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Weekend Investor: Protect Your Principal Now

October 10th, 2010 Leave a comment Go to comments

In the Income Portfolio, we have different types of investments that each in their own way deserves a place in your portfolio. Some of these investments become more or less attractive because that’s the way the market functions: some investments become over valued while other become undervalued.

Over the long term, you want to primarily be invested in common corporate stocks and other equity investments because they tend to do better compared to bonds and other types of debt. We don’t have bonds in the portfolio, but we do have a good chunk of preferred stocks which act a lot like bonds.

Here are the main points about equity investments:

  1. Equity gives you ownership of profits. Profits tend to go up over time, so equity prices follow.
  2. Equity gives you a stake in the dividends or other income that is produced by the business. As profits go up, dividend income tends to go up as well.
  3. The investment rides with the business, which can be both great (growing) or terrible (decay).

Here are the main points about debt investments:

  1. Owners of debt usually don’t get (or expect) significant capital appreciation.
  2. The amount of income offered is either fixed or tied to some target financial rate; therefore, it is not linked to the underlying business and therefore has no huge upside potential that equity owners get.
  3. The investment doesn’t ride with the business, in most cases a poorly performing business (but still viable) will pay its debt holders. Equity holders may be left holding the bag.

So when you look at each of these points, you see that each type of investment has its own advantages and disadvantages. Today, I want to talk about another way to take advantage of the attributes that debt instruments have: using the limit on capital appreciation (point #1 above) to protect your principal in equity investments.

What To Do When A Stock Is Overvalued

In short, what I mean is that you take an overvalued common stock, sell it and roll the proceeds into a preferred stock, or other kind of debt. Here’s why this is a good idea:

  • Equity prices do go up over time, but at times they become way over valued. When you sell you are locking in that high value profit.
  • When you roll the proceeds to an investment grade preferred stock, you still make money but because the principal value of the preferred stock will not likely be as volatile as the common stock. The expectation is that the common stock will not be able to maintain the over-valuation.
  • When the common stock comes back to a more normal valuation, do the reverse swap.

Example: Realty Income (O)

Realty Income (O) has become richly valued; it is now about 18X cash flow. The dividend yield on the stock is now about 5.0%, below its long term average. Realty Income’s preferred stocks (O-D and O-E) are each yielding between 6.5% to 7.0%. So, from an income point of view you will make more money with the preferred while the common “catches up”. It’s possible that when you combine capital appreciation, the common could catch up – but, that would require a higher sustainable price when the stock is already pretty expensive.

By swapping the common for the preferred, we get more income immediately while presumably taking less risk of principal loss.

The great thing about investing for income is that we don’t have to do anything because no matter what we still make money holding our positions now. So, another approach would be to put any new money into the preferred instead of the common stock.

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