Week 159 - Focus on “Compound Interest:” A Watch List of 77 Companies

Situation: If you’ve been reading this blog for long, you’re familiar with what we think is the “best” way for small investors to save for retirement, namely, the Vanguard Balanced Index Fund (VBINX), a low-cost hedged version of the S&P 500 Index. Recently, Warren Buffett went on the record and advised retail investors to use low-cost Vanguard index funds. His suggestion is to invest 90% of your retirement account in the Vanguard 500 Index Fund (VFINX) and the remaining 10% in the Vanguard Short-Term Treasury Fund (VFISX). Unfortunately, neither of these two approaches will pay you much of a dividend, and what dividend yield there is (plus its growth rate), barely keeps pace with inflation. In retirement, portions of those index funds would need to be sold every so often for you to fully benefit from that type of savings plan. From a budgeting standpoint, it makes more sense to receive income regularly from stocks (via dividend checks sent to you) while preserving the principal (your initial investment). 

If you are an established stock-buyer who picks stocks that return dividends, then the savings you’ve built up can produce dividend checks that grow every year and grow faster than inflation. I know, that seems like it isn’t possible but it is. Some companies have a record of increasing their dividend annually for at least the past 10 yrs (S&P calls those companies Dividend Achievers). Even better, there are 54 companies that have even been raising dividends for at least 25 yrs. S&P calls those companies Dividend Aristocrats. We recently picked 29 companies from that group of 54 for our Spring 2014 Master List (see Week 146). 

This week our focus is on building compound interest, which is created by the reinvestment of interest and dividends. For stocks, that means the next dividend payment includes a dividend payment on the last dividend. There are currently 239 Dividend Achievers. Recall that these are companies that have increased their dividend by 3-30%/yr for at least the past 10 yrs. By reinvesting the dividend earnings that you make while you are in your working years, and spending those funds during your retirement years, you will benefit from the only source of retirement income that traditionally grows faster than inflation.

The trick is to pick the right companies. To avoid selection bias, we’ve cast a broad net and examined every company that placed in the top two thirds of the Barron’s 500 List for both 2013 and 2012. There are 77 such companies, if you exclude those paying less than a 1% dividend and those where the sum of dividend yield and the dividend growth rate is less than 10% (see Table). That sum is a mathematical projection for total return/yr out into the future, based on the Gordon Equation.

Why do we start by narrowing down the Barron’s 500 List? Because that list is not selective. Simply stated, it is the largest 500 companies by revenue on the New York and Toronto stock exchanges. But the way in which Barron’s ranks those companies is valuable because their analysis uses 3 very important metrics: sales for the most recent year, cash-flow based return on invested capital (ROIC) for the past 3 yrs, and average ROIC over those 3 yrs. A letter grade is assigned for each of those 3 metrics, and the “ranking” you see in Columns I and J of the Table is the grade-point average (i.e., 4.0, 3.67, 3.33, 3.0, etc.).  

The 77 companies listed in the Table represent all the companies available for you to choose from, in terms of setting up dividend reinvestment plans (DRIPs) that are likely to provide retirement income that beats inflation. If you look at which companies are Dividend Achievers (Column N in the Table) and which have S&P bond ratings of A- or better (Column O in the Table), you’ll find that 30 companies qualify on both counts. Note that our Table has red highlights for underperformance vs. our benchmark (VBINX at Line 104 in the Table). The “Buffett Plan” is at Line 105 in the Table for comparison.

Since evidence suggests the market is currently overpriced, only 5 of those 30 companies have low risk. This means that there are no red highlights in Column E (Finance Value), Column K (5-yr Beta), or Column L (P/E). Those 5 companies are: WMT, IBM, ROST, MCD, TJX.

Bottom Line: Inflation is a certainty in the future and there could be periods of hyperinflation for brief periods. Part of your retirement income needs to have a high likelihood of outgrowing inflation. That cannot be accomplished by relying on gains earned via investments and payouts made through mutual funds, or by relying on Social Security cost of living increases. You have to become a “stock-picker” and monitor your investments.

Risk Rating: 4

Full Disclosure re: the 5 companies recommended above: I dollar-average into DRIPs for WMT and IBM, and reinvest quarterly dividends on MCD shares held in a DRIP. I also own shares of TJX.

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