The Prudent Investor

The Prudent Investor portfolio is designed to be safe, that is, safe relative to a more aggressive portfolio. The idea is not to find quick growing companies and capitalize on short term gains, but one where established companies will provide better than average returns over the long haul.

The current downturn in the Market has reinforced the importance of this type of portfolio, and it is in this context that I will look at the performance of each company still in the running in relation to the overall Market.

There have been two days where the DOW has dropped substantially over the past month, 27 February and 13 March. On these dates the S&P 500 dropped a total of 5.5% and the DOW dropped a total of 5.1%. Many things happen during days of large declines, two are notable in this current discussion.

The first is that speculative companies oftentimes take the hardest hit. As volitility is their nature, it makes sense that while the investor gains nicely on the up side, they also lose big on the down side.

The second is that quality companies go on sale and investors move towards the tried and true in an attempt to pick up bargains. As I am seeking to establish a conservative portfolio, I want to remove any companies that have greater losses than the Market on days when things turn sour. Let’s look at the comparisons.

As can be seen, none of the companies lost more on the combination of the two days than the Market as a whole. I do note that on 27 February McCormick did gain this honor, and more recently on 13 March this was the case for Pepsico, ConAgra, and Flowers.

A single day should not make for a decision, as it is certainly possible that other factors were involved, and I have yet to seriously begin examination of the companies. So this begs the question, “How about any other down days – how did these companies fare?”

In my next post I will look at other down days over the past five quarters to see how each company has done.

Having selected the Processed & Packaged Goods Industry of the Consumer Goods sector, it is time to begin looking at the companies. There are over 50 companies identified by Yahoo Finance to be in this industry, and no, I am not going to look at every one of them. <g>

I will narrow this list by removing those companies for which I can find a compelling reason not to keep. To begin, by removing companies that either do not have adequate information or are not making money, the number is reduced to 34.

The group offers an average P/E of about 29. I am not necessarily against high P/E companies, but they do tend to be rather volatile at times, and that is not the direction of this portfolio. If I allow companies to remain that sport a P/E as high as 25% above the average, then I can remove companies to reduce the list to 23. By the way, this removes the well-known Sara Lee Corp.

If you read how I selected the water utility that sits in the portfolio (or numerous messages around the Internet), then you will know that I am no fan of debt. There are a number of companies that have more debt than equity, so by removing them the count is reduced to 15. There are some notable companies that are dropped at this point – General Mills, Del Monte Foods, Campbell Soup, and the most significant for me, Kellogg. This company has significance in the regard that I currently hold it in my DRiP portfolio.

As I have so many companies from which to choose, I will remove companies that either offer no dividend, or a dividend less than 1%. This reduces the count to 10. Amongst this group id Diamond Foods, which processes, markets, and distributes nuts of all types. I gorged myself with them years ago in the press box at the Emerald Bowl in 2004.

So ten companies is a reasonable number from which to select, but I am going to make one more cut – I am removing companies with a Market Capitalization of less than $1B. I am looking to include a large, solid company, and removing small caps from the list yields the following list:

It almost looks like the longer the name, the smaller Market Cap. <g>

In my next post I will begin looking at each company in this list.

Having narrowed things down quite a bit, it is time to select an Industry in the Consumer Goods sector.

Here is what I have been looking at:

I have highlighted the values that beat the rest of the group. The key to understand here is that I am looking for something that will give me comfort, which might not necessarily be meaningful to someone else. For instance, a P/E of 12.9 is certainly lower than 25.7, but the companies that offer the lower P/E may not necessarily be better companies to purchase. That said, I am looking to make money and be able to sleep at night.

In that respect, how do these industries react to a major decline. Well, we very recently had one – the worst since 9/11 – so let’s look at how they reacted.

Food – Major Diversified acted more severely than the other two. All of these are better than the 3.27% drop on 27 February, with Processed & Packaged Goods reacting least severely.

So Processed & Packaged Goods will be the industry in which the next purchase will be made. Others may offer greater possibilities, but when it comes to safety as well as potential, I am confident that this is a good direction to take. Certainly, there is a company within this industry that will prove itself worth as the second company to enter the Prudent Investor portfolio.

Last post I noted the industries in the Consumer Goods sector that would be considered. Looking into the future is something that nobody can do, so I will be looking at current numbers in the hopes that they will help determine the most profitable path.

There are two numbers that very nicely separate this grouping into IN and OUT baskets. Return on Equity (ROE) is an indicator of profitability. Obviously, we want to invest in an area of profitability, and dividing the Net Income over the past twelve months by the shareholder’s equity (resulting in a percentage) is one means of measuring this. Eight of the fourteen industries have double-digit ROE values.

Net Profit Margin is another indicator of success. This value is obtained by dividing the income by the revenue (again, resulting in a percentage), and basically represents the percentage of revenue resulting from the income. Companies that can do more with what they’ve got than others get a nod.

Looking at the numbers for each of these industries I see a clear dividing line right down the center – seven companies have a value of 6 and above, while the other seven have a value less than 2.5. All seven of the former have double digit ROE, so we have whittled the industries down to:

• Cleaning Products
• Appliances
• Processed & Packaged Goods
• Dairy Products
• Beverages – Soft Drinks
• Business Equipment
• Food – Major Diversified

I am seeking an established company, and while growth is always advantageous, I have harped about debt long and hard in the past. As I have not changed my mind that an established company should not be wallowed in debt, I am going to remove Dairy Products and Business Equipment, as their Debt/Equity ratios are both above 1.

Finally, I do like the comfort of a dividend. In a case where a company’s price does nothing, at least the investor receives dividends as payment for holding the stock. Three industries average Dividend Yields over 2% and two average under 2%, so removing the latter removes Cleaning Products and Appliances.

This leaves me with three industries:

• Processed & Packaged Goods
• Beverages – Soft Drinks
• Food – Major Diversified

In my next post I will make a decision as to which industry to select so that I can begin looking at companies.

Now it’s time to start thinking about the next purchase. SJW Corp. falls in the Utilities sector, so here is a list of the other sectors:

• Basic Materials
• Conglomerates
• Consumer Goods
• Financial
• Healthcare
• Industrial Goods
• Services
• Technology

I believe that a company in the Consumer Goods sector will be the second company to be added to the portfolio.

Alas, note the number of industries in this sector is as follows:

How am I going to select from such a wide grouping? Well, since I am looking to create a conservative portfolio that should survive the ups and downs of the market as time passes, Consumer Goods is an excellent sector for selecting a company that will survive, regardless of the direction of the economy. Whereas some industries will suffer with an economic decline, others will not, and that will be my focus.

For instance, I will not be looking to purchase a company in the Photographic Equipment & Supplies industry because if the economy falls into a tailspin then this industry will suffer. In such a situation, people will continue to buy food, but will put off purchasing a new camera.

So which industries match this idea? Opinions may vary, but here is my list:

• Appliances
• Auto Parts
• Beverages – Soft Drinks
• Business Equipment
• Cleaning Products
• Dairy Products
• Farm Products
• Food
• Meat Products
• Office Supplies
• Packaging & Containers
• Paper & Paper Products
• Processed & Packaged Goods
• Rubber & Plastics

You will notice that I have excluded alchohol and tobacco from my list, despite the fact that they are excellent survivors of economic downturns. Personally, I have always been wary of litigation against these industries, especially tobacco, and am not willing to accept this additional risk. Your mileage may vary.

I removed Textiles from the list because although we all need to replace worn clothing, this industry includes many of the high-end companies (Eddis Bauer, Liz Claiborne, Perry Ellis, etc.).

I removed auto manufacturers but not auto parts – the latter might actually do better in a negative economic environment if people are opting to fix their cars, as opposed to buy new.

Next post I will further narrow the industries in an attempt to make a selection. I try to get these posts out on Tuesday and Thursday, and since I will be in Syracuse, NY for a film festival towards the end of the week, if you do not see a post on Thursday then it will be because I was not able to establish an Internet connection.  Alas, I will not have an Internet connection, so the next post will come on Tuesday.