Week 240 - Does Your Retirement Fund Need to Look Like a Rainy Day Fund?

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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Week 239 - The “Big 6” Agronomy Companies Are Starting To Merge

Situation: For the past 10 years, companies in the “Basic Materials and Energy” industries have made massive investments to support China’s infrastructure buildout. More than 10 million people a year in China moved from rural poverty to cities during that time. But now China’s government sees little need for more construction projects and manufacturing capacity. Labor costs have increased and more emphasis is being placed on satisfying the need for consumer goods. China is no longer an emerging market. Other countries in Southeast Asia are able to produce goods more cheaply and compete with China for market share. The problem now is that the worldwide supply chain for energy, basic materials, and food commodities is twice the size it was 10 yrs ago but the market for all those goods is only a little larger. Production can’t suddenly be cut in half which means that excess goods have to go into storage. There has never been a commodity crash as big as this. To make matters worse, the world has yet to shake off lingering effects of the Lehman Panic. People got by with less for so long that they’ve unlearned the habit of casual shopping. But food? Who guessed that consumers would even cut back on that? Many families in North America are losing interest in foods that aren’t healthy, farm goods that aren’t produced in an environmentally sensitive manner, and meat that isn’t produced with due consideration to every farm animal’s well being. That means the grocery store bill is larger every week for those families but they’re seeking out grocery stores that offer those products. “Factory Farming” is going out of style. 

Mission: Assemble growth-related metrics for the 6 largest companies that produce seeds, insecticides, herbicides and fungicides.

Execution: Dow Chemical (DOW) and duPont (DD) have decided to merge operations then spin off 3 companies. There will be one new company formed for agriculture, one for specialty chemicals, and and one for commodity chemicals. Syngenta (SYT) and Monsanto (MON) tried to merge, then broke off talks, and are now talking again. Bayer (BAYRY) and BASF (BASFY) have also held preliminary talks with potential partners. Let’s see what makes some of these 6 companies a target for purchase by other agronomy firms.

Administration: All of these companies are struggling. None of the US companies that S&P analyzes (MON, DD, DOW) has been able to grow Tangible Book Value (TBV) over the past 10 yrs, and stock prices average more than 20 times TBV (see Columns P-R in the Table). The main factor keeping these companies away from insolvency is the value of their strong brands. Risk metrics shown in the Table are very concerning, such as total return during the 2011 stock market correction (Column D), 5-yr Beta (Column I), and the BMW Method’s projection of price loss in a bear market compared to the 16-yr price trendline (Column O). On the other hand, the rewards to investors who bought any of these stocks at the market peak on September 1, 2000, have been quite satisfactory (see Columns C and M in the Table). Average dividend yield is ~3.4% and average dividend growth is 10.5% (see Columns G and H in the Table). The two weakest companies are duPont and Dow Chemical, so it is not surprising that those are the first to combine operations.

Bottom Line: Agronomy stocks aren’t for the faint of heart. You’d have to be a speculator who is able to weather volatility over at least two market cycles before reaping your reward. Now these stocks are on the bargain shelf, being forced to merge operations--which is just what an investor like Warren Buffett loves to see happening. Monsanto (MON) is the only one that might be a suitable stock to own for someone who is not a financial services professional. 

Risk Rating: 7

Full Disclosure: I dollar-average into MON and also own shares of DD.

Note: Metrics are current for the Sunday of publication; metrics in red denote underperformance vs. 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