Monday, August 28, 2017

Buying Stocks for a Dividend Growth Portfolio: Part 2b More Examples

A pleasant consequence of time in the market

From supplement to core holding

Diversifying assets within an asset class

Supplements as a hedge

Staying current

Stock-by-stock discussion of MCD, MSFT, INTC, UL, HON, HCH, F, WTR, NNN, plus UTX, BCE, ABBV, EMB, KMI, GG, PAAS, EMR, BBL

One of the more pleasant consequences of owning stocks and equity mutual funds is that they generate money. That money can be used to expand positions or it can be spent. This posting talks about one of the uses for funds generated along the way. Specifically, it talks about expanding and supplementing a core stock portfolio. As with the previous posting, it discusses actual examples in an attempt to provide information that's useful to others pursuing the same ambition.

Unlike the core 10 holdings this portfolio has not been restricted to hundred percent stocks. In fact, much of it was in a 401(k) which constrained investment options to mutual funds. However, over time it has increasingly come to hold additional core holdings. It was not necessary to keep this portfolio 100% in equities as long as it was supplemented by the larger Widows’ and Orphans’ Portfolio.

One reason for supplementing a core portfolio is to hold a position that hedges against specific risks associated with one of the core holding. In the presentation of the original 10 stock portfolio some alternatives were mentioned. Those alternatives often provide a hedge against the failure of a primary holding. However, another reason for adding to the core portfolio is even more important. Over time new phenomenon emerge as do new industries. Firms in those industries or reflecting the phenomena may belong in an updated core portfolio.

Another reason to expand the portfolio is that any portfolio that focuses on the objectives outlined for the 10 stock portfolio creates concentration risk. Many of the stocks that fit into a portfolio pursuing those objectives have certain common traits. For example, they may all be large-cap stocks, but they may also overlook certain industries. Two good examples are real estate and pipelines. Real estate and pipelines weren’t always separate industries. There was a time when it made sense for them to be a part of companies like those in the core portfolio. In fact, at the time the portfolio was initially constructed, the companies included substantial real estate and pipeline holdings. Changes in our tax codes encouraged their segregation into a different class of corporations. Further, as the portfolio grows, international exposure becomes increasingly justified in order to hedge the risks associated with having all investments in only one market. In the last financial crisis, diversification across markets internationally wasn't a very good hedge, but that was unusual.

As a risk management approach, a fixed dollar amount of investment in any one stock was discussed. As the value of the entire portfolio grows, more and more stocks will get to that dollar limit. Further, it may be desirable to move funds held in mutual funds because of 401(k) restrictions into individual equities. Some mutual funds may want to be retained in order to get exposure to areas like international equities or small-cap stocks. However, it may be easier to achieve the objectives of the investor by moving equity exposure from some mutual funds to individual stocks that meet a particular criteria.

This posting will discuss both the how and the why of supplementing the 10 stock portfolio. Stocks that were added to the core will be identified by an *. In each case, there will be a presentation of the investment thesis. Some of the stocks were initially purchased as a supplement, and then they became core holdings. The discussion will explain why that occurred.

Expanding the core holdings

*McDonald's (MCD) - Yum Brands (YUM) is an alternative. The investment thesis: Originally coverage of this industry was included with Pepsi. Therefore, once Yum Brands was spun off, an alternative was appropriate as a supplement for the portfolio. It would add a service industry that has proven durable. However, since the Widows’ and Orphans’ Portfolio already contained a fairly diverse set of industries, adding back the fast food representative was not urgent.

When it did seem appropriate to add this industry, a position in McDonald's was judged to be the better approach. It was based upon two extremely important factors. McDonald's brand seems stronger and their real estate holdings resulted in a much more conservative balance sheet. A previous posting, “McDonald's Two Businesses, One Strategy,” enumerated a number of other reasons why McDonald's appeared to be the appropriate selection for the portfolio.

That still left the problem of when to buy. The initial small position hardly constituted a core position. However, an opportunity to load up on the stock surfaced fairly recently. The posting referenced above discussed a number of management missteps taken by the previous Chief Executive Officer. They can be summarized as not understanding what business he was in. The behavior of management during that time can best be described as floundering. They consider breaking out the real estate holdings and focused on competing with the wrong competitors.

Consequently, the stock pulled back from about $100 a share and languished at about $90 per-share long enough to allow an accumulation of the stock. When a stock that's been increasing in value pauses and pulls back, it's time to investigate why. It was clear that the management was not capitalizing on the strength of their brand or the power of their business model. Nevertheless, the strength of the brand was still there as was the power of their business model. It required buying a stock of a company that had strengths that were being overlooked because of mismanagement.

In many respects, it was analogous to the situation described in connection with Johnson & Johnson and which may exist currently with respect to Pepsi. It is a very good illustration of why the buy part of a buy-and-hold strategy is so difficult.

Disclosure: I own MCD and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and to build a position by reinvesting dividends. However, I would not recommend it as an initial position in the portfolio with fewer than 15 stocks. At current prices, I would emphasize the need to start with a small initial holding.

*Microsoft (MSFT) – The investment thesis: Any core portfolio should include representatives of the technology industry. However, for many years all of the technology industry could be classified as speculative growth stocks. Once Microsoft began paying a dividend it became a candidate for status as a core holding. It has a very strong balance sheet, seems committed to dividend growth, and has strong brands even if they are threatened by technological change.

However, as mentioned in the original presentation of the Widows’ and Orphans ' Portfolio, the original position was small and taken based on a judgment about price (low $20s on a pullback). Mismanagement under the previous Chief Executive Officer provided some opportunities for small additional purchases (on pullback into the mid $20s). There wasn't any expectation that there would be huge gains from those purchases. After 3 1/2 years the stock was only in the mid-$30s. However, the dividend had been consistently raised, and clearly there had been efforts to develop new products, many of them total flops.

At about the time the Chief Executive Officer was changed, the market was behaving as if there would never be another sale of the PC, and Microsoft would never generate a new product. The market was overlooking the assets of Microsoft because of its previous mismanagement. The company still had a dominant position in a viable market. That position was based upon a strong brand which they could leverage into new markets. They still had tremendous software development capabilities. They also had ample resources to invest into the development of new products.

It seemed there was justification for doubling the position by investing more than the total that had been put into the stock as of that point. Once the initial signs that the new manager’s strategy was working started to appear, the position could be doubled again and considered a core holding.

Microsoft needed to demonstrate that it could recover from major setbacks such as the missteps of the previous manager. Once that was accomplished, it was legitimate to consider it a core holding. One should never forget the Buffet admonition to invest in companies that could prosper even if run by an idiot because sooner or later they will be.

Because of the need for some technology representation in the portfolio, Microsoft had been on the watch list for some time. In fact, small positions were bought and sold a couple of times. The same is true of a couple of other technology companies. There is no discussion of those early efforts to establish a position in the technology industry because none met my criteria for a conviction buy or the intent of a long-term hold. They were all trades from the start. There are plenty of examples of mistakes in that experience, but generally they are mistakes in trying to make shorter-term trades without a strong conviction about the durability of the company. That's one of the reasons that this and other postings have advocated not taking a position unless it can be taken with the intention of holding it for the long-term. It's also why the initial presentation of the portfolio included the comment: “In tech I’m not a good source for ideas.”

The approach of putting the company on the watch list and being patient about purchases allows one to build a portfolio without starting with an in-depth knowledge of every industry. Microsoft had been on the watch list for a long time before the initial purchase, and even when the accumulation began, it was done in steps. To the extent any damage was done by other trading activities in the technology industry, it was from ignoring that simple rule of waiting for a long-run opportunity.

Disclosure: I own MSFT and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. At current prices, I would emphasize the need to start with a small initial holding.

*Intel (INTC) – The investment thesis: Intel is a capital goods producer in a very capital intensive industry. It has very long cycles, but it has established a strong brand in its core market. It has tremendous technological expertise as well as intellectual capital. Historically the company has also demonstrated an ability to adapt to changes in the technology market into which it sells.

There are a couple of misperceptions about Intel that can be used to time purchases. The first is that the company can't adapt to changes in the marketplace. One only needs to read Andrew Grove’s book, ONLY THE PARANOID SURVIVE: HOW TO EXPLOIT THE CRISIS POINTS THAT CHALLENGE EVERY COMPANY, in order to realize that failure to respond to market challenges has not been the company’s history. If I were to fault the narrative in that book, it would be that it leaves the impression that the type of adjustment being described occurs quickly. Intel is in a capital-intensive industry where change requires time and investment.

The more recent example was the assumption that Intel could only produce processors for microcomputers. Rather, it is pivoting to processors for data centers without sacrificing its current position in the PC market. It's undoubtedly doing research on other potential markets, but it is a capital-intensive industry, and they have to be sensitive to the need to control ROI. The market’s obsession with PC sales when assessing Intel created a recent opportunity. In 2012 the company’s stock was being priced as if there would never be another sale of a PC, and Intel would never find another market to serve. At that point it was so extreme that it justified violating the rule of starting small. It is one of the few instances that justified initiating a position with a statement buy at $19.50.

The second misperception is that Intel is a growth story or a broken growth story. It is neither and never has been. It's a highly cyclical capital goods company. The reason that the statement buy could be used to initiate the position was that Intel had been on a watch list for a long time. During the time while it was on the watch list, it was possible to trade the stock to capitalize on the growth story/broken growth story phenomena.

Trading the growth story/broken growth story phenomena involves fairly long holding periods and fairly long periods of not owning the stock. As noted, it is a capital-intensive industry with long cycles. While it is in either phase of being perceived as a growth company or as a broken growth company, it is very hard to profitably trade the stock. To illustrate, Intel's ability to maintain and grow its dividend even during the period when many analysts were treating it as a dying company demonstrated a commitment and capability that justified viewing Intel as a core holding. Since then, it's been possible to make very few opportunistic buys based on price pullbacks, but there haven't been any opportunities to make another conviction buy.

Disclosure: I own INTC and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. At current prices, I would emphasize the need to start with a small initial holding, and then add to the position opportunistically based on price.

*Unilever (UL) The investment thesis: The Company has strong brands, a conservative balance sheet, and a long history of dividends. It was originally held as a supplemental consumer non-durables stock that provided direct international exposure.

Unilever was on the watch list before the need for international exposure justified purchasing it as a supplemental. It initially went on the watch list when it acquired the brands of a company called Corn Products International. Corn Products International had been a longtime hold as a core holding. It had provided the portfolio with exposure to two industries. One was corn sweeteners and the other was branded food products. Corn Products International broke itself up into two companies and Unilever bought the branded consumer products groups. They were strong brands. That purchase put Unilever on a watch list. When a company buys another company that has already been assessed as it good fit in the portfolio, it is time to put the acquiring company on a watch list.

After researching the company and following it for a few years, it was apparent that it was a viable candidate for a portfolio with the objectives of the Widows’ and Orphans’ Portfolio. As the portfolio grew, it became apparent that direct foreign exposure would fit with the portfolio's objectives. At that point, a position in Unilever was initiated with the intention of allowing dividend reinvestment to build the holding.

Developments in one of the existing portfolio positions can result in the need to expand on what was originally a supplemental position. As Proctor and Gamble struggled with its international operations, it created a need for a core holding with a firmer international footing. Unilever filled that gap in the portfolio’s holdings. While the primary reason for adding Unilever was always portfolio fit, Unilever has also experienced some shakeups that refocused the management on its core businesses.

One can time purchases of Unilever based upon the relative rate of recovery of the US economy versus the European economy. Although Unilever sells to a much broader audience than Europe, European stock markets tend to move based upon the outlook for the European economy. That phenomena is primarily due to the attitudes of European investors rather than the underlying impact of the European economy on all stocks listed on European markets.

Disclosure: I own UL and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who needs exposure to an international consumer non-durables company and who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

*Honeywell (HON) - The investment thesis: An industrial conglomerate that provides coverage in a number of industry areas, has a strong balance sheet, and has a history of paying rising dividends.

Honeywell was originally purchased as a supplement to GE and UTX. The objective was to extend the industry coverage. Extending industry coverage can reduce risk by reducing the industry concentration. So, the reason for initially holding it was as a supplement that fit the portfolio.

Because it supplies inputs into the aircraft industry, as do GE and UTX, it was the other industries it serves that made it a useful supplement. It has since sold off some of those other industries, and it is currently rumored to be looking to purchase additional exposure to the airline industry. The products it offers to the airline industry do not have much overlap with General Electric or United Technologies, but the fact that all three companies serve the airlines industry does present a concern.

However, as the execution risk associated with General Electric increased due to mismanagement, it was appropriate to look for an alternative industrial conglomerate to serve as a core holding. Underperformance of the core holding can be a reason for diversifying the holding that serves a particular purpose in the portfolio.

The original purchase as a supplement was made during a period when a long upward trend in the price temporarily plateaued. There was no change in the business or its growth prospects that justified the pause in the price appreciation. It is possible to make opportunistic purchases of stock in a company like Honeywell when such unjustified pauses in price appreciation occur. Other purchases were made to bring the portfolio weight of the total holdings of both General Electric and Honeywell to a desirable level. In other words, they were totally portfolio driven.

Disclosure: I own HON and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

*Welltower (HCH) The investment thesis: Provides exposure to the healthcare industry through something other than pharmaceutical companies, is well-positioned to benefit from the aging of the population, isn't overly exposed to regulatory risk related to health care, and provides exposure to real estate through a REIT.

As a portfolio of stocks grows, the overall asset mix of an investor shifts. Many investors have exposure to real estate through homeownership. As they pay off their mortgage, their exposure increases because of the greater equity in their home. However, homeownership represents a very concentrated form of asset ownership. It's one type of real estate in one single location. REITs provide a way to supplement that exposure to real estate.

Further, once the mortgage is paid off, one is no longer automatically increasing one's exposure to real estate. In addition, as the portfolio of equities rises, the relative weight of non-real estate stocks versus real estate is shifting. At some point, it becomes advantageous to own REITs from an asset-allocation perspective. Even within an equity portfolio, there should be some exposure to REITs. In a portfolio with the objectives of the Widows’ and Orphans’ Portfolio the fact they can move independently from the market in general is beneficial. REITs diversify the cyclical response of the holdings.

It's quite possible that the exposure to REITs would remain supplemental rather than becoming a core holding. Welltower and another REIT, discussed elsewhere, were initially purchased with that intent. So, portfolio fit was a justification for the initial purchase. The need for additional non-pharmaceutical exposure to the healthcare industry justified expanding that to a core holding.

The portfolio objectives preclude trying to capitalize on many types of short-run trends. However, demographic trends are sufficiently stable and long-term to justify purchases. Welltower is a way to capitalize on the aging of the population. So, portfolio fit is the principal reason for holding Welltower.

Timing the purchase of REITs is best done based upon price considerations. One approach is to set a target yield that has to be available before a REIT will be purchased. However, with Welltower a different type of opportunity materialized. During federal discussions of healthcare funding, investors will from time to time react by increasing or decreasing their exposure to entire segments of the healthcare service industry without regard to the details of the profiles of the individual companies in the industry. With respect to Welltower, it will occasionally drop along with all other REITs that serve the needs of an aging population without regard to its profile with respect to public-sector payments versus private-sector payments.

Disclosure: I own HCH and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. I would recommend it to anyone who needs exposure to the real estate industry, and who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. If they also need exposure to the health service industry in a form other than pharmaceutical, it could well be a core holding.

*Ford (F) - The investment thesis: A manufacturer in a highly-competitive industry that is extremely capital-intensive. It has demonstrated an ability to survive in that environment.

For years I viewed the auto industry in the same way that Warren Buffett viewed airlines: it was an industry that ate capital. If you want an example of an auto producer consuming capital, Tesla serves as a much better example than Ford. Nevertheless, it is an industry that requires huge capital investments. Consequently, Ford's ability to manage its balance sheet in a way that avoided bankruptcy during the financial crisis probably implies that financially it will be well-positioned for the transition that is occurring in the auto industry.

Ford is a recent addition to the core holdings. It will add the cyclical component, but the hope is that Ford has learned to manage its inventory and time its production in a way that will produce more consistent earnings. Traditionally the time to buy Ford was during periods when the car sales cycle had passed its peak and total volume had fallen and was still falling. During those periods, earnings would fall and the price-earnings ratio would rise. That is essentially the situation right now. However, there is more going on that may make this a unique opportunity to acquire Ford.

Developments in the auto industry have created a heightened level of uncertainty around the entire industries. The rates of technical advances as well as adoption rates for things like electric cars, self-driving cars, and shared ownership through services such as Uber are compounding the usual problem of trying to forecast the future. Ford has been perceived as not understanding the changes that are occurring and/or fumbling their response. The perception of failure has gotten way ahead of the shortcomings in the response, and it has created a unique buying opportunity. The disparity between an analysis of their actual response and the market's perception and reaction to their response justified a recent buy. It justified a buy that was larger than the usual initial position, but it was not so large as to preclude adding to the position as the stock underperformed so far this year.

The management transition that usually occurs with such a situation has already taken place. The issue now is how quickly the new management can demonstrate that they are on top of the situation. Thus far they succeeded in remaining profitable, but not in allaying the long-run fears. That will have to be done, and, when it is, the stock will recover.

Disclosure: I own F, and with my current dollar limit on the dividends from any particular holding, I would need a very compelling argument to acquire more shares. However, that could occur especially if the stock continues to decline at the same time there is evidence that management has begun to address the company's issues. I would only recommend adding it to a 20 or 30 year portfolio if the portfolio included a large number of companies with very different cyclical responses.

**Aqua America, Inc. (WTR) - The investment thesis:  A long history of stable-growing dividends, a water utility which has less risk from regulators than electric utilities, less competition from utilities trying to get into the gas industry than gas utilities, yet many of the same characteristics of electric and gas utilities.

Aqua is the long-term holding that slowly grew to the point of being a core holding. From a portfolio fit perspective, a utility should be represented in the portfolio. Because of their dividends, utilities often move over interest-rate cycle in a way different from that of the other stocks in the portfolio. That same characteristic, behavior over the interest-rate cycle, determines when it is opportune to buy this company. When interest rates rise, the stock of this utility falls or just doesn't rise. That's the time to purchase additional shares.

As implied by the discussion above, I have not had to make opportunistic purchases. Rather I just had dividend reinvestment working for me for a long time. However, during the recent aftermath of the financial crisis, a very unusual opportunity arose. The stock of the company fell as if the distress of the recession was going to cause people to stop drinking water. How absurd! An opportunistic purchase of the company stock at that point was appropriate.

Aqua also has the appeal of being overshadowed in the eyes of many stock analysts by American Water Works. As a consequence, it tends to be a bit more stable and behave in a way that is more closely related to the underlying performance of the company. American Water Works, at times, seems to be driven by investment styles rather than fundamentals. Nevertheless, American Water Works is a good alternative for a long-run investor.

Disclosure: I own WTR and from time to time add to the position through dividend reinvestment. I don't currently have any intention of buying or selling stock, I cannot guarantee that I would not buy it opportunistically if the stock price declines for reasons unrelated to the fundamentals of the business.

**National Retail Properties, Inc. (NNN) - The investment thesis: A REIT that provides exposure to retail real estate properties, leases are triple net which substantially reduces risk, in the past the company has maintained occupancy rates during economic downturns, and NNN has a history of dividend growth.

National Retail Properties is often compared on a stock-by-stock basis to Realty Income Corporation (O). Either would fit the portfolio fit rationale for holding a REIT in this area. The selection of National Retail Properties was based on a totally subjective assessment of the corporate level financial position of the two companies and the details of the properties they hold. Realty Income Corporation could easily be substituted with almost all of the justifications for purchases outlined below.

National Retail Properties was initially purchased as a supplement in the REIT space. Retail REITs seem more appealing than residential or industrial REITs or some of the specialty REITs at the time the position was initiated. As a long-run holding they have certain other advantages. Their cycle is more predictable since they profit based upon the overall performance of the consumer economy. Consumer behavior tends to be more stable than business investment behavior, and retail is not subject to the cyclical anomalies associated with housing, although it does have its own building cycle.

National Retail Properties would have remained a supplemental holding but for an opportunity that has arisen currently. The current perception seems to be that e-commerce will totally absorb the retail sector. All retail exposure is being discounted as if every retail property faced the same risk as many of the department stores currently, and bookstores previously, face from e-commerce. What is totally being ignored is the role of startup individual entrepreneurial enterprises in absorbing retail space. Also, being ignored is the use of retail space to provide services that are almost totally immune to e-commerce.

Disclosure: I own NNN and would recommend it to anyone who needs retail REIT exposure in a portfolio that they intend to hold for 20 to 30 years. I intend to make additional purchases on any price pullbacks.

Perspective or side note 1 – Each of the stocks that have been added to the core holdings represents a more risky investment than individual stocks in the 10 stock portfolio. However, looking at them as a group would indicate that they tend to represent risks that offset each other or a risk associated with one of the 10 original core holdings. A classic example would be pairing an industrial firm like Honeywell with the consumer non-durables like Unilever and supplementing it with the utility like Aqua.

Further, each one individually adds very little risk to the portfolio, and any increase in risk associated with holding them could be offset by the portfolio weight assigned to them. Modern Portfolio Theory stresses that it is not the risk associated with the individual investment that matters: It's the combined risk of the total portfolio that matters, and adding individual investments that may be higher risk if they were the only holding can allow an investor to move to a higher return without changing the risk-return profile of the total portfolio. 

Long-run supplements to the core holdings

In addition to expanding the core portfolio, stocks have been added that are intentionally held as a supplement to the core. They were added to the portfolio with the intention of being permanent supplements. They are discussed below.

United Technologies (UTX) - The investment thesis: Like General Electric and Honeywell, United Technologies is an industrial conglomerate that provides coverage of a number of industry areas, has a strong balance sheet, and has a history of paying rising dividends.

United Technologies has been held for a long time as a supplement to General Electric. It was originally purchased to hedge the risk of mismanagement at General Electric and to provide additional industry coverage. It was particularly effective at hedging competitive losses or mismanagement in either company’s aircraft engine division. Holding multiple competitors in the same industry can hedge out the risk associated with the performance of anyone competitor if the investor wants industry coverage but doesn't feel comfortable trying to identify the strongest competitor.

The primary subsequent purchases were dividend reinvestment. It is worth noting that dividend reinvestment can be a particularly advantageous acquisition strategy if stock in a company displays volatility unrelated to the business while retaining a stable and growing dividend. It is likely that a careful analysis of United Technologies business and stock performance can provide the basis for advantageous opportunistic purchases. I've made those types of purchases twice. First, when it pulled back from the high 80s to close to 70, and a second time when it pulled back from well above 100 into the 90s.

Disclosure: I own UTX and am accumulating additional shares through dividend reinvestment. I don't plan, but cannot rule out, opportunistic purchases on price pullbacks or even a statement buy if the opportunity arose.

Bell Canada (BCE) – The investment thesis: BCE Inc. represents an initial effort to overcome the US-centric nature of the telecommunications industry coverage implied by holding Verizon. In the international telecommunications space, it has the best potential of becoming a long-term holding.

Portfolio fit was the primary reason for acquiring the stock. Although all of the stocks in the initial Widows’ and Orphans’ Portfolio are US-based, other than Verizon, they all provided exposure to the economies of many countries other than the US. Thus, while Bell Canada increases the exposure to telecommunications, it diversifies the country exposure of the telecommunications holdings.

Price relative to the price of US-based alternatives can be used to time the purchase. It was purchased to extend the telecommunications coverage at a time when the US carriers’ stocks appeared to be too expensive.

Disclosure: I own BCE and do not expect to purchase or sell shares over the near-term. I would only recommend it to someone who wants international exposure in the telecommunications industry in a way that is consistent with the objectives of this portfolio.

AbbVie Inc. (ABBV) - The investment thesis: A pharmaceutical company with a history of dividend growth, a pure-play pharmaceutical supplement to the J&J holdings, a long history of dividend growth, and shareholder friendly behavior while part of Abbott's Laboratories.

Pharmaceuticals provide good candidates for a dividend-growth portfolio. It seemed appropriate to add a pharmaceutical as a supplement to Johnson & Johnson, but I had a hard time finding one. I purchased Pfizer, but ended up trading in and out of it two times. They were successful trades, but I would drop it whenever management would be placing too much emphasis on financial engineering and not enough on their core business of drug development. Abbott Laboratories seemed like a more stable growth company suitable for the portfolio. However, there did not seem to be opportunities to purchase it that were as relatively appealing as Pfizer.

When Abbott Laboratories started to be criticized and stock started to be penalized for its multiple business lines, the opportunity arose. Their history of shareholder-friendly behavior indicated that the depressed price during the period of controversy would result in either the company staying together and recovering or the company being broken up in a shareholder-friendly way.

As details for the breakup became known, an opportunity arose to purchase Abbott Laboratories with the intent of holding either part. Then after the split up there was a good chance that, with a little patience, an investor could recover more than half of the acquisition cost by selling the other part. There is a lot of uncertainty associated with corporate breakups such as what Abbott Laboratories went through. It's rare that one can rely on management's shareholder-friendly behavior enough to justify the strategy deployed here. With a willingness to take a position and hold it for reasonable amount of time, it seemed like a rare opportunity to trade into a desirable long-run position.

Abbott Laboratories has been on the watch list for a long time as a supplement to the J&J holdings. Consequently, it was possible to have enough confidence to proceed with the trade with the intention of holding a part of the split up company that is now AbbVie. This type of trade only makes sense if the investor is in a position to cover tying up about twice as much capital as they intend to eventually invest. An alternative that is usually preferable is to wait until after the split up, and then try to accumulate the desired position as the price of the stock fluctuates while things are being sorted out. That's especially true for spinoffs as opposed to splitting up of the company such as occurred with Abbott Laboratories. Future opportunities to accumulate ABBV will probably be limited and dependent upon rumors related to their drug development efforts. It is, however, the successor to a company with a long history of successful drug development, and thus when there are rumors that it has no pipeline, that may be the opportune time for a long-term investor to buy.

Disclosure: I own ABBV, and don't intend to buy or sell, but I recommend its purchase to an investor who is willing to accept the volatility that will occur with the successes and failures of its drug development efforts. I would not recommend it at its current price.

Enbridge Inc. (ENB) and/or Kinder Morgan, Inc. (KMI) - The investment thesis: Quasi-utilities that are in the business of collecting tolls for the transportation of oil and gas. They are C-corporations in an industry populated by many limited partnerships. They allow participation in the industry without the potential tax headaches of limited partnerships. Enbridge is the more conservatively run.

Enbridge is more likely to become a core holding if the need for exposure to pipelines increases. It has a more stable business structure and dividend history, and has avoided the temptation to over-leveraging and expanding too quickly that have been characteristic of other firms in the industry. However, Enbridge is primarily a natural gas pipeline as opposed to an oil pipeline.

Opportunities in the pipeline industry usually relate to the geography of the pipelines involved. I know of no other way to identify buying opportunities than by analyzing existing and planned pipeline paths. An illustration of that principle is possible, but it does not involve Enbridge. When the previous administration chose to block the building of the Keystone pipeline, it was possible to look at the geographic distribution of pipelines and identify primary beneficiaries. They did not necessarily have to be competitors in the transmission of crude. Blocking Keystone also had major implications for where the demand for transportation of refined products would be stretched allowing the existing pipelines to fully utilize capacity and raise charges. As a result, I purchased Pan American Pipeline and experienced about a doubling in price plus dividends. I exited the position to avoid the hassle associated with the limited partnership. The timing of the exit was opportune, but totally accidental. I used part of the proceeds to establish the position in Enbridge.

Disclosure: I own ENB and accumulating additional shares through dividend reinvestment. I have no intention of other major purchases but might if the opportunity arose. I also own KMI, but do not intend to accumulate more holdings. I would recommend ENB to anyone planning to build a portfolio using dividend reinvestment over the next 20 to 30 years. As an alternative to KMI, I would recommend TransCanada (TRP) for anyone planning to build a portfolio with dividend reinvestment over a prolonged period of time.

Goldcorp Inc. (GG) and Pan American Silver Corp. (PAAS) - The investment thesis: Precious metal exposure with production originating in politically-stable countries.

Previous postings have discussed investing in precious metal miners (FEBRUARY 21, 2014, “Without the Glitter”). The best time to buy miners of precious metals is very similar to the right time to buy mining firms in general; it is after the busting of a speculative bubble and the pain of the adjustment process to reduce output. The difference is that precious metal miners are responding to speculative bubbles, whereas other miners may be responding to longer-run economic developments.   

Precious metal miners can provide a hedge that is valuable. However, it is very important to understand what they actually hedge. Many of the postings on the that addressed gold focused on debunking various myths about what gold hedged. Understanding what gold actually does hedge was felt to be sufficiently important to warrant a posting on APRIL 5, 2010 entitled “Gold: Be sure you know what you’ve hedged.”  

Disclosure: I own positions in both GG and PAAS but at portfolio weights well below what is often recommended by those who try to prescribe cross-asset class portfolio allocations.

Emerson Electric Co. (EMR) - The investment thesis: A conservatively run industrial firm, a reasonable balance sheet, a long history of dividends and dividend growth, multiple products sold into multiple industries, but exposed to the construction industry’s cycles.

Emerson Electric, like any industrial firm, tends to move in cycles. The principal difference is that it can move largely driven by construction cycles, especially commercial construction. It is best bought during slumps in its end markets and earnings. The best way to view Emerson Electric is as analogous to the other industrial firms in the portfolio, except that it's closer to the consumer than some of the heavy industry portfolio holdings.

Disclosure: I own EMR and do not intend to increase or decrease my holdings. I would recommend it to anyone who wants to build a portfolio over a long period of time by reinvesting the dividends.

BHP Billiton plc (BBL) - The investment thesis: A global mining conglomerate with a long dividend history and the history of adjusting to multiple commodity cycles, trades on non-US markets. An alternative holding would be Rio Tinto (RIO).

Rather than repeat the justification for holding a BHP Billiton, I will be quoting from a posting on FEBRUARY 5, 2015: “BHPBilliton stock’s role in a dividend growth portfolio.” 

“It provides exposure to resource prices, foreign exchange markets, foreign stock markets, and indirectly to developing economies. The impact of the dollar on BHP Billiton is complicated and easy to underestimate: its output is priced in dollars.”

“BBL is actually in two businesses. One is the operation of extractive activities (mines and wells). The second is the allocation of capital across the development of those resources’ including the acquisition and sale of those mines and wells.”

“…despite the volatility of BBL's stock price, it can work to stabilize a portfolio. The volatility in the stock's price means that the timing of purchases is very important.”

The posting cited above provides a far more detailed explanation of why BHP Billiton might be appropriate for dividend growth portfolio. It also discusses the different forms in which a US investor could invest in BHP Billiton.

The buying opportunity with this miner is analogous to that discussed above in connection with precious metal miners. The time to buy is after the commodity prices have peaked and the miners have cut capacity to reflect the bust. The practice of buying a small initial position as soon as portfolio fit is judged to be appropriate resulted in a paper loss initially; accumulating over time, rather than with one large purchase, allowed averaging down the acquisition price.

Commodity cycles in industrial metals are much longer than those in the precious metals, thus the investor has the opportunity to wait until there are visible signs of the trough in the commodity price. Very little upside movement in the stock price is sacrificed by waiting for a confirming movement in the commodity price.

Comparing BHP Billiton to Rio highlights the risk associated with buying into a position as a company is preparing for a spinoff. If the intention is to hold part of the resulting two companies, the timing of the sale of the part that is not desired can become problematic. Unlike in the example above with Abbott Lab, the spun off entity did not sit comfortably in a Widows’ and Orphans’ Portfolio, even temporarily. Thus, eliminating the spun off position required a precision in timing that wasn't required with respect to Abbott Lab.

Disclosure: I own BBL and would recommend exposure to BHP Billiton or Rio Tinto in a dividend portfolio with the long-run horizon and the need for exposure to non-US markets and the mining sector. I do not intend to expand or contract my position in BHP Billiton.

The composition of the resulting portfolio

With the addition of these stocks, the portfolio size increases by nine more core holdings. That brings the total of core holdings to 19 positions. The weights of the 19 positions vary with the objective of having each holding contribute a certain amount to the dividend flow. The percentage and dollar value of each holding is still monitored, but dividend flow has become a deciding factor, primarily due to my age and need to draw cash from the dividend flow.

There are also nine supplemental positions mentioned thus far, 10 if Chevron is included. Many of those are held to hedge a particular risk associated with other holdings. The amount of the holdings of the supplemental positions varies substantially depending upon what they hedge. So, the total portfolio consists of 29 stocks. The three mutual funds that were held as supplements to provide exposure to international, small-cap, and real estate markets have been reduced to one mutual fund for small-cap exposure. The stocks that have been added to provide international exposure and real estate exposure were selected as more suitable for a portfolio with the objectives of the Widows’ and Orphans’ Portfolio.

There is yet another portfolio designed totally to supplement this portfolio. It will be discussed in the next posting. A primary objective of that portfolio was to accomplish the same objectives with absolutely no overlap with this portfolio. It consists of 10 stocks bringing the total up to 39 which is probably more than is required to accomplish the objectives. It's legitimate to view the additional 10 in the next posting as a separate portfolio. They are included because they present additional examples of how to recognize buying opportunities of stocks in a dividend-growth portfolio. Most of the stocks in that posting would qualify for almost anyone's dividend-growth portfolio definition.

Friday, August 25, 2017

Buying Stocks for a Dividend Growth Portfolio: Part 2a Core Examples

Never hold a stock simply because you bought it.

Always keep portfolio fit in mind and admit when you're wrong.

Focus on the total portfolio and don't be afraid to hold individual stocks through a cycle.

Stock-by-stock discussion of JNJ, PEP, MMM, BA, VZ, XOM, PG, BK to TD, PPG, GE.

In part 1 the discussion was generalized. It would be easy to blow it off as rules or ideas that are useless. This stock-by-stock analysis illustrates the principles outlined in that posting. Hopefully, it will provide useful information about how to approach building a similar portfolio.

As mentioned in the first posting, don't expect specific target purchase prices. Comments like buy on the dip below X dollars aren't terribly useful to anyone who wants to know why. If the answer is there's no reason for the dip, it may be a buying opportunity. But, the reason it is a buying opportunity is the incongruity between the stock’s price-performance and business performance. To identify that, one needs more than just that the price dipped. The buy opportunities discussed in this posting aren’t time specific and, in most cases, are long past. However, the reasons they were buying opportunities are explained. The reasons weren’t constructed after the fact; they’re the reasons why the stocks were purchased at the time they were purchased.

Also, look elsewhere if you're looking for a detailed analysis of any one of the stocks. These postings are going to cover a lot of stocks. None will be covered in tremendous detail, and there is no effort to focus on whether any one is currently a good purchase. Rather, the reason for the posting is that generally there are many descriptions of the stocks that should be in a dividend growth portfolio, but frequently there is failure to discuss how to get them into the portfolio. The only option that leaves is for one to constantly be looking through analyses of each of the individual stocks. The intent of these postings is to provide an alternative approach. Instead of monitoring a bunch of stocks, the option these examples offer is to look for particular situations as indicators that it is time to look closely at the stock.

So, for each of the stocks, what follows will present actual examples. It goes beyond the Widows’ and Orphans’ Portfolio as initially presented in this blog. The stocks in the original core portfolio of 10 holdings are identified by an *.

*Johnson & Johnson (JNJ) - The initial investment thesis: “I can’t figure out a single stock that can substitute for J&J’s combination of consumer non-durable, drug, and medical device exposure. J&J is well-run, conservatively financed with a strong balance sheet, their brand management is exemplary (some of their brand names have become product categories), and they pay a nice dividend.”

After formulating the investment thesis, the stock was compared to a number of alternatives that would have filled the industry diversification requirement. The comparison wasn't very sophisticated and detailed. Today, a lot more information is available to individual investor than was true in the past. However, Johnson & Johnson was the only company that covered three industries. Further, it was being penalized (lower P/E) relative to other pure pharmaceutical plays. Since it was being penalized for the very characteristic that made it appropriate for the portfolio, it was more appealing than the alternatives. Portfolio fit should always be a major consideration. When it's not, it can lead to some adverse consequences as described below when discussing Cincinnati Milacron.

JNJ was one of the first stocks purchased in constructing this portfolio. Since the portfolio was being built one stock at a time, it meant that the only additional purchases were dividend reinvestments while other stocks were being added to get up to a level that contained an adequate diversity of industries. (In fact, the purchase was made so long ago that it was before brokers offered dividend reinvestment options; dividend reinvestment began as soon as the option was offered). It wasn't just diversification across industries that was needed. Diversification involves multiple companies. Johnson & Johnson may be in three industries, but it is still run by a single management and generates only one set of financial results.

Later there were periods where for various reasons, such as the cyclical performance of Johnson & Johnson stock versus the stock market overall performance, it would have made sense to make small additions to this holding rather than other stocks. The well-run consumer durables company will often outperform the market during slow periods and underperform during booms. Generally, however, Johnson & Johnson is one of the hardest stocks for one to time purchases. It's generally well run and valued accordingly.

To illustrate, the first real opportunity to load up didn't occur until 2010, 2011. For me that meant a 30 year holding period without a strong conviction buy other than the initial decision that it belonged in the portfolio. The dividend reinvestment over a 30 year period meant that the initial small purchase had grown to a significant holding. However, 2010 and 2011 presented a window when it made sense to buy enough J&J stock to bring the holding to a level where the dollar value of the stock placed a limit on additional purchases as per the portfolio management rule discussed in the previous posting. The reason for the conviction buy is illustrative of an opportunity that occasionally exists with this type of firm.

The stock underperformed and the company was getting a lot of bad press because it had to recall a number of its over-the-counter drugs due to manufacturing defects. It was also clear that it was not being well managed. In a comment on a posting on SeekingAlpha on Mar 12, 2011 (Why I (Finally) Gave Up on Johnson & Johnson - Stephen Simpson, CFA) I acknowledged the validity of the author’s thesis for selling Johnson & Johnson, but went on to state: “However, JNJ is still a unique franchise. The point where we differ is how much damage has been done and how quickly it can be fixed.” Later in the discussion, “A new CEO would be nice, but they also need to clean up the Board. I'll stay around to vote for some changes.”

Before the proxy vote, I decided to double the position, express my displeasure (as if how I voted my shares really mattered), and watch what happened. It didn't seem likely that the Board would continue to allow this mismanagement to occur much longer. I believe that the brands were strong enough to recover. A Band-Aid is still a Band-Aid, not a self-adhesive medical strip. A Q-tip is still a Q-tip. Further, nonprescription pharmaceuticals represented a small portion of the business, and, even there, it seemed that they would survive and eventually correct the management deficiencies. What I concluded was that strong brands across multiple industries and a strong balance sheet trump a bad manager, especially if the mismanagement is widely recognized. When the market doesn't seem to realize that, it's time to buy.

However, that's looking backward: the question is what does it indicate about future investment opportunities. First, as it relates to Johnson & Johnson, opportunities will arise if the market comes to value firms focused on an individual industry above those with multi-industry exposure.

At the time of the initial acquisition of Johnson & Johnson stock, it was substantially discounted relative to Merck, Schering-Plough (subsequently absorbed by Merck), and one or two other pure play pharmaceuticals. But that creates only a minor opportunity, primarily important from a relative perspective. The truly big opportunity will arise if Johnson & Johnson again encounters problems in one of its business lines that absorbed headlines and influences the overall valuation of the stock.

Second, looking forward and comparing Johnson & Johnson's experience to that of industrial firms, it would appear that brand strength and industrial diversity accounts for much more if a strong balance sheet is retained and the brands are consumer brands versus industrial brands. For an illustration see the discussion of General Electric below. For an analogous illustration with a consumer product see the discussion of Pepsi below.

Third, if one is making regular additions to the portfolio, there will be times when one is buying stock knowing that the market is a disaster. As the economy turns down, it can be an opportune time to buy Johnson & Johnson since the stock tends to hold up better than the market in general and, in some cases, will rise even as the economy slows and the market declines.

Disclosure: I own JNJ and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. At current prices I would emphasize the need to start with a small initial holding.

*Pepsi (PEP) – The investment thesis: “Beverage and snack food exposure. It gave me fast food exposure also when I bought it. They hadn’t spun off YUM yet. But, I didn’t immediately replace the fast food exposure when they spun off YUM, which was unfortunate since both YUM and McDonald’s have done well. (They would have been the logical holdings). Later I purchased a little McD on the side for the portfolio.”

Pepsi was another one of the early portfolio holdings. The major reason was portfolio fit. Johnson & Johnson and Pepsi gave the portfolio exposure to six different areas of business activity. Pepsi is reasonably conservatively run, has a number of strong brands, and from time to time will be priced below any reasonable sum-of-parts valuation. (“Sum-of-parts valuation” may seem to imply a complicated analysis. It doesn't. All one needs to do is compare the P/E of Pepsi to that of Coke and a snack food manufacturer. If that's too much work, just keep an eye out for critical comparisons between Pepsi and their competitors).

A history of shareholder-friendly management is important. When companies like Johnson & Johnson or Pepsi are penalized for their diversification, it's a time to add them to the portfolio. The worst that can happen is that one of the businesses will be spun off as occurred with Yum Brands. If the management is shareholder-focused, that spinoff shouldn't penalize shareholders, but rather just restructure their holdings to include a new company. For a period of time before and after the spinoff of Yum Brands, it seemed like an opportunity to increase the holdings of PepsiHowever, as mentioned in the initial discussion of the Widows’ and Orphans’ Portfolio, doing so required the selling of the Yum Brands stock.

At times Pepsi will be treated as if it were only a beverage company. Frequently, it will be discounted as a beverage company because of its smaller market share than Coca-Cola. However, even during the so-called cola wars, Pepsi was a far more diversified company than just beverages. Further, its ability to hold its own against the strong brand and efficient marketing organization of Coca-Cola demonstrated effective brand management. When analysts and media focus on a single line of business and treat it as if it were the entirety of the diversified company, it's often time to add to the holdings. That was the original justification for Pepsi, and it is a situation that arises periodically with respect to Pepsi.

Pepsi has recently been criticized by activist investors for this diversification. The result was another of the type of strategic reviews that resulted in the spinoff of Yum Brands. In this case, management chose not to alter its line of businesses. The controversy surrounding that process has created some buying opportunities. However, the end of the controversy may not be the end of the buying opportunity. Now management will be under pressure to demonstrate that the decision to keep the company together was justified.

If the management decision to retain the current business lines starts to be questioned, it could depress the stock until there is a change in the management. An even greater danger is that management may decide to sell off some of the businesses and then proceed to do it in a way that is not stockholder friendly. The greatest danger when any company is reviewing its portfolio of businesses is that the company will start selling off businesses and then misallocate the resulting capital.

Disclosure: I own PEP and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

Cincinnati Milacron- The investment thesis: The portfolio needed industrial representation and the company was a heavy industry, capital goods producer.

This was also one of the earliest portfolio holdings. It's mentioned to illustrate the importance of careful consideration of portfolio fit and attention to the balance sheet of portfolio holdings. It also illustrates why it's important to start with a small initial investment.

At the time of the purchase, the company could be described as the metal bender’s metal bender. The diversity of industries that it served appeared to give it broad industrial exposure. However, it turned out that the product line was too limited and that its brand, while strong relative to US competitors, was not strong enough to withstand international competition. I learned the hard way that diversification should involve a diverse set of products, not just a diverse set of markets being served, and a strong brand has to be strong globally.

The experience also highlights the importance of starting with a small initial position rather than immediately making a full purchase. The initial position resulted in a loss, but revealed the mistake in the investment thesis quick enough to avoid the loss being substantial. The position was liquidated and later the company actually went through bankruptcy and no longer exists in the same form. Fortunately, I was able to sell it before too much damage was done and to replace it with a more suitable company (3M).

*3M (MMM) – The investment thesis: “No one can figure out what 3M is. So the company has decided they need a good ROI and dividend to get investor attention; it works and it is a great company strategy from a shareholder’s perspective.”

There are a number of characteristics of 3M that can easily be overlooked. The financial management is traditionally conservative. Their brand management has actually established some of their products, such as Scotch tape and Post-it notes, as the definition of a product category. They are able to stay very stockholder-friendly while at the same time they command an exceptional level of commitment from their employees. They certainly have a variety of products that are sold into a variety of industries as well as to consumers.

They have a track record in research and development that many other companies would love to duplicate. In fact, there have been numerous analyses that have tried to determine why their R&D is so successful. However, because their R&D so successful, it often leads to misunderstandings. From time to time following one of their successful new product launches, analysts will conclude that 3M cannot possibly produce additional products that will replace the growth in revenue that resulted from the most recent product. That can produce a buying opportunity. But, generally, most people who follow the stock are aware that no single product is that important. So any dip in the price is usually shallow and short. 3M is involved in too many different areas for a single product to have a decisive impact.

Because of the scope of 3M's offerings and the quality of the management, opportunities to expand beyond dividend reinvestment usually only occur when there is a general broad turndown in the economy. Although the company is known for some of its consumer products, it is, in fact, an industrial firm. A broad slowdown in the economy produces a falloff in revenue and profits. Because the financial metrics of 3M are probably the best understood aspect of the company, the revenue and profit forecasts can produce unjustifiable drops in the stock's price. When that occurs, additional purchases are warranted.

Disclosure: I own MMM and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. I'd also recommend stepping up the purchases during recessions. At current prices, I would emphasize the need to start with a small initial holding.

Perspective or side note 1 - In discussions of portfolio size it is often assumed that one needs to have a large number of companies in order to have adequate industry coverage. At the time they were purchased, these three companies (3M, Pepsi and Johnson & Johnson) provided exposure to very large number of industries: Pepsi was in three, Johnson & Johnson was in three, and 3M was in dozens in both consumer products and manufacturing products. These three companies probably produce hundreds of products.

The concentration risk was not industry coverage. Rather, the portfolio was concentrated in very large companies and companies with very conservative financial management. Currently, it is much in style to want companies to be narrowly focused rather than conglomerates. However, if conservatively managed, conglomerates can play an important role in a portfolio that shares the objectives of this portfolio.

It could be argued that holding fewer companies concentrates the risk of poor management, but one should keep in mind that a mutual fund manager is determining the entire portfolio of companies in a mutual fund. If he or she is a lousy fund manager, it extends to the selection criteria for all the companies in the mutual fund. Further, management is subject to trends in management style with many companies aspiring to be managed in the same way. Finally, the more companies there are in the portfolio, the greater the effort required to understand whether they are being managed in a way that is consistent with the objectives of the portfolio. For example, holding the entire S&P 500 would guarantee that the objectives of this portfolio would not be met. The portfolio does not seek to emulate the S&P 500 but rather produce a different result with a different objective. The trick is to identify companies that are being managed in a way that is consistent with results that allow the portfolio to achieve its objectives.

*Boeing (BA) – The investment thesis: “Unfortunately it has headline risk. But as a stock and as a company, it belongs. It has a business cycle that is totally out of synchronization with everything else.”

The fact that this company’s business cycle is out of sync with many other companies in the Widows’ and Orphans’ Portfolio is extremely important from a portfolio-fit perspective. However, it is a capital goods producer, and people often overlook the fact that it does have a cycle. There will be times when Boeing is priced in the belief that it is a growth stock. An opportunity arises when that growth stock hypothesis is proved incorrect. That sometimes occurs simply because of Boeing's product cycles, and it sometimes occurs because of a general downturn in the economy.

Often during the growth phase, Boeing's book of orders will become very large and only seems to grow. Panic sets in when some of those orders are canceled. This phenomenon can be sufficiently dramatic to justify holding off the initial purchase as long as Boeing is being viewed as a growth stock. Whether to do that depends upon how long one is willing to wait to secure the stock because the cycles can be quite long. If one is building out the portfolio one stock at a time, the delay could be justified. However, if one is building the entire portfolio at one time, a small initial purchase may be justified as long as the investor recognizes that they are buying the stock so that they have a stock that zigs when the others zag. The cyclical behavior can then be used to expand a position.

Boeing provides coverage for two industries: commercial aircraft and defense/government procurement. At times it can be priced as if it was only one of those two industries. When that happens, there is a slight opportunity to capitalize on the mispricing. Doing so requires an awful lot of analysis and is totally dependent upon that analysis being correct. I noted the phenomena but have never been able to capitalize on it. I recognize my limitations and realize that this type of analysis is, as they say, above my pay grade.

The best time to purchase stocks of the types of companies that belong in a widows’ and orphans’ portfolio is when things appear to be at their worst. It would be wrong to assume that the investment saying, “Be bold when others are fearful and fearful when others are bold” only applies to the total market. It also applies to individual companies. Boeing can provide dramatic examples.

For example, as discussed in more detail in another posting, the introduction of the 787 involved a high-profile lithium-ion battery problem. Aircraft are complex, highly technical products. There are going to be engineering challenges to overcome in the development of any aircraft. They are a big part of the development process, not a crisis. They often occur right before the aircraft is put into production. In the case of the 787, the problems were extensively publicized. As a consequence, right as Boeing is about to put a major new aircraft into production, the situation was being treated as a disaster rather than a success. I judged the engineering expertise of the critics to be inferior to that of the Boeing staff, and I made a substantial addition to my holdings.

Disclosure: I own BA and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. At current prices I would emphasize the need to start with a small initial holding.

*Verizon (VZ) – The investment thesis: “Is it a telephone utility, a cell phone, an internet delivery, or a cable company competitor? Don’t care what it is: it is well-run and well-positioned. It also has a nice dividend. While Boeing has its own cycle, Verizon tends the follow the inverse of the cycle for many of the other stocks on this list. Because of the dividend, it is sensitive to interest rate cycles over short-to-intermediate time horizons.”

I could have added AT&T as a potential alternatives in the initial presentation. However, I focused on Verizon because of the subjective impression that it's more disciplined than AT&T in its capital allocation. I had owned AT&T at various times as far back as when it was the monopoly phone company, and I had come to seriously question their capital allocation. Since the initial presentation of this portfolio, Verizon has become more cell phone focused. However, their more recent acquisitions have displayed a willingness to diversify in ways designed to capitalize on their presence in the cell phone industry.

The most common way to time purchases in the telecommunications industry is to play the interest-rate cycle. Because of their high dividends, the stocks of telecommunications firms are often viewed as a bond substitute. The interest-rate cycle can be used to time the purchase of the telecommunications company, and it would indicate that right now is not the right time to make the purchase if the objective is immediate capital gains. However, an alternative to delaying the initial purchase is to substitute it for any planned long dated bonds purchases.

However, interest rates are not the only consideration. The cell phone industry is currently highly competitive. That competitiveness is seen as a strong negative for the entire industry. However, I just purchased some additional Verizon stock, and the reason was that very competitiveness. The cell phone industry has always been highly competitive and Verizon has prospered. There's no reason to think it suddenly will become a loser.

It also has a number of advantages in that competition. First, it's more focused and concentrated on cell phones. Second, it's unlikely to be distracted by a major acquisition or merger. Finally, in that competition Verizon has the advantage of what is often considered the best network. Competition can indicate that things are changing and that isn't automatically a negative. If the market makes a mistake regarding the impact of competition, it can create an opportunity to buy. In this case, the opportunity may be more important than the interest-rate cycle.

The combination of fear that interest rates will rise in the near term and that competition will pressure margins has held Verizon stock price to a level I couldn't resist. The stock price is not going to bounce back over the short run, but the current price level is appealing to someone with a very long-run horizon.

Disclosure: I own VZ and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. I added to my holdings recently for reasons discussed above. I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. But, I would warn that, over the near term, there may not be any capital appreciation. Rather, the dividend reinvestment will be buying the stock at a depressed price.

*Exxon (XOM) – Chevron (CVX) is an alternative with a bigger dividend. The investment thesis: “If you believe oil is the fuel of the past, buy one of these companies anyway. They are hydrocarbon processors as well as miners/drillers.”

Exxon and Chevron are known for their ability to develop large complex oil and gas resources. It makes sense to purchase stock as they complete one of those major projects and transition from investing in the development to benefiting from the cash flow of the completed project.

It's easy to overlook the fact that they also have substantial exposure to refining. Their expertise is not exclusively geologically focused. They have experience and expertise in the chemistry of hydrocarbons. Hydrocarbons are extremely useful molecules and burning them is only one of the potential uses. It's also easy to overlook some of the skills their management has developed. Both companies have demonstrated an ability to plan for very long-run projects and to adjust plans as the environment changes.

Both companies have also demonstrated ability in the area of capital allocation. Their approach is shareholder friendly. When they don't see internal uses for capital, they aren't shy about trying to return the capital to shareholders. I wouldn't be surprised to see them shrink their capitalization while supporting the stock price through buybacks and dividends.

Currently considerable emphasis is placed on metrics such as the growth of proven reserves, the amount of investment in new projects, and the spread between crude oil benchmark prices and the price of gasoline. All are important to these companies as is the effect of changes in crude oil benchmark prices on these companies’ balance sheets. However, all of these metrics are measuring either the environment in which the company is functioning or the company's response to that environment. They influence but do not determine the success of the companies. Their success will be determined by their ability to get oil and gas out of the ground and to their customers in the form that reflects how those customers want those hydrocarbons.

Disclosure: I own both Exxon (XOM) and Chevron (CVX) and do not intend to purchase more shares of Exxon as long as I retain my current limit on the dollar value of dividend flows from any single stock. Chevron could be purchased or sold if at some future point I foresee a need to change my exposure to the industry. At present, I don't foresee such a need. Nevertheless, I would recommend either stock or both to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

Perspective or side note 2 -There is a pattern associated with the stocks held in the portfolio particularly with Verizon and Exxon being selected over higher-yielding AT&T and Chevron. At the time they were acquired the pattern of not necessarily picking the highest yielding alternative also applied to selecting Pepsi instead of Coke and Johnson & Johnson instead of the alternative drug companies being considered. Details regarding the products they offered and industries they were in were important, but not the only the reason for the selections. Verizon and Exxon in particular illustrate that point since, at the time they were purchased, their profiles were very similar to the alternatives being considered.

The selections were based on the belief that the management of those companies would behave in a way that was more consistent with the stock performing in the manner required in order to meet portfolio objectives. Details regarding their product offerings fed into that, but it was more extensive and required a little bit of research into the philosophy and strategy of the management.

The evidence at the time of purchase was not just a subjective impression about the management. In most cases, it was also possible to look at the historical performance of the stock and dividend. That didn't involve just looking at growth since, in some cases, the growth of the competitor had been greater over recent periods. Rather, it involved looking at the stability or consistency of the growth in both the price of the stock and the dividend. Whenever possible, the longest historical period available was used. The type of analysis can easily be done with the tools currently available.

The result seems to have been a more stable and consistent portfolio. However, I haven't back tested against all the alternatives that were considered. That would involve comparing a very large number of alternative scenarios since 10 stocks were involved, and, in each case, one or two alternatives were considered. The number of different potential portfolios is very large and the issue hardly justifies the analysis. The purpose of the portfolio wasn't to maximize the accomplishment of particular objectives. Rather, the purpose of the portfolio was to maximize the likelihood of achieving the objectives. The objectives were achieved, and thus the portfolio was successful.

*P&G (PG) or Colgate (CL) – The investment thesis: “One could cycle between Procter and Gamble, Clorox, Kimberly Clark and Colgate Palmolive and probably make a profit. But, that’s a lot of work for the marginal return over any one of the individual stocks. They tend to move together, so if you don’t like P & G, pick one of the others.”

Procter & Gamble is the representative of branded consumer nondurables in the portfolio. It is one of my later picks, and not one of my better picks. Some of the things that looked like strengths at the time have recently turned out to be Procter & Gamble's Achilles' heel. It had a more conservative balance sheet, a larger number of well-established brands, and reputation for excellent brand management. However, it used its balance sheet to acquire additional brands to the point where it lost focus on brand management for its existing brands. Put bluntly, its capital allocation missteps undermined the company's strengths.

However, despite the recent relatively poor performance of Procter & Gamble, the appropriateness of including a consumer nondurable company in the portfolio was justified. It's provided dividend growth and countercyclical price moves relative to the stocks of industrial firms. It's been retained in the portfolio, but the level of holdings has not been expanded. The investment thesis made clear that it was the industry coverage that was important, not the particular company. While I didn't try to trade between the different representatives of the industry, as discussed in the next posting, I did take advantage of their common portfolio function by acquiring the stocks of a number of the other companies. The exception is Colgate-Palmolive and the reason is simple. I've never identified a terribly appealing entry point.

Looking forward, with respect Procter & Gamble, there is a chance that the situation is analogous to others discussed above where mismanagement has caused the market to overlook or discount inherent strengths of the company. But, I will not be making a statement buy for two reasons. First, I've already hit my limit for holdings of Procter & Gamble, and there are comparable alternatives that don't increase the company-specific risk. That's a perfect justification for expanding the portfolio. Second, it's very hard to determine exactly when the type of mismanagement that has plagued Procter & Gamble will be stopped. It can go on for quite a while. Given my situation, it isn't worth making the investment of time and energy that would be required to confidently predict that the mismanagement is ready to stop.

Disclosure: I own PG and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. However, I would point out that, to some degree, they would be investing in a turnaround story, and if they want a more conservative investment, there are other options within the industry.

* Bank of NY Mellon (BK) - or Berkshire Hathaway (BRK-A or BRK-B) – The investment thesis: “Both are weird financial service companies for sure, but the financial service industry is tricky. I wish Mellon still had a retail bank, but Mellon is the firm purely in the financial services space that I feel most comfortable with for an intended ten year holding period. Berkshire isn’t a pure financial service play, but under the hype, it has a big financial service component. Even in troubled times you need to include at least one financial firm. Mellon has a dividend which they cut during the financial crisis. Berkshire doesn’t have a dividend and thus didn’t make this portfolio.”

The Mellon Bank component of the Bank of New York Mellon had been in the portfolio for many years. At the time the portfolio was originally formed, Mellon Bank included trust banking, retail banking, investment banking, and investment management. It added substantial coverage of the financial services industry. Continuing to hold it became an example of the mistake of holding onto a stock simply because it had already been bought.

Over time Mellon changed its profile and increasingly became essentially a pure trust bank. Consequently, the portfolio-fit justification for holding Mellon Bank weakened over time. That process involved a number of milestones that could have been used to justify selling the stock. They included the sale of its retail banking, a number of other similar repositioning transactions, and the merger with the Bank of New York.  A perfectly reasonable approach to portfolio management would have been to sell Mellon Bank or cut the size of the position as it narrowed its focus and to replace it or supplement it so that the portfolio fit remained.

I didn't undertake the analysis and screenings of alternatives that would have been required in order to respond to the changes in portfolio fit. Therefore, it's impossible to say whether responding would have improved the performance of the portfolio in terms of dividend flow or appreciation. However, responding would have reduced the risk associated with concentrating on a narrow part of the financial service industry.

Then during the financial crisis the company cut its dividend. The portfolio would have benefited if I had responded and selected TD as a replacement. However, as discussed in in MARCH 5, 2014, “The Widows’ and Orphans’ Portfolio and US Banks,” it wasn't the dividend cut that finally made it apparent that the company had to be replaced. The posting provides a detailed discussion of why Mellon was dropped. Changing the core portfolio holding is not a minor portfolio adjustment. In fact, other than some very rapid changes when I was first building the portfolio, Mellon is the first time any major core holding has been eliminated other than by bring bought by another company.

Further, much of the benefit of switching would have been contingent upon making the entire move at one time. I prefer and recommend building a position over a period of time rather than all at once unless there is some major catalyst in a stock that has always been on the investor’s watch list. Nevertheless, what the experience demonstrates is that it is always a good idea to have some idea of potential replacements for any of the portfolio holdings just in case something changes.

The March posting referenced above discussed initiating a position in Toronto Dominion (TD) and a small position in Wells Fargo. Wells Fargo didn't eliminate the regulatory risk. My statement at the time was, “It is impossible to guess when our government or a group of trial lawyers will decide that Wells Fargo would be a nice target for extortion.” Given that sensitivity, it should not be a surprise that Wells Fargo is no longer in the portfolio. The position in a Wells Fargo was initiated when investors were selling every bank as if they were all going to go out of business. As a consequence, in hindsight, Wells Fargo can be viewed as a successful trade, but a failure to find a new potential core position.

Disclosure: I do not own BK and have cut my exposure to US banking because of regulatory risk. I have not analyzed BK since eliminating it from the portfolio. I would recommend including exposure to the banking industry in the portfolio. The solution that I recommend is the selection of a Canadian bank as discussed in more detail below and in the posting referenced about. I would like to have a position in the US bank, but more than likely would keep it as a supplemental rather than a core holding. I have used BRK-B as a parking spot for temporary funds while waiting for opportunities to invest funds; however its lack of a dividend precludes its inclusion in this portfolio.

TD Bank (TD) - The investment thesis: The investment thesis is described in more detail in the posting referenced above and the posting described in the narrative below. The short version is: protection from US bank regulatory risk, a desirable US and Canadian footprint, and a strong brand built on a reputation for customer service.

With respect to Toronto Dominion, the March posting did express optimism that TD could serve as a core holding, but the posting did not identify a catalyst that would justify a statement buy. A subsequent posting (JANUARY 25, 2015, “The Canadian central bank’s rate cuts should put TD Bank on US investors’ watch lists”) mentioned seeing a catalyst (the market’s reaction to an earnings release) that justified adding to the position.  Even though it addresses a different stock, a more complete discussion of the type of catalyst mentioned with respect to TD can be found in a MARCH 30, 2010 posting entitled “Wall Street doesn’t run the world.”  The essential point is that different investors have different time horizons and that can be used to the advantage of the investor.

The January posting on TD provided a detailed explanation of why TD was being put on a watch list as a potential for future purchases. At the end of the year, the price of TD stock pulled back significantly, and,consequently, the position was expanded to the point where it could be referred to as a core holding.

Disclosure: I own TD and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. Nevertheless, I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

*PPG Industries, Inc. (PPG) – The investment thesis: “It is a conservatively-run chemical company. The chemical industry is a tough business, but their staying power is illustrated by” the fact that PPG has been a reliable dividend grower for over three generations.

PPG can present problems from a portfolio- management perspective in a 10 stock portfolio. As discussed in a posting on January 24, 2014 (“What is to be learned about stock acquisition?”), PPG has a lower dividend yield than the other stocks in the portfolio. As a consequence, managing it as a percent of the portfolio can result in a different conclusion from the conclusion one would reach by managing it as a percent of the dividend flow. It becomes particularly complicated if there are also dollar value guidelines one tries to apply to the portfolio. The January 24 posting described one of the opportunities that provided. As a consequence, PPG is the only stock in the portfolio that has been traded within the portfolio.

It has also been used to expand the portfolio by adding some of the stocks discussed in the next posting. In fact, as a result of bringing the portfolio weight of the holding up to a level that resulted in the desired dividend flow, it was possible subsequently to sell some of the PPG stock and purchase new dividend growth candidates. That was done in a way that resulted in an overall increase in the dividend flow from the new 10 stock portfolio.

At the same time, enough PPG stock was retained to allow dividend reinvestment and the occasional use of the dividends from the entire portfolio to build the position in PPG back to where it could be justified as appropriate for the original 10 stock portfolio on both dividend and dollar value of the holdings basis.

That buying and selling violated the “Requires very few changes over a long period of time” objective of the portfolio. It was only possible because I was neither reinvesting all the dividends nor spending all the dividend flow. Since it is my intention to either reinvest dividends in new stocks or spend them, PPG will continue to be a stable part of the 10 stock portfolio unless something totally unanticipated occurs.

Looking forward, the big opportunities to buy PPG occur during recessions or other economic slowdowns. In that respect, although for very different reasons, it is like 3M. They both provide examples of why the buy part of buy-and-hold is tricky, but because PPG doesn't have the range of products of 3M, it's even trickier with PPG. Other opportunities arise when the market seems to be focusing on dimensions of performance other than the strengths of PPG. However, they're harder to identify and often are relative opportunities rather than absolute buying opportunities. The posting cited above (“What is to be learned about stock acquisition?”) provides a description of how to identify such relative opportunities.

Disclosure: I own PPG and do not intend to purchase more shares for this portfolio as long as I retain my current limit on the dollar value of dividend flows from any single stock. However, I might trade in the stock at some point. I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends.

* GE (GE) or United Technology (UTX) – The investment thesis: “For the long-term you want companies that can survive bad managers. GE is doing that right now. The alternative United Technologies is better run right now and more of a pure industrial play, but GE will survive Immelt. Someday United Tech will be run by someone like Immelt who can’t admit he is in over his head.”

Obviously the ability to survive a bad manager is important, but the initial thesis was overly focused on that one dimension. Both companies are known for their product diversity and strong balance sheets. GE was chosen as a core holding and United Technologies as subsidiary due to GE's more extensive product offering and end markets. At the time the portfolio was formed, GE served both industrial and consumer (GE appliances) markets. It also had a small but highly profitable financial operation which temporarily became the heart of the company. Thus, the initial better portfolio fit deteriorated over time which, as will be discussed in subsequent postings, justified adding supplemental and other core holdings to the portfolio.

It should be noted that GE was not the first effort to fill this role in a portfolio. The initial effort was IT&T the renamed International Telephone and Telegraph. It was no longer just telephone and telegraph. It had become an industrial conglomerate which also had some consumer products including telecommunication. As has been the case quite often, the smallness of my initial investment in IT&T allowed me to make a mistake without destroying the portfolio. IT&T was replaced very rapidly when the implications of its weak balance sheet became obvious. So, the strength of GE's balance sheet was another reason for including it in a portfolio.

Efforts at opportunistic purchases of GE have yet to be proven as effective. Initially all investments in additional shares of GE took the form of dividend reinvestment. The dividend reinvestment worked out quite well during the accumulation phase. It's easy to overlook the power of the simple practice of reinvesting dividends. Also, shares were purchased during the financial crisis after GE had already cut its dividend. As might be expected, a heavy industry company that cuts its dividend will experience a more dramatic drop than the market as a whole. GE shares did recover: however, they have lagged the market, and performance relative to the market has recently deteriorated significantly. If I had sold the shares that I purchased during the recession, it could have been a successful trade, but it certainly hasn't proven itself to be an enhancement to the core portfolio.

Efforts to try to find purchase points to add shares while Immelt tried to figure out how to manage GE were frustrated by subsequent management errors. The lesson I learned from this experience is that the sharp downturn even to the extent of forcing the dividend cut doesn't necessarily result in management learning anything from their mistakes. Clearly, GE understands that cutting its dividend is not positive performance. However, they seem to find it just too convenient to blame it on the economy or bad luck.

Consequently, going forward, either the same strategy that was discussed in connection with Johnson & Johnson, holding the stock and voting proxies in order to encourage change, will work, or the stock will have to be abandoned as a core holding. There is reason to believe that with GE there is more risk to that strategy that was true with Johnson & Johnson. With Johnson & Johnson, changes in the portfolio of products were minor. With GE, Immelt changed the product mix and the markets they serve significantly. The risk is that the new management will continue to view managing their portfolio of products and the markets they serve as a solution to fundamental neglect of management of the existing product portfolio. That's always a major risk with conglomerates, and it is one of the reasons why the initial effort to use IT&T to fill this portfolio need failed.

In summary, the trick to adding to positions in conglomerates is to add to the holdings when the economy is weak and earnings are falling. However, that only works if the conglomerate recognizes that the issue is not what markets they serve, but rather how they are currently serving them and how they can do it better.

Disclosure: I own GE and do not intend to purchase more shares as long as I retain my current limit on the dollar value of dividend flows from any single stock. I would recommend it to anyone who wants to hold a stock for 20 or 30 years and build a position by reinvesting dividends. I would point out that if GE does not correct its mismanagement, a substitute industrial firm like Honeywell or United Technologies should be used to fill this portfolio need. I recently purchased some additional shares of GE in the belief that the new management cannot be worse than the last. But, that remains to be seen. I also own a much smaller position in UTX which I intend to build through dividend reinvestment and opportunistic purchases. I also own HON which will be discussed in a subsequent posting.


This posting addressed a 10 stock portfolio.  It is an attempt to describe buying opportunities for each of the 10 stocks in general terms that an investor can use going forward.  It is about how to manage and build a portfolio. Ten stocks is not a magic number, and the previous posting discussed criteria for adding to the portfolio. Hopefully this posting provides examples that will help other investors. What it doesn't do is provide a starting point or any guidance about whether this type of portfolio is appropriate for any particular individual. 

The resulting portfolio as it currently exists is presented below. The information presented is not a guideline for how to allocate resources. Rather, it is presented in order to illustrate the degree to which there is flexibility in weighting the different stocks to reflect an individual’s preferences. However, if starting the portfolio from scratch, more appropriate weighting would be equal dollar values in each stock. Initial investments would be kept very small and the portfolio would be built by adding a fixed dollar amount on some fixed schedule.

A substantial portion of the differences in the weights reflect the exceptional performance of some of the stocks over the recent past. The objective is to allow each stock to have good run while others don't. What matters is the overall portfolio value over time.

It is quite logical to ask why continue to discuss the 10 stock portfolio when the actual portfolio has been expanded. The reason is quite simple. It didn't seem appropriate to track the portfolio against the S&P on an annual basis. However, a posting on DECEMBER 25, 2010, “InvestingPART 5: Oldies: When looking back is most valuable” included a little spreadsheet toy that allows an IRA investor to look back on performance over a long period of time. Using that to establish actual experience, it was possible to compare performance to the overall market's performance. The market could be measured in a number of different ways (e.g., a posting on DECEMBER 31, 2010, “Investing PART 7: To everything there is a season”). From that analysis it appears that a 10 stock portfolio can provide core holdings that allow an investor to approximate returns on the market with less volatility. Further, it seems possible to maintain greater dividend stability and a higher yield. Granted, a conclusion from the analysis is not a rigorous proof since the return on the IRA depended on which the stocks entered the portfolio and the weights they had over time. Nevertheless, it seemed to indicate that the portfolio accomplished its stated objective. Thus, the 10 stock portfolio seems to still be relevant.

Disclosure: I own positions in all 10 of the stocks. The table above represents their weights when viewed from the perspective of a 10 stock portfolio. The 10 stock portfolio is presented for illustrative purposes only. The next posting will discuss other stocks that have been added to the core portfolio over time. Obviously, if other stocks are added to the portfolio, all of these portfolio weights are lower. In fact, as an older investor lowering the portfolio weight of any individual stock seems like an appropriate risk management strategy. Further, the dollar limits placed on any one individual stock as a part of the risk management strategy within this portfolio has necessitated expanding the number of stocks. In this and other postings on the same topic there are references to investing in a stock with the intention of trying to hold it for 20 or 30 years. Some, in fact most, of the stocks in this portfolio have been held that long, but realistically trying to plan for a 10 year holding period make sense. It may or may not work out or it may turn into a 20 or 30 year holding period, but starting with the idea that the decision is a long-run decision eliminates many, but not all, potential errors. It also forces the investor to correct errors quickly since ignoring them involves committing to a 10 year mistake.