Two years ago, I broke my standard protocol and told you two things that were happening, justifying it because I was also making the purchases in the KRIP, one of the only portfolios I publicly discuss because it deals solely with very large, very popular, very old companies that almost everyone in the country owns through an index fund or retirement plan. It was one of the few times I’ve ever publicly commented on a stock I was buying based on current valuation.
- I explained that Berkshire Hathaway was trading at the lowest valuation in decades, walking you through a rough version of the numbers.
- I laid out an intrinsic value argument for Wells Fargo, saying the stock was worth 2-4x the current market price of $24.42 when you looked out 5 years in the future.
Much to my irritation, since I wrote those posts, Berkshire Hathaway has jumped more than 45% and Wells Fargo, including dividends, is up nearly 82%. I had been hoping to buy a lot more but the market began to realize just how irrational the price put on these amazing long-term holdings was and other investors began to bid up the price.
Both are still cheap, though not nearly as much so as they were two years ago. Unfortunately, the rise in market value happened quickly enough that it pushed those two stocks, together, up to 52% of the assets of the KRIP. That would be fine in a concentrated, deep value portfolio if I were actively seeking out certain types of companies to own. That is not what this portfolio is. It represents assets that I’ve been buying as an insurance policy since I was very young to guarantee I never ended up broke like my parents were at the time. It is meant to be a classic Benjamin Graham and Philip Fisher conservative portfolio that could survive another Great Depression; that doesn’t rely on me being smart. I find great things to own, that can grow in value over time, wait for a good price, buy a block, stick it away, and ignore it. I want it to be as close to dumb money as I’m willing to go.
That means, for the KRIP, sometimes I might buy a company like United Technologies when it was close to fair value, even though there are more undervalued firms out there. I’m fine with that. I know exactly what I’m doing and am willing to live with the consequences. The only rules I’ve put on myself are that the portfolio should be well balanced so that it can do well in almost all environments, that there is almost no turnover (I’m not a fan of trading – in all of 2012, I didn’t sell a single share of any stock in my family’s personal portfolios), that I structure the holdings intelligently to maximize the return, and that none of the money is touched until at least the year 2042, at the earliest. Even then, I doubt I’ll break into it until much later, assuming I break into it at all. I may go ahead and put the securities in trust funds for my children and grandchildren.
Seeing $52 out of every $100 parked in two firms when I ran the KRIP spreadsheets made be very unhappy. A single correlated disaster, such as a catastrophic tsunami or earthquake on the Pacific Coast, would hit both stocks at the same time, devastating the results several years in a row. While both should be fine in the long-run, I would want to be buying more during such a disaster, not having to sit on my hands waiting for the damage to repair itself. What makes it worse is that subsequent to the purchases, Warren Buffett began buying even more Wells Fargo for Berkshire Hathaway, introducing more cross-exposure. That’s what got me more than anything; it wasn’t even that two stocks represented half the portfolio, it was the correlation in risk. What harmed one was likely to harm the other.
Sometimes Portfolio Strategy Has to Trump Individual Security Selection
I made a decision last week to begin selling off some of the Berkshire Hathaway around the edges, redeploying the money to other, non-correlated stocks. Don’t misunderstand me – Berkshire Hathaway is now, and will remain, by far one of, if not the, largest holdings in the KRIP. The sales won’t affect that. At $115, the stock seems like a fair shake for a 10-year run; a range of scenarios shows that, absent some large scale disaster, it would be relatively easy for the shares to grow to $250 to $500 each, depending on the returns earned by the underlying businesses, whether a dividend policy were implemented following Buffett’s departure, and the valuation multiple other investors were willing to ascribe the equity. There are very few other places I’d want my money working. In fact, I imagine that over the coming time period in question, the gains on the shares remaining on the books once I’ve concluded the sales will replace all of the proceeds of what I ultimately end up selling. That’s one of the joys of owning a wonderful collection of cash generators.
Nevertheless, I have a portfolio problem, not a stock problem, so I need to do this. (Don’t feel too sorry for me – having your two favorite holdings increase in value so they make you too much money is a first world dilemma I hope each of you experiences in your own life.) I’m not willing to accept this level of concentration.
The first sale happened this morning. I almost backed out of the transaction three or four times, before figuring that making myself take a small step would kick start the process. Finally resolved, I picked out my worst performing purchase (highest cost basis) of Berkshire Hathaway from that time period. It was a group of 153 shares of the Class B stock. I sold it for $17,640.53 against a cost of $12,093.10. This triggered a gain of $5,547.43, or 45.87% on principal. The compound annual rate of return during the time the shares were in the KRIP was 20.77%.
Selecting a Handful of Stocks to Replace the Berkshire Hathaway Equity
What made the decision from here tricky is that this particular block of Berkshire Hathaway shares are sitting in a tax-free pension plan that I cannot access for another 30+ years and that has restrictions on the amount of money I can contribute every 12 months; a limit that requires my accountants to do some math calculations and make sure rules are followed that I’ve never bothered to fully learn as they are complex and ever-changing. That means there would be quite a lot of utility for me if I could replace the stock with other holdings that had higher-than-average dividend yields, low valuations, and would serve as sort of quasi-equity bonds that pumped out money for me to invest in other holdings. This way, I may be restricted to how much cash I could put to work in the tax shelter, but I’d have created a backdoor way of funding the account; the dividends deposited from these new shares would be that mechanism. They would also serve as a stabilizing factor during rapid market declines as a result of a phenomenon known as dividend yield support.
We’ve talked about how investors are starved for yield right now, so they are driving up asset prices on anything that throws off spendable cash; e.g., the Master Limited Partnerships or food and consumer staples stocks. One option was to go deep down into the micro and small capitalization stocks that most investors won’t study and find a collection of good, solid companies. It sort of defeated the purpose of the KRIP in that it introduced some of the elements of the actively managed value portfolios, but that was going to be the go-to plan if I couldn’t find traditional blue chips that could be had on my terms. I also wanted, if possible, areas of the economy that were underrepresented.
What followed was the purchasing list you see below, all of which have now been executed. It consisted of three domestic businesses and three foreign companies, of which one is a new position and five add to existing holdings. I’m happy with the list but some of those firms were bought as second and third choices because I’ve reached the allocation limits I’m willing to accept on other stocks. If I were starting over tomorrow, I’d still be buying Wells Fargo, albeit with reduced return expectations. I’d much rather have General Electric, but I already hold a hefty pile of it and any more would exasperate the problem.
- 25 shares of McDonald’s Corporation for $2,515.70
- 26 shares of United Technologies for $2,515.70
- 51 shares of Dr. Pepper Snapple Group for $2,377.85
- 39 ADR of Royal Dutch Shell Class B (representing 78 shares in London) for $2,596.56
- 124 ADR of BP, plc (representing 744 shares in London) for $5,122.46
- 50 ADR of BHP Billiton (representing 100 shares in London) for $2,528.90
- Grand Total: $17,657.17
The new purchases generated net earnings that would have amounted to $1,844.36 over the trailing twelve months. The reason the oil, gas, and mineral stocks are so cheap is because investor’s don’t like that over the next 3-5 years, those earnings may expand to only $1,950. That’s fine with me given that they will serve as a sort of foundation quasi-equity bond for the KRIP. History has shown that buying these types of enterprises when they are out of favor tends to work out well in one’s favor. Getting a basket of high quality assets at cost that amounts to roughly 10.5% after-tax returns on purchase price is not something that will cause me a lack of sleep in the overall context of my other holdings. (Royal Dutch Shell is a famous example of this. The company was ignored by investors for around a century, selling for single-digit p/e ratios and fat dividend yields. That cheapness, combined with the cash it threw off, meant that a stockholder who owned it and reinvested the dividends ended up crushing almost every other security that came along in the 20th century.)
While I wait for sunnier days, I get paid. Specifically, in the coming year, the group is expected to pay dividends of $734.55, which is a 4.16% yield.
Let’s presume, for a moment, that reversion to the mean happens and the headwinds facing some of these enormous energy and mineral firms mitigate; that, between organic expansion in the underlying profits of the firms resulting in higher dividends, and the money that is plowed back into buying new shares of other dividend-paying firms, the stream of cash dividends on this block of securities grows at 7% per annum. Past experience shows this is a reasonable assumption when you factor in that reinvestment. This means by the time I am Warren Buffett’s age (we’re talking about Berkshire Hathaway funding the decision so it seems a fair comparison), these six businesses (and / or any spin-offs they turn out over the years), might deposit more than $343,400 in cash into my accounts. Forget the value of the shares themselves, which should be much higher. That’s just the cash component.
That is $343,400 in future cash, over 50+ years by selling cheeseburgers, french fries, diamonds, uranium, silver, gold, iron ore, aluminum, coal, oil, natural gas, chemicals, soda, airplane engines, and elevators. Given the nature of the commodity businesses, the timing of that cash will be wildly volatile, which doesn’t bother me at all.
That cash component gets around the limits on what I can deposit into the pensions, retirement trusts, IRAs, and other tax shelters. It serves as a sort of internally-funded mechanism constantly providing a fresh stream of money, even after I’ve reached the maximum figure of what I’m allowed to save each year.
That’s useful because not only is it more fun for me – I love allocating the money – it is a defensive measure when the stock market collapses because I may not be able to contribute more capital at the time depending on what the accountants tell me. That means I’d have a way to buy new shares within the plans themselves.
Again, as all of this money is held in a pension plan, I won’t have to send any of it to the government until I begin paying out benefits, and even then, there are some things that can lower the burden. Part of that is the structure I selected. It’s too complicated to get into here, but I actually bought Royal Dutch Shell Class B American Depository Securities (ADS) traded in New York, each of which represents 2 shares of Royal Dutch Shell Class B stock on the London Stock Exchange, which represents ownership in a Dutch firm.
Let me repeat the absurdity of that: I’m buying an American security that holds a British stock listing that represents ownership in a Dutch oil company. It sounds crazy but the result: No taxes. It has to do with the tax treaties between the United States and Great Britain and how you can’t recapture certain automatic dividend withholding of foreign governments in certain types of retirement structures. The bottom line is none of my dividends go to any of the three governments; I get to keep it all. It was a similar setup with the BP and BHP Billiton stakes, the latter of which I bought the BBL shares in London instead of the BHP shares in Australia because of a substantial price difference thought they are economically identical in almost every way that counts.
I’m also hoping my accountants will figure out how much I can kick in to the plan before the October deadline, which would let me organically lower the Berkshire Hathaway and Wells Fargo stakes without actually selling any shares as they became a smaller percentage of the expanded portfolio (I call it “diversification through deposits” since I’m not too keen on selling anything; when in doubt, I add more money to buy something else). The first sale wasn’t even remotely sufficient to remove the concentration risk but it was at least a start.