Investing For Credit Quality

by: Investment Pancake

Some of the riskier stocks in my portfolio have risen in price since I bought them, giving me a chance to de-risk at a profit.

Companies with lower credit ratings, lower dividend yields and high P/E ratios seem riskier to me than those with the opposite characteristics.

Fortunately, the market disagrees with my assessment.

Every dollar of my portfolio is invested in either index funds or individual stocks that have one common characteristic: investment grade credit ratings. Why? Because I simply don't invest in companies that aren't at least as responsible with borrowing money as I am. At the moment, however, there are five companies in my portfolio with investment grade credit ratings that hover right above junk status: Omega Healthcare Investors (OHI), Sherwin-Williams (SHW), Triton International (TRTN), Newell Brands (NWL) and EPR Properties (EPR). Together, these stocks comprise a roughly 2.8% share of my total portfolio - a far higher allocation than I feel comfortable with.

How did this come to pass? The good news is this: the best way possible. These may be the riskiest portions of my portfolio, but most besides EPR have performed exceptionally well since I bought them. Sometimes, higher risk does actually mean higher potential rewards... but I'm not one to push my luck. Part of my investment approach is to take lucky windfalls when I can get them and invest the proceeds someplace that offers returns less tied to dumb luck. And if I can do that without paying income taxes, so much the better.

SHW is one of the shares I hold largely in ROTH IRAs. This is a position that I can entirely eliminate without triggering a dime of tax. And though it is a fine company with fine products, I won't miss its elevated debt levels, high P/E ratio and sub-1% yield. Not that I'm complaining about the tax-free gain of nearly $145 per share over the last 5 years.

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Some SHW shares, however, are in a taxable account, and by selling them, I am going to trigger expensive capital gains taxes. Thankfully, idiocy comes to the rescue! You see, I also happen to own shares of the ALPS Alerian MLP ETF (AMLP) and shares of the iShares International Select Dividend ETF (IDV) - some of which are currently under water. AMLP and IDV produce hefty amounts of income, which is the only reason I ever bought them to begin with.

Here is a scenario that accurately describes the act of buying a fund or a stock simply for the yield. Imagine Mr. Market tossing pennies onto the ground but silver dollars into a smoking black pit that is inhabited by spitting cobras, poisonous spiders, rabid pit bull dogs and creepy-looking clowns. Oh sure, you can go for the safe, easy-to-collect pennies, but come on! Why not dive into the pit with rosy-cheeked, greedy delight and try to get those promising-looking silver dollars?

Should it really surprise any of you that my investments in IDV and AMLP haven't delivered returns that one could describe as... shall we say... stellar?

There is a time to stick to one's guns, and then a time to just admit you screwed up and move on. Both with your life in general and with your investments in particular. I'm going to do just that.

And then comes NWL. This was a recent impulse buy in two separate ROTH IRAs (which I detailed in a blog entry last year). The gains since then are anything but spectacular, but slim as they are, I'm happy that they're tax-free at least.

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Why did I buy NWL in the first place? I honestly can't remember. Maybe it is because I use Paper Mate pens and like them. Or maybe it was because I like the dividend yield and the company's "expedited" turnaround plan to shed lower-margin brands and pay down debt. My reasoning must not have been particularly good (since I can't remember what it was), but here is one thing that I will always remember: I am not competent at evaluating "turnaround situation" stocks. If I thought I could when I bought NWL, I remember now that I have never been good at that and should stick with what I am good at instead. I'm out.

Last of all comes OHI. I own shares across taxable and non-taxable accounts. Some of my share lots are up, some are flat, but I'm content to shed what I can without triggering a tax bill. Why? The answer, in a nutshell, is because this company is not only standing in a tumultuous industry, but it is doing so without the benefit of a bulletproof balance sheet. Today, I'm unloading a modest quantity of OHI shares that I hold in a ROTH IRA, which I bought just around this time last year. The timing was about as fortuitous as I've ever gotten.

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Having shed two companies entirely from my portfolio, trimmed exposure on one and dumped a "smart beta" ETF (that anyone uses the term "smart beta" ought to tell you everything you need to know about why not to invest in such things), the total percentage of "one notch above junk" companies in this portfolio is now 1.8% rather than 2.8%. That's a bit closer to my SWAN ("sleep well at night") levels.

Where will I put the proceeds? Obviously, it all goes into the highest-quality blue-chip stocks I can find that have the most promising dividend growth, rising shareholder equity, steadily growing earnings, high moats around the business and brilliant prospects for generous dividend increases in the future.

BlackRock (BLK) shares fit the bill for me. The stock has tanked recently, thanks to a falling stock market (which translates to falling assets under management) and competition from other low-cost ETF sponsors like Vanguard Group.

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But here is the sort of credit rating that helps me sleep well at night:

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Plus, I like to see steadily rising shareholder equity along with a steadily declining share count:

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Goldman Sachs, Inc. (GS) is another area that looks reasonably priced to me. The shares trade at a P/E ratio of 8 and are now several dollars below the $212 book value per share mark. Spending $197 for $212 worth of capital in a world-class business is exactly the sort of investment I am delighted to make.

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And here is the type of borrowing behavior I like to see:

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Last of all comes Raytheon (RTN). The stock is down, the P/E ratio reasonable, and last I checked, people all around the globe are either blowing one another to smithereens or trying to defend themselves against being blown to smithereens. Defense contracting is a business I don't see diminishing in importance anytime soon - although I expect that the budgetary stalemate brought on by the extreme ineptitude of the entire US elected branches of government will, no doubt, weigh on RTN shares and earnings.

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And here is the type of credit rating I prefer my companies to strive for:

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At the end of the day, I've reduced the riskiest areas of my portfolio, increased exposure to what I see as higher-quality businesses, and managed to avoid triggering capital gains taxes in the process. This sums up my basic strategy for today: when I have a run-up in the share price of riskier stocks in my portfolio, I look for opportunities to cash in on, and then use those gains to buy myself higher-quality businesses without paying a higher tax bill. If I'm lucky, I can also preserve my portfolio income in the process, but at the end of the day, I'd rather settle for safe pennies than climb into the dark with scary clowns and creepy spiders, hoping to find silver dollars.

After today's capital reallocation, the composition and performance of the portfolio is thus:

The portfolio continues to strongly outperform the Vanguard Total World Stock ETF (VT) by a healthy margin - which is the only reason I waste a moment of my time actively managing my portfolio. Part of the reason why has a lot to do with the chart you see below of how I allocate assets between higher-risk and lower-risk investments.

In a raging bull market, the best I can ever hope to do is to keep pace with the overall market, but during bear markets, higher credit ratings, lower P/E ratios and a steady wind of dividends blowing in off the water make all the difference in the world when it comes to preserving capital a bit better than average. When the global stock market returns to bull market status, you can rest assured that the 9.07% annual alpha this portfolio has enjoyed this year will almost certainly fall back down towards a level more like what I've gotten used to over the last 15 years (which is about 4.59%).

Disclosure: I am/we are long BLK, RTN, GS. 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: I am long all positions shown in the attached spreadsheet. Nothing in this article can be relied upon for any reason other than entertainment. I am not an investment or a tax advisor, and nothing in this article can be construed as either investment or tax advice. The article reflects my own personal thinking about my own personal portfolio, which has nothing to do with what you or anyone else should or should not do.