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.

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