Week 104 - Capitalization-weighted Index of 20 Hedge Stocks

Situation: Yield-hungry investors dominate stock trading as well as bond trading, and we all know why. It is because the US Federal Reserve has driven Treasury bond yields to historically low levels. Bonds of any maturity issued anywhere in the world have greater risk than US Treasuries, so non-Treasuries offer a higher interest rate than an equivalent Treasury. That added risk is priced into those rates. 

Buyers care little for the details. They just want to be paid enough interest to more than compensate for inflation. But they also know that high-yield bonds carry a significant risk of default, which makes them no less risky than stocks. Many investors have turned to stocks that a) grow dividends fast enough to more than keep up with inflation, and b) have other bond-like features like low volatility (i.e., low Beta). This blog has catered to those investors, until recently. But now this has become a “crowded trade”, and we are calling attention to its high cost for companies as well as investors. Many companies have tried to comply, but that means they lose the opportunity to grow their businesses at zero cost with Retained Earnings (RE). Instead, their free cash flow (FCF) is increasingly consumed by the need to grow their dividend--to attract buyers and boost the stock’s price. This type of “asset inflation” is exactly what Ben Bernanke had in mind when he had the Federal Reserve launch its bond-buying program 3 yrs ago. Unfortunately, several prominent companies have had to issue new stocks and bonds just to maintain the kind of growing dividend that investors expect. 

Here at ITR, we played along with yield-hungry investors as long as we could. But the competitive advantage of any company is linked to the cost of money for capital improvements. If free money (RE) is used, there is no need to go through the expensive (and embarrassingly public) rigamarole of issuing new stocks and bonds. So we are now changing our focus to identify solid companies that consistently grow FCF and have some left after paying a dividend. Such companies tend to pay a small but growing dividend. If you own stock in one, and you’re a retiree who depends on dividend checks, you’ll have to learn to occasionally sell some of the shares you hold. For example, Sherwin-Williams (Table) had a 2% yield two yrs ago but has a 1% yield now. You’ll notice, however, that its growth rate has increased from 20%/yr over the past 13+ yrs to 30%/yr over the past 5 yrs, growth that is increasingly funded by RE. 

With these thoughts in mind, we still have to identify bond-like stocks for you to consider owning in lieu of a high-yield corporate bond fund (i.e., a fund that holds bonds paying 6-8%/yr but those bonds have an S&P rating lower than BBB-). Instead of owning one of the top such funds, e.g. the USAA High Income Fund (USHYX in the Table), we suggest that you own bond-like stocks that behave like a good hedge fund (see Week 101).

Because low-Beta/high-yield stocks are the “in thing” to own (i.e., overpriced), we’ll need a screen that focuses instead on companies that have a recent record of beating out their competition without necessarily paying much of a dividend. We'll do that by depending first on the Barron’s 500 Table because it ranks companies with respect to recent growth in sales and cash flow. Then we apply our usual metrics to identify hedge stocks, i.e., stocks that a) beat the S&P 500 Index over the past 5 yrs and longer, e.g. since that Index reached its inflation-adjusted peak on 3/24/00; b) lost no more than 2/3rds as much as the S&P Index during the Lehman Panic; c) have a 5-yr Beta that’s no more than 2/3rds as high as the S&P Index 5-yr Beta; d) have an S&P stock rating of A- or better, and e) have an S&P bond rating of BBB+ or better. Except in the case of a regulated utility, we also require the company to be less than 50% capitalized by long-term bonds, have a positive FCF, and exhibit dividend growth that exceeds the 6.5%/yr dividend growth rate of the S&P 500 Index. 

Our screen of the S&P 500 Index turns up 20 companies (Table). All 20 are dividend payers, and only two aren’t yet Dividend Achievers. The exceptions are Costco Wholesale (COST) and General Mills (GIS), both of which are less than a year away from reaching the required 10 yrs of consecutive dividend increases. Seven of the 20 companies pay less than the 2% yield for the lowest-cost S&P 500 Index fund (VFINX). Taken together, the 20 companies have returned 11.9% since 3/24/00 (as of close of business on 6/17/00), and 14.6% over the past 5 yrs. But much of that outperformance is achieved by the smaller and more nimble companies. To compensate for that unhelpful aberration, we’ve set up a capitalization-weighted index by valuing the total return of the largest company (WMT) over the past 13+ yrs at 20 times more than the total return for the smallest company (HRL). Column N of the Table lists the multiplication factors for the other 18 stocks, based on market capitalization. That adjustment brings aggregate total return over the past 13+ yrs down to 9.5% (vs. 11.9%).

If you're just getting started as a DRIP investor, you’ll want to start the drill (of adding small amounts automatically each month to stock) in companies that are gaining on their competition. Those are the companies that improved their Barron’s 500 rank in 2012 vs. 2011. The companies that failed to do so are red-flagged in Column G of the Table. Choosing among the remaining companies is simply a matter of starting with one of those having the best capitalization-weighted growth records: PG, JNJ, TJX, KO and COST. But remember, stock-picking requires scale. (Academic studies have shown that a buy-and-hold stock-picker needs 20 stocks to have a reasonable chance of losing less than the S&P 500 Index in a bear market but still manage to track that index in a bull market.) 

Bottom Line: If you want to shy away from owning Treasuries while the Federal Reserve is driving yields lower than the rate of inflation, you’ll be better served by owning bond-like stocks than a high-yield bond fund. Trouble is, most investors have already made that switch so you’ll have to be selective as well as patient. Start by setting up DRIPs in “hedge stocks” that have been gaining on their competition. Then employ “dollar-cost averaging” by having the same amount withdrawn from your checking account each month for each DRIP.

Risk Rating: 5.

Full Disclosure: Each month, I electronically dollar-average into DRIPs for WMT, NEE, JNJ, IBM, and PG.

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