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 14, 2016

Trump as an Artistic Subject Matter

I did not realize at first, but after a few art projects featuring the face of Donald Trump, I now see that there is hardly a person I can think of in history who makes a better art subject than Donald Trump. The more you study the curves of his facial features, and the hews and shades of his skin, the more you realize that his face is really very interesting from an artistic standpoint. When his face is resting, it is hostile, ugly, brooding and sullen. The hews of Trump's face are a study in unnatural contrast. We see pallid, greying silver tones under his eyes, set in a fury of pink and orange stained jowells. The straw tones of his yellow hair morph into puse and grey flanges about the bulbous ears. The transitions in the colors we see in Trump's face are jarring, contrived, and phony.

Trump's face becomes most interesting from an artistic standpoint when he is raging. You notice the mouth contorting like a mollusk, the eyes narrowed to mere slits. I've also noticed Trump's penchant for curling his lips to expose his lower gums and yellow/brownish grey teeth.

I've titled the first picture "A Man is Only as Good as His Words." The second is "Pink is All The Rage." Feel free to copy the images, and put them onto a t-shirt or hat, if you wish.

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.

Saturday, September 24, 2016

Teaching Kids How To Invest

Would it surprise you to know that one of the very finest investors I know is my 11 year old? I say this not because his investment results are higher than the broader stock market (which is not something he could control) but because of his attitudes and behavior (which he can and does control).

One of the very first lessons I taught him about investing is that what you own isn't a piece of paper called "stock." What you own is a share of a business. To demonstrate this, I took him to McDonald's. We ate lunch, and I explained how the company buys supplies, hires people, cooks food and sells it for more than it cost to make. The company then takes these profits and opens more restaurants, so it can earn even MORE profits. The company also pays some of the profits to the people who own the company, and that is called a dividend. I explained to my kid that he owned a piece of McDonald's, since I had bought him some stock in McDonald's. He completely understood the idea that part of the table we were sitting at belongs to him, and all the people standing in line to buy Big Macs and fries - some of that money will belong to him, too. And he completely understood that if he wanted to own even more McDonald's, he could always save his money and buy more stock. You can buy the Happy Meal, or you can buy the company.

As the years went by, I'd sit down with my kid once in a while to look at his accounts, see how many dividends had come in, and then talk to him about how to use those dividends to buy more stock in businesses that he knew. He likes Starbucks, so we bought him some stock. He loves Star Wars, so we bought him some shares of Disney. He loves Coke, so we bought shares of the company. My main goal was to get him thinking about businesses, and what makes the businesses good or bad to own, and to really look at his portfolio as a portfolio of businesses, not a bunch of red and green arrows next to ever-changing numbers (which don't make much sense to an 11 year old, anyway, and should make even LESS sense to an experienced investor).

The most important thing I taught him was the idea of what capital is. I used an analogy that made a lot of sense to him as a 5 year old. I told him that money is like an apple. You can eat the apple, or you can plant it, grow an apple tree, and in a few years, you end up with supply of lots of apples that the tree will keep giving you. THEN, you can eat a few of those, and plant the rest, and instead of one apple tree, you have a whole farm with lots of trees growing lots and lots of apples. In the same way that you can plant apples to grow yourself a bunch of apple trees that will give you all the apples you will ever need, you can plant money into businesses like Disney, McDonald's or Starbucks, but instead of apples, they give you money in the form of dividends. You can plant those dividends into more shares of these companies, and then you get even MORE dividends. Investing is just like growing yourself a forest of apple trees.

From the time he was about 6, my kid completely understood that money can be used to grow more money, and you can reinvest that money and grow more money still. He understood that the longer you do this, the more you get. His entire concept of investing is based around compound income - he has no interest in buying low and selling high and in fact, he has never sold a single share of stock in his entire life.

My young friend does not hover over his brokerage accounts. Actually, he doesn't even bother to check them unless I remind him. When he looks at his brokerage accounts (once every month or quarter), he sees how many dividends he has earned, and then goes about deciding where to invest those dividends (although I oversee what he's doing).  He follows the same routine more or less each month or each quarter, and the sum total of his time spent as an investor is dedicated to just reinvesting his savings, and growing his apple orchard bit by bit by bit.

This seems simple enough to do, but in fact, many adults would struggle to match my young friend's discipline and utter lack of emotion when it comes to investing. He has seen certain shares of stock he owns crash by 90% - like his stock in Reed's (REED), a boutique root beer and ginger ale maker that my friend picked on his own for his investment account when he was about 5 years old. At one time, the stock was up 600%, but my friend didn't get remotely excited about that. Now that the stock has crashed and may never regain it's bygone heights, my friend doesn't seem to pay that much mind either. He seems to have a "win some, lose some" attitude. If you were to ask him about REEDs, he'd probably give you the "don't put all your eggs in one basket" talk. I haven't asked him directly, but I also sense that the Reed's stock crash taught him that there is a difference between a great product and a well managed business.

My young friend has done extremely well for himself, by any measure. As a parent, what is most important to me is that he is completely stress-free about investing, doesn't think it is too complicated or that he needs to pay someone to do it for him because he doesn't know enough (granted, the bulk of his portfolio was picked by someone else, who also happens to oversee what my friend actually does with his portfolio). He is very rational about it all. When prices are low, he buys more, and then he gets out of his own way and let's his investments work for him. I wouldn't say that investing is terribly interesting to my kid, but that's maybe why he's been so successful about being patient and disciplined.

Some parents may want to teach their kids about investing as well, and some may want to talk to their kids about investing in some of the ways I talked to mine. If so, I have created a special online tool that readers may copy and use. It is similar to one my kid has, and it's designed to do one thing: to show how much money a portfolio will pay you in twenty years if you reinvest dividends. It is, in essence, a spreadsheet version of an apple tree farm.

The key to this approach is that it becomes very obvious that saving small amounts today produces enormous amounts of income in the future. While stock prices whip around at random and don't give a continuous sense of progress, looking at portfolio income over time is much smoother and predictable, and can give a kid a better sense of progress.

Here is what the tool looks like.

What you could do is to open a brokerage account for your kid, and buy a few stocks. Using this Retirement Clock tool, you enter the ticker symbols for your kid's stocks in the top row. I added 8 columns, but you can add more based on the contents of your kid's portfolio. In the second row, enter the number of shares you have bought for your kid. The tool will calculate the total income the portfolio should project this year, and will automatically calculate the average dividend growth for each of the companies you bought, based on the last five years' worth of dividend growth (I caution readers to review this dividend growth area carefully - if you see something unrealistic, just insert your own estimate). The tool will also show how many dividends the portfolio should generate in 20 years, assuming you reinvest dividends at whatever today's portfolio yield is. I added an area for spending, so you can show what happens if you spend some portion of the portfolio income from time to time. As you see from the example, below, spending $5 in the first year, and saving the rest, produces a total of $14,995 of dividends after 20 years.  Spending $100 in the first year takes the cumulative dividend income down by over $200.


After you have input the ticker symbols and the number of shares, the last thing you will need to do to set the tool up is go into the chart that shows a dial with a projection for 20 years worth of dividends. What you want to do is to customize this dial so it goes from zero to whatever number of future accumulated dividends you want. To do so, click on the triangle button (shown below), hit "advanced edit".

Next, it will take you to the screen you see below.

Where it says "gauge range", put in zero to whatever number of future accumulated dividends you want to track. I picked $100,000. You see that there is a number $14,963 - that is the projected 20 year accumulated dividends for the portfolio I picked in this example. Where the chart editor says "Colored ranges", I picked zero to $14,963 as the red zone, and from $14,963 to $100,000 as green. The reason why? Going forward, as I help my kid reinvest dividends and buy more shares, and as companies I own increase their dividends, the total dividends I expect to earn over 20 years should go up from where it started ($14,963), and I can help my kid visualize her or his progress away from the red zone, and deeper and deeper into the green zone. The idea is that over time, the more dividend apples I help my kid plant, the larger that green forest of future dividend income will grow.

If you wish to use a copy of this tool, here is a link. Click it, and it will take you to Google Sheets. Once there, click "File" and then "Copy." That will give you an exact copy, which you can modify as you see fit, adding your own ticker symbols, number of shares, or any other changes to the functionality of the spreadsheet.

Monday, September 19, 2016

Enhancing Diversification and Income

In the last post, I detailed the reason why an investor only needs to get lucky once or twice in his or her investment career. Nobody can control whether they will get lucky at investing, but you can certainly control what to do with your lucky streak, if you have one.

Let's suppose that your stock portfolio outperforms the S&P500 by some reasonably margin. In the case of the Model Portfolio, we are about 16% higher than the S&P500 since I launched the experiment last November. The first step in the analysis is to figure out whether, in fact, your portfolio performance is due to luck or something else. If your portfolio performance is due to something other than luck, you have a choice: either (1) keep doing whatever worked until it stops working, and then do something else; or (2) quit while you're ahead, unless you can't. On the other hand, if your portfolio performance is due to luck, then you can't actually chose to keep "doing whatever worked" because you didn't DO anything that worked in the first place. You simply got lucky. I'd argue that means quitting while you are ahead, unless you can't.

I believe that most of the reason why the Model Portfolio outperformed the S&P500 is, sad to admit, due to luck. The first lucky break was investing in Valspar paints, which was bought out by Sherman Williams for a huge premium. I guarantee I did not have any way to know that would happen. True, I picked Valspar because it has steady and growing earnings, and happened to be a small but dominant player in the paints and coatings business. It makes sense that the company would become a takeover target, but frankly, you never know where and when lightning will strike. It struck Valspar and the Model Portfolio got an immediate boost - which I promptly locked in by selling Valspar stock at a huge gain. I reinvested those proceeds and the Model Portfolio income leapt higher as a result.

Another stroke of luck is that dividend investing suddenly came into vogue this year. As detailed in other posts, the price of various dividend focused funds has far exceeded the S&P500 since last November - which is not usual. I doubt it will last - most dividend stocks trade at a very high premium now compared to non-dividend paying stocks. Historically, that's actually the opposite of what you typically see. Suffice it to say, I guarantee that I had no idea this would happen, and no idea of how long it will last, either. Luck.

Finally, Brexit gave the Model Portfolio a very large bump higher. Events like Brexit by definition take the market by surprise. They are fundamentally unpredictable, and the outcome is more unpredictable still. When I sold some of the top performing stocks in the Model Portfolio, I put the proceeds into European index funds that had crashed by over 10% or more in view of the uncertainty unleashed by Brexit. I had no idea whether these fears reflected in the price of European index funds were justified or irrational. I took a gamble, bought the European index funds, and earned a dramatic and very speedy windfall in the process. Skill? No. I gambled and won.

So like I said.  The Model Portfolio is 16% higher than the S&P500, and I couldn't replicate that performance if I tried. In fact, trying would be completely irrational on my part - I am completely sure that my special investment savvy had little or nothing to do with where things stand today in terms of the price of the Model Portfolio.

If I were to sell off the Model Portfolio and place the gains into an index fund, I'd be guaranteed to keep that 16% lead over the S&P500, and that lead would grow at a compound rate. I wouldn't just stay ahead of the S&P500 - I'd become increasingly MORE ahead with each reinvested dividend.
The problem I see is that the yield on the S&P500 is half the yield on the Model Portfolio. If I sold out, I'd take a massive pay cut, and the whole purpose of the Model Portfolio is to beat the S&P500 based on earnings and cash flow growth, not price performance. In other words, selling everything and investing in the S&P500 isn't a viable option, based on my investment goals. That is why I've opted to do the next best thing to selling everything and investing in an index fund: diversify the portfolio holdings.

Last week, when I reinvested dividends, I added a small position in Extra Space Storage (ticker EXR), a company that operates and, in many cases, owns, self-storage units. EXR  has experienced explosive earnings growth due to demographic trends that are likely to continue for years. This week, I will add shares of American States Water (ticker AWR) which delivers water to homes and businesses located in California. The company has raised dividends for no less than 61 years, and the service is both essential to life and enjoys monopolistic benefits.  Appropriately, I can say that this business has a wide moat. Today, I will sell some shares of Apple (which now accounts for nearly 6% of the Model Portfolio by price) and MMM (which accounts for almost 6% of the portfolio by price). I will parlay those gains into AWR and EXR in the shares and proportions set forth below. As a result of this move, the portfolio will gain diversification AND enjoy a nice income raise up to $14,601. That extra cash flow should compound over time, and the total dividends I expect over the next 20 years should go up (the Retirement Clock tool estimates the 20 year dividends should go from $1,036,000 to $1,104,636 - but that assumes I can keep reinvesting dividends at a 4% yield, which may turn out to be far from true).

Thursday, September 15, 2016

Quitting In Stages As The End Game Approaches

In the real world, my investment approach with my actual portfolio is fundamentally very different from the Model Portfolio approach I write about here: I own blue chip dividend paying stocks, I collect the dividends, spend less than I own, and reinvest the balance into more blue chip dividend paying stocks. I rarely sell shares unless they become obviously overpriced - like if the average five year PE ratio hits 30 but the long-term average earnings growth is less than 8. I primarily favor lower priced shares of blue chip companies with a PE ratio in the area of 15 or even less. It's more or less exactly what you read about here.

The main difference is diversification. My vision is 100 different, unrelated sources of income, each contributing no more than 5% of my total portfolio income. The core of my approach revolves around the blue chip dividend paying stocks, but I also add preferred stock funds, real estate, bond funds, etc.  I'm less concerned with dividend growth or even maximizing portfolio income - more concerned with enhancing reliability and safety, and reducing financial stress.

At the moment, the Model Portfolio comprises 21 different companies. The income growth and capital appreciation is substantially higher than the overall stock market, and the stated goal of the Model Portfolio (produce $30,000 of income each year) is not terribly far off (maybe about 5 or 6 years, I'd guess). Some suggest that on Wall Street, you do well by doing what worked yesterday, and to keep doing it until it stops working, and then do something different. For me, the better idea is to start changing up your strategy once it's succeeded in getting you close to where you want to be. We aren't in the end game, but since we are in the halfway point a little less than a year into the Model Portfolio project, it's time to think about the end game with fresh eyes.

If this was the real world, my goal for the Model Portfolio would be, of course, to produce the $30,000 of reliable dividend income, but I would also want that income to be pouring in from at least 100 different unrelated sources, each contributing about $300 worth of dividends or distributions. There is safety in numbers. And frankly, I'd want to "lock in" the performance of the Model Portfolio relative to the overall stock market - the Model Portfolio income growth has been hundreds of percentage points higher than the income growth of the S&P500. One of the things you learn about investing is that you don't need thousands of investments that modestly beat the S&P500 year in and year out. You can do dramatically better than average with just one good year, or maybe two or three home-run investments over your lifetime.

A personal anecdote. In the mid 1990s, I bought a loft in a dirty section of lower Manhattan. There were abandoned buildings, and at nights, large rats scampered around in the gutters. It was a part of town where you don't go out at night.  The loft was cheap - about one year's worth of a first year lawyer's salary at a typical New York City law firm. Fast forward 7 years, and it was (and remains) the single most desirable and chic area in all of New York City. The price of that loft soared by nearly 700% over that time period. It was pure, dumb luck. A windfall, never to be repeated. I sold the space and found another apartment to rent nearby. I put the proceeds from the sale into some dividend stocks and watched my portfolio income quadruple right then and there. The internet bubble had just burst, and at the time, dividend paying stocks were selling at rock bottom prices - basically, I got lucky twice in one go.

The point of this story is that all it took was one well-timed windfall for me to be in a position where I could retire at age 35 if I wanted. Consistently picking stocks that beat the market year in and year out isn't how most people do it. One year where your portfolio is dramatically higher than the market can be that one-off, well timed windfall that turns into lifetime of steady, reliable income. An acquaintance once outperformed the stock market by nearly 36% one year. In early January of the following year, he sold the portfolio and bought an S&P500 index fund, and thirteen years later, he STILL boasts one of the most successful investment track records on Wall Street (the greatest investor in history, Warren Buffett, has outperformed the S&P500, assuming dividends are reinvested, by around 22% since 2003).

This is the most important point I can emphasize.  The thing about starting from a point 36% higher than the overall market is that my friend earned 36% more dividends that first year, which left him that much more to reinvest.  This created a mathematical certainty that his 36% lead over the stock market the first year would equate to a 36.72% lead the next year, 37.45% the year after that, and so on and so forth each year. Notice that the lead expands at a geometric rate each and every single year?  And notice that this guaranteed and growing lead over the stock market involves nothing more than owning precisely the same stocks as the S&P500??? It seems unfair that one investor can do exponentially better and better and better than another investor who owns precisely the exact same asset, but the power of compounding guarantees that a small head start can translate into permanent and permanently growing advantage. I'd argue that this explains why there is a growing wealth and income disparity around the Earth. Spending less than you own and reinvesting the balance has the unrelenting gravitation power of a black hole. My acquaintance understood that, and had the humility and common sense to act rationally as an investor.

The moral of the story is that knowing when to quit was far more valuable than knowing which stocks to pick. If you outdo the stock market by 16% this year, and you want to guarantee that you will outperform it next year by 16.32%, and 16.64% the year after, and to continue outperforming the stock market at an exponentially increasing rate for the rest of your life, sell everything and invest the proceeds into a broad S&P500 index fund and reinvest the dividends. I'd do that with the Model Portfolio, but then, what would I write about? Actually I'm kidding - I wouldn't because I could care less about beating the stock market and frankly, I don't like the way the stock market index funds are managed. They buy stocks when the price is rising, and sell when the price is dropping - the exact opposite of how I like to invest.

Getting back to the matter of knowing when to quit.  My story about the apartment is actually quite illustrative because of what I haven't told you yet.  As it happens, my choice to sell the apartment was nothing short of disastrous from the perspective of maximizing returns. The price for that space continued to soar and is most likely two to three times higher now than it was when I sold it. It's fair to say that I took my chips off the table way too soon, but I have always felt that having one penny more than you need is no blessing, whereas having enough is the greatest financial boon available. To risk sacrificing the latter in order to potentially achieve the former is my definition of irrational financial behavior.  This explains why I will never be a fabulously wealthy investor that anyone will ever read about in the Wall Street Journal, but I hope to always pay my bills on time.

If you stay in the investment game long enough, whether in real estate, stocks, or starting a business, you may eventually have a glorious and sudden stroke of luck. If this happens to you, remember that you can use just one lucky windfall or one really great year on the market as a toe hold to climb much higher, just by using the power of compound returns to your advantage.  By quitting too soon, you may forego further heady gains, but as long as you can pay your bills each month, who cares??? The income growth of the Model Portfolio is not quite the same level of windfall that I enjoyed with our apartment in Tribeca, but it's enough that I am thinking ahead now as to how I would "lock in" that performance if I were managing a portfolio with only these 21 stocks. I wouldn't do anything drastic, like sell it all and invest in an S&P500 fund. Instead, I'd undertake a slow and steady process of building out more and more diversification.  In other words, I wouldn't entirely abandon the approach that brought success, but I would evolve the approach towards the end goal I'd ultimately want to reach - in this case, $30,000 a year of reliable, steady income from 100 different unrelated sources.

My plan now is to continue reinvesting dividends for the Model Portfolio, but to add multiple new positions into other shares that I am personally familiar with - Phillip Morris International, the Royal Canadian Bank, McDonald's, Pepsi, Disney, and so forth. We may run into a limit with the Retirement Clock tool - I am unsure how many different positions the tool will track before getting glitchy. Ideally, I would think a stock portfolio of 50 different stocks in unrelated industries would be very diversified and safe, and that is what I will aspire to build (subject to the technical limitations previously mentioned). To the extent that I succeed in my diversification strategy, the implication is that we will see less of the explosive income growth in the portfolio that we enjoyed over the past year. They say that diversification is a terrible way to get rich, but the only way to stay rich. The same is true of income growth. 100 income sources can never produce the massive income growth of one carefully picked income growth stock. That's a trade off I'd be willing to make in the real world, and the purpose of this exercise is to demonstrate a real world approach that has worked well for me over the last 20 years... but hopefully sparing some readers the time-consuming (and occasionally expensive) learning curve that I laboriously ascended over that time period.

So, expect to see some new names added to the Model Portfolio. Today, I saw there was about $150 in new dividends, which I have invested into Extra Space Storage (ticker EXR). This is a small REIT that specializes in renting out short-term storage space near major metropolitan areas. The space is clean, the customer service is excellent, and the prospects for massive industry growth are pretty compelling. The price for the stock is expensive - translating to a PE ratio of 20, but the revenue growth is so high that actually, the valuation of the shares is fairly low.  The dividend growth is in the range of 40%, too - and there is plenty of room to grow from here.  By the end of this month, the Model Portfolio should produce a veritable flurry of dividends, some of which may find their way into EXR, others may find there way into some other new names I would like to add in order to diversify the business operations of the Model Portfolio.

Wednesday, September 14, 2016

Compound Return Investing and Bear Markets

Stock prices go up, stock prices go down. Knowing how temporary and fleeting stock prices can be, why is it SO bothersome to many investors when stock prices drop? I suggest that the answer can be found deep in the human brain. We feel that a current state of affairs is or may become permanent, or at least very long-lasting.

Is it rational to imagine that today's conditions might persist for the rest of your life? The answer, in fact, is yes.  Imagine you bought shares of the Dow Jones Industrial Average in 1906. By the time you reached 1942, you would have earned zero price appreciation. Collected nothing but dividends, and watched inflation devastate your economic return over a 36 year period. Or suppose you invested in the Dow Jones in 1962. By 1980, you'd have earned zero price appreciation - and you'd be left with the utterly devastating impact of a full decade of runaway inflation during the 1970s. Sadly, for a capital gains investor seeking to buy low and sell high, stock prices can stagnate or drop over 20, 30 or even up to 40 year time periods. Today's conditions can and sometimes do persist for the rest of your entire investing career.

To a compound returns investor, the prospect of a 40 year bear market is cause for absolute jubilation. Unlike a capital gains investor, a compound returns investor seeks to collect dividend income, reinvest it into more dividend paying stocks, and thereby collect a slightly larger amount of dividends in the future. And to repeat this process as frequently and for absolutely as long as possible. There is a fundamental difference between a compound return investor and a capital gains investor: the compound returns investor is a permanent net buyer of stocks, whereas the capital gains investor seeks to one day liquidate all or some portion of his or her stock portfolio, and is thus neither a net seller nor a net a buyer of stocks. Buyers of any description, be they buyers of stocks or cartons of milk, always cheer lower prices. This is the fundamental reason why a compound return investor yearns for a 40 year bear market as the ultimate financial boon.

The Model Portfolio is a perfect example of how investors can approach the question of capital gains investing verses compound return investing. Yesterday, we see that the Model Portfolio lost over 1.6% - on top of the more significant losses we saw last Friday. This translates to a capital loss of $5,923.

A capital gain investor may very well feel nauseous looking at these figures. True, the prices might bounce back at any given moment, but what if today is the start of a 20 or 40 year bear market? If so, then the capital gains investor will NEVER be able to reclaim that lost $5,923. The money is gone, it is gone forever, and the market could go even LOWER from here, resulting in dramatically larger losses that could also be permanent. This notion, which is perfectly rational, feeds the temptation to sell, and that temptation grows stronger and stronger with each tick lower of the market.

By contrast, the compound return investor sees a potential to buy more shares at ever lower prices, resulting in larger amounts of dividend income. The prospect of the market staying lower for 20 years or more is not only welcome, but secretly something the compound return investor prays for. The longer the market stays lower, the larger the amount of dividends the compound return investor will collect over time. Thanks to the collapse in certain share prices of stocks in the Model Portfolio, the Portfolio now carries a yield of nearly 4% - an astonishing 50 basis point leap over where the portfolio yield stood just one week ago. If only the stock market stays low for another 20 years, every time we purchase more stock with dividends we reinvest, those reinvestments will carry a yield of around 4% on average, and as a result, the impact of compounding will reverberate through time. Today's ripples will translate into tomorrow's tsunamis, and we will collect an additional $6,843 of dividend income over the next 20 years, compared to the dividends we'd have otherwise collected had the market not sold off yesterday.

I won't lie. I feel greedy when I see market prices swirling down the potty. I wish it weren't true, but watching the cumulative dividend dial tip into the green zone makes me want to rub my hands together. Such a pity that today, the Model Portfolio contains a cash surplus of only $29. I can't do much with that.

This is the most frustrating aspect of compound return investing:  the requirement for patience. Every month, dividends come in, but on some days, you experience a sell off in the stock market and have no cash on hand to invest. You find yourself hoping that the stock market will not rebound before you receive more dividends to reinvest, and consoling yourself with the notion that with any luck, perhaps the market will drop EVEN MORE by the time your next dividend payment rolls in.

Tuesday, September 13, 2016

A New Feature To The Retirement Clock Tool

I designed the Retirement Clock specifically to help investors focus on steadily rising portfolio income levels, instead of whimsically fluctuating portfolio price levels. I have now added a deceptively simple feature to the Retirement Clock: a new gauge that projects the total amount of dividends the portfolio may pay me over a 20 year time period ASSUMING I reinvest some portion or all dividends at TODAY'S portfolio yield. This new gauge is designed to accomplish two things.
First, the cumulative dividend gauge quantifies the cumulative benefit of reinvesting even small amounts. If I reinvest $100 worth of dividends today, I may generate an extra $4 of dividend income this year (not too exciting), but if I continuously reinvest that extra $4 dividend amount over the next 20 years, I could almost generate an additional $400 worth of dividend income (representing a 400% gain over the initial $100 reinvestment, which is rather exciting). The cumulative dividend gauge keeps my investing attention riveted on the single most important aspect of investing to me: ignore the nonsensical babble of stock market noise and meditate deeply on the issue of compound income growth.
Second, the new cumulative income gauge enables me to do what most investors cannot easily do: to feel greedy when others are fearful. Since the cumulative dividend gauge assumes that I reinvest dividends at TODAY'S portfolio dividend yield, I get far more bang for my buck when my portfolio price level is lower (which is when my portfolio yield will be highest). During a bear market or violent market selloff, my brokerage statement will be festooned with terrifying red arrows, but not the cumulative dividend income gauge. To the contrary, the harder stock prices fall, the higher my projected cumulative dividend income will soar deep into the green, replacing the endorphin-fueled flight instinct my brokerage statement inspires with the giddy hoots and squeals of greedy delight that come from watching portfolio income levels explode higher when I reinvest dividends into the maw of a bear market.
Let's use a visual example. Into the version of the Retirement Clock shown below, I have input my Model Portfolio of dividend stocks. In the first gauge to the left on the Retirement Clock, you can see that the Model Portfolio started with $10,000 of portfolio income when I launched it, and that the dividend income has grown to about $14,500 a year. The first gauge visually shows my progress towards my portfolio income goal of $30,000.
The second gauge shows how many years it should take my portfolio to generate $30,000 of income, based on the average dividend growth rates of the component stocks I own. When I launched the portfolio, the tool assumed I would reach $30,000 of portfolio income in 12.03 years, but I have cut that time down to 9.26 years.
(click to enlarge)
The third gauge all the way to the right details my current cumulative dividend projection as of yesterday, which is $1,036,259. I have set the gauge levels at $500,000 on the low end, and $2,000,000 on the high end. Over time, as I reinvest dividends, my cumulative dividend projection should tend towards the $2,000,000 mark. Also, the cumulative dividend gauge will either tip towards $500,000 or $2,000,000 depending on which direction stock prices happen to be going. Today, for example, the Dow Jones is crashing by 150 points as I write. The price of the Model Portfolio is down as well by over $2,196.
So, have I lost money in today's stock market fizzle? The answer is no. Look at the cumulative dividend section of the Retirement Clock. Thanks to the lower price on my portfolio, and higher yield at which I might be able to reinvest dividends, I see that today's stock market crash has EARNED me $3,335 in future dividends accumulated over the next 20 years.

True enough, the apparent benefits of today's market sell off may easily evaporate - the market could rally back long before I enjoy the benefit of having dividends to reinvest, costing me the chance to invest at lower prices. To that extent, the cumulative dividend meter is somewhat of an illusion, but I could just as easily ask whether the fallen prices of the portfolio's investments are EQUALLY illusory? What is the loss I suffer if a stock I owns drops in price, and I don't sell? The answer is NOTHING. Falling stock prices simply cost me the immediate opportunity to sell at higher prices, but if I never planned to sell in the first place, that cost is just as much an illusion as the cumulative dividend meter's projections about what dividends I might earn over 20 years if market prices remain at today's levels. Before you knock what I'm saying as a buch of mysticism, the theory is actually well grounded in quantum mechanics. All around the universe, particles flit into and cancel out of existence in a continuous quantum flux, but unless observed, the quantum fluctuations have a zero net effect on the level of mass in the universe. So too does the price of a portfolio flit into positive and negative territory. Ignore it or simply fail to take action based on it, and it is very much like the price fluctuations never even happened. 

You are welcome to use a copy of the Retirement Clock tool as a template to create your own spreadsheet. You can input your own ticker symbols, number of shares, change the number of positions, change the desired level of portfolio income, change the readings on the gauges and dials, input whatever "start date" you'd like to use to start tracking your portfolio income progress. You may even think up different features to add, or different ways to use them. If so, I invite you to discuss such new features or uses of existing features in the comment section so other readers can benefit.
To create your own Retirement Clock, use this link to go to Google Spreadsheets. If you don't already have one, you may have to create a free account for yourself on Google.
This link is in "view only" and you will not be able to make any changes. To create your own version that you can edit and update, when you access the Retirement Clock, go to the "File" key, and hit "make a copy." The screen should look like the image shot, below.
(click to enlarge)

And here is a recent painting.

Monday, September 12, 2016

Dividend Investing and Beachcombing at the Praia da Ursa

The Federal Reserve hints at raising interest rates a full 25 basis points, the the market sells off to the tune of nearly 400 points. Needless to say, the experts on CNBC are proclaiming a good deal of doom and gloom, and in typical form, they are generally congratulating themselves for having foreseen and foretold all.  This has grabbed the headlines, but in fact, is entirely irrelevant to investors who focus simply on generating compound returns.

What these "compound return" investors do is they own shares of dividend paying stocks, they collect the dividends, they reinvest those dividends into more dividend paying stocks, and thereby generate even higher dividends next time. Then they repeat the process over and over again, as many times and for long as possible. Why? Simple. The power of compounding is a direct function of time - the more often and longer a series of numbers compounds, the larger the numbers get. Knowing this, a compound return investor wouldn't wait around trying to guess whether the stock market will be up, down or sideways over any given period of time. The dividends come in, they get immediately reinvested into the best businesses the investors can find at the best price then available, and that's pretty much the end of the story.

We had some dividends trickle into the Model Portfolio last week, which I duly reinvested. Today, I see another $436 has come in.  The timing couldn't be better. Today, I have decided to reinvest that into more shares of Emersen Electric (ticker EMR), one of the oldest industrial production technology companies in America with a multi-decade track record for raising dividends. The business is currently in the process of repositioning it's high margin businesses, and looking to divest the lower margin areas. EMR will become a leaner and more profitable company as a result, but currently, there is a good deal of uncertainty about it's future profits and, predictably, the market has left the shares in the wastebin. To a value investor, snooping around dumpsters for bargains on high quality businesses surrounded by a miasma of question marks is what investing is really all about. Thanks to the stock market sell off on Friday, EMR now yields 3.74%. When the company completes the various spin offs and acquisitions it has planned, that dividend yield may or may not change - I would be looking at the combined yield for the parent company as well as the division that will be spun out to shareholders as a separate stand alone company. I will probably sell the spun out shares and just reinvest back into the parent company - which may cut dividends since part of it's profits will be carried along to the spun-out company. Depending on what the stock market does to the various prices of these companies, I may take a paycut or get a raise, and only time can tell.

The current composition of the Model Portfolio is as shown below.

You can also see the price performance of the Model Portfolio relative to the S&P500.  It fell 2.6% on Friday, compared to the S&P500 which fell about 2.38%.  You'd expect the Model Portfolio price to be more sensitive to potential fluctuations in interest rates - many investors use dividend stocks as a surrogate for bonds that they'd otherwise prefer to hold. If interest rates rise, the urge to own these stocks as opposed to bonds can quickly evaporate, causing wild price swings. Obviously, it is silly to own dividend stocks instead of bonds because equity is not remotely the same thing as debt. But many investors simply look at the yield and can treat the underlying assets generating such yield as fungible. Stupid, I know, but that particular form of stupidity is very good news to us. Lower prices on dividend stocks helps us grow our portfolio income that much faster.

Do you notice any similarity between the price chart for the Model Portfolio and the praia da Ursa that my wife and I climbed down last week? It's a stunning beach, and if you visit early enough in the morning, almost nobody is there. It is a very steep climb down to the sand, which you can infer from the massive rocky hills that border the sand. Like so many things in Portugal, it can be a bit difficult and time consuming to get to, but once you are there, you will feel that there is no better place on Earth.

Look! Nobody is here! We had the place to ourselves, almost. And if you were wondering, YES, the sky over Portugal actually is this color blue. This country is magnificent, and the natural beauty you find here is unlike anywhere else.

Wednesday, September 7, 2016

Reward Yourself For Being Lucky This Time By Being Safer for Next Time

The Model Portfolio consists of shares of 21 different companies, all of which offer long histories of solid earnings growth (whether as stand alone companies or businesses that were spun out from other entities), solid dividend growth, and each operating in different industries with key competitive advantages. The aim of the portfolio is to generate a reliable and consistently growing stream of income, which is why the portfolio holds shares of businesses that raise dividends regularly and have strong prospects to continue doing so for the indefinite future.  The reason for this goal is that by living off portfolio income alone, fluctuations in stock prices become irrelevant, which enables an investor to hold shares of a business for an extremely long period of time - potentially for multiple generations. Time is very much the friend to investors who rely on the power of compounding, and long holding periods go hand in hand with that.

A secondary aim of the portfolio is to own these sorts of steady businesses when the price of the stock is either a bargain or simply reasonable. Expensive stock is particularly risky, even if its a great business.

To help manage risk, the Model Portfolio is weighted so that each position doesn't contribute too large a share of the portfolio income. When a business cuts it's dividend, the overall impact on the portfolio will not be so much. We saw that when the Model Portfolio was launched last year and one company, Kinder Morgan, promptly slashed it's dividend by 75% despite repeated promises to shareholders that the company would INCREASE the dividend by 10% a year. The loss of income to the Model Portfolio was a few hundred dollars, and within a relatively short period of time, the portfolio income rose far above where the income started. Diversification of income sources helps insulate shareholders from losing too much income from the inevitable dividend set backs that occur every so often (and that usually are accompanied by robust price declines in the stock of any company that slashes it's dividend).

While the portfolio weighting is largely determined by portfolio income, I don't actually ignore stock prices entirely. Sometimes, share prices can get ahead of you, as we've seen with Stanley Black and Decker (ticker SWK). The stock is reasonably priced in my view, and the company has one of the safest dividends that exists. SWK has paid dividends every year for well over 120 years, through wars, depressions, recessions, boom times. It doesn't matter. They make great hammers, and everyone always needs a good hammer.  The Model Portfolio now holds nearly $28,000 worth of SWK, and the position now accounts for over 7% of the entire portfolio which strikes me as somewhat over-allocated. This is not surprising - SWK has surged 25% since last November. Another reason I contemplated selling a bit of this stock is that I tend to think that if you own something that has surged in price (but not necessarily value) over a very short period of time, you do well to use some of that gain to buy yourself more diversification and safety. Think of it as rewarding yourself for being lucky this time by being safer for the next time.

Something else I have been looking at is American Express Co. (ticker AXP). In the real world, I bought shares of Amex last year, mainly because the future of electronic cash payments is bright, and Amex has decades and decades of history of consistent profitability, and consistently above average dividend growth. I have avoided the stock for years because I always felt it was too expensive, but now, it trades at a PE ratio of close to 11. It has all the hallmarks of what I look for as an investor: a great company at an exceptionally cheap price.

I am selling 60 some odd shares of SWK and adding 111 shares of AXP to the Model Portfolio. The move will do nothing in terms of boosting portfolio income, but that is not the point of today's decision. The move will enhance the diversification of the Model Portfolio, which in my view makes it safer and a more reliable source of steady, growing dividends. The composition and price performance data for the Model Portfolio now follows.

In other news, we discovered a lovely hidden gem about 45 minutes outside of downtown Lisbon: Ursa Beach. Like many beaches in Portugal, the sandy part down by the water is only accessible by means of a thin rocky path that winds down a steep cliff.  From on top of the cliff, you can see there is a tremendous view. The wind is strong and the air is cool, but the sun is brilliant and strong and will keep you warm once you're down by the water.

We started our hike fairly early in the morning, and so when we reached the beach, we were almost the only people down there. There are explosive waves, extremely fine white sand, and plenty of shade thanks to the immense rock formations. This would be a very fine place to bring a picnic, have a late dinner on the sand and watch the sun set over the horizon.

Here is a close up photo of the two crags featured above.