Saturday, November 10, 2012

Mistakes Will Be Made

Mistakes happen. A good investor knows when he or she has made a mistake, and understands what to do immediately to correct the mistake.

There are many different types of mistakes that can be made when investing. Here are three of the most common:

1. Deviating from 'the plan'
2. Not enough research
3. Ignoring red flags

I had the fortune (or bad fortune...) of experiencing a bout of the first one recently, when I purchased Exelon Corp for my RRSP portfolio. Now you're probably wondering, why is that deviating from 'the plan'? You're a dividend investor, and Exelon pays a handsome 5-6% dividend. Well... that's exactly where the problem lies.

Recently, Exelon announced that should power prices not trend favorably, they will be forced to cut the dividend to maintain their credit ratings. This was an about face from their previous statement that the dividend is safe. As a result of this announcement, I immediately sold my EXC shares. The result was a loss of about $440 on a basis of $2500, offset by dividends received of ~$70, over a period of approximately 9 months.

Welp, that is a loss of 15% in 9 months. What did I do wrong? And how did I fall into making mistake number one?

As with most investor mistakes, they start with a snowball that does not appear like it will become a mistake, and before you know it, you're knee deep in the mistake without even knowing it. Luckily, I was able muster enough resolve to just bail on Exelon.

My snowball was that I saw Exelon's then 5% yield as attractive, decently supported (albeit payout levels were quite high in the 70-80% range), and even though it was not increasing, I felt if I started with a high yield, I could take a few years of no increases and still come out ahead.

While this does not seem particularly bad, it was the first step to deviating from my plan of dividend growth investing. Yes I do hold investments that haven't raised their dividend for some time, but none were as borderline as Exelon when it came to payout ratio. For example, a good chunk of my portfolio is Boeing, which had frozen its dividend for a long time, but its payout ratio was well below 40%, and recently resumed raising its dividend again. Through good management, and diversification, Boeing's dividend was successful in surviving the trough of its business cycle. Exelon is another story and whether the dividend is safe or not remains to be seen. The US economy continues to be weak to mediocre. I would not count on power prices rebounding in the next year.

Looking back, I should not have chased Exelon's 5% yield and 70% payout ratio, because the result after further decline in earnings is a payout ratio above 100%, 6% yield, and announced potential cut to the dividend. The last factor triggered my self imposed automatic sell. I will sell a stock if there is any hint of a dividend cut, regardless of price.

Fortunately for me, my Exelon position was quite small, about 1.5% of my total portfolio. Double fortunately, I didn't follow thru on a recent thought to add to the position. How unfortunate that would have been... Triple fortunately, the stock didnt drop too much before I could unload it.

Let this be a lesson learned. Stick to dividend growth names, and stick to the sweet spot of yield, between 1.5% and 4.5%. This example is exactly why chasing high yielding equities is dangerous like running with scissors. You never know what will make you stumble.


  1. That's a good loss if the stock has its last moment of breath. At least it's a small portion of your portfolio. Everyone always have a bad seed in their portfolio. Now I'm starting to think I'm spreading myself too much in certain stocks...

  2. well i dont think the company will go BK if thats what you mean :P but i think the odds of a dividend cut, with the economy sluggish, are quite high. theres been some studies that show the risk profile increases as yields deviate from the sweet spot (2.5-3.5%). sweet spot provides some of the lowest risk vs best long term returns.