Week 150 - Our Current List of Hedge Stocks

Situation: Our favorite way to look at risk is to make a guesstimate of what would happen to retirement investments in a bear market. Recall that a bear market occurs when the S&P 500 Index falls more than 20% from its most recent peak. That’s a different question than calculating what happens to those investments in a recession. Why? Because bear markets, such as the one-day 22% collapse in 1987, don’t necessarily presage a recession. The famed economist Paul Samuelson once quipped that “the stock market has called 9 of the past 5 recessions.” 

Some of the stocks in your portfolio need to be “downturn resistant” because, during a downturn, you are more likely to have financial difficulties and need to sell some assets to tide you over until better times. Perhaps you’ll have enough Treasury Notes and Savings Bonds for those to act as a safety net. If not, you'll need to either sell some stocks, or go deeper in debt. If you decide to sell some stocks, you’d rather not take a loss. The idea of having a few such Hedge Stocks is that those are unlikely to show much price depreciation in a market downturn. Even Warren Buffett, who counsels investors never to close out a good position, sold his entire large block of Johnson & Johnson shares going into the Lehman Panic. The proceeds were used to help assemble $26B in loans to six companies that badly needed capital (General Electric, Goldman Sachs, Bank of America, Dow Chemical, Swiss Re, and Mars Candy). His first loan of $5 Billion was to Goldman Sachs on 9/24/08--9 days after Lehman Brothers Holdings filed for bankruptcy. That heralded the Federal Government’s “bailout” of Wall Street banks in mid-October 2008, using almost half the $700B in “TARP” funds that was for a different purpose (i.e., to buy up mortgage-backed securities from the 7 surviving Wall Street banks). Warren’s timely display of confidence in Wall Street probably had more to do with averting another Great Depression than did the dollar amount of all the loans. Remember: Confidence in a company’s future is what impels investors to buy stock, not it’s balance sheet.

What else makes a company’s stock price go up or down? We need to examine that before we can understand the idea of a hedge stock. There are really only two factors to consider: 1) Is the stock over-priced? 2) Is the story broken (e.g. will the company collapse in a market panic)? “Overpriced” means that the 5-6%/yr rate of return realized by cautious investors throughout recorded history no longer applies. Note: that expected rate of return will stick close to the nominal rate of GDP growth, which in the USA has been 5-6% until recently. In other words, the price for a share of stock has to be less than 20 times the most recent 12 months of earnings per share to realize more than a 5% return. With lower returns, there is a valuation problem and hedge fund traders will be drawn to bet against (or short) the stock. You can easily find out if the P/E is over 20 by checking Yahoo Finance on your smartphone.

The second question is much harder to assess: Does the story that supports confidence in a company’s future stream of earnings still apply? Or is the story broken? This terminology dates to medieval Italy, where a banker would sit at a bench (banca) in the town square. If he ran out of money, the bench would be broken in front of him (banca rotta), later transliterated to “bankrupt.”

For any widely-held company, there is always a steady production of articles, blogs and TV commentators pointing to “factlets” suggesting that the story is broken. That’s how media outlets attract advertisers and readers (i.e., by creating anxiety). Quite simply, it is human nature to undermine a money-making story, particularly when you haven’t been a beneficiary. 

This makes it important to do your own “story” research for stocks that you own or want to own. For hedge stocks, researching the story is a little easier because they’re never “barnburners.” There’s no chance they’ll light up the investment universe, except of course for the “bond gnomes” off in a corner who would happily loan money to such companies. In a bull market, hedge stocks struggle to keep up with the S&P 500 Index but over the long term they’ll probably make money for their shareholders because of being downturn-resistant. When the stock market cracks, these companies don’t. Thus, it turns out that hedge stocks are not that hard to research. Their history of performance is one of limited price fluctuations, whether the market is headed up or down. 

We use the hedged S&P 500 Index as our benchmark and guide for finding hedge stocks. These stocks are buried in that hedged index (The Vanguard Balanced Index Fund  or VBINX). It is hedged in both directions: You are insulated from a market crash by its 40% allocation to high-grade bonds. Likewise, you benefit from market exuberance because the 60% allocation to stocks references an index of the 1000 largest companies. In other words, riskier mid-cap company stocks are included. Their high 5-yr Betas pull VBINX’s 5-yr Beta up to 0.91 from 0.6, which is where you’d expect for an index composed of 60% S&P 500 stocks and 40% high-grade bonds. That "balanced fund" strategy works because VBINX sank only 60% as far as the S&P 500 Index during the Lehman Panic (Column D in the Table), and has performed 50% better since 9/1/00, which is when the S&P 500 Index reached its inflation-adjusted high.

We also look for other metrics that are likely to prevent a hedge fund trader from betting against a company’s stock. These include: a dividend yield of at least 1.5%, outperformance relative to VBINX over both the short-term (5 yrs) and long-term, a P/E no greater than 22 (for the last 4 quarters of reported earnings), a Finance Value (Column E in the Table) that beats VBINX, a 5-yr Beta under 0.7, and an S&P bond rating of at “A-” or better. Metrics that underperform VBINX are highlighted in red.

Bottom Line: The value of owning a hedge stock is that you don’t need to hedge your downside risk by making an equivalent investment in a 10-yr Treasury Note or an inflation-protected Savings Bond. But our screen of S&P 500 companies turns up only 15 hedge stocks, even after bending our standards a little (Table). Twelve of the 15 are in “defensive” industries--utilities, consumer staples, and healthcare. Those 12 are what we call “Lifeboat Stocks” (see Week 106). McDonald’s (MCD), VF Corporation (VFC), and IBM are the only exceptions. If the market were not currently going through an overpriced moment, more companies would qualify. Of course, after a market collapse our search will become easier but that will also be when everyone (aside from Warren Buffett) is averse to investing. He has put a fine point on it: “Only when the tide goes out do you discover who's been swimming naked.”

Risk Rating: 4.

Full disclosure: I dollar-average into DRIPs at computershare.com for WMT, NEE, IBM, JNJ, and KO.

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