Situation: Every so often we go back to our comfort zone, the Dow Jones Composite Average (DJCA) of 65 tried-and-true companies. We call it the Stock-pickers Secret Fishing Hole (see Week 29). Why? Because the DJCA tends to outperform the S&P 500 Index and it has lots of the “old” companies that Warren Buffett likes, i.e., boring but stable moneymakers. Fifteen of the companies are regulated electric utilities (Dow Jones Utility Average or DJUA) and 20 are transportation firms (Dow Jones Transportation Average or DJTA), i.e., railroads, trucking outfits, freight forwarders, airlines, and ocean shippers. The remaining 30 are the so-called “blue chip” companies that make up the Dow Jones Industrial Average (DJIA). We like to periodically revisit the 65 company list because it includes many steady performers that don’t generate much excitement and may even be underpriced. And that’s exactly the kind of company we love to feature.
The annual fixed costs of railroads and electric utilities are so high that they’re organized as “legal monopolies” and require government regulation, which allows them to attract investors but still protect customers from being overcharged. Return on Equity is generally in the 10-12% range, and the effect that price changes have on demand (elasticity) is minimal. Warren Buffett likes that combination, so Berkshire Hathaway’s most prominent moneymakers are Berkshire Hathaway Energy (the largest electric utility in the US), and Burlington Northern Santa Fe (the second-largest railroad). Berkshire Hathaway also owns large blocks of stock in 8 DJIA companies: American Express (AXP), Coca-Cola (KO), ExxonMobil (XOM), General Electric (GE), Goldman Sachs (GS), International Business Machines (IBM), Johnson & Johnson (JNJ), and Wal-Mart Stores (WMT).
To drill down to those companies with exceptional value (see Table), we start with the Barron’s 500 List because it a) contains information on revenues and ROIC (Return on Invested Capital), b) uses that information to rank-order the largest US and Canadian companies, and c) lists the year-over-year change in rank. We then eliminate companies that don’t have S&P bond ratings of at least BBB+ and S&P stock ratings of at least B+/M. Finally, the 37 companies that remain are winnowed down to 20 by excluding those with a Finance Value (Column E in the Table) that doesn’t beat VBINX (Vanguard Balanced Index Fund). In other words, the excluded companies had losses during the 18-month Lehman Panic that were not mitigated by long-term gains. That leaves us with 11 DJIA, 4 DJTA, and 5 DJUA companies (see Table). As a group, these are safe stocks to own because they had losses during the 18-month Lehman Panic of only 18.4% vs. 46.5% for the lowest-cost S&P 500 Index fund, VFINX, and their 5-yr Beta is ~0.65 vs. 1.00 for VFINX.
Bottom Line: Embrace Sutton’s Law (i.e., go where the money is). It’s easier to cull a list of 65 for winners than a list of 500, and even more rewarding if the shorter list outperforms the longer one. For the past 34 yrs, the 65-stock Dow Jones Composite Index has returned 8.7%/yr (without dividends reinvested) vs. 8.3%/yr for the S&P 500 Index. As a typical stock-picker, i.e., someone who has a day job and a family, you have little time to research stocks. We’re here to help, and that means highlighting stocks worth holding in a retirement account. This week there are 20 for you to consider and 5 happen to be Warren Buffett favorites: Wal-Mart Stores (WMT), Johnson & Johnson (JNJ), ExxonMobil (XOM), International Business Machines (IBM), and Coca-Cola (KO). Fourteen are Dividend Achievers (see Column P in the Table) with 10+ yrs of annual dividend increases. Start your hunt by taking a closer look at those but be aware that 4 of the 14 appear to be overpriced (see Column K in the Table): Procter & Gamble (PG), Coca-Cola (KO), Dominion Resources (D), and Nike (NKE).
Risk Rating: 5
Full Disclosure: I dollar-average into WMT, NKE, XOM, and NEE, and also hold shares of MCD, D, IBM, JNJ, and CVX for dividend re-investment.
Note: metrics are current as of the Sunday of publication; red highlights denote underperformance vs. VBINX.
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Situation: Dow Theory predicts that a bull market will continue if the primary trend is upward, i.e., both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) are making new highs. The idea is that the movement of goods to satisfy demand is every bit as important as producing the goods. As of this writing, the DJTA continues to “confirm” the bull market denoted by the DJIA’s current all-time highs. The problem is that very few companies in that important Transportation Average are investment-grade quality. Only 5 of the 20 companies have 1) a long-term S&P credit rating of BBB+ or better; 2) an S&P stock rating of B+/M or better; and 3) enough revenue to appear on the Barron’s 500 List of the largest public companies on the New York and Toronto Stock Exchanges.
Those 5 are:
CSX Railroad (CSX),
Norfolk Southern Railroad (NSC),
Union Pacific Railroad (UNP),
Expeditors International of Washington (EXPD), and
JB Hunt Transportation Services (JBHT),
We’ve come up with 9 more companies that meet all 3 requirements and derive much (but not all) of their revenue from transportation-related activities. Three of the 9 happen to be among the 30 companies on the DJIA list:
United Technologies (UTX),
Caterpillar (CAT), and
Boeing (BA).
The remaining 6 are:
Canadian National Railway (CNI),
Sysco (SYY),
Canadian Pacific Railway (CP),
PACCAR (PCAR),
Cummins (CMI), and
Honeywell (HON).
How does our newfangled list of these 14 companies help? For starters, the quality is there. You can invest in any of the stocks issued by those companies at any time, as long as you only invest a small and fixed amount over regular intervals (dollar-cost averaging). Second, fundamental information is readily available because all 14 appear on the Barron’s 500 List published annually (in May). There you can find the most recent year’s sales, and the cash-flow related ROIC (Return on Invested Capital) vs. its 3-yr average. Then you can see how those data rank each company and how that ranking compares to the previous year. Third, we show whether the company was a small loser or a big loser during the Lehman Panic (see Column D in all the Table), and whether the company’s long-term total return (Column C in the Table) mitigated that risk (see Column E in the Table). If the Finance Value in Column E beats our benchmark’s (VBINX), you’re likely to benefit from owning the company’s stock instead of shares in VBINX.
Bottom Line: These stocks are the pulse of the economy, meaning they're high-risk high-reward. Only 5 of the 14 are Dividend Achievers, and only one of those (NSC) has a Finance Value that beat’s our key benchmark, the Vanguard Balanced Index Fund (see Table). But there is one other reasonable approach to investing in this sector, and that is to gradually build a position in iShares Transportation Average (IYT), which is an exchange-traded fund (ETF) that tracks the performance of stocks in the Dow Jones Transportation Average. When the earnings of transportation company stocks are growing at a nice clip, you can be confident that the economy is doing well. And vice versa. So own a few of these stocks and learn from their price movements. Then you won’t be mystified by the next lurch upward or downward in the stock market, and you won’t panic (sell) when others do. Except for the railroads (which are government-regulated to protect both customers and investors), the stocks in this week’s Table are not the “buy-and-hold” variety.
Risk Rating: 7
Full Disclosure: I own shares of CNI, UTX, and CMI.
NOTE: Metrics in the Table are current as of the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark (VBINX).
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Situation: Agriculture stocks potentially offer investors above-average rewards, given that 1) food is an “essential good” and 2) middle-class consumers in Asia continue to grow in numbers and demand more protein in their diets. Companies that supply farmers with equipment, seeds, insecticides, feed, and fertilizer depend on the weather cycle and population growth for their pricing power, instead of the economic cycle. Valuations on those production agriculture companies tend to track farmland values, which have been growing 14-15%/yr for the past 14 yrs vs. 4-5%/yr for the S&P 500 Index with dividends reinvested.
The problem for investors is that there are many Production Agriculture companies and most are in the mid-cap range or have less-than-investment-grade credit ratings. For this week’s blog, we’ll stick to analyzing those that appear on the Barron’s 500 List with S&P investment-grade bond ratings and S&P stock ratings of at least B+/H.
That leaves only 9 companies (see Table). Some have P/E values higher than the S&P 500 Index, which has been hovering around 20. To see whether this should be a concern, we looked at each company’s Enterprise Value relative to Operating Earnings, i.e., EV/EBITDA (see Column K in the Table). Any value over 13 suggests that the stock is overpriced. None fell into that category.
Bottom Line: We’ve come up with 9 Production Agriculture stocks that are appropriate for inclusion in a retirement portfolio. When you pick one or two to accumulate over time with dollar-cost averaging, you’ll receive dividend cheques in retirement that are likely to grow twice as fast as inflation (see Column H in the Table).
Risk Rating: 7
Full Disclosure: I own shares of MON, DE, CF, CMI, HRL, and DD.
NOTE: Metrics in the Table are current as of the Sunday of publication; red highlights denote underperformance relative to our benchmark, the Vanguard Balanced Index Fund.
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Situation: Oil and natural gas companies account for 8% of US GDP. Their stock prices mainly reflect 3 factors: 1) the pricing of front-month futures contracts, 2) the amount of proven and economically recoverable reserves in the ground, and 3) the expected rate of growth in the world’s appetite for oil. All of those numbers will fall if there is a recession in one of the world’s major economies. Europe is now on the brink of entering its third recession in 10 yrs (triggered by the crisis in Ukraine), which is one reason why the price of oil fell 40% between June and December. But there are two other reasons to consider.
The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!
The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.
Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.
Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks.
Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).
How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).
The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table.
Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio:
1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX);
2) the stock is an S&P Dividend Achiever;
3) the company’s bonds have at least a BBB+ rating from S&P;
4) the stock has at least a B+/M rating from S&P;
5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and
6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years.
Risk Rating: 6
Full Disclosure: I dollar-average into XOM and also own shares of CVX.
Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
