Friday, January 31, 2014

An Alternative to Trading Bonds.

Trading bonds substitutes.

During the financial crisis, clearly bonds represented an exceptional opportunity.  Not surprisingly, during the liquidity crisis, people were liquidating bonds at prices well below normal.  However, if one purchased bonds during the financial crisis, by about 2011 a well-constructed bond portfolio had appreciated so much in value that there was little incentive not to take the capital gain.  Interest rates were so low that holding bonds was a waste of one's capital.  The likely outcome was a loss of purchasing power over the remaining life of the bond.   Furthermore, with the Fed manipulating the entire yield curve, it was impossible to assess the risk of continuing to hold the bonds. 

Consequently, for the last few years, utilities, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) were viable alternatives.  However, just as bonds experienced substantial appreciation coming out of the financial crisis, REIT and MLP valuations have risen significantly since 2011.

MLPs presented an unusual opportunity when the President decided to postpone the decision on the Keystone pipeline for political reasons.  By acting counter to the economic pressure, the Administration guaranteed that the economic pressure would surface in the form of higher returns to alternative energy transportation options.  Alternative pipelines or pipelines that could benefit from the absence of Keystone were guaranteed to experience an increase in demand.  That greatly reduced the risk associated with selected other pipelines.  Those pipelines could be purchased as a bond substitute with very little downside risk and dividends substantially above the interest rate on bonds.  

In the MLP space, pipelines provide a potential substitute for bonds.  There near-monopoly on transportation along their routes insulates them from competitive pressures over a fairly long term.  It takes a long time to build a new pipeline, as Keystone illustrates.  Further, the decision on Keystone created a unique opportunity to select MLP pipelines.  It is not MLP structure that makes pipeline MLPs a potential bond substitute; it is the combination of their specific business and the MLP structure.  Consequently, mutual funds that are composed of all types of MLPs whether pipelines or not, are a poor substitute for bonds.  Individual MLPs would seem to be a more reasonable bond substitute because you can restrict it to pipelines and you know they yield.

Some of those pipelines would have served as a successful temporary bond substitute.  For example, Enbridge Energy Partners (EEP) provided a nice dividend, and that was about it.  However, as occurred with bonds coming out of the financial crisis, other pipelines would have appreciated to the point where there were substantial capital gains.  For example, between the end of 2011 and May 2013, the gain in Plains All American Pipeline (PPA) was almost 100% without including dividends.  By mid-2013 the logic of holding either was greatly diminished to the point where they no longer justified the additional tax complexity associated with MLPs.  Generally, the yield on MLPs had fallen.  Those that retained the high-yield did so because they became more risky.

For many years REITs were what the name implies: Real Estate Investment Trusts.  Thus, during the financial crisis and coming out of the financial crisis, REIT mutual funds represented a way to diversify into real estate.  The popularity of that shift, however, attracted firms that stretched the definition of real estate to the breaking point.  Consequently, by 2011, one had to pick individual REITs in order to ensure that the investment was really a real estate investment.  The security of real estate holdings is one of the reasons that REITs served as a potential bond substitute.  The other reason is the cash flow.

Among REITs, as long as it is real estate, no specific industry stands out as a natural substitute for bonds.  Most real estate can be replaced much faster than a pipeline.  Consequently, all real estate industries are more competitive than pipelines.  So, market considerations in the industry of an individual REIT are more important.  

One type of REIT that has some characteristics which make it a good candidate for a bond substitute is a REIT that specializes in “triple net” properties.  (Triple net properties generally have long-term leases where many variable expenses are shifted from the real estate owner to the occupant).  If the REIT has broad geographic exposure and a diversified base of renters, it takes on additional bond-like characteristics.  One does need to be careful about the amount of leverage on the REIT’s balance sheet.  That is particularly true of new REITs, but it is less of an issue with the larger REITs that have existed for a number of years.

The least specialized triple net REITs are concentrated in retail.   I have a large number of tenants.  The tenants may be entirely different retail segments, and they often have very broad geographic coverage. National Retail Properties, Inc. (NNN) provided a pretty good substitute for bonds from 2011 to 2012.  However, early in 2013 its valuation got way out of line as the stock appreciated in value.  A very popular triple net lease REIT is Retail Income Corp. (O).  Its monthly dividend structure appeals to many investors.  However, the appeal of that monthly dividend structure has resulted in higher valuation for Retail Income Corporation than National Retail Properties.  Its price followed a trend similar to National Retail Properties.  Of the two, National Retail Properties seemed to provide a better bond substitute.  But in both cases, by early in 2013, the valuation spikes justified exiting the positions.  If their prices fall off a bit more, National Retail Properties could be a very good bond substitute.

Another appealing area within the REIT space is healthcare REITs.  The demand for healthcare is reasonably stable.  Consequently, occupancy rates, an important metric in real estate, are fairly stable.  The risk in healthcare REITs is the stability of payment streams that result from government payments for health services (Medicare and Medicaid reimbursement rates).  However, it is possible to select healthcare REITs that are not extensively exposed directly to the whims of politicians regarding prices.  Basically, a REIT that owns the property and is dependent upon rents is more stable than one that both owns and operates the properties.  National Health Investors, Inc. (NHI) is one such REIT.  It has the added advantage that many of its hospitals and other facilities operate under a triple net lease.

A purchase of National Health Investors at any point during 2011 would allow one to currently exit with a capital gain, as well as the dividend stream.  That is true despite a price spike in May of 2013, and the subsequent decline.  But the combination of the run-up in the price of National Health Investors and then the price spike provided ample opportunity to adjust one's holdings in such a way as to end the year with holdings in this bond substitute at almost no cost.  LTC Properties (LTC) was formally known as Long-Term Care Properties and is another healthcare REIT.  Like Retail Income Properties, LTC pays a monthly dividend.  It displayed a price time path similar to National Health Investors.   Of the two, National Health Investors is the better bond substitute. 

An unfortunate side effect of monthly dividends is that the REITs attract investors whose only concern is the cash flow.  Consequently, REITs that pay monthly dividends tend to have higher valuations, and, other things being equal, they tend to be more risky.  Thus, while both National Health Investors and LTC Properties have been acceptable bond substitutes until their price spiked, National Health Investors was the only REIT that was worth retaining as a bond substitute after the price spike.  Its a ration seems more reasonable.

Other REIT sectors such as commercial space also provided a bond substitute.  However, unlike those cited above, commercial space REITs often have more limited geographic focus.  During the period from 2011 into 2013, a number of commercial space REITs were good bond substitutes.  However, because of their geographic focus, that ability to substitute is more ephemeral.  It depends upon too many factors: the quality of the REIT management, the performance of the local economies, and conditions in the local commercial real estate market.  Thus, it is not surprising that they are temporary holdings. 

Both the REITs and the MLPs as bond substitutes do not require expert timing although timing was more important with the REITs.  REITs seem to have been more influenced by the chase for yield.  However, the price spikes that preceded their decline provided the investor with a warning.  Their price decline was almost a mirror image of the spike.  However, for both the MLPs and REITs, an investor who is still holding those assets has not lost principal.  Not losing principal is an important requirement for a bond substitute.

As mentioned in “Rebalancing in a Manipulated Interest-Rate Environment,” utilities are the traditional equity substitute for bonds.  Thus, not surprisingly, there were opportunities to substitute utility stocks for bonds during the period from 2011 through 2013.  

When looking utilities, it is worth remembering that Verizon (VZ), which is sometimes considered a utility, was included in the widows’ and orphans’ portfolio.  One might ask whether Verizon belongs in the utility sector at all.  The question is legitimate given the importance of its unregulated businesses.  The point, however, is that Verizon retains enough regulated landline business to make it unnecessary to consider telecom utilities for a bond substitute. 

Electric utilities, which are often thought of as the prototypical utility, are so much of a regulatory crapshoot and had so many industry-specific risks, that they were not a good bonds substitute.  Although with the hard to find the data to prove it, electric utilities seem to suffer the most from regulatory whims.

Two gas utilities provided an excellent opportunity to substitute equity positions for bond holdings.  Both have the advantage that they operate in a number of subsectors of the gas industry.  AGL Resources Inc. (GAS) has been an excellent bond substitute for number of years.  It is to the point where it is almost a core holding, but only to the extent that one might hold bonds on a regular basis. 

The other, National Fuel Gas Company (NFG), was far less of a pure bond substitute.  It would have been totally inappropriate previous to 2012.  However, at the beginning of 2012, National Fuel Gas seemed to be priced based totally on its non-utility operations.  Consequently, one could acquire the company and get gas utility exposure almost for free.  That type of sum-of-parts analysis is usually not required to identify a utility is a bond substitute.  However, in the case of National Fuel Gas, it was essential since National Fuel Gas did not pay a high enough dividend to justify considering it as a bond substitute based on its dividend alone.  National Fuel Gas may continue to be an excellent investment opportunity, but by the end of the year it could no longer be justified as a bond substitute.  It could be sold and the proceeds used to purchase a more traditional bond substitute or held as cash.

The final area where it may be possible to find bond substitutes among the utilities is water utilities.  American Water Works Company Inc. (AWK), and Aqua America Inc. (WTR) are the two largest.  Water consumption is obviously extremely stable and insensitive to the economy.  One might conclude from that stability that water utilities would be a natural substitute for bonds.  However, both companies suffer from lower dividend rates than one would want in a bond substitute.  Despite that, Aqua America looks like an attractive bond substitute going into 2014.  The lack of sensitivity to the market and the economy is true of both the company’s business and its stock price.  Thus, it is a reasonable place to park money absent some more compelling bond substitute.

Interestingly enough, after having made that decision and purchased additional shares of Aqua America, an article in BARON’S on January 25, 2014, “Dow Slides 3.5% in a Global Retreat From Risk,” referenced the stock as attractive.  One might expect to find a reference to water utilities in an article talking about a stock market decline.  The rationale for holding Aqua America is that it is almost totally impervious to stock market fluctuations and economic cycles.  Fortunately, the stock did not jump after the reference in that article.  So, the stock is still an attractive investment.  A reasonable plan for 2014 is to add to the holdings of Aqua America as long as the price remains stable.

In summary, going into 2014, positions in National Health Investors, AGL, and Aqua America currently serve as bond substitutes.  However, it is reasonable to assume that during the year other stocks will have to fill the role bonds usually play. 

One other passing note, because of the repression of the interest rates, the period 2010 through 2013 and going into 2014 is one of the few times where holding more cash than normal made sense.  The cash needs to be available as opportunities arise to purchase bond substitutes.  The rationale behind the approach of holding cash and using bond substitutes that embody slightly higher risk was discussed in a posting on September 30, 2011 entitled “The Fed Cannot Force Investors toShift to a Different Risk-Return Profile.”




Wednesday, January 29, 2014

Rebalancing in a Manipulated Interest-Rate Environment

A continuing issue for 2014.

Rebalancing, in the broadest sense, just means selling an asset that is inappropriately large for a portfolio and using the proceeds to buy other assets.  Rebalancing in that broad sense was discussed in this blog on December 4, 2010, in a posting entitled “Investing PART 1:Background music.”  That posting was about diversification and asset allocation in general.  It presented a number of tools and data (e.g., guilt chart and asset class correlation matrix) relevant to the issue.

Rebalancing was specifically the target of a posting on December 12, 2010.  It was entitled “Investing PART 2: Adjust the treble and base.”  It was discussed again on December 31, 2010 in a posting entitled “Investing PART 7: “To every thing there is a season.”  Between them, those postings present reasonable strategies for rebalancing, as well as limitations.  This posting addresses some issues related to rebalancing that are particular to the financial environment over the last few years.

Most often rebalancing is discussed in connection with the mix of bonds and stocks.  However, as was discussed in connection with the previous postings this year, it also applies to equity holdings within a portfolio.  In many respects, for the last few years, rebalancing within the equity holdings has been easier than rebalancing between bonds and equities. 

The oft-quoted argument for a fixed portion of bonds within the portfolio is based upon the assumption that the unpredictability of equity markets creates a need for potential liquidity at any point.  Also, the return on bonds tends not to be correlated with the return on equities.  Consequently, rebalancing involves selling bonds when their returns have been high, on the assumption that that would be when stocks have had low returns or have gone down.  However, that argument rests on an assumption about the investor’s time horizon.

Bond holdings are, in many respects, always problematic.  There are major shortcomings of bond mutual funds.  Specifically, they defeat the principal purpose of bonds, which is to ensure a return of a specific amount at a specific time.  Even holding individual bonds presents a problem, mainly because they historically have a lower return than equities.  Thus, a reasonable approach is to only hold bonds with maturity dates designed to coincide with the investor’s need for liquidity. 

For the last few years, the Federal Reserve has completely undermined the logic and desirability of bond holdings.  Not only have they manipulated short-run rates, but through operation twist and quantitative easing, they are manipulating the entire yield curve as well as the spread between treasuries and mortgage-backed securities.  The net effect is what is known as financial repression.  It is worth noting that the repression focuses on fixed income investors.

One should keep in mind that every investment, even money (which always has a negative real return during periods of inflation), carries certain risks while hedging others.  As the Fed expanded its rate manipulation to include longer maturities, negative real returns became characteristic of bonds as well as money.  A logical response to the Fed's policy has been to look for substitutes for bonds. 

As mentioned in the postings cited above, one's investment options are not static.  New options arise over time.  Some of those new options can be used to hedge some of the same risks that bonds would hedge.  It is also possible to pick investment options that provide some return characteristics similar to bonds.  Options that are currently far more accessible to investors than they were a decade ago are Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and Limited Liability Partnerships (LLPs) in general.  Those options now trade like the shares of other companies.

One similarity with bonds is that they are backed by specific assets.  Granted, the claim on those assets is a lower priority than with senior secured bonds, but there is a claim, and, in many cases, that claim is on an asset that is more liquid than those of many corporate bonds.  Further, like bonds, the return on investment is the cash flow from the asset.  Some bonds’ only asset is the discounted cash flow from other financial assets they hold.  Thus, in some instances, one might judge an equity position in a REIT or MLP as better secured than some bonds. 

Interest rate risk manifests itself in a different way.  With a bond, one can always hold it until maturity, at which point it no longer has any interest rate risk.  There is no equivalent maturity date for equity positions in REITs or MLPs.  A rise in interest rates can be secular or long-term.  In which case, one cannot wait out the impact of the interest-rate change.  However, REITs and MLPs can raise their dividends to offset the impact of an interest rate increase.  Bonds offer no similar option.  Consequently, the cash flow from an investment in a REIT or MLP has a different profile from that of a bond.  One has to weigh the risks associated with the two differently structured cash flows and judge the degree to which the REIT or MLP is an acceptable substitute.  The same is true of utilities which were the traditional bond-like equity investment.

The Fed's policy has killed bond holdings as a conservative investment that could be held to maturity and rolled over.  As will be explained in the next posting with examples, bonds and bond substitutes have become more of a trade than an investment.  That is particularly true of bonds where fluctuations in the value of the bond can easily be a multiple of the interest earned over any period of time short of its full maturity.  The need to trade potential substitutes for bonds is partially a result of interest rate manipulation, but it is also related to other features of the substitutes.

Tuesday, January 28, 2014

Perspectives on management

The relationship between corporate management and portfolio management.

The previous postings about managing an equity portfolio (starting with “2013 Was a Very Educational Year”) intentionally minimized references to the financial analysis or technical analysis that supported the portfolio adjustments discussed in the postings (especially in “What is to be learned about stock acquisition?”).  The purpose of that approach was to demonstrate that investing can be done without extensive sophisticated analysis. 

Lest that comment be misunderstood, the point is not that one should throw darts at the financial page in order to construct a portfolio.   Once one has identified what looks like an appealing adjustment, additional analysis can be used to confirm that it is legitimate.  The amount of additional analysis one requires is really a matter of taste and there are numerous scores of guidance from textbooks to websites.

The approach works because the widows’ and orphans’ portfolio has a logic and an objective.  An important component of the logic behind the portfolio is to restrict portfolio holdings to well-respected companies that produce well-respected products.  One can learn a lot about the quality of a company from an analysis of the reputation of its products.

Another important criterion for inclusion in the widows’ and orphans’ portfolio is what for lack of a better term might be called robustness.  Robustness implies companies with reputations for conservative financial management and market leadership.  Buffett likes to say that he likes to invest in businesses that are so simple that they could be run by idiots, because sooner or later they will be.  Robustness does not have to originate from simplicity.  Robustness may originate from an ingrained corporate culture, unique assets, natural monopolies, strong brands, exceptional management or a variety of other factors.

Among those factors that contribute to robustness, the most fleeting is exceptional management, especially senior management.  It is easy to over-emphasize senior management's role.  They get paid a lot, so one might assume they must be doing something important.  The media likes stars, so they focus on senior management.  Most investors do not get exposure to other than the most senior managers.  However, the corporations in the widows’ and orphans’ portfolio are huge.  Any senior manager’s impact on the company is a lot like the impact of the helmsman of the supertanker.  Changes in the fortunes of the company only occur slowly.  Consequently, monitoring the quality of senior managers provides an opportunity for the long-run investor. 

The investor’s greatest challenge associated with using judgments about the quality senior management is deciding whether senior management's impact will be lasting.  In most cases, the portfolio is designed to include firms that can outlast weak management.  But, weak management provides an alternative opportunity.

Johnson and Johnson provided an example when it was run by Weldon.  He made a series of mistakes including ill-advised acquisitions that resulted in some embarrassing product recalls.  It was clear that he was overly focused on empire building to the detriment of the company's reputation for quality products.  At the time, a decision had to be made as to whether to abandon Johnson & Johnson as an investment or hang on in the belief that it would survive Weldon's mistakes.  If one judged that Johnson & Johnson would survive Weldon, when he was finally replaced it bdecame an excellent opportunity to acquire additional Johnson & Johnson stock.

If one felt that his management would have lasting impact, the response could been to shift to an alternative drug company.  Somewhere in between, there is a strategy that involves buying a different drug company with the intention of shifting the capital into Johnson & Johnson when Weldon was replaced.  One could also just accumulate the Johnson & Johnson dividends and wait for the opportunity to invest them.  If the widows’ and orphans’ portfolio is as well-designed as intended, the alternative was to hold onto Johnson & Johnson stock, and to use the dividends from the stock to purchase an alternative drug company.  Then, when Weldon left, some of the stock in the alternative drug company could be sold to purchase Johnson & Johnson shares. 

One should not misinterpret these comments about Johnson & Johnson during Weldon's management term.  Weldon did not achieve his position by chance.  He is a capable executive with a lot to contribute.  However, his talents were not what Johnson & Johnson needed at the time of his term.  Further, one suspects that some of the mistakes that were made could not have occurred without substantial support, perhaps encouragement, from some members of the Board of Directors.

That example is looking backward.  Looking forward, a review of the portfolio reveals that currently there may be similar opportunities among the holdings.  Empire building is not the only vice that sometimes afflicts bright people.  Very talented managers may just have the wrong skills for the particular challenges the company is facing.  One of the most dangerous situations is when a very talented senior manager cannot recognize his or her own managerial limitations.  That can originate from a variety of motivations from hubris to an evangelical commitment to a particular object.  It is extremely rare for it to be incompetence.  More often than not, it is a failure of senior managers to structure their environment in a way that capitalizes on their talents.  That structuring can be anything from delegation to divestitures.

Pepsi is a good example.  The business has been unable to realize its full potential.  The entire food group has not performed spectacularly, but Pepsi seems to be suffering more from self-inflicted constraints than the overall performance of the industry.  This situation has been going on for a number of years and has reached the point where there are now calls for separating the beverage and snack food businesses.  Pepsi's market position and size pretty much guarantee that it can survive such underperformance.  Therefore, its problems did not justify abandoning the stock.  At the same time, those same factors eliminated any urgency to address the problems.

Under the circumstances, Pepsi can perform reasonably, but not well, for a long time.  It has done just that.  Over the last few years, Pepsi's lack of a catalyst for a performance improvement provided an incentive to delay any investment in Pepsi.  Such underperformance generates increasing pressure on management.  It may be that 2014 is the appropriate time to begin reinvesting dividends in anticipation that the pressure will force some change. 

Previously, investing dividends from Pepsi in other firms in the industry, or similar industries, made sense.  Pepsi's relatively poor performance within the portfolio means that some step had to be taken to restore an appropriate weighting to the food and beverage industry component of the portfolio.  In that respect, it provided an opportunity to diversify into a broader representation of the total industry.  One could acquire a non-snack food firm like General Mills.  One also might consider other beverage companies less heavily represented by sugary beverages.  It seemed like a perfect time to have a beer.  Once a catalyst for improvement in Pepsi's performance can be identified, those stocks and/or their dividends can be used to enhance the holding in Pepsi.

General Electric has represented even more of a problem for the portfolio.  Almost from his first day, it has been apparent that Immelt was unable to control GE's future.  He walked into a period when GE faced significant challenges from the events of 9/11 and then the financial crisis.  However, his willingness to blame those external events for GE's performance made it quite apparent that he was not up to the task of controlling GE's future and ensuring its success.

The rationale for including GE in the portfolio included the statement that the company is sufficiently robust to survive a bad manager.  Thus, there is no reason to abandon the company.  It will prosper and perhaps 2014 will be when that begins.  However, over the last few years there was no rationale for adding to the position in GE.  In presenting the widows’ and orphans’ portfolio, United Technologies was mentioned as an alternative.  Given the situation at GE, investing GE’s dividends in United Technologies has made sense for over a decade and may continue to be the case.

Procter & Gamble was mentioned as the consumer nondurables component of the widows’ and orphans’ portfolio.  However, as was noted, Kimberly-Clark, Colgate-Palmolive, and even Clorox provide alternatives.  Thus, Procter & Gamble's management problems and the consequent underperformance of the stock make the consumer nondurables component of the portfolio the natural place to diversify away from the core into other comparable companies.  For example, one opportunity to diversify was mentioned in a posting on March 30, 2010.  The posting, “Wall Street doesn’t run the world,” mentioned an opportunity in one of the alternatives, Kimberly-Clark.  It was not until last year that Procter & Gamble’s stock was able to keep pace with the companies peers.

The underlying philosophy behind the widows’ and orphans’ portfolio is that it will provide a core, but not the totality, of one's equity positions.  Adding new positions might occur in response to a change in one of the portfolio holdings.  For example, when Pepsi spun off Yum Brands, it made sense to hold Yum Brands’ or add exposure to replace Yum Brands business in fast foods. 

If the basic portfolio holdings are durable, management problems represent a different kind of opportunity.  They present an opportunity to acquire non-core holdings or accumulate the dividends. Those non-core holdings can be used to expand the industry coverage of the holdings.  An example would be adding a non-snack food producer to supplement Pepsi's snack food business or adding a paper company like Kimberly-Clark to the nondurables.  In some cases, the supplemental company will be a competitor of the core holdings for some or all of its lines of businesses.  For example, United Technologies competes with General Electric in some business lines.  But between them, the two companies represent more business lines than either alone. 

In most cases, the additional stocks can be selected so as to strengthen the overall portfolio and enhance the performance over the long run.  However, it is the long-run portfolio objective, industry mix, and emphasis on quality holdings characterized by the core holdings of the widows’ and orphans’ portfolio that stay the same.

As with the other postings in this series, this posting was done without any reference to the financial statements of the corporation or technical analysis of the stock.  One should not conclude that a review of the financial statement is irrelevant to an assessment of management.  That is hardly the case.  Financial statements, especially the balance sheet, but also the cash flow statement, say a lot about management.  The income statement, which seems to receive the most press, probably says the least about management of the company.  They were ignored in order to show that sophisticated financial analysis and technical analysis are not required in order to identify investment options. 

Sunday, January 26, 2014

What is to be learned for 2014 planning?

It is good to have a plan.

Going into 2014, situations like Boeing, PPG and 3M create a tremendous temptation to chase their performance.  All three are excellent companies, and there are many reasons to believe that the conditions that led to the superior performance of Boeing's and PPG's stock are still in place.  3M on the other hand appears to be fully priced, although the stock has historically been able to maintain a premium for a number of years. 

Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.

Consequently, dividend flows are a consideration in planning for 2014.  Managing dividend flows involves three considerations.  First, one obviously cares about the total dollars the portfolio generates.  Second, the investor is risking capital to secure those dividends.  How much capital is at risk matters.  Consequently, the yield (rate of return the dividend represents) is also a concern.  Third, if one only cared about the total dollars and the rate of return, there would be a tremendous temptation to chase yield and to invest only in the highest yielding stock.  That would introduce considerable risk in two ways: the high-yield stock would become an inordinately large portion of the portfolio and that high-yield stock would probably embody considerable interest rate risk (risk of the decline in price if interest rates rise).  Therefore, the amount or portion of the dividend flow due to each individual stock is a consideration.  It is desirable to have the dividend flow originate from a variety of different stocks.

By purchasing additional shares of Boeing and PPG, the dividend yield (percentage rate of return) of the portfolio decreased.  Both have dividend yields lower than the average of the portfolio.  Further, selling GE shares in order to purchase PPG involved selling higher-yield shares to purchase ones with a lower yield.  Fortunately, dividend increases across a portfolio supported the dollar value of the dividends, but at a lower yield.  The total dividend flow from the entire portfolio is obviously a concern.  Nevertheless, a legitimate objective for 2014 is to restore the yield on the portfolio.

One of the considerations in making the purchases of Boeing and PPG shares was the dollar value of their dividends.  The total dollar value of the dividends from each individual component of the portfolio is managed in order to control risk.  The dividend flow is diversified so that no single firm’s dividend represents too much of a risk to the cash flow.  In fact, references to bringing holdings of Boeing and PPG up to desired levels involved a dollar dividend flow objective.  Thus, during 2014, one should consider investing dividends in those stocks that are not at the desired dollar payout.  At the same time, one would want to also increase the average yield of the portfolio.  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.

When one acquires a stock, one hopes that sales, profit, and/or dividends per share will increase.  It is of course best if all three increase.  During 2013, Boeing's launch of a new airplane indicates that sales and profits should increase going forward.  That should increase potential for higher dividends.  As it turned out, during 2013 Boeing met all three objectives when it raised its dividend.  PPG, by contrast, has done exceedingly well on maintaining profitability, and whether they increase their dividend significantly will be an important indicator of whether management retains their traditional shareholder-friendly posture.  By contrast, 3M increased their dividend, but it needs to confirm that they can generate profits to support future dividend increases.

A multiyear run up in value of stock, such as occurred with PPG, or one year near doubling, as occurred with Boeing, can disrupt the desired portfolio weightings of different stocks.  In fact, it was the performance of PPG and Boeing that justified the continued dividend reinvestment in Exxon and 3M during 2013.  In order to maintain a reasonable exposure to energy, it makes sense to plan to continue the dividend reinvestment in Exxon into 2014.  Adding exposure to Chevron is an equally viable approach.  Although 3M appears to be fully or overvalued, planning to continue dividend reinvestment for 3M also makes sense from the portfolio perspective.  Further, if it pulls back it will be a candidate for investment of dividends generated by other stocks.

As was mentioned, GE shares were sold in order to take advantage of the opportunity in PPG.  It may be appropriate to begin dividend reinvestment in GE during 2014.  If one held United Technology, an alternative to GE mentioned in connection with the widows’ and orphans’ portfolio, the situation is different.  GE is, in many respects, a unique industrial firm because of the substantial holdings in the financial sector.  Its management also creates some unique issues that will be discussed in a future posting.

Similarly, the Bank of New York Mellon is a candidate for dividend reinvestment.  Both the Bank of New York Mellon and GE fell substantially during the financial crisis.  As a consequence, they are below an appropriate portfolio weighting unless one purchased them at some point in the interim.  But there were no compelling reasons to purchase them previously.  However, the Bank of New York Mellon is particularly well situated going into 2014.  It is a potential candidate for reinvestment of dividends from other stocks.  However, it has one of the lower yields of the portfolio holdings.  Therefore, one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.

The other portfolio adjustment to consider is in the area of consumer non-durables.  Consumer non-durables play an important role in stabilizing the portfolio during market downturns.  However, the bull market since the financial crisis will have shifted the portfolio weighting of consumer non-durables to a lower level.  That was particularly true in 2013.  Consequently, Pepsi and Procter & Gamble (or Kimberly-Clark, Clorox or Colgate Palmolive mentioned as alternatives to Procter & Gamble) are candidates for dividend reinvestment or additional purchases.

It is important to keep in mind that the plan for 2014 is not about trying to pick the stock that will appreciate the most.  If that were the case, further investment in PPG would definitely be a candidate for consideration.  There are multiple rules for establishing limits on the weighting of an individual stock in a portfolio.  Some people use 5%, 10%, or 20% of the portfolio’s value.  An equally valid approach is to set a limit to the portion of total dividend flow that any individual stock should contribute.  There is a more subtle rationale for establishing a total dollar value to any individual holding (e.g., that limit could be determined by the relationship of the stock’s value to one's income needs over some period of time). But given PPG’S multiyear run it should have achieved close to the maximum weight one desires for an individual stock regardless of what technique is used for setting that maximum portfolio weighting.

If the plan were simply about picking the stock that has the potential to appreciate the most, the entire focus might be on a single stock.  A good guess is that Bank of New York Mellon or PPG would be that stock.  But such a focus is totally at odds with the objectives of the widows’ and orphans’ portfolio.  The objective is performance over a long-term horizon, not just over the next year.

Even with a multiyear time horizon for investments, 2013 illustrated that one can benefit substantially from simply monitoring what is going on a portfolio and adjusting purchases accordingly.  So, although there is a plan for 2014, that plan explicitly provides for using developments during the year to maximize the benefits of dividend reinvestments and new purchases.

Friday, January 24, 2014

What is to be learned about stock acquisition?

The market for individual stocks can be more profitable than the stock market.

This blog posted a discussion of a model large cap stock portfolio.  The posting on Sunday, January 9, 2011 was entitled “Investing PART 9: One version of the ‘Unfinished symphony.”  As it made clear from the subtitle, “The widows’ and orphans’ stock portfolio,” the portfolio was designed to be a boring (stable, low beta) and profitable equity portfolio.  Also, as implied by references to it as a “core” portfolio, the design was for it to be a boring and profitable portfolio when held year-in-and-year-out, not just in 2013.  Perhaps a better name for the portfolio would be the retirement portfolio.  However, it was introduced as a widows’ and orphans’ portfolio.  So, widows’ and orphans’ it stays.

There are advantages to targeting such a portfolio beyond just the boring profitability of the holdings.  Specifically, the portfolio is designed to require minimal maintenance. Just the act of holding a core set of assets generates familiarity.  Anyone who invests in a particular company will want to monitor its activities and learn about it.  Thus, over time, without a huge concentrated effort, the investor will become familiar with the companies.  At the same time, minimal maintenance implies that whatever effort is expended should be easy.  Furthermore, it is best if it does not require huge technical skills.

A low beta portfolio like the widows’ and orphans’ portfolio could easily underperform in a year like 2013.  Another posting about the same portfolio identifies how to avoid that trap.  As noted in the posting on Wednesday, January 12, 2011, “Investing PART 10: Know when to hold ‘em, know when to fold‘em,” one still has to decide when to purchase the core holdings.  The timing issue is much easier when it is being applied to a limited range of stocks, all acquired with the intention of a long-term holding period.

Again, 2013 provides a lot of guidance.  In fact, 2013 was a bit atypical in that it presented numerous illustrations of how to manage portfolio acquisition timing.  A January 11, 2014 BARRON'S article entitled “Stocks Hold Steady Despite Weak Jobs Data” cited relevant data from Bespoke Investors’ Group's year-end report: …“the S&P 500 stocks that went up the most were the smallest; those with the lowest dividend yields; the highest short interest, and the worst analyst ratings. In other words, the lowest-quality stocks rocked the house.”  That is not the type of year that would benefit a large-cap widows’ and orphans’ portfolio.

The article goes on to point out, “From time to time, however, relatively cheap stocks pop up—even high-quality companies, and often for short-term reasons. In times like these, a quick 10% drop in the shares of a well-known company with a solid business and a promising future could represent a nice entry point for investors with a two- to three-year outlook.”  Therein lies the guidance appropriate for any investor, especially one with a long-term horizon, and 2013 provided an excellent illustration of how the investor could easily take advantage of such opportunities.  A key word in the statement above is “easily.” Monitoring analysts’ ratings of a large number of stocks, having a judgment about the relative performance of large verses small companies in the S&P 500, and foregoing dividends are not easily incorporated into the philosophy of the widows’ and orphans’ portfolio. 

Noticing a 10% drop in one of the portfolio holdings is a bit easier, and 2013 provided ample opportunities to capitalize on such events.  Such opportunities will be discussed subsequently, but first, 2013 provided an even easier opportunity.  Again, it simply involves applying the same rule to the media as was discussed above in connection with portfolio strategy.

The need to analyze the motives of commentators does not just apply to general market commentary and discussions of portfolio structure.  It is equally true of discussions of individual stocks or bonds.  Here, however, an investor is justified if, occasionally, he or she suspects that there is maliciousness involved.  After all, nothing forbids short-sellers from commenting or duping the media into commenting for them.  Occasionally, the Hedged Economist has commented when short-sellers seem to be generating media coverage.  But, from an investor's perspective, the best strategy is to avoid any involvement in situations where that seems to be the case.

Malicious intent is hard to identify.  There are, however, easier opportunities to profit from focusing on the motives of commentators.  One should always keep in mind that the media is perpetually looking for scandals and bad news.  The saying, “if it bleeds, it leads” may be an exaggeration when applied to the business media, but a close approximation is nevertheless very true.  Even more to the point, when general media focuses on a business story, there is no doubt that the intent of the commentator is to find scandal and bad news.  What could be easier than just following the news and using the information to increase the return on a portfolio?  A little judgment is all that is required.

A review of 2013 provides an excellent example of just such an opportunity.  Boeing experienced difficulty in the launch of its new airliner.  It had experienced delays that held the stock down for a number of years.  Remember, Boeing is in the widows’ and orphans’ portfolio specifically because it moves according to its own development cycle.  However, in January, battery fires on Boeing's new airplane hit the news big-time.  

The launch of the new airplane is going to involve the identification of necessary enhancements to the original design.  Consequently, battery failures and other needed enhancements will undoubtedly be in the media again from time to time.  However, when general media starts second-guessing a premier, world-class aerospace firm on the development of airplanes, it is an opportunity far greater than trying to time a development cycle.  During January, and even into February, there were some excellent opportunities to purchase Boeing at a discount.

The opportunity was so great as to literally eliminate any long-term downside risk to the purchase.  It justified attracting any dividend reinvestment from Boeing or other stocks, as well as providing a strong argument for targeting Boeing with any new capital.  Boeing did much more than just recover from the temporary bad news associated with batteries.  In some respects, the bad news associated with batteries heralded the end of the development cycle for the new aircraft.  It was a cue that Boeing was about to transition from heavy investment in aircraft development into the launch of a major new aircraft.  Boeing went on to almost double by the end of the year and raised its dividend.  It does not take many stocks performing like Boeing to ensure the portfolio does not lag the general market. 

Opportunities like the Boeing situation are rare.  One such opportunity each year would be enough to keep an investor happy with the portfolio.  However, during 2013 other opportunities to enhance performance of a portfolio like the widows’ and orphans’ portfolio provided enough positive reinforcement (in the form of profits) to be sure that the lessons from 2013 would be remembered. 

The situation with Boeing only required paying attention to the general media.  The other opportunities required a little more attention.  But the widows’ and orphans’ portfolio is not intended as a buy it and forget it portfolio.  One has to pay attention to how the companies and their stocks are performing.  But it does not require detailed financial analysis or sophisticated technical analysis tools.

A perfect illustration is developments with PPG.  PPG is not as much of a household name as most of the other holdings in the widows’ and orphans’ portfolio.  So, it is not surprising that the opportunity in PPG results from monitoring the performance of the stock and the company. 

In 2012 PPG stock began to advance as the economy improved and the cost of its inputs fell.  A full year of advancing prices provided ample opportunity to notice the result and hopefully tweak an owner's interest as to what was going on.  All that was required to understand the advance was an understanding of the importance of natural gas as an input for PPG and an awareness of the impact that fracking was having on natural gas prices.

Checking the price of the stock periodically revealed that early in 2013 the stock’s price began to lag behind overall market performance.  Much of the underperformance was due to uncertainty associated with PPG’s decision to spinoff one of its business lines.  However, the overall profile of the corporation and its management remained much the same.  Further, the advantage PPG gains globally from its reliance on cheap US petroleum product (natural gas derivatives) remained in place.

The price was off 5% in mid-February and again in mid-March and April.  By the end of March and into April, the stock, which had outperformed the S&P during 2012, had underperformed the S&P by 10% in 2013.  Yet, the basic business story remained the same.  Stock market technicians have all sorts of complicated sounding names or what was happening like resting during a bull run or retracing.  They can also create all sorts of complicated mathematical or chart monitoring techniques for identifying such events.  However, no such complicated analysis was required.  All one had to do was notice that something funny was happening to the price of PPG stock.

It is important to note that excellent timing was not required to benefit from PPG’s performance.  There was a full year of appreciation of the stock to call attention to the performance of the company.  When the opportunity arose to get the stock at a discount, it lasted a couple of months.  If that opportunity was missed, a similar but less compelling opportunity arose again in June.  The price earnings multiple was continually indicating a discounted price.  Further, timing the total market was totally irrelevant. 

The principal complication associated with PPG was that it followed so shortly after Boeing had presented an opportunity that justified spending all available cash.  Some dividends would have accumulated in the interim.  Yet, the attractiveness of the PPG opportunity so soon after Boeing made it instructive in another way. 

PPG’s stock performance justified looking for an opportunity for a portfolio adjustment within the widows’ and orphans’ portfolio.  Just as the stock of good companies can be selling at a discount, some stocks in the portfolio can be performing better than justified by the company's outlook.  During February, March, April, if one owned GE stock, it was such a stock.  It was outperforming the S&P 500 with no justification other than hype.  Selling some GE stock with the intention of replacing it with dividend proceeds over time presented an opportunity to capitalize on the anomaly in the price of PPG.

The opportunities in Boeing and PPG are instructive because one did not have to be constantly analyzing stocks to become aware of the opportunities.  Simply monitoring the price of the stocks and knowing something about the companies was all that was required.  Additional analysis just confirmed the legitimacy of the apparent opportunity.   

Shifting some capital from GE to PPG may have required a little closer monitoring.  However, there were many indications that such a shift might be desirable, not the least of which was the relative performance of the stock prices and the relative P/Es of the stocks.  Looking at relative P/Es and the trends in relative P/Es is not required for the widows’ and orphans’ portfolio.  However, an opportunity like PPG justifies the additional effort.

The opportunities in Boeing and PPG were similar in two ways.  First, they were not fleeting.  One did not have to be monitoring the market every day in order to see the opportunities and have time to capitalize on them.  In both instances, the casual stock market investor had enough time to act and still look like an expert market timer.  Second, trying to time the total market was totally irrelevant to both opportunities.  If 2013 teaches investors nothing else, it made it infinitely clear that the key to success is individual stocks not the total market.  Boeing and PPG illustrate another important point.  One does not have to invest in highly speculative stocks in order to achieve portfolio performance.

One would not normally expect any single year to present two opportunities for acquisition that are as exceptional as Boeing and PPG.  In fact, in many years there may not be even one such opportunity.  Fortunately, the rest of the widows’ and orphans’ portfolio provided other opportunities of a much more common variety.  They are worth discussing simply because similar opportunities always exist.

A portfolio like the widows’ and orphans’ portfolio is going to generate dividends on an ongoing basis.  In all likelihood, for widows, orphans, and older retirees the dividends would be a source of income for living expenses.  For younger retirees, those accumulating for retirement, and those who only use investment earnings as discretionary income, whether and how to invest the dividends are issues. The balance of this posting is best viewed in that context. 

When discussing dividends, the first thing to address is automatic dividend reinvestment.  Investing the dividends in the same stock has a certain simplicity about it, as well as low-cost.  Its simplicity appeals to many investors during the accumulation phase.  Some advantages are:  First, for many people, not having dividends available makes it much easier to accumulate.  Second, reinvesting the dividends makes it much easier to calculate the total return being realized on each stock.  It makes calculating relative total returns extremely easy.  Third, it automates a process very similar to “dollar cost averaging.” (Dollar cost averaging involves periodically investing a fixed dollar amount in a stock regardless of how many shares result from the dollar amount).  Dollar cost averaging results in a lower average cost per share for the end position.  Fourth, it eliminates the necessity of having enough cash initially to acquire the entire position in the stock that one would like to eventually have.

Other investors find dividend reinvesting unattractive.  First, it involves giving up control of the timing, and thus price, of acquisitions of additional positions.  Put differently, the disadvantage of dollar cost averaging across an entire portfolio is that it eliminates the opportunity to take advantage of situations, such as Boeing and PPG and those described below.  Second, because different stocks will perform differently at different times, it necessitates rebalancing periodically within the equity portfolio.  Third, some investors legitimately place upper bounds on the size of any individual position.  Once they have acquired their dollar target or number of shares target, they want to stop accumulating shares in that company.

Clearly, there is no right or wrong about automatic dividend reinvestment versus accumulation of dividends for directed reinvestment.  It should be equally obvious it does not have to be an all or none proposition.  Automatic dividend reinvestment may be appropriate for some stocks but not for others.  Further, it may be desirable to have automatic reinvestment of a particular stock’s dividend during some periods and not during others.

With that general background regarding the reinvestment of dividends, is now appropriate to turn to specific issues within the widows’ and orphans’ portfolio.  First, however, is necessary to provide some background and a reminder that the purpose of the widows and orphans portfolio is long-term investment, not short-term speculation.  So, for example, during 2013, there were opportunities to trade within the portfolio that would look advantageous if one only looked at 2013.  For example, Verizon got off to a very good start in the year as investors chased yield and Johnson and Johnson became expensive about mid-year.  One could easily have traded from them into other stocks, or even between them.  Such trades would look good if one looked only at 2013.  But that sort of short-term trading is not what the widows’ and orphans’ portfolio is about.  The objective is to establish positions that can be maintained in the long-term.

Opportunities like those discussed above in connection with Boeing and PPG are the time to bring holdings in those stocks to the level one would anticipate holding for the long term (barring some unforeseen development).  Thus, using Boeing and PPG as examples, there would be no further need for dividend reinvestment.  Both Verizon and Johnson & Johnson had previously been in similar positions.  Stock in Johnson & Johnson represented a similar opportunity as it emerged from its difficulties with recalls of over-the-counter drugs and changed top level management.  Verizon presented a number of opportunities to increase holdings when the market was in decline.  That was especially true during the recent financial crisis.  While Verizon declined, it was reasonable to expect it to decline less than other stocks and to provide dividends that could be used to purchase the other stocks at reduced prices.  Pepsi presented a similar opportunity years before.  With these five stocks at the desired holding level since early in 2013, their dividends could be invested in other opportunities.

For most of the year Exxon presented an excellent opportunity to buy a first-rate company’s stock at a discounted value.  Reinvesting Exxon dividends in that type environment made infinite sense.  If on the other hand, one held Chevron, the other integrated oil mentioned as a candidate for the widows’ and orphans’ portfolio, dividend reinvestment was not as appealing.

Another stock where dividend reinvestment made sense was 3M.  It was a logical strategy going into the year, as 3M stock was reasonably priced.  About midyear, 3M stock began to outperform the S&P 500.  As it did, another behavior of its stock became apparent.  Normally, 3M's stock price fluctuations are not much more extreme than the overall market.  (3M has a five year beta only slightly greater than one).  Yet, during the second half of 2013, whenever the stock market turned down even slightly, 3M stock dropped more dramatically. 

Since the widows’ and orphans’ portfolio is an equity portfolio, those drops represented an opportunity to invest dividends accumulated from other stocks into 3M.  Investing the dividends earned by other stocks into 3M when it dipped was an easy way to add to total portfolio performance.

The net effects of all of these purchases (Boeing, PPG, 3M and Exxon) during 2013 was to increase holdings in the widows’ and orphans’ portfolio at prices closer to the 2013 low of the stocks than either the high or the 52 week average.  As a result, the widows’ and orphans’ portfolio easily outperformed the bull market run in either the S&P or the Dow.  However, it would be foolish to adopt either the S&P or the Dow as a benchmark.  There is ample evidence that if the S&P or the Dow is the appropriate benchmark, an index funds is the effective tool. The more important accomplishment is that the portfolio has acquired stocks at prices that create a margin of safety.  When the market turns down, as it inevitably will, the acquisitions should remain profitable.  In the meantime, they will generate continuing dividend streams.  Thus, the risk associated with the portfolio has been reduced without sacrificing return.