As 2016's first quarter draws to a close, price-conscious investors that were cooped up in storm shelters on Valentine's Day have suddenly reappeared, mostly no worse for the wear. Frankly, if you had pulled a Rip Van Winkle on January 1 and awoken on March 31, you might have thought a pretty uneventful three months for stocks just took place.
However, despite the basically flat line result, this was really one of the more volatile quarters in market history, with a 25% round trip move (11% down, then 14% up). If you were able to cherry pick near the recent bottom, you are probably sitting on some very attractive gains and/or yield points. If you panicked and sold substantial market exposure many weeks ago, you may find yourself in a worse place now than at the time you decided to sell.
This recent whipsaw price action should be instructive from many angles. One, I don't think this is a random event. I would be inclined to think that current conditions are conducive to producing frequent volatile market relapses. Two, if you aren't happy with how you responded this time around, hopefully, it has provided a valuable lesson as to what or what not to do during volatility.
Why Income Investors Are Different
Many total return market pundits tend to have a beef with various income investing strategies and their prevalent apathy to price volatility or price return. The first quarter is clearly a case, however, where obsession over price may have led to a premature, knee-jerk reaction by undisciplined overly price-conscious investors. For the average, disciplined income investor with cash, however, the decline could (and obviously should) have been viewed as a golden opportunity.
While total return or growth and income type strategies are practiced widely and are certainly worthwhile in their own right, purist dividend investors won't likely have the same portfolio construction and management techniques. This might include how or when buy and sell decisions are made.
The psychological reaction between return and purist income seekers may prove quite different when it comes to equity price movement. While there may be an equal reaction to a price drop in terms of value assessment and potential opportunity, if that drop becomes more substantial, the total return investor may be more inclined to blink as paper wealth gradually erodes. This may be especially true if the "losing" position is a disproportionately large one in a portfolio.
The dividend investor, on the other hand, so long as the income stream is perceived healthy and potentially growing, may be less psychologically impacted and inclined to sell during price upheaval. That may be idealistic in the real world, however, or even worse, foolhardy, especially if a price decline proves to be a leading indicator of a dividend freeze, drop, or outright elimination. Hello, Kinder Morgan (NYSE:KMI).
In any case, there can be clear differences in how price is viewed, and, consequently, why different decisions may be made when two or more investors confront exact or similar situations.
The Hard Sell: It's All About The Portfolio
A frequently heard market adage states that "there are many reasons to sell a stock, but generally only one reason to buy." Dividend growth investors would probably agree with the former part of the statement but disagree with the latter, since DGI is predicated on income growth as opposed to price appreciation, which is what the adage assumes. But I digress.
Although a specific sell decision would seem to be all about a particular stock, it really should be much more than that. A trim, swap, or sell should be looked at in terms of its impact on your entire portfolio and your overriding strategy. A security sale without a swap idea should generally be seen as an unproductive decision by the income investor since dividend income will drop as a result. The bigger the move, obviously the bigger the impact on the stream.
So when contemplating a sale or swap, what specifically should you be thinking of in terms of portfolio impact? Here's a laundry list of potential considerations:
- Why did you buy the stock in the first place? What, specifically, has prompted you to consider selling?
- How big is the position in terms of both allocated capital and income production relative to the rest of your portfolio?
- How much impact would the move have on sector configuration?
- If you aren't going about a swap, how long can you afford to have capital sitting idle?
- Is the move more of a timing decision or is it a risk management decision to position the portfolio more conservatively or aggressively?
- How much tax implication is there in the decision, if any?
- Are you making a knee-jerk decision or have you thought things through relatively well?
Some of these may seem pertinent to you, while others less pertinent, or maybe some not pertinent at all. Still, I'd opine that you really need to minimally peripherally consider your entire portfolio "forest" even when you might only be tending to one or a small number of trees at a time.
Case Study - Realty Income
In an article earlier this week, I discussed the situation at Realty Income (NYSE:O), a very popular durable dividend stock that has posted impressive total return over the past 2+ years. That return has been well in excess of the operating gains the company has made. While I resisted talking about valuation in that article, since the stock appears to be making moves in sympathy with the bond market, it's awfully difficult to ignore the bullish move. For the real estate purist, it's also hard to justify less than a 4% yield on an investment you might be able to generate double the income on with a stand-alone purchase of commercial property.
In terms of FFO, Realty Income trades at a 21X multiple while generating sustainable annual operating growth of 4-5 percent. This puts the company in a very select league of dividend peers that currently receives such valuation: Coke (NYSE:KO), Procter & Gamble (NYSE:PG), Colgate (NYSE:CL), and Hershey (NYSE:HSY), to name a few.
If you peruse the many recent articles on O, there doesn't seem to be much buy support, as most take the attitude of "great company, crummy investment at these levels." Of course, if you are a contrarian, that may be music to your ears.
Again, if you scroll the litany of questions I posed above, you are in a better position to determine whether you should sell, or minimally, pare the position. The decision may be much easier for someone where the stock accounts for 8% of total capital and 10% of total income versus another where it represents 1% of capital and 2% of income.
As I explained in the prior article, I think one can defend a purchase of O, even at these comparatively frothy levels, if there is a belief that long bond yields stagnate. I'd opine that a massive equity market correction, unless accompanied by a bond market sell-off, won't lead to a doomsday scenario for O.
For many, perhaps most, who are in at lower levels or have tax consequence attached, the most sensible thing to do might be to do nothing at all. If you bought O for its durable, slow growth of income, nothing material has changed in that regard. If nothing has changed, why sell?
For those still leaning towards a sale - referring back to our laundry list - what might you replace Realty Income with, or can you afford to have idle capital? The more portfolio and individual stock screens you put to the test, the more confidence you can have in the decisions you ultimately make. Don't expect to be right all the time, but as long as you can look in the mirror and justify your moves, you've probably engaged in adequate due diligence.
Is There Ever A Bad Time To Take A Profit?
Another market adage says that there's never a bad time to take a profit, since you never know when the market will turn on you.
Well, yes and no, I suppose.
Bailing on a stock with cause is much different than bailing without much cause, or worse, out of unjustifiable fear. I suspect there were many investors who had not experienced a sharp correction that ended up bailing out sometime in February. Now they may feel awfully stuck. Do I wait it out and hope the train returns to the station - or do I acknowledge somewhat of a mistake and build back that which I sold out of? If I had the answer to that, I'd be relaxing on a deserted beach somewhere, not sharing my secrets with you!
If an investor's desire is to lock in profits out of a trade because it seemed the market was going lower, that's one thing, and not a particularly good one at that. If they took a profit and engaged in a swap or simply decided that their overall portfolio was too aggressive, that's a whole different story.
Since income investing is typically more about cash flow than realizing profits, this may not seem like a highly pertinent topic. Still, income investors tend to come in various shapes and sizes, with some paying more attention to price than others.
At the end of the day, there may be times when taking a profit might not be your shrewdest portfolio move. You may be locking in a gain, but you may also be creating a problem for yourself if the market unexpectedly turns and you end up running along the track to catch up to the train.
As I noted earlier, the price apathy that a dividend growth investor might be able to employ is a tremendous discipline when it comes to dealing with market turmoil. Anything you can do to avoid the temptation to sell at the bottom is always helpful.
Giving up on a position or trimming a fondly looked upon stock is typically never easy. However, when you conduct personal portfolio screens and ask yourself the right questions, you're doing yourself a gigantic service versus waking up one morning and churning your entire portfolio. Emotion and investing are a dangerous pair.
While I don't think any portfolio position should be necessarily viewed as something to hold through thick and thin, income and dividend growth investors generally have less incentive to incessantly trade. This should be viewed as a positive thing, especially if you haven't developed good portfolio discipline yet.
Which leads me to my third and final adage:
A portfolio is like a bar of soap, the more you handle it, the smaller it becomes...
Disclosure: I am/we are long CL.
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.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.