What is the whole point of the Model Portfolio project? I launched this portfolio early in November of 2015 to show - prospectively and in real time - how an investor could build and manage a portfolio by focusing on harnessing the power of compound returns to grow portfolio income. What I did was to pick out stocks with long histories of rising dividends, exceptional management, time-tested products and services and above all, very reasonable stock prices. Once in a while, whenever the stock prices for these companies gets too high, I sell and reinvest the proceeds into lower priced shares of similarly high quality companies, usually that offer higher yields. The result of selling expensive, high quality dividend payers, and buying cheaper but equally high quality dividend payers, is a very consistently rising stream of portfolio income. I also make a point of investing only in businesses that also have solid prospects of raising dividends on their own. In other words, I am looking for a two-engine machine for growing portfolio income growth - one fueled by the business earnings from my companies, the other fueled by my own efforts to take advantage of some of the wackiness one often sees when it comes to stock prices.
The idea sounds simple enough, but it's actually a fairly quirky approach. The reason why is because most investors tend to focus far more attention on trying to generate capital gains in their portfolios, which makes it difficult to sell shares that are soaring in price, and replace them with shares characterized by sagging prices. By focusing on creating a growing stream of reliable portfolio income, it becomes far easier for an investor to want to sell stocks with soaring prices, and replace them with cheaper, out of favor stocks.
Here is an example of what I am talking about. Let's look at CSX - which earlier today accounted for nearly 7% of the Model Portfolio, in terms of capital price. The reason for this high concentration in CSX was largely accidental, and has to do with the fact that the stock prices for train companies was very low last year when I bought the shares, but has since soared (particularly after Donald Trump was elected).
At this point, the price for CSX is not trading at an unreasonably high level, but it is certainly a fully valued investment in my view. That fact, combined with the fact that CSX is now a disproportionately large holding for the Model Portfolio, has compelled me to look for a cheaper stock to buy.
Which brings me to BUD, an international beer and beverage maker and distributor. The stock trades at a PE ratio of slightly under 20, based on the last 5 years of earnings. That's not a screaming bargain, but is relatively cheap compared to the normal multiple we see for beverage companies like BUD. And the stock price has more or less been flushed down the potty over the last year for reasons that may have something to do with the crash in the Euro, general weakness in the beer/wine and spirits industries, and factors intrinsic to BUD itself.
The charts show something very clearly: CSX is rallying strongly, and BUD is crashing at least as strongly. And there is no end in sight. If I were dead set on preserving the price of my capital, I'd look at these charts and steer well away of BUD, and perhaps seek to buy more CSX.
HOWEVER, I am focused on building portfolio income. BUD yields 4%, CSX about 2%. This makes it an EASY choice for me to sell about half of the CSX stock in the Model Portfolio, and to use the proceeds to purchase shares of BUD instead. The result is an immediate $250 raise in the overall income of the Model Portfolio. In addition to a 1.7% raise in the overall level of income for the Model Portfolio, we gain more diversification across companies as well as industries, and we gain more international exposure (like all train lines, CSX only serves and American Market. BUD sells products across the entire planet). For these reasons, I feel that this adjustment not only will increase the portfolio income, but also make that income a bit safer in the process. Far from viewing BUD's crashing stock price as a source of anxiety, I'm rubbing my hands together. I hope the price for BUD stock continues to crash AFTER I buy the shares - I'll be looking to reinvest dividends soon, and would welcome the chance to buy even more shares of BUD at lower prices than what I will pay today.
The composition of the Model Portfolio is now thus:
The income of the Model Portfolio has grown over 52% since I launched the project early last November. It's very strong income growth, to say the least, and even if I were to just sit on my hands from this point forward, all of that income surge over the past year will compound dramatically in the years to come. But I will not be sitting on my hands. I never do. Not for long, at least.
One last word on capital gains. As it happens, buying cheap stocks and selling expensive stocks actually DOES tend to lead to higher capital gains. It is not difficult to understand how and why this would happen. Ironically, deemphasizing capital gains in favor of value and reliable portfolio income may be as good a way as any to garner long-term capital appreciation in your portfolio. Who can say? I can't. The Model Portfolio has very powerfully outperformed the broader stock market since inception, but that could change in the blink of an eye. The income growth, however, I believe is far more sticky than the capital appreciation - most of the companies in this portfolio have very stable dividend histories, and I don't see much reason to expect anything less going forward. Another reason why I pay more attention to earnings and cash flow than I pay to capital appreciation (or depreciation, for that matter).
Disclosure: I am/we are long CSX, BUD.
Additional disclosure: This is not investment advice and I am not an investment advisor.