Week 117 - Hedge Stocks Revisited

Situation: Hedge Fund managers often bet against (short) shaky or overpriced stocks. That means borrowing thousands of shares of that stock and immediately selling those. While waiting for the shares to fall far enough in price to provide a profit to the hedge fund (after being bought back and returned to the owner), the hedge fund has to pay that owner interest on the loan and the value of any dividends that she would have received. There are over 10,000 hedge funds, so other hedge fund managers often see the same opportunity and “pile on.” That creates a self-fulfilling prophecy because the stock price will certainly fall from the selling pressure--presumably enough to “discover” the real value of the firm. That means prices for many stocks will crash in the early months of a recession, particularly stock in companies financed primarily by debt (which is most of the S&P 500 companies, since interest on that debt is tax-deductible). You and I, however, would like to avoid that downdraft in our portfolios by investing in stocks that are less likely to be shorted. Here at ITR, we call those “hedge stocks” (see Week 46, Week 76, Week 95 and Week 101).

By definition then, a hedge stock has few (if any) of the characteristics that would tempt a hedge fund manager to short the stock. That’s a long list but the main problems that attract “shorts” are: 
   1) more long-term debt than equity (because debt can’t always be refinanced cheap); 
   2) apparent overvaluation (price/earnings ratio higher than 20);
   3) 5-yr Beta higher than ~0.65 (i.e., volatility is necessary to make a short sale work);
   4) ROIC less than ~10% (suggesting managerial incompetence);
   5) negative free cash flow (suggesting excessive or untimely capital expenditures);
   6) little or no dividend payout (since dividends add costs to a short sale).

This week’s screen looks at all 900 stocks in both the large-cap S&P 500 Index and the medium-cap S&P 400 Index. We exclude any stocks that have: 
   a) a P/E greater than 21; 
   b) a dividend yield less than 1.5%;
   c) a 5-yr Beta greater than 0.65;
   d) a total return/yr (since the S&P 500 Index’s inflation-adjusted peak on 3/24/00) less than that for the Vanguard 500 Index Fund (VFINX);
   e) a loss in total return over the 18-month “Lehman Panic” period greater than 30.2%, which is 65% as much as the 46.5% that VFINX lost.

We also exclude companies (aside from utilities) that had problems in 2012 with free cash flow (FCF), long-term debt, and return on invested capital (ROIC). 

This screen yields only 16 companies (see Table). Not surprisingly, 12 of those 16 are from “defensive” S&P industries (consumer staples, healthcare, utilities, and communication services). In other words, those 12 are “Lifeboat Stocks” (see Week 106). Aside from the 4 Utilities companies (WEC, SO, NEE, WTR), there are 2 Healthcare companies (JNJ and ABT) and 6 Consumer Staples companies, all food-related (KO, PEP, GIS, SJM, LANC, WMT). The remaining 4 companies (CB, HCC, MCD, CHRW) are all we could find to represent the 6 “non-defensive” S&P industries (Energy, Materials, Industrial, Financials, Information Technology, and Consumer Discretionary). In other words, those 4 are “Core Holdings” (see Week 102): 2 Financial companies (CB and HCC), one Industrial company (CHRW), and one Consumer Discretionary company (MCD). Red highlights in the Table indicate inferior performance vs. our reference benchmark: the Vanguard Balanced Index Fund (VBINX). Data are current through 9/27/13.

While your investment in any of these 16 hedge stocks need not be backed up 1:1 with an investment in US Treasuries, the very brevity of the list (1.8% of the 900 companies) shows why we suggest that you insulate your stocks from market crashes by owning an equivalent amount of Treasuries or A-grade bond funds. (We think that inflation-protected US Savings Bonds, if held for more than 5 yrs, are the best option. Interest accrues automatically, and isn’t taxed until the bond is redeemed.) Much of the downdraft in stock prices that occurs during a market crash is due to hedge funds shorting stocks. Should you happen to retire just before one of those downdrafts occurs, you’ll be pleased to hold some stocks that didn’t get shorted. An interesting sidebar here is that Hedge Fund Research recently published its findings for the average total return of stock-related hedge funds in the first 6 months of 2013, which was 7.7%. Our 16 hedge stocks returned almost twice as much, 14.6% (Column F in the Table).

Bottom Line: “Price Discovery” is important and hedge funds do a fine job of this by shorting overpriced or shaky stocks before they get too overpriced. Our analysis this week shows that all but 16 of the S&P 500 and S&P 400 stocks have one or more characteristic that might trigger a short sale. When short sales include more than a few percent of a company’s outstanding shares, the downside volatility becomes exaggerated. You can either a) accept this volatility, or b) weight your portfolio toward stocks that are relatively immune. We’ve found 16 relatively immune stocks for you to consider.

Risk Rating: 3

Full Disclosure: I dollar-average into DRIPs for WMT, ABT, JNJ, KO, and NEE each month, and also own some stock in MCD, PEP, and GIS.

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

Week 116 - Is there an “Optimum Portfolio” for the retail investor?

Situation: There has always been this myth of the “optimum portfolio” but exactly whose interests are best served by such a portfolio? We’re all different, after all, and of many minds. You may know that the left brain rationalizes everything to make us look better than we are and the right brain spouts poetry, solves math problems, and creates art, music, novels, architecture (along with gambling and other addictions). Ah, did I just mention gambling? There’s our clue to the optimum portfoliio. Pretty much any investor will take a risk once in awhile but she also wants most of her money to be in a safe place. So there’s the dichotomy.

Here at ITR, we keep gambling corralled in a small corner, writing only occasional pieces about commodity-related investments. The idea there is that (with enough basic information) the average investor can look at how commodities are used and make an investment where future benefits are more than likely to offset the not inconsiderable risks.

In Week 3, we set out our ideas on asset allocation, namely by proposing a recipe that calls for 3 helpings of bonds, two helpings of Core Holdings (Week 102), and one helping of Lifeboat Stocks (Week 106). The accompanying Table breaks out our current choices in each category.

Starting with bonds, US Treasuries are the place to be because all other bonds go down in value during a financial crisis but Treasuries go up, a lot. Some companies that make or market essential products also shine: People will pay the price dictated by supply and demand rather than go without heat, light, water, baby formula, Band-Aids, Tylenol, pizza, trips to the nearest McDonald’s, clothes, shoes and cleaning materials. Previous necessities, like a new car every 3 years, cable TV, soda pop, beer, quick stops at Starbucks, an evening out for dinner and a movie, and holiday travel soon become “out of reach” for the unemployed.

All 27 companies in the Table are A-rated by S&P, and none are rated high risk. This means that the second letter in the S&P stock rating is either an “L” for low risk, or an “M” for medium risk. 

14 are in defensive industries (healthcare, consumer staples, utilities). 
The remaining 13 stocks represent Core Holdings:
   5 of those are in S&P’s “consumer discretionary” industry (ROST, FDO, MCD, TJX, NKE)
   2 are in the “materials” industry (SHW and SIAL)
   2 are in the “information technology” industry (IBM and ADP)
   2 are in the “financial” industry (CB and TRV)
   1 is in the “industrial” industry (JBHT) and 
   1 is in the “energy” industry (CVX).

The Table has red highlights for metrics that underperform the Vanguard Balanced Index Fund (VBINX), which is weighted 40% in a bond index and 60% in a stock index.

Bottom Line: Every portfolio is a form of personal expression. In providing a "guide" to help you construct an optimum portfolio, our first concern is to guide you away from foundering on the shoals in a storm.

Risk Rating: 5

Full disclosure: my trading positions on companies in the Table consist of monthly automatic electronic additions to DRIPs in WMT, NKE, ABT, JNJ, IBM, and NEE.

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