My quarterly portfolio review discussed cutting holdings that are not part of my core as a protectionist strategy. With "sell in May" time approaching, I have become concerned that some of the capital gains may vanish. Over the past year and one-half, I have moved the majority of my portfolio into the dividend-growth camp, rolling over various trades and holdings that I purchased primarily for capital gains. Recently, I became convinced that now is the time to deal with the rest of them, taking the gains and redeploying them into more traditional, higher quality dividend-growth companies in their ideal portfolio location.
I am not alone in this thinking. Four days later, Bob Johnson wrote an article titled, "Reduce Your Portfolio's Downside Risk Before The Coming Market Correction".
In a comment to my quarterly review, I was asked if I would be comfortable with a 50% drop in portfolio. In this article I want to look at "crash and burn" events and the implications for the portfolio. In Part 2, I will look specifically at my actual portfolio with the same question in mind.
If I am moving into a more protectionist strategy, what I am protecting my portfolio from? The worst case scenario is holding companies that suddenly go bankrupt. Just uttering that word inspires fear, but before I panic, let's take a look at what would happen if my largest holding suddenly went bankrupt. McDonald's (NYSE:MCD) is by far my largest holding with a significantly outsized position of 7.63%. In no way do I think MCD is about to enter bankruptcy, but if I am trying to find the worst case of crash and burn for my portfolio then this would be it. Not only would I lose 7.63% of my portfolio, I would lose 7.9% of last quarter's dividends. This is quite serious.
But what is the likelihood? A typical company with a long dividend-growth history is considered a more 'safe' investment partly because struggling companies do not raise dividends year after year. A growing dividend supported by earnings is characteristic of a healthy company. This is why many dividend-growth investors sell when a dividend is cut, to remove the possibility of loss long before there can the slightest hint of bankruptcy. Even better is to be paying attention to the analysts comments regarding the dividend. Bonavista Energy (OTCPK:BNPUF) or (TSE:BNP) was a high yielding holding I owned briefly. Soon, it seemed that every time it was mentioned, the talking heads discussed the possibility, and later inevitability of a dividend cut. I took a small profit months before the cut was announced and bought Chevron (NYSE:CVX) instead. Once the 50% dividend cut was announced, the stock fell. People getting into Bonavista since the bottom have had really nice gains, but there are many companies with better balance sheets out there, including CVX. If you sell when people are getting squeamish about the possibility of a dividend cut, or are willing to sell at a loss after a dividend cut is announced, it may not be too difficult to avoid a bankruptcy situation.
Keeping well diversified is key. My portfolio is not a shining example of this (yet). I have two holdings that each make up more than 6% of the portfolio. As mentioned, MCD is 7.63%, and Inter Pipeline (OTCPK:IPPLF) or (TSE:IPL) is a robust 6.12%. MCD was one of my first long-term holdings back when I had shares in less than 10 companies. This holding represents only my original purchase; I have not purchased or sold shares since my original purchase. Gradually, the percentage of the portfolio it occupies has dwindled to half of the original, as contributions have grown the portfolio around it.
Being overvalued in Inter Pipeline was to be a temporary condition. I sold shares in overvalued companies in the same sector, and purchased additional shares in the undervalued IPL as a sideways move to realize and protect gains. I just did not sell and move back when what I expected did occur. I have been debating whether to trim the holding, but in the end, I have decided to mess about less with my portfolio, and simply continue to enjoy the 4.44% monthly dividend. If there is weakness in the sector this summer I will purchase more of the other companies with new money.
If I felt that either of these very large holdings were in danger of cutting the dividend, I would be trimming and moving the funds into something with less risk of damaging the portfolio and its income.
So far I have looked at the effect on the portfolio if the value of one of my stocks (albeit my largest) went to zero and what I am doing to analyze and diversify holdings to protect against that being too damaging.
Let's be a little more holistic. Instead of just looking at one isolated holding and reacting, let's think of this bankruptcy in light of the whole portfolio. What if one holding went to zero, one lost 50%, another did nothing, the majority got average market returns of 8%, and there was one stellar holding returned 30%. This reflects what is more likely to happen in portfolio action. For ease of calculation, I will assume 25 equal holdings of 4% in a $100,000 portfolio so that no one can complain it is not fair.
Beginning balance: $100,000
100% Loss: $4,000
50% Loss: $2,000
30% Gainer: $5,200
8% Majority: $95,040
Ending balance: $102,240
No one will argue that having one of your companies file bankruptcy is terrible and damaging to your portfolio, but this portfolio still returned 2.24%. Positive; even though terrible things happened.
The numbers will be more positive with more diversity or other holdings doing better than average. Basically, the lesson here is that one can tolerate some holdings doing absolutely terribly if the majority are managing alright. Another fear laid to rest.
Disclosure: I am long MCD, CVX, IPPLF. 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.