Betting On The Quiet Kid: A Look At The Rules And Philosophy Behind The Brown Bag Portfolio

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Includes: EPD, T
by: Michael Hesse
Summary

A brief(ish) history of the Brown Bag Portfolio and my intentions.

Some of the rules and philosophy behind the Brown Bag Portfolio.

Thoughts on two of my largest positions: Enterprise Products Partners and AT&T.

First of all, let me be absolutely clear, I am not a financial professional. I don't hold any advanced degrees in economics, finance or business. I do not advocate or recommend stocks, bonds, or any financial instrument for my readers or their investments. Please don't misconstrue any of my monthly musings as advice or make financial decisions based upon the thoughts or decisions that I document in these articles.

These articles are meant to document my financial/investment journey as honestly and accurately as possible. For those of my readers who may be new to the Brown Bag Portfolio series, let me give a brief recap. For those readers who have been following me since the beginning, you can drop down a couple of paragraphs. If anyone is interested in reading the first Brown Bag Portfolio article, you can find it here. I believe I've got it marked as always available (or whatever the nomenclature is), if not email me, and I'll try and go back and figure out how to do that.

In brief, I started my financial journey in July of 2016 with $150 that I used to open a brokerage account. I was in my early fifties and had the rather unpleasant realization that like so many other Americans I had no retirement savings. I'd been working since I was sixteen and I had nothing.

Prior to that rather dark epiphany, I'd had a 401k and hadn't really worried about my future or retirement. I was too busy working and raising my children. However, I'd drained my 401k years before to keep the lights on and mortgage paid when my now ex-wife was suffering from some serious medical issues. Fast forward to my early-mid forties and I had a serious medical condition of my own that racked up some six-figure bills, left me unable to work for a time, and ultimately became a factor in an ugly divorce and custody battle that spanned five years and enriched only the attorneys involved.

Skip ahead a bit more and I was now fifty-one and I had nothing. My new wife has a solid 401k, but I neither want to be dependent upon her or Social Security (which I don't believe will exist in any meaningful way by the time I retire - due to politicians of both parties who have raided the so-called "trust fund or lock box" for decades). I decided after some research that the only way I could reasonably build wealth in the time I had left was through the stock market.

I made some newbie mistakes immediately, chasing stocks up and panic-selling when they fell and a couple of smart or lucky decisions my first year. All the while, I started researching and reading and trying to learn as much as I could so that I could make better decisions. I found Seeking Alpha and a number of authors I liked and did further research, eventually deciding that I needed to make dividend investing the core of my portfolio. I did this for two primary reasons: 1) through dividend reinvestment programs (DRIP) my positions continue to grow without additional investment, and 2) the fact that I'm earning money while holding the shares helps tamp down the nervousness created during temporary (hopefully) drops in share prices.

After about a year of investing, I thought that there might be some value in honestly documenting my investment journey and wrote my first article for Seeking Alpha (Introducing the Brown Bag Portfolio). In it, I stated that I had made some lifestyle changes that resulted in a reduction of my expenses and how I was using that money to fund the portfolio. Chief among these was the fact that I was taking the money that I'd previously spent on lunches out (I'm a field service technician and on the road daily) and re-directing that money towards the portfolio (thus the name). Along the way, I've found numerous other areas in which to save and apply that money to my efforts as well.

Most Americans don't have hundreds of thousands of dollars to invest. Most of us struggle day to day with the myriad demands upon our time and money, but each of us can invest something... anything ... to improve our lives down the line. The problem most people have is that they don't understand the process, and many are leery of making mistakes or even understanding what the ramifications of their decisions might be. Reading or listening to experts who have millions or billions of dollars at their disposal and the decisions they make with it doesn't truly inform those of us who don't.

The reality of the situation is that at a certain income level (and what that level is up to interpretation), protecting wealth is more important than building wealth. Even if someone is still trying to build wealth the process is different for someone who can buy 10 or 100 shares of Amazon (AMZN) at a time than for someone who has to save for three months or longer to buy just one share. The psychology is different too.

So, in a nutshell, that's why I write these articles. First of all, they keep me honest, I can't sell out of a losing position and pretend to myself that it didn't happen. It's documented. One month, it was there, and the next, it's gone. Why? My readers might want to know what prompted that decision because maybe they're in a similar place. Also, for someone who's just saved up $500, $1,000, or more and wants to invest it and sees that I've just made a similar investment, he or she might want to know why I chose that particular stock when there were many others that I could have chosen. How did that turn out for me, ultimately was it a good or bad decision?

So, that's why I write about the Brown Bag Portfolio. Hopefully, Seeking Alpha will continue to publish my articles as I go along and other new investors will learn something about the process as I make my investments. We'll also be able to see how the portfolio develops and grows throughout the fifteen-year time horizon I've set and see together how it all worked out.

Okay, that rambled along for a bit longer than I intended, so let's get to the point of this particular article. This mid-month article isn't my usual wrap-up of the previous month documenting how the BBP actually did. This is more of a philosophy related screed on my rules for investing, current thoughts on what a full position means for me and a comparison of two of my largest positions: Enterprise Products Partners (EPD) and AT&T (T).

My first rule for investing is to have a concrete reason for doing so. For me, 'to better my retirement' is too nebulous. The reason for that is that it becomes too easy to falter along the way. If you've only saved $10,000 for retirement, you'll be better off than if you've saved nothing. Contrast this with a definite goal of building a portfolio that will provide $60,000 for your child's college education. Now, that's a goal that you can consistently work towards and provides you with the continuing motivation to sock away a couple hundred every month. My particular goal with the Brown Bag Portfolio is to provide enough dividend income to pay my mortgage, taxes, and insurance on my home, which I calculate to be approximately $16,800 a year.

My second rule is to have a time horizon. The shorter the horizon, the more risk you'll generally have to accept to reach your goal. Embrace that fact and plan accordingly. If you need a million dollars and you have forty years to reach that goal, you can invest rather conservatively.

My third rule is to embrace the concept of compounding interest. This is another reason why I've chosen dividend investing for the core of my portfolio. An investment paying 7% interest will double approximately every ten years. At six percent, your investment doubles every twelve years. Now, this isn't 100% true in regards to stocks because the price of the shares fluctuates over time, but use it as a general rule of thumb. If you're reinvesting your dividends, you'll purchase more or less shares each time that dividend is paid which will change your cost-basis.

This brings me to my fourth rule: Whenever possible utilize a dividend reinvestment program - DRIP. Even if you never make another out of pocket investment in additional shares, your holdings will grow over time.

Rule number five: Accept the fact that share prices fluctuate over time and that dividends are not set in stone. Dividends can be cut or eliminated (or increased... yay). Monitor your investments. You may not want to exit a position if the dividend is cut, but you'd better be aware of that fact at least.

Rule number six: Invest, don't trade. Now, I don't mean never sell a position, but try not to sell a position just because the current price on the shares has fallen. Sell if and when you believe that the underlying reason you bought those shares has changed. Or and this is a very good or, if the price has doubled or more on your original investment, I'd recommend selling enough shares to recoup your original investment and then let the rest ride. For those of you who gamble a little, this is like playing with the House's money.

Rule Seven: Do your homework before you invest. These days, there are a plethora of sources about every company available. Google it, go to the company's website and read the investor information, listen to the quarterly reports, read pro and con articles about the company. You'll find that there are almost too many opinions on just about any company and its potential. Not sure if I'm right about that? Just look up AT&T on Seeking Alpha... the consensus is almost a 50/50 split on whether or not this telecom company is a wise investment or a sucker bet. After you've absorbed all of that, make up your own mind. Stick to that decision as long as you continue to believe in the reasons that led up to that decision. If the situation changes get out and accept that decision as well. You may or may not be right, but you probably won't know for sure for several years.

Rule Eight: Don't buy all at once. For me this is an easy rule, I don't have the type of money available to buy a full position (more on what this is for me later) all at once. I'm building my positions over time. This rule has the advantage of potentially letting you buy additional shares at a lower price (if you still believe in the underlying story) and lowering your overall cost-basis. Previously, I bought in blocks of $500, last year I raised this amount to $1,000, and this year, I'm trying to purchase blocks of shares for approximately $1,500 at a time. This is to keep the commission charges down. If you're using a 0-commission site like RobinHood, then you can ignore that rule, but I'd still recommend not buying all at once.

Rule Nine: Devote the time necessary to continue your homework on your positions. For those of us who are not financial professionals, we may only be able to spend an hour or two a week keeping up on the information about each position. In that case, limit your number of holdings. I currently have seven positions and expect that, eventually, I'll have somewhere between ten and fifteen, but no more than that and honestly probably closer to ten. In 2019, my plan is to add one to two new positions and increase four of my current positions. That's the plan, but this is early January, so things may change in the future.

Rule Ten: This may be the most important rule. If you have a spouse or significant other, make sure that they are onboard with your overall goal behind your portfolio. They may or may not be involved in your day to day or month to month decisions in maintaining your portfolio, but they'd better be behind your reasons for building the portfolio in the first place. You don't want to end up in a position where that spouse or significant other looks at your portfolio as a piggybank. For the sake of transparency, let me put out there that due to my previous divorce and all the legal wrangling, my wife and I keep our finances separate. I do give her about half of what I bring home for the maintenance of our home and bills and a larger percentage of her income goes to our family expenses. However, she's very aware of the Brown Bag Portfolio and what my overall goal is, and is supportive of my efforts. She's also one of my followers, so she knows exactly what's happening on a monthly basis, let alone the fact that I talk about it (probably a little too much) with her frequently. Hi honey!

Okay, those are my ten rules. There probably are a few others that I have, but I can't think of them off the top of my head and you probably get the point anyways. In my last article, I mentioned that none of my positions was "Full" and that I would be discussing what a full position means to me later. Now's the time.

When we listen to experts discuss their portfolios or even some amateurs like me, you'll often hear that they have a full position in this or that company, but what does that really mean? For some people, a full position is a certain percentage of their portfolio, say 5%. For others, they may mean a certain dollar amount, say $10,000. I have a different take on the whole position thing.

For me, a full position is one where the dividends I'm earning from that position is 1/x of my overall dividend goal. So, If I'm going to hold fifteen positions, then each position needs to earn $1,120 a year in dividends (1,120 x 15 =16,800). However, this isn't as clear-cut as it may seem at first. First of all, I have several caveats to that broad rule of thumb:

1. I have greater faith in some companies than I do in others. So, for those "favorites", I'm comfortable having a larger position than others. For now, I want those favorites to provide 10% of my dividend goal ($1,680). If I decide to hold at ten positions, then I'll be comfortable with my favorites providing 15% of the dividend income each. For now, I'm keeping to the fifteen positions with my favorites occupying a 10% position of the dividend income.

2. Due to compounding and the fact that I have an approximate time horizon of 15 years, I expect that most of my positions should approximately double during that time horizon. With this in mind, then a full position is approximately half the end point I wish to reach or $840 in dividend income. Now, my favorite position (for those who are interested) is Enterprise Products Partners, which is currently paying a 7.14% yield. If all goes to plan, then Enterprise should double in approximately 10 years. I'm currently earning a little over $400 a year in dividends (distributions since Enterprise is a master limited partnership, but the effect is the same), so I will need to double my share count within the next five years. Just to be on the safe side, I'm going to say that it may take 12 years to double, so I've got three more years to increase my share count by 265 additional shares.

3. Even with compounding, some of my investments won't double during my time horizon. As long as the story still holds for those investments, I will have to continue purchasing X number of shares throughout the life of the portfolio.

Now, with all this said, there are a few other factors to take into account. The share price fluctuates. That should be a given to anyone who has spent more than a minute invested in the market, but let me just mention it again. When using DRIP, you may gain more or less shares each time the dividend is paid. You can't say that I'm earning a 7% yield now and expect to always earn a 7% yield, even if the underlying equity doesn't cut its dividend.

Also, I want to be cognizant of not becoming overly invested in any one particular stock. EPD is currently 25% of my portfolio; it was 40% when I started writing about the Brown Bag Portfolio. It's been as low as 20%. Although I'm comfortable with it being overweight in my current portfolio, I don't want it to always be. For the short term (the next two years), I don't mind it creeping to 30%, but if it grows much beyond that, I'll stop buying until it comes back down to the 20-25% range. Once it's at a full (half position), then I will stop actively purchasing shares and just let the DRIP work its magic.

To be honest, there's a danger in approaching things this way. If Enterprise Products Partners stock sees a precipitous decline, it will have a disproportionate effect on my entire portfolio. However, since I'm investing for the long term, this effect will lesson over time. Only if I needed the money or wanted to close out my position shortly, would I feel this effect. Given enough time and investment into other holdings any negatives will eventually be overcome (either by the growth of other investments or a reversal in the downward spiral of Enterprise's stock).

Now, I could attempt to lessen this issue by growing each position by the same percentage each year, or I could grow each position I have until they reached the same place as Enterprise before adding to my original position in Enterprise. I'm choosing not to do that in order to limit my commission charges and more rapidly grow one or two positions to the point where I can effectively leave them on autopilot and concentrate upon other areas. This may or may not be a good idea, so I'll periodically look back on how things are working and report my results and perhaps tweak my ideas.

Those are my current thoughts on position. I'm curious to hear back from any of my readers who may or may not agree with my thinking. As always, this is a work in progress.

Now, I've already written a bit longer than I expected to when I sat down this morning, but if you'll indulge me a bit further, I'd like to examine two of my largest positions and explain my differing thoughts on both. The first is Enterprise Products Partners, which I've already introduced. For those readers who may not be aware, Enterprise is a master limited partnership. That fact alone isn't relevant to my discussion here, but for those readers who might be interested, EPD issues a K-1 each year, and this may have tax implications depending upon which type of account the shares (or units for MLP's) are kept. Enterprise owns more than 50,000 miles of natural gas, NGL, crude oil, refined products, and petrochemical pipelines. It is also heavily involved in the storage, processing, and fractionalization of those products and operates an NGL import/export terminal in Houston. For a more detailed look at EPD and its business model, please see my article: Why Enterprise Products Partners is my favorite holding.

As I stated earlier, EPD is currently my largest position (about 25% of my overall portfolio), and for approximately half the time I've owned it, it's been below my cost-basis. Below is the three-year (weekly) chart for EPD. Its current yield is 7.14%.

3 year chart EPD

Normally, this would cause me some concern. It doesn't because I've been reading/listening to the quarterly reports and researching this company from before the time I purchased my first share. Through this, I've come to believe that Enterprise Partners is one of the best run and managed companies in the mid-stream space, if not the best. Management is experienced and conservative and doesn't get carried away with their success. In fact, throughout the past year, management has focused on strengthening its balance sheet. In 2016, the average MLP had a leverage ratio of 6.5, but EPD's never rose above 4.4. Keep in mind that anything below 5 is generally considered safe in this industry. Currently, Enterprise has reduced that level to 3.6 and should hit its goal of 3.5 soon.

My mistake, if it's that at all, is that I purchased the majority of my shares at times when the share price was too high. I should have waited for it to come down and made my purchases then. As you can see from the chart, over the past three years, it's hit $24 or below on multiple occasions, then most recently just a few weeks ago.

Unfortunately, each time EPD has seen its share price fall over the past three years, I've not been in a position to purchase more. One of my first goals for 2019 is to build $2,000 for a purchase in EPD when/if it drops below $25. Hopefully, I'll be ready the next time.

Now, AT&T is another animal altogether. While it currently pays a yield of 7.25% management has not reduced its debt level. In fact, with the recent acquisition of Time Warner, AT&T is now among the most highly indebted companies on earth. Thankfully, management has announced plans to reduce its debt to adjusted EBITDA ratio to the 2.5 range by the end of 2019. However, I personally need to see that play out before I purchase more shares. For comparison's sake, I've included AT&T's three-year chart below:

3 year chart AT&T

While AT&T is currently my fourth largest holding, until I see management successfully reduce its debt, I'm just not comfortable buying more shares, even with the abnormally large yield it's currently sporting. Management does not have a stellar record with its purchases, and the Time Warner merger has yet to prove itself. It may turn out to be a genius move, but I'm going to have to observe the results for a few more quarters before I give them any more of my dollars. I am willing however to wait and see how all of this plays out throughout 2019.

The difference in these two companies to me as an investor is much like the difference between two of my children (nope... not naming names). I've got one who talks a good game but has failed so far to deliver on the promises. While I have another that has quietly set about working their plan and delivering consistent results regardless of outside conditions. If I'm going to give my money to one, it's going to be on the quiet kid who delivers rather than on the big talker.

Disclosure: I am/we are long D, IRM, APLE, EPD, EPR, T, MAIN, OXLC. 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.