Wednesday, August 12, 2015

How well do you know your investment strategy?

I have been focusing on dividend growth investing for several years now. As such, I try to think about why it works, and also think about scenarios under which dividend growth investing would not work.

The premise of dividend growth investing is simple, yet not easy for many to grasp. Dividend growth companies are those that have managed to boost annual dividends for a minimum number of consecutive years. Some dividend investors require a five year streak of consecutive dividend increases, while others require ten or more. The next step is understanding whether that dividend growth was also accompanied by earnings growth. If it is, then the company should be analyzed further. The basic thesis behind dividend growth investing is that only companies with certain bulletproof business models can achieve a streak of annual dividend increases over a certain number of years. Without earnings growth, a company cannot continue to grow dividends into the future. And as dividend growth investors, our goal is to find the companies that will likely grow dividends in the future. The thesis then goes that a company that manages to grow earnings, and to grow dividends, is likely to continue doing so until something changes. This is where the idea of reviewing the business more thoroughly starts revealing itself. Another important thing to consider then is purchasing the company at a fair valuation. One should never overpay for a business, no matter how great fundamentals and growth prospects look. This is easier said than done however.

In addition, it is important to diversify across industries, countries and continents. And while nothing is guaranteed in life, a company that earns more and pays more in dividends, will likely be worth more over time.

So when will Dividend Growth Investing stop working for you?

If you overpay
If you lack patience and switch strategies
If you do not diversify
If you buy companies that are raising dividends but not growing earnings
If you do not focus on dividend sustainability
If you confuse chasing dividend yield with dividend growth investing
When dividend is cut I am out. If it is frozen/kept unchanged, I remain patient.

The basic premise is that a company grows earnings per share, and then starts growing dividends over time. However, if those companies never decide to pay dividends, they will never be on the list of dividend growth investors. The common belief these days is that managements are doing a better thing by repurchasing stock. This is a dangerous trend. Buybacks are lumpy in general, because managements tend to initiate them when they are flush with cash and stock prices are high, but cancel them when they are short on cash but prices are low. So essentially, companies manage to buyback a lot of stock when they are flush with cash and prices are high. Yet they get scared when their business is slowing down and shares are down. This is precisely the type of buying high and selling low that is detrimental to building shareholder wealth.

The second danger is if managements decide not to pay dividends. The dangerous ideas that are sold to investors is that selling 3% of portfolio is similar to paying a 3% dividend. This we all know is nonsense – dividends are always positive, rarely fluctuate, and thus provide more reliable way for someone who needs to live off their stock portfolio in the short-term. Share prices fluctuate wildly – thus for a $1 of earnings investors might end up paying you anywhere between $5 to $100. When you sell that future stream of earnings, you can expect to receive anywhere from 5 to 100 times earnings. And if you disagree with me on the 100 times earnings figure, please check out Twitter (TWTR). With dividend investing on the other hand, when Coca-Cola (KO) distributes 33 cents/share every quarter, this means that every investor who held the stock at a certain date will receive 33 cents/share. Between 1998 - 1999 there were times when Coca-Cola (KO) stock was selling between 29 to 54 times its earnings. So if an investor had to sell Coca-Cola stock to live off their nest egg, they would have received different prices for the same amount of shares they sell. And when you sell shares every quarter, you will end up with less shares over time and risk running out of money.

The other dangerous idea is that managements should retain all money in order to grow the business. When you have managements who are building empires, and more interested in their paychecks, you start creating some big issues down the road.

That danger is exacerbated by the increasing amount of passive investment strategies, where participants are being taught that it is not worth it to research investments, but it is preferable to blindly purchase all companies regardless of valuation or portfolio composition (index or mutual funds or ETFs). Not providing any effort is really dangerous mindset to be in, and could have dangerous consequences for corporate governance. If shareholders are taught that investment effort in researching companies and voting on proxies is futile, then they won’t be good corporate shareholders. As a result, managements would be able to do whatever they want. Isn’t it surprising that rising CEO pay coincided with increased mutual fund ownership of common stocks in the US?

The other danger is if companies adopt the worldwide approach to paying dividends. US companies pay a fixed amount, and grow it gradually over time. Many foreign companies target a payout ratio, which could lead to a fluctuating dividends from year to year.

A really good example is my review of Hershey (HSY). I generally like the company, and believe that it will do well over time. However, the shares seem to be overvalued perpetually. Back when the shares were selling at close to $106 in early 2015, I discussed how those who purchased high will suffer from lower expected returns. Now the shares are very close to fair value territory when they sell a little below $90/share. The company is expected to earn $4.16 in 2015, and $4.53 in 2016. The interesting thing is that the earnings estimate for 2015 is down from an expected $4.53/share when I analyzed the company in August 2014. At the same time, Hershey earned $3.77/share in 2014, which was an increase from the $3.61/share it earned in 2013.

I believe that the stock is attractive around the low to mid 80s right now. If you are a stickler for valuation like I am, there are options out there. If an investor sells one November 2015 put option the Hershey at strike $90 for $3.60, and the stock sells below $90 on November 20, 2015, they will have essentially purchased the stock at a cost of $86.40/share. If the investor sold the January 2016 put at a strike price of $90 for $4.55, and the put is exercised, the stock would be acquired at a cost of $84.45/share. If the investor were afraid that between November 2015 and January 2016 the stock price will be above $90/share, they can use the premium received to purchase shares of Hershey (HSY), and mitigate the risk of missing out.

Someone might look at all of that and decide that they should just purchase Hershey today at a little less than $90/share. The problem with this line of thinking is that your capital has an opportunity cost. If you overpay for an asset, you miss out on that other company that has similar prospects, but is cheaper. For example, Johnson & Johnson (JNJ) sells at 16 times expected earnings and yields 3%. The company has managed to increase dividends for 53 years in a row. Even General Mills (GIS) is cheaper at 19.90 times expected earnings and a yield of 3%, compared to Hershey's 21.60 times expected earnings and yield of 2.60%.

Full Disclosure: Long JNJ, KO, GIS and HSY. I also have HSY puts sold.

Relevant Articles:

The Live off Dividends Retirement Plan
Why I am a dividend growth investor?
Buying Quality Companies at a Reasonable Price is Very Important
- How to earn $900 in dividend income per minute
The Four Percent Rule is Dependent on Dividend Yields

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