Week 31 - Master List Stocks Have Great Long-Term Returns but What About Safety?

Situation: All 30 stocks in the ITR 2012 Master List (Week 27) have 15-year total returns that handily beat the S&P 500 Index, and all but one (KO) beat the Index in terms of price appreciation. (Go team!!) But stocks also carry the unhappy possibility of a company filing for bankruptcy, and thus leaving shareholders with nothing. That is the one key thing that separates stocks from bonds: Bondholders get all the assets remaining after a company files for bankruptcy. And this brings us to an important issue: There is no such thing as a “safe stock”. We think of it this way: there are 3 kinds of stocks: 1) risky stocks, 2) temporarily safe stocks, and 3) relatively safe stocks. Here at ITR we have a system for winnowing out risky stocks but (until this week’s blog post) we hadn’t developed a system for identifying the least risky, i.e., relatively safe stocks. This is important--we’re not just splitting hairs! For example, Kodak would definitely have been near the top of our 1972 Master List if we’d been picking value stocks back then. But Kodak recently filed for Chapter 11; anyone holding that stock over the past 40 yrs didn’t make money in the long-term and had to watch the price fall gradually while hoping for a chance to sell. Of course, such an investor would have been better off to sell at a loss when the company stopped increasing its dividend annually. That investor would have been well served by a "label and column" in the 1972 Master List announcing that Kodak was a stock that is temporarily safe.


This week we’ll distinguish between temporarily safe stocks which might later perform like Kodak, and relatively safe stocks. We’ll use a simple tool that does the job for most stocks,  which is to identify stocks with what Warren Buffett calls a durable competitive advantage: “A long-term or durable competitive advantage in a stable industry is what we seek in a business.” Such companies a) produce a product or service that has predictable value in the marketplace, and b) have been in the game long enough that they’re unlikely to be displaced by competitors. The main factor he uses to identify such companies is a steady increase in book value (preferably tangible book value) over ~10 yrs. 

When we use the most recent 10 yrs of S&P data to evaluate 9 yrs of growth in tangible book value for each of the stocks on our 2012 Master List (Week 27), we find that 5 had no down years (XOM, LOW, OXY, WMT, NEE) and 8 that had only one down year (CVX, MCD, NSC, WAG, BDX, CB, HRL, TROW). These 13 are relatively safe for long-term investment. You can set aside $26,000, call your broker, and buy $2,000 worth of stock in those 13 companies (and don’t forget to set up automatic reinvestment of dividends). Then you can do the Rip van Winkle thing for 20 years. Upon waking up, your nest egg will have out-performed a similar $26,000 invested in the S&P 500 exchange-traded fund (SPY) over the same period, and probably by a wide margin. Why? Because over the past 10 yrs those 13 stocks averaged a 12% growth rate in tangible book value vs. ~3% for the S&P 500 Index.

One problem though--Warren Buffett’s method is not useful for evaluating future growth of many consumer staples & health care companies that earn 50% or more of their revenues outside the US. Such companies often have no tangible book value. Why is that? Because their Boards of Directors don’t want to pay taxes twice--first to the host nation’s treasury and then, after repatriating the profits, to the US Treasury. So those companies choose to leave profits in the host nation as captive retained earnings, to be used for expanding operations in that country. The company may then have to borrow the money needed to pay shareholder dividends. This impairs book value but given the stability of worldwide cash flow, the possibility of bankruptcy is considered to be so remote that the chance is worth taking. Wal-Mart is an exception: Even though it increases tangible book value annually without fail (at a rate of 11% per year), overseas earnings are repatriated as needed to pay dividends. Here at ITR, we prefer to think that stock in a company without tangible book value is no better than a temporarily safe investment. 

Bottom Line: No stock is a “safe bet”. If you want to make a safe investment in one of the companies on our 2012 Master List (Week 27), buy that company’s bonds. But 13 of those 30 stocks qualify as relatively safe by meeting Warren Buffett’s criterion for a company with a “durable competitive advantage”: steady growth in tangible book value over ~10 yrs. Eleven of our Master List companies have been steadily growing their tangible book value at a rate of at least 8%/year (CVX, XOM, OXY, LOW, WAG, WMT, BDX, CB, NEE, HRL, TROW) and 4 of those have no red-flagged risk factors (2yr Bollinger Bands, 5yr Beta, long-term debt/capitalization, and FCF/div): XOM, WAG, BDX, and WMT. As a group, those 4 are a “safe bet.”

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