Week 108 - Vanguard Balanced Index Fund vs. 19 Stocks with Top-tier Finance Value

Situation: Our ITR blog strives to find a happy medium between bond and stock investments. The problem is, however, that bonds around the world are priced relative to a US Treasury 10-yr Note--the so-called “zero-risk investment.” That Note has traditionally paid interest that is at least 1.5% more than the rate of inflation, as measured by the US Consumer Price Index (CPI). That inflation rate has been 2.4%/yr over the past 30 yrs. When we buy a $1,000 10-yr Treasury Note, we expect to have ~$20 of interest fall into our checking account twice a year (in May and November). But for those of us who have purchased such a Note recently, between 4/2011 to 4/2013, it would only have paid ~$10 every 6 months. During those two years, the CPI grew 1.8%/yr. That Note paid you 2% but you lost 1.8% to inflation, leaving you with a 0.2%/yr return after inflation. That’s a lot less than the historical and customary return.  For this reason, retirees have been led to opt for high-yield bond funds, such as USHYX (see the Table). However, those “junk bonds” have about the same risk/reward ratio as stocks.

The preferred investment strategy that we advocate for would have you put half your retirement savings in US Treasury Notes, US Savings Bonds, or an A-rated investment-grade bond fund like PRCIX (Table). But during this current period when “financial repression” (see Week 76) is being imposed on us by the US Federal Reserve, it makes more sense to find bond-like stocks. Those offer less risk than high-yield bond funds like USHYX but more reward than high-quality bond funds like PRCIX. 

On a reward-minus-risk basis (Column E in the Table), it is important to remember that a high-quality bond fund like PRCIX will always outperform a mutual fund that mixes stocks with bonds. Even the best such balanced fund (VWINX in the Table), which has less than 40% stocks, comes up short. Stocks are a gamble, plain and simple. 

Now let’s pause for a moment to explain ITR’s main objective, which is to help you use the internet to buy-and-hold individual stocks in dividend reinvestment plans (DRIPs), and US Treasury Notes and Savings Bonds. The internet has created efficiencies for investors by lowering costs and raising information. Market inefficiencies that create arbitrage opportunities are largely a thing of the past. On a risk-adjusted basis, it is simply impossible to legally beat the market. Here at ITR, we look for companies and industries offering historically good returns that are  backstopped by internal controls and business plans that reduce risk. The only rational alternative is to accept market risks but stick to index funds.  

Let’s start by setting up a new benchmark: The Vanguard Balanced Index Fund (VBINX, see Week 86) will replace the Vanguard 500 Index Fund (VFINX). Going into the Great Recession, many of us had almost half of our 401(k) retirement account tracking the S&P 500 Index. By April of 2009, we'd lost 46.5% of what we started with 10/2007 (cf. VFINX at bottom of Column D in the Table) whereas VBINX lost only 28%. VBINX has other advantages besides being 40% invested in high-quality bonds (Barclay’s US Aggregate Index) and 60% in stocks (US Total Market Index): It is a) run by a computer and b) rebalanced daily.

Over the past two market cycles, starting with its peak on 9/2000, VBINX has returned 4.6%/yr vs. 2.7%/yr for the lowest-cost S&P 500 Index fund (VFINX). Inflation grew 2.4%/yr, so VFINX shares purchased on 9/1/00 have returned 0.3%/yr for the past 12.8 yrs! Those who purchased VBINX shares instead realized a 2.2% return after inflation, which is the same as the historic rate of return for US Treasury Bonds.

We have found 19 stocks that do better than VBINX by all metrics listed in the Table, AND have shown strong recent performance in Barron’s 500 rankings. We use that list to exclude companies that have fallen in rank between 2011 and 2012, unless the company had a score of 200 or better in both years. On a capitalization-weighted basis, the 19 stocks had an average total return of 10.8%/yr over the past 13 yrs (Column O in Table). The top 5 were: NKE, TJX, JNJ, CVS and COST.

Bottom Line: The Vanguard Balanced Index Fund is the best overall proxy for “the market” -- as viewed by professional investors who hedge their stock exposure with bonds. High-quality bonds go up in value during a recession, so those need to be in every retirement portfolio. During periods of financial repression, i.e., when the US Federal Reserve drives down interest on bonds (to push money away from safety and toward risk), investors will migrate away from bonds and put more money in bond-like stocks. We’ve found 19 such stocks, as measured by long-term finance value (reward minus risk), and short-term finance value (year-over-year growth in sales and cash-flow per Barron’s 500 List). 

Risk Rating (for the aggregate of 19 stocks): 3

NOTE: These 19 stocks will remain in place as our highest-quality choices until next May, when a new Barron’s 500 List is published. In the meantime, we’ll blog on the 10 companies in this week’s Table that can be purchased directly online at low cost through 
computershare (WMT, UGI, SO, NEE, NKE, SJM, COST, CVS, KO, and HD). To set up one of those DRIPs for automatic monthly investment, there are initial charges of $5-20 and monthly charges of up to $2.50. But there are no monthly charges for the utility companies (UGI, SO, NEE). Dividend re-investment is free, except for NKE, COST, KO, and HD where the fee can be as much as $3.00. 

Full Disclosure: I use dollar-cost averaging (through computershare) to buy shares each month for DRIPs in JNJ, NEE, WMT, KO, ABT, and NKE.

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

Week 107 - Gambling vs. Charity: How to Tell the Difference

Situation: Whether you trade stocks actively or use a “buy and hold” strategy, you’ll need to know the pitfalls of your risk profile. If you go for stocks that have a strong record of rewarding investors, you need to know that many of those same stocks are favored by short sellers. At some point, many high-flyers fall in price, fast. Sure, if you hang on to them for 10 yrs you’ll still get a nice return. But if you have to sell into a bear market, the “shorts” will pick your shares up for cheap: You have gambled and lost. On the other hand, you may get sucked into buying financial or technology stocks that are impossible to analyze, decide to hang on to those in a bear market because you're a believer, then find that your returns can’t (and won’t) keep up with inflation: You have made a charitable contribution.

Let’s start with quantitative definitions for gambling and charity. Gambling would be buying stock that historically gives returns equal to or better than the strongest definition of a “business case,” which is that you’ll very likely double your money in 10 years even after adjusting for inflation. Looking at the past 10 years, that means a total return of 7.1%/yr to double your initial investment + 2.4%/yr for inflation = 9.5%/yr. Going to the Buyupside website to check out stocks composing the S&P 100 Index, we find that 50 satisfy that requirement. However, only 25 of those had losses during the 18-mo Lehman Panic period that were no more than 2/3rds as great as the loss of the lowest-cost S&P 500 Index fund (VFINX). Investing in any of the remaining 25 companies would therefore label you a gambler, unless you’re a stolid “buy and hold” investor. Some of the “blue-chips” in that high return/high risk category are AT&T (T), Walt Disney (DIS), UnitedHealth Group (UNH), United Technologies (UTX), Caterpillar (CAT) and Boeing (BA).

Charity is easier to define: that’s where 10-yr total returns were less than inflation (2.4%/yr). There are the 9 “charity cases” in the S&P 100 Index: 

Five are financial companies

American International Group (AIG)

Citigroup (C)

Bank of New York Mellon (BK)

Morgan Stanley (MS)

Bank of America (BAC)

Two are information technology companies 

Dell (DELL)

Intel (INTC)

One is an industrial company that gets most of its earnings from loans (GE)

One is a pharmaceutical company (LLY).

You are not interested in leaving money on the table for short sellers or charity cases. So what about the remaining 66 companies in the S&P 100 Index that don’t pose those risks? Some must have a “business case” for attracting investment, as well as a business plan that limits losses during a bear market. Let’s find those by confining our attention to companies that had 10-yr total returns of at least 9.5%/yr but lost no more than 2/3rds as much as VFINX during the Lehman Panic (i.e., lost 31% or less).There are 25 such companies. Owning those stocks makes business sense and isn’t a gamble. To determine which are likely to continue to prosper, we turn to the Barron’s 500 Table that analyzes recent sales and cash flow trends. Seventeen of those companies were either in the top 200 for both 2011 and 2012, or had a higher rank in 2012 than in 2011 (Table). Three of those 17 are on our list of Lifeboat Stocks (see Week 106): COST, ABT and SO. Two companies (NKE and IBM) are on our Core Holdings list (see Week 102).

Bottom Line: Excessive risk-taking amounts to gambling, since short-sellers stand ready to buy your volatile stocks when you give up and sell them cheap. Alternatively, you can “ride out the storm” and hold onto those stocks--provided you are very confident the company will recover lost sales. But for financial and technology stocks, you’re unlikely to ever have enough confidence in future revenues to make that judgment. Holding onto those stocks in a bear market can amount to charity. For example, Intel and General Electric are former high-flyers that haven’t kept up with inflation for the past 10 years! 

"The markets can remain irrational a lot longer than you and I can remain solvent” - A. Gary Schilling, 1993.

Risk Rating: 4

Full Disclosure: I dollar-average into DRIPs for IBM, ABT, and KO; I also have stock in Accenture and Berkshire Hathaway.

Week 106 - Lifeboat Stocks Revisited

Situation: Defensive stocks will become the anchor for your retirement savings. They’ll need to form at least a third of your stock portfolio going forward and more after you retire. Those companies are in the 4 defensive industries: communication services, utilities, healthcare, and consumer staples. Stocks issued by the best such companies are what we call Lifeboat Stocks (see Week 8, Week 23 and Week 50 for further discussion). 

For this week’s update, we’ll merge two databases: the 201 stock Dividend Achievers, which are those companies that have increased their dividend annually for the past 10 or more yrs; and the Barron’s 500 Table, which lists the 500 exchange-traded companies that scored highest on sales and cash flow growth for the most recent year (2012), comparing those scores to each company’s score for the previous year (2011). Previous criteria remain in place, such as the requirement that the stock be A-rated by S&P and the company’s bonds carry an S&P rating of BBB+ or better; losses during the Lehman Panic no more than 2/3rds as great as for the lowest cost S&P 500 Index fund (VFINX), and total returns greater than VFINX since a) the last inflation-corrected S&P 500 Index peak on 3/24/00, and b) over the past 5 yrs. Stocks also have to have a 5-yr Beta less than that for the S&P 500 Index (which is set at 1.00). We added two companies that have only increased dividends for 9 consecutive yrs: General Mills (GIS) and Costco Wholesale (COST).

We turn up 16 companies (Table), all of which have outperformed VFINX over the past 5 yrs. Ten companies maintained or increased their Barron’s 500 rank in 2012: Southern (SO), McKesson (MCK), General Mills (GIS), AmerisourceBergen (ABC), JM Smucker (SJM), Johnson & Johnson (JNJ), Coca-Cola (KO), Costco Wholesale (COST), Procter & Gamble (PG), and Kimberly-Clark (KMB). Of those, MCK, ABC, SJM, COST and KMB had Retained Earnings (RE) after paying dividends. In other words, those 5 companies can use some free, after-tax money to fund upcoming projects. Thirteen of the 16 meet our criteria for hedge stocks, so ownership of stock in any of those companies does not need to be backed up with an equivalent investment in US Treasuries or Savings Bonds (see Week 104). Those are the 13 that have a 5-yr Beta less than 0.65, which excludes MCK (0.84), ABC (0.75), and BDX (0.83).

Bottom Line: Retirement is draining if you have sleepless nights worrying about stocks. So opt for a heavy concentration of stock in companies from the four “defensive” industries, i.e., communications services, utilities, healthcare and consumer staples. We call the best of those Lifeboat Stocks and have come up with 16 for you to examine further. Johnson & Johnson (JNJ), Procter & Gamble (PG), and Coca-Cola (KO) are the hardy perennials here, but we find 5 others that look almost as good on our screens for both remote and recent Finance Value: Southern (SO), General Mills (GIS), JM Smucker (SJM), Costco Wholesale (COST) and Kimberly-Clark (KMB).  

Risk Rating: 3

Full Disclosure: I have stock in JNJ, PG, KO, and GIS.

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

Week 105 - Updating the Stock-picker’s Secret Fishing Hole

Situation: The term “stock-picker” generally refers to a longer term investor, someone who takes a long position in a company. Shorter term investors often take a short position by borrowing a stock and immediately selling it, thinking that its price is too high and it can be bought back later at a lower price. If you read this blog regularly, chances are good that you’re a long. Warren Buffett is a long. At the 2013 Annual Meeting of Berkshire Hathaway, he and Charlie Munger made it clear that they have never taken a short position and never will. This begs the question: "Where do you find the best stocks to own long-term?" 

In this blog, we try to highlight companies worth owning over the long term, companies that have finance value due to a business plan that their managers have perfected over time. Most such companies are in a boring business. People will drift away from you at a cocktail party if you talk about owning stock in companies with products such as toothpaste, electricity, plastics, and Tylenol. Where there is a grouping of many such companies, that would be what we call a “stock-picker’s secret fishing hole” - secret because it's too boring to talk about. Here at ITR, we think many such companies can be found in the Dow Jones Composite Index of 65 stocks (see Week 68). Those are picked by the WSJ’s managing editor for their sustainable earnings growth. Twenty are transportation companies, 15 are utilities, and the rest are “industrials” - the 30 companies composing the famous Dow Jones Industrial Average (DJIA). The 65-stock list typically has a turnover rate of less than 5%/yr: in the average year, two companies will be removed from the list (usually because of a merger) and replaced with two others.

Finance Value has to be estimated before you put money toward financing a company. We have a good metric for long-term Finance Value (reward minus risk with respect to total returns - see Column E of the Table where red highlights denote lower long-term Finance Value), and another good metric for recent Finance Value (increasing sales and cash-flow growth for the past 1-3 yrs as determined from the Barron’s 500 List). A company’s 2012 rank on the Barron’s 500 List is noted in Column F of the Table and compared to the 2011 rank in Column G. If the rank is lower in 2012 than in 2011, we red-highlight the 2012 rank and consider the company to have a recent Finance Value that is trending lower. 

We find that 10 of the 65 companies earn high marks by both measures, and list those at the top of the Table. In the next 3 sections of the Table, we break out data for “industrials”, transports and utilities. As expected, several of the 10 top companies are rarely mentioned in the financial press. These are companies such as Consolidated Edison (ED) among the utilities, and JB Hunt Transportation Services (JBHT) among the transports. JBHT has been so rewarding to its investors for so long that you have to wonder what business news editors are thinking when they avoid publishing news about JBHT. They’d probably defend themselves by saying something like this: “Trucking is a fragmented, high-revenue, high-cost industry with a low profit margin. So why write articles about such a boring group of small companies.” Here at ITR, we’ll answer that by saying: “All money is green. Any company that consistently makes a lot of it is worth your readers’ attention.” 

Bottom Line: Today’s blog simply puts a fine point on one of Warren Buffett’s investing tricks: find established companies that have carved a moat around a business by making mundane things happen better than their competitors.

Risk Rating: 5

Full disclosure: I have stock in JNJ and KO.

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