Situation: Membership in “The 2 and 8 Club” is based on the FTSE High Dividend Yield Index, which consists of the ~400 companies in the FTSE Russell 1000 Index that reliably pay an above-market dividend. Real Estate Investment Trusts (REITs) are excluded from the FTSE High Dividend Yield Index because their dividend payouts are variable, being fixed by law at 95% of gross income. But those payouts are usually higher than the yield on an S&P 500 ETF (e.g. SPY), which is ~2%. We are curious as to whether any REITs meet the 5 basic requirements for membership in “The 2 and 8 Club”, and find that there are 4 (see Table). However, REITs are typically “small cap stocks.” Only one of the four in our Table is a large enough company to be included in the FTSE Russell 1000 Index (Simon Property Group; SPG).
Mission: Populate our Standard Spreadsheet for REITs. Select only those that meet the 5 basic requirements for membership in “The 2 and 8 Club”:
1) above-market dividend yield;
2) 5-Yr dividend growth of at least 8.0%/yr;
3) a 16+ year trading record that is analyzed weekly for quantitative metrics by the BMW Method;
4) an S&P Bond Rating of BBB+ or higher;
5) an S&P Stock Rating of B+/M or higher.
Add a column for FFO (Funds From Operations; see Column P in the Table), which is a ratio that the REIT Industry substitutes for P/E.
Execution: see Table.
Bottom Line: Pricing for REITs is negatively correlated with rising interest rates but not as much as you might suspect. This is likely because the dividend yield for most REITs remains above the interest rate on a 10-Yr US Treasury Note. Pricing is more sensitive to the likelihood that the REIT will have enough FCF (Free Cash Flow) to fund dividend payouts (see Column R in the Table). Overall, it is hard to argue against the idea that high-quality REITs are a good “bond substitute.”
Risk Rating: 4 (where 10-Yr US Treasury Note = 1, S&P 500 Index = 5, gold bullion = 10)
Full Disclosure: I dollar-average into SPG and own shares of KIM.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.
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Situation: You’d like to invest in stocks without leaving money on the table. The alternative is to invest in the S&P 500 Index, which is a derivative subject to the kind of Program Trading that caused the “Black Monday” crash on October 19, 1987. Even after 3 decades of refining New York Stock Exchange technology to apply lessons learned from that crash, its recurrence remains a distinct possibility.
You can invest in stocks without getting swept up in full fury of the next crash by using a few precautions: 1) Avoid stocks that have a statistical likelihood of losing more money than the S&P 500 Index per the BMW Method, i.e., avoid stocks highlighted in red at Column M in our Tables. 2) Use dollar-cost averaging to invest through a Dividend Re-Investment Plan (DRIP) in stocks that aren’t highlighted in red, and continue automatically investing in those each month throughout the next crash. 3) Avoid non-mortgage debt and have at least 25% of your assets in Savings Bonds, 2-10 Year US Treasury Notes, cash and cash equivalents.
Mission: Looking at the 30 stocks in “The 2 and 8 Club” (see Week 329), set up a spreadsheet of those that do not have red highlights in Column M.
Execution: There are 12 such stocks (see Table).
Administration: Note that Costco Wholesale (COST) is not listed in the FTSE High Dividend Yield Index upon which “The 2 and 8 Club” is based. While dividend growth rate is 13.0%/yr, its dividend yield is only 1.3%, which is much lower than the ~2%/yr required for inclusion in the FTSE High Dividend Yield Index. This overlooks the fact that Costco Wholesale issues special dividends of $5 or more every other year! So, I’ve chosen to make COST an honorary member of “The 2 and 8 Club.”
Bottom Line: You do have a chance of beating the S&P 500 Index without gambling, by investing in high quality growth stocks that are unlikely to lose as much as that index in the next market crash. But we find only 12 such stocks, which means you’d need to invest in all 12 to avoid selection bias.
Risk Rating is 5, where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold = 10.
Full Disclosure: I dollar-cost average into IBM, KO, XOM and NEE, and also own shares of MO and TRV.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com
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Situation: Objective reality is mercenary. Business deals are largely about “transferring risk to a less knowledgeable party.” We know better than to take these things personally, but we tire of the rat race and look forward to drinking with friends on the weekend.
We often take risks ourselves, to recover from our mistakes (divorce, buying a “fixer-upper” in a changing neighborhood, not kicking adult children out to face the world, etc.).
To avoid becoming alcoholics or gamblers, we must tend better to our personal relationships and try not to be an avatar of money. How does one do that? Three ways: One is about the way we invest, making wise choices. That would include having a large cash position, and a nest egg of stocks and bonds that aren’t gambles. Another is in the messages we give off, the optics and emojis we emanate. Finally, we must place a high value on family life, loyalty.
We all know how to give the impression that we’re about money, which is to “dress for the job you want”. At the opposite end of the spectrum, you’ll find people who are sans artifice but steady and reliable. They don’t armor themselves in upscale clothing, makeup, or scents. Men would then find themselves leaving the suit jacket, the sport coat, the tie, the permanent-press shirt, and the shiny shoes in the closet. And maybe think about replacing that expensive ride with a Prius Two or small Tesla.
For women, it would mean falling out of bed in the morning to compose her ensemble, which may include clothing that doesn’t cover up tattoos, no makeup, and Skechers as the default choice in footwear. Once so-attired, openness toward whomever comes naturally, without giving a thought to talking up or down to that person.
Let’s look at the money side. What does “having a large cash position” mean? It means you either hold Treasury Bills at www.treasurydirect.gov (and dollar-average into 2-Yr Treasury Notes as well as Savings Bonds), or you hold a large cash balance at an FDIC-insured bank.
Why is cash important? A recent Wall Street Journal article titled “Longer CFO Tenure is Good for Companies” has a good explanation. When faced with the Lehman Panic in 2008, the CFOs who kept their jobs used good people skills to hold on with successive CEOs but also went into the crisis with large cash positions on the company ledger. Not surprisingly, the companies that have these long-tenured CFOs tend to have unusually good stock performance. Simple message, isn’t it? Good people skills combined with a propensity to hold large cash positions. And, it doesn't depend on a lot of experience. Some of those CFOs were barely 30 years old when the Lehman Panic hit. It's a matter of values.
Mission: Assemble a list of A-rated Dividend Achievers that have Tangible Book Value and also have shown less volatility than the S&P 500 Index over the past 20 years.
Execution: see Table.
Bottom Line: This is a “tortoise and hare” blog, the Central Thought being to “live long and prosper.” Use little debt and maintain a large cash position, that’s the easy part. You just need to say “no” a few times, and walk the talk (meaning no artifice or excess in your habits). The hard part is hewing to family life. Believe it or not, that’s the best way to prevent high blood pressure. I know. I’m a doctor. (Try getting through a divorce without high blood pressure.)
For equities, the 10 stocks in the Table have returned almost 12%/yr since the S&P 500 peak on 7/19/07 vs. ~7%/yr for the S&P 500 Index ETF (SPY). For cash, the iShares 1-3 Year Treasury Bond Index ETN (SHY) has returned 2.0%/yr (vs. inflation of 1.7%/yr).
Risk Rating: 4 (where 10-Yr US Treasury Note = 1, S&P 500 Index = 5, gold = 10)
Full Disclosure: For equities, I dollar-average into JNJ, PG and NEE, and also own shares of HRL, TRV, MMM, and WMT. For cash, I dollar-average into ISBs (Inflation-Protected Savings Bonds).
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Situation: You need a way to save for retirement that is safe and effective. We agree with Warren Buffett’s approach which is to use a low-cost S&P 500 Index fund combined with a low-cost short-intermediate term US Treasury fund. If you’re wealthy, make the stock:bond mix 90:10. If not, move toward a 50:50 mix.
If you’re a stock-picker but fully employed outside the financial services industry, find a formula that won’t require a lot of your time for oversight and maintenance. The S&P 500 Index has too many stocks, so stick to analyzing the Dow Jones Composite Index. Those stocks have been picked by the Managing Editor of the Wall Street Journal. Start with the 20 companies in that 65-stock index that pay at least a “market dividend” and are Dividend Achievers, i.e., have raised their dividend annually for at least the past 10 years. We call that shortened version The Growing Perpetuity Index (see Week 261). It also excludes companies with less than a BBB+ S&P Bond Rating or B+/M S&P Stock Rating. But companies with with ratings lower than A- tend to develop problems, as do companies with negative net Tangible Book Value. (The SEC requires that the sale of newly-issued shares on a US stock exchange not dilute a company’s net Tangible Book Value below zero.)
Mission: Revise “The Growing Perpetuity Index” to exclude companies with negative Tangible Book Value, as well as companies with an S&P Bond Rating less than A- or an S&P Stock Rating less than A-/M.
Execution: We’re down to 9 companies (see Table).
Administration: Our Benchmark for companies that pay a “good and growing” dividend is the Vanguard High Dividend Yield ETF (VYM at Line 14 in the Table). That fund represents a subset of the Russell 1000 Index of the largest publicly-traded US companies which pay at least as high a dividend yield as the average for the full set. As it happens, all of the companies in the subset that have A ratings from S&P on their bonds and stocks are Dividend Achievers.
In next week’s blog, we highlight the 11 companies in VYM that aren’t in the Dow Jones Composite Index. Then you’ll need to track only 20 companies on your adventure into stock-picking! But be aware: 30% of those 20 companies are boring utilities, meaning that clear-eyed stock-picking isn’t glamorous at all. It’s just making money by not losing money, which is Warren Buffett’s #1 Rule.
Bottom Line: Stock-picking becomes a problem for non-gamblers at the Go/No-Go point, i.e., after 5 years of trying, you need to think about giving up if you can’t beat the total return/yr for an S&P 500 Index fund (SPY or VFINX) by at least 2%/yr. This is because you need to cover your greater transaction costs and capital gains taxes that are being expensed out. We’re suggesting that you start with 9 “blue chip” stocks that have a reasonable likelihood of letting you stay in the game after a 5 year probation period. Of course, you’d be opening yourself up to selection bias because there is a greater risk of loss vs. investing in all 500 stocks. Academic studies have shown that you’d need to own shares in at least 50 companies to largely overcome that risk.
Risk Rating: 6 (10-Yr Treasury Note = 1, S&P 500 Index = 5, gold = 10).
Full Disclosure: I dollar-average into NEE, MSFT, JNJ, KO, and UNP. I also own shares of MMM, TRV, and WMT.
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Situation: We know for certain that this is a period of great anxiety in credit markets. Trillions of dollars in loans have been made by banks in Southern Europe and East Asia that are now worth less than a third of their face value. Many of these loans were made by private banks, but governments are ultimately “on the hook” for the debt. With non-performing debts on their books, banks have less ability to make worthwhile loans to support economic growth, education and upgrades of infrastructure. A credit crunch is going to happen, unless these bad debts are boxed up, tied with a ribbon, and sold to the highest bidder. Remember: the credit crunch of 2008-09 quickly cut worldwide GDP growth per capita in half, from 2%/yr to 1%/yr. And it didn’t start to recover until this year.
What’s the best way for you to drill down on this subject? I suggest that you read Peter Coy’s article, which appeared in Bloomberg Business Week last October. His analysis responds to the International Monetary Fund’s 2016 Global Financial Stability Report that was hot off the press. Here are bullet points from that report: “medium-term risks continue to build”, meaning 1) growing political instability; 2) persistent weakness of financial institutions in China and Southern Europe; 3) excessive corporate debt in emerging markets. In China, combined public and private debt almost doubled over the past 10 years, and is now 210% of GDP (worldwide it’s 225% of GDP).
Mission: What’s the best way to tailor your retirement portfolio in response to these global risks? Become defensive. That doesn’t just mean having a Rainy Day Fund that is well-stocked with interest-earning cash-equivalents (Savings Bonds, Treasury Bills, and 2-Yr Treasury Notes). It means overweighting high quality “defensive stocks” in your equity portfolio. What is the Gold Standard? Companies in the S&P 100 Index that are in the 4 S&P Defensive Industries:
Consumer Staples;
Healthcare;
Utilities; and
Communication Services.
Large companies have multiple product lines, and membership in the S&P 100 Index requires a healthy options market for the company’s stock, to facilitate price discovery. You have to drill deeper in your analysis, to be sure the company’s S&P credit rating is A- or better, and its stock rating is A-/M or better. Statistical information has to be available from the 16-Yr series of the BMW Method and the 2017 Barron’s 500 List. Check financial statements for signs of high debt: long-term bonds that represent more than a third of total assets, operating cash flow that covers less than 40% of current liabilities, or an inability to meet dividend payments out of free cash flow (FCF). Exclude companies with negative Tangible Book Value.
Execution: By using the above criteria, we uncover 7 companies out of the 32 “defensive” companies in the S&P 100 Index (see Table).
Bottom Line: Defensive companies are less interesting than growth companies or companies involved in the production of raw commodities. But high-quality defensive companies, such as Johnson & Johnson (JNJ) and NextEra Energy (NEE), consistently grow earnings faster than GDP and are quick to correct any earnings shortfall. All an investor need do is learn to read financial statements, and regularly examine websites for data on companies of interest.
Risk Rating: 4 (where 1 = 10-Yr Treasury Notes, 5 = S&P 500 Index, 10 = gold bullion).
Full Disclosure: I dollar-average into Coca-Cola (KO), NextEra Energy (NEE), and Johnson & Johnson (JNJ). I also own shares in Costco Wholesale (COST) and Wal-Mart Stores (WMT).
NOTE: Metrics are current for the Sunday of publication. Red highlights denote under-performance vs. VBINX at Line 15 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 4-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K. Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning shares in a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 20 in the Table. The ETF for that index is MDY at Line 14. For bonds, Discount Rate = Interest Rate.
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Situation: 60℅ of Americans over age 65 are “overwhelmingly” dependent on Social Security and 20% are totally dependent (“Animal Spirits”, George A. Akerlof and Robert J. Shiller, Princeton University Press, Princeton and Oxford, 2009, p. 124). To maintain Social Security in its current form, with cost of living adjustments (COLA), would consume ~2℅ of the country's taxable income going forward. The average monthly benefit (July 2016) for a retired worker is $1350. Contrast this with the US “poverty threshold” of $1200/mo.
Mission: Outline constraints on the 20% who are totally dependent on Social Security and the 40% who have some savings but remain overwhelmingly dependent on Social Security. Create a spreadsheet of the types of assets held by the latter group.
Execution: To live independently on $1350/mo, an individual or couple would have to start retirement debt-free and remain so. If they are living rent and mortgage free in their home, they will not be able to afford the expenses (maintenance, property tax, utilities) unless they take in a renter. A car would also not be affordable due to expenses (insurance, tires, maintenance, registration). The discipline of sticking to a budget rules out the use of credit cards; a debit card and checking account are a better plan. They would need to use accrual accounting. That is, assign all $1350 of income each month to budgeted expense, including a savings account for non-recurring capital expenditures on new clothes, vacations, income taxes and medical/dental expenses.
The 40% who find themselves overwhelmingly dependent on Social Security probably had no intention of ever owning stocks or stock mutual funds, preferring instead to use FDIC-insured savings accounts, Savings Bonds, whole life insurance, 1/10th ounce gold coins and a money market fund (or short-term bond fund) obtained from a broker. They are savers rather than investors and don’t want to place their savings at risk. They’d like to avoid losing money to inflation, and may be aware that the only zero-risk/zero-cost investments are 10-Yr Inflation-protected Treasury Notes and IRA-like Inflation-protected Savings Bonds obtained online.
This cohort doesn’t want to gamble, which means they don’t want to invest in asset classes that always seem to fall in value during a recession. That restraint rules out stocks, corporate bonds, and REITs but not the equity in their own home. They may strive to own a home, but until the Housing Crisis they weren’t fully aware of the risk. Now they know that only Treasury Notes and gold can be counted on to rise in value during a financial crisis.
Administration: see Table.
Bottom Line: Live small, stay out of debt, close any credit card accounts and keep track of every penny in an accrual accounting ledger.
Risk Rating: 3 (where Treasury Notes = 1 and gold = 10).
Full Disclosure: I dollar-average into Savings Bonds and hold Treasury Notes at www.treasurydirect.gov. I hold an intermediate-term US Treasury Bond Fund in a retirement account.
NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 13 in the Table.
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Situation: The stock market is overpriced, which is the obvious outcome of “quantitative easing” and ultra-low interest rates. US Treasury bonds and notes carry an interest rate that is close to the projected inflation rate over their holding period. Stocks, in spite of their added risk, are the only path to portfolio growth. For that reason, the business news increasingly talks up “bond-like” stocks.
Mission: In last week’s blog, we set up criteria for defining “bond-like” stocks, starting with the requirement that they be Dividend Achievers, i.e., the dividend has been increased annually for at least the past 10 yrs. Now we’ll use those same criteria to highlight “below the radar” stocks, e.g. those issued by companies that don’t have sufficient revenue to be included in the 2016 Barron’s 500 List.
Execution: We exclude any Dividend Achiever from consideration if one or more of the following conditions apply:
1. Revenues are insufficient to warrant inclusion in the 2016 Barron’s 500 List;
2. S&P bond rating is less than BBB+ or (in the absence of a rating) debt/equity is less than or equal to one;
3. S&P stock rating is less than B+/M or S&P assigns a denominator of “H” to the rating (indicating high risk of loss);
4. WACC exceeds ROIC;
5. Finance Value (Column E in our Tables) falls more than for the Vanguard 500 Index Fund (VFINX);
6. Dividend yield is less than for VFINX;
7. 16-yr CAGR is less than for the S&P 500 Index (^GSPC);
8. Dividend yield + 16-yr CAGR is less than 11.4%. NOTE: This metric has predictive value for Net Present Value (NPV) and is highlighted in yellow at Column Q in the Table.
9. Predicted loss to the investor at 2 standard deviations below 16-yr price CAGR is more than 36% (see Column P in the Table).
Bottom Line: We’ve found a dozen Dividend Achievers that appear attractive for long-term investment, even though most reside in the S&P 400 MidCap Index. Not surprisingly, 7 of the 12 are utility stocks. But the strongest stock of the group is Tanger Factory Outlet Centers (SKT), a real estate investment trust.
Risk Rating: 5 (where US Treasuries = 1 and gold = 10)
Full Disclosure: I own shares of Lincoln Electric (LECO).
Note: Metrics are current for the Sunday of publication. Metrics highlighted in red denote underperformance relative to our key benchmark (VBINX at Line 25 in the Table). NPV inputs are listed and justified in the Appendix for Week 256.
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Situation: Warren Buffett suggests that investors follow certain guidelines, such as “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” If you read this blog regularly, I’m guessing you’re partly a gambler like the rest of us. Warren is just asking us to engage that superego (which we all possess) and be prudent while building a nest egg. Some money is for gambling, the rest has to look a lot like a Rainy Day Fund (see Week 203) and be suitable for weathering an unforeseen financial calamity. Retirement or unanticipated medical expenses could prove to be such a calamity. To prevent that, you’ll need to construct a retirement portfolio that is weighted with stocks that behave in a bond-like manner, and Treasury Notes. (Growth stocks, with their greater risk of loss, could do long-term damage to your retirement portfolio if the market were to crash soon after you retire.) Think about it. When we were young, financial advisors stressed the importance of owning growth stocks because we’d have time to recover from a crash and still come out ahead compared to owning Treasury Notes and bond-like stocks. But retirement planning uses the opposite logic. You don’t have time on your side, particularly if you’ve reached age 55 and your retirement savings amount to less than 4 times your income.
The problem: Almost half of the US’s soon-to-be-retired population has no access to a workplace retirement plan, and retirement savings for that age group only average $1000. If you, or someone you know, is in that cohort, then the least risky and lowest cost way to start digging out of that hole is to set up a “MyRA” online. That will help you save up to $15,000 in US Treasury issues by investing as little as $2.00 a time. “Interest earned is at the same rate as investments in the Government Securities Fund, which earned 2.31% in 2014 and an average annual return of 3.19% over the ten-year period ending December 2014.” During that 10-yr period, inflation averaged 2.04% you would have cleared a 1.15%/yr profit if MyRA accounts had been available then. Before MyRA accounts became available, only Federal employees had access to the Government Securities Fund. It pays the aggregate interest rate for all outstanding government securities that have more than 4 yrs remaining to maturity. There is no better way to reliably clear a profit net of inflation, net of transaction costs (zero in this case), and net of taxes (zero if you convert to a Roth IRA after investing the initial $15,000). Free money no strings attached.
Mission: Come up with a safe mix of assets for a Rainy Day Fund, i.e., a mix that has little chance of losing money in a financial crisis yet has a high chance of making a profit in each market cycle after allowing for expenses (inflation, taxes, and transaction costs). This is difficult to accomplish, as you might have noticed from reading our previous blogs on the subject (see Week 28, Week 33, Week 44, Week 112, Week 119, Week 151, Week 162, Week 188, Week 203). Our benchmark for Rainy Day Funds is the Vanguard Wellesley Income Fund (VWINX) at Line 15 in the Table, which is 60% bonds and 40% stocks. Its annual return has exceeded expenses (inflation, taxes and transaction costs) in 21 of the past 25 yrs while averaging 8.8%/yr, which beats inflation by 6.5%/yr.
Execution: No single investment (other than a MyRA) will protect you from losing money after inflation, taxes and transaction costs, but US Treasury Notes come close. Over the past 5 yrs, 10-yr Treasury Notes have paid 4.0%/yr if interest payments are reinvested in new 10-yr Notes (you can buy those cost-free in amounts of as little as $100 at treasurydirect.gov). Inflation took 1.2% and taxes took another 1.4%, leaving you with a 1.4%/yr profit. Why invest for the sake of a 1.4% return? Well, you need a safe place for some of your money. You don’t know when you’ll need it but you know that day will come. Wouldn’t a bond mutual fund be better? Those fluctuate a lot in value when interest rates change, going down when rates go up (and going up when rates go down), whereas, all of your principal investment is certain to be returned when a Treasury Note matures. Why not buy corporate bonds? Those carry high transaction costs and can’t beat comparably dated Treasury issues on a risk-adjusted basis. Why is that? Because all fixed-income investments are priced off Treasuries. A corporate bond is marketed to pay the investor a high enough interest rate to compensate for its risk of default. The risk-adjusted return of a 10-yr corporate bond is the same as the risk-adjusted return of a 10-yr Treasury Note issued the same month of the same year. You might as well point-and-click at treasurydirect.gov to get all your bonds, since transaction costs are zero, taxes are less, and inflation-protected options are available. The simplest way to invest in 10-yr Treasury Notes is to schedule monthly purchases of Inflation-Protected Savings Bonds (ISBs) online. You can point-and-click to sell those anytime. Proceeds go into your checking account the following business day, at which point you become liable for Federal Income Tax on the accrued interest. (You have no liability for state or local taxes.) If you cash an ISB before holding it for 5 yrs, you’ll miss out on one interest payment.
What about owning “safe” stocks? There isn’t such a thing but you can justify owning stock in selected “utilities” and “communication services” companies for even a minimal-risk Rainy Day Fund. The utilities industry has 3 different types of companies: fossil-fuel based providers of electricity, natural-gas based providers of space heating, and renewable energy based electricity providers that use nuclear, solar, or wind energy. I invest in NextEra Energy (NEE) as the renewable-energy electricity provider because it is the leader in using renewable and non-polluting sources of intermittent and unreliable power (wind and solar). But to continuously and reliably provide power from a renewable and non-polluting source, there is only one option: nuclear power. The severity and momentum of global warming is such that nuclear will have to become a much bigger power source than it is at present. There is only one electric utility in the US that both specializes in delivering nuclear power and has a large fleet of such units: Exelon (EXC). Picking a natural gas utility is tricky though. There are no large utilities dedicated to providing natural gas for space heating, partly because the price of natural gas varies so much. Second best is to choose a company that diversifies equally into natural gas and electricity markets. I like Dominion Resources (D), which has an extensive pipeline network for natural gas and “operates the largest North American interstate gas storage system.” Finally, you need to choose a “communications services” company. I like AT&T (T).
Bottom Line: If you’re “late to the game,” your Retirement Fund needs to look like a minimal-risk Rainy Day Fund. The emphasis here is to avoid loss, not to get rich. We’re really looking at a version of “The Tortoise and Hare” story whenever we design a Rainy Day Fund. Given enough time (2-3 market cycles), the slow and steady growth of a Rainy Day Fund composed 40% of low-risk stocks and 60% of 10-yr Treasuries will benefit from the near-absence of losses during stock market crashes. Eventually, its “price return” will eclipse the S&P 500 Index (compare Lines 12 and 20 at Column K in the Table), and do so at less risk (compare Lines 12 and 20 at Column M in the Table). But take good care of your health during those sunset years because 2-3 market cycles is a long time.
Risk Rating: 3
Full Disclosure: I dollar-average into 10-yr T-Notes, NEE, D, T, and EXC at the ratios indicated in the Table.
Note: Metrics in the Table are current as of the Sunday of publication; metrics highlighted in red denote underperformance relative to the Vanguard Balanced Index Fund (VBINX), our key benchmark. Returns in Column C of the Table date to September 28, 1992, because that is when VBINX was first traded.
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Situation: You don’t want to outlive your money. So, you’ll need a retirement plan that is robust enough to stay on track until you’re 100. Monthly payments from Social Security, plus Required Minimal Distributions from a 401(k) Plan, should see you through. However, a fixed-income private annuity or a workplace pension plan won’t keep up with inflation. After age 50, you’re allowed to add $6,500/yr to your IRA, which can contain stocks, bonds and mutual funds of your own choosing. To spend from your “Nest Egg” in retirement, most advisors recommend some variation of the “4% Rule." Its originator, Bill Bengen, back-tested the math (assuming an even split between bonds and stocks) and “found that retirees who withdrew 4 percent of their initial retirement portfolio balance, and then adjusted that dollar amount for inflation each year thereafter, would have created a paycheck that lasted for 30 years”. Nowadays, interest rates are being held at artificially low levels by almost every Central Bank. So, you’d better start your retirement with an appropriate adjustment (~60% stocks and ~40% bonds).
Mission: Find out if a new retiree who has stocks and bonds in a 60:40 mix can follow the 4% rule without drawing down principal (the initial retirement balance adjusted for inflation). Given that retirement savings are defensive by definition, those bonds should be 10-yr US Treasury Notes and/or a low-cost intermediate-term investment-grade bond fund like the Vanguard Interm-Term Bond Index (VBINX in the Table). Those stocks should be issued by 6 or 7 large-capitalization companies (i.e., those in the S&P 100 Index) selected from the list of Dividend Achievers representative of the 4 defensive S&P industries (HealthCare, Utilities, Communication Services, and Consumer Staples).
Execution: The Table reflects a 20 yr period of analysis using our standard spreadsheet. The assumption is that retirement began 20 yrs ago, and that each line item had the same value as every other line item at that time. No additional funds have been added. PLAN A represents my approach, i.e., to invest in 7 stocks that are collateralized with 10-yr US Treasury Notes (reinvested upon reaching maturity). PLAN B uses a bond fund instead of 10-yr Treasuries and stocks that are more growth-oriented (see Column L in the Table). Overall, there are 12 stocks in the S&P 100 Index that qualify by having Dividend Achiever status, an S&P stock rating of B+/M or better, and an S&P bond rating of BBB+ or better. NOTE: NextEra Energy (NEE) meets all criteria for inclusion in the S&P 100 and will likely be added soon, making a total of 13 stocks that are suitable for inclusion in a conservative retirement plan.
Bottom Line: Inflation averaged ~2.2%/yr over the past 20 yrs, so the 4% rule would fail to maintain principal if the average total return/yr for Plan A or Plan B were less than 4.0% + 2.2%. Plan A returned over 7%/yr and Plan B returned approximately 10%/yr. So, the value of the original investment, corrected for inflation, remained intact over the first 20 yrs of retirement. The same is true for the past 5 yrs (shown in Column F of the Table) when inflation averaged ~1.5%/yr. There is no material difference between PLAN A and PLAN B, given the slightly higher risk profile of PLAN B (see Columns J through L in the Table).
Risk Ratings: 4 (PLAN A) and 5 (PLAN B)
Full Disclosure: I have stock in KO, JNJ and WMT, and dollar-average into NEE, T, PEP and ABT as well as 10-yr T-Notes.
Note: Metrics highlighted in red denote underperformance vs. our benchmark (VBINX). Metrics are current as of the Sunday of publication.
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Situation: Individual stocks are not a core asset unless you’ve created your own diversified mutual fund (i.e., 40+ stocks covering all 10 S&P Industries). The reason why individual stocks are considered a liability and not a core asset is because competition (aided by unforeseen technological advancements) can doom the prospects of any one company. There are 5 Core Assets, and your investment portfolio will need representation from some of each:
1) diversified US stock mutual funds, especially index funds like VFINX and VEXMX (see the Table).
2) Bonds, mainly US Treasuries but also intermediate-term investment-grade bond index funds like VBIIX (see the Table).
3) Commodity-related investments. The relevant index fund is a “broad basket” collateralized futures ETF composed of iShares S&P GSCI Commodity Indexed Trust (GSG in the Table).
4) Real estate. Most of us already have too much invested in real estate (i.e., the equity in our homes). The relevant REIT index fund is VGSIX in the Table.
5) Cash-equivalents such as Savings Bonds, a Savings Account at an FDIC-insured bank, a short-term Treasury fund like VFISX (see the Table) or 3-6 month Treasury Bills purchased for zero cost at treasurydirect.
Mission: Set up a reasonable asset allocation, i.e., one that has worked well for me, using index funds as examples. This allocation needs to meet the standards of an acceptable personal retirement investment fund, and it does. However, opinions vary across a large spectrum. At one extreme, we have Warren Buffett who recommends that his relatives rely on a low-cost S&P 500 Index fund for 90% of their asset allocation, with the other 10% being invested in a short-term US Treasury fund. However, most investment advisors stress the importance of balancing among the 5 Core Assets listed above. In other words, hedge your bet on stocks even though the S&P 500 is well known to have outperformed all other asset classes over all rolling 20-yr periods on record. Warren Buffett takes a dim view of hedging strategies and continues to make bets that the S&P 500 Index will outperform international indexes as well as an esteemed group of hedge funds. The main reason for you to hedge your bets is that you’re not as rich as Warren Buffett’s relatives and could be financially devastated by a crash in the S&P 500 Index (if that’s where 90% of your retirement assets reside). So, hedging is a form of insurance and you’ll be glad you have it. (I never feel bad about dollar-averaging 30% of my new investment dollars into 10-yr Treasuries and Inflation-Protected Savings Bonds.)
What lies at the other end of the spectrum of advice being offered by investment advisors? Well, if you include accountants and business school professors as “advisors” you’ll find a sizeable minority who recommend that most of your retirement savings be in US Treasury Notes and Bonds having as average of ~5 yrs remaining until maturity. You can do that yourself simply by dollar-averaging into 10-yr Treasury Notes through the zero-cost Treasury website. When I was living in New York City (while going to medical school), I had a personal accountant who made that exact recommendation when I asked for his views on asset allocation. I had great respect for him as a wise and prudent man but thought his recommendation bordered on the absurd. Then, a few years ago, I went to business school and started hearing the same view again, first from an accountant in my study group and then from a professor of Banking and Finance. Finally, I read Henry Paulson’s book about his experiences as US Treasury Secretary, titled “On the Brink.” Prior to that posting, he’d been the CEO of Goldman Sachs. In the book he mentions that his personal savings are limited to bonds. In other words, the message you’re hearing at this end of the spectrum is that bonds are backed by the assets of the institution issuing them, whereas, stocks are backed by nothing other than a faith in future earnings.
Execution: We recommend that you balance stock and fixed-income investments 50:50. Real Estate Investment Trusts (REITs) are a hybrid between stocks and bonds but (when assembled into and REIT) they’re essentially a type of bond called a “growing perpetuity” and I allocate 15% there. Cash equivalents are also bonds and I allocate 5% to those. Then I allocate 15% to intermediate-term bond index funds and 15% to Treasury bonds and notes, which brings me up to 50% allocated to fixed-income. For stocks, I allocate 30% to S&P 500 stocks (which represent 75% of the US market) and 10% to smaller capitalization stock mutual funds. Commodity-related stocks represent 10% of my portfolio, though the recent underperformance of many “long cycle” investments has caused many advisors (including me) to cut back to 5%. In summary, you now have a formula for allocating 50% to stocks and 50% to bonds or bond hybrids (see Table).
Bottom Line: Core assets are vital to your financial well being. There are 5 categories, and this week’s Table gives index fund examples using an allocation that has worked well for me. By mixing 5 core assets you create your own hedge fund, the idea being to match returns of the S&P 500 Index over time while taking on less risk of a serious loss. Note: risk-adjusted returns for index funds in the commodity-linked and smaller capitalization stock categories typically underperform actively managed mutual funds.
Risk Rating: 5
Full Disclosure: I dollar-average into 10-yr Treasury Notes, and have VFINX-like and VEXMX-like investments in my 401(k).
Note: Metrics highlighted in red denote underperformance relative to VBINX. Metrics are current for the Sunday of publication.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Situation: Many of us (most?) will not make our “Retirement Savings Number” by the time we qualify for full Social Security benefits. What’s a Retirement Savings Number? That is the dollar amount of retirement benefits needed to replace 75% of your pre-retirement wages and salary. Will you make your number? If not, aspects of your life will probably need to be replaced by less costly versions. Why not start working on “right-sizing” your life now and delay full retirement a little longer?
Mission: Outline the areas where lifestyle adjustments can be made without feeling the full effects that job loss entails. Forty years of working a job makes it more than a livelihood; it becomes a “personhood.” Chances are you will miss at least some aspects of the job and the respect it gave you in the eyes of others. Now is the time to focus on finding ways to limit costs but still invest in yourself enough to afford retirement.
Execution: Let’s start with your home. Frequently, we have more living space than needed. Let’s assume you’re comfortable and the mortgage is almost paid off. How can you turn it into income? Reverse mortgages carry hidden costs that limit their attractiveness. Instead, think about converting part of your house into an attractive apartment for rent. Better yet, sell the house and take out a low-cost annuity through TIAA-CREF or Vanguard. Rent only enough living space to meet your retirement needs.
Next is your car. Think about leasing because it is then possible to have a new car every 3 years and benefit from greater dealer incentives than can be had by purchasing a car. Remember that by leasing a scaled-down version of the vehicle you’ve been driving you’ll save money needed for paying bills that increase in retirement (like medical bills). Japan specializes in producing trouble-free but high-quality cars; Honda Civics and Toyota Corollas get excellent gas mileage and come without “sticker-shock.”
This leads into the importance of drawing up a monthly budget. Start by eliminating all debts; use whatever means necessary. This effort will gradually decrease the amount of interest you pay, leaving more money to spend. Food, utilities, rent, and your car lease are the big expenditures; dedicate specific parts of your income to paying those bills. Next comes clothes and entertainment, including travel and recreation. For most retirees, clothes and travel become items they save for, so dedicate part of your income to a savings account. If enough money doesn’t reach that account, then buying new clothes and taking trips will have to be curtailed. This budget limits you to spending “cash on hand.” Your credit cards will show a zero balance at the end of each month, no matter what.
It has been shown through many medical and wellness studies that your weight will have a very big impact on the quality of your life. As we near retirement age, 2/3rds of us are overweight. That translates into both inconvenience and expense during your sunset years. Now is the time to learn how to eat less and smarter. Learn to love having more nuts and veggies, make a habit of “meatless Mondays”, and give up pastries and desserts. Exercise is important for cardiac health but it also makes you hungrier. You won’t lose weight unless you have the discipline to stick with a 2000 Calories/day diet.
“Where's the money [discussion], Lebowski?” You want to find a way to make your Retirement Number, and hope we’ll provide a clear path to resolving that problem. It starts indirectly with lifestyle adjustments that lower expenses and increase income. After that, move directly into plugging any holes in your finances. Three options are available, starting with a delayed retirement. The Social Security Administration will increase your lifetime monthly benefit 8% for each year that you put off retirement. If you retire at age 70 instead of age 62, you’ll go from having your full retirement benefit cut by 25% (retirement at age 62) to having it increased by 32% (retirement at age 70).
It’s now becoming reasonable to make stocks a larger part of your overall retirement savings, to balance the amount of money most of us currently have in bonds. Social Security is a system for paying out interest on US Treasury Bonds. If your full benefit is going to be $1500/mo, and 30-yr Treasuries are paying 3% interest, you have a non-transferable account at the US Treasury worth $600,000. That means the rest of your retirement accounts (defined-benefit pension, IRA, 401k, 403b, plus taxable stocks and bonds) likely need to be 75% in stocks (see this week’s Table for a 12-asset example which carries an expense ratio of only 0.51%). Even then, you’re unlikely to reach the recommended 50/50 balance between stocks and bonds. Does having that much in stocks make you nervous, given recent history? Well, 100 years of history gives a better perspective: Stocks, with dividends reinvested, have grown at 10.1%/yr vs. 5.0%/yr for 10-yr Treasury Notes with interest reinvested. Inflation averaged 3.2%/yr. A 50/50 balance between stocks and bonds would have grown 4.0%/yr after inflation (allowing 0.2%/yr for transaction costs).
Your third option is to prepare to hold a part-time job after you retire. That may require you to get more college education or pay for training and credentialing. (Licensed Practical Nurses and long-haul truck drivers, for example, are in short supply.) But find a way to do that without borrowing money. Why do you need to have no debts when you transition to part-time employment, and have to remain debt-free thereafter? Because you’ll be living on a fixed income (except for any dividend-growing stocks you might own and any salary increase you might get from your part-time job). That means your Return on Assets (ROA) is essentially zero (negative after considering inflation). Debts predictably grow larger when ROA is less than the interest rate of those debts.
Bottom Line: Making money is about cutting costs and investing in yourself. For example, pay off your debts and invest in your health. If you can't afford to retire then delay retirement, live on a budget, right-size your life, and accept the necessity for part-time employment after you retire. You'll also need to keep investing in stocks for the rest of your life, learning along the way to safely make money with money. That means taking advantage of the magic of compound interest by reinvesting dividends and interest. It also means low-cost investing, online, making automatic monthly additions to dividend-growing stocks from your checking account and backstopping those with 10-yr Treasury Notes at zero cost. You can start today by gradually rebalancing your personal retirement accounts (IRA, 401k, 403b) to reflect the fact that Social Security and Defined Benefit Pensions are bond equivalent holdings in your name. You’ll want those tax-deferred accounts to be 75% invested in stock mutual funds (as well as your taxable accounts) to achieve the 50/50 stock/bond balance that most advisors recommend you maintain throughout retirement.
Risk Rating: 4
Full Disclosure: I dollar-average into 10-yr Treasury Notes and all 9 of the stocks listed in the Table.
Note: Metrics in the Table are current for the Sunday of publication; red highlights denote underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Situation: Commodities are priced in dollars but those prices reflect worldwide supply and demand, not US economic forces. To further complicate matters, agricultural commodities are priced to reflect regional climate events. The 2012 US drought was so severe that China decided to decrease its reliance on the US for corn and instead ramp up domestic production and source more corn from Argentina and Ukraine. This highlights how population growth is the main driver for commodity production, whether it is basic materials needed to expand infrastructure, energy for electricity production and transportation, or meat and grain for grocery stores. The problem for commodity producers is the necessity for a large up-front investment, whether for oil and gas exploration, mining operations, or the web of technology and infrastructure that brings the “green revolution” to farming. Such investments typically involve large expenditures for property, plant, equipment, powerplants, internet access, storage facilities, paved roads, pipelines, and railroads. In turn, those high initial costs drive research and development into innovations that promise to reduce up-front costs. The result is affordable food, construction methods, fuel, and electricity. Once in place, production efficiencies tend to overshoot; supplies exceed demand for a period, as we see happening now with oil and natural gas production.
Investors in commodity-related companies always face a roller-coaster ride, one that is often out-of-phase with regional economic cycles. As a result, commodity-linked investments tend to follow supercycles. Their “non-correlation” with GDP serves to benefit investors. This week’s blog is occasioned by the just-published Barron’s 500 List for 2015. That list gives a grade to the 500 largest companies in the US and Canada by using 3 equally-weighted metrics:
1) median 3-yr return on investment (ROIC),
2) change in the most recent year’s ROIC relative to the 3-yr median, and
3) revenue growth for the most recent fiscal year.
Each company’s 2015 rank is compared to its 2014 rank. There are 60 commodity producers; half were up in rank, half were down. We’re interested only in the companies that were up, since there’s no easy way to know why a company was down or when its rank will stop falling. And, since most of our readers are looking for retirement investments, we’re not interested in companies that have an S&P bond rating lower than BBB+ or an S&P stock rating lower than B+/M. Taken together, those restrictions remove all but 7 of the 60 companies from consideration (see Table).
These 7 stocks are different from those we usually think of as prudent for retirees. Notably, the average 5-yr Beta is high, and most are down one Standard Deviation from their 16-yr trendline in price appreciation (see Column M), whereas, recent pricing for the S&P 500 Index (^GSPC) is up two Standard Deviations. While we do like to invest in commodity-related stocks because of their out-of-sync behavior, extremes are a little un-nerving.
It gets worse. In Column N of the Table, the downside risk comes into sharp focus. That’s where the BMW Method (see Week 193, Week 199 and Week 201) is used to predict your loss by incorporating 16 yrs of weekly variance in price trends. For example, a 47% loss is predicted for our group of 7 stocks in the next Bear Market, whereas, the S&P 500 Index is predicted to sustain a 32% loss. You’ll find this information in the BMW Method Log Chart for each stock. Start by using the S&P 500 Index as an example. Find ^GSPC at the bottom of the 16-yr series, click on it, and look for “*2RMS” in the upper left-hand corner. Subtract that RF number (0.68) from 100 to get the predicted 32% loss at 2 Standard Deviations below the price trendline. That degree of price variance is projected to occur every 19-20 yrs.
This price variance is important to be aware of because a high degree of price variance over time means the party can end quickly. When a commodity-producing company’s Tangible Book Value for the past decade gives it a Durable Competitive Advantage (see Column R and Week 158), there’s little likelihood that its earnings will grow more than 7%/yr over the next decade (see Column S), which we estimate by using the Buffett Buy Analysis (see Week 189). Only one stock passed that test, National Oilwell Varco (NOV). In other words, the very impressive returns achieved by this select group of 7 stocks (see Columns C, F and L in the Table) come with a very impressive risk of loss.
Several academic studies have shown that the only way to legally “beat the market” is to take on a commensurately greater risk of loss. One example analyzed Jim Cramer’s success at picking stocks for CNBC’s “Mad Money” TV show. To make a long story short, you need to understand that over a 20-yr period you’ll probably be further ahead (on a risk-adjusted basis) by investing in a low-cost S&P 500 Index Fund (VFINX at Line 16 in the Table) than by investing in any combination of commodity-related companies.
Think about it. Commodity-related companies depend on the infrastructure and sustainability needs of fast growing countries like China, Brazil, India, Nigeria and Russia. Such a heavy reliance on commodities in countries with such large populations will be reflected in the success of mutual funds that focus on international stocks or natural resource stocks. The Vanguard Total International Stock Index fund (VGTSX at Line 18 in the Table) and T Rowe Price New Era Fund (PRNEX at Line 17 in the Table), respectively, are good low-cost examples. Are either of those mutual funds a better (i.e., risk-adjusted) place to put your retirement savings than VFINX? No. The reason is that investing in commodities is a hedging strategy. Any effort to smooth out (hedge) returns does exactly that. It protects you from Bear Market losses while reducing your Bull Market gains. Stocks go up 55% of the time, so over the long term a hedging strategy will underperform the market.
Bottom Line: Here at ITR, we like to call attention to investments that don’t track the S&P 500 Index. By having a few investments that are out-of-sync with the economic cycle, you may be able to limit the damage to your portfolio from a market crash. Our favorite non-correlated asset is the 10-yr US Treasury Note (when held to maturity), which you can obtain for zero cost. Our next favorite is stock in one or two commodity production companies, especially those where revenues reflect changes in the weather cycle. In particular, companies that supply farmers with tractors, center-pivot irrigation systems, diesel engines to power such equipment, fertilizer, herbicides, fungicides and ways to efficiently get crops and cattle to markets.
Risk Rating: 7
Full Disclosure: I own stock in CMI.
Note: metrics highlighted in red denote underperformance vs. our key benchmark (VBINX); metrics are current for the Sunday of publication.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
