Sometimes, buying lower quality companies can boost income and returns. But there are some important things to keep in mind. Looking at Digital Realty (NYSE:DLR), in particular, it enticed me with its higher than average yield of 4.8% when I started my position in it. At last Friday's close, it yields 6% due to a substantial price pullback over 9 months.
It originally made up over 6% of my portfolio, and its dividends made up over 16% of my annual dividend amount. The financial sector portion of my portfolio paid one third of my dividends. I felt I was relying too much on one sector to provide a secure and growing income stream. So I sold the weakest of the bunch, Digital Realty. Now, the financial sector makes up only 16% of the portfolio, and pays me 23% of total dividends - an allocation I'm more comfortable with.
Valuation-wise, DLR looks like a bargain. Value Line gives it a 2016-2018 projection price range of $65 to $95. That is an upside of 25% to 83% from the Friday's closing price of $51.86. At the time of my purchase, I treated Digital Realty like a meal instead of a snack. In fact, I over-allocated capital to it. It was bigger than a full position (because I didn't have a full concept of allocation at the time). Value Line rates Digital Realty Trust with a Safety of 3 and Financial Strength of B+.
Going forward, to reduce risk, for a lower quality company, I can set a number of rules to prevent loss of capital (or at least lower the probability).
~ Rules for having a Lower Quality Company in the Portfolio ~
Rule 1: Limit the Capital Allocated
I should have allocated half a full position at most and buy a quarter of a position each time. For example, if my full position were $5,000, then, I should buy $1,250 at a time, and the maximum cost is $2,500. Going one step further is to limit one's portfolio to have, say, 10% of lower quality companies - for boosting income and return.
Rule 2: Buy with a Significant Margin of Safety
I should have started buying with a margin of safety instead of starting to buy it when it was close to the fair value range. For instance, if I determine Digital Realty to have a fair value near $62.5, I can set a margin of safety of 20% to only start buying it around $50.
Rule 3: Develop Selling Rules as Part of the Plan
Some investors have selling rules in place such that if a holding drops 10%, they sell. The idea is capital preservation. This works for some and not for others. If one is buying at a margin of safety, then, there should be less need for this selling rule.
One condition where I see this 10% rule shouldn't be applied is when a recession occurs. In a recession, the market could go down more than 25%. If the 10% rule is in place, then it would be very damaging to the portfolio. But then, we don't know a recession will happen until it hits. So at the end of the day, whether a selling rule should be applied depends on if an investor is comfortable with their holdings and allocations.
Buying lower quality companies may boost return and income, but I must remember to limit the capital allocated to it up to a half position, buy it with a significant margin of safety, and possibly develop a rule to sell. Actually, applying the above rules to any purchase is not a bad idea.
Moreover, I think it's essential to know oneself, one's risk tolerance, and one's comfort levels. For example, all my holdings pay a dividend. (I tried to think outside the box to buy a growth company with high compounding earnings growth, but I just can't bring myself to do it - yet.) These are areas I'm still exploring. And I think this is a journey that every do-it-yourself investor goes through and must find out on his or her own.
Maybe what I should have done is buy high quality companies only in the first place to build a stronger foundation for my portfolio - companies with Safety of 1 or 2 and financial strength of A or better, before branching out. What is your take?