Situation: Risk is headline news again!! Consumers and corporations alike are taking on less risk these days but governments are still struggling. This is because governments are singularly able to increase spending during a recession. The central banks of the US and China spent heavily in early months of the recent recession and are now able to switch gears and think about repairing their lopsided balance sheets. European central banks, on the other hand, aren’t as dynamic and those economies now face a drawn-out recession. US corporations have cut borrowing (the S&P 500 Index Debt/Equity ratio has fallen from 1.6 to 1.2 over the past 3 yrs). US consumers have trimmed household debt and are still avoiding taking on new risks like real estate or stock purchases.
Put simply, our key question for this week’s blog is: How should the ITR investor measure the risk of investing in stocks? And a follow-on question: When is it smart to purchase a risky stock that has tumbled in value? Let’s dispense with the second question first. “Big money” is made in two ways, one of which is legal (taking on risk) and the second illegal (making trading decisions based on inside information). One of the effects of risk is to magnify volatility so that the stock will outperform in a rising market; but the downside amounts to a “near death experience” in a falling market. Experienced traders don’t consider buying stock in a “fallen angel” until after it has recovered ~40% of its lost value, and such a recovery can sometimes take years. The ITR DRIP investor isn’t going to want to be caught holding one of those stocks on the eve of retirement.
Now to address the first question: how is risk measured? In evaluating a company, “risk” is about volatility, debt, and cash flow that might not be enough pay a dividend. Price volatility can be assessed from the interactive graph function at Yahoo Finance by picking a stock index and charting it’s Bollinger Bands (BB) over the most recent two year (499 day) time span, setting the standard deviation at 4. To have a BB reference index that weights utilities and transportation companies better than the S&P 500 Index, we like to use the Dow Jones Composite Index (DJA) as our reference index for volatility. The Dow Jones Utility Index is a good metric for the performance of companies that provide essential goods, and the Dow Jones Transportation Index reflects “the pulse of the economy” better than the S&P 500 Index. The Dow Jones Composite Index will outperform the S&P 500 Index over extended periods of time. Why? Because it over-weights “boring transports and utilities.”
For the remaining two risk metrics (debt and cash flow), we use accounting data that can be found at both Yahoo Finance and the online Wall Street Journal (wsj.com). Long-term (LT) debt that is more than 1/3rd of total capitalization is a red flag. Free cash flow (FCF) is our most important risk metric because it’s the source of dividend growth: FCF is red-flagged when it’s less than two times the current dividend payout. How is FCF measured? By going to the Statement of Cash Flows. Start with “net cash flow from operations”, i.e., the bottom line of the first part of a Cash Flow Statement. Then subtract from that number the first item (capital expenditures) of the second part - called “cash flow from investments”. Divide that number by the first item (dividends paid to holders of common stock) of the third part, which is called “cash flows from financing.” An FCF/div greater than 2 indicates that the company can comfortably pay its usual dividend and consider raising its dividend. Wikipedia gives two examples under the topic of “cash flow statement”; the second example (XYZ co. LTD) can be used to follow the guidance above. This company is unlike those on our Master List, in that it has negative cash flow from operations and yet pays a large dividend. FCF/div = -0.65. The accompanying table shows the 4 numbers from the Cash Flow Statement that are used to determine FCF/div for each company.
In the accompanying table <click here>, we provide risk metrics (2yr BB volatility score, LT debt/cap, and FCF/div from the most recent annual report) for each stock in the ITR Revised Master List (Week 16). We also note the current dividend and the average rate of dividend growth over the past 10 years. Our risk analysis shows that 10 of these companies are well-managed from the standpoint of risk: JNJ, ABT, BDX, WAG, MKC, ADP, XOM, MMM, GD, and TROW.
Bottom Line: Know what you’re buying. Rather than attempting to hit the ball out of the park by picking stocks poised to reap windfall profits from a bull market, a sounder approach is to get on base with a walk or single. Leave the home run attempts to the gamblers while you carefully build your retirement portfolio using sound, well thought-out decisions.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 25
Sunday, December 18
Week 24 - Equity Summary
Situation: In the previous two blogs, we used virtual investments of $900/mo (beginning on 2/3/97) in representative Core Holdings (XOM, MMM, UTX, NSC) and Lifeboat Stocks (JNJ, WMT, NEE) to illustrate how we’d set up the equity half of a personal portfolio. Of our virtual dollars, two-thirds were invested in Core Holdings ($150/mo in each of 4 stocks, or $600/mo) and one-third in Lifeboat Stocks ($100/mo in each of 3 stocks, or $300/mo). This distribution reflects the ITR Goldilocks Allocation strategy (Week 3).
This week’s blog demonstrates the outcome of making 179 consecutive monthly purchases into those 7 DRIPs, ending on 12/1/11. <see attached spreadsheet> While the total investment was $161,100, the total return was a healthy $324,036 (TR = 7.74%/yr). The benchmark we are using is SPY, the Exchange Traded Fund the mimics the S&P 500 Index. SPY had a total return of 2.55%/yr based on 179 consecutive monthly purchases of $200 (commission of $4 per purchase). The total investment in SPY was $35,800, which then grew to $43,975. Inflation over that same 15 yr period was 2.32%/yr, as measured by the Consumer Price Index. In other words, our 7-stocks beat inflation by 5.42%/yr and beat the market by 5.19%/yr. In a future blog, we will provide a Credit Summary which will detail the outcome from investing $900/mo in bond funds as per a Goldilocks Allocation.
Summary: Do-It-Yourself (DIY) investing has obvious cost savings compared with going through an intermediary, such as a mutual fund manager. More to the point, it requires an investor to take personal responsibility for acquiring a working knowledge of investments and performing a modicum of research using the web. The goal is to “maintain what you’ve obtained” instead of participating in a market panic by selling your shares. Markets are moved more by fear than greed, such as the fear of a “margin call”. Many investors rely on help from borrowed money, i.e., by investing borrowed dollars and using the purchased stock as collateral for the loan. A “margin call” occurs when the broker requests additional capital (cash) from the investor to back an investment that has lost value. That is, the original loan is no longer backed with adequate collateral. As a DRIP investor on auto-pilot, however, you welcome a market panic because you are buying more shares than usual with your monthly investment. So, when should you sell a DRIP chosen from stocks in our Master List? We know of only 4 conditions that would trigger that:
a) you need the money to retire;
b) the company has gone 18 months without raising its dividend;
c) the company has gone 18 months without having a dividend yield higher than the yield on the S&P 500 Index;
d) the company has resorted to issuing bonds rated lower than BBB+ by S&P.
Bottom Line: Our ITR blog is for value investors who aren’t interested in buying stock with borrowed money or selling stock in a falling market. These are called "Rip van Winkle" investors, in honor of the off-hand comment from an investment guru that he’d have done better by not touching his portfolio for 10 or 20 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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Summary: Do-It-Yourself (DIY) investing has obvious cost savings compared with going through an intermediary, such as a mutual fund manager. More to the point, it requires an investor to take personal responsibility for acquiring a working knowledge of investments and performing a modicum of research using the web. The goal is to “maintain what you’ve obtained” instead of participating in a market panic by selling your shares. Markets are moved more by fear than greed, such as the fear of a “margin call”. Many investors rely on help from borrowed money, i.e., by investing borrowed dollars and using the purchased stock as collateral for the loan. A “margin call” occurs when the broker requests additional capital (cash) from the investor to back an investment that has lost value. That is, the original loan is no longer backed with adequate collateral. As a DRIP investor on auto-pilot, however, you welcome a market panic because you are buying more shares than usual with your monthly investment. So, when should you sell a DRIP chosen from stocks in our Master List? We know of only 4 conditions that would trigger that:
Bottom Line: Our ITR blog is for value investors who aren’t interested in buying stock with borrowed money or selling stock in a falling market. These are called "Rip van Winkle" investors, in honor of the off-hand comment from an investment guru that he’d have done better by not touching his portfolio for 10 or 20 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 11
Week 23 - Lifeboat Stocks Revisited
Situation: In an earlier blog (Week 8), we defined Lifeboat Stocks as high-quality companies in defensive sectors of the economy (utilities, consumer essentials, health care). And by high quality we mean companies that have: low debt, a good credit rating, a dividend over 2%, and at least 10 yrs of annual dividend increases. In a later blog (Week 17), we introduced the use of accounting ratios to determine whether a company’s stock can be classified as fitting the category of “growth” or “value” and explained why we favored value. In this week’s blog, we will try to explain how some companies that qualify as a Lifeboat Stock (i.e., good credit rating and paying dividends with annual increases) can still carry considerable debt.
When a buyer makes a 20% down payment on a $200,000 house, then sells that house a year later for $240,000 (net of costs), that buyer’s out-of-pocket expenditure of $40,000 becomes $80,000. In accounting terms we would say that the Return on Equity (ROE) was 100%. Taxes will need to be paid on the $40,000 capital gain unless the gain is invested in another house but taxes are not due on monies used to pay interest on the mortgage. A US corporation works in a similar way, except that a business loan’s principal is not repaid, as in our mortgage example, until at the loan’s termination date. Boards of Directors, like homeowners, find this arrangement attractive because they can use someone else’s money to grow equity, tax-free.
When a company provides something that is fundamentally essential (i.e., electricity, pharmaceuticals,payroll services or diapers) there is an even greater temptation to use borrowed money, and that is because that company is unlikely to lose money during a recession. It can still make the owed interest payments on schedule. And, as is the case with homeowners, the cheapest form of debt is long-term (LT) debt after considering all risks. Typically, a company will “roll over” the Principal payment due at the maturity of its loan by taking out a new LT loan in the same amount. However, if there is a credit crunch when the company needs to do so, there will undoubtedly be higher interest to be paid, or possibly a need to issue more stock to finance the Principal payment. A company could also be going through a lean period when it’s Return on Assets (ROA) is less than the interest rate it will have to pay on its new loan. In other words, it won’t be able to get a loan it can afford. What this means is that the company will be paying an interest rate that is higher than it’s ROA, which means the company is in the process of going bankrupt. It will have to pay a much higher interest rate to compensate a creditor for issuing a “junk bond”. Incidentally, this principal also applies to countries, as we are witnessing with the European Union.
The attached <spreadsheet> examines all of the ITR Lifeboat Stock candidates in terms of LT debt/capitalization, ROE, ROA, and P/BV, or the ratio of Price to Book Value (assets minus liabilities). Debt is subtracted from the value of the company's assets, which are owned by shareholders, but a company that efficiently uses borrowed money to increase its revenue will also show an increase in assets that is proportional to the increase in its liabilities. BV will remain stable and the share price will remain a reasonable multiple of BV. If BV falls because the value of its assets no longer cover its liabilities, then P/BV will soon reach double digits. To qualify as an ITR Lifeboat Stock, we are looking for companies with P/BV of less than or equal to 3.5, ROA greater than 8% (indicating ample ability to afford interest payments), ROE greater than the S&P 500 Index ROE (currently 16.5%), and LT debt/capitalization less than or equal to 35%.
ABT, JNJ, MDT, BDX, ADP, WAG, and WMT meet our criteria and are classified as Lifeboat Stocks. In addition, NEE, SO and MDU are utilities with government-backed credit and otherwise meet our requirements for being a Lifeboat Stock. The other companies on the spreadsheet do not meet those requirements. Taking one company from each of the main S&P Industries from which Lifeboat Stocks are drawn (consumer staples, health care, utilities), we’ll make a virtual investment of $100/mo in each DRIP (WMT, JNJ, and NEE) starting 2/3/97. Commissions are $1 per month for WMT and JNJ; NEE has no commission. Total returns were 5%/yr for WMT, 4.85%/yr for JNJ, and 7.78%/yr for NEE. This compares to 2.55%/yr for SPY (commission for monthly DRIP investment = $4). Spreadsheet information will be provided in next week’s Summary blog.
Bottom Line: Lifeboat stocks provide some of the ballast that helps to preserve your portfolio during market turmoil; bonds provide the rest.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
When a buyer makes a 20% down payment on a $200,000 house, then sells that house a year later for $240,000 (net of costs), that buyer’s out-of-pocket expenditure of $40,000 becomes $80,000. In accounting terms we would say that the Return on Equity (ROE) was 100%. Taxes will need to be paid on the $40,000 capital gain unless the gain is invested in another house but taxes are not due on monies used to pay interest on the mortgage. A US corporation works in a similar way, except that a business loan’s principal is not repaid, as in our mortgage example, until at the loan’s termination date. Boards of Directors, like homeowners, find this arrangement attractive because they can use someone else’s money to grow equity, tax-free.
When a company provides something that is fundamentally essential (i.e., electricity, pharmaceuticals,payroll services or diapers) there is an even greater temptation to use borrowed money, and that is because that company is unlikely to lose money during a recession. It can still make the owed interest payments on schedule. And, as is the case with homeowners, the cheapest form of debt is long-term (LT) debt after considering all risks. Typically, a company will “roll over” the Principal payment due at the maturity of its loan by taking out a new LT loan in the same amount. However, if there is a credit crunch when the company needs to do so, there will undoubtedly be higher interest to be paid, or possibly a need to issue more stock to finance the Principal payment. A company could also be going through a lean period when it’s Return on Assets (ROA) is less than the interest rate it will have to pay on its new loan. In other words, it won’t be able to get a loan it can afford. What this means is that the company will be paying an interest rate that is higher than it’s ROA, which means the company is in the process of going bankrupt. It will have to pay a much higher interest rate to compensate a creditor for issuing a “junk bond”. Incidentally, this principal also applies to countries, as we are witnessing with the European Union.
The attached <spreadsheet> examines all of the ITR Lifeboat Stock candidates in terms of LT debt/capitalization, ROE, ROA, and P/BV, or the ratio of Price to Book Value (assets minus liabilities). Debt is subtracted from the value of the company's assets, which are owned by shareholders, but a company that efficiently uses borrowed money to increase its revenue will also show an increase in assets that is proportional to the increase in its liabilities. BV will remain stable and the share price will remain a reasonable multiple of BV. If BV falls because the value of its assets no longer cover its liabilities, then P/BV will soon reach double digits. To qualify as an ITR Lifeboat Stock, we are looking for companies with P/BV of less than or equal to 3.5, ROA greater than 8% (indicating ample ability to afford interest payments), ROE greater than the S&P 500 Index ROE (currently 16.5%), and LT debt/capitalization less than or equal to 35%.
ABT, JNJ, MDT, BDX, ADP, WAG, and WMT meet our criteria and are classified as Lifeboat Stocks. In addition, NEE, SO and MDU are utilities with government-backed credit and otherwise meet our requirements for being a Lifeboat Stock. The other companies on the spreadsheet do not meet those requirements. Taking one company from each of the main S&P Industries from which Lifeboat Stocks are drawn (consumer staples, health care, utilities), we’ll make a virtual investment of $100/mo in each DRIP (WMT, JNJ, and NEE) starting 2/3/97. Commissions are $1 per month for WMT and JNJ; NEE has no commission. Total returns were 5%/yr for WMT, 4.85%/yr for JNJ, and 7.78%/yr for NEE. This compares to 2.55%/yr for SPY (commission for monthly DRIP investment = $4). Spreadsheet information will be provided in next week’s Summary blog.
Bottom Line: Lifeboat stocks provide some of the ballast that helps to preserve your portfolio during market turmoil; bonds provide the rest.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, December 4
Week 22 - Core Holdings
Situation: Seasoned investors will try to strike an investment balance between equities (ownership rights that yield dividends or rent) and credits (loans that pay interest). They also attempt to balance their core holdings with “hedges” that are designed to mitigate potential losses. We introduced an ITR Goldilocks Allocation (Week 3 blog) that is designed to protect against bear markets by investing 67% of the entire portfolio in Lifeboat Stocks (see Week 8 blog) and high grade bonds. The remaining 33% is risk capital--core “cyclical” stocks that rise or fall with world markets.
Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.
On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.
For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGT, WMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:
3 energy stocks (XOM, CVX, OXY)
3 manufacturers (GD, EMR, UTX)
1 conglomerate (MMM)
1 railroad (NSC)
We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.
The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).
Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Goal: Orient the ITR reader to potentially useful core holdings by providing specific examples.
On the equity side, a Goldilocks-type of allocation will assign 33% of holdings to Lifeboat Stocks. An additional 17% is distributed to multinational stocks whose strength is the ability to capture revenue from emerging markets. These two types of holdings mitigate against portfolio losses caused by recession and dollar devaluation, respectively. In fact, recent global market events have demonstrated that emerging markets reflect the US market and are not de-linked, as was once thought. This stands to reason because emerging markets such as Brazil, India and China market goods and services predominantly to the US rather than their own consumers. This then means that companies on the ITR Master List which are dependent on revenue from emerging markets will also fit the classification of “core holdings” (e.g. MCD & MMM). The result is that our equity allocation in the “at risk” category is weighted at 67%, while the remaining 33% is composed of Lifeboat Stocks used to hedge that risk.
For the individual investor, core holdings represent one of the few available opportunities to “beat the market”. As defined, core holdings exaggerate market swings because we’ve excluded the moderating effect of “defensive” (lifeboat-type) stocks. This makes it important to have a strategy in place to reduce and “even out” that risk over time. One means of accomplishing that is to purchase stock in large companies that have the resources to recover from recessions. Reinvesting dividends, and making regular periodic purchases through a DRIP to buy shares that are “on sale”, also helps to attenuate that risk. Examination of the 20 largest companies on the ITR Master List shows that 10 are Lifeboat-type defensive stocks (ABT, JNJ, MDT, WAG, KO, CL, PEP, PG, TGT, WMT). Core holdings can be selected from the remaining 10 companies. Investing in those companies that have a return on equity (ROE) above the S&P 500 Index average (16%), and a Price:Book ratio less than 3.3, leaves:
3 energy stocks (XOM, CVX, OXY)
3 manufacturers (GD, EMR, UTX)
1 conglomerate (MMM)
1 railroad (NSC)
We’ve made an example pick of 4 stocks that represent core holdings and included an emerging markets play (MMM), an energy producer (XOM), a manufacturer (UTX), and a railroad (NSC). We’ll back-test our example by making a virtual investment of $150/mo in each of the 4 DRIPs from 2/3/97 to the present. We’ll use SPY as a proxy for the S&P 500 Index, and the Consumer Price Index as a proxy for inflation. Having to pay commissions reduces a monthly DRIP investment by $4/purchase for SPY, MMM and NSC, and $2.50 for UTX. The XOM DRIP, however, doesn’t have a commission.
The result of our analysis shows that (as of 11/30/11) SPY had a total return of 2.58%/yr vs. inflation at 2.32%/yr. The stocks used in our example, however, did much better with a return of 5.18%/yr for MMM, 8.70%/yr for UTX, 7.86%/yr for XOM, and 11.3%/yr for NSC. In the aggregate, an investment of $106,800 ($600/mo x 178 mo) grew to $234,352 (8.58%/yr). We are using the above example to prepare a spreadsheet for our readers that will be presented two weeks from now. We are incorporating calculations for two Lifeboat Stocks into this week’s example based on information we will discuss in next week’s blog (Lifeboat Stocks Revisited).
Bottom Line: DRIPs of 4 cyclical stocks (selected from ITR’s Master List) outperformed SPY by 6%/yr over the past 15 years.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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