Trading Around A Core: The Big Picture

Includes: BMS, VFC
by: Parson

On September 4, 2012, my first Seeking Alpha article was published. The purpose of the article was to briefly describe an approach to Dividend Growth Investing [DGI] described as Trading Around a Core. Some anecdotal real life results from using the approach in my IRA were then presented and compared to a hypothetical Buy and Monitor approach, as well as the S&P500 benchmark. That article can be read here. I intend to update the information at the year's end, and report each core stock trade that takes place from September 1 to December 31 in all five accounts. It seems to me that, taken in isolation, the trades in the IRA are divorced from the big picture. The reader will not understand why trades in the IRA balanced the consolidated five account portfolio unless the reader knows the composition of the entire portfolio. Hence this article.

The method, even if it proves to be beneficial in practice, is not suitable for everyone. If you do not have a substantial amount of money to invest, the transaction costs may negate the benefit. If you are trading in a taxable account, taxes may negate the benefit. If you do not have the time to monitor the portfolio on a daily or at least weekly basis, this method is not for you. There is a real possibility that the method may prove to provide no benefit whatever and it is unsuitable for everyone. In greater detail than in the first article, the method calls for the following steps for the reasons discussed.

1. Sell all mutual funds and Exchange Traded Funds. Fund Managers are not managers in some respects. They are functionaries bound by the prospectus of the fund. When the stock market performs poorly, the investing herd heads for the exit, and the "manager" must sell to meet redemption demands even though she may know that this is the time to start buying. Conversely, when the stock market is perceived to be attractive and money comes rolling in, she must buy regardless of valuation because the prospectus demands it. It is not my aim to demean fund managers. I presume them to be honest and diligent people. It is my aim to point out that herd behavior may force fund managers to buy high and sell low. You are free from the requirements of a prospectus to make better decisions than a fund manager if you choose to be. Your expense ratio may be considerably lower than any fund could dream of. I'm not suggesting that you sell all funds tomorrow. Wait for favorable prices and sell in increments, if you decide to sell at all.

2. Invest in stocks that have a long history of increasing revenues, increasing earnings, and increasing dividends. All U.S. traded stocks with at least a five year history of annually increasing dividends are on the Champions, Contenders, and Challengers spreadsheet [CCC]. Of the thousands of public companies, only a few hundred have adopted the "true religion" of paying reliably increasing dividends. Fewer than that have the ability to do so for years into the future. Do your own due diligence and draw up a wish list that is reasonably diversified by sector, at the very least. Also consider diversifying by market capitalization. There are smaller but well known companies on the list with market capitalization below $10 billion. How long your wish list should be depends on how many stocks will be purchased. This in turn depends on how many dollars you have to invest, how much diversification is needed to make you comfortable, and what allocation scheme you choose. Opinions vary widely about how many stocks are needed for a diversified portfolio. Jim Cramer says five is the minimum. As I understand Modern Portfolio Theory, you should own a portion of every stock issue in the known universe, as well as every other known asset class. I only claim that the correct answer lies somewhere between the two.

3. Determine a dollar allocation scheme that meets your needs. I chose to have the smallest position no less than half the largest position. There is nothing magic about this ratio, it just met my needs because I had a few fairly large positions dating back as far as 1993 that had large unrealized capital gains, especially Johnson & Johnson (NYSE:JNJ) and Chevron Corp. (NYSE:CVX). Selling any amount of these shares would have generated tax liabilities disproportionate to the benefit, and the stocks were on the [CCC] list. They also met the requirements of step 2. I chose to use allocation amounts of $50K, 75K, and 100K because 100K was about 10% of the portfolio value at the time. The $75K allocation provided a place to put JNJ. The $50K allocation provided a place to put CVX. Again, there is nothing magic about having three allocation amounts in increments of $25K. You may choose to have five different amounts or only one, depending on your circumstances.

4. During the accumulation phase, exercise a great deal of patience, buy in reasonable increments (no more than 20 to 25% of the desired allocation, for example), purchase when the Relative Strength Index [RSI] is low and the Moving Average Convergence Divergence [MACD] is below zero, but starting to bottom, as indicated by the histogram. If you are not familiar with these technical indicators, has an excellent chartschool with informative articles on dozens of technical indicators. You may well find one (or already know of one) that works better for you. Technical indicators are not crystal balls. If "accounting irregularities", massive missteps as in the case of Knight Capital Group (NYSE:KCG), or tsunamis strike, no technical indicator is going to help you avoid the damage. Still, they provide a useful tool, and my philosophy is to use every appropriate tool available, or at least the ones I understand. Fundamentals tell me what stocks I want to own. Technicals tell me when to buy them.

5. More likely than not, there will be mistakes and backtracking along the way. Certainly there was in my case. Starting out, I wanted to have at least one stock in each of the major sectors, but never found a material stock I felt good about. I finally settled on Bemis Company, Inc. (NYSE:BMS), but it never seemed to move up or down much from either a price or a technical standpoint. With only about half of a $50K allocation purchased, I finally decided to build out the position below $30 per share if I could, or sell all of it above $32, if I couldn't. One or two more small purchases were made below $30, but then it shot up over $2 per share in one day in late January 2012, so I sold it all at $32.04. There were simply too many better opportunities to deploy the cash to either chase BMS or wait for it. As I write this, BMS is at $30.79, so this is an example of backtracking that, at least so far, turned out well. Then there was V.F. Corporation (NYSE:VFC) that investors shunned in January 2011 because the price of cotton was so high. But the value of raw cotton in a T-shirt is like the value of wheat in a loaf of bread; insignificant compared to the other costs involved. After checking out the fundamentals, I bought 100 shares on 1/13/11 at $82.12, but the price rose to $97.19 by 2/22/11, so I took the money and ran. Huge mistake. VFC is presently selling for $152.41 and trending up. The point is, don't be too afraid of changing your mind. Either changing or staying the course may be the wrong decision, but neither BMS or VFC has harmed me or discouraged me.

6. When the accumulation phase ends, celebrate. Then begin the maintenance and promotion phase as described in the first article. Sell when the stock is 5% over allocation and the technicals indicate selling is appropriate. Buy when the stock is 5% under allocation after checking the technicals. Due diligence is not a one time event, it is a continuing process. Again, there is nothing magic about 5%, it is more a guide than a rule. I have made some trades when a large position was only a little more than 3% over allocation, either to buy shares of a smaller position that was screaming "Buy Me!", or because the technicals of the larger position were screaming "Sell Me!" and I needed more cash in reserve. At present, there are several stocks in the portfolio that are more than 5% over target, but neither the fundamentals nor the technicals support selling. As with any other endeavor that is a blend of art and science, there is a learning curve to go through. This is maintenance.

7. Promotion occurs when sufficient dividends and capital gains accumulate to take a stock to a higher allocation. The big question then is which stock to promote. I prefer to wait until a stock drops to the point where I would have added some shares to bring it back to its previous allocation, then pile on sufficiently to bring it into the lower range of the higher allocation. Example: fictional stock [XYZ] is presently allocated at $50K. Over $25K in cash is on hand. The fundamentals look good. XYZ drops to $47K, and the technicals look good. The fundamentals still look good. This is not a repetitious sentence. The fundamentals looked good before the drop in price, but attempt to determine the reason for the price drop. If you are convinced it is just market noise, buy enough shares to bring XYZ to $71,250, the lower end of the next higher allocation. If you are wrong and the stock price hasn't bottomed, there is room to buy more at a lower price. If you are right, and the stock price has bottomed, XYZ will probably increase to $75K with no further action required.

8. As an alternative to Promotion, you might choose Initiation, meaning starting an entirely new position in a different stock. Better yet, you may chose to start a position in two different stocks, let them compete to see which is the "winner" then drop the "loser". Having never done this successfully (see VFC and BMS in step 5 above), it will be a learning experience for me if and when the time comes. At the moment, I'm still internally debating how to define "winner" and "loser." I have never successfully added an entirely new stock to my core; I have only dropped a few. The method is still a work in process.

In addition to JNJ and CVX, the core portfolio contains shares of the following companies. The number after each symbol is the approximate market capitalization of the company.

Abbott Laboratories (NYSE:ABT) $105b

Kinder-Morgan Energy Partners L.P. (NYSE:KMP) $28b

Proctor & Gamble Co. (NYSE:PG) $189b

AT&T Inc. new (NYSE:T) $215b

Sysco Corp. (NYSE:SYY) $18b

Kimberly-Clark Corporation (NYSE:KMB) $33b

Pepsico, Inc. (NYSE:PEP) $112b

McDonald's Corp. (NYSE:MCD) $92b

Health Care REIT, Inc. (HCN) $13b

Consolidated Edison Inc. (NYSE:ED) $18b

Emerson Electric Co. (NYSE:EMR) $36b

The Toronto-Dominion Bank (NYSE:TD) $76b

The Clorox Company (NYSE:CLX) $9b

JNJ and CVX have market caps of $187b and $224b, respectively.

Without further ado, here is a table for the core portfolio.


Data as of Market Close, August 31, 2012


Dividend Dividend Target Holding
Stock Shares Price / Share Amount $ Value $ Value $
KMP 1230 82.77 4.92 6,051.60 100K 101,807.10
PG 1515 67.19 2.248 3,405.72 101,792.85
ABT 1510 65.54 2.04 3,080.40 98,965.40
T 2660 36.64 1.76 4,681.60 97,462.40
JNJ 1140 67.43 2.44 2,781.60 80K 76,870.20
SYY 2480 30.30 1.08 2,678.40 75K 75,144.00
KMB 897.2933 83.60 2.96 2,655.99 75,013.72
PEP 1030 72.43 2.15 2,214.50 74,602.90
MCD 665 89.49 2.80 1,862.00 60K 59,510.85
HCN 1010 58.44 2.96 2,989.60 59,024.40
ED 970 60.62 2.42 2,347.40 58,801.40
EMR 1150 50.72 1.60 1,840.00 58,328.00
TD* 645 81.88 2.87 1,850.20 50K 52,812.60
CVX 470 112.16 3.60 1,692.00 52,715.20
CLX 700 72.75 2.56 1,792.00 50,925.00
CASH 4,654.65
TOTAL 41,923.01 1,095K 1,098,430.67

* TD Dividends are in Canadian Dollars, the dividend amount depends on the currency exchange rate.

OK, I can already hear the mutterings of discontent and disillusionment. There are five target allocations instead of three. There is an explanation.

From August 31, 2011 until August 13, 2012, there were only three target allocations as discussed. On August 13, 2012, it occurred to me that there would be some benefits to narrowing the gap between the three target allocations, that is, modify the allocation amounts to $60K, $80K, and $100K over time. This met my needs for several reasons.

First, I had run out of JNJ shares that I was willing to sell. The legacy shares from 1993 reside in my wife's separate account and probably will until I have shuffled off this mortal coil. I had made the following JNJ trades in my IRA during the last year.

9/22/11 Buy 48 shares @ $61.98

10/28/11 Sell 48 shares @ $65.79

6/11/12 Buy 75 shares @ $62.63

6/22/12 Sell 75 shares @ $66.83

On August 30, 2012, I bought 50 shares of JNJ in our joint account after JNJ had dropped to $67.04 from over $69. In short, I needed some JNJ that I could justify selling in the low $70s outside my wife's account so that I could continue taking advantage of the short term price swings, so the allocation target was raised to $80K.

Second, it is easier to make a jump of $5K or $10K than to make a jump of $25K. That is, $5K or $10K in dividends and realized capital gains will accumulate a lot faster than $25K.

Third, raising seven stocks by $10K and four stocks by $5K requires about $90K. The same amount of cash would only promote three or four stocks using $25K gaps instead of eleven.

Fourth, it avoids the big question of which stock to promote mentioned in step 7 above.

Fifth, it makes the mental math of calculating 5% easier. I'm a little lazy.

This is neither promotion nor initiation as described above. Maybe it should be called tiding, as in "a rising tide lifts all boats" (except the top boats that are in dry dock.) Maybe it should be called Social Promotion because the lesser students benefit while the top students don't. Or Bracket Creep. All suggestions will be gladly considered. Anyway, the portfolio was in transition mode for the last 18 days of the one year period discussed in the first article, but I didn't want to muddy the waters in an article that was growing lengthy.

Whatever it is called, it reinforces the notion that the portfolio parameters should be revised if the new parameters better suit the investor's needs. My aim is to complete the transition by August 2013, and there will once again be three target allocations.

Three things about the table need explanation. There are fractional shares of KMB because my wife's IRA is a small account and the transaction costs of trading in it would hurt the performance of the account. So it is on a Dividend Reinvestment Plan [DRIP].

All the table data is taken from the brokerage statements and has not been modified to reflect any new information since August 31. In addition to buying 50 shares of JNJ, 50 shares of PG have been sold and TD has increased the dividend to 77 Canadian cents per share per quarter. At the end of August, the JNJ trade had not settled yet, so the additional 50 shares are not reflected in the table.

The cash shown is the total cash in all five brokerage accounts only. No outside bank accounts, Money Market accounts, savings accounts, or cash equivalents are included. I believe I have devised a method of balancing inflows and outflows of cash from all five accounts so that the five accounts can be considered a "dead pool" and an undistorted apples-to-apples comparison can be made at the end of the year. Simply put, any cash that appears in the accounts not attributable to the core (dividends from non-core stocks or proceeds from selling non-core stocks at settlement date) will immediately be transferred to the linked bank account.

Disclosure: I am long ABT, CLX, CVX, ED, EMR, HCN, JNJ, KMB, KMP, MCD, PEP, PG, SYY, T, TD. 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. I have no position in (KCG), (BMS), or (VFC) and no plans to initiate any positions within the next 72 hours. The reader is strongly cautioned that the author is experimenting with an unproven method that is not in keeping with conventional wisdom. Employ the method at your own risk.