Week 269 - “Buy and Hold” Barron’s 500 Defensive Companies

Situation: You will become a “risk-off” investor the day you retire. The most you’ll be able to draw from your retirement savings is 4%/yr, preferably 3.5%. That amount has to be re-calculated each year by adding enough to compensate for inflation. You’ll also need to match revenues with expenses, with the goal of spending 1/12th of that yearly income each month. Inflation won’t be your main problem, as long as 50% of your retirement savings are in the stock market, where prices inflate at about the same rate as your food and utility bills. In normal economic times, the interest paid on bonds you own will also track inflation. For example, the yield on 10-yr Treasuries has stayed at 2.3%/yr ahead of inflation since 2000, and over the past 140 yrs. Your problem will be living on a fixed income with an inflexible budget. Money to buy new clothes or take a vacation will have to come from a savings account that you’ve set up for non-recurring capital expenditures, an account that you contribute to every month.

To increase your spending power, three options are relatively common: 1) rent out part of your house and raise the rent faster than inflation raises your expenses; 2) find a part-time job where your after-tax income is likely to grow faster than inflation; and/or 3) benefit from “risk-off” stocks that you bought before retiring, stocks that you never plan to sell (because they pay a good and growing dividend). Let’s dig deeper on Option 3, living off dividend income.

Mission: Provide fundamental information about each company that pays “risk-off” dividends likely to grow faster than inflation.

Execution: I know what you’re thinking: this is alchemy. And you’re right. In a world that arbitrages every financial asset every day, there is no such thing as free money after accounting for inflation and transaction costs. So, let’s start with how finance professionals do it. They invest in AAA sovereign bonds. These days, they have to pay for that privilege. In other words, the safest bonds (German Bunds) pay negative interest. You’re not going to do that, so you’ll have to take a little bit of risk. 

What is a “risk-off” dividend-growing stock? The risk that a dividend won’t increase continuously relates to the health of that company’s Balance Sheet. You’ve heard the phrase: “Bullet-proof Balance Sheet.” That means the company keeps cash (and cash-equivalents like US Treasury Bills) in a bank vault or with the US Treasury, and also has non-strategic assets that traders know can be sold for a good price, even during a recession. In recent blogs, we’ve talked about companies that have a “clean Balance Sheet” and have boiled that term down to tracking 4 ratios:  

   1. Total Debt:Equity is under 100% (or under 200% if the company is a regulated public utility). That means senior managers will still “call the shots” in a crisis, not the bankers.
   2. Long-Term Debt:Total Assets is the most important marker of a company’s “general financial condition." That ratio needs to be under 30% (35% if a regulated public utility). Long-term debt has to either be renewed at maturity or returned to the lender. In a financial crisis, the rate of interest that bankers charge for a renewal (“rollover”) will likely be higher than for the original loan. In the Lehman Panic, many companies found that rollovers were unavailable at any rate of interest. To avoid declaring bankruptcy, those companies had to either repay maturing loans by selling assets or find a “White Knight,” such as another company willing to assume that obligation as part of an acquisition.
   3. TBV:Px is a positive number. You want the stock’s price to include Tangible Book Value. Most S&P 500 companies don’t have TBV. Their book value lies mainly in the perceived value of their brand, which accountants call “goodwill” when the company is sold for more than its book value. But remember that property, plant and equipment are carried at historic cost when calculating book value. So, goodwill is more than just the perceived value of the brand. It’s the buyer’s perception of current value for property, plant, and equipment. TBV may be negative for a short period after a company restructures, e.g. by selling non-strategic assets to pay down LT debt as Procter & Gamble (at Line 7 in the Table) did recently. If the other 3 ratios indicate a clean Balance Sheet, the TBV will likely continue to be raised on schedule.
   4. Div:FCF is a positive number. Going into a Bear Market, you don’t want to own stock in companies that make a habit of borrowing money to pay their dividend. Always be suspicious of companies that don’t pay their dividend out of Free Cash Flow (i.e., “cash from operations” minus capital expenditures). 

Administration: Most companies with A-rated stocks pay good and growing dividends. S&P calls those with a 10+ yr record of annual dividend boosts Dividend Achievers. Another quick way to find relatively safe stocks is to take a close look at those issued by companies in “defensive” industries (Consumer Staples, HealthCare, Utilities, and Communications Services). Why? Because they sell essential goods and services. Unfortunately, that extra bulwark against bankruptcy leads many of those companies away from maintaining a clean Balance Sheet and toward a reliance on borrowed money. And banks will comply. Even during the Lehman Panic, Johnson & Johnson (with its AAA credit rating) had no difficulty borrowing money at attractive interest rates. We also use another safety factor when looking for “risk-off” companies, which is to confine our search to Barron’s 500 companies. Why? Because those companies have large revenue streams, capturing revenue from multiple product lines. One or two of those lines will continue to grow during a recession, reducing the impact from lines that loose sales. 

We find 7 Dividend Achievers in defensive industries that are sufficiently “risk-off” to be suitable for inclusion in a “buy and hold” retirement savings plan (see Table). 

Bottom Line: It’s a nice idea, to find “safe companies” that pay a good and growing dividend. A retiree who paid $50,000 for stock in such companies over a 10 yr period prior to retirement will not be confined to living on a fixed income. By the time she retires, those stocks will be yielding 4-5% of their initial cost, and that $2000+/yr of income can be expected to grow 9+%/yr going forward. Ten yrs into retirement, she’ll be receiving dividend checks totaling ~$5000/yr. We’ve turned up 7 Dividend Achievers that are good bets for accomplishing that feat. In the aggregate, they’ve increased their dividend 12%/yr over the past 16 yrs (see Column H in the Table). None have a statistical risk of price loss in a Bear Market that exceeds the 31% loss projected for the S&P 500 Index, and their average projected loss is only 25% (see Column M in the Table).

Risk Rating: 4 (where Treasuries 
= 1 and gold = 10)

Full Disclosure: I dollar-average monthly (www.computershare.com) into NEE, PG and JNJ, and also own shares in WMT and HRL.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 14 in the Table. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = the moving average for stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is 16-Yr CAGR. Price Growth Rate is the mean or trendline 16-Yr Price CAGR (http://invest.kleinnet.com/bmw1/). Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The NPV template is found at (http://www.investopedia.com/calculator/netpresentvalue.aspx).

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