February 2021 Update - A Small Experiment


See first post on this series for background on the Dividend Portfolio and the Speculative Portfolio. 

S&P 500 moved up a gentle 1% in Feb.  Nasdaq moved down a gentle 1.5%.  But what an explosive month it was!  The speculative portfolio swung 10% up and down on some days.  It was stomach churning experience, even though as I mentioned in my introductory post, the Speculative portfolio is only 10% of my investments and the swings are largely inconsequential for my overall financial well being.  I tried my best to stick to the investment thesis and to learn.

CNN Fear and Greed Index started the month at 35 (0 being extreme fear), while the market was close to all time high.  Too much fear considering how small the drop in the last couple of days of Jan have been relative to the massive 2020 bull market.  Likely GameStop was rattling everyone.

 

The month ended with more jitters.  However, the Fear and Greed Index has actually swung towards greed this month and ended February at an even 50.

With that background, I want to revisit the investment thesis:

Dividend growth beats high dividend and equity portfolios

So says Vanguard based on decades of research.  The question is, does what held true for past decades hold true for this decade?  The Small Experiment is all about testing out this hypothesis over 10 years.  We are just in Month 2, so there is a long road ahead.

Before we get to how my Speculative and Dividend portfolios are doing,  I have been thinking about how I would eventually (after 10 years) choose a winner and feel like I am confusing myself.  To recap - I have two portfolios, a Dividend portolio that specializes in companies that pay 2% or so in current dividend and are growing them at 10% every year, and another Speculative portfolio in which I buys good shares that I feel are overpriced.  On the face of it, what I want to see is which portfolio has more money at the end of the decade - right?

But the more I think about this, the more I am confusing myself.  Lets say the goal is to live off of the dividend at the end of the 10 years.  Suppose further, that the Dividend portfolio has 500K in it after 10 years and is yielding my targeted 10%.  Lets also say that the Speculative portfolio has 1M in it.  Is the Speculative portfolio then the winner?  On the face of it yes, except if I want to live of interest alone.  If this is the case, then I would need to "buy" an income with the 1M portfolio.  1M invested in bluechip companies at the end of 10 years is going to yield only $20K (2%) in dividend.  However, the 500K Dividend portfolio will yield 50K!

If course, getting to 500K and yielding 10% on it may be impossible, since dividend reinvestment will increase the average cost of shares and reduce yield.  This is likely why the scenario I outlined cannot happen.  But I can't help thinking choosing the winner may be a more complicated choice than it appears on the surface.  I will work this out with a model and try to present the scenario in a future post.

In the mean time we are off to the race without even having decided on how we would call it!

Here are some ideas from this month in Investing.

Cut the losers and let the winners run

Such a simple rule.  It is also an important rule when you are always 100% invested, because when market dips, you don't have spare cash to throw at bargains.  You have to sell something to buy something.  I was on both sides of the rule in Feb.  

I sold a little bit of my NVDA (winner) to buy MGNI.  NVDA went up a bit.  MGNI went down a bit.  Overall, this is a trade I would take back.  Not that I don't believe in MGNI, but NVDA is a winner.  There is no reason to trim it.  I should have sold a loser instead.

In another trade, I sold TPIC and bought ABCL.  TPIC is a stock that I deeply believed in.  A wind energy company in a democratic administration.  Cant lose!  However, the market was telling me otherwise.  The stock was down 20% from where I purchased it and was the worst performing stock in the Speculative portfolio.  Normally I would have held on to it because "i will be eventually right".  But my Speculative portfolio is not intended to further my "normal" behavior.  I sold it to buy ABCL, which was a stock I had decided to buy a while ago, but was waiting for the right entry point.  TPIC is down a further 25% since I sold it, while ABCL is up 5%.  

Closed End Funds are an interesting investment option

Closed End Funds do not have free inflow or outflow of capital from them.  That is, they do not allow new investors to increase the capital base of the company.  After an initial "IPO"  capitalizes the fund, the fund does not get any new money from investors.  When you buy a closed end fund, you are buying one of the existing shares from another investor.  In a regular Mutual Fund, you are buying from the fund directly and they are issuing new shares and increasing the capital base of the fund when you buy.  This marks the main difference between a closed end fund and a open fund and is the basis of all the ways in which they behave differently.  Unlike an open fund, a closed end fund does not need to constantly look for new investment opportunities when new money flows in (since there is no new money flowing in).  Conversely, it does not have to worry about liquidating its assets when there are unexpected redemption (since there is no redemption - you get out by selling your share to someone else who is, hopefully, willing to buy).  In an open fund, you are returning your share to the Mutual Fund and they redeem cash for it.

The lack of worry about unexpected redemption rate means that closed end funds can invest in illiquid, long term investments.  This is the basis for opportunities in closed end funds.  The long term (and illiquid) nature of their investments cause the impatient investors to often sell them off when the prospects for those investments look dim.  Funds can often trade at large discount to the value of the underlying assets they hold.  The catch being that the assets themselves can be illiquid, meaning who knows if they are valued correctly!  I don't quite understand exactly why discounts to NAV happen so often in closed end funds, but it could be because

  1. The assets are illiquid, and so investors may not believe the valuation that the fund assigns to them.
  2. The funds use leverage and investors may ding the fund for the risk this entails.
  3. Loss of trust in management of the fund can also cause discounts over net asset value.  After all, the only way for you to get out is by selling your shares to others.  Others will not be willing to buy if there is a negativity surrounding the management.
In any case, even assuming that funds selling at a discount are at a discount for a reason, there seem to be opportunities that are more structural and slow moving (and hence can be taken advantage of by part time investors). 
 
When oil sold off last year, I felt that it would eventually come back.  Usually I have preferred owning oil stocks.  However, this time I chose to invest in NRGX, a closed end fund that specializes in credit for energy industry.  It has some interesting exposures that could be long term big paydays including Rivian Series E.
 
NRGX was selling for 30% discount to NAV (net asset value - or the value ascribed to the assets the fund has purchased with its capital) when I purchased it, and was yielding close to 10% dividend (TTM).  The market probably felt there was no way for the dividend to hold up in a pandemic (a reasonable, and as it turned out correct assumption).  Like all my dividend stocks, my bet was that the dividend would eventually recover, and I was willing to be patient.  Not only is NRGX up nicely, it has also given me two dividend payouts so far.  Once oil recovers completely, I expect the dividend also to recover to its pre-pandemic levels and this may end up being a very high yielding investment in my Speculative portfolio because of my low entry point.

Finally, here are the numbers since Jan 2021:

S&P 500: 1.9%

Dividend Portfolio: 12.5% (up from 1.7%)

Speculative Portfolio: 35.8% (up from 20.7%)

The dividend portfolio did particularly well on down days of the market when money seemed more to be redistributing to dividend stocks from Tech darlings than moving out of the market.  LUV and DIS performed especially well in Feb.   Overall, the Dividend Portfolio did a lot better in February than in January which was a full tear bull market and harsh on dividend stocks.  In fact, gains in the Dividend Portfolio was a much better indicator of market correction than the Fear and Greed index.  I wonder if strong gains in the dividend portfolio in Feb is in fact a ill omen for the market as a whole in March. 

The Speculative portfolio seems to have ignored the market volatility and grown strongly again in Feb.  This is slightly misleading.  A closer look shows most of the gains were concentrated in a single stock: PUBM.

See you all in March!

End Note

My non-financial read for the month: Neither education, nor erudition cure bigotry.

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