Situation: When does a temporary loss of capital become permanent? Answer: When we sell. Lesson: Pay more attention to low-volatility large-capitalization blue-chip companies.
Mission: Screen the 65-stock Dow Jones Composite Average for low Beta, large-cap stocks, meaning those listed in the iShares Russell Top 200 ETF (IWL) that have a 5-year Beta of 1.00 or lower (per Barron’s). Include all companies having a 5-yr Beta lower than 0.70, which traders call Sleep-Well-At-Night stocks (SWANs). For companies with a 5-yr Beta between 0.70 and1.00, include only those with a 10-yr total return/yr that exceeds the 10-yr total return/yr for the S&P 500 Index ETF (SPY).
Execution: see Table of 18 companies.
Analysis: Warren Buffett’s favorite metric is found in Column T 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. Seven companies meet that standard (MRK, AMGN, KO, JNJ, MCD, PG, CSCO). 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 have capitalized the company by issuing long-term bonds (see Column Z). Six companies have a BUY rating from Morningstar (AEP, HON, NEE, DUK, CSCO, VZ), and 7 companies have a Debt to Equity ratio lower than 1.0 (MRK, UNH, CAT, JNJ, WMT, PG, CSCO). Mr. Buffett also states that a high Free Cash Flow Yield (Column K) reflects good management because Retained Earnings allow a company to expand operations (or pay down debt) at zero cost. Free Cash Flow remains after paying dividends at 12 companies (MRK, UNH, AMGN, CAT, HON, KO, JNJ, MCD, WMT, PG, UNP, CSCO). 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 O and P): Six companies have a PEG lower than 2.5 for both time periods (MRK, UNH, AMGN, CAT, HON, CSCO). Nine companies are A-rated (MRK, CAT, AEP, HON, JNJ, WMT, NEE, PG, CSCO). Six companies are cited 4 or more times (MRK, CAT, HON, JNJ, PG, CSCO).
Bottom Line: We find two Pricing Anomalies that should interest investors. 1) Eight companies have 10-yr total returns that beat the S&P 500 Index (MRK, UNH, CAT, HON, MCD, NEE, UNP, CSCO). We call those License-To-Print-Money (LTPM) stocks because they are high-reward and low-risk. 2) There are 5 SWANs with a 10-yr Required Rate of Return that is higher than their 10-yr Actual Rate of Return (KO, SO, DUK, D, VZ), meaning their cost of capital exceeds their return on capital. Stocks in such straits normally do not have a low enough 5-yr Beta to be SWANs. So, difficulties being faced at those companies are likely temporary.
Risk Rating: 6 (where 10-yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into MRK, CAT, AEP, JNJ, MCD, KO, SO, WMT, NEE, PG, UNP, CSCO and VZ, and also own shares of UNH, AMGN, HON, DUK and D.
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