How I Created My Portfolio Over A Lifetime – Part VI
Summary Introduction and series overview. When and why I might trim a position or two from my portfolio. The methods I use to liquidate a position. Back to Part V Introduction and Series Overview This series is meant to be an explanation of how I constructed my own portfolio. More importantly, I hope to explain how I learned to invest over time, mostly through trial and error, learning from successes and failures. Each individual investor has different needs and a different level of risk tolerance. At 66, my tolerance is pretty low. The purpose of writing this series is to provide others with an example from which each one could, if they so choose, use as a guide to develop their own approach to investing. You may not choose to follow my methods but you may be able to understand how I developed mine and proceed from there. The first article in this series is worth the time to read based upon some of the many comments made by readers, as it provides what many would consider an overview of a unique approach to investing. Part II introduced readers to the questions that should be answered before determining assets to buy. I spent a good deal of that article explaining investing horizons, including an explanation of my own, to hopefully provoke readers to consider how they would answer those same questions. Once an individual or couple has determined the future needs for which they want to provide, he/she can quantify their goals. If the goals seem unreachable, then either the retirement age needs to be pushed further into the future or the goals need to become attainable. I then explained my approach to allocating between different asset classes and summarized by listing my approximate percentage allocations as they currently stand in Parts III and III a. Part IV was an explanation of why I shy away from using ETFs and something akin to an anatomy of a flash crash. In Part V I did my best to explain why holding cash, especially when assets valuations are relatively high, may be better than being fully invested at all times. In this article I will explain when, why and how I remove positions from my portfolio. I will provide two examples, one for each of the two methods I use. When and why I might trim a position or two from my portfolio There are two reasons that I might want to sell a stock position from my portfolio. The first is when the company management changes direction or the business model in a way that does not appear to be sustainable to me. This one should be obvious, but I do not want to exclude anything that could be useful to those just starting out. If the fundamental reason I bought the stock has changed, such as the moat has been washed away by technological advances creating easy entrance by competitors, I must reassess whether holding the position still makes sense. Usually, in such a case, the answer is no. Thus, I will want to sell the stock and look for another investment with a more sustainable growth/income business model still intact. The second reason is when I sense, for many reasons, that the market and by extension some of my positions, have reached overly high valuations. I will discuss the many reasons in a moment. But, for now, suffice it to say that when I feel that I could find a better investment for my money in terms of total return potential, I consider selling the position. The method, in this case, is to sell calls. In the first case I will sell the position outright on a day when the stock is exhibiting some price strength (usually when the broader market is up and lifting most stocks higher). In the second case, I will sell the calls when the stock is over its fair value by 20 percent or more and do so while the stock is still near its 52-week high. The methods I use to liquidate a position I want to provide two examples, one to explain each situation in which I decide to sell a position. The first example is Best Buy (NYSE: BBY ) which I first recommended in this article back on October 7, 2011. But I did not buy the stock at that point because my recommendation was to sell put options in hopes of either collecting a 20 percent annualized return on cash or to buy the stock at a discount. I ended up collecting the cash and the option expired worthless. The next time I made a similar recommendation came in my December 23, 2011 article . This time I was successful, having sold two put options, collecting $2.39 per share, with a strike price of $20 while the price at the time stood at $23.28. I did not expect to get put the shares but, as it turned out, the stock fell all the way down to near $11 per share in November of 2012. I ended up owning 200 shares of BBY with a cost basis of $17.61 in mid-January 2013 with the price at $15. I had originally wanted the shares because of BBY’s position as the leading electronics retailer after a consolidation in the space and because of my personal experiences while shopping at three different BBY locations. I received some negative feedback after my original article that customer service in some areas had become less than desirable. I considered that to be more of a localized situation as my recent experiences had been superior. Then something changed. All of the highly knowledgeable employees that I had previously made my shopping experience enjoyable suddenly disappeared. The employees that replaced them barely spoke English and were not as interested in helping find what I needed but totally focused on selling me something along with some other things that I did not need. They were highly trained in selling but knew little about the products they were charged with selling. Fortunately for me this happened in September, 2013 with the price trading near $38 per share. I dumped my 200 shares on September 16th at $38.50. One of the major reasons why I had bought stock in the company, excellent customer service, had changed dramatically. I was lucky to be shopping and having the experience when I did. Sure the stock went up to over $43 per share in November of that year, two months after I had sold. But I felt no regret at the time. My decision was based upon the assumption that the company had decided to lower labor costs and try to increase dollars per sale at the expense of customer service. Management probably did not think it would be sacrificing so much in the customer experience, but, in the end, the result was horrific. Results disappointed and the stock price fell back to a low of $22.15 on January 2014. I was not tempted to add back shares at that price. While I would have profited nicely if I had, the company had broken my faith and I will not look back. Of course, the bigger future problem for BBY will be competing over the Internet with the likes of Amazon and some smaller electronics specialty sites. The stock now stands at $37.78. I believe it is over valued at that price relative to its future prospects. The second example is a company than I have held in my tax-deferred IRA account since 2006 with a cost basis of just over $30 per share. McCormick (NYSE: MKC ) is one of my all-time favorite companies but the stock has, like many quality stocks in the current environment, has become over valued by my estimates. The current share price is $79.62 (as of market close on Friday, October 2, 2015). I really do not want to sell these shares because the company is still doing everything right and the future remains bright. However, when the price of a stock gets to be over valued by 20 percent or more I like to sell calls above the current price. If the stock rallies and remains above my strike price I end up having to sell the stock for 25 percent or more above what I consider to be fair value. My estimate of fair value for MKC is $66. I get to that price base by using the dividend discount model [DDM] with a discount (or my hurdle rate) of nine percent. Dividends have increased handsomely over the past five and ten years, at nine and 9.1 percent, respectively. However, I believe that the growth prospects going forward will be lower, not only for MKC but for most multi-national corporations, as growth in emerging markets is slowing and not likely to regain the levels of the past decade in the foreseeable future. My estimated compound annual growth rate for MKC dividends is 6.6 percent. Plug in the numbers and we end up with a fair value of $66.01 per share. As I mentioned before, I do not want to lose this position but it will not break my heart if these shares get called away at $85 before year end. Since the position is in my IRA account I am not worried about a tax consequence. I would not sell calls so close to the current price if it were in a taxable account. I figure that if the position gets called away I will probably look for a better yield in another quality stock that has been beaten down more. Of course, if it does not get called away I am happy because the stock is not likely to fall much below fair value. It seems to hold up very well even during the worst recessions. Everyone has to eat and we like to season our food to taste. That goes for all seven billion of us; or at least those can afford to be choosy. That number has grown and will continue to growth but I suspect the rate of growth to slow considerably for at least the next five years. Summary I intend to get more into some of the common mistakes investors make when not paying attention to tax consequences in the next article. After that I want to get back to the basic concepts of saving and investing goals and methods, primarily for those just starting out, but also applicable to those who are nearing retirement and not quite comfortable with where they are at this stage of life in terms of having enough to last through their remaining years in comfort. There are always a few tough decisions to make but they are generally well worth considering. As always I welcome comments and questions and will do my best to provide details and answers. This is one of the best aspects of the SA community. We can learn from each other and share our perspectives so that other readers can benefit from the comprehensive knowledge and experience represented here.