Week 95 - Hedge Stock Picks for 2013

Situation: In several of our blogs over the past year, we’ve tried to identify stocks that behave like an above-average hedge fund (using a definition based on information provided by Warren Buffett at the May 2012 Annual Meeting of Berkshire Hathaway--see Week 30). A qualifying stock would need to beat the S&P 500 Index over the past 10 yrs while losing less than 65% as much as the S&P 500 Index lost during the Lehman Panic, and would need to maintain a 5-yr Beta of 0.65 or less to show that it would be likely do as well during the next financial panic. In this week’s blog, we merge those standards with ITR’s long-standing requirement that stocks used as a base for retirement planning be 
   a) Dividend Achievers, meaning they have consecutive annual dividend increases for at least the past 10 yrs; 
   b) have a dividend yield close to or better than the 15-yr moving average for the dividend yield on the S&P 500 Index (1.8%); 
   c) have an S&P stock rating of A- or better and an S&P bond rating of BBB+ or better;
   d) have no more than 50% of total capitalization coming from long-term debt; 
   e) have positive free cash flow (FCF) in the most recent year according to The WSJ;
   f) have a return on invested capital (ROIC) sufficient to cover the cost of capital (at least 8% for non-financial companies).

General Mills (GIS), which will be added to the 201-stock Dividend Achievers List published by S&P early next year, has been made a part of our list too. 

Since we began blogging about hedge stocks (see Week 76, Week 77, Week 82, Week 93), there are 11 stocks that consistently keep qualifying (Table). This list is important to you, the investor, for the simple reason that you don’t need to back up ownership of these stocks with an equal investment in Treasury Notes (or inflation-protected Savings Bonds). That precaution is necessary when purchasing other stocks in case the next financial panic happens soon after you retire when you’ll be particularly loathe to sell stocks that are repressed in value. Then you can sell bonds instead, which will be up in value.

We have only one concern about the hedge stocks in our Table, which is an increasing tendency for those companies to borrow money in order to keep raising their dividend annually. This trend started in 2005 when Procter & Gamble borrowed money to pay the part of its growing dividend that free cash flow (FCF) couldn’t fund. This was done to avoid bringing overseas earnings back to the US, which would result in a 30% tax (on top of taxes already paid to foreign countries). This increasingly affects the companies in our list of hedge stocks, since most are mainly expanding overseas. Only 6 of the 11 companies have money left in FCF after paying their dividend. Those “Retained Earnings” are the best way to grow the company, since they come at no cost. Eventually, the tax policy of the US Government will have to stop penalizing companies for overseas operations.

Bottom Line: Even though there are only a few stocks that qualify as “hedge stocks”, it is important for you to set up DRIPs in one or two of these and add money regularly through automatic deductions from your checking account. That’s not only a good way to prepare for retirement but it’s also the best way to hedge against the risk of hyperinflation. 

Risk Rating for the aggregate of 11 companies: 3.

Full disclosure: I have DRIPs in MKC, MCD, ABT, KO and IBM.

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