Wednesday, April 30, 2014

The importance of yield on cost

Yield on cost is a controversial term, which is calculated by dividing the dividends received from an investment over the cost paid for the shares. There are many arguments whether yield on cost matters or not. I typically view yield on cost as a forward looking metric, which combines my yield and growth expectations into a single indicator that translates into tangible dividend income at a future point. As a dividend growth investor, I want to purchase companies that can afford to regularly grow dividends out of consistent earnings growth.

For example, let’s assume that I invest in a company like Yum! Brands (YUM) which yields 2% today, but could easily afford to grow distributions by 12% /year over the next decade. This would be fueled by strong emerging markets growth in places like China, where competitor McDonald’s (MCD) is a distant second. While a 2% current yield is low for many income investors’ standards, a consistent growth in earnings and distributions could lead to much higher dividend incomes and strong capital gains for investors who buy today. A $1,000 investment today would generate $20 in annual dividend income. If annual dividends grow by 12%/year over the next decade, the annual dividend income will grow to $62, for an 6.20% yield on cost. Chances are that the stock will still yield 2% - 3% ten years from now. As a result, your $1,000 investment would likely have generated significant capital gains in the process as well.

When I first got started in dividend investing, I focused my energies on high-yield closed-end funds. I was attracted to their high yields, and monthly distributions. Unfortunately, at least once every year, each of these funds cut distributions. The stock price would fall, but the dividend yield would correct to the previous level. I would fool myself into believing that reinvesting the distributions into more shares would maintain my income and net worth. Unfortunately, the falling distributions meant that the share prices were declining, which meant that my losses were compounding. My yield on cost was decreasing as well. While my current yield was 10% – 12% on investments such as the Managed High Yield Plus Fund (HYF), my yield on cost was much less than that. Only through reinvestment of distributions was I able to have lower losses.

At the end of 1999, HYF traded at $10.70/share and paid 12.50 cents in monthly distributions. By 2004, HYF was trading around $6/share, and paying a monthly distribution of 5.50 cents/share. The distribution decreased all the way to 4 cents/share by the end of 2007, while the stock price was around $3.71/share. Currently, the Fund is trading around $2/share, and pays a distribution of 1.50 cents/share. You can see that the yields remained high throughout the period. However, for investors who purchased in 1999 or 2004, the yield on cost is equivalent to anywhere between 2% - 3%. In addition, these investors would be sitting at huge unrealized losses.

Other companies who offer similar high yields today, with the prospect of lower distributions over time, include US oil and gas royalty trusts. These trusts purchase established oil and gas assets, and pay out all of the net cashflows to investors. Once the oil and gas wells that these trusts own are pumped out dry in two or three decades, there will be nothing left over. Furthermore, the amount of oil and gas pumped out every year will decline over time, and unless prices increase at much faster rates, distributions will be projected to decrease. This information is typically shown in securities registration statements filed with the SEC. Unfortunately however, many yield chasing investors do not bother reading prospectuses.

Compare this to a typical dividend growth stock where the company is committed to raising dividends per share out of earnings. This type of company is typically overlooked by many yield hungry investors. However, most dividend growth companies in the dividend achievers or dividend champions lists tend to follow a slow and steady approach to raising distributions. Over time, the stock price increases, and yield stays in the same low range. The yield on cost increases however, as evidenced by the high amount of dividend income received by our dividend investor.

Of course, improving fundamentals such as earnings per share are what truly provides the fuel behind rising dividends. Rising dividends is typically a byproduct of rising sales and income.

A few companies that fit the perspective of higher expected earnings over time, and higher dividends include:

The Coca-Cola Company (KO), a beverage company, manufactures, markets, and sells nonalcoholic beverages worldwide. Over the past decade, the company has managed to increase dividends by 9.80%/year, supported by a 7.90% annual increase in earnings. This dividend king has managed to increase dividends for 52 years in a row. Currently, the stock at the top range of valuation range for me at 19.60 times forward earnings. The stock yields 3% at present levels. At a 7% growth in dividends, yield on cost could reasonably be estimated at 11% - 12% in 2034. Check my analysis of Coca-Cola.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. Earnings per share increased from $3.32 in 2008 to $5.26 in 2013, while quarterly dividend amounts went up from 46 cents/share to 94 cents/share in the same time frame. Philip Morris International has managed to increase dividends for 6 years in a row. Currently, the stock is attractively valued at 16.20 times forward earnings and yields 4.50%. At a 9% growth in dividends, yield on cost could reasonably be estimated at 25%  - 26% in 2034. Check my analysis of Philip Morris International.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. Over the past decade, the company has managed to increase dividends by 9.90%/year, supported by an 8.60% annual increase in earnings. This dividend achiever has managed to increase dividends for 11 years in a row. Currently, the stock is attractively valued at 18.20 times forward earnings and yields 3.10%. At an 8% growth in dividends, yield on cost could reasonably be estimated at 14% - 15% in 2034.Check my analysis of General Mills.

ConocoPhillips (COP) explores for, develops, and produces crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids worldwide. Over the past decade, the company has managed to increase dividends by 15.70%/year, supported by a 6.20% annual increase in earnings. This dividend achiever has managed to increase dividends for 13 years in a row. Currently, the stock is attractively valued at 12.30 times forward earnings and yields 3.70%. At a 7% growth in dividends, yield on cost could reasonably be estimated at 14% - 15% in 2034. Check my analysis of ConocoPhillips.

Johnson & Johnson (JNJ), together with its subsidiaries, is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. Over the past decade, the company has managed to increase dividends by 10.80%/year, supported by a 7.20% annual increase in earnings. This dividend king has managed to increase dividends for 52 years in a row. Currently, the stock is attractively valued at 17 times forward earnings and yields 2.80%. At a 7% growth in dividends, yield on cost could reasonably be estimated at 11% in 2034. Check my analysis of Johnson & Johnson.

Full Disclosure: Long YUM, MCD, KO, PM, JNJ, COP

Relevant Articles:

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Monday, April 28, 2014

Two Dividend Kings Extending Their Dividend Growth Streaks in April

My strategy for financial independence is called dividend growth investing. I constantly monitor the group of dividend champions and dividend achievers for companies which are attractively priced. I then analyze them in detail, in order to determine if the business can continue earning more, in order to pay me rising dividend checks in the future. I have managed to build my dividend freedom portfolio one stock at a time over the past six years. I am incredibly patient, which is why I hold on to any quality company I bought, as long as the dividend is not cut or eliminated.

One part of my monitoring process is regularly checking the list of companies that have recently announced increases in their dividend rates. Company management only approves increasing dividends if they expect earnings to improve over the next several years. That is why dividend increases are typically a bullish sign for investors who hold dividend growth investments. Over the past month, there were a couple dividend kings, which extended their streak of regular dividend increases.

The Procter & Gamble Company (PG), together with its subsidiaries, manufactures and sells branded consumer packaged goods. The company’s board of Directors approved a 7% hike in quarterly dividends to 64.36 cents/share. This marked the 58th consecutive dividend increase for this dividend king. Over the past decade, Procter & Gamble has managed to increase dividends by 10.60%/year. This was fueled by a 7.60% increase in annual earnings per share over the same period. Analysts expect the company to earn $4.21/share in 2014 and $4.54/share in 2015. In comparison, Procter & Gamble earned $3.86/share in 2013. Currently, the stock is fairly valued at 19.30 times forward earnings and yields a very sustainable 3.10%. I would plan on adding to my position in the company, unless of course there are other more attractive investments available. Check my analysis of Procter & Gamble.

Johnson & Johnson (JNJ), together with its subsidiaries, is engaged in the research and development, manufacture, and sale of various products in the health care field worldwide. The company’s board of Directors approved a 6.10% hike in quarterly dividends to 70 cents/share. This marked the 52nd consecutive dividend increase for this dividend king. Over the past decade, Johnson & Johnson has managed to increase dividends by 10.80%/year. This was fueled by a 7.20% increase in annual earnings per share over the same period. Analysts expect the company to earn $5.88/share in 2014 and $6.33/share in 2015. In comparison, Johnson & Johnson earned $4.81/share in 2013. Currently, the stock is attractively valued at 17 times forward earnings and yields a very sustainable 2.80%. I plan on adding to the company this year, subject to availability of funds. Check my analysis of Johnson & Johnson.

Those companies have managed to accomplish their dividend streaks, because they had strong business models, and diversified streams of earnings that kept growing through good and bad years. This is the type of quality income security that every dividend investor worth their salt should study.

Full Disclosure: Long JNJ and PG

Relevant Articles:

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Friday, April 25, 2014

Maintaining Moats in times of Technological Changes

Over the past thirty years, we have witnessed unprecedented changes in technology. Some of the industries affected included newspapers, mail services, telecommunications and business forms processors.

In the pre-internet era, news were provided primarily through newspapers and television. The newspaper was published mostly once or twice per day, and included all of the information that someone would need for a given topic or their broad geographic location. The main revenue driver was the classified ads section, which provided essential information about jobs, services and special deals in the community. It provided an essential service by connecting buyers and sellers for goods and services in the area. Unfortunately, with the advent of the internet, news is quickly disseminated and available online in real-time. As a result, few people are actually willing to pay for news. In addition, sites such as Craigslist have managed to replace classified ads section in newspapers with their own bulletin board where interested parties can meet and exchange goods or services. This has eroded moats in the newspaper industry, and led to steep declines in profits. Previously, newspaper companies such as Gannett (GCI) and New York Times (NYT) were known for their long histories of raising distributions. The decline in newspaper profits and the financial crisis led to dividend cuts across the board. The only winners that have managed to somehow preserve their moat are specialized providers of information. A newspaper can still provide information online, but only to those who pay for it.

Mail services are another industry where the internet led to declines in profits. Fewer people send ordinary letters or greeting cards these days, as this has been replaced by email and egreetings. The US Postal Services has been slow to adapt to the new reality, has government mandates related to locations and store hours, and as a result has been losing billions. The one bright spot of the explosion in e-commerce have been packages. If you purchase a good online, you still need to have it delivered to you. This is where FedEx (FDX) and United Parcel Service (UPS) have been able to capture market share, and been able to grow profits. For companies like Pitney Bowes (PBI), which provides mail processing equipment and integrated mail solutions, the decline in importance of mail has affected bottom lines and has caused dividend payout ratio to rise to unsustainable levels and a dividend cut in 2013.

The world of telecommunications has been particularly affected by technology. Prior to the 1980’s split of AT&T, telecom was mostly a monopoly and earning utility like returns. After almost three decades of changes, fixed line services are a dying business, rendered obsolete by mobile phones. The telecom business is highly competitive, and it is pretty easy for a customer to switch carriers after their contract expires. There are a few fixed line telecom firms traded in the US, which pay very high yields and have dividend payout ratios exceeding 100%. These include Frontier (FTR) and Windstream (WIN). Given their declining distributions over time, I do not foresee anything else but dividend cuts. Time is certainly not an ally for a dying business like fixed line telephony. I am also highly skeptical of telecom firms like Verizon (VZ) and AT&T (T), since providing cell phone service is a commodity product that requires huge upfront investment and huge investments every few years or so, simply to keep up with competitors. All major cell phone carriers in the US carry similar phones these days, and have essentially similar customer experiences. Verizon and AT&T have mostly managed to earn a lot of money, because they managed to gather most of the subscribers through mergers and acquisitions. However this has happened at the expense of number three and number four carriers.

In addition, the business is characterized by the need for huge investments every few years or so, in order to maintain their status quo in the hot new technology of the day, whether it is LTE or 4G. I own a very small amount of Verizon, as a result of my investment in Vodafone (VOD) in early 2013. However, I doubt that dividends will grow fast enough to maintain the purchasing power of your income over the next 20 - 30 years.

As a result, the goal of the dividend investor is to focus on industries, which would benefit from technology, and whose moats would not be impacted. I highly doubt that technology would impact food companies like General Mills (GIS) or companies like PepsiCo (PEP). I also doubt that consumers who brush their teeth with Colgate-Palmolive (CL) products or those who shave every day using Procter & Gamble (PG) products like Gillette would impact the way these companies do business. On the contrary, technology could lead to more efficient supply chains, further reduction in inefficiencies, and further improving products to better fit the needs of customers.

Full Disclosure: Long VZ, VOD, GIS, PEP, CL, PG

Relevant Articles:

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Wednesday, April 23, 2014

Dividend Growth: The Risk of Being Cocky






There are many risks to investing. One of the major risks that could ruin a portfolio’s chances of generating adequate dividends are purely psychological. Investors who act/are overconfident in their abilities, tend to rush through, and make silly mistakes that could be disastrous. Being cocky might work in certain areas of life, but not in investing on the financial markets.

One of the risks that overconfident investors take is when they create a concentrated dividend portfolio. These concentrated portfolios typically include no more than ten to fifteen individual securities. These cocky investors claim that they create these concentrated portfolios because they are only investing in their best ideas. According to these investors it is much easier to focus all your energy on ten individual stocks and research all there is to them, than to focus on thirty or more companies. The reason why I view these investors as overconfident is because they are forgetting that sometimes, no matter how great you are at analyzing investments, some unknown factor might cause you to still lose money. If just one out of ten companies eliminated dividends and fell substantially in the process, it could mean trouble. Contrast this to a portfolio of 30 companies, which is properly diversified and allocated to different sectors. An unexpected blow to one company would not jeopardize the dividend income stream.

One other thing that makes me wonder about investors with concentrated portfolios of stocks is the sleep well at night factor. I sleep very well at night knowing that I personally own more than 40 individual dividend paying stocks. That way, if I picked the next Enron or Bank of America (BAC) who cut or eliminated dividends, I would still have 38 more positions which would maintain and even increase dividends. In a ten stock dividend portfolio, one or two stocks that cut or eliminate distributions could spell trouble.

In my portfolio, I have a decent allocation of Energy stocks. I own or have owned Exxon Mobil (XOM), Chevron (CVX), British Petroleum (BP), ConocoPhillips (COP) and Royal Dutch Shell (RDS/B). In 2010 BP had the big issue with the oil spill. I truly believed that it would not have that big of an impact, and imagined it would be similar to the Valdez issue with XOM in 1989. At this point I was speculating that nothing would happen. In hindsight, I should have sold right when the first bad news broke in 2010, but instead I held on. I replaced BP with Royal Dutch Shell when the dividend was eliminated. Some would argue that in a concentrated portfolio where BP was held, the owner would have had a much faster response than myself. To this I say, great but you cannot simply afford to sell at the moment that there is any slight chance of trouble in a business you are invested in. Otherwise you would never hold any company for any period of time. My ability to hold on to positions has been rewarded in the case of Johnson & Johnson (JNJ), when they had big recalls in 2010. In addition, simply selling all financials indiscriminately during the 2007 – 2008 financial crisis would have been a mistake as well, as some companies actually maintained distributions. M&T Bancorp (MTB) is a prime example of a company which maintained its dividends, despite the fact that it was one of the TARP recipients. I never added money to my small position from 2008 however, which is why it is merely a footnote in my list of dividend holdings today. However, I have recovered almost one-quarter of my purchase price from the dividends received since 2008.

Another argument that proponents of concentrated dividend investors use is the quote from Warren Buffett “Diversification is protection against ignorance”. I have a great respect for Buffett, but know that unfortunately, there is only one Buffett. The Oracle of Omaha has had his Berkshire Hathaway investment’s pretty diversified over the past 40 - 50 years. He has made some pretty bad bets in the past, including purchasing the ailing Berkshire Hathaway (BRK.B) in the first place in the late 1960s. I for example own over 40 individual stocks. They are the best ideas I have accumulated over the past six - seven years of focusing exclusively on dividends. In a previous article I explained that researching stocks and keeping up with major developments doesn’t really take that much time. Once you learn the story behind a successful company, it does not take as much time to update your knowledge every year.

I have observed people with concentrated portfolios, and I have been able to classify them in two categories. The first category is those who are using “play money”. At the end of the day, I would never take an “expert” dividend investor seriously, if they do not have substantially most of their investable portfolio in dividend stocks. An investor who purchases some dividend stocks, while having the majority his/her investable assets in other vehicles, all the while claiming to be an expert is probably teaching you the wrong skills. After all, how can someone who does not actually plan to rely on dividend income for retirement teach you about dividend investing for retirement?

The second category consists of people who want to outperform the market, and believe that this is the easiest way to do so. These are the gamblers, who know that concentrating their portfolios in a few risky investments could pay off big time. Their goal is to generate some impressive track record in a short period of time, in order to sell investors their managed fund services. After all, if you find one company that would go up 100% in a period where the market is up only 10%, this looks pretty impressive. However, your portfolio results would be much better if you have 9 other stocks versus 29 other stocks in an equally weighted portfolio.

As a dividend investor, my goal is not to outperform the market but to generate a stable income stream that will proving a growing amount of income every year. That is why I invest most of my money in dividend growth stocks. I would not receive a pension, and I also plan on retiring much earlier than 55. As a result, safety of principle and income is as important to me as growing it over time. It would be stupid to risk my nest egg in an ego boosting exercise to prove that I can outperform the market. While I know that even the best researched top dividend stock can ultimately cut dividends in the future, my goal is to minimize this risk, while maximizing the potential of my income portfolio to grow distributions above the rate of inflation, all the while principal is safely growing as well.

Full Disclosure: Long RDS/B, CVX, COP, JNJ, MTB, BP,

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Monday, April 21, 2014

Seven Sleep Well at Night Dividend Stocks

For my retirement, I am planning on relying exclusively on income from my dividend portfolio. In order to achieve the dividend crossover point, I would need to be prudent about saving and then investing the cash in quality income stocks at attractive valuations. The valuation part is generally easy to convey using simple numerical equations such as:

1) A ten year record of annual dividend increases
2) Annual dividend growth exceeding 6%
3) A Price/Earnings ratio below 20
4) A dividend payout ratio below 60%
5) A minimum yield of 2.50%

I usually run this screen on the dividend champions list once a month and come up with ideas for further research or with alerts that stocks I like are attractively priced. The more difficult task is evaluating quality when it comes to stocks. It is often said that beauty lies in the eyes of the beholder. When assessing quality in income stocks, I am often finding that what I identify as quality might be trashed by someone else.

In general, a quality company is the one that has strong brand name products and services that customers are willing to pay top dollar for. The products/services associated with this brand name represent quality, and offer something of value to consumers that is only offered by this company. When a company is offering something that is uniquely distinguished, and is not a commodity, it can then charge a premium and can pass on cost increases to consumers if input costs increase.

For example, you can purchase Cola products from many companies including PepsiCo (PEP), RC Cola and Coca-Cola (KO). However, for many consumers throughout the world, Coca-Cola offers a refreshing taste that is unique to the product they like. Even if someone was able to reverse engineer Coke, they would not be hugely successful because they would offer a largely untested product that the consumer is not familiar with. The company has managed to increase dividends for 52 years in a row, and pays an annual dividend of 3%. Check my analysis of Coca-Cola.

The same is true for PepsiCo (PEP), which is a close rival of Coke in the Cola Wars. PepsiCo however is much more than a soft drinks company. It also sells snacks to consumers such as Lays potato chips. The food business is incredibly stable, as consumers are typically used to buying the brands they trust on their trips to the grocery store. In addition, it is much easier to charge higher prices for your product that the customer likes.The company has managed to increase dividends for 42 years in a row, and pays an annual dividend of 2.70%.  Check my analysis of PepsiCo.

Another quality company is Wal-Mart Stores (WMT), which is used by 100 million shoppers every week. The company is offering the lowest prices for everyday items that shoppers ultimately purchase. Wal-Mart has been able to distinguish itself as the lowest price store as a result of its massive scale in the US. That has allowed it to dictate terms for its suppliers, many of which feel lucky to have their products on display at the largest retailer in the US. For a competitor to replicate this success, it would take an enormous amount of capital and years of experience. The company has managed to increase dividends for 41 years in a row, and pays an annual dividend of 2.50%. Check my analysis of Wal-Mart Stores.

International Business Machines (IBM) is a quality technology company that I have always found to be slightly over valued for my taste. I like the fact that the firm has been able to successfully transform itself into essentially what is now a global consulting company, from the pure hardware behemoth it once was in the 1980’s and early 1990’s. The firm has achieved that by building relationships with clients, gaining their trust and offering them services that provide them great value. In business, relationships are very important. Technology is one aspect of the business, where companies are less likely to venture with an unknown firm simply to save a few bucks. It would be much easier to justify selecting a company like IBM for an important technology implementation, than a little known firm. Plus, if the IBM consultants have a working knowledge of a company or industry, they would be much better at delivering value for their clients. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 2%. Check my analysis of IBM.

Philip Morris International (PM) sells its Marlborough brand of cigarettes all over the world. Phillip Morris International has a high exposure to emerging markets, where number of smokers is increasing, along with their disposable incomes. Plus, it is not exposed to ruin if one country decides to ban tobacco outright. PMI has a wide moat, because it would be extremely difficult for a new company to start and compete against the long established brands like Marlboro. Consumers generally stay with the brands they are used to buying. Cigarettes are an addictive product, which spots very good pricing power. In addition, PMI has the economies of scale which ensure that its costs stay low relative to the competition. The company has managed to increase dividends for 6 years in a row, and pays an annual dividend of 4.50%. This is why this is the security I like best.

Another firm I like is Kinder Morgan Partners (KMP). This master limited partnership has the longest network of oil and gas pipelines in the US. It also has pipelines transporting oil and gas in Canada as well. The beauty of pipeline business is that it is federally regulated, and that companies that build pipelines seldom have competition. In essence, they are natural monopolies that connect the operators of oil and gas wells with the refineries and other end users, while receiving a toll charge. The amounts of oil and gas consumed in the US is remarkably stable, which is why a company with little competition that manages to charge toll type rates that are indexed with inflation seems like a good idea. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 7%. Check my analysis of Kinder Morgan.

The last company on the list is McDonald's (MCD). There are over 35,000 restaurants world-wide, which bear the name McDonald's. Over 80% of those restaurants are franchised, which means that McDonald's is earning a boatload of royalties off those restaurants merely for their right of using the strong brand name, without taking the risk and significant capital expenditures associated with restaurants. These franchise agreements last several decades, which all but ensures a regular stream of cash being sent to the headquarters. In many cases however, the company also owns the real estate under the restaurants ( both company and franchised), which is a hidden asset on the balance sheet, since many locations are on busy intersections and therefore extremely valuable. Plus, consumers like McDonald's, who is always quick to look for new opportunities for growth such as drive-through windows, new markets, change in menus, expanding store hours or drive-through lanes, etc. The company has managed to increase dividends for 38 years in a row, and pays an annual dividend of 3.20%. Check my analysis of McDonald's.

What makes this investments sleep well at night ones is the fact that their income is produced by a diverse set of divisions, geographies and products. Plus, I find them to be fairly valued in today's market, and I believe they have bright futures that would bring in more earnings and dividend income for shareholders in the decades ahead.

Full Disclosure: Long MCD, PM, KMR, KMI, KO, PEP, IBM, WMT

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Friday, April 18, 2014

Dividend ETF’s Are Bad for Investors: Here is Why






The Exchange Traded Funds (ETF) industry has ballooned since 1993, when the first ETF on S&P 500 was introduced. Currently, there are hundreds of ETF’s covering many investment strategies present. One strategy which is also being covered with dividend etf’s includes dividend paying stocks. In this article I would discuss the positives and negatives of dividend ETF’s, and explain why they are bad for income investors.

Pros:

Some of the positives of owning dividend ETFs include instant diversification, ability to invest passively and the ability to gain exposure if you do not have a lot of money.

1) Instant diversification,

The biggest allure of dividend ETF’s is the fact that investors can easily purchase a basket of shares with just one trade. This basket of shares would be representative of different industries included in the index, and would reduce the risk that our investor overcommits to a certain sector if they are prone to chasing yield for example. Plus, you get to pay one commission to purchase a whole basket of stocks, or some companies might let you purchase ETF's commission free.

2) Ability to invest passively

Another appeal of dividend ETF’s is that it lets investors purchase a basket of stocks, and then not have to worry about analyzing stocks, monitoring 30 - 40 companies in detail. This is the job of the investment manager in charge of the ETF, who reads annual reports, keeps up with current environment, calls companies and does all the leg work so that the investor does not have to do it. Reading annual reports could sometimes be an intimidating or very boring task for some investors. The dividend ETF is ideal for investors who want to set the investment, and forget it.

3) Good for beginning investors who are still learning and have less than $10,000

The investment in a dividend ETF or dividend mutual fund is probably best for beginning investors who have less than $10,000 to start with. It offers them instant diversification and passive investment at the fraction of the cost of a do-it-yourself portfolio using an online broker. Dividend ETF’s also make it very easy for investors to put additional funds to work, while maintaining sector diversification in the index and without worrying which of the 30 - 40 securities is the best one to buy.

Cons:

1) Annual costs

While Dividend ETF’s provide investors with instant diversification and the ability to let someone else to worry about the mundane details, the Ivy League investment manager comes at a price. In addition, most companies that offer dividend ETF’s also want to earn a fair profit on this product. As a result, investors in some of the largest dividend ETF’s like SPDR S&P Dividend (SDY) and iShares Dow Jones Select Dividend Index (DVY) pay 0.35% – 0.40% per year in management costs. If the stock portfolios in those ETF's yield 3% on average, this means that 12%-13% of your dividend income will be paid out as an investment tax. If our investor is also in the top bracket, and pays 23.80% federal tax on the income, they would end up with only two-thirds of their desired dividend income. While placing your stocks in a tax-deferred account such as a Roth IRA can eliminate taxation issues, placing your investments in ETF’s would result in recurring annual charges. In fact, investment companies end up charging their fees on a daily basis. This compounding of fees could cost investors large amounts of money over a normal 20 - 30 year investment period. While many ETF’s are now commission free at various brokerage houses, investors would need to pay a commission for most of the dividend ETF’s out there.

2) Investors have no say about which stocks the ETF holds

Another negative of dividend ETF’s is that investors have no say on how these baskets of stocks should be invested. Sometimes, a dividend ETF might hold shares that do not fit in its strategy for months. For example, back in 2008 and 2009, the SPDR S&P Dividend ETF (SDY) held on to shares of companies that cut or eliminated distributions for several months after the fact. As a result, a portion of the capital of this ETF was not properly invested and was not generating much in dividend income for investors. In addition, many dividend ETF’s are placing higher weights on higher yielding stocks, which could increase risk for income investors. This increases exposure to companies with accidental high yields which are large because the dividend is in danger. In addition, some of these ETF’s also tend to focus mostly on higher yielding sectors like utilities and financials, which could increase risk as the portfolios would not be properly diversified.

3) Investors fail to learn about investing

The most successful investors make their own investments, after a careful analysis. If investors simply purchase an ETF, they might not truly get an understanding of what they are buying and could pay a high price over time. Educating yourself on how companies make money, how the economy works and understanding how to value a security would be beneficial to investors who follow stocks, bonds, commodities or real estate. If they blindly buy ETF’s or mutual funds without fully understanding what they are getting into, they might be much more likely to lose money by selling out during bear markets or by getting overly excited about the wrong investments at the most inopportune times.

4) If not enough money is attracted, the ETF could be closed

Another less known risk about dividend ETF’s is that if the fund fails to attract enough investors, it could end up closing and returning money to investors. If our investor is passive and only checks their portfolio once or twice/year, this could mean that they can potentially miss on potential upside by not being invested in the markets. A small ETF size typically also translates into higher bid/ask spreads and higher annual costs.

5) Too much turnover

I am a pretty passive dividend investor, who makes sell transactions very rarely. In fact, I have realized that one of my largest mistakes I have committed in the past few years was selling fine companies in order to get something that I thought is better. The end result of this mistake is that I have ended up with more paperwork, and transaction costs, without really achieving a better benefit. Talk about reinvestment risk. Therefore, I am not a fan of ETFs or Mutual funds that have turnover, which produces capital gains that investors have to foot the bill for, without really getting anything extra. The issue with dividend ETFs is that they contain quite a lot of turnover, and unfortunately the investor does not have any say about it. Honestly, if a company I own froze dividends for a few years, it would not be a strong enough sell signal for me. I also don't want to sell a company when it splits into two after raising dividends for 40 years, despite the fact that the new companies lack a record of dividend increases. This happened with Altria (MO) after it spun-off Kraft (KRFT) and Phillip Morris International (PM) in 2007 and 2008.

6) Valuation

With ETFs, investors have no say over the valuations at which companies are purchased or added. For example, a dividend ETF portfolio could include stocks which are ridiculously overvalued and selling at 30 - 40 times earnings. Even the best dividend stock is not worth overpaying for, since paying too much could potentially lower investors returns (dividend income and total returns). When you purchase a dividend ETF/dividend mutual fun, you end up buying stocks regardless of their valuation, which could be detrimental to long-term results. As an individual stock picker, I carefully weigh valuation and prospects before purchasing a security for my own individual portfolio.

7) Concentration Risk

For many dividend ETF's, you usually have the top 10 holdings account for a significant chunk of the portfolio. This is because those funds tend to weight portfolios based on market capitalization, rather than sensible investment criteria such as valuation, safety of dividend and stock analysis. For some dividend ETFs, the top 10 holdings have accounted for over 45% of portfolio value. This creates too much unnecessary risk for the portfolio, since a failure will be felt much more if it comes from one or two of the top ten holdings, than from one or two of the lower weighted ones. In my portfolio, I usually strive for equal weighting.

For my personal portfolio, I tend to invest in stocks directly, and build my exposure to different sectors from the ground up. I have a direct say on portfolio weights, and selecting only companies whose stocks are attractively priced at the moment. My only cost is the commission to buy or sell securities. If commissions were $5/trade, an investors purchased shares in $1000 increments, then this comes out to a 0.50% one-time cost. This is a much better cost than paying 0.35% – 0.40% every year. During a 20 - 30 year period the costs are going to reduce income over time. In addition, I have flexibility to exit stocks that do not make sense right away, and reinvesting the funds into another security that makes sense. Plus, if you achieve a certain net worth, your investment costs might be close to nill with some brokerage houses.

Full Disclosure: Long MO, PM, MDLZ, KRFT,

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Wednesday, April 16, 2014

When to sell your dividend stocks?






Ideally, your holding period should be forever. Investors who purchase shares in prominent dividend paying companies with the intent of flipping them within a few months are likely to make a lot of mistakes. This is because by frequently buying and selling stocks, investors incur costs such as taxes and commissions, which drain their capital. Studies have shown that the investors who make the most trades per year tend to earn mediocre returns at best. This is because a successful investment would likely pay in rising dividends over many decades to come. A lousy investment would be one where dividends are cut or eliminated as earnings per share decline. Even the best businesses can experience such adverse situations a few times during their lives. A patient investor should let the company work its problems out, especially given the fact that they are in it for the long haul, as long as dividends are at least maintained. You have already delegated your investment in the hands of company management indirectly, who work to increase earnings and pay you the dividends. Thus, micromanaging business conditions does not strike as particularly rewarding. Many times companies fall onto hard times, and keep a dividend frozen, only to resume increases in a few quarters or years. Just think of General Mills (GIS), which has paid dividends for over 115 years, and has never cut it. There have been times where it achieved a streak of 30+ years of consecutive dividend increases, followed by a few years where dividends were frozen.

An impatient investor who sells after dividend freezes might increase portfolio turnover dramatically, increase their investment costs, and sell securities which have experienced temporary turbulence. For example, in 2009, Hershey (HSY) froze dividends, thus ending a 30 year streak of dividend increases. Selling would have been a mistake, as the company resumed increases a year after it kept distributions unchanged. The dividend has since increased by over 60%, which is not too bad for a five year holding period.

When a dividend is cut or eliminated however, this is management’s way of saying that things are indeed bad. Dividends are a sacred cow, which might be frozen from time to time, but very rarely cut or eliminated. As a result, a dividend cut shows that this business is likely in trouble. As a dividend investor, this is when I decide to sell my position automatically. This safeguards the capital left, and provides a fresh perspective after the sale is done. The reason for this automatic sale is to prevent me from being overly emotionally attached to a stock, and rationalize my holding until it is too late. For example, dividend investors in Bank of America (BAC) enjoyed a rising dividend for 30 years in a row, before the dividend was cut two times between 2008 – 2009. This took the quarterly dividend from 64 cents/share to 1 cent/share If you sold right after the first announcement, you could have managed to get out around $29 - $30/share. If you held BAC stock for the past 20 years however, and you rationalized that the bank would eventually bounce back, you suffered from no dividend income on this portion of your portfolio for 5 - 6 years in a row. Sometimes, admitting mistakes is difficult, but costly if nothing is done about it.

If the dividend cut is reversed and the company initiates or increases dividends, you can get back in. In a typical dividend growth portfolio consisting of 30 – 40 securities, I would expect a dividend cut to occur at least once per year. On the bright side, if 39 portfolio holding raise distributions by at least 2.50%, and one completely eliminated distributions, your income will stay flat. Chances are however that the 39 companies will increase dividends by 6%/year, and the capital you deploy from the dividend cutter will generate some return when invested elsewhere.

Full Disclosure: Long GIS

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Monday, April 14, 2014

How to monitor your dividend investments






Once an investment is purchased, it has to be monitored frequently. While monitoring is important, it is also important to avoid too much action with your investments. The hardest part of dividend investing is sitting and doing nothing for years if not decades. The good businesses will usually take care of themselves, while the bad businesses may produce some dividend payments for you for a few quarters before cutting them or eliminating them completely.

The way I monitor investments is by focusing on annual reports and maybe quarterly reports and press releases. I usually update my stock analysis about once every 12 – 18 months as well. I do this mostly to aide me when deciding to buy a stock or not. I discuss the conditions that would cause me to sell in the next chapter. An investor should apply extreme caution to dealing with information that is noise, and does not really present you with material information about the business you own. Examples include analyst opinions on stocks, news articles from mainstream media sources or TV commentary from the likes of CNBC. You should apply your judgment in determining whether you would benefit by listening to this noise.

In the analysis, I look for rising earnings per share, dividend per share, sustainability of distributions and how the business is doing. If you have spent a lot of initial time learning about the company, there would not be much to learn from year to year. For a period of several years however, you might learn about new acquisitions, divestitures, and plans on how to grow the business. You should be careful if management focuses too much on growth at any price, as this could result in poor performance in the fundamentals that matter to you as a dividend investor. For example, if a utility company you own is trying to revolutionize energy market by trading energy, electricity and internet bandwidth, without focusing its attention to actual profits, this could be a red flag. This is Enron of course, which was a sleepy company until management got crazy in the 1990’s and eventually bankrupted shareholders and left thousands of employees without a job.

Investors might also monitor investment for extreme overvaluation. For example, a business that is ridiculously overvalued might be better off sold, although this could be evaluated in light of the steep tax liabilities it could produce. Sometimes it might make sense to hold on to a temporarily overvalued business, merely because the investor expects the improving fundamentals will “bail them out” eventually. For example, Coca-Cola (KO) and Wal-Mart (WMT) were terribly overvalued in 1999 – 2000. However, the improved fundamentals eventually bailed investors out. Of course, the capital invested in Coca-Cola and Wal-Mart didn’t deliver much in terms of dividend income, and could have been invested somewhere else. However, if significant unrealized profits were generated, selling and buying something cheaper could have been an exercise in wealth destruction. This is because there are no guarantees that the undervalued security in an overheated market is not a value trap. Therefore, investor would have been better off simply holding off, and reinvesting dividends elsewhere.

One should also monitor positions that go above a certain pre-set threshold. For example, if you hold 40 individual securities in your portfolio, each position would account for 2.50% in an equally weighted portfolio at the start. Over time however, it would not be unreasonable to have a position or two which turn out to be outstanding winners, and prove to be multi-baggers ( they increase in price several times above your purchase price). If such a position now accounts for 10% of portfolio value and dividend income, it produces a larger strain on portfolio income for diversification purposes. If you are in the accumulation stage, you can simply add new funds and dividend payments received and apply them to other attractively priced securities. As a result, the overall weigh of the multi-bagger would decrease. In the retirement phase, you can simply reallocate dividends towards other securities. The main idea is to try to let your winners run for as much as possible, and not tinker with your portfolio too much, unless there is extreme overvaluation, dividend cut or a fundamental shift in fundamentals. The only reason why I would always sell is included in the next chapter.

Full Disclosure: Long WMT, KO

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Saturday, April 12, 2014

Nine Reasons I Read Dividend Mantra Every Day

There are several sites I read daily, as part of my routine to check what other investors are doing with their money. Many of those include dividend investing sites, but I also look at sites covering general investment and investor psychology. One sites I have been following since 2011 is Dividend Mantra, written by Jason Fieber. There are several reasons why I personally start my day with his site.

1) His stock analyses

He thoroughly analyses companies he buys, including qualitative and quantitative factors. I enjoy the fact that he tells readers about the story behind each company, and reasons why he purchased it. It is very interesting how different dividend investors with somewhat different approaches to analyzing companies end up with a very high overlap of quality dividend paying companies in their portfolios.

2) He earns a middle class salary,

This makes his efforts relevant to a large base of investors. This is a very powerful lesson, which shows that everyone can make it in investing, as long as they find the right strategy, save high portions of income consistently, and keep being persistent for long periods of time. Even if you start with a few hundred dollars a month using a no-cost broker like Loyal3, you can still amass a sizeable collection of dividend paying stocks over time.

3) He is frugal with money.

Jason writes about his monthly income and expenses, which include things as mundane as delivery pizza he ordered to buying and selling a scooter. I think that one of the largest contributors behind his accumulation of a six figure portfolio is due to his high savings rate. I am lucky to also have a very high savings rate as well, which is a definite plus, because it allows be to find enough capital to deploy every month, and kick start my dividend growth compounding. It is a site where frugality meets dividend growth investing.

4) He plans to retire early.

Jason tries to retire at the age of 40, which is a pretty lofty goal. He started his journey at the age of 28 – 29, which means that he expects to be financially free within a decade of saving and investing. Given the fact that he has shown the stamina to keep putting money in dividend paying companies on a consistent monthly schedule, I am more than confident that he will achieve his goal. As I had mentioned earlier, in order to determine whether you can retire early, you need to determine how much you are spending. The next step is determining how much you will spend in retirement, and work backwards to achieve this goal. The key inputs in your financial independence calculation include money you are putting every month to work, investment returns and time you allow your capital to compound.

5) We have very similar personalities and strategies

The one thing that I like about Jason is that we have a lot of things in common. I am fairly frugal, and I put money in dividend paying stocks, because I think this is the best strategy for someone like me who wants to live off an investment portfolio. I also plan on achieving financial independence early in life, in order to achieve something else with my life, other than enduring a 50 – 60 hour weekly grind at my job.

6) He is able to motivate himself and readers to keep the good fight

One of the reasons I like reading his site is the dose of motivation that puts things in perspective. I think that few people really stop to think about the true cost of buying a new car or a new TV every few years. Jason discusses why those might not be important for your true happiness, and how you only live life once. Therefore, you need to spend it in the way that is best for you, not how others are telling you to spend it. He is able to visualize his ideal retirement, and how it would free up his time from having to exchange his time for money.

7) He had all odds stacked against him, yet he still persevered through hard work to get where he is today

Actually, he has had it much more difficult than I have ever had it. Some of his stories are really scary for me to read, although it does make it even more telling how far ahead he has come. It is great how he had his awakening moment in his late 20s, that has truly provided the spark that will lead him to greatness. I guess it is at the moments of despair that the seeds of future success are planted.

8) His dream is built in real time

He is a dividend growth investor who is building his dream in real time. Unlike most other stories of persons who retired early a long time ago where you hear about them only after they have retired, you get to see Jason save and invest his money in quality dividend stocks every single month in almost real-time.

9) He is a celebrity

Jason has been interviewed by the USA Today, CNBC etc. He is a role model for many people who want to be able to live life on their own terms. I see him as a positive role model, whose story should be more widely followed than the other celebrity gossip people usually waste their time on. I would much rather read about his monthly income and expenses on the cover of People magazine or on E!, than anything about the Kardashians. I don’t read those magazines, but I know a lot of people do, and their views are shaped by these publications.

When I started my own site in 2008, I planned on posting my monthly income and expense, as well as how much I earn in dividend income, but I decided against it. I didn’t feel safe revealing everything about myself to the world, and still don’t. Kudos to him for doing what he is doing, and motivating people to take ownership of their financial lives.


Friday, April 11, 2014

How to deal with new cash from dividend payments






As a dividend investor, you have the luxury of receiving regular cash infusions into your portfolio on a regular basis. During the accumulation stage, you will also have extra cash that you would need to deploy on a regular basis. Even once you become retired however, you might still find a trickle of excess cash finding its way to your bank accounts, that you might decide to put to work in your dividend portfolio. You then have the opportunity to deploy this cash in one of two ways that you believe are the most optimal for your portfolio. The two options are to reinvest automatically (DRIP), or reinvest manually. Another option could be to mix and match both strategies.

Each of those strategies has its pros and cons. The major negative about DRIPing is that investors risk reinvesting distributions into shares without regards to valuation or opportunity cost. It could be very costly in the long run, if you mindlessly allocate dividends received into the overvalued companies that generated them, particularly if more attractive places for this cash are available. This is one of the reasons why I usually combine new cash with dividends received every month, and then make a purchase in my best ideas at the time.

One of the positives of DRIPs is that you are taking immediate advantage of the power of compounding, by putting cash dividends received into more shares right away. That way, you are not wasting time trying to accumulate enough cash so that it is cost effective to make an investment. Plus, you can set it and forget it, and take a more passive approach to compounding your wealth and passive income.

Another advantage of automatic dividend reinvestment is that you are not charged a commission when putting money back into the same stock that distributed cash for you. I do not advise anyone to pay more than a 0.50% in commissions before investing in dividend paying stocks. If you lose a portion of dividend income to excessive brokerage fees, you are shooting your compounding process in the foot. This is why automatic dividend reinvestment is ideal for situations where your dividend income is low, or you cannot add money to this account, in order to justify waiting for a set amount of capital to accumulate in cash.

I only reinvest dividends automatically for my Roth IRA account, which I started in 2013. This is because I can only put $5,500 per year in it, and the amount of dividend income generated per year is a couple hundred dollars. Therefore, it is not cost effective to wait for cash to accumulate and pay an exorbitant commission of over 2%, which would stump the turbocharging effect of growing dividends that are being reinvested. It is much better to reinvest dividends back into the company that paid them for free, rather than taking the time and paying a steep fee in order to reinvest elsewhere. Manual dividend reinvestment is quite inefficient for smaller portfolios with no new additions of capital. For my taxable portfolios, which are the lions share of everything however, dividends are reinvested selectively.

Full Disclosure: None

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Wednesday, April 9, 2014

How to Manage Your Dividend Portfolio






The hardest part about investing is sitting down, and not doing anything. Just monitoring your portfolio even when its quoted value drops by 50% in a given year, is something that only a very small number of investors can achieve. Studies have shown that the most investors usually perform very poorly when making investments. Those that buy and hold on, are a very rare breed. However, these are the types that save a ton in commissions, taxes and have the best chances of generating the most bang for their investment bucks.

Wall Street makes its money if you actively buy and sell stocks. It nickels and dimes you in commissions, bid/ask spreads, annual fees etc. The hedge fund managers and high speed computers are all operating at a day to day or minute to minute time frame. They see orders from small investors as prey. However, as dividend investor, you should not care whether you paid $37 or $37.01/share for Coca-Cola. Your edge lies in the fact that you would hold the stock for as long as it maintains and raises its dividend. This is where your edge against the Wall Street types comes from.

Your other edge as a long-term investor comes from deferring taxes paid to the IRS. If you bought Coca-Cola in 1988 for a split-adjusted $3/share, you are now sitting on an unrealized capital gain of $35 - $36. At 15% in taxes, this is more than what you paid for the stock. Those who buy and sell securities frequently, end up paying a ton to the tax man. Of course, if they are really bad at investing, they can generate a lot of tax deductions for themselves to use for years against taxable incomes.

Your other edge comes from the fact that you should not care how you are doing against a benchmark like S&P 500. Many mutual fund manager are evaluated based on how they did against a benchmark within a 3 month period. This is non-sensical – as quotations in the short run are just noise. You can’t judge the performance of an investment strategy based on short-term period of less than one year. You also have a much better chance of succeeding, if you have a strategy that fits your investment goals and objectives ( see first article in the series). If your goal is to generate a rising stream of income, that would pay for your expenses in retirement, you should not worry that the quoted value of your dividend stocks is down by 50%, as long as the underlying fundamentals are still intact.

What I am trying to show with those examples above is that your portfolio management should be very passive in nature. You should sit tight, and watch your dividends deposited in your accounts.

I usually sell only after a dividend cut. I have modified my criterion of selling if I thought stock was severely overvalued, but so far my results are pretty mixed with that. In retrospect, I would have been slightly worse off sticking with the original investment I sold. Therefore, you should be very careful about selling securities. This is because a factor that might influence you to sell could seem important at the time of sale, but in reality could be just noise in the data. With long term buy and hold investing, you stand the greatest chances of earning the most in dividends and capital gains. The best results are probably still ahead for you. If you think about it, if you focus on strong franchises such as Coca-Cola (KO), Wal- Mart Stores (WMT) and McDonald’s (MCD), chances are that 20 years from now, your investment would likely be worth several times your initial capital outlay. If history is any guide, you can likely expect an annual dividend income stream which is equivalent to approximately 20% yield on cost. Therefore, while your amount at risk is fixed, your upside is virtually unlimited.

There are a few more traps that suck investors into selling their stock prematurely, and therefore not participating fully in any dividend upsides:

- Do not sell simply because you have a huge gain

- Do not sell if your stock trades at a P/E of 23 and replace with a stock with a P/E of 20

- Do not sell because of dividend freeze

- Do not sell because of spin-offs

The most important thing about investing is to be patient. It is true that you won’t make money on all of your stock selections. A portion of the businesses you purchase today would likely be obsolete in 20 -30 years, thus cutting or eliminating distributions, while another portion would likely be mediocre dividend growers. The dividend growth from the remaining winners however would likely more than compensate for the lost dividend income from the losers.

As a result, it is wise to accumulate dividends in cash, and use it to buy the most attractive securities at the time. If a position accounts for more than 5%, do not add to it. Unfortunately, if it becomes 10%, determine if new cash added over next year to other positions can lower positions weight in portfolio. Otherwise, you might need to trim it.

Full Disclosure: Long KO, WMT, MCD,

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Monday, April 7, 2014

How to analyze investment opportunities?






I have discussed before my criteria for screening dividend stocks. The screen narrows down the list of companies to look into more detail, to a more manageable level. In addition, it makes you focus on a set of companies with minimum set of earnings and dividend growth characteristics which are cheaper. Therefore, you would avoid looking at Automatic Data Processing (ADP) at 26 times earnings that yields 2.50%, and instead focus on researching the likes of Chevron (CVX) at 10.70 times earnings that yield 3.40%.

However, it is very important to avoid being short-sighted in regards to stock screens. This is due to the fact that data could not be fed correctly, or it might be misrepresented in the database you are using. For example, some companies usually record one-time adjustments to earnings. Any astute dividend investor should know to exclude these one-time items from the calculation of price earnings ratios. Back in 2010, Coca-Cola had to record a one-time gain on the acquisition of Coca Cola Enterprises North American Bottling Operations. As a result, the stock appeared as a much better bargain in comparison to PepsiCo (PEP). However, this was an illusion, made possible by the one time gain discussed earlier.

The opposite also happens, where a onetime adjustment could push earnings so low, that the P/E ratio and dividend payout ratios scream avoid. In reality, if a one-time adjustment should be taken out, it would usually show that the stock might be a good opportunity.

This is why simply relying on a stock screen to find ideas is not sufficient. This is also why astute dividend investors should research every prospective buy candidate one at a time.

For every company I look at, I focus on several quantitative factors to begin with:

1) Rising earnings per share over the past decade
2) Rising dividends per share over the past decade
3) A stable and sustainable dividend payout ratio
4) Returns on Equity that are stable over time

I also try to read the annual report, and quarterly press releases from the company. There is usually a lot of information, but not all of it can be actionable. I usually try to understand the company’s business while reading reports. However, the thing I am most interested in is trying to determine if there are catalysts for growth in earnings. Only a company that manages to grow earnings per share over time, will be able to afford to increase distributions for its loyal shareholders.

Companies can grow earnings by selling more products, creating new products and services, expanding in new markets, increasing prices, cutting costs, squeezing out inefficiencies, buying back stock, acquiring competitors to name just a few ways. Sometimes, companies can manage to grow earnings per share through a combination of all of the above. For example, Coca-Cola (KO) can earn much more per share, if it manages to convince the average consumer in China and India to drink as many servings of its product as the average US consumer. The average US customer consumes 401 servings of Coca-Cola product every year, compared to 39 in China and 14 in India.

I usually like to see companies which offer a product or service which is unique, and results in repeatable sales to consumers. I also look for companies that have strong brand names for products or services, which are pursued by a fan base of loyal customers. If the customers really like your product or service, and cannot get it anywhere else due to various reasons, you can have very good pricing power. This could be extremely profitable, if there is a limited amount of government regulation. This is referred to as the business having a moat, or strong competitive advantages.

For example, consumers who like Coca-Cola, would be much less likely to buy a Pepsi (PEP). Therefore, if a store does not offer Coke, customers are likely to go to another store to purchase their daily fix. The same is true for other branded products like Hershey (HSY) bars for example.

Full Disclosure: Long KO, PEP, CVX, ADP

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Friday, April 4, 2014

When to buy dividend paying stocks?






Dividend investors should not view every stock they purchase as a price that fluctuates on a computer screen however. On the contrary, they should view each stock purchased as a share in a business. Therefore, the most important thing to focus on is the underlying strength of the business you are investing in, and not day to day fluctuations in security prices.

Once an investor has a list of quality businesses, he needs to be able to decide at what prices to purchase them.

Fluctuations in security prices should be utilized by the enterprising dividend investor to his or her own advantage. In order to be rational and allocate their money in the most efficient manner, the intelligent dividend investor should have devised a system for buying. This system would allow the investor to acquire shares of quality companies at a reasonable price.

The intelligent dividend investor should know that even the best company in the world, is not worth purchasing at any price. Therefore, they should realize the value of being patient, and only buy securities when they are available at attractive valuations. The number of quality companies selling at cheap prices would vary depending on the conditions on the stock market. During times of Irrational Exuberance, it would be almost impossible to find securities, whose prices are not bid up in the frenzied environment. The opposite happens during stock market panics, when doom and gloom circles the common psyche of scared investors, who rush to unload their holdings at rock bottom prices. During these panics, the number of bargains could typically be overwhelming.

However, these environments on both ends of the spectrum of extreme circumstances are relatively rare in occurrence. An investor is much more likely to experience an environment which is somewhere in the middle, with quality securities being available from some sectors, but not in others. Again, having the entry system and the patience to wait for those opportunities is of utmost importance.

For example, I usually run a screen at least two times per month on the list of dividend champions. I use the following parameters:

1) A company raising dividends every year for at least a decade
2) A price to earnings ratio of less than 20.
3) Annual dividend growth exceeding twice the annual rate of inflation
4) A dividend yield that exceeds 2.50%, which is slightly higher than the yield on S&P 500
5) A dividend payout ratio below 60%, in order to ensure sustainability of distributions

Note: For REITs and MLPs, I look for FFO and DCF information, rather than earnings. As those as more advanced securities, they are not the point of this article.

The output of this screen only provides with a quantitative view of a list of businesses. It should not be an automatic signal to buy, especially if the investor knows nothing about the businesses that are produced by that screen. If the investor has analyzed the companies that are on the screen already, he or she can put their money to work by acquiring shares in these enterprises.

It is important to also take into account existing portfolio weights and holdings, after screening for attractively valued quality dividend growth stocks. When presented with the results of the screen, investors should first always initiate positions in quality companies that are rarely undervalued. Then, they should add to existing positions, as long as they are not taking a prohibitively high portfolio weight. Again, this paragraph assumes that the investor already has knowledge of the company they are buying, and finds it to be a quality company.

It is very common for the investor to see the same companies on the screen for months or even years to come. Therefore, it could be wise to be on the lookout for candidates that are new to the screen results. In addition, it might also be important to get into the habit of monitoring companies you are interested in for steep drops on negative news, which could also present an opportunity to buy a quality company at a bargain price. Unfortunately, these usually do not come out with a consistency that a twice monthly regular screen would produce. Therefore, keeping an open view could prove to be profitable.

In addition, I also like it when the companies I am investing in have a plan to grow earnings per share. Examples include IBM’s (IBM) strategy to grow earnings per share to $20 by 2015.

Full Disclosure: Long IBM

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