Here’s The Difference Between A Real Estate Correction And A Crash





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Vast tomes have been written about the investing prowess and legendary success of Warren Buffett.

And it's not hard to see why the man is revered as the "Oracle of Omaha" because literally no one in history has managed to achieve long-term results such as these:

  • Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has generated 20.8% annual returns over the past 50 years vs. S&P 500's 9.7%.
  • Buffett's personal track record over the last 72 years (since age 15) has been 25.5% CAGR vs. S&P 500's 11.2%.

Of course, Buffett's ability to turn $6,000 in 1945 into $75.6 billion today included periods where he was buying some very esoteric investments, as well as decades of running investment partnerships and making deals that regular investors can't duplicate.

Which is why my goal here isn't necessarily to exactly recreate Buffett's empire, because no one can do that. Rather let's take a look at what we can learn from the master to see how we can optimize our own investing style and hopefully become financially independent so that we can live our dreams.

Dissecting The Master's Method

A 2013 study by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen in a collaboration between the New York University, Copenhagen Business School, and AQR Capital Management found some important factors to Buffett's amazing success.

The study found that Berkshire Hathaway had achieved a 30-year Sharpe ratio (total return/standard deviation-risk free rate of return) of 0.76, greater than any stock or mutual fund (over a rolling 30-year period) that's traded between 1926 and 2011. It was also nearly double that of the overall stock market.

In other words, Buffett is truly the king of risk-adjusted total returns. But how exactly did he accomplish this?

The researchers found several key factors that have helped Buffett to become the greatest investor in history. Specifically, a portfolio dedicated to stocks that were:

  • Safe (low volatility)
  • Cheap (undervalued)
  • Dividend stocks (stable, growing, cash rich businesses with above-average dividend yield)

In addition, Buffett has historically used about 1.6 to 1 leverage, which is a modest amount that is capable of withstanding even incredibly violent market crashes on the order of 50% to 54% (as seen in both 2000-2003 and 2008-2009).

Each of these factors have been shown by numerous other studies to indeed result in additional alpha (as do small cap stocks), meaning market-beating total returns.

In other words, Buffett's strategy is to start with a list of high-quality dividend growth stocks, then wait until they are undervalued, and then buy them for the long-haul (buy and hold forever unless investment thesis breaks), and use the max amount of safe leverage to boost his returns to their highest potential.

Of course most of Buffett's leverage is courtesy of free insurance float, which means that any investor attempting to recreate this system will need to do everything possible to minimize their borrowing rates.

Ok, so now that we understand the basics of how Buffett became the greatest investor to ever live, let's see how we can apply it to the world of retail investing.

My Investment Philosophy

Note that this article is in no way offering personal financial advice. Everyone's investing needs are different and what follows is merely the long-term investment strategy that works for me, based on my personal, and unique time horizon, risk profile, and investing temperament.

It's important to realize that no single investment strategy will work for everyone. You need to consider your own needs, goals, risk profile, and most importantly, temperament (how do you feel about a 50% market crash? Can you be "greedy when others are fearful"?).

So here's my investment profile:

  • Goal: Primarily income, and secondarily total returns
  • Time Horizon: 50+ years (i.e. likely won't ever need this money to live on)
  • Risk Tolerance: Very High (I yearn for a 50% market crash)
  • Temperament: Value, Contrarian, i.e. I'm happiest when markets are falling and love "catching falling knives"

Because of my unique personal situation, i.e. medically retired from the Army, with a moderate pension ($1,680 per month) and free VA healthcare, technically I never have to work again.

Of course, the reason I went into military medicine (goal of becoming Army trauma surgeon) was to serve society and try to maximize my potential by helping to save the world.

So, now my career is dedicated to helping teach the world to invest better by spreading the gospel of long-term, value focused, dividend growth investing.

In addition I hope to become rich enough to join Buffett and Bill Gates in eventually (50-75 years from now) signing the giving pledge (along with 166 and counting other billionaires) and donating at least 50% of my wealth to charities (over time) that I am passionate about. Right now the number one charity on my list is GiveDirectly.

In addition, because I've spent several years in soul crushing poverty (literally couldn't afford to eat for a month), I've learned to be happy while being pathologically frugal, much like Buffett who never spends more than $3.17 for breakfast at McDonald's (NYSE:MCD) (my favorite restaurant is Wendy's (NYSE:WEN)).

In other words, like Buffett, I'm obsessed with making money, having money (because being poor and living in financial insecurity SUCKS), and managing money, but prefer not to spend it on myself.

This gives me a very long-term focus, because my ultimate goal, to put it bluntly, is to become an immortal (Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Calico subsidiary is working on reversing aging and curing death) billionaire philanthropist and literally help save the world (obviously I don't lack for ambition).

Which means that my approach to money is:

  • Money is a tool so you need to have a plan for how to put it to good use
  • You need enough to feel secure, but what matters is mainly experiences with family and friends (the ultimate source of happiness)
  • The most valuable thing about money is financial flexibility and freedom from fear (can't be happy if you're worried about starving)
  • The world is a scary and uncertain place, so you can never have too much money
  • To help alleviate the world's problems (i.e. bring about Star Trek Utopia) will cost a mind-boggling amount, and take centuries or even Millennia
  • So let's get to work on building that charitable trust/philanthropic empire ASAP

Ok, so that's me, and my goals (i.e. life quest) in a nutshell. But how exactly do I plan to become this uber plutocrat philanthropist king?

Introducing Dividend Sensei's EDDGE 3.0 Investment System

Since 1871, the S&P 500 has generated a 9.1% CAGR (6.9% adjusted for inflation) turning a $10,000 investment back then into about $3.2 billion today ($165.4 million adjusted for inflation).

Buffett himself has stated that for the vast majority of investors, a low-cost S&P 500 index fund is the best default option. And given that I'm the world's laziest workaholic, I tend to agree that if you can't beat the market over time, there is no sense in stock picking.

After all, each investment requires a substantial amount of due diligence, and you have to keep track of holdings.

That's why every stock I own is one that I expect to earn 10% or greater, unlevered total returns over time.

Fortunately, determining which stocks meet this criteria is relatively easy, given that studies show that over the long term, total returns for dividend stocks generally follow the formula yield + dividend growth.

Now, given my personal experiences with a lack of liquidity (i.e. Venezuela like starvation and poverty), my first priority is high income, but I also want to eventually have very frequent dividend inflow into my portfolio, preferably every business day or two.

Thus the name of my system, the Eternal Daily Dividend Growth Endeavor or EDDGE 3.0 (because this is the third incarnation of this portfolio).

However, unlike EDDGE 1.0, which launched with $200 invested in 200 stocks, resulting in an average daily dividend of $1 to $2, with this portfolio I'm starting from the opposite end, meaning highly concentrated and diversifying over time.

Thus I've funded my Interactive Brokers (NASDAQ:IBKR) account via ACAT transfer of my top five yielding stocks (more on that in a moment).

Now here's how I plan to diversify that over time (to around 100 holdings over the coming years).

I have five categories of stocks in my universe (high-quality names I've spent thousands of hours researching and screening):

Now an important point on MOTUs. Because this is a dividend growth portfolio, I am limiting the max concentration of MOTUs to 10% of holdings and just 5% of invested capital, due to how I weight my positions.

That weighting is dividend yield focused, with a rule of $1,000 initial investment per full yield point, rounded up by 1.

For example, MasterCard currently yields 1.9%. Thus in EDDGE 3.0, I would buy a $2,000 position, rounded up to the nearest share.

Meanwhile, something like Pattern Energy Group (PEGI) with a 6.6% yield gets $7,000 to start.

In terms of buying more, if a stock drops 10%, then I'll add another $1,000, and if a quarterly grower is in my top 10 holdings, then it gets an additional $1,000 every time it raises its dividend.

MOTUs get an extra $1,000 once per year if they grow their revenue by at least 15%.

Of course, because this is a margined portfolio, things get a bit more complicated.

The Details

In my EDDGE 1.0 and 2.0 portfolios, my approach to leverage was to just build out my portfolio and leverage everything by 1.6 across the board.

However, that resulted in a frustrating problem, mainly that whenever the market would present a great buying opportunity, such as a stock falling 5% to 10% in a day due to missing earnings expectations, or a secondary offering (for MLPs and REITs), I had no dry powder to buy more.

Thus in EDDGE 3.0 I'm limiting my use of margin to purely opportunistic value purchases while cycling through my buy list with my own equity capital.

For example, when I funded my Interactive Broker account (Friday, September 8, 2017), I had $1,453 in cash arrive along with my five high-yield stocks.

So I used that cash to buy the highest-yielding stock in my high-yield category; in this case ARI. Because Apollo Commercial Real Estate has a 10.3% yield, the initial position size is $11,000, meaning that is where I'll be focusing all my savings until I've purchased $11,000 in ARI stock.

After that, I move onto my highest-yielding quarterly grower, Delek Logistics Partners (DKL), which gets an $10,000 initial position.

Then it's onto the highest-yielding monthly payer, Whitestone REIT (WSR), followed by the fastest growing low-yielder, MercadoLibre (MELI).

MOTUs get added one at a time when I hit the next 10th position number, so at 10 positions, 20 positions, 30 positions, etc.

That's how I plan to deploy my capital. As for the leverage, well, that's where the contrarian value focused part of the portfolio comes in.

I'm maintaining all margin in reserve for when the market gets crazy, such as if an already undervalued stock such as Qualcomm (QCOM), or Disney (DIS) falls 5+% in a day on non-thesis breaking news (as recently happened).

The same goes with black swan events, including WSR's 5% drop the Monday after Hurricane Harvey hit, because 2/3 of its malls are in Texas.

Or how about Equifax's (EFX) bombshell revelation that it got hacked, causing the share price to plunge by 18% at the open the next day.

Similarly, with Brexit, the entire market crashed for two days, creating bountiful opportunities to deploy super cheap margin (2.66%).

Speaking of margin, because I'm a relatively small fish (for now), I'm paying 2.66% for my margin (1.5% + Fed Funds rate). That's actually very good, considering that the broker I came from, Robin Hood charged 5% to 6% and most brokers charge even more than that.

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Source: Interactive Brokers

As you can see, the more you borrow the cheaper the margin becomes, down to as little as 25 basis points + Fed Fund rate on margin between $3 and $200 million (1.32% currently).

Cheap margin is essential, because remember that Buffett was using insurance float which is basically free.

To help lower that cost even more, I've signed up for IBKR's supplemental yield program or SYP, in which the shares I own outright can be lent to short-sellers and I receive 50% of the margin they pay to borrow the shares.

While the SYP is not necessarily guaranteed income (your shares may not get lent out) and the margin rate on individual stocks varies greatly (from 0.25% to 10%) and changes over time, currently this program has the potential to generate (for my current portfolio) an additional $70 per month or $840 per year.

That's a 10% boost to my dividend income, and more importantly covers my current annual interest cost of $485 by almost two to one.

Or to put another way, at the moment, assuming that my shares do get lent out, IBKR will be paying me, to borrow on margin, to buy highly undervalued stocks opportunistically.

Of course, that's only because I've just started and my leverage is a low 1.27. At a final 1.6, that $840 per year in SYP funds would be offsetting $1,085 in annual interest cost, resulting in a net interest cost of $245 and an effective margin rate of 0.6%.

Not quite free, but darn close to it. Better yet, as I scale up over time, adding more savings and growing my equity and thus borrowing more on margin, I'll be able to borrow at lower rates and hopefully bring that effective margin rate to zero or better.

Particularly during the next recession, the Fed is almost certain to take rates to zero, and during a bear market, demand by short-sellers for shares rises (higher margin on shares lent out), meaning that during a bear market, you can actually attain negative margin rates to go along with the firesale prices on all manner of high-quality, high-yield dividend stocks.

Now a quick note on leverage. I fully realize that it's a double-edged sword, and like fire, a potentially valuable tool that can either cook your food and warm your home, or, if misused, burn it to the ground and kill everyone you care about.

The reason I'm capping my leverage at 1.6 is because with portfolio margin (that will kick in at $110,000 in equity), the 15% margin maintenance requirement allows for a 2008-2009 like 54% market crash while avoiding a margin call.

Thus, the margin capital I'm deploying now on already undervalued and beaten down names should be safe, barring another great depression (which isn't likely given the Fed response to preventing one during the financial crisis).

But what exactly does EDDGE 3.0 look like today? Given that I have my entire life savings invested in this portfolio, and will continue to do so going forward (like I said HIGH risk tolerance), this detail is rather important.

Portfolio Today

Initial ACAT Transfer

Stock

Category

Position (Shares/Units)

Value

% Of Portfolio

New Residential Investment Corp (NYSE:NRZ) High-Yield 914 $14,935 22.1%
Genesis Energy (GEL) High-Yield/Quarterly Grower 549 $14,701 21.7%
Golar LNG Partners (GMLP) High-Yield 609 $13,144 19.4%
Uniti Group High-Yield 651 $12,044 17.8%
Dynagas LNG Partners (DLNG) High-Yield 831 $11,425 16.9%

Source: IBKR account

As you can see, I funded the portfolio with just five high-yield stocks, exclusively Midstream MLPs and REITs.

Then, on Friday, officially day 1 of EDDGE 3.0, it was a busy day of diversification.

Stock

Category

Position

Value

% of Portfolio

Gladstone Land Corp. (LAND) Fast Growth/Monthly Payer 406 $5,014 7.4%
Qualcomm Fast Growth 100 $4,970 7.3%
Kroger (KR) Fast Growth 147 $3,106 4.6%
Equifax Fast Growth 17 $2,105 3.1%
Disney Fast Growth 21 $2,040 3.0%
Apollo Commercial Real Estate (partial position) High-Yield 82 $1,455 2.1%
Tesla (TSLA) MOTU 3 $1,030 1.5%

Qualcomm and Disney I had been watching closely since they were already highly undervalued, and then this week got hit with 5% single day declines (the trigger for opportunistic buying).

Gladstone Land is the gold standard of farm REITs, and recently got the Brad Thomas stamp of approval. A secondary offering caused it to fall 5%, so I scooped some up.

Kroger and Equifax were some of the biggest losers of the day, thanks to a disappointing earnings report for Kroger (that actually beat expectations) and of course Equifax's giant hack.

While the hack will indeed be a black eye for some time, I'm confident that EFX will survive and continue to generate double-digit dividend growth for the foreseeable future.

Apollo Commercial is where I'm currently deploying my savings, and Tesla? Well, it's a MOTU play based on my confidence in Elon Musk's optionality ability, specifically that the company's future business will be dominated by a subscription Tesla robo taxi service.

The reason I went with Tesla first, ahead of other, and arguably less overvalued MOTUs such as Alphabet, Amazon, and Alibaba (BABA), is I wanted exposure to the ramp up of the Model 3.

So, as of the end of Friday, September 8th, this is what EDDGE 3.0 looks like:

  • Portfolio size: $85,967.95
  • Equity: $67,723.70
  • Margin: $18,244.05
  • Leverage Ratio: 1.27
  • Annual Margin Cost: $485.29
  • Annual Dividends: $8,514

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Source: Simply Safe Dividends

  • Annual Net Dividends: $8,029 (avg. of $669 per month, $33 per business day)

As for the portfolio itself?

  • Total Positions: 12
  • Yield: 10.17%
  • Yield on Cost: 9.84%
  • Price/Fair Value: 0.83
  • Weighted Beta: 0.92
  • Projected Long-Term Dividend Growth: 5.78%
  • Projected Unlevered Long-Term Total Return: 15.62%
  • Projected Levered Total Return (leverage 1.6): 24.39%

Note that when it's finally complete, I anticipate that EDDGE 3.0 will have a 5% to 6% overall unlevered yield, with 10% to 11% dividend growth. Assuming 1.6 leverage and a long-term net margin rate of 1%, that should, at least theoretically, result in total returns of about 24.6%

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Source: Morningstar

As you can see, the portfolio is currently deeply concentrated in deeply undervalued small-cap value stocks and in the MLP and REIT sectors. That is by design. My investment strategy is to be bold, and buy what's most on sale, regardless of how concentrated that makes me.

Right now, REITs and MLPs offer some of the best bargains on Wall Street, so I intend to buy bucket fulls of quality dividend stocks with both hands if and for however long the opportunity lasts.

And while the weighted beta of 0.92 indicates that the portfolio should be less volatile than the S&P 500, I know from experience that small-cap REITs and MLPs, being both rate sensitive and prone to market freak-outs over oil prices, can be ludicrously volatile.

However, I am more than prepared for that, having already lived through numerous market crashes (while remaining invested), including:

  • Tech bubble bursting (life savings down 50% at one point)
  • 2008-2009
  • Oil crash (spent 18 months accumulating all the way down)

And while not a crash per say, in the first three months of August, I saw my portfolio decline by 12% in three weeks (oil prices fell hurting MLPs). Not a fun experience, especially since I was preparing to move brokers and launch this portfolio so was unable to fully take advantage of that buying opportunity.

However, now I'm fully up and running, and am salivating at the opportunity to fully embrace my contrarian nature. Bring on the overdue market correction!

Finally, a note on those projected returns (close to Buffett's 72-year 25% CAGR record).

I'm sure that such projections sound crazy to many, and will probably result in plenty of howls of protest, peals of laughter, and guffaws from some readers.

Let me be very clear that I am not actually predicting that I can get anywhere close to those returns, especially in the short-term.

After all, this portfolio is essentially an experiment built around models constructed from numerous studies spanning decades of market data.

However, as we've seen countless times on Wall Street, models are imperfect, and money printing strategies can work until they don't.

Which is why I always keep in mind the immortal words of Yogi Berra:

"In theory there is no difference between theory and practice. In practice there is."

In other words, models and backtests are great for creating a logical investing system that's tailored to your needs. But at the end of the day, all such systems are based on past performance, and 100% of profits are generated in the future, without the benefit of hindsight.

Which is why I'm excited to share this journey, part of a lifelong learning experience for me, with my readers, in real time, with real money, and real excitement.

I'm sure it's going to be a thrilling ride going forward.

The Plan Going Forward

My plan for EDDGE 3.0 is to do relatively short weekly updates, assuming that I bought or sold anything that week.

Each month I plan to do more detailed articles highlighting some of the stocks I'm adding, specifically why I consider them a strong long-term buy.

And finally once a quarter, I'll do a detailed (like this article) look at how the portfolio is actually performing.

The Bottom Line

Don't get me wrong, I'm not declaring myself the next Warren Buffett, nor am I saying that I expect to match or even beat Buffett's results.

However, I do believe that with careful planning, tight discipline and risk management, and a dedication to long-term, value focused, buy and hold investing in dividend growth stocks, it is possible to achieve stunning long-term investment success and become financially independent.

So join me on what I hope to be the adventure of a lifetime, and a very educational and profitable journey for both of us.

Disclosure: I am/we are long NRZ, GMLP, DLNG, UNIT, GEL, KR, DIS, EFX, TSLA, LAND, ARI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source : https://seekingalpha.com/article/4105569-buffett-inspired-real-money-high-yield-dividend-growth-portfolio

Here's My Buffett-Inspired Real Money, High-Yield, Dividend Growth Portfolio
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