Week 114 - Mid-2013 Master List

Situation: Every investor needs a short list of carefully-screened stocks to kick-start her own research. We try to do that by revising our ITR Master List quarterly (see Week 92 for discussion). The problem is the competition that we stockpickers face: well-hedged mutual funds like Vanguard Wellesley Income (VWINX) and BlackRock Global Allocation A (MDLOX), ETFs like Vanguard Consumer Staples (VDC), conglomerates like Berkshire Hathaway (BRK-B), and large corporations that get most of their revenues from diverse international markets, like 3M (MMM), Exxon Mobil (XOM), Procter & Gamble (PG), Coca-Cola (KO), Johnson & Johnson (JNJ), and McDonald’s (MCD). All of these have done as well or better than the S&P 500 Index: Let’s look at 9-yr Total Returns/yr since the same point in the last bull market (i.e., Aug, 2004), compared to the lowest-cost S&P 500 Index fund--the Vanguard 500 Index (VFINX) which has returned 7.4% through 8/13/2013):
        VWINX: 7.4%
        MDLOX: 8.5%
        VDC: 10.8%
        BRK-B: 8.4%
        MMM: 7.5%
        MCD: 19.3%
        XOM: 10.4%
        PG: 7.4%
        KO: 9.8%
        JNJ: 8.8%
All of the above stocks have their ups and downs but you’re not going to lose money by owning shares in any of them over an extended period of time. By equal-weighting your initial investment in all 10 stocks and then practicing dollar-cost averaging, you’re likely to succeed at net-net-net investing (turning a profit after transactions costs, inflation, and taxes, see Week 28 and Week 112) over the next 10 yrs. I’m not alone in this opinion. For example, Warren Buffett has sold several derivative contracts that pay if the S&P 500 Index doesn’t exceed ~1100 (it’s already ~1700) on a fixed date between 2019 and 2028. In the meantime, he collects big premiums on the contracts. But if he loses the bet, Berkshire Hathaway has to pay billions of dollars to the counterparties. (These are amounts that exceed the interim premium payments over 5-fold.) He thinks the main risk of loss has to do with nuclear war.

So where does that leave our new screen for ITR Master List stocks? Well, some of the above names keep popping up: Coca-Cola, McDonald’s, and Johnson & Johnson. To stay ahead of the game, we recently altered our approach, and the screen no longer excludes companies that have a dividend yield less than the Vanguard 500 Index Fund (VFINX). Why? Because dividends reduce free cash flow (FCF), which is free money that can be used to grow the company. The only alternative way for a company to expand is to issue more stocks and/or bonds, which is not only expensive but also lowers the stock price and can handicap innovation. Looking at the 18 stocks in the Table, you’ll see that 9 currently have a lower dividend yield than VFINX. Nonetheless, 15 are what S&P calls Dividend Achievers because they’ve increased dividends annually for the last 10 or more yrs. The exceptions are Costco Wholesale (COST), CVS Caremark (CVX), and AmerisourceBergen (ABC), all 3 of which are within 2 yrs of being designated Dividend Achievers.

To screen, we started with the Barron’s 500 table, where companies are ranked on the basis of recent growth in sales and cash flow. Then we excluded any company with a 3-yr Beta greater than the 3-yr Beta for Vanguard Balanced Index Fund (VBINX), which is 0.88, AND any that lost more than the 28% that VBINX lost during the Lehman Panic (10/07-4/09). We also excluded companies that couldn’t match or exceed VBINX in terms of Total Return/yr since 9/1/00 (the low point in the previous market cycle), AND over the past 5 yrs. Finally, companies that are mainly funded by loans and companies that have less than an A- rating from S&P were excluded. Of the remaining 18 companies, 12 (Table) are from one of the 4 “defensive” industries (see Table). Defensive industries are considered to be consumer staples, healthcare, utilities and communication services because their products have low elasticity (i.e., people pay up for their products even when the economy sucks). Therefore, those 12 defensive stocks, which were picked up by our screen, are what we like to call Lifeboat Stocks (see Week 106): WMT, UGI, HRL, GIS, SO, NEE, ABT, SJM, JNJ, ABC, CVS, KO. The 6 companies from non-defensive industries include 5 “consumer discretionary” companies: ROST, FDO, MCD, TJX, COST and one “materials” company (SHW). Four non-defensive industries have no representation in our ITR Master List, and those are: Energy, Industrials, Financials, and Information Technology. Why is that? Risk! All are latecomers to the party when the economy begins to emerge from recession, and their stocks tend to fall the furthest in value during the recession. It’s those industries that make you shy away from investing in an S&P 500 Index fund like VFINX. In other words, your natural instinct is to leave the party just as the punch is getting spiked.

Bottom Line: Our ITR Master List cues you to buy stock in companies that help build retirement savings without ruining your sleep. Coca-Cola (KO) is the most nervous-making company on our Mid-2013 ITR Master List. We know you can live at peace owning KO stock because Warren Buffett tells you so almost every time he’s on TV. All of the companies on the list are well-valued by investors so you need to set up a dividend reinvestment plan (DRIP) for each one you select. Why? They’re expensive now because future earnings have already been discounted in their share price. That means you’ll want to start with a small investment and keep adding that same amount on a regular basis, e.g. by setting up a DRIP with automated monthly withdrawals from your checking account. The advantage is that you’ll get to buy more shares using the same number of dollars when the price inevitably falls.  

Risk Rating: 4

Full Disclosure: I make monthly automatic additions to DRIPs in WMT, NEE, ABT, JNJ, and KO.

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