Situation: Warren Buffett, in his Annual Report to Berkshire Hathaway investors this spring, included a “letter” to his relatives. It recommended that they structure investments in their “trusts” as follows: 90% in the Vanguard index fund dedicated to the S&P 500 Index (VFINX) or the index fund dedicated to the total US stock market (VTSMX), and 10% in the Vanguard managed fund dedicated to short-term US Treasury Notes (VFISX). His main concern was to minimize their investment costs while tracking stock market returns.
Our readers aren’t as rich as his relatives. So, we suggest that you back your stock investments 1:1 with US Treasury Notes & Bonds, other AAA-rated bonds, Savings Bonds, or the Vanguard Intermediate-term Treasury Fund (VFITX). In other words, the most prudent long-term investment balances large-capitalization US stocks with risk-free AAA bonds. And by “long-term”, we mean that you intend to hold your investment for at least 20 yrs in anticipation of using it for retirement purposes. Our benchmark for “Risk-On” investors is the Vanguard Balanced Index Fund (VBINX), which is composed 60% of a capitalization-weighted index of the total US stock market and 40% of an investment-grade US bond index (mainly US Treasuries). For “Risk-Off” investors, our benchmark is Vanguard’s Wellesley Income Fund (VWINX), which is 60% bonds and 40% stocks. “Risk-Off” investors are those who have moved closer to drawing on retirement income and have less investment time available to recover from market fluctuations.
When calculating your 1:1 stock:bond balance, remember to include the present value of your Social Security account, which would be $164,000 if you were to qualify today for a beginning payout of $2000/mo and were to receive monthly payouts for the next 11 yrs, assuming a discount rate of 5.6%. That discount rate is the sum of the “risk-free” rate (2.6% interest on a 10-yr Treasury Note) and “risk” (i.e., inflation, as reflected in a 3.0%/yr estimated annual cost-of-living adjustment). Total payments would amount to almost $305,000 over 11 yrs, with a monthly payment of $2636 in the 11th yr.
We need to draw attention now to the costs that are associated with investment accounts. How important are those costs? Well, the standard rule of thumb for business accountants is to note any cost as being “material” if it represents more than 5% of revenues or earnings. Upon noting said cost, the accountant will delve deeper to determine whether it is justified. Using that guideline, let’s look at the past 100 yrs of returns from owning 10-yr Treasury Notes and reinvesting interest payments vs. owning shares of the S&P 500 Index and re-investing dividend payments. Over that 100 yr period of time, the key facts are:
1) Inflation averaged 3.22%/yr;
2) Total returns on 10-yr Treasury Notes averaged 5.05%/yr (1.83% after inflation);
3) Total returns on the S&P 500 Index averaged 10.16%/yr (6.94% after inflation);
4) Total after inflation returns for our recommended 50:50 allocation averaged 4.39%/yr;
5) Therefore, transaction costs (expenses) become material when the expense ratio reaches 0.22%/yr, which would bring the after inflation total return down to 4.17%/yr;
6) The relevant Vanguard funds are VFITX (intermediate-term Treasuries) with an expense ratio of 0.20%/yr, and VFINX (S&P 500 Index) with an expense ratio of 0.17%. Both of those expense ratios are less than 0.22%/yr, so transaction costs are immaterial.
Vanguard index funds were invented by John Bogle to provide retail investors with market-tracking investments that have immaterial transaction costs. (The only remaining costs are taxes and inflation.) The issue that concerns Mr. Bogle is that the average retail investor has an expense ratio of 2.2%/yr, which is 10 times too much! That is the reason why Warren Buffett thinks so many investors are being disappointed. Half of their after-inflation returns are being eaten up by costs, 90% of which can be eliminated by sticking to Vanguard index funds.
Treasury Notes don't provide interest payouts that grow faster than inflation, but Vanguard's S&P 500 index fund (VFINX) has grown its dividend payout 4.7%/yr since 1980, which is 1.5%/yr faster than inflation over that 34-yr period. However, those payouts bounce around a lot because ~150 companies don’t pay a dividend. Only about 150 increase their dividend annually.
Now you have the explanation why the purpose of this blog is to interest you in buying stock monthly (online) in selected companies that have increased their payout for at least 10 yrs at a rate 3-4 times faster than inflation. Some of those companies charge no transaction costs for automatic monthly investments (see Week 162). Examples include NextEra Energy (NEE), Abbott Laboratories (ABT), and ExxonMobil (XOM) for shares purchased through computershare.
Bottom Line: Here at ITR, we stress two things: minimizing transaction costs and maximizing retirement income. For this week’s Table, we’ve used our “Risk-On” benchmark (VBINX) supplemented with Vanguard’s intermediate-term Treasury fund (VFITX) to construct a 50:50 stock:bond fund, i.e., 75% VBINX and 25% VFITX. By having 25% invested in a Treasury bond fund, you’ll have an investment that goes up in value during a recession, and also provide a way to pay for unforeseen emergencies that often crop up during a recession. Alternatively, you can invest in the Vanguard Wellesley Income Fund, or a 50:50 mix of the Vanguard 500 Index Fund (VFINX) and the Vanguard Intermediate-term Treasury Fund (VFITX). All 3 of these options are worry-free and track the markets in a manner that gives you protection from a crash in the stock market. Plus, you don’t have to fiddle with picking stocks and the added complexity they bring to paying taxes.
Risk Rating: 4.
Full Disclosure: I invest monthly in inflation-protected Savings Bonds at and in NEE and ABT.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, October 26
Sunday, October 19
Week 172 - Core Holdings for an Overpriced Market
Situation: The stock market is currently overpriced when assessed by several criteria. Economists, including the Nobel Laureate Robert J. Shiller, are trying to figure out why this is so. As a small investor, all you need to know is that the stocks in your portfolio that have a price/earnings (P/E) ratio higher than 20 are in a danger zone. In other words, your total return from that investment is less than 5% unless earnings improve. On a risk-adjusted basis, you’d do better parking any newly available funds in US Savings Bonds.
Even though stocks are overpriced, advantages remain for you to accumulate more for your portfolio. That is because you will receive growing dividends in retirement, however, to purchase more it is best to stick to dollar-cost averaging. Invest a little each month into an online Dividend Reinvestment Plan (DRIP). That way, you automatically smooth out the fluctuations in price. The bigger problem right now is that people prefer to cut back on investments in growth stocks when the market is overpriced. That’s not a good investment strategy, and we explain why below.
Bonds, and hard assets like gold and real estate, just don’t have the growth horizon that stocks currently have. Trouble will come for stocks from only 3 broad categories:
1. if interest rates and inflation spike upward (unlikely);
2. if companies stop growing earnings almost 10%/yr (unlikely);
3. if economic indicators herald a recession in a major economy (somewhat likely for the EuroZone and China).
Because stocks remain the asset of choice, they are becoming overpriced. In particular, the buyers of bond-like stocks (i.e., those that have historically had a good total return and increase their dividend ~10% year after year) are crowding out the sellers. Prices for strong and stable “defensive” stocks, like Abbott Laboratories (ABT) and Colgate-Palmolive (CL), drift higher than what their earnings can justify.
Does this really matter? Yes it does because timid investors see that price action and come off the sidelines to buy stock. Eventually, there’s almost no one left who wants to buy an overpriced stock and the market develops cracks. Buyers will only emerge when prices have fallen far enough for fundamental measures of value to justify the purchase. By that time, a lot of investors are underwater and are selling their Savings Bonds to fund cash-flow emergencies. The important point here is that a bear market can happen when the economy is doing just fine, as we saw on October 19, 1987. The Dow Jones Industrial Average fell 22.6% that day for no apparent reason other than “the big guys were selling their stock” because the market had gone up 44% in the previous 6 months.
For this week’s Table, we’ve listed all of the Dividend Achievers in the Barron’s 500 List that have an S&P bond rating of BBB+ or better and an S&P stock rating of A-/M or better. (That “M” in the denominator denotes medium risk, whereas, “L” denotes low risk.) To focus on growth companies we’ve excluded companies in the 4 “defensive” industries: healthcare, utilities, communication services, and consumer staples. The remaining 6 S&P industries are where we look for our “Core Holdings” (high-quality growth companies, see Week 102). Those industries represent 66% of the capitalization of the S&P 500 Index. Quite simply, your stock portfolio can’t capture market returns unless 2/3rds of it is in stocks issued by companies in those 6 industries: materials, energy, financial, industrial, consumer discretionary, and information technology. Even though those stocks will scare you when the market swoons, don’t sell unless the company’s “story” is broken.
Most of the stocks in the Table are fully valued at present, i.e., have elevated P/E ratios (Column J) because investors expect those companies to have strong earnings growth over the next year. You don’t know what the future will bring, so look for companies that don’t have a P/E over 20. Try to spend your research time on the few companies that have hardly any metrics highlighted in red, which denotes underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).
Note: Companies that don’t have a Finance Value (Column E in the Table) higher than that for VBINX were excluded, as were companies that pay a dividend that amounts to more than 55% of their earnings (the “payout ratio,” Column I Table). Finally, companies that had a lower Barron’s 500 rank in 2014 than in 2013 were excluded, unless they ranked in the top 2/3rds both years (see Columns L&M Table).
Bottom Line: There are still some bargains to be found among growth stocks. The 17 companies in the Table meet our criteria for Core Holdings, but most are overpriced (average P/E = 22). Their investors have already enjoyed a strong run (Column F Table), and many will be looking to take profits. But there are 6 companies on the list that still offer good value relative to risk: ROST, QCOM, CB, IBM, LMT, GPC.
Risk Rating: 6
Full Disclosure: I dollar-average into NKE and IBM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Even though stocks are overpriced, advantages remain for you to accumulate more for your portfolio. That is because you will receive growing dividends in retirement, however, to purchase more it is best to stick to dollar-cost averaging. Invest a little each month into an online Dividend Reinvestment Plan (DRIP). That way, you automatically smooth out the fluctuations in price. The bigger problem right now is that people prefer to cut back on investments in growth stocks when the market is overpriced. That’s not a good investment strategy, and we explain why below.
Bonds, and hard assets like gold and real estate, just don’t have the growth horizon that stocks currently have. Trouble will come for stocks from only 3 broad categories:
1. if interest rates and inflation spike upward (unlikely);
2. if companies stop growing earnings almost 10%/yr (unlikely);
3. if economic indicators herald a recession in a major economy (somewhat likely for the EuroZone and China).
Because stocks remain the asset of choice, they are becoming overpriced. In particular, the buyers of bond-like stocks (i.e., those that have historically had a good total return and increase their dividend ~10% year after year) are crowding out the sellers. Prices for strong and stable “defensive” stocks, like Abbott Laboratories (ABT) and Colgate-Palmolive (CL), drift higher than what their earnings can justify.
Does this really matter? Yes it does because timid investors see that price action and come off the sidelines to buy stock. Eventually, there’s almost no one left who wants to buy an overpriced stock and the market develops cracks. Buyers will only emerge when prices have fallen far enough for fundamental measures of value to justify the purchase. By that time, a lot of investors are underwater and are selling their Savings Bonds to fund cash-flow emergencies. The important point here is that a bear market can happen when the economy is doing just fine, as we saw on October 19, 1987. The Dow Jones Industrial Average fell 22.6% that day for no apparent reason other than “the big guys were selling their stock” because the market had gone up 44% in the previous 6 months.
For this week’s Table, we’ve listed all of the Dividend Achievers in the Barron’s 500 List that have an S&P bond rating of BBB+ or better and an S&P stock rating of A-/M or better. (That “M” in the denominator denotes medium risk, whereas, “L” denotes low risk.) To focus on growth companies we’ve excluded companies in the 4 “defensive” industries: healthcare, utilities, communication services, and consumer staples. The remaining 6 S&P industries are where we look for our “Core Holdings” (high-quality growth companies, see Week 102). Those industries represent 66% of the capitalization of the S&P 500 Index. Quite simply, your stock portfolio can’t capture market returns unless 2/3rds of it is in stocks issued by companies in those 6 industries: materials, energy, financial, industrial, consumer discretionary, and information technology. Even though those stocks will scare you when the market swoons, don’t sell unless the company’s “story” is broken.
Most of the stocks in the Table are fully valued at present, i.e., have elevated P/E ratios (Column J) because investors expect those companies to have strong earnings growth over the next year. You don’t know what the future will bring, so look for companies that don’t have a P/E over 20. Try to spend your research time on the few companies that have hardly any metrics highlighted in red, which denotes underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX).
Note: Companies that don’t have a Finance Value (Column E in the Table) higher than that for VBINX were excluded, as were companies that pay a dividend that amounts to more than 55% of their earnings (the “payout ratio,” Column I Table). Finally, companies that had a lower Barron’s 500 rank in 2014 than in 2013 were excluded, unless they ranked in the top 2/3rds both years (see Columns L&M Table).
Bottom Line: There are still some bargains to be found among growth stocks. The 17 companies in the Table meet our criteria for Core Holdings, but most are overpriced (average P/E = 22). Their investors have already enjoyed a strong run (Column F Table), and many will be looking to take profits. But there are 6 companies on the list that still offer good value relative to risk: ROST, QCOM, CB, IBM, LMT, GPC.
Risk Rating: 6
Full Disclosure: I dollar-average into NKE and IBM.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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