Friday, January 8, 2016

A Change of heart on REITs and MLPs

My goal as an investor is to generate a sustainable stream of dividends, which will pay for my expenses in retirement. I need this income stream to be as secure as it can be, in order to pay my expenses during recessions, depression, bull markets or bear markets.

My recent experiences with Kinder Morgan got me thinking a little bit about pass through entities in general. I am starting to question whether those dividends are indeed as bulletproof as I once thought they were. It is tough to have a change of heart, especially after enjoying a rising stream of dividends with Kinder Morgan (KMI) and REITs like Realty Income (O) between 2008 and 2015.

After some thoughts, I have come to believe that pass through entities are less reliable than regular corporations during times of distress. And during times of distress you need to have the comfort in knowing that your distribution is secure so that you can hold on to your stocks. If we are in a recession, and a company decides to cut dividends, we are in for a double whammy – lower dividend income along with lower value of the investment. I want durable dividends, no matter what happens stock market or economy. I want to receive dividends throughout the stock market or economic cycle.

I have been either lucky or a good stock picker, because a good portion of my pass-through entities have done very well in the past 7 -8 years. However, my experiences with Vereit (VRE) and Kinder Morgan (KMI) are showing me that perhaps I was more lucky than I would care to admit.

I think that over time, I started letting riskier companies in my portfolio, and I may have started chasing yield. Losing  some discipline is not a good trait to have. Chasing yield is another trait to avoid. Perhaps, if I don't see enough quality selling at good prices, I should not be decreasing my quality requirements and just allocating my cash left and right.

I realize that when a company needs to continuously sell bonds or stocks to grow, and pays all of its free cash flow to shareholders, it could get in a dangerous position. When you ask for the kindness of strangers when the financial markets seem to be falling apart, you are asking for trouble. When you don’t have a lot of flexibility, your company might have to decide between continuing as a going concern or cutting dividends. Of course, in this situation of distress, the dividend is the thing that will go away. It doesn’t matter if the portfolio of assets is stable and generates recurring cashflows that are relatively dependable – when you invest for the long-term, but continuously depend on the short-term mood of Mr Market to obtain capital, you are exposing yourself to excess risks.

The other issue is if you have a manager on top, who is really an empire builder. I am afraid that a lot of projects that were financed in the past two years in real estate and energy might have only been done because the cost of capital was really low. When you have the pressure to allocate capital, you are drowning in cash, and your competitors are having a similar pressure, the potential for return on investment is decreasing.

The more I think about it, the more I realize that I am more comfortable with stable companies like Diageo (DEO) or Johnson & Johnson (JNJ). These companies generate enough in earnings to cover their dividends even if those earnings stay flat for several years. There is a built in margin of safety in dividends, that can provide some stability in case of short-term turbulence in earnings and revenues. A company like Kinder Morgan or a REIT have a very limited margin of safety in dividends given the fact that they send almost all of their free cash flows to shareholders/unitholders.

This doesn't mean that those REITs or pipeline companies cannot deliver excellent long-term results. It only means that the dividend income they generate is one step lower in safety, relative to regular corporations such as those in the consumer staples sector. As an investor, my goal is to get dividends that are dependable, so I can live off my portfolio. If a company is too risky to maintain dividends during a recession, then it has no place in my dividend portfolio.

Therefore, when I hold a company like Diageo (DEO), I am more confident holding even if the stock price falls by 50%. In the case of pass-through entities, when the stock price falls by 50% and they need to access capital markets, their free cash flow is squeezed leaving less money for dividends. This increases the chances of a dividend cut.

The action plan as a result of this change of heart is that I will be gradually reducing my exposure to pass-through entities such as REITs and MLPs (or MLP C-Corps). Most of my REITs are close to 52 week highs, while most of the MLP C-Corps are close to 52 week lows. Perhaps this move shows that I have realized I don’t understand as much as I thought before. I had roughly 5% - 6% of portfolio to REITs and little over 2% in MLP C-Corps or MLPs by the end of December 2015.

I slowly began this move in all companies affected early this week, which was unfortunate, because markets were crashing. I will likely be phasing out of those entities, subject to pricing and valuations of course. Since the stock market is a competitive game, I will not be providing more specific information on this topic. Most of those REITs will end up being sold in taxable and tax deferred accounts and the money in invested in a diversified REIT Fund in a tax deferred account.

Full Disclosure: Long all companies listed above

Relevant Articles:

How to define risk in dividend paying stocks?
Dividend Investing Risks
Margin of Safety in Dividends
The Humility Dividend Growth Portfolio
Three Investing Lessons I Learned the Hard Way

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