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KenBob Investment Plan
#1
This is a narrative version of the core strategy for my taxable account. I have mutual funds in my retirement accounts, while I do all my individual stock selection in the taxable account. Having been laid-off a few times during the Great Recession, I like the flexibility of having funds available to supplement my emergency cash.

My goal is to acquire investments that will provide an income stream for retirement, which is about 10 years away. I prefer stocks to bonds due to the ability of assets to rise in value with inflation; however, I am skeptical that the historic rate of capital gain increases will continue (discussed previously in the forum). Therefore, this strategy considers inflation, but does not consider real capital gains.

A short list of 30 stocks has been developed from which the best value stock is bought up to a market value limit of $10,000 (as adjusted by weighting). When this market value limit is exceeded, the next best value stock is bought. This is a diversification over time strategy. I consider the $10,000 market value limit as a good compromise between rate of diversification and concentration on the best value stock. When all 30 stocks meet the market value limit, the limit will either be raised or additional stocks added to the short list.

The short list of stocks was developed by requiring an investment grade corporate credit rating and considering an adjusted yield parameter, a qualitative assessment of the company, and diversity of industries. The adjusted yield parameter accounts for dividend growth and debt. The dividend is extrapolated to grow for 5 years. By including the debt per share with the price, this parameter models a scenario where the company issues additional shares to replace the debt.

Adjusted Yield = Dividend x (1 + (Dividend Growth - Forecast Inflation) x 5 years)/(Price + Debt/Share)

I don't use historic dividend growth data. Forward looking data is used whenever possible. In this case, I believe that increases in payout ratio by companies (such as McDonalds) makes historic dividend growth rates suspect. Instead, I use projected earnings growth rates for dividend growth rate, but prorate the dividend growth rate when the payout ratio is above an optimum payout ratio (assumed to be 50% for most common stock).

Stock valuation is based on the stock market value and a comparison with corporate intermediate term bond yields. A stock's adjusted yield must be greater than the corporate bond yield minus the current inflation rate. The market value of a stock is assumed to be where the stock's forward PE ratio equals the S&P 500's forward PE ratio. I have looked at what factors best correlate with current stock pricing. The only meaningful correlation I found was with forward PE ratio. This is also the basis for the dividend value parameter used to select the best stock value.

Dividend Value = Adjusted Yield x Market Forward PE/Stock Forward PE

Stocks are weighted by the corporate credit rating.
A- to AAA = 1.0
BBB+ = 0.8
BBB = 0.5
BBB- = 0.2
<BBB- = 0

A stock will not be sold simply because it is overvalued. Selling of stock is done with the intention of avoiding capital loss or impairment of income. A stock will be sold for the following reasons:
Fraudulent accounting has occurred
The dividend has been cut
Payout ratio is greater than 1
Book value is less than 0
Credit Rating is less than BBB-

Trimming is done to reduce exposure due to temporary weakness in the stock fundamentals. If the change is judged to be permanent, selling the stock will be considered. A stock can be trimmed to the weighted market limit for the following reasons:
Dividend growth rate is less than the forecast inflation rate
Payout ratio is greater than 80%
Debt per share is greater than market value
Credit rating has been reduced
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#2
KenBob, very interesting.

I'm a little confused on what the Adjusted Yield and Dividend Value results are telling you. I'm going to run some of my holdings through the formulae and see if that tells me anything. I would assume it's all in Excel as calculating all that would be tedious for a big list.

I like the fraudulent accounting mention as a reason to sell. I need to add something like that to my business plan. Don't know why I didn't think of that before now.
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“While the dividend itself is merely a rearrangement of equity, over time it's more like owning an apple tree. The tree grows the apples back again and again and again, and the theoretical value of the tree doesn't change just because of when the apples are about to fall.” - earthtodan


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#3
Only thing I don't understand is this obsession with credit rating. Especially weighing your whole portfolio based on just credit rating. I guess it's a risk management thing for you but apart from making sure that you don't load up on companies that are likely to default, what do you hope to accomplish with it? Surely your own research into the company... even a quick glance into the finances (such as earnings, earnings growth, debt levels and structure etc) will weed out the horrible ones?

Not only are these credit ratings more geared towards the debt market than stocks, you will also have to remember that they are just invented by a couple of big agencies who are wrong just as often as everyone else. Maybe even more often since the companies pay the credit agencies to rate them. And the credit agencies have HUGE control over certain market movements, which I guess is fine if you believe that they (or their employees) are most definitely not going to take advantage of this power that they have. You don't even need to go back 10 years to see the mess that several banks were in because their AAA rated loans defaulted or suddenly got converted into junk-rating. In other words you are putting your research into the hands of other people... people who don't exactly have a great history of doing things right.

I'm not saying to completely disregard the credit rating. But I can't understand basing your whole portfolio weighing system on it. Would it not be better to weigh the companies based on your own research and opinion of them and their future?
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#4
The adjusted yield started as a means of comparing stock yield to bond yield. The differences between the types of assets being considered with adjusted bond yield being adjusted for inflation and adjusted stock yield being adjusted for dividend growth and debt. Over the years, I have come to use the adjusted stock yield as my principle stock performance number.

The dividend value parameter is used as a way of combining performance with relative market valuation, so a stock at any point in time may be selected for purchase.

The credit rating is used as a means of quantifying default risk. I can and do look at other parameters as limits for selecting stock, but I wanted to include default risk as the weighting parameter. As soon as you use diversification to reduce risk, weighting of the various stocks becomes an issue. I decided that since diversification is used to reduce risk, so should the weighting. This allows me to hold larger amounts of the high quality stocks, while not precluding stocks that are of lower quality but may have high potential. I know that credit rating is not perfect and I do know the history, but credit rating is still the best overall parameter I can find for default risk.

This is an investment strategy which in many ways tries to mechanize the process after the selection of the short list of stocks. However, the investor must supervise the process realizing that none of the data is perfect.
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