Situation: “It was the best of times, it was the worst of times…” That’s how investors will come to regard the current macroeconomic situation. The “best of times” because both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) are making new, inflation-adjusted highs. The “worst of times” because every major economy on the planet is locked in a grinding, low-grade borderline deflation because of unsustainably high interest payments on overall debt, owned by individuals, corporations and governments. How can the “retail” investor play this moment? What kind of asset allocation do YOU want to be sitting on? If you have enough income to open a new position, what should you bet on? A stock, a bond, cash-equivalents, gold, a home mortgage (instead of renting), commodity futures, or whole life insurance?
Here in the US, stock indices are loudly declaring a primary upward trend, which Dow Theory says will be sustained until either the DJIA or DJTA drops below a previously important low. That would mean a drop of more than 60%. Such an occurrence seems unlikely, short of World War III or a global pandemic. Central Banks are going to keep interest rates low for as long as it takes that “free money” to pump investment up enough for growth in productivity and employment to bring down per-capita debt. During that period, stock market returns over rolling 5-yr periods are unlikely to beat 10%/yr, even here in the US, which is the one place where deflation no longer remains a looming threat (see Week 143).
Given that stock investments are the best known way to beat inflation while having enough income to take advantage of compound interest (see Week 157), you’ll keep buying stocks unless overpricing becomes widespread, meaning you can no longer find a high-quality yet reasonably priced stock. Once the price/earnings ratio for the S&P 500 reaches 20, as it did recently, it doesn’t make much sense to buy stock unless you know how to ferret out the few remaining high-quality bargains. Let’s do that now.
First, we’ll apply Warren Buffett’s method to find out which companies have a “Durable Competitive Advantage” (see Week 135, and “DCA” in Column K of this week’s Table). This method computes a simple trendline for growth in Tangible Book Value (TBV, see Column L) over the past decade. If that rate is higher than 7%/yr, and TBV has no more than two down years, then the company has a Durable Competitive Advantage. The problem is that not many CEOs align TBV growth with earnings growth. They’d rather spend that money on a merger or acquisition. That’s particularly true for companies in defensive industries, where the risk of bankruptcy is nil, and they can do this because their products are essential.
Next we want to know if the company’s stock price has become higher than its trendline for earnings growth can justify. To address that issue, Warren Buffett takes companies with a Durable Competitive Advantage and subjects them to a stress test, which we call the Buffett Buy Analysis (see “BBA” at Column M in the Table). The trendline for earnings over the past decade is extended out for a decade in the future. That dollar amount of earnings is multiplied by the lowest P/E ratio seen over the past decade to project a price 10 yrs from now. If the company pays a dividend, the current amount of that dividend is multiplied by 10 and added to the earnings projected for 10 yrs from now. (Mr. Buffett’s idea here is that the economy will be in the doldrums for the next 10 yrs such that the company will be unable to raise its dividend. However, companies that are able to maintain dividends will be rewarded with a higher stock price.) Those companies that have a Durable Competitive Advantage, but are projected by their BBA to grow their stock price slower than 7%/yr over the next decade, are rejected. In other words, their current price is so high that expected growth has already been “discounted” by enthusiastic buyers.
By applying this analysis to the 500 companies in the Barron’s 500 List, which are the largest companies (by revenue) on the New York and Toronto stock exchanges, we are left with just 26 companies to consider (see Table). Of these, only Ross Stores (ROST), Monsanto (MON), TJX Companies (TJX) and Franklin Resources (BEN) are found in the “universe” of 63 companies we consider to be worthwhile candidates for your retirement portfolio (see the Table for Week 122). None appear on our 29-stock Master List (see Week 146). In other words, all 26 companies in this week’s Table are chancy investments that have to be backed dollar-for-dollar with Savings Bonds or 10-yr Treasury Notes. As Warren Buffett recently stated: “If you’re not a professional, you are thus an amateur.” So cover your bets.
Bottom Line: Be careful how you deploy new money into this overheated market. The 26 stocks we’ve found are worthwhile bargains for you to consider but come with considerable price volatility (see Columns D and I in the Table). Even knowing that these stocks are not overpriced at the time of this writing (6/1/14), you still need to know whether the “story” supporting that stock price remains intact. If the story is broken, then the stock is overpriced. Researching THAT detail requires more attention than you’ll have time for on weekends. But start slowly, with an easy assignment. Analyze the 3 “blue chip” stocks on the list that are part of the Dow Jones Industrial Average: Cisco Systems (CSCO), Travelers (TRV), and JP Morgan Chase (JPM). Each is a dominant player in its industry, and it is those industries (finance and information technology) where professionals earn their greatest rewards by deciding on the right entry point for buying the stock as well as the right exit point.
Risk Rating: 7
Full Disclosure: I own shares of MON, CF, ACN, and TJX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, July 6
Week 157 - Capitalism is a Two-Trick Pony. Learn Both Tricks.
Situation: Sometimes, people with similar socioeconomic advantages become wealthy while others don’t. Sometimes, politicians like to say “the wealthy” have learned to acquire “unearned income” from compound interest, which is correct. Whether or not the acquisition of that skill constitutes real work is debatable. Compound interest is one of the pillars of capitalism, but it can’t work its considerable magic unless a family or business chooses to divert 10-15% of its disposable income away from consumption and toward long-term investments, specifically those that spin off dividends that grow annually and are reinvested to “compound” the benefit. The other pillar of capitalism is accrual accounting, which is the discipline of paying recurring expenses in real time by identifying and encumbering a specific part of current income. That leaves only non-recurring capital expenditures to be “financed”, which is usually accomplished by selling assets, borrowing money, or issuing stock.
Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)
The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses.
For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary.
The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.
Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.
Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Maximize your use of compound interest and accrual accounting. By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree.
Risk Rating: 3
Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at treasurydirect.gov, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at computershare.com.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)
The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses.
For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary.
The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.
Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.
Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).
Bottom Line: Maximize your use of compound interest and accrual accounting. By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree.
Risk Rating: 3
Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at treasurydirect.gov, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at computershare.com.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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