Wednesday, December 24, 2008

* Managing The Risk Of A Dividend Cut With Allocations

One tactic to help manage the risk of a dividend cut is to limit your allocation in any single investment to a maximum of 5%. However, if the allocation is measured by market value, our portfolio may still be at significant risk of a dividend cut. Consider the following:

Below are four of my holdings showing and their percentage of my income portfolio's market value:
  • Commercial Net Lease Realty, Inc. (NNN) 5.7%
  • Realty Income Corp (O) 4.6%
  • Alpine Total Dynamic Dividend Fund (AOD) 4.1%
  • Eaton Vance Global Dividend Opportunities Fund (ETO) 5.2%
Both NNN and ETO are slightly over the 5.0% limit, but not enough to be concerned about. However, when I calculate each of these securities as a percent of my total dividend income the results are not as benign, as shown below:
  • Commercial Net Lease Realty, Inc. (NNN) 7.9%
  • Realty Income Corp (O) 5.0%
  • Alpine Total Dynamic Dividend Fund (AOD) 18.9%
  • Eaton Vance Global Dividend Opportunities Fund (ETO) 12.2%
Combined, these four securities represent 44% of my dividend income compared to only 19.6% of the market value of my income portfolio. I currently have 43 securities in my income portfolio. If each security in the portfolio were equal weighted, then each security should only represent 2.3% of the whole. How did I get into this position?

I have not purchased any O since June 2007 when it was trading at $26.02. With a 12/19/08 closing price of $24.54, its price has has held up relatively well. My average basis in NNN was $21.42 earlier this year. In November, I purchased some additional shares at $14.24 bringing my average basis down to under $20. NNN closed at $16.57 on 12/19/08.

Three stocks were sold in October that had cut their dividends and this created a significant amount of income that needed to be made up. I strongly suspected that AOD was trading well below its underlying value and purchased a large block of it. At the time it was yielding just under 37%. Ten days later the fund itself confirmed my suspicion in a press release saying they had begun purchasing its own shares. Jill K. Evans, co-manager of the Alpine Total Dynamic Dividend Fund was quoted saying:
“We know the Fund’s holdings represent strong value right now and seeing 20% plus discounts on a strategy using dividend paying stocks and no leverage, no options, no bonds, and no preferred stock made it clear to us we had to take advantage of this for our shareholders.”
November brought more two more large dividend cuts. Once again I was scurrying to find an acceptable way to make up the lost income. This time I turned to ETO to make up a large part of the income. November's income lost was larger than October's so I spread the purchases around to other high yielding securities, including NNN.

December came and I knew I could not withstand dividend cuts as experienced in the previous two months. I had no more high risk options that I was willing to take. So far it looks like I will make it through Decemebr without a major bump in the road.

I will point out that the above purchases are not quite as risky as it would first appear. The two highest percentages belong to funds (AOD and ETO) so the risk of a draconian cut is much less than an individual stock since funds are made up of many individual stocks. Nevertheless, their percentages are higher than I am comfortable with and I need to build up a risk reserve for future use, so I will work the two funds' balances down with some sales over the next several months.

In the same way you must align your actions with your goals, you must also align your risks with your goals. To that end, I am now tracking each of the securities' percentage of the total income and I will not make an additional purchase if it exceeds 5% in either market value or income. With some careful planning and execution, we will not only make it through this financial crisis, but we will prevail.

Full Disclosure: Long NNN, O, AOD, ETO