Week 43 - Finance Value of Master List Stocks

Situation: In last week’s blog (Week 42), we introduced the idea that an asset worth financing requires the exercise of due diligence prior to purchase: Finance Value = Reward - Risk. When you start accumulating a stock, you are making a prospective purchase, i.e., you purchase the hope of a future profit. In our experience, we have found only one way to apply real numbers to estimate whether a solid “business case” exists for making that bet. That is to conduct a Buffett Buy Analysis (BBA), which requires earnings data extending back 9-10 yrs. That calculation is explained in our Week 30 blog and gives a projected growth rate over the next 10 yrs. To have confidence in that number, you also need to know whether the company has what Warren Buffett calls a Durable Competitive Advantage. That assessment requires Tangible Book Value data going back 9-10 yrs. If Tangible Book Value grew steadily at an average rate of over 7%/yr, the company has a Durable Competitive Advantage. If the BBA also projects growth of over 7%/yr, then the basic requirement for a good business case has been met: the investment doubles in value over 10 yrs, which calculates out to be a total return of 7.18%/yr. If you know how the stock did for the last 10 yrs (retrospective reward), and how it did for the worst months of the last bear market (retrospective risk), you’ll be able to come up with its retrospective Finance Value (reward minus risk). The prospective reward is BBA and your confidence about realizing that reward lies in whether or not the company has a Durable Competitive Advantage. As for assessing prospective risk, you’ll have to rely on current risk metrics (LT debt/total capitalization, FCF/div, and ROIC) as explained in the Week 42 blog.

This week, we will look at ITR Master List stocks (Week 39) that look good “across the board.” We will also examine IBM, a former Master List stock that has risen so much in price that its dividend yield is only 1.7%, i.e., lower than the Master List cutoff point of 2.0%. We provide updates on IBM because it is a permanent member of our 12-stock Growing Perpetuity Index (Week 32). We’ll also examine bond mutual funds to highlight why we recommend those as hedges (low risk combined with respectable returns).

Turning to the ITR Master List (Week 39), we can populate our spreadsheet (see Table) with the same key data as last week. The Table shows companies in a descending order of recent finance value (reward minus risk). Bear in mind that BBA often cannot be applied for defensive stocks--those in our Lifeboat Stock category--because many of those companies do not see a need to maintain reserves in the form of Tangible Book Value (see blog from Week 30). Therefore, we cannot determine whether the company has a Durable Competitive Advantage (i.e., the ability to relentlessly increase Tangible Book Value at +7%/yr). However, the BBA can still be calculated. Since Warren Buffett places great weight on estimating a company’s Durable Competitive Advantage, and he is CEO of Berkshire Hathaway Corp, you can read how he guesstimates Durable Competitive Advantage for such companies (Berkshire Hathaway owns hundreds of millions of shares of two: Procter & Gamble and Coca-Cola).

Looking at the Table, we see that all 3 utility stocks in the ITR Master List stand out (NEE, SO, WEC), as do all 3 energy producers (XOM, CVX, OXY). CH Robinson Worldwide (CHRW) has always been a strong performer so it carries a high P/E. The company policy eschews the use of debt, and it is the leading logistics company in a world where commerce is relentlessly globalizing. You wouldn’t be overpaying given the very high ROIC, which reflects how rapidly their business is expanding. McDonald’s is another crowd-pleaser, since it supplies food at affordable prices in developing countries with large populations just emerging from poverty. Wal*Mart (WMT) also sells food and essentials to the developing world at very low prices. Amazingly, its stock climbed 16% during the worst 18 months of the Great Recession! Hormel Foods (HRL) and McCormick (MKC) are other high quality defensive stocks that provide food staples at low prices.

Bottom Line: Look before you leap. When you become a part-time financier by purchasing stock in a company it puts you at risk of losing all you have wagered. Know whether or not there is a business case for making that investment in the first place, then periodically check to see if it remains true. Professional investors can be counted on to “short” any stock from time to time, which drives down the price. This tempts non-professional investors to sell. If you’ve made a sound decision to buy that stock, you can ride out these periods. If you are dollar-cost averaging your purchases in a DRIP, you even want the short-sellers to do their thing because you’ll be buying more shares each month. The shares are literally “on sale”!

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com

Week 42 - Our Short List of Commodity-related Companies

Situation: In previous blogs, we’ve reviewed companies that deal in commodities and pay dividends. These include mining operations, drillers, pipeline operators, railroads, refinery operators, oil service and agriculture-related companies. (For a review, see blogs for Week 40, 35, 26, 20 and 10.) Even though investments in commodity-producing companies are risky, we’ve identified 9 where that isn’t the case, and six of those are already on the ITR Master List (Week 39).

Our main assignment in writing a finance blog is to provide methodology for determining when it appears worthwhile to purchase a financial product like a stock. Because commodity-related companies are so risky, we’re going to have to take extra care to separate “wheat” from “chaff”. We find that there are 4 “factors” that provide the necessary insight:

   a) historical long-term price and dividend performance (or “retrospective reward”);

   b) historical episodes of peril to the stock’s price (or “retrospective risk”);

   c) metrics for determining the likelihood of continued growth in Core Earnings (Week 30) that will support increased dividends and/or price (or “prospective reward”);

   d) metrics for determining the likelihood that the stock’s future price and/or dividend will become imperiled (or “prospective risk”).

When we bring the information gleaned from these 4 factors together, we can identify companies (BOTH retrospectively and prospectively) that satisfy one of the most important governing equations for investing: Finance Value = Reward - Risk. Let’s examine each in more depth.

Retrospective reward: Here we’ll use a traditional “business case” example: an investment needs to double in 10 yrs. This means it needs to have an annualized total return of 7.1% or better. Using a “virtual purchase” of 100 shares in our attached Table, the dividends paid for 10 yrs were summed and then added to the proceeds from liquidating those shares.The goal is to see if our money doubles (exclusive of trading costs). We’ll assume all purchases were made on 7/1/02 because that’s almost 10 yrs ago and happens to be the bottom of the ”dot.com” bear market. In summary, you’ll need to know if a stock’s past performance qualifies it for an intelligent investor’s consideration. This step is as far as most investors get in their analysis, which is why we’ll use the term intelligent investor in our discussion.

Retrospective risk: This is often hard to put a number on, but since the Lehman Panic of 2008-09 it’s become easier. We have one fraction to solve: the numerator is the price of the asset on 4/1/09 and the denominator is the asset price on 10/1/07. That 18 months saw the steepest loss in stock market valuation since the Great Depression. Here at ITR, we set the upper limit as the loss suffered by the balanced fund that out-performed all others (having at least 40% of assets in stock): the 22% loss sustained by the Vanguard Wellesley Fund (VWINX). That fund also happens to be the only one we’ve found that somewhat mimics the ITR Goldilocks Allocation (Week 3) where we invest ~50% in large companies with dividend-paying stocks and ~50% in intermediate-term investment grade bonds. (VFINX, the least-expensive S&P 500 index fund, lost 44%.) 

The take-home message is that Finance Value =  Reward - Risk. Using the attached Table, we inserted numbers in that equation: i.e., subtract Column “I” from Column “H” and you have a number that indicates the recent Finance Value of each of the 9 companies.

Prospective reward: We measure this by using the Buffett Buy Analysis (BBA), which we described in Week 30 & Week 31. To summarize, if Tangible Book Value has grown steadily for the past 9-10 yrs (at a rate greater than ~7%/yr) the company is considered to have a “Durable Competitive Advantage”. That means it is reasonable to project the next 10 yrs of growth by using a formula that assumes the economy will be in tough shape and the company won’t be able to raise its dividend. In addition, assume its Price/Earnings (P/E) ratio will remain stuck at the lowest level seen in the past 10 yrs. The Buffett Buy Analysis is a severe “stress test” but because the company has a Durable Competitive Advantage it is assumed it will be a survivor. That means its rate of Core Earnings Growth (Week 30) over the past 9-10 yrs will likely continue for the next 10 yrs, partly because its competitors will fall by the wayside. The take-home message is that not many companies perform well enough to have a Durable Competitive Advantage BUT those that do warrant much closer attention.

Prospective risk: We’ve often mentioned that Risk (i.e., the chance that a company will go through a “Near-Death experience” during a recession) is mainly because of issues with debt and/or cash-flow. The most critical debt issue that can arise is the need to return principal to holders of Long-Term (LT) debt by a date certain. So we set a limit on the acceptable amount of LT debt outstanding as 45% of total capitalization. Cash-flow issues can be complicated to analyze but when a dividend-paying company has to borrow money to pay (or keep increasing) its dividend, we lose interest.

So let’s look at Free Cash Flow (FCF) as an example, which is the amount left over from Net Operating Cash Flow after purchase of additional fixed assets (property, plant, and equipment) for expanding the business. FCF is then divided by the total amount of dividends paid. We’re only interested in companies that consistently raise their dividend, so if FCF/div isn’t any greater than 1.5 we become concerned: maybe the company will have to borrow money to increase the dividend next year. Bear in mind that there are other calls on a company’s Retained Earnings, such as paying interest on its debt. Many companies encounter problems with cash flow or debt because their managers want to grow the company by using Retained Earnings (best option), but will take advantage of a favorable market by taking out LT loans (next best option). New stock is issued only as a last resort. Why? There are many reasons but usually it’s that interest on loans is not taxable. That begs the next question, which is why don’t more companies go bankrupt? Answer: Corporate managers find a way to grow earnings fast enough to pay down old debt as fast as new debt is added. You already know that earnings growth is the key to raising dividends annually, and that we use one number to measure the likelihood of that happening: Return on Invested Capital (ROIC). An ROIC value of 10% is acceptable but when it is less than 13% we’re not happy unless the company carries very little LT debt and/or has a high FCF/div.

You’ve seen many of the metrics discussed above on previous spreadsheets but haven’t seen them together. In this week’s Table, we display the above 4 factors (each with its appropriate metrics) in the order discussed so you’ll be able to compare companies “across the board”. Companies that rise and fall in value with the economic cycle rarely look good when all is laid bare, particularly commodity-related companies. Nonetheless, we’ve found 9 that are presentable. Only 3 are pure-play commodity producers: Occidental Petroleum OXY, an exploration & production company, Hormel Foods HRL, a pork producer, and Monsanto MON, a seed producer. Two produce fertilizer, FMC and POT. ExxonMobil (XOM) and Chevron (CVX) drill for oil & gas but also operate refineries that produce chemicals with a steady market. CH Robinson Worldwide (CHRW) is the main US “middleman” for transporting commodities around the world, and Canadian National (CNI) is the largest railroad in one of the premier commodity-producing countries.

Bottom Line: Some commodity-related companies are suitable for long-term investment by using dollar-cost averaging and dividend re-investment but not many. For most, you’d have to be a speculator, i.e., someone who knows when to get in and when to get out.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com