Portfolio - Dec 2013

We are coming close to year-end and like for every dividend blogger out there, it is also time for me to review my portfolio and draw some conclusions:

- Total collected dividends in 2013: EUR 406
- Expected dividends for 2014: EUR 539
- Current book value: EUR 9,842
- Current gain in market value (MV): EUR 539.

There have not been any changes to the portfolio in comparison to Jun 2013 except for some trading activity on part of K+S and Realty Income. Realty was added to the portfolio in early December and in my view, it was attractively priced at EUR 29 (see latest post). My K+S exposure was reduced yesterday as it represented the largest position of the portfolio and was simply over-weighted given its price collapse in 2013. I sold 17 stocks at a price of EUR 22.25 and incurred a loss of EUR 189.

One can always argue whether waiting for a full recovery is the better strategy, but I concluded that I do not have any clear insight into the fertilizer market and that the chances of the market to find back to its cartel-like structure are difficult to assess. The fact that the conflict between Uralkali (Russia) and Belaruskali (Belarus) has also a political dimension does not make this assessment easier. I am convinced that the current exposure of EUR 1,000 fits much better to my overall portfolio.

I can well imagine following the same approach for E.on as well, but at the moment I still see more potential for this one, even if it might take considerable time to unlock it.

Intel is another candidate which could be worth selling. Not only would I incur a profit of +17%, but I could also replace it with a more stable company with similar yield like Philip Morris for example.

Clear winner this year is Deutsche Post which almost doubled (+91%) in value since beginning of 2012. I expect the dividend to be raised from EUR 0.70 to EUR 0.75 which is well in line with the concept of dividend growth investing.

Overall portfolio yield stands at 5.48%, slightly lower compared to the 5.69% as per June 2013. This is mostly due to the forecasted reduction of the K+S dividend and the USD/SGD/GBP depreciation against the EUR which had some negative impact on dividend distributions of Intel, TICC, SingTel and Royal Dutch Shell.

What are my goals for 2014? This is simple:

1. Write more articles
2. Closely monitor the market situation
3. Further grow the portfolio by 3-5 investments
4. Be patient and wait for the right investments

Happy new year to everyone! :-)

Stocks - BUY - Realty Income

There is one new position to report which I added to my portfolio in December. This was actually against my recommendation not to enter the market at current prices (see Market – Oct 2013). There was, however, one fundamental change in November which allowed me to act against my own recommendation: This was Draghi’s announcement to once again reduce the base rate (from 0.50% to 0.25%). This step represents another cut-back on my savings account and as a result I freed up more resources for additional dividend investments.

In the past weeks the stock price of Realty Income came down to a level of EUR 30 (USD 40) and was within an acceptable range. Hence, I entered at EUR 29. Timing could have been better as the price went even further down to EUR 26.60. But, as usual, you never get the cheapest entry point. 

Many experienced dividend investors are currently discussing the impact of Fed tapering and are more defensive towards investments in REITs. As a long-term investor I remain confident in Realty’s business model and its track record:

- Equity REIT (no mortgage REIT)

- Portfolio of 3,800 commercial properties across the US

- 74 consecutive dividend increases

- Market capitalization of USD 7.4bn (largest US commercial REIT)

- S&P BBB+ investment grade rating

- Equity ratio of 60%

There are many articles and lots of extensive stock analysis on seeking alpha and other websites so I refer to these sites for a detailed analysis.  

I hold no position in this stock or in the sector and deem a yield of 5.50% attractive enough as entry price. 43 stocks at EUR 29 are enough for now. Further additions are possible if considered suitable from a portfolio perspective.

Real estate - Financing aspects

In part 1, I concluded that a real estate investment cannot be separated from its financing aspects.

In order to dig deeper into this matter and put some hard facts behind my reasoning, I calculated some annuity schedules at a 3.25% p.a. interest rate and an annuity of EUR 1,400 for different debt levels in a range from EUR 150,000 to EUR 425,000. For simplicity, I chose an annuity of EUR 1,400 as this is my current rental expense per month.

Then I drew a chart of the results with loan life (final repayment date of the loan) on the x-axis and loan balance on the y-axis. The result is shown below:

An annuity always consists of a repayment amount and an interest portion which, of course, is bigger in the beginning of the repayment phase as the borrower is paying interest on the fully-drawn loan.

The chart shows very well how the interest compounding effect works:

Although debt is raised by the same amount of EUR 25,000 for each curve, the distance between the curves on the x-axis (i.e. loan life) is continuously increasing. The difference in years between the curves is displayed in the colored scale to the right of the chart.

The described effect is similar to a dividend growth strategy only that it works in the opposite direction. To be more clearly, the interest compounding effect works against the borrower and it works even stronger against the borrower, the more debt he borrows.  

That said, I colored the various curves on a scale varying from dark green (healthy financing) to dark red (unhealthy financing) to indicate which loan amount, in my view, is affordable given a monthly annuity of EUR 1,400.

My conclusion is that the compounding effect becomes critical at a repayment horizon of ca. 30 years. But even at shorter horizons, the interest portion as part of total debt service is already significant. It actually makes you kind of sad to see the huge amounts paid in form of interest expense during the loan life. The chart below shows the exact proportions of the interest and repayment components:

Given the figures above, it becomes clear that a loan life of 30 years is acceptable, but carries already a significant interest burden on the borrower’s side. If possible, it is therefore advisable to use shorter repayment horizons for loans. Personally, I deem a loan life of ca. 20 years (ca. 75% repayment and 25% interest portion) as balanced and therefore appropriate for my own considerations.

Based on this result and an annuity of EUR 1,400 it is apparent that my maximum loan amount is capped at EUR 250,000-275,000. If I assume and equity portion of EUR 150,000 to be accumulated by my mid-thirties this adds up to a total investment of EUR 400,000-425,000. Unfortunately, these prices are not achievable for a terrace house in the Munich area in the foreseeable future. 

Of course, at the age of 30 I have some more room for financial leverage as there should be a few salary increases ahead. But on the other side, this additional income will probably be directly consumed by my future kids and family :-). So I am on the safe side staying with my EUR 1,400.

Getting back to my colleague’s investment, it is rather clear that with an acquisition price of EUR 550,000 and a EUR 125,000 of equity, he is pretty much damned to repay his loan for the next 35 years. What that means in terms of interest burden should be clear by now. Even if his financial strength, represented by the amount of his annuity, is higher than mine by some hundred Euro this is still not enough to repay below 35 years. Tables below show some sensitivity analysis in this respect:

In addition, he has a 3.50% p.a. fixed interest rate agreement while I am assuming 3.25% p.a.. This indicates that his loan life might be even higher than 35 years.

So, what are the conclusions from the calculations and arguments explained above?

- I will not buy any real estate in the Munich area at current prices (moving away from Munich to a more favorably priced city could make sense in the mid-term).

- I still have a long way to go to reach my goal of EUR 150,000 of required equity
- I will stick to my dividend income strategy and hopefully this strategy will help contributing towards achieving this goal

Real estate - Basic considerations

A couple of days ago a colleague of mine proudly reported that acquiring his own property was one of his best investment decisions in life. In 2010, he paid EUR 550,000 for a rather basic terrace house in the outskirts of Munich. He financed the acquisition through EUR 125,000 of equity and the remainder through a mortgage loan at a 3.50% p.a. fixed rate. He was very proud of his investment. To me paying off a loan for the rest of my life appears not so promising. Who knows what will happen during such a long period of time!?

I have been asking myself for some time now whether my dividend income strategy is really superior to a regular real estate investment. The reasons for not having considered such an investment so far were rather practical in nature:

First of all, with 4 years of professional experience I still consider myself to be a job starter. Being flexible and not put on the chain has been very important for me in today's fast-paced work environment. Secondly, prices for real estate in German cities (and particularly in the Munich area) dramatically increased in the past years. They swiftly reacted to the ECB monetary policy of low interest rates. As a consequence, it takes more time to build up the equity required to be granted any mortgage loans. Of course it might also be possible to pursue a real estate investment without any equity at all. Whether this is a good and sustainable way forward is, however, another thing.

When I turned 30 last month, I felt that it is time to reconsider my personal situation and review my investment goals. Lets give more thought into this.

What are the pros and cons of either strategy?

1. Dividend income

+ continously growing return on investment if long-term dividend growth rate is positive

+ diversification across various sectors and geographies

+ investment amounts can be randomly split across assets

+ real estate exposure can also be achieved via investment in REITs

+ moderate risk concentration

+ hedge against inflation

- considerable tax impact (25% witholding tax (Abgeltungssteuer) on interest and dividend income)

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- high variation in market value during stock market turmoil

2. Real estate

+ appreciation of property value if asset location has a positive long-term outlook

+ saving of monthly rental expenses

+ interest on loan is tax deductible if asset is rent to 3rd party

+ hedge against inflation

- no diversification across sectors and geographies

- high risk concentration

- difficult to split up the investment

- interest burden (paying interest on any loans which is not payable when renting)

- considerable tax impact (3.5% land transfer tax (Grunderwerbsteuer))

- regulatory risk / risk of financial repression (higher taxes, extra duty)

- limited mobility

I am sure I missed out some aspects of each investment strategy. Nonetheless, it seems that given my current personal circumstances a dividend income strategy has more advantages compared to a real estate investment.

However, there is one aspect which is worth to highlight: My girl-friend and I currently pay EUR 1,400 per month of rental expenses for our 3-room apartment. I consider this as money thrown out of the window. Wouldn't it be better to buy a property, really own something, and pay-off a mortgage loan instead? In my view, saving the rental expense is a real advantage of real estate even though I would have to invest all equity into such a new project at once. I could still start all over again with my dividend income strategy in parallel once this investment is made.

You might be asking 'why is he still hesitating then?' Well, main reason is the following: As I wrote in the beginning, prices in the market have exploded since 2009. I would even say that prices in Munich increased faster than my personal savings rate throughout the last years. This does not mean that I did not save enough, but rather that there was a run into real estate due to the low interest environment.

Experts believe that there is no real estate bubble in German cities, but I deem real estate prices of 30-35x of annual rental income in the Munich area as over-priced. At this price levels, I would have to finance a very large portion of the acquisition price through loans.

This is the critical point here: While the interest compounding effect in a dividend income strategy works for me, it works against me when I take on a loan.

Now, what does that mean in detail? How can I make sure that the financing is still bearable? Of course, I do not want to drown in financial indebtedness.

Lets have a closer look into this in part 2.

 

Market - Oct 2013

It is time for another market update. Following my August post, I decided not to invest in SingTel and Capitamall and leave my portfolio as it. This did not have to do with the two companies' fundamentals, but rather with general market conditions. Although I have accumulated quite a significant amount of cash reserves, I am of the view that markets have already gone too far. I will therefore stay invested, but will not add any major positions to my portfolio for now. 

In the current environment, there are still no alternatives to stocks, but I feel that I was long too late and already missed the biggest part of the rally. In my view, the risk of a market correction is too high and it outweighs the bit of extra return from another investment.

Let’s have a look on the stock indices of my core markets. What has happened since August?

There were German elections in September with the outcome of a great coalition between Christ Democrats (Merkel) and Socialists. Both parties support the EURO policy and will hold a large voting majority (504 of 631 seats) in the Bundestag. Any objections from opposing parties (the Greens and left-wing communist party with together 127 seats) will have no impact on the country’s politics. 

Markets are relieved that the newly founded German anti-EURO party did not make it into the Bundestag. Just like the Liberals, it remained below the 5% threshold with still remarkable 4.8% of total votes. I would have liked the idea of having one party in the Bundestag questioning the EURO policy – even though this would have caused market consternation. 

Anyway, it is how it is and as long as there are no exceptional bad news from Southern Europe, the DAX will remain dependend on the Dow Jones which in turn is stimulated by the Fed policy. 

This leads us to my next core market, the US. After rumors about a war conflict in Syria, Obama follows a diplomatic approach and now relies on the U.N. to put Assad’s chemical weapons under international control. For the moment it seems as if the risk of a new war conflict is banned.

What about the Fed? Well, as if I already felt it in my last update, the Fed delayed bond tapering as it believes the US economy still needs support. In the end, everything will stay as it is. Nobody expects a slow-down of the USD 85bn monthly stimulus to the US economy still within 2013. For the moment, it seems likely that the Fed stimulus will be maintained for a much longer time. Even if it will be reduced within 2014, I wonder how much longer it will take to completely end it. And more importantly, how will markets react when the Fed announces it will cut or even end the stimulus? 

Another factor that has caused market fears was the US government shutdown in October and the potential of a US sovereign default. I did not even had this on my agenda and I guess most people already forgot the last time when a similar situation occurred back in April 2011. Although almost no one expects an US default to occur, there is still no visible solution to the US sovereign debt problem except for ‘kicking the can further down the road’ to the next deadline and hoping for an economic recovery until then. The next funding deadline is Jan. 15, 2014 and the next debt ceiling deadline is Feb. 7, 2014. In the meantime, a congressional committee will work out a longer-term budget deal. It seems as if global markets can rest until then.

Since start of September there was also a remarkable upward correction in the STI and a good opportunity to re-buy cheap has passed. Like markets in Europe and the US, the STI reacted negatively to rumors about tapering of quantitative easing and a pending attack on Syria. Bad news about flattening growth in emerging markets and asia probably also had some impact on the performance. I guess similar to the DAX and DOW JONES, the STI has recovered in the meantime due to the recent positive news trend.

Having said this, it is quite fascinating to see how interdependent all markets are and how important the US monetary policy has become for the world economy. It is this market property which makes me a bit thoughtful about the overall developments. Do prices currently really reflect the intrinsic value of stocks or has everyone just become really desperate about the lack of alternative investment opportunities?

Let's see where the journey of unprecedented loose monetary policy leads us by the end of the year. It seems as if we have new market records in front of us, but the key question is for how much longer... 

As usual, the media associated the tapering of QE and the pending attack on Syria as the causes for the correction. - See more at: http://www.bigfatpurse.com/2013/09/singapore-permanent-portfolio-update-aug-2013/#sthash.CZVmwtil.dpuf