Wednesday, January 30, 2013

It's Good To Buy The King?

Recently I decided to shuffle my retirement accounts somewhat. A mutual fund company I have kept an IRA with made some changes to their investment policies that I'm not particularly interested in (it's not bad stuff, it's just not a strategy that I'm using). Rather than move the funds to another mutual fund company, I've decided to put them into a brokerage account, which will give me the option of purchasing individual company stocks instead.

I'm a big fan of mechanical investing/trading systems, those being strategies that generate buy and sell signals based on simple criteria. I like these methods because, while they're not perfect, they help to avoid something I consider to be far worse: analysis paralysis

There's also the time factor. Any approach to investing you can cite other than a mechanical method will probably consume a lot of one's time. I also consider this to be a bad thing because one's time is finite, so the quicker an effective strategy can be, the better. 

Recently Cappy linked to an article that discussed this (among other things): Do This Instead of Investing Your Money...
Phil, for example, a very wealthy friend in his 40s, is an expert in municipal bond investing. But he didn’t become wealthy by investing in bonds. He got wealthy as a marketing and Internet entrepreneur and by leveraging some debts and eliminating others. Nowadays, he buys and sells bonds – but he spends only a few hours a month on it. For Phil, investing is a part-time way to increase the value of his savings. It is not – and never has been – his primary road to wealth.
It’s the same with all my millionaire friends. They all have their own investment preferences and practices. But like Phil, none of them spends more than a small portion of his working time on investing.
To paraphrase the article: work at increasing your income, keep dept in check, and put your surpluses to work for you. Just be sure that managing your surpluses (investing your cash) doesn't end up working you. Mechanical investing methods can be how you do this.

For years I've been intrigued by one such method, the Dogs of the Dow strategy. Simply stated, to use this strategy you buy the ten highest yielding stocks of the Dow Jones Industrial Average, hold them for one year, then sell any that are no longer among the ten, replacing them with whichever companies have moved onto the list. As far as annual returns go, this strategy does fairly well.

This certainly fits my criteria for being mechanical and simple, but it leaves out something that I think is important: rising dividends. Good, strong companies are able to raise their dividend payouts over time so as to return increasing amounts of cash to their shareholders. Thus, the yield on a particular stock can vary from investor to investor, depending on when each of them purchased their shares. For example: two people own Coca Cola stock. The first just got her shares and enjoys a 2.8% yield. The other investor had a lower yield when he bought his, 2.69%. However, he bought his shares in 1988 and held them so that now his yield on his cost is 33.69% annually (and that doesn't include the appreciated value of his shares).

You lose that if you sell, for once the order goes through, you're back to cash and your yield is zero. That's my big gripe with the Dogs. There's also the not-so-small point that by the Dogs methodology, a stock gets onto the buy list because it has a relatively high yield. That's something that can happen simply because of fluctuations in the price of the company's shares, which can occur even if the dividend is stagnant. If a company is not raising its dividend consistently, then you might as well just buy a bond.

Enter the Dividend Aristocrats.

I won't lay out what the Dividend Aristocrats are - I've linked to a definition of that so you can read it there. Unlike the Dogs, which qualify as buys simply due to a momentary yield, the Aristocrats only get to be on the list after having raised dividends consistently for twenty-five years and regardless of what their yields are. That's no guarantee that they always will, but it's a better place to start.

So then I could use that list instead of the Dogs list and handle it the same way, by picking the top ten as of now, hold them for a year, and adjust my holdings once each year. But, as I said, I don't want to do that because then I don't get to participate in what makes the Aristocrats what they are, companies that tend to pay their shareholders more over time.

Instead, I'm considering buying the top however many Aristocrats, then holding them indefinitely, unless any one of them cuts their dividend. Instead of selling positions that leave the top ten each year, I'll simply stop buying more of them until they return to the top, and instead begin building positions in the companies that have moved up the list.

But then I wonder, how many of "the top" should I buy? Ten is an arbitrary number. So would be nine, eight, seven, etc. But there's one number that isn't arbitrary: #1.

Why not just go right to the top of the list, buy up as much of the highest yielding Aristocrat at that moment (the "King," if you will) as I can, hold it, and in subsequent quarters, years, etc. buy up whatever other Aristocrats that in turn eventually take the top spot?

There's numerous reasons I'm aware of that some would advise against doing this, not the least of which is the possibility that something has a momentarily high yield because the underlying fundamentals of the business are crashing - a yield is only a stated yield and not an actual yield until it is paid; a stock going down in flames can suddenly gain a high yield simply because the board of directors has not yet announced a dividend cut from the prior level. This wouldn't create a diversified portfolio (at first), the value of the principal could fluctuate wildly due to being concentrated in so few positions, etc.

It's all just ideas for now. Like I said at the beginning, I like the time and effort that mechanical investing methods can save a person, but that doesn't mean that some time and effort isn't involved in getting them started. There needs to be a little thought put into the system before launching it, but if done right, the bulk of the effort should be up-front with subsequent maintenance of the strategy being relatively easy, leaving you free to get back to other stuff. In any case, the "alternative" - not thinking about it at all - doesn't work out so well:

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