Situation: This phrase originated with poker players. It speaks volumes and quickly came to be adopted first by the financial community, and now the First Lady. It means that you need to become aware of all the available ways to meet your goals, then find a path forward that is most worthwhile and comes with the least risk of damaging your finances. Yes, that requires you to surf the web for hours and talk with experts. But if your daughter is college-bound, you’d better help her apply for available scholarships and teach her how to draw up a “term list” for available loans. Make an appointment with her high school guidance counselor, then visit colleges with her.
The risk:reward ratio for the stock market isn’t as good as the bond market’s, but the bond market is considerably more opaque to the retail investor, and can only teach you how to grow your money slowly. The transparency of publicly-traded corporate stocks, combined with their being the most rewarding asset class, means that stocks will have to dominate your retirement savings (if you start late). There is enough information available on the internet that you can try for a long-term return of 9% a year. How? By investing in A-rated stocks that have been appreciating that fast for the past 25 yrs. If you are afraid of owning stock in such companies, that’s understandable, given that most would lose more than an S&P 500 Index fund in a market crash (see Column N in the Table). You can likely achieve a 9%/yr return at less risk by doing something as simple as dollar-averaging into the S&P 400 MidCap Index ETF (MDY), or Berkshire Hathaway (BRK-B) which is an agglomeration of over 100 mostly Mid Cap companies.
Mission: Apply the 9% rule to the Dow Jones Composite Index (65 stocks) and the S&P 100 Index.
Execution: The companies we look at have a 9% trendline rate of price appreciation, meaning a Compound Annual Growth Rate (CAGR) calculated by the “least squares” method from weekly price points over the past 25 yrs. Stocks with a recent price trend that is two standard deviations above or below the trendline price are excluded, since there is no way to confidently predict that prices will return to the trendline. All companies are required to have at least an A- credit rating from S&P and at least an A-/M stock rating. The ratio of long-term debt to total assets cannot exceed 33% (see Column N in the Table). Tangible book value per share must be no less than -6%, which is the rate for Procter & Gamble (see Column O in the Table). Dividends over the past 6 months must have been paid from free cash flow (Div/FCF as noted in Column P of the Table).
Administration: The main competition that corporate stocks face comes from corporate bonds of similar risk, which are bonds rated at the lowest “investment grade” level, i.e., below Standard & Poor’s BBB+ rating or Moody’s Baa1 rating. But bonds (or bond funds) with that rating don’t pay even half the 9% you stand to gain from well-research stocks issued by the largest corporations. For example, the interest rate for the average Moody’s US Baa corporate bond on 11/15/16 was 4.36%. Paybacks to stock investors, in the form of dividends and/or share repurchases, tend to track that Baa rate. When you own such a bond, the interest payment is made every 6 months (i.e., 2.18% of the amount you invested) and that check will reliably show up in your mailbox until the bond matures.
Contrast that to the situation for high quality stocks in our Table, which have appreciated in price at least 9%/yr over the past 25 yrs (see Column K in the Table). Those had total returns of only 2.4%/yr during the 4.5 year Housing Crisis (see Column D in the Table), even though their total returns averaged ~10%/yr over the past 16 yrs, a period that included two severe recessions (see Column C in the Table). You get the picture, which is that you’ll have to own stocks and endure volatility if you waited until age 50 to start putting 15%/yr of your salary into a retirement plan. But if you had started saving that much at age 30, you could have taken a middle road, one where you would stand to double your money every 10 yrs (i.e., get a 7.2%/yr return), and do so with less risk, by investing in a low-cost bond-heavy mutual fund like the Vanguard Wellesley Income Fund (VWINX), which returned 4.9%/yr during the 4.5 year Housing Crisis (see Line 21 in the Table).
Bottom Line: Get out your pencil sharpener and green eyeshade, because making money from stocks is a lot of trouble. To simplify that task, stick with stocks issued by the largest corporations. Or, if you lack the time or interest to become a closet financier, invest in index funds that are composed of stocks issued by smaller corporations. Why a Mid Cap index fund? Because to get the 9%/yr price appreciation that is typical of Mid Cap growth stocks, without incurring their much greater risk of bankruptcy, you’ll need to hold positions in hundreds.
Risk Rating: 6 (where 10-yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into 6 stocks in the Table (UNP, NKE, JNJ, NEE, MSFT, PG), and own shares in 6 others (CAT, MMM, HON, GD, WMT, EMR).
NOTE: Net Present Value serves a valuable purpose, in that the calculation brings together the effects of dividend yield, dividend growth, and capital appreciation--while deducting 9%/yr from the dollars contributed by each of those cash flows. A positive NPV number means you’re not leaving money on the table--as long as you’re unable to find a safer investment that more reliably pays 10%/yr long-term. NPV is a retrospective analysis. If dividend growth were to fall below the trendline established over the past 10 years, NPV would go down. If price appreciation were to fall below the trendline established over the past 25 years, NPV would go down. But if increases were to develop in either, the Net Present Value of an investment made today would increase. The trick is to confine your attention to companies that have a clean Balance Sheet (see Columns N-P in the Table). But you also need to try balancing your stock picks across all 10 S&P Industries--to avoid the considerable risk that comes from selection bias.
Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 24 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline (“least squares”) CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 29 in the Table. The ETF for that index is MDY at Line 23.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, January 8
Sunday, January 1
Week 287 - Learn To Earn 9%/yr From Stocks Long-term
Situation: It is not difficult to pick 6 defensive stocks that will earn 6%/yr long-term (see Week 269). But try to pick 6 diversified stocks that will earn 9%/yr long-term without scaring you half to death. That is an order of magnitude more difficult but can be accomplished. Along the way, you’ll learn how not to “leave money on the table.”
Mission: Produce a spreadsheet that incorporates key tactics for picking stocks, limiting the sample to stocks in the S&P 100 Index that 1) had total returns/yr of at least 9% over the past 16 and 25 yr stretches; 2) had total returns/yr of at least 0% during the Housing Crisis (4/07-10/11); 3) have at least a market yield (currently 1.9%); 4) have had dividend growth of at least 9%/yr over the past 5 yrs; 5) have had trendline (“least squares” method) price growth of at least 9%/yr over the past 25 yrs; 6) have a clean Balance Sheet, meaning that long-term debt is no greater than 1/3rd of total assets, the company has Tangible Book Value (barring temporary short-term indebtedness to complete an acquisition), and the company is able to pay dividends from Free Cash Flow; 7) the S&P rating on the company’s long-term debt is no lower than A-; 8) the S&P rating on the company’s stock is no lower than B+/M.
Execution: We find 6 companies that satisfy all requirements (see Table).
Administration: For efficacy, the key tools we use are to 1) select from a pool of “mega-cap” companies, specifically those in the S&P 100 Index because it has an important safety feature: efficient “price discovery” based on the requirement that listed companies actively trade put and call options at the Chicago Board Options Exchange (CBOE); 2) demonstrate that Net Present Value is a positive number when using a 9% Discount Rate and 10-yr Holding Period. For safety, our key tools are to 1) calculate 3 ratios for determining whether or not the company has a clean balance sheet, and 2) select from companies that have a market yield or better.
Bottom Line: Stock-picking at this level requires research time, focus, money, and enough discipline to avoid the two great dangers that Warren Buffett has identified: “I’ve seen more people fail because of liquor and leverage — leverage being borrowed money.” Getting a 9%/yr return over time is mainly about amortizing risk through diversification, which can be accomplished more safely and efficiently by dollar-averaging into a “Mid Cap Blend” index fund, like the SPDR MidCap 400 Index ETF (MDY), or Berkshire Hathaway (BRK-B) which is an agglomeration of 100 mostly Mid Cap companies. During the Housing Crisis (4/07-10/11), MDY and BRK-B had total returns/yr of -0.7% and -0.3%, respectively (see Column D in the Table).
Caveat: By “shooting for the moon” like this, you will hone your stock-picking skills but also lose a lot of money from time to time (at least on paper). In other words, you would be fully committing to market risk. So, start by regularly investing small amounts in MDY and BRK-B. Then pause to reassess. Move on to Blue Chip companies (i.e., the 30 companies in the Dow Jones Industrial Index) that carry low risk and almost meet our criteria, such as Procter & Gamble (PG at Line 11 in the Table), which only grows dividends 5.0%/yr. PG clears our other hurdles and has a positive NPV at the 9% discount rate (see Column Y in the Table).
Risk Rating: 6 (where 10-yr Treasuries = 1, the S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, PG, and NEE, and also own shares of AAPL, HON, CAT, and MMM.
NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 17 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years (no dividends collected in 10th year), Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 5-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline (“least squares”) CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table. The ETF for that index is MDY at Line 16.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Mission: Produce a spreadsheet that incorporates key tactics for picking stocks, limiting the sample to stocks in the S&P 100 Index that 1) had total returns/yr of at least 9% over the past 16 and 25 yr stretches; 2) had total returns/yr of at least 0% during the Housing Crisis (4/07-10/11); 3) have at least a market yield (currently 1.9%); 4) have had dividend growth of at least 9%/yr over the past 5 yrs; 5) have had trendline (“least squares” method) price growth of at least 9%/yr over the past 25 yrs; 6) have a clean Balance Sheet, meaning that long-term debt is no greater than 1/3rd of total assets, the company has Tangible Book Value (barring temporary short-term indebtedness to complete an acquisition), and the company is able to pay dividends from Free Cash Flow; 7) the S&P rating on the company’s long-term debt is no lower than A-; 8) the S&P rating on the company’s stock is no lower than B+/M.
Execution: We find 6 companies that satisfy all requirements (see Table).
Administration: For efficacy, the key tools we use are to 1) select from a pool of “mega-cap” companies, specifically those in the S&P 100 Index because it has an important safety feature: efficient “price discovery” based on the requirement that listed companies actively trade put and call options at the Chicago Board Options Exchange (CBOE); 2) demonstrate that Net Present Value is a positive number when using a 9% Discount Rate and 10-yr Holding Period. For safety, our key tools are to 1) calculate 3 ratios for determining whether or not the company has a clean balance sheet, and 2) select from companies that have a market yield or better.
Bottom Line: Stock-picking at this level requires research time, focus, money, and enough discipline to avoid the two great dangers that Warren Buffett has identified: “I’ve seen more people fail because of liquor and leverage — leverage being borrowed money.” Getting a 9%/yr return over time is mainly about amortizing risk through diversification, which can be accomplished more safely and efficiently by dollar-averaging into a “Mid Cap Blend” index fund, like the SPDR MidCap 400 Index ETF (MDY), or Berkshire Hathaway (BRK-B) which is an agglomeration of 100 mostly Mid Cap companies. During the Housing Crisis (4/07-10/11), MDY and BRK-B had total returns/yr of -0.7% and -0.3%, respectively (see Column D in the Table).
Caveat: By “shooting for the moon” like this, you will hone your stock-picking skills but also lose a lot of money from time to time (at least on paper). In other words, you would be fully committing to market risk. So, start by regularly investing small amounts in MDY and BRK-B. Then pause to reassess. Move on to Blue Chip companies (i.e., the 30 companies in the Dow Jones Industrial Index) that carry low risk and almost meet our criteria, such as Procter & Gamble (PG at Line 11 in the Table), which only grows dividends 5.0%/yr. PG clears our other hurdles and has a positive NPV at the 9% discount rate (see Column Y in the Table).
Risk Rating: 6 (where 10-yr Treasuries = 1, the S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into UNP, PG, and NEE, and also own shares of AAPL, HON, CAT, and MMM.
NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 17 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256: Briefly, Discount Rate = 9%, Holding Period = 10 years (no dividends collected in 10th year), Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 5-Yr CAGR found at Column H. Price Growth Rate is the 25-Yr trendline (“least squares”) CAGR found at Column K (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table. The ETF for that index is MDY at Line 16.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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