Lessons From The Kinder Morgan Bloodbath for Income Investors

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The Kinder Morgan (KMI) bloodbath that culminated in a 75% cut in its dividend last night after the bell and a roughly 60% loss year to date has been sickening to behold. A good deal less so for me as I sold Kinder Morgan Energy Partners (KMP) in the spring of 2014, largely on the recommendation of Josh Peters at Morningstar.

For a while this looked too cautious and even a bit foolish as KMI announced its takeover of KMP and both stocks put in a substantial rally. But such is the price of risk management. You give up some potential upside if everything goes great, but you’ll be in better shape if things turn south.

Here is a link to Josh’s rationale, in his own words:
Video: Josh Peters Not Buying the New Kinder 8-14-2014

Kinder’s Biggest Problem: No Margins of Safety

I mean “margin of safety” more broadly than just buying at a discount to fair value a la Ben Graham. There was no margin of safety around Kinder Morgan’s business model, leverage, or its distributable cash flow coverage ratio.

1. No Margin of Safety With Its Business Model — While advertised as a simple fee-based pipeline business, a significant portion of Kinder’s business is in enhanced oil recovery — oil production. This was great with $100 a barrel oil, but not so much after it fell to $40 a barrel. So cash flows were punished significantly by the oil price crash.

2. No Margin of Safety With Leverage — Running at almost 6 times debt to EBITDA, Kinder was roughly twice as indebted as its more conservative peers. Thus, it ran out of borrowing capacity when the decline in its stock price made it uneconomic to fund growth expenditures by issuing shares of stock. This crystallized recently when Moody’s put their debt on Creditwatch Negative for a downgrade to junk status. They had little choice but to cut the dividend in response.

3. No Margin of Safety With Their Distributable Cash Flow Coverage Ratio — Kinder Morgan has had the pedal to the floor by paying out every cent available for a long time, computed in an aggressive fashion. This kind of thing works as long as nothing goes wrong. Not very smart to own such a business as an income-focused investor.

Lessons From Kinder Morgan’s Bloodbath for Income Investors

Inverting the Kinder Morgan case, you want to look for a business with stable cash flows. Or to the degree that its cash flows are cyclical, you want to have excess distribution coverage so the stress on the distribution will be manageable in a downturn. And for sure, you don’t want a company that is levered up to the max in the good times so it has no excess borrowing capacity in a downturn.

Ideally, you want a company with a margin of safety in all three areas. 2 out of 3 should be a minimum for consideration. If you can learn these lessons without paying the tuition of a permanent loss of capital, you will be far ahead of the game.

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”
— Benjamin Graham

“The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.”
— Seth Klarman

See also:

As Oil Keeps Falling, Nobody Is Blinking

The Stock Market Is Missing the Warning from Junk

Donald Yacktman: “Viewing Stocks As Bonds” | Talks at Google

What Bill Gates Shares With the Skeptical Environmentalist

Mark Zuckerberg’s Billion-Dollar Chance to Save the World

WSJ: Population Implosion: How Demographics Rule the Global Economy

As Paris Meeting Approaches, Climate Change Movement Shows Its Lack of Seriousness

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I am not a Climate Change denier. There is some evidence that, all else equal, human activity may contribute at the margin to a very gradual increase in the Earth’s average temperature. However, that doesn’t mean that it will cause a cataclysm, that it is the biggest problem facing the world, or that an infinite price should be paid to halt or reverse it. The inability or unwillingness to put it in proper perspective, do sensible cost/benefit analysis, and seek realistic solutions is what keeps the Climate Change Movement from being a force for good.

The fundamental fact of human existence is that our wants are infinite and our resources are limited. I believe in spending reasonable sums for research and development on solar and other technological improvements that may solve the problem or help manage the consequences at an acceptable cost to humanity.

But as this peer reviewed paper by Bjorn Lomborg shows using the standard MAGICC Climate Model, the current prescriptions of the Climate Change Movement call for the world to spend on the order of $85 TRILLION through 2100, with an effect of only 0.17 degrees Celsius. This is almost zero progress for an incredible cost, while hundreds of millions of people in the world are starving, lack basic sanitation, and don’t have access to electricity.

What a stunning thing that such a group of people with collectively high IQs can be so blinded to common sense. Something tells me that incentive-caused bias (promoting the view that will keep their research budgets well-funded) is not limited to those pushing fossil fuels. Not to mention the profiteering by Al Gore and friends which by some accounts has him approaching billionaire status.

It is the responsibility of sensible people in the scientific community to think outside the box and work to create technological solutions to the problem. Not to demand a gigantic and pointless penance from humanity which cannot even properly feed and clothe all of its members.

See also:

Gambling the World Economy on Climate

Impact of Current Climate Proposals

The Tyranny of a Big Idea: The Attraction of the Secular Mind to the Politics of Impending Apocalypse

Capitalism Makes You Cleaner

Is Climate Science Really Settled?

The Scientific Method and Climate Change

Income vs. Total Return? I Want Both!

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Ignore The False Dichotomy

If you want a topic to start a flame war on a finance blog, Income vs. Total Return is almost as good as Active vs. Passive. But like the latter, the former is a false dichotomy. Why choose between them when you can have both?

In honor of Morningstar’s Income Investing Week, Christine Benz has posted an article on the importance of avoiding this false choice.

While I think it is fair to say that Christine hews to a relatively more income agnostic approach than I do, I certainly appreciate her point that you can’t afford to ignore total return when investing for income. We each need to draw the line for ourselves, but this is a useful framework for figuring out our own individual emphases.

But first, let’s take a look at the 2 solo approaches.

The Income-Agnostic Total Return Approach

This approach means that you plan on selling off part of your portfolio each year when you are in retirement/drawdown mode. The upside is that you can potentially have higher returns. The downside is that you may get killed selling into a downturn by dollar-cost averaging in reverse. This is very painful in a down market.

This can be alleviated somewhat by having a substantial allocation to bonds, but in my opinion the bond market as currently priced represents return-free risk. Bonds may not be correlated with stocks, but if the long-term returns stink, you might as well just use cash as a sandbag. If stocks are a bit overvalued, and I think they are, then bonds in general are screamingly expensive, unless we are in for 20 years like Japan after 1990.

The Total-Return-Agnostic Income Approach

There are those who invest only in the highest yields and don’t care about total return. Some of those folks are currently holding Kinder Morgan (KMI). They tell themselves that the price doesn’t matter because they are never going to sell it, they plan on just living off of their dividends.

But what if the dividend isn’t sustainable? With high leverage and 10-20% of cash flows coming from oil production, Kinder looks a bit iffy. They have already reduced their dividend growth projection from 10% per year to 6-10% a year. I have a hard time seeing how they will meet this goal without an oil price recovery.

As an income investor, you need to look very carefully at the business model to make sure it is in a defensive business whose cash flows will support the dividend even in a downturn. You definitely don’t want to be the last one out the door after a dividend cut on a stock like this.

The Best of Both Worlds: Income and Total Return

Which brings me to the sweetspot: substantial yields from defensive businesses that can grow their dividends at a good clip. The archetype is a 3% yielding stock that can grow 7% per year. Or a 5% yielder that can grow 5% per year. Bought at a fair price, such a stock should have a long-term total-return profile on the order of 10%. That should be competitive with the S&P 500 over a full market cycle.

10% total-return profiles from stocks with already substantial dividends are currently difficult, but not impossible, to find. But this general approach should generate good long-term returns at lower volatility than an index fund.

And the practical benefits of this strategy are a stable and growing annuity-like stream of dividends which you can potentially live off of, and that should keep you protected from inflation. It becomes easy to answer the question: When can I retire? When your dividend income is large enough to cover your expenses.

Now, this approach isn’t for everyone, as individual stock risk means you have to more actively monitor and manage your portfolio than an index fund investor, but the rewards can be very practical and solve much of the puzzle of how to turn your portfolio into a stream of income for retirement.

See also:

Morningstar’s Income Investing Week

Dwelling on Quality

McCormick Spice – Almost Perfect

The Power of Dividends

Berkshire Hathaway’s Latest 13F

Market Selloff Rule #1: Don’t Do Stupid Stuff

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Don’t Do Stupid Stuff

The key to investment success is not making unforced errors. Strive to be consistently not stupid like Buffett and Munger.

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
— Charlie Munger

Be Rational, Not Emotional

Key to that is acting rationally and not emotionally. Emotional decisions equal stupid decisions. If you can’t handle a selloff without emotionally selling into it, then you’d better cut your permanent allocation to stocks.

Allowing fear to make you sell into a decline is to line the pockets of more rational investors. Don’t be the patsy for Seth Klarman or Warren Buffett.

“Rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers.”
— Seth Klarman

Manage Your Risks

An investor needs staying power to succeed in the marathon of investing. Think about managing your risk in the good times so you can make it through the bad times without losing your cool.

“Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”
— Seth Klarman

Focus on Value

If you focus on price and not on value, you are like Charlie Munger’s one-legged man in an ass-kicking contest. All else equal, the lower the price, the better the value.

“Fallible, emotional people determine price; cold, hard cash determines value.”
— Christopher Davis

Selloffs Are The Price Of Good Long-Term Returns

A stock market selloff is a feature, not a bug, of the investment world. Selloffs are the price you pay for the good long-term returns you can get from stocks.

Look For Opportunities and Margins of Safety

Stocks are the only thing people hate to buy when they go on sale. Rational investors look to a market selloff as an opportunity to find good businesses at cheaper prices. Unless the fundamentals of a business have deteriorated, a lower price means higher forward returns. It also may give you a margin of safety.

“Smart investors look to the market not as a guide for what to do but as a creator of opportunity.”
— Seth Klarman

Buy Businesses, Not Ticker Symbols

Think about the business underlying the stock. Have the fundamentals changed? How about the cash flow outlook? Is the dividend still well-supported? Thinking this way and looking to the long term is the only sensible way to invest. Otherwise, you are just speculating.

“The gambling nature of Wall Street has little or no interest in the serious, underlying nature of businesses.”
— Irving Kahn

Less Is Usually More

If you have a good plan, often the right action is to do nothing. Don’t confuse activity with productivity.

“Patience is the individual investor’s greatest advantage over the market.”
— Todd Wenning

Keep Company With Other Rational, Sensible Investors

Your peers are those who will influence your behavior. So keep company with other calm, sensible investors, and weed out the information sources and people that tend to be Chicken Littles and scaremongers. This will make it easier to do the rational thing.

“Try to socialize — in the real world and in online social media — only with investors who are calm and methodical. After all, whatever your peers pay attention to, you will also concentrate on — so following more-sensible people will help inoculate you against panic.”
— Jason Zweig

Some rational reads:

A Dozen Things I’ve Learned from Charlie Munger about Making Rational Decisions: 25iq

To Sleep Well at Night Buy Businesses Not Sardines: Total Return Investor

Assorted Quotes from Neil Woodford: Clear Eyes Investing

The Nature of Value

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This video interview of Nick Gogerty by Jake Taylor is a great introduction to some of the important ideas in Gogerty’s book The Nature of Value. Looking at value in this way will lead us to be better investors in businesses, and not simply traders of tickers. This is really a fascinating and wide-ranging interview.

Some of Gogerty’s main points from his book are:

1. The economy is an evolutionary, adaptive system that selects and evolves for greater and greater value creation over time.

2. Value is important because it is closer to economic truth than price.

“Value, in the simplest sense, is the human perception of what is important.”
— Nick Gogerty

3. Value is a process and not just a static entity.

“We should look not just at life and at value as static entities, but at life and value as continuous flows through a system that adapts for greater and greater flow capacities.”
— Nick Gogerty

4. Experience curve effects are one of the main mechanisms for increasing efficiency and value creation in a company, a cluster, and an economy.

5. Identifying companies with sustainable economic moats is key to the nature of value approach to investing. This requires us to understand the dynamics of the business, as well as, how the business interacts with other companies within its cluster to compete and create value.

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
— Warren Buffett

6. Clusters exhibit periods of “punctuated equilibrium” that last for a period of time, and are followed by periods of upheaval, and eventually a new temporary equilibrium.

7. Key to investing well is choosing companies in stable clusters with a slow rate of change in strategy and capabilities. This would include the Lollapalooza and Cash Cow clusters.

Companies in innovative clusters with fast rates of change in products and capabilities are many times not great places to invest, such as with the internet boom at the turn of the century. A lot of value was created, but most of it flowed to customers, and not to companies within the cluster. This is a key insight, and is worth the price of the book to me. The following chart shows the matrix of cluster types according to cluster stability and life cycle stage.

Cluster Stability v. lifecycle stage

8. Return on capital is more important to value creation than absolute growth in revenue and profits at lower rates of return.

If additional capital can only be deployed at lower and lower rates of return, capital should be returned to shareholders so they can allocate it to higher return areas. Otherwise, value is destroyed.

Gogerty on the Prerequisites for Prosperity

Soft infrastructure like property rights and the rule of law are key for prosperity and the nature of value approach to work. The lack of these is the main reason for the appalling human suffering in much of Africa. The best anti-poverty program in the world is to create such soft infrastructure. This explains why years of foreign aid to Third World countries has had little positive impact as corrupt elites embezzle aid and stifle the value creating capacities of the common people. Thus, the nature of value approach is really a moral and human imperative, and not simply a device to make money for yourself.

The Problem With Keynesian Aggregation and The Attempt to Reduce Economics to Arithmetic Formulas

Gogerty’s approach highlights a blind spot of many Keynesians who suggest that companies should just throw more money at plant and equipment and invest for growth. This mechanistic, aggregationist approach, which seeks to reduce economics to arithmetic formulas where more inputs equals more outputs, ignores the true evolutionary nature of an economy. Rather, return on capital is crucial for value creation, which leads to success for companies and economies, as well as, overall societal well-being. Capital discipline, and not growth at any cost, should be the aim for CEOs and allocators. Otherwise, value will be destroyed and well-being will decrease.

“The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low….Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building.”
— Rob Arnott and Cliff Asness

See Also:

How Your Rates Will Move When The Fed Does

Big Jump in Interest Rates Confirms Upside Breakout

Gundlach: Long Bond Wants the Fed to Tighten This Year But It Won’t Happen

Mother Nature Designed You To Be a Bad Investor

Dash of Insight: How to Think About Risk

Five Bedrock Principles for Investors