How Do You Know When You've Found 'Alpha'?

Includes: EMR, FLO, KO, PG, RYN, TIS, WEC
by: Dividend Sleuth

I was introduced to stocks when I joined an investment club in February, 1982. The Dow Jones Industrial Average was at 800. Now it stands at 16,000.

Alpha and The Land of Critical Mass

One of the first investment radio programs that I remember was Bob Brinker's Moneytalk. Brinker, now 72, still encourages people to seek the land of critical mass. "Critical mass" is Brinker's term for accumulating enough money to live on for the rest of your life.

Later, when I first saw a reference to the Seeking Alpha website, I intuitively knew that SA's mission was similar to Brinker's.

"Alpha" has multiple meanings in our culture. A dominant person in a couple or a group is sometimes said to have an "alpha" personality or functionality. I'm a member of an organization that has an engineer for a finance chairperson. He reports the group's income as the alpha, the group's expenses as the beta, and the difference as the delta.

Within the scope of modern portfolio theory, alpha is a measure of performance on a risk-adjusted basis. Investopedia says:

"Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha."

In "Why Asking Your Adviser to Seek Alpha is a Good Investment Strategy," Bill Carrigan puts it this way:

"In the investment community alpha represents the degree to which an adviser or portfolio manager has added value relative to a benchmark index."

Alpha: A Metaphor for Your Personal Investment Goals

Seeking Alpha is a "community of communities" of investors. Like any large group of people, there are various sub-groups or niches where people with like-minded goals coalesce. The specific definition of "alpha" may vary among members of the Seeking Alpha community, but a common theme is that "alpha" refers to the target, or goal, sought by each investor. My SA cohort is a community of people that is focused on dividend stocks.

For some, "alpha" may be a target dollar amount, as in "I want to achieve a stock portfolio with a $1,000,000 market value." Or, "alpha" may be a moving dollar target, such as, "When I start drawing Social Security, I want to be able to draw from my IRA an amount equal to my monthly Social Security check." In this case, the dollar target is not the market value of the portfolio but rather the average monthly income produced by the portfolio.

Alpha is a Moving Target

"Alpha" for some younger investors may be a vague, yet-to-be-defined goal. A young investor may not know exactly how much he or she will need in retirement. The goal may seem very distant and all one knows is that it will take a great deal of effort, or investment savvy, or luck to get there.

One's definition of "alpha" may change as one ages and as one's life is impacted by various events. Some events may make "alpha" seem more distant and less likely--such as a job loss, a devastating illness or accident, a divorce or a severe bear market. Some events may hasten the arrival of "alpha," such as an unusual job opportunity, a more successful than expected business venture, an inheritance, a long and healthy work life or a raging bull market.

In short, "alpha" is a moving target. At age 30, one may define "alpha" as a $1,000,000 portfolio. After decades of inflation, "alpha" may be redefined as a $3,000,000 portfolio.

Brinker Pointed Me Toward Alpha

In the late 1990s, when I was a regular listener to Bob Brinker's Moneytalk, I had a concept, but not a dollar target, for "the land of critical mass." I knew I was a long way from that land. Brinker saw the "tech bubble" growing, and I agreed with him. I moved a large part of my IRA to Real Estate Investment Trusts (REITs). That was my first appreciation for the ballast that dividend-paying stocks give a portfolio. I didn't know it then, but this was an important step toward seeking "alpha."

William Bengen's 1994 article in the Journal of Financial Planning advocated a "4% rule," which said one should not withdraw more than 4% of one's retirement account per year. Bengan's "rule" was popularized by various financial publications such as Forbes. SA contributor Morgan Myrmo (among others) has written about this concept in several articles, including "The 4% Plan--A Permanent Income Stream Solution."

Bengen Gave Me a Map To Alpha

Articles about Bengen's work, coupled with my early positive experiences with REITs, helped sharpen my idea of what "alpha" might look like. This caused me to navigate my IRA toward dividend-paying stocks. If I could average 4% a year in dividends, I could withdraw the dividends without selling stocks. As the stocks appreciate and the dividends grow, I would have dealt (at least partially) with the issue of inflation.

At that point, I realized that I had discovered a "map" to the "land of critical mass." I wasn't there yet. It wasn't in sight. But, at least I had a plan for how to get there: Accumulate stocks with growing dividends.

Retirement is a Moving Target

I'm about to use the word "retirement," but before I do I need to offer a caveat. "Retirement," like "alpha," is a moving target. Last week I received a Christmas letter from a friend announcing his second retirement. He has been working at a "part time" job for a long time after his first retirement. Another friend once said, "I retired at 70. Now that I'm 80, I'm just going to quit."

During the two years prior to my (first) retirement, I developed a plan to rollover part of my pension account to my IRA, with a continued focus on dividend-paying stocks. For over a year (including the dark days of late '08 and early '09) I kept a "dummy portfolio" roughly equal to the amount that I intended to rollover. I refined, or tweaked, that portfolio closely and when the time came for the rollover (in July, 2010), I knew exactly what to do with the funds.

Navigating Toward Alpha

"Alpha," or "the land of critical mass," wasn't yet in view, but it felt good to know that some of the distance on the "map" was already behind us. The journey had begun.

Three-and-a-half years ago I retired (the first time). After a month of "rails to trails" bike riding with my wife, I began a part-time job in a field related to my 40-year career. One of the nice aspects of the "part time" nature of this job is that it gave me the invaluable gift of time to navigate my IRA closer to "alpha."

In recent years I have wrestled with all the investment issues that are commonly discussed among Seeking Alpha contributors and readers. I have "chased yield" by being enamored with high-yielding business development companies, mortgage REITs, closed-end funds that write call options, and with some higher-risk master limited partnerships.

I have debated whether to focus in greater detail on 12-15 stocks (thus risking inadequate diversification), or whether to hold 35-40 stocks (thus risking inadequate oversight). I once bought shares of Flowers Foods (NYSE:FLO) because I thought the dividend was near 4%, only to realize that I had failed to note that I was applying the pre-split dividend to the post-split stock price. FLO is a great company and it was not a bad purchase, but that was a wake-up call to me that I had too many stocks to adequately manage. I pruned the portfolio, choosing higher-yielding stocks and selling some whose prices had rapidly appreciated--such as Procter & Gamble (NYSE:PG), Dover (NYSE:DOV), Illinois Tool Works (NYSE:ITW), Kimberly-Clark (NYSE:KMB), and PepsiCo (NYSE:PEP).

I later realized that I had followed some of these companies for decades and I became confident that my schedule now permitted me to adequately "keep up" with a larger portfolio. So, I began to reacquire some of the blue-chip "dividend champions" (such as Emerson Electric (NYSE:EMR) and Coca-Cola (NYSE:KO)). In short, I believed that the risk of inadequate diversification was greater than the risk of failure to adequately monitor the individual stocks. This is not a one-size-fits-all decision. What works for one investor may not work for another. What works in one season of a person's life may not work during another season.

I have continued to redefine the exact dollar target associated with "alpha." One reason it is difficult for a young person (or even someone just a few years from retirement) to know the exact nature of "alpha" or the contours of "the land of critical mass" is one may not know how much income will be needed in retirement until it happens.

One of the gifts of retirement (even semi-retirement) is that you may be able to live a simpler lifestyle. One of my friends says, "There are two ways to be rich: Get more or want less." When you approach "alpha," or the "land of critical mass," you may discover that you need more money than you thought you would. Or, you may discover that you actually need less.

A Focus on Monthly Income Rather than Market Value

During these three-and-a-half years, my work with the IRA has become more sharply focused on average monthly dividend income. I have a round-number awareness of my IRA's fluctuating market value, but I can tell you the exact average monthly dividend income. This monthly figure changes only when I buy or sell a stock, or when a company raises or lowers its dividend.

During 2013, we have seen the broad averages rise in true bull market fashion. On the other hand, it has been a mixed year for dividend-paying stocks. Since May, some dividend-paying stocks have been in a major correction or a bear market (as defined by down 20% or more). I have viewed the May-December 2013 period as a time to selectively become overweight in some REITs and some utility stocks.

In late 2012 and early 2013, when it was difficult to find bargains, I "parked" some cash in high-yielding BDCs and CEFs. As REIT and UTE prices declined, I rotated some of that money out of BDCs and CEFs into REITs, UTEs and some other dividend-payers, such as Orchids Paper Products (NYSEMKT:TIS). I diversified, choosing to hold more companies. This reduced my average monthly income but it gave me a greater confidence in the ongoing growth of the portfolio's income. One example: I sold Annaly Capital (NYSE:NLY) and bought more Dividend Champions.

Eventually, Alpha Becomes a Real Set of Numbers

In late November, 2013, I told my wife that I had navigated the portfolio to the point that "I have this thing close to the way I want it." So, I anticipate much less portfolio turnover in 2014. I have now determined a "base goal" for average monthly dividend income going into 2014 and I have a set a goal for growing that monthly figure during the course of 2014 as the portfolio companies increase their dividends. In short, "alpha" has become a real set of numbers.

I now feel more like a baseball manager looking after a really good team rather than a team owner scouring the horizon for a half-dozen new players. I still have my "shopping list," but I have winnowed the list to three stocks that I hope to buy in 2014. I'm overweight in some stocks and some sectors because I believe they are currently undervalued. If I'm right and these securities or sectors bounce back, I will trim to my core position and use the proceeds to further diversify. If yet-to-be-identified unusual bargains appear, I'm not opposed to buying more, but at this point I hope the portfolio modifications will be minor.

The three stocks currently on my "short" buy list are Rayonier (NYSE:RYN), Wisconsin Energy (NYSE:WEC), and Procter & Gamble (PG). In a sequel to this article soon after January 1, I will update my Retirement Income Portfolio and provide more specifics.

Entering the Harbor

I have not yet arrived at "alpha," or the "land of critical mass." But, after years of "full speed ahead" (and sometimes "damn the torpedoes"), I feel like a boat captain slowly moving into the harbor at idle speed. The "map" is wrinkled and full of notations. The destination is in sight. I'm still working at it, but now most of the heavy lifting comes from the steadily growing dividends of prior investments.

I believe you know you've found "alpha" when you're in steady-as-she-goes mode rather than moving from one hot idea to another and from one strategy to another. It's a sifting process and a reliance on the "tried and true." That's the wisdom that has been brought to this community by many contributors such as David Fish and his work with Dividend Champions, Contenders and Challengers.

Disclosure: I am long EMR, KO, TIS. 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.