Saturday, February 18, 2017

Catching up

It's been several months since I last wrote about the Cash Growth Portfolio. Since December 13th, I sold FBL Financial and JPM Morgan, and placed all the proceeds into AZSEY and WPC. I reinvested dividends, writing about each and every single financial decision on SeekingAlpha, where I maintain a blog under the name "investment pancake." I won't rehash the whole sordid affair here, but today, the Cash Flow Growth Portfolio is very far ahead of the overall stock market. The composition of the portfolio today is as follows. As you see, the income is already 38% higher than it was when I launched the portfolio just last year, largely because I have been selling stocks as they get expensive and buying beaten down shares at lower values. For those who wish to read about the blow by blow choices when I made them, perhaps it can shed some light on how the thinking process, mixed with a healthy dose of dumb luck, brought in such robust returns. The key point to everything I write is that the stock market has a sort of blind spot. The market will frequently value two high quality companies in similar ways, but the stocks will have vastly different yields. This makes it routinely possible to exchange shares of a more expensive, lower yielding company for shares of a less expensive, higher yielding company of equivalent value, and in so doing, clock in a portfolio income raise each time.

As you see, the benefits on the portfolio's income growth speak for themselves. In fact, the approach also has benefits in terms of lifting the value of the portfolio with time - mostly by locking in gains when stocks become very over-priced relative to less attractive offerings elsewhere in the market. The Cash Flow Growth portfolio is already 8% higher than the S&P500.

But this is not the reason for returning to my writing here, on the Investor Underground. In truth, I've been far more busy unwinding my affairs in the United States. We have sold all of our furniture and belongings back in the USA, and are in the middle of selling our house as well.

It's more than unwinding our physical belongings, though. I realize that my family and I are unwinding our American dream. My wife and I went to ivy league schools, worked in prestigious firms. We borrowed vast sums to buy a massive house, and always looked to somehow get ahead - not just in terms of material, but position. Prestige. Being people who people would boast about knowing.

Today, I know that I will never amount to anything, and once more, I don't care. I just do what I do each day, mostly small tasks to keep our tiny apartment clean and my family well fed. My wife plans trips so we can take our kid to see the whole world. We have dear friends, people we would do anything for. This consists of the sum total contribution we will ever make to society, and that is okay for us now.

We are consuming less and less, it seems. We're anti-consuming - giving almost everything away to the point where every piece of clothing I own fits into a large suitcase, and besides that, I have a computer, some pens and art materials and shoes. We are so disconnected to the rat race now, I don't know how to reconcile that with my ongoing interest in financial markets. It leaves me at a loss for words, at times, and so without anything good to say, I've opted to say nothing.

I'll close by saying that it's been over a year and a half since we quit our jobs and moved to Portugal, and we have absolutely made the transition. We aren't the same people. We changed, not in the ways we expected. We really and truly escaped.

Tuesday, December 13, 2016

DIvidends Hit The Cash Flow Growth Portfolio

A few months ago, I launched the Cash Flow Growth Portfolio. It's designed to work like the Model Portfolio - I buy reasonably-priced, world-class businesses, I collect and reinvest the dividends into more shares of whatever's cheapest at the time, and once in a while, I sell high priced holdings and buy new, cheaper holdings. The entire goal of the portfolio is to grow the portfolio income, but to never sacrifice the quality of the portfolio's holdings. At this point, the Model Portfolio has gotten off to a good enough start that it's tough to say whether it's continued outperformance of the stock market is due to "trade legacy" - one or two lucky or smart moves a long time ago that render a portfolio permanently higher than the overall market. To that extent, the Model Portfolio project has an intrinsic flaw. It may no longer demonstrate in an ongoing manner that the stock market is inefficient and that investors can utilize said inefficiencies to their own advantage.
My solution? Every year, come up with a NEW portfolio project, and repeat the same process I use with the Model Portfolio. Year after year, if each portfolio reliably delivers income growth in excess of the dividend growth on the stock market, I like to think that my point has been made. If not, well, I must have gotten lucky with the first Model Portfolio (and also gotten lucky over the last 20 years with my personal portfolio). Totally possible.
More dividends have come in last night to the Cash Flow Growth Portfolio - $214 to be exact. This amount I shall invest into more shares of Extra Space Storage (ticker EXR). This will raise the income growth of this portfolio to nearly 7% since I launched it back in October. After buying 2 more shares of EXR, the composition of the Cash Flow Growth Portfolio shall be thus:
(click to enlarge)
And the relative performance of the portfolio verses the S&P500 is thus:
(click to enlarge)

The Trump Trade

Recently, our fearless leader, our future Commander in Chief, took to Twitter (as he is prone to do), to trash Pfizer (PFE). I have owned PFE for some time, collected dividends steadily over the years, and am a happy shareholder. The stock dropped almost 5%, and I took the opportunity to buy a few more shares (more than a few, to be perfectly honest). Since then, the price has rebounded, and I'm glad I took the time to buy more of the stock. Today, the company announced a handsome dividend increase, so in other words, I got paid twice. About $800 a year in extra dividends, all thanks to Donald Trump.
Today, our Commander in Chief, the great mastermind of Twitter launched into producers of the F-35, driving down stock prices for dividend paying companies like Lockheed Martin (ticker LMT) by nearly 5%. And once again, I took the time to buy a few extra shares, and that's when the light bulb went off.....
If you are a hispanic, a muslim, a gay or transgendered person, or a female, you might not care much for our future President. But hey, doesn't mean the guy can't put a little spare change in your pocketbook, right? If you can't beat 'em, make a ton of money off 'em!
So here is the concept. Every time our fearless Commander in Chief opens his yap and knocks some company's (or industry's) stock price into the toilet, buy the stock. Oh, sure, it sounds really scary when the President of the United States thrashes a company for selling expensive jets or whatever. Fact is, the stock market has no IDEA of how to deal with Trump's various musings (yet). Trump just says things, makes stuff up, shoots from the hip, and then gets distracted and moves on to something else. So what to make of this? In typical stock market form, sell first, ask questions later.
Oh, but that is not what we do. What we do is to take advantage of the fact that others do that. When you combine an irrational stock market with an irrational (or at least, undisciplined and unpredictable) President, and all I see ahead is a yellow golden brick road to profits. I might not have been a Trump supporter before, but by god, I am a die-hard Trump supporter now.
So I'm setting aside political differences, and I'm going to sell some shares of CVX (which is way up, thanks to various Opec deals, extra-Opec deals, and most of all, thanks to the fact that the US President thinks global warming from fossil fuels is a hoax), and I'm going go buy more LMT. All the Twitter ranting aside, before too long, the USA is going to want to bomb someone, somewhere, and Lockheed contracts will be rich and profitable.
It will be a short-term pay cut, but one I am willing to make. The Model Portfolio has more than enough oil exposure, and the oil investments have been fantastic in the short-term return. SO let's move onto bombs and jets, shall we?
(click to enlarge)

Monday, December 12, 2016

Another Big Slog of Dividends to Reinvest in Model Portfolio

$461 materialized in the Model Portfolio overnight, and now it is time to reinvest that dividend into a low priced, high quality company - preferably one that we already own. Unilever (ticker UL) is where I will be putting today's windfall - adding 11 shares at Friday's closing price. My reasoning is simple. The Euro is down (HARD), but UL sells products all over the world and earns profits in every currency type that exists. The fact that Unilever's stock price is denominated in relatively weak priced Euros says NOTHING about the company's profitability, the quality of it's products, the value of it's brands.

By adding more shares of Unilever, the Model Portfolio income continues it's steady climb upwards. We've seen a recent raise by WP Carey (ticker WPC), added more shares of various companies by reinvesting dividends, and we recently sold shares of JPM and replaced them with slightly higher yielding Realty Income (ticker "O"). The last time I bought UL, over a month ago I think, the income of the Model Portfolio stood at $14,870. Today, after a very productive month, the income has exploded higher, and now stands at $15,784. A 6% raise in slightly over one month is pretty good, all things considered. In the real world, I'm rewarding myself with a trip to Munich with the family, so we can see the Christmas markets and drink hot spiced wine (Lisbon is a lovely, sunny 60 degrees at the moment - not particularly Christmas-esque if you're used to snow and cold weather this time of year).

I must sound like a broken record at this point, but the lesson I am trying to impart is basic and bears annoying repetition. There is too much information about the stock market. This information is as endless as it is irrelevant. Almost the only thing people are talking about is trying to guess which stocks will rise the fastest, or whether the stock market will rise or fall. I advise that investors ignore all of that. Ignore the drivel and chatter of CNBC, focus ONLY on creating a stable, safe and reliably growing stream of portfolio income, and one day, your portfolio will churn out enough stable income that you can retire, live off dividends, and never sell another share of stock again in your entire life. Focus on just three key factors:
(1) organic income growth from owning portfolio companies that
have a solid track record when it comes to raising dividends; 
(2) reinvesting dividends into relatively low priced shares; and
(3) selling portfolio companies after they rally and use the proceeds to buy shares in other high quality dividend growth companies that have seen price declines, provided you can buy the latter at a low price/earnings ratio and relatively higher dividend yield. 

It's this last point that ends up being the sticking point for many people. The only reason to buy and sell stock based on valuation is if you think that somehow you're getting a bargain. Many people (including Nobel Prize winning economists like Eugene Fama) argue that the stock market, as a whole, digests all information instantly, and nobody can "know" more than the stock market. I agree with them in that particularly point. Where I disagree is when people like Eugene Fama assume that because the stock market digests every piece of information available, stock prices are somehow "rational", and that the price of a stock must equal the value of the stock. It's perfectly plausible for multiple people to interpret the same information differently. It's possible for a multitude of people to interpret information incorrectly. And it's possible for multitudes to ignore information, and focus on things like price trends instead of corporate earnings quality. I'd go farther and claim that not only is this possible - it's NORMAL. The stock market today is noisy, momentum driven, wildly impatient and extremely short-sighted. This is a systematic quality of the stock market. So many investors use passive index investing that characteristics fundamental to individual companies can often go ignored.

In short, the stock market offers prices for stocks that have NOTHING to do with the intrinsic value of the business, and does so routinely. Sometimes it's not obvious when that's happening, but oftentimes it is. That's really the secret to how I've been able to grow the Model Portfolio income by almost 60% in a little over a year. It's the secret to how I grow my own portfolio income, and it's the secret to why I retired to Europe when I was in my early 40s. I really believe anyone could do the same thing (probably better than I can) - which is why I show how I make investment decisions in real time with the Model Portfolio (as well as the Cash Flow Growth portfolio, which I recently launched).

I don't expect or even recommend that anyone would necessarily own the same stocks I have used for the Model Portfolio (I do, as it happens, but I own many more shares in other companies besides these). The point of the project is not to tout this investment over that investment. It's to describe an investing technique, or at least a general investment philosophy.

The Model Portfolio composition is thus:
(click to enlarge)
The Model Portfolio continues to outperform the S&P500 by around 15% since I launched the project in November of 2015. That's fine, but it isn't what I aim to do. My aim is to outperform the S&P500's dividend growth rate, and by that metric, it's not even in the same ballpark. The S&P500's dividend growth rate looks to come in around 7%, compared to the Model Portfolio's income growth rate of 58%. 

(click to enlarge)

Friday, December 9, 2016

Model Portfolio Update

The cash geyser at the Model Portfolio just keeps doing it's thing. Another $159 in dividends has materialized overnight into the Model Portfolio. As it happens, one of the components of the Model Portfolio, a REIT called WPC, has, once again, raised dividends. They tend to do that as regular as clockwork. And as it happens, the price for WPC has been falling recently.
Let me be very clear: there is no greater joy on Earth than a company with a falling stock price and rising earnings. And unlike earnings for, let's say, a car manufacturer, WPC's earnings (and expenses) come in under fixed, insured long-term leases. Those rising earnings are very, very durable. Combine falling stock prices, rising earnings and rising DIVIDENDS????? Heaven. Pure heaven.
This is why I will reinvest today's dividends into 2 more shares of WPC. This move will increase the total portfolio income by $7.92. The stock prices in the Model Portfolio may zig and they may zag, but the portfolio income just keeps rising, bit by bit, like a snowball rolling downhill.
It's curious, but in Europe, I don't meet many investors who focus much, if any, attention on actively growing their investment income. The mindset here is completely different. Actually, I don't meet many people who own stock or stock funds - mostly pension funds do that, individual investors, not so much. Instead, individual investors seem to favor real estate and bank accounts - or even stacks of cash locked into vaults. I've only talked to one person here about stocks and stock funds - she was entirely obsessed with the idea of buying shares with the hope that they'd rapidly rise in price so she could sell at a quick profit. When I spoke to her about the idea of slowly accumulating income, and using it to buy more things that generate income, and growing the income at a compound rate, I might as well have been trying to explain quantum mechanics. 
That's good news for the rest of us, but I wonder what accounts for the vast cultural differences between a US investor and a European investor? 

The composition of the Model Portfolio now stands as follows:
(click to enlarge)

Thursday, December 8, 2016

Cash Flow Growth Portfolio

On October 27, 2016, I launched a new portfolio that I call "the Cash Flow Growth Portfolio." It is a companion project to the Model Portfolio, but with fewer holdings and, obviously, a shorter track record. My reason for launching this new project was largely to demonstrate that the results of the Model Portfolio project can be replicated over, and over, and over again, year in and year out, using an investment approach I call "compound income growth" investing. 

The key assumption to compound income growth investing is that over time, the price of capital will track the rate of growth on the income that capital produces. For example, if I own a company that pays a very steady, predictable dividend that grows at a steady and predictable pace, the price for the stock of this company will rise at about the same rate as the dividends increase. 

Why make this assumption? The answer is because based on 100 years worth of data, accumulated and published for free on Professor Robert Shiller's homepage at the Yale School of Management, the average rate of dividend increases in the S&P500 over the past century is about 7% in real terms. The average return over this same period is also 7%. I figure that if the relationship between dividend increases and stock prices has held up for the last 100 years, it will probably do so over the next century. 

If you accept that stock prices should track income growth, how might that impact your investment approach? On a broad scale, you would clearly want to focus on steady, reliable and low risk portfolio income, and on growing that income consistently over time. In my view, there are three key factors the influence how you'd make investment choices to accomplish that:
       (1) Only invest in companies with exceptionally strong track records for steadily raising dividends over exceptionally long periods of time. This will probably mean investing in companies with time-tested products and services, decades worth of steady dividend payments, enduring competitive advantages and notoriously good management;
       (2) Reinvest the dividends you receive into more shares of dividend paying companies, hopefully at the lowest prices you can find. Ironically, this means you will find yourself HOPING that stock prices for companies you own will drop, so you can buy more shares at even better prices; and 
       (3) If you own two equally high quality companies, and the stock price of one company has risen while the other has fallen, consider selling the more expensive company and buying more shares of the cheaper company. Give special consideration to whether the YIELD on one company is much higher than the yield on the other company, so that by selling shares of the lower yielding stock and buying shares of the higher yielding stock, your portfolio will get a raise. But the absolute most important thing to remember is that the quality of either company must be the same. Replacing a steady, low yielding electrical utility like Con Edison with a risky, high yield stock in a dubious company that routinely cuts dividends, will probably backfire.

These are the three main steps I take when managing the Model Portfolio, the Cash Flow Growth portfolio and, in fact, my own portfolio in real life. The trickiest part of doing this style of investing, by far, is uncovering the truly best managed companies that exist, and being able to put a reasonable value on the company's shares. To do so, I generally do not look at the stock price - I review ten or twenty years of earnings reports and read customer reviews and so forth. Then I come up with a range of reasonability for the value of the company. Only AFTER I do that will I look at the stock price. If the market price is below my own best guess about the value of the company, I buy it. If the market price is very substantially higher than my own guess about the company's value, I sell it if I already own it, and steer clear of the stock if I don't already own it.  

Sounds clear enough, but the only way to get a real flavor of how to do it is to watch the decision-making in action, in real time. This is why I launched the Model Portfolio and Cash Flow Growth Portfolio projects. 

Originally, the Cash Flow Growth Portfolio owned a large chunk of JPM stock, which in my view is now priced to perfection. Maybe even slightly overcooked. I have opted to sell that position for this portfolio, and to reinvest the proceeds into Royal Canadian Bank (ticker RY). Why this bank? Because Royal Canadian raises dividends regularly and robustly, thanks to a wide moat and sound bank practices in a growing market. Royal Canadian is an excellent business, and it's reasonably priced.

As a result of this action, the income of the Cash Flow Growth Portfolio is now roughly 7% higher than it was in October of this year. The composition and income performance of the portfolio is thus:

(click to enlarge)

The price performance of the Cash Flow Growth portfolio relative to the S&P500 is about 2.45% higher since launch. That difference could vanish in a puff of smoke, but the run up in JPM accounts for a significant portion of the portfolio's outperformance relative to the S&P500. Soooo, by selling JPM now, we're locking in that gain - and taking the time to book a nice income raise as well. Here is the chart:

(click to enlarge)

Wednesday, December 7, 2016

Model Portfolio Adjustment

The Model Portfolio owns 261 shares of JP Morgan, which we purchased at a time when banks were not cool. Now that banks have suddenly become cool (courtesy of rising interest rates that many believe are destined to only go higher). The PE ratio for JPM reflects that consensus - a consensus that I think is probably wrong. But who am I to argue with money? We have made 40% in less than a year, and the valuation for this business is stretched... at least in my view. Not crazy high, mind you, but stretched. The dividend yield is about 2.3%, although that could be misleading if the CEO makes good on his hints about a special one-time dividend. This is not a screaming sell, but I think we can do better.

Now let's go back in time to a day when the Model Portfolio owned a large position in Realty Income (ticker O). We sold those shares months ago when the stock was flirting with $70 a share. Oh, but times have most certainly changed. The stock has sunk to $55 a share and is now priced reasonably in my view. The yield is 4.37%, which isn't fantastic for a REIT, but O is a particularly well managed operation that carries a premium. I'm okay paying for quality... just not too much. I wouldn't call O a bargain, but it's investible.

So, I will sell our JPM Morgan position now, and plow the proceeds back into our old favorite, O. At current prices, that comes to about 393 shares of O.... and a very, very nice bump in the Model Portfolio income, to $15,756 per year. We have now clocking in income growth of almost 58% since November of 2015 when I started this project. The composition of the Model Portfolio now stands as follows:

(click to enlarge)

The entire aim of the Model Portfolio project is to demonstrate how investors can grow their income by investing in companies with unimpeachable dividend histories, by investing in these companies at low prices, selling the shares if and when they become overpriced, and then reinvesting the proceeds into shares of lower priced, but equally high quality, companies that pay a higher dividend yield. And by reinvesting dividends into more shares of whatever is cheapest at the time. And keeping up the work for years. It's slow, but progress can be steady and of course, that progress compounds over time.

The Model Portfolio continues to outperform the S&P500 since I launched the project last year. The spread now stands at 15.26%. It's worth noting that the composition of the Model Portfolio is entirely dividend producing, yield stocks. These were supposed to crash when interest rates rose, but that has not universally been the case. Conclusion: ignore the consensus on what interest rates may or may not do, and DEFINITELY ignore the consensus on the conjectural fallout from said moves in interest rates.

Instead, try to focus exclusively on finding the best run businesses money can buy, at the best prices available. If you own exceptionally well managed businesses, they'll adapt to whatever the environment may be, leaving you very little (if any) reason to second guess the business managers who work for you. If you did nothing besides that, you'd garner exceptional investment results.

If you want to take it a step further, buy exceptional businesses when they're out of favor, and sell them when the stock market is paying top dollar, and reinvest your dividends with maniacal regularity into the cheapest, best run businesses you can find at the time. Keep that up for 20 years, and I am willing to bet that you will garner surprisingly exceptional investment results. Nobel Prize winners would disagree strongly with that statement... and that is precisely why I decided to publish this series to begin with. The experts are wrong, and would probably all agree that theoretically, I don't exist. But as the late, great Yogi Bera said "In theory, practice and theory are the same, but in practice, they aren't."

(click to enlarge)

The Great Escape

How do you know when it's time to quit a really lousy job? That's what my most recent painting is about. Pulling the plug. Tossing in the towel. The Great Escape.

Anyone who has worked in a setting they truly cannot abide can probably empathise with how an octopus might feel working in a back alley sushi bar.

Fortunately for this octopus, he's a compound return investor. He has been steadily reinvesting dividends into the lowest priced blue chip stocks he can find, and now that his dividend income exceeds his salary, he can afford to toss his apron on the floor and storm out the front door. He doesn't even have to worry about burning bridges or leaving on good terms or any of that sort of thing. He can make a statement. Let's hope this proves to be a one way trip for our eight legged friend.

Tuesday, December 6, 2016

The Great Snail Race

One of the benefits of investing for compound income growth is that there is a high degree of regularity about it. The dividends come in, you buy more shares, your income goes up, and next month, the same thing. While the share prices may whip around in volatile chaos, the portfolio's income just keeps chugging along, day in, day out. This style of investing is sort of like watching a sloth working on a very, very slow moving assembly line. If you are looking for excitement, you certainly won't find it here. 

And there is very little guesswork involved. Do I sit around trying to guess what will happen to the stock market if Donald Trump is elected president? No. Do I try to guess whether interest rates will rise or fall, and how that will impact stock prices? Obviously not!  I simply invest when I have spare cash available, and I see a well run company trading at a reasonable price. I write down how many new shares I bought, adjust my portfolio income slightly higher, and go back to doing whatever I was doing before. 

And on that note, another $272 of dividends has come rolling in to the Model Portfolio. I am investing those into 25 more shares of Navios Midstream Partners (ticker NAP), raising the portfolio income to $15,288, which is nearly 53% higher than the portfolio's income when it launched in early November of 2015. In the real world, I don't own this stock and probably wouldn't - I don't need the extra income, so I mainly focus on lower yielding, lower risk assets at this point. For the Model Portfolio, the goal is to grow portfolio income to $30,000 a year, so higher yielding assets are welcome. 

(click to enlarge)

And with that, the great snail race continues. 

In the real world, I am now putting Realty Capital (ticker symbol O) back on the buy list. As you know, we sold a massive quantity of that stock several months ago at a price between $68 and $70 a share. It was a grossly overvalued stock. Today, the shares trade at $54, which is high, but reasonable. I am looking to buy back much of what I sold. I am also turning attention towards utilities and telecom shares, all of which are down sharply thanks to rising interest rates. It's a great time to be an income growth, value oriented investor.

Friday, December 2, 2016

Trains, Beer, or Both?

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).

Monday, November 14, 2016

Ode to Dividends

Whilst we slept in our beds, dozing and snoring,
the little elves have been busy and true.
What to buy now, we decide, though the task may be boring,
for dividends of $148 the Model Portfolio hath accrued!
More shares must we buy, and cheaply, he thought,
so t'was Unilever (ticker UL) that Alex he eyed,
for now the Euro hath been flushed down the pot,
three shares was the number he buyed!
A wee boost in the income of the Portfolio model,
but over time this too shall compound.
So that Alex may swill more white wine by the bottle
whilst gloating over bargains he's found.

In response to some reader's comments regarding readability of my previous spreadsheet, I have simplified the layout to more easily track the Portfolio's income performance.

Friday, November 4, 2016

Month-end dividend reinvestments

This month, the Model Portfolio had collected a little over $240 by the time I returned to Lisbon from our vacation in the Azores. This amount I invested into a single share of Lockheed Martin (ticker LMT).

I also spent a few moments contemplating what it would mean if Donald Trump actually were to be elected as the US President.

Many well known, vocal investors have announced that they are hedging their portfolios against potentially horrific losses if Trump is elected. I tend to think that sort of behavior is a bit of a waste. Not only is there no way to know how the stock market would react to a Trump presidency, but the quest to protect a portfolio from falling prices is insane unless you have a plan to sell the entire portfolio in the near term. And if you had such a plan, I'd say you have no business owning stocks to begin with.

If the stock market collapses in epic form in the aftermath of a surprising Trump victory, my plan is to celebrate the availability of lower stock prices. I will continue reinvesting dividends, like always, only I will be buying at lower prices and thereby earning a higher yield and future reinvestment rate. There is one very interesting metric to show why I am actually HOPING for lower stock prices, and why spending money to buy put options or other hedges for my portfolio is the last thing on my mind.

At today's stock prices, my recently launched cash flow growth portfolio is expected to generate $1,089,044.81 in dividends over the next 20 years.  That ASSUMES that I will be able to reinvest future dividends at today's portfolio yield, which is 3.39%.


Now watch what happens if the portfolio price drops 25%.

Obviously, a falling portfolio price equates a rising portfolio yield, which means I end up getting far more bang for my buck when I reinvest dividends. $167,836 more bang for my buck to be precise. Why on Earth would I want to HEDGE that result? It would be the best thing for me.

Well, but for the fact that it would mean Donald Trump got elected to be the next President, with any number of unknown, absurd possibilities following in his wake. Let's just say I will be far more worried about a third world war than falling stock prices, per se.

Friday, October 28, 2016

If I had to build a simple portfolio today, what would I do?

Two days ago, I thought about the question of what I would do if I had to create a new portfolio with just a small handful of stocks, which I thought offered the best prospects for a solid dividend yield, solid dividend growth, solid business prospects for the future and a reasonable stock price. I came up with the following new portfolio which I will call The Cash Flow Growth Portfolio.

The idea behind this project is simple. Do what I always do, which is to grow portfolio cash flow as quickly as possible without sacrificing the quality of the portfolio's business composition. How? Reinvest dividends into the best priced shares available at the time, sell any stocks that become absurdly priced and buy cheaper stocks of similarly high quality companies that are trading at lower share prices. My goal for this portfolio? Like most people, I care about how much income my portfolio pays me today, but what is really more important is how much income it will pay me in total over a very long stretch of time.

As currently configured, my Retirement Clock Tool estimates that this portfolio could produce about $1,036,000 of dividend income over the following 20 years, assuming that the businesses continue to raise dividends at the same rate they have done over the past 5 years, and assuming I can reinvest dividends at today's yields. Both are huge assumptions, so the $1,036,000 figure is very much an educated guess. But as investors, guesses about the future are all we have to go by, and if the guess is reasonable, it's all we can possibly settle for.   Stated more precisely, my goal is to maximize the amount of possible income that the portfolio might pay over over 20 years based on the dividend growth and dividend yield we see today.

The composition and portfolio income for the Cash Flow Growth Portfolio is as follows:

In subsequent posts, I will explain why I picked the companies listed here, go into some detail on what makes them special, and why I think they are poised to deliver income growth that far exceeds the S&P500, and why I think the stocks are either cheap or at least fairly valued.

For those who wish to copy this spreadsheet, which self-updates for dividend growth rates and dividend payment rates, feel free to do so. Here is the link:

What Are the Main Lessons of the Model Portfolio Project?

We are quickly approaching the first anniversary date for the Model Portfolio, which I launched in November of 2015. My concept for the Model Portfolio project was (and is) to demonstrate that 99% of investors make a costly mistake by trying to generate capital gains on their portfolio, buying stocks in the hope that the stock price will rise. My approach is quite different - I virtually ignore stock prices, and focus on maintaining a portfolio that generates a growing stream of reliable income. I am explicitly NOT attempting to grow the composite price of my portfolio, which probably means that my goals are roughly the opposite of a normal investor's goals.  That may explain why my investment behavior is the opposite of most investors' behavior.  Those who seek capital gains tend to avoid stocks with dropping share prices, and will even SELL stock simply BECAUSE the price is dropping and they want to avoid further losses. Not I. When I see the price of a stock I own soar above the intrinsic value of the company, I sell the stock and reinvest the proceeds into shares of far lower priced stocks with higher dividend yields. And when I see share prices dropping for a company I own, I focus on buying more shares - it'll probably be where I reinvest dividends each month unless I find better deals elsewhere. By swapping out lower yielding assets for higher yielding assets without sacrificing quality, and reinvesting dividends wherever I can get the best deal available at the time, I can can typically grow my portfolio income at a far higher rate than the dividend growth rate for the S&P500. I'll get to that in a moment.

First, let me make the most important point of all. Here is a thought experiment. Suppose I grow my portfolio dividend income 1% faster than the S&P500 this year, and then next year, my portfolio dividend growth drops back to match the growth rate on the S&P500 for the rest of all time. And let's suppose that I reinvest dividends into an S&P500 index fund for the rest of my life, so I'm getting the exact same yield on my reinvestments.  Would that mean that my portfolio income would be permanently 1% ahead of the S&P500 for the rest of my life?

The answer is NO. Thanks to that 1% lead in year one, and constantly reinvesting dividends to grow my portfolio income base, over a 50 year period, my portfolio income would be nearly 50% higher than the S&P500, not 1% higher. An early lead tends to magnify over time if you just leave it alone.

Getting back to the Model Portfolio, this past year has brought dividend income growth of 48.77%, dramatically outstripping the dividend growth rate on the S&P500 by nearly 1000%. That's the sort of early lead I like. And it gets better still. The yield on the Model Portfolio is almost twice the yield on the S&P500, and as long as that remains true, that means that my dividend reinvestments will deliver double the compound growth rate as reinvested dividends on an S&P500 fund deliver. All things being equal.

Obviously, all things are never equal. The biggest risk I see is that the components of the Model Portfolio will not increase their dividends in the future at the same rate as the 500 companies in the S&P500. If so, that could either amplify or minimize the impact of the dividends I reinvest next year. Generally speaking, over the past 100 years, companies in the S&P500 have tended to raise dividends by around 7% a year. The Model Portfolio, however, consists of a mix of companies that together would have historically raised dividends by around 9% a year. I am betting that the dividend growth rate for the companies I own will outgrow the dividend growth rate on the S&P500. It might turn out that I'm wrong, though. Time will tell.

In sum, there are now three factors that could work in my favor. First, I'm already ahead, which means I'm starting from a larger income base than I would have started from had I just invested in the S&P500 last year, instead of the Model Portfolio. Second, the Model Portfolio has a higher yield than the S&P500, so the dividends I reinvest into the Model Portfolio will produce more income than they would if I were to reinvest them into the S&P500. And third, the companies I own in the Model Portfolio have stronger dividend growth records than the broader mix of companies in the S&P500. I rely on these three "advantages" in real life, when I manage my own portfolio. My aim is to demonstrate how these advantages can work for other investors, and to share my approach in real time so investors can see how I'm approaching and addressing different problems and opportunities with this investment approach.

Looking back, what are the main sources for the rapid income growth on the Model Portfolio? The answer is that a couple of the portfolio investments soared in value, and I sold them. We saw shares of Valspar paints, McCormick spices, General Mills, Realty Income all explode far above the actual value of the underlying businesses, which meant we sold at premium price levels. I had no idea ahead of time this would happen with these particular companies, or indeed, any companies I own. The best guess I had was that if you own excellent businesses, eventually, the stock market notices and when it does, stock prices can get bid into stratospheric levels. You can't predict if or when, but you know it when you see it when a stock rallies 20% in a day, or trades at a PE ratio of 25, 30, or even higher.
The proceeds of those types of sales went into assets that were trading at prices far below the actual value of the businesses. We bought shares of a European index fund that had dropped 20% in the wake of Brexit, and sold those shares shortly thereafter at a 15% gain. We bought shares of REITs when interest rate concerns had pummeled the stock prices, and shares of telecommunications firms when regulatory risks were driving the stock prices lower. And we reinvested dividends with religious fervor into cheaply priced shares of blue chip stocks with decades of dividend growth history.

This month, it's been more of the same. Our investment in Stanley Black and Decker (ticker SWK) has sprinted higher and now, quite frankly, the shares are priced to perfection. Johnson and Johnson (ticker JNJ) has done well, and the PE ratio on the stock is in extremely high territory. I sold off about half our positions in these two names, and purchased shares of Lockheed Martin (ticker LMT), which is a fairly valued stock, and Kimberly Clark (KMB), the price of which has been grinding lower for months and dropped violently this week. As a result of these exchanges, I have enhanced the diversification of the Model Portfolio (which now consists of 26 positions, rather than the 20 positions we started with), and grown the dividend income to $14,823.87 a year, which is about $200 per year higher than it was earlier this week. AT&T (ticker T) raised it's dividend this week by a small amount, complimenting dividend increases we've already seen this month from companies such as Omega Healthcare Investors (ticker OHI) and American Express (ticker AXP).  We are basically on track this month to accomplish portfolio income growth in the three ways we like best: (1) sell expensive stocks and buy cheap stocks; (2) receive dividend increases from companies we own; and (3) reinvest dividends regularly into low priced shares.  And I will tell you a secret about what to expect next month, next year, and next decade. It will be the same three things I just said.

It's as dull as watching paint dry or grass grow, but when you find investing to be exciting, you can be pretty sure that it's because you are heading straight over a cliff without a parachute... which is exciting also, but not very smart or profitable.

The composition of the Model Portfolio is now as shown below. You will note that I have removed a few functions from the Retirement Clock tool, which hopefully simplifies the presentation a bit. Remember, readers are always free to set up their own Retirement Clocks using the spreadsheet that I use. It's available for free, and you can download it off of Google Docs by clicking the link at the end of the page, and once in Google Docs, clicking the "make copy" icon. Just remember that I have manually input some of the dividend growth assumptions - the spreadsheet automatically retrieves dividend growth rates for all positions unless you input your own assumptions, and will self-update for any dividend increases by any of the component companies or funds.

And here is the link for those who wish to create their own Retirement Clocks.

Sunday, October 16, 2016

Recent Drawings

This is an abstract drawing of a street in Lisbon.

This is an abstract design of a woman reading an Ipad on a couch.

Friday, October 7, 2016

Valuation Levels of the Stock Market

Is the stock market expensive? The answer should be "yes, if it is trading at a valuation that is similar to times in the past when investors lost money" and "no, if it is trading at a valuation that is similar to times in the past when investors made money."  There is nothing more objective than making or losing money. Any statement about what valuation "ought to be" is useless. Any statement about valuation being above or below average is also entirely useless unless that information translated into investors making or losing money under similar conditions in the past.

In that spirit, I have done a two part analysis.  First, I have calculated how much an investor would have earned over a ten-year period if he or she bought shares of the S&P500 on any given date, and reinvested dividends back into the stock market at prevailing market prices over the ensuing 10 year period. If an investor bought shares and subsequently made money over the following 10 years, the investor paid a fair or low price. If the investor did not make money over the following ten years, it means that the stock the investor bought was too expensive. I put the resulting data onto the graph, below, denoted by the red line.

The second thing I did  was to subtract the interest rate on a ten-year US Treasury from the earnings yield for the S&P500 for all periods since 1871. The resulting "earnings premium" calculation is a good measure for how expensive stocks are, because it shows the price of dollar's worth of corporate earnings (earnings which are uncertain and unpredictable) verses a dollar's worth of risk-free interest on a US Treasury. For example, if my $100 investment in the S&P500 yields $7 in earnings, but a $100 investment in US government bonds yields $5, then stocks are priced relatively less than bonds and I stand to earn a $2 premium. Conversely, if my $100 investment in the S&P500 only yielded $4 in earnings, then stocks are priced relatively more than bonds and I stand to earn a negative premium of $1.

The graph below shows that there is at least some relationship between the earnings premium on the S&P500 and future returns earned over a subsequent ten year period.  Generally speaking, a low earnings premium often translates to negative investment returns over the following ten year period, whereas a high earnings premium translates to very solid returns over the following ten year period. The relationship is far from perfect, but it supports the argument that stocks are cheap when earnings premiums are high, and expensive when earnings premiums are low or negative.

A quick glance at the chart, though, demonstrates that something happened in 1979. All of a sudden, the earnings premium collapsed, and based on past history, you would think that stocks became very expensive relative to bonds at that point. It appears stocks stayed expensive until about 2004 or 2005. Regardless, the period of 1979 to 1995 was a very lucrative time to be a stock investor.  Why?

I suspect that the answer is because interest rates soared into double digit territory, virtually off the charts compared to all earlier periods since 1871. Rapidly rising interest rates and elevated inflation rates chipped away at the value of bond principal to such an extent that perhaps bonds were no longer truly "risk free" at this point. Interest rates topped out at 14% in 1982, but remained elevated by most historical standards until the early to mid 1990s, and arguably shed their status as radioactive dog droppings in 1997. I pick 1997 as the anti-radioactive dog dropping date for bonds because that was the year when the stock returns dropped with violent speed. You could also infer that as interest rates returned to normal from their elevated state, the relationship between the earnings premium and future returns also resumed in force. Since the earnings premium on the S&P500 was very negative in 1997, unwary stock investors were bespattered by the very radioactive dog dropping that had plagued bond investors for much of the late 1970s and 1980s.

Today, the earnings premium is in the range of 2% to 3%, which is close to average since 1871. Interest rates remain exceptionally low, however. One could argue that the period of 1930 through 1960, where interest rates in the USA hovered between 2 and 3%, may be the closest analogy to where we stand today. During that period from 1930 to 1960, the relationship between the earnings premium and future stock returns was especially strong. Perhaps it will be different this time, and perhaps not.

In sum, I don't see a strong reason to assume stocks are particularly expensive or cheap today - at least not from an historical perspective focused on earnings and interest rates.

Monday, October 3, 2016

The Vampire's Retirement Plan

You are a vampire. You are destined to live for eternity, and have cultivated a mild distaste for work. Your home is paid off, doctor bills aren't a major concern for the undead, and your diet is basic and inexpensive, if not somewhat monotonous. You don't need much to get by.
You've managed to put aside an emergency fund equal to roughly 2 years' worth of living expenses. And you have also managed to accumulate a good sized stock portfolio that generates dividend income. But today is momentous, because for the first time in your long life, you just received a dividend check that is 20% larger than your average living expenses.
As you walk down the bustling streets of New York City, you hear a crash and a scream. You turn around and people are pointing at an open office window twenty stories above street level, and gaping at the body of a stock broker who has just jumped out of that window. It is September, 1929, and a few minutes ago, you just told your boss to go pound salt and you quit your job. In the history of the US stock market, it is accurate to say that your timing could not have been any worse.
Since you are a vampire, your retirement is going to last for an arbitrarily long time and spending down principal is not an option. Rather than spend down your capital, you have adopted "The Vampire's Retirement Plan." The way it works is dead simple. Your plan is to invest in the overall stock market (the undead are notoriously lazy when it comes to stock research and active management). You will live off dividend income, and never sell a share of stock in the rest of your long life. For any month where your living expenses are less than your dividend income, you will simply divide the savings in half - one half you will reinvest into more shares of stock, the other half you will add to savings. You plan to utterly ignore stock prices from now until eternity - you will simply reinvest each month you can afford to, regardless of what the stock market happens to be doing. In any month where your living expenses are greater than you dividend income, you will withdraw cash from your savings account and, if all else fails, you will sell stock and live off the proceeds.
Looking back today at your untimely retirement choice of 1929, how will it have turned out for you? To answer your question, I've run an analysis based on 145 years of historical data on the S&P500 compiled and made publicly available by Professor Robert Shiller of the Yale School of Management. Professor Shiller's data includes inflation rates, dividend rates, and stock prices (among other data). What I have done is to add several new functions and columns into Professor Shiller's spreadsheet. The first new column shows the number of hypothetical shares of the S&P500 you would have at the start of each month (column I). In column J, I show the total dividends you would receive, based on your number of shares and on the dividend rates provided in Professor Shiller's historical data. Column K shows your spending, adjusted for inflation using the price index data from Professor Shiller's data. Column L shows your savings (if any) for months where you dividend income exceeds your living expenses. Column M uses a logic function, and either adds your savings (or subtracts the shortfall of spending verses dividend income) from the previous month's cash balance in your savings account. Column N shows the total number of new S&P500 shares you can afford to buy with your savings (if any), and Column O shows how many S&P500 shares you have at the end of the month - adjusted for any new shares you see in Column N.
Here is snap shot of your situation in 1929. You own 2127.61 shares of the S&P500 worth $66,594 at the prevailing market prices for the S&P500 in September 1929. You earn $166.66 a month in dividends and spend 80% of that amount on living expenses, leaving you a budget of $133.66. And you have a savings account of $3,329, equal to 5% of your stock portfolio or about 2 years' worth of living expenses, depending on how want to look at it.
(click to enlarge)
Skimming down the spreadsheet, readers can appreciate why it is the case that by June, 1932, you are getting nervous. Your stock portfolio has hit an all time low of $10,366.15. Fortunately, the impact of deflation has lowered your monthly living expenses somewhat, but the dividend income you receive has dropped from $166 a month down to $119.44 a month, thanks to widespread corporate dividend cuts and an outbreak of bankruptcies across corporate America.
Things are about to get much, much worse. By October, 1932, you have your first month where your living expenses exceed your dividend income, and you must now dip into cash savings to make up the shortfall. This situation of having to dip into savings will persist until August of 1936, at which point, things will start to look up. For a time.
The lean years start up again in earnest in 1938 as corporations slash dividends. A bout of deflation saves the day, and you are able to limp by using your savings and enjoying lower prices on your basic living expenses.
(click to enlarge)
This, unfortunately, is only a taste of what's to come. From May of 1942 until April of 1949, you will routinely dip into savings every single month to cover your living expenses. Some months, you will not even have remotely enough dividend income to cover your rising living expenses, and by the end of this miserable seven year stretch, you will have depleted your savings account to $1,822. Twenty years after the greatest stock market crash in history, your brokerage account has sagged to a mere 50% of it's former 1929 glory.
(click to enlarge)
Fortunately, 1949 marks the low point in your investment career. From this point forward, your dividend income will cover your living expenses, and your ability to save and invest will put the compound returns genie squarely into your corner. By 2016, your savings account has burgeoned to $922,965, and your brokerage account is worth $8,348,117. Your portfolio dividend income of $14,830 easily covers your $1,847 a month worth of living expenses.
(click to enlarge)
Next, let's look at a chart that plots out the data from the spreadsheet, comparing your living expenses (or unliving expenses, if you prefer) to your portfolio income.
(click to enlarge)
The Vampire's Retirement Plan would have withstood the worst stock market decline in history, a depression, World War II, and wave after wave of dividend cuts and corporate bankruptcies, and countless recessions and wars besides. It would have eliminated any form of longevity risk (making it an ideal model for young retirees, zombies and others), and would result in zero capital gains taxes. Best of all, it would enable the retired vampire to utterly ignore stock prices, since she would never be required to sell a single share to cover her living expenses. More than anything else, it would have required steady nerves and discipline to stick with the plan when all hope seemed to fade. In sum, history teaches us that vampires should (1) own a diversified stock portfolio; (2) work and save until their living expenses equal 80% or less of their portfolio income; (3) hold enough cash to cover at least a couple of years' worth of living expenses, and tap those savings only when needed; (4) never sell stocks or spend principal; and (5) when their dividend income exceeds their living expenses, save half and reinvest the other half into more income producing shares of stock - regardless of market conditions.

Sunday, October 2, 2016

The Greatest Trader In History vs. A Compound Return Investor

It's New Year's Eve, 1929. Champagne corks are flying, jazz music blaring, and there is a sense of wealth and prosperity in the air. But you are nervous. Through the music and dancing and general merrymaking, you see dark clouds on the horizon. You have become convinced that the stock market is going to crash, and take down the global economy with it.

But first, a bit of history on who you are. On February 1, 1871, you purchased 100 shares of an S&P500 fund.

Whoa whoa whoa!!! Stop the music! There were no such things as S&P500 funds in 1871!!!!!

Okay, you got me there. So, what I've done is to take Robert J. Shiller's Stock Market Data from his homepage. The data professor Shiller has collected starts at 1871, and shows price levels, dividends, and other data relevant to stock market performance over the past 145 years. I have added a few columns to his spreadsheet. I assumed an investor could purchase units of the S&P500, and put that into newly created column M. For purposes of today's example, I assumed that you bought 100 units of the S&P500 in 1871, at a cost of $452, which is based on the value of the S&P500 at that date.

Every month, you receive dividends on your shares (I show the total number of dividends you receive based on the number of shares you own in column N). You reinvest those dividends each month into more shares of the S&P500, at whatever price is then available. I show your total new shares that you buy with your dividends in column O.  In column P, you see the total number of shares you own after you've reinvested your dividends and, in column Q, I show the market value of your portfolio at the end of each month based on the market price and the number of shares you own.

So it's New Year's Eve in 1929. You have done very well since you bought your 100 shares in 1871. Thanks to your continual reinvestment, you now own 2085.93 shares of the S&P500, at a total market value of $51,856. That's an 8.5% return every year over the last 58 years (let's assume for the purpose of this exercise that in addition to being rich, you also happen to be immortal).

But you are very nervous that the stock market will crash, and are about to make the single best timed trade in the history of the entire stock market itself. The next morning, January 2nd of 1929, you sell your entire stock portfolio and move all of the proceeds into bonds. The morning before the sale, your portfolio generated $149.06 a month in dividends. After you sell it and switch over to an all bond portfolio, you will get $154.45 a month in interest payments. The move seems to make perfect sense simply from a valuation standpoint of stocks relative to bonds. You figure that since bonds pay more than stocks, so they must be worth more.

History will prove you correct. And you will not even so much as set foot back into the stock market for the next 26 years, until the market has completely recovered it's 1929 highs in 1955. During this time, you will avoid 26 gut wrenching years of volatility, a World War, and economic depressions across the planet, but your money will not be idle. You will invest your $51,856 into ten-year government bonds, and reinvest the interest payments into more ten-year bonds, allowing the power of compounding to work it's magic.

You'll be glad you did. In January of 1955, your portfolio will have doubled while the stock market's price level will have gone virtually nowhere. Your portfolio is now worth $103,188, thanks to your master stroke trade, and you will have avoided the single worst collapse of stock prices in the history of the global markets.

But skip back in time to 1929. Unbeknownst to you at the time, as the champagne corks were flying and the jazz music was blaring, there sat across the room from you another investor who had considerably less trading skill and luck than you. This other investor is, in fact, the laziest investor anyone could ever be. He is a moron. He ignores stock prices entirely. When it comes to investing, all he does, THE ONLY THING he does, is to own stock, collect the dividends, and reinvest those dividends into more shares of stock, at whatever price is then available to him. Like you, in January of 1929, he owns 2085 shares of the S&P500 worth a total of $51,856. But unlike you, he will watch the value of his portfolio sink, and sink, and keep sinking to an all time low of just $12,177 in June of 1932. And in the face of these horrific losses, he will just keep collecting dividends and reinvesting them into more shares of the S&P500. Unthinkingly.


As the stock market swoons throughout the 1930s, this moron is able to buy shares at miraculously low prices every time he reinvests dividends. In 1929, for example, the moron across the room is only able to afford to buy 6 shares of the S&P500 with the dividends his portfolio earns. In the depths of 1932, however, he can afford to buy 29 shares of the S&P500 with the dividends he earns! While the moron's portfolio price has crashed to only $12,177, the number of shares of the S&P500 that the moron has managed to accumulate has exploded higher, from 2085 shares before the 1929 crash, to 2552 shares in the darkest depths of 1932. And still he keeps doing nothing besides reinvesting his dividends.

Fast forward to 1955. The chart of the Dow Jones would suggest that the moron investor would only now have broken even from the heady days of 1929 when his portfolio was worth $51,856. The chart, however, is a lie (most stock charts are). The chart you've seen of the Dow Jones does not show the impact of reinvesting dividends into more shares, which is what the moron investor bases his entire investment behavior on. By 1955, the moron has not broken even. The moron's portfolio is worth $317,687. He has earned 7% a year on average over the past 26 years, and far from breaking even, the moron's portfolio is actually now up 600%.  More astonishingly, the moron's stock portfolio in 1955 is paying $1,186 in dividends every single month, which is almost 1000% more dividend income than the portfolio earned in 1929.  You, however, savvy stock trader that you are, only collect $223.95 a month from your bond portfolio. The moron has beaten your income performance by nearly 500%.

The moral of the story is pretty clear. The way to invest intelligently is to invest like the moron investor: collect dividends and reinvest them into more shares. Period.

But there are a couple of other morals of the story, too.  One thing the exercise shows is that bear markets benefit those who invest like the moron investor. Since the moron investor is a permanent buyer of stocks, he does quite well when stock prices are low. Let's fast forward now from 1955 to 1981, and see how the moron investor does over the NEXT 26 years. The moron investor's portfolio will be worth $3,074,195 by January of 1981, representing an average annual return of 9%. It's a better run for the moron than the 1930s, but honestly, not THAT much better.

Another interesting finding is that since 1871, owning stocks and reinvesting dividends is far, far more profitable than owning bonds and reinvesting the interest. from 1871 to 2016, if you start out with 100 shares of the S&P500 worth $452 in today's dollars, you'd end up with a portfolio worth $123,253,444, representing a 9% average annual return over the last 145 years. Had you put your $452 in 1871 into ten year US bonds and reinvested your interest payments, your portfolio would be worth only $357,983 by 2016. It's not even close.

And what if you bought 100 shares of the S&P500 in 1871, held them for 145 years and did NOT reinvest your dividends? Your $452 portfolio would be worth $212,700, representing an average annual gain of roughly 4%. Failing to reinvest dividends would cost you roughly $123,000,000 over a 145 year period, which roughly equates to a 99.8% underperformance.

The best way to demonstrate the impact of reinvesting dividends is with a picture. The picture, in fact, nicely explains rising income and wealth inequality in America. I took the total return data crunched from the data from Professor Shiller's spreadsheet and graphed the results for a hypothetical investor who reinvests dividends, verses one who does not. The difference in returns over the past 145 years are quite literally almost off the charts.

In the real world, these results would be muted somewhat by factors such as taxes, surprise spending, brokerage fees, and so forth. Nobody can buy a $452 portfolio in 1871 and hold it through 2015. But even with slippage for taxes, fees and similar factors, any wealthy family with reasonable estate planning could transmit income-producing wealth (such as stocks) to heirs who, if frugal, could continue a family legacy of savings and investing. You'd get a result that looks rather similar to the results of my study here.

Simply put, the wealthy can afford to save income and invest it into more income producing assets, whereas the less wealthy must consume all or a larger portion of their income, costing them full access to the power of compounding. Using actual stock market data from 1871 to 2016, I have created a chart to show how and why the wealthy in America are getting wealthier with time, while those who do not save and invest are falling farther and farther behind at a faster and faster rate.

Bottom line: reinvesting dividends is important. Putting it mildly. Certainly more important than predicting and avoiding stock market crashes. And what is the solution to rising income and wealth inequality? Get the rich to spend more,  get the poor to save and invest more, or some combination of the two.

Thursday, September 29, 2016

September Portfolio Actions

The end of the month is generally when I review portfolio holdings and reinvest dividends and, occasionally, make adjustments to holdings. The Model Portfolio's lead over the S&P500 has continued to widen, and now stands at nearly 16%. The recent uptick in performance of the Model Portfolio seems to have quite a bit to do with the recovery of oil prices. We purchased an ETF that tracks a broad index of master limited partnerships (ticker AMLP) which were (and remain) very cheap. As oil prices firm, new investor money is pouring into the yield-rich sector, and our holdings have reaped the benefit. We have also seen a strong flow of capital into Chevron (ticker CVX) and Kinder Morgan (ticker KMI). Higher stock prices mean that it will be less profitable to reinvest dividends in these areas of the portfolio, so I view the chart shown below as terrible news.

Fortunately, we had some good news this month. Foremost, we earned a very pleasant raise from American Express (ticker AXP) , which raised it's dividend by slightly over 10%, from .29 cents per quarter to .32 cents per quarter, or $1.28 a year. This comes to an increase of $14 a year for the Model Portfolio - about .09%. The increase seems hardly worth noting when you simply look at the immediate cash in hand this dividend increase gives us, but becomes more exciting when you consider the effects of how this raise will compound over the next 20 years. Prior to the American Express dividend increase, the Model Portfolio expected roughly $1,004,807 in dividends to accrue over the next 20 years. But after the dividend increase, thanks to the impact of compounding and the slightly higher portfolio yield, the total expected dividends for the Model Portfolio surged to $1,006,536. That represents an increase of $1,729 over the next 20 years, and as long-term investors, the focus is on cumulative income and not simply the immediate increase of $14.

Alas, that good news is offset by a genuinely troubling development with Wells Fargo (ticker WFC). Over a period of years, the bank cheated customers, opening unauthorized accounts the customers never asked for or needed, simply to generate bonus awards for bankers who appears to have brought in more business. Worse, the bank attempted to obfuscate this fact, hiding it from shareholders and from the board of directors FOR YEARS. My general rule is this: I never do business with anyone I don't trust. I don't care whether the opportunity appears golden or not. The same rule applies when I buy or own stock. The shares could be trading at wildly cheap levels, and if it's shares of a company that lies to shareholders and cheats customers, I want nothing to do with it. I will not own or buy the shares at any price.

I have opted to liquidate our position in Wells Fargo bank, and to divide the proceeds among Extra Space Storage (ticker EXP), American States Water (ticker AWR), and a new position: AT&T (ticker T). As a result of these adjustments, the income sources of the Model Portfolio are now slightly more balanced, we've spread exposure from one line of business (banking) to three unrelated businesses (water, phones and storage space), and increased the income of the Model Portfolio to $14,678 per year - a gain of about $78 per year or roughly half a percent. The composition of the Model Portfolio is now thus:

Going forward, as dividends poor in at the end of the month, I'm going to simply put them into more shares of American Express, and will adjust the Model Portfolio accordingly. I will also look to retain approximately 60 cents, to buy myself an espresso at my favorite cafe where I do most of my investing work: The Cafe Brasilliero in the heart of the old section of Lisbon. Nothing beats doing the work you love in a space you love to be in.