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Investment Pancake
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My investment process is (1) own rock solid businesses with healthy earnings and that pay me dividends, (2) spend less than I earn, and (3) reinvest what I don't spend into similar businesses, at the lowest price available at the time. I avoid selling, or dipping into principal.
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  • Month End Investment Plan.

    With the end of the month approaching, I've started to develop plans to reinvest dividends. Overall, October has been a great month. We had some dividend increases come through from a variety of companies, but what is perhaps most surprising is the industry where we earned the greatest dividend increases: energy infrastructure. These days, you read more analyst opinions predicting bankruptcies in the oil industry, and not so much about dividend increases. Navios Midstream Partners (NYSE:NAP) runs a business leasing oil tankers, and announced a healthy 2.4% increase to it's already generous dividend. Navios shares are up somewhat this month, but still strike me as a good bargain. Sadly, I own enough of those shares as it stands, and will not be purchasing more until Navios comprises a smaller portion of our portfolio income.

    The second surprise was Kinder Morgan (NYSE:KMI), which announced a robust dividend increase, albeit one that is somewhat smaller than the dividend increases the company had previously projected. The stock has been tanking all month, and took a particularly nasty dive on October 22, when the company's earnings came in lower than expected.

    Generally, I am keenly interested in falling stocks coupled with rising dividends, so I spent some time reviewing KMI's earnings announcement. After doing so, I am left with the following takeaways.

    First, most investors (myself included) assumed that if a company is paid for simply moving a product (oil, let's say) from point A to point B, the price of the product is irrelevant to the company's earnings. It's like a toll booth - the price of cars doesn't directly impact how much the toll booth operator gets paid. MLP investors generally assumed that crashing oil prices would have no impact on the earnings from midstream MLP companies, because those MLP companies are, in essence, toll booths. I even thought that lower oil prices would translate to HIGHER profits for MLP companies, since consumers usually are happier to consume MORE of a commodity when prices are low, and suppliers are anxious to supply more of it to keep their profits up. To my mind, lower oil prices suggested that more oil would get pumped, and those MLP toll booths would be raking in money hand over fist. It turns out I was only half correct - which is a fancy way of saying I was wrong. But there's more.

    At the earnings conference, the CEO of KMI points out that the company is, indeed, generating greater cash flow, and faces a number of profitable opportunities to develop future projects (particularly with natural gas pipelines). In that sense, the assumption that lower oil and gas prices could equal more tolls was (and continues to be) correct. So, what's the problem?

    The problem is funding future projects. MLPs, like KMI, distribute most of their cash flow to shareholders, and rely on outside funding (like issuing more shares of stock or bonds) in order to fund new projects, instead of just keeping the money they earn from operations and using it to build more operations. With stock prices for MLPs crashing, few are anxious to sell more shares. Debt levels are already high, too. This creates a dark, dark cloud over the prospects of funding new projects, without which, future income growth is not going to be possible.

    KMI hints that it has other means of attracting outside financing besides new share issuances (or ladening on more debt), but during the conference call, opted to not spell out what those means are. Mr. Market HATES that sort of uncertainty, and the stock sold off in frenzied, disorderly chaos. But the main point, though, is that MLPs in general seem to face a dilemma: stop doing new projects, or cut dividends. The latter approach is not available - the tax status of MLPs depends on distributing most of the company's cash flow to shareholders. The result we will likely see is that there will be far less spending on new MLP projects, and far lower investment in MLP capital. That is, unless other firms can replicate whatever magical funding source KMI hinted at during their conference call. I am dubious.

    But in fact, lower capital spending (and slower income growth) strikes me as a good thing in the long run. When there are fewer new pipelines, there will be less new production of the underlying commodities. That will raise prices, and with rising prices, you'll see more pressure to start spending on new pipeline projects. It is, in other words, a cycle. I suspect we are entering the front end of that cycle, where projects fall through and the seeds are sown for future bottlenecks and skyrocketing prices for pipelines.

    The upshot is that dividend growth in the MLP sector could stagnate or even reverse slightly, because without new projects, there are limited means to grow distributions from existing infrastructure (contractual escalation clauses being the main source of very slow growth going forward). It means that MLP investors at today's prices should be happy to collect a 8% yield, but not expect much (if any) growth. One year ago, MLP investors collected a 5% yield, but expected gangbusters yield growth. Arguably, we're in a better position now - when it comes to yield, we already have a bird in the hand, and shouldn't expect that there are many birds in the bush for a long time. But over a very long period of time, when the cycle moves forward and you don't have sufficient infrastructure to move oil or natural gas around, that growth will surely kick in. MLP investors will be well paid while they wait.

    The CEO of KMI was wrong. He bet he could grow his company's earnings and distributions faster than possible, and seems to have bet that commodities pricing wouldn't stop him. I think he was wrong for all the same reasons MLP investors in general were wrong when it comes to the relevance of commodities prices. But the source of the error wasn't cash flow projections so much as future income growth and future capital spending. Everyone blew it when it comes to guessing about the birds in the bush. That's the problem with trying to predict the future. But when you have a big enough bird in the hand today, you don't really need to care much about how much bigger that bird will grow, or about the what, how, when, why and how many supporting that future growth.

    With 6% or 7% today, I don't need high distribution growth, and so I am inclined to reinvest our dividends into KMI this month. With whatever I have leftover, I will be looking at AXP or IBM. AXP fell almost 6% on poor earnings, but recently raised it's dividend by 10%. I don't know if the stock is cheap, but it's a good company and the stock is down. That's about as far as my analysis goes with American Express. IBM also dropped about 6% on lackluster earnings, and now trades at a single digit PE ratio. Good company, good dividend growth, cheap stock. End of my analysis on IBM.

    Ultimately, I will have to wait until next week to decide how much to put into each of these new investments. In the meanwhile, though, we will be taking a train up to Porto, where we will distract ourselves with good food and wine.

    Tags: NAP, AXP, IBM, KMI
    Oct 23 4:17 AM | Link | 4 Comments
  • A Farewell To Sugar High ETFs.

    (click to enlarge)Sundown

    And so, the sun sets on the days of "sugar high" ETFs - those with high but unsustainable yields, high management fees and high asset churn rates. I said my farewells to REM and IDV, and in their place added companies with lengthy histories of raising dividends - MMM, IBM, SWK, VAL, BUD, PEP, LMT, EMR, KMI. I also put in a couple of newer companies that have only limited dividend histories, but high yields and reasonable prospects to maintain those yields in the near term. NAP and TGH made the list, albeit in somewhat smaller percentages than the funds I moved into lower yielding, more predictable business names. I also added more exposure to our REITs, which have come down along with everything else in the marketplace. In short, our portfolio is more about businesses that rent buildings or pipelines, that make cereal, tampons, house paint, hammers, beer or engine parts, and which are nearly religious in making regular, growing distributions to owners.

    I took losses on our IDV and REM sales, although since most of our shares were purchased in 2009 and 2010, the losses were somewhat less dramatic than anticipated. Also, as a result of moving capital into far lower yielding securities, we took a haircut on our portfolio income. As a result, our income level is down for the month, but I'll rest easier.

    I have one last item on the agenda for this month, which will be to reinvest our month-end dividends. My goal is to build exposure to positions that account for relatively little of our portfolio income, but that are exceptional businesses with solid prospects for future dividend growth:















    When next Monday comes and our dividend payments have settled, I will pick whichever one of these businesses has the best yield, or the highest intrinsic value relative to price, and invest our dividends there. At today's prices, AXP, NSC, TMP or JPM could be the best values. AFL may have the lowest PE ratio, but the prospects for growth are somewhat limited by demographic trends in the Japanese market, from which the company earns significant premiums. The price earnings ratio for AFL is low, but that doesn't make the stock a bargain per se. I'll be giving these five names careful scrutiny when I deploy dividends next week. Going forward, I suspect that I'll likely repeat the process each month, at least until I can build our exposure to these under-represented names within our portfolio.

    And now, a fantastic piece of outdoor art we found near the docks at Santa Apolonia. The artist chips at the sides of walls, creating relief images that usually feature faces. Then, he applies spray paint -in this case, images of mechanical parts to go with the relief image. I couldn't help thinking of this image while I worked today reallocating our portfolio into more dividend growth names. I found myself empathizing with the figure in this picture, to be honest.

    (click to enlarge)Graf

    Sep 28 3:54 PM | Link | Comment!
  • Reducing Portfolio Turnover

    (click to enlarge)I own two funds that have, quite frankly, turned out to be disastrous investments. Yes, in both cases, the funds have lost money since I bought them, but that is not why I consider them to be horrible. The main reasons why I have determined to largely exit these investments are (1) both funds have high management fees; (2) both funds have very high asset turnover; and (3) both funds have steadily cut dividends over the past few years.

    The first fund is REM, a mortgage REIT investment fund managed by Ishares. The fund invests in mortgage REITs, curious creatures that borrow $30 for every $1 of capital they own, in order to purchase pools of mortgages trading at a slightly higher yield than the fund's cost of borrowing. It's a great business when it works - a license to print money, frankly, unless interest rates do something the manager never anticipated (which is roughly something that happens all the time). The fund only holds 38 different positions, and yet, somehow manages an asset turnover of 42%. What is the manager doing? Since I cannot answer you, I see little justification for holding the fund much longer.

    The problem is that this fund yields 14%, and the income accounts for over 1% of our portfolio income. Selling it would involve a severe haircut - until now.

    The bright side of things is that as REM has cut dividends and dropped in price, OTHER stocks I follow have dropped in price while raising (or maintaining dividends), and now trade at yields that are comparable to REM. I will replace this fund with shares of TGH and NAP, both of which are in the shipping industry, and both of which are quite risky, but far less so than REM. TGH yields 12% today, and NAP is yielding close to 14%. NAP benefits from very long term charters for it's tankers, so the income and cost structure are locked in and the CEO, Angelika Frangou, is pretty much the best in the business. TGH has somewhat shorter term lease structures for it's shipping containers, but in a sickly industry, it's one of the best run outfits and is likely to survive until the industry turns around again. Both NAP and TGH borrow extensively - 75% debt to assets is high, but actually on the low side in the shipping industry. It certainly is less leverage than what you typically see in the MREIT business, where debt loads are routinely 1000s of times the capital value.

    The next fund on my chopping block is IDV, another Ishares fund focused on dividend growth. This fund claims to be passive but is anything but. Over half of the fund's assets are churned every year, and the dividend growth is negative. Fortunately, this fund only yields 4.7% now, thanks to a significant dividend cut earlier this year. Replacing it? Easy. I will be adding the following positions in roughly equal proportion:KMI, NHI, VTR, NNN, BUD, PEP, LMT, IBM, MMM, AMLP and EMR.

    Overall, the most important goals I hope to accomplish with my strategy are as follows:

    (1) I can harvest tax losses;

    (2) I can reduce my exposure (almost to zero) to high turnover, "passive funds" that are actually more like hedge funds in terms of how frequently they trade in and out of positions;

    (3) I can all but exit our exposure to the MREIT business;

    (4) I can reduce my exposure to funds that have a history of dividend cuts;

    (5) I can gain more exposure to companies and funds with stable dividend structures that should, if anything, lead to more dividend increases in the future; and

    (6) I can more equally diversify the percentage of portfolio income I earn from each of the 12 sources I will be boosting, moving closer to my ideal portfolio where I own 100 positions, each accounting for 1% of my portfolio income.

    The move will drop out income level by about $800 a year, which is relatively small compared to the $155,000 worth of IDV and REM that I will be selling. The move will completely wipe out all income growth I have had all month long, so compared to where we were at the start of the month, the only change I will see to our income is a change in the quality and sustainability of the income.

    But it is bitter medicine. I'm content to see our portfolio price drop 10%, 20%, or even harder. But watching our portfolio income drop by .01% is very unpleasing. I suppose I deserve a little pain, though, because without running into a brick wall once in a while, how else will we learn not to charge into brick walls in the first place?

    I'm facing the music. Investing in REM and IDV was a mistake. I invested in IDV because I felt the fund could do a better job than I could do of picking stocks that would increase dividends. It had a higher yield than most funds. It offered cheap and easy access to a well diversified pool of stocks I might not otherwise have any exposure to. Those were fine motivations, but I knew it had high turnover and I invested in it anyway. Wishful thinking, greed, or an unwillingness to admit a mistake and move on.

    With REM, I had owned shares in various individual MREITs, and wanted to harvest losses without changing the footprint of my investment. I would, for example, sell shares of AGNC to trigger short term losses, and then plow the proceeds into REM, keeping my income level constant and gaining diversification in the process. In retrospect, I should have stepped back and asked myself whether this was even a business I wanted to be in to begin with. The MREIT business model has almost fable like aspects of spinning straw into gold, which of course seems to good to be true. I forget that if something seems too good to be true, it is either not good, or not true, or possibly both. My desire to keep a high level of income blinded me from the simple truth that it's better to invest in a 3% yielding stock growing at 10%, than a 10% yielding stock shrinking by 3%. Put differently, I was so focused on income growth, I failed to make income quality the paramount goal, and that cost me.

    Sep 27 11:43 AM | Link | Comment!
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