Recently, there has been a spike in volatility and many in the market are on edge about the possibility of a future recession. At High Dividend Opportunities, we receive numerous questions both in our public articles and in the HDO chatroom.
Downswings can frequently be a cause of stress, fear, and doubt. It is easy to have confidence in your investment system when you see green in your account more often than not. When you start seeing red across nearly every holding, that little nagging voice sneaks in- "Am I invested in the right companies? Did I make a mistake? Should I sell?"
Anyone who has invested for any length of time has asked themselves these questions. It is only natural. Fear and doubt can be far more dangerous to a portfolio than any recession.
Fear can cause you to sell investments at a loss when the loss is temporary. Then when the share price starts bouncing back, you might buy a "dead cat bounce", only to suffer even larger losses when you sell again. Or, attempting to avoid buying a short bounce, you might wait too long and buy back the same company at a price higher than what you sold it for. At some point, we have all probably made the mistake of selling out of fear, and unless you are incredibly lucky, it does not work well.
Data by YCharts
Consider the recent pullback in December. The general market dropped 15% in less than a month. When do you sell? At a 10% loss? 15% loss? If 10%, are you then going to buy back just a week later at essentially the same prices you sold at? That just creates excess costs and potential tax events. If your magic line is 15%, then you would have sold everything right at the bottom of the market! At the time, some thought we were headed into a full bear market, falsely believing that would have caused you to miss out on a great start to 2019.
The only real way to profit from market timing would have been to sell very early in December and buy back in at the end of December or early January. A move that is very easy to make looking at historical charts, but requires extraordinary luck to pull off in real time.
When you consider the uncertainty, transaction costs, tax consequences and the potential for mistaking a very temporary dip for a recession, moving in and out of the market is not a practical option for retail investors.
At HDO, we have a system designed primarily to provide a high level of current income while preserving capital. We all love capital appreciation, but we also recognize that in bear markets prices will go down for virtually all investments. Since we have confidence in our system, we have the courage to hold through downswings, secure in the knowledge that our income stream will continue and the capital gains will come when the market rebounds.
We have faced many skeptics on Seeking Alpha, who are quick to point out our individual misses. Misses happen, and when you are focused on high-yield investments, occasionally you will step on a landmine. While they look horrible on the individual investment level, our diversification and selection help us produce not only market-beating returns but a portfolio that has a high level of cash flow.
Someday, our portfolio is going to have a 40%+ drawdown. So will everybody else's portfolio. It is our confidence in our system and the much more stable stream of cash flow that will help us quell our natural fear response- which would lead us to make emotionally charged decisions.
Backtesting is a method of looking at how a particular portfolio would have performed over a certain period. Portfoliovisualizer.com provides a convenient tool to test portfolios over a range of dates and compare multiple portfolios to each other, and/or to an index.
Today, we are going to backtest the HDO Model Portfolio. This is a portfolio of our recommendations in specific equities as well as CEFs and ETFs. It is a bit of a challenge since some of our current investments did not exist, so we cannot test the entire portfolio. To ensure we had enough investments to have under 3% allocation in each, we included several tickers that we have sold in recent years. (Yes, we did include CBL Properties (CBL) and other picks that performed very poorly during the recession, even though it is no longer in our portfolio.)
Another weakness is that the portfolio visualizer assumes that 100% of the money is invested on a specific date. At HDO, our portfolio is built by taking advantage of opportunities and dips that sometimes only last a very short period. Blindly buying the entire portfolio in one day is not recommended and leads to lower results. In this case, it led to an initial yield of 7.3%. Building the portfolio in 2005 and 2006 would have led to higher initial yields on capital.
For comparison, we will use the list of "Dividend Aristocrats", as published by Eddy Elfenbein in February of 2007. Companies that are now defunct were excluded. Investing in dividend aristocrats is often seen as a "safer" investment method and is popular for its focus on cash-flow.
Additionally, we include SPDR S&P 500 Trust (SPY) since it tracks the broader market. Let's see how the HDO Model Portfolio measures up.
The dates are from April 2007 to December 2011.
- Portfolio 1: HDO Model Portfolio
- Portfolio 2: Dividend Aristocrats
- Portfolio 3: SPY
First, let's look at performance without reinvesting dividends.
As we would expect from three well-diversified portfolios, their performance through the recession was fairly similar. They all ended with 1% of each other. The HDO portfolio was the most volatile, with a drawdown of just under 57%, but in the end, all of the portfolios survived.
So how does one stomach going from having $500,000 to under $250,000? For most people, that is a house, a car, and a vacation. It is little comfort that everyone else experienced roughly the same decline.
The key for us at "High Dividend Opportunities", is we are income-driven. We do not focus on getting large unrealized gains, our number one focus is on high-current income.
When it comes to income, High Dividend Opportunities crushes the other portfolios. Did it experience some cuts? Yes. Perhaps surprising to some, the reduction was substantially smaller than the Dividend Aristocrat portfolio.
While the "High Dividend Opportunities ('HDO') portfolio had the sharpest drop in price, the income levels remained much higher and had a much smaller reduction. While it is disappointing to go from $32,825/year in income to $27,436/year, the HDO portfolio continued to produce meaningful cash-flow.
Remember, the balance of the HDO portfolio was only $1,000 less than the Dividend Aristocrat portfolio. Is it worth have a balance that is $1,000 after 4-years for an extra $10,000-$18,000 in annual cash flow?
Cash flow provides investors options. At High Dividend Opportunities, we have investors of all ages and financial situations. That means some are still accumulating and do not need cash. Others rely on their dividends to supplement their retirement/social security. For those who are still accumulating, a recession offers an opportunity for an HDO style portfolio to outperform even more dramatically.
Due to having much larger cash-flow, when reinvesting dividends, the HDO portfolio is buying substantially more shares during the heart of the recession. We are all familiar with the mantra "buy low, sell high", but how do you buy when your investments are crashing without injecting new cash?
A portfolio designed to produce high levels of cash flow is going to be super-charged by being able to significantly invest at the bottom of a recession. As a result, post-recession the HDO portfolio substantially outperforms and instead of a balance that is $1,000 less, the HDO portfolio is over $123,000 higher without the addition of outside funds. It is the ability of the portfolio to organically invest, especially at the bottom of the market, that makes high-yield investing outperform.
Some Investors Can't Afford To DRIP
Reinvesting dividends will always outperform cashing dividends out. If an investor is in accumulation mode, we have shown how reinvesting their dividends will cause a high-yield strategy to outperform.
However, many of our members at High Dividend Opportunities have to take Required Minimum Distributions or RMDs. Others rely on income from their portfolio to fund their lifestyles.
For those investors, they have to take cash out of their investment accounts. One of the huge benefits of a high-yield strategy for them is that they can consistently draw cash out of their account, without being forced to sell shares at what might be a bad time.
We have seen how our portfolio performs through a recession, but let us look at the long-term view. We will assume that the investor wants to withdraw $30,000 per year in quarterly installments of $7,500, or roughly 6% of the original $500,000 investment. Since the investor needs cash-flow, they have to pull it out regardless of whether or not there is a recession. Any dividends that are not withdrawn will be reinvested.
Additionally, we will assume the investor wants that income to grow with inflation. From April 2007 to April 2019, 12 years with $0 of new capital invested:
The HDO portfolio continues to outperform, despite a significant drawdown in 2015.
Despite taking out over $30,000/year in income for the investor to spend on whatever their needs are, the HDO portfolio exceeded the original $500k investment by 2013. The Dividend Aristocrat portfolio did not achieve that until 2017, and an investment in SPY would still be underwater to this day.
The HDO Model Portfolio is self-sustaining for investors who want, or need, to withdraw consistent income.
Buy low, sell high. We have all heard it a million times, yet when stocks are in decline, so many lose their heads and sell. We see it with individual stocks or sectors like we are seeing in mall REITs right now.
The very same authors who advised buying Washington Prime Group (WPG) when it was trading at $14/share are now advising selling below $5. When the market turns for other investments that are now being touted as "SWANS" and "blue chips", will they be equally quick to sell those at a loss?
We have seen some solid companies hit troubled waters so far in 2019. Boeing(BA) and 3M (MMM) are both American institutional companies frequently described as blue-chips. Both are down more than 20% from recent highs. Tesla Motors (TSLA), a momentum, cheered by bulls as a transformational and "disrupting" company of the future is more than 50% off their 52-week highs. There is no doubt that money can be made by investors who caught these stocks on their way up, but it is important not to count your chickens before they hatch.
At High Dividend Opportunities, we focus on investments that offer a high-current yield. Often, the reason the yield is high is that they are currently undervalued or overlooked by the market. Occasionally, this leads to large capital gains when the price corrects upward. We experienced this recently with iStar(STAR) up 25% in just 2 weeks and Safehold (SAFE) up over 50% since our recommendation in September.
Other investments like Macquarie Infrastructure Corporation (MIC) has provided us with high levels of income for years, even as the price has significant bouts of volatility and the dividends are sometimes reduced.
We don't get every call right, sometimes we have to fold as we did with CBL.
Core investments like EPR Properties (EPR) or Ares Capital (ARCC) that we seek to pick up on any dips, confident in the underlying strength of the company to continue paying a strong dividend and capital appreciation.
Our investment strategy is not complicated, we find opportunities that have
- High current yields
- Are likely to continue paying the current dividend
- Have a sustainable business plan
- Will be able to weather adverse conditions
At HDO, we are fortunate to have a diverse team of authors with different backgrounds and different specializations. This helps us to quickly identify high-yield opportunities that have great promise.
So how can we hold through a 50%+ drawdown? Because we know that our system works. The portfolio will recover, and while the portfolio is down 50%, that means we can use our excess cash to acquire new opportunities at a huge discount. What looks scary when we check our balance, is often an opportunity to acquire shares at decade long lows.
Since we prioritize cash-flow, our portfolios will have more cash and therefore more buying power at the bottom of the market than other strategies.
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Disclosure: I am/we are long ARCC, MIC, STAR, EPR, WPG. 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.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.