Like many investors when I began building portfolios I focused on stocks. I hoped to build a portfolio that would ultimately rain down dividends. Some small positions at first only paid less than a dollar in dividends, once those dividends reinvested, they grew to pay over a dollar. I also work on investments that yield more; however I continue to make smaller investments, because I believe an investor must learn how to make ten cents, before being able to make a dollar, and so on.
Recently a relative of mine told me he is fully invested in one brokerage’s mutual funds. I know many people do this, however it is contrary to my personal strategy. Of course what works for one person, or institution, might not work for another; it is imperative to find what works for you. In this article I will recount a conversation I had recently with two non investors, I will also go over some basic methods of research that may be useful for beginners trying to find companies and funds to start with. I want to emphasize that beginner investors must realize the stock market is currently at an all-time high, and interest rates are at historic lows, so it is important to consider not diving in all at once, remember “slow & steady wins the race.”
Conversing With Small Business Owners
Recently two entrepreneurs, who own a small animal care business, asked me about the basics of investing; they asked how one goes about buying stock. I said most people use a brokerage, such as Fidelity or Vanguard; one asked if you have to use a brokerage, or if you could go online and just find people selling stock. I explained some investors use DRIP investing (a dividend reinvestment plan) directly through a stock transfer agent like Compushare, though most investors to the best of my knowledge use brokerages.
I explained many companies issue stock and bonds, the reply was “that’s what I don’t understand.” These small business owners are not alone, many people simply do not live on Wall Street, though companies traded on Wall Street depend on them as consumers. When I told them bonds generate cash periodically, one responded “that sounds good.” I went on to tell them interest rates are low, inflation takes a toll on the bond’s value, and bonds will go down when rates go up.
One of the entrepreneurs said she wanted to invest in corn, and I replied I would look for a company involved with farming like Archer Daniels Midland (ADM) over an investment directly into corn. I actually invest a very small amount into corn and I’ve found the performance to be lacking; for instance this ETF (CORN) is down 7.7% YTD (year to date) while the S&P 500 (SPY) is up 10.5% YTD.
Since these small business owners run an animal care company I said they might look at (PETS) and Wal-Mart (WMT) — I also explained they could look up mutual funds that hold companies’ stocks and bonds using Morningstar’s shareholder feature. I told them I had wanted exposure to Wal-Mart bonds for a while and recently used Morningstar to find major holders, then invested in Vanguard Total Bond Market ETF (BND). Some small business owners of course compete with Wal-Mart, some would not invest in it; however these business owners said they were not opposed to investing in it, and have friends employed by the retail giant.
Take a look at Vanguard Total Bond Market ETF’s Wal-Mart corp. bond holdings, listed in the fund’s most recent prospectus:
The columns show the Wal-Mart bonds’ coupon, maturity date, face amount and market value, the face amounts and market values are in millions. For instance the last line shows Vanguard’s ETF held nearly 22M 5.625% coupon bonds due 4/15/2041. As of the prospectus date the 2041 Wal-Mart bonds were worth over $28M.
For every $1,000 bond the 5.625% coupon pays $56.25 a year, notice the first listing only has a 1.625% coupon, it pays $16.25 a year, however matures in 2014. Most Wal-Mart bonds currently on the market have a make whole call, the company is rated Aa2 by Moody’s and the last long-term debt rating action I see was the downgrade to Aa2 in 1996.
Growth Fund vs. Value Fund
Now what I’d like you to do is try to find one large cap. company you can agree with. To do this I will list the holdings of two top rated large cap. stock mutual funds. Since the holdings change from time to time I will show recent top ten and more current top ten holdings in the two mutual funds:
T. Rowe Price Growth Stock, Inception Date 4/11/1950, Large Cap. Growth Mutual Fund (PRGFX)
- Apple (AAPL)
- Google (GOOG)
- Amazon (AMZN)
- Mastercard Incorporated (MA)
- Crown Castle International (CCI)
- Qualcomm (QCOM)
- Danaher Corporation (DHR)
- eBay (EBAY)
- priceline.com (PCLN)
- American Tower Corporation (AMT)
I picked this fund because it is a large cap. fund, I am also thinking of investing in it at some point. Yahoo! Finance’s top holdings list is from 12/31/2012, I went to T. Rowe’s page for the fund and see the top holdings have been updated. I’ve highlighted the stocks that were dropped in red and the stocks new to the top ten in green. Here are the changes:
As of 4/30/2013:
- American Tower
- Crown Castle International
- Gilead Sciences (GILD)
- Visa (V)
Notice Amazon now tops the list, and though its P/E is sky high I still like the company. Since its P/E is a point of contention I favor exposure through a mutual fund.
I have linked each stock ticker to the company’s Morningstar shareholder page, these pages show top mutual fund owners of the stocks and when applicable the top mutual funds invested in their bonds. These funds might meet your criteria, or they might not, however it is likely there is a mutual fund out there that is perfect for you. (To review my criteria for mutual funds please read my previous LearnBonds article.)
Since I’m not familiar with Crown Castle I picked it. I looked the stock up and found the company works in diversified communications. Take a look at Crown Castle’s stock ticker page on Yahoo! Finance, notice the P/E is 140. Some investors believe you should look for a P/E around 20, since this is a point of contention I am going to double and triple check the figure on Morningstar and Google Finance.
To further research Crown Castle I looked back at its stock chart, CCI hit a low of $10.19 in November 2008, it is now priced above $73. Investors have a good point of reference in gauging possible worst case scenarios by looking to the downturn in late 2008. Next I will pull up Crown Castle’s P/E history on YCharts, now compare that to Wal-Mart’s P/E history. Crown Castle’s P/E lives above 80, Wal-Mart’s lives below 20.
Wal-Mart’s low during the downturn was around $46 and it pays a dividend whereas Crown Castle does not (you can tell Wal-Mart appeals to me more than Crown Castle for these reasons.) Out of curiosity I’m going to view the fund’s complete holdings, it does not hold Wal-Mart, however it does hold 3 million shares of Twitter, I view this as a positive.
Now let’s look at a value fund:
Weitz Partners Value, Inception Date May 30, 1983, Large Cap. Blend (WPVLX)
- AON plc (AON)
- Berkshire Hathaway (BRK.B)
- Redwood Trust (RWT)
- Valeant Pharmaceutical (VRX.TO)
- Texas Instruments (TXN)
- Wells Fargo & Co (WFC)
- FLIR Systems (FLIR)
- Iconix Brands (ICON)
- Liberty Global (LBTYK)
- Target (TGT)
I know I need to double check with the fund’s home page to see if the top holdings have changed. So I’m going to Google search the name of the fund, or Google search the name of the fund family to find their website. Here are more current top holdings:
As of 3/31/2013:
- DIRECTV (DTV)
- Berkshire Hathaway
- AON plc
- Valeant Pharamaceuticals
- Redwood Trust
- Texas Instruments
- FLIR Systems
- Wells Fargo & Co
- Liberty Global
- Iconix Brands
These two mutual funds hold stocks, though the Morningstar shareholder page gives you a place to begin exploring the companies’ bonds. I’m going to pick Wells Fargo from the list above, one reason I like it is because Berkshire invests in it; now I’m going to go to Morningstar’s bond page for Wells Fargo and look at their outstanding bonds. I see a ton of short-term debt and far less long-term debt.
What I also want to know is how much the company makes and how much debt the company has? There are two ways to go about finding the answers to these questions; first you could go to Yahoo! Finance and view the company’s key statistics and income statement. The second way is to Google search “Wells Fargo” & “investor relations,” the company’s investor relations page will have links to annual reports and statements.
Go find the annual and quarterly net income for the company you picked, find the average for the past couple years and the past few quarters. Then go to the company’s key statistics page on Yahoo! Finance and check out how much cash it has and how much debt it has. Wells Fargo’s data is as follows:
- $14.8B net income average annually last three years
- $4.7B net income quarterly average last four quarters
- $221B cash
- $194B debt
The point of this exercise is to begin reviewing large cap. stocks. Similarly you can begin to review mid cap. and small cap. stocks the same way. Though, personally I like to begin building a portfolio with large cap. companies. There are many strong companies in the S&P 500 not represented by these few stocks, to get a sense for a few companies I consider to be potential core holding please review my article, Strategic Investing In Equity And Debt: Target 2042. Keep in mind that article was written last year.
Quality is Everything, (but Coca-Cola’s Not Worth $4.4 Trillion)
The stock market fascinates many people, because fortunes can potentially be made. I remember being told one day there was a stock trading over $10,000 a share. It was 1992 and the stock was Berkshire Hathaway (BRK.A), I looked at the quotes in the Wall Street Journal and clearly Berkshire’s stock stood out by several thousand dollars a share.
I wish I had enough time to explain to the entrepreneurs the fact there are few companies that put shareholders first. Of course now Berkshire Hathaway is well over $160,000 a share, with a $279B market cap. If you compare Berkshire to Coca-Cola though, you will see Coke is $42 a share and has a $187B market cap. You have to understand for Coke to go to $84 a share, its market cap. would go to $374B.
Many people like Coca-Cola, the company raises its dividend and makes an average of $9B a year in net income; approximately $2.1B a quarter currently, however the stock simply can not go up past a certain point (as in go up to $1,000 a share because its market cap would be $4.4 trillion .) One reason is the fact there are 4.5B shares of Coca-Cola outstanding.
There are only 1.6M shares of Berkshire Hathaway Class A shares outstanding, additionally Berkshire Hathaway implemented a share buyback, they also recently bought back $1.5B worth of company stock from an individual’s estate. When a company buys back shares of their own stock, generally they retire the stock, and there are fewer shares outstanding; thus the remaining shares of the company can potentially be more valuable.
When discussing the concept of an income snowball, I believe it is important to discuss historically strong companies, such as Berkshire and Coca-Cola. Simply put: Quality is everything; as an investor you need to calculate whether companies are worth the amount you’re paying, to do this you can check out:
- their annual and quarterly income (also look to revenue, cost of revenue, admin. expenses, research & development, and EBITDA)
- their cash balance and debt (keep in mind these numbers can and will change)
- their P/E and market cap
- number of share outstanding (is the company diluting by issuing more shares, or buying back?)
- dividend growth (does the company have a strong history of raising its dividend, if it has one?)
- remember companies are not stationary, so look for overall direction (try YCharts to see long-term graphs)
Understanding The Market Is Tough
So much depends on when you enter the market. Say you started a portfolio in 2007 and shortly thereafter saw the market take a hard nosedive. This investor may think of the stock market as a sort of black hole, compared to the investor who started their portfolio in late 2009, and quickly saw their holdings soar. This is the nature of investors’ relation to the market, if it goes up and an investor makes money they think its great; if they lose money, the market seems like an unsafe place to invest. Investors must know there is always a possibility a company could go bankrupt and they could default on their bonds, this is one reason to be patient, do research and consider diversifying. You might look at the Dow Jones in 1,000 point increments, keep cash on hand and / or create a bond ladder, have a plan for if the Dow goes into various ranges just like you might “save for a rainy day (on the market.)”
As was the case with the entrepreneurs, when it comes to the subject of bonds there is a lot of confusion. One reason for this may be the fact bonds are usually more expensive. Whereas a stock might be $20 a share or $40 a share, bonds most often are priced somewhere around $1,000 (unless it is a zero coupon, which does not make payments each year.) Furthermore it seems 90% of financial news focuses on stocks, the news of course covers major announcements about interest rates; then goes right back to stock coverage.
Investing in stocks may seem more attractive, because a stock could go up 3% or more in a single day. Of course the downside to this is a stock could fall, hard. The last point I made to the entrepreneurs, was about a company’s P/E, EPS and net income. I explained, and it’s worth repeating, some investors favor companies with price-earnings ratios less than or equal to 20, and investors should look elsewhere if they see a company has negative earnings per share. To me a company’s net income picture is very important, though some bond investors look to EBITDA (earnings before interest, taxes, depreciation and amortization.)
An Income Snowball
As I left the two small business owners I thought of a few important points I did not have time to go over. Namely municipal bonds as sources of tax-exempt income, since the conversation was focused on companies. Though beginning investors may not be as concerned with tax ramifications because they may be in lower tax brackets; of course tax-exempt income is important to non-IRA accounts.
Comfort zones and risk assessment are also pivotal, and an understanding that the market is unpredictable. I believe it is important not to gamble with investments; one reason a certain investment might look great is because it is basically too good to be true. Take the Facebook (FB) IPO for instance, investors poured money into it above $40 a share on the first day. The stock proceeded to fall, hitting a low around $18 in September 2012.
Whether you invest in stocks or bonds, a good rule of thumb to consider is investing in companies you would like to own; and won’t mind looking at, or adding to in case the market falls. I don’t want to see my investments go into the red, however if I really like the company based on its brand, its advancements and its financials I don’t feel as bad if it turns negative for a while (if it pays a dividend I can reinvest it and accumulate more shares.) It is also important to set benchmarks, investors may need to weigh a loss cutting strategy, or profit taking strategy depending on an investment’s performance or the overall direction of the market.
Let’s look at some basics of non-IRA and IRA accounts; what I’d like to do is include a stock, stock fund, mutual fund and two bond funds in each account, in addition to cash. The non-IRA will use at least one muni. bond fund whereas the IRA will use corp. bond funds. The smallest non-IRA example will keep more cash to begin with and won’t include a mutual fund, the goal of this account is to add more cash over time to be able to buy a mutual fund.
First let’s look at templates for allocations, then I will fill out the same portfolios with holdings. You will notice the allocations will not line up exactly, though it is important to set guidelines and realize that you can move towards or away from those figures over time:
|portfolio size||stocks||stock fund(s)||mutual fund||bond funds||cash|
Keep in mind this is just an example, you can tailor the amounts to suit your own preferences. Now let’s look at an IRA allocation template. Since many mutual funds have lower minimums for IRAs I will include a mutual fund in the smallest portfolio.
|portfolio size||stocks||stock fund(s)||mutual fund||bond funds||cash|
It is up to you to decide if you want a mutual fund or multiple mutual funds that hold stocks, bonds or both.
Next I will use the templates and pick some stocks, mutual funds and bond funds to fill in the examples. In the IRA I will choose Berkshire Hathaway Class B stock, I will also look for a couple other stocks. Keep in mind throughout the process:
- allocation to large cap. and mid cap.
- allocation to growth and value
Process of Researching
While forming this example I will look to Seeking Alpha author David Fish’s Dividend Champion lists for companies’ stocks and bonds I might want exposure to directly and through funds. I also searched “what stock has paid dividends longest” and found This Dividend King Has Paid Dividends For 97 Years Nonstop about 3M Company (MMM). Though the stock is at a high, I like its low P/E, high EPS and debt to equity ratio; therefore I will use it in the example. I will also use General Electric (GE), Ford (F), Conoco Phillips (COP) and Yahoo (YHOO).
A few stocks in the Dividend Champion articles interested me, however their yields were below 3%, their stock prices were high and I’m not overly interested in their industries. The companies are Air Products & Chem. (APD), Stanley Black & Decker (SWK) and a Dividend Challenger: Rock-Ten Co. (RKT). So I am going to Morningstar and looking for funds that hold their stocks or bonds. Here are their shareholder pages:
I also just looked up each companies’ key statistics on Yahoo! Finance, they all have far more debt than cash. For this reason I am going to cut Rock-Ten, and since I see SPDR S&P Dividend (SDY) is a top holder of both Air Products and Black & Decker stock I will add SDY to the stock fund example.
I also want exposure to some big names like Hershey (HSY), Nike (NKE), and / or Disney (DIS). You can pick companies you believe are equivalent to these types of big brand name companies. I’d like exposure to one of their stocks and one of their bonds, so again I am going to Morningstar’s shareholder pages.
- Vanguard Dividend Appreciation ETF (VIG): owns 4.8M shares of Nike
- iShares Barclay’s Intermediate Credit Bond Fund (CIU): holds Hershey and Nike bonds (I do not particularly like the $110 price on this fund, though I will use it for the example.)
For the mutual funds I am going to pick one stock fund and one balanced mutual fund:
- American Century Heritage Investor (TWHIX)
- Dodge & Cox Balanced (DODBX): Dodge & Cox is only rated 3 stars, however it is one of the best performing balanced mutual funds YTD. DODBX has a transaction fee at some brokerages, it could be substituted with a similar fund without a transaction fee.
For the high yield bond funds I am going to use:
- SPDR Barclay’s High Yield Bond ETF (JNK)
- PIMCO High Income (PHK)
- Vanguard Total Bond Market ETF (BND): For more exposure to investment grade bonds, like Wal-Mart’s
|portfolio size||stocks||stock fund(s)||mutual fund||bond funds||cash|
You might notice I added several positions to the larger portfolio:
- Microsoft stock (MSFT)
- iShares S&P 500 Value Index (IVE)
- iShares S&P 500 Growth index (IVW)
- Loomis Sayles Bond Retail (LSBRX)
- Lazard U.S. Realty Income (LRIOX)
- T. Rowe Growth Stock (PRGFX)
- Vanguard Wellesley Income (VWINX)
- USAA High Income (USHYX)
- Western Asset High Yield Opportunity (HYI)
- Calamos Convertible & High Income (CHY)
- BlackRock Strategic Bond Trust (BHD)
- BlackRock Core Bond Trust (BHK)
The American Century fund has a $2,500 minimum in IRAs, however I used it anyways in the example. The percentages in the original template do not line up exactly with the example portfolio above. However, I have not changed the percentages in the template to match the percentages in the example portfolio, so you can see the differences. Likely you will encounter similar differences if you set about drawing up a template, then go to actually invest. Each investor will find areas that interest them, and work for them within their own portfolios.
I prefer exposure to investment grade bonds and high yield bonds, though in the smallest portfolio I chose two junk bond funds. In reviewing funds for the larger portfolio I found the two BlackRock funds; they appear to have high yields, BHD’s is 6.9% and BHK’s is 5.9%. I plan to do further research to decide whether I will add them to my collection of BlackRock ETFs.
Now I will make a similar chart for a non-IRA, I will use a few different stocks and funds; however I will use Berkshire Hathaway again in some of the portfolios. I will also add:
To find tax exempt funds I am simply Google searching “tax-exempt ETF” and “high yield tax exempt ETF.” I picked Vanguard High Yield Tax Exempt mutual fund, though it has a $3,000 minimum, Vanguard is known for very low expense ratios. I have also added:
The funds that top the Google search list of high yield tax exempt ETFs include:
I will also include a fund I invest in, DTF Tax Free Income (DTF) and some more funds I find while researching.
Please keep in mind most investors ultimately want more exposure to stocks. Top businessmen like Warren Buffett believe in no allocation to bonds at this time, because interest rates are so low. Though I would not rule out conservatively investing in stocks and bonds currently. You can direct fixed income, from bonds, to stocks over time.
So, it is important to be mindful of the current market levels and keep cash on hand for times when better opportunities may present.
|portfolio size||stocks||stock funds||mutual funds||bond funds||cash|
Remember in the non-IRA the point of the smaller portfolio is to build up enough to buy a mutual fund. There are some that have $1,000 minimums in non-IRAs, such as Sextant Growth (SSGFX) in fact this portfolio could consider Sextant Core (SCORX) when it has $1,000 available to invest. In order to build up cash an investor can set their income funds to pay cash. You could also consider adding $50 – $100 a month to your non-IRA, or whatever you can comfortably afford for investment purposes.
Even though stocks are taxable when they pay dividends, or are sold for profits — long or short-term capital gains — if they can outperform their fixed income counterparts the profit after taxes is the goal. Remember it is important to decide whether you want to reinvest your dividends or have them pay cash, many long-term investors reinvest their stock dividends.
Here are the additions to the larger non-IRA portfolios.
- Coca-Cola stock (KO)
- Pepsi stock (PEP)
- Apple stock (AAPL)
- Vanguard REIT Index ETF (VNQ) taxable
- USAA Tax Exempt Long-Term (USTEX) tax exempt
- T. Rowe Price Capital Appreciation (PRWCX) taxable
- Vanguard Wellesley (VWINX) taxable
- Individual Muni. Bonds – Your pick of in state bonds; look for credit rating, yield and duration that works for you.
- Nuveen Municipal Value Fund (NUV)
- Western Asset Muni High Income Fund (MHF)
- Eaton Vance Muni Income Trust (EVN)
Given the current run-up in stocks I actually recently sold a high yield tax-exempt income mutual fund, and replaced it with a mutual fund with more exposure to stocks. Though my hope is to reacquire muni. bond funds in that non-IRA over time.
Slow & Steady
Hopefully you see the importance of mutual funds in these examples. I have noticed since mutual funds require more to begin with, if the market is favorable they can generate more profit. If the market goes in the other direction, they should accumulate more shares.
When starting a new portfolio, keep in mind you absolutely do not need to get everything at one time. If you keep a list of potential investments you can wait and look for a better entry point. Though the market has run-up in the near-term, it is prone to weakness and swings in both directions. In the past 20 years the market has tended to fall in proximity to major elections (transitions of power) for instance.
Instead of not allocating to bonds at all currently I believe in proper allocation. Ideally a bond fund that is well managed will continue to invest in newer bonds in the future. For instance Vanguard Total Bond Market ETF holds nearly 50M Wal-Mart bonds due between 2014 and 2015, so it is possible the fund managers will take those proceeds and invest into newer positions by 2016. If rates are back up by that time, the fund may be able to acquire new investment grade bonds with higher coupons.
Simply put bond funds may not be ‘get rich quick’ investments, though they have long-term potential. All too often the person who goes for the supposed ‘get rich quick’ promotion doesn’t realize until it’s too late, the only reason something may be advertised as such is to try to benefit the promoter at the expense of the person who gives them their money.
Building a large source of dividends and income may not be as easy as rolling a giant snowball. However the concept is the same, an investor can start with a small amount and try to build it into something much bigger. Keep in mind there is a lot more to investing than can be covered in a single article or conversation, companies can look great and literally disappear over night, this is why I like diversification. Some investors are more successful than others, however one of the truths of investing is that long-term investors tend to outperform short-term investors, on average. Whereas the short-term investor might try to throw even more money than they have into a single bet; the long-term investor can exercise more patience and use a more deliberate approach, having to consider whether a potential investment will fit into their overall portfolio for many years; not a few hours or a few days.
If you have any comments on strategies for building IRAs or non-IRAs please leave a comment below.
Disclaimer: This article is not a recommendation to buy or sell, the examples herein are for educational purposes. Please consult a financial adviser to determine proper allocations (if any) to meet your financial objectives. I am long AMZN, BRK.B, COP, GE, F, FB, GILD, GLW, KO, MSFT, PEP, PETS, WMT, YHOO, VNQ, VNQI, VTI, BND, PHK, DTF, HYI, CHY, WVALX, TWHIX, LSBRX, LRIOX, VWINX, USHYX, SCORX, USTEX, PRWCX, and VBINX. I am now long PRGFX and BHD. I am considering MMM, PFF, EVN, JPS, IVW, IVE, DODBX and SDY.