Situation: Stock-picking is a good way to build a retirement portfolio, if you have enough time and enthusiasm. It requires that you delve into fundamental company practices far enough to select and follow a dozen or more stocks. But how do you start, and where should you focus your efforts? For sure, you’re not going to analyze all 500 stocks in the S&P 500 Index (^GSPC). But you can become familiar with the 65 stocks in the Dow Jones Composite Index (^DJA). We call it the Stockpicker’s Secret Fishing Hole because it often outperforms the S&P 500 Index. For example, price appreciation over the past two market cycles for ^DJA has been twice as great as for ^GSPC (see Column C at Lines 52 & 54 in the Table). ^DJA also benefits from being a “managed” index: its stocks are picked by a Wall Street Journal committee chaired by the Managing Editor.
Mission: Produce our standard spreadsheet for all ^DJA stocks that have revenues high enough to warrant inclusion in the Barron’s 500 List. Exclude any that have an S&P stock rating lower than B+/M, or an S&P bond rating lower than BBB+, and determine which of the remainder have a Durable Competitive Advantage (DCA).
Execution: Of the 38 companies that meet mission criteria, 18 are suitable for long-term investment because much of their book value is in real (“tangible”) assets that track earnings growth. Warren Buffett says this confers a “Durable Competitive Advantage” if tangible assets have been growing at least 9% per year over the most recent decade, and if there have been no more than two down years (see The Warren Buffett Stock Portfolio by Mary Buffett and David Clark, Scribner, New York, 2011). Given that the Great Recession sharply reduced economic growth over the past decade, I’ve loosened that standard to 7%/yr with no more than 3 down years.
The 18 companies listed below meet our requirements. All have a Price/Tangible Book Value ratio that is less than 10. In other words, real assets (as opposed to brand value or “goodwill”) represent at least 10% of the share price (see Columns T-V in the Table). I use this system, and dollar-average into the 7 stocks with bold typeface:
Apple
Nike
NiSource
Public Service Enterprise Group
NextEra Energy
Microsoft
JB Hunt Transport Services
Wal-Mart Stores
American Express
Union Pacific
Chevron
ExxonMobil
Travelers
Expeditors International of Washington
CSX
Cisco Systems
JP Morgan Chase
Goldman Sachs
Bottom Line: “High quality megacaps are the name of the game.” You’ll need a system for recognizing value and sustainability among those large capitalization companies. S&P charts for individual companies list the Tangible Book Value (TBV) for each of the past 10 yrs and are available through most brokerages, as well as S&P. By using a calculator for Compound Annual Growth Rate, you can arrive at each company’s Durable Competitive Advantage (growth in TBV). If the company has no TBV, its liabilities exceed the value of its real assets; you’ll need to delve into its Balance Sheet before deciding to assume that much risk. We’ve filtered through the 65-stock Dow Jones Composite Index and come up with 18 companies that look worthwhile, using our standard spreadsheet supplemented with calculations of their Durable Competitive Advantage.
Risk rating: 5
Full Disclosure: In addition to the 7 stocks above that I dollar-average into, I own shares of UTX, DD, MMM, INTC, KO, IBM, JNJ and MCD.
Note: Metrics in the Table are current for the Sunday of publication; those highlighted in red denote underperformance vs. our key benchmark (VBINX at Line 45 in the Table). Total returns/yr (in Column C of the Table) date to the penultimate S&P 500 Index peak that occurred on 9/1/2000.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 24
Sunday, January 17
Week 237 - Respect The KISS Rule
Situation: How do we save for retirement? After all, a typical adult is disinclined to reduce discretionary spending by the needed ~50% to plan for her future (and that’s assuming that a series of favorable events will transpire). To effectively save for retirement, most people have to make a game out of it. We substitute the discretionary entertainment value that comes from immediate consumption by instead watching our nest egg grow. The entertainment value we receive can be amplified by trying to be more clever than our neighbors and co-workers. With the help of a financial advisor, we play around with our retirement portfolios. But it doesn’t have to be that way. You can forget about entertainment and one-upping your friends. Just pick mutual funds that balance stocks and bonds. Or pick only one, such as the Vanguard Balanced Index Fund (VBINX), which serves as Jack Bogle’s only personal investment during most years. He’s the originator of index fund investing and founder of Vanguard Group. Jack Bogle respects the KISS rule: “Keep it simple, stupid.” But he has many critics in the community of investment advisors (as the above link makes clear). Their main criticism is that VBINX minimizes international investing and overlooks “core” assets like real estate investment trusts (REITs), small-cap stocks, and commodities.
Mission: Test a balanced portfolio of “core assets” consisting of US stocks, international stocks, US bonds, international bonds, REITs, and Commodities. In other words, combine the most diversified mutual funds for US stocks (VTSMX), US bonds (VBMFX), real estate investment trusts (VGSIX), commodity futures (QRAAX), international bonds (RPIBX), and international stocks (VGTSX).
Execution: Since the S&P 500 Index peaked on 9/1/00 (see Table), total return/yr for these 6 core assets has come in at 3.6%/yr, matching the lowest-cost S&P 500 Index fund (VFINX). Broad diversification among core assets is meant to reduce the risk of an S&P 500 index fund without reducing returns. The 6 core assets we selected did achieve our objective. Risk measures were lower for this asset group (see Columns D and I in the Table). However, these core assets under-performed VFINX by a wide margin during the bull market of the past 5 years (see Column F in the Table). More importantly, their average expense ratio is 3 times higher at 0.52% (vs. 0.17% for VFINX). And, QRAAX has to be purchased through a broker.
As a “rule of thumb” you want some assurance that your investment will meet the “business case” and double in value over the next 10 years, i.e., total return will increase by at least 7%/yr. If the dividend yield plus the dividend growth rate is at least 7%, that is likely to be the case (see Columns G and H in the Table where those instances are highlighted in green). Core assets, except for the real estate fund (VGSIX), do not meet that criterion.
Administration: Mutual funds also have “tail risks,” a term used to describe unlikely yet destabilizing events. Managed funds are sold on the basis of performance, which means managers tend to choose small- and mid-cap stocks that often perform remarkably well (meaning they have a high return on equity or ROE), due in part to being overcapitalized by loans and bonds that are “less than investment grade.” Of course, that indebtedness is ignored when calculating ROE. Index funds are also sold on the basis of performance and overly dependent on their smallest (i.e., riskiest) companies for that performance. Finally, mutual funds maintain minimal cash balances which can force them to sell their bonds or stocks at a loss during a bear market (i.e., conduct a “fire sale”). In other words, they have to immediately honor every investor’s request to have her money returned. None of these problems exist if you’re a shareowner. You get to decide how much risk you want to assume and whether or not to “ride out” a bear market, or even continue dollar-averaging into your favorite positions, so as to “vacuum up” shares that mutual funds are unloading at a loss.
By now you’re getting the point: part of your retirement portfolio has to be devoted to owning shares in a diversified group of strong companies that you’ve selected, so as to avoid the “buy high, sell low” roller coaster that mutual funds can’t avoid. They’re constrained by market forces and the inflows/outflows of investor’s cash. They’ll engage in “momentum investing” as they ride bull markets up, and “fire sales” as they ride bear markets down. By owning individual stocks, you choose whether to play along or not. Individual stocks also have their place in a retirement portfolio for another reason we often highlight. Many companies issue dividends that have increased 2-5 times faster than inflation for more than 10 years, whereas, distributions from stock mutual funds rarely keep up with inflation (see Column H in any of our Tables). That means you don’t have to cash out shares during retirement but instead can simply live off your income. For example, you can do quite well by investing in 5 stocks (that represent half the S&P industries) combined with owning 10-yr Treasury Notes in a 60% stock/40% Treasury Note ratio (see Line 14 in the Table).
Bottom Line: Broad diversification among “core assets” will allow you to match the performance of the lowest-cost S&P 500 Index fund (VFINX) while incurring less risk, as long as you ignore transaction costs, advisory fees, and front-end brokerage charges. But professional money managers prefer to get you into “core assets” for the very reason that they live off advisory fees (as well as often gaining a piece of the income from transaction costs and brokerage relationships). Warren Buffett is right. You will beat 90% of professional investors by investing online through Vanguard Group--placing 90% of your savings in the lowest-cost S&P 500 Index fund (VFINX) and 10% in the lowest cost US government short-term bond index fund (VSBSX), as shown in Line 23 of the Table. The key benchmark we recommend to our readers is the Vanguard Balanced Index Fund (VBINX) at line 21 in the Table, which does even better than the Buffett Plan while incurring less risk.
Risk Rating: 5
Full Disclosure: I own shares of MCD, JNJ, and KO, as well as dollar-average into T, NEE and Treasury Notes.
Note: Metrics highlighted in red denote underperformance relative to 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
Mission: Test a balanced portfolio of “core assets” consisting of US stocks, international stocks, US bonds, international bonds, REITs, and Commodities. In other words, combine the most diversified mutual funds for US stocks (VTSMX), US bonds (VBMFX), real estate investment trusts (VGSIX), commodity futures (QRAAX), international bonds (RPIBX), and international stocks (VGTSX).
Execution: Since the S&P 500 Index peaked on 9/1/00 (see Table), total return/yr for these 6 core assets has come in at 3.6%/yr, matching the lowest-cost S&P 500 Index fund (VFINX). Broad diversification among core assets is meant to reduce the risk of an S&P 500 index fund without reducing returns. The 6 core assets we selected did achieve our objective. Risk measures were lower for this asset group (see Columns D and I in the Table). However, these core assets under-performed VFINX by a wide margin during the bull market of the past 5 years (see Column F in the Table). More importantly, their average expense ratio is 3 times higher at 0.52% (vs. 0.17% for VFINX). And, QRAAX has to be purchased through a broker.
As a “rule of thumb” you want some assurance that your investment will meet the “business case” and double in value over the next 10 years, i.e., total return will increase by at least 7%/yr. If the dividend yield plus the dividend growth rate is at least 7%, that is likely to be the case (see Columns G and H in the Table where those instances are highlighted in green). Core assets, except for the real estate fund (VGSIX), do not meet that criterion.
Administration: Mutual funds also have “tail risks,” a term used to describe unlikely yet destabilizing events. Managed funds are sold on the basis of performance, which means managers tend to choose small- and mid-cap stocks that often perform remarkably well (meaning they have a high return on equity or ROE), due in part to being overcapitalized by loans and bonds that are “less than investment grade.” Of course, that indebtedness is ignored when calculating ROE. Index funds are also sold on the basis of performance and overly dependent on their smallest (i.e., riskiest) companies for that performance. Finally, mutual funds maintain minimal cash balances which can force them to sell their bonds or stocks at a loss during a bear market (i.e., conduct a “fire sale”). In other words, they have to immediately honor every investor’s request to have her money returned. None of these problems exist if you’re a shareowner. You get to decide how much risk you want to assume and whether or not to “ride out” a bear market, or even continue dollar-averaging into your favorite positions, so as to “vacuum up” shares that mutual funds are unloading at a loss.
By now you’re getting the point: part of your retirement portfolio has to be devoted to owning shares in a diversified group of strong companies that you’ve selected, so as to avoid the “buy high, sell low” roller coaster that mutual funds can’t avoid. They’re constrained by market forces and the inflows/outflows of investor’s cash. They’ll engage in “momentum investing” as they ride bull markets up, and “fire sales” as they ride bear markets down. By owning individual stocks, you choose whether to play along or not. Individual stocks also have their place in a retirement portfolio for another reason we often highlight. Many companies issue dividends that have increased 2-5 times faster than inflation for more than 10 years, whereas, distributions from stock mutual funds rarely keep up with inflation (see Column H in any of our Tables). That means you don’t have to cash out shares during retirement but instead can simply live off your income. For example, you can do quite well by investing in 5 stocks (that represent half the S&P industries) combined with owning 10-yr Treasury Notes in a 60% stock/40% Treasury Note ratio (see Line 14 in the Table).
Bottom Line: Broad diversification among “core assets” will allow you to match the performance of the lowest-cost S&P 500 Index fund (VFINX) while incurring less risk, as long as you ignore transaction costs, advisory fees, and front-end brokerage charges. But professional money managers prefer to get you into “core assets” for the very reason that they live off advisory fees (as well as often gaining a piece of the income from transaction costs and brokerage relationships). Warren Buffett is right. You will beat 90% of professional investors by investing online through Vanguard Group--placing 90% of your savings in the lowest-cost S&P 500 Index fund (VFINX) and 10% in the lowest cost US government short-term bond index fund (VSBSX), as shown in Line 23 of the Table. The key benchmark we recommend to our readers is the Vanguard Balanced Index Fund (VBINX) at line 21 in the Table, which does even better than the Buffett Plan while incurring less risk.
Risk Rating: 5
Full Disclosure: I own shares of MCD, JNJ, and KO, as well as dollar-average into T, NEE and Treasury Notes.
Note: Metrics highlighted in red denote underperformance relative to 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
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