Situation: “You’ve got your show horses and your work horses.” This month’s blog highlights work horses of the industrial sector, meaning those that pay an above-market dividend yield and reliably grow that payout every year.
Mission: Take the industrial companies in Vanguard’s High Dividend Yield ETF (VYM) and eliminate any that aren’t in the iShares Top 200 ETF (IWL). Also eliminate any that aren’t in the Vanguard Dividend Appreciation ETF (VIG), which is composed of companies that increase their dividend annually but leaves out companies with a dividend yield that is thought to be unsustainable (the 25% with the highest dividend yields). Also, eliminate any that issue bonds rated lower than A- by Standard & Poor’s.
Execution: see Table of 10 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 Trailing Twelve Months (TTM) is a good number, and 4 companies qualify: LMT, CAT, ETN, ITW. His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (Column AL) and is negatively impacted by the extent to which managers have capitalized the company by issuing long-term bonds (Column X). One company (HON) has a BUY rating from Morningstar, and 4 have a Long-Term Debt to Equity ratio lower than 1.0 (GD, ADP, EMR, ETN). Mr. Buffett also thinks 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; 9 companies qualify (LMT, CAT, GD, ADP, HON, WM, ETN, ITW, UNP). His third point (that the stock be available at a sensible price) is addressed by 1-yr and 5-year Forward PEG ratios (Columns O and P); 3 companies have PEGs lower than 2.5 at both intervals (GD, HON, UNP). There are 3 A-rated companies (see Month 153): CAT, GD, UNP. Seven companies have 10-yr total returns that exceed their 10-yr Required Rates of Return (capitalization cost), as shown in Columns D and E: LMT, CAT, GD, ADP, WM, ETN , ITW. The most highly cited company is GD (5 times).
Bottom Line: Fewer than 10% of the largest 200 companies in the S&P 500 Index meet these criteria for safety. Pricing for shares in the industrial sector is cyclical, but these 10 companies have 10% lower volatility than the S&P 500 Index (see Column C). This makes them less likely to fall steeply in price during a bear market (as shown in Column F) and therefore outperform the S&P 500 ETF (SPY) after 10 years (see Column E).
Risk Rating: 6 (10-yr Treasury Note = 1, S&P 500 Index = 5, gold bullion = 10)
Full Disclosure: I dollar-average monthly into LMT, CAT, UNP, and also own shares of GD and HON.
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