Situation: One of the most actionable newsletters we’ve published came out 6 months ago: Month 129 - 26 A-rated Non-financial companies in the iShares Top 200 Index - April 2022. It describes how we arrive at a workable Watch List of companies. As such, this newsletter relates to the most important criticism we’ve received from our readers. Namely, that information in our most actionable newsletters isn’t tracked over time.
Mission: To update last April’s newsletter every six months, starting this month. The overall goal of our newsletter is to present companies and ETFs that beat the S&P 500 Index over the Trailing Sixteen Year (TSY) period on a risk-adjusted basis.
Execution: see Table of 23 Companies selected from the iShares Top 200 ETF (IWL).
Administration: We’ve upgraded our requirements to designate a company “A-rated” (see Appendix). Six of last April’s companies no longer meet requirements: Cisco Systems (CSCO), Intel (INTC), 3M (MMM), United Parcel Service (UPS), Eaton plc (ENT) and Comcast (CMCSA), but we’ve found 3 IWL companies that do meet requirements: American Electric Power (AEP), Archer Daniels Midland (ADM), and Honeywell International (HON). New requirements for the A-rated designation include having a 16-yr RRR, meaning a Required Rate of Return (see Column D of the Table) that is no less than the 16-yr Actual Rate of Return (Column E). RRR is calculated by using the Capital Asset Pricing Model which has 4 moving parts (see sample in Appendix).
Analysis: Warren Buffett’s favorite metric is found in Column T of the Table: Return on Tangible Capital Employed. He thinks a 20% return for the last fiscal year (lfy) is a good number. Nine companies meet this standard: LLY, MRK, PG, TXN, JNJ, PEP, LMT, ITW, QCOM. His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (see Column AP) and is negatively impacted by the degree to which managers capitalize the company by issuing long-term bonds (see Column Y). Four companies have a BUY rating from Morningstar (APD, HON, PEP, QCOM), and 11 companies have a Long-term Debt to Equity ratio lower than 1.0: MRK, ADP, PFE, PG, ADM, TXN, APD, JNJ, WMT, RTX, GD. Mr. Buffett also states that a high Free Cash Flow Yield (Column L) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost. 17 companies meet that standard: LLY, MRK, ADP, WM, PFE, PG, ADM, TXN, KO, HON, JNJ, LMT, ITW, RTX, CAT, GD, QCOM. His third point (that the stock be available “at a sensible price”) is addressed by 1-yr and 3-year Forward PEG ratios (see Columns O and P): Only 4 companies (HON, RTX, GD, CAT) have PEGs under 2.0 for both intervals. Seven companies are cited 3 times (MRK, PG, HON, TXN, JNJ, RTX, QCOM).
Bottom Line: Stock-pickers need to track “fundamental” metrics over time for companies on their Watch Lists.
Risk Rating: 7 (where 10-yr US Treasuries = 1, S&P 500 Index = 5, and gold bullion = 10).
Full Disclosure: I dollar-average into MRK, NEE, AEP, PFE, PG, TXN, JNJ, PEP, LMT, WMT, RTX, CAT, and also own shares of APD, TGT, KO, HON, GD.
Appendix: Requirements for A-rated designation are to 1) be listed in the Vanguard High Dividend Yield ETF (VYM); 2) have the 16-yr trading history required for quantitative analysis by the BMW Method; 3) issue corporate bonds rated A- or better by S&P; 4) issue common stock rated B/M or better by S&P; 5) have shown positive earnings growth for the trailing 12 months; 6) have shown positive Book Value for the most recent quarter; 7) have capitalization from issuance of corporate bonds that is no more than 2.5 times capitalization from issuance of common stock (equity), 8) have a 16-yr Rate of Return in Column E in the Table that is no less than the 16-yr Required Rate of Return or RRR in Column D in the Table, and 9) be domiciled in the United States.
Appendix: Calculation of RRR by using: a) Market Return (S&P 500 Index); b) Risk-free Return (10-yr US Treasury Note); c) Risk (5-yr Beta); d) Holding Period (we use 16 years so as to include a major recession). Procedure: subtract the 16-yr Risk-free Return (Vanguard Intermediate Term Treasury Fund with ticker VFITX) from the Market Return (16-yr SPDR S&P 500 ETF with ticker SPY) to get the market effect on pricing. Multiply the market effect on pricing by the 5-yr Beta to get the risk attached to that effect. Then add back the Risk-free Rate to get RRR. For example, the Vanguard Utilities ETF (VPU) has an RRR of 5.8%/yr because SPY minus VFITX for the 16-yr holding period is 6.0%/yr, and 6.0% times VPU’s 5-yr Beta of 0.47 is 2.8%. Adding back the 16-yr VFITX total return of 3.0%/yr gives VPU’s 16-yr RRR of 5.8%/yr. The actual 16-yr total return for VPU of 8.9%/yr is less than the actual 16-yr total return for SPY 9.0%/yr. But SPY has a 16-yr RRR of 9.0%/yr because the 5-yr Beta for the S&P 500 Index is fixed at 1.00 by convention. Stock traders think of RRR as the hurdle rate that must be achieved to equal the market’s return on a risk-adjusted basis.
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