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