Where to invest the money from the sale of Kinder Morgan stock?

Last week was particularly busy for me on the investing front. I ended up selling almost my entire position in Kinder Morgan (KMI) at approximately $16/share after the company cut dividends by 75%. The surprising part was that the company went from forecasting 6% - 10% annual dividend growth to a 75% dividend cut within the span of one month. I decided that rather than hope for the best, I should cut my losses and reevaluate the situation with a clear head. This decision would also allow me to claim all losses on my 2015 tax return.

My average cost basis on Kinder Morgan stock that I bought outright was about $30/share. I started buying the shares after the IPO in 2011, and bought more until 2013. The company was one of my best ideas. I didn’t buy new stock outright since late in 2013. I have received several years worth of dividends. From a tax perspective, I get to reduce my income by the amount of the loss (technically I reduce any capital gains first, and then I get to deduct up to $3,000 and roll-forward any losses for future tax returns). The reduction in tax liability is helpful to soften the losses. Since the last time I made an investment in Kinder Morgan in late 2013, I have collected approximately $4/share in dividend income. I did hold a small portion of my Kinder Morgan position ( approximately 7% - 8% of my shares) in tax-deferred accounts such as an IRA, where the tax basis was in the mid-30s. I reinvested of my dividends there, and I won't get any deduction on the loss. A portion of those shares will likely be forever stuck in a tax-deferred account since the position is so small, that it would not be cost effective to sell the shares and then buy something else with the proceeds.

A large portion of Kinder Morgan stock came from my investment in Kinder Morgan Management (KMR) however. I received cash dividends of a little less than $2/share for only 1 year – before that I had received shares in lieu of distributions. This was a tax-free way of receiving distributions in stock at a discount, which made compounding easier and a no brainer decision. Either way, I came up only slightly behind on those investments from this legacy position from Kinder Morgan Management (KMR), despite what it looks like a low tax basis of approximately $20/share.



Of course from an opportunity cost perspective, I would have been better served elsewhere. This is the problem with opportunity costs however – they don’t provide any useful information, because of their perfect 20/20 hindsight. This regret is one way to not learn as an investor. I am "lucky" because I didn’t try to catch this falling knife, and average down. Nor did I buy cheap companies like Caterpillar, National Oilwell Varco (NOV), BHP Billiton (BBL) etc. My goal has never been to be the hero who called the bottom. Somewhat counterintuitively my analysis of my investments during the bull market from 2009 - 2015 shows that it is best to make money when you are adding money when things are getting better. I find it easier to follow the trend, and add money after things have stabilized, than try to catch a falling knife. Buying on dips only works when the underlying business fundamentals are rock solid. If a stock is declining in price because the fundamentals are deteriorating, this could end up burning investors who are buying on the way down. This happened a lot during the financial crisis in 2007 - 2009. Somehow, those who survived only remember the epic story of how Buffett and Munger bought Wells Fargo at the bottom in 2009. The forgot about looking for a bottom in Citigroup, Bank of America, Wachovia, Washington Mutual, General Electric etc.

Either way I have decided not to rush into investing the whole amount out at once.

For some reason, ever since the summer of 2015 I have been somewhat bearish on US equities. This is why I eliminated all margin debt outstanding and also started investing in fixed income with new money I get every month from savings. I see some divergence between popular US indexes such as S&P 500 and the rest of US listed companies. It looks like most of the gains this year have come from a relatively tiny amount of large-cap stocks. Many of those stocks defy conventional valuation measures. At the same time, I have observed a lot of investors making victory laps and proclaiming that they are 100% invested in equities. Being mostly in equities looks like a no-brainer decision after more than 6 years of rising equity prices. The problem is that many of those investors were public with their portfolios only during a bull market. Some of them are pretty new to investing in general.

Some investors for example talked about how it makes no sense to have an emergency fund. Those same investors went from being completely silent about their personal financial situation to being brave enough to share their successes of the past 7 - 8 years. So perhaps, you can use those investors as contrarian indicators. Of course, I do not subscribe to the idea that I should make forecasts to make money. I merely use those examples because I found out that I am too exposed to equities. I believe that a 15% - 20% allocation to fixed income could be helpful. So while I won’t be selling any of my stocks, I will keep selectively reinvesting dividends, maxing out 401 (k), but using some of my excess cash to build my CD ladder. I may also decide to buy some TIPs in tax-deferred accounts, to hedge against the risk that buying CD’s is a mistake from an inflation perspective.

At the same time there has been a stealth bear market in commodities, energy, basic materials and international stock markets. The decline in energy prices since the summer of 2014 has taken many by surprise. The other surprise is the fact that energy prices have remained low for a period of time, which could have implications on economies and related sectors. For example, I was surprised that pipelines have been under attack, and some like Kinder Morgan (KMI) have admitted defeat by slashing dividends. Since most companies tend to follow each other’s steps closely, I wouldn’t be surprised if other pipeline companies at the general or limited partner level like ONEOK Inc (OKE) and Williams (WMB)and Enbridge Energy Partners (EEP) don’t end up slashing dividends as well. I will hold on to them for the time being until I am proven otherwise of course.

As a result of my experience, I would be careful about buying pass-through entities at this time. When I analyze all the dividend cuts I have had, I am noticing a pattern where many of the cuts originate from pass-through entities. Examples include American Capital Strategies (ACAS), American Realty Capital (ARCP) and now Kinder Morgan (KMI). This fact is something that makes me want to pause, and reexamine if I really want to have exposure to any pass-through entities (the other reasons against pass-through entities are sprinkled within this lengthy article).

I am more confident about some pipelines like Enterprise Product Partners (EPD), which is where I invested a portion of my Kinder Morgan proceeds. I probably invested approximately 17% – 20% of my Kinder Morgan cash proceeds into Enterprise Product Partners (EPD). Welcome back to K-1 forms. Because of the reasons I discussed above and below this paragraph, I may not add material amount of dollars to this MLP ( though I will reinvest the distributions).

While I don’t care about falling stock prices, I do care if that affects the ability to finance operations, and the ability to maintain a dividend. I also do not agree that just because a company’s stock price is low, it is automatically a good investment. If a company’s business model is not materially changed, then a lower price could be a bargain. However, if the company’s ability to generate cash flows is impaired, then a lower price could be justified. As John Keynes says, when the facts change, I change my mind. The facts speak that the managements of companies like Kinder Morgan do not have good near-term visibility as to their cash flow and dividends. The fact is that management went from forecasting annual dividend growth of 10%, to cutting the dividend by 75% in the span of one month. If they don’t have visibility, and change their minds so quickly, then these are dividends I cannot really rely upon when I plan to live off dividends in retirement. The stock price could double to $30 in the case of Kinder Morgan, and I would still not regret selling my shares.

One of the issues with pipelines that few think about it, is that lower energy prices could lead to lower exploration and production. This could decrease the volume of energy being transported. In addition, there is counter-party risk, where producers with shakier financials would end up renegotiating transportation contracts or being unable to stick to their terms if their financial conditions further deteriorate.

In the case of pipelines, many investors are realizing that these entities need access to capital by selling equity or debt. If the cost of that capital is too high, then any further growth will be difficult to finance. In addition, this would make the ability to rollover existing credit that matures over time very difficult and expensive. When you have a run on the bank and everyone is requesting their money at the same time (or wants to charge all of a sudden a premium for the privilege of investing with you through equity or debt), it doesn’t matter if you have assets with tremendous quality. Perhaps this is what Buffett was discuss in his annual reports on the importance of maintaining $20 billion in liquidity on Berkshire Hathaway’s balance sheet:

“We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Now I would also not be surprised if we see bear raids on other pass-through entities such as Real Estate Investment trusts. For example, Realty Income (O) looks overvalued today. There was a bear raid on the stock in 2010, when a famous hedge fund investor had a long presentation against the stock. There was a bear raid on Digital Realty (DLR) in 2013 as well, which was unsuccessful. As we all know, Barron’s and certain hedge funds were bearish on Kinder Morgan since late 2013. They were wrong for two years, but ultimately Richard Kinder proved them right by admitting defeat and cutting the dividend.

As a result of the sale of my Kinder Morgan stock, my dividend income will be reduced by approximately 7% - 8% (this calculation assumes the dividend income goes to zero because I sold almost all the stock). This would reduce my forward income projections for 2016 from a little over $15,000 to a little over $14,000. The lesson learned is that I should not have a single company account for so much of my dividend income (though I did discuss this lesson back in 2011). So this would potentially set me back from my goals by almost one full year. If that $14,000 grows by 6%, due to organic dividend growth in 2016, the forward dividend income will be at $14,840 by the end of 2016. If that $14,000 is reinvested in companies yielding 3% on average at the time on investment, it would generate an additional $420 in forward dividend income. This would bring my forward dividend income to a little over $15,200 at the end of 2016. A portion of that dividend income will be used to fund my Roth IRA.

Of course, if I invest the money from the sale of my Kinder Morgan stock at an average yield of 3%, the forward dividend income will increase by approximately $300. I already invested a portion of the money (1/6th to 1/5th) in Enterprise Product Partners (EPD), and an even smaller position in Diageo (DEO). I may invest a little more in Enterprise Product Partners (EPD), but as I mentioned above, I do not want to be adding more money to pass-through entities. A portion of the money could be used to purchase shares in Hershey (HSY), if the put options I sold a few weeks ago end up in-the-money at expiration in six month. It is possible that if Kinder Morgan starts raising dividends in 2016 or 2017, I will allocate as much as 1/5th of the money back into the entity and give it a second chance. On the other hand, a dividend cut from Williams Companies (WMB), ONEOK Inc (OKE) and Enbridge Energy Partners will cause me to sell and lose out on as much as ~$800 in forward dividend income. If I reinvest the proceeds I may be able to recover that dividend income back up to $300 - $400.

At the end of the today however, I am not accounting for new investments in those dividend income calculation projections. Unfortunately, most of my new money will be allocated to my 401 (k) and HSA accounts as part of my plan to increase the tax efficiency of my net-worth. That money is invested in low cost index funds that yield a little more than 2%. The overall dividend yield there is approximately 2%, so this could deliver several hundred dollars in annual dividend income. Another portion of new money will be used to build up my fixed income allocation. When I finish building the CD ladder a few years from now, it would likely generate a few thousand dollars in interest alone. This would take 3 - 4 years to complete of course, though I don’t have this income accounted for in my long-term income projections. Most of my dividend investments in 2016 will be using dividend income I receive during the year, or due to sales that I may need to reinvest back into the portfolio.

Full Disclosure: Long EPD, OKE, WMB, DEO, EEQ, KMI (a few shares left over that are not worth it selling due to commission costs)

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