One of the reasons I started this blog was to educate others and to improve my own investing. This is why I like to keep my readers up to date on my portfolio changes. For the most up to date portfolio changes follow my twitter account as I will usually tweet first and then follow-up with a blog post. By keeping an open book of my portfolio and changes to it, I hope to generate discussion so others can see how I put my investing philosophy into practice.
With my recent purchases and sale of Kinder Morgan Inc. [KMI Trend Analysis] I would say that I have not put this philosophy to good use. I first purchased Kinder Morgan Inc. on November 6, 2015 for $25.50 (8% dividend yield at the time) and then again on December 1, 2015 for $22.66 (9% dividend yield at the time) which reduced my average price to $24.04. Just a week later on December 8, 2015 Kinder Morgan Inc. announced that they were cutting the dividend and I sold all the shares for $14.75 per share in the after hours market. Pretty awful returns overall, as I managed to lose 38.6% in roughly a month. Thankfully I didn’t own too much as the shares I purchased represented roughly 2.5% of my portfolio. Still this kind of loss hurts, especially when it could have been avoided if I had listened to my own advice! Instead I got greedy, went yield chasing and was a little naive to trust management’s dividend growth estimates of 6-10% for the next few years.
First lets take a look at why I initially invested:
- Long dividend streak – Kinder Morgan Inc. merged with a few other partnerships in 2014 and only became a company that traded on the stock market in 2011. Prior to that people invested in the partnerships. When you looked at the dividend streak of the partnerships and Kinder Morgan Inc. together it was something like 17 years in a row. (Going from memory here, so this might be a little off)
- Wide moat – Kinder Morgan is the largest energy infrastructure company in North America. They are a pipeline company and collect a pretty steady stream of cash flows. Morningstar rates them a wide moat stock.
- Shareholder interests aligned with management – Richard Kinder the founder of the company owns more than 10% of the company and when he was the CEO he collected an annual salary of $1. The rest of his compensation came from the dividend on the shares he owned.
- High dividend yield with growth – I bought shares at the 8% and 9% dividend yield levels. The shares had just dropped because management was estimating 10% dividend growth per year until 2020, but lowered their estimates to 6-10% per year. This sounded fine to me. I could start with a very high dividend yield and expect 6 to 10% dividend growth each year.
You can see from the points above that we have some strong characteristics of a good dividend growth stock, but we are missing a few key points, namely the financial strength of the company and the dividend sustainability.
Where I went wrong:
- Not financially strong – When I invested in Kinder Morgan Inc. I looked at an old Valueline report which rated them a B++ for financial strength which was above the B+ minimum rating for financial strength I look for. S&P had given them a BBB- credit rating at the time I invested, and I typically want to see BBB+ or higher. Rather than going with the more conservative BBB- S&P rating and deciding not to invest because the company wasn’t financially strong and didn’t meet my BBB+ or higher requirement, I justified the purchase. My justification at the time was that the company had just increased their dividend (usually a good sign) and their cash flows were stable because of the toll like nature of a pipeline business and they were expected to grow.
- Dividend Sustainability/Payout Ratio – Kinder Morgan’s payout ratio based on earnings per share was above 100%, but they focus on distributable cash flow (DCF) as opposed to earnings per share stating that “Distributable cash flow before certain items is a significant metric used by us and by external users of our financial statements, such as investors, research analysts, commercial banks and others, to compare basic cash flows generated by us to the cash dividends we expect to pay our shareholders on an ongoing basis.“ Even the payout ratio based on DCF was close to 100% which didn’t leave the company with much money left over for business growth and ultimately one of reasons why they cut the dividend.
To fund growth in the past Kinder Morgan Inc. would use debt or sell more shares to raise the capital required for its growth initiatives. When oil prices dragged the industry down the stock price dropped making it more expensive to raise money through share issuance. Because they were already rated BBB- any more significant debt would have meant a lowering to junk grade from investment grade. When they increased their ownership stake in a company with a lot debt , one of the ratings agencies put them on watch and the company was forced to act in order to protect its investment grade status. With issuing more shares or debt effectively off the table they chose to cut the dividend 75% and use the excess cash flow to fund business growth.
When Kinder Morgan Inc cut their dividend I sold immediately per my selling criteria.
Related article: In What Conditions Would I Consider Selling A Stock?
There are three main lessons I have learned from this investment. The first and most important is that financial strength should be a deal breaker for me. My investing horizon is long term and ideally I’d like to hold on to my investments forever as I collect an increasing stream of dividend income. I should only be investing in financially strong companies that can survive long term AND continue to increase the dividend. This starts with a financially strong company. This is something that I already know, but I ignored my own advice, went yield chasing and hoped that it would be OK. Hope is not a good investing strategy! Before buying shares I should have looked at the credit rating of BBB- and not invested because it wasn’t at BBB+ or higher.
The second lesson is that I should not rely on what others (management in this case) say when the numbers don’t make sense. The payout ratio based on DCF was quite high so the annual dividend growth of 6-10% that management was forecasting was not sustainable based on these high payout ratios.
The third and last lesson is that when dividend yields get very high (8% and above) they are usually at a greater risk of a dividend cut.
No one is perfect, and I’m sure I’ll make mistakes in the future, but in the meantime I hope to learn from this investment and move on. Hopefully if I can stick to my plan I can limit these mistakes. I know Kinder Morgan Inc. used to be a dividend growth darling, so I’m curious to hear if any of my readers were caught unaware with Kinder Morgan? Even if you didn’t invest in Kinder Morgan Inc., I’d like to hear of your past investing mistakes and what you learned from them.
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