Situation: Investors should pay attention to asset classes that fluctuate in value out-of-sync with the S&P 500 Index. Such asset classes are said to have minimal or negative “correlation” with large-capitalization US stocks. Emerging markets and raw commodities are important examples. Those are a natural pair, given that most countries in the emerging markets group have an economy that is based on the production of one or more raw commodities.
The idea that you can find a safe haven for your savings, one which will allow you to ride out a crash in the US stock market, is a pleasant fiction. Articles in support of that idea are published almost daily. But unless you are a trader who can afford to rent or buy a $500,000 seat on the Chicago Mercantile Exchange, you probably aren’t deft enough to arbitrage the various risks accurately enough before they develop (and at low enough transaction costs) to avoid losing money in a crash.
If you really want to ride out most crashes, invest in a bond-heavy balanced mutual fund that is managed by real humans. The Vanguard Group offers one best, and it comes with very low transaction fees (Vanguard Wellesley Income Fund or VWINX). To refresh yourself on the competitive advantages of investing in food and agriculture companies, see our most recent blog on the subject (see Month 91). To refresh yourself on the competitive disadvantages, study this month’s Table and Bottom Line carefully.
The essential fact is that economies require money for spending and investment. That comes down to having consumers who are confident enough about their employment prospects and entrepreneurs who are confident enough about their ability to invest. Those consumers and entrepreneurs can be relied upon to transfer their successes to the larger economy by saving money, taking out loans, and paying taxes. National economies are interlinked. Because of the size and innovation of its marketplace, the US economy is the main enabler for most of the other national economies. Logic would suggest that the valuation for any asset class will roughly track the ups and downs of the S&P 500 Index, either as a first derivative or second derivative.
Mission: Use our Standard Spreadsheet to analyze US and Canadian food and agriculture companies that carry at least a BBB rating on their bonds (see Column R).
Execution: see Table.
Administration: Of the 25 companies listed in the Table, only one meets Warren Buffett’s criteria of low beta (see Column I), low volatility (Column M), high quality (Column S), strong balance sheet (Columns N-R), and TTM (Trailing Twelve Month) earnings plus mrq (most recent quarter) Book Values that yield a Graham Number which is not far from the stock’s current Price (Column Y). That company is Berkshire Hathaway. We use a Basic Quality Screen that is less stringent as his: 1) an S&P stock rating of B+/M or better (Column S), 2) an S&P bond rating of BBB+ or better (Column R), 3) 16-Yr price volatility (Column M) that is less than 3 times the rate of price appreciation (Column K), and 4) a positive dollar amount for net present value (Column W) when using a 10-Yr holding period in combination with a 10% discount rate (to reflect a 10% Required Rate of Return).
Bottom Line: Only 8 companies on the list pass our Basic Quality Screen (see Administration above): HRL, COST, PEP, KO, DE, FAST, CNI, UNP. At the opposite end of the spectrum, 9 companies have a below-market S&P bond rating of BBB. So, those stocks represent outright gambles.
Aside from Berkshire Hathaway, none of the 25 companies can be said to issue a reasonably priced “value” stock. We’re dealing with 24 “growth” stocks, only a third of which are of high quality. Three of the 9 with BBB bond ratings have high total debt levels relative to EBITDA (see Column O in the Table) that are unprotected by Tangible Book Value (Column P): SJM, MKC, GIS. The good news is that only one of the 9 appears to be overpriced, and that company (MKC) is a quasi-monopoly that has little risk of bankruptcy because it has “cornered” the US spice market.
In summary, you can do well by investing in this space as long as you understand that you’re dealing with a fragmented food industry, one that is flush with companies of dubious quality. You might like to be well-informed about these companies because food, like fuel, is an essential good, and the food industry enjoys steady growth. Why? Because the number of people in Asia & Africa who can afford to consume 50 grams of protein per day grows by tens of millions per year.
Risk Rating: ranges from 6 to 8 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion =10).
Full Disclosure: I dollar-average into TSN, KO and UNP, and also own shares of AMZN, HRL, MO, MKC, BRK-B, CAT and WMT.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Showing posts with label qualitative risk. Show all posts
Showing posts with label qualitative risk. Show all posts
Sunday, April 28
Sunday, January 19
Week 133 - Here’s a “Safety First” Retirement Plan With Expenses Under $7/yr
Situation: We all know that investing for retirement is problematic, uncertain, and expensive. We’ve all thought about what it would feel like to depend solely on Social Security for retirement income. And, we all know that the current level of government financing for Social Security is unsustainable due to the relentless growth in the numbers and longevity of retirees, combined with ever fewer workers per retiree contributing to fund the program. Anyone over 50 who doesn’t understand the effect this could have on her sunset years hasn’t been paying attention the past few decades.
Mission: Design a personal retirement plan to supplement Social Security and workplace retirement plans. The plan must minimize transaction costs, bankruptcy risk, and inflation/deflation risk to whatever extent possible.
Here’s how we suggest setting up such a plan. Stocks grow in value during inflation while bonds grow in value during recession. You’ll need both. If you dollar-average by investing small amounts of money 50:50 into bonds and stocks on a regular basis, your retirement savings will grow regardless of inflation and deflation.
As an aside, Central Banks (such as our Federal Reserve) have so many ways to disguise and allay deflation that we only know they are doing so when interest rates fall to absurdly low levels. Pundits call it “printing money” but the technical term is Financial Repression (see Week 79). We’re in a period of financial repression now, meaning that money is so cheap for corporations and banks to obtain that prices for stocks and real estate rise faster than earnings or rents can justify. The Fed’s idea is to “jump start” the economy enough--by encouraging private investment with free money--that it will grow on its own. Once victory is declared and financial repression ends, the favor is returned. Stock and real estate prices will then slow their growth while earnings and rents catch up. Since free money will no longer be available, interest rates will rise to normal or temporarily inflated levels. When will financial repression end? Judging from precedent, that won’t be soon. To prevent deflation following World War II, it lasted from 1947 until 1980.
To eliminate the risk of bankruptcy, purchases for this plan are confined to stocks and bonds that have a AAA credit rating from Standard and Poor’s. When we checked the candidates, we found that 4 companies qualified, along with 10-yr US Treasury Notes. The stocks are Microsoft (MSFT), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Automatic Data Processing (ADP). Treasuries can be obtained at zero cost at treasurydirect; we recommend inflation-protected 10-yr Notes which are sold in January and July of each year. XOM and JNJ can be obtained at no cost through computershare, although you’ll be charged $1 for each JNJ purchase if you use automatic withdrawals from your checking account. (There is no charge for separate point-and-click JNJ purchases through computershare.) Purchases of MSFT shares through Microsoft’s online transfer agent are expensive, and there’s no online transfer agent for ADP. So, it is best to use a low-cost online broker for those. For example, you can use TD Ameritrade or Capital One. The cost per trade at those sites is currently $6.95.
JNJ is a hedge stock (see Week 126), so you don’t need to back up those purchases with an equal purchase of 10-yr Treasury Notes. That leaves 3 stocks (MSFT, XOM, ADP) to be balanced with Treasuries (or listed as 7 items in all, see the Table). For example, you could decide to invest $4,200/yr. That is, $600/yr per line item which is the same as $300/half, $150/qtr, or $50/mo. For XOM, automatic withdrawals from your checking account in the amount of $50/mo is both free and convenient using computershare. For zero-cost investments in JNJ and 10-yr Treasuries, go online every 6 months to invest $300 in JNJ at computershare and $900 in 10-yr Treasuries at treasurydirect. For lowest-cost investing ($6.95/yr) in ADP and MSFT, make alternate-year purchases of $1200 each through an online broker like Capital One or TD Ameritrade. In summary, T-Notes, JNJ and XOM are free; MSFT and ADP are purchased on alternate years for $6.95. Your out-of-pocket cost is $6.95/yr. This plan carries considerably less risk than VWINX, the safest low-cost balanced mutual fund (see Columns D and J in the Table), even though 10-yr returns are almost identical (Column F). Note: metrics in red indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX).
When you retire, change from automatic reinvestment of quarterly dividends to having the dividends mailed to you. For Treasuries, there is no automatic reinvestment of interest. You receive interest payments twice a year deposited into your checking account, and return of the principal amount ($900) after 10 yrs. When you retire, stop making any “rollover” purchases, which you may have scheduled for T-Notes that are maturing every 6 months. Then you simply receive the principal amount of maturing T-Notes in your checking account. Reinvest T-Note interest payments in inflation-protected Savings Bonds at treasurydirect and hold those for at least 5 yrs before cashing them in, at which time you’ll be taxed for the accumulated interest payments.
Bottom Line: It’s always a good idea to have a personal retirement savings account, even if you already contribute the maximum allowed amount to a company-sponsored retirement plan. Why? Because corporations can change or discontinue their employee retirement plans. And, the Federal government will no doubt be changing long-standing Social Security policies for future retirees. You can have a tax-advantaged aspect of your personal, point-and-click retirement savings account simply by having your accountant declare it to be an IRA, as long as the annual limit for contributions isn’t exceeded.
To avoid gambling with your personal retirement savings plan, you’ll need to include investments with AAA credit ratings. That way you don’t have to worry about bankruptcy. And make sure you hedge against the risk of recession because anytime that stocks go down, T-Notes go up. Finally, don’t spend any money on transaction costs that you don’t absolutely have to spend.
Risk Rating: 3
Full Disclosure: I regularly buy 10-yr T-Notes, MSFT, JNJ, and XOM.
Mission: Design a personal retirement plan to supplement Social Security and workplace retirement plans. The plan must minimize transaction costs, bankruptcy risk, and inflation/deflation risk to whatever extent possible.
Here’s how we suggest setting up such a plan. Stocks grow in value during inflation while bonds grow in value during recession. You’ll need both. If you dollar-average by investing small amounts of money 50:50 into bonds and stocks on a regular basis, your retirement savings will grow regardless of inflation and deflation.
As an aside, Central Banks (such as our Federal Reserve) have so many ways to disguise and allay deflation that we only know they are doing so when interest rates fall to absurdly low levels. Pundits call it “printing money” but the technical term is Financial Repression (see Week 79). We’re in a period of financial repression now, meaning that money is so cheap for corporations and banks to obtain that prices for stocks and real estate rise faster than earnings or rents can justify. The Fed’s idea is to “jump start” the economy enough--by encouraging private investment with free money--that it will grow on its own. Once victory is declared and financial repression ends, the favor is returned. Stock and real estate prices will then slow their growth while earnings and rents catch up. Since free money will no longer be available, interest rates will rise to normal or temporarily inflated levels. When will financial repression end? Judging from precedent, that won’t be soon. To prevent deflation following World War II, it lasted from 1947 until 1980.
To eliminate the risk of bankruptcy, purchases for this plan are confined to stocks and bonds that have a AAA credit rating from Standard and Poor’s. When we checked the candidates, we found that 4 companies qualified, along with 10-yr US Treasury Notes. The stocks are Microsoft (MSFT), Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Automatic Data Processing (ADP). Treasuries can be obtained at zero cost at treasurydirect; we recommend inflation-protected 10-yr Notes which are sold in January and July of each year. XOM and JNJ can be obtained at no cost through computershare, although you’ll be charged $1 for each JNJ purchase if you use automatic withdrawals from your checking account. (There is no charge for separate point-and-click JNJ purchases through computershare.) Purchases of MSFT shares through Microsoft’s online transfer agent are expensive, and there’s no online transfer agent for ADP. So, it is best to use a low-cost online broker for those. For example, you can use TD Ameritrade or Capital One. The cost per trade at those sites is currently $6.95.
JNJ is a hedge stock (see Week 126), so you don’t need to back up those purchases with an equal purchase of 10-yr Treasury Notes. That leaves 3 stocks (MSFT, XOM, ADP) to be balanced with Treasuries (or listed as 7 items in all, see the Table). For example, you could decide to invest $4,200/yr. That is, $600/yr per line item which is the same as $300/half, $150/qtr, or $50/mo. For XOM, automatic withdrawals from your checking account in the amount of $50/mo is both free and convenient using computershare. For zero-cost investments in JNJ and 10-yr Treasuries, go online every 6 months to invest $300 in JNJ at computershare and $900 in 10-yr Treasuries at treasurydirect. For lowest-cost investing ($6.95/yr) in ADP and MSFT, make alternate-year purchases of $1200 each through an online broker like Capital One or TD Ameritrade. In summary, T-Notes, JNJ and XOM are free; MSFT and ADP are purchased on alternate years for $6.95. Your out-of-pocket cost is $6.95/yr. This plan carries considerably less risk than VWINX, the safest low-cost balanced mutual fund (see Columns D and J in the Table), even though 10-yr returns are almost identical (Column F). Note: metrics in red indicate underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX).
When you retire, change from automatic reinvestment of quarterly dividends to having the dividends mailed to you. For Treasuries, there is no automatic reinvestment of interest. You receive interest payments twice a year deposited into your checking account, and return of the principal amount ($900) after 10 yrs. When you retire, stop making any “rollover” purchases, which you may have scheduled for T-Notes that are maturing every 6 months. Then you simply receive the principal amount of maturing T-Notes in your checking account. Reinvest T-Note interest payments in inflation-protected Savings Bonds at treasurydirect and hold those for at least 5 yrs before cashing them in, at which time you’ll be taxed for the accumulated interest payments.
Bottom Line: It’s always a good idea to have a personal retirement savings account, even if you already contribute the maximum allowed amount to a company-sponsored retirement plan. Why? Because corporations can change or discontinue their employee retirement plans. And, the Federal government will no doubt be changing long-standing Social Security policies for future retirees. You can have a tax-advantaged aspect of your personal, point-and-click retirement savings account simply by having your accountant declare it to be an IRA, as long as the annual limit for contributions isn’t exceeded.
To avoid gambling with your personal retirement savings plan, you’ll need to include investments with AAA credit ratings. That way you don’t have to worry about bankruptcy. And make sure you hedge against the risk of recession because anytime that stocks go down, T-Notes go up. Finally, don’t spend any money on transaction costs that you don’t absolutely have to spend.
Risk Rating: 3
Full Disclosure: I regularly buy 10-yr T-Notes, MSFT, JNJ, and XOM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, June 3
Week 48 - Oil & Gas Producers
Situation: Oil & Gas producers have been the cornerstone of the world’s economic edifice for 50 yrs and will likely serve in that capacity for another 50. But when it comes to pricing those products, companies are left at the mercy of worldwide demand. China is now driving 40% of demand for commodities, even though it has only 20% of the world’s population. With respect to oil & gas, the US still ranks first but China is gaining fast and is #1 with respect to demand for iron ore and copper. China’s appetite is so great that commodity producers are in danger of over-expanding just as China reaches its monetary borrowing limit. Investors have to keep an eye on supply & demand, except with respect to oil & gas (because supply rarely outstrips demand for any length of time).
Our mission in this week’s blog is to document the return and risk from owning stock in oil & gas producers, relative to owning other types of stock. We can start with a database of global stocks - the 2,157 companies larger than $1B in stock market value in the Kiplinger Stock screener found at this link. We narrowed that list to 97 companies of the type we find attractive. In other words, these companies meet our criteria of having a:
market capitalization >$5B,
dividend yield greater than 1.4%/yr,
5 yr dividend growth greater than 5.8%/yr,
current return on investment (ROI) greater than 10%/yr,
current return on assets (ROA) greater than 6.9%/yr, and
price/earnings ratio below 17 (to exclude overpriced companies).
The group of 97 companies that makes our cut includes most of the companies on the ITR Master List (Week 39).
The oil & gas producers have been placed at the top of the attached Table. For comparison, the cyclical “Core Holding” stocks (Week 22) compose the following group in the Table. Similarly, the non-cyclical “Lifeboat Stocks” (Week 23) are listed next. Gold mining stocks form the last group (Week 45), followed by an S&P 500 Index fund.
Companies in each group are listed in decreasing order of finance value (which is calculated as returns minus risk). Data indicating outstanding company performance are highlighted in light blue, whereas, data indicating sub-par performance are highlighted in red. A quick scanning of the spreadsheet shows oil & gas stocks pick up most of the light blue highlights indicating outstanding company performance.
Bottom Line: A prudent investor cannot escape the necessity and wisdom of investing in oil & gas producing companies. This position, as related to long term investing, is acceptable because the risk of loss in value during a bear market is remarkably low for the oil & gas stocks on our Master List (i.e., XOM, CVX and OXY), particularly given the extent of out-performance during a bull market.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Our mission in this week’s blog is to document the return and risk from owning stock in oil & gas producers, relative to owning other types of stock. We can start with a database of global stocks - the 2,157 companies larger than $1B in stock market value in the Kiplinger Stock screener found at this link. We narrowed that list to 97 companies of the type we find attractive. In other words, these companies meet our criteria of having a:
market capitalization >$5B,
dividend yield greater than 1.4%/yr,
5 yr dividend growth greater than 5.8%/yr,
current return on investment (ROI) greater than 10%/yr,
current return on assets (ROA) greater than 6.9%/yr, and
price/earnings ratio below 17 (to exclude overpriced companies).
The group of 97 companies that makes our cut includes most of the companies on the ITR Master List (Week 39).
The oil & gas producers have been placed at the top of the attached Table. For comparison, the cyclical “Core Holding” stocks (Week 22) compose the following group in the Table. Similarly, the non-cyclical “Lifeboat Stocks” (Week 23) are listed next. Gold mining stocks form the last group (Week 45), followed by an S&P 500 Index fund.
Companies in each group are listed in decreasing order of finance value (which is calculated as returns minus risk). Data indicating outstanding company performance are highlighted in light blue, whereas, data indicating sub-par performance are highlighted in red. A quick scanning of the spreadsheet shows oil & gas stocks pick up most of the light blue highlights indicating outstanding company performance.
Bottom Line: A prudent investor cannot escape the necessity and wisdom of investing in oil & gas producing companies. This position, as related to long term investing, is acceptable because the risk of loss in value during a bear market is remarkably low for the oil & gas stocks on our Master List (i.e., XOM, CVX and OXY), particularly given the extent of out-performance during a bull market.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, August 28
Week 8 - Lifeboat Stocks
Situation: Investors aren’t interested in losing money. So when they venture into direct ownership of stocks, they want to start by investing in companies that can sidestep risk.
Goal: Orient the investor to companies that (a) meet our investment criteria (Mission and Goals), (b) carry low debt (Week 7 - Risk), and (c) are in “defensive” industries that weather recessions, i.e., utilities, consumer staples, and health care (Week 6 - Summary).
Any buy-and-hold investment portfolio contains stock in companies that sell things consumers can’t avoid buying. Those companies don’t have to cut prices during a recession. People always buy toothpaste at the price they’re used to paying: there is no elasticity of demand. Even if the cost of making toothpaste goes up, passing those costs onto the buyer will not reduce demand. There is a Vanguard consumer staples Exchange Traded Fund, VDC, that illustrates this idea. When graphed vs. SPY, both increased together in price during the 2004-2007 economic expansion but VDC held up much better during the subsequent recession.
There are 9 companies producing consumer staples that meet the ITR investment criteria:
Health care companies are defensive in nature and also have pricing power but those stock prices are particularly sensitive to government regulation and patent expirations. Nonetheless, this industry has performed without peer. One reason is that pharmaceutical companies have to recognize research and development (R&D) expenses on their financial statements as an operating cost, which is then written off (or "amortized") annually. No other industry is so dependent on R&D: fixed costs (property, plant and equipment) usually dominate and these are amortized over decades. There are 3 health care companies meeting the ITR investment criteria that avoid being bloated with debt:
Goal: Orient the investor to companies that (a) meet our investment criteria (Mission and Goals), (b) carry low debt (Week 7 - Risk), and (c) are in “defensive” industries that weather recessions, i.e., utilities, consumer staples, and health care (Week 6 - Summary).
Any buy-and-hold investment portfolio contains stock in companies that sell things consumers can’t avoid buying. Those companies don’t have to cut prices during a recession. People always buy toothpaste at the price they’re used to paying: there is no elasticity of demand. Even if the cost of making toothpaste goes up, passing those costs onto the buyer will not reduce demand. There is a Vanguard consumer staples Exchange Traded Fund, VDC, that illustrates this idea. When graphed vs. SPY, both increased together in price during the 2004-2007 economic expansion but VDC held up much better during the subsequent recession.
There are 9 companies producing consumer staples that meet the ITR investment criteria:
Procter & Gamble (PG)
Wal-Mart (WMT)
Coca Cola (KO)
Pepsico (PEP)
Kimberly-Clark (KMB)
Colgate-Palmolive (CL)
McCormick (MKC)
Sysco (SYY)
Hormel Foods (HRL)
However, PEP, CL, and KMB are burdened with debt, leaving only 6 companies that ITR has dubbed “Lifeboat Stocks” in the consumer staples industry - a safer haven for queasy investors following a stock market roller-coaster ride.
Health care companies are defensive in nature and also have pricing power but those stock prices are particularly sensitive to government regulation and patent expirations. Nonetheless, this industry has performed without peer. One reason is that pharmaceutical companies have to recognize research and development (R&D) expenses on their financial statements as an operating cost, which is then written off (or "amortized") annually. No other industry is so dependent on R&D: fixed costs (property, plant and equipment) usually dominate and these are amortized over decades. There are 3 health care companies meeting the ITR investment criteria that avoid being bloated with debt:
Johnson & Johnson (JNJ)
Abbott Laboratories (ABT)
Becton-Dickinson (BDX)
Public utility companies are defensive because electricity is a necessity, guaranteed and priced by the state. These monopolies have enormous fixed costs and are financed mainly with government-guaranteed debt. Only one company
Public utility companies are defensive because electricity is a necessity, guaranteed and priced by the state. These monopolies have enormous fixed costs and are financed mainly with government-guaranteed debt. Only one company
NextEra Energy (NEE)
meets our investment criteria and carries a below normal debt load for that industry. NEE is actually two companies, one being Florida Power and Light and the other being Next Era Energy Resources - an unregulated electricity distributor that owns more wind and solar generating capacity than any of it’s North American counterparts.
Finally, there is an unusual information technology company that performs like a lifeboat stock:
Finally, there is an unusual information technology company that performs like a lifeboat stock:
Automatic Data Processing (ADP)
This, you may recall, is one of only 4 companies that carry a AAA bond rating. It has little long-term debt (0.7% of capitalization) because it’s business plan generates such a small return on assets that use of debt financing cannot be justified (unless interest rates are very low). ADP is used by other companies to outsource their routine business services. For example, it is the largest company in the world processing payrolls. ADP also accepts a variety of additional “human resources” assignments: e.g. tax filings and business-to-business (B2B) transactions, such as those between an employer and an automobile dealer. ADP will hold payroll funds for a short period of time, e.g., to make Social Security transactions, assign funds to 401(k) plans, etc., and during this period the funds are invested in ultra-short term bonds.
Interestingly, 8 of the 11 Lifeboat Stocks performed substantially better than SPY during the down-turns of October 2008 and August 2011: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE. And, all 8 measure up well with respect to the 6 risk parameters outlined in our Week 7 blog Risk. As of 8/25/2011, 6 of these 11 have outperformed SPY over the most recent one month, 3 month, 6 month, one yr, two yr, and 5 yr intervals: KO, BDX, ADP, HRL, and MKC.
Bottom line: We have identified 11 Lifeboat Stocks: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE, HRL, SYS, and MKC. The total return from investing $200/mo in each (since January of 1993) exceeds the total return from investing $200/mo in SPY over that period. Five of these companies are in our Growing Perpetuity Index (KO, PG, WMT, JNJ, and NEE). The results from making a $200/mo investment in each of these 5 companies vs. SPY are broken out in the accompanying Lifeboat Stocks Table. Their out-performance is unambiguous.
<click here to move to Week 9>
Interestingly, 8 of the 11 Lifeboat Stocks performed substantially better than SPY during the down-turns of October 2008 and August 2011: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE. And, all 8 measure up well with respect to the 6 risk parameters outlined in our Week 7 blog Risk. As of 8/25/2011, 6 of these 11 have outperformed SPY over the most recent one month, 3 month, 6 month, one yr, two yr, and 5 yr intervals: KO, BDX, ADP, HRL, and MKC.
Bottom line: We have identified 11 Lifeboat Stocks: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE, HRL, SYS, and MKC. The total return from investing $200/mo in each (since January of 1993) exceeds the total return from investing $200/mo in SPY over that period. Five of these companies are in our Growing Perpetuity Index (KO, PG, WMT, JNJ, and NEE). The results from making a $200/mo investment in each of these 5 companies vs. SPY are broken out in the accompanying Lifeboat Stocks Table. Their out-performance is unambiguous.
<click here to move to Week 9>
Sunday, August 21
Week 7 - Risk
Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;
(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and
(c) the S&P downgrade
have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Subscribe to:
Comments (Atom)