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  • How should one manage a portfolio when the stock markets are highly priced; yields are low; volumes are low; and the market decline has not occurred?
  • Strategy to manage your current portfolio includes: cancel your DRIPs; sell covered calls on your over-valued winners; and place stop losses.
  • Balancing risk and return proposes that you: buy interest sensitive securities; exchange some fixed income for preferred shares; and, buy proxy securities.

How should one manage a portfolio when the stock markets are highly priced; yields are low; volumes are low; and the "Sell in May and go away" market decline predicted by experts and past experience has not materialized? Both risk and return are magnified - there may be a bubble, and the indices continue to climb. This creates two questions that we need to address:

  1. What to do with your current portfolio?
  2. What to do to balance the risk of a correction with the desire for return?

Strategy to Manage Your Current Portfolio

For your existing portfolio, what not to hold (or sell) is as important as what to buy. There are fewer stocks offering acceptable risk-reward trade-offs, so adjust your portfolio:

  1. Continue to hold and build strategic positions. Invest (on dips, when possible) rather than trade. Buy securities for the long-term; it is difficult to buy low and sell high in a short time-frame - and in this market - when near-everything is richly priced. Price decreases are opportunities to build strategic positions at attractive prices. In other words, have no fear of market declines; consider market declines in the same way that you would consider a sale at a retailer.
  2. Cancel your Dividend Reinvestment Plans (DRIP). I recognize that this is an unpopular statement, but rather than automatically reinvest across all of your portfolio, I propose that you reinvest your dividends in your best opportunities. In other words, if you currently have 12 securities DRIPped, cancel the reinvestment programs, and reinvest the dividends yourself in the one or two best (value and/or yield) opportunities.
  3. Sell your "dogs". Almost everyone has a few investments that have underperformed. Get out while the market is frothy and you can get most of your capital back. If the market plummets, the poor performers will drop the most. For taxation reasons, you may want to sell non-strategic holdings which have capital gains, in order to offset the losses.
  4. Sell covered calls on your over-valued "winners". If you hold a position which you believe is over-valued, but you are not certain if it is time to sell, earn a fee and a premium by selling a covered call (a promise to sell the shares at a defined price, at a future date). There are many other options strategies available, but this one is tailored to a currently-owned position and a very conservative investor. If the shares drop below the strike price, they will not get called (you will retain your shares), and you will keep your fee. If they rise, you will cap your gain at the strike price, but dispose of shares that you would have otherwise sold at what you believed was an over-valued price.
  5. Sell non-strategic positions and positions in industries with high volatility. Certain industries follow a boom-bust cycle (e.g., Resources), and others are relatively steady (e.g., Utilities). Remain invested in those within your comfort zone; that said, it may be time to reduce your exposure to large market swings. Certain types of securities, such as Mortgage REITs (mREITS), rely on financial engineering, with typically high leverage; you should assess if these are in your investment comfort zone.
  6. Place stop losses. The DOW 30, and mega-cap companies in general, appear to be at or above fair price. This SA article by Ray Merola is the first in a series which discusses "Premier Companies, But Overpriced Stocks" - Do not buy companies which are trading above (your definition of) a reasonable price (based on P/E, yield, and any other ratios that drive your investment approach). If you are not prepared to divest these positions - perhaps you feel that there is still room to run higher - then place stop-losses (an order to sell the shares if it drops below a defined price) to protect your gains.

These steps will reduce risks associated with your current portfolio, but will not create the potential to earn a better return.

Balancing Risk and Return

You can mitigate your risks by investing in U.S. T-Bills, but your return would be negligible (if positive). You need to augment your portfolio by buying yield-oriented and tax-advantaged securities.

  1. Buy interest-rate sensitive securities. These securities have underperformed, recently, so do not have as far to fall. Most are high-yield and many of these companies provide necessities (e.g., water, power, and heating) and will always be required - so Utilities, Infrastructure, and REITs, are attractive. Choose assets that you can touch - real estate, dams, wires, and pipelines. Contrary to the popular perspective, seek leveraged balance sheets; companies which have fixed assets with long-term financing benefit from the low interest rate environment - even after rates rise. Are all of these interest sensitive? Unfortunately, they are; that said, it will take a long time to emerge from this global slowdown. This suggests that interest rates will be flat-to-slow-rise over the next several years, so your 4%-8% yielding securities will have a long time and yield cushion. REITs are tax-advantaged securities. Their distributions (not dividends) are largely a "return of capital" (typically, much of the distribution is sourced from depreciation). From a personal taxation perspective, taxes are deferred until the security is sold, so hold these outside of tax sheltered accounts. There are a number of utilities and infrastructure companies - many which are MLPs - which provide a high yield as a downside cushion. Some exhibit much lower volatility; have long-term contracts in place; and/or have significant "green energy" footprints. Many utilities are putting cheap, long-term financing in place, which will permit them to provide excellent returns for many years after interest rates rise. Regulated utilities may have opportunities to increase rates with an improving economy (associated with increased interest rates). In other words, rising rates may not be bad for the interest-rate sensitive sectors.
  2. Reduce and shorten your Fixed Income portfolio. With the risk of rising interest rates, and a global trend from bonds to stocks, most of your fixed income portfolio should be laddered to mature in the next 2 - 3 years. If you have not already done so, reduce this asset class, as the opportunity for real returns has largely "evaporated". Bonds may be a safe-haven for a stock market correction, but generally will not provide a very attractive risk/return profile.
  3. Exchange some Fixed Income for Preferred Shares in your portfolio. These are long-term investment classes which provide a high yield (but low-to-no growth). Typically, these do not rise and fall with the same volatility of the overall stock market. They include straight (fixed-rate) preferred shares and rate-reset preferred shares. If rates go down, straight preferred shares will continue to pay their defined dividend. Rate resets will adjust the payment, so will benefit from rising rates. Buy a mix of these two types, in order to balance the risk of interest rates rising or declining. Many preferred stocks pay tax-advantaged dividends - instead of interest-paying bonds. They are also riskier, but this is well-compensated by the much-higher yield. the yields on preferred shares are multiples those of bonds, even before the impact of taxation. Many preferred stocks with long maturities are "in the doghouse", in anticipation of rate increases. To mitigate risks, never pay more than the (typically $25) redemption value, target cumulative shares (if they skip one dividend payment, the obligation to pay you is cumulative, rather than foregone), and buy mainly rate-reset shares. These reset the dividend rate paid to investors - usually every 5 years. If rates go up, your yield increases; correspondingly, your yield will decrease with declining rates. My view is that these provide up to three times the yield of bonds, so the current yield, and the reset to match the future rates, provide a cushion for long-term investors.
  4. Buy proxy securities. It is possible to purchase industries and high yields while reducing risk, by buying proxy positions. For example, if you want Retail exposure, buy Retail REITs as a proxy. You will benefit from a higher and tax-advantaged yield, and potentially gain from higher rents charged to retail tenants when they perform well. Want Oil & Gas industry exposure, but not comfortable with resource stocks? Purchase the pipelines which move their products, and which meet yield and investment risk targets. You may not fully benefit from a huge increase in the price of the commodity, but will participate in the gain while investing in a less volatile industry.
  5. Hold some cash and gold. Again, do not be afraid to position part of your holdings to protect from a "bear market". One should hold some (often a small) percentage of an investment portfolio in cash or gold. Take advantage of corrections by investing this cash at opportune times, while gold (and perhaps other resources) provide a hedge for a financial disaster.

Other Considerations and Conclusion

There are other factors which should temper your investment strategy and decisions. They include:

  1. Do not buy (read: sell) securities with low or no dividends; if things go wrong, you will not be paid to wait, and if things go right, you will enjoy a great income stream to reinvest. My general rule is to only buy stocks which pay dividends. If you have a dividend-growth strategy, only buy those which grow dividends. To mitigate risks, the current yield should be at least 2x the 10-year U.S. T-Bill rate, and foreign ones 3x (to account for taxation differences). If you are a dividend growth investor, the forward yield should meet your growth target criteria.
  2. Invest in sectors which people need, rather than want. It is pleasurable to take a vacation, but one cannot live without water and shelter. This should create a higher floor for valuations, in the event of a market correction.
  3. Purchase small positions in many securities. If you only buy mega-cap companies, then this would not necessarily apply. If you buy small companies, then buy correspondingly small positions.
  4. Build your positions through a few purchases - do not buy your entire position in one transaction. This assumes that you use a discount broker (low transaction fees), with a goal of managing your overall position cost in a frothy and thinly-traded market.
  5. Look down-market for opportunities. Although Warren Buffet believes that one should buy the industry leader, "number 2 tries harder". Consider buying small and mid caps for both the higher yield and growth.
  6. Assess your investment returns net of taxes and fees. Certain investments and distributions are taxed at higher rates than others; consider this as an essential part of your investment decision. Do not buy funds - unless there is a strategic objective, such as holding gold - do your own investing and avoid these fees.

This is my strategy, and I recognize that it may not be yours. There are many different forecasts and analyses which conflict with this approach. The goal of this article is to assemble some ideas for you to consider. We are experiencing an unusual market condition - with unsubstantiated price increases, and volatility driven by global unrest, foreign and local government manipulations and rumors. Your investing success will be driven by how you manage your portfolio and create your return on investment.

Source: An Investment Strategy For These Highly-Priced Markets