Week 389 - Bond ETFs

Situation: You want to balance your stock portfolio with safe bonds. Right? Well, here’s a news flash: You need to start thinking about balancing your bond portfolio with safe stocks. Why? Because the world is gorging itself on debt--households, municipalities, states, nations, and corporations most of all. Yes, this is understandable because the Great Recession was so disabling that central banks everywhere dropped interest rates lower than the rate of inflation. It was free money, so people borrowed the stuff and invested it. Just as the central bankers had intended. Economic activity gradually returned to normal almost everywhere, now that 10 years have passed since Lehman Brothers declared bankruptcy on September 15, 2008. But the Federal Open Market Committee is removing the punch bowl from the party and raising short-term interest rates by a quarter percent 3-4 times a year. Bondholders are stocking up on Advil due to interest rate risk (duration), meaning that for each 1% rise in short-term interest rates there is a material reduction in the value of an existing bond that is worse for long-term than short-term bonds. 

If a company is struggling and has to refinance a maturing issue of long-term debt, it will have to pay a materially higher rate of interest vs. that paid to holders of the expiring bond. This may impact the credit rating of its existing bonds, driving it closer to insolvency. General Electric (GE) is an especially vivid example of how this works. A few short years ago, GE had an S&P rating of AAA for its bonds. That rating is now BBB+ and falling fast. Larry Culp, the CEO, is desperately selling off core divisions of the company in an attempt to avert bankruptcy. 

Mission: Use appropriate columns of our Standard Spreadsheet to evaluate the leading bond ETFs, and compare those to the S&P 500 Index ETF (SPY) as well as a stock with an S&P Bond Rating of AA or better.

Execution: see Table. 

Bottom Line: To offset the risks in your stock portfolio (bankruptcy, market crashes and sensitivity to fluctuation of interest rates), you need a bond portfolio. Why? Because high quality bonds rise in value during stock market crashes and/or recessions, have much less credit risk, and usually less interest rate risk. Stock prices are more sensitive to short-term interest rates than any but the longest-dated bonds, e.g. 30-Yr US Treasury Bonds. Stock indexes like the S&P 500 Index (SPY) have average S&P Bond Ratings of BBB to BBB+, compared to AA+ for 30-Yr Treasuries. To cover those risks, you’ll need a bond fund that has low-medium interest rate risk and high credit quality. BND and IEF are examples (see Table). BIV differs only in having medium credit quality per Morningstar. TLT has high credit quality but also has high interest rate sensitivity. TLT can be compared to a stock with high credit quality and high interest rate sensitivity, e.g. Pfizer (PFE; see Table). The main thing to remember is that stock market crashes are invariably accompanied by a booming bond market (flight to safety). That’s a good thing because governments will have to take on a lot more debt to finance social programs like unemployment insurance.

Risk Rating: 1 for BND and IEF (where 10-Yr Treasuries = 1, S&P 500 Index = 5, gold = 10)

Full Disclosure: I own bond funds that approximate BIV and TLT.

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

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Week 372 - DJIA Companies in “The 2 and 8 Club”

Situation: The Dow Jones Industrial Average (DJIA) is generally thought to be the most stable reflection of the stock market. As it should be. Those 30 companies are picked by the Managing Editor of the Wall Street Journal to do exactly that. Here at ITR, we have our own, less subjective, measure of stability: companies that pay a good and growing dividend. In other words, companies with a dividend yield and dividend growth rate that are as good (or better than) the DJIA’s ~2% yield and ~8% growth rate. We propose that you pick such stocks out of the DJIA, thinking you’ll just have to do better than you would have done by investing in the Exchange Traded Fund (ETF) for the DJIA (DIA), which is called “Diamonds” for good reason. 

Mission: Run our Standard Spreadsheet for the 8 companies in the DJIA that are members of “The 2 and 8 Club” (see Week 360).

Execution: see Table.

Administration: We have made two changes to “The 2 and 8 Club”: 1) Companies with a BBB+ S&P rating for their bonds are no longer accepted (see Column T in the Table); 2) all companies in the Russell 1000 Index that meet requirements (see Week 327) are included in “The 2 and 8 Club”(see Week 366). So, that phrase no longer refers specifically to companies in the S&P 100 Index.  

Bottom Line: These 8 stocks have performed remarkably well vs. DIA. Total Returns over the past 11 years (see Column C) were 26% greater, Finance Values (see Column E) were 25% better, dividend yields were almost 30% better (see Column G), dividend growth was almost 80 faster (see Column H), and the rate of price appreciation over the past 16 years was more than 70% faster (see Column K). So far so good, but the devil is in the details. We also measure risk. The story there is a bit shocking, even though these very stable companies were able to shake off challenges posed by the recent crash in commodity markets (see Column D). 

Five year price volatility was almost 25% greater (see Column I), P/E was twice as great (see Column J), and quantitative analysis of stock prices over the past 16 years predicts that losses will be almost 40% greater in the next Bear Market (see Column M). In other words, the risk-adjusted returns for these 8 companies are not significantly different than those for the DJIA. This conclusion is consistent with what we were taught in Business School, i.e., there are only two ways for a stock picker to “beat the market.” 1) use insider information (illegal), 2) take on more risk. Your best chance to beat the market without incurring more risk is to invest in the highest quality utilities, beverages, and pharmaceuticals (see Week 367).

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

Full Disclosure: I dollar-average into MSFT, JPM, CAT and IBM, and also own shares of TRV, MMM and CSCO.

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

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Week 228 - Barron’s 500 Stocks with 5-16 Yrs of Below-Market Volatility and Above-Market Returns

Situation: You don’t want to lose sleep worrying about your stock portfolio, but you also don’t want to depend entirely on index funds for retirement planning. Most readers of this blog have decided to supplement their retirement income with dividend checks that grow 2-5 times faster than inflation. The stockpicker’s goal is to get risk-adjusted returns that meet or beat S&P 500 Index returns. That takes a lot of time and requires understanding how markets work, meaning a steep learning curve extending over 10 or more years. And, it is almost impossible to find stocks that will perform for you at the high level over the long term (as this week’s blog makes clear). To get that result you would need to become a short-term trader of stocks that are not widely followed by analysts (Google “Peter Lynch” to see what I mean). If you’re not willing to become that kind of trader, then a better choice is to invest in the lowest-cost S&P 500 Index fund, the Vanguard 500 Index Fund (VFINX), or its bond-hedged version, the Vanguard Balanced Index Fund (VBINX). Or, accept that fact that few of your long-term stock picks are going to have total returns that out-perform the S&P 500 Index on a risk-adjusted basis over 2-3 market cycles.

Mission: Find stocks that have better risk-adjusted returns than the S&P 500 Index over 2-3 market cycles. Start by looking at the largest companies in the US and Canada using the Barron’s 500 List to gain information about key fundamentals. Specifically, we want to find those that have had below-market volatility over the past 5 and 16 years and returns that have beat the S&P 500 Index over the past 5 and 16 years. Eliminate any stocks that have S&P bond ratings lower than BBB+ or S&P stock ratings lower than B+/M.

Execution: We have been able to identify only 6 stocks that satisfy our criteria (see Table). If you have been reading our blog regularly, you’ll know that we call such stocks unicorns. Four of these 6 unicorn stocks pay an above-market dividend, and the other one (Nike) increases its dividend more by than 20% a year. Our list has turned up “bond substitutes” of high quality but all bond substitutes are in great demand. Why? Because the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has eliminated the ability of banks to trade bonds for their own account. In other words, the principal market for bonds has dried up. It is going to be a long time before bonds again become a place where you can park money in anticipation of interest payments that more than compensate for inflation. 

And now, a word about the method we use to find unicorns in the Barron’s 500 List. To find companies with Below-market volatility over the past 5 yrs, we use 5-yr Beta, and at 16 yrs we use the predicted loss that would be incurred if the stock’s price dropped 2 Standard Deviations below trendline, per the BMW Method. To find companies with above-market returns at 5-yrs, and since the S&P 500 Index peaked on 9/1/00, we use the Buyupside total return stock calculator. To assess the past 16 years of price appreciation, we use the BMW Method. All comparisons are to either the S&P 500 Index or the lowest-cost stock mutual fund that mimics that index (VFINX). 

Bottom Line: We’re looking for “unicorn” stocks and found 6 (see Table). The method we use will probably never turn up more than 10 stocks, given that outperformance is almost always accompanied by greater volatility. The problem for you, the reader, is that we’ve used historical data. In other words, there’s no way of knowing whether these 6 stocks will continue to outperform while exhibiting below-market volatility.

Risk Rating: 4 

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

Note: Metrics highlighted in red denote underperformance vs. our key benchmark (VBINX). Metrics are current for the Sunday of publication.

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Week 130 - Seeking Alpha? Here are 10 companies

Situation: More than just a technical term in statistics, “alpha” has come to have Unicorn-like significance for traders. Indeed, some investors think of alpha as the Holy Grail of investing. The non-mathematical definition of alpha carries little cachet. It refers to Annualized Total Return from an investment that is in excess of what can be accounted for by fluctuations in the mean value for that asset class, i.e., market-beating returns. It seems that alpha should be simple to achieve since, by definition, half of investments do better than average. For stocks issued by well-established companies, half would have superior returns. The problem is that many such beknighted companies fall out of that category with remarkable frequency, only to be replaced by others that also fall out with remarkable frequency. The result? You should follow Warren Buffett’s advice to retail investors, which is that you’re best off sticking to a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund (VFINX).

But the myth survives in the lay press that you and I can “beat the market” if we but pay a fee to the investment guru, brokerage, or hedge fund of the hour. Here at ITR, we say forget the fee and do-it-yourself online with dividend reinvestment plans (DRIPs). More importantly, we encourage you to forget the myth. It isn’t achievable anyway, for periods longer than 20 yrs, unless you are Warren Buffett, John Templeton, or Peter Lynch. But there are kernels of wisdom in the writings and quotations of those three luminaries, which you and I can use to our advantage: Don’t buy stock in good companies that make money rapidly in a bull market. Instead, look for good companies that lose money slowly in a bear market. That’s why every one of our tables has a Column D that states how much each company’s stock lost during the Lehman Panic. We don’t think companies that lost more than 28% over that 18 month period are worth your attention, since that is how much the hedged S&P 500 Index lost as measured by the Vanguard Balanced Index Fund (VBINX), vs. the 46.5% lost by the lowest cost S&P 500 Index fund (VFINX). Hedging is necessary. So, the idea is to stick to an index fund and seek your own alpha. To do that, you will need to pick DRIP stocks that have made more than VFINX while losing less than VBINX in the Lehman Panic. 

Let’s look for companies that beat VFINX for both the past 21 yrs (two and a half market cycles) and the past 5 yrs. We’ll pick those from our universe of 55 companies that have beaten that index since 2002 (see Week 122) and eliminate any company that lost more than the 28% loss sustained by VBINX during the Lehman Panic. Surprisingly, we find 10 companies that have pulled off the alpha feat (see Table). Half of those companies have names that are familiar to anyone who shops: Nike (NKE), TJX, Sherwin-Williams (SHW), Hormel Foods (HRL) and Colgate-Palmolive (CL). They are what they are, namely, unexciting but also able to post good profits year in and year out. Who doesn’t need the stuff they sell? Try going a year without toothpaste, meat, shoes, marked-down new clothes, and paint. In short, most of these companies don’t have great performance because they grow earnings rapidly in a bull market. Instead, it’s because their earnings hold up well in a bear market. Remember: when one of your stocks drops 50% in a recession it has to go up 100% just to get back where it was. In the meantime, 3 to 5 yrs have passed while you’ve had that “dead money” sitting in your brokerage account.

Bottom Line: It is possible to “beat the market” over a long period of time by owning stock in companies that have a strong, recession-proof brand.

Risk Rating: 4

Full Disclosure: I have stock in IBM, Nike (NKE), and Hormel Foods (HRL).

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Week 97 - Capitalization-weighted Index of 11 High-quality Dividend Achievers

Situation: What is a high-quality stock? Here at ITR, we advocate a “buy and hold” strategy of stock selection, our goal being to set up a dividend reinvestment plan (DRIP) for each selection. We advocate that you start small and add a little each month, by having that amount withdrawn electronically from your checking account. That means you've got a lot at stake if you change your mind about a stock and liquidate your DRIP. Before starting down that path, you need to have a definition of “quality” (there are many to choose from) that will let you get into a stock and stay invested for the long term.

We’ve offered some tips in previous blogs (see Week 3, Week 50, Week 72, Week 87 and Week 93):
   a) plan to have at least 4 DRIPs;
   b) avoid companies with long-term debt that is worth more than the stock;
   c) avoid stocks that have a 5-yr Beta higher than the S&P 500 Index's (1.00);
   d) favor companies that have positive free cash flow (FCF).

Recently, we’ve seen that a number of fine companies with positive FCF don’t have enough FCF to pay their dividend. That means they’ll have no Retained Earnings (RE) with which to fund next year’s growth, and the company has to raise more cash (sell more stock, issue more bonds, or lobby government officials to make more tax expenditures). Companies get caught in this bind for 3 reasons: 1) The economy is still in the Intensive Care Unit (so to speak): Revenues can’t generate enough FCF to afford the dividend policy that the company has trained its investors to expect (e.g. annual raises sufficient to cover inflation). 2) That dividend policy needs to remain stable when there is a slack economy, since it is an effective way to keep investors in the stock market given the paltry income they get from bonds. 3) Foreign earnings are difficult to repatriate because 20-25% will have to be turned over to the Internal Revenue Service (i.e., the difference between low tax rates in developing countries and high tax rates in the United States). For that reason, most companies reinvest earnings in the same country that produced the earnings.

Here at ITR, "High quality” means simply that the company has Retained Earnings at the end of the year. That's the essence of capitalism. Rational investors favor investment-grade bonds, since return of their original investment is guaranteed. There are no guarantees that a stock will retain value. Remember, the Central Thought of business isn’t to make money . . . it's to redistribute the risk of losing money. A stock investor holds out hope that her chosen company will grow in value by deploying Retained Earnings. Most companies don’t have Retained Earnings; they have to expand by issuing stocks or bonds which costs at least 8%/yr.

The accompanying Table was constructed from a list (see invescopowershares) of 201 Dividend Achievers, i.e., companies that have increased their dividends annually for the past 10 or more yrs. Those companies were screened as follows:

   1) Any company’s stock that had a total return during the Lehman Panic period (10/07 thru 3/09) worse than -30% (vs. -46.5% the lowest cost S&P 500 Index fund--VFINX) was discarded .

   2) Any stock that has a history of growing dividends less rapidly than 5%/yr, which is the dividend growth rate for VFINX, was discarded. 

   3) Companies with a dividend yield less than 1% were discarded. 

   4) Companies that don’t have an S&P stock rating of at least A-, and an S&P bond rating of at least BBB+ were discarded. 

The remaining companies were checked against the Buyupside website for performance vs. VFINX over the past two market cycles, beginning with the peak that occurred on March 24, 2000. Since then, VFINX has grown at a rate of 2.3%/yr through the reinvestment of dividends--price performance has only been 0.3%/yr. None of the companies that remained after applying the above screens performed as badly as VFINX, so none had to be discarded. 

Then we used The WSJ to collect data on FCF, LT debt, ROIC, ROE and RE. Any company that didn’t have Retained Earnings in 2012 was discarded, as was any company that didn’t have an ROIC sufficient to pay ongoing costs of capitalization (at least 8%/yr). Companies where LT debt accounted for more than 50% of total capitalization were also discarded. 

We ended up with 11 companies remaining that were ranked by the market value of their stock. Appropriate multiples ($1-11) were used to arrive at a capitalization-weighted index that has paid 9.3%/yr over the past two market cycles (vs. 2.3%/yr for VFINX).

Bottom Line: Consider having your key DRIPs in the very few large companies that remain able to grow by reinvesting their Retained Earnings, namely, WMT, IBM, XOM and ABT. Add DRIPs for smaller companies when you’re able to do so without going into debt, neglecting your health, avoiding exercise, or skipping vacations.  

Risk Rating: 4.

Full Disclosure: I have DRIPs in WMT, IBM, XOM, and ABT. Automatic monthly additions for XOM and ABT carry no charges; there is a $1.05 charge for WMT and a $1.00 charge for IBM. I invest $280/mo in these 4 DRIPs, for an initial expense ratio of 0.73% ($2.05/$280).

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Week 86 - Low-risk Dividend Achievers vs. a Balanced Index Fund

Situation: The stocks we are calling “The Dividend Achievers” in the accompanying Table look like they can mint money. But for how many years will any one of these 26 “internally hedged” companies continue to have the pricing power and good management that make such outperformance possible? Pricing power comes from having a competitive advantage AND a product that is in demand but a tad short in supply. As an example, let’s take food products in the US. These stocks are expected to show price inflation that is 1% greater than the the overall Consumer Price Index for the next 2-3 yrs. Why is that? Because worldwide demand is growing while supply is constrained due to unpredictable events such as soil erosion, a dwindling availability of water, and an increase in temperatures to a range that is suboptimal for grain. The point is that there is always a reason for outperformance, and pricing power is usually the key to finding it. Pricing power is fungible . . . it won’t last. 

Where should a recent college graduate invest to secure her retirement 40 yrs from now? Readers of our blog know we favor defensive industries (consumer staples like food and housewares, utilities, health care) because people keep spending for those goods and services even during a recession. For example, look at this week's Table: 18 out of the 26 companies are in defensive sectors. 

Using our previously defined criteria (see Week 76), these 18 companies are internally hedged. By this we mean that their stock a) fell less than 65% as far as the S&P 500 Index during the Lehman Panic, b) has a 5-yr Beta less than 0.65 (meaning it will do as well in the next panic), and c) beat Vanguard's S&P 500 Index fund (VFINX) for the past 20 yrs. All of our best stock picks are on that list. Those paying a miniscule dividend now are likely to pay more in the future. None need to be backed 1:1 by an inflation-protected US Savings Bond or similar AAA credit.

But the tricky part is choosing which 5 or 6 of those stocks you want for your dividend reinvestment plans (DRIPs). If you're a "one-stop shopper", you won't take the time. In that case, we recommend the Vanguard Wellesley Income Fund (VWINX). 

For the rest of us, how should we pick stocks from this list of low-risk Dividend Achievers? These companies have a long history of annually increasing their payout so you can project future cash flows from that rate of increase. Simply add the current dividend yield (Column F, Table) to the historical rate of dividend increases (Column G) found on the Buyupside website. This produces the number in Column H, which is your projected rate of total return: 5.7% in the case of VWINX. Vanguard Wellesley Fund has done better than that over the past 20 yrs (Column I) because of capital gains realized upon the sale of bonds. How does that explain the outperformance? It happens because interest rates have steadily declined over the past 30 yrs, therefore, the bonds gained in value and a capital gain was realized when the bonds were sold. That also explains why utility stocks have outperformed (NEE, SO, WTR, UGI, SJI), since utilities are often capitalized with the help of bonds backed by a state government. When interest rates are low, cheap financing translates into a high return on invested capital (ROIC) to provide handsome annual increases in dividend payouts. To learn more about the rationale behind the above-method for arriving at the net present value of a stock, read The Four Pillars of Investing by William Bernstein (McGraw Hill, New York, 2002, ISBN 0-07-138529-0), the only book you need to read as a part-time investor.

For stocks other than utilities, deviations of the 20-yr total returns (Column J) from the discounted cash flow model (Column I) have more complex explanations. Here at ITR, we like to see agreement between predicted and actual returns. Good examples of this include the S&P 500 Index (VFINX), the average of 26 "hedge" stocks (Line 28, Table), Ross Stores (ROST), Family Dollar Stores (FDO), Hormel Foods (HRL), Chubb (CB), Abbott Laboratories (ABT), IBM and Procter & Gamble (PG). Predictable returns denote a stable competitive advantage. To gradually build a position in such stocks is sound investing, not gambling.

But all of these investment choices carry the risk of “pilot error", however small. We humans aren’t always rational allocators of capital but computers can be programmed to do an acceptable job. If you have $10 Million and take it to Goldman Sachs for them to invest on your behalf, they'll probably turn the task over to a computer. On June 20, 1996 Vanguard set up a Balanced Index Fund (VBINX) that has had an annualized total return since then of 7.2%/yr vs. 6.9%/yr for VFINX. The VBINX computer allocates 60% of your money to a total US stock market index and 40% to Barclay’s Capital US Float Adjusted Bond Index. The expense ratio is very low (0.25%), and there are no loads or other costs apart from requiring you to start your account  with a check for $3000. Turnover is relatively low, even though the computer rebalances the 60/40 allocation daily.

So what is the point to this? The point is that once programmed, computers have less pilot error in decision making. Why a 60/40 split? Because that's what was in vogue when the fund was launched. Here at ITR, we prefer a 50/50 split but with a computer doing the stock picking and rebalancing it’s reasonable to take the extra risk of carrying more stocks. After all, we break our 50/50 rule whenever we can find an internally hedged stock. The Table lists all 26 hedge stocks we know of that are A-rated, have 10+ yrs of dividend growth, and have been publically traded for 20+ yrs.

Bottom Line: 40 yrs is a long time to save for retirement and a lot can change. Let's assume that you are not interested in making an avocation of investing but want to keep your money somewhat insulated from human error and management fees. And, you also want it to grow with the economy. Then maybe a balanced index fund is your best choice. For a very long investment horizon, such as a Roth IRA that will keep paying tax-free returns long after you die, a balanced index fund is arguably the only choice. 

Risk Rating: 2.

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Week 81 - Core US Food and Beverage Companies

Situation: The worldwide food and beverage industry is very mature, very fragmented and very competitive. We need to sort companies into manageable groups to allow analysis of investment potential. We started with those based in the US and came up with a list of 20 noteworthy stocks (see the attached Table). Not all are in the business of producing food and beverages. We’ve included the largest seed company (Monsanto), the largest farm equipment company (John Deere), the largest trucking company dedicated to delivering food products and prepared meals (Sysco) and a freight forwarding company (CH Robinson Worldwide) that delivers its own line of vegetables (The Fresh 1) anywhere in the world that has an air freight terminal. We sorted these 20 companies into two groups of 10 in the Table. The upper group has 5-yr Beta values less than 0.65 and Total Returns during the 18 months of the Lehman Panic that fell less than 65% as far as the S&P 500 Index Total Returns. This leads us to think of those 10 companies as being “bond-like” and having such low risk that there’s no need to hedge an investment in these companies with an equal investment in 10-yr US Treasury Notes, or inflation-protected US Savings Bonds, or a high quality investment-grade intermediate-term bond fund (see Week 76 for more information on hedges). To find substantial risk factors associated with these stocks, you have to look deeper. We have identified what we consider to be some key risk factors and red-flagged values denoting higher risk (see Columns H-M in the Table). Only 3 stocks that have no red flags, and they are the ones with the highest Finance Value (Reward minus Risk: Column E), namely Hormel (HRL), CH Robinson (CHRW) and General Mills (GIS). You can think of these 3 companies as having little uncertainty related to earnings growth going forward. Bottom Line: Food is so essential that the top 10 companies (Table) rival regulated utilities for stability and dependable earnings growth, even though food companies don’t have government-guaranteed credit and return on equity. Risk Rating: 3.

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Week 80 - 2012 Total Return for the Growing Perpetuity Index

Situation: The US economy has improved but only enough for job growth to keep up with population growth. The stock market, on the other hand, is pointing to the likelihood that the rate of economic expansion (GDP) will soon double to more than 3%/yr. We’re in a bull market, which we define as the S&P 500 Index outperforming the “blue-chip” 65-stock Dow Jones Composite Index. During 2012, there was a wide gap between the two with the S&P 500 Index gaining 13% vs. 5% for the Dow Jones Composite Index. Those are price-only indices so dividends, which are ~30% greater for the blue-chip index, aren’t counted. Therein lies the problem! Fear of going over the “fiscal cliff” had investors pulling money out of stocks that pay good dividends. Those dividends would have been taxed approximately twice as much had we gone over the cliff. We didn’t and are predicting that 2013 will see a renewed interest in dividend-paying stocks.

It’s time to update our previously published Growing Perpetuity Index (GPI, see Week 66). The 12 companies in our GPI  are the bluest of blue-chips, and had an average Total Return of only 3.8% (Table). For 5 and 10 yr periods, the GPI handily outperformed the S&P 500 Index, as well as the Vanguard Dividend Growth Fund, a more appropriate benchmark for the GPI (Table). We have separated those 12 stocks into two groups, 7 that are low risk and 5 that are high risk.

Warren Buffett has stated on several occasions that stocks having a 5-yr Beta greater than 0.7 are best avoided. And the better hedge funds generally have 5-yr betas of less than 0.7. Indeed, at the May 2012 annual meeting of Berkshire Hathaway, Mr. Buffett indicated that a group of 5 above-average hedge funds lost 35% less than the S&P 500 Index during the Lehman Panic (Week 46). In other words, those hedge funds had a 5-yr Beta of less than 0.65. That is why we have recently started breaking our blog tables into two groups: an upper group that lost less than 65% as much as the S&P 500 Index during the Lehman Panic and had a 5-yr Beta less than 0.65, vs. a lower group that doesn’t meet that standard (see Week 78).

Our GPI has 7 such companies in the top group (Table): Wal*Mart (WMT), McDonald’s (MCD), NextEra Energy (NEE), IBM (IBM), Johnson & Johnson (JNJ), Coca-Cola (KO) and Procter & Gamble (PG). Those 7 had an average total return of 8% in 2012. More importantly, the aggregate data for those 7 stocks (line 9 of the Table) is impressive. Only two other A-rated dividend-paying stocks in the S&P 500 Index can come close to matching that data set, namely, Darden Restaurants (DRI) and General Mills (GIS). Darden Restaurants’ credit rating is too low to warrant inclusion in our Master List (Week 78) and General Mills has only raised its dividend for 6 consecutive yrs, instead of the 10 required for inclusion in the Master List. A recent hit movie (“Moneyball” based on the 2003 book of the same name by Michael Lewis) dwelt on this point by showing that a baseball team composed of players that individually had a low market value could outperform richer teams if those players collectively had a high on-base percentage. This concept came earlier to the investment world, in the early 1980s, when Michael Milken showed that “fallen angels” (corporate bonds that had slipped below an investment-grade rating) could give good results if, as a group, key ratios were at an investment grade level.

The point here is that every company’s competitive advantage is a work in progress. Some years the pieces fall together nicely but other years see a potent competitor taking market share. Only by holding a number of well-chosen stocks can you pull ahead of the pack.

Bottom Line: If you’re within 15 yrs of retirement, confine your stock-picking to tickers with a 5 yr Beta of less than 0.65 that lost less than 65% as much as the S&P 500 Index during the Lehman Panic.

Risk Rating: 3.  

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Week 76 - Hedging Stocks vs. Financial Repression

Situation: As of 12/7/12, a “risk-free” 10-yr US Treasury Notes yields 1.63%. This is vs. the 4.12% paid just 5 yrs ago. Meanwhile, the Consumer Price Index (inflation) has grown at a rate of 2.2% over the past 5 years vs. 2.9% over the 5 years ending in 12/07. This means that a 10 yr Treasury Note purchased on 12/07/07 paid 1.2% more than inflation, whereas, a 10 yr Treasury Note purchased on 12/07/12 paid 0.6% less than inflation. That 1.8% “trim” is called Financial Repression. It occured as the Federal Reserve gradually took two trillion dollars worth of Treasury Bonds and Notes out of circulation, thereby increasing the price (and lowering the yield) of remaining Bonds and Notes. This drives down the “yield curve” and the net result is that investors become willing to take greater risks with their money to escape the losses due to inflation that result from sitting on cash in the form of Treasury Bills and Notes. Investors are denied a “safe harbor” for part of their investments and are being pushed into using that money to expand factories, provide new services, buy homes and hold more stocks.

The idea is to boost the economy while reducing the amount of interest the US Government pays on its debt. Wikipedia defines Financial Repression as “any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.” It is a disguised form of inflation, since all asset classes eventually come to be priced higher (by that same 1.8% noted above) vs. historic valuations relative to inflation. Some leading economists have concluded that Financial Repression is a form of taxation (cf. Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different. Princeton University Press, 2008, p. 143).

You may think that these monetary policies will soon end and the economy will recover enough to grow at its usual 3%/yr faster than inflation. Well, the last time the Federal Reserve employed Financial Repression it lasted from 1945 to 1980. When used by central banks of other countries, it has averaged 20 yrs in duration (Carmen Reinhart and Belen Sbrancia, National Bureau of Economic Research working paper, 2011). Over the last 35 years, Sweden’s use was the briefest at 6 yrs (1984-1990).

What is our goal for today’s blog? How do we defeat Financial Repression in order to save for our retirement. That is a tall order, given that every asset class is valued relative to US 10-yr Treasury Notes. Hedge funds, however, are designed to respond to asset class impairment. In response to the Lehman Panic, many hedge fund traders hopped into gold, oil, and emerging market stocks. Then they tried high yield (and emerging market) bonds and high yield stocks. All of those predictably became overpriced. Thus, hedge funds haven’t fared all that well over the past year or two. Now they’re taking a closer look at dividend-growing companies in “defensive” industries, namely, healthcare, consumer staples, and utilities, even though stock in those companies has also become high-priced. 

In this week’s blog we take that approach and simply ask, which stocks fit our definition of a Hedge Fund (see Week 46)? That would be a stock that has beat the S&P 500 Index over the past 10 & 5 yrs, and fallen less than 65% compared to the S&P 500 Index during the Lehman Panic (10/07-4/09). That means we’ll have to stick to looking at stocks with a 5-yr Beta of 0.64 or less. And, since the S&P 500 Index had only a 1% total return for the past 5 yrs, we’ll only look at stocks with a 5-yr total return at least as great as that for “risk-free” money, which is 2.8% (i.e., the average rate of interest on 10-yr US Treasury Notes over the past 5 yrs). Because this blog is about saving for retirement by reinvesting dividend income, we’ll only look at stocks with a dividend yield of at least 1.8% (i.e., the 15-yr moving average for S&P 500 dividend yields). And, since there’s not much point in starting with a dividend-paying stock that doesn’t meet the “business case” for investment (see Week 68), we’ll exclude stocks that have a 5-yr dividend growth rate of less than 6%/yr. Finally, we’ll check financials on the WSJ website and exclude any that:
   a) have a return on invested capital (ROIC) less than the weighted average cost of capital (WACC), 
   b) are capitalized mainly by long-term loans, or 
   c) didn’t have enough free cash flow (FCF) last year to pay at least half of this year’s dividends.

In this analysis, we have turned up only 10 companies (Table). As expected, most come from one of the 3 “defensive” industries: ABT (Healthcare), WEC, NEE (Utilities), and MKC, HRL, GIS (consumer staples) but each of the remaining 4 (MCD, CHRW, CB, IBM) come from one of the other 7 S&P industry classifications. It will come as no surprise that all 10 companies have an S&P stock rating of A-/M or better, and an S&P bond rating of BBB+ or better. 

We compare these 10 stocks with our two favorite benchmarks (see Week 3):
   a) a 50:50 split between low-cost mutual funds tracking the S&P 500 Index (e.g. VFIAX) and the Barclays Capital Aggregate Bond Index (e.g. PRCIX); and
   b) the only mutual fund that is balanced ~50:50 between stocks and bonds, low-risk, low-cost and performs like a good hedge fund: Vanguard Wellesley Income Fund (VWINX). For you, the safest, cheapest, and least time-consuming way to save for retirement is to employ one of those benchmarks. 

Bottom Line: Hedge funds seek to beat the S&P 500 Index during bull markets but fall less during bear markets. We set out to see which stocks perform like an above-average hedge fund (i.e., fell less than 65% during the Lehman Panic while beating the market) by using the most rigid criteria. We find that such safe & effective stocks are rare, and don’t necessarily hide out in the 3 “defensive” industries (healthcare, consumer staples, utilities). In other words, we had to look at all 114 stocks in Zack’s database that meet our key criteria (capitalization of at least $8 Billion, dividend yield of at least 1.8%, 5 yr dividend growth rate of at least 6%, and ROIC of at least 9.5%). 


Risk Rating: 3. In other words, ownership of these stocks doesn’t have to be hedged with ownership of an equivalent amount of 10-yr US Treasury Notes and/or their untaxed equivalent (Savings Bonds) or a investment-grade bond fund like PRCIX. They’re internally hedged, much like the two utility stocks (WEC, NEE) but for more complex reasons having to do with competitive advantage (a topic we’ll explore in future blogs).

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

Week 75 - S&P 100 Companies without Red Flags

Situation: We all know that President Harry Truman preferred one-handed economists because he found the phrase “on the other hand” to be so exasperating. And, increasingly, the tables that accompany our blogs are sprinkled with red flags. So this week we’ll publish a Table that doesn’t look like it has the measles!

You’ve already heard that we favor large companies with multiple product lines ringing up sales. Why? Because that creates internal support, meaning that when sales crump in one line the company has the resources and talent needed to fill that hole. Anyone who has played on a good sports team or fought in a good military unit understands that concept. But stock traders don’t (or won’t) embrace it because the company then becomes too difficult to value “by the sum of its parts.” This means the stock’s price will lag behind its earnings growth. But you don’t care because you use a “buy and hold” investment strategy.

Accordingly, we’ve screened companies in the S&P 100 Index for the following traits (Table):
a) Dividend yield greater than or equal to 1.8%;
b) 10 yr annualized total return greater than or equal to 5%;
c) Losses during the Lehman Panic less than those for the S&P 500 Index;
d) Finance Value (b plus c) that beats the S&P 500 Index;
e) 5 yr annualized total return of at least 2.9% (i.e., the “risk-free” rate determined by averaging the interest rate of 10 yr US Treasury Notes over the past 5 yrs);
f) 5 yr dividend growth rate of at least 4%;
g) Return on Invested Capital (ROIC) of at least 10% over the trailing 12 months;
h) Long-term debt that is less than half the company’s total capitalization;
i) Last year’s free cash flow (FCF) is sufficient to fund this year’s dividends.

Our screen turned up 10 companies. Note that 6 of the 10 are from the Stockpickers Secret Fishing Hole (Week 29 & Week 68), which is the 65-stock Dow Jones Composite Index (DCA). Excluding regulated utilities (which have too much debt and too little free cash flow to pass our screen), there are 32 DCA companies in the S&P 100 Index. So the chance of a DCA company passing our screen is 19% (6 divided by 32) vs. 5.9% (4 divided by 68) for a non-DCA company.

Bottom Line: You can win by staying away from companies that are inefficient (low ROIC), have high LT debt, or pay dividends with retained earnings and borrowed money instead of using free cash flow. There is no bad news in our screen. If your portfolio contained these stocks throughout the past 10 yrs and you kept buying more during the Lehman Panic, then you’re a smart “vulture investor."

Risk Ranking: 6 (see Week 72).

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