Tag Archives: Investing

Income vs. Total Return? I Want Both!

16 Monday Nov 2015

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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

25 Tuesday Aug 2015

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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

08 Monday Jun 2015

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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

Lessons from the 2000 Tech Bust

24 Friday Apr 2015

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Yesterday the Nasdaq finally bested its record high set in 2000 at the zenith of the tech frenzy. This has occasioned a lot of “Where Are They Now” type features on many of the boosters of that bubble: Mary Meeker, Henry Blodget, Ryan Jacob, Jack Grubman, Frank Quattrone, and Paul Meeks.

Technology is not a sector that I’m generally interested in investing in because economic moats are so hard to find in that area. A tech company is only as good as their last product. Many tech companies seem to be about one product cycle from extinction. As Blackberry and many others have shown, you can be on top of the world at one moment, and then practically out of business five years later.

I skew more toward Warren Buffett’s skepticism toward investing in innovation. While great innovations improve society, innovative sectors are many times not great wealth creators — as experience has shown with autos and aviation. But I think there are a couple of great lessons we can take from the Tech Bust.

Valuation Matters

Jason Zweig reminds us that at the peak of the bubble, people were paying “dozens or hundreds of times” the long-term S&P 500 average of around 16 times earnings. And the thing is, at the height of the bubble it made sense to a lot of people, because their neighbors were getting rich by forgetting about valuation and just buying at any price. Which worked until the greatest fool had bought in.

“Success in investing is not a function of what you buy. It’s a function of what you pay.”
— Howard Marks

Cash Generation Is Key

Most of the high-flying Internet stocks had negative cash flow in 2000. The term cash-burn rate became the only metric that mattered once the air went out of the balloon. A company that cannot fund its operations through organic cash flow doesn’t have much of a future.

Paul Meeks, one of the Tech Bubble stars listed above, has bounced around since the Tech Bust and is again running money, although he is targeting very different companies these days. As he says in this article, “If it doesn’t generate cash, it’s not really a business.”

Words to live by.

“At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.”
— Warren Buffett

Howard Marks: Focus on Buying Cheap, Avoiding Losers, and Survival

19 Sunday Apr 2015

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This is a great talk from Howard Marks. What a joy to see a brilliant mind in action. My notes and thoughts follow.

Randomness Dominates

You shouldn’t act as if the things that should happen are the things that will happen. Humility is needed.

Beware of outcome bias. You can’t tell from an investment outcome whether a decision was good or bad because of randomness and luck. The longer the successful track record, the more likely skill is involved.

Balancing Probabilities and Consequences Is Key

Thinking in terms of probabilities and the expected value from a course of action is the first step. But then you must think about the consequences of being wrong. A very small probability event that you can’t survive may make you choose a different course of action.

As Marks puts it, you don’t want to be the skydiver who is right 98% of the time.

“It’s not sufficient to survive on average. We have to survive on the bad days.”
— Howard Marks

Focus on Avoiding Losers

Charles Ellis says that if the game isn’t controllable, it’s better to work to avoid losers than to try for winners.

Risk control is Oaktree’s primary focus. They don’t swing for the fences. Oaktree’s motto: “If we avoid the losers, the winners take care of themselves.” Just lop off the left tail of the probability distribution.

Weed out the problems, like tending a garden. Focus on consistency.

The Relationship Between Price and Value

If you buy a high quality asset but you overpay for it, you are in big trouble. Remember the Nifty Fifty in the late 1960s and early 1970s.

“The secret for success in investing is buying things for less than they are worth.”
— Howard Marks

Planning Assumptions Versus Macro Forecasts

Macro forecasts are worthless, but planning assumptions are necessary with individual companies. Just don’t make big one-way bets based on these assumptions. Assume a range of outcomes and seek survivability.

Don’t Chase the Crowd

You make no money doing the things that everybody wants to do, you make money by doing the things nobody wants to do that then turn out to have value.