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