CFK Income portfolio is back to outperforming its primary index. YTD, the CFK Income account is +7.3% vs. +1.6% for the Russell 2000.
Unfortunately, this outperformance isn't exactly coming the way we would wish. Month to date we are "only" down -2.1% vs. -7.1% for the Russell 2000. This, however, does bring up a couple nice things about Income portfolios.
First, if you have constructed the portfolio decently, the overall payout should just keep chugging along. CFK Income for instance currently has an expected yield of 9.5%. That yield went up a bit this month, not down. This brings us to the second nice thing about downturns.
In times of turmoil, income portfolio yields typically go up, not down. This isn't because the payout actually goes up, but rather because what you have to pay to capture that income stream has declined. This helps the mind to realize some of these investments just might be "on sale". A very important change of mindset that both help one stick to their plan and can lead to an increasing income stream over time. Downturns can become a chance for one to up their investment paycheck.
The mindset of, "Hmmh, these stocks just went on sale a bit. I could now capture up to a 6% raise (9.5% yield instead of 9%) is a good thing. As is, "I wonder if the sell off is quite done yet? Should I add now, or wait a bit longer?". See how those are both positive constructive questions which help one to move forward logically, instead of letting fear cause us to act like a deer in the headlights?
Over long periods of time, downturns you to capture income streams at a discount and thus to move up the overall portfolio's income stream. Investors who have as part of their written strategy."
I'm going to let the dividends build in cash, until index Y drops 9.7% then invest 1/3 the cash on hand. At 19.7% I invest 1/2 the remaining cash (about 1/3 the original if you already reinvested 1/3 and nothing else changed). At 29.7% I put all remaining cash in the market.
Can reduce risk when times are good and increase income streams when they are bad. I did an unscientific study on an even more basic method than this back in 2016.* To my surprise it didn't just reduce risk, it also improved total returns slightly.
Think about it. Isn't late 2008 and early 2009 when the world was about to end and very attractive covered yields were widely available exactly when you wish you had bought more? The strategy above would have put the first 1/3rd in too early but would also have allowed you to capture a small raise with each minor downturn before and after. The point, however, isn't this strategy or reinvest all after a 20% drop, or even reinvest immediately. The point is to have a strategy and write it down.
Having written trading, allocation, and money management strategies can help you to act appropriately when times are tough. They can help you become less emotional with your investment decision-making, at least counteracting some of the emotion you can't help but feel.
*Excerpt from an article published back in June 2016:
Is it better to reinvest immediately or to wait until a 20% drop?
I tend to reinvest dividends regularly in whatever equity I think represents the best value at the time. However, one idea I have frequently toyed with is to instead hold the funds in cash only reinvesting once the market (or the particular portfolio) dropped 20%. I like the idea of this second method not so much for higher returns but rather it seems logical to me that it would reduce volatility without reducing returns "that much". I continue to follow my method for now, but wonder if maybe the alternate method might be a better choice when I am less active in investments and/or less willing to take on risk.
So, I decided to do a little one-day study on some asset and see just how much of a difference it would make. I wanted something that represented a portfolio at least somewhat similar to my Search for Value portfolio (SFV) but of course at 3.5 years that portfolio itself did not have enough history to be useful. I wanted something that would go back at least prior to the last Great Recession the longer the better.
The S&P 500 is an obvious choice. One can get many decades of history on it. However, it is not really very representative of the Search for Value portfolio since it mainly holds large-cap established stocks with relatively minor dividend payouts. The Search for Value portfolio is decidedly small-cap value, with some preferreds and bonds, plus a distinct leaning towards pass-through and other securities which payout 8% or more in dividends. So, I needed something that more closely reflected that kind of mix.
This turned out to be much harder to find than I expected. I first did searches for ETFs. They would have been optimal because various online tools I am familiar with treat them like stocks making the rest of my job much easier. There is already software out there that will give you nice graphs with and without dividends reinvested, unfortunately, the ones I have access to do not handle mutual funds. So, I wanted an ETF.
I used various screeners, but over and over again, I kept running up against the same problem, most ETFs just haven't been around long enough to be useful in this study. The few that have were not any more representative of my portfolio than the S&P 500.
Next, I looked at closed-end funds. You can find ones that are a bit more representative of my portfolio, but once again none of the ones that had existed long enough to be useful. Additionally, the CEFs that had been around a long time come with a significant drag from fees. When you are talking about a CEF that has averaged maybe a 5-7% return over the last 20 years, having a 1.5-3.5%+ drag from fees is very significant. So much so that they too were really not representative of my portfolio, primarily individual equities with no fee drag. Virtus Global Dividend and Income Fund (ZTR), at first seemed to fit the bill with its long 29-year history, 11% payout, and relatively reasonable 1.3% fee, but looking at the actual holdings:
It was clear this was actually a bunch of mega-cap dividend payers, nothing like my small-cap pass-through security centric portfolio. It was clear there was no way actual dividends from the holdings of this fund were actually funding the double-digit payout, rather a combination of leverage and returning of capital was being used.
ZTR wasn't totally useless, however, I was able to quickly run an online tool which showed ZTR returns with and without dividends reinvested:
This showed once again something I already knew and had proved to myself over and over again, dividend reinvestment matters. As you can see above, ZTR is not a particularly well performing CEF. Its average annual return is only 2.3% since 1995, hardly worth paying a 1.3% fee to achieve. However, the 11% payout, clearly emphasizes the value of reinvesting dividends. If you had reinvested dividends in ZTR, you would have achieved a 5.1% return. Still, nothing to write home about but twice what you would do otherwise. Put a different way, by reinvesting dividends regularly, you are buying more shares when the CEF is low priced and boosting your overall return by about 3%. I can tell you have read a number of different studies that show essentially the same thing. Regular reinvestment of dividends boosts returns meaningfully while also lowering volatility a bit. It matters.
That, however, was not the point of this study. Finally, although I knew it meant a lot more effort in excel, I switched to mutual funds. Mutual funds have been around forever and there are lots of them. Surely, I could find one that put out a high amount of dividends, invested in some preferreds and bonds, as well as high dividend small-cap securities, and had been around a couple decades? Well, once again this was a much harder search than I expected, but eventually, I did find one that fit the bill: Yorktown Multi-Asset A (APIUX). At least enough that I'm not going to continue a search that should have taken 15 minutes but instead took over 4 hours.
As you can see:
Yorktown does have a sizeable holding of pass-through securities - ARCC, NRZ, and TWO have all been SFV holdings at one time or another; ARCC still is. Also, ARI, SLRC, and BGCP are all securities I have looked at in the past and would hold given the right price. Yorktown also keeps a sizeable amount of its portfolio in bonds and preferreds (30% currently) and has most of its holdings in US-based assets (83% currently). This is also similar to SFV. Yorktown's long-term return has been about 7.2%, a little less than what I have done over the last 17 years but if you add back in the 2.5% in fees, it gets a lot closer. Also, Yorktown has almost 20 years of data available and throws out a meaningful 6.5% dividend which is pretty close to the what SFV does.
I finally found my candidate.
It might have different holdings and a bit lower performance, but it was close enough. After all, I wasn't trying to find a good investment (note I do not think Yorktown is a good investment, that is not the point). Rather I was just trying to find a fund somewhat similar in holdings to SFV which had enough data for me to back-test. The other indirect benefit here is this is definitely not curve fitted. It is a decent but not particularly well-performing fund, and it is definitely not one chosen to prove a predetermined point. It is just the first one I came across which seemed applicable. Most importantly, it is not the absolute performance I care about anyway. It is rather the relative performance between reinvesting dividend immediately or waiting until the fund had dropped 20% to reinvest which I am interested in.
I won't waste everyone's time by dropping it here, but I was able to download 19 years of daily price and dividend history for Yorktown into Excel (ask if you want a copy). I was then able to refresh my Excel skills figuring out how to write a formula which calculated whether there has been a 20% drop from the last high, keeping the dividends in cash until then and then reinvesting that cash the next day (ha, this 50-year old has still got it!). As it turns out this actually on occurs 4 times - Sept. 2008, Nov. 2008, March 2009 (all Great Recession), and strangely enough Aug. 2015. So, there a lot of cash built up between the start of March 1998 and that first reinvestment in Sept. 2008. We should expect quite a drag. By comparing that to the returns which occur from reinvesting the dividends immediately, we should see just how much performance it costs us by building up all that cash.
Except it didn't. As you can see the reinvest dividends immediately vs. holding them in cash made almost no difference in returns between March 1998 and the Great Recession. $10,000 invested in the two portfolios has almost the same value whether you reinvested those dividends immediately (blue line) or let them build up cash (orange line = value in fund + cash buildup). This was surprising to me. I had assumed there would be significant underperformance. Maybe it is because this diversified fund only returns 7% on average (I say only but that was still good enough to earn it 4 stars from Morningstar) and did have very low volatility up to the Great Recession. I am not really sure but I cannot find any errors.
Another observation was the fund did not have a big buildup in the late 90s only to crash in the early 2000s during the dot.com bust. This is logical as it does not typically own technology and other exciting investments but rather fixed income investments and heavy dividend payout pass-through securities.
Once the Great Recession hits, of course, things start to change. Yorktown loses over 40% from high to low during the Great Recession ($11.72 to $6.51 per share). I can tell you from experience that pass-through securities lost every bit as much in price as the market did during the Great Recession. They however also kept paying out pretty much the same in dividends. So, the pass-through security stocks were affected, while the underlying businesses those stocks represented were not affected as much.
All that cash that was building up in the reinvest after a 20% portfolio got reinvested during the Great Recession. It did not get reinvested at the lows, the majority of it goes back in at a price of $9.16 a share (a 20% drop from recent highs, but still 30% higher than the eventual low at $6.51). That, however, does not prevent it from being a good plan, once the market starts to recover so to do the two portfolios, only one of them has a few more shares in it; the one that waited and reinvested the majority of funds during the Great Recession rather than before it.
Another surprise, however, is that there is really not that much difference. While the reinvest after a 20% decline fund goes from 962.5 shares before reinvestment to 1,382.6 post reinvestment, a large change as expected, the reinvest immediately fund already had 1,326.9 shares from reinvesting as each dividend was paid. I don't know if this is merely coincidence, but the difference in number of shares between the two is only 4% (= 1,382.6/1,326.9 - 1), much less than I expected.
My last surprise observation, the reinvest only after a 20% decline fund, actually did slightly better than the reinvest immediately fund. This is despite that fund sitting there building cash for over 10 years! Ultimately investing $10k in Yorktown in March 1998 and reinvesting dividends as they get paid since then resulting in an account value of $22,353 on June 16, 2017. Investing the same $10k in Yorktown on the same date but only reinvesting after the fund had dropped 20% resulted in $25,130 in account value on June 16, 2017. Surprisingly the building cash option not only had less risk but slightly outperformed on overall return.
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Income coverage including names such as:
- Archrock (AROC) from $9.18 - A compression equipment lessor with significant cash flows which help it benefit from the high secular growth trend in North American natural gas volumes. A 4.2% dividend growing 10-15% per year, with 2.76x coverage last quarter.
- Capital Product Partners (CPLP) from $2.64 - A diversified ship leasing company which inexplicably sandbags its true distributable cash flow coverage. 11% tax advantage yield and no K-1!
- Ladder Capital (LADR) from $12.30 - A Commercial mREIT which enjoys internal management with solid capital allocation skills, and a positive correlation to interest rate increases (A 1% increase in interest rates is expected to increase net investment income by 9%). 7.8% distribution covered at 1.1x.
Disclosure: I am/we are long AROC, CPLP, LADR.
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: This article mentions risky investments and various investment strategies. I do not know your goals, risk tolerance, or particular situation; therefore, I cannot recommend any specific investment or strategy to you. Please do your own additional due diligence.