The 27 (Really 28) Stocks That Fit Buffett’s High-Quality Buy Criteria

From Barron’s and according to Credit Suisse these are the 27 companies (although the list is 28) that fit Warren Buffett’s high-quality investment criteria right now.

  • Hanesbrands (HBI )
  • Hasbro (HAS)
  • Carter’s (CRI)
  • Ross Stores (ROST)
  • Dollar General (DG)
  • Wal-Mart Stores (WMT)
  • CVS Health (CVS)
  • Walgreens Boots Alliance (WBA)
  • Aon (AON)
  • UnitedHealth Group (UNH)
  • Aetna (AET)
  • Cigna (CI)
  • Universal Health Services (UHS)
  • Johnson & Johnson (JNJ)
  • Bristol-Myers Squibb (BMY)
  • General Electric (GE)
  • Honeywell (HON)
  • General Dynamics (GD)
  • Snap-On (SNA)
  • Acuity Brands (AYI)
  • Carlisle Cos. (CSL)
  • MSC Industrial Direct (MSM)
  • Toro (TTC)
  • C.H. Robinson Worldwide (CHRW)
  • International Flavors & Fragrances (IFF)

The next three stand out because they are technology companies and Warren has repeatedly said tech companies are not in his circle of competency.

  • Oracle (ORCL)
  • CA (CA)
  • Amdocs (DOX)

Warren did buy IBM so maybe an investment in Oracle and its recurring revenue streams and high switching costs could be attractive. I still say it’s a stretch.

Source:

27 High-Quality Stocks Warren Buffett Might Buy (Barron’s)

What Warren Buffett Wouldn’t Do

When looking for guidance from our role models we often ask “what would they do”? Maybe we should invert the question and ask, “what wouldn’t they do”?

Bloomberg does and asks what wouldn’t Warren Buffett do?

INVESTING

Don’t be too fixated on daily moves in the stock market: “Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.” (from letter published in 2014)

Don’t get excited about your investment gains when the market is climbing: “There’s no reason to do handsprings over 1995’s gains. This was a year in which any fool could make a bundle in the stock market. And we did.” (1996)

Don’t be distracted by macroeconomic forecasts: “The cemetery for seers has a huge section set aside for macro forecasters. We have in fact made few macro forecasts at Berkshire, and we have seldom seen others make them with sustained success.” (2004)

Don’t limit yourself to just one industry: “There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” (2008)

Don’t get taken by formulas: “Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” (2009)

Don’t be short on cash when you need it most: “We will never become dependent on the kindness of strangers… We will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.” (2010)

Don’t wager against the U.S. and its economic potential: “Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder… We will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.” (2015)

Read the rest of the article by following the link below for what Warren wouldn’t do as a manager in a business.

Source:

Here’s What Buffett Wouldn’t Do, and Maybe You Shouldn’t Either (Bloomberg)

Dividend Growth Investing for the Entrepeneur and Building Passive Income

Passive income.

It’s the holy grail. Earning income while you sip Mai Tais with warm tropical ocean water lapping at your toes.

If you do a Google search for “passive income” the first thing that pops up is Smart Passive Income by Pat Flynn. The main theme is building an online business that will require a lot of work, time, and effort up front but then will generate income and cash flow with minimal work going forward. Passive income. For the most part.

I think one the best ways to build a truly passive income stream is through dividend growth investing. No income stream is 100% passive. Some work is needed but with dividend growth investing the large publically traded companies are doing the grunt work. We just have to find the cheap to fairly priced high-quality businesses that can invest our capital, compound it, and pay us an ever increasing dividend off the proceeds.

Inerestingly enough in episode 174 of Pat Flynn’s Smart Passive Income Podcast our two worldviews combined. Pat and his guest Ryan Moran talk about their strategies for reinvesting the income they receive from their online businesses. After reinvesting income back into their businsesses or into new businesses, Mr. Moran’s second choice is investing in “ever increasing dividend paying stock”.

He is talking about Dividend Aristocrats and investing for dividend growth.

There are about 100-200 stocks that are publically traded that have increased their dividend every year for at least 10 years…

They’ve increase the amount that shareholders are getting in the form of cash flow. Even if the stock is going down they incease their dividend as a way to keep investors happy.

One of the dividend aritstocrats mentioned by Ryan Moran was Coca-Cola (KO). Putting aside whatever your views are on the future of Coca-Cola, it is a great example of the power of dividend growth investing, the reinvestment of the dividends, and compound growth to build future passive income.

Dividend Reinvestment vs. Spending Your Dividends

The short version, for the casual readers of the site: Imagine you had two identical investors, James and Thomas, both of whom bought $10,000 worth of Coca-Cola stock in mid-June 1962. James reinvests his dividends, Thomas does not.

  • Thomas without Dividend Reinvestment. Thomas bought $10,000 worth of Coca-Cola in mid-June 1962. This resulted in 131 shares in his account. He ignored the stock. Over the past 50 years, he collected $136,270 in cash. That is more impressive than it appears because $1 in dividend income back in the 1960’s had significantly more purchasing power. Adjusting for inflation, the current dividend equivalent of the cash income he was paid is $193,350. On top of this, his 131 shares of Coca-Cola have grown into 6,288 shares of Coca-Cola with a market value of $503,103.
  • James with Dividend Reinvestment. James bought $10,000 worth of Coca-Cola in mid-June 1962. This resulted in 131 shares in his account. He reinvested all of his dividends over the years. He never added to nor took away from the position over than those reinvested dividends. Today, James is sitting on 21,858 shares of Coke stock with a market value of nearly $1,750,000. His annual cash dividend income is nearly $22,000.
Image courtesy of Josh Kennon. Click image to enlarge.
Image courtesy of Josh Kennon. Click image to enlarge.

The real world example is Warren Buffet who first purchased Coca-Cola (KO) in 1988.

Over the years, Coke has split its stock many times. Now Warren Buffett’s original purchase price is around $3.25 per share (split adjusted). In 1988, Coke paid a dividend of $0.075 per share (split adjusted too). Coca-Cola now pays $1.22 per share, which represents a 38% current annual yield on Buffett’s original investment. By staying in Coca-Cola’s common stock, a high-quality dividend growth company, Berkshire-Hathaway receives a 38% cash return every year on its original investment just in dividends!

Geese That Lay Golden Eggs

If you’re buying the right dividend growth companies and letting them compound over time for the next 10-20 years then it is like what Ryan Moran said, “buying geese that lay golden eggs”.

Dividend Growth Over Current High Yield

Ryan Moran adds a value component to his buying criteria. He is only looking for companies that yield 4%. This is where we differ. Everyone has their own systems to reduce the universe of equity investments to choose from. However, the yield requirement is excluding a lot of great dividend growth companies. Companies that may only pay 1-3% but can grow their dividends at compound annual rates in the double digits.

Abbot Labs is great past example. It has not approached a 4% yield but it has grown its dividend at above average annual rates for a very long time. Abbot Labs dividend growth is what made Grace Groner a very wealthy woman not its high current yield.

Visa and MasterCard are two current portfolio holdings that we expect to produce tremendous dividend growth over the foreseeable future. We think they both can do 20% per year or more. Both of them currently yield less than 1%.

You also have to be wary of companies with high current yields because the market may be discounting slower dividend growth or worse, a potential dividend cut. We’ve seen it recently with Kinder Morgan (KMI). Its yield got over 10% as its stock sold off because investors were expecting a dividend cut. Kinder Morgan’s debt load and dividend policy where unsustainable at the current price of oil. Then Kinder Morgan cut their dividend by 75%.

While we disagree with Ryan on the current yield criteria, we don’t disagree with him on this point. If you truly want to build passive income from your savings then start now. Don’t flip the switch once you retire. Start buying dividend growth stocks and reinvest your dividends. Let the companies compound your money over a very long time. As each company increases their dividend you will buy more stock which increases your dividend income which allows you to buy more stock which increases your dividend income. So on and so forth until you have built up a truly passive income stream.

Sources:

Smart Passive Income Podcast Episode 174 (Smart Passive Income) on iTunes

Reinvesting Dividends vs. Not Reinvesting Dividends: A 50-Year Case Study of Coca-Cola Stock (Joshua Kennon)

AMM Dividend Letter Vol. 22: Controlling our Fears and Investing for the Long Haul with Union Pacific

This is from the AMM Dividend Letter released September 3, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Deep in your brain lies a small almond-shaped structure called the Amygdala. Among other functions, it is part of the brain’s reflexive system and it is good at quickly generating emotions like fear and anger when we’re presented with new, out of place, or scary stimuli. The amygdala also links directly to areas of the brain that prime our fight or flight response: breathing rate, heart rate, the release of corticosterone (a stress hormone), and the release of norepinephrine for alertness & arousal.

We are a social animal and our amygdalas have developed to respond to body language and speech. We are not just afraid of physical dangers but also alarming social signals. While this served a great function in early human social development, it can hurt us in the modern world. Especially when it comes to investing.

Take the standard TV news image of a broker on the floor of the stock exchange after a bad day in the market. His face is buried in his hands. Other brokers are yelling over each other, with clear signs of stress on their faces. The color red is prominently displayed on the screens behind them. Providing a narrative to this image, the news anchor describes the action as a drop, a crash, a plunge, or mounting losses. The more you hear “losses” the more active your amygdala becomes. Your breathing and your heart rate increase and your reflexive fight or flight system kicks in and a decision needs to be made now!

Over the centuries money has become the equivalent to safety and well-being. Money now represents maintaining life. When we experience a financial shortfall it is registered in our brain the same way as being in mortal danger. When the stock market goes down and our fear center lights up our reflexive decision is to sell (i.e. stop the bleeding!) and to do it now. We need to protect ourselves from this terrible stimulus.

To be better investors, we need to override our fear-inducing reflexive brain. We need to learn to love stock market corrections. We want lower prices. It allows us to buy high-quality companies at a cheaper price. One of our firm’s core principles is that the price you pay determines your return. Lower prices are one of the main components for higher expected returns.

One way to assess broad market value and expected returns is to look at a relative valuation measure and track subsequent market returns. The CAPE stands for Cyclically Adjusted Price to Earnings Ratio. It calculated by taking the current price of the S&P 500 and dividing by its average inflation-adjusted earnings from the previous 10 years. It is not without its faults, but it is a decent way to look at the overall valuation of the equity market and the potential total returns over the next 10 years.

The table below is from Ben Carlson’s A Wealth of Common Sense and it is a summary of the subsequent average, median, high, and low 10-year returns for the S&P 500 at various ranges of CAPE.

Table courtesy of A Wealth of Common Sense. Click image to enlarge.
Table courtesy of A Wealth of Common Sense. Click image to enlarge.

A high CAPE (i.e. higher prices) on average leads to lower 10-year future returns. When the CAPE reached its highest level ever, 45, during the tech bubble the subsequent 10-year returns were negative. On average, 10-year returns increase the lower CAPE gets.

From Multpl.com.

Shiller CAPE

We are currently at 26.37. A High CAPE does not mean the stock market is destined for an immediate correction or even a crash; though we may be in one as we write this letter. The CAPE is a long-term valuation measurement, and should not be used as a short-term trading signal. The CAPE is a tool to estimate our expected future returns from equities.

At today’s level of CAPE, we have to plan for lower average returns over the next 10 years. This is why we need to learn to love stock market corrections. A stock market correction is very painful in the short-run, but it is good for the long-run returns in portfolios. Stock market corrections give investors a chance to invest more money at much lower prices and/or rebalance their portfolio from lower return securities like bonds in to stocks. If your portfolio is built for the next 10, 15, or 20 years then you want every opportunity to get as much money invested as you can at the lowest price possible.

The stock market will correct, but the long-term trend is unquestionably positive and has shown time and time again that those who stay disciplined and override their short-term fears will be rewarded.

Image from DFA via The Reformed Broker. Click image to enlarge.
Image from DFA via The Reformed Broker. Click image to enlarge.

Sincerely,
Your Portfolio Management Team

Dividend Stock in Focus

Union Pacific (UNP): $85.70*
*price as of the close September 3, 2015

The Civil War ended 146 years ago, but it’s not too late to profit from it.

In 1856, the U.S. 34th Congress proposed a bill to commission the building of a Transcontinental Railroad. Because of the recent Gadsden Purchase, the route could be built along a Southern Route avoiding potential poor winter conditions along a proposed Central Route.

The late 1850s and early 1860s weren’t necessarily a harmonious time between Northern and Southern States. The bill stalled in congress until 1862. With the Southern States in secession, the Pacific Railroad Act of 1862 passed with a central route that traveled through Union loyal territories and states.

Then on May 10, 1869, this occurred:

Image from Wikipedia. Click image to enlarge.
Image from Wikipedia. Click image to enlarge.

The Central Pacific Railroad building East from Sacramento met the Union Pacific Railroad building West from Council Bluffs, Iowa at Promontory summit. Leland Stanford drove the ceremonial Golden Spike in and the first Transcontinental Railroad was completed. Well, if you don’t count the fact that Sacramento and Council Bluffs didn’t directly connect the line to either the Pacific or Atlantic Oceans.

Central Pacific eventually merged with Southern Pacific. In 1901, Union Pacific bought a controlling stake in Southern Pacific. Then in the longest merger ever, Union Pacific finished its integration of Southern Pacific in 1996. Union Pacific owned and took control of a very valuable railroad asset and this was just the start of the trend.

Since 1862, Union Pacific built and bought other extremely valuable railway assets all over the Western U.S. It is the control of these assets that has allowed Union Pacific to survive since the Civil war and to become one of the two major class I railroads operating in the Western U.S. It is the control of these assets that should allow Union Pacific to thrive well into the future.

Dividend History:

UNP has grown their dividend at a compound annual rate of 22.8% over the last 9 years. Back in February of this year UNP raised its quarterly payout again by another 10% to $0.55. This puts the total dividends for the fiscal 2015 year on track to be 15% higher than fiscal 2014.

Data from S&P Capital IQ. Click image to enlarge.
Data from S&P Capital IQ. Click image to enlarge.

UNP’s payout ratio is 36% leaving the dividend well covered by earnings and plenty of room to continue to grow their dividend.

Catalysts for Dividend Growth and Price Appreciation:

Prized Assets

Starting a new railroad company is so costly that it is prohibitive. There used to be over 40 class I railroads. Then after the 1980s Stagger Act the 40 railroads merged into 8 with four railroads taking the largest share. Norfolk Southern (NSC) and CSX Corp. (CSX) controlling transportation East of the Mississippi River. BNSF (owned by Berkshire Hathaway) and Union Pacific (UNP) controlling transportation West of the Mississippi River.

If you want to move large amounts of goods to or from West Coast ports in the most cost efficient manner the railroads are it. Union Pacific’s rail network spans 23 states, 32,000 miles, and connects to all major seaports on the West Coast and the major seaports along the Gulf of Mexico West of the Mississippi River Delta.

Image from Union Pacific website. Click image to enlarge.
Image from Union Pacific website. Click image to enlarge.

Pricing & Investment Discipline

UNP competes with BNSF in the Western U.S. In the mid-2000s, the two companies realized that they were hurting each other’s overall business by competing so hard on price. UNP refocused on price discipline and refused business that did not meet their required returns. The new price discipline allows UNP to raise its prices far faster than its costs leading to increased returns and profit margins rivaling those of Google.

 Data from S&P Capital IQ. Click image to enlarge.
Data from S&P Capital IQ. Click image to enlarge.

CFO Rob Knight who is partly responsible for UNP’s large margin expansion created the Network Planning Group. 70 analysts make up the group. The analysts are not simply number crunchers; they are managers from the field with working knowledge of how to run the business. The groups’ task is to get a 15% rate of return on all new business. If UNP can’t get a 15% rate of return then UNP does not do the business. Continued pricing and investment discipline will maintain UNP’s profitability and ensure reasonable growth in the years to come.

Intermodal

Intermodal shipping is the long haul transportation of shipping and truck containers. It is the fastest growing segment for railroads and it accounts for about 46% of total traffic now. Union Pacific used to be less exposed to intermodal vs. competitor BNSF but now intermodal accounts for 22% of Union Pacific’s revenue. Transporting containers from ports inland via railroads is 10-30% more cost efficient than shipping by trucks. The price difference depends on the length of the haul with longer hauls providing bigger savings. Transporting containers by railroads also provides 4:1 fuel efficiency when compared to trucks.

Intermodal is estimated to be about 18% of the trucking industry’s traffic. Even though lower fuel costs make shipping by trucks more attractive, the industry has a large shortage of drivers which pushes labor costs up. Even the new self-driving trucks still need a “driver” to be in the truck. This provides UNP with an opportunity to continue to gain market share in intermodal traffic.

Revenue for transporting containers is based on per container unit. A rail car with doubled stacked containers earns twice the revenue compared to a single stacked car. Continued growth in intermodal shipping allows UNP to double stack more cars increasing revenue and profitability per intermodal rail car.

At the start of this year, both the Los Angeles Port and Long Beach Port endured a shutdown due to labor strikes. The container ships couldn’t dock and unload their goods. Some ships sat and waited while others went to other Western Ports. Some ships with goods destined for the eastern U.S. took the time penalty and went through the Panama Canal. The labor strike hurt UNP’s intermodal traffic and efficiency in early 2015. The labor strike is over and traffic at the two ports is picking back up as they work through the backlog.

Mexico

UNP owns a 26% stake in Ferrocarril Mexicano (aka Ferromex). The railroad covers 70% of Mexico and serves the Mexico City – Guadalajara – Monterrey triangle. Ferromex has access to four ports on the Pacific Ocean and two on the Gulf of Mexico.

Ferromex has a complicated ownership structure. UNP owns 26% and the rest is owned by Infraestructure y Transportes Mexico (ITM) which is a division of Grupo Mexico. Grupo Mexico is planning an IPO of 15% of ITM. The IPO will provide clarity on the value of UNP’s 26% stake in Ferromex.

Mexico is opening up its oil fields to foreign investment in the hope it can increase output, improve efficiency, and grow the economy. This should increase the amount of oil, other petrochemicals, and drilling equipment shipped over the rails further benefiting Ferromex and Union Pacific.

Mexico is also attracting significant investment from automakers. $22.6 billion has been invested or pledged for auto and auto parts plants. Currently, 1 out of 5 cars in North America are made in Mexico and that number is expected to increase to 1 in 4 by 2020 according to an article in USA Today. UNP transports the raw material south and offloads them onto Ferromex lines. Then Ferromex brings the finished cars North and transfers them over to UNP to finish their journey.

Pre-Mortem (Potential Risks to our Thesis):

Coal

One of the most profitable items to transport for Union Pacific is coal. The shale oil boom has driven natural gas prices lower and coal-fired power plants are switching over to natural gas. Plus, more EPA mandates have driven the cost of mining and using coal much higher. In response the demand for coal has declined.

Union Pacific transports coal from the Powder River Basin in Wyoming. It is much cheaper to mine coal in the Powder River Basin than in the Eastern U.S. Also, the sulfur content of the coal from the Powder River Basin is much lower than Appalachian coal. While demand has declined, coal is still needed to meet America’s power demand. The U.S. Energy Information Administration expects coal will still provide 34% of our power needs in 25 years.

Powder River Basin coal will likely be the first choice, especially if the price of coal per ton is the only factor. However, coal demand can continue to decline if natural gas prices stay low for a very long time allowing further replacement of coal-fired power plants with gas-fired ones. Also, if newer greener energy technologies can reasonably replace our baseline power needs from coal-fired power plants then coal demand will decline further.

Low Oil Prices

Low oil prices hurt UNP in two ways. First, UNP adds a fuel surcharge to all freight it transports and high oil prices lead to extra fuel surcharges boosting UNP’s bottom line. Lower oil prices means lower fuel surcharges to UNP. The company does make it up with lower diesel costs but there is a lag time between lower fuel surcharges and the declining price of diesel.

Second, low oil prices hurt UNP with lower freight volumes. UNP transports the materials needed to drill for shale oil and then transports the oil back. Transporting oil over their rail network is very profitable for UNP because the oil companies provide most of the assets. Lower oil prices have lead to decreased rig counts and less need for drilling materials.

A third issue is emerging. Spurred by recent train derailments that have lead to explosions and oil spills, law makers are thinking about reducing the speed limit trains carrying oil can travel. They are also contemplating increased safety measures. More safety measures will increase the cost to transport oil lowering profitability. A speed limit reduction will cascade throughout UNP’s operations reducing operational efficiency as switching and loading stations wait longer for the slower oil trains.

Recession

A growing economy needs raw materials and the goods it produces transported throughout it. A recession leads to a drop in the need for raw materials and the transport of finished goods. A recession will hurt Union Pacific’s freight revenue and carloads. However, recessions are short-term cyclical issues and the U.S. economy will grow again. By staying disciplined with their prices and with their investments, Union Pacific will come out the other side a stronger company.

Conclusion:

Warren Buffett and Charlie Munger coined the phrase “economic moat”. It means a business that has a large and generally sustainable competitive advantage over its competitors. This advantage allows the company to generate returns on capital far above its cost of capital and above its closest competitors.

One of the ways to find a company with a strong economic moat is to look for companies that have an almost monopolistic market position and can maintain pricing power while also raising their prices over time. Union Pacific is just such a business. If Buffett and Munger had their way I’m sure they would’ve bought both BNSF and Union Pacific. Lucky for us they didn’t and we’re able to buy the only other way to efficiently move goods around the Western U.S.

Our estimate of fair value for Union Pacific is $115 per share. At current prices, we get to buy a company full of trophy assets at a large discount. Owning one of the two ways to efficiently move goods around the Western U.S. is a recipe to generate strong returns for its owners.

All previous letters are archived here.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

12 Lessons Learned From Warren Buffett

From the Financial Times what Seth Klarman has learned from Warren Buffett.

  1. Value investing works. Buy bargains.
  2. Quality matters, in businesses and in people. Better-quality businesses are more likely to grow and compound cash flow; low-quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.
  3. There is no need to overly diversify. Invest like you have a single, lifetime “punch card” with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.
  4. Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.
  5. Risk is not the same as volatility; risk results from overpaying or overestimating a company’s prospects. Prices fluctuate more than value; price volatility can drive opportunity. Sacrifice some upside as necessary to protect on the downside.
  6. Unprecedented events occur with some regularity, so be prepared.
  7. You can make some investment mistakes and still thrive.
  8. Holding cash in the absence of opportunity makes sense.
  9. Favour substance over form. It doesn’t matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity.
  10. Candour is essential. It’s important to acknowledge mistakes, act decisively, and learn from them. Good writing clarifies your own thinking and that of your fellow shareholders.
  11. To the extent possible, find and retain like-minded shareholders (and for investment managers, investors) to liberate yourself from short-term performance pressures.
  12. Do what you love, and you’ll never work a day in your life.