Week 8 - Lifeboat Stocks

Situation: Investors aren’t interested in losing money. So when they venture into direct ownership of stocks, they want to start by investing in companies that can sidestep risk.

Goal: Orient the investor to companies that (a) meet our investment criteria (Mission and Goals), (b) carry low debt (Week 7 - Risk), and (c) are in “defensive” industries that weather recessions, i.e., utilities, consumer staples, and health care (Week 6 - Summary).

Any buy-and-hold investment portfolio contains stock in companies that sell things consumers can’t avoid buying. Those companies don’t have to cut prices during a recession. People always buy toothpaste at the price they’re used to paying: there is no elasticity of demand. Even if the cost of making toothpaste goes up, passing those costs onto the buyer will not reduce demand. There is a Vanguard consumer staples Exchange Traded Fund, VDC, that illustrates this idea. When graphed vs. SPY, both increased together in price during the 2004-2007 economic expansion but VDC held up much better during the subsequent recession.

There are 9 companies producing consumer staples that meet the ITR investment criteria:

Procter & Gamble (PG)

Wal-Mart (WMT)

Coca Cola (KO)

Pepsico (PEP)

Kimberly-Clark (KMB)

Colgate-Palmolive (CL)

McCormick (MKC)

Sysco (SYY)

Hormel Foods (HRL)

However, PEP, CL, and KMB are burdened with debt, leaving only 6 companies that ITR has dubbed “Lifeboat Stocks” in the consumer staples industry - a safer haven for queasy investors following a stock market roller-coaster ride.

Health care companies are defensive in nature and also have pricing power but those stock prices are particularly sensitive to government regulation and patent expirations. Nonetheless, this industry has performed without peer. One reason is that pharmaceutical companies have to recognize research and development (R&D) expenses on their financial statements as an operating cost, which is then written off (or "amortized") annually. No other industry is so dependent on R&D: fixed costs (property, plant and equipment) usually dominate and these are amortized over decades. There are 3 health care companies meeting the ITR investment criteria that avoid being bloated with debt:

Johnson & Johnson (JNJ)

Abbott Laboratories (ABT)

Becton-Dickinson (BDX)

Public utility companies are defensive because electricity is a necessity, guaranteed and priced by the state. These monopolies have enormous fixed costs and are financed mainly with government-guaranteed debt. Only one company

NextEra Energy (NEE)

meets our investment criteria and carries a below normal debt load for that industry. NEE is actually two companies, one being Florida Power and Light and the other being Next Era Energy Resources - an unregulated electricity distributor that owns more wind and solar generating capacity than any of it’s North American counterparts.

Finally, there is an unusual information technology company that performs like a lifeboat stock:

Automatic Data Processing (ADP)

This, you may recall, is one of only 4 companies that carry a AAA bond rating. It has little long-term debt (0.7% of capitalization) because it’s business plan generates such a small return on assets that use of debt financing cannot be justified (unless interest rates are very low). ADP is used by other companies to outsource their routine business services. For example, it is the largest company in the world processing payrolls. ADP also accepts a variety of additional “human resources” assignments: e.g. tax filings and business-to-business (B2B) transactions, such as those between an employer and an automobile dealer. ADP will hold payroll funds for a short period of time, e.g., to make Social Security transactions, assign funds to 401(k) plans, etc., and during this period the funds are invested in ultra-short term bonds.

Interestingly, 8 of the 11 Lifeboat Stocks performed substantially better than SPY during the down-turns of October 2008 and August 2011: PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE. And, all 8 measure up well with respect to the 6 risk parameters outlined in our Week 7 blog Risk.  As of 8/25/2011, 6 of these 11 have outperformed SPY over the most recent one month, 3 month, 6 month, one yr, two yr, and 5 yr intervals:  KO, BDX, ADP, HRL, and MKC.  

Bottom line: We have identified 11 Lifeboat Stocks:  PG, KO, WMT, ADP, JNJ, ABT, BDX, NEE, HRL, SYS, and MKC. The total return from investing $200/mo in each (since January of 1993) exceeds the total return from investing $200/mo in SPY over that period. Five of these companies are in our Growing Perpetuity Index (KO, PG, WMT, JNJ, and NEE). The results from making a $200/mo investment in each of these 5 companies vs. SPY  are broken out in the accompanying Lifeboat Stocks Table. Their out-performance is unambiguous.


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Week 7 - Risk

Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.

In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:

(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;

(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and

(c) the S&P downgrade

have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.

Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.

<click this link to view the Risk Table>

S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and 
e) rivalry among existing firms.

S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.

LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.

TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.

BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).

RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.

MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.

Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.

Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%)  for the ITR Growing Perpetuity Index.

What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.


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Week 6 - Summary

Situation: Investors have many options, whether they are savers or gamblers, but few of these options are simple, straightforward, and cheap. Our blog meets these objectives by ignoring the ups and downs of stock, bond, commodity, and real estate markets: we identify very long term investments of high quality and low risk, then show the investor how to put a regular investment plan on “autopilot.”

Goal: Once a month, our weekly ITR blog will be a review of the previous 4 or 5 weekly installments. While we are not personal investment counselors, our summaries are an attempt to condense ideas – and thereby provide a degree of guidance to investors who are getting started.

In our Mission and Goals statement, we introduced the ITR Growing Perpetuity Index of 12 stocks. In our Week 4 blog, we provided further details of this index. In Week 5 we provided an ITR Master List of all stocks in the S&P 500 Index that meet our investment criteria, and we introduced a new feature, “The Incubator,” where we are creating a sample investment platform. Now (Week 6) we compare the total returns since 2/1/93 for 8 Growing Perpetuity Index stocks to the total return for SPY. We make 3 assumptions: 1) quarterly dividends are reinvested; 2) $200 is added on the first trading day of each month; and 3) a 2% commission is paid (leaving $196/month for investment). By reinvesting dividends, we capture the power of compound interest. By purchasing a fixed dollar amount of shares each month, we capture the power of dollar cost averaging.

For example, the effect of dividend reinvestment on an investment made in SPY can be illustrated by using the 10 yrs from 12/29/00 (when SPY closed at $131.19/share) to 12/31/10 (when SPY closed at $125.75/share). Although each share of SPY lost 0.42%/yr in value over this period, dividend reinvestment resulted in a total return of 1.3%/yr (moneychimp). Dollar cost averaging (adding $200/month) increased SPY’s total return to 1.9%/yr (because stocks were “on sale” for much of that decade).

In Week 4, we explained why these12 stocks were selected for inclusion in our Growing Perpetuity Index:

• ExxonMobil (XOM)
• Wal*Mart (WMT)
• Procter & Gamble (PG)
• Chevron (CVX)
• IBM (IBM)
• Johnson & Johnson (JNJ)
• Coca-Cola (KO)
• McDonalds (MCD)
• United Technologies (UTX)
• 3M (MMM)
• Norfolk Southern (NSC)
• NextEra Energy (NEE)

DRIPs are available for all 12 stocks but 8 happen to be available at computershare with minimal or no commissions (XOM, WMT, IBM, JNJ, KO, MCD, UTX, NEE). Not only does the “point and click” investor benefit from one-stop shopping but these 8 companies happen to represent all 7 S&P industries that contribute companies to our Growing Perpetuity Index, namely:

• consumer staples (WMT, KO)
• consumer discretionary (MCD)
• health care (JNJ)
• energy (XOM)
• utilities (NEE)
• information technology (IBM)
• industrials (UTX)

This helps to provide diversification for your portfolio. Regular investment in only one company from each of these 7 categories does carry some risk, namely the risk that the chosen company will not be a stellar performer for that sector. However, companies meeting the ITR criteria are “blue chips” that minimize such risk. By undertaking regular, very long term DRIP investment in a company from each of the 7 industries, a newbie investor would achieve total returns in excess of the S&P 500 Index and do so with less risk. Why is there less risk? Two reasons: Firstly, all 3 “defensive” sectors of the stock market are represented: consumer staples, health care, and utilities. Consumers continue to spend on those sectors during a recession and stock prices hold up better. Secondly, the 34 companies (in Week 5) that meet our criteria carry less than half as much debt as the S&P 500 Index as a whole (Debt/Equity = 0.60 vs. 1.25): When revenues fall off in a recession, companies lose value because of the need to service their debt by paying interest and returning principle on bonds that come due. Revenues may not be sufficient to cover those legal obligations so bankruptcy looms in the immediate future.

This week we provide a Total Returns Table where we compare the Total Return (i.e., dividend reinvestment gains + gains from monthly $200 purchases) for each of these 8 stocks over 18.5 yrs (2/1/93 to 8/1/11) to the total return for SPY. This Table shows that stocks chosen because of their high quality and low risk far outperform the S&P 500 Index as a whole. Why is that? It is because most of the companies in the S&P 500 combine low quality with high risk. The 34 exceptions are in our Week 5 ITR Master List.

Bottom line: There is a simple, cheap, and straightforward way to invest in stocks. It requires patience, attention to detail, and the ability to ignore market gyrations.


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Week 5 - Master List of Companies Meeting the ITR Criteria

Goal: To pin down which companies in the S&P 500 Index conform to the ITR selection criteria and detail the benefits and risks of owning stock in each over the past decade.

click here to open the Master List Spreadsheet

Legend for the ITR Master List:

Large S&P 500 Companies (n = 19): Stocks selected from the S&P 100 Index. Most of these are multinationals that derive 40-70% of sales from foreign countries.

Smaller S&P 500 Companies (n = 15): Stocks selected from the 400 smaller companies in the S&P 500 Index. Such companies typically have a focused business plan and a less hierarchical management style. These companies have fewer institutional impediments to innovation and can be more nimble in responding to market stresses caused by competition, obsolescence, and recession.

Ticker: Company symbol used for stock trading purposes. (Click on the ticker to view the "Investor Relations" page at the company's website.)

2000-10 TR: Annualized gross Total Return (reinvestment of dividends plus price appreciation) for a stock purchased at close of business (COB) 12/29/00 then sold at COB 12/31/10 (see discussion in Week 4 blog). Our benchmark, SPY, had an annualized gross total return of 1.3% for that 10 yr period. Returns are even lower when costs are subtracted - to calculate net total returns: trading commissions and fees amount to ~2% for each BUY or SELL order placed through a stock broker; inflation averaged 2.4%/yr over that 10 yr period (Inflation_Calculator); and tax rates on dividends and capital gains are set at 15%. To reiterate: fees, capital gains taxes, taxes on dividends, and inflation are not accounted for in calculating the gross Total Return (in Column 3).

Dividend: Current quarterly pay-out per share multiplied by 4 and divided by the recent stock price (expressed as %).

Ann Div Incr: consecutive annual dividend increases.

Stk Rating: "A" is S&P's highest stock rating, with relative benefit sometimes qualified with a "+" or "–" sign; L, M, and H denote a separate assessment of risk: low, medium, or high. Risk in this case represents the extent to which the stock’s value is likely to be impaired or improved during a bear or bull market, respectively.

Bnd Rating: Most companies are financed by both bonds and stocks. Bond ratings denote the risk of bankruptcy. AAA is S&P's highest bond rating, currently held by only 4 companies (ExxonMobil, Johnson & Johnson, Microsoft, and Automatic Data Processing). BBB- is the lowest “investment-grade” rating. BB+ and lower ratings are reserved for “junk status” bonds (also termed "high yield" bonds), which have odds of default greater than 1 in 20.

S&P Industries: S&P has 10 industry categories. Only the telecommunications industry is not represented on our Master List. It is obviously difficult to pigeonhole the major revenue source for a multinational company. Nonetheless, S&P analysts make an effort to do so because the fluctuation of stock prices and dividend payouts depend somewhat on the company's key industry, it is either moving into a new industry or has become an outlier in its historic industry.

5 yr Beta: The variance of a stock’s price relative to the S&P 500 Index (Beta = 1.00) calculated each trading day over a 5 yr period and then averaged. For example, a Beta of 0.83 for 3M means that the price of 3M went up or down 83% as much as the S&P 500 Index over the 5 yrs before the current month. Barron’s Dictionary of Finance and Investment Terms (1998, Fifth Edition, Barron’s Educational Series, Inc.) ends its definition with this sentence: “A conservative investor whose main concern is preservation of capital should focus on stocks with low betas, whereas, one willing to take high risks in an effort to earn high rewards should look for high-beta.

Debt/Equity: Total debt divided by shareholder’s equity (total assets minus total liabilities). The Debt/Equity ratio for the S&P 500 Index is ~1.25. “Blue Chip” companies normally top out at 0.85 but may temporarily go higher to expand in support of strong revenues.


Bottom Line: 34 companies meet the ITR criteria for profitable long-term investment with acceptable risk. Of those 34, five (XOM, PG, MKC, NEE, UTX) stand out for providing steady returns (Mean Gross Total Return = 8.8%/yr) and good payouts (Mean Dividend = 2.8%) while maintaining a low S&P Risk Rating. Those 5 companies also issue bonds that carry an S&P rating of "A" (or better), and have very low price variance vs. S&P 500 Index (Average Beta of 0.53 vs. 1.00). For comparison, the annualized Total Return of the S&P 500 Index clunked along at 1.3% over the past decade, and it currently pays a dividend of 1.9%.


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