Month 141 - 24 A-rated Mid-Caps and Large-Caps - April 2023

Situation: This is our most important Watch List, so we update it every 6 months. Since the last version appeared (Month 135 - October 2022), we’ve added mid-cap companies and 3 new requirements for the A-rating (see Appendix). As a result, 10 companies have been deleted (ADP, WM, TXN, HON, KO, PEP, RTX, ITW, CAT and QCOM) and 11 added (PCAR, ED, SNA, ATO, XEL, WEC, LIN, HRL, LNT, UPS and CSCO).

Mission: Analyze all companies in the FTSE Russell 1000 Index ETF (IWB) having a reliably above-market dividend yield, low price volatility, and strong Balance Sheet. 

Execution: see Table of 24 companies.

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 do so: MRK, LMT, LLY, SNA, JNJ, PG, PFE, UPS, and 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 capitalize the company by issuing long-term bonds (see Column Z). Six companies have a BUY rating from Morningstar (AEP, APD, NEE, LNT, PFE and CSCO), and 14 companies have a Long-term Debt to Equity ratio lower than 1.0 (MRK, ADM, GD, PCAR, ATO, SNA, APD, JNJ, WMT, LIN, PG, HRL, PFE and CSCO). Mr. Buffett also states that a high Free Cash Flow Yield (Column K) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost; 16 companies meet that standard (MRK, LMT, LLY, ADM, GD, PCAR, SNA, JNJ, WMT, LIN, PG, HRL, LNT, PFE, UPS and CSCO). 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); 6 companies (MRK, LLY, GD, APD, UPS and CSCO) have PEGs under 2.5 at both intervals. Four companies are cited 4+ times (MRK, PFE and CSCO).

Bottom Line: A-rated companies are our response to the observation that “It is the destruction of capital during market declines that has the greatest impact on long-term portfolio performance.” (Gerard Minack, Morgan Stanley strategist.) Ten stocks outperformed the S&P 500 (i.e., exhibited Alpha) over the past 10 years while having a lower 5-yr Beta (MRK, LMT, LLY, GD, ATO, SNA, APD, NEE, LIN and CSCO). We call those Hardy Perennials.

Risk Rating: 6, where 10-year Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10.

Full Disclosure: I dollar-average into MRK, LMT, LLY, SNA, AEP, JNJ, WMT, NEE, PG, PFE, UPS and CSCO, and also own shares of ATO, APD, LIN and TGT. 

Appendix: Eleven criteria required for an A-rating: 1) being listed at VYM (the Vanguard High Dividend Yield ETF), 2) being listed for 16+ years at the New York Stock Exchange, 3) having at least an A- S&P rating on the company’s corporate bonds, 4) having the company’s common stock rated at least B+/M by S&P, 5) having positive earnings per share (EPS) for the trailing twelve month period (TTM), 6) having a positive book value per share for the most recent quarter (mrq), 7) having long-term debt no greater than 2.5 times equity, 8) having a 10-year actual rate of return greater than the 10-year required rate of return (RRR), 9) having no dividend cuts in the past two years, 10) having a 5-year Beta lower than 1.00, 11) having a total debt to EBITDA (mrq) ratio no higher than 2.5 unless there is collateral (tangible book value).

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