Saturday, January 26, 2013

The Most Dangerous Time to Pick High-Yield Stocks

The most dangerous time to pick high-yield stocks is in the late stage of a bull market, which I believe we're in today.

One of the oldest investment adages is that "bull markets climb a wall of worry" and that has certainly been true of this market. Despite all the various crises -- Greece, the Eurozone, fiscal cliffs, debt ceilings, Manti Te'o's girlfriend, etc. -- many major global markets are at or near five-year highs. 

From a dividend investor's perspective, however, it's precisely the worry that provides the opportunities to buy quality high-yield shares -- defined loosely here as companies with strong balance sheets, plenty of dividend cover, a good track record of raising dividend payouts, and sustainable competitive advantages -- at discounted prices.

As markets rally and the worry dissipates, however, dividend yields naturally go in the opposite direction and the number of good opportunities dries up.

Quality rallies early

Consider the performance of the SPDR S&P Dividend ETF (SDY) -- which tracks the S&P High Yield Dividend Aristocrats Index -- versus the SPDR S&P (SPY) since the nadir of the financial crisis.

Source: Yahoo! Finance
Just about neck-and-neck over the period, but let's take a look at how they performed in the two years after the low-point in the market:

Source: Yahoo! Finance
For most of this two year period, the SDY steadily outperformed the index. Eventually, however, the index caught up and they've been trading pretty much in-line ever since:

Source: Yahoo! Finance
Though the S&P High Yield Dividend Aristocrats Index may not be the perfect tracker of "quality" dividend stocks, I do consider it a fair proxy. As such, we can gather from this example that quality dividend payers got snapped up fairly quickly in this bull market. By early 2011, the Aristocrats index was likely trading at or near fair value.

Once the quality names have been picked up in the early stages of a bull market, investors looking for a combination of high-yield and quality are normally left needing to compromise one for the other.

This isn't to say there aren't special cases for investors to pick up quality high-yield names at a discount during a bull market -- markets can also overreact to a bad earnings report or temporary sector concerns -- but, as a whole, quality high-yield names are normally snapped up early on.

Scraping the bottom of the barrel

When examining a high-yield stock in this type of market, it's imperative to examine why the stock's yield remains well above the market average. If it possesses market-average risk and growth potential, it stands to reason that its yield should also approximate the market average and that investors should have bid up the stock price by now. If its current yield is still 2x the market average, then, it's probably a good indication that something is wrong with the underlying business -- either it has considerable risk factors or its growth outlook is quite meager. In either case, it probably can't be defined as a "quality" dividend payer.

To further illustrate this concept, let's step into the way-back machine for a moment and travel back to early 2008, near the end of the previous bull market. At the end of 2007, the S&P 500 average dividend yield was 1.89% putting any stock over 3.8% firmly into the high-yield category (my rule-of-thumb is 2x the market average in the U.S.).

I was able to find a helpful table of the highest-yielding Dow 30 stocks as of January 24, 2008 and examine their subsequent five-year dividend growth rates.

Source:, Yahoo! Finance; Altria dividend growth as of June 2008, post-PM spin off.
The dividend-based performance of these shares since the end of the last bull market is certainly mixed, with Altria being the stand-out star, especially when you factor in the performance of Philip Morris International over the period. AT&T and Verizon did reasonably well, too, but you certainly got what you paid for -- high-yield and low dividend growth. As for Pfizer, Citigroup, and GM...the numbers speak for themselves. 

A look at the highest-yielding stocks in the S&P 500 from around the same time is even more troubling, with a number of famous dividend blow-ups found therein. 

Granted, a good percentage of the 1,000+ dividend cuts by U.S. companies in 2008 and 2009 were financials and I don't expect another massive round of dividend cuts in the near future, but the principle holds true that investors should be very skeptical of the highest-yielding stocks in the late stages of a bull market as the "margin of safety" has shrunk considerably.

A cautionary tale

If you've already built your dividend-focused portfolio, this may be a good time to review the highest-yielding names in your portfolio, but it isn't necessarily a screaming sell signal if you have a long time horizon and can afford to be patient. On the other hand, if you're starting to build a dividend-focused portfolio right now or are looking to add new names to your portfolio, proceed with caution when considering high-yield stocks.

As always, thanks for reading and please post any comments below or on our dividend investing community page on Google Plus.


@toddwenning on Twitter

Saturday, January 5, 2013

How I Beat the Market Over the Past Five Years

I don't make a habit of checking my portfolio's performance, but it being a new year and all, I decided to log onto my U.S. broker's website and check on my performance as of the end of 2012.

Over the past 1, 3, and 5 year periods my mutual fund investments were just slightly ahead of the market average. I was okay with that, however, since I own mutual funds (and a few ETFs) primarily as an insurance policy on my stock-picking efforts (if I royally mess up, the thinking goes, at least I'll earn the market return elsewhere) and to fill in any gaps in my portfolio.

Fortunately, the performance of my brokerage (non-fund) holdings was pretty good:

As of Dec. 31, 2012; Personal rate of return via broker's website; S&P data from Reuters
Admittedly, the one year figure is nothing to write home about, but I'm more focused on the five-year returns, which I consider to be a better length of time for evaluating investment performance* as it greatly reduces the effects of chance in results.

As such, I thought this was a good opportunity to review what worked and didn't work for me over the past five years.

What worked

Keeping transaction costs to a minimum: Over the past five years, I made fifty transactions in this account -- most of which were buys. Transaction costs were well below 1%, leaving more money in my pocket and less in my broker's.

Regularly reinvesting dividends: In most cases, I automatically reinvested dividends back into the stocks that paid them. There's some debate about whether you should automatically or manually reinvest dividends, but automatic worked best for me. I might have been able to redirect dividends to better opportunities elsewhere in my portfolio, but I could have also misallocated the money or waited too long. Looking back at my reinvestment prices, I picked up some additional shares at really good prices during the financial crisis, Greece worries, etc. when I might not have otherwise.

Buying from forced sellers: Unsurprisingly, some of my best performing picks came during the financial crisis of late 2008 into 2009 -- among them, Philip Morris International, Home Depot, Kinetic Concepts, and AmTrust Financial. The pickings during that time were, in hindsight, incredible and I wish I had invested more aggressively. I don't think I did anything special during that period other than put money to work in quality names and let them take care of themselves.

That was a rare market, however, and it's not often that we can buy from forced sellers. The key, then, is to always have some cash ready to take advantage of those opportunities. Fortunately, I did have a good amount of cash available during the financial crisis, having sold a few big winners in mid-2008 such as Core Labs and Sun Hydraulics (I own SNHY again today).

Being opportunistic: While forced selling situations don't come around often, I took advantage of a number of opportunities where the market soured on specific names or sectors. In fact, I love it when the market gets down on a competitively advantaged company due to either a temporary setback or another reason outside the company's control.

For example, I picked up shares of Tradestation in August 2010 at a time when the market was down on brokers due to the low rate environment and depressed trading revenue. (Indeed, many broker share prices remain depressed today for the same reason.) However, TRAD had some special assets that the other brokers didn't -- an advanced trading platform that catered to active traders, as well as a deep database of derivatives pricing history. It also had a great balance sheet and was small enough to potentially be a nice bolt-on acquisition for a larger company. Fortunately, TRAD was acquired in 2011 to register a 60% gain in my portfolio.

Focusing on singles and doubles, not home runs: While it's true that a few big winners can make up for a lot of losers, taking flyers on speculative companies just doesn't fit with my investing temperament. If I tried to employ such a strategy, I would have probably made many more mistakes along the way, getting nervous if the investment went against me, etc. and realized more permanent losses of capital.

Instead, I focused on buying companies with substantial competitive advantages that had temporarily fallen out of favor. When the market corrects its mistake, the quality companies may generate a 50-100% return as opposed to being a multi-bagger as a speculative company might, but I also don't lose any sleep in the process.

Not being afraid to take gains: Two of my stocks were acquired at nice premiums over the past five years, but I also made it a practice to sell stocks that shot 15%+ beyond my fair value estimate. It's true that you shouldn't cut your winners and water your weeds, but it's also true that a paper gain is just that until it is sold and turned into cash. Don't be afraid to prune a little where necessary and put the cash to use elsewhere.

What didn't work

Before this spirals too far into becoming a self-congratulatory piece, I did make some significant mistakes along the way that I think diminished my five-year results.

I made some emotional decisions: I bought Home Depot around $24 in 2008 for the right reasons, but sold it for a 30% gain in 2010 after I'd had a bad experience shopping at Home Depot. Though Home Depot may have terrible customer service -- and it certainly does most of the time -- American homeowners don't have much choice when it comes to shopping for home improvement goods, as the scale advantages that HD and Lowes have keep competition at bay. Poor customer service doesn't matter all that much if there aren't many other places to take your business. Had I held on through today, I'd be sitting on at least a 160% gain. Stupid. Whatever I rolled those proceeds into hasn't performed nearly as well.

I didn't invest enough in my high conviction ideas: Great ideas don't come around often, and when they do, it's important to take advantage and invest more capital than you normally would in other stocks. Over the past five years, I missed some opportunities to do just that. While there's surely some hindsight bias there, there were few massive surprises in my portfolio -- my best ideas generally outperformed my good ideas -- and I should have invested more in my best ideas.

I bought some things for the wrong reasons: In early 2009, I was convinced that we were headed for rapid inflation, so I bought the iShares TIPS ETF. Trying to be clever with a macro-call here backfired. While I generated a ~10% return from that investment, I could have done better in just about any stock at the time given it was near the nadir of the bear market.

I also bought shares of Pfizer in 2008 primarily because it had a very high dividend yield and a long track record of making payouts. Unfortunately, the company cut its payout in January 2009 after it acquired Wyeth, quickly souring my investment thesis. Getting burned here did inspire me, however, to dig deeper into why companies cut their dividends and probably saved me from future mistakes. A small price to pay for a good lesson, I guess.

What matters now

Hopefully my results show that a) individual investors can, in fact, beat the market in the longer-term, b) that you don't need a complex algorithm or be a professional trader to do so, and c) that a conservative and patient approach can deliver great results.

That's said, what's done is done. The past is the past. Though I'm very pleased with how my portfolio performed over the past five years, I'm more focused on not repeating the same mistakes over the next five years. If the market teaches us anything it's that past performance is not indicative of future results, so I'm reminded not to get lazy or cocky, but rather to stay focused.

Hello 2013!

I hope everyone had a happy and relaxing holiday season. The Mrs., the hound, and I spent our holiday driving nearly 2,000 miles across seven states to visit friends and family in Virginia and Ohio.

It was close quarters in the rental car, for sure. :)

Backseat driver

Here's to a great start of 2013. As always, please post any comments or questions you might have in the comments section -- or better yet, on our Google + community page on dividend investing.


@toddwenning on Twitter

*On the importance of using five-year returns as a means of evaluating investment performance: Diamond Hill Investment Group