Week 47 - Stocks that Rock!

Situation: Some stocks perform so strongly in economic downturns that there’s not much need to balance the risk of ownership with a hedge like intermediate-term Treasury Notes or Savings Bonds. Utility stocks are the traditional example of this phenomenon, and that is because at least half of their capitalization is gained by issuing long-term bonds. Those bonds have a lower rate of interest because of the implicit guarantee of the utility by a state government. When an economy is in recession, the bonds also are issued at a lower rate of interest. This leaves the utilities with more retained earnings, which are frequently needed for plant upgrades. That reduction of interest expense also makes it possible to pay down some debt. The question for this week is: Do any other stocks show those attractive, recession-proof features? It’s worth the effort to look closely to find any others because those stocks could be owned without the necessity of balancing the risk of bankruptcy with an equal investment in bonds.


Interestingly, there are a few utility-like stocks out there that fit our criteria. We’ve found 10 on our Master List (Week 39). In the accompanying Table, we have compared those with the 3 utility stocks on the Master List. The stocks are ranked in the order of Finance Value because this represents the reward gained over ~10 yrs minus the risk of loss during the 2007-09 bear market. Taken together, these 13 stocks perform like a modern hedge fund (see Week 46). Seven of the 13 stocks are also found in what we call the Lifeboat Stocks category (see Week 8 & Week 23): WEC, MKC, HRL, SO, ABT, BDX, NEE. The remaining 6 stocks are part of what we call Core Holdings (Week 22): MCD, CHRW, OXY, CB, CVX, XOM. (Numbers highlighted in light blue in the Table indicate out-performance and numbers highlighted in red indicate under-performance.)


Bottom Line: There are some stocks that behave (after a fashion) like utility stocks by having strong returns in recessionary times and, therefore, don’t have to be hedged.


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

Week 46 - What is a Hedge Fund?

Situation: If you have a pension plan at work, the plan’s administrators are probably allocating 10% or more of your contribution to hedge funds. Most hedge funds don’t come cheap. Charges typically consist of an annual fee of 2% plus 20% of returns from any outperformance over the S&P 500 Index in a 3-4 yr period. Hedge funds purport to secure a long-term gain that beats the returns of the S&P 500 Index, with reinvested dividends. Hedge funds also try to incur less risk of short-term loss during “bear markets.” You may recall from our previous blog about hedges (Week 37) that Merriam-Webster’s Collegiate Dictionary (11th ed.) defines a “hedge” as balancing a risk, specifically “to protect oneself from losing or failing by a counterbalancing action.” In other words, if the risk of a 20% or greater loss in the S&P 500 Index were to be fully hedged, the total return for the hedged portfolio during that bear market would be 0%. In reality, almost all of the leading hedge funds lost at least 10% during the 2007-09 bear market. Today’s goal is to determine exactly how much the best hedge funds lost so that we understand what such an investment entails. 

Recently, Warren Buffett found the answer by betting against the whole idea of a hedge fund. He states that the high expense of investing in a hedge fund means it can’t beat an investment in a no-load S&P 500 Index fund like VFIAX (Vanguard Admiral S&P 500 Fund). He placed a bet to that effect with Ted Seides, of Protege Partners LLC, which markets one of the biggest hedge funds. Mr. Seides picked 5 different hedge funds to determine an average for the best performance the hedge fund industry can offer. The bet runs for 10 yrs, from 2008-17, and the winner receives a $1,000,000 zero-coupon 10-yr US Treasury Note for his favorite charity. To date, the 5 hedge funds are down 5.9% but VFIAX is also down, at -6.3% (read this link). Warren Buffett made this information available at Berkshire Hathaway Corporation’s annual meeting on May 5th. He noted that VFIAX beat the hedge funds in each of the last 3 yrs but is still behind overall because of its greater loss (36% vs. 23%) during 2008. That means the 5 best hedge funds went down only 64% as far (23/36 = 0.64) as VFIAX during the bear market year of 2008. See this link for additional information.

Over the worst 18-months of that bear market (10/07 - 4/09), VFIAX fell 45%. Now that we know the 5 best hedge funds fell only 64% as far as VFIAX during 2008, i.e., the middle 12 months of that 18-month bear market, we can multiply that 45% value (for the 18-month VFIAX loss) by 0.64, which equals 29%. Any mutual fund that returned more than VFIAX over the past 10 years, AND fell by less than 29% during the 18-month bear market would qualify to be called a hedge fund by this definition. 29% is a serious loss that most investors won’t accept. In other words, people take the “hedge” term literally. A well-designed hedge means there would be 0% loss during a bear market. 

Here at ITR, we believe you’ll do better than VFIAX and most hedge funds over 10 yrs by using DRIPs of value stocks selected from our Master List (Week 39), combined with dollar-cost averaging and dividend re-investment. You probably can’t afford a DRIP for each of the 31 Master List stocks but you can have one for each of the 12 stocks in our Growing Perpetuity Index (see Week 4, Week 21 & Week 32). Those 12 stocks have returned an average of 9.5%/yr since 7/02 and lost only 22% in the 18-month bear market. Seven stocks in the Growing Perpetuity Index actually fulfill the definition above of a modern-day hedge fund: MCD, IBM, NEE, CVX, XOM, PG, KO. Those 7 gained 10.8%/yr and lost only 23% in the bear market (MCD lost only 3%). If you had DRIPs for all 7 stocks, with an equal amount invested each quarter in ISBs (inflation-protected Savings Bonds), your total return since 7/02 for that 50:50 stock:bond investment would have been 8.0% and you’d have incurred a bear market loss of only 10% along the way. 

Bottom Line: Save yourself the fees and build your own hedge fund.


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

Week 45 - Dr. Copper

Situation: Copper’s price/ton is often referred to as “Dr. Copper” because it is a predictor of economic activity. In recent years, this has been less true because growing countries have learned to stockpile copper during slack periods. Nonetheless, the build-out of infrastructure utilizes a lot of copper, much of which is sold as wires, tubes and rods made from copper or copper alloys. These are welded, brazed, or soldered into a final product. Therefore, infrastructure build-out affects many manufacturers, especially those that make mining and welding equipment: Caterpillar (CAT) and Lincoln Electric (LECO). Interestingly, gold producers also get caught in Dr. Copper’s web, since minerals containing the two elements are commonly found together. All copper mining companies produce significant amounts of gold, whether they admit it or not. And the largest gold mining companies are happy to point out that they also produce large amounts of copper: American Barrick (ABX), Newmont Mining (NEM), and Goldcorp (GG).

Here we go again! Talking about commodities in a blog geared to conservative investors who eschew buying stock options or buying stock with borrowed money. In our blogging, we go to great lengths to distinguish investing vs. speculating. The reality is that developing countries in Asia, the Middle East, East Europe, and Latin America rely on commodities to stoke the engines of commerce. In Week 43, we found that some commodity-related companies on the ITR Master List (Week 39) make sound long-term investments with limited downside risk (XOM, CVX, OXY, CNI, HRL, CHRW). In this week’s blog, we examine commodity-related companies that are on the cusp of qualifying as a sound investment, beginning with copper. As usual, we’ve limited our search to dividend-paying companies because low-cost DRIPs are the safest way to build a position. And, since we depend on access to the metrics accumulated by Standard & Poor’s, we will only include in our examination the largest companies outside the S&P universe.

For copper, we’ve identified 8 companies that are worth a close look (see attached Table) but 5 of those (ABX, NEM, GG, CAT, LECO) are not specifically in the business of mining for copper. The other 3 have extensive copper-mining operations around the world: Rio Tinto (RIO), Freeport McMoRan Copper & Gold (FCX) and Southern Copper (SCCO). The Table makes it evident that most of these are in the speculative range as an investment. In other words, you’d have to know when to buy shares and when to (quickly) sell. Lincoln Electric (LECO), however, appears to be an exception and worth considering as a long-term holding. It passes muster with respect to Total Return, Finance Value, BBA (projected 10-yr growth), Durable Competitive Advantage, LT debt/capitalization, FCF/div, and ROIC. (You can check out blogs from Week 43, Week 42, and Week 40 for more info on those metrics.) Were it not for its low dividend payout (1.4%), LECO would be a stock on the ITR Master List. 

Bottom Line: Mining companies are riskier investments than drilling companies, even the companies that mine copper and gold. Caveat emptor!

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

Week 44 - Getting Started with Net-Net-Net Investing

Situation: When one initiates a long-term investment plan, there are 3 cost-centers that must be confronted:

   a) the fees & commissions levied on purchases

   b) the taxes levied on profits

   c) inflation 

Net-Net-Net Investing is all about what you are left with at the end of the day: net of fees & commissions, net of taxes, and net of inflation. In other words, it is your true profit, and that is the true profit that fund managers seldom discuss. The costs mentioned will ultimately determine whether your portfolio is a “profit-center” or “cost-center.” Some dividend re-investment plans (DRIPs) have no costs for startup, re-investing the dividend or automatic electronic purchases (e.g. XOM, NEE, PG). Neither do purchases of US Savings Bonds or US Treasury Notes, when purchased using treasurydirect. 

You probably know that profits from the sale of stock and dividends earned, are taxed at a lower rate than income. This is because you have already paid taxes as a co-owner of the company. When you cash out a Savings bond, you will be taxed for interest earned as though it were ordinary income but you won’t pay taxes during the accrual period--as interest is reinvested and accumulates. Savings Bonds, therefore, act like a standard IRA as regards taxes. Inflation, however, is hard to beat. But you can buy inflation-tracking investments such as inflation-protected Savings Bonds (ISBs) and stocks. There are also bond mutual funds that exclusively purchase inflation-protected investment-grade bonds, VIPSX for example, which was highlighted in blue (see the Table with Week 43) as being a good “hedge”.

Where to start today’s discussion? We suggest reading the ITR Goldilocks Allocation (Week 3) where you’ll see an equal investment is apportioned between stocks (in the form of DRIPs) and bonds (as no-load intermediate-term investment-grade mutual funds and 10-yr Treasury Notes). Inflation is the main risk of owning bond mutual funds. To protect yourself, it is best to purchase the Vanguard Inflation-protected treasury fund (VIPSX). An even better solution is to own ISBs, since those have built-in tax savings and track inflation even more closely than an inflation-protected bond fund. For the 50% allocation to DRIPs, the Goldilocks Allocation assigns 25% to Core Holdings, 16.6% to Lifeboat Stocks, and 8.3% to international stocks. (For a review of Core Holdings and Lifeboat Stocks see Week 22 & Week 23). International stocks and mutual funds are tricky to own--many risk factors come into play that don’t affect domestic stocks. Fortunately, some US-based companies gain more than 70% of their revenue outside the US. Three of our Master List companies (Week 39) stand out in that regard: McDonald’s (MCD), CH Robinson Worldwide (CHRW), and 3M (MMM).

Which company stocks should you consider first? Those are the companies with excellent metrics  “across the board” (found in the top half of the Table for Week 43). As a Core Holding, ExxonMobil is hard to beat (XOM). Others worth considering are its competitors, Chevron  (CVX) and Occidental Petroleum (OXY). Canadian National Railroad (CNI), IBM, and Chubb (CB) are others. Lifeboat Stocks with “across-the-board” appeal include Hormel Foods (HRL), McCormick (MKC), Becton Dickinson (BDX), as well as the 3 electric utilities (NEE, SO, WEC). 

Using data that we laid out in that Table, we’ll examine the results of a virtual investment of $300/mo - with $150/mo into ISBs, $75/mo into XOM, $50/mo into BDX, and $25/mo into MCD. All 3 DRIPs are available at computershare. Costs for set-up and automatic investments into XOM and BDX are negligible. However, the MCD drip carries significant transaction costs: it is better to mail in a single check for $300 each year, from which $6.00 will be deducted.

Results from an investment as described above over the past 9.75 yrs (Week 43 Table) are as follows:

   ISBs have returned 4.7%/yr

   Stocks in the ratio indicated by the Goldilocks Allocation (3 parts XOM, 2 parts BDX, 1 part MCD) returned 12.1%/yr on average (but also experienced price depreciation of 24.8% over the worst 18-months of the Great Recession).

Our virtual investment in stocks and bonds together returned 8.4%/yr. That compares favorably with the high-quality, low-cost Vanguard Wellesley Income Fund, which returned 5.6%. In terms of Finance Value (Week 42, Week 43), which compares total return to losses over that 18-month period, our 3 stocks comes in at -11.7% vs. -38% for the S&P 500 Index Fund. Our way of calculating Finance Value is to put a number on risk (i.e., price loss/gain during a bear market) and subtract/add that number to the long-term total return (cf. Table Week 43). This is an arbitrary but nonetheless quantitative and generalizable way of comparing one investment to another in terms of past performance. It’s a way of answering the inevitable question: Sure, your company earned real money for its shareholders over the past 10 yrs but how close did it come to declaring bankruptcy or needing a Private Equity fund to bail it out?

Bottom Line: What is the actual take-home pay from your accumulated investments? Let’s imagine you did as well as the S&P 500 Index since 7/1/02 (total return = 6%), which would mean you’re a very good investor. Then subtract 2.5% for inflation (i.e., growth in the Consumer Price Index). Also subtract one-fourth (1.5%) for taxes. Now you’re down to 2% but nevertheless still ahead. Unfortunately, 2% also happens to be the amount that private investors have been found to spend on average for the fees & commissions levied by fund managers and stock/bond brokers. In other words, you had no take-home pay. Some fees are even as high as 4%. Now look again at our stock and bond example as given above. Stocks and bonds (50:50 allocation) returned 8.4%/yr. After taking out 2.1% for taxes and 2.5% for inflation we’re left with 3.6% for costs and profit. What were the costs? Well, purchasing Savings Bonds costs you nothing, neither did XOM & BDX purchases via DRIPs. McDonald’s stock cost you $6 out of the $3600 you spent annually on stocks and bonds (i.e., total costs = 0.17%/yr). This means your annualized return net of inflation, taxes, and costs (i.e., your take home pay) comes to (3.60% - 0.17%) or 3.43%/yr. Dude, looking good.

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