Week 232 - Safe and Effective Stocks for Trying to Beat the S&P 500 Index Long-Term

Situation: As a general rule, you should use index funds to build a retirement portfolio. Why? Because you can’t beat the market on a risk-adjusted basis (after allowing for transaction costs) unless you apply the art of buying low and selling high. A reasonable alternative to index funds is to “buy and hold” high quality stocks. The growth in their dividend payouts often beats inflation by a wider margin than payouts from a low-cost S&P 500 Index fund like the Vanguard 500 Index Fund (VFINX) or its bond-hedged version--the Vanguard Balanced Index Fund (VBINX) which we use as our benchmark. You’ll want to look for companies that have a Durable Competitive Advantage, i.e., those that have doubled their Tangible Book Value over the past decade. Nonetheless, you’ll need to have rules that give you a chance to beat the S&P 500 Index on a total return basis long-term. Otherwise, you’d be better off investing in VFINX or VBINX.

Mission: Set up rules that allow an investor to take calculated risks in order to buy high quality stocks that have a reasonable chance of beating the S&P 500 Index long-term. 

Execution: Rule #1 is to buy stocks that have demonstrated improving fundamentals over the most recent 3 yrs, as determined by the stock’s Barron’s 500 Rank this year compared to last year. Rule #2 is to buy stocks that have a Durable Competitive Advantage (see Week 227 for further elaboration on Rules #1 and #2). Rule #3 is to find out which of those stocks have a price appreciation history that beats the S&P 500 Index over the past 2-3 market cycles while having less risk of loss, as determined by the BMW Method. Rule #4 is to not overpay for the stock, i.e., EV/EBITDA needs to be no greater than that for the S&P 500 Index, which is rarely higher than 11. Finally, you don’t want to buy stock in companies that have sustainability issues, meaning the S&P stock rating is lower than B+/M or the S&P bond rating is lower than BBB+ (see Table).

By adhering to this algorithm, you’re focus will be on building a position in companies that are out-of-favor, companies that are preparing to outperform when current headwinds lose their strength. Warren Buffett has often addressed this point: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.“ The trick is to see through the headwinds that are holding down a company’s stock. No one knows when that will occur, but it is not hard to find out if a company’s management is preparing for that day.

Bottom Line: Given that the US stock market is currently overpriced, we are able to come up with only 6 candidate stocks for purchase. Four of those 6 are electric utilities. Utilities pay high dividends. So, utility stocks are expected to fall in price as the Federal Reserve raises interest rates. In other words, that fall in price compensates for the eroded value of their dividends compared interest payouts on newly-issued bonds. 

Risk Rating: 6

Full Disclosure: I dollar-average into NEE.

NOTE: Metrics are current for the Sunday of publication; metrics highlighted in red denote underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX). Column C in the Table lists the total return/yr on a stock purchase made 9/28/92, the first day of trading for VBINX.

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