Monday, April 19, 2010

Portfolio Changes

While doing some research on covered call performance for a discussion we were having on the JustCoveredCalls Yahoo group, I came across the performance data for the Snider Investment Method. Although I've never used this method, I'm familiar with it from studying their patent application, and I agree with the investment philosophy of it's founder, Kim Snider.

An interesting paragraph that caught my eye was the following:

"In some circumstances, the option market for a particular stock disappears (due to merger, low demand, etc.) In these cases, we substitute another similarly priced stock and continue our method. Any losses that are realized in the substitution process are not reflected in the yield calculation. These losses are not taken out of the Stake but transferred over to the cost basis of the substitute stock. They are treated in the same manner as unrealized losses in other positions where no substitution has occurred."

This got me to thinking. As of April expiration my portfolio consisted of 34 open positions, some of which were older positions I established before I changed my stock selection criteria to focus on solid companies with a history of generating free cash flow and increasing dividends. Based on this criteria, I should only be holding companies that are members of the Dividend Champions. So, why not use the method described above to replace some of my current holdings by substituting them with an equal or lessor number of Dividend Champions?

I identified 23 stock positions that would be eligible for substitution and decided to consolidate them into 15 new positions. The process of consolidation was to simply combine the cost basis, income received, and cash available from the original 23 positions, and then divided those totals by 15 to get the average cost basis, income, and cash for each new position. Doing it this way allows me to track the yield on the original invested capital (i.e. yield on cost). Any unrealized profit/loss will be transferred over to the cost basis of the new positions.

Next I had to decide what starting date to use for the new positions, since each of the original positions were established on a different date. The starting date is used to calculate the annualized yield on cost. I decided the best method was to use the average starting date of the original positions for each new position. It's not exact, but it's close enough for my purposes.

The final result will be an 8 position reduction from 34 to 26 positions, which will allow me to get out of those older positions and into better companies, while maintaining the same cost basis and generated income for reporting and tracking of the original investment. As a result, these new positions will show an average unrealized loss of about 18% and average annualized yield of about 11%. Now all the companies in my portfolio will be solid dividend payers and either members of the Dividend Champions or candidates to be included in the future.

I'll be establishing these new positions sometime this week or next and will post them in the Trades section as soon as each position is established. So stay tuned.

My portfolio will now be limited to 26 positions, consisting of 24 equity positions and 2 fixed income positions, which will be a lot more manageable going forward. Whenever a stock no longer meets my criteria, I will use this same method to substitute another stock. So, in essence, what I've done is divide my working capital into 26 positions, which will be maintained for as long as I run this portfolio. The stocks within these positions may stay the same or change as needed. This is an unusual approach to portfolio management, since most portfolios track each stock as an individual position, which is what I've done in the past. However, I think this new method makes the most sense for tracking the yield on the original invested capital. I'm constantly thinking outside the box, and this approach is definitely in that category. We'll see how it works out.