Situation: We’re not out of the woods yet. The Lehman Panic (2008) reached into every corner of the world. The Chairman of the Federal Reserve (Ben Bernanke) immediately recognized it to be an existential threat on the scale of the Great Depression. Being a lifelong student of that event, he knew our government would have to mobilize extensive fiscal and monetary resources quickly to prevent a deflation that was already underway. Otherwise, we'd be in the same predicament as Japan by having an interminable recession. Economic activity of all kinds decreases during deflation, since people soon come to realize that whatever they want to buy now will be cheaper if they wait until next year.
Much of our economy remains at risk. For example, check out Wal-Mart’s most recent earnings report. Remember, to overcome the Great Depression it took the $4 Trillion dollars of spending required to finance World War II ($53 Trillion in today’s dollars). And it wasn’t finished until returning soldiers had completed their college educations under the GI Bill, and the Interstate Highway System had been built.
Treasury Secretary Paulson, when faced with the Lehman Panic, had little difficulty explaining the problem and its remedy to President George W. Bush (who has an MBA from Harvard). President Bush summed up the problem for reporters with what Warren Buffett has called the most important 10 words in economic history: “If money isn’t loosened up, this sucker could go down.” Congress and the Federal Reserve mobilized more than a Trillion dollars a year to turn the economy around, and similar undertakings were soon adopted by China and Great Britain (but only later by Europe). All of the world’s major economies are still shaky, and will remain dependent on cheap credit for years to come. That cheap credit will arrive courtesy of central banks, acting in concert (see Week 76 and Week 79).
Our new Chairman of the Federal Reserve Board, Janet Yellen, has made it clear that she will not tolerate even a whiff of deflation on her watch. Her barometer for recovery is the unemployment rate, which is hard to bring down because too many companies were forced to introduce too much automation. Why? To bring costs in line with falling revenues after the Lehman Panic.
Deflation is about the downward spiral of prices. In this case too few dollars are chasing too many goods and services, which is the opposite of inflation where too many dollars chase too few goods and services. But why are there too few dollars? After all, the Federal Reserve is doing all it can to flood the banking system with dollars. Unfortunately, banks choose to leave most of that money earning interest at the Federal Reserve, funds classified as excess reserves. Bankers would like to loan that money at higher interest to “economically viable” customers, but those haven’t shown up in steadily increasing numbers. A year ago there was a sharp uptick in mortgage loans but that died down after interest rates began to climb in expectation that the Federal Reserve would soon taper QE-3, the policy of buying $85 Billion of government bonds every month in order to force interest rates lower.
Why are unemployment rates so high in so many countries? Well, its because there aren’t enough employed people to spend money, so goods and services have to be marked down in price. That, in turn, discourages companies from hiring new workers to produce more goods and services. Now you understand why government spending (and hiring) is needed to “jump start” the economy (so-called Keynesian Economics). However, when governments are heavily indebted (and becoming more so due to the falloff in revenues) that tool cannot be applied with the necessary force.
Looking at the bigger picture, there are two answers to the question of “when does it end?” Both have to do with the confidence employers have in the future of their local economy. One is that the global credit bubble has only been deflated in the US and Great Britain. But Europe, along with China and most other developing economies, continue to struggle trying to put in place the kind of regulation and transparency that has worked so far for the US and Britain. This includes insured savings accounts, credible and publicized “stress tests” for every bank, elimination of “off balance sheet entities” in the corporate sphere, and privatization of “state owned entities” in the government sphere. Some countries (like Argentina) are past the point where those changes could turn things around, so currency and import controls become inevitable along with devaluation of the currency. Remember: it is only reasonable to use credit if the rate of return on your assets exceeds the interest rate on the money you owe. Otherwise, the fraction of your income that is used to service debt will increase relentlessly, and eventually cause bankruptcy. For a company, that means its free cash flow won’t provide enough dollars to allow it to capture opportunities by expanding. For a government, that means there won’t be money left over to expand educational opportunities and upgrade the transportation network enough to meet the needs and expectations of a growing population. Conclusion: per capita debt has to start falling before the lingering recession can be brought to an end.
But an even larger problem is that civil unrest occurs when a country can’t or won’t provide a future vision for its citizens, and take concrete steps in that direction. When a government finds itself facing large general strikes (e.g. Greece, Spain and Cyprus in the past few years), or starts warring on its citizens (e.g. several Middle Eastern countries even more recently), stock markets around the world tend to suffer. Why is that? Because the ability of a government to service its debt is critically dependent on the day-to-day functioning of its economy (people going to work and paying taxes). That debt is held by banks, sovereign wealth funds, and hedge funds around the world. They count on receiving regular interest payments, and especially the return of their principal when the loan comes due. When private corporations make loans to governments that repay less than the full amount, as Greece has done recently, the next time a heavily indebted government has to borrow money it may face creditors who demand a rate of interest that is somewhat higher than that country’s nominal GDP (i.e., its Return on Assets). That spreading effect is called "contagion." It affects the wealth of the International Monetary Fund (funded mainly by the US) and money center banks everywhere. Almost every drop in the US stock market over the past 5 yrs has been due, in part, to economic paralysis or domestic unrest occurring somewhere outside the US. For details read Chapter 16 of "After the Music Stopped: the Financial Crisis, the Response, and the Work Ahead," by Alan S. Blinder (former Vice Chairman of the Federal Reserve Board), Penguin Books, 2013.
You will need a way of telling whether deflation or inflation is expected by the markets. Gold is a currency that can be substituted for fiat (paper) money during periods of economic crisis. The amount of gold in the world just manages to keep up with the growth in population, so its price cannot be inflated or deflated (except by speculation). The price of gold falls when economic storms pass, as well as when deflation occurs. On the other hand, the threat of inflation knocks down the price of Treasury Notes, whereas, deflation causes a sharp increase in their value (see Table). Over the past two yrs, the price of gold has fallen ~25% because the economy has been steadily improving. Inflation, however, is so low (under 1%) that it creates a worry about deflation. But 10-yr Treasury Notes, instead of being more valuable are becoming less valuable. That is, their price is falling as interest rates rise. So, deflation is not an immediate worry but the Federal Reserve must continue to perform its high-wire balancing act.
Bottom Line: Deflation risk will haunt the world’s economies for as long as it takes those economies to stop growing their per capita debt. But I doubt if deflation will quite happen. Why? Because central banks are learning to “print money” in whatever amounts necessary to keep excess reserves high and interest rates low. Look at Japan, for example, where recent monetary policy changes have dovetailed with fiscal policy changes in an attempt to flood the economy with money to stop a grinding deflation that’s been going on for almost 20 yrs. And it just might work. (Japan has the advantage that almost all of its government debt is in the hand of its own citizens.) Underwater economies have to use those excess reserves and low interest rates to grow, which unfortunately amounts to taking money and investment opportunities from older people and offering those to better educated younger people. This will inevitably happen because the pain that politicians experience from trying to manage economies that are increasingly sluggish will otherwise only grow. Large and growing interest payments will eventually rein in government spending for the aged and infirm. Social safety nets may start to fray but jobs in the private economy will come to be prized over those in the shrinking public sector. That means taxes can be used to pay down debt, allowing governments more room to spend on growth: industrial policies designed to promote education, competition, and job growth in the private economy (which is, after all, the main source of government revenues).
Risk Rating: 5 (things could go either way).
Full Disclosure: I regularly buy inflation-protected US Treasury Notes but don’t invest in gold. In other words, I actively hedge against the risk of deflation but don’t hedge against the risk of hyperinflation--aside from being primarily invested in stocks (which respond somewhat to hyperinflation).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 30
Sunday, March 23
Week 142 - A “Starter” Hedge Fund
Situation: Every retirement website has to offer a generic plan, one that’s scalable and highlights its best ideas. Here at ITR, we stress the importance of gradually accumulating stock in companies that increase their dividend annually. Why? Because dividend-paying stocks historically grow wealth, whereas, investments in other asset classes result only in “forced savings” for the most part. In other words, after accounting for inflation, transaction costs, and taxes, you’re not earning much! Over the past 35 yrs, the S&P 500 Index has grown an average of 6.6%/yr but with dividends reinvested it has grown 9.9%/yr. Companies in the Index that increase their dividend annually do even better. We also stress the importance of owning some US Treasury Notes or Savings Bonds because those go up in value when stocks go down. Remember: You’ll probably need extra money when the economy’s in recession, and you certainly don’t want to sell your stocks then. Finally, we stress the basic concept behind a hedge fund, which is that you are most likely to prosper in the long run if you don’t lose money in the short run. In other words, maintain what you’ve obtained. That means paying close attention to the Finance Value of each asset you buy. Know its history of losses and deduct those from its history of gains.
This week’s Table lays out the least complex package we can devise to illustrate our ideas. It has fewer than 10 items so you can use it as a “starter” retirement plan. Red highlights denote underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX), which is a hedged version of the S&P 500 Index. We have stressed ownership of bond-like stocks, so Johnson & Johnson (JNJ), Procter & Gamble (PG), McDonald’s (MCD), and NextEra Energy (NEE) are good examples. But there are also growth stocks that sometimes offer investors good finance value while paying little or no dividend. Examples are The TJX Company (TJX), Nike (NKE), and Berkshire Hathaway (BRK-B). International Business Machines (IBM) has characteristics of both. While all of the companies have high Finance Value (Column E in the Table), two have a 5-yr Beta (Column I) that denotes more volatility than we like. So we offset the risk attached to each of those two (IBM and NKE) with an equal investment in Inflation-protected Savings Bonds (ISBs).
All but two of the stocks (TJX and BRK-B) can be purchased through dividend reinvestment plans (DRIPs) at computershare. To keep your investment costs low, you’ll need to purchase those just once a year by using an online stockbroker. That can be done for as little as $6.95/trade at TD-Ameritrade, Merrill Lynch Edge, or Capital One. Savings Bonds are zero-cost investments that can be purchased online at treasurydirect and carry the same tax advantages as an IRA. Column M in the Table lays out the transaction costs for each trade, and Column N shows the annual charges for investing $100/mo (or $1200/yr) in each item. If you invest $12,000/yr, your transaction costs will be $79.90, or an expense ratio of 0.67%.
Bottom Line: The idea is to invest small amounts regularly in fewer than 10 different assets where the risks are offset internally. That allows you to have an aggregate investment that is very attractive in terms of both recent and long term gains, as well as risk. Reinvest dividends while you’re still working. After you’ve retired, cash the dividend checks and add that money to your income.
Risk Rating: 3
Full Disclosure of current activity: I make monthly additions to DRIPs in NEE, IBM, JNJ, NKE, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
This week’s Table lays out the least complex package we can devise to illustrate our ideas. It has fewer than 10 items so you can use it as a “starter” retirement plan. Red highlights denote underperformance relative to our benchmark, the Vanguard Balanced Index Fund (VBINX), which is a hedged version of the S&P 500 Index. We have stressed ownership of bond-like stocks, so Johnson & Johnson (JNJ), Procter & Gamble (PG), McDonald’s (MCD), and NextEra Energy (NEE) are good examples. But there are also growth stocks that sometimes offer investors good finance value while paying little or no dividend. Examples are The TJX Company (TJX), Nike (NKE), and Berkshire Hathaway (BRK-B). International Business Machines (IBM) has characteristics of both. While all of the companies have high Finance Value (Column E in the Table), two have a 5-yr Beta (Column I) that denotes more volatility than we like. So we offset the risk attached to each of those two (IBM and NKE) with an equal investment in Inflation-protected Savings Bonds (ISBs).
All but two of the stocks (TJX and BRK-B) can be purchased through dividend reinvestment plans (DRIPs) at computershare. To keep your investment costs low, you’ll need to purchase those just once a year by using an online stockbroker. That can be done for as little as $6.95/trade at TD-Ameritrade, Merrill Lynch Edge, or Capital One. Savings Bonds are zero-cost investments that can be purchased online at treasurydirect and carry the same tax advantages as an IRA. Column M in the Table lays out the transaction costs for each trade, and Column N shows the annual charges for investing $100/mo (or $1200/yr) in each item. If you invest $12,000/yr, your transaction costs will be $79.90, or an expense ratio of 0.67%.
Bottom Line: The idea is to invest small amounts regularly in fewer than 10 different assets where the risks are offset internally. That allows you to have an aggregate investment that is very attractive in terms of both recent and long term gains, as well as risk. Reinvest dividends while you’re still working. After you’ve retired, cash the dividend checks and add that money to your income.
Risk Rating: 3
Full Disclosure of current activity: I make monthly additions to DRIPs in NEE, IBM, JNJ, NKE, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 16
Week 141 - An Update on Berkshire Hathaway
Situation: In a past blog (see Week 125), we characterized Berkshire Hathaway’s B shares (BRK-B, priced around $120/sh) as a “hedge fund for the masses” and we’re sticking to it. The reason we could make this designation is because there are two parts to the company that act to counterbalance each other in a way that maximizes returns and minimizes risks. Almost 2/3rds of the company is made up of more than 80 wholly-owned subsidiaries that are, for the most part, “low risk” enterprises. These include electric utilities, a railroad, a car insurer, a restaurant chain, and a trucking company. The remainder of Berkshire Hathaway is an investment portfolio holding stock in 42 companies that are, for the most part, “high risk” enterprises.
Many investors like to have the latest information on what Warren Buffett is up to, so we have summarized the major current holdings of Berkshire’s investment portfolio for you in the Table. Red highlights denote higher risk or lower performance vs. the benchmark we like to use, VBINX, which is a low-cost hedged S&P 500 Index fund.
How are the two parts of Berkshire Hathaway performing? For 2013, Berkshire Hathaway as a whole was up 27.4% in value vs. 28.9% for the lowest-cost S&P 500 Index fund, VFINX (see Column G in the Table), whereas, the average stock in the Berkshire Hathaway’s investment portfolio was up 31.7%. These results are as expected, given the overall robust performance of the stock market and the relative risk of Berkshire’s wholly-owned subsidiaries vs. its investment portfolio.
As of Dec 31, 2013, the value for all of Berkshire Hathaway was $294 Billion, with the investment portfolio representing $105 Billion. In other words, 36% of the company’s value is in marketable common stocks. Berkshire Hathaway is in the financial services industry, so it is not surprising that stock in such companies represents 43% of its investment portfolio. Wells Fargo (WFC) alone accounts for 20% of that portfolio and American Express (AXP) 13%. Every quarter, the Securities and Exchange Commission (SEC) requires large companies to submit an update of their investment holdings. We’ve perused Berkshire’s recently issued “13-F filing” for the 4th quarter of 2013, and summarized the results for company holdings that are larger than $0.5 Billion (in Table). Two companies were excluded because their stock was issued only recently: General Motors (GM) holdings worth $1.6 Billion, and Liberty Media (LMCA) holdings worth $0.78 Billion. When this filing is compared with the previous quarter’s, we see that Berkshire Hathaway has exited from positions in Dish Network and GlaxoSmithKline plc but has added a position in Liberty Global plc valued at $0.26 Billion. Warrants that Berkshire had been holding in Goldman Sachs (GS) have been converted to shares worth $2.2 Billion.
Taking a closer look at the investment portfolio (Table), we see only 3 financial services companies (WFC, AXP, USB) among the largest 10 holdings (denoted in the Table with green stock tickers in Column B). Not surprisingly, given Warren Buffett’s prowess as a stock picker, all 7 non-financial companies have finance values (Column E) higher than our benchmark’s (VBINX). Costco Wholesale (COST) is the only one in that high value group that isn’t in the Top 10 holdings, so it stands to reason that COST is a candidate for further accumulation.
BRK-B shares are priced around $120/Share, making those easy to accumulate by using a low-cost online brokerage such as TD-Ameritrade. And, it is a hedge stock by our definition (i.e., a stock that a hedge fund trader would be unlikely to bet against). Why? Because of characteristics that minimize its volatility enough to temper a hedge fund trader’s enthusiasm: a) it has outperformed the hedged S&P 500 Index (VBINX) since the market peak on 9/1/00 and over the most recent 5 yrs, as well as the past year; b) its losses during the Lehman Panic were limited (28.8%) while the S&P 500 Index fund lost 46.5% (see Column D in the Table); c) it has a 5-yr Beta of 0.29 (Column J) that is much less than the hedge fund industry average ranging from 0.6 to 0.7; d) it has a trailing P/E much less than the market’s (Column K); e) it has an AA S&P bond rating. Berkshire Hathaway falls down on only one criterion for discouraging a hedge fund trader. It doesn’t pay a dividend. Remember, traders bet against a stock by entering into a “short sale.” That involves borrowing and immediately selling a stock in the hope that it will fall in value, at which point it is bought back cheap and the shares returned to the original owner, pocketing the difference between what was earned on the sale and the cost for re-purchase. However, when the stock pays a dividend the trader (or the boss) has to reimburse the original owner in an amount equal to the value of each quarterly dividend over the holding period. That’s a nuisance, and a significant expense. Berkshire Hathaway doesn’t pay a dividend so its shares can be shorted without incurring that expense.
To summarize, it is very unlikely that the price of Berkshire Hathaway’s stock would ever be driven down more than 5% because of “short” sales. And, because it is so well managed, Berkshire doesn’t need to pay a dividend in order to gain the investors trust. That means all of its Free Cash Flow is being used to grow the company instead of some being diverted to pay dividends. There is also a tax advantage to waiving dividends: Shareholders are already being taxed at the 35% “corporate” rate, so why would they be happy being taxed again at the 15-20% “individual” rate on the same earnings in the form of dividends?
Bottom Line: The reader should feel comfortable buying BRK-B shares, knowing that her investment will have unusually low volatility while being representative of a broad swath of the market.
Risk Rating for BRK-B: 4
Full disclosure: I have stock in Berkshire Hathaway, and make monthly additions to dividend reinvestment plans for WMT, IBM, KO, XOM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Many investors like to have the latest information on what Warren Buffett is up to, so we have summarized the major current holdings of Berkshire’s investment portfolio for you in the Table. Red highlights denote higher risk or lower performance vs. the benchmark we like to use, VBINX, which is a low-cost hedged S&P 500 Index fund.
How are the two parts of Berkshire Hathaway performing? For 2013, Berkshire Hathaway as a whole was up 27.4% in value vs. 28.9% for the lowest-cost S&P 500 Index fund, VFINX (see Column G in the Table), whereas, the average stock in the Berkshire Hathaway’s investment portfolio was up 31.7%. These results are as expected, given the overall robust performance of the stock market and the relative risk of Berkshire’s wholly-owned subsidiaries vs. its investment portfolio.
As of Dec 31, 2013, the value for all of Berkshire Hathaway was $294 Billion, with the investment portfolio representing $105 Billion. In other words, 36% of the company’s value is in marketable common stocks. Berkshire Hathaway is in the financial services industry, so it is not surprising that stock in such companies represents 43% of its investment portfolio. Wells Fargo (WFC) alone accounts for 20% of that portfolio and American Express (AXP) 13%. Every quarter, the Securities and Exchange Commission (SEC) requires large companies to submit an update of their investment holdings. We’ve perused Berkshire’s recently issued “13-F filing” for the 4th quarter of 2013, and summarized the results for company holdings that are larger than $0.5 Billion (in Table). Two companies were excluded because their stock was issued only recently: General Motors (GM) holdings worth $1.6 Billion, and Liberty Media (LMCA) holdings worth $0.78 Billion. When this filing is compared with the previous quarter’s, we see that Berkshire Hathaway has exited from positions in Dish Network and GlaxoSmithKline plc but has added a position in Liberty Global plc valued at $0.26 Billion. Warrants that Berkshire had been holding in Goldman Sachs (GS) have been converted to shares worth $2.2 Billion.
Taking a closer look at the investment portfolio (Table), we see only 3 financial services companies (WFC, AXP, USB) among the largest 10 holdings (denoted in the Table with green stock tickers in Column B). Not surprisingly, given Warren Buffett’s prowess as a stock picker, all 7 non-financial companies have finance values (Column E) higher than our benchmark’s (VBINX). Costco Wholesale (COST) is the only one in that high value group that isn’t in the Top 10 holdings, so it stands to reason that COST is a candidate for further accumulation.
BRK-B shares are priced around $120/Share, making those easy to accumulate by using a low-cost online brokerage such as TD-Ameritrade. And, it is a hedge stock by our definition (i.e., a stock that a hedge fund trader would be unlikely to bet against). Why? Because of characteristics that minimize its volatility enough to temper a hedge fund trader’s enthusiasm: a) it has outperformed the hedged S&P 500 Index (VBINX) since the market peak on 9/1/00 and over the most recent 5 yrs, as well as the past year; b) its losses during the Lehman Panic were limited (28.8%) while the S&P 500 Index fund lost 46.5% (see Column D in the Table); c) it has a 5-yr Beta of 0.29 (Column J) that is much less than the hedge fund industry average ranging from 0.6 to 0.7; d) it has a trailing P/E much less than the market’s (Column K); e) it has an AA S&P bond rating. Berkshire Hathaway falls down on only one criterion for discouraging a hedge fund trader. It doesn’t pay a dividend. Remember, traders bet against a stock by entering into a “short sale.” That involves borrowing and immediately selling a stock in the hope that it will fall in value, at which point it is bought back cheap and the shares returned to the original owner, pocketing the difference between what was earned on the sale and the cost for re-purchase. However, when the stock pays a dividend the trader (or the boss) has to reimburse the original owner in an amount equal to the value of each quarterly dividend over the holding period. That’s a nuisance, and a significant expense. Berkshire Hathaway doesn’t pay a dividend so its shares can be shorted without incurring that expense.
To summarize, it is very unlikely that the price of Berkshire Hathaway’s stock would ever be driven down more than 5% because of “short” sales. And, because it is so well managed, Berkshire doesn’t need to pay a dividend in order to gain the investors trust. That means all of its Free Cash Flow is being used to grow the company instead of some being diverted to pay dividends. There is also a tax advantage to waiving dividends: Shareholders are already being taxed at the 35% “corporate” rate, so why would they be happy being taxed again at the 15-20% “individual” rate on the same earnings in the form of dividends?
Bottom Line: The reader should feel comfortable buying BRK-B shares, knowing that her investment will have unusually low volatility while being representative of a broad swath of the market.
Risk Rating for BRK-B: 4
Full disclosure: I have stock in Berkshire Hathaway, and make monthly additions to dividend reinvestment plans for WMT, IBM, KO, XOM, and PG.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 9
Week 140 - Build Your own Hedge Fund
Situation: You want to invest for retirement in such a way that your retirement income grows faster than inflation. The only way to do that is with stocks. But the only way you can be confident your retirement income will grow faster than inflation almost every year is to construct your portfolio as a hedge fund. That means you want your portfolio to lose a lot less than the stock market during downturns yet make almost as much during upturns. So, the risky stocks in your portfolio will have to be backed 1:1 with US Treasury Notes.
Let’s build a workable portfolio of stocks and US Treasury Notes, and keep it simple. You’ll want stocks issued by the 12 largest companies that are Dividend Achievers (see our Table). Four of those (CVX, XOM, UTX, MMM) have a 5-yr Beta that exceeds 0.67, meaning those stocks could be down a lot just when you start your retirement and, therefore, need to be backed by an equivalent investment in 10-yr US Treasury Notes. There are 4 entries for T-notes in the Table to account for that.
Then, we’ll need to see how much it will cost you to apply automatic “dollar-cost averaging” as the safest way to build your portfolio. Yes, you’ll over-pay some months but that will be balanced by the months you under-pay (it’s what statisticians call Reversion to the Mean). The only way you can do that with an income of ~$100,000/yr is to go online and put a small amount of money regularly (say $60/mo) in each of the 16 lines of investment in the Table, for a total of $960 per month. (If you make less money, decrease the lines of investment by half (to 8 from 16) for the first ten yrs, then invest in the other 8 over the next 10ears. $960/mo for the full portfolio sounds like a lot. But I’m sure you know by now that at least 10% of your gross income has to be set aside for retirement. Otherwise, you’ll be setting aside 20% after you reach age 55.
If you have a 401(k) or 403(b) plan through your employer, allot half to the available stock index and half to the available bond index. Then supplement those funds with parts of the portfolio in the Table that you’ve had your accountant declare to the Internal Revenue Service to be your IRA.
How much does the portfolio cost? Looking at Columns L-P in the Table, you’ll see that 2% of your yearly investment goes to expenses. Total returns over the past two market cycles (Column C in the Table) for this plan have come to ~8%/yr, which leaves an estimated 6%/yr gain if you’d been in the plan since 2000. However, your fixed costs (2% of each year’s expenditures) carry less weight with time because the value of the investment has more than doubled since 2000. In other words, the expense ratio for the plan drops to less than 1%/yr after you’ve been in the plan for more than 9 yrs.
What’s not to like? Well, you have to keep track of which 12 companies are the largest Dividend Achievers. You’ll probably need to add a company every 5-10 yrs, which means you’ll have to start a dividend reinvestment plan (DRIP) in that company and stop adding money to one of the existing DRIPs. You’ll also need to remember not to sell the DRIP you’ve dropped (no pun intended), unless that company fails to increase its dividend for two consecutive years. Another problem is that Treasury Notes purchased through treasurydirect don’t have automatic reinvestment of interest payments. But the Treasury website offers a couple of advantages over DRIPs: 1) There is an “inflation-protected” alternative to all of the standard offerings; 2) Savings Bonds offer total returns that approximate those for 7-10 yr Treasury Notes, and pay interest that is automatically reinvested (like a DRIP). More importantly, taxes are deferred on interest accruals until the Savings Bond is redeemed. In other words, Savings Bonds work like an IRA. You save money by not having to pay taxes until after you spend the money.
To simplify your life, cover each monthly investment in one of the riskier DRIPs by an equal investment in Inflation-protected Savings Bonds (ISBs) instead of 10-yr Treasury Notes. For example, the Table shows 4 such companies, stock investments which you'd like to hedge by putting $240/mo into an ISB. (But that becomes $250/mo because ISBs come in $25 gradations.) A final problem is that computershare only provides DRIPs for 11 of the 12 companies in our Table. If you choose to purchase 3M stock each month, you'll need to set up a DRIP through Wells Fargo.
OK, how do we know this portfolio will act as a hedge fund? If you’ll refer back to our Week 117 blog, you’ll see that a hedge fund is defined by hedge fund traders. It’s in the eye of the beholder. That means it is composed of assets that hedge fund traders are rarely tempted to bet against (or "short"); they’d rather own them. That means the portfolio ideally has to a) beat the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles, Column C), b) lose less than the 28% that VBINX lost during the 18-month Lehman Panic, c) have a 5-yr Beta that’s less than the 0.67 long-term average for the hedge fund industry, d) pay at least a 1.5% dividend, and e) have a trailing P/E no higher than 20. Now look at Line 18 in the Table to see that the portfolio we’re proposing exceeded those 5 requirements in every area except 5-yr Total Return (Column F). That small lag in performance during the unusually strong bull market of the past 5 yrs is more than made up for by outperformance in the safety areas (Columns D & I).
Bottom Line: If you go to the trouble to set up this portfolio, and have the discipline to stick with it through thick and thin for 10+ yrs, you’ll come out ~2%/yr ahead of simply investing in our benchmark, which is the hedged S&P 500 Index (VBINX in the Table). But it will take a couple of market cycles to reach that success because a) your expenses in the first few years will be too large a fraction of your net asset value, and b) the advantage gained over the benchmark by having all your stocks in a category that grows dividends much faster (see Column H in the Table) takes time to have an impact. But, from the outset you’ll be facing less volatility. The portfolio in the Table had average losses during the 18-month Lehman Panic of 11.3% vs. 28% for VBINX, and the current 5-yr Beta is 0.5 vs. 0.93 for VBINX.
Risk Rating: 2
Full Disclosure: I make automatic online monthly investments in WMT, NKE, JNJ, IBM, KO, XOM, and PG. I also own stock in MCD, CVX, PEP, UTX, and MMM. I hedge investments in XOM, CVX, UTX, and MMM with equal investments in 10-yr and 20-yr Inflation-protected US Treasury Notes.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Let’s build a workable portfolio of stocks and US Treasury Notes, and keep it simple. You’ll want stocks issued by the 12 largest companies that are Dividend Achievers (see our Table). Four of those (CVX, XOM, UTX, MMM) have a 5-yr Beta that exceeds 0.67, meaning those stocks could be down a lot just when you start your retirement and, therefore, need to be backed by an equivalent investment in 10-yr US Treasury Notes. There are 4 entries for T-notes in the Table to account for that.
Then, we’ll need to see how much it will cost you to apply automatic “dollar-cost averaging” as the safest way to build your portfolio. Yes, you’ll over-pay some months but that will be balanced by the months you under-pay (it’s what statisticians call Reversion to the Mean). The only way you can do that with an income of ~$100,000/yr is to go online and put a small amount of money regularly (say $60/mo) in each of the 16 lines of investment in the Table, for a total of $960 per month. (If you make less money, decrease the lines of investment by half (to 8 from 16) for the first ten yrs, then invest in the other 8 over the next 10ears. $960/mo for the full portfolio sounds like a lot. But I’m sure you know by now that at least 10% of your gross income has to be set aside for retirement. Otherwise, you’ll be setting aside 20% after you reach age 55.
If you have a 401(k) or 403(b) plan through your employer, allot half to the available stock index and half to the available bond index. Then supplement those funds with parts of the portfolio in the Table that you’ve had your accountant declare to the Internal Revenue Service to be your IRA.
How much does the portfolio cost? Looking at Columns L-P in the Table, you’ll see that 2% of your yearly investment goes to expenses. Total returns over the past two market cycles (Column C in the Table) for this plan have come to ~8%/yr, which leaves an estimated 6%/yr gain if you’d been in the plan since 2000. However, your fixed costs (2% of each year’s expenditures) carry less weight with time because the value of the investment has more than doubled since 2000. In other words, the expense ratio for the plan drops to less than 1%/yr after you’ve been in the plan for more than 9 yrs.
What’s not to like? Well, you have to keep track of which 12 companies are the largest Dividend Achievers. You’ll probably need to add a company every 5-10 yrs, which means you’ll have to start a dividend reinvestment plan (DRIP) in that company and stop adding money to one of the existing DRIPs. You’ll also need to remember not to sell the DRIP you’ve dropped (no pun intended), unless that company fails to increase its dividend for two consecutive years. Another problem is that Treasury Notes purchased through treasurydirect don’t have automatic reinvestment of interest payments. But the Treasury website offers a couple of advantages over DRIPs: 1) There is an “inflation-protected” alternative to all of the standard offerings; 2) Savings Bonds offer total returns that approximate those for 7-10 yr Treasury Notes, and pay interest that is automatically reinvested (like a DRIP). More importantly, taxes are deferred on interest accruals until the Savings Bond is redeemed. In other words, Savings Bonds work like an IRA. You save money by not having to pay taxes until after you spend the money.
To simplify your life, cover each monthly investment in one of the riskier DRIPs by an equal investment in Inflation-protected Savings Bonds (ISBs) instead of 10-yr Treasury Notes. For example, the Table shows 4 such companies, stock investments which you'd like to hedge by putting $240/mo into an ISB. (But that becomes $250/mo because ISBs come in $25 gradations.) A final problem is that computershare only provides DRIPs for 11 of the 12 companies in our Table. If you choose to purchase 3M stock each month, you'll need to set up a DRIP through Wells Fargo.
OK, how do we know this portfolio will act as a hedge fund? If you’ll refer back to our Week 117 blog, you’ll see that a hedge fund is defined by hedge fund traders. It’s in the eye of the beholder. That means it is composed of assets that hedge fund traders are rarely tempted to bet against (or "short"); they’d rather own them. That means the portfolio ideally has to a) beat the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles, Column C), b) lose less than the 28% that VBINX lost during the 18-month Lehman Panic, c) have a 5-yr Beta that’s less than the 0.67 long-term average for the hedge fund industry, d) pay at least a 1.5% dividend, and e) have a trailing P/E no higher than 20. Now look at Line 18 in the Table to see that the portfolio we’re proposing exceeded those 5 requirements in every area except 5-yr Total Return (Column F). That small lag in performance during the unusually strong bull market of the past 5 yrs is more than made up for by outperformance in the safety areas (Columns D & I).
Bottom Line: If you go to the trouble to set up this portfolio, and have the discipline to stick with it through thick and thin for 10+ yrs, you’ll come out ~2%/yr ahead of simply investing in our benchmark, which is the hedged S&P 500 Index (VBINX in the Table). But it will take a couple of market cycles to reach that success because a) your expenses in the first few years will be too large a fraction of your net asset value, and b) the advantage gained over the benchmark by having all your stocks in a category that grows dividends much faster (see Column H in the Table) takes time to have an impact. But, from the outset you’ll be facing less volatility. The portfolio in the Table had average losses during the 18-month Lehman Panic of 11.3% vs. 28% for VBINX, and the current 5-yr Beta is 0.5 vs. 0.93 for VBINX.
Risk Rating: 2
Full Disclosure: I make automatic online monthly investments in WMT, NKE, JNJ, IBM, KO, XOM, and PG. I also own stock in MCD, CVX, PEP, UTX, and MMM. I hedge investments in XOM, CVX, UTX, and MMM with equal investments in 10-yr and 20-yr Inflation-protected US Treasury Notes.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, March 2
Week 139 - 2014 Watch List for the S&P 500 Index
Situation: Every stock-picker has a watch list, a convenient way to follow the growth and safety of companies that interest her. Two problems have to be addressed: how many companies to follow, and why those particular companies. We think our readers would appreciate it if we could strive to be comprehensive, and that is facilitated by cutting the number of metrics used to one that tracks with growth and one that tracks with safety.
Growth, we think, is best evaluated by the people who put out the Barron’s 500 List every May. They examine over 3,000 companies in terms of the trend in a) cash-flow based return on investment over the prior 3 yrs, and b) sales growth over the previous year. To winnow that list, we pick only the companies that have scored in the top 300 for the two most recent years. Then we exclude companies that didn’t start issuing stock until after 2000 (because there’s not enough data to determine long-term trends by using less time). Remember: We’re looking for companies that you can invest small amounts of money in each month by using a dividend reinvestment plan (DRIP), so that you can spend those stock dividends after you retire. One advantage of having a long-term horizon is that you don’t need to worry about overpaying or underpaying for those shares each month. Why? Because you’ll be “dollar-cost averaging.” That means your price per share shows “reversion to the mean” long-term rate of price appreciation; each stock develops its own “signature” rate after a decade or two of trading.
Safety has many facets but for our Watch List we have to pick one metric that distills those factors. We’ll use the Standard & Poor’s credit rating for long-term company debt (Column N in our Table), and exclude any companies that have less than an A- rating. Most companies are willing to pay S&P to assign a rating, even if the company doesn’t currently issue long-term bonds (just in case it might want to someday). An A-rating from S&P is the finance industry’s "Good Housekeeping Seal of Approval."
That leaves one problem unaddressed: Why should we create a Watch List. What’s the goal? Our goal always is to find well-managed companies that raise their dividend annually, since that growth rate translates into your annual dividend pay raise after you retire and start cashing those checks (see Column H in the Table). We’re also looking for companies that have a Durable Competitive Advantage (Column Q in the Table), referencing a method created by Warren Buffett (see Week 135).
Finally, we’re looking for hedge stocks (see Week 117). Our definition for a hedge stock is evolving. At the moment, it is a stock that a) beats the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles), b) loses less than the 28% that VBINX lost during the 18-month Lehman Panic, c) has a 5-yr Beta that’s less than the 0.67 average for the hedge fund industry, d) pays at least a 1.5% dividend, and e) has a trailing P/E no higher than 20. Why all those requirements? Because each one acts to discourage a hedge fund trader from shorting the stock.
Bottom Line: Our Watch List has 69 companies (Table), most of which are risky. You see that from the extent of losses during the Lehman Panic (Column D) and the 5-yr Beta (Column I), where values that show underperformance relative to the benchmark (VBINX) are highlighted in red. But that’s to be expected when you screen for growth. Remember: There are only two known ways to beat the S&P 500 Index: Take on more risk, or trade on the basis of insider information. In this country (different from most countries in the world), you’ll land in jail if you trade on insider information (remember Martha Stewart?). That leaves taking on more risk, which is why Jim Cramer’s stock picks tend to beat the S&P 500 Index. In this week’s blog, we’ve helped you consider a growth company for inclusion in your stock portfolio by excluding any that don’t have at least an A- credit rating. In other words, even if the company’s stock fell a lot the company is still unlikely to wind up in bankruptcy court.
We’ve turned up 24 Dividend Achievers (Column O in the Table), which are companies that have raised their dividend annually for the past 10 or more years. Four more companies are soon to be Dividend Achievers because they’ve increased their dividend annually for 9 yrs: Microsoft (MSFT), Costco Wholesale (COST), Deere (DE) and BlackRock (BLK). There are 6 companies with a Durable Competitive Advantage (Column P) but only two of those are also Dividend Achievers: Ross Stores (ROST) and Wal-Mart Stores (WMT). We found only one hedge stock: Coca-Cola (KO).
Risk Rating: 7
Full Disclosure of active trading in these stocks: I dollar-average into DRIPs for WMT, MSFT, PG, KO, IBM, NKE, and ABT.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Growth, we think, is best evaluated by the people who put out the Barron’s 500 List every May. They examine over 3,000 companies in terms of the trend in a) cash-flow based return on investment over the prior 3 yrs, and b) sales growth over the previous year. To winnow that list, we pick only the companies that have scored in the top 300 for the two most recent years. Then we exclude companies that didn’t start issuing stock until after 2000 (because there’s not enough data to determine long-term trends by using less time). Remember: We’re looking for companies that you can invest small amounts of money in each month by using a dividend reinvestment plan (DRIP), so that you can spend those stock dividends after you retire. One advantage of having a long-term horizon is that you don’t need to worry about overpaying or underpaying for those shares each month. Why? Because you’ll be “dollar-cost averaging.” That means your price per share shows “reversion to the mean” long-term rate of price appreciation; each stock develops its own “signature” rate after a decade or two of trading.
Safety has many facets but for our Watch List we have to pick one metric that distills those factors. We’ll use the Standard & Poor’s credit rating for long-term company debt (Column N in our Table), and exclude any companies that have less than an A- rating. Most companies are willing to pay S&P to assign a rating, even if the company doesn’t currently issue long-term bonds (just in case it might want to someday). An A-rating from S&P is the finance industry’s "Good Housekeeping Seal of Approval."
That leaves one problem unaddressed: Why should we create a Watch List. What’s the goal? Our goal always is to find well-managed companies that raise their dividend annually, since that growth rate translates into your annual dividend pay raise after you retire and start cashing those checks (see Column H in the Table). We’re also looking for companies that have a Durable Competitive Advantage (Column Q in the Table), referencing a method created by Warren Buffett (see Week 135).
Finally, we’re looking for hedge stocks (see Week 117). Our definition for a hedge stock is evolving. At the moment, it is a stock that a) beats the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles), b) loses less than the 28% that VBINX lost during the 18-month Lehman Panic, c) has a 5-yr Beta that’s less than the 0.67 average for the hedge fund industry, d) pays at least a 1.5% dividend, and e) has a trailing P/E no higher than 20. Why all those requirements? Because each one acts to discourage a hedge fund trader from shorting the stock.
Bottom Line: Our Watch List has 69 companies (Table), most of which are risky. You see that from the extent of losses during the Lehman Panic (Column D) and the 5-yr Beta (Column I), where values that show underperformance relative to the benchmark (VBINX) are highlighted in red. But that’s to be expected when you screen for growth. Remember: There are only two known ways to beat the S&P 500 Index: Take on more risk, or trade on the basis of insider information. In this country (different from most countries in the world), you’ll land in jail if you trade on insider information (remember Martha Stewart?). That leaves taking on more risk, which is why Jim Cramer’s stock picks tend to beat the S&P 500 Index. In this week’s blog, we’ve helped you consider a growth company for inclusion in your stock portfolio by excluding any that don’t have at least an A- credit rating. In other words, even if the company’s stock fell a lot the company is still unlikely to wind up in bankruptcy court.
We’ve turned up 24 Dividend Achievers (Column O in the Table), which are companies that have raised their dividend annually for the past 10 or more years. Four more companies are soon to be Dividend Achievers because they’ve increased their dividend annually for 9 yrs: Microsoft (MSFT), Costco Wholesale (COST), Deere (DE) and BlackRock (BLK). There are 6 companies with a Durable Competitive Advantage (Column P) but only two of those are also Dividend Achievers: Ross Stores (ROST) and Wal-Mart Stores (WMT). We found only one hedge stock: Coca-Cola (KO).
Risk Rating: 7
Full Disclosure of active trading in these stocks: I dollar-average into DRIPs for WMT, MSFT, PG, KO, IBM, NKE, and ABT.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
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