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

37 comments:

  1. Thanks for the article. These investing lessons are important especially for those wanting to start or just recently started their dividend portfolio. I just started and there is immediately the problem of diversification. I currently own only 8 companies. Diversification will come through time. However, one of those 8 companies is KMI, so a hugh bleeder. This is a lesson for me. However, I wonder if I could have done it differently. I'm saving money in order to add another company to my portfolio every 1 or 2 months. Time will tell. For now, I'm holding on to KMI, but selling if there will be a dividend cut.
    Thanks for your articles. Always interesting to read (and learn).

    ReplyDelete
    Replies
    1. Well, the jury is still out on KMI. Diversification protects against the unforeseen.

      But expectation is that the dividend will be cut – how we got there in the span of the month from 6-10% annual growth to a fear of dividend cut is very interesting.

      Delete
  2. Thanks for sharing, DGI. Very timely.

    One thing I've learned over the years is...

    The market can stay irrational longer than you can stay solvent.

    I think about that in regards to KMI...a little humor keeps me sane.

    SAK

    ReplyDelete
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    1. Usually, things deteriorate so rapidly when everyone is throwing in the towel and abandoning ship. But if you are diversified, and have to leverage, you should be fine.

      If you hold 50 positions, and some fixed income, you can’t lose it all.

      Delete
    2. Exactly correct DGI. They always take the stairs up and the elevator down. I'm pretty well diversified...34 positions and KMI was one of the largest at about 3%...but I am still about 45% cash. All the KMI is in tax advantaged account so no tax harvesting.

      Really enjoy your writings and your outlook on investing.

      SAK

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  3. Great and valuable lesson DGI,

    You are one of the person accepting your failures, not everyone out there willing to do. You are a very successful person because of these characteristics.

    I am a Canadian investor and in a situation like you. My largest hold is Enbridge (TSX: ENB). Canada's largest pipeline and utilities company, and we use their server everyday in our life. This stock represents about 6% to 7% of entire portfolio.

    Some unknown reason, it is moving downward. I added few more shares last week. After I read your post, I feel I am making mistake in investing more money into a single company.

    Lets wait and see,

    Best regards,

    ReplyDelete
    Replies
    1. I prefer to write about failures, rather than successes. I view failures as learning opportunities.
      What I am doing however is a poor way of building audience. To get the most readers I need to post only successes, and remain upbeat about anything. Instead I have chosen to try to be a decent investor, though the jury is still out on that one.
      I think that everyone decided that the volumes of oil and gas transported over those pipelines will be down a lot or that those pipelines will not be used any more. I think that pipelines will be here to stay, though we might get some dividend cuts in the process. I would be hesitant against concentrating too much in one single company. I am thinking that a 3% - 4% maximum allocation is best for me.

      Delete
    2. You always put out very interesting pieces and you are right, stick with the positives. But being a big reader of lots of financial articles, sadly it looks like the way to get the audience is to always talk about the negative. There are so many guys that I read calling for the sky to fall every single day....the negative sells.....it really does...and that is what is sad about most financial pieces these days. Everyone wants to be the start of the next Big Short style book.

      Delete
  4. These are great lessons for people to learn from.
    I like #3 - patience......time in the market. Especially for young investors.
    In my youth, I kept thinking there was some 'system' of 'method' to beat the market.
    The stock market is extremely efficient and options are a mathematical zero-sum game.
    About the only advantage the little guy has is his longer time frame.

    ReplyDelete
    Replies
    1. Your words of wisdom are so true. I have nothing else to add!

      Delete
  5. Energy company stock prices are so low it seems reasonable that many bankruptcies and considerable consolidation will happen in the next two years. Could Exxon/Mobil buy KMI at $25? Could Chevron buy Linn Energy at $4 and acquire considerable natural gas holdings? Each purchase would benefit the buyer but inflict heavy losses for anyone waiting for the eventual turnaround. Time will tell.

    ReplyDelete
    Replies
    1. This is why some pipelines are consolidating. I think we may see more M&A action in 2016.

      Delete
  6. I know I get frustrated when I do what I consider a significant amount of due diligence and still encounter significant paper losses. I continually tell myself that if the underlying business is sound, then paper losses don't mean anything unless I actually sell. In my case, I was drunk on SDRL and it's yield. I didn't realize that basic economics (supply/demand) could impact a business in such a significant, negative way. I can't see or think clearly when I'm drunk. It seemed like 6-10% declines were occurring every day...or worse. I sold when the dividend was discontinued and nursed my hangover...promising myself I'd never drink again and chase yield.

    I know it isn't a fair comparison when holistically looking at the companies, but the performance of KMI lately reminds me a lot of SDRL as it seems to have significant daily stock price decreases. KMI seems to be stuck between a rock and a hard place. If they need to raise capital....either issue more stock and dilute existing shareholders...or...add to their already high debt levels...or...reduce the dividend and plow the $$$ back into whatever project they are considering.

    I normally don't sell a stock unless the dividend is cut. In KMI's case, I don't see how they have a way to be overly successful without having a negative impact to the shareholder. I sold approximately half my position early last week even though they haven't decreased the dividend. I would still consider getting back into the stock as the KMI picture changes...I think the decreases will continue for awhile.

    Life is a lot easier when I'm not hungover....

    ReplyDelete
    Replies
    1. The reason why stocks do well over time is because they test the nerves of even the most patient shareholders with vicious declines. Many bail out, never to invest in stocks again.

      Others persevere, and stay to fight for another day. Covering the downside

      It has taken me a while, but I have learned the hard way that pass through entities are easier to break. That includes REITs too

      Delete
  7. All 3 are great points. 'Time in the market', not timing the market is what really matters. The world is risky enough, we don't need to add to it by under diversifying or chasing yield.

    ReplyDelete
  8. Like you I received most of my KMI from my KMR holdings and it put me a very overweight position. The stock price was rising and I set a $45 sell price to deversify into other dividend stocks. I missed the sell price by $0.50 and it has been down hill since. I am holding on for the dividend, but learned that I should have averaged out of KMI as the price was going up, instead of swinging for the fence. Now I can only hope it will get back to my average cost of $25 while not cutting the dividend. Thanks for the education I receive from your articles.

    ReplyDelete
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    1. In hindsight, I should have sold a portion after the merger in late 2014. On the other hand, I considered KMI to be one of my best ideas. Plus, I have always found that when I sell something to buy something else, I make mistakes in 80-90% of the situations. So I have found that doing nothing is the best action under most situations – though not in all situations.

      Delete
  9. Blog post of the year! We learn more from our mistakes than from our successes.

    ReplyDelete
  10. Another holder of KMI here. I would be happier if they bite the bullet and cut the dividend. It's the uncertainty which is hurting the stock. The longer the company takes to do this - and the higher the yield - the more selling it will fuel. I'm assuming Richard Kinder isn't sitting on his laurels on this. I bought one of the dips last year, which is now swimmingly underwater!

    ReplyDelete
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    1. The odds are high that the dividend will be cut. Let's wait and see what happens. If dividend is cut, the price will be very low, and the debt situation will be taken care of.

      But then if Richard Kinder gets financing, he may decide to take Kinder Morgan private again...

      Delete
  11. new to this but i've been following your blog. this topic has me wondering, why don't you just go with diversified ETFs if you want to own a little bit of everything?i thought the goal with individual stocks was you went with your best ideas.

    ReplyDelete
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    1. My take on this is that, yes, you want to go with your best ideas, but you should have 20-25 good ideas to protect yourself if one idea is a disaster. ETFs tend to hold hundreds of stocks.....that's too many.....if you look at what the ETFs hold, the bottom half of the holdings can be quite garbage-y

      Delete
  12. DGI, good article. I am however not a huge proponent of diversification... remember Phil Fisher? I like your statement -"This is why I need to create systems to protect myself from myself". I totally understand that, since the biggest damage creator in my portfolio was done by ME. Now I have certain processes around and reading from you all have got a finance blog under a different ID. The blog acts as my window to the outside world and I treat myself as a fund manager. That kind of approach seems to have worked.
    Keep writing and keep learning.. its never too late as long as we emerge intelligent and not make the same mistake again. Good luck!

    ReplyDelete
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    1. Phil Fisher did a lot of work in selecting and researching companies though.
      But I am smart enough to know I am not Phil Fisher, which is why I diversify. My experience with companies that don’t work out as expected confirm that diversification is important. I’d much rather have average results than swing for the fences and lose.

      Delete
  13. "People who swing for the fences forget the fact that you only need to get rich once in life". - So, so true! Words of wisdom.

    ReplyDelete
  14. Great post! It was a great reminder to not be greedy, but to be patient. Keep up the good work!

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  15. Thanks for the article on investing lessons you've learned. I find the mistake/lesson articles to usually offer a lot more insight than the reasons to buy. I started thinking about KMI and its place in my portfolio earlier this year since I was in a similar situation as you where the portfolio weight was a lot less than the dividend weight. Luckily I've done a pretty good job of not adding even more even though the valuations continued to make sense, assuming the dividend is in fact safe. After the huge decline over the last couple months it's now about 2.0% of my portfolio but over 7.5% of my dividends. If I wanted a more concentrated portfolio I would require a much larger margin of safety between dividends and expenses for FI; however, the simpler thing seems to be to just own more companies by purchasing when the valuations make sense. It'll significantly decrease the single company risk.

    ReplyDelete
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    1. To be honest, the longer I invest, the more conservative I become. This is because I get to see how unpredictable the world truly is. This is why it is important to devise my affairs in a way that I preserve my dough and income, while also growing that nest egg without taking undue risks. The goal is to get rich once, and then preserve that, rather than swing for the fences.
      I didn’t add anything to KMI since 2013, and allocated dividends elsewhere. I am glad I decided to take a diversified approach to investing, rather than invest only in my best 10 -15 ideas. I am starting to ponder whether it makes sense to catch a steeply falling knife. It may make sense to buy more when the price is bouncing off the bottom, rather than while it is working its way towards creating a bottom.

      Delete
  16. An old co-worker is hounding me for advice on how to best chase yield. I have of course warned him of the dangers but I think it is falling on deaf ears. Sometimes, experience is the only teacher that will be heard.

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    1. Tell them to buy a 10 year CD. Use the interest income to buy speculative high yielding stocks. Worst case scenario their purchasing power is slightly lower in a decade, but they haven't lost it all.

      Delete
  17. I think it is a good idea to include non-cyclical stocks too as you build your core dividend portfolio. And make sure it is one of the leading stocks in its sector. I live by a simple belief...investing in dividend stocks will get me to where I want to be, but it takes a long-term view to get there with the right stock.

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  18. The complete oil-industry is under risk, of getting unprofitable. So the shares will get dump and somehow worthlesse. (it is also a problem of mine)

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  19. I think this lesson (chasing yield) has finally sank in for me after the whole KMI mess. I am just going to avoid panicking and hold since I have time on my side. I am trying to add more securities too! You think 30-40 is the sweet spot for different stock holdings?

    JT

    ReplyDelete

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