Sunday, September 16, 2018

Portfolio Construction On Ensuring The Sustainability of Cashflow

I received a lot of queries pertaining to the amount of little cash that I'm holding for my investment purpose so I thought I'll use this chance to explain the thought process on my portfolio construction.

Our goal as a family has always been to ensure that we have $5,000 / month worth of passive income in order to reach our definition of financial independence. Working back the maths, this means we would need $60k/year or $1m portfolio at 6% yield.

While this amount would give us financial independence, we also know that we needed some sort of margin of safety so over the long term we also aim for our passive income to exceed our expenses by 1.5x in order for our capital to grow.

With this in mind, our objective would look like this:

1.) $1m Liquid Portfolio at 6% yield -> Provides Cashflow which covers expenses at 1x -> Short Term Goal
2.) $1.5m Liquid Portfolio at 6% yield -> Provides Cashflow which covers expenses at 1.5x -> Long Term Goal

P.S: You can insert your own respective short term and long term goal and it doesn't have to be the same with other people.

We have our eyes on meeting our short term goal which we have been working towards the past 10 years and hopefully in about 2 years time from today we'd be able to come close to it.


There's a lot of compounding collaboration among the three which helped to propel the growth of the portfolio faster.

For example, when I receive my salary income on the 25th of each month, the first thing I did immediately was to put aside the amount of expenses (known factor) needed for the next 30 days and invest the rest of the savings into companies which would yield me 6% returns or above (more on this later).

This helps to ensure two things

The first requires us to work on a strict tight budget that we have to put aside on spending but allows some room of flexibility to work with during the month itself. This means that if we are overspending for this week, we are able to adjust our programme for the following week by finding activities to do that require lesser spending. This allows us to consistently practice lifestyle habits that require hunger and restraint.

The second allows us to consistently put our capital to work every month without fail and this contributes to the growing portfolio even though our returns in the market might suck sometimes. For example, we managed to hit a record high in our portfolio 7 out of the 8 months this year through consistent amount of capital injection that we put in each month. This is further propelled by once a year variable bonus one-off and dividends which we never fail to consistently reinvest back into the market. Albert Einstein will call this compounding at its very best and we can already see the outcome of the mechanism working.



With the focus on human capital and savings now working as planned, and at the high level of capital that are being reinvested into the market, we needed to ensure our returns on investment is positive so the money that we put in can work harder for us throughout day and night.

You can sense by now that I am a big fan of compounding, hence the companies that I invested in would revolve around companies that yield consistently high amount of free cash flow and high payout ratio yet have to be sustainable.

Looking back at our own objective in mind, we also wanted to ensure that we invest in companies with minimally 6% cashflow return as this is the hurdle rate that we have in order to reach financial independence.

With this objective in mind, you can see that we are not a big fan of gold because they are commodities assets which doesn't yield cashflow hence it doesn't meet our objectives. Furthermore, we believe that we are in a country where the state of the currency is stable (triple A rated) hence gold investing just doesn't make sense for us to include in our portfolio. Over the long term, we just feel that our equity portfolio will be enough to trump over gold returns.

We are also not a big fan of short or long term bonds, corporate bonds, or any sort of bonds including the Singapore savings bond because of two things.

The first is the nature of the bonds as an asset itself.

Most bonds are essentially fixed income which provides us with payout at regular intervals with no participation in growth. They are essentially debts which investors loan to companies which they will redeem at maturity which we will get back our par value. While they provide regular payout at intervals, it doesn't correlate to our long term goals which is to achieve a 6% cashflow and a growing capital assets.

At our age, we believe this doesn't provide the best avenue to grow our assets.

Second, even if there are corporate bonds that are yielding in excess of 6%, there are the risks involved in the company defaulting as a result of non-payment. We can only look at the recent example of Hyflux perpetual bonds to account for such high yield nature payoff.

With that in mind, we trust that our best avenue to achieve a consistently 6% yield and a growing assets is through investing in an equity portfolio.

For those who attended my last talk on Investor Exchange 2018, you would have heard about the strategy on my preferred 6 + 4 = 10% which Kyith helped to explain in detail here.

What I am seeking is essentially investment that yield characteristics such as:

1.) Generates High Amount of FCF and Dividends Yields That Are Sustainable

There are a few companies that exhibits these characteristics in a nutshell.

The goal of this is to ensure that the dividends investors are receiving are sustainable over the long term basis and in the likely event of a recession, the dividends are less likely to be cut.

Companies that are asset lights and providing services as part of their core businesses are usually in a better position to generate their free cash flow as they are not required to reinvest huge amount of funds back into their assets to fund their growth.

HRNet Group Ltd is one example of such company where it derives revenue by matching companies with employees for a recruitment fee. In addition to professional recruitment, they also provide flexible staffing as part of their businesses hence human labor is a major part of their core expenses.

Between 2007 and 2017, the company's net profit compounded by a massive 12.7% and it even survived a few past recession including the big one during the GFC.

2.) Lots of Cash In Their Balance Sheet

I don't generally like companies that keep a lot of cash in their balance sheet without rewarding their shareholders with it.

But when we combine high free cash flow and high dividend yield with plenty of cash in their balance sheet, this becomes a powerful investment.

A good example of such investment is Vicom, which is one of the core investment in my portfolio.

When you have companies that exhibits such characteristics, it tells a story that the dividend payouts are likely to be sustainable, even in the a period of a recession.

With the company yielding 6% at this point, it is difficult to find another of such company that yields both in terms of high yield and high cash.

Goldpac Group listed in HK is another that exhibits such characteristic and is one in my watchlist.

3.) Nature of Business Model

The nature of a business model, especially how they perform during their trough is also important in my consideration.

For example, the business model of a Developer vs Reits is vastly different even as they are both in the same property industry.

While a developer requires time to bid for the land, build and launched it for a sale, Reits come from a business model of renting it out which means investors will get a more consistent payout as compared to a developer which earnings can be more lumpy in nature.

In addition, I usually look out for Reits that exhibits a long WALE because it would mean that they are locking in a better certainty with likelihood of surviving recession period, if any.

In terms of Dividends payout, it is also more consistent for investors who depend on it to fund their lifestyle.

The different industry of Reits will also play a crucial role in deciding which I will blog separately some other time.

Final Thoughts

I find that I am simplifying my objective a lot today as compared to when I started off.

With the initial availability of a human capital injection, I wanted to be straightforward when it comes to saving and when it comes to choosing my companies for investment. 

They don't have to be complicated that comes with many variable options but can give me the required returns for the objective I am seeking.

In fact, my portfolio today consisted of only 8 companies which I believe provides sufficient diversification but exhibits the same nature as I mentioned above.

So when people question why I am holding so little cash in my portfolio, my answer to them is I am constructing my overall portfolio based on its "cashflow" generation, which started from the day I received my salary to the month I save and to the type of companies that are inside my portfolio.

They are all cashflow cow to me.

Thanks for reading.

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8 comments:

  1. Hi, i just wan to understand further as i have a fren who shares similar strategy as u.
    Will there be so many good buys out in the market if you invest regularly every month? If happen that there is a big market correction to warrant a good buy, n you dont have the war chest, wont it be frustrating?

    ReplyDelete
    Replies
    1. Hi Kris

      For me, I always hv something to buy in my watchlist or I just kept on adding to my current position so that wont be a worry... I feel at this valuation there are still many attractive company to buy.

      I do still have a day job so there will be monthly “warchest” to utilize every month and at every quarterly interval I have dividends coming in so that will be my other sources of “warchest” top up which happens automatically.

      I may employ and keep some warchest if say i am no longer working but for now I try to keep myself almost fully invested all the time.

      Delete
  2. I think B's strategy has worked well for him all these years...we can see from his portfolio performance so far.

    There should be no best strategy in the market nor fit everyone, we should employ those work well for our personality.

    Having said that, I am still struggling with my own strategy now haha.

    ReplyDelete
    Replies
    1. Thank you for your kind words.

      I agree with you that the best strategy is the strategy that we invented ourselves that fit our character.

      Delete
  3. Hi.. Do you set aside some funds to top up ur cpf account?

    ReplyDelete
    Replies
    1. Hi chenheyuan

      I do top up a few hundred each month, mainly for tax purposes reason but it kills two birds.

      This is not my main focus though, I just do it whenever I have my excess savings at the end of each month :)

      Delete
  4. I envy how well your strategy has worked out for you. However, everyone has their own strategy that works for them when it comes to creating their portfolio.

    ReplyDelete
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