5% Income Strategy For 2019 And Beyond

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by: Financially Free Investor
Summary

The stock market has been in a mini-correction mode since last month, and the future direction remains unclear.

The risks remain due to concerns about earnings growth, stretched valuations, trade disputes, inflationary concerns, and a rising rate environment.

We present a 4-pronged all-season portfolio strategy to generate 5% income, lower risks, and smaller drawdowns.

The strategy is simple to implement though requires some initial work.

The stock market had a 10% correction last month, and it has been stuck in a narrow range since then. The battle between the bulls and bears is not over yet, and the future direction of the market remains unclear. The risks are elevated due to concerns about future earnings growth, stretched valuations, trade disputes, inflationary concerns, and a rising rate environment. We believe no one has a crystal ball to know the future market direction. Fortunately, to be successful in investing, we do not need to know the future market direction. Besides, there are no recessionary pressures on the horizon, at least yet. The recent turmoil in the stock market has actually brought the stretched valuations in check.

Markets will go through their usual ups and downs, have small as well as big corrections from time to time, but that should not discourage us from investing. What we need to do is to make a well thought-out plan based on our own goals and risk-tolerance and implement the plan systematically.

As investors, ideally we want to capture the majority of the gains of the bull-market but would like to avoid any major losses when the eventual big correction arrives. This is, of course, easier said than done because it is very difficult to know when that moment arrives.

If you are an index investor, it is almost impossible to avoid major corrections. You ride to the top as well as to the bottom along with the broader market. A vast majority of the folks find it emotionally too difficult to cope with major losses and just bail out just at the wrong time.

Moreover, if you are nearing retirement (or already retired), a big correction, early in the retirement, can be devastating. A 30% correction will require 60% gains in the future just to erase the losses, whereas a 50% correction would need 100% gain to get even. So, as investors, we need to plan ahead and need to have a game-plan for any situation. In retirement, one needs to have a portfolio that is income-centric so that one does not have to worry and stress about the market's gyrations.

The Multi-Basket Investment Approach:

The best way to prepare for any kind of market whether it is bull market or a bear market is to follow some sort of systematic approach. None of the plans or strategies would be perfect, so it may be best to have multiple strategies since when one strategy zigs, some other will zag. Convert your portfolio into at least 3 baskets (or buckets). Each basket should have unique goals and objectives. We are going to present one such portfolio of four baskets for conservative investors or retired folks.

Let's assume for the sake of an example, that "Total Investment Capital [TIC]" is $1 million.

Portfolio type

Suggested Range (% of TIC)

Allocation followed in this article

Basket-A

DGI Portfolio

30-40% of the TIC

40% of the TIC

Basket- B

Risk-Adjusted (2-Securities) Income Portfolio

25-30% of the TIC

30% of the TIC

Basket- C

High-Income Portfolio

20-25% of the TIC

20% of the ITC

Basket- D*

Cash, Gold or Cash-like securities (For conservative investors and retirees)

10-20% of the TIC

10% of the TIC

* The last basket could vary, for example, it would be different for a younger investor when compared to a 70-year old retiree. This cash-like bucket may not be needed by younger investors. Instead, they should use this bucket as a high-growth bucket. However, more conservative investors could allocate as much as 15% or 20% of the TIC.

Subsequent to the formation of baskets, you should preferably write a "plan-of-action" for each basket. Since the nature of each basket is different, so will be the plan-of-action. Again, for the sake of an example, we may have the plan of action for the Basket-A (DGI Basket), something like below:

  • This is our do-nothing part of the portfolio once the positions are established. A position/stock should be sold/ exited only if something fundamentally has changed with the company.
  • Keep collecting the dividends for income; withdraw the dividends only (if you are in withdrawal stage). Otherwise, reinvest the dividends automatically.
  • Monitor the positions at least on a quarterly basis. Keep an eye if their dividends are covered by the cash-flow generated by the business. If the cash-flow does not cover the dividend on a prolonged basis, a dividend cut would be unavoidable, and we should sell or reduce the exposure.
  • If in the accumulation phase, add some additional dollars every year to the portfolio, investing in some of the existing or new stocks which are reasonably valued.

Obviously, the plan-of-action for other Buckets would be different.

Sample Portfolios for First Three Baskets

You could structure the above three baskets in a variety of ways, based on your personal preferences, goals, and risk tolerance. However, just to provide a starting point, we will provide sample portfolios for each of the three baskets.

Basket A: DGI Basket - Dividend Income

Goals and Filtering Criteria:

  • Dividend yield at least matching S&P 500, or preferably over 3%.
  • Yearly dividend growth of about 5% or Chowder-number to be at least 8.
  • Smaller drawdowns than the broader market during past corrections.
  • Large-cap, blue-chip company with a sizable moat in its industry.
  • Should have at least raised the dividends in the previous 5 years. Better yet 10 or 15 years.
  • Not more than 3 or 4 names from the same sector. At least one company from each sector/ industry-segment. Reasonable valuation.

The best way to structure a dividend-income portfolio is to select stocks of 20-30 large, blue-chip companies that have a history of paying and raising dividends year after year. This should make the foundation or "Core" of our investments. Just like the foundation of a house, the foundation of our Portfolio needs to be strong. You should choose the strongest stocks from each sector, which are available at a fair price.

We present (see below) a sample DGI portfolio consisting of 20 names, a majority of which are relatively conservative names, provide a decent dividend and trading at relatively cheap valuation. If you are putting new capital into the portfolio, we recommend buying in 4 or 5 separate lots spread over a year at least. This will avoid a situation where the market has a major correction just after you buy.

List of 20 DGI Stocks:

Company Name

Ticker

(Billion)

Industry

Div

Yield

5-yr Divi Growth %

(11-14-2018)

52-Wk High

Distance from 52-Wk High

General Dynamics Corporation

(GD)

53.3

Aerospace/ Defense

2.07%

9.4

180.08

229.95

-21.69%

Ford Motor Company **

(F)

37.9

Auto Manufacturer

6.29%

21.8

9.54

13.23

-27.89%

AT&T Inc.

(T)

186.2

Communications

6.59%

2.2

30.33

39.18

-22.59%

Exxon Mobil Corp.

(XOM)

330.5

Energy

4.21%

6.9

78

89.07

-12.43%

Valero Energy Corp.

(VLO)

35.7

Energy

3.83%

36.5

83.57

124.44

-32.84%

Prudential Financial, Inc.

(PRU)

39.1

Financial

3.80%

14.4

94.62

126.02

-24.92%

Wells Fargo & Company

(WFC)

257.3

Financial/Banking

3.26%

13.1

52.74

65.93

-20.01%

Bank of America Corp. **

(BAC)

284.4

Financial/Banking

2.16%

64.4

27.76

32.84

-15.47%

Johnson & Johnson

(JNJ)

386.8

Healthcare

2.47%

6.7

144.25

148.32

-2.74%

AbbVie Inc.

(ABBV)

132.7

Healthcare/Biotech

4.35%

17.7

88.22

123.21

-28.40%

Gilead Sciences, Inc. **

(GILD)

91.7

Healthcare/Biotech

3.21%

29.7

70.92

88.8

-20.14%

Illinois Tool Works Inc.

(ITW)

44.1

Industrial

3.01%

14.2

132.98

178.88

-25.66%

Reality Inc

(O)

18.7

REIT

4.22%

6.2

63.17

63.5

-0.52%

Public Storage

(PSA)

36.3

REIT

3.84%

12.7

208.38

232.71

-10.46%

The Home Depot, Inc.

(HD)

204.8

Retail/Home-imp

2.30%

24.1

179

213.85

-16.30%

Apple Inc.

(AAPL)

886.44

Technology/ Cons.

1.50%

10.5

186.8

233.47

-19.99%

QUALCOMM Inc.

(QCOM)

65.7

Technology/Semic

4.58%

14.1

54.16

75.09

-27.87%

Texas Instruments Inc.

(TXN)

90.8

Technology/Semic

3.26%

21.5

94.48

119.89

-21.19%

Microsoft

(MSFT)

805.7

Technology/Software

1.68%

13.1

104.97

116.18

-9.65%

Dominion Energy Inc.

(D)

48.5

Utility

4.51%

7.6

74.02

84.91

-12.83%

AVERAGE

3.56%

17.3%

-18.68%

** The dividend growth rate is less than 5 years, or the dividend growth has been inconsistent.

Basket B: Risk-Adjusted, 6% Income, and Capital Preservation Basket

Goals:

  • Preserve capital during big corrections
  • Smaller drawdowns, possibly no more than 15%
  • Nearly 6% Income~10%
  • Total-returns over any 10-year rolling period.

This basket can be formed in many ways, from very simple and easy to implement strategies to some complex ones. However, here we will provide a very simple, easy to implement strategy:

A Simplified 6% Income Portfolio:

If you have read our previous articles on this topic, this is the most simplified version of our 6% income portfolio. We are trying to achieve simplicity without compromising much on the income or the total returns. This is still a monthly rotation risk-adjusted portfolio but invests in only one of the two securities at any given time. At the end of each month, we will look back at the performance of the two securities over the previous six months period and select the security which has performed better. We will use Cash as the risk-hedge asset.

Below are the two securities in addition to Cash for this portfolio, invested in only one of them at a time:

EV Tax-Advantaged Dividend Fund ( EVT)

The Fund seeks high total return with current income and capital appreciation through investment in dividend-paying common and preferred stock. The fund is invested roughly 75% in dividend-paying equities, 10% each in Preferreds and Corporate bonds. Eaton Vance is the fund sponsor. The fund uses 21% leverage. It also pays a decent monthly distribution of 7.57%.

In a sense, we have chosen EVT as a proxy for S&P 500, but with a little leverage and with some mix of Preferreds and High-Yield Corporate Bonds. But for the most part, it moves up or down with S&P 500. You could replace it with any similar equity closed-end fund, but results could vary. You could also replace it with S&P 500 but back-testing results were inferior by a couple of percentage points, and income distribution will be very small.

iShares 7-10 Year Treasury Bond ETF ( IEF)

This ETF tracks the investment results of the ICE U.S. Treasury 7-10 Year Bond Index. The underlying index measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than seven years and less than or equal to ten years.

Or Cash

We remain in cash when none of the securities have performed above the risk-free rate of return.

We will present the back-testing results (based on an initial investment of $100,000) from the year 2005-2018, which includes at least one bear market of 2008-2009 financial crisis. Below is the performance of the portfolio in comparison to the S&P 500 Index:

Performance of Income Portfolio Vs. S&P 500:

Below is a chart showing how the portfolio was invested over the years:

Next is the year-wise income distributions provided by this portfolio. This chart assumes that we had a capital of $100,000 invested in the portfolio at all times. Dividends were NOT re-invested. You can see that on an average we got 6% income from this portfolio, some years were down, but some others were up.

Basket C: High Income Basket

Goals:

  • 8% Income from distributions.
  • ~10% Total-returns over any 10 year period.

Now, the obvious question would be if a high-yield portfolio would be appropriate for a conservative investor. We believe that there is a place for a high yield bucket. It definitely has more risk than our other buckets. But with proper allocation and staggered buying, the risk can be minimized. We will structure this high-income bucket with three types of securities, namely REITs including Mortgage REITs, BDCs (Business Development Companies), and some CEFs.

Security Type

Symbol

Name

(11-14-2018)

BDCs/mREIT

ARCC

Ares Capital Corporation (ARCC)

9.00%

MAIN

Main Street Capital Corporation (MAIN)

5.99%

NLY

Annaly Capital Management (NLY)

11.93%

GBDC

Golub Capital BDC (GBDC)

6.84%

NRZ

New Residential Investment (NRZ)

11.34%

REIT

O

Realty Income Corp (O)

4.22%

OHI

Omega Healthcare Investors (OHI)

7.50%

STAG

STAG Industrial (STAG)

5.37%

STOR

STORE Capital Corporation (STOR)

4.41%

VTR

Ventas, Inc (VTR)

5.25%

CEFs

RFI

Cohen & Steers Tot Ret Realty (RFI)

7.97%

UTF

Cohen & Steers Infrastructure (UTF)

8.44%

BBN

BlackRock Taxable Muni Bond (BBN)

7.13%

KYN

Kayne Anderson MLP (KYN)

12.23%

HQH

Tekla Healthcare Investors (HQH)

9.19%

PCI

PIMCO Dynamic Credit Income (PCI)

8.54%

JPC

Nuveen Pref & Income Fund (JPC)

8.00%

STK

Columbia Seligman Premium Tech (STK)

9.81%

Total/ Average

7.95%

Likely Behavior of the Multi-Basket Portfolio:

In the 2008-2009 financial crisis, S&P 500 index ( SPY), lost slightly more than 50%, from top to bottom. For so many folks, it was very painful to see their savings reduced to half. Based on our experience of how different securities behaved during that crisis, we will present table to see how our above baskets would behave during a similar panic in the future. Please note below are our estimates only and have no scientific basis, and future events cannot be guaranteed.

A Bull-Market scenario:

IF

SPY gains 10%

IF

SPY gains 30%

IF

SPY gains 50%

Basket A (DGI)

Cap=400,000

3 - 4% Income

Gains 10%

=440,000

Gains 30%

=520,000

Gains 50%

=600,000

Basket B (Risk-Hedged)

Cap=300,000

6% Income

Gains 7%

=321,000

Gains 20%

=360,000

Gains 35%

=405,500

Basket C (High Income)

Cap=200,000

8% Income

Gains 8%

=216,000

Gains 27%

=254,000

Gains 45%

=290,000

Bucket D (Cash, Gold, Treasuries)

Cap=100,000

2% Income

No Gain

=100,000

No Gain

=100,000

No Gain

=100,000

TIA=1,000,000

5% Income

(Average)

= 1,077,000

(+7.7%)

= 1,234,000

(+23.40%)

= 1,395,000

(+39.5%)

A Bear-market scenario:

SPY loses 10%

SPY loses 30%

SPY loses 50%

Basket A (DGI)

Cap=400,000

3-4% Income

Loses 6%

=376,000

Loses 20%

=320,000

Loses 32%

=272,000

Basket B (Risk-Hedged)

Cap=300,000

6% Income

Loses 4%

288,000

Loses 10%

270,000

Loses 15%

=255,000

Basket C (High Income)

Cap=200,000

8% Income

Loses 15%

=170,000

Loses 35%

=130,000

Loses 56%

=88,000

Bucket D (Cash, Gold, Tres.)

Cap=100,000

2% Income

No Loss

=100,000

No Loss

=100,000

No Loss

=100,000

TIA=1,000,000

5% Income

(Average)

=934,000

(-6.6%)

=820,000

(-18.0%)

=715,000

(-28.5%)

In our opinion based on the past events, the above strategy should capture the majority of the gains (though not all) in the rising markets (+40% vs. 50% or 23% vs. 30%). However, it should lose much less during corrections, especially severe bear-markets (loses about 28% when the broader market loses 50%). In addition, more importantly, the portfolio should keep providing significant income which would help ride out any bear market. In our example, it would be providing an income of roughly $50,000, which will be good enough to ride out any storm. On top of that, we are maintaining over $100,000 of cash all the time to meet any emergency needs and provide a cushion in a bear market.

Total Income from the Four Baskets:

Investment

Income

Basket A

DGI Stocks (3.5% dividends)

400,000

14,000

Basket B

6% Income

300,000

18,000

Basket C

High-yield bucket (8% Income)

200,000

16,000

Basket D

Treasury, CDs, Cash (2% Income yield)

100,000

2,000

TOTAL

1,000,000

$50,000

Concluding Thoughts

The stock market just had a 10% correction last month, and it has been stuck in a narrow range since then. That said, we do not have the slightest idea whether the stock market indexes will be higher or lower by the year-end or next year. Though the economy is still healthy and growing, unemployment is at its lowest, and there are no indications of any near-term recession. However, the biggest concern is if the Feds are raising the interest rates too fast. Higher interest rates have already put a dent on the housing market trajectory. That said, there are so many variables in the market that no one can predict the market direction for the near or medium-term, with any certainty.

With this in view, we believe we should be almost fully invested. Sure, some cash reserves to the extent of 10-15% is always a good idea. We have presented above a diverse investing approach with multiple baskets, which will provide an extra layer of diversification and safety. Above all, the combined portfolio should generate a very decent income of 5%. We do admit that this approach would require more work than index-investing and may not be appropriate for everyone. The main idea is to get the readers thinking about a multi-basket investment approach.

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes; however, the author holds many of the same stocks in his personal portfolio.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, WMT, WBA, CVS, LOW, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, JPS, JPC, TLT. 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.