Sometimes, buying lower quality companies can boost income and returns. But there are some important things to keep in mind. Looking at Digital Realty (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It originally made up over 6% of my portfolio, and its dividends made up over 16% of my annual dividend amount.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?