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.

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