Monday, December 7, 2015

Three Investing Lessons I Learned the Hard Way

In my site, I try to stress out the importance of diversification, patience and not chasing yield. The truth is that I have learned the hard way to keep those items in mind, any time I am investing my hard earned money. Many investors will ignore the teachings of this article, because these lessons might sound like a common sense approach to them. Others will ignore them, before they haven’t yet experienced the debilitating loss of capital or future opportunity by failing to adhere to these sound principles. Only a select few investors, who keep an open and inquisitive mind would be able to learn, without having to go through painful losses that typically precede learning in the investment field. I know these principles to be sound, because any time I fail to adhere to them, I always lose money.

The first lesson I have learned is never to chase yield. I have chased yield in the past, and have gotten burned doing it. The first time I chased yield, I was following a high-yield junk bond closed-end-fund, that was yielding 10-12%. The trust kept cutting distributions, but it kept yielding 10%-12%. As a result I thought I would just keep reinvesting distributions, and make up for the losses in income. Unfortunately, yields stayed the same because prices kept decreasing over time. Luckily, I saw the folly of my thinking, since my yield on cost was decreasing. After my issue with Managed High Yield Plus Fund (HYF), I decided to focus on companies that increase distributions. This is when I learned the second lesson the hard way.

The second lesson I have learned is always to understand what I am purchasing. I then started chasing companies like American Capital Strategies (ACAS) in 2008, which had a very high yield and had raised dividends for almost 10 years in a row. Of course, I didn’t really know much about Business Development Companies, and I didn’t really know how sustainable those high distributions really were. The company managed to increase dividends for a few quarters after I purchased, followed by a dividend suspension in November 2008. I quickly sold for a 66% loss, and reinvested my money elsewhere. I had chased yield, and I had also invested in a company that I didn’t know intimately well. In order to have a sustainable dividend income, you need to invest in companies that will keep generating earnings in order to maintain dividends during the recessions of the next 30 years. Otherwise, a company that pays a high dividend is of no use for you, if it goes into trouble the minute a recession starts. Luckily, the financial crisis hit shortly after I invested, and I learned a valuable lesson, while I was still building my dividend portfolio.

The third lesson I have learned is to be patient. As an individual, I am very impatient. This is why I need to create systems to protect myself from myself. I know that the one thing that would make me successful is time in the market, where I patiently hold on to my stock holdings through thick and thin, and patiently reinvest my dividends in the best ideas of the time. I do strive for financial independence by 2018, which is why I might start fiddling with my portfolio holdings, in order to reach out for an extra point in yield. I tend to stop myself in 99 out of 100 times I get myself thinking about those switches. I do this since I remind myself that chasing yield and getting into something I do not understand as well as the company I already own, might not be best for me. Plus, I often remind myself of the pain I usually experience four times a year, when I pay my estimated taxes on dividend and capital income. This is enough to prevent me from being too active in the stock replacing front. In the rare occasions where I do get bored enough however, I may switch out of perfectly good companies, and move into not so great investments. In the process, I end up slightly worse off, because I am chasing yield and not thinking straight.

Putting everything in perspective is important. Now that I am talking about investing lessons, it may also be helpful to talk about Kinder Morgan (KMI).

My current experience with Kinder Morgan is a great case study. I have owned the stock since 2008, when I purchased Kinder Morgan Management LLC (KMR), and made most of my investment by 2013. (I did make a few smaller purchases in early 2013, a swap in mid 2013, and late 2013). While I do think I understand the business well, I may have overlooked certain risk management techniques. For example, Kinder Morgan has been my largest position (both general and limited partner) for something like 5 - 6 years. Under normal conditions, the company's dividend is sustainable from operating cash flows. Under those conditions the company has the ability to raise capital to grow operations. However, as I said last week, entities that rely on capital markets to grow their operations could be subject to an extra risk of a dividend cut. This is because they have to choose between paying a dividend and maintaining their credit rating when access to capital markets is severely restricted. If markets are not willing to provide capital at favorable terms, it will be difficult to refinance existing obligations, grow the business and maintain distributions to shareholders. I believe that the business of Kinder Morgan is sound, and the fee generating assets will be there to come decades from now. However, when your business model runs the risk of a "run on the bank", you may not do too well during a short-term tumultuous period in the market. Therefore, I am starting to reconsider whether pass through entities such as MLPs, REITs, BDCs could be relied upon for dependable dividend income in retirement, due to the added embedded risk there.

The other lesson from Kinder Morgan is that one should never hold too large of a position in a single entity. There have been times in the past when Kinder Morgan accounted for 5% - 6% of my portfolio. One mistake I made is selling a large portion of my Enterprise Product Partners (EPD) and swapping into ONEOK (OKS), Kinder Morgan Inc (KMI) and Kinder Morgan Management (KMR). This move concentrated my risk into Kinder Morgan. (ironically, if I were to sell Kinder Morgan after a dividend cut, I may end up putting some of the money into Enterprise Product Partners). As I kept adding money to my portfolio however, and reinvested dividends selectively elsewhere all those years, the relative position weight decreased. When you have a high yielding stock that already has a high weighting in your portfolio, your dividend income is at a greater risk of loss. This is because a greater portion of your dividend income is derived from this individual investment. Again, this comes down to diversification, and not being overly reliant to a certain company or sector. For example, while Kinder Morgan accounts for roughly 2% of my total portfolio, it accounts for roughly 8% of dividend income.

Luckily, I have always maintained a diversified portfolio of dividend paying stocks. This has definitely shielded me from devastating losses, that would have taken me back years to recover. If you are not holding a diversified portfolio of at least 30 - 40 individual dividend paying securities, that are representative of as many sectors as possible ( that make sense due to valuation, quality etc), you are simply asking for trouble. This is because even if you think you know everything about a certain company or its industry, there are always things outside your control that can derail your plans.

If you hold a heavily concentrated portfolio consisting of 10 – 15 securities, you might be overexposing yourself to dividend cuts from as little as one or two companies. In addition, if most of your companies share a common trait, such as being pass-through entities, you are definitely asking for it. I am increasingly believing that I should try to be as diversified as possible. If I would like exposure to soda, I would purchase Coca-Cola (KO), PepsiCo (PEP) and even Dr Pepper Snapple. That way, I would win no matter which of the three companies ends up dominating. Plus, each one will have different risk-return characteristics, since PepsiCo generates substantial amounts of cash from snacks, and Dr Pepper Snapple (DPS) used to be often undervalued, repurchases a lot of stock and could be acquired one day by the big boys. Same is true for big oil and gas companies. I own Chevron, ConocoPhillips, Royal Dutch Shell, Exxon-Mobil and BP. That way, I can sleep well at night, and know that company specific risk is reduced greatly. To me, it is more important to cover my downside, rather than swing for the fences. People who swing for the fences forget the fact that you only need to get rich once in life.

Full Disclosure: Long KMI, KO, PEP, DPS, CVX, COP, RDS/B, XOM, BP

Relevant Articles:

Is your dividend income riskier than expected?
Dividend Investing Risks
How to define risk in dividend paying stocks?
Sector Allocations for Dividend Growth Investors
My Dividend Growth Plan - Diversification

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