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

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

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

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

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

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

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

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

Execution: see Table.

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

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

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

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

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

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

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

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

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

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

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Month 94 - Food and Agriculture Companies - Spring 2019 Update

Situation: Investors should pay attention to asset classes that fluctuate in value out-of-sync with the S&P 500 Index. Such asset classes are said to have minimal or negative “correlation” with large-capitalization US stocks. Emerging markets and raw commodities are important examples. Those are a natural pair, given that most countries in the emerging markets group have an economy that is based on the production of one or more raw commodities. 

The idea that you can find a safe haven for your savings, one which will allow you to ride out a crash in the US stock market, is a pleasant fiction. Articles in support of that idea are published almost daily. But unless you are a trader who can afford to rent or buy a $500,000 seat on the Chicago Mercantile Exchange, you probably aren’t deft enough to arbitrage the various risks accurately enough before they develop (and at low enough transaction costs) to avoid losing money in a crash. 

If you really want to ride out most crashes, invest in a bond-heavy balanced mutual fund that is managed by real humans. The Vanguard Group offers one best, and it comes with very low transaction fees (Vanguard Wellesley Income Fund or VWINX). To refresh yourself on the competitive advantages of investing in food and agriculture companies, see our most recent blog on the subject (see Month 91). To refresh yourself on the competitive disadvantages, study this month’s Table and Bottom Line carefully.

The essential fact is that economies require money for spending and investment. That comes down to having consumers who are confident enough about their employment prospects and entrepreneurs who are confident enough about their ability to invest. Those consumers and entrepreneurs can be relied upon to transfer their successes to the larger economy by saving money, taking out loans, and paying taxes. National economies are interlinked. Because of the size and innovation of its marketplace, the US economy is the main enabler for most of the other national economies. Logic would suggest that the valuation for any asset class will roughly track the ups and downs of the S&P 500 Index, either as a first derivative or second derivative. 

Mission: Use our Standard Spreadsheet to analyze US and Canadian food and agriculture companies that carry at least a BBB rating on their bonds (see Column R).

Execution: see Table.

Administration: Of the 25 companies listed in the Table, only one meets Warren Buffett’s criteria of low beta (see Column I), low volatility (Column M), high quality (Column S), strong balance sheet (Columns N-R), and TTM (Trailing Twelve Month) earnings plus mrq (most recent quarter) Book Values that yield a Graham Number which is not far from the stock’s current Price (Column Y). That company is Berkshire Hathaway. We use a Basic Quality Screen that is less stringent as his: 1) an S&P stock rating of B+/M or better (Column S), 2) an S&P bond rating of BBB+ or better (Column R), 3) 16-Yr price volatility (Column M) that is less than 3 times the rate of price appreciation (Column K), and 4) a positive dollar amount for net present value (Column W) when using a 10-Yr holding period in combination with a 10% discount rate (to reflect a 10% Required Rate of Return).

Bottom Line: Only 8 companies on the list pass our Basic Quality Screen (see Administration above): HRL, COST, PEP, KO, DE, FAST, CNI, UNP. At the opposite end of the spectrum, 9 companies have a below-market S&P bond rating of BBB. So, those stocks represent outright gambles. 

Aside from Berkshire Hathaway, none of the 25 companies can be said to issue a reasonably priced “value” stock. We’re dealing with 24 “growth” stocks, only a third of which are of high quality. Three of the 9 with BBB bond ratings have high total debt levels relative to EBITDA (see Column O in the Table) that are unprotected by Tangible Book Value (Column P): SJM, MKC, GIS. The good news is that only one of the 9 appears to be overpriced, and that company (MKC) is a quasi-monopoly that has little risk of bankruptcy because it has “cornered” the US spice market. 

In summary, you can do well by investing in this space as long as you understand that you’re dealing with a fragmented food industry, one that is flush with companies of dubious quality. You might like to be well-informed about these companies because food, like fuel, is an essential good, and the food industry enjoys steady growth. Why? Because the number of people in Asia & Africa who can afford to consume 50 grams of protein per day grows by tens of millions per year.

Risk Rating: ranges from 6 to 8 (where 10-Yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion =10).

Full Disclosure: I dollar-average into TSN, KO and UNP, and also own shares of AMZN, HRL, MO, MKC, BRK-B, CAT and WMT.

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

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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 383 - Dow Theory: A Primary Uptrend Resumed on 9/20/2018

Situation: The Dow Jones Industrial Average (DJIA) fell 9% from the end of January to the end of March because of a developing trade war. The Dow Jones Transportation Average (DJTA) confirmed this move, suggesting that a new primary downtrend was developing. However, neither the DJIA nor the DJTA reached previous lows. By 9/20/2018, the DJIA reached a new high confirming the new high reached a month earlier by the DJTA. So, the decade-long primary uptrend had resumed after an 8-month hiccup. Why? Because trade war fears had abated. 

Both the DJIA (DIA) and DJTA (ITY) have out-performed Berkshire Hathaway (BRK-B) over the past 5 years, which is unusual. This leads stock-pickers to pay more attention to the stocks that are most heavily weighted in constructing those price-weighted indices. 

Mission: Take a close look at the top 10 companies in each index by applying our Standard Spreadsheet.

Execution: see Table.

Bottom Line: Eleven of the 20 companies issue bonds that carry an S&P rating of A- or better, and 6 of those 11 carry an S&P stock rating of A-/M or better: Home Depot (HD), UnitedHealth (UNH), 3M (MMM), Boeing (BA), International Business Machines (IBM), and Union Pacific (UNP). In that group, only IBM has failed to outperform BRK-B over the past 5 and 10 year periods.

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

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

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Week 312 - Farm Equipment

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

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

Execution: see Table.

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

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

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

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

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

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

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

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Week 173 - Why Vanguard?

Situation: Warren Buffett, in his Annual Report to Berkshire Hathaway investors this spring, included a “letter” to his relatives. It recommended that they structure investments in their “trusts” as follows: 90% in the Vanguard index fund dedicated to the S&P 500 Index (VFINX) or the index fund dedicated to the total US stock market (VTSMX), and 10% in the Vanguard managed fund dedicated to short-term US Treasury Notes (VFISX). His main concern was to minimize their investment costs while tracking stock market returns.

Our readers aren’t as rich as his relatives. So, we suggest that you back your stock investments 1:1 with US Treasury Notes & Bonds, other AAA-rated bonds, Savings Bonds, or the Vanguard Intermediate-term Treasury Fund (VFITX). In other words, the most prudent long-term investment balances large-capitalization US stocks with risk-free AAA bonds. And by “long-term”, we mean that you intend to hold your investment for at least 20 yrs in anticipation of using it for retirement purposes. Our benchmark for “Risk-On” investors is the Vanguard Balanced Index Fund (VBINX), which is composed 60% of a capitalization-weighted index of the total US stock market and 40% of an investment-grade US bond index (mainly US Treasuries). For “Risk-Off” investors, our benchmark is Vanguard’s Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks. “Risk-Off” investors are those who have moved closer to drawing on retirement income and have less investment time available to recover from market fluctuations.

When calculating your 1:1 stock:bond balance, remember to include the present value of your Social Security account, which would be $164,000 if you were to qualify today for a beginning payout of $2000/mo and were to receive monthly payouts for the next 11 yrs, assuming a discount rate of 5.6%. That discount rate is the sum of the “risk-free” rate (2.6% interest on a 10-yr Treasury Note) and “risk” (i.e., inflation, as reflected in a 3.0%/yr estimated annual cost-of-living adjustment). Total payments would amount to almost $305,000 over 11 yrs, with a monthly payment of $2636 in the 11th yr.

We need to draw attention now to the costs that are associated with investment accounts. How important are those costs? Well, the standard rule of thumb for business accountants is to note any cost as being “material” if it represents more than 5% of revenues or earnings. Upon noting said cost, the accountant will delve deeper to determine whether it is justified. Using that guideline, let’s look at the past 100 yrs of returns from owning 10-yr Treasury Notes and reinvesting interest payments vs. owning shares of the S&P 500 Index and re-investing dividend payments. Over that 100 yr period of time, the key facts  are:

        1) Inflation averaged 3.22%/yr;

        2) Total returns on 10-yr Treasury Notes averaged 5.05%/yr (1.83% after inflation);

        3) Total returns on the S&P 500 Index averaged 10.16%/yr (6.94% after inflation);

        4) Total after inflation returns for our recommended 50:50 allocation averaged 4.39%/yr;

        5) Therefore, transaction costs (expenses) become material when the expense ratio reaches 0.22%/yr, which would bring the after inflation total return down to 4.17%/yr; 

        6) The relevant Vanguard funds are VFITX (intermediate-term Treasuries) with an expense ratio of 0.20%/yr, and VFINX (S&P 500 Index) with an expense ratio of 0.17%. Both of those expense ratios are less than 0.22%/yr, so transaction costs are immaterial. 

Vanguard index funds were invented by John Bogle to provide retail investors with market-tracking investments that have immaterial transaction costs. (The only remaining costs are taxes and inflation.) The issue that concerns Mr. Bogle is that the average retail investor has an expense ratio of 2.2%/yr, which is 10 times too much! That is the reason why Warren Buffett thinks so many investors are being disappointed. Half of their after-inflation returns are being eaten up by costs, 90% of which can be eliminated by sticking to Vanguard index funds. 

Treasury Notes don't provide interest payouts that grow faster than inflation, but Vanguard's S&P 500 index fund (VFINX) has grown its dividend payout 4.7%/yr since 1980, which is 1.5%/yr faster than inflation over that 34-yr period. However, those payouts bounce around a lot because ~150 companies don’t pay a dividend. Only about 150 increase their dividend annually. 

Now you have the explanation why the purpose of this blog is to interest you in buying stock monthly (online) in selected companies that have increased their payout for at least 10 yrs at a rate 3-4 times faster than inflation. Some of those companies charge no transaction costs for automatic monthly investments (see Week 162). Examples include NextEra Energy (NEE), Abbott Laboratories (ABT), and ExxonMobil (XOM) for shares purchased through computershare.

Bottom Line: Here at ITR, we stress two things: minimizing transaction costs and maximizing retirement income. For this week’s Table, we’ve used our “Risk-On” benchmark (VBINX) supplemented with Vanguard’s intermediate-term Treasury fund (VFITX) to construct a 50:50 stock:bond fund, i.e., 75% VBINX and 25% VFITX. By having 25% invested in a Treasury bond fund, you’ll have an investment that goes up in value during a recession, and also provide a way to pay for unforeseen emergencies that often crop up during a recession. Alternatively, you can invest in the Vanguard Wellesley Income Fund, or a 50:50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Intermediate-term Treasury Fund (VFITX). All 3 of these options are worry-free and track the markets in a manner that gives you protection from a crash in the stock market. Plus, you don’t have to fiddle with picking stocks and the added complexity they bring to paying taxes.

Risk Rating: 4.

Full Disclosure: I invest monthly in inflation-protected Savings Bonds at and in NEE and ABT.

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