The Best Offense Is A Good Defense

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Includes: BLK, CMI, DUK, EDV, HDV, ICSH, ISTB, ITW, IYR, MAA, MLPA, MMM, NEAR, NNN, O, PEP, ROOF, SCHD, SDY, SHV, SHY, SJM, SMDV, SPHD, SPTM, SPY, SPYD, SRC, TLT, VDC, VER, VGLT, VIG, VNQ, VOO, VPU, VTI, VYM, WEC, WELL, WPC, XLP, XLU, ZROZ
by: Cashflow Capitalist
Summary

My investment portfolio, split between the Robinhood and Vanguard platforms, is made up of high yield, low volatility, defensive stocks.

My goal is not to beat the S&P 500 but rather to outperform it in income generation long term.

Nevertheless, I compare my portfolio's total return over the last two years to that of the S&P 500 to illustrate a lesson I've learned.

I sat down recently to review my portfolio's performance the last few years, especially compared to the S&P 500 (SPY). Now, beating the SPY is not really a goal of mine, either short-term or long-term. Rather, my five overarching goals are to build:

  1. A growing income stream, at
  2. Low risk of income disruption, with
  3. Substantial diversification,
  4. A mix of low yield / high growth and high yield / low growth stocks, and
  5. A target 10-year yield-on-cost of 7+% for core holdings and 10+% for riskier holdings.

I'm an adherent of Robert Kiyosaki's view of wealth as outlined in Rich Dad, Poor Dad. Wealth is not what is traditionally defined as "net worth," because the market value of assets is based, in part, on human psychology and animal spirits. That paper "wealth" may prove fleeting or illusory, as many tech stock shareholders found out in 2000 and real estate investors found out in 2008.

Rather, wealth is the total income thrown off by one's portfolio of assets. Those assets can be real estate, stocks, bonds, ownership of small businesses or other cash-generating ventures - anything other than one's own, direct labor. Income from assets is either passive or semi-passive. In the case of a small business, an app, a book, or a YouTube video, the initial creation requires labor (sometimes lots of it), but the income generated thereafter is at least semi-passive.

Income is liquid. It's money immediately available for other uses. Capital gains are only liquid at the time of sale. But at that point, the asset is gone and no longer available to throw off income. Income is repeatable. Capital gains are not.

Total return may be nice according to this view of wealth, but it isn't the most important performance metric. So why compare my portfolio, with unique goals, to the total return of the SPY? To show that investors don't have to choose between one or the other.

Relatively higher yield stocks, up to about double that of the SPY, can outperform over the long term. Dividend growth stocks yielding on average around 50% higher than the SPY regularly do outperform the SPY. See, for instance, the Vanguard Dividend Appreciation ETF (VIG) vs. SPY over a full market cycle:

Chart Data by YCharts

Note that VIG's full-year dividend fell 4.6% during the recession, while SPY's fell ~20%. Thus, by the income view of wealth, investors in SPY lost four times the amount of wealth during the Great Recession as investors in VIG. Notice, also, that the price of VIG fell less during the recession, meaning that it had less ground to make up afterward.

The VIG shows that, by an admittedly narrow margin, defensive, dividend growth stocks produce alpha in the long run.

In other words, the best offense is a good defense.

My own combined investment portfolios (on Robinhood and Vanguard) demonstrate that, at least in the late phase of the market cycle, one can (1) beat the SPY (2) with lower volatility and (3) an average dividend yield over three times higher (5.5% average yield). After some commentary on my portfolios' performance over the last few years, I'll finish with an explanation of how I knew (or at least believed) that we were late in the market cycle.

Robinhood Portfolio

Here's the Robinhood portfolio and some background behind the performance since June 2017:

(Author's Portfolio on the Robinhood Platform)

The first slump was the Spring of 2018, when REITs fell off a cliff due to rising interest rate fears. As you can see below, REITs fell off a cliff again in December 2018 when the Fed raised the funds rate and chairman Jerome Powell telegraphed more rate hikes in 2019.

Chart Data by YCharts

In both instances, REITs screamed "oversold." Yields of even blue-chip REITs such Mid-America Apartment Communities (MAA) and Welltower (WELL) shot up, especially in the Spring of 2018.

After the S&P 500 had fallen ~20% at the end of 2018 and global growth continued to slow in 2019, the Fed began to change its tune on rates. The probability of lower interest rates, along with a race to defensive sectors, served as a powerful tailwind to REITs.

In the Fall of 2018, long-term Treasury (e.g. the Vanguard Extended Duration Treasury ETF (EDV)) prices collapsed and yields climbed to around 3.25%, almost double the yield of the SPY. That, to me, also screamed "oversold."

During the Christmas Eve selloff, I was buying high-quality consumer staples such as PepsiCo (PEP) and J.M. Smucker (SJM), utilities such as Duke Energy (DUK) and WEC Energy (WEC), more REITs like VEREIT (VER) and Spirit Realty Capital (SRC), and a few high yield ETFs such as the iShares Core High Dividend ETF (HDV) and the Global X MLP ETF (MLPA).

Lastly, this year I've said goodbye (for now) to a handful of cyclical stocks, even high-quality ones, that I had held for a relatively short period of time. Admittedly, I sold some of them, such as Cummins (CMI) and BlackRock (BLK), too early. Had I held longer, I could have gotten out with significantly higher returns. In retrospect, perhaps I should have known that falling interest rates would boost stock returns. But hindsight is always 20/20.

Thankfully, I at least held on to dividend growth stalwarts 3M (MMM) and Illinois Tool Works (ITW). Though I would classify each as a cyclical, their track records and recession performances distinguish them as blue chips.

Notice that the portfolio has performed quite well since June 2017, especially considering that (1) it began in the summer of 2017 as only a handful of REITs and (2) for most of this time, there has been a substantial allocation to ultra-short term bond ETFs (currently 11.8% of total cost basis).

Vanguard Portfolio

Now, switching over to my Vanguard portfolio, I should mention the frequency of trades. Robinhood offers commission-free trading, and thus, in my portfolio on that platform I typically build positions through multiple small purchases. There is always the temptation to "over-trade," buying and selling too frequently, but for the most part I believe I refrain from giving in to that temptation.

Vanguard, however, is not designed for frequent transactions. It is a platform built to encourage long-term buy-and-hold investing (not to mention its own commission-free ETFs). Thus, in my Vanguard portfolio, I have only ten individual stocks plus one long-term Treasury ETF (EDV).

My transition to a more active investment strategy was sparked by examining a target date retirement fund in Vanguard and deciding that there must be a better way to invest. As interest rates approach zero, I'm not sure that traditional age-based stock-vs.-bond allocation funds will continue working as intended. After all, long-term Treasuries and stocks are both currently trading near their all-time highs, so who knows whether they will move in tandem in the opposite direction in the case of a market crash.

During the summer of 2017, I sold my position in the target date fund and exchanged that into individual stock holdings and a money market. Holding cash turned out to be quite rewarding when the Spring of 2018 rolled around and REITs dropped.

(Author's Portfolio Performance on the Vanguard Platform)

After buying mostly high-quality REITs (such as Realty Income (O), National Retail Properties (NNN), and W.P. Carey (WPC)) and a few other dividend stocks that spring, I basically ignored the Vanguard portfolio. Lo and behold, it has performed pretty darn well in the meantime. This portfolio is much more concentrated, and it would get pummeled if interest rates spiked, but this year it has proven its ultra-defensive character.

High Yield Defensive Portfolio Vs. SPY

Let's compare the performance of the Vanguard and Robinhood portfolios against each other as well as the S&P 500.

My Vanguard portfolio is up 37.9% since June 2017, which amounts to roughly 16.84% total return per year.

My Robinhood portfolio is up 23.4% since June 2017, which amounts to roughly 10.65% total return per year.

The weighted average total return of the combined portfolios over this time period (since June 2017) has been 29.86%, or 13.57% per year.

Compare this to the performance of the SPY during this same time frame: 25.72% total return, or 11.43% per year. This includes an 18+% total return in 2019 alone.

Chart Data by YCharts

And most importantly to me, the Robinhood and Vanguard portfolios have thrown off three times the amount of income as SPY over this time frame. I estimate that my annual dividend growth should average around 4-5% versus SPY's average of 6% since 1990. Of course, SPY's dividend growth during bull markets will be much faster (~10% on average), but its payout during recessions will fall more.

For instance, SPY's dividend payout fell 35% from 1969 to 1976. It fell 7% from 1977 to 1983. It fell 5% from 1990 to 1993. And it fell 12% from 1999 to 2002. I aim, of course, for continual dividend growth through recessions, but even assuming a low- to mid-single digit fall in dividend income, I'll still be doing better than the average recessionary income loss for SPY.

The Dead Giveaway of The Late Phase

What gave away that we were moving increasingly further into the late stage of the market cycle?

For a fuller discussion of my thought process on this subject, see my article "How To Beat The Market In The Late Stages Of The Cycle."

But to break it down to one word: Debt. To be more specific, corporate debt-to-GDP spiked in response to artificially low interest rates.

As the Fed raised rates, it gradually put more and more pressure on corporate income statements. Eventually, this pressure would result in corporate cost-cutting, including layoffs. This risks an uptick in unemployment, which, according to the Fed's mandate, it cannot allow.

Once corporate debt-to-GDP reached the previous peak reached in 2008-2009, I surmised that we were in the late stage of the cycle.

Moreover, federal debt-to-GDP has also risen to unsustainable and dangerous levels, well on its way back to the highs reached in the wake of World War II:

Source: Trading Economics

This, along with rising interest rates, has caused federal interest outlays to skyrocket:

Increased federal interest expenses crowds out discretionary spending and very likely hampers GDP growth. Not good for stimulating economic expansion or spurring inflation. Online articles began appearing in the Fall of 2018 talking about rising federal interest outlays. This, to me, was another signal of the arrival of the late phase. Federal interest expenses spiked in the years before the Great Recession as well:

It may be difficult to know exactly when rising interest rates will begin having these negative effects, but we can take a hint from the typical number of times the Fed raises rates before recessions hit.

From 1987 to 1989, the Fed raised the funds rate 3.75%. From 1993 to 2000, it raised the rate 3.5%. From 2004 to 2006, the Fed raised it by 4.25%.

Now, from 2015 to 2018, the Fed only raised the rate to 2.5%, but that was after a very prolonged period (six years) of near-zero rates. I, like most people, would have expected the Fed Funds rate to reach as high as 3.5-4%, but considering the nation's debt buildup, it makes sense that the Fed would not raise it further.

Conclusion

I find it useful to periodically review my portfolio's performance and analyze why it has performed the way it has. I always learn something that probably should have been obvious to me already but somehow wasn't.

This most recent portfolio review has taught me that sometimes, especially toward the end of a market cycle, the best offense is a good defense. Moreover, playing defense at the first surefire signs of the cyclical turning, rather than waiting until everyone agrees with you, is tremendously rewarding.

Disclosure: I am/we are long O, NNN, MAA, SRC, VER, ITW, MMM, EDV, NEAR, SHV, WPC, PEP, SJM, DUK, WEC. 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.