Friday, August 26, 2016

Pay Raise

They've done it again. Altria (ticker MO) has hiked the dividend, now to a level of .61 cents per quarter. This continues a decades long streak of raising, raising, and raising dividends. I'm not a smoker or a big fan of it, but as a business, you just don't get a better dividend producing machine than MO (or Philip Morris International, for that matter). This dividend increase will take the portfolio income by over $41 a year.

The composition and income level of the Model Portfolio is as follows:

I know. You're saying "$41 a year? Lucky you! Go buy a new Porsche!" Well, consider this. That extra $41 will get invested, producing more income in future years that can get reinvested. How much? Look. Here is a chart showing the total amount of dividends the Model Portfolio will pay in 20 years BEFORE the Altria dividend increase. I will earn $1,236,386 of dividends.

Now look how much income the portfolio will generate AFTER I factor in the $41 pay raise from Altria:

That is an extra $4,938 of dividends over the next 20 years, well more than 100 times more than the dinky little $41 raise this year.

If you asked me what is the only important aspect of investing, I would tell you to look again at these two charts. What they show is the power of compound returns. This is, in fact, the only thing I truly focus on as a money manager: buy assets that produce steady income, and reinvest that income into more assets that produce steady income. Repeat often and for as many years as you can.

Okay, I admit that sometimes I like to sell expensive stocks with high PE ratios and low yields, and replace them with cheaper stocks with low PE ratios and higher yields. When I do that, I sometimes can snag myself an immediate raise of of a few hundred bucks a year. At times, it might not even look worth the effort... that is, until you look at the cumulative impact of the move over a period of 20 years. In fact, if nothing else in the world inspires a person to avoid the highest priced stocks in favor of equally good businesses with lower PE ratios, the exercise I just went through ought to help out quite a bit in that regard. Little ripples in the pond today reverberate into tsunamis twenty years from now. The impact becomes more profound once you start looking out 60 years. That's what inspired me to give a little bit of high quality dividend paying stock to my kid a few days after he was born. And why we sit down once a month to reinvest those dividends. I can show him with a chart like the one above what a $41 pay raise will do to my kid's net worth by the time my kid is my age. I'll tell you right now, my kid is a natural born saver. My kid has an implicit grasp of the power of compounding, having grown up watching it in action for most of my little guy's life.

You can cut this part and use it yourself, or as a tool to instruct your own children about the power of saving and investing. Just click the link, copy, and plug in your own ticker symbols and amounts. The spreadsheet will do the rest- just make sure to double check the results, and also note that it doesn't work automatically with ETFs or mutual funds.

Wednesday, August 24, 2016

Self Evaluation

What got me especially interested in picking stocks was the fact that there is a nearly unanimous consensus on the part of people who are much smarter than I am that  picking stocks is a money-losing waste of time. It's fairly common knowledge that so-called "contrarian" investing can be very profitable. For example, when virtually every stock analyst on Wall Street pans a particular stock as destined to crash or go nowhere, it's not unusual for that stock that will end up rallying the most. The reason why is that by the time the analysts are all in agreement, most of the big smart money has already sold the stock, leaving buyers relatively more abundant than sellers. My thought is that if contrarian investing can be profitable with regards to individual stocks or industries, why not with an entire investment philosophy?

Many investors stick their money into an index fund (such as the S&P500) and call it a day. Some believe that it is impossible to second guess the market, so investing in a business because of that business' earnings or the price of the company's stock is actually IRRATIONAL.  Now this creates a very interesting opportunity. It is much easier to buy a stock in a great company at a fabulous price if the seller is philosophically opposed to even thinking about the company's earnings.

But if it were so easy, why do so few people succeed at it? I'd say the answer is because most people, index fund investors and active managers, aspire to buy low and sell high. They are investing NOT to own a stream of earnings from a business, but to simply speculate that the price of stock will move higher.

I agree with the experts: that doesn't work. Nobody can predict the unpredictable, nor should they try. But can you predict that the earnings for a company like Coke will continue to grow for the foreseen future? Of course you can! And if you care about owning a piece of those earnings for years or even decades to come, you don't even need to think about the stock price. You are making money when the company is making money, REGARDLESS of whether your stock position is priced higher or lower.

The prevalence of index funds and efficient market theory doesn't create so much of an opportunity to buy low and sell high and outperform the stock market in the process. I would say it creates the opportunity to purchase very high quality streams of corporate income at very compelling prices, and to grow your share of corporate earnings much faster than the average rate of earnings growth on the S&P500. Make no mistake - the price of your portfolio may or may not exceed that of the S&P500. Stock prices can be fairly irrational for long periods of time. But if you accept that you are making money when your business is earning money, then you honestly should not care what the price of your portfolio is doing or, in fact, what it ever does in the future.

That said, the fact that an opportunity exists at all does not in any way imply that you are the guy who will succeed in getting it. This is why I ask myself what I would do IF I didn't make a career out of trying to hand-select investments. The answer is that I would invest in a selection of different types of assets, and I would do what the experts say I should: invest in passive index funds. Specifically, I would invest in passive index funds that track stocks, real estate investment trusts, master limited partnerships, preferred stocks and bonds. The funds I would pick would be the ones with the lowest management fees and the least turnover. That leaves me with the following short list:

For stocks, the Vanguard Total Market Fund (ticker VTI). The expense ratio is an almost impossibly low .05% a year.

For REITs, the Ishares Dow Jones US REIT index (ticker IYR). The expense ratio for this fund is .44% a year.

For MLPs, the Alerian MLP Fund (ticker AMLP). The expense ratio for this fund is .85% (in part, that expense ratio is high due to the tax quirks that result from the fund's structure.

For preferred stocks, the Ishares S&P US Preferred Stock Index (ticker PFF). The expense ratio is .47% for this fund.

For bonds, I'd only go with tax-exempts since I'm in a high tax bracket. I'd go with the Ishares S&P National AMT-Free Municipal Bond index (ticker MUB). The expense ratio is .25% a year for this fund.

Given my age, I'd be comfortable putting 11% of my portfolio into each of IYR, MUB, PFF and AMLP, and the remaining 66% into VTI. By doing so, this would give me a somewhat reliable yield of about 3.3%, and over time, it would be reasonable to expect the income to grow by about 4% a year on average (although obviously, some years the income would fall, some years it would go nowhere, some years it would go up). My total managerial expense for this portfolio would be a very comfortable .2% a year. Net of fees, that would leave me 3.1% a year of income. I will call this my "Passive Income" portfolio.

Assume that I had taken my capital last November, and put it into the Passive Income portfolio I just described. I'd have earned a capital gain of 4.5%, and would be generating 3.1% of income, all without so much as lifting a finger. This 7.6% combined income/ capital gain is basically my opportunity cost for being a private funds manager.

My value added as a fund manager is equal to anything MORE than 7.6% worth of return I earn. If my efforts actively managing a portfolio earn my LESS than 7.6%, then it goes without saying I should quit picking stocks because I'm not good at it. The whole point of picking stocks is to feast on the gap left by the overwhelming mass of investors who buy index funds and thereby ascribe to a "buy high, sell low" philosophy. If you can't beat 'em, join 'em. Never truer words were spoken.

As you can see from the attached chart, my current yield on the Model Portfolio is 4.31% a year.

The capital gain on the Model Portfolio currently clocks in at 17.73% since last November.

That gives a combined capital gain/income return of 22.04% - which means I have earned about 14.44% a year extra for my effort of managing the Model Portfolio compared to what I would have earned with the Passive Income portfolio. That's a high enough delta to potentially make it worth my while, but the time I spend managing could be deployed doing something else. I still need to see whether active management of a portfolio is a really good use of my time.

SO for my next step, I multiply the value of my portfolio by 14.44%. At last check, the value of the Model Portfolio comes in at $368,000, which means I have added about $53,139 of value as an active funds manager of this fund. In some senses, that $53,139 is what you could think of as a salary I've earned myself. I estimate that I spend about 20 hours a week reading annual reports and articles and the like, but I take a lot of time off to travel. I figure about 800 hours a year is what goes into the business of running an actively managed portfolio - at least the way I do it. It comes to $66 an hour.

In fact, I used a similar approach with my actual portfolio when I decided to quit practicing law. I just looked at my average returns over a period of about 7 years, and came to an hourly figure that was meaningfully higher than what I earned as a lawyer. I'd suggest that anyone who is thinking about going to work for themselves as a fund manager think about going through a similar exercise. It might tip the scales in one direction or the other, if you are on the fence about whether working for yourself in this capacity is something you really want to do. And I'd give yourself periodic reviews, too. Obviously, some years might not work as well as others. You may need to be patient with yourself at times, but also not stubbornly keep at a project that is costing you time and capital. Knowing when to stop is hard enough that Confucius defined "a wise man" as one who knows when to stop.

The remaining question I'd ask is how long of a track record do you need? If you outperform some benchmark for a day, should you run out and quit your day job? By the same token, do you need to demonstrate 10 years of consistent benchmark-beating returns? I suspect the answer lies somewhere in the middle, but ultimately, you would need to ask yourself what you'd want to see if you were interviewing a professional to work for you.

Tuesday, August 23, 2016

Smuckers Jam

This is a perfect example of why one should not hold expensive stock, no matter how excellent the business might be. Smuckers Jam (ticker SJM) is a leading producer of food products that range from jam (of course) to instant coffee. It's a dull business, consistently profitable for many decades, and pays an ever increasing dividend (as it has for decades). Great company, no question.

But as of yesterday, the PE ratio for this thing was in the high 20s - nosebleed territory for a slow-growing, stodgy enterprise like Smuckers. At one time, I owned tens of thousands of dollars worth of this stock, but grew nervous enough about it that last month, I sold all but a small position. I'm glad I did.

The company reported impressive revenue today of $1.82 billion dollars, which was a bit shy of expectations. Analysts believed that the revenue would actually come in at $1.89 billion, so this was about a 3% miss for the quarter. That miss sent the stock price down by over 8% today, wiping out far over $1 billion worth of the company's total market cap. Think about it: how does a $70 million revenue miss for one quarter translate to a $1 billion loss in the value of the entire company? The answer is simple: It Doesn't. The problem here was that the stock was absurdly valued leading into today's earnings announcement. Absurd enough that eventually, something needed to give. As it happened, the excuse today is that the revenue came in lighter than expected, but honestly, it could just as easily been ascribed to the price of beans in China, or whatever other excuse you can cook up.

Personally, I see today's episode with SJM bodes poorly for many other consumer staples shares that have been bid up into the stratosphere as far as price goes. Make no mistake, there are many fine consumer staples companies that will continue to be profitable (very profitable), but paying 25, 30, even 40 times earnings for these businesses is simply insane. They ought to be worth something more like 15 to 18 times earnings, and not much more.

In the real world, I have reluctantly shed positions in businesses like Kellogg's, Pepsi, General Mills, Kimberly Clark. Instead, I have been buying shares of European based consumer products, such as Diagio, Nestle, or Unilever, which offer better value in my estimation. For the most part, though, I am steering myself away from the industry, because as much as I love to invest in brands, it is very difficult to accept the high level of risk that comes with owning very richly priced shares of stock. Watching SJM's stock today serves as a stark reminder.

Monday, August 22, 2016

An Efficient Market Fairytale

Today is the most important day in the life of the Model Portfolio. But first, a bit of history.

In the throws of the Brexit crisis (brief though it was), we took the opportunity to liquidate a number of very expensive positions in shares of consumer staples stocks, and put the proceeds into AMLP (an MLP ETF) and VGK, the Vanguard Group's total European stock index ETF. Since that day, VGK has rallied explosively, and is up by nearly 13% since the time we bought it just a couple of months ago. Since we put a large amount into that position, as you'll recall, the gains have been spectacular. Dumb luck, to be honest, but it's what we do with that luck that counts.

I never actually planned to keep that investment in VGK for long. It was designed as a place holder, a broad and cheap fund where I could park capital until I had some better idea with what to do with the money. The Model Portfolio is not designed to be an index fund, but an actively managed, hand selected batch of around 20 different securities. I look for well managed businesses with decades of healthy profits and proven business models. I look for steady and growing dividend payments. I look for competitive advantages that seem enduring. I look for reasonable debt levels. And above all, I look to buy businesses with those characteristics when they are cheap, and sell them when they get expensive. An index fund is actually the exact OPPOSITE of what the Model Portfolio is all about, and I am going to explain that more in just a couple of paragraphs. For now, please read on.

For those who follow the Model Portfolio, you already know that the purpose of the exercise is to create a portfolio that will churn out a steady and growing stream of income from reliable, top-shelf businesses. I started the Model Portfolio last November, with an allocation of shares designed to produce about $10,000 of dividend income a year. Since launching the project, my primary goal is always to maintain a portfolio of high quality businesses that trade at reasonable prices, and my secondary goal is to "trade up" when opportunity strikes, swapping expensive stocks with lower yields for cheaper stocks in equally good businesses that offer higher earnings per share (and, if available, higher dividend yields with lower dividend payout ratios). I set out to grow the Model Portfolio income from $10,000 a year to $30,000 a year, and have used my "retirement clock" spreadsheet to track the income progress, the income growth progress, and to project the probable number of years it will take before the Model Portfolio finally achieves it's $30,000 a year of dividend income.

And at long last, I have identified two strong European companies to replace VGK, and in the process, to deliver a very healthy raise. The first is Diagio PLC (ticker DEO) is a British company that produces beer, wine and spirits. I bought 160 shares of DEO. The company trades at a very reasonable PE ratio. The second is Allianz SE (ticker AZSEY) is an insurer based out of Germany, but with operations across Europe and the world. The company trades at a PE ratio of only 8, and offers a dividend yield of 6%. I bought 1,662 shares of AZSEY. Selling VGK and replacing it with DEO and AZSEY will lift the overall annual expected income of the Model Portfolio to $15,885 per year. This represents a gain of $5,886 per year of income above and beyond the $10,000 of annual dividend income expected when I launched the portfolio last November. The dividend growth of the portfolio comes out to an annualized 73% a year at this rate.

Now, why is today the most important day in the life of the Model Portfolio? The answer is because the dividend growth of the Model Portfolio is roughly 1000% higher than the average earnings growth rate for the S&P500 (which for the past century has stood at 7% per year on average). 1000% in under a year is a big, round number. Big enough that it doesn't look like statistical noise. Here is why I am telling you this.

The Nobel Prize for economics was shared by one of my favorite authors and thinkers, the father of modern portfolio theory, Eugene Fama. Professor Fama has "proven" that the stock market is perfectly efficient and rational, and therefore, it is not possible for a person to reliably outperform the stock market through security selection. Most people who try to grow the price of their portfolio faster than the stock market's price increase will end up dramatically underperforming the broader stock market. In fact, ALMOST EVERYONE who tries fails, and for this reason, the efficient market theory is more or less the gospel of the financial world.

I'm here to tell you today that everyone missed the boat. The fact that nobody can reliably outguess the market when it comes to stock prices says NOTHING about whether the market is efficient or rational when it comes to valuing corporate EARNINGS. It only proves that stock prices are unpredictable, but stock prices and corporate earnings are not necessarily the same things at all.

If you look at corporate earnings, you will quickly see that the stock market places vastly different prices on the earnings of one company (say, 8 times earnings in the case of Allianz) than on the earnings of a similar company (for example, 20 times earnings in the case of Chubb). Does that really make very much sense in a world where the stock market is perfectly efficient and rational? If so, then it shouldn't make a difference to a portfolio's earnings to swap shares of Chubb for Allianz. In the end, the portfolio's earnings ought to end up growing more or less in line with the overall market (which should come out to around 7% a year on average, assuming the portfolio is appropriately diversified).

On the other hand, if the only reason why Chubb's earnings are priced more richly than the earnings of Allianz is because the stock market is inefficient and irrational at valuing corporate earnings, then it should be possible to grow a portfolio's share of corporate earnings far faster than the rate of corporate earnings growth for the overall stock market, simply by selling "expensive" earnings and replacing them with "cheap" earnings. And all things being equal, the more irrational and inefficient the market is when it comes to pricing earnings, the faster the portfolio's earnings growth ought to be relative to the earnings growth of the overall market.

And that is precisely what I've done with the Model Portfolio (and for the last 20 years, with my own portfolio as well). I've seen many examples of "expensive" earnings and "cheap" earnings over the past months, and used those opportunities to buy and sell stocks and grow the Model Portfolio's income by over 10 times the average earnings growth rate for the S&P500. If the market was rational and efficient, I couldn't have done it with the Model Portfolio over the last year. To the efficient market people out there, all I have to say is "how you like them apples?"

So let's sum it up. As an investor, my approach is to say "I don't know or care what the stock market will do in the future." The only thing I focus on is growing my share of corporate earnings, not growing the composite price of my portfolio (in the real world, I literally have no idea what the price of my portfolio is on any given day or even any given year). I use the actual dividends I get in my hand each year as the basis for how I calculate my portfolio earnings, because corporate income statements can be very misleading, whereas cash money is unambiguous and hard to argue with. If I see a way to buy a stream of high quality earnings at a good price, I buy it, and if the stock stays cheap for a day, a year, a decade, I don't care. I am happy to buy MORE shares that will entitle me to a greater percentage of the company's high quality earnings. And if those shares become expensive, then I'll sell them so long as I can find a cheaper alternative place to park my capital. And the more wacky and insane the stock market is when it comes to pricing corporate earnings, the faster I am going to grow my share of corporate earnings. I'm focused squarely on what the efficient market theorist types ignore (earnings) and almost entirely ignore what the efficient market theorists focus on (stock prices).

The composition of the Model Portfolio is now thus:

I've just gotten through lambasting price performance as an entirely meaningless goal, but I realize that we have total return investors out there. Some would say dividend growth is not an appropriate metric to measure portfolio growth, but I will tell you that over time, there's a chance that the price growth of a portfolio might fall somewhat roughly into line with the underlying earnings growth of the portfolio. I have no clue about what those chances are, by the way, or how long it would take for all that to shake out. Regardless, for those who care about such things, here is the relative performance of the Model Portfolio compared to the S&P500 since I launched the Model Portfolio project last November:

You know, I'll share something with you on a personal note. Years ago, I dreamed of becoming a finance professor, running a small hedge fund, and living in Europe. I even went so far as to apply to INSEAD business school, and moved to Paris completely convinced that they'd let me into their PhD program in Finance. I realize that seems fairly presumptuous, but I have a couple of Ivy League degrees and earned over a 4.0 GPA from each school. I still can't spell my way out of a paper bag, or tell right from left, but I'm just being honest when I say that I have a wildly impressive academic background. The hedge fund rout seemed straightforward - I have a fantastic track record at beating the market, and with the academic credentials to go alongside (as in, being a tenured finance professor at a top tier business school), this all seemed like an ideal plan.

Well, the business school idea didn't pan out, and ultimately I moved back to the USA from Paris. The hedge fund thing wouldn't have worked either - maybe it's the full body tattoo work, but let's just say that I don't exactly fit in with the country club folks. Like it or not, the country club folks really matter in the world of money management, but I cannot act like them for more than about 3 minutes.

So, I decided to take matters into my own hands. I hired myself to manage my own money, and to make the internet my classroom, teaching real-time money management decisions, explaining them and how to think about the big picture in a way that stands convention on it's head (and that pays way more, too). In retrospect, thank heavens I didn't opt to pursue a teaching gig at a business school. If they heard anything I have to say about finance, I'd get whisked out the door. Running my own private hedge fund for myself (technically, I suppose that makes me a private family office) has paid off a bit better than practicing law, but even if it didn't, I don't care as long I have food on the table.  Moving to Portugal was just the perfect cherry on top of it all (everyone here has tattoos and could care less about money and finance, it seems). I have never been happier in my life. I think it is a good idea to not predicate your dreams on getting someone else's permission. Better to tweak that dream a bit, and then go do it on your own terms.

And that's what I do. Today, I'm trying to disprove all of modern portfolio theory on the basis that stock prices are irrelevant to investing. Tomorrow, who knows what we'll sink our teeth into. Here in the investor underground, anything can happen and probably will.

Monday, August 8, 2016

Musings on REITs and IRAs

When we moved to Portugal, one of our visions was to simplify our lives significantly. For example, I used to own over 12 pairs of shoes. Now I own two pairs (in case one gets wet). We had an enormous kitchen in the USA, filled with hundreds of different pieces of cooking equipment (some of which we never even used once). Today, we own three pots and two frying pans. Our living space is Spartan and minimalist, and generally speaking, we've never been happier. When you own a home in a high cost jurisdiction like NYC or Washington, DC, and rent the home out and move to a low cost jurisdiction like Portugal, you have the opportunity to indulge in the most luxurious of recipes for happiness: "twice the income, but half the needs." There is no greater sense of liberation than to own nothing more than the contents of a carry-on bag and a brokerage account, an up-to-date passport and a conviction that you can go anywhere and do anything without anyone else's permission. While that doesn't exactly describe our condition, it's a sort of visionary guideline. 

As part of our plan to get by with less, we opted to forego a car, and have lived in Lisbon for almost a year getting by on Uber, and occasional trips on the old electric trolleys. This Summer, though, we've decided to explore more of Portugal than just Lisbon, and to get out into the Portuguese countryside, there is no option but to drive. We found that it is cheaper, in many cases, to do a long-term car rental in Portugal than to buy a car outright, and that is what we have opted to do. Every day or so, we wake up early, pack a few things, and drive off to explore the coast. This leaves limited time to update blogs, read annual reports, or study finance. 

I question what's wrong with me. Why is that I can sit watching the fishing boats pull into a rocky harbor, and be thinking about tax law and finance? I have no answer to that question, but can share a personal anecdote that may offer some utility to readers contemplating all the fun and games you can have with retirement accounts. 

By way of disclosure, what I am about to describe is a clear indication that 99% of the outcome of your financial decisions is based on luck, 1% on a good plan. Better make that 1% count. 

In the depths of the financial crisis in 2009, I felt that the market was in a panic and that stock prices were too low. I believed they could go far lower, and stay lower for a decade or perhaps even permanently.  I already had most of my liquid net worth tied up into stocks, so I couldn't very well buy more shares, but there is another way to "lock in" the benefits of low stock prices: I converted one of the IRAs I owned into a ROTH IRA. 

By doing so, I was forced to pay income taxes on the capital value of the IRA in 2009, which I felt was depressed by low market prices. I converted about $80,000 worth of IRA assets into ROTH IRA assets in 2009, and paid income tax on that $80,000 over the following two years under the conversion rules then applicable under the Internal Revenue Code. I had many capital losses in 2009, which I was able to use to offset some of the $80,000 of income I realized on the IRA conversion. I calculate that I ended up paying about a $24,000 in extra income tax on the IRA assets I converted into ROTH IRA assets (both Federal and State). I paid that tax using other assets I owned, which means I gave up an opportunity for capital appreciation and income on $24,000.

In exchange for paying that income tax up front, the ROTH IRA will never draw so much as a penny of income taxes for the rest of my life and the life of whomever I leave the ROTH IRA to after I die. That could potentially be 100 years of income-tax-free growth and income. 

I had no clue about the future direction of stock prices and didn't want to base my decision on that. Instead, I looked at the yield I could own on certain high quality assets available for purchase. My theory was that if I could buy assets that paid reliable dividends, I could pay off that $24,000 tax hit with dividend income in a few years, and then going forward, all dividend income beyond that would be pure gravy.

I sold off the contents of my IRA (mainly S&P500 index funds) and reinvested almost everything into shares of REITs - especially Realty Income (ticker O) and National Retail Properties (NNN). There were two reasons for making this move.  First, REITs are tax-exempt entities. They earn rents income-tax free, and distribute the rents to shareholders who then must pay income tax. When that shareholder happens to be a ROTH IRA, there is no shareholder level income tax. Accordingly, if you own shares of a REIT through a ROTH IRA, NOBODY at any level of the ownership chain pays any income tax on those distributions. I felt that amounted to a valuable double dip that would push the value of the ROTH IRA up significantly over time. 

My second bit of reasoning was that in 2009, shares of the REITs I bought had a yield of 8.5%, and a long track record for raising distributions over time. I felt that by owning high yielding dividend producers with impeccable track records for dividend growth, I could almost count on an 8.5% tax benefit compounding and growing every year. I figured that with a tax-exempt yield of 8.5% growing at 5% a year, I could completely pay off the $24,000 worth of income tax that I paid up-front when I converted the IRA assets into ROTH IRA assets... IRRESPECTIVE of whether the price for the REITs remained flat for decades. The main motivation that I had in 2009 (and that I still have to this day) was (and is) to make financial decisions that could work well IRRESPECTIVE of stock prices. Trying to predict stock prices is bad business, and the only way to get out of that business is to render stock prices irrelevant in your life and your financial planning.

Fast forward to today. As I'd planned, I have received many dividends from O and NNN over the years, which I have religiously reinvested into various other income producing assets. The income on my ROTH IRA grew from about $6,800 a year in 2009 to over $15,000 a year today, thanks to O and NNN raising dividends and also due to the impact of reinvesting. This year, I sold off most of the shares of O and NNN, and reinvested the proceeds into a broader basket of securities. The capital price for the ROTH is now almost $320,000. That translates to a gain of $240,000 since 2009 - all of which is income tax free to me and to my heirs. Of that $240,000 gain, I estimate that nearly $75,000 consists of dividend payments that have been entirely tax-exempt - which means I have paid off my $24,000 tax bill 3 times over. Obviously, the price of the ROTH assets could drop violently at any given moment of the day, but the income that the ROTH generates is quite stable and will hopefully continue to grow at a compound rate as the companies I own raise dividends, and I reinvest those dividends into more shares of other income producing assets. 

Luck and timing have been paramount to the success of this strategy, but one day, I would be willing to bet that the stock market will crash and there will be some other sort of financial crisis that will send stock prices reeling to the ground. When that day comes, there will be opportunities to purchase high yielding assets with strong dividend growth histories. Perhaps those assets will even be tax-exempt entities like REITs. The strategy I described may or may not work out as well in the future, but perhaps a strategy that shares certain elements of what I described might be available. If nothing else, some of the thinking and reasoning behind the strategy could be useful for investors, which I hope will be the case.

Friday, July 29, 2016

Month End Model Portfolio Adjustments

The Model Portfolio has accumulated a grand total of $148 as of the end of the month, which is enough to add 5 shares of Capital Care Properties (ticker CCP), a chronically undervalued REIT that was recently spun out of Ventas (ticker VTR). That minor purchase managed to add a few dollars worth of portfolio income, and we also have had a slight bump in portfolio income due to dividend increases by two of our holdings: Realty Income (ticker O) and Omega Healthcare Investors (ticker OHI). The total portfolio income has grown to $13,669.94, which is a 26% improvement from the first date I introduced the portfolio to the world last November.  The portfolio is up 17% since that time, or nearly 14% higher than the S&P500 over the same time period. In theory, the portfolio capital growth ought to closely track the portfolio's income growth, but I've seen the disparity in portfolio capital growth and portfolio income growth persist for years upon years at a time. It's only when you look at a portfolio over periods of about 10 years that anything begins to make any sort of rational sense, it seems.

We've seen a very little impact on the portfolio when looked at through the lense of the Retirement Clock tool. I have been working to get to a point where the Model Portfolio generates $30,000 of income a year, which will be a threefold increase from the income level of the portfolio last November. I now estimate that it should take 9.86 years to hit that goal, based on the dividend growth rates for each of the portfolio companies, the total number of shares the portfolio owns of each company, and the current income level of the portfolio. Remember, you are always free to copy the Retirement Clock tool and adapt it for your own purposes - I have provided links to this tool in previous articles.

In the real world, I have found this tool quite useful for teaching my 11 year old the value of saving and investing. The only modification is that instead of projecting the number of years to retirement, I've adapted the tool to track the possible level of portfolio income in 40 years. This is a simple modification to make to the spreadsheet, and the incredible thing is to see how a small investment today of a few hundred dollars can translate to hundreds and hundreds of dollars of extra income over a time period of 40 years. The very best investors don't think about fleeting stock gains over the next day, month or year. They look out over the course of decades and decades, relying on the only sure thing when it comes to investing, which is the power of compound returns. Once you grasp the power of compounding, it becomes obvious that the best time to start investing is several minutes after you are born. And the time to instill in a child an innate appreciation for the importance of saving and investing could start as early as 4 or 5 years old, which is when my kid got his start. Every single month, the two of us sit down together, tally up the dividends he has earned, decide where to reinvest them, and then look at what sort of improvement he has made to his lifestyle in the very distant future. I no longer need to tell him that it is important to save money and live within your means. He feels that the process of building portfolio income is somewhat like a slow-moving video game, but with a very tangible payoff for playing.

Below are screen shots that track the performance of the portfolio and the portfolio income growth.

Last of all, I attach here a painting of Obidos, which is a lovely medieval town about an hour and a half outside of Lisbon. There is a castle high on the top of a hill, which looks out over fields with lavender and rows of almond trees. At the risk of sounding like a broken record, Portugal has some of the most beautiful countryside anywhere on the planet.

Wednesday, July 13, 2016

Enhancing the Retirement Clock

Arguably, the three most important factors to managing money are (1) saving, (2) reinvesting, and (3) spending. I have now folded all three of these into the retirement clock tool, which you can copy and use for free.

Last time we spoke, we looked at the Model Portfolio, and determined that it should produce about $30,000 a year in dividend income within roughly 10 years from today. I set $30,000 as the ultimate income production goal for the portfolio - but you can input any other desired income level you want if you copy the link provided below. That projection is based purely on the composite dividend growth rate of the portfolio, and does not take into account the all important factor of reinvesting dividends.

Using the new spend/save feature to the Retirement Clock tool, I see that in fact, the portfolio ought to produce approximately $30,000 in eight years, not ten. That assumes I can reinvest dividends at the overall yield of the Model Portfolio, which today is 3.79%.

Reinvesting is highly significant when it comes to retirement planning - in this case, it's a full 2 years' worth of significant. But it still doesn't answer the broader question of whether the investor in this example must wait 8 years until he or she retires. To answer that question, we need to look at the person's savings and spending plans as well as his or her portfolio and reinvestment habits.

Let's suppose an investor has $20,000 in cash savings that he or she is willing to use to pay for living expenses. Cash savings could enable the investor to retire PRIOR to the date when his or her portfolio is projected to produce the entire $30,000 of retirement. Using the new spending, saving, reinvestment tool, it looks like a hypothetical investor could actually retire in only FIVE years, using his or her cash savings to supplement the shortfall in portfolio income. The investor would still have $7,512 of cash left over, as well.

In fact, though, the investor could retire even quicker by NOT reinvesting his or her cash into more shares of stock. It would be ideal for the investor in this case study to use portfolio income to build up cash to pay future living expenses. If the investor in this case spent three years building up his or her cash savings, he could retire in only three years, live off portfolio income and draw down his or her cash savings to make up the shortfall between living expenses and portfolio income. Needless to say, there is a massive difference between retiring in ten years verses retiring in just three years' time. Ironically enough, investing can hurt more than it can help.

Here is a link that you may copy and use to access the Retirement Clock tool. Simply go into the spreadsheet, click "file", click "copy" and you will be able to input data and make any changes to the spreadsheet you wish. My aim in providing this spreadsheet is not to provide answers about when or under what circumstances a person can retire - my goal is only to provide a framework around which an individual could base his or her own independent judgment about retirement.

Last of all, here is the total performance of the Model Portfolio from November of 2015, when I launched it, until today. For the first time, the portfolio has now outperformed the S&P500 by 14%, but with substantially less volatility. Why? Most of the gains are attributable to selling shares of stock that became very expensive due to either corporate takeovers, or just usual stock market insanity. Some of the performance is also attributable to the fact that in the immediate aftermath of Brexit, I sold "safe harbor" US assets and bought shares of an ETF that tracks the widely reviled European stock market (which has since come back with a fury).

Monday, July 11, 2016


Received $143 in new dividends, enough to purchase 2 shares of Emerson Electric at $53.81 a share. This new purchase boosts the income of the Model Portfolio to $13,604.  The Model Portfolio now is configured as follows:

And now, why don't we briskly move on to the more important topic of what happens when an octopus attacks a ninja temple:

Wednesday, July 6, 2016


It's simple. HCP is going to cut it's dividend. They are spinning off some of their troubled properties, but as a result, they will have to take on new debt and also will earn far fewer Funds from Operations - about $500,000,000 less, to be precise. That makes the current dividend completely unsustainable. Shareholders will receive shares of the newly spun out entity, which may pay a dividend, but there are legal issues and investigations brewing that could stop that dividend right in it's tracks.

It's all an unknown, and unknown is not what we do with our money. Accordingly, I have eliminated HCP from the Model Portfolio and replaced it with a Care Capital Properties, a recently spun off company from Ventas - one of the premier healthcare REITs in the USA. CCP has a higher credit rating, but has less of a track record than HCP. In fact, CCP has been around for years, but operating within a much larger REIT. It does have a long history, but not as a stand-alone enterprise. Generally, I won't own any business that has not been seasoned with at least two decades of operating history - CCP has that, only it's much harder to ferret that history out since it was originally part of Ventas.  What CCP needs is time, and I have plenty to give. CCP also has a higher yield than HCP, and far better prospects for growing Funds from Operations and, ultimately, the dividend. In short, this looks like a classic higher yield for less risk trade, and I am pleased to oblige.

CCP has no track record for raising dividends, so the assumed dividend growth rate is 0%. I will update that estimate based on when and whether CCP raises it's dividend, which I expect should happen later this year.

The Model Portfolio continues to perform better than the S&P500 - about 13% at this point. There has been some drag due to my recent allocation out of some very expensive US stocks and into shares of a European index fund. There may be ongoing drama unfolding in Europe over BREXIT, which may provide attractive opportunities to buy even more shares. Time will tell.

Sunday, July 3, 2016

Thoughts on the Political Process

The Presidential Election in the United States. I am at a loss for words. Fortunately, I can easily do paintings to sum up my impressions on the matter.

Wednesday, June 29, 2016

The Limits of Macroeconomics

Macroeconomics is useless when it comes to investing. I can guarantee you that a couple of days ago I would have sworn that as a consequence of Brexit, the global economy would fly into a tailspin, banks would fail, and stock markets would swoon. That doesn't mean I sold any stocks - on the contrary, I bought stocks. But my expectation... no, my CONVICTION, was that stock prices around the Earth would be 30% lower by today. Throw in a terrorist attack in Istambul, a currency panic and the prospects of revolution breaking out across Northern Ireland and Scotland, and I promise you that I can conceive of not one single plausible outcome where stock prices would remain relatively flat.

And here is the Model Portfolio's stock price performance as of this morning. It is largely unchanged from where it stood this time last week. In the real world, my personal portfolio is actually modestly HIGHER than where it stood immediately prior to Brexit.

There are only two possible conclusions. Possibility one: I am right that Brexit is an unmitigated economic and financial disaster, but the entire planetary stock market is wrong. Possibility two: I am an idiot. And then there is a third possibility: both possibilities one and two are correct.

This leads to a practical consideration vis-a-vis predicting stock prices. DO NOT TRY. Ignore them. And ignore the macroeconomic drivers that may (or just as likely, may not) underlie stock prices. The Model Portfolio consists of businesses that produce things like hammers, baby powder and gasoline, or provide services like choo choo train deliveries or the provision of electricity to American households. When you really think about, people will use hammers and baby powder and leave their garage lights on overnight by accident REGARDLESS of the integrity or dissolution of the EU - or any other macroeconomic development for that matter. If someone comes up with a better alternative to the hammer, I suspect that the stock price for a company like Stanley Black and Decker (ticker SWK) might swoon, but given my track record for predicting stock prices, you'd be an even greater idiot than I am, were you to listen to my prognostications.

There is a silver lining in all this fog of idiocy and incompetence, which is that none of it matters. Even if you don't ever look at the stock market again, it's still relatively straightforward to earn exceptional investment returns and income growth. Pick companies with fantastic products and high levels of managerial excellence. From this large universe of possible investments, select those with 10, 20, maybe 100 years of solid dividend growth history. From this winnowed selection of potential investments, buy those with stock prices that are very reasonable - a price earnings ratio of under 20 might be ideal, but obviously, even lower is even better. Collect the dividends and reinvest them into shares of more of the same sorts of companies, and you're done.  You can dramatically outperform the stock market if you do those things, and avoid the temptations to do anything but.

Yes, I broke that rule a few times, and sold some stocks when the PE ratio got up into the 30 range. And yes, I timed the market, buying shares of European stock index funds in the immediate wake of Brexit - but I did that strictly because the valuation of the entire European stock market was literally less than half the valuation of some of the shares of stock that I sold (Pepsi has a PE ratio of 29, General Mills a PE ratio of 27, and Visa a PE ratio of 29).  So, it's not precisely market timing that drove my decision to deviate from my previous plan of buying 20 companies and holding them forever. The market gave me a once-every-decade opportunity to swap shares of expensive stocks for shares of a bargain priced stock index.

Will the European stock markets rally from here? Don't know, don't care, not relevant. The 1,800 companies I bought two days ago will continue to pay dividends, these will sometimes rise and sometimes fall, but mostly rise over the next 50 years, and the earnings yield on all these companies comes to about 8% compared to the negative interest rates that now prevail across Germany and select other European markets. Investing is a binary process of either making money or losing it, so from that perspective, a positive 8% earnings yield is infinitely higher than a negative .3% interest rate. In the move Wall Street, the character Gordon Gekko summarized his investment strategy thusly: "I only bet on sure things."  Infinitely higher returns - those are the sort of odds that even Gordon Gekko would like.

Monday, June 27, 2016

How to Make Brexit the Gift That Will Keep On Giving

We have touched before on the process of selling expensive stocks, and using the proceeds to purchase shares of less expensive stocks of similarly high quality businesses. I tend to view expensive stocks as inherently more risky than cheaper stocks of high quality companies. I'd say the same for the stock market as a whole: all things considered, it's less risky to own shares of an broad-based passive index fund with a composite price/earnings ratio of 15 than, say,  a composite price/earnings ratio of 25. And I'd say that generally speaking, it is less risky to own a broad based index fund than shares of any one company. If you can trade stock in a single company with a PE ratio of, let's say, 30, for shares of a broad based index fund with a PE ratio of, lets us say, 10, then you can reduce risk on TWO counts with the click of a few buttons.  How often do you get a chance to do that? Watch and see.

But first, a bit of history and background. The Model Portfolio consists of 20 individual stocks, each with a strong record of dividend growth, each with solid business prospects and each with a reasonable and fair valuation. I started the project last November in an effort to demonstrate several general approaches to dividend growth and risk management. The portfolio, when I launched it, generated $10,000 of income per year, and I set a goal to grow that income as rapidly and safely as possible to $30,000. A couple of days ago, the Model Portfolio generated $11,180 of income per year, representing annualized income growth of 18%. And it is about to get even better. A whole, whole lot better.

The Vanguard European Index fund (ticker VGK) represents 98% of the entire European public equity market, trades at a composite PE ratio of around 13 or 12, and offers a yield of nearly 4%. It is nearly half the cost of the S&P500, which is not rational. VGK comprises many of the same sorts of businesses you find in the S&P500, and like the S&P500 companies, most of the holdings of VGK do plenty of business both within and outside of Europe. Indeed, most of the companies in the S&P500 do an extraordinary amount of business in Europe as well, so really, there ought be no significant distinction in terms of how US verses European large cap stocks are priced. And yet, the price difference is, at the moment, jaw dropping.

But the case for why VGK is cheap becomes even more stark when I compare the PE ratio for the European stock market with the PE ratio for three of the most expensive holdings of the Model Portfolio. The composite PE ratio for every company in Europe is slightly over 1/3rd the PE ratio for Pepsi (ticker PEP), General Mills (ticker GIS) and Visa (ticker V) which all trade at PE ratios closer to 30 and offer yields that are only half the yield of VGK. This creates an opportunity. My plan is to sell all three of PEP, GIS and V, and put 2/3rds of the proceeds into VGK.

The remaining 1/3rd of the proceeds will go into the Alerian MLP ETF, ticker AMLP. This is a index fund that tracks oil and gas pipeline companies. To determine whether a pipeline company is cheap or not, investors look at price over distributable cash flow, rather than reported earnings (tax deductions for depreciation understate the actual economic earnings of pipelines). On that basis, MLPs are a bargain at today's prices. Far cheaper than PEP, GIS and V, to say the least, and capable of generating consistent dividends and dividend growth.

A word on that. It is difficult to guess what the dividend growth rate will be for VGK. Some years, the dividends paid by every company in Europe will drop, other years, they will grow. On average, I'd expect them to grow about in line with the historical dividend growth we've seen in the past 50 years - around 7% on average. For AMLP, it's even harder to guess. Most pipelines are leased out for periods of 20 years or more, with built-in escalation clauses to account for inflation. 4% is a typical escalation clause, so I will assume AMLP's dividends could grow by that amount over the long term.  I expect my guesses will be wrong, but at the moment, they seem reasonable.

I have now just sold all positions in V, PEP and GIS and have produced $58,032 of investible cash. That will buy me 841 shares of VGK and 1778 shares of AMLP. As a result of this move, the Model Portfolio is now far more diversified, and owns far cheaper assets than it did before.

Brexit has also introduced a flight to quality in the global stock markets, driving the PE ratio of defensive stocks with stellar dividend histories into the stratosphere. I have made a second alteration to the Model Portfolio. Historically, the Model Portfolio has held 189 shares of Proctor and Gamble (ticker PG). It's a remarkable company with a stable dividend and decades of dividend growth. Currently, the stock yields approximately 3%, which is fantastic in a world of low interest rates. It seems the stock market agrees, and the shares now trade at a PE ratio of 28.

PG's dividend seems safe - they paid out $2.59 per share in dividends last year, and earned $3.06 per share, leaving a small but still comfortable cushion. Can PG grow the dividend substantially from here? That will depend on sales and whether they keep up their share buyback program, but the truth is, the company already distributes most of what they earn, which limits the amount of potential growth going forward. The market, however, has awarded PG a truly astronomical share price - in part due to risk aversion on the part of investors who are anxious for safe, predictable income, and yet, are starved for it because interest rates are actually NEGATIVE in many parts of the world thanks to post-Brexit jitters. If you can't make money in safe bonds, why not look towards safe stocks that pay safe dividends? PG's price seems to reflect a movement on the part of income investors to pile into these sorts of stocks at any price possible.

But not all income stocks are anywhere near as expensive as PG. JP Morgan is a bank that has been in business since the late 1800s. It has seen it's share of ups and downs, but is a proven survivor of all sorts of financial conditions. The shares now trade slightly below book value - meaning that for every $60 you spend on the stock, you buy $67 worth of the bank's tangible assets. And the bank is obviously worth more than the cash and securities on it's books - there are dramatic intangible benefits such as valuable business connections and financial know-how, which attracts billions of dollars worth of deals to JPM every year. These intangible assets are now priced below zero, which in simple terms, is a bargain.

JPM trades at a PE ratio of 10, or roughly 1/3 the PE ratio of PG. And unlike PG, JPM only pays out less than a third of it's earnings each year as dividends. The bank could easily boost it's dividend payments dramatically, even if bank earnings were to stagnate or fall for many years to come. In fact, a day or two after I bought the stock, JPM hiked it's annual dividend by 10% and boosted it's share buyback program - that will certainly lift earnings per share and augurs well for future dividend increases.  The dividend from both PG and JPM appear safe in my view, but the prospects for dividend growth are far superior at JPM.
Brexit may have severe ramifications for bank earnings over the next few years. I have no way of knowing. The prospect of Brexit having a negative impact on bank earnings has been reflected in share prices for banks all over the world, including JP Morgan. It is not a widely desired industry on the part of investors, and a very out of favor stock... precisely my reason for buying it. PG, by contrast, seems to one of the darlings of the investment world, commanding a premium valuation that, while potentially justified, seems excessive and risky. Accordingly, I will sell all shares of PG, and buy 261 shares of JPM with the proceeds.

In a simple nutshell, I have used Brexit to sell the highest priced stocks of the Model Portfolio, and to buy the most loathed stocks in industries like finance or energy, and to buy the most loathed regions (Europe). The composition of the Model Portfolio is now thus:

One thing that is immediately clear is that not only is the portfolio income a couple of thousand dollars a year higher, but the projected income growth is substantially higher as well. Accordingly, the projected time it will take for the portfolio to generate $30,000 a year in stable income has dropped magnificently.

In terms of stock performance, the Model Portfolio continues to outperform the S&P500 as always. Stock prices are chaotic nonsense - indeed, that is precisely why we have been able to grow the portfolio income so quickly since last November. Because of the insanity of the marketplace, we are easily able to sell preposterously priced stocks and to buy dirt cheap stocks in equally exceptional businesses. Every time we do, portfolio earnings surge. But given the stupidity of market prices, its is only fair to conclude that when it comes to measuring portfolio performance, stock prices are very, very unreliable.

Saturday, June 25, 2016


The UK population has voted to leave the EU. The continued existence of the EU is no longer assured. The financial disruption from a potential disbanding of the EU is significant, unheard of in history, and fraught with risk. For example, what is the value of a Euro today, if the currency itself might not exist (or might only exist in a far more limited group of countries) in the foreseeable future? If you can't answer that question, then as a risk manager, how could you own anything denominated in Euros? The intrinsic risk of owning shares of any European asset has increased dramatically, and that may (indeed, should) give rise to selling pressure, and a destruction of wealth across Europe and the United Kingdom. The ripples from the financial fallout  would certainly reach Asia, and North America as well. The potential now for a global recession (or worse) is far higher, due entirely to the existential threat of one of the world's principal currencies, and the value of banks and other institutions that trade in and (and trade by) the Euro. Central banks are powerless to stop it this time. Cutting interest rates below zero, literally handing free money out, it doesn't create real wealth when you've got factories closing down and people losing jobs. Do I think stock prices will drop by 50% over the next year or so? Obviously I have no idea, but that outcome would not surprise me. I wouldn't be surprised if European stocks end up dropping by 70% or worse before this crisis is over.

What impact does any of this have on the Model Portfolio? Look for yourself.


If you are wondering what you are looking at and don't see it, don't be surprised. The reason why is that there has been no impact, whatsoever, on the dividend payments expected this year. Perhaps there may be slower dividend growth going forward if there is a pandemic global recession. Then again, interest rates may collapse, enabling companies to borrow for little cost (or even at a negative cost), purchase back stock, and thereby increase earnings (and dividends) per share. It's an unknown, but either scenario seems equally plausible. Even if companies slash dividends, what dividends do come in will be deployed into far lower priced shares, fueling dividend growth in the good old fashioned way: saving and re-investing.

So what action does Brexit prompt from a portfolio management standpoint? In the case of the Model Portfolio, none. None whatsoever. The reason why is simply that neither Brexit nor the plausible outcomes that derive from it offer any foreseeable impact on the stated goal for this portfolio, which is to produce a steady, reliable, and growing stream of income equal to $30,000 a year, as promptly as possible.

What would change my thinking? Easy. If any stocks in the Model Portfolio become wildly over-valued, I might look for shares of other companies (or even index funds) that are far cheaper. For example, now that interest rates appear destined to drop and stay down for many years to come, REITs have suddenly come into vogue. A couple of the positions in the Model Portfolio are REITs, and not surprisingly, they are rallying and if that were to continue, then the stock prices may become irrationally high. By the same token, broad based index funds that track European equities, such as the Vanguard Europe FTSE ETF (ticker VGK) may become cheap. This past Friday, VGK dropped 11% in US dollar terms, and now offers a very appealing yield of 3.65%.  Realty Income (ticker O) offers an almost equivalent yield, but suppose that VGK fell hard enough (or Realty Income rallied hard enough) to give VGK a substantially higher yield than O? A broad based stock index like VGK has far less company specific risk than owning individual shares - so in that sense, swapping O for VGK may be a way to purchase more income for less risk.

Why haven't I made that trade now? Simple: O has a superior dividend growth record than the entire VGK index. Before trading O for VGK - indeed, trading anything - I would need the valuation question to be as obvious as a whipped cream pie in my face. For example, if O were yielding 3%, and VGK's average dividends over the last five years provided a yield of maybe 6%, I'd give very serious thought to exiting O and purchasing VGK. Moreover, I'd perform this valuation exercise across all positions I owned.

The truth is, Brexit offers nothing more than perhaps an opportunity to retire from fund management. Once investors can buy broad index funds that reliably provide ample income in excess of their needs, there is no longer much (if any) reason to ever own individual stocks again. Not unless you happen to have a morbid fascination with owning businesses and doing all the work that goes into it. Your's truly suffers from this very affliction, but the Model Portfolio project isn't designed to track what I enjoy doing. It's designed to produce a source of reliable income that generates at least $30,000 a year, and to accomplish that goal as promptly as possible. If that means swapping out high quality shares of individual companies for diversified, low cost funds with stable dividend streams, that's what I'll do.

The implosion of European stock prices may, in fact, give us an opportunity to do something along those lines, and that would obviously be the best news imaginable. There is no way to predict, and predicting stock prices is very much the antithesis of how we do investing here in the Investor Underground. Watching stock prices dive headlong into the toilet while we salivate and rub our hands together, that's precisely what we do. Financial Armageddon can shave years off your financial goals if that means creating a source of passive, reliable income that exceeds your needs. I've lived through enough bear markets to understand that they're the single greatest gift in the world to value investors, and hopefully, I have done a satisfactory job of explaining the math behind why that is. Look at the retirement clock, and watch what will happen if Mr. Market offers us ridiculously cheap values on assets with reliable, steady income.

Another word on stock price risk. It's worth asking how the Model Portfolio stacks up against the overall stock market in terms of price decline risk. On the day of Brexit, the composite price for the Model Portfolio dropped 2.85%. The broader US stock market (as measured by theVanguard Total US Stock Market ETF, ticker VTI) dropped 3.65%, and the total global stock market (as measured by the Vanguage total world ETF, ticker VT) dropped 5.31%. The volatility of the Model Portfolio is substantially lower than the volatility of the stock market as a whole - which is not an accident. Because all of the companies in the Model Portfolio pay dividends, some investors who might otherwise own bonds could buy shares of these companies as an alternate income source. As a result, when stock prices are tanking and bond prices are in rally mode (as is often the case), shares of dividend paying companies like Southern (ticker SO), or Altria (ticker MO) or Realty Income (ticker O) may fall less than the broader stock market, or indeed, actually rally. The tendency of these sorts of stocks to do that can reduce the overall price volatility of the portfolio.

A final word on Brexit. I'm a business person, and look at bad news, fire, blood, black smoke and suffering as an opportunity to make money. A collapse of the global financial system, or anything close to it, is great news for value oriented investors. Those who follow the Model Income type of approach would probably come out making a fortune (certainly what happened during the dot com bust and the 2008 financial crisis).  However, from a human standpoint, I view Brexit as nothing short of a disaster. It represents a repudiation of openness, cooperation among cultures and peoples, and the triumph of xenophobia and nationalistic selfishness. I view it as a precursor to trade wars which, so often in history, lead to military confrontations. I believe the enemies of Western culture - groups like Isis - have scored a massive victory against Europe. Divide and conquer. The trade wars that are sure to come will destroy jobs, and reduce the quality of life in Europe and certainly within the United Kingdom. Disgruntled voters in the UK yesterday may even find themselves in the future as being both disgruntled and HUNGRY. So, as an investor, I may celebrate the potential for falling stock prices and bargain hunting, but make no mistake. Brexit is nothing more than the first step towards an economic, financial and potentially even humanitarian disaster. Some may read this last statement and conclude that I am overly dramatic. I may be - but sadly, I read history in my spare time. Let's hope I failed to understand any of it, or that contrary to the old saying, history does not actually repeat itself.  Fortunately, I am wrong more often than I am right, and knowing this, I can only hope that my track record of failure at predicting future outcomes of complex events will continue unabated.

Tuesday, June 21, 2016

Model Portfolio Update

We approach a critical point in the history of the European Union. Great Britain will vote on Thursday whether to remain in the EU, or to pull out. Should Great Britain leave, there will most certainly be a financial crisis, not only in the UK (which will bear the brunt of the economic and financial fallout), but throughout the world. The prospect of this happening has been a recent drag on stock prices - particularly those of European and UK firms.

But that comes as great news for value investors. The Model Portfolio has received another $120 in dividends, taking the total cash position of the portfolio up to $156. I will use that cash to purchase 3 additional shares of Unilever (ticker UL), which derives most of it's earnings in Euros and the stock price is denominated in Euros as well. The company is not cheap, but currently trades at a fair price, which is all an investor can ask for.

The Model Portfolio has now outperformed the broader stock market by about 12% since the day I launched the portfolio.

Stock prices can be fickle, irrational, and are inherently unpredictable and unreliable. Where I put my focus is on how much stable income the portfolio generates, and how quickly that income rises with time. The goal of the Model Portfolio is simple:  allow a hypothetical investor to retire and live on portfolio income for life, without ever having to sell a single share of stock, or withdraw so much as a penny of principal from the portfolio. The benefit of this goal is that an investor who never spends principal is far less likely to go broke than an investor who spends principal regularly. As importantly, an investor who never NEEDS to sell any assets will never be forced into selling stocks when the stock market is down. Investors who are immune from loosing purchasing power due to falling share prices are better positioned to BUY more shares when stock prices are falling.

These are the primary reasons for why the goal of the Model Portfolio is to generate stable and growing income. The primary methods for reaching that goal are: (1) own companies with excellent businesses; (2) own companies with strong prospects for paying a growing stream of dividends for the next few decades; (3) reinvest those dividends into the best priced shares available at the time. The goal is compound income growth, and reinvesting into cheap shares accounts for much of the fuel for that growth (that, and owning companies that regularly grow their dividends).

That's all I do when it comes to money management. Once in a while, I have opted to sell shares of a portfolio investment - particularly where I see the shares as being wildly overvalued - which is why I recently sold shares of McCormick (ticker MKC) and bought shares of Apple (ticker AAPL). Earlier, I also sold shares of Valspar (ticker VAL) when the Sherwin Williams company announced that it was going to purchase Valspar at a fabulous premium. Other than these two transactions, the only transactions I have engaged in with the Model Portfolio is to reinvest dividends, steady as can be. As a result, the income of the Model Portfolio has grown from $10,000 a year (I intentionally started the Model Portfolio with $10,000 of projected annual dividends) to $11,185, which comes to an annualized dividend growth rate of 18.64%. What's noteworthy is that it's been possible to attain that growth rate IRRESPECTIVE of the fact that the broader stock market really has gone nowhere during this time. I'm not joking when I say that stock prices aren't terribly relevant to investment performance if you focus on income growth, and income growth investors can do just peachy irrespective of what the Dow Jones Industrial Average is doing on any given day, month, year or even decade.

Attached is a view of the tool I use to track the income growth of the Model Portfolio. I am also attaching a link to the spreadsheet, so readers can copy the spreadsheet and use it for their own purposes, making whatever modifications they see fit to make.

As I have written in the past, my aim is not to promote a particular portfolio of companies. On the contrary, there are plenty of better investment options I can think of besides those currently held in the Model Portfolio. Instead, my only aim is to illustrate a general approach to investing, and to show, in real time, what sort of results an investor might obtain if he or she used a similar philosophy. And to be clear, I am buying more shares of Unilever NOT because I am betting on the outcome of the upcoming UK vote on whether to remain in the EU or not. I have no idea what the outcome will be, and don't care. I am quite sure that consumers will be purchasing Unilever's many different products REGARDLESS of whether the EU exists in it's current form or not. It seems the stock market is less sanguine about Unilever's prospects in the face of a so-called "Brexit" and the stock is now reasonably priced. So ends my analysis of what to buy with the $156 of dividends accumulated in the Model Portfolio's coffers.

And here is the link to the spreadsheet, which you are free to copy:

Model Portfolio Update

We approach a critical point in the history of the European Union. Great Britain will vote on Thursday whether to remain in the EU, or to pull out. Should Great Britain leave, there will most certainly be a financial crisis, not only in the UK (which will bear the brunt of the economic and financial fallout), but throughout the world. The prospect of this happening has been a recent drag on stock prices - particularly those of European and UK firms.

But that comes as great news for value investors. The Model Portfolio has received another $120 in dividends, taking the total cash position of the portfolio up to $156. I will use that cash to purchase 3 additional shares of Unilever (ticker UL), which derives most of it's earnings in Euros and the stock price is denominated in Euros as well. The company is not cheap, but currently trades at a fair price, which is all an investor can ask for.

The Model Portfolio continues to outperform the broader stock market by about 11% since the day I launched the portfolio.


But stock prices can be fickle, irrational, and are inherently unpredictable and unreliable. Where I put my focus is on how much stable income the portfolio generates, and how quickly that income rises with time. The goal of the Model Portfolio is simple: it is to allow a hypothetical investor to retire and live on portfolio income for life, without ever having to sell a single share of stock, or withdraw so much as a penny of principal from the portfolio. An investor who never spends principal is far less likely to go broke than an investor who spends principal regularly. And an investor who never NEEDS to sell any assets will never be forced into selling stocks when the stock market is down.

These are the primary reasons for why the goal of the Model Portfolio is to generate stable and growing income. The primary methods for reaching that goal are: (1) own companies with excellent businesses; (2) own companies with strong prospects for paying a growing stream of dividends for the next few decades; (3) reinvest those dividends into the best priced shares available at the time, so as to generate compound income growth.

Period. Once in a while, I have opted to sell shares of a portfolio investment - particularly where I see the shares as being wildly overvalued - which is why I recently sold shares of McCormick (ticker MKC) and bought shares of Apple (ticker AAPL). Earlier, I also sold shares of Valspar (ticker VAL) when the Sherwin Williams company announced that it was going to purchase Valspar at a fabulous premium. Other than these two transactions, the only transactions I have engaged in with the Model Portfolio is to reinvest dividends, steady as can be. As a result, the income of the Model Portfolio has grown from $10,000 a year (I intentionally started the Model Portfolio with $10,000 of projected annual dividends) to $11,185, which comes to an annualized dividend growth rate of 18.64%.

Attached is a view of the tool I use to track the income growth of the Model Portfolio. I am also attaching a link to the spreadsheet, so readers can copy the spreadsheet and use it for their own purposes, making whatever modifications they see fit to make.

As I have written in the past, my aim is not to promote a particular portfolio of companies. On the contrary, there are plenty of better investment options I can think of besides those currently held in the Model Portfolio. Instead, my only aim is to illustrate a general approach to investing, and to show, in real time, what sort of results an investor might obtain if he or she used a similar philosophy. The approach is to largely ignore stock prices UNLESS the investor is looking to buy more shares on the cheap. The approach is to use the power of compounding by consistently spending less than the investor earns, and using the savings to buy more shares of excellent businesses at the best prices available.

I am buying more shares of Unilever NOT because I am betting on the outcome of the upcoming UK vote on whether to remain in the EU or not. I have no idea what the outcome will be, and don't care. I am quite sure that consumers will be purchasing Unilever's many different products REGARDLESS of whether the EU exists in it's current form or not. It seems the stock market is less sanguine about Unilever's prospects in the face of a so-called "Brexit" and the stock is now reasonably priced. So ends my analysis of what to buy with the $156 of dividends accumulated in the Model Portfolio's coffers.

And here is the link to the spreadsheet, which you are free to copy:

Monday, June 20, 2016

Harvesting Losses to Make Tax Free ROTH IRA Conversions

There is much debate on the subject of when, indeed whether, it makes sense to convert a traditional IRA to a ROTH IRA. The general question people ask is whether you come out ahead by paying tax up front when you convert an IRA into a ROTH, in exchange for receiving tax-free income and appreciation on the ROTH IRA assets in the future.

If, however, you can convert an IRA into a ROTH IRA and pay little to no tax up front, there is no debate whatsoever - it ALWAYS makes sense to own a source of tax-free income if you can get it for free. To make the conversion tax-free, the taxpayer can avail himself of ordinary income tax deductions. Owning rental real estate is a fantastic way to generate substantial ordinary income tax deductions in the form of property tax, mortgage interest, depreciation and associated business expenses for the property. A second approach is to harvest tax losses, which can enable an investor to offset up to $3,000 of ordinary income. For example, suppose that a taxpayer owns an ETF such as the Ishares S&P500 ETF (ticker SPY), and has been buying shares regularly for years. Shares of a fund (or stock) are generally held in separate lots in a brokerage account. Some of the lots of shares may be showing capital losses, other lots may be showing gains. The taxpayer may SELECT which lots to sell, and may specifically sell those lots that show capital losses and keep the lots that show gains. By selling the loss positions, the taxpayer will realize the capital losses which are then available to offset other capital gain income, or that may offset an amount of ordinary income up to $3,000 per tax year. The taxpayer can't reinvest the proceeds from the sale of SPY back into SPY - that will disallow the loss under the so-called "wash sale" rule, but he CAN reinvest those proceeds into a substantially identical S&P500 index fund such as Vanguard's S&P500 fund (ticker VOO).

Nothing has really changed in terms of what the taxpayer owns - he's simply traded one ETF for another. But with $3,000 in tax losses, the taxpayer can now convert up to $3,000 of a traditional IRA into a ROTH IRA. That $3,000 will grow tax-free and generate tax-free income for the rest of the taxpayer's lifetime (and part of the lifetime of his or her beneficiaries if the taxpayer dies and leaves whatever is left in the ROTH IRA to his or her heirs).  By doing this regularly, year in and year out, the taxpayer can make significant strides towards converting taxable accounts into tax-free accounts, without incurring any up-front tax cost for doing so.

Saturday, June 11, 2016

New Ipad

What better way to determine whether a company is worth owning than to buy it's products? We bought the new Ipad Pro, and have quickly determined that the product is, in fact, magic. I cannot believe what this tool is capable of doing, and the comfort and ease with which it does it. It feels elegant. It is intuitive, simple, streamlined, and unleashes creativity in the hands of the user. In short, this may be the single best thing I have bought all year. Take a look at the art I created last night with the program Procreate on the new Ipad. I just learned by doing, and it was fairly simple, too.

I bought Apple stock (ticker AAPL) on account of the company's earnings growth, low debt, strong potential for dividend growth, and exceptionally low price earnings ratio. I will say that all of these things are meaningless without flawless, magical and perfect products. The Ipad Pro is just that sort of product. The Model Portfolio now holds an extra $191 in dividend income that came in on Friday - I will use that to purchase 2 more shares of Apple stock.

Friday, June 10, 2016

The Rising Tide Of Dividends

We are back from Madrid, and into the cool breezy sunshine of Lisbon. It is the most beautiful country in the world, Portugal. We keep the windows open all day, and can hear birds chirping and the wind rustling the leaves in the trees out in the little courtyard our apartment faces. It was a short trip to Madrid, but a long drive, and as we drove across the Vasco de Gama bridge, all of us felt almost like cheering to be back home.

The Model Portfolio has now accumulated another $385 in cash from new dividends that have come in over the last few days. Let's see how many retirement days that will buy us. Here is where the Model Portfolio stands at the moment. You can see the ticker symbols for every position in this portfolio at the top of the Retirement Clock spreadsheet on row 1, and right below on row 2, you can see the number of shares. You can also see the total number of shares we have purchased since we first started to use the Retirement Clock tool, which is on row7. So far, we've added 9 shares of HCP with dividends that came in earlier in the week.

Look at the gauge to the left, and you can see that we are generating $11,600 in dividend income each year. On the gauge at the right, we see 11.8 years until the portfolio reaches it's stated goal of generating $30,000 a year. Since we first stated to use the Retirement Clock tool, we have purchased 143.76 days of extra retirement time because (1) we reinvested dividends and bought more shares of income producing stocks; and (2) we sold shares of an expensive stock (MKC) and bought cheaper and higher yielding  shares in a bargain stock (Apple).

I have decided to reinvest the $385 in new dividend income into shares of Altria (ticker MO). At some point, I will write an article that details more why I pick one stock verses another for this portfolio, but for now, I only want to illustrate how to think about compound income and how to generate it. At yesterday's closing price of $65.86 per share, I can afford to buy 5 more shares of MO. Doing so will take my annual portfolio income to $11,171.66, which is only an improvement of $11 per year. Not super exciting. What is more exciting, though, is what happens with an extra $11 of portfolio income compounding relentlessly over time: it adds 5 days of extra retirement time. You can see that my total contributions towards retirement now stands at 148 days since I first started using the Retirement Clock tool last week, and that I now only have 11.79 years left to go before this portfolio churns out $30,000 a year.

I launched the Model Portfolio last November, and when I did, the portfolio generated $10,000 of dividend income per year. Today, the income has grown at an annualized rate of 19.35%. That rate of growth is not going to continue. It was largely fueled by a couple of big "one off" events; namely, selling shares of Valspar paints and McCormick spices, and using the proceeds to buy much cheaper stocks. These were gifts from an irrational being known as The Stock Market. There is no way to foresee whether further gifts will be forthcoming or not, so all an investor can do is wait, reinvest dividends into the cheapest stocks available at the time, and if a portfolio holding ever does become irrationally expensive, be prepared to do something about it.

It remains the case, as ever, that the pursuit of income growth is not mutually exclusive with the pursuit of capital appreciation. In fact, I suspect the two go hand in hand, PROVIDED that you invest in high quality companies. The search for pure yield is sure to end in tears and losses, whereas the search for companies that produce exceptional products and deliver masterful services is the bedrock foundation for any investment approach that stands any chance of success.