Annual Wealth Building Review

It’s been a year since I started tracking my net worth. This started after I had made the big withdrawal on my 401K but before I purchased any real estate. It has been an exciting and tumultuous year! All I can say is that I wish I had started tracking my progress years ago. I might have realized sooner that things weren’t working. But there’s no value in lamenting the past.

I’ll start with total growth and then break things down to my various assets. In the past year, I’ve seen 85.48% total growth of my net worth.  That is pretty good considering I paid a 37% effective tax rate this year due to the penalties of making an early withdrawal on my 401K. With that tax burden out of the way, I’m hoping next year delivers a strong performance.

Real estate

My real estate holdings have grown by 20% since first purchase. Now take that with a grain of salt; the values are based on Zillow. I won’t really know the value until I sell a unit. But at least it gives me some sense of their value.

My Florida town home has increased from it’s purchase price by about 12%. This isn’t of much value, because I don’t plan to sell it. But instead, it gives me reassurance that I bought it at a good price. All the other short sales that were going on in the same subdivision are gone, and they have even built a new building in this yet uncompleted neighborhood. These are all signs of the real estate recovery in Florida. It definitely shores up future opportunities in case I need to open a HELOC against it to access any cash.

Mortgage debt on my rental properties has dropped by $7200. That’s only a 1.7% reduction in rental debt, but I just started paying off the smallest mortgage by an extra $1000 this month. So, you’ll have to read next year’s annual report to see how well this feeds my wealth building plan.

I could pencil in the value of my new home I purchased back in March and look at its appreciation, but there is no value in that. Nor is there any benefit in looking at the growth of my previous residence either. Instead, what’s more important is how I used this unplanned opportunity to open a new position in wealth building. Which leads us to…

Stocks

My biggest stock position is Vanguard Natural Resources. But you can’t measure it’s performance by growth in value. That’s because the monthly dividends are being used to pay off my HELOC. The price of the stock doesn’t show a big growth history like Berkshire Hathaway. To best way to illustrate its growth is to take its value and subtract the HELOC balance.  That would show where all the spare dividend cash has been going.

I started with a little over $1000 of VNR a year ago. I have increased that position several times. But back in March, I plunged in by putting the left over cash from the sale of my previous home (made possible by the HELOC used for financing) into more VNR. So far, I have reduce my HELOC balance by -0.82%. It doesn’t sound like much, but I have only been using this cash flow machine for a few months. Next year, the fruits of that should begin to show much better.

My position in Berkshire Hathaway has grown by a modest 6%. My position in Apple has grown by 21%. That is partially because I bought more Apple when it dipped below $400/share. I still believe Apple will continue to grow and innovate, and with the amount of cash they have, it feels like a safe investment to me.

EIUL

My EIUL has done exactly what is was supposed to do. My contributions were increased back in May by 4% to represent cost of living increases. It is slightly ahead due to some small credits being paid. It’s actual value compared to the amount of contributions represents a 5.1% growth factor. This isn’t bad considering I’m paying big values. But the most important thing it is doing right now is locking in its growth. The value of it will not go negative, and when the next market correction appears, it will keep chugging along even as my stock portfolio takes a hit.

401K and Roth IRA

I still have my 401K with my current employer. It’s value has grown by 31%. My Roth IRA, which are refocused on holding stocks and reinvesting by DRIP, has grown by 22%.

If I assume that the real estate holdings are unrealistic, it might suggest that the rest of investment plan is actually doing worse than these plans. But these plans are currently riding the tide of QE from the Fed and other factors. When the next correction hits, they will probably get a hard knock. My Roth IRA might be okay, because I have refocused it on stocks and not mutual funds. But considering I can’t put any more money in it, it’s fine where it is.

Next year

Next year’s report should be more exciting because I have upped the pay off of one rental mortgage by $1000/month. That combined with 100% occupancy is also helping me to increase my rental cash reserves by $1000/month as well. When things get replenished, I can direct that money towards a rental mortgage and knock it out even faster.
Do I expect the same amount of growth? Hardly. 85% growth in one year is actually way above the mean. You should never depend on it or think you can keep it up. A big piece of this is Zillow telling me my rentals are probably worth more than I could actually get for them. In the next five years, when I finally sell one, I’ll get a proper correction to my net worth.

But there is one thing I’m sure of: everything is doing much better now that I have taken an active role in wealth management.

Increasing my position in three valuable stocks

I recently increased my position in Apple (AAPL), Berkshire Hathaway (BRK.B), and Vanguard Natural Resources (VNR).

Apple

Apple has taken a beating over the past six months, which has caused their price to fall. From a technical perspective, the debate rages on about whether it’s time to buy or sell. But I don’t buy stocks purely from a technical perspective. My wealth building plans don’t involve buying a stock one day and then selling it week later if it increases 5%. That is the behavior of day traders. There are countless studies that have shown that day traders, on average, lose money. In this one, it is reported that 8 out of 10 day traders, over a six month period, lost money.

Instead, my stock investments are driven by more fundamental concepts. Is Apple going to continue to making money with the iPhone? What about the iPod and iPad? Will Apple continue to innovate and make new, ground breaking devices? They have a long history of developing new concepts in consumer electronics and generating a healthy profit. The fact that I’m writing this post on my MacBook Pro (which I’ll never give up due to it’s quality) is another data point.

In April of this year, Apple reported $43.6 billion in quarterly revenue, up from last year’s Q1 $39.2 billion quarterly revenue. Increased earnings is important. Their profits sank slightly from last year’s $11.6 billion to this year’s $9.5 billion, so I’ll be keeping an eye on that. They sold 37.4 million iPhones this quarter compared to 35.1 million in last year’s quarter, a 6.6% increase. They also pulled in $12.5 billion of cash flow from operations leaving them with a cash balance of $145 billion. They are sitting on a huge mountain of cash, and part of the suspense is that they haven’t decided where to plow their huge cash proceeds. Should they decide to develop some new product, they have the cash in the bank to move forward. So I took advantage of the drop in price and increased my position.

Berkshire Hathaway

It seems awkward when people keep betting against Warren Buffett. I see article after article pointing out how now it seems time to bail on Berkshire Hathaway. Others frame it like “Five Reasons Why It’s Time To Sell”. Frankly, Buffett’s got a much longer historical record than any of these people writing the negative articles. Go back in time, and see how people reacted when Buffett dodged the tech industry.  People thought he was daft, had lost his touch, and yet, Berkshire Hathaway didn’t get crushed when the Dot Com bubble collapsed. If you read the annual shareholder’s report, you will get a lot of insight in Berkshire Hathaway operates. It’s probably more akin to the concept of a mutual fund without the nasty issues mutual funds contain. The company owns or has significant investment in over sixty companies. It has had a good 18-28% annualized growth in book value of the past 40+ years. And when others bail out, it doesn’t cause bad results to lock in, the way mutual funds do. You can think of it like a mutual fund, except the person running it has a long, public record compared to the unknown person running your mutual fund, who has no obligation to actually meet your needs, just their own brokerage.

Vanguard Natural Resources

The last company I have poured more money into is Vanguard (not to be confused with Vanguard Brokerage). Vanguard is a master limited partnership. This means they pay 90%+ of their earnings as distributions to unit holders. These payments are essentially tax free. An added benefit is that this company distributes earnings on a monthly basis rather than a quarterly one. I’m using my position in it to pay off a HELOC and hence keep my position. In the long run, if I can pay off the HELOC, I will have a cash flow machine that won’t stop. I can then point it at my rental portfolio and let it help me continue to build wealth. Combine that with their history of increasing payouts, and it sounds like a good deal to me. What are the taxable implications? Instead of paying taxes on the monthly distributions, you pay taxes on the depreciated cost basis. This means that while you hold the stock, it’s original cost basis keeps falling. So if you sold it one day, at a loss to the price you originally paid, you might still face a hefty capital gains tax. But considering my plan is to never sell the stock, it makes for a sweet deal.

While I have a nice pile of cash sitting around to cover my real estate play, it doesn’t hurt to plow some spare cash into companies that I have done extensive research on. I’m only managing five stocks, so it makes it possible for me to track what they’re doing. If I was trying to handle 200, that would be impossible. I’m also not stuck with the decisions of others when they decide to bail on their mutual fund. Warren Buffett doesn’t have to liquidate anything if there is some downturn in the price of the stock, compared to a mutual fund manager who doesn’t have enough cash on hand. Instead, he can focus on what he needs to do: find better deals, invest when the price is down but the quality of businesses are up, and continue to grow the value of the shares of which he owns more than me.

Always be prepared if you receive chunks of money

It’s good to always be thinking, “what would I do if I had a bunch of money?” I was reflecting on a previous article I had written, and really observed how the people that get a lump of cash often call a radio show because they DON’T know what to do. It’s important that we aren’t caught off guard and panic, but instead are prepared with a plan in mind.

The reason is, opportunities occur. We need to be prepped and ready to go with putting that money in action. For a long time, many years in fact, I had developed an approach that any big chunks of money I received would be sent into a spare bank account. I would “park” the money there, and let it collect. That way is was a little out-of-sight/out-of-mind. Every few months, I would examine the bank statements, and think about what to do with it.

Back in 1999-2000, before banking went online, I worked a particular assignment that paid me double my usual salary. I also had huge reimbursements for food and lodging. So I called up my local bank and asked if I could set up an automated deposit to another bank. My checkbook was filling up too fast! They said sure, not a problem. Apparently, they’ve been doing this type of stuff for decades!

Suffice it to say, working this way for over a year allowed me to sock away plenty of cash. At the time, I bought mutual funds and also kept enough cash to put a down payment on a house a couple years later. I didn’t just spend the money on things, I saved for the future.

What about today?

My wealth building plans of today are very different than back then. At one time, a few years ago, my plans had shifted to the point that if I came in contact with a big sum of cash, I would focus on paying off our primary mortgage. Much to my benefit, the money didn’t materialize before I learned to NOT DO THAT.

Here is my current mental process for dealing with big sums of cash:

  • Can this money be used to buy cash flowing assets (real estate or VNR)?
  • Would the cash flow be enough to pay any carrying costs and still profit?
  • If not enough for real estate or VNR, what about a solid growth stock like BRK-B?
  • Have all costs, risks, and rewards been considered?
That is how I was able to take the sale of my previous home and quickly figure out that it would be better to buy a big position in VNR instead of paying off the HELOC. When the HELOC costs me 4% and VNR pays 8.6%, then the profit margin is clear.

I am also looking at cashing in my next stock option to buy even more VNR in order to pay off the HELOC faster.

Finally, when I withdraw the remains of my 401k, I’ll probably buy another chunk of BRK-B. There are no carrying costs involved with that chunk of money, so I think it would be good to “park it” in BRK-B. Should pay much better than a money market fund let alone some index fund.

What do these options provide?
I’m now at the point where if one part of my wealth building plan needs help, another part can assist. For example, if BRK-B grows really fast, it’s always an option to sell a piece of it and pay off a real estate loan. Or if I build up enough VNR and pay off the HELOC, I can target the monthly dividend towards the rental loans or buying more BRK-B. Or I can sell one of my rentals and buy another EIUL in four years and a day to lock in the wealth.
Options beget options. The more active I make my role in my investment plan, the better I seem to do. It also pays to get out of investment vehicles that offer little if any choices and have a bad history of performance (401k and mutual funds anyone?) By being ready with plans in place, we are more likely to spot these opportunities and not get steered into destroying our wealth building vehicles like mortgages out of panic from some radio host.

Are your stocks paying a special dividend to avoid taxes?

I hope you enjoyed my recent series of articles on net worth. I’ll definitely revisit the topic in the future. But right now, I wanted to address something else that has been happening recently.

An interesting phenomenon is happening. Many companies are paying special dividends as the year comes to a close. In fact, I just saw an article where the Washington Post Co. is planning to pay it’s entire 2013 dividends on December 27, 2012. Some but not all companies are paying an extra dividend.

The companies that are doing this are trying to hedge the risk of Congress not reaching a deal over the so-called “fiscal cliff” and thus seeing tax rates go up on January 1st. This especially extends to taxes on dividends. Right now, unsheltered dividend income is taxed at 15%. If nothing happens, then it will go back to up to the owner’s regular income tax rates next year.

What does this mean for a long term dividend investor?

I’m definitely one of them, even if stocks aren’t a majority of my investment portfolio. How am I prepared for these new tax rates? Well, I have rebuilt my investment portfolio to be tax smart.

  • Most of my stocks are inside a Roth IRA, meaning any dividends I receive are not taxed.
  • I have units of an MLP in a non-tax sheltered account. MLP dividends are mostly tax free and don’t benefit from IRA shelters.
  • Real estate depreciation doesn’t appear to be on the table, and most of my depreciation only shields rental income.
  • And I haven’t heard anyone talk about adjusting tax laws in regards to EIUL policies, so that is secure for now.

This means I have things structured so that most of my wealth building won’t be impacted heavily by these daily headlines.

I used to invest in mutual funds wrapped in a 401K and also had some stocks, but I didn’t really know what I was doing, because I didn’t take an active role in researching things. If you pulled me over and asked me what my long term wealth plans were, it wasn’t more than, “throw money into my 401K.” On rare occasion I looked at the stocks that I owned and made changes, but not many.

Now I monitor things much more closely. I only have five stocks, which means I can keep track of them. None of them appear to paying a special dividend, but I’m watching for any announcements.

Bottom line

Essentially, my biggest exposure is going to be any rising income tax rates and social security tax rates on my active income from my job. If you read The Millionaire Next Door, one key thing that is pointed out is that most millionaires don’t earn a $1 million/year, but instead have a net worth exceeding $1 million. Most of these millionaires aren’t high income earners like doctors and lawyers. This lets them duck the high marginal tax rates while building business equity, real estate holdings, and strong stock portfolios.

So what changes do I have in mind if taxes go up next year? Not many. I would normally be concerned if one of my stocks decided to stop paying dividends. One of my key criteria in stock selection is to pick one that not only has a history of paying dividends but also of increasing the dividends every year. If one of my stocks decided to pay all of its 2013 dividends in the next couple of weeks, I will keep an eye on it, to see if they resume regular payments in 2014. If they put on the brakes, then I will do more research at that time to see whether to keep it, or close my position and hunt for a replacement.

While Apple has started paying dividends, I don’t treat it the same way. I bought it for appreciation. Berkshire Hathaway doesn’t pay any dividends so it isn’t subject to the new dividend tax rates either. Both of these positions are based on the long historical growth they have exhibited, and the fact that they aren’t my at the top of my wealth building plan. Is your wealth building plan setup to take some knocks? Send me a message and we can talk about it.

Rebalancing my portfolio – part 2

I already mentioned the first step in rebalancing my portfolio: replacing my 401k with an EIUL. My second step is investing in some dividend aristocrats and holding onto them FOREVER, pulling in dividends and reinvesting them for the long term.

What’ll you take – dividends or appreciation?

There are a few stocks that have been paying dividends for over 20 years. And not only that, they have increased their dividend payments each year. It’s not that hard to find them. Better than that, some go back over 50 years in paying increasing dividends, each and every year. These are sometimes referred to as blue chip stocks.

There are a couple of ways to make money off of stocks. Either you buy low and sell high (we call that appreciation), or you buy and hold, waiting for dividends payments to come in. By taking the dividend route, you can buy more shares with the dividends and grow your capital, further increasing dividends payments. The longer you stretch this out, the less you are worried about the appreciation of your stock.

People have made a living out of predicting the rise and fall of stocks. They are called fund managers, and they consistently underperform the market indices. They try to guess (yes, I said guess) when the stock will be low and buy it, and try to predict the high to sell. Do you know what happens when they are wrong? Nothing! In 2008 a LOT of mutual funds increased their fees because so many people were pulling out of mutual funds.

When you pick some blue chip stocks that have stood the test of time, you aren’t gambling on appreciation. Instead, you are investing in the power of the company.

Only buy companies you know

Notice how I said investing in the power of the company? That is because you shouldn’t buy stock in companies you don’t know a thing about. Just because a whole gaggle of people are diving into something (Facebook’s IPO anyone?), doesn’t mean you are catching the low. Often when you follow the news, you are late to the game.

Did I mention dividends? Yes, that is the main thrust of this part of my plan, but there is someone out there who HAS stood the test of time in picking stocks: Warren Buffet. That’s why when I got my first dividend payout, I bought one share of Berkshire Hathaway B (BRKB). He has averaged double the market for the past 40 years. No one else has come close. His stock doesn’t pay dividends, but he definitely knows how to grow stock value.

The tax man cometh

No investment strategy can be complete without considering taxes. Since the government has a huge appetite, you need to figure out how you are going to make as much as possible while being strategic in how much you get to keep (like how I couched, ehh?).

One option is to buy in an open account. That means you are buying with after-tax money, and any gains are subject to the tax laws of the day. They will tax you on any gains when you sell as well as any dividends you are paid. Over time, this can eat up your returns.

In my previous article, I mentioned that using a Roth IRA shouldn’t be your primary vehicle for retirement savings. I mean that. Roth IRAs limit you to putting away $5000 a year, and that just isn’t enough for a comfortable retirement. But it doesn’t mean you shouldn’t take advantage of what you CAN put in there. That is why this is just a part of my long term plan (you’ll have to wait for part 3).

There is an old adage: would you pay taxes on a bag of a seeds or on the yield of the field where you planted? In many forums, I have seen people comment that if your tax brackets are identical at the beginning and the end, then it doesn’t matter whether you pay now or later. That is absolutely true. And…very unlikely.

When someone suggests that when I retire I shouldn’t worry about tax rates because I will have less needs, then that smells like someone is setting me up for a rough landing. I would prefer to work towards having MORE when I retire than I have now. Then, deciding what to do with the extra money will become a nice problem to have. That is better than deciding which shift to work at Walmart because I didn’t save enough!

So, if I set things up to pay taxes as I approach retirement, I could either pay less taxes or pay more, based on what direction the government takes. That sounds REALLY risky. I would rather take my knocks now, and then be tax free at retirement.

Think about it: does the government want the taxes from your $100,000 today, or would they prefer to tax your $250,000 that you built up as you enter retirement? As Dave Shafer says, you don’t think the government invented IRAs and 401Ks to reduce their revenue stream do you?

Of course, I have heard the argument made that you should take every tax discount you can now. Waiting until retirement to find that they have changed the tax code and plan to tax you on both ends is a risk of its own. I can appreciate that, because how many times has the government changed it’s mind when it comes to tax codes? This is what you might call caught in their cross hairs. My crystal all is as cracked as yours, but I’m going to gamble that taxing on both ends of a Roth is much LESS likely than tax rates being HIGHER when I retire.

What I bought

So after pouring over historical reports, spreadsheet data, and a little self speculation, here is what I have bought.

  • General Dynamics (GD) – they have a history of paying increasing dividends over 20 years, while currently sporting a 2.88% dividend yield. On April 11th, they announced a $0.51/share dividend. I believe that the need for military aircraft isn’t going to diminish anytime soon.
  • Chevron (CVX) – they have been paying increasing dividends for over 24 years, while showing a dividend yield of 3.34%. They are one of the Big Oil companies. Because this planet is going to be running primarily on oil for the next century, I believe this is not only a good investment, but a good hedge against inflation.
  • Apple (AAPL) – they don’t have a consistent history on paying dividends, but have a long history of consistent growth. This is one of those I-think-people-will-keep-buying-their-stuff feelings. They actually reached a point where they have too much cash and not a clear idea on what to do next. Sounds like a nice problem to me.
  • Berkshire Hathaway B (BRKB) – this is another non-dividend payer, but there is a 40-year history of growing bigger than the market. Heck, they hardly ever do a stock split. The only reason this one split recently had to do with a particular company they had acquired. Other than that, I expect this one to keep growing.
Beyond these four, I don’t feel compelled to buy any other companies at this point in time. That may sound crazy, but did you know that the theory of diversification asserted that owning more than 30 companies produced a diminishing set of returns? When you own some mutual fund that has dozens of stocks, if not hundreds, there is no way for you to analyze it. You are totally in the hands of the fund manager, and their track record isn’t good.
I originally started with General Dynamics, Chevron, and Apple, but just received my first dividend payment. I thought owning a piece of Warren Buffet would probably be good for me, so I got underway. From here on, you can see how things perform as I continue blogging. Please show me where the TV personalities are blogging about which mutual funds they own.
Please don’t just buy what I buy. Do your own research and decide for yourself what you’re comfortable with.

Disclosure: Long on GD, CVX, AAPL, and BRKB.

Cross posted from http://blog.greglturnquist.com/2012/05/rebalancing-my-portfolio-part-2.html.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.