A Half Dozen Or So Things I Have Learned from Josh Peters About Investing

05 Thursday Jan 2017

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Congratulations to Josh Peters, who is moving on from being founding editor of the Morningstar DividendInvestor newsletter to managing a mutual fund. I’ve made some real money by looking over his shoulder and getting turned on to some great companies by him over the years.

But more than that, I am deeply grateful to Josh for his unvarnished sharing of his investment process, warts and all. Crystal clear thinking coupled with honesty and integrity oozed out of everything he wrote for the newsletter. Josh, thanks for being a great mentor and good luck in your new job!

Here are some things I’ve learned from Josh over the years:

1). A secure and growing dividend can give you a margin of safety beyond just price.

2). Don’t rely on forecasts or make big macro bets, but have a range of reasonable planning assumptions, like a normalized 10 year treasury yield of 4 – 5%.

3). Investing for income and total return are not only not mutually exclusive, they are better together. A secure and growing dividend bought at a reasonable price is a good foundation for meeting your long-term financial goals.

4). Valuation matters when investing in dividend paying stocks. It should never devolve into just a hot trade where you are buying them at any price because it has worked in the recent past.

5). The most important question to ask about a potential investment in a dividend paying stock is this: Is the dividend safe? You want to understand the cash flow dynamics of a business to avoid dividend cuts, as this is the key to successful equity income investing. Josh did this well with his decision to bail on the Kinder Morgan family in 2014, more than a year before Kinder Morgan (KMI) cut its dividend by 75%.

6). Josh’s Dividend Drill is a great format for evaluating a dividend-paying stock. It has 3 main steps:

Step 1 — Is it safe?

Step 2 — Can it grow?

Step 3 — What is a reasonable long-term total return target?

To me, Josh has represented the best of Morningstar, of which I am a big fan. His successor, Mike Hodel, has some big shoes to fill, but here is hoping he is up to the task. It certainly helps that he has the entire Morningstar team behind him.

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— Rob Arnott and Cliff Asness

Recent Portfolio Moves

28 Thursday Jul 2016

Posted by JC in Uncategorized

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Income Investing, Investing

Mid-Year Portfolio Moves

I’ve maintained radio silence for a while, but I haven’t been idle. Being largely invested in a mix of defensive dividend yielders and growers, I’ve had a great first 6 months of the year, up 18.6% on a total return basis. With utilities, REITs and consumer staples up big year-to-date, I’ve trimmed some of my winners. I raised about 9% cash and put about half of that to work in a new stock. I may be early, but risk management is my discipline.

Contenders for New Money

There are a lot of great stocks I have on my watchlist. Here are some of them, and my thoughts on them:

TJX (TJX) — The parent of T. J. Maxx, Marshall’s and HomeGoods is a formidable discount retailer. Many consider it Amazon-proof because of their ability to source high-quality discount goods. There is also the treasure hunt factor luring shoppers into the stores and away from their computers. Yields 1.3%. Ross Stores (ROST) is their competitor and a similar good performer. Stock is just not cheap enough and the yield is not high enough to get me to pull the trigger. Probably my loss.

Wells Fargo (WFC) — The best of the big banks. More involved in “boring old banking” than their megabank peers. Warren Buffett owns just shy of 10% of their shares. The upside is that it’s relatively cheap. I also like this one for its portfolio diversifying properties — it benefits from higher rates and a stronger economy. The downside is that the current low interest rates and the flat yield curve are crushing their NIM (Net Interest Margin). Political bashing in this election year makes for short-term downside, but now highly-regulated banks are in their best shape from a safety and soundness and capital standpoint in decades. Despite a generous 3.2% yield, I don’t see the urgency to buy it here, especially since their dividend growth rate downshifted to 1/2 a cent per share per quarter in 2016.

Ford Motor (F) — The only car company not to be bailed out in the financial crisis. Great turnaround under Alan Mullally. Fat 4+% yield (plus special dividends) is attractive. Just too cyclical for me. With some auto loans stretching to 72 months, what happens to demand when the economy slows, and/or the Fed raises rates? Reported earnings today and was slammed down by 8% on guidance for a contraction in sales in 2017.

Compass Minerals (CMP) — Sells mainly highway deicing salt for winter driving and has a small (10% of revenue) sulfate of potash business. Their long-lived, low-cost salt mines like the one at Goderich in Ontario benefit from salt’s low value-to-weight ratio and their access to cheap shipping throughout the Upper Midwest by barges on the Great Lakes and Mississippi River. Great 4% yield. Short-term concerns include the very warm winter last year leading to high salt inventories and weak pricing. 20% of their salt business by volume occurs in the UK and will take a currency hit from Brexit. A normal-ish winter in terms of snowfall would increase cash flows and help the dividend growth outlook. The long-term concern of global warming means that I want a big margin of safety on this one. Recent selloff has my trigger finger getting a bit itchy.

Fastenal (FAST) — A great operator in a fragmented industry, sells fasteners and other industrial supplies to industrial and retail customers. Nice 2.9% dividend yield. They have been struggling to manage their transition from their hyper-growth store opening phase, to their current effort to invest in their sales force to sell their vending solutions to industrial firms. This and recent weakness in manufacturing prompt me to take a pass for now.

Microsoft (MSFT) — Thank God for the arrival of Satya Nadella to replace Steve Ballmer. Nadella has refocused the company on investing in and growing their cloud business, Azure. Azure offers IaaS (Infrastructure as a Service) and PaaS (Platform as a Service) on a subscription model — you only pay for what you use. They are number 2 in the cloud to Amazon Web Services and growth was over 100% in the recent quarter. Given the explosion in data and computing power needed in the future, this looks like a secular grower with a lot of runway. They also have a SaaS (Software as a Service) business that is transitioning their legacy businesses to Office 365, and their Dynamics business includes ERP & CRM solutions. I don’t really know much about the wisdom of the LinkedIn deal, but given his performance so far, I’m willing to give Nadella the benefit of the doubt. With much improved capital allocation including a 2.6% dividend yield and good historic and expected dividend growth (this article anticipates an 11% dividend increase announcement in September), this is my kind of stock — a cash cow with good growth prospects.

If you can’t guess, Microsoft was the winner of my investment derby, and is the newest member of my portfolio, with a 4%+ weighting.

Don’t Let Anyone Tell You Dividends and Dividend Growth Don’t Matter for Stock Returns

This great chart from Eddy Elfenbein shows the S&P 500 scaled against a 2% dividend yield. The rally since 2009 has been more than just the Fed. But, so-called bond-like stocks are expensive now. You want to discriminate between them (no ETFs for me) and prepare your portfolio for higher rates.

In a time of low projected future returns on the indexes from the likes of Jeremy Grantham at GMO and Rob Arnott at Research Affiliates, people have rationally decided that all else equal, a higher yield with mid single digit growth will get you closer to a high single digit total return than an S&P 500 index fund is likely to do. As long as you sell the ridiculously overvalued in favor of the less overvalued and manage your risk.

But I believe it is definitely time to lean a bit more toward value and the unloved. On this basis, Wells Fargo and Compass Minerals are high on my list for future buys.

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Lessons From The Kinder Morgan Bloodbath for Income Investors

09 Wednesday Dec 2015

Posted by JC in Uncategorized

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Dividend Cut, Income Investing, Investing, Josh Peters, Kinder Morgan, KMI

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

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Income vs. Total Return? I Want Both!

16 Monday Nov 2015

Posted by JC in Uncategorized

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Income Investing, Investing, Total Return

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