Situation: We’ve just been through a market crash, and many of us trimmed our bets as the market imploded. Finance professionals avoid doing that, since they live by a single Commandment: Thou shalt not recognize (in Financial Statements) a loss (of Capital). Warren Buffett translates that for us retail investors: “Rule #1: Never lose money; Rule #2: Never forget Rule #1.”
Mission: Develop a system that largely removes the temptation to sell into a market crash. Start with Warren Buffett’s basic advice to retail investors, which is to keep the 5-yr Beta of their stock portfolio at approximately 0.70. That means half its value has to be in SWANs (Sleep Well At Night stocks). The remaining half carry no more than a market risk (5-yr Beta = 1.00). To model a system, prioritize liquidity and restrict sample size by looking at only the 35 stocks in the 65-stock Dow Jones Composite Average (DJCA) having a 5-yr Beta under 1.00. Exclude any stocks with a 10-yr Required Rate of Return (RRR) that exceeds the 10-yr Actual Rate of Return. For stocks with a 5-yr Beta between 0.70 and 1.00, include only ALPHAs (stocks that beat the S&P 500 Index over trailing 5 and 10 year periods.
Execution: see Table of 17 stocks.
Analysis: Warren Buffett’s favorite metric is found in Column S of the Table: Return on Tangible Capital Employed. He thinks a 20% return for the last fiscal year is a good number. Seven companies do so: MRK, UNH, AMGN, JNJ, MCD, LSTR, PG. 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 choose to capitalize the company by issuing long-term bonds (see Column Y). Three companies have a BUY rating from Morningstar (AMGN, AEP, PEG), and 7 companies have a Long-term Debt to Equity ratio lower than 1.0 (MRK, UNH, ATO, JNJ, WMT, LSTR, PG). Mr. Buffett also states that a high Free Cash Flow Yield (see Column K) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost; 9 companies meet that standard (MRK, CAT, UNH, AMGN, ATO, JNJ, MCD, WMT, LSTR, PG). His third point (that the stock be available “at a sensible price”) is addressed by one and 3-5 year Forward PEG ratios (see Columns N and O). Three companies (MRK, UNH, AMGN) have PEGs under 2.0 at both intervals. Nine companies are A-rated (see Column AQ): MRK, ATO, ED, AEP, XEL, JNJ, WMT, NEE, PG. Five companies are cited 4 or more times (MRK, UNH, AMGN, JNJ, PG).
Bottom Line: Taken together, the 17 low-volatility stocks beat the S&P 500 Index ETF (SPY) after 5-yr and 10-yr holding periods (see Columns E and H in the Table).
Risk Rating: 4 (where 1 = 10-yr US Treasury Note, 5 = S&P 500 Index, 10 = gold).
Full Disclosure: I dollar-average into MRK, CAT, AEP, SO, JNJ, MCD, WMT, NEE, LSTR and PG, and also own shares of UNH, AMGN and ATO.
"The 2 and 8 Club" (CR) 2017 Invest Tune Retire.com All rights reserved.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
