Month 137 - S&P 100 Watch List - December 2022

 Situation: We like to compare our portfolio’s performance to the market’s performance (SPY). If we come up short, we’re “leaving money on the table”  that might better have been spent on SPY or a night at the opera.

Mission: Devise a numbers-based approach for getting 10-year total returns from our stocks that match SPY’s on a risk-adjusted basis. For example, Johnson & Johnson (JNJ) with its 5-yr Beta of 0.56 has a 10-yr Required Rate of Return (7.6%/yr) vs. SPY with its 5-yr Beta of 1.00 having a 10-yr Required Rate of Return that is 71% higher (13.1%).

Execution: see 15 S&P 100 companies in this month’s Table.

Administration: Watch Lists screen out stocks with red flag issues or concerns. We’ll start by eliminating companies that issue bonds rated lower than A- by S&P, as well as companies that don’t have a 16 year trading record in their present configuration. Then we’ll eliminate companies with one and 10 year returns that are less than their Weighted Average Cost of Capital (WACC). For the 10-year period, WACC calculations are unavailable, so a close approximation is used: Required Rate of Return (RRR). We screen out Possibly Overpriced companies by using a substitute for P/E: Enterprise Value divided by Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA). Companies with an EV/EBITDA higher than 16, which is the upper limit of the S&P 500’s historic range (11-16), are reported separately at the bottom of this month’s spreadsheet. There are 19 Possibly Overpriced companies. 

Analysis: Warren Buffett’s favorite metric is found in Column S of the Table (Return on Tangible Capital Employed). He thinks anything higher than a 20% return for the last fiscal year (lfy) is a good number. Nine companies meet that standard (MRK, ABT, TXN, GOOGL, HD, JNJ, LMT, UPS, BMY). His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (see Column AQ), and is negatively impacted by the degree to which managers capitalized the company by issuing long-term bonds (see Column Z). Three companies have a BUY rating from Morningstar (GOOGL, TGT, JPM). Eight companies have a Debt to Equity ratio lower than 1.0 (MRK, ABT, PFE, TXN, GOOGL, JNJ, LMT, GD). Mr. Buffett also states that a high Free Cash Flow Yield (Column J) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost. Fourteen companies meet this standard (MRK, UNP, ABT, PFE, TXN, GOOGL, HD, JNJ, JPM, LMT, CAT, UPS, GD, BMY). His third point (that the stock be available “at a sensible price”) is addressed by the 1 year and 3-5 year Forward PEG ratios (see Columns N and O): Two companies have a Forward PEG that is a lower than 2.0 at both time points (GOOGL and GD). Nine companies are A-rated (MRK, PFE, TXN, TGT, JNJ, JPM, LMT, UPS, GD). Five companies are cited 4 times (MRK, TXN, GOOGL, JNJ, LMT). 

Bottom Line: In business school, you’d learn that there are only two ways to beat the market: Do insider trading (which is illegal) or take on more risk, which means to overweight stocks that have a 5-yr Beta higher than 1.00. Investors often overweight such stocks through a Fear Of Missing Out (FOMO). Warren Buffett is of the opposite mind. He encourages investors to run portfolios with an average 5-yr Beta of 0.7, which means overweight stocks that have a 5-year beta of ~0.7 or lower. Those are called Sleep Well At Night stocks (SWANs). This month’s Table has 5 FOMOs (TXN, GOOGL, HD, JPM, CAT) and 5 SWANs (MRK, PFE, JNJ, LMT, BMY). 

Risk Rating: 5

Full Disclosure: I dollar-average into MRK, UNP, PFE, TXN, HD, JNJ, JPM, LMT, CAT and UPS, and also own shares of GOOGL and TGT.

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