Barron’s released their current “Barron’s 400″ index this week. They said,

“Get stock ideas from Barron’s index that measures a diversified group of U.S. companies based on strong fundamentals.”

OK, so we looked for some ideas for equity-income investors.

We sorted the list by trailing yield and eliminated all those with a yield lower than the composite 2.28% yield of the index — you’ll probably be able to get the index yield from a likely future ETF offering based on the Barron’s index.

That left 65 companies in 37 industries.

Then we sorted that shortened list to include only the highest yielding company in each of the industries.

Here is the list:

click image to enlarge

Barron’s 400 Index Description:

The Barron’s 400SM index, calculated by Dow Jones Indexes, measures the performance of a diversified group of U.S. companies selected in part based on fundamentals-related rules-based criteria. The index includes companies that have scored highest according to fundamentals-related rankings calculated by MarketGrader.com. Additional rules-based screening provides for sector and market cap diversification. The index is licensed by Dow Jones Indexes.

Barron’s 400 index rules

• 400-company index; equally weighted
• Underlying universe: Dow Jones Wilshire 5000
• Companies ranking highest based on fundamentals-related scores calculated by MarketGrader.com.
• All selections must have a minimum float-adjusted market cap of $250 million
• At least 25% of all selections must have a market cap above $3 billion
• The number of selections in the same industry sector cannot exceed 20% of index (80 companies)
• No REITs are eligible for index selection
• All index selections must have reported quarterly or annual results within the last six months
• All selections must have a minimum 3-month avg. daily trading dollar value of $2 million

[The index is equal weighted which seems to be an idea that is gaining popularity.  We recently wrote about the S&P 500 equal weight index which S&P describes as outperforming the standard market-cap weighted S&P 500. ]

Unfortunately, Barron’s did not reveal the fundamental criteria they and MarketGraders used to construct the index, leaving investors to work on faith in Barron’s and the performance charts.  That is less than fully desirable, but the list may still be a good place to do some idea mining.

Barron’s Index Relative Performance:

click to enlarge image

You can view the index attributes on the Barron’s site and download the full list from the attributes page.

Note: We are not recommending any particular stock in the full or high yield list, just providing research grist for the do-it-yourself investor, hoping it will save you some time and help you develop your own ideas.

Richard Shaw
QVM Group LLC

[Securities mentioned in this article: GNK, MO, QSII, INTC, LDR, SPH, SYY, AEO, DRI, BBT, HOG, CCL, NTRI, PG, MMP, BWP, HGT, ITW, LLY, NUE, GFIG, CVX, VR, KNL, CALM, ROK, CNP, GHL, CAT, EMR, STX, ARLP, DD, TNH, PEP, GPC]

Business Week recently published an article “Stock Screen: Buy ‘Em Like Buffet“. It presented a list of 49 stocks they screened according to five criteria they report Warren Buffett uses, plus their own criteria to filter out overvalued stocks.  The five criteria were:

• Free cash flow of $250 million or more
• Net profit margin of 15% or more.
• Return on equity greater than 15% for each of the past three years and the most recent quarter.
• Shareholder value increasing at least as much as retained earnings over the past five years.
• Liquidity — market capitalization of  $500 million or more.

We thought it might be interesting to go a step further and review that list of 49 stocks in terms of the S&P Star ratings for near-term market performance and current fair value.  S&P uses a 5 star rating system with 5 being the best.

The following 13 stocks from the list of 49 was rated 4 or 5 by S&P for each of near-term market performance and current fair value:

Garmin (GRMN)

Infosys Technologies (INFY)

Microsoft (MSFT)

Oracle (ORCL)

Taiwan Semiconductor (TSM)

MEMC Electronic Materials (WFR)

Halliburton (HAL)

SAP (SAP)

Satyam Computer Services (SAY)

Schlumberger (SLB)

Stryker (SYK)

Telefonica (TEF)

Freeport-McMoran (FCX).

Checking that list of 13 stocks against the Value Line rating system for timeliness of investment (1 being best), we found that 6 were highly rated as 1 or 2 for timeliness:

Infosys Technologies (INFY)

Oracle (ORCL)

Halliburton (HAL)

SAP (SAP)

Schlumberger (SLB)

Stryker (SYK).

See our prior article on use of multiple analysis services for stock screening.

Any of the stocks in the list of 49, 13 or 6 could be a good place for do-it-yourself investors to begin their own research into potential opportunities.

Richard Shaw
QVM Group LLC

Rational “do-it-yourself” stock investors will seek some degree of third party research or opinion in their investment process.  That at least reduces the amount of work they need to do to reduce the size of the universe they evaluate, and it may provide them with ideas for stock selection.

Some of those independent investors pay advisors to coach them and provide a sounding board, while others use rating services to screen stocks for investment prospects.

For a large portion of do-it-yourself investors, these five rating services are stock screening sources, each of which uses a five level rating scale:

• Standard & Poor’s Outlook
• Value Line Investment Survey
• Morningstar
• Reuters street consensus
• Schwab Equity Ratings.

We think it’s important when using a screening tool to know about the overall pool of data, and not just pull a screened list from a “black box”.

The first issue is the general way the ratings are created.  One way to classify the ratings could be:

• Rules-based and machine-generated (Value Line and Schwab)
• Process-based and judgement-generated (S&P and Morningstar)
• Aggregation of all reporting analysts (Reuters street consensus)

The table below shows the number of companies at each timeliness rating level from the five rating systems, and the number of companies at each financial strength rating level from S&P and Value Line (as of Aug 21, 2008):

click image to enlarge

Notice that Value Line and Schwab (rules-based, machine-generated ratings) show an approximately symmetrical distribution of ratings with the greatest number at the HOLD level, fewer at UNDERPERFORM and OUTPERFORM, and fewer still at SELL and BUY.

S&P and Morningstar (process-based, judgement-generated ratings) show non-symmetrical distribution of ratings with the largest number of companies at HOLD, and more in the OUTPERFORM and BUY levels than in the UNDERPERFORM and SELL levels.

The Reuters street consensus is seemingly euphoric about companies by comparison to the other rating systems  with more OUTPERFORM and BUY than the sum of HOLD, UNDERPERFORM and SELL.

Both S&P and Value Line have similar percentages of their universes rated highly for financial strength, but Value Line has a lower percentage of companies rated as weak than S&P.

Best of Both Worlds

One way for do-it-yourself investors to play it “safe” would be to seek the best of both worlds by using both a rules-based, machine-generated system and a process-based, judgement-generated system (example: Value Line and S&P).

One way to use two systems that use different methods, would be to make a list of all stocks that are highly rated by one or the other, and then do your own research and filtering from that list to arrive at your selections.

Another way to use two systems, would be to find those highly rated stocks that are common to both rating systems, and then work from that shorter list.

For example, if you used Value Line and S&P, and if you screened for stocks rated BUY or OUTPERFORM, you would end up with two lists totaling 920 stock recommendations.  However, if you screened for those stocks rated BUY or OUTPERFORM by both systems, you would arrive at an intersection list of 125 stocks.

Sample of Intersecting Stocks:

Here is a sample of the lowest market-cap 10% of stocks that intersect the list of BUY or OUTPERFORM by Value Line and S&P.

We are not recommending these stocks, just presenting a sample of the intersection list.  They may or may not be good ideas.  Even with data services, you need to make your own judgements about what makes sense to you and for you.

Unless you have lots of time to do research, you would benefit by engaging some form of personal or subscription third party help in your do-it-yourself investing.

Richard Shaw
QVM Group LLC

Executive compensation and board largess with high paid executives is a hot topic recently.  That spurred us to look comprehensively at some factual comparative data on the total cost of boards of directors and top executive teams among the S&P 500 companies (proxy SPY or IVV).

For that purpose, we utilized the corporate governance database provided by The Corporate Library (www.TheCorporateLibrary.com) which tracks corporate actions, including executive compensation, and ranks public companies on several dimensions of corporate governance.

We found The Corporate Library database to be an excellent resource on all manner of questions about corporate actions, ranging from proxy issues, to board composition and cross linkages, to executive compensation and other matters.  They roll it all up into a net corporate governance rating.

COST OF BOARDS OF DIRECTORS:

We identified the ten highest cost and the ten lowest costs boards of directors within the S&P 500, shown in the table below.

One concern with boards is that they may be so comfortable with their compensation that they are reluctant to vote against high executive pay packages.   For that reason, if all other factors are equal (and they never quite are), we would by somewhat shy about investing in companies where board membership is a path to significant wealth.

On the other hand, board membership is real work if approached properly, and too little director compensation may not encourage effective oversight.  For that reason, all other factors being equal, we would be cautious about investing in companies where the board doesn’t get paid enough to be fully engaged — or where the low board cost is due to too many company executives on the board who do not receive separate board pay.

To add perspective to the board compensation in the table, we also show the aggregate compensation of the top five executives for each company, as well as the sum of board cost and executive team cost as a percentage of company net income.

COST OF TOP EXECUTIVE TEAMS:

Over the entire S&P 500 the simple average of the aggregate compensation of the top five executives is $28.6 million, or approximately 2.4% of company net income.  That compares to a simple average aggregate dividend payment to owners of the company of 45.7%

Those statistics are only for companies with positive earnings.  Companies with loss positions in the most recent FY were excluded from the calculations.

[Note that "simple average" is unweighted, giving the largest company the same weight as the smallest company.]

In the table below, we show the ten highest cost executive teams and the ten lowest cost executive teams, and the percentage relationship between that compensation and net income.

There isn’t a great deal of difference in the total expense of executives between these highest and lowest cost teams.  They both average about 2.4% to 2.5% of net income, which is also the simple average for the entire S&P 500.

EXECUTIVE TEAM EXPENSE RATIOS:

Comparing aggregate top executive team compensation to net income isn’t exactly an expense ratio, because the net income is after the compensation expense, but comparing the one to the other in percentage terms is illuminating.  We are calling it “expense ratio” here for lack of a better term.

In the table below, we show the 20 companies with the highest and the 20 with the lowest aggregate executive team compensation expressed as a percentage of the company net income.

Not surprisingly, the companies with higher compensation expense ratios are generally smaller and with lower profits than those with low expense ratios.

Expense ratios in the 10+% range for the top five executives appear more like “carried interests” than compensation for management — treating executives more like owners than top level employees.

While compensation must be “competitive” it also needs to be scaled to the size of the company.  We are not comfortable with the top executives receiving large packages that have size on the same order of magnitude as the dividends (if any) paid to the owners of the company.

We did not study the dividend stream for these particular companies, but with dividends generally 0% to 50% of net income, we would not be comfortable seeing the top five executives receiving 10% to 20% or more of net income.

We favor companies with executives who are strongly motivated by their compensation packages (and who use their own money to buy real shares instead of being given options or loaned company money to buy shares).  We prefer to avoid companies where executive compensation is so high that is looks more like a carried interest than wages and incentives.

Richard Shaw
QVM Group LLC

The vast majority of S&P 500 companies (proxy SPY or IVV) are profitable on a 12-month basis, but some have profits strongly on the rise and others have profits strongly on the fall.

This article presents the 20 companies with the highest ratio of 12-month to average 3-FY net income, and the 20 companies with the lowest ratio.  Only the 469 companies with positive 3-yr average net income were considered.

(income in the millions)

FY 1 is the first prior fiscal year.
FY 2 is the second prior fiscal year.
FY 3 is the third prior fiscal year.

A prior post presents information about the 31 S&P 500 stocks with negative 3-year average net income.

An Excel spreadsheet containing this data for all constituents of the S&P index is available on email request.

Richard Shaw
QVM Group LLC