Monday, December 14, 2015

Where to invest the money from the sale of Kinder Morgan stock?

Last week was particularly busy for me on the investing front. I ended up selling almost my entire position in Kinder Morgan (KMI) at approximately $16/share after the company cut dividends by 75%. The surprising part was that the company went from forecasting 6% - 10% annual dividend growth to a 75% dividend cut within the span of one month. I decided that rather than hope for the best, I should cut my losses and reevaluate the situation with a clear head. This decision would also allow me to claim all losses on my 2015 tax return.

My average cost basis on Kinder Morgan stock that I bought outright was about $30/share. I started buying the shares after the IPO in 2011, and bought more until 2013. The company was one of my best ideas. I didn’t buy new stock outright since late in 2013. I have received several years worth of dividends. From a tax perspective, I get to reduce my income by the amount of the loss (technically I reduce any capital gains first, and then I get to deduct up to $3,000 and roll-forward any losses for future tax returns). The reduction in tax liability is helpful to soften the losses. Since the last time I made an investment in Kinder Morgan in late 2013, I have collected approximately $4/share in dividend income. I did hold a small portion of my Kinder Morgan position ( approximately 7% - 8% of my shares) in tax-deferred accounts such as an IRA, where the tax basis was in the mid-30s. I reinvested of my dividends there, and I won't get any deduction on the loss. A portion of those shares will likely be forever stuck in a tax-deferred account since the position is so small, that it would not be cost effective to sell the shares and then buy something else with the proceeds.

A large portion of Kinder Morgan stock came from my investment in Kinder Morgan Management (KMR) however. I received cash dividends of a little less than $2/share for only 1 year – before that I had received shares in lieu of distributions. This was a tax-free way of receiving distributions in stock at a discount, which made compounding easier and a no brainer decision. Either way, I came up only slightly behind on those investments from this legacy position from Kinder Morgan Management (KMR), despite what it looks like a low tax basis of approximately $20/share.



Of course from an opportunity cost perspective, I would have been better served elsewhere. This is the problem with opportunity costs however – they don’t provide any useful information, because of their perfect 20/20 hindsight. This regret is one way to not learn as an investor. I am "lucky" because I didn’t try to catch this falling knife, and average down. Nor did I buy cheap companies like Caterpillar, National Oilwell Varco (NOV), BHP Billiton (BBL) etc. My goal has never been to be the hero who called the bottom. Somewhat counterintuitively my analysis of my investments during the bull market from 2009 - 2015 shows that it is best to make money when you are adding money when things are getting better. I find it easier to follow the trend, and add money after things have stabilized, than try to catch a falling knife. Buying on dips only works when the underlying business fundamentals are rock solid. If a stock is declining in price because the fundamentals are deteriorating, this could end up burning investors who are buying on the way down. This happened a lot during the financial crisis in 2007 - 2009. Somehow, those who survived only remember the epic story of how Buffett and Munger bought Wells Fargo at the bottom in 2009. The forgot about looking for a bottom in Citigroup, Bank of America, Wachovia, Washington Mutual, General Electric etc.

Either way I have decided not to rush into investing the whole amount out at once.

For some reason, ever since the summer of 2015 I have been somewhat bearish on US equities. This is why I eliminated all margin debt outstanding and also started investing in fixed income with new money I get every month from savings. I see some divergence between popular US indexes such as S&P 500 and the rest of US listed companies. It looks like most of the gains this year have come from a relatively tiny amount of large-cap stocks. Many of those stocks defy conventional valuation measures. At the same time, I have observed a lot of investors making victory laps and proclaiming that they are 100% invested in equities. Being mostly in equities looks like a no-brainer decision after more than 6 years of rising equity prices. The problem is that many of those investors were public with their portfolios only during a bull market. Some of them are pretty new to investing in general.

Some investors for example talked about how it makes no sense to have an emergency fund. Those same investors went from being completely silent about their personal financial situation to being brave enough to share their successes of the past 7 - 8 years. So perhaps, you can use those investors as contrarian indicators. Of course, I do not subscribe to the idea that I should make forecasts to make money. I merely use those examples because I found out that I am too exposed to equities. I believe that a 15% - 20% allocation to fixed income could be helpful. So while I won’t be selling any of my stocks, I will keep selectively reinvesting dividends, maxing out 401 (k), but using some of my excess cash to build my CD ladder. I may also decide to buy some TIPs in tax-deferred accounts, to hedge against the risk that buying CD’s is a mistake from an inflation perspective.

At the same time there has been a stealth bear market in commodities, energy, basic materials and international stock markets. The decline in energy prices since the summer of 2014 has taken many by surprise. The other surprise is the fact that energy prices have remained low for a period of time, which could have implications on economies and related sectors. For example, I was surprised that pipelines have been under attack, and some like Kinder Morgan (KMI) have admitted defeat by slashing dividends. Since most companies tend to follow each other’s steps closely, I wouldn’t be surprised if other pipeline companies at the general or limited partner level like ONEOK Inc (OKE) and Williams (WMB)and Enbridge Energy Partners (EEP) don’t end up slashing dividends as well. I will hold on to them for the time being until I am proven otherwise of course.

As a result of my experience, I would be careful about buying pass-through entities at this time. When I analyze all the dividend cuts I have had, I am noticing a pattern where many of the cuts originate from pass-through entities. Examples include American Capital Strategies (ACAS), American Realty Capital (ARCP) and now Kinder Morgan (KMI). This fact is something that makes me want to pause, and reexamine if I really want to have exposure to any pass-through entities (the other reasons against pass-through entities are sprinkled within this lengthy article).

I am more confident about some pipelines like Enterprise Product Partners (EPD), which is where I invested a portion of my Kinder Morgan proceeds. I probably invested approximately 17% – 20% of my Kinder Morgan cash proceeds into Enterprise Product Partners (EPD). Welcome back to K-1 forms. Because of the reasons I discussed above and below this paragraph, I may not add material amount of dollars to this MLP ( though I will reinvest the distributions).

While I don’t care about falling stock prices, I do care if that affects the ability to finance operations, and the ability to maintain a dividend. I also do not agree that just because a company’s stock price is low, it is automatically a good investment. If a company’s business model is not materially changed, then a lower price could be a bargain. However, if the company’s ability to generate cash flows is impaired, then a lower price could be justified. As John Keynes says, when the facts change, I change my mind. The facts speak that the managements of companies like Kinder Morgan do not have good near-term visibility as to their cash flow and dividends. The fact is that management went from forecasting annual dividend growth of 10%, to cutting the dividend by 75% in the span of one month. If they don’t have visibility, and change their minds so quickly, then these are dividends I cannot really rely upon when I plan to live off dividends in retirement. The stock price could double to $30 in the case of Kinder Morgan, and I would still not regret selling my shares.

One of the issues with pipelines that few think about it, is that lower energy prices could lead to lower exploration and production. This could decrease the volume of energy being transported. In addition, there is counter-party risk, where producers with shakier financials would end up renegotiating transportation contracts or being unable to stick to their terms if their financial conditions further deteriorate.

In the case of pipelines, many investors are realizing that these entities need access to capital by selling equity or debt. If the cost of that capital is too high, then any further growth will be difficult to finance. In addition, this would make the ability to rollover existing credit that matures over time very difficult and expensive. When you have a run on the bank and everyone is requesting their money at the same time (or wants to charge all of a sudden a premium for the privilege of investing with you through equity or debt), it doesn’t matter if you have assets with tremendous quality. Perhaps this is what Buffett was discuss in his annual reports on the importance of maintaining $20 billion in liquidity on Berkshire Hathaway’s balance sheet:

We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Now I would also not be surprised if we see bear raids on other pass-through entities such as Real Estate Investment trusts. For example, Realty Income (O) looks overvalued today. There was a bear raid on the stock in 2010, when a famous hedge fund investor had a long presentation against the stock. There was a bear raid on Digital Realty (DLR) in 2013 as well, which was unsuccessful. As we all know, Barron’s and certain hedge funds were bearish on Kinder Morgan since late 2013. They were wrong for two years, but ultimately Richard Kinder proved them right by admitting defeat and cutting the dividend.

As a result of the sale of my Kinder Morgan stock, my dividend income will be reduced by approximately 7% - 8% (this calculation assumes the dividend income goes to zero because I sold almost all the stock). This would reduce my forward income projections for 2016 from a little over $15,000 to a little over $14,000. The lesson learned is that I should not have a single company account for so much of my dividend income (though I did discuss this lesson back in 2011). So this would potentially set me back from my goals by almost one full year. If that $14,000 grows by 6%, due to organic dividend growth in 2016, the forward dividend income will be at $14,840 by the end of 2016. If that $14,000 is reinvested in companies yielding 3% on average at the time on investment, it would generate an additional $420 in forward dividend income. This would bring my forward dividend income to a little over $15,200 at the end of 2016. A portion of that dividend income will be used to fund my Roth IRA.

Of course, if I invest the money from the sale of my Kinder Morgan stock at an average yield of 3%, the forward dividend income will increase by approximately $300. I already invested a portion of the money (1/6th to 1/5th) in Enterprise Product Partners (EPD), and an even smaller position in Diageo (DEO). I may invest a little more in Enterprise Product Partners (EPD), but as I mentioned above, I do not want to be adding more money to pass-through entities. A portion of the money could be used to purchase shares in Hershey (HSY), if the put options I sold a few weeks ago end up in-the-money at expiration in six month. It is possible that if Kinder Morgan starts raising dividends in 2016 or 2017, I will allocate as much as 1/5th of the money back into the entity and give it a second chance. On the other hand, a dividend cut from Williams Companies (WMB), ONEOK Inc (OKE) and Enbridge Energy Partners will cause me to sell and lose out on as much as ~$800 in forward dividend income. If I reinvest the proceeds I may be able to recover that dividend income back up to $300 - $400.

At the end of the today however, I am not accounting for new investments in those dividend income calculation projections. Unfortunately, most of my new money will be allocated to my 401 (k) and HSA accounts as part of my plan to increase the tax efficiency of my net-worth. That money is invested in low cost index funds that yield a little more than 2%. The overall dividend yield there is approximately 2%, so this could deliver several hundred dollars in annual dividend income. Another portion of new money will be used to build up my fixed income allocation. When I finish building the CD ladder a few years from now, it would likely generate a few thousand dollars in interest alone. This would take 3 - 4 years to complete of course, though I don’t have this income accounted for in my long-term income projections. Most of my dividend investments in 2016 will be using dividend income I receive during the year, or due to sales that I may need to reinvest back into the portfolio.

Full Disclosure: Long EPD, OKE, WMB, DEO, EEQ, KMI (a few shares left over that are not worth it selling due to commission costs)

Relevant Articles:

Is your dividend income riskier than expected?
Do not get emotionally attached to a dividend position
Dividend Investing Risks
Replacing dividend stocks sold

27 comments:

  1. I share many of your concerns regarding the KMI situation. I think long term it'll still be a good holding, but can we trust management after what's happened over the last few months? Reiterating 6-10% annual dividend growth and the cutting dividends by 75% a month later is troublesome. It could just be there's a lack of visibility like you said, but if there's a lack of visibility one month out what is there to make me believe they can get multi year plans right? However, the assets are still there and if management truly goes with self funding growth, rather than cutting the dividend just to increase the cash flow to take on more debt, then the company will be much more stable in the long run. The assets are still solid and I still expect us to be using O&G over the next 10-20 years which means pipelines will still be a necessity.

    I've contemplated selling now for tax purposes and reentering the position once there's more clarity on their short term future and I'm still trying to work that out.

    ReplyDelete
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    1. I have caught a lot of investors say " the situation is tough today, but in the long-term of 20 -30 years things will be better".

      I catch myself doing the same thing. To me, this sometimes sounds like wishful thinking, and in some cases where I have caught myself saying that, it indicated that I hadn't really done good research in the first place. Thus I was hoping that some magical fairy would "bail me out".

      The reality is that we don't know what the future holds. A lot of things could go wrong.

      Though I do agree the assets are good, and I will reconsider KMI if things change.

      Delete
  2. Dividend Growth Investor,
    First off, sorry for your loss! No matter how you "dress it up", financial losses still hurt in the stock market (or anywhere). As you discussed, we want to learn as much as we can from each loss so we (hopefully) don't repeat them again.
    I too have a loss I will be recognizing real soon- BBL. I thought (and still do) that it is one of the "strongest" diversified mining companies out there, but in view of the wholesale collapse of essentially ALL commodities (oil/ Nt. Gas, copper, iron ore, coal, other metals, etc., etc.), they have come down HARD. That have not cut their dividend (yet), but barring some incredible turnaround in all commodities, I think it is only a matter of time. They can't continue "bleeding money" paying a dividend that uses all their cash flow and have to support it with debt.
    I do feel you may be wrong with your thesis about all pass through entities- specifically REITS. Because REITS (we'll run ones at least) have a diversified group of tenants, their stream of income is more diversified than a pass through like KMI, or even a miner like BHP/ BBL. Realty Income has very strong "suite" of diversified tenants (grocery stores/ pharmacy stores/ clothing/ car repair/ shoe stores/ Walmart/ Home Depots/ etc.)- therefore their income is NOT dependent on one slice or sector of the economy. They are going to be sensitive to the overall economy- like a recession, but NOT as sensitive to individual sectors as KMI, BHP/ BBL, etc. If we have a real strong overall downturn, essentially all stocks will come down including REITS. But I'm not so sure they belong in the same boat as KMI, at least not the "strong" moat REITS.
    Now the mortgage REITS- that's a different story!

    ReplyDelete
    Replies
    1. What are you talking about?

      How am I "dressing up" anything?

      As for REITs - a lot of things could go wrong under scenarios that are not really that preposterous.

      Just ask yourself the question - "What Could Go Wrong?"

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  3. Well I hope your tax loss harvesting pays off, that's certainly a good strategy with the likes of such an aggressive move by KMI. I completely agree on EPD, and in fact have a small position in that partnership. They were much less aggressive a few years back and stand to benefit from continuing to grow their dividends. And this might be a good time to begin slowly adding some of their shares, in fact from a recent M* interview with Josh Peters, post the KMI cut, he also feels comfortable with MMP and SEP. I purchased EPD when their yield was 5.89% and it is now up just into the 6% yield. If I see further share price erosion I might add a slight increase to my exposure.

    ReplyDelete
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    1. What tax loss harvesting?

      I sold KMI because I don't trust its management. They are cutting the dividend to be building all those projects, when demand could likely be lower than their projections. Plus they have debt maturing - how are they going to handle that?

      Josh Peters seems to have sold out of KMI in 2014, so he might know what he is talking about. EPD does seem more conservatively run. I need to research MMP and SEP.

      Thanks for stopping by!

      Delete
    2. "What tax loss harvesting?" Paragraph 1 last sentence

      Delete
    3. Not sure what I meant with that comment

      Delete
  4. I'm still on the fence on selling out my small KMI holding. I bought near the top, 41.00 so have taken a big haircut.
    I also have been building a CD ladder, very conservative I know but I'm sleeping better LOL!
    Yes a lot can and probably will go wrong for the future, Low oil prices and contentious election cycle will only exasperate things.

    Just remember you can't win if you don't play!

    ReplyDelete
    Replies
    1. I don't understand your last comment. Please elaborate.

      Delete
  5. Canadian banks. I like TD and Scotia. Good dividends and a secure investment.

    Beth from Canada.

    ReplyDelete
    Replies
    1. I would have expected Canadian banks to start getting into more trouble given the energy troubles we are seeing. I do own the top 5 banks north of the border.

      Delete
  6. I'm keeping my KMI right now. Got in at $24 and can't tax loss harvest. What do you think about RDS or BP as a replacement for that dividend income? Both seem to be beaten down a little more than they should right now.

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    1. RDS.B and BP could also end up cutting their dividends. The safest energy dividend I would consider is the one from XOM - if that one is cut, then we may be in for some big trouble,

      Delete
  7. I agree with you, I'm feeling a bit anxious about the markets and would like to have investments other than pure dividend stocks. Have you ever considered bond etf's ? I've been looking into some but every time I turn on CNBC they seem wary about high yield bond (junk bonds) in the face of rising interest rates so that makes me wonder about the entire bond market. I even have some that are commission free in my brokerage like BLV.

    ReplyDelete
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    1. Well, markets gyrate like crazy all they want. The real problem is that we are having deteriorating fundamentals in some companies, which justifies those lower prices in some cases.

      It is important to stick to your plan - in my case I am holing on to my dividend stocks and reinvesting dividends.

      I am maxing out 401K and HSA, and investing there.

      With anything left over, I am creating a CD ladder.

      I am not a fan of bond funds - I can get better results with a CD ladder.

      I would advise against watching CNBC

      Delete
    2. Nothing wrong with creating a CD ladder..... may end up being a very smart move....

      Cheers and Happy Holidays..

      Delete
  8. DGI, I can appreciate your tax-loss harvesting strategy and your disappointment in KMI management with their misstep in projecting and then reversal. However, I am going to continue on. I have a cost basis of $30/share in one portfolio and $23/share in my emergency fund (yes, my emergency fund) is invested in dividend paying stocks contrary to many. I believe that management quickly recognized that their business model after converting to C-corp was not sustainable. When I look at the fundamentals, they are still sound based on contracts in place and how those contracts are structured. Their debt ratio is at 55.5% and the lowest it has been in eight years (according to Motley Fool). I have not lost total faith in management, so I will continue to monitor them.

    I do want to thank you for your continued devotion to the dividend passive community.

    ReplyDelete
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    1. I appreciate your input. If your strategy/analysis calls for holding, you should hold. It is smart to follow your own strategy, and not others. Hopefully the investment works out for you!

      Thanks for stopping by!

      Delete
  9. What do you think of the Kinder Morgan preferred? It is trading at a discount, with a huge coupon.

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    1. Of the top of my head (Sorry, I am out and typing this on my iPad.), I think the coupon is only good for 3 years however, after which the preferred have a mandatory conversion clause.

      Which is why a price below par might be justified ( as long as KMI stock is down).

      Delete
  10. Your KMI situation is an example of why stock picking is so difficult. You can dress it with all the research and analysis that you want, but in the end it is still stock picking and you're still subject to the unknowable. And when you make a transaction, someone who likely has done more research and has better information is on the other side. Taxes in a taxable account compound the difficulty.

    I am skeptical that dividends will retain their tax preferred status. As you noted to a poster above, "what if you're wrong?" You probably would have been much better in a plain vanilla stock index fund.

    If you want high yield, then buy a low cost high yield stock fund. If you want total return, buy a low cost index fund. In the long run, odds are the performance will converge to the same number, the winner being determined by who has the lowest costs and turnover.

    So to answer your question about what to do with KMI proceeds, take a break from the dividend only mindset and read up on and then put a pen and pencil to a total return approach. Sit on the cash for a while, and wait for a good old fashioned market panic. When it comes, buy a plain vanilla stock index fund. It might take a couple of years, but history shows that it will eventually come.

    I expect this comment won't be well received, but what the heck.

    ReplyDelete
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    1. There is nothing special about index funds. An index fund is just a portfolio of stocks that fit a certain set of criteria. Companies are weighted based on float and market capitalization for those like S&P 500.

      For my goals, I follow a strategy where I pick stocks that fit a certain criteria and hold them for many years. So you can say that I am creating my own index, though I do not pay any fees to a manager and I have flexibility about tax loss harvesting ( index is a fancy word for portfolio)

      Some selections don’t do as well as expected ( like KMI). But there are always a few bad apples with any strategy – index funds have had their fair share of complete disasters. Index funds held shares in famous corporate failures such as Worldcom, Eastman Kodak, Polaroid, Enron, Various Airlines etc.

      Index funds do well relative to other mutual funds because of their low costs and low turnover. I have low costs and low turnover in my portfolio.

      But, just because your index fund does better than 80% of mutual funds, that doesn’t mean you will earn good returns. And just because your index fund does better than 80% of mutual funds, doesn’t mean you will earn any returns if you forget about valuation. For example, the S&P 500 performed horribly in the past 16 years with almost no real returns and wide swings in values.

      Picking the right index or an asset class that is covered by an index is actually an active decision. If I buy a US stock index, my results will be different than a Foreign Stock Index, or an Emerging Stock Market Index or a Bond Market Index.

      Now if someone has no idea on how to invest their money, and has no desire or no time to learn, index funds in a 401K are the way to go. This covers roughly 80%+ of the working population in the US, so at least you have a large group of people who think like you. In my case, I index a portion of my portfolio, due to limitation on 401K investment choices.


      Delete
    2. Thanks, DGI. I am in a similar situation with the proceeds from my KMI disposal. Fortunately I have a substantial capital gain from a real estate sale that I need to offset, so the pain of the loss is not quite as bad as it would have been. I am not sure I will ever own KMI again. RK did a terrible job of communicating the situation with shareholders, and I believe the current yield is way too low to justify the inherent risks with this holding.

      Delete
  11. Cant see how Wells Fargo is in the same boat as Citigroup or BoA.
    Wells Fargo has always had much better fundamentals and still does today. If you look at a combination of factors like roe, peg, book value increases, debt levels, profit margins, dividends etc Wells Fargo crushes all other big banks. Even after cutting dividends their combination of fundamentals were still so far ahead of the other big banks that buffett and munger were picking the best of the best. They have done the same with ibm.

    Kinder Morgan had big negative free cash flow 3 of the last 5 years. And that was with oil rising in price. kmi also has been issuing shares like crazy...tripling common shared outstanding and piling on debt during profitable times. Their cash on hand has been steadily going down. Their dividend payout ratio was 346% according to Yahoo finance. Cant see how this was ever a fundamentally sound company or a strong balance sheet. Not trying to be critical but the dividend cut seemed inevitable. Certainly not a growth investment. I own potash corp with a much stronger balance sheet and I think there is a chance even that dividend might get cut. But they have had five years straight of great positive cash flow and they have actually been repurchasing shares.

    ReplyDelete
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    1. So did you buy WFC in 2009? While its fundamentals were better than say a BAC, BAC fundamentals were pretty good too ( perhaps the acquisitions they made in 2008 made them worse off than before)
      The issue I am debating is that Buffett and Munger are doing much better analysis and have much better experience than the average investor who:
      1) Sees that a company like GE, WFC cuts dividends
      2) Sees that these companies return several hundred percent
      3) Decides it is profitable to buy after a dividend cut
      4) Concludes that they should be buying after a dividend cut.
      My research shows that on aggregate, buying after a dividend cut is a losing strategy. You have some outliers like GE or WFC of course that are more of an exception than the rule. My research is also now showing that I need to avoid companies that are so cyclical that they even have to cut a dividend.
      Buying an IPO is also a poor strategy. However, if you bought after the IPO’s of Home Depot, Microsoft, Google and Cisco, you would have beaten the market, and possible even done better than Buffett. But those examples are exceptions rather than the rule.
      I have written several articles about KMI in the past month, so please refer to those to address your questions. I am not going to repeat myself any more.
      I hope you do well on POT. I am afraid the effects of the ending of the commodities/emerging markets boom from 1999 – 2008/2011 are still being felt everywhere.

      Delete
  12. I recently sold all my KMI shares at $17.00. Fortunately I sold most of my KMI shares at $41.55 to pay off credit card debt, not knowing that was a good idea. I will never again invest in the oil and/or natural gas industry. From now on I'm buying only the best Dividend Aristocrats which I will hold forever.

    ReplyDelete

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