April 28, 2015

I Am Starting to Make Some Strategic Asset Shifts in the KRIP

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.

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.

Scribbling Out Rough Comparisons

After I had made the decision about which companies to the add to the KRIP, I double checked myself with a dumbed-down analysis of a handful of contenders, transforming them all into $100 stocks and projecting future earnings and dividends to standardize the presentation. Most of the time it’s fairly advanced, clean spreadsheets. But I was playing The Sims 3 (see comment thread in that post) and didn’t want to stop the game so I started writing by hand.  I almost added Clorox.  I probably should have; maybe I’ll pick some of it up.  It’s cheaper than its peers and has beautiful economics.  I also almost added shares of Lorillard.  Chevron was on the list as of last night but I decided to put the money into more BP, instead.

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.

  • FratMan

    If Berkshire paid a 3% dividend relative to market value, would you have considered using fresh deposits plus the re-allocation of (growing) Wells Fargo and Berkshire dividends to gradually shift the direction of your portfolio, or would that not change the calculus substantially enough?

    • http://www.joshuakennon.com/ Joshua Kennon

      Yes, that would have been my preferred method but given the size of the position it wouldn’t have been enough.

      The problem with Wells Fargo will sort itself out when the dividend is back where it should be in the next few years, though, if the stock ends up in the $70 to $80 range before 2017 or so, I may sell off half of the position, keeping the same size stake I have now but suddenly freeing up a large pile of money to spread out horizontally into other companies.

  • Nick Pape

    “…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…”

    Can you elaborate on this tax free pension plan you’ve set up?

    • http://www.joshuakennon.com/ Joshua Kennon

      I won’t go into too many details about our own situation, but I will say my household and businesses now find themselves in a position of having the oddest collection of retirement plans that sprang up organically over the years. Some of them cannot be contributed to any longer (e.g., the Roth IRAs from my youth due to income limits, though that can be sidestepped with backdoor conversions) but still hold shares of companies I bought almost a decade ago. Some were setup to maximize the amount of money my spouse and I can put away personally, outside of the companies, without triggering any funding requirements for anyone but us (e.g., using our copyright royalties to fund a Simplified Employee Pension IRA, which between a married couple, will allow you to deposit up to $100,000 per year and get a tax write-off for it as if you never made the money, then compound the money tax-free until you are 59.5 years old just like it were a regular IRA). Then you can split off some of those, once you’ve funded them, into “self-directed” plans, that let you expand far beyond stocks and bonds into directly held real estate and private businesses, but can run into nightmares such as the UBIT or self-dealing rules. The biggest provider of those is a firm called equity trust, but they are not something anyone should consider doing lightly. Theoretically, you could buy an entire hotel or apartment complex and collect rent tax-free for decades, but if you use any debt, you’ll have to pay some taxes within the fund because it’s a quasi-contribution-in-kind. You have to protect to make sure you don’t screw up or one of the plans might get “disqualified” and you’d immediately owe taxes and penalties on all of the money. Then you can setup plans at the businesses, themselves, though you have to worry about stuff like the top hat rules. My goal for the next 5 years is to find a way to implement a Roth 401(k) system without throwing anything off so I can move to it.

      With so much of my family income coming from K-1s and entities other than me (I have $0 in wages, it’s all investments through LLCs and other structures), they file extensions through September (for the companies) and October (me personally), gather all of the information, and tell me where to put money, in which amounts, and how much I save in tax deductions and deferrals. They figure out which mix of plans is going to result in the greatest savings, and how much I’m allowed to put into each based on the finalized tax filing, then I get an email and start writing checks.

      Sometimes, the retirement plans are based on rules in the tax code that are one-off gifts, that can’t be repeated. For example, a couple of years ago, there was a situation where if you bought shares of a small c-corporation with assets of $50 million or less, you would never have to pay any taxes at all on any of the capital gains you generated from the sale, but only if you bought between a certain window of time and held on for at least 60 months. It was part of that monstrosity of a bailout package and was almost certainly a buyoff to some richer Congressional donor somewhere but anyone could take advantage of it. So there’s this odd situation where suddenly, certain shares of stock sitting in a fully taxable brokerage account or custodial account at a bank are off limit because they have the effect of being in a Roth IRA or pension without actually being in a Roth IRA or pension as long as you continue to hold them to the deadline based on your purchase date.

      That’s why I refer to the whole mess as “the retirement plans, accounts, and trusts”. I never have any idea what I’m going to be allowed to put aside in any given year, or if there are going to be special opportunities that open up, like the no capital gains on small business stock, with effectively no limit on them that will cause me to look hard for an appropriate asset that meets the classification. They run the numbers and tell me before the final extension deadline in October.

      Then, on top of that, you can setup an actual honest-to-God private pension plan, which will pay you benefits but is subject to a tremendous amount of restrictions on what you can do and how the money is managed due to retirement laws that govern them. Don’t even think about it unless you are making at least $25,000 a month.

      The reference was to the fact that generally, not always but broadly speaking, most of the money put in tax-shelters cannot avoid taxes and penalties until the year 2042 as Congress seems to have adopted the 59.5 year old threshold for almost all types of benefit plans.

      That’s vague enough I feel comfortable, but detailed enough it should point you in the right directions to study the options yourself if you wanted to do something similar. One thing I will say: I do not, at present, use any equity-indexed variable annuities despite their theoretical ability to completely bypass taxation by retirement because I have yet to find one where the payoff structure or the investment choices were sufficiently beneficial to offset the expenses charged by the insurance companies and financial institutions that run them. I’m always looking – one of these days, I’m sure a window will open and I’ll be able to grab it, but I have yet to find this great white whale so don’t even go down that path.

      • Nick Pape

        Haha.. Thanks for responding! I was particularly curious based on your chosen wording. I’m actually quite interested in setting up a SEP-IRA for my consulting & software development business now.

      • Bill

        I love posts and comments like this, thanks Joshua. Could you recommend any great books or websites that covers some of this stuff in detail that you’ve read?

        • http://www.joshuakennon.com/ Joshua Kennon

          One of the best places to start is the IRS documentation. They publish free guides you can get online (e.g., IRS Publication 590), or you can walk into your local IRS office and pick up the publications (they are printed on newspaper stock and you’ll end up with a pile a foot or two high).

          Guides like this one, this one, and others often include small passages that can be really informative. Another great source is law offices that specialize in certain areas. They often write working papers or white papers on a topic that can be great reads and give you ideas about what to research next.

      • http://www.dividendgrowthinvestor.com Dividend Growth Investor

        The private pension plan thing is really intriguing. It would be nice if the IRS allowed individuals working for others to also be able to set up their own Defined Benefit plans. Based on my level of savings, I am only able to put only a portion in tax-deferred accounts. If I were completely self-employed however, and had my own solo 401K or DB pension plan, I could potentially defer much more in tax-sheltered accounts. I guess it is sad that those at the upper end that don’t really need the tax-shelters to help them build a large nest egg have more options than someone in the middle end like me that probably should be saving a lot for their retirement.

  • ZaVodou

    “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. ”

    Royal Dutch Shell is a british-dutch company. You bought Class B that represents ownership in the British part of the company, not Dutch.

    Class A is the Dutch part with withholding-tax of 15 %.


    • http://www.joshuakennon.com/ Joshua Kennon

      Not anymore. Your information is 13 years out of date.

      The old legal structure with the British firm (Shell Transport) stockholders receiving 40% of the profits and the Dutch firm (N.V. Koninklijke Nederlandsche Petroleum Maatschappij) stockholders receiving 60% of the profits that had been in place since July 5, 1907 as a response to trying to defend against John D. Rockefeller’s invasion of Europe was ended in a massive reorganization in 2005 following the reserve scandal. The two firms, British and Dutch, merged into a single, consolidated entity. The old, individual stocks were delisted and the new entity, the parent company, is called Royal Dutch Shell plc, has a primary stock exchange listing in London, a secondary listing in Amsterdam, is headquartered and has tax domicile in The Hague, Netherlands, with a registered office in London.

      It’s all the same firm today. The only difference between the Class A and Class B shares is the tax loopholes the company uses to attract foreign investors based on their own nation’s tax situation.

      (The “too complicated to get into here” was a social nicety with a subtext of, “this is boring and I don’t want to have to explain it as it is besides the point of this post.” Trying to explain would have required a detailed breakdown of the old partnership structure, a walk-through of the 2005 merger, then a tutorial on how a company can have two Classes of stock, each domiciled in different places with different tax rules, have those shares listed in both London and Germany under multiple currencies, with a listing in Amsterdam, too, and then how some of those securities can be wrapped in other securities called ADS and traded on the New York Stock Exchange in yet a third currency. And then, after all of that, explain to a beginner the Class A SCRIP dividend program and – oh yeah – if you are a certain type of qualified pension or non-profit, you can actually avoid the withholding tax on the Class A shares and go after whichever has the highest pre-tax yield at the time.)

  • Tyler Phillips

    Hi Joshua.. Just a quick question regarding BHP Billiton.

    It seems that the ADS of BHP Billiton listed on the NYSE have a lower dividend yield than the shares listed in London. If so, why did you purchase the ADS in your KRIP portfolio, and not the actual London shares like you did for your family member the other day?

    • http://www.joshuakennon.com/ Joshua Kennon

      I was writing my response in the comment box and realized other people may be interested in the structure of the securities so I just turned it into a post on the breakdown of the various securities related to BHP Billiton that are relevant to an American investor. I answered your question in there and expanded on the differences.

      • Tyler Phillips

        Great, thank you.

        I guess it wasn’t just a “quick question” after all 😉