Tax Efficiency

I figured a little reflection was the order of the day as we recently completed tax season in the US, and yes, I had to pay for the first time in years. My initial take was Trump’s tax law did no favors to those of us on fixed incomes – rather tilting the scales to benefit the wealthy and to a lesser degree the working class – though there were winners and losers across the board. In preparation for next year’s fiasco, I’ve been attempting to ascertain some of the intricacies of the changes. Previously, I opined on the foreign tax credit remaining in place. Today’s revelation potentially turns conventional wisdom on REITs on its’ head.

Sage advice has typically been – with a few exceptions – REITs are best held in tax advantaged accounts, like IRAs. The new tax law adds a few wrinkles to this concept, which Justin Law outlines nicely. The essence of his piece is that Section 199A distributions now have a 20% deduction which may warrant a review how tax advantageous REITs are in ones tax deferred versus taxable portfolio. DGI darling Realty Income (O), recently reviewed by Tom at Dividends Diversify, could well be a poster child for this type of analysis as last year’s payouts were 77.1% Section 199A and the remainder Return of Capital. The delay in this week’s post was due to some difficulty in completing a review of the fourteen REITs in my portfolio.

Two of my REITs were excluded from this analysis as I have them classified as probable sales, Uniti as their dividend cut was likely a debt covenant issue and Lamar as their IRS reporting is not straightforward (the corporate filings differ from the filings on the shareholders’ behalf). As all of my REITs are in taxable accounts, using Justin’s generic template, they were first ranked by the new Section 199A exclusion.

  1. American Tower (AMT) 99.68%
  2. EPR Properties (EPR) 95.94%
  3. Washington RE (WRE) 91.89%
  4. Outfront Media (OUT) 86.10%
  5. Iron Mountain (IRM) 83.04%

The next tier combined Qualified dividends and Cap Gains as their tax treatment is similar (and not onerous):

  1. Duke Realty (DRE) 22.59%
  2. Kimco Realty (KIM) 18.29%
  3. Prologis (PLD) 17.33%

The one tier I need to keep an eye on is the Return on Capital with Vereit (VER) 86.17% and Crown Castle (CCI) 34.39%. This part of their distribution is tax deferred until sold or the cost basis reaches 0.

The ugly tier is the Section 1250 gains with a 25% tax rate.

  1. Spirit Realty (SRC) 49.2%
  2. Spirit MTA REIT (SMTA) 21.2%

I consider this to be a one-off due to the spin of SMTA from SRC. Kimco (26.94%) could fit in this category as well although my sense is that their portfolio repositioning is the culprit, but there are opposing views to mine.

Bottom line, I’m willing – even eager – to pay taxes. Yet the rules of the game reward those able to minimize the government’s share. While the key resides in understanding the nuances of the rules, I say, “Seek the rewards and let the games begin!”

Advertisements

My World of Banking

A comment thread on a recent post cornered part of my thought process recently.  I realized that I was assuming a baseline of knowledge of the audience.  For newer readers and newer investors, my apologies.  To that end, the questions raised by doptionsseller are worthy of greater elaboration.  I won’t dive into the history as the basics are generally known to all – The Financial Crisis decimating the industry from which new regulations were formed.  Regardless of your personal view on regulation, I’ve found over the years that with an understanding of the rules the game can be played more advantageously.  The following details a portion of my thought processes and the evolution my strategy has experienced.

THE TARP YEARS

In 2009, the FASB changed the rule on mark-to-market accounting with the result being renewed investment in financial institutions.  In 2013, I started reinvesting in the sector with banks that refused TARP – taking security over uncertainty.  All the while I kept my eye on the TARP recipients and in 2015 began investing in some that had repaid the government.  I also looked at some that were unable to repay but shied away as the bulk of the paper was auctioned by the government to hedge funds, one being Hildene’s Opportunities Growth Fund II.  

Some, like Blue Valley Ban Corp (BVBC), bought out the hedge funds preferred stock due to relatively onerous terms (5% rising to 9%).  In recent news coverage, they’re laying claim to victory.  While I concur great strides have been made, they still don’t pay a dividend and have a looming balloon payment due in 2020 (on a current 5.25% variable rate note).  In my opinion this is a company limping along the right path but looking over their shoulder for the next economic downturn.  Others have yet to repay the respective funds.  Either way, this space carries more risk than I’m willing to bear. 

Dodd-Frank Stress Tests (DFAST)

With the advent of DFAST, I realigned my methodology to conform with these standards with conventional wisdom being consolidation was a foregone conclusion.  The ranges being assets < $10B, $10-50B, $50-250B and $250B and over.  In 2014  most of my investments were in the $10 – $50 range.  As I realized banks had real costs associated with breaking the $10B barrier, in 2015 I migrated more into smaller asset sized banks.  The one rule I have (which I’ve broken a few times) is that a dividend is paid to compensate my patience.  This bucket is the majority of my bank holdings.

Mutual Conversions

In late 2015 I found another investing angle.  Similar to an IPO, thrifts converting to stock companies are called 2-step conversions.  The first being the sale of stock to their depositors and the second a conversion to a full stock company.  Flush with cash, I’ve seen minimal downside.  Patience is required as there is a three year wait (by law) before they can be acquired.

Courtney over at Your Average Dough invests in some conversions but takes it a step further by becoming an account holder first.  Trickier but more lucrative if you guess right.

Arbitrage

Another opportunity is subsequent with an merger announcement.  There are times when analysts waffle on their decision to recommend – or not.  BOKF’s recent acquisition of CoBiz is one example.  It was two days before analysts determined it was a good deal.  Meanwhile I picked some up before the price went up.  Cautionary note: The reverse can be true as well.


As you can see, there are multiple ways to play the game and my approach has changed with the times and as my knowledge/experience increased.    This type of investing is not for everyone either.  Only a portion of my portfolio is handled in this manner.  But if success arrives the gains can be stellar!

 

Uh-Oh …

In last weeks’ post I shared that effective January, my portfolio will experience two dividend cuts.  Based on how my holdings are structured, the overall impact will be a but a blip.  The greater hit is to my pride.  Other than M&A or spinoff activity, never have I experienced more than one cut in a year.  This, my friends, is with forty years of investing under my belt.  And now we have two announcements in the span of one week.  Also (and perhaps warranted), The Dividend Guy published a piece that essentially says that, “hey, I might have screwed up on OZK but at least I never invested in these dogs”.  Like yours truly.  Happy fifth year to you bud and let’s see if that record holds for another thirty.

Seriously though, the GE and OMI situations can’t be any more different.  The only commonality is the cut.  The Dividend Guy mentions a couple of others as well – which I don’t own.  I continue to be suspicious of the real strength of the overall economy as MAIN also announced a revision to their dividend policy (though not directly a cut).  As an investor looking toward dividends, if this is the beginning of a trend it may be time to pare some of the speculation and migrate towards a more conservative posture.

Meanwhile, in these types of circumstances I feel compelled to share my reasoning and anticipated reactions.

Owens & Minor (OMI)

I have to concur with Dividend Guy’s observation earlier this year that this was “dead money”.  I pretty much reached the same conclusion when I reduced my holdings by about 20% in 2015.  I was content with the minimal dividend growth due to their stellar track record.  The sea of change began in earnest in 2017 with fears of the Amazon effect.  Then a couple of losses to competitors (one being CAH).  Current pressure is hitting them on at least two fronts: the trend for hospitals to in-source and the ability to pass on increasing costs.

Being a patient investor I could accept all of the above and even a frozen dividend as they sort out the issues.  But an unexpected cut of this magnitude leads me to believe there is another shoe to drop.  Obviously I’m not alone in this concern on the earnings call, an analyst from Robert W. Baird & Co. asked the operative question, ” … And how comfortable are you with the covenants at this point on the debt position?”  Last time I saw this question was when Orchids Paper (TIS), another former DGI darling, was in their free fall.  I still like OMI’s logistics but they failed to capitalize on the head start they enjoyed prior to this advantage becoming a commodity. 

OMI accounted for 3.46% of my 2017 dividends received and through 3Q 2018 had been reduced further to 1.89%.  As this is an IRA holding I’m limited in the loss realization but intend to sell after ex-dividend and replace with a Canadian stock (with no tax withheld in IRAs).  I suspect my Q1 2019 numbers will see minor impact in the Y/Y growth.


General Electric (GE)

On GE, Dividend Guy’s analysis matches mine, hands down, purely from a DGI perspective.  GE, however (in my view) never regained their prior glory when the financial crisis exposed their warts.  There is but one reason to have GE in a portfolio and it’s not the dividend, it’s corporate actions – which include things like spinoffs (which were the subject of one of my muses).

As this type of approach is speculative in nature, it pays to be mindful of the weightings.  In my case, GE has ranged from 0.05% – 0.07% of total dividends for the past two years.  My self-imposed maximum for speculation is 1% per issue.  Therefore, I’m well within my targets.

So I consider this similarly to a currency trade where GE stock is the fiat.  The wild card is the exchange rate when the spins are finalized.  Best case is that GE is now fairly or under valued, in which case pending actions will be in my favor.  Worst case I get a unfavorable cost basis that reduces (under current law) my tax basis.  Therefore with minimal downside (unless GE goes belly-up) I intend to increase my GE holdings (once the price settles) to the nearest round lot and await the spins.


Therein lies my strategy for dealing with these events.  I’ll attempt to follow the adage: When life gives you lemons, make lemonade!

Work Freedom Day

Once per year – assuming a static or growing portfolio – the day arrives where current year dividends paid exceed the prior years’ total dividends.  For me, yesterday (October 19th) was the day.  Now the term, coined by Dividend Life in 2014, is a little bit of a misnomer as I don’t work but the concept is applicable.  This compares favorably with last year (October 25th) but still shy of my all time best (in retirement) of October 4th in 2016.  The improvement this year is largely attributable to Tax Cuts and Jobs Act which resulted in increased regular and special dividends.  Whether this is a one-off or sustainable remains to be seen but as my mother was fond of saying, “Don’t look a gift-horse in the mouth.”


I’ve been noodling over an article for awhile – one of those that need to be absorbed in doses.  I see bits and pieces of me across all levels, but probably a three – maybe a four.  The relevance?  In a recent post (9 Sep) I stated:

Bank OZK (OZK) has had some curious moves of late with a costly name change and repositioning from federal to state oversight. These, along with their increasing exposure to high value CRE gives me pause.

Obviously the esteemed Jason Fieber is not among my handful of readers as he initiated a position on 1 October citing:

There are some concerns over its loan portfolio (when are there not concerns about a business?), especially seeing as how the bank has aggressively moved into construction lending in recent years. This tiny bank is behind some of the biggest projects in some of the biggest markets in the US.

But these concerns seem to be more than priced in. It’s almost as if the last four years of growth are worth nothing. Of course, growth could, and likely will, slow in the new construction market. And sticking to strict lending standards means opportunities might dry up.

The market’s (and my) concerns were that “strict lending standards” weren’t consistently followed.  Fast forward to Thursday’s earnings report:

On July 16, 2018, the Bank changed its name to Bank OZK, changed its ticker symbol to “OZK,” and adopted a new logo and signage, all as part of a strategic rebranding. As a result of this name change and strategic rebranding, the Bank incurred pretax expenses of $10.8 million during the third quarter and $11.4 million for the first nine months of 2018.

During the third quarter of 2018, the Bank incurred combined charge-offs of $45.5 million on two Real Estate Specialties Group (“RESG”) credits. These two unrelated projects are in South Carolina and North Carolina, have been in the Bank’s portfolio since 2007 and 2008, and were previously classified as substandard. The combined balance of these credits, after the charge-offs, is $20.6 million.

The CRE issues are centered on two projects in the Carolinas, one a mall with Sears exposure.  I have no conviction that these are one-time issues.  Much depends on the economy and the hurricane related recovery in this area.  Yet I couldn’t resist the the opportunity to average down yesterday on the 26% price drop.  So yes my crystal ball worked this time, but no I didn’t sell in September, nor did I short.  Which is why I may not be a Level 4.


Inspired by Catfish Wizard and Jim Cramer’s Power Rankings, this weekend I’ll add the 2019 DGI Picks by Sector as a Menu Item (fun and games only!).  If you’d like to be included, submit your top pick for each sector.  I’ll probably recalibrate the results around Thanksgiving to provide a level playing field.  🙂

Bank Strategy – 2017/2018 Review

During the 2007/2008 financial crisis, bank stocks were one place many investors fled from – like herds of lemmings.  I can’t say this was unreasonable as these companies sustained blow after blow – some deserved and some not.  When a company such as Lehman collapses,  mortgage  GSEs are federalized and mortgage lending comes to a grinding halt one has to consider the Chicken Little scenario – is the sky really falling?  From this systemic failure emerged a new dawn on the heels of legislation, notably Dodd-Frank.  Though far from perfect, this bill in 2010 established a floor from which the system could be rebuilt.

To paraphrase Warren Buffett, my view was this fear and dysfunction presented an opportunity.  With the dust beginning to settle, in early 2013 I dipped my toes back into Financials.  With the exception of Prosperity Bank (PB), which I classified as a Core position at that time along with a few others, these holdings – peaking at about 32% of the total portfolio in aggregate – didn’t exceed the 1% threshold individually.  Financials currently hold 29.9% and are trending down.  Truth be told, this group did provide the octane enabling my portfolio to consistently exceed the benchmark.

The Dividend Diplomats employ a similar small bank strategy but our approaches differ.  Whereas their baseline is the dividend screen process, I rely more on size and geography.  This is due primarily to embedded distortions in a TARP (and post-TARP) world as well as historical factors regarding bank failures.  For example, Lanny’s Isabella Bank purchase wouldn’t make it onto my list as I consider Michigan banks inherently risky due to the number of failures within the state during the last crisis.  You could posit a macro versus micro view in our perspectives.

Since I began this strategy I’ve periodically reported my results with my 2015 and 2016 reviews.  I was remiss earlier this year as the pace of significant mergers decreased in the post-Trump world.  This activity is now accelerating due to two factors, I think.  The first being the Dodd-Frank modifications enacted in May making it less onerous for banks of a certain size to combine.  The second being rising interest rates.  This one is less obvious as rising rates should be a boon to banks.  However, the spread between long and short rates is compressing (perhaps inverting soon?) which is where much of the profit is derived.  So the results, please?

Bank Strategy
YEAR TTL FULL PREM REVERSE % NOTES
2014 6 1 2 21.9% 41 positions
2015 16 3 0 38.7% 49 positions
2016 8 2 0 13.8% 58 positions
2017 16 1 0 25.8% 62 positions
2018 15 5 1 19.23% 78 positions

Note: through 7 Oct 2018

Of interest is that the majority of 2017 was mostly a year of consolidation with smaller banks (usually thinly traded or private) being acquired by one of my holdings.  2018 is interesting in that a number of mergers have a cash component which adds to the complexity of determining the ‘real’ valuation resulting in some initial pricing or recommendation assessments by firms on Wall Street.  I bought into two of these before the assessment changed in my favor (resulting in an unanticipated unrealized gain).

Now that this sector is pretty much fairly valued unless some compelling opportunity presents itself I’ll hope for some of the remaining 73 to be acquired and place my cash elsewhere. 🙂

My 3Rs – Revitalize

In the first two posts of this series, I highlighted my thought process in basically the recent past and present.  Today will attempt to bring the investment landscape of the future into focus.  I will be the first to admit that I have a jaded view of the present – i.e., not being aligned with the economic views espoused by the current administration.  The upcoming midterms have the ability to shuffle the deck even further.  The assumption set I used (which easily could be argued with) is:

  • The current administration will continue to be embattled by prior missteps – primarily in vetting – (resulting continuing indictments and guilty pleas)
  • This could be further hampered by loss of one – or both – chambers of Congress
  • I (currently) anticipate no major activity regarding impeachment, 25th amendment or resignation

Basically a recipe for gridlock – which will put the brakes on some of Trump’s more polarizing policies.  Without a Democratic landslide, I don’t see a major rollback but also don’t see further continuation on a partisan path.  Therefore my view is a continuation of trade tensions (notably Canada and China), rising deficits and interest rates resulting in a slowdown in the US economy.  While the economy is currently growing, the metrics I am watching are debt levels (student loan and state government), the inability of rising wages to keep pace with inflation and savings rate.  Though the concerns are endless, a greater domestic focus tends to mitigate much of the risk but bring me to one conclusion: Regular Americans’ disposable income may be in shorter supply next year.

With this theory outlined, it’s time to fit the remaining pieces into my puzzle of a portfolio which allows for roughly 1/3rd allocation to conservative speculation.  Frankly, my outlook is a bet that the US economy has been front-loaded into the midterm elections.  The downside if incorrect is that I’ve added some slower growth positions.  If correct I’ve generated a little alpha.

Tariff Myself

In the spirit of the times, I completed the move of my Johnson & Johnson (JNJ) and Church & Dwight (CHD) positions to M1 Finance.  I plan to add Colgate (CL) as a new position in the near future.  With M1 being a no-fee broker, my intention is to add new funds whenever I purchase toothpaste, mouthwash or deodorant throughout 2019 with the aim for these companies to attain about 2%, 3% and 1% of the portfolio respectively.

Corporate Actions

I intend to ride the M&A wave in addition to selected spinoffs.  I rarely participate in IPOs but do make an exception from time to time.  I continue to add to my banks that have completed two-step conversions.  This month has seen activity in this area as follows:

  • added to GBNK and sold IBTX locking in a total gain of 46.4% (16.3% annual return).  Assuming their merger with GBNK completes I’ll be assigned more shares of IBTX than I previously had.
  • added to SHPG as they received another approval in their merger.
  • Initiated a post-IPO position (from the 30 day over-allotment period) in Amalgamated Bank (AMAL).  This due to their intention to initiate a dividend next quarter.

Averaging Down

Yes, there are times when I’m underwater on some investments, most of these being holdings of less than 1%.  It would be a fair assessment that something was amiss in my initial analysis as several of these are foreign caught in the cross hairs of the strong US dollar.  One reason I tend to scale in to investments is to take advantage of opportunities to average down when my  original premise remains intact.  These tend to be intermittent purchases.

There, in three parts, is my strategy going into 2019.  As my dividend goals for 2018 are close to being met, I am now starting the realignment process so I’ll be hitting the new year with a running start.

I’d love to hear your thoughts the processes you use!

 

My 3Rs – Revamp

Last post in this series I highlighted my views from the rear view mirror.  Going into 2019 will see more changes than normal.  No I’m not selling any positions but changing the emphasis (allocation) on certain issues.  The game plan is for reinvested dividends and fresh money to gradually swing the portfolio into balance with the new targets.

Continue reading