Situation: If you’ve been picking stocks for a retirement portfolio, and have more than 15 years of experience, you’ve learned enough about risk to appreciate last month’s blog about Haven Stocks (Month 104). You’re probably ready to take on more risk for more reward, assuming that you’ve learned how to ride out a market crash without selling. Warren Buffett, the reigning value investor, also stretches beyond investing in large-capitalization value stocks like those discussed in our Month 103 blog about Berkshire Hathaway’s portfolio.
In his most recent Annual Letter to the shareowners of Berkshire Hathaway, Warren explains how to do that by focusing on Retained Earnings (see the excerpt below in Appendix). Retained Earnings are what’s left over from Free Cash Flow after Dividends have been paid. Free Cash Flow is what’s left over from Operating Earnings (EBIT) after Capital Expenditures have been paid. Warren Buffett uses Return on Net Tangible Capital to estimate whether Retained Earnings are likely to be substantial. Return on Net Tangible Capital is the same as the familiar ROCE (Return on Capital Employed) except that Capital Employed is changed from Total Assets minus Current Liabilities to Total Assets minus Intangible Assets minus Current Liabilities. He thinks 20% is a good Return on Net Tangible Capital (see Column P in the Table).
The company’s CEO will eventually deploy Retained Earnings to build a better company faster. The cost for deploying that capital is zero. Going forward, the return on that investment is approximately the same as the return on Operating Earnings, which is EBIT (Earnings Before Interest and Taxes) divided by Market Capitalization. In a well-managed and well-positioned company, that return represents a high rate of Compound Interest over time--the 20%/yr Return on Net Tangible Capital that Warren Buffett is looking to achieve in most years on most of Berkshire Hathaway’s portfolio.
The trick, of course, is to find such companies. The Dow Jones Industrial Average (DJIA) is a good place to start, given that those companies have traditionally been picked (in part) because they expected to have a high Free Cash Flow Yield (see Column H in the Table).
Mission: Pick companies from the 30-stock DJIA that have S&P ratings on the bonds they’ve issued that are A- or higher, and insert a new column in our Standard Spreadsheet for Free Cash Flow Yield (Column K). Exclude any DJIA companies that do not have an S&P stock rating of at least B+/M, or do not have the 16 year trading record that is required for quantitative analysis by the BMW Method (https://invest.kleinnet.com/bmw1/). (We display at Columns L-M in the Table a summary of BMW Method findings for the most recent week.)
Administration: see Table.
Bottom Line: These 19 companies have an aggregate Return on Net Tangible Capital of 19.5%, which almost meets Warren Buffett’s requirement of 20%. Whether any of these stocks can be bought at a “sensible price” is not an easy question to answer. Here at ITR, we call a stock “sensibly priced” if the 50 day moving average in the price per share is no more than twice the Graham Number (see Columns AC & AD) and is no more than 25 times the 7-yr P/E (see Column AF). Five companies meet those criteria: PFE, INTC, JPM, TRV, IBM.
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, NKE, PFE, BA, KO, INTC, PG, JPM, WMT, JNJ, CAT and IBM, and also own shares of UNH, CSCO, AAPL, DIS, TRV and MMM.
Appendix: Excerpt from Warren Buffett’s February 2020 Letter to the shareowners of Berkshire Hathaway: “Charlie and I urge you to focus on operating earnings and to ignore both quarterly and annual gains or losses from investments, whether these are realized or unrealized...Over time, Charlie and I expect our equity holdings – as a group – to deliver major gains, albeit in an unpredictable and highly irregular manner. To see why we are optimistic, move on to the next discussion. The Power of Retained Earnings. In 1924, Edgar Lawrence Smith, an obscure economist and financial advisor, wrote Common Stocks as Long Term Investments, a slim book that changed the investment world. Indeed, writing the book changed Smith himself, forcing him to reassess his own investment beliefs. Going in, he planned to argue that stocks would perform better than bonds during inflationary periods and that bonds would deliver superior returns during deflationary times. That seemed sensible enough. But Smith was in for a shock. His book began, therefore, with a confession: “These studies are the record of a failure – the failure of facts to sustain a preconceived theory.” Luckily for investors, that failure led Smith to think more deeply about how stocks should be evaluated. For the crux of Smith’s insight, I will quote an early reviewer of his book, none other than John Maynard Keynes: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
Warren concludes that history lesson on this note: “Charlie and I have long focused on using retained earnings advantageously. Reinvestment in productive operational assets will forever remain our top priority. In addition, we constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.”
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Showing posts with label return on assets. Show all posts
Showing posts with label return on assets. Show all posts
Sunday, November 22
Week 229 - Stocks with 5-30 Years of Risk vs. Reward Data That Beat the S&P 500 Index
Situation: In last week’s blog (see Week 228), we turned up 6 “unicorns” (stocks with above-market returns and below market risk) over 5-16 yr holding periods. This week we’ve extended the holding period out to 30 yrs. Once again we turned up 6 unicorns (see Table) but 3 of those weren’t on last week’s list. In other words, only 3 companies in the 2015 Barron’s 500 List have outperformed the S&P 500 Index over 5, 16 and 30 yr periods while presenting the investor with a less risk than the S&P 500 Index. Those companies are Kimberly-Clark (KMB), NextEra Energy (NEE), and DTE Energy (DTE). Aside from investing in such minimally risky “defensive” stocks, you would do better by investing in the broad diversification of a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund (VFINX). Or, you can seek higher returns by taking on more risk!
Mission: Develop a logical plan to have your stock portfolio outperform the S&P 500 Index by taking on more risk.
Execution: Academic studies of this problem have shown that you have two options:
1) pick stocks issued by 40+ large-capitalization companies that represent all 10 S&P industries, while avoiding those with long-term debt (see Week 158);
2) pick a low-cost stock index fund that represents the next most risky layer of the market, i.e., mid-capitalization companies covered by the S&P 400 Index. There is an exchange-traded fund that will do that for you, the SPDR MidCap 400 ETF Trust (MDY at Line 16 in the Table).
Bottom Line: If you want to beat the S&P 500 Index, you’ll have to take on more risk. Why? Because there are only 3 stocks that have had better risk-adjusted performance than the S&P 500 Index over the past 5, 16 and 30 yrs (KMB, NEE, DTE). That’s not enough! Academic studies have shown that you need to diversify your holdings across all 10 S&P industries in order to spread out risk that occurs in downturns. This means you need to hold upwards of 40 stocks in your portfolio to avoid “concentration” risk. Or, you can pick a mid-capitalization stock index fund (e.g. MDY) and save yourself a lot of trouble. Over the past 5-yr holding period, that choice would have given you better returns than the Vanguard S&P 500 Index fund (VFINX) but with a greater risk of loss (compare Lines 15 and 16 at Columns C, D and I of the Table). Over a 30-yr holding period (with regular additions through dollar-cost averaging), the returns are again greater for the Mid-Cap fund (see Lines 19 & 20 at Column M in the Table) but the risk of loss is significantly lower (see Column O at Lines 19 & 20 in the Table). This is a logical way to beat the S&P 500 Index without taking on more risk. Holding periods of 16, 20 and 25 yrs will also do that for you, per the BMW Method. Why does a Mid-Cap stock index carry less long-term risk than the S&P 500 Index? Because smaller companies have less access to long-term financing through bond sales. In other words, Mid-Cap companies have choppier earnings growth than S&P 500 companies, and are still establishing their brands. So, they are less able to attract a syndicate of banks that will back the issuance of a long-term bond with an interest rate that is lower than the company’s ROA (Return on Assets). Having no long-term debt means there is little chance of a company going bankrupt (or being acquired by another company for less than book value).
Risk Rating: 6 (because MDY will always have a higher 5-yr Beta than VFINX, which has a Risk Rating of 5, as will any broadly diversified collection of 40+ stocks).
Full Disclosure: I dollar-average into NEE.
Note: Metrics are brought current for the Sunday of publication; metrics highlighted in red denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Develop a logical plan to have your stock portfolio outperform the S&P 500 Index by taking on more risk.
Execution: Academic studies of this problem have shown that you have two options:
1) pick stocks issued by 40+ large-capitalization companies that represent all 10 S&P industries, while avoiding those with long-term debt (see Week 158);
2) pick a low-cost stock index fund that represents the next most risky layer of the market, i.e., mid-capitalization companies covered by the S&P 400 Index. There is an exchange-traded fund that will do that for you, the SPDR MidCap 400 ETF Trust (MDY at Line 16 in the Table).
Bottom Line: If you want to beat the S&P 500 Index, you’ll have to take on more risk. Why? Because there are only 3 stocks that have had better risk-adjusted performance than the S&P 500 Index over the past 5, 16 and 30 yrs (KMB, NEE, DTE). That’s not enough! Academic studies have shown that you need to diversify your holdings across all 10 S&P industries in order to spread out risk that occurs in downturns. This means you need to hold upwards of 40 stocks in your portfolio to avoid “concentration” risk. Or, you can pick a mid-capitalization stock index fund (e.g. MDY) and save yourself a lot of trouble. Over the past 5-yr holding period, that choice would have given you better returns than the Vanguard S&P 500 Index fund (VFINX) but with a greater risk of loss (compare Lines 15 and 16 at Columns C, D and I of the Table). Over a 30-yr holding period (with regular additions through dollar-cost averaging), the returns are again greater for the Mid-Cap fund (see Lines 19 & 20 at Column M in the Table) but the risk of loss is significantly lower (see Column O at Lines 19 & 20 in the Table). This is a logical way to beat the S&P 500 Index without taking on more risk. Holding periods of 16, 20 and 25 yrs will also do that for you, per the BMW Method. Why does a Mid-Cap stock index carry less long-term risk than the S&P 500 Index? Because smaller companies have less access to long-term financing through bond sales. In other words, Mid-Cap companies have choppier earnings growth than S&P 500 companies, and are still establishing their brands. So, they are less able to attract a syndicate of banks that will back the issuance of a long-term bond with an interest rate that is lower than the company’s ROA (Return on Assets). Having no long-term debt means there is little chance of a company going bankrupt (or being acquired by another company for less than book value).
Risk Rating: 6 (because MDY will always have a higher 5-yr Beta than VFINX, which has a Risk Rating of 5, as will any broadly diversified collection of 40+ stocks).
Full Disclosure: I dollar-average into NEE.
Note: Metrics are brought current for the Sunday of publication; metrics highlighted in red denote underperformance vs. the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, August 30
Week 217 - Metals and Mining Companies with Improving Fundamentals
Situation: We’re always on the lookout for improved business conditions in companies that depend on “long-cycle” commodities. “Green shoots” are now popping up for those that use rocks and minerals as their main feedstock. Why should you care, since all classes of commodities have been falling in price for some time now? Our reasoning is that you need to follow commodities, if only from a distance, because their prices often respond to factors unrelated to the business cycle. What this means is that commodities can help balance risk associated with stocks and/or bonds. Commodity-related companies represent what’s known as “non-correlated assets.” Their stocks have particular value as moderators of portfolio performance. The reason for this is that commodity production carries large initial fixed costs and usually requires extensive logistical networks, but those large “costs of entry” also discourage competitors, so companies have an opportunity to build a strong brand if not a wide moat. There are risks. Once a commodity is found to be in short supply, it takes years to expand production (because of those large fixed costs), by which time shortages may have been corrected through innovative technologies or product substitution. The commodity’s price may fall because of innovations, substitution and newly expanded production. This will make it difficult to justify further investment but also makes it easy for strong companies to “buy out” weak competitors. Possibly one or two of these strong companies will become responsible for further innovation and substitution, then earn profits that exceed those of its competitors. Any excess of the commodity will likely be placed in storage because dialing back production (to meet demand) will not happen fast enough to prevent a precipitous drop in prices.
Mission: Identify large metals and mining companies that are showing steady improvement in Return on Invested Capital (ROIC) and revenues.
Execution: We’ll start with the Barron’s 500 Lists for 2014 and 2015, which rank the 500 largest companies traded on the Toronto and New York stock exchanges by revenue. Those rankings “compare companies on the basis of three equally weighted measures: (1) median three-year cash-flow-based return on investment; (2) the one-year change in that measure, relative to the three-year median; (3) sales growth in the latest fiscal year.” Eight metals and mining companies had a higher rank in 2015 than 2014 (see Table). Only one, Nucor (NUE), is an S&P Dividend Achiever, meaning its dividend has been increased annually for at least the past 10 yrs. Interestingly, all but Southern Copper (SCCO) carry a “buy” recommendation from S&P and/or Morningstar (see Columns T and U in the Table). With respect to our favorite performance metrics, these 8 companies as a group (see Line 10 in the Table) have greatly out-performed the S&P index fund for metals and mining companies (XME) at Line 19 in the Table.
Bottom Line: These 8 leading metals and mining companies are in recovery mode after a bad decade. While their stocks represent speculative investments by any standard, they also carry modest valuations, selling at 1.8 times book value vs. 2.7 for the S&P 500 Index (see Column K in the Table). However, most of the companies in the metals and mining sector ETF (XME) have yet to show signs of recovering from a deflationary decade and sell at only 1.4 times book value. It still remains to be seen whether the world economy will be successful at emerging from the deflation that followed the Lehman Panic. But if it is, most of these companies will double in value over the next two years. Caveat Emptor: these are speculative stocks; none are suitable for inclusion in a retirement portfolio.
Risk Rating: 9
Full Disclosure: I recently purchased stock in Alcoa (AA).
Note: Metrics in the Table are current as of the Sunday of Publication; those highlighted in red denote underperformance relative to our key benchmark (VBINX at Line 16 in the Table).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Identify large metals and mining companies that are showing steady improvement in Return on Invested Capital (ROIC) and revenues.
Execution: We’ll start with the Barron’s 500 Lists for 2014 and 2015, which rank the 500 largest companies traded on the Toronto and New York stock exchanges by revenue. Those rankings “compare companies on the basis of three equally weighted measures: (1) median three-year cash-flow-based return on investment; (2) the one-year change in that measure, relative to the three-year median; (3) sales growth in the latest fiscal year.” Eight metals and mining companies had a higher rank in 2015 than 2014 (see Table). Only one, Nucor (NUE), is an S&P Dividend Achiever, meaning its dividend has been increased annually for at least the past 10 yrs. Interestingly, all but Southern Copper (SCCO) carry a “buy” recommendation from S&P and/or Morningstar (see Columns T and U in the Table). With respect to our favorite performance metrics, these 8 companies as a group (see Line 10 in the Table) have greatly out-performed the S&P index fund for metals and mining companies (XME) at Line 19 in the Table.
Bottom Line: These 8 leading metals and mining companies are in recovery mode after a bad decade. While their stocks represent speculative investments by any standard, they also carry modest valuations, selling at 1.8 times book value vs. 2.7 for the S&P 500 Index (see Column K in the Table). However, most of the companies in the metals and mining sector ETF (XME) have yet to show signs of recovering from a deflationary decade and sell at only 1.4 times book value. It still remains to be seen whether the world economy will be successful at emerging from the deflation that followed the Lehman Panic. But if it is, most of these companies will double in value over the next two years. Caveat Emptor: these are speculative stocks; none are suitable for inclusion in a retirement portfolio.
Risk Rating: 9
Full Disclosure: I recently purchased stock in Alcoa (AA).
Note: Metrics in the Table are current as of the Sunday of Publication; those highlighted in red denote underperformance relative to our key benchmark (VBINX at Line 16 in the Table).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 25
Week 38 - Italy: A Story About a Country with Insufficient Return on Assets
Situation: Two days after the second bailout of Greece, a news article appeared on the front page of the NY Times (2/22/12): “For Greece, a Bailout; for Europe, Perhaps an Illusion.” The article ended by parsing Italy’s sovereign debt, which has reached an awesome #3 on The Hit Parade of the World’s Largest Debtors. It currently stands at 120% of Gross Domestic Product (GDP). ‘Italy is essentially in a sovereign debt trap,’ said Richard Batty, global investment strategist at Standard Life Investments. For Italy’s debt to be sustainable, the country’s economy must grow at a nominal [i.e., not inflation-corrected] rate of 5% a year, or the interest rate on its 10-yr bond must be 3.6%, Mr. Batty estimates. During Europe’s most recent boom period (2002-07) Italy’s nominal GDP grew at an average rate of only 3.6% and its 10-yr bond has a yield of 5% (even with a big rally this year). Mr. Batty is pointing out that a country must grow its economy at least as fast as the rate of interest it pays on outstanding debts.
Mission: Explain to our readers why Return on Assets (ROA), which for a country is approximately equal to nominal GDP, has to equal or exceed the interest rate on that country’s debt. If it doesn’t, the country’s debts can only continue to grow relative to nominal GDP. When private investors lose confidence in a country’s bonds, that country’s treasury will be forced to offer a higher rate of interest on new bonds to attract a different class of private investor, one interested in “junk bonds”. Those new investors then buy insurance, or Credit Default Swaps (CDS), that pay if the country defaults. The country has entered a “debt trap” because soon most of its tax revenues will go toward paying interest on its debt; default becomes unavoidable.
A country’s assets start with its birth-rate. Add to that the educational system that produces the nation’s workforce. Add increased efficiency in delivering a technologically sound education and the result is higher output/hr from the average worker, i.e. a gain in productivity. The growth rate of the workforce added to the growth rate of productivity equals nominal GDP. If productivity declines because of competition from other countries, GDP stalls-out or falls. Mature economies have a demographic problem because the death-rate becomes higher than the birth-rate. This problem can be solved by importing workers with valuable skill sets to boost productivity. Growth of productivity is also slowed by “friction”. There are many examples of friction, particularly professions with high barriers to entry that lock out new workers and prevent new technologies from taking hold, and/or education systems that fail to provide students with relevant skill sets.
To summarize: Italy’s nominal GDP (workforce gains + productivity gains) grows at only 3.6%/yr in good times. Italy has been paying for growth in its workforce and gains in productivity by borrowing money at an interest rate of ~5%. What this means is that Italy can only emerge from its debt trap by growing GDP faster. It can accomplish this by importing more skilled workers and removing friction from its productivity machine. There is no chance that investors will accept a lower interest rate on Italy’s 10-yr bond until that happens. But once it happens interest rates will drop below the rate of growth in nominal GDP, provided the Italian government uses the increase in revenue to pay down debt.
Bottom Line: Return on Assets (ROA) is an accounting ratio that carries a powerful and immutable impact. Not only countries but every family and business must respect its message: Grow revenues at least as fast as the interest rate on your outstanding debt (or don’t borrow money). But one country’s fiscal & monetary situation does not necessarily resonate with another’s. The US economy, for example, has strong growth when emerging from periods of slack because friction is less of a problem here than in almost any other country. Debt/GDP currently is 0.9-1.0 but is likely to fall below 0.85 over the next 3 years--assuming that nominal GDP growth continues to trend at 5-6%/yr and interest rates on 10 yr Treasury Notes continue to trend at 2-3%. The Federal Reserve has promised to continue its policy of Financial Repression through 2014, so those low interest rates “are baked into the cake.” How does this affect you the investor? It means you have been given a strong incentive to take on some risk. Invest in the US economy: borrow for college, start a family, buy a house, open a business, take more interest in stocks. Now is your time.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Explain to our readers why Return on Assets (ROA), which for a country is approximately equal to nominal GDP, has to equal or exceed the interest rate on that country’s debt. If it doesn’t, the country’s debts can only continue to grow relative to nominal GDP. When private investors lose confidence in a country’s bonds, that country’s treasury will be forced to offer a higher rate of interest on new bonds to attract a different class of private investor, one interested in “junk bonds”. Those new investors then buy insurance, or Credit Default Swaps (CDS), that pay if the country defaults. The country has entered a “debt trap” because soon most of its tax revenues will go toward paying interest on its debt; default becomes unavoidable.
A country’s assets start with its birth-rate. Add to that the educational system that produces the nation’s workforce. Add increased efficiency in delivering a technologically sound education and the result is higher output/hr from the average worker, i.e. a gain in productivity. The growth rate of the workforce added to the growth rate of productivity equals nominal GDP. If productivity declines because of competition from other countries, GDP stalls-out or falls. Mature economies have a demographic problem because the death-rate becomes higher than the birth-rate. This problem can be solved by importing workers with valuable skill sets to boost productivity. Growth of productivity is also slowed by “friction”. There are many examples of friction, particularly professions with high barriers to entry that lock out new workers and prevent new technologies from taking hold, and/or education systems that fail to provide students with relevant skill sets.
To summarize: Italy’s nominal GDP (workforce gains + productivity gains) grows at only 3.6%/yr in good times. Italy has been paying for growth in its workforce and gains in productivity by borrowing money at an interest rate of ~5%. What this means is that Italy can only emerge from its debt trap by growing GDP faster. It can accomplish this by importing more skilled workers and removing friction from its productivity machine. There is no chance that investors will accept a lower interest rate on Italy’s 10-yr bond until that happens. But once it happens interest rates will drop below the rate of growth in nominal GDP, provided the Italian government uses the increase in revenue to pay down debt.
Bottom Line: Return on Assets (ROA) is an accounting ratio that carries a powerful and immutable impact. Not only countries but every family and business must respect its message: Grow revenues at least as fast as the interest rate on your outstanding debt (or don’t borrow money). But one country’s fiscal & monetary situation does not necessarily resonate with another’s. The US economy, for example, has strong growth when emerging from periods of slack because friction is less of a problem here than in almost any other country. Debt/GDP currently is 0.9-1.0 but is likely to fall below 0.85 over the next 3 years--assuming that nominal GDP growth continues to trend at 5-6%/yr and interest rates on 10 yr Treasury Notes continue to trend at 2-3%. The Federal Reserve has promised to continue its policy of Financial Repression through 2014, so those low interest rates “are baked into the cake.” How does this affect you the investor? It means you have been given a strong incentive to take on some risk. Invest in the US economy: borrow for college, start a family, buy a house, open a business, take more interest in stocks. Now is your time.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 11
Week 23 - Lifeboat Stocks Revisited
Situation: In an earlier blog (Week 8), we defined Lifeboat Stocks as high-quality companies in defensive sectors of the economy (utilities, consumer essentials, health care). And by high quality we mean companies that have: low debt, a good credit rating, a dividend over 2%, and at least 10 yrs of annual dividend increases. In a later blog (Week 17), we introduced the use of accounting ratios to determine whether a company’s stock can be classified as fitting the category of “growth” or “value” and explained why we favored value. In this week’s blog, we will try to explain how some companies that qualify as a Lifeboat Stock (i.e., good credit rating and paying dividends with annual increases) can still carry considerable debt.
When a buyer makes a 20% down payment on a $200,000 house, then sells that house a year later for $240,000 (net of costs), that buyer’s out-of-pocket expenditure of $40,000 becomes $80,000. In accounting terms we would say that the Return on Equity (ROE) was 100%. Taxes will need to be paid on the $40,000 capital gain unless the gain is invested in another house but taxes are not due on monies used to pay interest on the mortgage. A US corporation works in a similar way, except that a business loan’s principal is not repaid, as in our mortgage example, until at the loan’s termination date. Boards of Directors, like homeowners, find this arrangement attractive because they can use someone else’s money to grow equity, tax-free.
When a company provides something that is fundamentally essential (i.e., electricity, pharmaceuticals,payroll services or diapers) there is an even greater temptation to use borrowed money, and that is because that company is unlikely to lose money during a recession. It can still make the owed interest payments on schedule. And, as is the case with homeowners, the cheapest form of debt is long-term (LT) debt after considering all risks. Typically, a company will “roll over” the Principal payment due at the maturity of its loan by taking out a new LT loan in the same amount. However, if there is a credit crunch when the company needs to do so, there will undoubtedly be higher interest to be paid, or possibly a need to issue more stock to finance the Principal payment. A company could also be going through a lean period when it’s Return on Assets (ROA) is less than the interest rate it will have to pay on its new loan. In other words, it won’t be able to get a loan it can afford. What this means is that the company will be paying an interest rate that is higher than it’s ROA, which means the company is in the process of going bankrupt. It will have to pay a much higher interest rate to compensate a creditor for issuing a “junk bond”. Incidentally, this principal also applies to countries, as we are witnessing with the European Union.
The attached <spreadsheet> examines all of the ITR Lifeboat Stock candidates in terms of LT debt/capitalization, ROE, ROA, and P/BV, or the ratio of Price to Book Value (assets minus liabilities). Debt is subtracted from the value of the company's assets, which are owned by shareholders, but a company that efficiently uses borrowed money to increase its revenue will also show an increase in assets that is proportional to the increase in its liabilities. BV will remain stable and the share price will remain a reasonable multiple of BV. If BV falls because the value of its assets no longer cover its liabilities, then P/BV will soon reach double digits. To qualify as an ITR Lifeboat Stock, we are looking for companies with P/BV of less than or equal to 3.5, ROA greater than 8% (indicating ample ability to afford interest payments), ROE greater than the S&P 500 Index ROE (currently 16.5%), and LT debt/capitalization less than or equal to 35%.
ABT, JNJ, MDT, BDX, ADP, WAG, and WMT meet our criteria and are classified as Lifeboat Stocks. In addition, NEE, SO and MDU are utilities with government-backed credit and otherwise meet our requirements for being a Lifeboat Stock. The other companies on the spreadsheet do not meet those requirements. Taking one company from each of the main S&P Industries from which Lifeboat Stocks are drawn (consumer staples, health care, utilities), we’ll make a virtual investment of $100/mo in each DRIP (WMT, JNJ, and NEE) starting 2/3/97. Commissions are $1 per month for WMT and JNJ; NEE has no commission. Total returns were 5%/yr for WMT, 4.85%/yr for JNJ, and 7.78%/yr for NEE. This compares to 2.55%/yr for SPY (commission for monthly DRIP investment = $4). Spreadsheet information will be provided in next week’s Summary blog.
Bottom Line: Lifeboat stocks provide some of the ballast that helps to preserve your portfolio during market turmoil; bonds provide the rest.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
When a buyer makes a 20% down payment on a $200,000 house, then sells that house a year later for $240,000 (net of costs), that buyer’s out-of-pocket expenditure of $40,000 becomes $80,000. In accounting terms we would say that the Return on Equity (ROE) was 100%. Taxes will need to be paid on the $40,000 capital gain unless the gain is invested in another house but taxes are not due on monies used to pay interest on the mortgage. A US corporation works in a similar way, except that a business loan’s principal is not repaid, as in our mortgage example, until at the loan’s termination date. Boards of Directors, like homeowners, find this arrangement attractive because they can use someone else’s money to grow equity, tax-free.
When a company provides something that is fundamentally essential (i.e., electricity, pharmaceuticals,payroll services or diapers) there is an even greater temptation to use borrowed money, and that is because that company is unlikely to lose money during a recession. It can still make the owed interest payments on schedule. And, as is the case with homeowners, the cheapest form of debt is long-term (LT) debt after considering all risks. Typically, a company will “roll over” the Principal payment due at the maturity of its loan by taking out a new LT loan in the same amount. However, if there is a credit crunch when the company needs to do so, there will undoubtedly be higher interest to be paid, or possibly a need to issue more stock to finance the Principal payment. A company could also be going through a lean period when it’s Return on Assets (ROA) is less than the interest rate it will have to pay on its new loan. In other words, it won’t be able to get a loan it can afford. What this means is that the company will be paying an interest rate that is higher than it’s ROA, which means the company is in the process of going bankrupt. It will have to pay a much higher interest rate to compensate a creditor for issuing a “junk bond”. Incidentally, this principal also applies to countries, as we are witnessing with the European Union.
The attached <spreadsheet> examines all of the ITR Lifeboat Stock candidates in terms of LT debt/capitalization, ROE, ROA, and P/BV, or the ratio of Price to Book Value (assets minus liabilities). Debt is subtracted from the value of the company's assets, which are owned by shareholders, but a company that efficiently uses borrowed money to increase its revenue will also show an increase in assets that is proportional to the increase in its liabilities. BV will remain stable and the share price will remain a reasonable multiple of BV. If BV falls because the value of its assets no longer cover its liabilities, then P/BV will soon reach double digits. To qualify as an ITR Lifeboat Stock, we are looking for companies with P/BV of less than or equal to 3.5, ROA greater than 8% (indicating ample ability to afford interest payments), ROE greater than the S&P 500 Index ROE (currently 16.5%), and LT debt/capitalization less than or equal to 35%.
ABT, JNJ, MDT, BDX, ADP, WAG, and WMT meet our criteria and are classified as Lifeboat Stocks. In addition, NEE, SO and MDU are utilities with government-backed credit and otherwise meet our requirements for being a Lifeboat Stock. The other companies on the spreadsheet do not meet those requirements. Taking one company from each of the main S&P Industries from which Lifeboat Stocks are drawn (consumer staples, health care, utilities), we’ll make a virtual investment of $100/mo in each DRIP (WMT, JNJ, and NEE) starting 2/3/97. Commissions are $1 per month for WMT and JNJ; NEE has no commission. Total returns were 5%/yr for WMT, 4.85%/yr for JNJ, and 7.78%/yr for NEE. This compares to 2.55%/yr for SPY (commission for monthly DRIP investment = $4). Spreadsheet information will be provided in next week’s Summary blog.
Bottom Line: Lifeboat stocks provide some of the ballast that helps to preserve your portfolio during market turmoil; bonds provide the rest.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 4
Week 22 - Core Holdings
Situation: Seasoned investors will try to strike an investment balance between equities (ownership rights that yield dividends or rent) and credits (loans that pay interest). They also attempt to balance their core holdings with “hedges” that are designed to mitigate potential losses. We introduced an ITR Goldilocks Allocation (Week 3 blog) that is designed to protect against bear markets by investing 67% of the entire portfolio in Lifeboat Stocks (see Week 8 blog) and high grade bonds. The remaining 33% is risk capital--core “cyclical” stocks that rise or fall with world markets.
Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.
On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.
For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGT, WMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:
3 energy stocks (XOM, CVX, OXY)
3 manufacturers (GD, EMR, UTX)
1 conglomerate (MMM)
1 railroad (NSC)
We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.
The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).
Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.
On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.
For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGT, WMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:
3 energy stocks (XOM, CVX, OXY)
3 manufacturers (GD, EMR, UTX)
1 conglomerate (MMM)
1 railroad (NSC)
We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.
The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).
Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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>
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