Monday, June 1, 2015

Dividend Investors have an advantage over everyone else on Wall Street

I believe that dividend investors have an inherent edge against everyone else on Wall Street. This comes down to several traits, which set them apart from the crowd.

1) Dividend Investors are patient

Dividend investors have a long-term horizon. As a result, they invest for the next 20 – 30 years, not for the next quarter or year. You can afford to be patient, focus on what matters in the long run, and ignore short term noise. If the company you invested in suffers a temporary set-back  in price, you can double up, and get more stock for your buck

Wall Street, meaning mutual funds, or hedge funds, invest with an eye on short-term performance. If you manage money, and you do worse than your benchmark for a quarter or two, you might get fired. This is even if you get the stock ultimately correct. If you bought Berkshire Hathaway (BRK.B) in 1998 - 1999, you would have been fired by early 2000, since you “underperformed the market”. About 15 years later, you would have crushed that ‘market”. But you would have been unemployed long since. This is because everyone else focuses on irrelevant short term noise – stock price fluctuations, earnings misses of one penny per share, and tries to outguess everyone else. At the same time active investors end up paying steep commissions and fees and taxes in the process, and essentially killing their compounding process in its infancy.

I like the fact that as a stock picker, I can afford to hold my stocks essentially forever. I also can afford to pass up on investments that are overvalued, and would likely generate poor returns. It is well documented that turnover is bad for investment portfolios. The funny story is that even so called passive index funds have high turnovers, as they constantly add and remove companies, purge spin-offs or carve-outs, adjust their weightings due to share repurchases or sales by founders, or due to arbitrary changes in rules. As a stock picker I do not have to follow rules that make me sell investments for no good business reason. For example companies like Unilever (UL) and Royal Dutch (RDS.B) were removed from S&P 500 in 2002, because of a rule against including foreign companies. Surprisingly, those were successful enterprises, which had contributed to the index by outperforming it since they were included 50 years ago. However, a company like Phillip Morris International (PM), which does all its business outside the US, is kept in the index. Other changes include weighting based on free float, implemented in the middle of last decade. The most eye-opening experience is that the investors of the original S&P 500 companies did better than those who held the index between 1957 and 2003. I also do not need to re-balance my portfolio or add shares in companies with no earnings, just because their market capitalization is high enough. Indexing is still a great way for a large portion of savers to accumulate retirement nest eggs. However, it is not perfect, and too frequent changes or too widespread of an adoption and ignoring valuations could deliver poor returns going forward. On a side note, I allocate a large portion of my annual savings to index funds, as I max out my 401 (k) and ultimately the HSA accounts each year. The tax-deferred nature of those accounts make it a no-brainer to use them, even if I have to place the money in index funds.

2) As a dividend investor, you don’t have to suffer from investment myopia.

- You don’t have to care about meaningless short term fluctuations
- You are not going to fire yourself because of meaningless comparisons to a benchmark ( see point 3 below)
- You also won’t have to pay 1- 2% in fees per year that most mutual funds and investment advisers charge or the 2/20% that hedge funds charge.

Most importantly you have the patience to stick to your ideas for the long term, and avoid overtrading. Overtrading and lack of diversification are the number one reason for the mediocre performance of ordinary investors in general.

Many of the companies I have purchased have done relatively fine in terms of dividend increases over time. However, if I had myopically focused on earnings per share every quarter, or if I have ran away the moment stock prices fell or “underperformed” an arbitrarily chosen index, I would have made a grave mistake. The thing is, many companies I buy can stay flat in stock price for a long time. As an accumulator of assets, this is not a problem, because it allows me to buy more stock with less dollars. Only after a few years do those companies start producing the type of long-term capital gains and increased dividends that make investors want to salivate. For example, Johnson & Johnson (JNJ) was difficult to own in 2010 when it sold for $60/share and was involved with recalls. Fast forward four years later and it is selling at a much higher price, and most importantly earns more and pays a much higher dividend per share.

In another example, I held Kinder Morgan Management LLC (KMR) between 2008 and 2014, before it was acquired by Kinder Morgan Inc (KMI). There were some hedge funds that were short Kinder Morgan which were attempting to manipulate investors into panic selling in 2013 - 2014. While the position was flat for a while, and did worse relative to others, I stuck to my guns and were rewarded. The reason I stayed with Kinder Morgan LLC (KMR) is because it was cheap, delivered the results I purchased it for, and was compounding my capital tax free in the process. I do not let fear or greed dictate what I do.

If I were a mutual fund or a hedge fund, I would suffer from capital redemptions when things are tough. For example, many investors ask for their money back during bear markets and during periods of relative underperformance. This does not allow any time for investment ideas to work out. Therefore, the edge that I have against others is the fact that I have permanent capital. The money I put to work in the stock market will likely never be withdrawn. This is because I plan to live off dividends, and never tough principal. If I touch the principal, chances are I have a rare disease and a short amount of time left anyways, so stock market performance would be the last thing on my mind. And long-term would likely be less than a couple of years anyways in that case.

3) As a dividend investor, you work towards your own goals and objectives

Many are surprised by the fact that I do not find benchmarking my portfolio to an index like S&P 500 to be relevant. The truth is that my investing tries to accomplish a set of goals and objectives I have set for myself. My goal it to be able to generate a certain amount in passive dividend income before the end of this decade. ( roughly around 2018). As a result, I save money each month and invest them in the best dividend stock ideas I could find at the time. I look for:

- Companies with a proven track record of dividend growth,
- Available at attractive valuations
- With rising earnings and prospects for rising earnings

I then add those shares to my portfolio, reinvest dividends selectively and hold for as long as the fundamentals still make sense. I try to maintain a diversified portfolio, which is why I avoid adding to the ten largest positions I have. With each $1000 that I invest in a stock yielding 3% today, I generate $30 in annual income that will grow above the rate of inflation and will support me in retirement forever. As long as that income grows over time and dividends are not cut, I will hold forever. I could not care less whether the price of this investment is down to $500 or up to $5000, as long as my dividends are neatly deposited in my brokerage account in a timely manner.

You can see that whether my portfolio does better or worse than some benchmark is irrelevant for my goals and objectives. In fact, Certificates of Deposit have beaten the S&P 500 since the end of 1999.  Everyone is focused on beating the market. I am not, because to me beating the market doesn't mean anything to me. My goal is to achieve my goals and objectives, not to beat some benchmark. I would accomplish my goals by generating returns, not by obsessing over returns relative to others. Let's assume that my goal is to generate $2,000/month in retirement income. If I retire on $2,000/month or $3,000/month, and this is less than the $5,000/month that another investor needs, I would consider myself a success, not a failure. Anyone who believes that as a failure probably needs to get their brain wiring examined by a licensed professional.

4) As a dividend investor, you are a long-term investor

In this day and age, everyone is mesmerised by instant news covering economics, stock markets etc. The average holding period of securities is in months these days, rather than decades ( like it were 50 - 60 years ago). There is high amount of activity among mutual funds and other "sophisticated" investors. There is an entire industry of high-frequency traders, which skim a portion of a penny any time a stock is traded. As a dividend investor, my goal is not to profit from meaningless short-term price changes. As a dividend investor my returns will be dependent on the fundamental success of the companies I ultimately end up investing in. In addition to focusing on quality, minimizing risk of failure, and focusing on prospects for growth, I also need to make sure I do not overpay too much for those companies. As a result, my ability to profit will be dependent on the success of the enterprises I pick. If Johnson & Johnson (JNJ) keeps growing over the next 30 years, I will be able to earn a higher amount of dividends almost every year for those next 30 years. In addition, if Johnson & Johnson manages to grow earnings per share over those next 30 years, chances are that the intrinsic value of the business will grow significantly in the process.

Johnson & Johnson (JNJ) is expected to earn $6.14/share in 2015, and pay $3/share. Let's assume that the company grows earnings per share and dividends per share by 5%/year, and that it will sell at a P/E of 16 for the next 30 years. This means that by 2045, earnings per share will reach $26.50 and dividends could reach close to $13/share. The shares could fetch $424. If we reinvest those dividends in a tax-deferred account, this $98 investment today could mushroom to over $1046.

Therefore, the largest amount of profits will be generated by those who identify an asset with a good prospect, and then purchase it at fair valuations. The big return will be generated by sitting on this asset for decades, and quietly compounding income and capital. Having the patience to allow the power of compounding to do its simple magic, and the permanent capital to implement it with, is your edge against everyone on Wall Street.

Full Disclosure: Long JNJ, KMI, and BRK.B

Relevant Articles:

Dividend Growth Stocks are Compounding Machines
Successful Dividend Investing Requires Patience
Let dividends do the heavy lifting for your retirement
How to retire in 10 years with dividend stocks
Dividend Growth Stocks Increase Intrinsic Value Over Time

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