Week 21 - Recent Performance of Growing Perpetuity Index

Situation: A new business cycle started on Oct 1, 2009 (when the S&P 500 Index 250-day moving average started moving up). We’re 8.5 quarters into the new cycle, long enough to assess total returns for the 12 companies in our Growing Perpetuity Index (Week 4).

We’ll examine the outcome from investing $100 at the start of each quarter to buy XOM, WMT, PG, CVX, IBM, JNJ, KO, MCD, UTX, MMM, NSC, NEE and re-invest dividends received from each. We’ll also assume those investments are cost-free, to allow us to compare our investment with the essentially cost-free Vanguard Admiral S&P 500 Index Fund (VFIAX) that is used by Warren Buffett as the benchmark for all asset classes. We will assess raw returns, unadjusted for management expenses, trading commissions, inflation, or taxes. The Vanguard fund has an expense ratio of merely 0.06%/yr because it requires a large initial investment of $10,000. We will also compare those returns with two balanced funds we have assessed previously, i.e., the Blackrock Global Allocation A (MDLOX) and Vanguard Wellesley Fund (VWINX).

Calculating our results as of 11/15/11, the attached <spreadsheet> is a summary of returns. Only 4 stocks under-performed the S&P 500 Index (PG, JNJ, MMM, and NEE) but all 4 showed positive returns for the ~2 yr period we examined. A total of $10,800 was invested ($900 in each of the 12 stocks), which grew to $12,797 representing a total return of 16.0%/yr (vs. 9.32%/yr for VFIAX and 2.73%/yr for the Consumer Price Index). That out-performance is not surprising given that the Growing Perpetuity Index includes iconic brands that are long-term dividend growers and typically yield more than the S&P 500 Index. Moving forward, we have no way of knowing which of the 12 will disappoint but we do know from back-testing that it is unlikely to be these same 4 stocks. For example, during the decade prior to the recent recession the under-performers were Coca-Cola (KO), Norfolk Southern (NSC), and 3M (MMM). After the recession ended, KO and NSC became strong performers. The performance of MMM is likely to improve if more international markets, like Japan’s, emerge from recession. Therefore, the ITR investment recommendation we will make is that you should regularly invest the same amount in every stock of the Growing Perpetuity Index, even if it only happens once a year. If that’s not practical, we encourage you to research the companies in the ITR Master List and purchase at least 4 DRIPs. Keep in mind that new companies will move onto the list (while others may be removed) on a quarterly basis, whereas the 65 companies in the Dow Jones Combined Average (from which the Growing Perpetuity Index companies are selected) rarely change. If your first 4 DRIPs are XOM, WMT, MCD, and IBM, you will have a solid investment.

Of the funds we mentioned earlier, one (MDLOX) under-performed the S&P 500 Index while the other (VWINX) more than kept up. Treasury notes (VFIUX) also did well.

Bottom Line: Investing regularly in as many of the Growing Perpetuity Index stocks as possible is almost certainly a way to “beat the market”. But a low-cost, bond-centric balanced fund like VWINX will also allow you keep up with the market without all the fuss and worry.


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

Week 20 - Mining & Drilling for Key Commodities: Oil & Gas

Situation: The key commodities extracted from the ground (oil, natural gas, copper and gold) are heavily traded on regulated futures exchanges. Open interest amounts to almost $100 billion but many more contracts trade “over the counter”, i.e., removed from the prying eyes of competitors and regulatory agencies. Some of the companies that find and extract commodities also refine, transport, and/or sell their product. Other companies provide additional services and equipment.

Goal: Orient the ITR investor to dividend-paying companies that produce (or support the production of) key commodities.

This week’s blog takes the ITR investor beyond the Master List into cyclical companies that take more chances with more up-front money. Why? Because these companies supply us with essential commodities. High fixed costs characterize every company that extracts materials from the earth by mining or drilling. When commodity prices are high, new companies are tempted to enter the fray, which then drives prices down. The companies that survive the melee can’t afford to continue innovating and expanding; production remains flat or declines until the economy re-expands enough for the survivors to “pick up the slack”. Most companies that dig commodities out of the ground are dependent on investors who are willing to lose everything in the hope of a big return. If it’s a young company that hasn’t had a chance to expand into safer sidelines (refining, transporting, merchandising), it will likely fail. However, these “junior miners” have enormous upside potential and therefore attract investors who want to gamble.

To analyze companies that mine gold & copper, or drill for oil & gas, it is helpful to focus on a particular geological province that attracts a typical grouping of companies. The Western United States is rich in such provinces with the current favorite being the shale formations that mainly yield natural gas. The recoverable oil & gas in these formations is 3 times that known to be present in Saudi Arabia. 

To take a closer look, we will focus our attention first on natural gas plays west of the continental divide. Drilling activities there have expanded rapidly for two reasons: new discoveries and technological breakthroughs that allow formerly marginal geology to be drilled anew. Drilling has increased dramatically since the advent of horizontal drilling and hydraulic fracturing (“fracking”). The Piceance Basin in NW Colorado is the most active recent find but production is rapidly expanding in the well-mapped Green River Basin in SW Wyoming and NE Utah.

The accompanying spreadsheet <click here to open> provides information about 9 companies active in exploration and production (E&P), plus 4 others that provide services and equipment (CAT, NOV, BHI, and SLB). The 6 pure E&P companies are riskiest (APC, NBL, EOG, DVN, ECA, COG) but the 3 companies with refineries (XOM, CVX, and RDS-B) do well through thick and thin, with significant fluctuations in share price because of being tightly tied to the economic cycle. The 4 servicing companies show the fastest earnings growth in each business cycle but with even more marked fluctuations in share price. This pattern (of mining & drilling suppliers reaping the most profit) has held true since as far back as the 1849 California Gold Rush.

All 13 companies pay dividends and are followed by S&P.  XOM, ECA, CVX, and NBL are active in Piceance Basin; DVN, RDS, COG, EOG, APC, APC, and CVX are active in Green River Basin. The drilling activity is hard to miss if you’re driving along I-70 in Colorado between the towns of Rifle and Grand Junction. You’ll see many oil service trucks plus the roadside buildup of servicing depots (e.g. near DeBeque). Driving I-80 west of Rawlins, Wyoming, is even more revealing because there is little else to see. An entire city (Wamsutter) has been built for oil workers where only a single gas station existed 15 years ago. Driving through that barren stretch at night is otherworldly because of lights and mists around drilling rigs that are hard to see by daylight.

The big problem with investing in E&P companies is that there always seems to be a wide variation in the quality of management and a shortage of skilled workers. These problems are related because good workers tend to follow good managers. If you’re investing in Exxon (XOM), Chevron (CVX), Shell (RDS-A) or Schlumberger (SLB), that problem has likely been solved. Here at ITR, we’ve been trying to get a handle on the others. We’ll keep you informed of our progress looking at shale plays.

Bottom Line: Drillers have to make a large up-front investment in order to make a lot of money several years down the road (living with a big “maybe”). Most drilling companies are small and don’t last long but do start strong by using money from impatient investors who are attracted to the potential for great rewards. The drillers that do succeed typically look for sidelines with more stable revenues, i.e., lay pipelines, refine petroleum & develop commodity chemicals, transport those products, and open service stations to fuel planes, ships, trucks, and cars.


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

Week 19 - Really Simple Savings

Situation: Many investors want to spend about as much time planning for retirement as they would spend planning for a vacation. They can’t afford to be “dollared to death” by fees and commissions. At the same time, they need a balanced portfolio which means that the “balancer” (or hedge) will increase in value when the stock market tanks.

Goal: Find a straightforward way for a 50 yr old investor to begin to seriously plan for retirement at age 65, without an exorbitant outlay of time or money to set up the portfolio.

Most probably this type of investor doesn’t follow the markets or invest each month in separate DRIP accounts. And we would also guess that $500/mo is the most our investor will commit to setting aside. These caveats leave a Roth IRA composed of no-load mutual funds as the best investment option. The reason is because a Roth IRA is unique among retirement investment options due to its tax-free status with no taxes levied on withdrawals ever, even for the unused money that goes to heirs.

Half the monthly money allotted by our investor ($250/mo) should be used to purchase shares of an S&P 500 Index Fund. The other half should be invested in an intermediate-term US Treasury Fund (i.e., a fund that essentially buys 10-yr Treasury Notes and holds those to collect interest until the principal is returned). Why these two particular choices? Related to stock purchases, this type of investor cannot assume the risk of under-performing compared to the market. Related to bond purchases (i.e., the hedge), this type of investor needs to be in the safest possible market. That would be the asset that the entire world wants to own when financial markets collapse: US Treasury Notes.

All “no-load” mutual fund companies offer both S&P 500 and T-Note funds with low expense ratios. We’ll use T Rowe Price funds to calculate outcomes for monthly purchases made from 2/3/97 through 11/1/11 (14.8 yrs). PREIX is the S&P 500 Index Fund and PRTIX is the intermediate-term US Treasury Fund. Investing $250/mo in each would result in $52,975 in the stock fund (total return = 2.2%/yr) and $69,853 in the bond fund (total return = 5.3%/yr) for a compound annual growth rate (CAGR) of 3.9%/yr (1.5%/yr after inflation). Our investor’s out-of-pocket investment over this time would have been $86,500 and total value would be $122,828. The S&P 500 fund paid out $472 in dividends over the past 6 months and the T-Note fund paid $783 in interest (i.e., the two together currently yield a little over 2%). Since the beginning of good record-keeping practices (1926), the CAGR after inflation is 2.3% for T-Notes and 6.7% for the S&P 500 Index without factoring in expenses. The rule-of-thumb for advising investors (as to what they can expect for planning purposes) is 2% and 4%, respectively. So a 50:50 combination is expected to yield 3%/yr. However, that overlooks the fact that the CAGR drifts upward when leverage (or borrowed money) is used to fuel investments. The opposite occurs with de-leveraging. In other words, when governments/companies/individuals borrow money to make improvements in their investments, those investments grow in value at a more rapid rate than if revenues alone are used to make improvements. When that borrowed money is returned to the lender, revenues are depleted so severely that little is left for “growth” (just google “Italy” for a timely example).

Saving for retirement doesn’t have to be complicated but it does have to be sincere. If you religiously set aside $500/mo beginning at age 50, you’ll have around $125,000 at age 65 in the example above. After retiring, you can spend the $200+/mo of dividends and interest and leave the principal intact. That would allow your spending power to keep up with inflation and your heirs will be titillated. Or you can cash out the funds and purchase an annuity that pays ~$800/mo but won’t keep up with inflation or leave anything for heirs.

Bottom Line: This 50:50 Stock/Bond example is a benchmark for a simple, safe and cheap Roth IRA plan. Interestingly, the initial $500 invested on 2/3/97 held its value throughout two bear markets, though it did fall back to parity ($500) at the depths of the last bear market on 3/9/09. We’ll use that feature to help gauge the safety of other Roth IRA strategies.

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

Week 18 - Hardy Perennials

Situation: Some companies manage to perform well through thick and thin.There are lessons to be learned by looking at price performance over the short, intermediate, and long term. Stocks that yield more than the S&P 500 Index provide more of their total return from dividends than price appreciation, but a consistent price appreciation is indicative of dividend payouts that will keep increasing. It can also act as a tip-off to where the economy might be headed. 

Goal: Find common characteristics among the companies that compose the updated ITR Master List and have outperformed the S&P 500 Index over the last 3 mo, 1 yr, 5 yr and 15 yr intervals.

These 11 stocks fit the above criteria and made our cut:
        CVX
        XOM
        OXY
        NEE
        MCD
        NSC
        CL
        WMT
        ADP
        MKC
        ABT

In a previous blog, we discussed what we called Lifeboat Stocks which are companies that sell consumer necessities and carry low debt. This blog's particular group of ITR stock picks has prices that tend to track the S&P 500 Index during bull markets but hold up better during bear markets. Interestingly, of these 11 stocks we find that 5 (MKC, ADP, ABT, NEE, and WMT) are also Lifeboat Stocks. What does this tell us? Quite simply put, that the past 15 years have been dominated by bear markets. 

The remaining 6 stocks (CVX, XOM, OXY, MCD, CL, and NSC) represent “core holdings” that tend to track the ups and downs of the S&P 500 Index. In order to outperform in hard times, these 6 companies would also have to be producing, transporting, or selling essentials. And this does appear to be the case: gasoline stations, electricity, and fast food restaurants have become necessities in our modern society. Each of these 6 companies also faces strong competition, so their out-performance has to be rooted and grounded in management’s focus on innovation and execution. 

Hardy perennials are flowering plants that take root and then continue to sprout and grow on a yearly basis. This requires a root system that is adapted to surviving sometimes severe weather, often with less than ideal soil conditions. Gardeners come to think of hardy perennials as being not that much different from weeds in that they can be difficult to eradicate and highly adaptable. We will revisit companies that continue to behave like “hardy perennials”.

Bottom Line: We are living through some tough times. The strongest companies remain those that focus on meeting the average consumer’s basic needs.

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