Wednesday, February 26, 2014

Investing and Mistake Avoidance

Excellent piece by Morgan Housel hits an important topic, investment success is more about avoiding the downside than striving for blinding insight:

"If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you." 
At the risk of invoking a Buffettism to prove the above, when searching for dividend stocks I always keep in mind his saying that "more money has been lost reaching for yield than at the barrel of a gun." Investors in Boardwalk Partners recently learned this the hard way.

Up until about two weeks back, Boardwalk investors were cruising along with shares in the mid $20s range, collecting around an 8% dividend yield. Sure dividend growth was somewhere between tepid and non-existent; in 2011 Boardwalk paid $2.10/share by 2013 it was only raised to $2.13. But at 8% why concern yourself with growth?

However at the same time, Boardwalk's coverage could not keep up with maintaining much less growing its yield, payout ratio in 2013 was 190%, not exactly sustainable. The warning flags were there for all to see. The result was dividend got cut by around 80% and shares getting hammered down by around 40%. An investor depending on that beefy 8% yield, is staring at a yield on cost that is very likely under 2% on their cost, making it lower than the S&P. It gets even worse, because there's no good exit - the underlying economic engine (the shares) is repriced.

A related idea - the Loser's Game - comes from Howard Marks' "The Most Important Thing" and his reading an article by Charley Ellis:

Charley’s article described the perceptive analysis of tennis contained in “Extraordinary Tennis for the Ordinary Tennis Player” by Dr. Simon Ramo, the “R” in TRW. Ramo pointed out that professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that his opponent can’t return. But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play.

Charley took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners is unlikely to pay off. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling. I can’t remember saying, “Eureka; that’s the approach for me,” but the developments over the last three decades certainly suggest his article was an important source of my inspiration.

 Bringing this all back to investing and dividends, investors in Boardwalk paid a very high price for that temporary extra point or two of yield versus looking at the coverage ratios (not just yield) and avoiding the downside and going with a company with a larger margin of safety around its income stream. Instead of reaching for yield, why not just win by not losing, say kick back and enjoy a refreshing Coke or a Pepsi instead?

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