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Retired engineer from the oil services industry. I began investing in the stock market in a significant way in 1992 and currently manage a portfolio of 15 core dividend growth stocks. I am not and never have been employed in any aspect of the financial industry.
  • How Lucky Survived The Housing Market Crash With Housing Related Stocks

    "Generals are always preparing to fight the previous war." The most familiar example of this tendency is the Maginot Line. It was an extensive network of fortifications that France built along its border with Germany after World War I. The purpose was to get a head start on trench warfare, which was the predominant strategy during that previous war. The French hoped to dissuade the Germans from ever invading France again. The Germans flew aircraft over it, their Panzer tanks drove around it, and Paris was taken on June 14, 1940. Elapsed time, about six weeks.

    Investors sometimes behave like generals. Having suffered through the "tech wreck" from the NASDAQ peak in January 2000 to its bottom on October 9, 2002, some investors swore off technology stocks. I hope for their sanity, they didn't pile into housing related stocks. But maybe we should pursue that and see where it leads. Perhaps all housing related stocks were not the kiss of death during the housing boom and bust.

    Consider the fictional case of an only child who comes from a family of means. His name is Lucifer, which he hates, so he calls himself Lucky. He attends M.I.T., and graduates with a degree in Computer Science in the spring of 1996.

    Sadly, his parents both pass away within a few months of his graduation, leaving him their seven figure estate, primarily a well-diversified portfolio of blue chip stocks, bonds, and cash. Lucky's parents had been reluctant to discuss financial matters, considering it unseemly. So Lucky knows little about investing. He remembers reading an article by Peter Lynch, but all he can recall is "invest in what you know."

    Being the executor of his parent's wills, he hires an attorney, finds that the home they lived in was leased, settles their final affairs, and takes a job in Silicon Valley.

    Wanting to learn about investing, he starts watching CNBC. He learns that any dotcom IPO with a high "eyeball count" is likely to soar after the offering. Earnings get little attention, dividends none at all. The NASDAQ is where the action is, and many are getting wealthy in very little time.

    Remembering Peter Lynch's sound bite, he liquidates his parent's portfolio and invests it all in tech startups. If there is one thing he knows, it's computers, networks, and the internet. All goes well for several years until the spring of 2000. It is not until a week before October 9, 2002, the day the NASDAQ bottoms, that he remembers a cynical old professor explaining the seven phases of a project.

    Phase 1: Uncritical acceptance.

    Phase 2: Wild enthusiasm.

    Phase 3: Mild concern.

    Phase 4: Deep despair.

    Phase 5: The search for the guilty.

    Phase 6: The punishment of the innocent.

    Phase 7: The reward of the uninvolved.

    Lucky realizes that he is leaving phase 4, and entering phase 5. Determined to break the progression, he liquidates the technology holdings, salvaging one million dollars. He has now unwittingly completed phase 5, and entered phase 6.

    He takes vacation from his job so he can concentrate on finding better investments.

    Browsing the internet, he stumbles upon an article extolling the virtues of Dividend Growth Investing. Intrigued, Lucky decides to combine that idea with other factoids he has heard.

    A house is a great investment because of the tax advantages.

    A house always increases in value.

    A house is usually a family's largest investment.

    A house is the one thing that a family will not give up, cutting expenses in every other area to keep it.

    Owning a house is a part of the American Dream.

    A house is like a retirement account. Empty nesters downsize and use the excess to fund retirement.

    A house is a hedge against inflation.

    The U.S. Government encourages everyone to buy a house, demands equal opportunity, and invents more subsidies and liberalized lending standards on a regular basis.

    They are not making any more land.

    All of the above have been true since the 1950's.

    Lucky comes to the conclusion that housing related stocks that also meet the definition of Dividend Growth stocks are a lead pipe cinch.

    Using his broker's stock screener, he soon discovers five stocks that are housing related and have been paying annually increasing dividends for at least 24 years. They are Leggett & Platt (NYSE:LEG), Lowe's (NYSE:LOW), Sherwin-Williams (NYSE:SHW), Stanley Black & Decker (NYSE:SWK), and Valspar (NYSE:VAL).

    (Stanley Works changed it's name in 2010, after the acquisition of Black and Decker.)

    Lucky knows from listening to Jim Cramer's Mad Money segment "am I diverted", (or divisive, or devoted, or whatever), that five stocks are all that are needed for a good portfolio. Lucky had only seen the segment once, and had been distracted at the time by his girlfriend being distracting. He is a little surprised that no home builders were returned by the stock screen, but he also knows that computers don't make mistakes.

    He wants to buy equal dollar amounts of each of the five stocks. Still, he is leery of having 40% of his portfolio in paint manufacturers. So he compromises, and decides to put 25% of the portfolio in each of the other three stocks, and split the remaining 25% between SHW and VAL.

    Lucky logs in to his brokerage account and buys the requisite number of shares of each of the companies. His portfolio is structured as shown below.

    Lucky has heeded some other financial advice he picked up from Suze Orman, and put away a few months of living expenses in a savings account.

    Lucky sells his car and all other personal property of value, and cashes out his savings account. He resigns from his job. He instructs his broker to mail a brokerage check for the dividends quarterly, as well as tax documents, but no statements. He writes his email and brokerage account log in names and passwords on the back of his broker's business card, and puts that in his wallet. Lucky settles all his debts, cancels all accounts, and renews his passport for 10 years. He invites his girlfriend to join him in his future, but when she hears what he has done and what he plans, she declines.

    He flies to the Caribbean, then takes passage on an inter-island ferry to a remote island, where the cost of living is low, and the pace of living is slow. He does not take a computer, smartphone, or any other means of communication. They would be of little use, because the island is primitive in terms of communication. For him, it is time to escape the rat race, savor the moment, and enjoy the natural joys and rhythm of life.

    Phase 6 of a project is now complete. Innocent Lucky has punished himself by resigning gainful employment, losing his girlfriend, dropping out of society to a large extent, and most ominously, constructing a financial equivalent of the Maginot Line. It is a portfolio immune from the tech wreck of the past, but seemingly susceptible to the danger of the future.

    How did Lucky err? Let me count the ways.

    He did not diversify by asset class, i.e., stocks, bonds, and cash equivalents, precious metals, real estate, and others.

    He did not diversify his stocks by sector.

    He performed little research on the stocks he chose to invest in, considering only one criteria (housing related) and one metric (annually increasing dividends.)

    He did not consider valuation.

    He bought in one transaction, arrogantly as Mr. Cramer would say.

    He assumed that the future would be like the past, never questioning if something about the housing market had changed.

    He did not monitor his stocks. He deliberately put himself in a position where he could not.

    It seems that the only thing arguably good about his decisions was investing in Dividend Growth stocks. Would that be enough to survive all the blunders?

    Lucky finds a small, palm roofed hut to live in for a few hundred dollars a month. It has running water, a small kitchenette, and a half bath in a lean-to. He opens a bank account, rents a tiny PO box, and mails his broker the address.

    His first major purchases are a beach umbrella, a beach towel, a fishing spear, a pair of river shoes, and a crystal radio. He spends a lot of time on the public beach. He uses the umbrella for shade, and as an antenna for the crystal radio. There is only one radio station, so he hears a lot of Bob Marley, Harry Belafonte, and Jimmy Buffet, but never a word from Warren Buffet. In the evening, he would spear a few fish near the reef, wearing his river shoes. Why the fish were wearing his shoes, I don't know.

    (OK, I stole that joke from Groucho Marx. "One morning I shot an elephant in my pajamas. How he got in my pajamas, I don't know." Animal Crackers, 1930.)

    Money is scarce the first few years, but the income increases steadily. Presented below are the annual dividends generated by the portfolio. Note that 2002 includes less than one quarter. 2012 includes less than 3 quarters.

    (click to enlarge)

    By 2011, Lucky's dividend income was about the same as his salary had been in Silicon Valley. The S&P Index peaked on October 9, 2007, but Lucky did not know that. The index bottomed on March 9, 2009, but he did not know that either. The broker's check for the dividends did not indicate which dividends came from which stocks, and Lucky didn't much care, as long as each check was for more than the last.

    His annual 1099-DIV did give details, but Lucky never opened the envelope. He took it to an accountant's office on the island who filed the simple tax return electronically for a reasonable fee. The accountant's internet access was through a satellite dish, one of the few privately owned portals on the island. The accountant also set up quarterly estimated tax payments through the Electronic Federal Tax Payment System (EFTPS), drafting the payments via the Automated Clearing House (ACH) from his local bank account.

    (Whether EFTPS or ACH transactions through a non-US bank are actually possible or not, I do not know. If not, suspend reality for a short while.)

    By 2009, Lucky had moved into the only town on the island, rented a one-bedroom, nicely furnish apartment on the second floor, above a real estate office. He had a private balcony overlooking the small bay and the ocean beyond. The real estate office closed in mid 2009, and the space remained vacant for years. Then a Starbucks opened on September 1, 2012 complete with free Wi-Fi and loaner computers for customers, to be used on the premises.

    After the grand opening was over and the novelty dissipated, he went in to the Starbucks on September 20, ordered a latte and a loaner laptop, got out the old business card, and logged onto his e-mail account. His account deleted unread emails after 90 days, so he only had a few dozen. After deleting all the ones for Cialis, Viagra, and diet aids, and those from Nigerian oil ministers and dying English widows, he had only one.

    It was from his broker, who advised that a portfolio worth more than $3.3 million should really be more diversified. Lucky made a deal with the Starbucks manager to buy the computer for a healthy premium to its value, with the understanding that he could use the restaurant's Wi-Fi until the first week of October. Lucky's passport was to expire in early October, and he had to return to the U.S. to renew it.

    He took the computer to his apartment. After looking at his latest brokerage statement, he noticed that he had twice as many shares of LOW and VAL, due to two for one stock splits in 2006 and 2005. After identifying a few highs and lows for the S&P Index and SPY, and looking up historical prices for his five stocks, he constructed the table below.

    (click to enlarge)

    Phase 7 of a project can now be considered complete. Lucky, the uninvolved, has been rewarded. The elapsed time is a few days short of ten years.

    "There are three kinds of lies: lies, damned lies, and statistics." I have listed some, if not all, of the ways Lucky erred in constructing the portfolio, but can identify only one thing he did right. Still, it is erroneous to draw "cause and effect" conclusions based on correlations. That is, it does not necessarily follow that buying dividend growth stocks caused the portfolio performance, to the exclusion of all other factors. Maybe Lucky got lucky. There may be survivor bias in these results, but none that I know about.

    When I was a student learning the rudiments of statistics, the example used to demonstrate this faulty leap of logic from effect to cause was a motorcycle safety study conducted by the Army, circa 1977.

    The Army brass were concerned by the high rate of motorcycle injuries and deaths among the ranks, so a research team was formed. Data gathered included demographics (age, sex, address, occupation, etc.), physical characteristics (height, weight, identifying marks of various sorts, eye and hair color, shoe size, etc.), motorcycle details (brand, type, engine displacement, etc.), training and safety history, and motorcycle usage patterns.

    Then the statisticians crunched the numbers, and found that the single factor most predictive of motorcycle accidents was tattoos. That is, there was a high degree of correlation between tattoos and accidents. Do tattoos cause motorcycle accidents? Seems unlikely. Do motorcycle accidents cause tattoos? No. Permanent markings on the skin, maybe; but not decorative.

    The statisticians hypothesized that both accidents and tattoos are caused by a third factor. Call it the "I must strive to be different and attract the attention of total strangers" mentality. Keep in mind that a tattoo in the seventies meant something different than what it means today. The statisticians never thought to ask the motorcycle driver if he was a thrill seeking showoff with self esteem issues.

    It is my hunch that Lucky's stocks survived the housing boom and bust because of the behavior of the company managers during the time. Under the constraints of paying increasing dividends, they used the remaining cash flow as efficiently as possible. They kept a close eye on the expenses, and expended funds on projects that had the best probability of success, and the best return on investment. This story doesn't prove the thesis. It does support the argument.

    Which of these five stocks do I suggest you buy or sell? I have no opinion. I have done no research on these stocks, other than picking them off the Champion, Contender, and Challenger list, and looking up historical information.

    I hope that you have found the story both entertaining and informative, and look forward to your comments.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Sep 26 11:10 AM | Link | 2 Comments
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