Flows from good and growing dividends are more likely to predict rewards to the investor than Capital Gains from a history of price appreciation. Accordingly, Version 3.0 re-casts the index to include only those ^DJA companies that are in “The 2 and 8 Club” (see Week 329) of high-quality companies with a dividend yield of at least 2% and a dividend growth rate of at least 8% for the past 5 years. The result is a 13 company Watch List, not all of which are Dividend Achievers. Only 7 are holdovers from Growing Perpetuity Index, v2.0:
   NextEra Energy
   3M
   Exxon Mobil
   Coca-Cola
   IBM
   Microsoft
   Caterpillar

Mission: Apply our standard spreadsheet (see Table) to the 13 companies in the 65-company Dow Jones Composite Index that are in “The 2 and 8 Club.”

Execution: see Table.

Bottom Line: The value of picking from among the highest-quality stocks in the Dow Jones Composite Index is not just that it’s the smallest and oldest index, but also that it is continuously vetted by the managing editor of The Wall Street Journal. Companies that don’t stand muster are replaced by companies that do. By adding the several requirements for inclusion in “The 2 and 8 Club” (e.g. S&P bond ratings cannot be lower than A-), you have a good chance of selecting half a dozen stocks that will beat the S&P 500 Index over a 10-Yr Holding Period (see Column Y in the Table). You’ll also be taking on more risk (see Columns D, I, and M in the Table), which you’ll ameliorate by trading new entrants to “The 2 and 8 Club” for those that are leaving.

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

Full Disclosure: I dollar-cost average into MSFT, XOM, NEE, KO, JPM and IBM, and also own shares of TRV, PFE, MMM, and CAT.

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

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Week 334 - Barron’s 500 Commodity Producers That Pay Good And Growing Dividends

Situation: In recent weeks, we’ve seen how difficult it is for a stockpicker to beat the S&P 500 Index. But by selecting a number of stocks from a high quality list of 30 stocks with good and growing dividends, i.e., “The 2 and 8 Club” (see Week 329), you might meet that goal. 

The downside is that you have to worry about risk-adjusted returns. After all, a low-cost S&P 500 Index fund has transaction costs of less than 0.2%/yr, and doesn’t confront you with capital gains taxes until you after you retire (when you’ll be in a lower tax bracket). As a stockpicker, your transaction costs will be at least 1% of Net Asset Value (NAV) each year. And, if you’re diligent about selling stocks whenever their 5-Yr dividend growth rate drops below 8%/yr, you’ll face a capital gains tax of ~1% of NAV because you’ll have real gains after almost every sale. That means you have to pick a discount rate (to project likely returns) that is 2%/yr higher than the discount rate for the S&P 500 Index, which is 7.0%/yr, since the 20-Yr total return for SPY (the SPDR S&P 500 Index ETF) is 7.0%/yr. That’s why we use a 9% Discount Rate when calculating Net Present Value (NPV) for columns V through Y in our Tables.

You’re chances of beating the S&P 500 Index in a risk-adjusted manner come down to two options: 1) pick only those stocks that have less volatility than the S&P 500 Index (see companies without red highlights in Column M in any of our Tables); 2) pick stocks issued by companies that have the most volatile earnings because those will outperform the S&P 500 Index by the widest margin when their industry is in a Bull Market. This week we’ll look at Commodity Producers, since that’s the highest risk industry outside real estate. Note: Real Estate stocks are excluded from our baseline index for “The 2 and 8 Club”, which is the FTSE High Dividend Yield Index.

Mission: Set up a spreadsheet limited to Commodity Producers in “The 2 and 8 Club”, because almost all of those have shown higher price volatility over the past 16 years than the S&P 500 Index per the BMW Method.  

Execution: see the 12 companies in this week’s Table.

Administration: Starting with Commodity Producers in the FTSE High Dividend Yield Index that are also in the 2017 Barron’s 500 List, we exclude any that do not have an S&P credit rating of BBB (or better) and an S&P stock rating of B/M (or better). We also exclude any that do not have the 16 years of price data required for statistical analysis by the BMW Method. 

Bottom Line: Commodity Producers have one thing in common. They’re inefficient deployers of capital (see Columns Z and AA in the Table). In other words, these companies fail to meet the standard metric for efficiency, which is that Return on Invested Capital (ROIC) is more than twice the Weighted Average Cost of Capital (WACC). Pulling stuff out of the ground almost always wastes capital at some point, unless there is an opportunity for combining a) Economies of Scale with b) oversight of each worksite by a Funds Administrator.

Note that 3 companies (ADM, APD, PX) in the 30-stock Extended Version of “The 2 and 8 Club” (see Week 329) are among the 12 companies that pass this week’s screen of Commodity Producers (see Table). Those 3 are the best place to start your research.

Risk Rating = 9, where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10.

Full Disclosure: I dollar-cost average into XOM and also own shares of CAT.

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

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Week 332 - Defensive Companies in “The 2 and 8 Club”

Situation: The Dow Jones Industrial Average keeps making new highs, “confirmed” by new highs in the Dow Jones Transportation Average. According to Dow Theory, we are in a “primary” Bull Market. That is a period when investors should be paying off their debts and/or building up cash reserves. It is also a period when stocks in “growth” companies become overpriced, and stocks in “defensive” companies become reasonably priced (after having been overpriced). It’s a good time to research high-quality companies in “defensive” industries: Consumer Staples, Health Care, Utilities, and Communication Services. 

Mission: Develop our standard spreadsheet for companies in “The 2 and 8 Club” (see Week 327) that are in defensive industries (see Week 327), and add any companies that are close to qualifying.

Execution: (see Table)

Administration: We’ll use the Extended Version of “The 2 and 8 Club”, which simply matches companies on two lists: The Barron’s 500 List and the 400+ companies in the FTSE High Dividend Yield Index. The Barron’s 500 List is published annually in May, and ranks companies by their 1 & 3 year Cash Flows from Operations, as well as their past year’s Revenues. The FTSE High Dividend Yield Index lists US companies that pay more than a market yield (~2%) and are thought unlikely to reduce dividends during a Bear Market. Companies that appear on both lists but do not have a 5-Yr Compound Annual Growth Rate (CAGR) of at least 8% for their quarterly dividend payout are excluded, as are any companies that carry an S&P Rating lower than A- for their bonds or lower than B+/M for their stocks.

Note the inclusion of Costco Wholesale (COST) at Line 4 in the Table. Although it has an annual yield lower than the required 2% for its quarterly dividend, the company has also issued a supplementary dividend every other year for the past 5 years. In those years, the dividend yield exceeds 5%. In calculating Net Present Value (see Column Y in the Table), we have used adjusted values for Dividend Yield (5.4%) and 5-Yr Dividend Growth (2.1%) in an effort to present an assessment closer to reality. That boosts NPV 42% over what it would be had supplemental dividends been ignored.

Note the inclusion of Coca-Cola (KO) at Line 9 in the Table. Although it has a 5-year dividend CAGR of 7.7%, which is slightly lower than our 8% cut-off, KO is a “mega-capitalized” company that has a major influence on prospects for the Consumer Staples industry.  

Bottom Line: Experienced stock-pickers can usually look forward to a decent night’s sleep, if experience has taught them to overweight their portfolio in high-quality “defensive” stocks that pay a good and growing dividend. By restricting our Watch List to companies in “The 2 and 8 Club”, we’ve found that there are only 10 defensive stocks you need to consider during this opportune time, i.e, when valuations are lower for “defensive” stocks because “growth” stocks become the overcrowded trade in a primary Bull Market.

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

Full Disclosure: I dollar-cost average into KO and NEE, and also own shares of COST, AMGN, MO, and HRL.

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

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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.

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

Week 316 - 2017 Barron’s 500 List: A-rated “Defensive” Companies That Moved Up In Rank During The Commodity Recession

Situation: A stock-picker can’t beat the market, given that transaction costs and tax inefficiencies reduce returns by 1-3%/yr compared to the lowest-cost S&P 500 Index fund  (VFINX), which returns 7-8%/yr. To effectively compete with that, stock picks would need to return 9%/yr. That’s one of the reasons why we use a discount rate of 9% when calculating Net Present Value. 

In business school, I was taught that there are only two ways to beat the market: Plan A is to trade on “insider information” (patently illegal); Plan B is to take outsize risks (i.e., run a portfolio where the capitalization-weighted 5-Yr Beta is greater than 1.0). Those of us who are employed full time in Financial Services may become good stock-pickers because we know a particular industry very well, the result being that we overweight our picks in that industry. In other words, we’re engaged in a legal form of insider trading. For example, doctors and dentists are often savvy traders of health-care stocks. 

The stock-picker who had the longest run beating the S&P 500 Index was Peter Lynch, who managed Fidelity’s Magellan Fund from 1977 through 1990. He relied on diversification, running ~1000 stocks with the help of a dozen analysts, but focussed on retail stocks. He claimed that the insights his wife shared with him after a day of shopping were pivotal to his success. You get the point: Invest in what you know.

But what about Plan B (risk taking)? Like Plan A, that approach requires you to run a portfolio concentrated in particular industries. But unlike Plan A, those stocks have to be in boring “Defensive” industries, i.e., the ones where sales grow only as fast as the population grows (Consumer Staples, Healthcare, Communication Services, and Utilities). By overweighting defensive industries, you insulate your portfolio. When the market crashes, those industries tend to keep on growing their earnings. Than means you’re following Warren Buffett’s Rule #1: Never Lose Money.

Mission: Analyze the recent Commodity Recession (see Column D at Line 26 in the Table), which was almost severe enough to keep both GDP and the S&P 500 Index from growing. 

Execution: see Table.

Administration: Commodities are a key driver of the economy, so the Commodity Recession gave us a rare opportunity to see which companies out-perform without that key driver. You’ll need some background information. Of the 22 commodity futures contracts that compose the Bloomberg Commodity Index, the 5 classified as “Energy” are strongest, with a combined weight of 30.57% (Natural Gas, Brent Crude Oil, West Texas Intermediate Crude Oil, Ultra-Low Sulfur Diesel, and Unleaded Gasoline). When those are down ~20%, the S&P 500 Index will barely rise even though GDP might keep going up. Whether we like it or not, the prices of petroleum products will be the best predictors of the stock market for the next 10+ yrs. To be successful, a stock-picker has to anticipate the ups and downs in prices for energy commodities, and be positioned to reap good returns from stocks of A-rated S&P 500 companies that maintain or improve their valuation metrics during a commodity recession. 

Key metrics relate to cash-flow based ROIC, specifically the most recent year vs. the 3-Yr median, as well as sales growth for the most recent year. The Barron’s 500 List (published each May) ranks the largest 500 companies on the New York and Toronto stock exchanges in terms of those 3 metrics. We’re interested in knowing the names of ALL the A-ranked S&P 500 companies that moved up in rank. Most of those will be in “Defensive” industries. The few that are in “Growth” industries either have a business plan that allows them to be “hardy perennials,” or enjoy a special situation that allows them to take advantage of a Commodity Recession. This week we cover “Defensive” industries. Next week we’ll cover the few “Growth” industry out-performers.    

Bottom Line: The costs associated with owning the Vanguard 500 Index Fund (VFINX) are nil, whereas, the costs of owning (and trading) stock in a few dozen companies are substantial. And, the capital gains taxes that you’ll pay each year for trading those stocks are erratic and immediate vs. what you’ll pay upon eventually selling your VFINX shares. Your stock portfolio has to outperform the S&P 500 Index by 2-3%/yr to equal the returns you’d realize from owning VFINX shares. Invest smart, by knowing that the market goes down eventually and doing something about it ahead of time. Either stick to industries you know, or hedge by overweighting the stocks of companies in “Defensive Industries.” The 14 shown in the Table are a good place to start your research. Pay close attention to Columns P-S because even these companies can swoon in a market crash if they have messy Balance Sheets (messiness is highlighted in purple).

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

Full Disclosure: I dollar-average into JNJ and KO, and also own shares of HRL and WMT.

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

Week 312 - Farm Equipment

Situation: Food production is experiencing a “glitch.” Too many people know how to do it too well. Food commodities are being supplied in excess of demand, tapping out storage facilities. Farmers are doing well to “break even” after expenses, i.e., Cost of Goods Sold (CGS) is barely covered by prices paid at the grain elevator. There may not be enough money left to make “precision farming” upgrades to farm equipment. Relations between farmers and their bankers have become strained, since bankers typically refuse to make long-term loans for anything other than farmland. That leaves farm equipment dealers having to make the long-term loan or forego the sale.

Mission: Outline the equipment requirements for farming and create a spreadsheet of public companies that supply such equipment.

Execution: see Table.

Administration: Farming is now in the digital age, where GPS satellites collect information on vegetation and soil that the farmer can buy to better regulate irrigation and the application of fertilizer. His agronomist will use the data to make more cost-effective decisions on the use of pesticides, herbicides, and fungicides. “Precision farming” can sometimes double crop yields compared to the pre-satellite era. But the result of using these devices on his tractor, wi-fi downloads to his agronomist, and upgrades to the accompanying software has not only been expensive but the added efficiencies have to cut crop prices in half. The “family farm” is rapidly disappearing from the planet.

Bottom Line: Commodities will always be risky investments, even the most essential (food and fuel). When there is something people can’t “live” without, the business world will allocate capital toward its production. That effort continues until overproduction converts multi-year profits to multi-year losses. Subsistence farming is giving way to corporate farming because of the abundance of capital being allocated to crop production. Shortages of skilled labor limit the buildout of “precision farming”, giving rise to further technological breakthroughs. These are expensive, and contributed to the 10.5% decline in US farm incomes last year, extending a trend that started in 2014. 

The increases in farm productivity are likely to keep crop prices low until the less-efficient farms (both family and corporate) go out of business. We’re in a period when farmers are less able to afford new equipment and need to make greater use of services to upgrade existing equipment, where Deere (DE) is the dominant company. An increased emphasis will also be placed on non-food uses for corn (268 processing plants in US and Canada) and oilseeds (64 processing plants in US and Canada), where Archer Daniels Midland (ADM) is the dominant company with 265 food & non-food processing plants worldwide. Ethanol, biodiesel, and soy oil plants dot the landscape of farming regions and are a convenient point of sale for farmers, which also link to rail and barge networks that transport crops to food processing plants worldwide. Investors also need to consider owning stock in one of the smaller companies: e.g. Raven Industries (RAVN is the leading supplier and servicer for precision agriculture products) and Valmont Industries (VMI is the leading supplier and servicer for center-pivot irrigation systems).   

Risk Rating: 7-8 (where 10-Yr US Treasuries = 1, S&P 500 Index = 5, and gold = 10). 

Full Disclosure: I dollar-average into XOM and also own stock in CMI, preferring to wait and see whether a new commodity supercycle will be starting soon.

Note: We use discounted cash flow from dividends and sale of the stock (after a 10-Yr holding period) to estimate Net Present Value; see Columns V-Z in the Table. The exponential growth rate in stock price over the next 10 years is estimated to be an extrapolation of the growth in stock price over the past 16 years. The Discount Rate is set at 9%, meaning that a stock with a positive NPV would return more over 10 years than a 10-Yr US Treasury Note paying 9%/Yr. Dividend Growth over the next 10 years is extrapolated from Dividend Growth over the past 4 years. Be aware that our NPV calculation is for comparative purposes only. Any rise in the rate of interest paid by 10-Yr Treasury Notes would diminish stock NPVs, provided that those Notes continue to carry a AAA credit rating from S&P.

Red highlights in the Table denote underperformance relative to our benchmark: Vanguard Balanced Index Fund (VBINX) at Line 22. Purple highlights denote metrics of concern.

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

Week 306 - A-rated Dividend Achievers That Have Outperformed The S&P 500 For 25 Years At Lower Risk

Situation: Some companies have served investors well over the past 25 yrs, compared to an investment in the Vanguard 500 Index Fund (VFINX). If we define “gambling in the stock market” as a statistical probability of losing more than you would from VFINX in any given market calamity, we find that 10 of those outperforming companies aren’t gambles. As long as those companies retain their management culture, as well as their competitive advantages, they’ll continue to outperform at less risk vs. the S&P 500 Index. 

Mission: Subject those 10 companies to our standard spreadsheet analysis, except that in calculating Net Present Value we’ll use the rate of price appreciation over the past 25 yrs instead of 16 yrs, i.e., the BMW Method.

Execution: see Table.

Administration: Our conditions for inclusion are that companies must meet a high standard of quality. S&P ratings for both their stock and bond issues cannot be lower than A-. Balance Sheets must be clean, meaning that Long-Term Debt cannot constitute more than a 1/3rd of total assets, Tangible Book Value cannot be negative (we grant a little leeway in the event of a recent acquisition), and dividends have to be paid from Free Cash Flow (FCF). Companies must have annual revenues that are high enough to warrant inclusion in the Barron’s 500 List of large US and Canadian companies. 

Bottom Line: These 10 companies represent 6 of the 10 S&P Industries (see Column Z in the Table). Each stock’s predicted risk of loss (at 2 Standard Deviations below trendline price appreciation per the BMW Method) is less than the S&P 500 Index’s projected loss (see Column M in the Table). All 10 have positive NPVs at a 9% Discount Rate, suggesting that you’re likely to realize at least a 9%/yr total return over a 10 year Holding Period, whereas VFINX has a negative NPV (see Column Y in the Table). Hormel Foods (HRL) and NextEra Energy (NEE) have the highest NPVs.

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

Full Disclosure: I dollar-average into NEE, and own shares of TRV, ABT, MMM, and HRL.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote under-performance vs. VBINX at Line 18 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 3-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning shares in a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table. The ETF for that index is MDY at Line 17. For bonds, Discount Rate = Interest Rate.


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