Week 6 - Summary

Situation: Investors have many options, whether they are savers or gamblers, but few of these options are simple, straightforward, and cheap. Our blog meets these objectives by ignoring the ups and downs of stock, bond, commodity, and real estate markets: we identify very long term investments of high quality and low risk, then show the investor how to put a regular investment plan on “autopilot.”

Goal: Once a month, our weekly ITR blog will be a review of the previous 4 or 5 weekly installments. While we are not personal investment counselors, our summaries are an attempt to condense ideas – and thereby provide a degree of guidance to investors who are getting started.

In our Mission and Goals statement, we introduced the ITR Growing Perpetuity Index of 12 stocks. In our Week 4 blog, we provided further details of this index. In Week 5 we provided an ITR Master List of all stocks in the S&P 500 Index that meet our investment criteria, and we introduced a new feature, “The Incubator,” where we are creating a sample investment platform. Now (Week 6) we compare the total returns since 2/1/93 for 8 Growing Perpetuity Index stocks to the total return for SPY. We make 3 assumptions: 1) quarterly dividends are reinvested; 2) $200 is added on the first trading day of each month; and 3) a 2% commission is paid (leaving $196/month for investment). By reinvesting dividends, we capture the power of compound interest. By purchasing a fixed dollar amount of shares each month, we capture the power of dollar cost averaging.

For example, the effect of dividend reinvestment on an investment made in SPY can be illustrated by using the 10 yrs from 12/29/00 (when SPY closed at $131.19/share) to 12/31/10 (when SPY closed at $125.75/share). Although each share of SPY lost 0.42%/yr in value over this period, dividend reinvestment resulted in a total return of 1.3%/yr (moneychimp). Dollar cost averaging (adding $200/month) increased SPY’s total return to 1.9%/yr (because stocks were “on sale” for much of that decade).

In Week 4, we explained why these12 stocks were selected for inclusion in our Growing Perpetuity Index:

• ExxonMobil (XOM)
• Wal*Mart (WMT)
• Procter & Gamble (PG)
• Chevron (CVX)
• IBM (IBM)
• Johnson & Johnson (JNJ)
• Coca-Cola (KO)
• McDonalds (MCD)
• United Technologies (UTX)
• 3M (MMM)
• Norfolk Southern (NSC)
• NextEra Energy (NEE)

DRIPs are available for all 12 stocks but 8 happen to be available at computershare with minimal or no commissions (XOM, WMT, IBM, JNJ, KO, MCD, UTX, NEE). Not only does the “point and click” investor benefit from one-stop shopping but these 8 companies happen to represent all 7 S&P industries that contribute companies to our Growing Perpetuity Index, namely:

• consumer staples (WMT, KO)
• consumer discretionary (MCD)
• health care (JNJ)
• energy (XOM)
• utilities (NEE)
• information technology (IBM)
• industrials (UTX)

This helps to provide diversification for your portfolio. Regular investment in only one company from each of these 7 categories does carry some risk, namely the risk that the chosen company will not be a stellar performer for that sector. However, companies meeting the ITR criteria are “blue chips” that minimize such risk. By undertaking regular, very long term DRIP investment in a company from each of the 7 industries, a newbie investor would achieve total returns in excess of the S&P 500 Index and do so with less risk. Why is there less risk? Two reasons: Firstly, all 3 “defensive” sectors of the stock market are represented: consumer staples, health care, and utilities. Consumers continue to spend on those sectors during a recession and stock prices hold up better. Secondly, the 34 companies (in Week 5) that meet our criteria carry less than half as much debt as the S&P 500 Index as a whole (Debt/Equity = 0.60 vs. 1.25): When revenues fall off in a recession, companies lose value because of the need to service their debt by paying interest and returning principle on bonds that come due. Revenues may not be sufficient to cover those legal obligations so bankruptcy looms in the immediate future.

This week we provide a Total Returns Table where we compare the Total Return (i.e., dividend reinvestment gains + gains from monthly $200 purchases) for each of these 8 stocks over 18.5 yrs (2/1/93 to 8/1/11) to the total return for SPY. This Table shows that stocks chosen because of their high quality and low risk far outperform the S&P 500 Index as a whole. Why is that? It is because most of the companies in the S&P 500 combine low quality with high risk. The 34 exceptions are in our Week 5 ITR Master List.

Bottom line: There is a simple, cheap, and straightforward way to invest in stocks. It requires patience, attention to detail, and the ability to ignore market gyrations.


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Week 5 - Master List of Companies Meeting the ITR Criteria

Goal: To pin down which companies in the S&P 500 Index conform to the ITR selection criteria and detail the benefits and risks of owning stock in each over the past decade.

click here to open the Master List Spreadsheet

Legend for the ITR Master List:

Large S&P 500 Companies (n = 19): Stocks selected from the S&P 100 Index. Most of these are multinationals that derive 40-70% of sales from foreign countries.

Smaller S&P 500 Companies (n = 15): Stocks selected from the 400 smaller companies in the S&P 500 Index. Such companies typically have a focused business plan and a less hierarchical management style. These companies have fewer institutional impediments to innovation and can be more nimble in responding to market stresses caused by competition, obsolescence, and recession.

Ticker: Company symbol used for stock trading purposes. (Click on the ticker to view the "Investor Relations" page at the company's website.)

2000-10 TR: Annualized gross Total Return (reinvestment of dividends plus price appreciation) for a stock purchased at close of business (COB) 12/29/00 then sold at COB 12/31/10 (see discussion in Week 4 blog). Our benchmark, SPY, had an annualized gross total return of 1.3% for that 10 yr period. Returns are even lower when costs are subtracted - to calculate net total returns: trading commissions and fees amount to ~2% for each BUY or SELL order placed through a stock broker; inflation averaged 2.4%/yr over that 10 yr period (Inflation_Calculator); and tax rates on dividends and capital gains are set at 15%. To reiterate: fees, capital gains taxes, taxes on dividends, and inflation are not accounted for in calculating the gross Total Return (in Column 3).

Dividend: Current quarterly pay-out per share multiplied by 4 and divided by the recent stock price (expressed as %).

Ann Div Incr: consecutive annual dividend increases.

Stk Rating: "A" is S&P's highest stock rating, with relative benefit sometimes qualified with a "+" or "–" sign; L, M, and H denote a separate assessment of risk: low, medium, or high. Risk in this case represents the extent to which the stock’s value is likely to be impaired or improved during a bear or bull market, respectively.

Bnd Rating: Most companies are financed by both bonds and stocks. Bond ratings denote the risk of bankruptcy. AAA is S&P's highest bond rating, currently held by only 4 companies (ExxonMobil, Johnson & Johnson, Microsoft, and Automatic Data Processing). BBB- is the lowest “investment-grade” rating. BB+ and lower ratings are reserved for “junk status” bonds (also termed "high yield" bonds), which have odds of default greater than 1 in 20.

S&P Industries: S&P has 10 industry categories. Only the telecommunications industry is not represented on our Master List. It is obviously difficult to pigeonhole the major revenue source for a multinational company. Nonetheless, S&P analysts make an effort to do so because the fluctuation of stock prices and dividend payouts depend somewhat on the company's key industry, it is either moving into a new industry or has become an outlier in its historic industry.

5 yr Beta: The variance of a stock’s price relative to the S&P 500 Index (Beta = 1.00) calculated each trading day over a 5 yr period and then averaged. For example, a Beta of 0.83 for 3M means that the price of 3M went up or down 83% as much as the S&P 500 Index over the 5 yrs before the current month. Barron’s Dictionary of Finance and Investment Terms (1998, Fifth Edition, Barron’s Educational Series, Inc.) ends its definition with this sentence: “A conservative investor whose main concern is preservation of capital should focus on stocks with low betas, whereas, one willing to take high risks in an effort to earn high rewards should look for high-beta.

Debt/Equity: Total debt divided by shareholder’s equity (total assets minus total liabilities). The Debt/Equity ratio for the S&P 500 Index is ~1.25. “Blue Chip” companies normally top out at 0.85 but may temporarily go higher to expand in support of strong revenues.


Bottom Line: 34 companies meet the ITR criteria for profitable long-term investment with acceptable risk. Of those 34, five (XOM, PG, MKC, NEE, UTX) stand out for providing steady returns (Mean Gross Total Return = 8.8%/yr) and good payouts (Mean Dividend = 2.8%) while maintaining a low S&P Risk Rating. Those 5 companies also issue bonds that carry an S&P rating of "A" (or better), and have very low price variance vs. S&P 500 Index (Average Beta of 0.53 vs. 1.00). For comparison, the annualized Total Return of the S&P 500 Index clunked along at 1.3% over the past decade, and it currently pays a dividend of 1.9%.


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