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Portfolio Update

Making the Grade

By Roger S. Conrad, on Jan. 22, 2016

After Kinder Morgan (NYSE: KMI) slashed its dividend last year to placate Moody’s Investors Service and retain its coveted investment-grade credit rating, avoiding the next big cutter became the cause célèbre for investors. Accordingly, we’ve revised our quality grading system to reflect risks related each company’s spending needs and cost of debt and equity capital.

Our proprietary quality grades encompass five factors that reflect the strength of a company’s balance sheet and the stability of its earnings and dividend:

  • Dividend coverage;
  • Revenue reliability;
  • Regulatory risk;
  • Near-term refinancing needs; and
  • Operating efficiency.

These ratings highlight the spectrum of dividend risk, from A-rated companies that are up to snuff in all five areas and F-level names that fail to live up to our standards in at least two areas.

The number of criteria in which a company earns a superior rating determines its overall quality grade, but A-rated names exhibit a certain X factor in that these various strengths reinforce one another—a virtuous cycle that’s difficult to achieve and critical to generating sustainable wealth for shareholders. For example, a company with a healthy payout ratio usually boasts conservative management and a sustainable business model.

Of course, investors shouldn’t rely on quality grades alone. Even the safest names sometimes earn a Sell rating if their valuations reach unsustainable levels. Lower-quality stocks could also receive a Buy rating if their shares trade at the right price and/or upside catalysts could improve their grade.

Nevertheless, quality grades warn of deterioration in a company’s underlying business and can help risk-averse investors decide which stocks to avoid.

But Kinder Morgan made the grade in four of these five categories before slashing its dividend by 75 percent in December 2015. The company had a long track record of meeting management’s guidance for cash flow and distribution growth. Revenue also held up well, despite the effects of plummeting commodity prices on its dry-bulk storage business and carbon dioxide segment.

The midstream operator also had no problems with its regulators and routinely completed its projects on time and budget. Kinder Morgan has significant debt maturities over the next two years, equivalent to 13.5 percent of its market capitalization after the recent selloff. The company hadn’t experienced any challenges rolling over debt, and most of its paper traded at a premium to par value.

But the threat of a downgrade from Moody’s Investors Service, coupled with the sharp selloff in the stock, prompted management to slash the dividend and opt to retain cash flow to fund growth projects and pay down debt.

Although this decision made a great deal of sense for the company’s overall health, the dividend cut and subsequent selloff in the stock dealt us and other shareholders a painful loss.

Accordingly, we’ve made two major improvements to the Lifelong Income Portfolio to help readers gauge the risk associated with each holding.

First, we divided the Portfolio into conservative and aggressive segments; risk-averse investors should weight their portfolio to the safer names. Despite this shift in presentation, we remain committed to building a balanced portfolio that provides enough diversification to offset weakness in a particular industry or holding.

We’ve also expanded the list of qualitative and quantitative factors that go into our quality grades, with an eye toward avoiding the pain associated with liquidity constraints.

Monitoring bond yields for signs of deterioration is a crucial exercise in these uncertain times.

 

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