Friday, April 17, 2015

Philip Morris International (PM) Dividend Stock Analysis

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes, other tobacco products, and other nicotine-containing products. Its portfolio of brands comprise Marlboro, Merit, Parliament, Virginia Slims, L&M, Chesterfield, Bond Street, Lark, Muratti, Next, Philip Morris, and Red & White. The company was created in 2008 when Altria (MO) spun-off its international tobacco operations into Philip Morris International. Between 2008 and 2013, I believed Philip Morris International to be the security I like best. As a result it is one of my largest positions.

Philip Morris International has managed to boost dividends in every single year since 2008. The last dividend increase was in September 2014, when the quarterly dividend was raised by 6% to $1/share. The quarterly dividend has increased from 46 cents/share in 2008. The chart below shows dividends from 2008 to 2015. There were only 3 dividend payments made in 2008, and for 2015 it assumes that the dividend stays unchanged at $1/quarter. It is likely that it will be increased in October 2015, but it is unclear at this time what the increase will be.


In the future, the company can grow earnings per share through acquisitions, entry into new markets, through price increases that exceed decreases in demand, increase in market shares, through new product offerings (such as e-cigarettes) and through share buybacks. I would be curious to see whether PMI tries to diversify beyond tobacco in the future, into other areas such as packaged food for example or alcoholic beverages. The company is committed to returning 100% of cashflow to shareholders, which it has achieved through dividends and share buybacks.

Everyone is aware of the legislation risks behind tobacco companies, and dangers of tobacco investing. As a result, I am not going to discuss those. For those who do not like companies like PMI due to ethical considerations, I respect that. However, please do not try to impose your own ethical considerations on others.

The main positive for PMI is that the company is not dependent on the mercy of a single government and a single market, in terms of unfavorable legislation or bans on tobacco products. For example, the fact that Australia initiated plain packaging laws on cigarettes was not a blow to globally diversified companies like PMI. In addition, even if this plain packaging law spreads to the UK or a few other countries, the diversified nature of PMI’s operations could soften the blow. On the other hand however, it is more cumbersome to deal with 180 governments, which all have different laws and regulations regarding the manufacturing, processing and sale of tobacco products. The fact that a single government entity cannot throw a deadly blow to PMI is a plus. The other positive is that tobacco usage in certain places like emerging markets is actually growing. The downside is that profits per unit are higher in the developed world, and lower in emerging markets.

PMI has managed to increase earnings per share from $2.75 in 2007 to $5.26 in 2013. Since then, earnings per share have decreased and are expected to fall to $4.35 for 2015.


As a company that operates in countries outside of US, PMI is exposed to currency fluctuations. The company reports results in US dollars, but sells its products for Euros, Rubles, Yen, Rupees etc. This means that annual results in US dollars will fluctuate from year to year. This explains partially the reason why earnings per share have not been growing since 2013, when they were $5.26/share. Rather, earnings per share fell to $4.76 in 2014 and are expected to fall further down to $4.35 in 2015. One of the reasons for declines is the increase in the US dollar against other currencies. The unfavorable foreign exchange impact is equivalent to $1.15/share in 2015, which could bring back those earnings to $5.50. Even if you add in the currency impact, of $0.34 in 2013 and $0.80 in 2014 and expected $1.15 in 2015, earnings per share would have been flat for 3 years in a row however. The general belief is that these currency fluctuations make the company performance look worse than it is. I usually view currency fluctuations as a wash – you get some years where currencies go your way, and then years where they go against you. The negative part about PMI’s exposure to foreign exchange rates however is that emerging market currencies usually tend to depreciate against the dollar over time. Therefore, I am a little cautious about taking out foreign exchange impact since it is a normal cost of doing business. Emerging markets reflect 45% of company’s revenues in 2014.

The drop in earnings per share has pushed the dividend payout ratio up, and resulted in slowing down of dividend growth. In itself, a high payout ratio for a tobacco company is not as big of a problem.

However, when earnings per share are dropping, it is a slight cause for concern. The company has recently canceled its stock buyback program. Since May 2008, when PMI began its first share repurchase program, the company has spent an aggregate of $37.7 billion to repurchase 601.4 million shares. This represented 28.5% of the shares outstanding at the time of the spin-off in March 2008. The average price was $62.61 per share. However, the company is not repurchasing any shares for the time being, citing unfavorable currency fluctuations. In comparison, Philip Morris International has one of the most consistent share buyback programs between 2008 and 2014.


In 2014, PMI exceeded its one-year gross productivity and cost savings target of $300 million. In 2015, PMI's productivity and cost savings initiatives will include, continued enhancement of production processes, the harmonization of tobacco blends, the streamlining of product specifications and number of brand variants, supply chain improvements and overall spending efficiency across the company. This is something that could help in attaining future growth in earnings.

In general, I like PMI because the company has a wide moat. This means that its products have strong brand names, pricing power and loyal customer usage. In addition, PMI usually is number one or number two in most of its major markets in Europe, EMEA, ASIA etc. This strong advantage results in recurring sales and earnings for shareholders for years. This wide moat is the reason why I am willing to sit out any short-term turbulence in Philip Morris International. Since my holding period is the next 20 - 30 years, I am willing to sit out short-term weakness ( 3 - 5 years) if I believe that a company has solid long-term potential.

In contrast, Altria (MO) has done spectacularly well since 2008. The most interesting thing to learn is that in 2008, everyone (myself included) believed that PMI will do much better than Altria. Quite on the contrary however, Altria did better because it had a lower P/E ratio and a higher starting yield, which was coupled with consistently high growth in earnings per share. The moral of the story is that when it is conventional wisdom to accept something as a given, the real money making opportunity could be to pursue the alternative viewed as less desirable. By defying skeptics, Altria has rewarded its shareholders much better than PMI since 2008. However, Altria is riskier, since it derives most of its profits from US tobacco sales. The next major source of earnings is its stake in brewer SAB Miller.

Shares of Philip Morris International are not selling for 17.90 times forward earnings and yield 5.10%, with a payout ratio of 92%. If you adjust forward earnings for currency of $1.15/share, the forward P/E drops to 14.20 and payout ratio drops to 72.70%. After looking at the data, I would not consider adding to PMI today.  Of course, it is one of my largest positions, so common sense on diversification tells me that I should not buy more even if I wanted to. I believe that in the long-run, PMI’s profits will likely rebound. The nice thing is that I will be paid a high dividend in the process, which I can allocate into other interesting opportunities.

I do not like it when the dividend payout ratios is too high for companies I own and where earnings have been flat or going lower. While the risk that the company will cut dividends is low, since it has some room to maneuver after it has canceled stock buybacks, the risk for a dividend cut increases the longer the payout stays closer to 100%. I would like PMI to prove skeptics wrong, and return back to growing earnings. We all know that without rising earnings, dividend growth cannot be achieved in a sustainable fashion. That being said, I still think the long-term picture (10 - 20 years down the road) is solid however once short-term woes are behind us.

Full Disclosure: Long PM and MO

Relevant Articles:

How to become a successful dividend investor
Altria Group (MO): A Smoking Hot Dividend Champion
Dividends versus Share Buybacks/Stock repurchases
Philip Morris International versus Altria
Five Dividend Paying Companies with Consistent Share Buybacks

Wednesday, April 15, 2015

Does Paying a Dividend Reduce a Company’s Value?

One of the biggest misconceptions about dividend investing is that the value of your investment decreases by the amount of the dividend you received. This is a logical fallacy that I hear time and again, and really makes me lose hope in the human race. The origins of the fallacy are that it confuses stock prices with stock values.

There is a difference between price you pay and value you receive. One can easily find stock prices on the internet or in newspapers. Stock prices fluctuate widely, by going from exuberant highs to depressing lows.

The value of companies however does not fluctuate that much on a daily basis. I am referring of course to the intrinsic value of the business, which would be realized in an arms-length transaction involving the sale of the whole company. While it is quite possible to purchase quality shares at a discount to intrinsic value, it is quite rare that a private seller would dispose of his/her total stake in a company at a fire-sale price.

The fallacy about the reduction in prices, that confuses price and value stems from the concept of the ex-dividend day. The ex-dividend date is the first day that a stock trades, at which point the buyer is not eligible to receive the latest dividend payment that was declared. As a result, the share price is cosmetically reduced by the amount of the dividend. If you believe that markets are somewhat efficient, then you should likely also believe that participants expect this dividend to be declared every 90 days or so. In fact, options markets incorporate the level of dividends in the pricing of these derivatives. Therefore, I would think that equity markets incorporate dividend expectations into the current price as well. Shareholders of a company like Coca-Cola (KO) can reasonably expect a quarterly payment of 33 cents/share every 90 days. This translates into an accrual of roughly a third of a cent every single day. I would think that between ex-dividend dates, investors who hold the stock merely accrue that 1/3rd of a cent every single day. On the ex-dividend date, this receivable is recognized in full, which is when it becomes visible to everyone else.

This is how I described this situation in a previous article:

If we make an analogy with bonds, one would note that the prices for both bonds and dividend stocks are decreased by the distribution amount on the ex-dividend date. With bonds however, interest is accrued daily and when you sell the security before the distribution date, you still get a prorated portion of the distribution. For example, let us assume that an investor purchases a 6% bond that pays every 6 months. The bond investor would then receive $30 on a $1000 bond on June 30 and $30 on December 31. By Mar 31, the bond has accumulated an accrued interest amount of 1.50%. If the investor manages to sell the bond at some random price, say 100%, the investor would actually receive the proceeds from the price and the accumulated interest for a total gain of 1.50%. It is interesting to note that dividend haters always focus on the ex-dividend date when discussing their opinions that dividends are a wash, since they give you cash but reduce your stock price. In fact, dividend stocks probably also accrue the dividend amount over time. As a result, investors do not really “lose” anything when ex-dividend date comes. In fact, this is mostly a cosmetic change, since stock prices are not directly tied to fundamentals but to other factors. Because stock prices fluctuate all the time, what truly affects stock prices is earnings, economic expectations, inflation interest rates, investor sentiment. The fact that stock prices are trading “ex-dividend” doesn’t really show on stock prices, unless a large special dividend is being paid out. As a result, stock dividends are already “calculated” by the marketplace and added to the stock’s valuation.

If you still do not believe me, think about the following scenario. A company earns $1/share and sells for $10/share. Now, if that company distributed a $10 special cash dividend, it will not trade at $0. That is because it still has a $1/year in earnings power. Only a fool would sell this stock at $0.

Astute dividend investors know that merely stockpiling cash on a balance sheet does not result in any value for shareholders. If however there is an announcement that a $10 pile of cash will be paid out as a special dividend, this will unlock the hidden value represented on that balance sheet. In the example provided above, that $10 stock will likely sell for close to $20 after that special dividend announcement.

In conclusion, when a company pays you a dividend, your investment value is not really reduced by the amount of the dividend, because the earnings power is the same. And company values are based on the discounted amount of future earnings streams from now on up until judgment day.

Dividends come from earnings that the company paying them has generated. As a result, the dividend is directly connected to the company’s fundamentals. The stock price on the other hand is something completely separate from the underlying business in the short run and is determined by investor emotions. This is why most dividend investors ignore stock price fluctuations, and invest in companies they would be perfectly fine holding for ten years even if the stock market was closed for ten years.

Full Disclosure: Long KO

Relevant Articles:

Dividends versus Homemade Dividends
How to never run out of money in retirement
Dividend Investing Misconceptions
Four important dates for dividend investors
Coca-Cola (KO): A Core Holding for Dividend Growth Investors

Monday, April 13, 2015

Six Companies Showering Shareholders with Higher Dividends






Checking for dividend increases is one of the tools I use to monitor my portfolio holdings and companies I am interested in. I have found that the rate of growth in company dividends shows the near term management sentiment in profitability for the enterprise. If management expects business as usual, they are much more likely to stay the course and maintain the rate of dividend increases from prior years. However, if tougher business environment is expected on the horizon, wise management will curtail dividend growth or might halt further increases in distributions.

In the past week, there were several companies that announced increases in dividends, which I am interested in. In addition, a company I have been monitoring initiated a dividend for the first time.

QUALCOMM Incorporated (QCOM) designs, develops, manufactures, and markets digital communications products and services in China, South Korea, Taiwan, and the United States. The company operates through three segments: Qualcomm CDMA Technologies (QCT), Qualcomm Technology Licensing (QTL), and Qualcomm Strategic Initiatives (QSI). The company raised its quarterly dividend by 14.30% to 48 cents/share. This marked the 13th consecutive annual dividend increase for this dividend achiever. The ten year dividend growth rate is 21.70%/year. This is typical for companies in the initial stage of dividend growth. Currently, Qualcomm is selling for 13.80 times forward earnings and yields 2.80%. While I have been familiar with the company since the days of the dot-com boom, I would add it on my list for further more detailed research.

Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, petrochemicals, and refined products in the United States and internationally. This master limited partnership increased its quarterly distribution to 37.50 cents/unit. This represents an increase of 5.60% over the distribution paid at the same time last year. This master limited partnership has managed to increase distributions to unitholders for 16 years in a row. In the past decade, distributions have increased at a rate of 6.60%/year. I first initiated a position in 2010, but sold in 2013 to pursue Kinder Morgan and ONEOK Partners ( and later ONEOK). I would be interested in initiating a position back in Enterprise Products Partners at current yields above 5%. The current yield is close to 4.50% now. I should probably post an updated analysis of the partnership as well.

Plains All American Pipeline, L.P. (PAA), through with its subsidiaries, engages in the transportation, storage, terminalling, and marketing of crude oil, natural gas liquids (NGL), natural gas, and refined products in the United States and Canada. The company operates in three segments: Transportation, Facilities, and Supply and Logistics. Plains All American Pipeline raised its quarterly distributions to 68.50 cents/unit, which represents an increase of 8.70% over the distribution paid at the same time last year. This master limited partnership has raised distributions to unitholders for 14 years in a row. In the past decade, distributions have increased at a rate of 8.30%/year. Currently, this MLP yields 5.50%. I will add it on my list for further research. As a side note, the General Partner Plains GP Holdings, L.P. (PAGP) raised distributions as well. However, unlike other General Partners this one has a lower yield at 3.20%

Genesis Energy, L.P. (GEL) operates in the midstream segment of the oil and gas industry in the Gulf Coast region of the United States. This MLP raised its quarterly distribution to cents/unit, which represents an increase of 10.90% over the distribution paid at the same time last year. This master limited partnership has raised distributions to unitholders for 12 years in a row. In the past decade, distributions have increased at a rate of 14%/year. Currently, this MLP yields 5.50%. I will add it on my list for further research.

Airgas, Inc. (ARG) supplies industrial, medical and specialty gases, and hard goods. The company operates through two segments, Distribution and All Other Operations. Airgas increased its quarterly dividend by % to cents/share. This marked the 13th consecutive annual dividend increase for this dividend achiever. The ten year dividend growth rate is 28.40%/year, which again is typical for companies in the initial phase of dividend growth. The shares are currently overvalued at 22 times forward earnings and yield 2.25%. I would add the company to my list for further research. On a side note, I own shares of competitor Air Products & Chemicals (APD) so I am familiar with the industry. However, the industry as a whole does not offer an attractive entry price today.

Constellation Brands, Inc. (STZ), together with its subsidiaries, produces, imports, and markets beer, wine, and spirits in the United States, Canada, Mexico, New Zealand, and Italy. The company initiated its first dividend payment in 45 years of 31 cents/share for it’s a shares (STZ) and 28 cents/share for its B shares (STZB). The company is overvalued at 25.10 times forward earnings and yields 1%. The forward earnings of $4.85 for 2015 are a nice increase from the $1.19/share earned in 2005. I would add the company on my list for further research. However, I prefer Diageo (DEO), since it offers a better value today.

In general, I am looking for quality companies that are attractively valued, which have a track record of raising dividends, and which could grow earnings in the future. It is helpful to own a company with a decent initial yield, which has sustainable dividend and can grow that dividend in lockstep with growth in earnings.

Full Disclosure: Long KMI, APD, OKE, DEO

Relevant Articles:

Buying Quality Companies at a Reasonable Price is Very Important
How to read my weekly dividend increase reports
Dividend Stocks Provide Protection in Any Market
Why Dividend Growth Stocks Rock?
Buy and Hold means Buy and Monitor

Friday, April 10, 2015

Ameriprise Financial (AMP) Dividend Stock Analysis

Ameriprise Financial, Inc. (NYSE:AMP), through its subsidiaries, provides a range of financial products and services in the United States and internationally. Ameriprise operates in five segments - Advice & Wealth Management, Asset Management, Annuities, Protection and Corporate & Other. The company was created as a result of a spin-off from American Express (NYSE:AXP) in 2005. Ameriprise Financial has paid dividends since 2005, and has increased them every year since then.

The company's last dividend increase was in April 2014 when the Board of Directors approved a 11.50% increase in the quarterly distribution to 58 cents /share. The company's peer group includes Principal Financial Group (NYSE:PFG), Northern Trust (NASDAQ:NTRS) and Waddell & Reed (NYSE:WDR).

Since going public in 2005, this dividend growth stock has more than doubled in price.


The company has managed to deliver a 12% average increase in annual EPS since 2004. Analysts expect Ameriprise Financial to earn $9.76 per share in 2015 and $11.14 per share in 2016. In comparison, the company earned $8.74/share in 2014. Over the next five years, analysts expect EPS to rise by 17%/year.

Ameriprise Financial has actively used share buybacks to reduce the number of shares outstanding from 247 million in 2005 to 191 million by 2014.

The company operates in five segments. I expect that in the future, its growth will likely come from the Advice & Wealth Management and Asset Management segments, while Annuities and Protection segments will shrink as a percentage of the overall revenue pie.

• Advice & Wealth Management (32.20% of Operating Income); This segment provides financial planning and advice, as well as full-service brokerage services, primarily to retail clients through our advisors. A significant portion of revenues in this segment is fee-based, driven by the level of client assets, which is impacted by both market movements and net asset flows.

• Asset Management (32% of Operating Income); This segment provides investment advice and investment products to retail, high net worth and institutional clients on a global scale through Columbia Management in the US and Threadneedle, which operates internationally. Revenues in the Asset Management segment are primarily earned as fees based on managed asset balances, which are impacted by market movements, net asset flows, asset allocation and product mix.

• Annuities (25.70% of Operating Income); This segment provides RiverSource variable and fixed annuity products to individual clients. The RiverSource Life companies provide variable annuity products through our advisors, and our fixed annuity products are distributed through both affiliated and unaffiliated advisors and financial institutions. Revenues for the variable annuity products are primarily earned as fees based on underlying account balances, which are impacted by both market movements and net asset flows. Revenues for the fixed annuity products are primarily earned as net investment income on assets supporting fixed account balances, with profitability significantly impacted by the spread between net investment income earned and interest credited on the fixed account balances.

• Protection (10% of Operating Income); This segment provides a variety of products to address the protection and risk management needs of our retail clients, including life, disability income and property casualty insurance. The primary sources of revenues for this segment are premiums, fees and charges we receive to assume insurance-related risk. The company earns net investment income on owned assets supporting insurance reserves and capital supporting the business. Ameriprise Financial also receives fees based on the level of assets supporting variable universal life separate account balances.

• Corporate & Other (#N/A). This segment consists of net investment income or loss on corporate level assets, including excess capital held in Amerprise subsidiaries and other unallocated equity and other revenues as well as unallocated corporate expenses

Overall, I am very bullish on companies that offer the tools to assist the 60 million Baby Boomers in their retirement. As there are 10,000 boomers retiring each day, there is the need for financial planning advice. Financial advisors help individual investors craft a plan, and execute it, while trying to create a long-term relationship with the client. The future growth of the company would come from building and retaining long-term relationships with customers. The company has an active sales force of 9,600 financial advisers, which help address customers' needs by selling them Ameriprise products. Almost 75% of its advisors are independent franchisees, who have the right to use the Ameriprise name. Approximately 25% of them are employees of the company.

I believe that investors who utilize the services of a financial advisor are more likely to stick to that advisor. As a result, I believe that investor assets with an adviser at a place such as Ameriprise are stickier than assets under a mutual fund company such as T.Rowe Price. The personal relationship with a client can provide benefits to both the inexperienced investor and the adviser. And a company like Ameriprise can offer an integrated approach to wealth management, and utilize its position in providing annuities and insurance products as well. It also helps that Ameriprise has positioned itself well as the place to obtain financial planning advise. The added risk for Ameriprise is that the advisers could take clients away if they switched to a competitor. However half of the company’s advisers have been with Ameriprise for over a decade, and have an average tenure of 18 years.

Future growth will also be dependent on attracting more client money both domestically and internationally. Future growth will also be aided by strategic acquisitions, which will expand the pool of assets under management. A rising market generally helps in increasing assets under management, which is accretive to revenues and profitability.

Rising stock prices will results in higher revenues and profits. On the contrary, if stock prices were to take a breather or even decrease, this will provide a headwind against further profit growth. In the long run, security prices generally tend to follow an upwards trend. Therefore, it might be a good idea to hope for a stock market correction, before initiating a position in a company like Ameriprise. A correction could provide for an even better entry price.

The return on equity has been pretty consistent between 8 and 11% between 2005 and 2012.The only dip was in 2008, during the depths of the financial crisis. Since then, this indicator has been going up and is reaching 20% in 2014. I generally want to see at least a stable return on equity over time. I use this indicator to assess whether management is able to put extra capital to work at sufficient returns.

The annual dividend payment has increased by 27.20% per year over the past five years, which is higher than the growth in EPS. This was possible because as a new dividend payer, Ameriprise started paying out a small amount, which was later increased significantly.

The dividend payout ratio has increased from 5% in 2005 to 25.90% in 2014. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.


Currently Ameriprise Financial is attractively valued at 12.90 times forward earnings, yields 1.85% and has a sustainable distribution. I recently added to my position in the stock and plan on adding to it further if current yield is closer to 2.50%.

Full Disclosure: Long AMP, TROW

Relevant Articles:

Eaton Vance (EV) Dividend Stock Analysis
T. Rowe Price Group (TROW) Dividend Stock Analysis
Four Dependable Dividend Stocks I Bought Last Week
Key Ingredients for Successful Dividend Investing
Companies I am Considering for my Roth IRA

Wednesday, April 8, 2015

The Value of Dividend Growth



Many investors who invest for income focus exclusively on yield, in order to build the necessary income stream to support them in retirement. While yield is one factor to consider, successful dividend investing is the outcome of focusing one’s attention to quality stocks that can grow earnings and dividends over time, and purchasing those at attractive valuations. Unfortunately, over the past century, inflation has been eating away the purchasing power of your dollars. As a result, companies that can grow distributions over time are much more desirable for income investors, since they will maintain purchasing power of their distributions without the need to reinvest these distributions. Companies that can grow revenues and earnings over time are much more likely to reward their investors with consistent dividend raises.

The value of dividend growth is most evident when someone attempts to reach a target level of dividend income. Investors in the accumulation stage, who focus on yield alone, can only rely on new fund additions and dividend reinvestment to grow their income. Dividend investors who focus on dividend growth in addition to dividend reinvestment and addition of new funds have a third tool to aid them in their goals. As we saw in actual examples I showed before, high yields, growing dividends and dividend reinvestment can result in turbocharging of dividend growth.

For example, let’s assume that an investor has a $100,000 portfolio in dividend stocks yielding 3% with no dividend growth. Their dividend income would be $3,000/year. However, if a second investor had purchased dividend growth stocks yielding 3% that also grow distributions at 6%/year with his funds, and didn't add any money, his projected dividend income would have grown to $3,180/year. In order to have generated the additional $180 in annual dividend income at 3%, the first dividend investor would have had to add $6,000 simply to keep up with the second investor. Over time, the second investor would generate higher income than the first one, who has to keep adding money simply to keep up. If the second investor also reinvests distributions and adds new money, they can reach their investment goals much faster.

The types of quality income stocks that can generate both earnings and dividend growth include:

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has raised distributions for 45 years in a row. In the past decade, Altria has managed to boost dividends by 11.60%/year. The stock currently sells for 18.30 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.

T. Rowe Price Group, Inc. (TROW) is a publicly owned asset management holding company. This dividend champion has raised distributions for 29 years in a row. In the past decade, T. Rowe Price has managed to boost dividends by 16.60%/year. The stock currently sells for 16.90 times forward earnings and yields 2.50%. Check my analysis of T. Rowe Price for more information about the company.

Johnson & Johnson (JNJ), together with its subsidiaries, researches and develops, manufactures, and sells various products in the health care field worldwide. This dividend king has raised distributions for 52 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.80 %. Check my analysis of Johnson & Johnson for more information about the company.

Emerson Electric Co. (EMR) provides technology and engineering solutions to industrial, commercial, and consumer markets worldwide. It operates through five segments: Process Management, Industrial Automation, Network Power, Climate Technologies, and Commercial & Residential Solutions. This dividend king has raised distributions for 58 years in a row. In the past decade, Emerson Electric has managed to boost dividends by 8.10%/year. The stock currently sells for 15.10 times forward earnings and yields 3.40%. I last analyzed the company on this site a couple years ago. I need to post my updated analysis soon.

While all of these companies are great, another important factor of long-lasting success in dividend investing is diversification. By owning at least 30 individual stocks representative of as many industries that make sense, investors would lessen the risk that a few bad apples can decimate their retirement portfolio.

Full Disclosure: Long MO, TROW, JNJ, UTX, EMR

Relevant Articles:

Dividend Champions - The Best List for Dividend Investors
Dividend Kings List for 2015
Rising Earnings – The Source of Future Dividend Growth
The Perfect Dividend Portfolio
Successful Dividend Investing Requires Patience

Monday, April 6, 2015

My Favorite Exercise With Dividend Paying Stocks

I love dividend growth investing. I find it amazing that for the price of exchanging my labor for money at my job, and then identifying at least 40 or so dividend paying stocks, I will get paid dividends for decades in the future. This means that in 2044, I will be receiving income because of a decision I had made over 30 years prior to that point.

The reason behind this love for dividend investing is the fact that I like to build things, let them grow, and achieve my desired set of goals and objectives. I know that many investors choose not to do dividend investing, because they lack the patience to sit tight and earn a 3% - 4% yield in a current year. They would much rather trade actively, than wait for the power of compounding to quietly help them achieve their goals over time. On aggregate, those who actively trade end up much worse off than a simple investment in Certificate of Deposit or Treasury Bonds.

Many of those investors tend to criticize the fact that in the initial stages, anyone who puts say $1000, would not earn more than $30 - $40/year in dividend income. Where most others see nothing of interest, but only boredom that is not worth it, I see opportunity. I view each stock in my portfolio as an income generating asset that pays me to hold it, as it transforms capital, know-how, and human ingenuity into products or services that it sells to customers around the world for a healthy profit. Over time, businesses become smarter about processes, and how to do things more efficiently in order to maximize earnings. The people who work in those businesses make decisions every day, so that my interest in the business can generate profits and pay for my dividends. In essence, by being a dividend capitalist, you are having your money work hard for you, so that you don’t have to.

I view each of those dividends as dollars I didn’t need to physically work for. In other words, if you make $20/hour (average wage in the US), for every $20 in annual dividend income you receive, you can afford to work one hour less per year. Of course, this is an oversimplification, because a dollar of dividend income is worth more than a dollar of salary income, because dividends are a more tax efficient form of income. In addition, a dollar of dividend income does not require much time commitment from the dividend investor.  Over time, as more income generating assets are added to the portfolio, and dividends grow and are reinvested, the power of compounding eventually reaches a precipitation point in the dividend crossover point. Therefore, one should never despise the days of small beginnings. They should rather start their financial independence journey as early as possible, in order to benefit from the power of compounding to the maximum point.

I love the fact that if I build an equally weighted portfolio today consisting of 40 companies, and putting $40,000, I have a chance of generating over $38,000 in annual dividend income in 40 years. The money generated by the portfolio will be enough to cover the amount invested almost every year. This exercise assumes a 3% starting dividend yield and annual dividend growth of 6%/year.

The cash I earn from the portfolio is also essentially reducing the amount of capital I have at risk. For example, if I invest $1000 in Coca-Cola today, I can reasonably assume that I will receive about $30 - $32 in annual dividend income. If the dividend increases by 7%/year, this means that dividends will double every decade. This means that in 17 years, I would have received dividends equivalent to my entire investment, and I would also still be holding on to the original cash generating asset. Most importantly, over time, the quiet power of compounding would lift the amount of earnings, dividends and values of the average business that I invest in.

I know that of the 40 companies I purchase today, not all will be there in 2044 or 2054. Contrary to popular beliefs however, I expect that only a small percentage of those companies to fail outright. Many will end up merging with competitors, get acquired, change names or do spin-offs. Some will do just fine, while a small number will probably end up delivering outstanding returns to the portfolio, both in terms of dividends and capital gains. As a result, the goal is to do nothing but sit on that portfolio, and reinvest dividends when received in the best values available at the moment. It is important to avoid the temptation of selling

Since most investors I know do not have a lump sum just sitting there, waiting to be invested, the best course of action would be to start dollar cost averaging their way every month. If one gets into the habit of saving as much as possible, and then putting that capital in a broadly diversified portfolio of blue chip dividend stocks, reinvests dividends, and allows themselves a 20 – 25 years’ time horizon, they should do pretty well for themselves over time. This strategy worked even for those who were unlucky to start investing in US companies right before The Great Depression started. I view every $1000 that I save, I can essentially buy more time, and more freedom, that makes me get closer to my dividend crossover point. I love setting cash machines up, and then reinvesting dividends for decades to come.

As a result of all this, I have ended up with several brokerage accounts. I love starting a brokerage account from scratch, and then putting as much as I can save that month into it. The start is always slow, and usually the first dividend checks do not appear for one to three months at first. In addition, they could be anywhere from a few cents to a few dollars. As I keep putting more money to work however, as companies I own increase dividends, and I keep reinvesting those dividends into more shares, the total dividend income starts to reach pretty nice figures. It is absolutely exhilarating to watch the fruits of your regular investing efforts materialize. Once the portfolio achieves critical mass of $100,000 invested, I stop adding more money to it, and move onto my next portfolio building. I merely let the power of compounding do its heavy lifting over the next 30 years, while also remaining under the SIPC insured limits of $500,000 per account, that prevent me from partial loss of capital in case of broker failures.

In order to build wealth, it is important to focus on the big picture. We spend so much time in the present, that we sometimes get to forget that dividend investing is about putting money today, and leaving it uninterrupted for 25 years or so. In other words, the worries of today represent minor fluctuations relative to where things could be in 25 years. Focusing on noise today could prevent the investor from benefiting from the long-term power of compounding, which is what would truly bring success to the patient investor. Remember, time in the market is more important than timing the market.

I am often hearing even today that the stock market is about to crash, so people should wait on the sidelines and accumulate cash. I vehemently disagree with this - it is far better to have the discipline to put some money to work every month, like clockwork, and let that capital compound for 25- 30 years. In 25 - 30 years, it would not matter whether you purchased shares at the high or the low for the year. Even the 1987 stock market crash looks like a minor blip when taken in perspective.

A few companies available at fairly attractive valuations today include:

3M Company (MMM) operates as a diversified technology company worldwide. This dividend king has raised distributions for 57 years in a row. In the past decade, 3M has managed to boost dividends by 9%/year. The stock currently sells for 20 times forward earnings and yields 2.50%. Check my analysis of 3M company for more information about the company.

The Chubb Corporation (CB), through its subsidiaries, provides property and casualty insurance to businesses and individuals. This dividend champion has raised distributions for 33 years in a row. In the past decade, Chubb has managed to boost dividends by 9.80%/year. The stock currently sells for 13.20 times forward earnings and yields 2.30%. Check my analysis of Chubb for more information about the company..

Eaton Vance Corp. (EV), through its subsidiaries, engages in the creation, marketing, and management of investment funds in the United States. This dividend champion has raised distributions for 34 years in a row. In the past decade, Eaton Vance has managed to boost dividends by 12.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.40%. Check my analysis of Eaton Vance for more information about the company.

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has raised distributions for 45 years in a row. In the past decade, Altria has managed to boost dividends by 11.60%/year. The stock currently sells for 18.30 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.

T. Rowe Price Group, Inc. (TROW) is a publicly owned asset management holding company. This dividend champion has raised distributions for 29 years in a row. In the past decade, T. Rowe Price has managed to boost dividends by 16.60%/year. The stock currently sells for 16.90 times forward earnings and yields 2.50%. Check my analysis of T. Rowe Price for more information about the company.

Johnson & Johnson (JNJ), together with its subsidiaries, researches and develops, manufactures, and sells various products in the health care field worldwide. This dividend king has raised distributions for 52 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.80 %. Check my analysis of Johnson & Johnson for more information about the company.

Genuine Parts Company (GPC) distributes automotive replacement parts, industrial replacement parts, office products, and electrical/electronic materials in the United States, Canada, Mexico, Australia, New Zealand, Puerto Rico, the Dominican Republic, and the Caribbean region. This dividend king has raised distributions for 59 years in a row. In the past decade, Genuine Parts Company has managed to boost dividends by 6.80%/year. The stock currently sells for 19.20 times forward earnings and yields 2.70%. Check my analysis of Genuine Parts Company for more information about the company.

W.W. Grainger, Inc. (GWW) operates as a distributor of maintenance, repair, and operating (MRO) supplies; and other related products and services that are used by businesses and institutions primarily in the United States and Canada. This dividend champion has raised distributions for 43 years in a row. In the past decade, W.W. Grainger has managed to boost dividends by 18.20%/year. The stock currently sells for 17.80 times forward earnings and yields 1.90%. Check my analysis of W.W. Grainger for more information about the company.

United Technologies Corporation (UTX) provides technology products and services to building systems and aerospace industries worldwide. This dividend achiever has raised distributions for 22 years in a row. In the past decade, United Technologies has managed to boost dividends by 12.90%/year. The stock currently sells for 16.80 times forward earnings and yields 2.20%. Check my analysis of United Technologies for more information.

Full Disclosure: Long all companies listed above

Relevant Articles:

How to define risk in dividend paying stocks?
Stress Testing Your Dividend Portfolio
Time in the market is more important than timing the market
Common Misconceptions about Dividend Growth Investing
Warren Buffet’s Favorite Exercise

Friday, April 3, 2015

Becton, Dickinson (BDX) Dividend Stock Analysis 2015


Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. The company is a member of the dividend champions list, and has been able to boost distributions for 43 years in a row.

The company’s last dividend increase was in November 2014 when the Board of Directors approved a 10.10% increase to 60 cents/share. The company’s peer group includes Medtronic (MDT), Baxter International (BAX) and St. Jude Medical (STJ).

Over the past decade this dividend growth stock has delivered an annualized total return of 11.30% to its loyal shareholders.


The company has managed to deliver an 10.50% average increase in annual EPS since 2004. Analysts expect Becton Dickinson to earn $6.78 per share in 2015 and $7.42 per share in 2016. In comparison, the company earned $5.99/share in 2014.


Becton Dickinson has also managed to repurchase plenty of shares over the past decade, bringing the number of shares from 263 million in 2003 to 197 million in 2014. The company is not expecting much in terms of share buybacks following the acquisition of Carefusion, in an effort to deleverage quickly.

Becton Dickinson operates in three segments:

Medical (Over 50% of sales)

BD Medical produces a broad array of medical devices that are used in a wide range of healthcare settings. The primary customers served by BD Medical are hospitals and clinics; physicians’ office practices; consumers and retail pharmacies; governmental and nonprofit public health agencies; pharmaceutical companies; and healthcare workers.

Diagnostics (almost one third of sales)

BD Diagnostics provides products for the safe collection and transport of diagnostics specimens, as well as instruments and reagent systems to detect a broad range of infectious diseases, healthcare-associated infections (“HAIs”) and cancers. BD Diagnostics serves hospitals, laboratories and clinics; reference laboratories; blood banks; healthcare workers; public health agencies; physicians’ office practices; and industrial and food microbiology laboratories.

Biosciences (Approximately 14% of sales)

BD Biosciences produces research and clinical tools that facilitate the study of cells, and the components of cells, to gain a better understanding of normal and disease processes. That information is used to aid the discovery and development of new drugs and vaccines, and to improve the diagnosis and management of diseases. The primary customers served by BD Biosciences are research and clinical laboratories; academic and government institutions; pharmaceutical and biotechnology companies; hospitals; and blood banks.

I like the fact that almost half of revenues is derived from items that are essential and disposable, and which creates the need for customers to repeatedly keep buying more syringes and needles to name a few. I like that the Diagnostics segment is also characterized by recurring revenue streams, as the customers would face high switching costs if they move to another competition. Becton Dickinson’s scale allows it to compete effectively in the Medical segment.

Becton Dickinson should be able to generate higher sales in due to the sustainable demand for its diabetes products, disease testing products, and cell analysis products. The company generates almost 60% of its sales from international operations, which is expected to increase as it grows its presence in emerging markets. Becton Dickinson is also active on the acquisition front and is investing heavily in research and development, which should benefit the company through new product launches. Becton Dickinson has a solid long-term potential for its business, due to its strong position and due to the bullish prospects for its industry. The company enjoys strong demand for its products and a more favorable pricing than other competitors in its industry.

The company is in the process of acquiring Carefusion (CFN) for $12.20 billion, most of which is going to be paid in cash. The deal is expected to close in the first half of 2015. Given the cheap rates at which cash is available, this acquisition is likely to be accretive since it is paid for mostly in cash. The main risk is that Becton Dickinson has never made such a large acquisition before, which means that there is some integration risk.  The benefits include cost savings, increase in number of product offerings, improves scale and results in more access to different markets globally, including emerging markets. For example, the company expects to save $250 million by 2018 simply by reducing overhead and realizing efficiencies in manufacturing and operations.

The return on equity has increased from 22% in 2005 to 23.50% by 2014. I generally want to see at least a stable return on equity over time.

The annual dividend payment has increased by 13.70% per year over the past decade, which is higher than the growth in EPS. In my previous analysis I found that that BDX was one of the top dividend growth stocks for the past decade. The past four dividend announcements were for a hike of 10% in dividends each time. Going forward, I would expect dividend growth to closely approximate 10%.



A 10% growth in distributions translates into the dividend payment doubling every seven years on average. If we look at historical data, going as far back as 1975, one would notice that the company has actually managed to double distributions every six years on average.

The dividend payout ratio has increased from 27% in 2005 to 42% in 2013, before falling back to 36.40% by 2014.  A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

Currently Becton Dickinson is slightly overvalued at 20.20 times forward earnings, yields 1.70% and has a sustainable distribution. I initiated a small starter position in the stock in late 2013, after which the stock took off. This prevented me from adding more fresh capital to the company. As a long-term dividend investor in the accumulation phase, I get excited if the companies I am interested in are on sale, because I get to buy more shares with my limited amounts of capital. Although this price is a low probability event, I plan on adding to my position on dips below $96/share, equivalent to an entry yield of 2.50%. If I relaxed the requirement and required an entry yield of 2% however, I would need the stock price to fall below $120/share before adding more money to the company.

Full Disclosure: Long BAX, BDX and MDT

Relevant Articles:

Three Dividend Raises I am Thankful For
Baxter International (BAX) Dividend Stock Analysis
Top Dividend Growth Stocks of the past decade
Should you sell after yield drops below minimum yield requirement?
Evaluating Dividend Growth Stocks – The Missing Ingredient

Wednesday, April 1, 2015

Taxable versus Tax-Deferred Accounts for Dividend Investing

Dividend investing is a great strategy for accumulating income producing securities, which pay their owners cash on a regular basis. These cash distributions are viewed as taxable incomes in the eyes of the Internal Revenue Service (IRS). Depending on the taxpayers adjusted gross income, they could end up paying as much as 20% on the dividends they received. Compared to the top marginal rates on ordinary income such as salaries or bond interest however, dividend income has much lower tax rates. In retirement, qualified dividend income will not be subject to federal taxes for married couples earning $95,000/year (assuming no other sources of income). Unfortunately, it would take the average dividend investor years of accumulating assets, before they reach their dividend crossover point. This will result in them paying taxes throughout their accumulation phase. Many investors have the choice to shelter some or most of their investments in tax-sheltered accounts which could either postpone or eliminate the need to pay taxes on their investment incomes. By reducing or eliminating tax waste in the accumulation phase, dividend investors could reach the dividend crossover point much sooner than by doing it with taxable accounts alone.

There are several tax deferred account options for US investors who are still earning a paycheck. These include regular and Roth IRA’s in addition to 401 (k) plans. Each of these accounts has its pros and cons.

Traditional IRA’s provide investors with a tax benefit today, and allow them to compound their gains for years to come but have to take required minimum distributions at the age of 70 ½ years. Distributions are taxed as ordinary income. However there are strict eligibility rules that do not allow high income households to get the deductibility of contributions. Other negatives include the low contribution limit of just $5,500/year. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. The largest negative includes a 10% early distributions penalty that the IRA imposes if someone withdraws funds prior to the age of 59 ½ years. However, you can pretty much invest in almost anything with your IRA.

Roth IRA’s do not provide any tax benefit to investors today, but allow for tax free compounding of capital and tax free distributions from the account at the age of 59 ½ years. Direct contributions can be withdrawn tax-free at any time, although investors need to wait until they are 59 ½ years old, before they can withdraw gains from the account without a penalty. Investors cannot put more than $5,500/year in a Roth IRA, and there are strict income eligibility requirements to open an account as well. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. Another advantage of a Roth IRA is that there are no required minimum distributions requirements. With my Roth IRA’s, I can pretty much purchase any US Dividend Growth Stock I choose, and I like this flexibility. Tax payers are taking a gamble with Roth IRA’s however, as cash strapped Congress could decide to tax distributions in the future. Of course, it is also likely that tax rates on qualified dividend income will increase before Congress doing anything about limiting or taxing Roth IRA's for middle-class consumers.

The 401 (k) plan is the company sponsored defined contribution plan, that millions of Americans are eligible for. The annual contribution limit is $18,000/year for those under the age of 50. If you are over the age of 50, you can contribute up to $24,000/year to your 401 (k). The majority of 401 (k) plans allow participants to put pre-tax contributions today, and enjoy tax-free compounding of capital. They do have required minimum distributions starting at the age of 70 1/2 years old. This is when you will have to pay ordinary income taxes on any money you withdraw from the 401 (k). An increasing number of employers are now also offering Roth 401 (k) contributions, with the same limits as the traditional 401 (k). The nice thing is that contributions are after-tax, the money compounds tax-free, and there are no taxes to pay on investment earnings. The drawback of most 401 (k) plans for many investors is the limitation on the types of investments to choose. A good 401 (k) plan will offer low cost mutual funds to investors. A really good 401 (k) plan will also offer a Brokerage Link window, that would allow investors to pick their own investments. A really bad 401 (k) plan will include high-fee mutual funds with sales loads. If the fund you are purchasing charges an annual management fee of 1%/year, chances are this is part of the offering of a bad 401 (k) plan.

One disadvantage of both accounts (IRA and 401 (k)) is that you cannot deduct investment losses, or offset them against investment gains. In addition, foreign dividends are subject to witholding taxes at the point of origin despite the fact that they are in a tax-sheltered account. Unlike taxable accounts, investors cannot get a tax credit for these foreign tax withholdings. Dividends in tax-sheltered accounts of US investors which are derived from Canadian or UK companies are not subject to tax withholdings.

Despite popular beliefs however, Master Limited Partnerships can be held in tax deferred accounts, as the UBTI which scares investors off is mostly a non-event ( and has been in my few years as an MLP investor, although things might change). In the years that I have owned ONEOK Partners (OKS) and Enterprise Product Partners (EPD), I have never had positive UBTI.

In addition, investors need to choose whether to open a Roth or a Traditional IRA with their $5,500 in a given year, but cannot open both. Investors can still have an IRA and a 401(k) plan however. Given the lack of investment options in 401 (k) plans, they are of limited value to the self-directed dividend growth investor. 401 (k) plans are helpful as a tool to minimize taxes and get the company match, and buy a few index funds, which is why they work for mostly passive investors. The nice thing about 401(k) plans that I utilized in 2013 is that if you quit your job, you can rollover the money into an IRA. After that, you can pretty much invest in anything you want, including creating your own dividend stock portfolio.

In my investing portfolio, I keep most of my holdings in taxable accounts.The taxable accounts give me a lot of flexibility in my investments, and I can add or withdraw as much as I want at a moment’s notice. I do pay taxes on my investment income, but I also get to do tax loss harvesting on my investments.

I expect that by the end of 2015, I would have approximately 10 - 15% in tax-deferred accounts such as 401 (k), IRA, Roth IRA, SEP IRA and Health Savings Accounts (HSA). This is mostly because I used to believe that there are too many restrictions on withdrawing principle and accumulated gains from these tax-advantaged accounts. As a result, I used to contribute only the bare minimum to my 401 (k) in order to get the company match.  As I researched further, I realized that it is possible to withdraw money out of an IRA before the age of 59 and a half penalty free. With Roth IRA's, contributions can be withdrawn penalty-free at almost any time. With 401 (k) plans, investors can start withdrawals penalty free if they have separated from service, and they are 55 years of age or older. Or, just like with IRA's, investors can use Substantially Equal Period Payments (SEPP) and withdraw money to live off at any age. The only catch is that if you start withdrawing money using SEPP, you need to continue doing it for the next 5 years or until you turn 59 1/2 years - whichever is longer.

The part I don't like about taxable accounts is that I was paying too much in taxes on salary and investment income. Taxes are the largest expense item on my personal income statement. Therefore, I have been maxing out all tax-deferred investment vehicles like crazy since early 2013 (luckily for some I was able to contribute for 2012 as well). I have saved tens of thousands of dollars in Federal and State taxes in the process. Prior to that epiphany, I had only contributed slightly more than the employer match I received. If I had to do it all over again, I would have been much smarter about the tax-efficiency of my investments. If my accumulation phase lasts for one decade, this means I would have to pay taxes on the money I want to invest in a taxable account, and then pay taxes on distributions I receive for that entire decade. It is little consolation that when I become FI, my dividend income will be tax-free. When you have too much waste in the accumulation phase of investing for retirement/FI, you end up with less money to invest, since you are paying so much in taxes.

My goal in retirement is to essentially live off dividends (qualified dividends) and pay no taxes in retirement. Using 2015 rates, a couple that is married and filing jointly will not pay any federal taxes if they earn less than $95,500 in qualified dividend income. This exercise assumes that the couple has no other source of income.

The couple will have a standard deduction of $12,600, and the personal exemptions will be $8000 ( $4000 per person), for a total of $20,600. In order to avoid paying taxes on qualified dividend income, the couple needs to make sure that they stay in the 15% marginal tax bracket. The highest income per that bracket for 2015 is $74,900. Therefore, adding $74,900 to $20,600 gets us up to $95,500.

My strategy for tax-free income is to live off qualified dividends and not pay any taxes in the process. However, I also expect to convert 401 (k) and IRA balances into Roth slowly. You can recall that I get a 25% - 30% deduction for putting money in 401 (k) and IRA today. My goal is to convert that amount in 401 (k) and IRA slowly into a Roth IRA when I retire, and to pay no taxes in the process.

How is that possible?

Let’s assume that a married couple files taxes jointly and has no other income than $74,000 in annual qualified dividends. This means they will pay no taxes on that qualified dividend income. However, if they rolled over $20,600 from an old 401 (k) into a Roth IRA, they will pay zero taxes on the conversion.

This is possible, because a 401 (k) to Roth IRA conversion creates ordinary taxable income. However, ordinary taxable income that is lower than the sum total of the standard deduction and personal exemptions creates a taxable liability of zero. The sum total of the standard deduction and personal exemptions for a married couple comes out to $20,600 for 2015. And of course, since the sum of the $20,600 IRA conversion and the $74,000 in qualified dividend income is less than $95,500, the total income stream will be tax-free at the Federal level.

Therefore, if the couple has a 401 (k) with $100,000 in it, they can expect to convert it into a Roth IRA within 5 years or so and pay no taxes in the process. This is a pretty sweet deal, because the couple likely received hefty tax breaks in saving the money into a 401 (k) in the first place. However, they converted it into a Roth IRA, which means that any future distributions from this Roth IRA will be tax-free. This is the type of deal where you get your cake and you eat it too, which is very appealing to the Dividend Growth Investor.

And to add another thing for you to think about, it is important to complete these 401 (k) to Roth IRA conversions before you start claiming Social Security benefits. This is because the addition of Social Security Benefits will increase ordinary taxable income, and could lead to paying some tax on the 401 (k)/IRA to Roth IRA conversion. In addition, it is really important that the conversion of a 401 (k)/IRA to Roth IRA occurs prior to the age of 70 and a half years, in order to avoid having to make required minimum distributions (RMD). Those Required Minimum Distributions from a 401 (k) or IRA are subject to ordinary income taxes. If you have already completed the conversion to a Roth IRA prior to the age of 70 and a half, you will not have to make required minimum distributions. This is why tax planning is so important - it can add more money for the investor, speed up the process of asset accumulation, and reduce tax expenses in retirement.

Full Disclosure: None

Relevant Articles:

How to Retire Early With Tax-Advantaged Accounts
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
My Dividend Goals for 2015 and after
How to accumulate your nest egg

Monday, March 30, 2015

Comparing your results to S&P 500 could be dangerous for dividend investors

As a dividend growth investor, I tend to create diversified portfolios full of companies that regularly raise dividends. I try not to overpay for shares in these companies, when I put my money to work. Dividends are more stable than capital gains, which is what makes them ideal for those who want to live off their nest eggs. The end goal for me is to generate as much in dividends to pay for my regular expenses every month. I expect the forward dividend income generated in my taxable accounts to reach the dividend crossover point at some point around 2018. The stable nature of dividend income makes it easier provides much more confidence in projecting future dividend income at a certain point. On the other hand, I cannot tell you whether the value of the portfolio will be twice as much as today's or half as much.

However, I regularly receive some feedback from new readers, because they might have overheard about the importance of benchmarking against a common benchmark, such as the S&P 500. While I have tracked results versus S&P 500, I think that this is not a value added activity for my strategy and my goals. I believe that tracking my total return performance relative to S&P 500 is not going to add any actionable insights, that would help to me achieving my goals. My goals including reaching a certain target annual dividend income within a certain time period. Whether I do better or worse relative to some random benchmark is irrelevant to my long term goals and objectives.

I monitor the annual operating performance of the businesses I have invested in, as I review them at least once every 12 - 18 months. I also review press releases regarding quarterly results, dividend increases announcements, mergers and acquisitions. I track the organic dividend growth rate for my portfolio. I also track dividend income received, and try to understand whether growth came from organic dividend growth, dividend reinvestment and new cash contributions. As you can see, it doesn't matter for my goals and objectives, if over the next 5 - 10 - 15- 20 years the total return on my portfolio is better or worse than the S&P 500. Not only is relative performance versus a benchmark lacking actionable insights for me, but it could be downright dangerous for dividend investors like me.

The biggest danger in comparing my performance to that of the index, is reaching dangerous conclusions. For example, stock prices do not go up or down in a straight fashion. They move depending on a variety of factors, that few can predict in advance. Sometimes, even quality companies might be under appreciated by market participants, and their stock prices might stagnate for extended periods of time. At the same time stock prices can be increasing, as evidenced by stock indexes. However, if the fundamentals of the underlying businesses are doing well and improving, then holding on to those businesses might still make sense. This is because while their price is doing worse relative to the stock market index, they are getting more valuable, despite being underappreciated by the stock market. It might take the quoted price some time before investors realize this discrepancy and bid up the price. If I sold undervalued shares, to buy something that has done well in price, I would be selling low and buying high. I believe that this is not smart investment behavior. Please remember that the stock market is there to serve you, not to instruct you. The time to sell a business is when it no longer performs to expectations, not because the stock prices a group of other businesses have done better in the past 3 - 6 months.

For example, back in 1999 - 2000, many shares of tobacco companies, financials, utilities and REITs were punished by investors who wanted new economy technology companies. The popular indexes such as S&P 500 and Dow Jones Industrial's Average added technology companies in 1999 - 2000. The performance of those companies was great for a while, as everyone gobbled up those shares in speculative frenzy. The old economy boring companies were not viewed as attractive enough. If a dividend investor had sold their tried and true investments because they underperformed for a short period of time, they would have made a terrible mistake.

If I am impatient however, I would feel like I am missing out by comparing my “slow moving” stocks to the index and chances are I would sell as a result of the exercise. This is usually at the same time that the index would likely start dragging its feet, while the shares of the former “slow mover” finally get appreciation by buyers. I see this happen again and again. This is why most individual investors never make any money in stocks – they go from one strategy to the next, chasing hot strategies and looking for something that magically works all the time. If they stick to a slow and steady strategy like dividend growth investing, they would do very well for themselves over time. This is because rising earnings per share, leads to rising dividends per share, which ultimately makes stock prices more valuable. Plus, the fact that most dividend investors are truly passive, they can compound their capital for decades investing in what they know. Studies have shown that the more passive the investor, the higher the chances for satisfactory long-term performance.

My goal should be to have a portfolio that produces slow and steady returns that I can live off of. If I get scared because my portfolio underperforms for a few years, and I end up switching at the worst possible time, I would likely never make any money investing in stocks. The real lesson here is to have a solid understanding behind my strategy, and then to have the patience to stick to it through thick and thin. If I sold my dividend portfolio holdings today and I invest everything in an S&P 500 fund, my dividend income will drop by 45 - 50%. This will be caused by the fact that I will have to pay capital gains taxes on unrealized capital gains and I will have to accept a lower current yield. This change would actually require me to spend more time working at a job that I might or might not enjoy. Since I am not a robot, I have a limited number of years on this earth that I can spend working, rather than enjoying life. In addition, index funds contain a lot of companies that do not pay dividends. And as we know, relying on capital gains works great during a bull market and prices move up. However, if prices are flat, as they were between 1929 - 1953 or 1966 - 1982 or 2000 - 2012, my portfolio will not last for long if it doesn't yield anything. Selling off stocks in your portfolio results in less stocks available over time. If prices do not grow fast enough, you will deplete your portfolio. Selling off chunks of my portfolio to live off is similar to cutting the tree branch you are sitting on. Why not just pick the fruit from the tree, and let it grow uninterrupted?

When someone tells me they are going to sell securities from their portfolio, they are essentially telling you that they blindly believe the stock market will only go up during their retirement. This flawed thinking ignores past history, and sequence of return risks in the portfolio distribution phase. It also resembles the flawed belief by some homeowners between 2000 - 2008 that they can tap equity from their appreciating homes and spend the proceeds. Treating your house like a piggy bank, and relying on increases in house prices to live off turned out to be a poor choice. Spending too much time comparing yourself to the Joneses, is another folly people do. To me, comparing total returns of my portfolio relative to that of someone else's is a perfect example of keeping up with the Joneses. This can only lead to folly behavior.

I am not a big fan of dividend funds or dividend ETF's either. Even dividend growth funds tend to do bizarre things such as keep companies that have cut dividends for almost an year, as was the case of Citigroup in 2008. Another bizarre thing I have seen is when some companies are not included, or others are taken out, as was the case of Altria (MO) being dropped from the S&P Dividend Aristocrats index in 2007. A third example includes my purchase of Higham Institution for Savings (HIFS) in 2010, which was not covered anywhere else except on the list provided by David Fish.  As you can see, indexing does not work for my goals and objectives. However, it could still work for anyone else. Because I am the only one who truly cares about reaching my own goals and objectives, I create my own portfolios by picking individual stocks.

To reiterate the biggest danger in comparing to index funds is that any under or over performance produces no actionable insight for my portfolio management. On the contrary, it can cause me to abandon my strategy at the worst time possible, simply because I “underperformed” the index. With dividend growth investing, I would likely at least match total returns of S&P 500 over long periods of time like 20 years for example. This could include variations in under or over performance over periods of time of varying lengths. However, just because I underperformed for 3 years, it doesn’t mean I would underperform for next 3 years. Because of reversion to the mean, the 3rd year of underperformance might mean that dividend stocks are cheaper than the stock market as a whole. Therefore, they could provide much better returns for the next few years, relative to a market index such as the S&P 500. As usual, past performance is not a predictor of future performance.

The real reason why everyone encourages individual investors to buy index funds in the first place is because some individual investors are horrible at making investment decisions. Not only are they terrible at investing, but they are overconfident and overtrade, fail to stick to a single strategy because they are afraid of missing out on the next big thing. The common fallacy among inexperienced investors is that you need to find the next Microsoft to make money in stocks. Unfortunately, few ever find the next Microsoft, but many lose a lot of money in the process. In fact, these investors would have been better off simply buying and holding on to the original Microsoft in the first place.

(The conclusion that individual investors are terrible at investing is based on data I have analyzed from DALBAR. While I am sure DALBAR is a reputable organization, I have learned to always take information with a grain salt and some healthy dose of skepticism. This is because the information is used by financial providers, advisers and mutual fund companies in order to get clients. Since Dalbar's clients are financial services companies, DALBAR has an incentive to show how bad individual investors do on their own.  If you prove to investors that they need help from the financial industry, they are more likely to come and earn money for your company. There is an incentive for DALBAR to not compare apples to apples, in order to make a case against individual investors. So, as Charlie Munger says, "Never ask a barber if you need a haircut" )

The truth is that if you build a diversified income producing portfolio with companies that are purchased at fair prices, and you do little activity every year, you stand a chance to do pretty well over time.

I reached these conclusions after studying the performance of the original 500 stocks in S&P 500 in 1957 versus index, as well as the ING Corporate Leaders fund for the past 50 years. Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index? Did you also know that S&P 500 frequently makes changes to its index methodology, which would have reduced past performance numbers?

In addition, if you study the history of the ING Corporate Leaders fund, you can gain a glimpse of the potential in a truly passive buy and hold portfolio. The trust was formed in 1935 with a list of 30 blue chip dividend paying stocks. Given the mergers, acquisitions, dividend eliminations, the list is now down to 22 companies. Over the past 50 years, the fund has managed to return 10.20%/year, versus 9.80% for the S&P 500. The trust sells when a company eliminates dividends or stock price falls below $1.

To summarize, it looks as if the only way to achieve my goals and objectives is by constructing portfolio myself, by purchasing companies with sustainable advantages at fair prices, and then holding passively for the long run. Being passive should be the goal, as selling is usually one of the biggest mistakes investors make. It is a mistake because few can just sit tight and enjoy the ride while ignoring the noise out there. Frequent churn could be costly. Cutting investment costs to the bone is also very very important. If you have a $1 million portfolio invested in index funds, you are likely paying $500 - $1000 every year. You can easily purchase stakes in 30 – 40 of the largest dividend paying blue chips listed in America, and just hold them for eternity. Some of those will fail in the next 40 - 50 years, others will merge or be acquired or spin off countless subsidiaries. A third group would likely still be around 40 – 50 years later, showering you and your descendants with more dividend income than you ever imagined in your wildest dreams.

Update: I have received a tremendous amount of hate mail from index investors related to this article. One index investor just wished me that my portfolio goes to zero. I wonder if they realize that their wish means S&P 500 will also go to zero.

Full Disclosure: Long MO, HIFS

Relevant Articles:

Dividends versus Homemade Dividends
Why I am a dividend growth investor?
Dividend Portfolios – concentrate or diversify?
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
How to be a successful dividend investor

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