We All Make Many Mistakes, What Do We Do Next?

Includes: AGNC, DX, LNCOQ
by: Bob Johnson

This article describes investing mistakes I made this year. This public confession is a humbling experience. However, I know that I'm not alone for we all make mistakes. We will look at the underlying reasons for these mistakes and the alternative ways of addressing them. This should help an investor gain understanding of areas in their own financial decision making where mistakes could be made and understand ways of dealing with them when they do.

The Setting

I'm retired, in the distribution phase of investing. Income is the paramount concern, preservation of capital is important. I define risk as the result of any situation that causes you to not have the money you need, when you need it. By that definition, a portfolio of the most conservative, most stable income producers could put you at risk because they might not produce adequate and growing yield for income now and in the future. Treasury bonds might be an example of that, as could a portfolio overloaded with slow growing utilities. A capital loss due to a poor purchasing decision can reduce your principal. That is the case here.

An Overall Strategy

Those of you who have read my articles before know that I take a core and satellite approach to investing. The idea behind this is to own a core of solid Blue Chip companies, stocks that pose little risk and take little of your attention. This enables you to take more risk and seek higher yield with the Satellite Holdings, and get a higher total income than you might get otherwise.

Related previous articles are:

Nothing Matters Much More Than Today's Income

2012 Core Dividend Growth Portfolio Results: Rethinking Strategy For 2013

The Core

Let me assure you that I while I have made mistakes, my holdings are essentially good ones. I have a very nice Core Portfolio of mostly Blue Chip C type corporation stocks. This Core, with 23 roughly equally weighted stocks, is shown below. These firms are not likely to go out of business, nor are they likely to cut their dividends, which produce a very nice current yield of 4.2%. The header of the table listing my core portfolio is green.

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The Satellites

In addition to those core holdings, I have some healthcare REITs and a triple-net REIT, some midstream MLPs, and two Business Development Corporations with half positions each. This collection of satellite holdings is colored yellow.

Usually the higher yielding stocks are not regular C type corporations, as those are in my Core Portfolio. They are MLPs, REITs and BDCs. The firms have several things in common. First, they exist because of special tax legislation, which in many cases requires that they pay out a large percentage of their income, and they are untaxed at the level of the entity. Second, they are mostly smaller cap firms. Third, their higher risk is apparent from many perspectives, one of these is the lower credit ratings they have compared to the Blue Chips.

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I do not believe that high risk and high return are joined at the hip, but if I'm knowingly going to take more risk, I want a higher return. Let me emphasize that we cannot use a simple measure of volatility, such as beta, to measure risk.

Chuck Carnevale has recently published a two-part series on mitigating risk, which is well worth reading. It reinforces my common sense perspective that even the smoothest road (low beta) can lead to perdition. For example, the mREIT American Capital Agency Corp (NASDAQ:AGNC) has a stunningly low beta of 0.19. This small, specialized lender has a history of dividend cuts, and there may be more to come. On the other hand, the huge mining corporation, BHP Billiton plc (BBL) has a beta of 1.83. Standard & Poor's rates the company's debt A+, and the firm has a long string of dividend increases. In addition, it has a written company policy, which states that it will increase dividends each year if possible, and worst case, it would hope never to cut dividends.

It is our hope that the rewards of such investments will have a much greater impact on our personal bottom line than the risks will. That is, we must be very skillful at selecting opportunities, hoping that we are buying those where the market is overestimating the risk or underestimating the reward. That way we get inordinate returns. This return in excess of compensation for the risk borne is alpha. Therefore, we are seeking alpha, that is excess returns, and discard the notion that beta determines the risk. Put another way, I believe in an "Inefficient Market Theory," where common sense tells us that a lot of the people, and therefore the market, are wrong a lot of the time.

My personal experience leads me to believe that large cap corporations with growing earnings and dividends are the least risky equities available. If you add to that a wide economic moat, good credit rating, adequate debt coverage, a high current ratio and reasonable payout ratio, you should have a stable holding. Then, buy it when the valuation is favorable.

We All Make Many Mistakes

Unlike at Lake Woebegone, we sometimes learn that we are also part of that group that can be wrong, at least some of the time.

Here we are with 8 months of the year behind us. So far, the dividends paid to me from this Satellite Portfolio have been as expected at a 6.44% yield.

I have some concern about the BDCs because of their very small size. My fear is that these firms, some with only a dozen employees, would not be able to avail themselves of the needed resources in tough times. This might be in the area of leadership or in the area of credit. In addition, there is an added degree of complexity in evaluating the companies these firms have debt relationships with, and many shades of risk in the different type of loans. So far, I feel I have been compensated very nicely for embracing these risks.

However, as Zero Mostel sang in the opening scene of Fiddler on the Roof, "If I were a rich man…" That is to say, if I did not need the income, I would stay away from some of these small firms and alternative investments. Do I really have the skills and knowledge to evaluate them? Marginally, I would say. I have a much clearer understanding of midstream MLPs (pipeline and storage operators) and Real Estate made of bricks and mortar than of small business-to-business lenders.

Higher Yield Investment Alternatives

While I'm satisfied with the above, the below is disturbing. I could start off saying that I'm underwater on Linn Company, LLC (LNCO) because of the Barrons article, It said on May 3, 2013, "The firm's partnership units, which trade at $38.50, may be worth less than half of their current quote, based on a range of financial measures, including book value, cash flow, and the value of energy reserves."

I could add that my mREITs are down because of the Fed. Here is a headline from an online article, "Uncertain Federal Reserve Policy Makes Mortgage REITs a Risky Bet." There is some truth in that headline as there is some truth in the fact that Barron's article poisoned LNCO. But it is not the real truth or the whole truth. It took me some time to figure out where I went wrong. One could say that it was the result of chasing yield, and there is some truth in that too. However, after much reflection I came up with the basic problem. Here is the rest of the story.

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I do not have enough depth of understanding of how mREITs work to be an investor in them. I understand them on the surface, perhaps I should say superficially. Much that goes on in their inner workings is a mystery to me. Here is one sentence from a recent article by Scott Kennedy on AGNC, "American Capital Agency's Mid-Q3 2013 Book Value Projection And Derivative Portfolio Valuation Analysis - Part 3."

"As a reminder, interest rate swaptions are basically options to enter into underlying interest rate swap contracts. Whereas interest rate swap contracts have no upfront stated costs but incur gains (losses) as swap rates fluctuate, interest rate swaptions have an implicit upfront cost upon creation of a specific interest rate swaption (like any typical option contract)."

That sentence is from a 4,800 word document that is only one part of a 3 part series. Frankly, I do not have the time or desire to develop the necessary background to understand derivatives that did not exist when I did my business study. I do not want to devote the time that would be required to dig through 3 articles containing this analysis, let alone develop the ability to do a thorough evaluation myself. I feel Author Kennedy's work is excellent, and no doubt invaluable to readers who want to make mREITs a significant part of their portfolios. I am sure they will find it profitable. That is not me. To put it simply, I'm trying to invest in something I do not understand. That is my error.

The same is the case with LNCO, the type C Corporation tied to LINE. While I understand the business of midstream MLPs quite well, this Exploration and Production Company, E&P, is a horse of a different color. It deals in several kinds of derivatives, and in accounting methods that I do not completely understand. While I comprehend the drilling of holes in the ground to find oil, the buying known resources to bring the oil to market, and to a large degree the hedging of future production, the complexity here is beyond me. I have no idea if what it does with the books is generally accepted and is legal. Again, I'm trying to invest in a business I do not understand. That is my error.

If one does not understand a business, it is impossible to do a useful due diligence on it.

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Keeping It in Perspective

One thing I have gradually learned to do over the years is frame situations in such a way that I do not blow things out of proportion. The psychological effects of realization of an error in judgment can do more damage than the financial aspects of a poor choice. Is this error going to change your life? In most cases the answer is no. What is the size of the financial impact compared to your net worth? Often it is not large. Regardless of the impact, you must move forward.

You are doing yourself a disservice if you spend a lot of time beating up on yourself. After all, we all make many mistakes in this life. Assess the situation objectively, and discern the causes of the mistake so that you do not repeat it. Then move on. Devote your energy to making concrete and realistic plans to move forward, and execute these plans. Benefit from being a wiser person and consider the value of your gains in knowledge.

What Do We Do Next?

Aware that mREITs are a riskier class of asset than most investments, I took modest positions in them. I'm holding these stocks and LNCO at a loss. This is not the same kind of temporary loss that one experiences on a day-by-day basis. The normal market fluctuates, stocks dip, markets correct. This, however, has the potential of being a permanent loss of capital. Here are some of the alternatives concerning the next actions.

  • Sell, and take the losses. Invest the proceeds elsewhere.
  • Hold, wait for the stocks to come back.
  • Buy more of the shares now, averaging down and lowering per share cost.

Are not those always our choices? To buy, sell or hold? If I do sell, what then? My loss to date is about just under 2% of the value of my portfolio, certainly not a catastrophe. Nevertheless, I wonder how much of the income I can replace.

What I am Doing Now

In mid-summer, I reduced my positions by about a third in AGNC and LNCO. That is, I reduced my risk by reducing the amount I had at stake.

I also have stops (Stop Limit orders) on each of the positions, AGNC at $19.50, Dynex (NYSE:DX) at $6.75 and LNCO at $24.50. When the stocks increase a little in price, I will move these higher. My intent at this point is to prevent a catastrophic loss if they should fall precipitously on bad news. This has happened before, as LNCO illustrated on July 1 to July 3. I will reevaluate this strategy at the end of the month. Most likely, I will close these positions before the end of the year and have this all behind me.

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Meanwhile, I am considering alternatives. Some feel AGNC is a good value at todays price and many think that LNCO will emerge from its trouble.

Advice From A Flight Instructor

I recall my first flight instructor, a man named Arthur Hajula, who was the operator of a little dirt strip in the small town where I grew up. I was always posing some unlikely situation to him, and asking him what one should do if they found themselves in a particular precarious position. It might be a question like, "If you are flying to the island and you suddenly find yourself flying in dense fog, and can't see a thing, what do you do next?"

Invariably his answer would be, "Don't get into a situation like that."

I will be happy to answer any questions I can about this article, and would be pleased to know what your strategy might be in this situation.

Disclosure: I am long AGNC, DX, LNCO, BBL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.