Wednesday, June 4, 2014

Focus on High Yielders with Growing Distributions

In a previous article, I mentioned that as a long term dividend investor, I do not try to pursue a strategy of active dividend investing. As I gain more experience however, I tend to closely scrutinize companies which are not performing up to my requirements. In general, these companies tend to have a higher yield, slower or nonexistent distributions growth, and have neutral business growth outlooks at best. I have previously simply held on to such companies, and reinvested distributions elsewhere. But recently, I have began reconsidering whether my income portfolio would be better off disposing of these potential high yield traps.

Many dividend investors focus on dividend yield in their starting analysis of potential income investments. In general, the higher the yield, the higher the dividend income that the investor would receive. This could be even more common for investors who have not saved a sufficient amount of money, which is why they are searching for any type of a shortcut, in order to get them to the desired level of income in retirement.

The main risk with such a strategy is that by focusing exclusively on the yield or the desired level of income, the retired investor could end up overlooking certain factors, which could be devastating for their retirement. If the dividend paying company cannot support the distribution payments, chances are that it would cut or eliminate it. This would cause severe drops in income, along with decrease in the stock price, as fewer investors would be willing to purchase an asset with limited or no income potential.

In my process of looking at dividend stocks, I look for several things, before I even decide to analyze a stock. I look for a trend of consistent dividend increases, a dividend payment that is adequately covered from earnings or cash flows as well as attractive valuation. After I uncover a stock that fits these loosely defined quantitative criteria, I tend to analyze qualitative factors, in order to guesstimate whether the company would be able to generate higher earnings per share over time. Each company is different, but some of the most common drivers behind future growth include expanding the business in new territories, introducing new products, acquiring competitors, reengineering the business in order to attract new clients. Another important set of drivers include having products or services, where the number of customers is expected to increase, and where the quality of the company’s offering helps it maintain pricing power.

For example, the low interest rate environment has made many retirees switch to dividend paying stocks. The primary outcome of this hunger for yield is that many companies in the utilities and real estate investment trust arenas have been bid up by investors. As a result, their yields are at multi-decade lows. One example includes Consolidated Edison (ED), a regulated utility that supplies electricity and steam power to millions of customers New York City. The company has boosted dividends for 40 years in a row. However, in 2012 it yielded less than 3.80%. In addition, it had only been increasing distributions by less than 1% per year over the past 17 years. At this rate, the purchasing power of your dividend income stream has been ravaged by the eroding power of inflation. I analyzed the stock and noticed that going forward, because of the unfavorable regulatory environment for utilities in New York, the company could not count even on decent earnings growth to support a higher dividend growth rate. As a result, back in 2012 I decided to sell the stock and purchase units of ONEOK Partners (OKS), which have the capacity to deliver much higher distribution growth over time, had sustainable distributions and as an added bonus yielded more. I only kept a few shares in another legacy account, for which it was not cost-beneficial to sell.

In previous articles I had mentioned that I want to hold a diversified portfolio of stocks coming from as many sectors that make sense. In general, the more I study historical dividend stock information, the more I realize that utilities are great only for current income for a period for 5 -10 years. Utilities in general tend to have poor dividend growth rates, which are typically overlooked by yield hungry income investors. In addition, many utilities tend to cut dividends every couple of decades or so, after which they start raising distributions again. Many utilities do provide with the added income stability during a period of economic turmoil, such as the one observed during the 2007 – 2009 financial crisis. However some like Ameren (AEE) did cut distributions during that tumultuous time.

Utilities of course are not the only sector that dividend investors should scrutinize closely, in their quest for rising dividend incomes. Some companies that I used to own, such as Cincinnati Financial (CINF) have had a hard time covering distributions in recent years, and have raised distributions only by nominal amounts for the past six years or so. While having a long streak of consecutive dividend increases is impressive, and speaks a ton about the company’s dedication to rewarding long-term shareholders with a rising stream of cash each year, I do prefer to see substance. In other words, I would much rather hold a slightly lower yielding stock, with a shorter streak of dividend increases, which however has the potential to generate higher earnings and dividends growth. This is a preferred investment in comparison to a higher yielding, but lower growth company such as Cincinnati Financial (CINF) or Consolidated Edison (ED). As a result of my dissatisfaction with Cincinnati Financial, I replaced the stock with shares in five Canadian banks in early 2013.

To summarize, while it is important to thoroughly analyze stocks before purchasing them, it is also important to not get married to positions. Buy and hold investing does not mean buy and forget – regular monitoring of positions is a must for the serious dividend investor. This would ensure the longevity of the dividend income stream by identifying potential troublemakers well in advance, and replacing them with opportunities with better prospects.

Full Disclosure: Long ED, OKS

Relevant Articles:

Active Dividend Growth Investing
Margin of Safety in Dividends
Utility dividends for current income
High Dividend Utility Stocks – Are they a trap for dividend investors?
Spring Cleaning My Dividend Portfolio

5 comments:

  1. Good post today. This is precisely why I am probably not going to assembly my own dividend portfolio. Given my family history, I believe there is a strong chance of suffering from dementia at some point in the future rendering me unable to make the analyses described above. In addition, my wife has no interest or ability to do so either and given her family history she may live into her mid 90s. Fortunately for me, the yield from a blend of Vanguard index funds and Social Security should provide more than adequate income.

    As much as I would love the challenge of assembling and managing a portfolio, there are compelling reasons not to do so. Another reason is that my assets are mostly taxable. Moves you describe could be a taxable event and any move by someone who has to take control of my portfolio in the future due to my incapacitation could trigger a large taxable event. Moreover, we have seen capital gains taxes begin to creep upward again, so the favorable treatment they have received in the last decade or so could begin to diminish.

    I think investors need to consider what will happen if they become mentally impaired. Likely, it will be a slow gradual process. I have had personal experience with a relative who was brilliant before her cognitive ability declined. This experience made a profound impression on me and the need to seriously consider that possibility in my own situation.

    Just some food for thought.

    Perhaps, a plan could be devised to transition from a dividend stock portfolio to a Vanguard dividend fund once the portfolio reaches critical mass. This could be possible in tax sheltered retirement accounts with no adverse tax consequences.

    ReplyDelete
    Replies
    1. I am sorry to hear about your family history with health issues.

      However, a well diversified portfolio of properly selected 40+ individual dividend paying blue chips should do reasonably well without much management for years if not decades.The next person after you can simply cash the dividend checks.

      Of course, if noone is interested in managing the money, the real issue is not dividend stocks or index funds. This is because someone who has no idea about money and investments can squander equally as well a family fortune, whether it includes dividend paying stocks, farmland, index funds, real estate etc.

      Maybe the real question to think about is having a sound estate plan, and providing instructions in advance what to do with assets in case of incapacitations/death. A trusted person/family member/ professional adviser could come into play, who can execute this arrangement. In addition, the people who are going to inherit a lot of money need to be coached on how to handle the bounty. This should start very early on with the kids, teaching them deferred gratification when they are young, and then teaching them lessons about finances.

      Delete
    2. Thanks for your reply.

      Delete
  2. As a Canadian Utilities and Banks are the two sectors where you can find reasonable yield and dividend growth. Fortis (FTS) is a boring utility that has 4% yield and 4% dividend growth rate, it is often considered bond like by many investors (And unlike some utilities has fallen off its highs in past 12-18 months.) I do own a US utility that appears a good compromise on yield and dividend growth, Avista AVA. I have owned it for past ~4.5 years (4% yield and 6% and dividend growth) it has done very well for me so far.

    ReplyDelete
    Replies
    1. Hi Gary,

      Thanks for stopping by. I own small stakes in the big 5 Canadian banks. I like the Canadian banks, and would love to add to position if we get further weakness.

      Best Regards,

      DGI

      Delete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts