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.

No comments:

Post a Comment