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KenBobOH's Investment Plan

Introduction

The investment goal is to provide income during retirement.  With the wave of baby boomers nearing retirement, income assets should have increased demand, while capital gains will be tricky due to increased asset ownership.  Assets that produce income should hold up the best.  Early accumulation of income vehicles is prudent.

Equity income is variable income, not fixed income. The investor must accept that is the nature of dividends. Dividends can grow to match or exceed inflation rate; however, dividends can decrease when a company, industry, or economy runs into trouble. Overall, a well-selected portfolio of dividend stocks will do better in the long run than fixed income.

Overpaying for a stock should be avoided, since asset sales will be required during retirement.  The problem is that all the valuation techniques have too much uncertainty to be useful.  Instead, I try to get the best income value (good yield with low risk) for my money.

Target Portfolio Development

My wife and I have several accounts.  I have a target portfolio which each account is constantly striving to match.

The portfolio consists of 25 to 50 stocks to provide diversification.  Stocks are selected that have good quality, financial sustainability, an adequate dividend, and dividend growth greater than inflation.

The quality of a company is determined by the credit rating and a qualitative judgment of the strength of the company.  An investment grade credit rating eliminates known, low quality stocks.  The minimum credit rating is BBB-; however, BBB is preferred, since the market reacts very badly to a downgrade from investment grade.  Credit rating is especially important for industries with high debt load (such as utilities and REITs), since the ability to raise money is dependent upon the credit rating.  Avoid complicated situations, such as LLCs, foreign stocks, resource extraction companies, and master limited partnerships and their general partners.

Further screens are an operating cash flow payout ratio of less than one and a 5 year dividend growth rate higher than the 5 year inflation rate.

I measure income value using what I call Adjusted Yield:

Adjusted Yield = Dividend/(Price + Debt/Share + Preferred/Share)

This is essentially the ratio of dividends to total capital.  Using this measure, I can account for the role debt plays in providing the dividend.

Holdings are weighted by adjusted yield to reflect value.  The weighting is constantly changing with the market, so the weighting will increase with price decreases.

Portfolio Management

Buy the underweight stock in the portfolio that has the highest adjusted yield.

The discipline for selling stocks is harder than buying.  Trading generates fees and taxes on capital gains.  Stocks should be sold to avoid capital loss or impairment of the income stream.  The following are my sell rules:

  • Sell immediately if there has been fraud.  Fraud isn't just bad news. Fraud means there is something rotten in a company and you have no idea how deep it goes.
  • Sell if management is not acting in the long-term interest of the company.
  • Sell the stock if the company fundamentals have seriously deteriorated.
    • Dividend has been eliminated
    • The operating cash flow is negative
    • Credit Rating has been reduced below BBB-

For spinoffs, the parent company will generally be kept while the spinoff will be sold, since assets are spun-off for a reason. For acquisitions, small acquisitions are normally acceptable; however, major acquisitions will generally result in a sale, since major acquisitions are frequently failures.  A company that is acquired will generally be sold.

Trimming a stock portfolio is a risk management tool to reduce the risk of capital and income loss. A stock will be trimmed if the business fundamentals weaken. Weakening business fundamentals should be evaluated to determine whether they are severe enough and permanent enough to justify selling the stock.

  • The dividend growth rate is less than the inflation rate
  • The payout ratio exceeds 1
  • The credit rating has been reduced

Rebalancing should not be used just to maintain the portfolio weighting, since indiscriminate rebalancing can reduce income.  Rebalancing can be used to increase income by selling overweight stocks, which have seen dividend yield decrease with a valuation increase, and buying higher dividend, underweight stocks.  The problem is that these transactions will be taxed for taxable accounts.  By assuming that part of the proceeds of the sale is used for taxes and income is maintained, the minimum required dividend yield for the new stock can be determined.

New Yield = Old Yield/(1 - Tax Rate)