Income please, hold the risk.

As an individual investor focused on income producing equities, and someone who manages similar investments for others, one of the most important analyses I perform is an assessment of risk. I have come to live by the following… “Is it safe? Is it cheap?” Full credit for this mantra goes to Marty Whitman at Third Avenue Funds. Much has been written over time about “margin of safety” and the fact is that the best company in the world can be a lousy investment if you pay too much for it.

For my purposes, RISK is defined as the potential for permanent loss of capital and/or a long-term impairment in the value of the investment, and/or a significant impairment in the income production of the investment.
One of the portfolios I run belongs to a lovely woman in her mid-eighties (I’ll call her “Mom”). When he passed away a few years ago, her husband (I’ll call him “Dad”) left Mom pretty well off, and completely clueless regarding her financial situation. I took over management of her assets upon Dads’ death.

Needless to say, this one is a bit “different.” This is not just any client. As “Mom” says, I’ll never be too big or too old to keep her from swatting me on the back of the head if I screw up. Trust me... it’s not an experience you want to have.

“Mom” lives fairly frugally. She owns her home outright and is able to live comfortably off her Social Security and the RMD from her IRA. She has not had to touch any funds in her taxable investment accounts. The problem that I saw with her portfolio was that there was inadequate growth. Each year the RMD increased and portfolio income was not keeping pace, thereby causing a need to sell a portion of her investments each year in order to fund the RMD.

The recent massive decline in the stock market has presented a fabulous opportunity. A huge degree of risk has been removed from specific individual equity investments precisely because 1) prices are low because like a rising tide raises all boats, a falling tide does the opposite without regard for the seaworthiness of the ship, and 2) the outgoing tide has revealed many naked swimmers in the sea of the stock market. Please note that I do not know or care whether the “market” is over or under valued. Having bought and sold a couple of businesses in my career, I am comfortable valuing a business, not a market.

In the case of Mom, this ebb tide has allowed me to reallocate her retirement portfolio in such a way as to meet all of the following requirements:

1. Generate sufficient income to fund her RMD entirely out of income for several years
2. Provide for sufficient income growth to maintain portfolio income in line with required increases in her RMD
3. Provide the potential for (hopefully substantial) capital appreciation over time
4. Minimize the risks outlined in the second paragraph while achieving the above goals.

A final, secondary goal is the preservation and maximization of the value of Moms’ estate for her heirs (of which I am one, unless she changes the will) when the inevitable date arrives and she joins Dad in the great hereafter.

In trying to achieve these goals, I use individual dividend paying stocks for income, income growth and capital appreciation and I analyze each company I purchase for Moms’ portfolio from the following perspectives.

1. Is the company safe? Downturns come and go and I am not so much interested in current results as I am interested in the company’s’ ability to weather the downturns and continue forward without permanent impairment. The daily/weekly/monthly fluctuations in a company’s stock price are largely irrelevant. I look for companies with strong balance sheets and strong cash flows. Judging management has also become a bit easier when judging the safety of a particular company. While there is truth in the “rising tide" saying, the current economic situation has thrown a bright light on managements’ ability to navigate rough waters. In the words of Syrus Pubilius, “Anyone can hold the helm when the sea is calm." I want pilots who can handle the storms.
2. Is the dividend safe? Is it adequately funded out of cash flows and available cash on hand? Is it likely to remain so?
3. Will the dividend grow? Here there are two elements of concern. First is the long-term prognosis for the business. Can the company grow and increase its’ earnings and cash flows? Second is a demonstrated willingness on the part of the company’s board to increase the dividend more or less in line with the growth in the company’s earnings and cash flows.
4. What are the alternatives? Coke versus Pepsi as it were.
5. Is the price cheap and more importantly, is it cheap enough? Valuing a company will, if you are doing it correctly, produce a range of values, not an absolute number. Buying below this range provides a warm and fuzzy margin of safety to nestle in. I personally feel that the harder this analysis is to do and wider the range of values that are derived from the analysis, the less likely the answer to the above question is to be “YES.”

For any investment, I have a long-term target rate of return, which combines yield on cost, with anticipated growth and varies based upon my perceived risk that the investment carries. Another cliché (from Moms’ deep well of such things) is “Better safe than sorry.”

Finally, a word on DRIPs. I do NOT use DRIPs. I do not believe in “set-it-and-forget-it” investing. I whole-heartedly endorse reinvesting dividends but I would rather deploy excess cash based on my current analysis of investment alternatives. Frankly, all else being equal, my willingness to reinvest in a company is inversely proportional to the change in the price of the company’s stock price.