Week 166 - “Risk-On/Risk-Off” Investing in Response to Global Economic Patterns

Situation: Most of us take more risks with our investments when the world looks to be in good shape economically, and fewer risks when it doesn’t. For example, throughout 2008 investors were risk-averse and tended to sell their losing positions. It was a “Risk-Off” year by all accounts, and that selling did great damage to the retirement savings of roughly a billion people worldwide. The freed-up funds mostly went into US Treasury Bonds and German Bunds, lowering interest rates enough to leave investors in those bonds with no inflation-adjusted income for years. You see the problem, don’t you? Investors should have continued trading stocks in 2008 instead of holding a “fire sale.” The result of all this selling was that stocks became increasingly underpriced relative to their value, as assessed by time-tested methods of fundamental analysis. But where were the buyers? They showed up two years later.

We all need to take a deep breath and agree that our “animal spirits” sometimes lead us to take unreasonable risks when global economic patterns look rosey. I’ve done it, you’ve done it. The cure? Develop a consistent “Risk-Off” investment regimen, and stick with it through good times and bad. The only alternative is to panic when things look bad, and that means selling stocks at a loss. Remember, Warren Buffett's #1 Rule is to "never lose money."

What, exactly, is a consistent Risk-Off investment regimen? Warren Buffett has often said he looks for established companies in boring industries, companies that have built their brand through generations of managers. He likes Procter & Gamble, Coca-Cola, Wal-Mart Stores, Johnson & Johnson, IBM, Heinz, Mars, Wells Fargo, American Express, and Exxon Mobil. In 2008, he sold Johnson & Johnson stock only because he wanted to help out some floundering companies like General Electric and Goldman Sachs, but he otherwise continued to invest in a disciplined manner (e.g. moving to buy the Burlington Northern Santa Fe railroad). Once he buys a stock or company, he does so with the intention of never selling it. Exceptions are rare: 1) To free up money for younger associates to invest, he has done some selective selling; and, 2) he’s done some trading while learning to invest in the energy industry. The point is that he’s the quintessential “Risk Off” investor, and a model for us all to follow.

Where do we go to find a tidy list of old and mostly boring companies that stock analysts tend to yawn at (or just plain overlook)? Here at ITR, we go our “stockpickers secret fishing hole” (see Week 68 and Week 105), which is my name for the Dow Jones Composite Index of 65 companies (30 industrials, 15 utilities, and 20 transportation companies). Railroads and electrical utilities are highlighted there, for example, and have been among the best-performing sub-industries over the last few years (see Week 148). But few, if any, stock brokers are going to try and interest you in buying those. Why? Because they’re government-regulated “and regulators might get it wrong.” Regulation in these stocks is necessary for two reasons: 1) the companies are monopolies; 2) prices for their services need to be set high enough for the companies to afford massive fixed costs and still make a profit. In this week’s Table, you’ll find 11 electric utilities and 3 railroads because those companies prosper in good times and bad. 

We’ve screened the 65 companies in the Dow Jones Composite Index, excluding those that a) don’t have long-term trading data, or b) have insufficient revenues to make it onto the Barron’s 500 List. We came up with 37 companies that either showed a higher rank by Barron’s criteria in 2014 than in 2013, or were ranked in the top 2/3rds for both years. The benchmark we use for “Risk Off” investing is the Vanguard Wellesley Income Fund (VWINX), which is 60% bonds/40% stocks. The benchmark we use for “Risk On” investing is the Vanguard Balanced Index Fund (VBINX), which is 40% bonds/60% stocks. VWINX has a low 5-yr Beta of 0.5, whereas, VBINX has a 5-yr Beta of 0.92, which is almost as high as the S&P 500 Index’s 5-yr Beta that is set at 1.0. This wide discrepancy is mainly because bonds have 70-80% less risk than stocks. Red highlights in the Table denote underperformance vs. VBINX.

NOTE: Our screening starts with the Barron’s 500 List of the largest companies (by revenue) on the New York and Toronto stock exchanges. That list is published each year in May and gives letter grades to each company in 3 areas: median three-year cash-flow-based return on investment (ROIC); the one-year change in that measure relative to the three-year median; and adjusted sales growth in the latest fiscal year. Those letter grades are equal-weighted and the combined grade determines the company’s rank for the year.

If you look at total returns for those 37 companies (Table), 20 outperformed VWINX in all 3 time periods (past 22, 10, and 5 yrs) but only 4 of those stocks lost less money for investors than VWINX did during the Lehman Panic: MCD, JBHT, SO, NEE. This was in spite of the fact that aggregate returns of the 37 companies not only beat VWINX at all 3 time periods but also beat the lowest-cost S&P 500 Index fund (VFINX) in all 3 time periods! So, picking safe stocks is trickier than picking a mutual fund that has built-in safety features. The only reason to pick stocks is to have a source of retirement income that outgrows inflation: Note that Dividend Growth values in Column I of the Table are typically 3-4 times greater than the rate of inflation. You have to “pick and track”. No mutual fund will do that for you.

When we look across the 3 market cycles since the 7/90-4/91 recession, we find that a bond-heavy balanced fund (VWINX) protects its investors from most of the stock market losses incurred during each recession. VWINX lost money in only 3 of the last 22 yrs: 1994 (-6.2%), 1999 (-3.6%), and 2008 (-9.1%), whereas, the S&P 500 Index lost money in 6 yrs, including a 33% loss in 2008. The protection that comes from high-quality bonds is what allows VWINX to grow from a point of preserved value at the beginning of recovery from each recession, instead of wasting months (or years) to make up for lost value.

Bottom Line: Stock-picking is the best way to have some retirement income that beats inflation (see Week 159), but it’s not the best way for a “retail investor” to accumulate wealth. We’ve found 37 stocks that (as a group) handily outperformed the S&P 500 Index after holding periods of 22, 10, and 5 yrs. But only 4 of those stocks could beat a bond-heavy balanced fund (VWINX) in all 3 time periods while losing less than the 16% that VWINX lost during the 18-month Lehman Panic. Two are regulated utilities (SO and NEE), the third is a trucking company (JBHT), and the fourth is a downscale restaurant chain (MCD) that thrives on recessions. So, if you didn’t start investing in those 4 companies 22 yrs ago, and kept adding money along the way, you’d have been better off investing in VWINX. Our standard stock-heavy benchmark, the Vanguard Balanced Index Fund (VBINX), only beat VWINX in the most recent 5-yr period because a severe recession has led to a strong bull market in stocks. Conclusion: We all need to learn how to become “Risk Off” investors by making a plan for investing a certain amount each month, then sticking to it through thick and thin.

Risk Ranking for the aggregate of 37 stocks: 6

Full Disclosure: I dollar-average each month into DRIPs for JNJ, NKE, PG, NEE, WMT, and MSFT, and also own shares of IBM, KO, UTX, MMM, MCD, and DD.

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