Week 112 - Net-Net-Net Investing Revisited

Situation: The S&P 500 Index has recovered from the Lehman Panic, and now relies for its value on the assumption that GDP will soon be growing at 3%/yr. A lot of “ifs” are involved, mainly from the fact that almost 50% of revenues for S&P 500 companies are being earned outside the US. From here on, it’s going to be more difficult to make money from stocks, net of costs, net of inflation, and net of taxes. That’s what we all are after, right? You don’t like the roller coaster (years of double-digit returns followed by years of double-digit losses) or you wouldn’t be reading this blog. And you think this bull (market) is on its last legs, don’t you? (Even though reasoned analysis says otherwise: read this link). Nonetheless, there is a 50:50 chance that the stock market will undergo a correction in the next few months. So this is a good time to revisit the issue of net-net-net investing. Is there a way to come out ahead, that is, to make a nice profit after transaction costs, inflation, and taxes most years and only lose a little in the other years? Academic studies suggest that’s hard to do: you’re an above-average investor if you make 0.5% profit/yr over an extended period. So let’s consider the options.

At the top of this week’s Table we have 10 stocks that have beaten the Vanguard Balanced Index Fund for the last 13 yrs, while maintaining low 5-yr Betas, high dividend growth rates, and strong recent returns. However, as a group those stocks still lost 3.6% during the 18 month period of the Lehman Panic starting late in 2007 and ending in the spring of 2009 (Column D, Table). Coca-Cola (KO), for example, lost almost 16%. All 10 stocks have lost money for their investors during one or more years over the past 13 (Column K, Table). Berkshire Hathaway B shares lost money for 5 of those 13 years (and 28.8% during the Lehman Panic), while arguably being the best hedge fund available to retail investors (see Week 101). In other words, even the most conservative stocks still give their shareholders a roller-coaster ride. Just a less bumpy one. Those who can hold on will do well, but what about those who have just retired and need to cash out some of their stock portfolio?

Can bonds give stable returns? Well, yes. Those who make their living in finance know enough to mainly invest in bonds for that very reason. They also know to buy individual bonds in face amounts of at least $25,000 to reduce transaction costs, then hold those bonds to maturity--at which point they’re almost certain to get their $25,000 back. Bond mutual funds are a different animal, very different. Why? Because bond mutual funds fluctuate in value depending on inflation/deflation expectations, interest rates, the risk of default, and economic crises. Buying a bond and holding it to maturity negates those concerns, especially if its an inflation-protected bond (e.g., you might recover $30,000 at maturity instead of $25,000).

Nonetheless, there is one short-intermediate term investment-grade bond index fund that appears worthwhile, the Vanguard Intermediate-term Bond Index Fund (VBIIX). It is invested in US Government bonds, US corporate bonds, and international bonds, with maturities ranging from 5 to 10 yrs (Table). Its strengths lie in high credit quality, being globally all-inclusive, and having a prudent risk cut-off point (10 yrs). But there will be occasional years when even VBIIX loses money. It lost 2.9% in 1999 but hasn’t had a down year since, which makes it a top candidate for net-net-net investing.

Sometimes there are years when both bonds and stocks lose money. It’s called stagflation and last occurred in the early 90s. For example, the managed balanced fund we like, Vanguard Wellesley Income Fund (VWINX) which is 60% bonds and 40% stocks, lost 4% in 1994. The managed bond fund we like, T Rowe Price New Income Fund (PRCIX), lost 1.9% that same year. And, you need to be aware that both funds lost money in 2008 (Column K, Table).

If you own a bond and hold it to maturity, you can’t lose money on that investment. But, how much buying power has that $25,000 lost over 10 yrs? That leads us into a discussion of the “zero-risk” investment. This investment is focused on the purchase of inflation-protected 10-yr US Treasury Notes that are held to maturity. You can go into treasurydirect and buy US Treasury Notes in multiples of $100 in less than a minute (if you’ve already registered your computer and checking account) at zero cost. Most maturities come with an inflation-protected version. That means the US Treasury automatically increases your principal to reflect up-revisions of the CPI (Consumer Price Index). Your principal is not decreased in the event of a down-revision in CPI, i.e., in a period of deflation. You also receive a fixed interest payment every May and November. The up-revisions to your principal, and the payments of interest, are taxed. You’ll be out 25-30% of those gains but that represents your only reduction in cash flow. Note that when your principal is returned to your checking account after 10 yrs of being used by the government, its buying power is guaranteed to be the same as 10 yrs earlier. Because of interest payments, you’ll realize a gain (profit) every year, one that is net of transaction costs (zero), net of inflation (compensated), and net of 25-30% the government takes back in taxes. What’s the trick? Well, there are two: 1) you need to hold the Notes to maturity because interest-rate fluctuations in the overall bond market influence the day-to-day market value of any bond; 2) you’ll need to employ dollar-cost averaging by making regular quarterly purchases, since the fixed rate of interest on each Inflation-Protected Treasury Note will vary because it has to be set at a level that will allow the Note to attract sufficient buyers.

An alternative method is to buy Inflation-protected US Savings Bonds (ISBs) on a regular basis. However, these are only available in limited amounts, $6000/yr, and are based on Treasury Notes with 5-7 yr maturities (so their fixed interest rate is less than that for Inflation-protected 10-yr Notes). Interest payments are also less than for a 5-7 yr Note because of the built-in tax-advantage: Savings Bonds aren’t taxed until cashed out.  Another alternative is to invest in the mutual fund (VIPSX in the Table) that invests in Inflation-protected Treasury Notes & corporate bonds with maturities of 7-20 yrs. That fund started on June 29, 2000, so total returns/yr (Column C of our Table) date to then to show valid comparisons between inflation-protected securities and other investments. Red highlighted values denote under-performance vs. VBINX.

Bottom Line: There is one way to make a profit, every year, from investing: regular online purchases (using a fixed amount of dollars) of Inflation-protected 10-yr US Treasury Notes. If you are starting young, it is best to hold those in a self-directed Roth IRA (to eliminate taxes). What’s the catch? You won’t make much money this way but the key here is that you won’t be losing money either. It is the antithesis of gambling.

Risk Rating: 1

Full Disclosure: I invest quarterly in 10-yr Inflation-Protected US Treasury Notes, and monthly in DRIPs for half the stocks at the top of the Table: WMT, NEE, ABT, JNJ, and KO.

News Flash: Nobody makes much money from investing unless her day job is finance-related or she’s had decades of experience combined with careful study of the markets AND international business trends. (Otherwise everybody would do it.) Even then, there’s a “fly in the ointment” which is the time you take away from your family and friends, and lost opportunities for recreation and exercise. Time is money, so in the end you have to ask yourself: Have I been running a cost center or a profit center? But even if you decide it’s been a cost center, you’ll have had a very interesting avocation.

Note: earlier discussions of this topic occurred at Week 28 and Week 44.

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

Week 111 - Information Tech & Communication Services Stocks with Dividend Growth

Situation: When a country is digging itself out of recession, industries recover in a predictable pattern. Corporations start spending more on capital equipment upgrades (infrastructure, computers, software, ships, planes, locomotives, rail cars, pipelines) while avoiding new hires as long as possible. Then new hiring takes place followed almost immediately by an uptick in consumer discretionary spending (autos, housing, appliances, restaurants, etc.). Since the economic future appears brighter to the consumer (ie., workers), much of this spending is financed by credit, allowing interest rates to rise and banks to recover. The increased profits that start with “consumer discretionary spending” finally affect the financial, communication services, and information technology industries. Those industries suffered the most during the recession but now start to exhibit strong growth that eclipses defensive industries like healthcare, utilities, and consumer staples, including food.

Painful as it is, investors need to dollar-average some money into technology stocks throughout the recession and recovery periods. This is best done with a balanced index fund where 40% exposure to bonds hedges the volatility of such growth stocks (see VBINX in the Table). For you investors who want to try your stock-picking skills on growth companies, look for those that not only pay dividends but those whose managers try to hold onto long-term investors by growing dividends even during recessions. That’s a unique feature of American capitalism. (In other countries, dividends are paid in proportion to Free Cash Flow). There aren’t very many technology companies with such a record of relative stability, and a lot of those are small or medium-sized companies that have carved out a niche based on patents: only 9 of the 19 companies in the Table are in the S&P 500 Index.

For this week’s blog, we’ve looked at computer technology companies that have managed to increase their dividend annually for the last 10 or more yrs. Verizon Communications and Accenture have been added because those are large information technology companies that are within 3 yrs of being counted among such “Dividend Achievers.” That is Standard & Poor’s name for companies that have increased dividends annually for the past 10 or more yrs. There are 201 such companies; the full list can be found at the website for the Exchange-Traded Fund (PFM) that owns a capitalization-weighted amount of shares in all 201 stocks. For companies that perform less well than VBINX on a particular metric, we’ve highlighted that metric in red. Since we’re confining our attention to companies in the most competitive of industries, there are many red highlights. Nonetheless, we find 4 companies that are:

   a) large enough to be in the S&P 500 Index, and
   b) perform about as well or better than VBINX on a long-term, risk-adjusted basis (Column E).

Those 4 are: International Business Machines (IBM), Accenture (ACN), Automatic Data Processing (ADP), and Verizon Communications (VZ). To evaluate recent finance value, we look to the Barron’s 500 table published each year in May, where companies are ranked with respect to cash flow and sales trends over the most recent 1 & 3 yr periods. We’re particularly interested in companies that improved their 2012 rank over their 2011 rank (Columns J & K). Accenture (ACN) and Verizon Communications (VZ) are among those, and therefore have both long-term and recent Finance Value. You’ll need to dig deeper before deciding whether or not you’d like to start a dividend reinvestment plan (DRIP) in either company.

Bottom Line: Stock-picking is hardest for computer technology companies, but those companies are central to the Information Revolution that has eclipsed the Industrial Revolution. Trouble is, information technology changes so rapidly that even the strongest companies can fall by the wayside. But the biggest of them usually recover to some extent, since their core technologies are both patented and essential to industry-wide standards that underpin the Information Revolution. Nonetheless, their investors can become disappointed for long periods, and will often decide to sell at a loss rather than support a charity. The good news is that companies recognize these concerns and have developed dividend policies that are more shareholder friendly. Intel (INTC) and Microsoft (MSFT) are instructive examples; International Business Machines (IBM) also stumbled but then moved quickly to redirect its business plan to one that supports stable growth. 

Risk Rating: 8

Full Disclosure: I have stock in IBM, INTC, ACN, and MSFT.

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

Week 110 - Capitalization-weighted Index of 20 Leading Food Producers

Situation: In our blog for Week 100, we studied the overall food and beverage industry, noting that it is fragmented but remarkably profitable. For investors, the problem is to find out which companies can remain efficient at cost & debt control while having a sustainable business plan.

So we’ve drilled down on producers around the world and come up with 20 companies (Table), by evaluating long-term Finance Value (Col E in Table) and recent trends in cash-flow and sales. The list includes 3 seed producers (MON, DD, SYT), fertilizer producers (POT, AGU, MOS), one agricultural products wholesaler (ADM), two soft-drink companies (PEP, KO), and 11 producers of packaged foods and meats (MDLZ, CAG, CPB, HRL, K, GIS, SJM, HSY, TSN, NSRGY, DANOY). When 10-yr total returns (Col C in the Table) are compared to the market capitalization of these companies (Col L), we see that stock performance (Col C) times capitalization weight (Col M) gives an overall 10-yr total return of 11.9%% (Col N). This is significantly different from the average return of 14.2% (Col C), indicating that outperformance by smaller companies is distorting the average performance (which is a finding with almost all industries). Interestingly, 4 of the top 6 companies (performance X capitalization) are based outside the US: Potash (POT), Nestle (NSRGY), Syngenta (SYT), and Danone (DANOY); Coca-Cola (KO) and Monsanto (MON) are the US-based companies.

Bottom Line: The problem US investors have picking food stocks is that many of the best companies are foreign, with Nestle being the most familiar name. Buying stock in a foreign company is challenging, since currency fluctuations can have a remarkable influence on the dollar-denominated conversion value of the stock, particularly for companies like Syngenta and Nestle that are based in Switzerland.  

News Flash:  Commodity investing is a global game. You're a player to the extent that such companies in your portfolio are either based outside the US, or get most of their sales there.

Risk Rating: 7

Full Disclosure: I have stock in KO, POT, GIS, DD, and HRL.

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

Week 109 - Women need to plan for retirement differently than men

Situation: Gee, are we stating the obvious? The average man depends on Social Security to anchor his retirement, whereas, women have to rely more on savings because their Social Security checks are smaller. Why? Women leave the workforce from time to time, as caregivers for children and/or parents. And the reality that continues to plague women is that even when working full-time, they will be paid less money than a man with the same skills doing the same job. Why? Because her employer will consciously or subconsciously handicap the risk that she will resign (or take a leave of absence) to become a caregiver, or relocate when her husband takes a better job. According to published studies, her former employer will hire a new employee who has no more than a 50:50 chance of replacing the lost effort and ability of the woman who left, even after a one-year training period.

In practical terms for a retirement portfolio, what does this mean? Lower earnings + fewer earning years = a smaller Social Security check. Now let’s compound this with the additional complexity women face, with greater uncertainty than men due to living a longer life. Is her husband’s life insurance policy going to be adequate? Has he written a suitable will? Will she stay married to him and benefit from the larger Social Security check that married couples receive? Perhaps she is unmarried but living with a man and raising their children. In that circumstance, she faces an almost palpable risk of future destitution.

We’ve noticed some differences in long-term saving styles between men and women. Men tend to invest with the idea that they’ll be able to make a profit--even after transaction costs and losses to inflation and taxes! This is a challenging goal (see Week 28), even for those with a finance-related degree who devote most weekends and evenings to the project. Women have an uncanny knack for knowing that is a foolish idea and instead seek to “maintain what I’ve obtained." Women will work hard to save money then put it where it won’t lose value. When women think about putting money in the stock market, they prefer stock in companies they know something about, or have a comfort level with. Peter Lynch, who managed Fidelity’s Magellan Fund in the 70s and 80s, used to quip that his wife was his best financial advisor. People thought he was joking, so he took to pointing out her good picks and why she had made them. Her recommendations were based on her experience as the family shopper, and her general view of business activity around Boston. Peter Lynch, and Warren Buffett, are the only known big investors who have consistently beaten the S&P 500 Index for decades. Peter did it for 22 consecutive years; Warren has done it for rolling 5-year periods since 1975. Academic studies also identify a gender difference in stock-picking, with women being more risk averse than men and perhaps better at predicting how a company’s retail products will play out in the market.

In addition, women have different needs for money than men and have more trouble finding investment advisers who will help them meet those needs. The financial services industry is still a men’s club, and not many of those guys have learned how to engage in genuine level communication when advising a woman. In addition, men are usually trying to “solve” different life problems than women. Women tend to be focused more on quality of life, meeting the needs of children, and family issues. It is the rare husband who will invest money left over from his wife’s salary in a manner that will be useful to her when she is a retiree, and perhaps even a widow (aside from buying life insurance and jewelry). He is usually interested in adding her savings to his pool of often risky investments, even if he’s investing in “her” IRA. Over time, a woman with a good job will learn to develop her own savings plan, and will increasingly take personal responsibility for that plan, instead of paying an investment advisor. The internet has made all that much easier (thankfully).

For those women who manage to become an aggressive (and probably secretive) saver, there are a number of ways that her retirement savings can be eroded. There are those “one-off” expenditures; there are children starting out in life, there's her own health care or housing needs, etc., that have a way of popping up unexpectedly. Stocks cannot be counted on to help in a crisis, since those crises (e.g. unemployment) usually happen when the stock market is down. We have to remind ourselves that stocks need to be sold no less than 3 yrs in advance of any known need. Those proceeds have to be put in a savings account, or US Treasury Bills and 2-yr Notes (treasurydirect) until needed. The reason for this is that those are the only zero-cost investments that are guaranteed to a) give back your original investment, and b) pay interest that reflects inflation to some degree.

What else is available to help a “female head of household” have some financial security? What about other investments? Income earned from the principle of an investment-grade bond fund is secure but not the principal itself, because inflation will erode her ability to recover the value of her initial investment on short notice (just as a recession will increase its value). Jewelry can be hoarded for a rainy day but she can only sell it back for approximately half of its original cost. Real estate is a reliable savings vehicle only if it pays rent (or imputed rent if she lives in the property). But a house or apartment can be problematic to sell on short notice. Remember, the time when you need money the most is, unfortunately, the same time when the real estate market is likely to be down. How about our friend gold? Gold fluctuates even more widely in value than real estate and pays no rent, nor can you live there.

Bottom Line: What women really need is a Rainy Day Fund (see Week 33) composed of DRIPs in the best Lifeboat Stocks (Table), low-cost mutual funds that hedge against stock market risk (VWINX, VBINX, BRK-B), and a large helping of Treasury Bills/Savings Bonds (treasurydirect), plus an FDIC-insured savings account (and/or CDs) at her local bank. We also strongly urge women who have limited revenue available for investing to read our blog called “Retirement on a Shoestring” (see Week 14 and Week 15).

Risk Rating: 3.

Full Disclosure: I am a male in the financial services industry. I make monthly additions to DRIPs in 5 of the 10 Lifeboat Stocks (see Week 106) that are listed in this week’s Table: NEE, ABT, WMT, JNJ and KO.

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