As I explained in my portfolio update 63, I'm now focused on paying down margin and thus won't be making changes to my real money portfolio for the foreseeable future. In fact, I've now realized the wisdom of Buffett's warning against using margin.
My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage...Now the truth is - the first two he just added because they started with L - it's leverage... It is crazy in my view to borrow money on securities... It's insane to risk what you have and need for something you don't really need... You will not be way happier if you double your net worth." - Warren Buffett (emphasis added)
Now, as with all Buffettisms, this one needs clarification. Margin is not necessarily evil, it's merely a powerful financial tool that must be used with extreme caution. I know several investors who cap their leverage at 20% or maintain home equity lines of credit that can be used to pay down 100% of margin quickly in a market meltdown.
The reason that Buffett is warning the average investor against leverage is that it amplifies both financial gains/losses but also emotions.
Since emotions are the Achilles' heel of most investors and results in terrible market timing that badly hurts long-term returns, for the vast majority of investors, margin is a tool that's best avoided.
Why am I personally not planning to use even modest amounts of margin in the future? The worst December for stocks since 1931 has shown me that it's not enough to minimize the risk of being wiped out (via a margin call). The risk of a total loss of capital must be zero. After all, even if the odds of losing 100% of your money is 1/1000, eventually, you'll still get wiped out. Thus, even decades of painstaking saving and smart investing could be lost, which is indeed insane.
Because while I'm unlikely to face disaster this time (I'm still a portfolio decline of 45% away from a margin call and have $60,000 in emergency funds I can tap if need be), the core of my investing strategy stems from being able to "be greedy when others are fearful" and take advantage of the market becoming insanely stupid and provide quality companies at obscene discounts to fair value.
You're neither right nor wrong because other people (the market) agree with you. You're right because your facts are right and your reasoning is right - that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."- Warren Buffett (emphasis added)
With margin, you absolutely have to worry about other people. If our leaders (specifically President Trump or Fed Chairman Jerome Powell) mess up badly enough, the economy and the stock market could be sent spiraling into a crash that could make even the smartest long-term strategy fail catastrophically.
In other words, to paraphrase Einstein, there are two things that are infinite, the universe and short-term market stupidity, and I'm not quite sure about the universe. On October 19, 1987 (Black Monday), the Dow fell 22.6% in a single day. That's a 20 standard deviation event that is theoretically (using standard probability theory) supposed to occur once every 4.6 billion years (roughly the age of the earth).
However, according to a 2005 Harvard study, a 1987-style one-day crash is actually a once in a 104-year event.
What's more, 5% and 10% single-day crashes are expected to occur, on average, every 1.6 years and 13 years, respectively. And as Mark Hulbert, author the Hulbert Financial Digest points out, the last 5% single-day decline was in August 2011, and the last 10% daily decline was over 30 years ago.
So, not just are we overdue for some even wilder single-day declines, but we can't forget how margin actually works at most brokers. Brokers borrow at very short-term rates to extend margin loans to clients. In the event of another 2008-2009 style financial crisis (a low probability but inevitable event over 50+ years), the brokers could change their margin rules overnight. That's because most margin agreements state that:
While brokers normally provide two to five days to cover a margin call, in the event of either a seizing up of credit markets (that could put the broker's survival in jeopardy) or a full-blown market panic (like 1987), even modest amounts of margin could become dangerous and trigger forced selling at ludicrously low valuations of even the highest quality, low-risk stocks.
Since my time horizon is 50+ years, I must not just minimize my portfolio's risk of succumbing to a critical point of failure by eliminating all such risks of a permanent loss of capital (across the entire portfolio).
This is why my new plan is to pay off all the margin as quickly as possible ($9K per month in savings and net dividends) and then initiate a new capital allocation strategy. This should be accomplished by the end of Q1 2020.
This approach ensures that I'll be able to avoid hoarding cash for years on end (because 5-9.9% pullbacks are frequent) but avoid situations like now when I'm forced to sit back and watch the best bargains in a decade (or ever in some cases) pass me by.
But while I may be suffering from my foolish and risky use of leverage, that doesn't mean I can't help others cash in on the golden opportunities now raining down all around us.
This is why I've launched a new series, the "best dividend stocks you can buy today." This is my collection of watchlists for Grade A quality dividend growth blue chips that make fantastic buys right now. If you've wondered "where should I put my money today?" this list is it. The goal is to highlight stocks that can realistically deliver 13+% long-term total returns (over the next decade) via a combination of yield, long-term cash flow/dividend growth, and valuation returning to fair value. Every single stock on these watchlists is one I consider a sleep-well-at-night, or SWAN, stock.
I use the same valuation-adjusted total return model that Brookfield Asset Management (BAM) uses, and they have a great track record of delivering 12-15% CAGR total returns (in fact, it's their official goal as a company, and they usually exceed that target).
There are four carefully curated lists designed to focus on:
The portfolio also has 25% firm sector caps, to minimize the chances that, no matter how great the bargains, we'll never become so concentrated in one sector (a mistake I made with my real money portfolio) as to be at risk of industry-wide devastation harming the portfolio's long-term income or returns.
And to show the power of long-term, deep-value dividend growth investing (and live vicariously through this new portfolio while I pay off margin on my real money one), I'm also going to be tracking these recommendations going forward. That's in my Deep Value Dividend Growth Portfolio or DVDGP. Note that when my margin paydown is complete in 2020, the approach I'm using in these articles will become my official policy for deploying all of my own real money.
This is currently a paper portfolio I'll be maintaining on Morningstar and Simply Safe Dividends to not just provide in-depth portfolio stats but also the total returns over time. The rules for the portfolio are:
Again, this is purely a tracking (paper) portfolio. I'm not yet putting real money into it until the first pullback of 2020, once I've eliminated all risk from my actual portfolio (margin hits zero and cash starts piling up). The purpose of this series is to try to show the power of this approach, which I've adapted from Investment Quality Trends, which has been using it to sensational effect since 1966.
That includes during strong market rallies, where, despite rising valuations, there are still plenty of quality, low-risk dividend growth stocks worth buying.
Last week we made $500 purchases in each of these stocks
The NEP, AY, and CWEN were all opportunistic buys made when PG&E (PCG) announced it was planning on filing for Ch 11 bankruptcy due to massive legal liabilities of $30 billion related to fires its equipment may have started in 2017 and 2018.
YieldCos meltdown down on the news because there is some uncertainty about whether or not this might affect the long-term PPAs they have with the utility.
NextEra Energy Partners (8.5% of capacity leased to PCG) has already assured investors that the potential PCG bankruptcy will not affect its long-term growth plans nor its self-funding business model (through 2020 at least). Thus we moved up the mid-February purchase of NEP to last week.
Clearway Energy has the most exposure at 23% of capacity, and its investor relations have said that the pass-through and FERC regulated nature of the contracts means they should not be subject to renegotiation in bankruptcy court. That's not a guarantee though as the New York Times pointed out in the last few days.
Legal precedent is on the side of the yieldCos which are now trading as if contract renegotiations and steep fee reductions are sure to happen.
That's why Morgan Stanley just issued a note saying it doesn't expect PCG to even attempt to renege on its yieldCO PPAs for the following reasons
These contract costs are passed through to customers, so a reduction in contract costs does not benefit PG&E shareholders or creditors...Many key policymakers in California are committed to increasing renewables growth and rejection of the PPAs would have a chilling effect that would deter renewable projects developers from working on new projects...Furthermore, PG&E needs the electricity. If it cancels the contracts the company needs to find more than 2GWh of electricity to meet its customers’ demand." - Morgan Stanley (emphasis added)
Bloomberg agrees with Morgan Stanley on the grounds that California's ambitious plans to get 100% of its power from renewables by 2045 would make such a screwing over of solar and wind energy providers extremely counterproductive.
Ultimately I'm confident that the market's worst-case scenario fears won't play out, which is why I made these highly opportunistic purchases. However, anyone looking to invest in these yieldCos needs to keep in mind that while the business models themselves are low risk, the risk to their cash flows from this probably bankruptcy isn't zero, and their share prices may remain depressed for some time because Ch 11 legal proceedings are a slow moving process.
The Equinix purchase was made after I added it to the bear market buy list as part of my overall research process (for other sites).
With our diversification goals met, I plan to slow my additions to the bear market buy list significantly. Mainly as I research stocks for Simply Safe Dividends (four weekly deep dives per week), I may periodically add something to the list.
Thus, we're mostly done growing the portfolio's new holdings for now, barring some unexpected great opportunities (like when entire industries meltdown due to overblown concerns as occurred with yieldCos last week).
But with earnings season now upon us, there is always the chance for major freakouts and crashing prices, so stay tuned each week to see if we took advantage of any overreactions to earnings misses or weak guidance for 2019.
This group of dividend growth blue chips represents what I consider the best stocks you can buy today. They are presented in five categories, sorted by most undervalued (based on dividend yield theory using a 5-year average yield).
The goal is to allow readers to know what are the best low-risk dividend growth stocks to buy at any given time. You can think of these as my "highest-conviction" recommendations for conservative income investors represent what I consider to be the best opportunities for low-risk income investors available in the market today. Over time, a portfolio built based on these watchlists will be highly diversified, low-risk and a great source of safe and rising income over time.
The rankings are based on the discount to fair value. The valuations are determined by dividend yield theory, which Investment Quality Trends, or IQT, has proven works well for dividend stocks since 1966, generating market-crushing long-term returns with far less volatility.
That's because, for stable business income stocks, yields tend to mean-revert over time, meaning cycle around a relatively fixed value approximating fair value. If you buy a dividend stock when the yield is far above its historical average, then you'll likely outperform when its valuation returns to its normal level over time.
For the purposes of these valuation-adjusted total return potentials, I use the Gordon Dividend Growth Model, or GDGM (which is what Brookfield Asset Management uses). Since 1956, this has proven relatively accurate at modeling long-term total returns via the formula: Yield + Dividend growth. That's because, assuming no change in valuation, a stable business model (doesn't change much over time) and a constant payout ratio, dividend growth tracks cash flow growth.
The valuation adjustment assumes that a stock's yield will revert to its historical norm within 10 years (over that time period, stock prices are purely a function of fundamentals). Thus, these valuation total return models are based on the formula: Yield + Projected 10-year dividend growth (analyst consensus, confirmed by historical growth rate) + 10-year yield reversion return boost.
For example, if a stock with a historical average yield of 2% is trading at 3%, then the yield is 50% above its historical yield. This implies the stock is (3% current yield - 2% historical yield)/3% current yield = 33% undervalued. If the stock mean-reverts over 10 years, then this means the price will rise by 50% over 10 years just to correct the undervaluation.
That represents a 4.1% annual total return just from valuation mean regression. If the stock grows its cash flow (and dividend) at 10% over this time, then the total return one would expect from this stock would be 3% yield + 10% dividend (and FCF/share) growth + 4.1% valuation boost = 17.1%.
Top 5 High-Yield Blue-Chips To Buy Today
Top 5 Fast-Growing Dividend Blue-Chips To Buy Today
Top 5 Dividend Aristocrats To Buy Today
Top 5 Dividend Kings To Buy Today
These are the blue chips which I expect to generate 13+% total returns at their target yields. Note that all total return estimates are for a 10-year annualized basis. That's because total return models are most accurate over longer time frames (5+ years) when prices trade purely on fundamentals and not sentiment. This allows valuations to mean-revert and allows for relatively accurate (80% to 95%) modeling of returns.
The list itself is ranked by long-term CAGR total return potential from target yield. Stocks at their target yield or better (bolded) are good buys today.
Note that the bolded stocks are all at target yield or better, meaning it's a great time to either add them to your portfolio or add to an existing position.
We're mainly focused on large-cap US dividend stocks because the goal of this portfolio is to only own low-risk SWAN stocks. Low-risk is defined as low-risk of a dividend cut during a recession.
I'm imposing a firm 25% sector cap for diversification purposes. No matter how undervalued a sector, it's not wise to go above 25% (your personal sector cap may vary and could be lower).
The heavy focus on tech will come down next week when I add to non-tech positions on stocks that are still active on the watchlist.
The portfolio's income is likely to be highly concentrated into the highest-yielding names, at least until it becomes more diversified over time. A good rule of thumb is you want to limit income from any one position to 5% or less. We've now achieved that goal in DVDGP.
While we may never fully get to the dream of daily dividend payments, we're currently getting paid every week. And the monthly income flow will smooth out nicely over time.
Note that the 10-year dividend growth figures are artificially low because my tracking software doesn't average in anything that hasn't existed for those time periods. Some of these stocks have IPO-ed in the last five years, and so, the 1-year and 5-year growth rates are the most accurate. These figures are purely organic growth rates and assume no dividend reinvestment.
The dividend declines during the Financial Crisis were due to REITs (such as Kimco and Simon) which cut their dividend (as 78 REITs did during the Great Recession) as well as our large exposure to mega-banks. Fortunately, since then, the REIT sector has deleveraged and enjoys the strongest sector balance sheet in history.
This means that during the next recession, most REITs will not cut their payouts, especially Kimco, which has a BBB+ credit rating and will be getting an upgrade to A- in 2019 or 2020. Simon is one of just 2 REITs with an A credit rating.
Similarly, I am confident that every bank we own (C, JPM, BAC, GS) will maintain its dividends through future recessions (though they are likely to be frozen).
There is no official dividend growth target, though I'd like to at least maintain long-term dividend growth (either 1-year or 10-year) which is above the market's historical 6.4% payout growth rate. The huge jump in the 1-year dividend growth rate is courtesy of some of our semiconductor stocks, several who raised their dividends by over 100% in the past 12 months.
While maintaining 12.3% long-term dividend growth is likely beyond our portfolio's ability, according to Morningstar, the projected EPS (and thus dividend) growth rate is about 11%.
The quality of these stocks can be seen in the far-above-average returns on assets and equity of this portfolio (good proxies for quality long-term management and good corporate cultures).
What's DVDGP is also far more undervalued offers a much higher yield and should achieve far superior dividend growth compared to the broader market. While our EPS growth may match the S&P 500 (based on analyst expectations), the S&P 500's dividend growth rate is about half that of its earnings due to non-dividend stocks as well as corporate America's bigger focus on buybacks vs. dividend hikes.
As an added benefit, the average market cap is smaller, providing yet another alpha factor (smaller stocks tend to outperform). Note that the overall focus is on blue chips, which means that the average market cap is likely to rise over time (but remain far below the market's $100 billion average).
Beating one's target benchmark is extremely difficult, even for professional money managers. That's because "hot funds" see lots of new money flows which makes it harder to recreate that success the next year.
In addition, during market declines retail investors pull money out causing professional money managers to be forced sellers instead of buying at fantastic valuations. Thus, just 0.45% of mutual funds remain in the top quartile of performers for five consecutive years.
This is why DVDGP is a margin free portfolio, using steady cash inflows (simulating steady and high savings) to buy opportunistically. There is no guarantee that the strategy can beat the market over time, but avoiding the biggest pitfalls of active money managers means I believe we have a very good chance.
Note that I'm adding one new slot to these tables every week until it shows our top 10 best and worst performers.
|Stock||Cost Basis||% Gain|
The good news is that due to our monthly additions to all stocks that remain active buy recommendations, the more any stock falls in the short term, the lower our cost basis will become.
|Stock||Cost Basis||% Gain|
The downside of our dollar cost averaging approach is that we also raise our cost basis for early winners. However, since we only buy great companies at good to great valuations, ultimately, we should be able to deliver very strong returns. That's because winners tend to keep on winning, and thus adding to winners even at a higher cost basis should help keep the portfolio well balanced and avoid getting too top heavy with out of favor companies that could cause very long stretches of underperformance.
Don't get me wrong, I much prefer to recommend buying great companies when "there's blood in the streets". But even with the stock market roaring higher by 14% over the past month, there are still dozens of great long-term low-risk dividend growth opportunities to be found.
And while it's true that stocks are currently climbing a large wall of worry that could cause them to pull back sharply in the coming weeks or months, ultimately the fact is that time in the market, not timing the market, is what most income investors should focus on.
Which is why, no matter what the market is doing, each week I'll be presenting you with what I consider to be the best dividend growth ideas for new money today. After all, no matter what the broader market does, some industries or sectors will always be out of favor, making for great buying opportunities that you (and the DVDGP) can and should take advantage of.
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