Week 102 - Core Holdings Revisited

Situation: The US economic recovery and Treasury yields are finally climbing in tandem. The current interest rate on 10-yr Treasury Notes almost exceeds the dividend yield of the S&P 500 Index, which will attract yield-hungry investors (who had been putting their money in high-yield stocks and bonds) back into Treasuries. 

This move is timely, as it puts a fine point on the importance of having 2/3rds of your stock allocation in what we call “Core Holdings." Those are high-quality companies within industries that are the engine of a growing economy (see Week 22). Those include energy, materials, consumer discretionary, financial, information technology, and industrial stocks. In recent years, our focus has been on the stocks of companies in defensive industries (healthcare, telecommunication services, consumer staples, and utilities) because of their higher dividends and lower volatility.

Most of the better companies in the Core Holdings category have modest dividend yields in the 1-2% range. That’s because the corporate strategy is to grow earnings during an economic recovery and then reinvest in their own growth at zero cost by using Retained Earnings (RE). That seems to be a wiser use of Free Cash Flow than paying dividends (which are difficult to fund during slack years), then issuing stocks or bonds at a cost of 8+%/yr to grow the company. The danger, of course, is that the CEO will instead use RE to make an acquisition that is not synergistic with that company’s Business Plan. History suggests such acquisitions seldom work out. By having to accept the discipline of paying a good and growing dividend, the CEO has less leeway to spend foolishly. To sum up, you'll have to pick carefully among companies that use RE to fund their growth.

You can calculate how much of a company’s historical Return on Equity (ROE) can be funded with Retained Earnings (Table). But frequently you will be given little insight into whether a successful company’s Business Plan will remain stable and transparent when RE swells to hundreds of millions of dollars or more. To sum up again: RE is the ultimate Competitive Advantage. It’s the one that makes capitalism work but it can be squandered. You, the investor, will be better off in the long run if you invest in Core Holdings that fund their own growth, for the most part, by using RE. 

For this week’s Table, we combine two lists: the recently updated 201-company Dividend Achievers, and the Barron’s 500 Table that was published 5/4/13. The former is for companies that have raised their dividend annually for at least the past 10 yrs. The latter is for companies that have increased sales and cash flow-based ROIC for the past year and cash flow-based ROIC for the past 3 yrs. We have identified the S&P 500 companies that are on both lists, then added any other S&P 500 companies have shown year-over-year improvement in their Barron’s rank. Companies that don’t have at least an A-/H S&P rating for their stock and a BBB+ rating for their bonds are discarded, as are any that lost more than 2/3rds as much as the S&P 500 Index lost during the Lehman Panic. As a final screen, only those companies that beat the S&P 500 Index by the following metrics were retained: total return since the inflation-adjusted S&P 500 peak on 3/24/00, dividend growth rate, 5-yr total return, and 5-yr Beta. 

Our analyses have identified 12 companies, all but one of which are among the Dividend Achievers. The exception, Travelers (TRV), is one year away from becoming a Dividend Achiever. In other words, the best growth companies pay at least a small dividend that grows annually. 

The companies on our list, aside from Nike (NKE), McDonald’s (MCD) and IBM, are companies you might not have heard of before. But if you’re a shopper, you’ll know that TJX, Sherwin-Williams (SHW), VF Corporation (VFC), and Ecolab (ECL) sell high-quality goods at attractive prices. The only growth industry that isn’t represented here is energy, so we’ve included Exxon Mobil (XOM) under the Benchmarks heading at the bottom of the Table. It is the only energy stock that comes close to meeting our criteria, and will be featured in next week’s blog about oil & gas producers and refiners. 

Remember, companies that develop useful products from raw materials will almost never have a 5-yr Beta less than 1.00 because commodity prices fluctuate too widely. That also means that even the best commodity-related companies will sometimes underperform the S&P 500 Index for years at a time. Having said that, XOM remains the premier Core Holding. You won't go wrong by setting up an automatic transfer of $50/mo from your checking account into the XOM DRIP at zero cost (see computershare).

Bottom Line: Grow your stock portfolio with the economy, even though you might wish you had bought some of those stocks when the economy was in recession.

Risk Rating: 7

Full Disclosure: I have stock in MCD, IBM, and XOM.

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