Situation: Investors who want to pick individual stocks need a “training wheels” approach. Start with a list of 65 companies that have already been vetted by Wall Street professionals: the Dow Jones Composite Average (DJCA). Then limit your attention to large-capitalization companies. Why? Because those are likely to have a) more than one product line, and b) access to a line of credit large enough and cheap enough to allow the company to “ride-out” a market crash. Finally, it is important to pick companies that have raised their dividend annually for 10+ years (but don’t have an unsustainably high dividend yield), then exclude companies that issue bonds rated lower than A- by Standard & Poor’s.
Mission: Select from stocks found in a) the 65-stock Dow Jones Composite Average, b) the iShares Russell Top 200 ETF (IWL), and c) the Vanguard Dividend Appreciation ETF (VIG).
Execution: see Table of 19 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 9 stocks qualify: CAT, UNH, V, JNJ, PG, MSFT, AAPL, HD, CSCO. His second point (that the company be “run by able and honest managers”) is addressed in Morningstar reports (Column AN) and negatively impacted by the extent to which managers capitalize the company by issuing long-term bonds (Column Z). Two stocks (MSFT and NKE) have a BUY rating from Morningstar, and 10 companies have a Long-Term Debt to Equity ratio lower than 1.0 (MRK, TRV, UNH, V, WMT, JNJ, PG, MSFT, CSCO, NKE). 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; 17 companies meet that standard (MRK, CAT, TRV, UNH, KO, HON, V, WMT, JNJ, IBM, PG, MSFT, AAPL, HD, UNP, CSCO, NKE). His third point (that the stock be available at a sensible price) is addressed by 1-yr and 5-yr Forward PEG ratios (Columns O and P). Eight companies have a PEG lower than 2.5 at both intervals (MRK, TRV, UNH, V, HON, JNJ, MSFT, NKE). There are 9 A-rated companies in Column AO (MRK, CAT, TRV, WMT, JNJ, PG, NEE, UNP, CSCO). Fourteen companies have a 10-yr total return that is greater than its 10-yr Required Rate of Return (capitalization cost), as shown in Columns D and E: MRK, CAT, TRV, UNH, KO, V, WMT, JNJ, NEE, PG, JPM, MSFT, AAPL, HD. Seven companies are cited 5 or 6 times: MRK, TRV, UNH, V, JNJ, PG, MSFT.
Bottom Line: Over the past 20 years (Column Q), these 19 stocks have appreciated 5% faster/yr (in price) than SPY (the S&P 500 Index ETF), while being exposed to no greater risk of loss (Column S).
Composite Risk Rating: 6 (10-yr US Treasury Notes = 1, S&P 500 Index = 5, and gold = 10)
Full Disclosure: I dollar-average into MRK, KO, WMT, JNJ, NEE, PG, MSFT, HD and UNP, and also own shares of CAT, UNH, V, HON, IBM, JPM, AAPL, NKE and CSCO.
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