Situation: The stock market is overpriced, and will remain so until bonds pay enough interest to compete with stocks toe-to-toe. I doubt that will happen in the next few years, given that inflation-adjusted 10-yr Treasury Notes are selling very well while paying only 0.42% interest, as of 11/1/14. (Full disclosure is needed here: I admit to being a recent buyer.) So, let’s identify and discuss the next best thing to bonds for stabilizing a retirement portfolio. Are there any large-capitalization US stocks left that are reasonably priced?
Good question, and a hard one to answer. The exchange-traded fund for the S&P 100 Index is OEF (Line 19 in the Table). As expected, it has similar metrics to VFINX, Vanguard’s S&P 500 Index fund (see Line 20). But there are interesting differences. OEF can be considered to be a tad less risky because it pays a little higher dividend, has a little lower 5-yr Beta, lost a little less during the Lehman Panic, and has a 15% lower P/E. With respect to the key metric for someone who is saving for retirement, it has 70% higher dividend growth (Column H in the Table). The S&P 100 Index is the place to look for a good retirement stock, particularly when the market is overvalued. Why? Because that’s typically a time when mid-cap and small-cap stocks are even more overvalued than usual.
How can you be sure a stock isn’t overpriced? The best comparison to make is to examine its price in regards to its Tangible Book Value (TBV). If price/TBV is less than 3, the stock isn’t overpriced. We set the cutoff point twice as high in our assessment, at ~6 (see Column O in the Table). Our reason for doing that is to ensure that we identify stocks that have true value. Next, we look at EV/EBITDA: Enterprise Value (market value of all the stocks and bonds used to capitalize the business) divided by Earnings Before Interest, Taxes, Depreciation, and Amortization (i.e., "operating earnings" to an accountant). Cash spent on new projects is not considered in EV/EBITDA, and neither is the cash spent to buy and service loans. EV/EBITDA can be very revealing. For example, Costco Wholesale (COST) has a P/E of almost 30 but its EV/EBITDA is less than half that (see Columns J and K in the Table).
Another helpful metric is Dividend Payout (Column L in the Table). If a company is sending more than half its profits to shareholders, it won’t have much Free Cash Flow left to produce and market more and/or better products. That means the company’s managers will probably need to borrow money to expand. Issuing more stock isn’t as attractive to them as issuing a bond or borrowing from a bank, since the revenue that will be used to pay interest on that loan isn’t taxable. Choice #1 (using Free Cash Flow to expand) increases TBV, whereas, Choice #2 (borrowing money to expand) reduces TBV.
Bottom Line: After all the number crunching, we find that there are 10 companies in the S&P 100 Index that are reasonably priced and carry high ratings from S&P on both their stock and bond issues.
Risk Rating: 6
Full Disclosure: I dollar-average into WMT and MSFT.
NOTE: Metrics in the Table are current as of the Sunday of Publication.
Post comments below, or email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 14
Sunday, December 7
Week 179 - The ITR “Master List” for Fall 2014
Situation: Twice a year, we try to look into the future using the lens of the past. Currently, the US stock market has reached a plateau due to overvaluation. Alan Greenspan, in his recent book “The Map and the Territory” (The Penguin Press, New York, 2013), explains overvaluation by saying that "demand to acquire the stock of a company is sated as the company becomes adequately funded [and such companies] will yield low prospective rates of profit until the excess capital is withdrawn and presumably reinvested in more promising ventures." In other words, there is no such thing as a stock that looks like a good bet year in and year out. That’s why you need to pick stocks wisely and then dollar-cost average your choices.
You’ve no doubt noticed that our Master List keep getting shorter as the risk of a Bear Market increases. We began with 34 (large and small) companies (see Week 5) and now we’re down to 10 large companies (see Table). Those 10 are chosen from our 9 Lifeboat Stocks (see Week 174) and 17 Core Holdings (see Week 172). We eliminate any that aren’t "Dividend Aristocrats" (25+ yrs of dividend growth) or lost more during the Lehman Panic than the 28% that our “risk-on” benchmark (VBINX) lost.
This week, for the first time, we ask whether you’d be better off investing in all 10 of those companies, or would you be better off investing in Vanguard Wellesley Income Fund (VWINX), which is the “risk-off” benchmark that we recommend for retirement portfolios. It is not too difficult to build a portfolio of stocks with a higher dividend yield and/or faster dividend growth rate than the S&P 500 Index, particularly if you stick to companies have grown their dividend annually for at least 25 yrs. Those companies have a long and stable history of rewarding their investors through good times and bad. By owning shares in a few such companies you can look forward to receiving dividend checks in retirement that grow faster than inflation. But will you end up with more retirement assets by doing that? This week’s blog tries to answer that question.
Long term, VWINX has been the most stable and rewarding mutual fund. It is balanced roughly 40:60 between high quality stocks and investment-grade bonds, respectively. VWINX has returned 10.6%/yr over the past 35 yrs, which is identical to the return for the lowest-cost S&P 500 Index fund, the Vanguard 500 Index Fund (VFINX). Bonds in VWINX go up in value whenever stocks go down. That means VWINX has had only 4 down years in 35 (average loss of 6.3%) vs. 8 for VFINX (average loss of 11%). The lesson here is to hedge your stocks with high quality bonds. We suggest that you use inflation-protected US Savings Bonds because those never lose money and carry all the tax advantages of an IRA.
We’ve blogged often about the risk of owning individual stocks, and use several metrics like 5-yr Beta (Column I in our Tables) to highlight that risk. But there’s only one sure-fire metric: How much did investors lose during the last Bear Market (Column D in our Tables)? Warren Buffett likes to make analogies about core principles, and his analogy for this one is “You can only tell who’s swimming naked when the tide goes out.” With bonds, risk is easier to gauge because the interest that a corporate bond pays vs. the interest that a US Treasury bond (with the same maturity) pays is a direct measure of credit risk. The difference between those two interest rates is called “the spread” and the higher the spread, the riskier the bond. In other words, you’re paid more interest because you’re willing to take on more of the risk of bankruptcy. US Savings Bonds purchased online at treasurydirect are a zero-cost, tax-advantaged way to invest in 10-yr US Treasury Notes, the safest investment on the planet (according to Warren Buffett). You’ll appreciate having those Savings Bonds available to fund the non-recurring capital expenditures that are bound to appear during the next market calamity. (You certainly won’t want to sell stocks at a loss.)
The 10 “buy and hold” stocks in this week’s Table include 4 Hedge Stocks (see Week 150): WMT, CB, JNJ, PEP. Those stocks don’t need to be backed with inflation-protected Savings Bonds (ISBs). To answer our question (Is it better to invest in those 10 stocks or in VWINX?), we’ll make a virtual investment of $50/mo in each of the 10 stocks ($500/mo) backed by another virtual investment of $300/mo in ISBs. (Thus, you see 6 entries for ISBs in the Table). We’ve made stock purchases online at a dividend reinvestment sites like computershare or shareowneronline wherever transaction costs can be less than ~2%/yr. If the costs are higher, we’ve resorted to using a discount brokerage like Edward Jones (one of several that are available). For our virtual portfolio, we found it necessary to do that for 3 stocks (GWW, CB, PEP), buying one a year in that order. Our virtual investment then totaled $1800 once a year for 3 yrs with reinvested dividends, which accomplishes the same goal as investing $50/mo for 3 yrs at a dividend reinvestment site online.
Bottom Line: You can construct a 10-stock portfolio and be ahead of VWINX while maintaining the same risk profile (e.g. a 5-yr Beta of ~0.45). Over the past 14 yrs, our virtual portfolio returned ~9.5%/yr vs. ~7.3%/yr for VWINX. However, that ~2.2%/yr advantage is reduced to ~1.8%/yr after you subtract transaction costs of ~0.4%/yr: $321.65 spent during the first 3 yrs (Column R in the Table) divided by an investment of $28,800 = 1.12%, which is ~0.4%/yr. Dividend yield plus dividend growth is also better with 10 stocks than with VWINX (8.6% vs. 2.2%, see Columns G and H in the Table). During retirement, you’ll probably be able to cash those quarterly dividend checks without needing to sell the underlying shares, as opposed to having to sell shares of VWINX to come up with the same amount of cash. Of course, there is greater selection bias in picking 10 stocks than in owning shares of a managed stock/bond mutual fund like VWINX. Getting an extra ~1.8%/yr might justify the additional time and energy you’ll spend managing your portfolio but always consider opportunity costs. For example, a better choice for building retirement wealth might be to invest in VWINX, then use the time and energy you’ve saved to further your education and get a better day job.
Risk Rating: 3
Full Disclosure: I dollar-average into ISBs, WMT, ABT, and PEP. I also own shares of HRL, JNJ, and BDX.
NOTE: Metrics in the Table are current as of the Sunday of publication.
Post comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
You’ve no doubt noticed that our Master List keep getting shorter as the risk of a Bear Market increases. We began with 34 (large and small) companies (see Week 5) and now we’re down to 10 large companies (see Table). Those 10 are chosen from our 9 Lifeboat Stocks (see Week 174) and 17 Core Holdings (see Week 172). We eliminate any that aren’t "Dividend Aristocrats" (25+ yrs of dividend growth) or lost more during the Lehman Panic than the 28% that our “risk-on” benchmark (VBINX) lost.
This week, for the first time, we ask whether you’d be better off investing in all 10 of those companies, or would you be better off investing in Vanguard Wellesley Income Fund (VWINX), which is the “risk-off” benchmark that we recommend for retirement portfolios. It is not too difficult to build a portfolio of stocks with a higher dividend yield and/or faster dividend growth rate than the S&P 500 Index, particularly if you stick to companies have grown their dividend annually for at least 25 yrs. Those companies have a long and stable history of rewarding their investors through good times and bad. By owning shares in a few such companies you can look forward to receiving dividend checks in retirement that grow faster than inflation. But will you end up with more retirement assets by doing that? This week’s blog tries to answer that question.
Long term, VWINX has been the most stable and rewarding mutual fund. It is balanced roughly 40:60 between high quality stocks and investment-grade bonds, respectively. VWINX has returned 10.6%/yr over the past 35 yrs, which is identical to the return for the lowest-cost S&P 500 Index fund, the Vanguard 500 Index Fund (VFINX). Bonds in VWINX go up in value whenever stocks go down. That means VWINX has had only 4 down years in 35 (average loss of 6.3%) vs. 8 for VFINX (average loss of 11%). The lesson here is to hedge your stocks with high quality bonds. We suggest that you use inflation-protected US Savings Bonds because those never lose money and carry all the tax advantages of an IRA.
We’ve blogged often about the risk of owning individual stocks, and use several metrics like 5-yr Beta (Column I in our Tables) to highlight that risk. But there’s only one sure-fire metric: How much did investors lose during the last Bear Market (Column D in our Tables)? Warren Buffett likes to make analogies about core principles, and his analogy for this one is “You can only tell who’s swimming naked when the tide goes out.” With bonds, risk is easier to gauge because the interest that a corporate bond pays vs. the interest that a US Treasury bond (with the same maturity) pays is a direct measure of credit risk. The difference between those two interest rates is called “the spread” and the higher the spread, the riskier the bond. In other words, you’re paid more interest because you’re willing to take on more of the risk of bankruptcy. US Savings Bonds purchased online at treasurydirect are a zero-cost, tax-advantaged way to invest in 10-yr US Treasury Notes, the safest investment on the planet (according to Warren Buffett). You’ll appreciate having those Savings Bonds available to fund the non-recurring capital expenditures that are bound to appear during the next market calamity. (You certainly won’t want to sell stocks at a loss.)
The 10 “buy and hold” stocks in this week’s Table include 4 Hedge Stocks (see Week 150): WMT, CB, JNJ, PEP. Those stocks don’t need to be backed with inflation-protected Savings Bonds (ISBs). To answer our question (Is it better to invest in those 10 stocks or in VWINX?), we’ll make a virtual investment of $50/mo in each of the 10 stocks ($500/mo) backed by another virtual investment of $300/mo in ISBs. (Thus, you see 6 entries for ISBs in the Table). We’ve made stock purchases online at a dividend reinvestment sites like computershare or shareowneronline wherever transaction costs can be less than ~2%/yr. If the costs are higher, we’ve resorted to using a discount brokerage like Edward Jones (one of several that are available). For our virtual portfolio, we found it necessary to do that for 3 stocks (GWW, CB, PEP), buying one a year in that order. Our virtual investment then totaled $1800 once a year for 3 yrs with reinvested dividends, which accomplishes the same goal as investing $50/mo for 3 yrs at a dividend reinvestment site online.
Bottom Line: You can construct a 10-stock portfolio and be ahead of VWINX while maintaining the same risk profile (e.g. a 5-yr Beta of ~0.45). Over the past 14 yrs, our virtual portfolio returned ~9.5%/yr vs. ~7.3%/yr for VWINX. However, that ~2.2%/yr advantage is reduced to ~1.8%/yr after you subtract transaction costs of ~0.4%/yr: $321.65 spent during the first 3 yrs (Column R in the Table) divided by an investment of $28,800 = 1.12%, which is ~0.4%/yr. Dividend yield plus dividend growth is also better with 10 stocks than with VWINX (8.6% vs. 2.2%, see Columns G and H in the Table). During retirement, you’ll probably be able to cash those quarterly dividend checks without needing to sell the underlying shares, as opposed to having to sell shares of VWINX to come up with the same amount of cash. Of course, there is greater selection bias in picking 10 stocks than in owning shares of a managed stock/bond mutual fund like VWINX. Getting an extra ~1.8%/yr might justify the additional time and energy you’ll spend managing your portfolio but always consider opportunity costs. For example, a better choice for building retirement wealth might be to invest in VWINX, then use the time and energy you’ve saved to further your education and get a better day job.
Risk Rating: 3
Full Disclosure: I dollar-average into ISBs, WMT, ABT, and PEP. I also own shares of HRL, JNJ, and BDX.
NOTE: Metrics in the Table are current as of the Sunday of publication.
Post comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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