This morning, I had to put together a retirement account for a relative. The mandate was:
- Broad diversification
- Individual stocks, no funds of any kind
- Only high quality companies with very strong balance sheets
- A history of dividend increases that exceed the rate of inflation
- Good current valuation
- No buy or sell changes for at least 10 years
- The account won’t be accessible for 35 to 40 years
- Large companies that everyone would recognize and are likely to be around a long time; no small start-ups or midcaps.
- Some positions are legacy, though I could sell small amounts if necessary (e.g., Wal-Mart and Berkshire Hathaway)
- Dividends are to be automatically reinvested at no cost, plowed back into the company that paid them
- The initial funds in the plan are to split into fewer than 15 stocks.
- A list of “permanent” companies is to be made for future reference; every year, when more money is added to the plan, the cheapest stocks relative to intrinsic value on the list I created wil be added as new positions with the fresh funds until the portfolio has a total of 40-50 companies.
The problem I ran into is so many of the businesses I’d like to be buying right now are fully or overvalued. Hershey is a classic example – it’s a brilliant business, with unmatched economics and a strong controlling shareholder. Yet, it’s trading at a forward valuation multiple of 22. I do not think earnings will be growing by 15% per share for the foreseeable future, meaning it cannot be justified if I want to end up toward the upper end of the historical returns earned by equity ownership of this class of assets.
This meant a list of 50 to 100 companies I prepared got whittled down to only a handful of stocks, including the legacy positions. On top of this, I had to choose at least one stock from certain industries (e.g., at least one pharmaceutical) to meet the mandate. I couldn’t just put 20% of the assets in Wells Fargo, which is clearly still a great deal right now for a long-term owner, even though it is a better deal than PepsiCo, which is also a fantastic long-term holding, just more expensively priced. This put me in the odd position of actually buying some of the very companies that I, myself, sold only three or four months ago, because the portfolio owner had a different set of objectives; this was to be a “my grandchildren will inherit this and I don’t want to think about it between now and then so I’ll accept slightly lower returns” portfolio, not a “make me the most money possible by being what Ben Graham would call an enterprising investor” portfolio.
In the end, the portfolio ended up with an earnings yield of 6.71% and a cash dividend yield of 2.83%. I’m more than satisfied given the parameters.
The valuation multiple and the growth rates are lower than S&P 500, but the dividend yield is twice as high. With all of the money being reinvested tax-free with no brokerage costs, it’s slightly deceptive as the two figures are closer than one would imagine. Basically, I mirrored the long-term return potential of the index over very long periods of time, while avoiding companies that are likely to change substantially.
- 2 conglomerates
- 2 oil & natural gas giants
- 1 mining, metals, and minerals group
- 2 consumer staples powerhouses
- 1 restaurant
- 1 foodservice logistics company
- 2 soft drink & snack companies
- 1 discount retailer
- 1 bank
- 1 pharmaceutical
The actual holdings, including legacy positions bought several years ago, are:
- Berkshire Hathaway
- BHP Billiton
- Dr. Pepper Snapple Group
- Exxon Mobil
- General Electric
- Procter & Gamble
- Wal-Mart Stores
- Wells Fargo & Company
As for weighting, the largest position is 9.75% of assets, the smallest 6.00%. I’ll be glad to see that fall to 3% to 5% once the other positions are added in coming years because I turned over a sheet of 26 company names that would serve as a shopping list for future years until the portfolio reaches its target of 40-50 holdings. The money will compound tax-free for more than a generation, and even if a handful of the businesses go bankrupt, it should still result in a large increase in wealth despite the 30% to 50%+ drops that unquestionably will occur from time to time; that is the nature of the public securities markets, which can be volatile in the short-term.
The names on that list included many of the firms I, myself, would like to own at the right price – Brown Forman, Diageo, General Mills, McCormick, American Express, Johnson & Johnson, Colgate-Palmolive, Deere & Co., United Technologies, Kellogg’s, Unilever, Coca-Cola, Tiffany & Company, Hormel, J.M. Smucker’s, etc. There were a disproportionate number of food, beverage, and consumer staples companies because the nature of the mandate; I have no idea if Google will still be around in 50 years but I am near certain that most of the jam and jelly in the nation will come from Smucker’s orchards.
Even the returns end up being just average, which is perfectly satisfactory, the risk relative to other portfolios I’ve seen is so much lower, I can’t imagine an informed, rational investor losing any sleep, especially once the number of holdings has increased to the target range, which will take several years. The portfolio is already self-funding so that, in the coming years, tens of thousands of dollars in fresh, new money will get plowed back into the firms that distributed the cash to owners, increasing the equity stake held in the plan. Short of a Great Depression, it is all but assured based on a conservative projection of compounding, that as long as the contributions keep up with the projections, the account will be worth many million, perhaps even tens of millions, dollars by the time it can be tapped. That’s what happens when you are talking about a near 40-year timeframe; the numbers start getting crazy once you pass 25 years.
The annual expenses on the portfolio are zero. As in $0.00. It’s a large enough account the broker doesn’t charge anything for dividend reinvestment and the commission for the initial purchase is less than $9 per position. Unless you are getting free trades as part of a bank (e.g., someone living in California might get free equity trades at Wells Fargo’s brokerage division because they have their mortgage at the bank), it’s impossible to get any more efficient. By retirement, total costs will likely have ended up being, at most, 1/10,00th of 1%. It will result in many hundreds of thousands of extra dollars in the end that would have gone to financial institutions.
The trades are all executed, and I prepared a group of spreadsheets for the account owner to track their share of the net earnings and cash dividends by position, industry, and total, which they can access from a secure link any time they feel like it.
It was a lot of fun to do over my morning cup of coffee, before I jumped into my own agenda list for the day. Still, I’ll be much more satisfied when the roster includes at least a dozen or two dozen more names, which will come with time.