- I take a detailed look at both sides of this argument using historical market data to support each philosophy.
- I reflect upon the words of the "Masters" that I've recently interviewed, using their wisdom to mold my opinions.
- Ultimately, I come to a conclusion and explain why that is. I invite all to critique my own opinion in an attempt to enhance my portfolio management plan.
Introduction and Re-Branding:
I'm doing a bit of re-branding here. A couple of weeks ago, I wrote an article titled: "The Mike Tyson School Of Portfolio Management Part 1: Introduction And Finding Focus." The article was focused on the fact that just about all individual investors have a plan (if we don't, we don't really have any business managing our portfolios) but, that sometimes, these plans don't carry enough depth; sometimes, we don't have a plan for when the original plan goes wrong. This was tied to Mike Tyson with his quote, "everybody has a plan until they get punched in the mouth." Mike wasn't talking about investing but I can't think of many more words that hold true in the markets. When times are good, we all talk about our plans, our goals, our holdings, our buy lists, our income streams, etc. But, when the bear defeats the bull and times get messy, investors have a tendency to make devastating mistakes with regard to their long-term financial health. This series of articles was meant to focus on this plan within a plan. This series is about preparing for the inevitable punch in the mouth that the market will dole out. I thought it was a solid idea, especially with the market hovering near all-time highs in the midst of what's been called a secular bull market. It's in times like this we sometimes get complacent; that we let our guard down. If you allow this to happen, that unseen right hook will do the most damage. This is why it's important to keep those hands up and that chin down at all times in the ring. There are no lulls in the market, it never takes a break. It might seem like it does, from time to time, but the reality is that at any moment, widespread sentiment could turn on a dime.
Well, with all of this said, the first piece of this series didn't do as well as I might have hoped from a page view perspective. It seems that the SA investing community doesn't find Iron Mike quite as interesting as I do. That's OK though, as always, excelsior. I still think it's important for individual investors to consider potential steps to take in both tangible and mental preparation for an unexpected bear market (aren't they all?). So, because of this, I will move on with the series. I'll just drop the boxing metaphors and Mike Tyson references. Like I said, regardless of how the information is presented, I think it's worthwhile. Sure, it's a little less fun without old Mike Tyson involved, but that's alright, we'll make due anyway.
Looking back, this is the teaser I gave at the end of part one, I said that part 2 would be focused on, "protecting the capital by selling shares; knowing how, when, and why to sell shares and the process of locking in profits." I know that many DGI investors think that selling shares is a bad idea. The idea with DGI is share accumulation. This is one way that we build our income streams. However, after questioning some of the great DGI minds that this site has to offer and doing a bit of soul searching myself on the topic, I've decided that it can be in my best interests to sell shares periodically, for several different reasons which I will discuss in this piece, as a means of protecting my invested capital.
The Potential Power Of The Buy & Hold Concept:
But, before I get into sell shares, let's take a step back and look at buy and hold investing for a second. There are two sides to every story and I want to give both philosophies their due. Buy and hold investing has proven to be a successful philosophy over the years. Identifying wonderful companies, buying their stock, and holding on for decades has made quite a few people very, very wealthy. This sentiment was echoed by Chris DeMuth Jr. is an interview I did with him earlier in the year. Here is an excerpt from that piece; Chris's response not only proved his point clearly, but garnered quite a few chuckles from readers as well:
"(NW): A common theme throughout this series thus far has been the importance of buy and hold portfolio management. The message sent directly to me has been that more than anything else, time is my best friend as an investor. However, I recognize that many investors do well in the markets moving into and out of positions fairly regularly. What are your thoughts with regard to buy and hold investing?
(CD ): Buy and hold is almost always the best strategy. Fidelity recently studied their best performing clients. Their best performers fell into two categories:
They forgot that they held Fidelity accounts, or
They had died."
Probably the greatest example of the potential success that comes along with buy and hold investing coming from the ownership of a single stock is this: the story of Coca-Cola (NYSE:KO ). I've seen this story told before, it isn't new, groundbreaking information, though it can serve as a soothing reminder to investors with very long-term horizons that sometimes (if not just about all the time), doing nothing is the best course of action when it comes to managing a portfolio of high quality assets.
In 2012, when Coke announced its most recent stock split, the company told a story to go along with the news. In the press release outlining the 11th split in the company's 92-year history, management had this to say:
The Coca-Cola Company's common stock began trading in 1919. Since its original listing, the stock has split 10 times - first in 1927 and most recently in 1996. With all dividends reinvested annually, one share of common stock purchased for $40 in 1919 would be worth approximately $9.8 million today. During the same time, The Coca-Cola Company's market value has grown from approximately $20 million to more than $165 billion."
Isn't that amazing? KO shares have posted a 7.5% annualized ROR since 2012 with dividends re-invested as well, meaning that the original $40 spent would be worth well over $10M today. Hearing this, I can't help but be incredibly angry at my great grandfather for not jumping on this opportunity when he had the chance.
Here is another powerful image taken from KO's investor relations page focusing just on the power of stock splits over time. With re-investment, it's much more impressive obviously, but I have neither the time nor energy to figure out how many total shares one would have amassed over the last 95 years. That said, KO's figures show that even without re-investing one's dividends since the IPO, each original share bought in 1919 has fractured into 9216. Or, a better way to look at it from an income investor's standpoint, for each original share of KO one purchased at the IPO in 1919, they'd be receiving $12165.12 in annual dividends in 2015.
One last historical comparison before I move on. I'll compare the long-term holding/compounding power of a well-run company to that of the world's most famous historical measure of wealth: gold. In 1919, the price of one troy ounce of gold was $20.67, meaning that you could basically purchase two ounces of gold rather than buying that original IPO share of Coke. Remember, an ounce of gold in 1919 is the exact same as it would be today. Gold doesn't grow, it doesn't compound, it is shiny, however, and rather rare, meaning that it has been sought after through the ages. Moving forward to today, one ounce of gold costs roughly $1150. Individual shares of Coke are still priced in the $40 range. It would seem as though gold has been the much better investment over the years until you realize that this $40 coke price today is not split adjusted. As previously stated, each original share has morphed into over 9,200 shares today. With re-investments, each original share of KO would be worth over $10M, or roughly the buying price of 8700 ounces of the yellow shiny stuff today. Even if you hadn't been re-investing the dividends throughout the years, that original KO share would be worth $382,464 today at the $41.50 price/share, or enough to buy 332 ounces of gold. Just the 2015 annual income alone off the 9216 shares have spawned from each original IPO share would be enough to buy 10 ounces. All in all, buy and hold investing seems to be a wonderful idea when it comes to building wealth.
"But wait a second, you're cheating," you say. And I get it; by choosing Coke for my long time buy and hold example, I am cheating. Hindsight is 20/20 and Coke is one of the greatest business stories out there. Actually, this piece isn't even about buy and hold investing. The focus here is about selling shares as a means of capital preservation. Personally, I don't hold nearly as tightly to buy and hold strategies as many of my fellow DGI brethren. That said, I think it's only fair to present both sides of the story; while I might sell shares from time to time, I want to make it clear that I also believe in a buy and hold type strategy, I appreciate its upside potential. I just don't get married to my holdings.
The Flip Side: Market Turnover And Taking Profits
Here is one of my primary arguments for taking profits. As stable as we view the mega-cap, dividend aristocratic, blue chip companies today, history has shown that as the world turns, businesses inevitably rise and fall. People talk about wonderful companies like KO, Procter & Gamble (NYSE:PG ), 3M Company (NYSE:MMM ), etc. all the time. Sure, these companies have paid an annually increasing dividend for more than half a century. I've boasted about the wealth generation abilities of these companies myself. I truly believe in it. That said, take a look at these 3 images and tell me in the comment section how you react.
This is a picture of the DOW components 100 years ago, in 1915. There were 12 companies included then. Take a close look. how many of them are still a part of the index today?
Answer: One; General Electric (NYSE:GE ). This was surprising to me, and a little unsettling. I know many of the companies that exist today were around back then. I know that DOW is just one way to look at the stock market (I used it because it was the best method of tracking market turnover that I could find with acceptably sized images). Either way, 100 years and just one survivor. I know people love to hate GE. All I have to say at this point is, well done.
Here's another image from the wonderful DOW timeline that CNN Money offers. I'm only going to be cutting out 3 images from this source which spans 131 years. It's a fun little slide show they have over there; definitely worth a look. Anyway, here are the DOW components in 1928, the year the index expanded to 30 companies.
At this point, we're starting to see a few more familiar names, though still not nearly as many as I would have expected. And now we move onto our final image, the DOW 30 as it sits today in 2015.
As you can see, dramatic change has been under way. A lot has happened during this 87-year jump. Not only does this show the volatility of the index, but it helps investors with trend spotting as well. The power dynamic has started to shift from the left side of the screen to the right. These sections aren't listed in alphabetical order, and I can only assume that is the effect the people at CNN Money were trying to create. Either way, the trend seems undeniable. The shift is more clear when one allows the video to play and the screen moves in real time.
My point being with all of this, is that in the markets, things change. The past is not an accurate predictor of the future. There are just too many unforeseen variables. That said, I like using the past as a means of attempting to understand the world and oftentimes, we see that it does help to spotlight future trends. This trend of change is real. If anything, it seems to be accelerating. Since 2000, there have been 9 changes to the DOW 30 components already. Between 1924 and 1940, there were a bunch of changes made too. The recent data is not unprecedented, though overall, recent volatility in the index is high.
I've embraced this change and although I cannot predict it, I can take defensive measures to protect against it. Speaking of predictions, I'd love to hear what you all have to say with regard to potential future turnover with today's DOW rankings. According to the past, in another 100 years, heck even 50 or 25, this list should look entirely different than it does today. Looking over the current components, there might be a few potential weak spots that stick out but for the most part, these companies all seem incredibly strong. That's why they're here right? Well, I bet people said the same in 1928 or really any year between now and then.
My Conclusion: Selling Grossly Over-valued Shares Ultimately Protects Capital
Anyway, back to my defensive measures. Maybe this is because I'm stubborn, but I do think that the market focused retail investor can do well for himself by selling shares from time to time. I think that the most important aspect of selling shares when managing one's portfolio is the reasoning behind the sale. Obviously, this should go without saying. However, I see people make highly irrational, speculative sales all of the time. It's not up to me to judge the reasoning behind another's sale. Every investor has an individual plan because all of our lives are different.
However, I think far too often investors focus much more on their due diligence process when making purchases and ignore that very same process for selling shares. That said, getting back to the original focus of this article, I think it's important for everyone to consider the prerequisites and potential qualifications for a sale as a part of their plan, so they aren't forced into
emotion, spur-of-the-moment decisions.
Before I get to the major qualifications for me to consider making a sale, I'll post another excerpt from my Learning From The Masters series that speaks to this issue. I admit that I've taken much of my own portfolio management plan from David Van Knapp. I've been following his advice on running my portfolio like a business for several years now. His words have been very influential to me personally, which is why I was recently excited when he accepted my request for an interview. The Q&A in its entirety can be found here. Below is a short bit of the conversation we had that directly relates to making sales and having a guidelines in place before hand to help guide the process.
"NW: Several times you've mentioned making sales. I was almost surprised to see this because throughout this series, several of the Masters, and especially those who would likely be identified as DGI investors have fallen decidedly into the "buy and hold" category. What is your mindset when it comes to making sales? Do you have a set of rules that trigger sales? And lastly, (this gets back to the asset allocation question), do you have a system for trimming exposure, especially when it comes to your major winners? Or, do you think it's best to simply let your winners run?
DVK: My mindset is that my default decision, in the absence of compelling evidence to the contrary, is not to sell.
I do have seven selling guidelines (not rules) in my business plan. My process is to investigate and seriously consider selling any stock for these reasons:
(A) It cuts, freezes, or suspends its dividend.
(B) It bubbles or becomes seriously overvalued.
(C) I become aware of significant fundamental changes impacting the company.
(D) It is going to be acquired.
(E) It announces plans to split itself up or to spin off a separate company.
(F) Its current yield rises above 9% or drops below 2.5%.
(G) Its size increases beyond 10% of the portfolio.
Normally, I let winners run, but I consider the 10%-max position size guideline to be even more important. That's why I have trimmed some positions (one was up to 19% of the portfolio) in order to get their relative size down."
Now, although I truly respect Mr. Van Knapp and view him as a mentor of sorts when it comes to my personal portfolio management growth, I've simplified this bit of the equation for myself.
Rules that I ignore completely are F and G. I don't have yield threshold requirements in my own portfolio. I track yield and use it as a relative valuation tool, but I'm happy to own both low and/or high yielders. It's the business that I'm more interested in partnering with, not the yield percentage. I also don't pay much attention to portfolio weightings. I have what I consider to be "full" positions so that I remain diverse in my holdings, but if one of these growths is tremendously due to fundamental expansion (meaning that it maintains a price in the fair value range), I am happy to hold a high quality asset regardless of the overweight exposure that I might have to it. What I would likely do in this situation, rather than sell shares as a rule, is to stop re-investing back into that company and focused my purchases elsewhere within the portfolio as a re-balancing effort.
David's first two reasons, A & B, are the primary reasons that I've sold shares in the past. "A" should be obvious to just about any dividend growth investor. We aren't able to increase our annual income streams and enjoy the long-term benefits that come along with compounding if our assets aren't playing their roles in the system. There are no certainties in my portfolio management strategy, I like to stay flexible. That said, a dividend cut is about as automatic as it gets when it comes to my cutting ties with a company. A freeze isn't all that far behind because like I said before, a frozen dividend isn't playing its part in the compounding game.
Chevron (NYSE:CVX ) and ConAgra (NYSE:CAG ) are two examples of companies that I've sold so far this year because of freezes. More in-depth coverage of these sales can be found here (Chevron) and here (ConAgra). Looking at the price action since I made the sales, one of them: Chevron seems like a good idea, in the short term at least, being that I sold it at $111.11 and the stock is trading at $93.60 today. ConAgra, on the other hand, has shot up nicely since I removed it from my portfolio. I sold CAG back in March for $35.09. I was up 21% on my original investment and the company had gone two years without a dividend increase. Well, today the stock trades at $41/share; meaning that if I had been more patient, that 21% cap gain could have been a 41% cap gain. But with that said, do I regret my decision? No. Sure, I'd rather lock in a larger increase any day but I don't have a crystal ball and how was I supposed to know on March 20th that Berkshire would take out Kraft soon thereafter, giving wings to the entire large scale packaged food industry? When I sold the fundamentals had changed significantly since I purchased the stock originally and the dividend wasn't doing its job. That was all it took. No regrets, no remorse, no stress. A focus on the growing dividend allows for these things to happen.
David's C, D, and E examples are all rules that I've taken to heart. There are way too many possible variables for me to adequately cover here talking about these bullet points in a paragraph or two (they deserve their own article in their own right), but what I can say is that when large scale changes like these happen with a company, or even within an industry of one of my holdings, I take note and act accordingly. Typically, I view M&A activity in a bullish light. I don't think that I've sold in one of these situations yet, though that doesn't mean that there won't come a time when I will.
David's "B" example is the real reason that I wanted to write this piece. So often I see people touting buy and hold because of the long-term compounding capabilities that I highlighted with my KO example above. and more often than not, these are the same people who decry purchasing overvalued stocks because it narrows one's margin of safety and really hampers compounding because of the high likelihood that eventually, the market will correct itself and revert to the fundamental fair value. I get it; fair value is a subjective term and will differ from analyst to analyst. That said, it does exist and in a vast, diverse market, it just doesn't make sense to overpay for a certain asset when there are so many other options out there trading at better values. I don't disagree with these men and women who are champions for value investing and believe that it should play a major role in the construction of a dividend growth portfolio. What I do disagree with is the idea that fundamental valuation and due diligence stops once a purchase is made. I believe it should remain an ongoing process.
What I'm trying to say is this: If you're so focused on purchasing companies trading at or below their fair values because you aren't interested in buying overvalued shares, then why are you interested in holding onto grossly overvalued shares once they're already in your portfolio? Obviously, the "you" in this situation is theoretical, I'm not calling out anyone in particular, though I do think it would be a productive exercise for all individual investors to consider the above question.
For instance, I love Nike (NYSE:NKE ) as a company. I think it's a blue chip brand in a growing industry with plenty of tailwind left in the sails. Not only do I really like Nike's products, the style they have, the colors, the look; I like the fact that until doctors stop recommending exercise as a means of achieving a healthy lifestyle, Nike will have a massive market of customers looking to buy their products. Let me be blunt: our species is becoming fat. Studies have proven this to be the case here in America especially and chronic illness, especially related to the heart, is on the rise in many emerging countries due primarily to the environmental factors that come along with living a "westernized" lifestyle. This is a sad reality, but one that bodes well for Nike.
That said, as much as I like this company and the tremendous tailwind that I see, I'm simply not willing to pay 30x earnings for portfolio exposure. Even with Nike's impressive 24.48% 1-year EPS growth, I can't justify the current valuation, especially when 5-year EPS growth lags the 1-year by a considerable amount and the PEG ratio sits at 2.5x. Take a look at this Nike F.A.S.T. Graph. it clearly points to the fact that the company's shares are (and have been for awhile now) overheated.
I think most conservative, buy and hold, DGI investors would agree that NKE is just too expensive to buy at today's prices. Well, I take this another step forward and say that it is simply too expensive to own.
I know this is a bit more complicated when potential capital gains taxes are involved. I know the 5-year dividend growth rate is an impressive 15.3%, and expectations are for similar performance moving forward. Nike offers tremendous growth potential. The company's management effectiveness statistics are off the charts, nearly doubling its peers' performance when it comes to ROA, ROE, and ROI.
But because of the very high cost associated with the shares in today's market, all of this comes with a potentially devastating risk. Looking forward, the consensus estimate for Nike's EPS is $4.18. Let's imagine a scenario where the stock, for whatever reason, sells off to its long-term historical normal P/E range at 21.3x. At that valuation, NKE shares are priced at $89.03. This is a loss of 21%.
But it's more than that. What if you owned Nike as a speculative/growth piece of an income-oriented portfolio? In this scenario, not only did you lose a large chunk of your original investment due to over-valuation, $23.96/share to be exact, but it would take nearly over 21 years for NKE's dividend to recoup those funds using the company's current $1.12 annual payment. Sure, the dividend will likely grow, knocking this yearly total down. Maybe with dividend growth it takes you 12 years to earn back the dollars lost, maybe it takes you 10. Either way, in my opinion, it's not worth the risk that could have been so easily minimized or completely eliminated by taking profits or completely cutting ties due to the market's willingness to over-valuate the stock.
This is why I say that selling shares can be an effective method of capital preservation, even within a dividend growth portfolio where the sale cuts into your current income stream. I know many will disagree with this sentiment. I admit that my logic could be largely flawed here. I hope that you will do your best in the comment section to prove me that I am mistaken; I'm always happy to hone my craft and improve as an investor.
But before you do, I want to make a couple things clear. One, I am not saying that I adhere to the mindset that, "if I wouldn't buy something at today's prices then it's not worth owning." Many of my current holdings have appreciated to the point that I would no longer be interested in buying shares at their current prices. This is the point of value investing, by using patience and a highly vigilant screen, one is able to target shares that have been irrationally undervalued by the market and capture the upside that is given by such a large margin of safety when the market corrects its mistake. I don't think this is what David was saying either. I'm not talking about shares that have reverted to fair value or slightly above. I am talking about shares that have become irrationally, grossly overvalued. This doesn't happen nearly as often in the realm of DGI stocks as it does in the more speculative areas of the market, but when it does, I see no reason why an investor shouldn't react to the market's folly and take an irrationally high profit.
And the reason being for this train of thought is this: I am confident in my own evaluation methods and I believe that in the short-to-medium term after a sale, I will be able to find another company that is either undervalued or trading at fair value to use my profits to gain exposure to. These new exposures will offer my substantially wider margins of safety and therefore, increase the defensiveness of my portfolio. Also, they will likely have higher current yields as well, since their dividend yields wouldn't have been diminished by soaring stock prices.
Some would call this market timing. And I guess, to a certain extent it is. However, it isn't speculative market timing because if I know one certainty about the market, it is this: there will always be good values popping up from time to time. I don't put much stock in the "efficient" market theory. I don't think this sort of fundamentally-based recycling of cash within a portfolio based off of the market's irrational responses to trends or events is any different with regard to market timing as trying to buy low (which is what I hear most buy and hold investors claiming to try and do).
The basic rule within the market, and even within a dividend growth portfolio in my opinion (though I know others will disagree) is that investors are supposed to buy low and sell high. In theory, this makes perfect sense. In practice, both are difficult because only in hindsight will an investor really know if he achieved his goals. Sure, buying and holding is great, but it is essentially ignoring the latter half of this equation. I'm not saying that dividend growth investors should go hog wild with portfolio turnover, but why not grab low hanging fruit when it presents itself, especially when "Mr. Market" is the one pulling down the branch, offering you the goods?
Disclosure: I am/we are long KO, GE. (More. ) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.