Saturday, January 11, 2014

New Purchase

As you people know, I prefer to announce my buys and sells in advance. I want people to know what I'm going to do before I do it and why I'm doing it. I hate when people give me after the fact information, when they've had a chance to enjoy some success first.

We can't learn from that! This blog is about me explaining what I do and why I do it and then we all can see what works and what doesn't. That's how we learn, by helping each other.

Anyway, a check was sent off to TD Ameritrade today and should hit the account by next Tuesday. It might be Wednesday before the purchase is made. I'm going with IBM unless some market moving news comes out between now and then.

Here is the thought process:

In the next few days, I will be making another purchase in the Project $3 Million Portfolio. I thought I'd share some insight into how I go about the process.
I've had quite a few requests about my stock selection process, and although I don't mind sharing it, it is time consuming to take people through the process. So, I thought I would write it down here and simply link to it when asked again.
The very first thing I look at is a company's financial strength ratings, their credit rating if you will. I look for companies that rate a 1 or 2 for Safety by Value Line, or a BBB+ rating by Morningstar if you don't have access to Value Line, and I look at S&P Capital IQ for Quality ratings of B+ or better.
If a company doesn't meet the quality rating, or I can't confirm one, I go no further, unless I'm specifically looking for a speculation company.
These companies I purchase are supposed to provide us with a lifetime of income and the best way to insure that is to own quality. Quality is job #1.
I have a watch-list of 48 companies that pass the quality stage. These are the companies I monitor for opportunity.
As I look over the watch-list, I have to see what I own and decide which sectors I want to go with. Here is the current portfolio weightings:
Consumers ... 43.2%
MLP's ... 14.5%
Utilities ... 13.5%
Industrials ... 8.1%
REIT's ... 5.6%
Healthcare ... 4.2%
Business Services ... 4.1%
Energy ... 3.8%
Technology ... 3.1%
Financials ... ZERO
Since the portfolio is so heavily weighted in consumers, anything consumer related is out this time around. That would include WMT or TGT for example.
I decided to focus on the sectors with weightings under 10%, to help build some balance as we go forward this year.
In looking over my watch-list, it isn't valuations I look to first. I look for companies rated to beat the market over the next 6 to 12 months. Fidelity has a rating system called StarMine and the research firms in the system provide ratings from zero to ten to determine where the collective firms rate a company currently. Anything from 7.0 and up is a Bullish rating.
The reason I want some momentum here is because I want the position to have a good chance of getting off to a good start. We're in a good economic and market environment right now where the tide is supposed to raise all boats. By getting off to a fast start, it provides peace of mind during market corrections.
Out of 48 companies on the watch-list, and considering the sectors I was looking to invest in, only 3 companies passed the StarMine ratings test. They were MSFT... 9.0, IBM ... 9.5 and CSX ... 9.1 If I was willing to add consumer related, WMT rated out at 7.4.
Once I have the list narrowed down, I then look to see who provides the best discounts to fair value. I use S&P Capital IQ for these ratings. According to S&P, MSFT is selling at an 18.8% discount. IBM is selling at a 30.7% discount to fair value, and CSX is overvalued by 4%. I like to see discounts of 15% or more, but will settle for less when I have to. I eliminated CSX from consideration until better valuations present themselves.
The next step, since this is a dividend growth portfolio, is to determine the total dividend return when you combine yield to the dividend growth number, what is known as the Chowder Rule.
I won't delve into the fundamentals until the quality ratings, discounts and dividend growth numbers are acceptable. I don't wish to dig deep and then find out the dividend growth is unacceptable.
When you take the current yield and add it to the 5 year compounded annual growth, I want to see a number of 12% or better when the yield is 3% or higher, or a number of 15% or better when the yield is under 3% but above 2%.
MSFT has a Chowder Rule number of 18.98%. IBM has a Chowder Rule number of 16.27%, so both companies qualify.
I want to see where the company has a consecutive string of raising the dividend. I'll accept 5 years, but I prefer 10 or more. The more the better.
IBM has a 17 year string and MSFT has a 7 year string. Both qualify.
At this point I look at earnings. I look at the last 10 years and I want to see where earnings have increased at least in 7 of those 10 years.
IBM has seen their earnings rise in 10 of the last 10 years. I really like this! MSFT has seen their earnings rise in 7 of the last 10 years. Both qualify.
At this point, it isn't a matter of who has the better numbers, both companies qualify for the next step, where the final decision will be made.
This is important! I don't go with the best yield and dividend growth. I go with the company with the better underlying fundamentals, and that's the next step.
I look at current PE's vs historical PE's to help determine valuation.
IBM's current yield is 11.% and normal PE is 16.6%. MSFT's current PE is 13.3% and normal PE is 18.1%. Both are still looking good. But when I look at return on equity and return on invested capital, I see that IBM's numbers are on the rise and MSFT's numbers are on the decline.
Estimated earnings growth, and I realize they are just estimates, show IBM at 10.2% and MSFT at 9.1%.
When I look at all the firms that cover these companies, StarMine tracks their buy, sell or hold ratings for accuracy. I always look at the reports by the top two firms for accuracy on a company and these companies aren't tops with every company they cover.
The top two firms for accuracy calls on IBM are Jefferson Research with an 84% accuracy rating and then comes Ford Equity Research with a 73% accuracy rating. Both companies have a Buy rating on IBM.
The top two firms for accuracy calls on MSFT are the same two companies, so this makes this easier to decipher. Jefferson Research has an accuracy rating of 84% and has a Hold rating on MSFT. Ford Equity has a 73% accuracy rating and has a Strong Buy on MSFT.
Since Jefferson Research is more accurate than any other firm with their calls on these two companies, I delved a little deeper into their research.
Earnings Quality ... Strongest
Cash Flow Quality ... Strongest
Operations Efficiency ... Strongest
Balance Sheet ... Strongest
Valuation ... Least Risk
Earnings Quality ... Strongest
Cash Flow Quality ... Strong
Operation Efficiency ... Strong
Balance Sheet ... Weakest
Valuation ... Least Risk
Both companies are still worthy of purchase, and some people may choose MSFT because of the higher yield and slightly better Chowder Rule number, but IBM presents the stronger fundamentals at this time, and it's those fundamentals that are going to drive the dividend growth.
So, when the cash hits the account, I will be taking out a position in IBM the middle of next week.


  1. Thanks for sharing your thought process. It seems like you value analyst' opinions very highly when considering your purchases. Have they ever let you down in this regard?

    Good luck with your new position in IBM!

    1. It's not their buy or sell ratings I value, it's the numbers behind it. When I can confirm the numbers from several sources, and the numbers are favorable, that's what I value.

      I can see if earnings are rising or not, analysts or no analysts. I allow them to judge the quality of those earnings, and if there's one thing analysts like to do, is out-smart each other. So, I'll use that.

      If IBM's share price does what they say it's going to do, that's gravy with me. It's the safety of the dividend, and the dividend growth that is important to me. The analyst numbers have a big part in swaying me on that point.

  2. Chowder, thanks for sharing your thought process. I looked pretty closely at both IBM and ACN over the last couple years. I opted to build my position in ACN instead of IBM, and still believe it offers the better investment in that industry. ACN seemed to have better initial yield, dividend growth, more consistent earnings along with similar share buy backs. At this point, I've been happy with my decision, just curious if you happened to compare those two stocks as well- and if so what swayed you towards IBM.

    1. Brian, ACN never passed the very first criteria I look for in my stock selection process.

      >>> The very first thing I look at is a company's financial strength ratings, their credit rating if you will. I look for companies that rate a 1 or 2 for Safety by Value Line, or a BBB+ rating by Morningstar if you don't have access to Value Line, and I look at S&P Capital IQ for Quality ratings of B+ or better. <<<

      I could not find Quality Ratings or Credit Ratings for ACN.

      The formula I use is:

      High Quality + High Current Yield + High Growth of Yield = High Total Return.

      ACN may turn out to be an excellent investment, but unless it can qualify under the High Quality aspect of the formula above, I won't consider a company unless I'm looking for a speculative position. I am looking to add a long term investment at this time, not a speculation company.

      Again, ACN may outperform IBM, I don't know. What I do know is that if I own companies that meet the formula above, that formula never fails to produce successful long-term positions. People may fail the formula, but the formula never fails the people.

    2. Chowder, thank you that makes sense. I'll consider adding that check to my initial stock selection criteria. I appreciate you taking the time to respond and for posting this blog. You inspired me to start my own project 3 million, only wish I had started 10 years ago!

  3. many thanks for sharing your thoughts.
    what screening methods you to come up with 48 stocks on your watch list in the first place? (what you wrote here was how you came up with the final one from this 48 watch list).

  4. just try to learn: you said the current holdings has "Technology ... 3.1%"....I couldn't find Tech stocks in the portfolio---what is the symbols?

    1. Screening: ... I simply looked in Value Line for a list of companies that rated 1 or 2 for safety, in sectors I might be interested in investing in. Then it's a matter of waiting for the right opportunity.

      ADP is listed under the technology sector, then it gets broken down into the business services industry.

  5. thanks, chowder.
    do you mind telling us at what price you bought IBM? (if you already bought it)

    1. Yes, it was purchased. Price of purchase is $185.03.

      The price actually had the nerve to drop below my entry but it responded as I expected it to. ... Ha!

  6. Thanks Chowder for sharing your knowledge here. I too would like to start a portfolio with the same objectives as project 3 million. Do you recommend that I replicate your current holdings equally weighted? Thanks

    1. Leto, you can use this portfolio as a blueprint if you wish. I can't tell you what you should do. I merely show what I do and explain why. If that helps you in how you establish your portfolio, then I see nothing wrong with that.

  7. Thanks for your insight Chowder. I've got a few different questions about your approach:
    1. When evaluating quality, you use either Value Line, Morningstar, or S&P Capital IQ. I don't have access to Value Line, but use the other two. If a stock has a favorable quality rating (B+ or better). However, if StarMine ranks the accuracy of S&P at a low accuracy, for instance only getting a 35% for IBM, should that make you re-evaluate the initial quality rating of the company?
    2. Do you evaluate different fair-value calculations or just simply use S&Ps? Using IBM as an example, S&P rates the fair value at $242.20 vs. Morningstar at $208 (which I realize, some may not have access to). Out of 22 brokers (which I'd give less weight to their opinion vs. Morningstar), Yahoo Finance has:
    Mean Target: 193.59
    Median Target: 190.00
    High Target: 235.00
    Low Target: 160.00

    Naturally, the more opinions you get, the more variation you will receive. Still, S&P has the highest valuation, which could change whether IBM qualified with their discount/fair-value calculation.

    Predominantly, I ask these questions to held guide my evaluations and hopefully others; I have nothing in particular with or against your decision with IBM, but using it as an example.

    Thanks for the help in advance!

    1. By the way, I also recognize that Yahoo Finance can have outdated information or projecting future target price, which would differ from the current valuation.

    2. Jason,

      The answer to question #1 is no. The StarMine rating has nothing to do with the fundamentals of the company, re: quality ratings.

      The StarMine ratings are timing issues. It rates the past accuracy of the results based on their timing with regard to issuing buy, sell or hold calls.

      If I have two companies to choose from which are very close to each other via the fundamentals, I'll choose the one with the higher StarMine ratings because price is expected to go higher over the next six to twelve months. I can then come back to the company with lower StarMine ratings next time, and probably still get a decent price since it isn't expected to rise as fast.

      Regarding question number 2, it doesn't matter to me what the price points are between the reporting agencies. I'm looking to see that the consensus is saying the trend will be higher. Since I'm not going to be selling at the price point anyway, it doesn't matter if one source says fair value is $242 and the other says $208. If I'm buying at $180, consensus thinks price is going higher.

      In looking at discount to fair value, I stick with S&P Capital IQ because my charting service uses their data as well.

      I'm looking for consistency there too. I use M* and Value Line to confirm that each of them think earnings are going higher, the dividend is safe, and price should be heading higher.

  8. Do the earnings from today worry you at all?

    1. Every company goes through business cycles where earnings aren't as strong as they are at other times. It's part of doing business. You can't hold a company long-term, and benefit from the power of compounding, unless you sit tight and ignore the short term noise.

      I allow for companies to have down years in earnings. Part of the stock selection process is looking for companies that have raised their earnings in 7 out of the last 10 years. That means you have to hold during the down years and by reinvesting the dividends, all of those add-on shares are being bought at a discount.

      IBM has had down years before, and they kept on clicking over the long-term.

      So no, I am not concerned at this time.

  9. Chowder, I have really enjoyed reading your blog/posts on SA as you have really helped open my eyes; to both the vast long term potential in dividend stocks and how reckless I've been since starting my roth IRA five years ago in 'chasing' the next hot stock... I recently opened long positions in AFL, KMI, O, HCN, and am still researching which energy utility company to go with (took a look at the geographical energy consumed and was surprised to see the highest per capita in the midwest..... Anyway, the reason I am posting- reinvesting dividends is money as it's just icing on the cake... but I came across various posts where people keep citing all of these worries with UBTI/UBI taxation and thus losing any/all tax benefits of the Roth... I figured the path of least resistance would be to ask you directly as this is not your first rodeo!

    Thanks, consider me a follower to the 3 million dollar promised land!

    - Matt

    1. Matt, distributions from MLP's are mostly return of capital, not earned income. Due to this, the distributions are not taxed when held in a taxable account. The return of capital actually lowers your cost basis, and after a period of time, it is possible to end up with a zero cost basis. At that time, I believe the distributions are then taxed as capital gains.

      The tax shelter is lost in an Ira since an Ira is a tax sheltered account as it is.

      You can hold MLP's in tax deferred accounts, but if you do, then you have to worry about UBTI. Most of the pipeline companies don't throw off enough UBTI to worry about initially. I can't speak for other types of MLP's.

      The problem comes at the time when you might want to sell, or might have to sell. The bookkeeping tactic that allows you to receive return of capital, as opposed to earned income, has something to do with depreciation of the MLP's assets. At the time of the sale, the government "recaptures" that depreciation. Over a long period of time, it can be quite a sum that is deducted from the proceeds of the sale. Therefore, even though the MLP may be in an Ira, there will be taxes due.

      To keep it simple, I placed KMR and KMI in our Ira's and all other MLP's in our taxable accounts.

      On another note, if you decide to own EPD, and are willing to reinvest the distributions, EPD passes on a 5% discount to the reinvested unit price. TD Ameritrade and Fidelity pass those discounts along at no cost of administering it.

    2. Thank you for the clarification Chowder! Do you see this often misconstrued? I don't think a lot of people are aware of this...

      So I have a roth IRA and a 401k through work (pre tax dollars) in which I can purchase individual stocks and whatnot. Would that be a better place to own MLPs since I will be paying the taxes as I make withdrawals in 35 + yrs?

      Thanks again

    3. I would not purchase MLP's in an IRA or 401K if looking long term. The recapture of depreciation would potentially wipe out a lot of your profits.

      I said it's legal to hold MLP's in an Ira, I just don't think it's prudent to do so because of recapture.

      KMR and KMI are one way to eliminate the recapture problem and a way to own the pipelines in an Ira or 401K.