Showing posts with label dividend investing. Show all posts
Showing posts with label dividend investing. Show all posts

Friday, October 17, 2014

Two and a half purchases I made this week

This is going to be a short article. The purpose is to discuss how I was able to acquire shares in two companies this week. The third transaction is explained in more detail below.

The first company I purchased shares in included Eaton (ETN). Eaton Corporation plc operates as a power management company worldwide. The company has increased dividends for five years in a row. However, it has not cut dividends to shareholders but increased it every other year since 1983. The company has managed to deliver an 11.80% average increase in annual EPS over the past decade. Eaton is expected to earn $4.60 per share in 2014 and $5.34 per share in 2015. In comparison, the company earned $3.90/share in 2013. The annual dividend payment has increased by 13.80% per year over the past decade, which is higher than the growth in EPS. Currently, Eaton is attractively valued at 13 times forward earnings, and has a dividend yield of 3.30%. I initiated a position in the company in the past quarter, and have since added to it. I would be looking forward to adding to my position in the company in the coming years, subject to availability of funds, opportunity cost and valuation. Check my analysis of Eaton on Seeking Alpha.

The second company in which I purchased shares was Williams Companies (WMB). It owns the general partner interest in Williams Partners (WPZ) and Access Midstream Partners (ACMP) along with any limited partnership units in both MLPs. Those are pretty valuable, especially if the pipelines do manage to increase cashflows. Williams Companies is a dividend achiever, which has managed to raise dividends for 11 years in a row. The company has a pretty aggressive plan to increase dividends per share through 2017 and expects to pay $2.46 in 2015, $2.82 in 2016, and $3.25 in 2017. Given the current annual payment of $2.24/share, which translates to a roughly 4.70% current yield, I would be interested in the company even if growth slows down to 5% – 6%/year. But no, Williams Companies expects to grow dividends by 15%/year through 2017. Those projections are one of the reasons I initiated a position in the company a few months ago. Given that pipelines are under pressure in the past two weeks, I think prices are starting to get more attractive. I probably need to write a more detailed analysis of the company, so please stay tuned.

These purchases are relatively small, given that I didn’t expect to have enough funds till sometime in November. I might make another small purchase either next or the week after next week. The purchases I am trying to make are basically additions to shares of companies I own, in an effort to increase positions by taking advantage of decreasing prices.

The third transaction I did earlier did week involved some shares of Kinder Morgan Inc (KMI), which I sold in my taxable account and purchased Kinder Morgan Management LLC (KMR). Since I am replacing one security for another, I view this as a half “purchase”. Actually, since once the deal closes I will end up with KMI anyway, it shouldn’t even be considered a purchase. A few weeks ago, I discussed that there is an arbitrage opportunity, where by purchasing KMR shares, an investor who waits till the acquisition by Kinder Morgan Inc is complete, can end up with more KMI shares than purchasing them outright. This is because the price of KMR shares is lower than the conversion factor times the value of KMI shares. If that paragraph is making your head spin, read the whole article explaining the process.

On the plus side, Kinder Morgan Inc (KMI) announced it increased quarterly dividends to 44 cents/share, which is a 7.30% increase over the same rate paid in the same quarter last year. Unitholders of Kinder Morgan Energy Partners (KMP) will get a quarterly distribution of $1.40/unit, which is a 4% increase over the same distribution paid to unitholders in the same quarter last year. Given that Kinder Morgan Management LLC (KMR) is equivalent to KMP, minus the ominous tax structure of a partnership, and given its higher yield relative to Kinder Morgan Inc ( plus it is not taxable since I get shares "reinvested" without triggering any taxable liabilities to the IRS), I think that I made the right choice. Now if Kinder Morgan Inc (KMI) drops to $30 or below, I would replace my remaining position with Kinder Morgan Management LLC (KMR) shares.

The other half I transaction I did was the fact that I replaced most of my position (90% or so) in ONEOK Partners (OKS) in my taxable account with the general partner ONEOK Inc (OKE). There are multiple reasons for the switch. The first reason is that if you like an MLP, the best returns in terms of dividend growth and capital appreciation are always derived from investing in the general partner. Thus I believe that OKE will do better than OKS over the next decade. I also made a mistake by chasing yields in the first place in 2011, when I sold OKE to buy OKS. Chasing yield on my part is not the smartest thing to do. I discussed this mistake in a previous article I posted a few months earlier. I needed to fix the mistake, once I identified it. Another reason for the change is that I need to simplify my life, as I will no longer have to do K-1 forms. They are not that difficult for me to do, and ONEOK Partners (OKS) does a really good job in showing you what forms to file with the IRS. However, if I am no longer in charge of the DGI portfolio ( due to death, disability, insanity etc), I know that this would make it more difficult for whoever inherits the dough. Thus, I used the sell-off in the pipeline sector to get in on the general partner, which declined much faster and much more than the limited partner units. On the surface, it sounds crazy that I replaced a 5.80% current yield for a 4% current yield. The thing of course is that the second yield is expected to grow by 10%/year, while the first higher yield would grow much slower. Over time, investing in the general partner interest will likely achieve better yields on cost. For the time being, I am still going to keep the remaining ONEOK Partners (OKS) in my IRA however.

Full Disclosure: Long ETN, WMB, KMI, KMR, OKE, OKS

Relevant Articles:

Ten Dividend Seeds I Planted for Long Term Income
Canadian Banks for Long Term Dividend Growth
How to buy Kinder Morgan at a discount
Kinder Morgan Limited Partners Could Face Steep Tax Bills
Seven Dividend Stocks I purchased for the long-term

Wednesday, October 2, 2013

Two dividend payers I recently purchased for my taxable accounts

For the first five years of this site, I have mostly discussed companies I found attractively valued for investment, as well as my dividend investing strategy. However, I rarely discussed the companies I have been purchasing in my accounts. This is because I believed that it was much better to discuss the tools of the trade and my investment philosophy and ideas, rather than focus too much in on recent investments. I never even published my investment portfolio in detail, until recently. Readers could only guess what I owned by going through articles, and checking my full disclosures. However, through interactions with readers over the years, I have realized that some enjoy reading about specific investment ideas that I have added money to.

Over the past ten days, I made two purchases in my regular taxable stock accounts. I purchased Realty Income (O) and British Petroleum (BP).

When I last analyzed Realty Income (O), I mentioned that I would only purchase it at a specific yield. Well, back on September 21 I tweeted about my purchase of the stock as I found the yield to be attractive. The company has managed to raise dividends multiple times per year since going public in 1994, and continued raising even during the dark days of the Great Recession in 2008 and 2009. After an acquisition closed in early 2013, Realty Income raised distributions by over 19%. I like that this triple net REIT continues growing through targeted acquisitions of competitors and properties and that it is not afraid to look outside the box in order to find attractive uses of its capital at attractive cap rates of return. You are also paying for the expertise of the management team, which has done a superb job of ensuring quality tenants, diversification and keeping the properties occupied.

One of the risks behind REITs is that rising interest rates would cause investors to sell their stocks off, and purchase bonds instead. As an investor, I realize this could potentially increase the cost of capital for Realty Income, which obtains money to grow through stock or debt issuance. As long as new properties are acquired at rates of return above cost of capital however, future acquisitions should continue adding to the pool of funds available for shareholder distributions. In addition, while interest rates would increase, they would likely do so very slowly and would likely reach about the same levels that we had prior to the 2008 – 2009 crisis first. In addition, I would much rather have my money in a business like Realty Income that provides the potential to generate a high dividend yield today and the opportunity for dividend growth versus a long US Treasury Bond at a similar yield. This is because an increasing dividend payment over time would keep the purchasing power of my income and protect it from inflation. Fixed income instruments do not do this for you. Currently, Realty Income yields 5.40% and has a ten year dividend growth rate of 4.20%/year. It trades at 16.70 times FFO ( assuming FFO of $2.40/share).

The other company I purchased was British Petroleum (BP) on September 30. In addition, I also sold a January 2015 put with a strike of $42. If the stock trades below $42 at expiration date, I would have to buy it at $42/share. However, my effective cost would be slightly less than $37/share. If the stock trades above $42/share, I would end up with the equivalent of slightly more than $5/share. The option premium received financed a portion of my purchase of BP.

Before I discuss the purchase, I wanted to discuss my history with the company. I initially purchased shares back in 2008, and considered them one of the safest dividends for current income. However, the events in 2010 led to a dividend cut, after which I sold out my position completely and reinvested the proceeds into Royal Dutch Shell (RDS.B). I sell automatically after a dividend cut, as a means to protect myself from getting married to a company that is collapsing. I do not want to be in a position of someone who has received dividends from a company for 40 years, and is emotionally attached to the stock, and therefore ignores warning signs that the business is in trouble. This could lead to losses in investment capital, which could result in going back to work. There have been investors who hold on for too long to a lost cause, and then end up not only losing their income source but also their capital. I also do not want to end up justifying to myself that a business will bounce back, while I am experiencing the pain from losses and hoping, rather than assessing the situation with a cool head.

Since the company has started raising dividends after the cut however, I am willing to give it another try. I think that the Gulf of Mexico spill is a major reason why the stock is still so cheap at 9 times forward 2013 earnings and 7.90 times forward 2014 earnings. However, I think that the fear of bankruptcy for BP is larger than the total cash outlays it would end up expending over time for the oil spill. Therefore, I sense an opportunity to purchase an asset at reasonable valuations that no one likes. The stock also yields 5.10% with a $2.16 in annual dividend. The total amount dividends paid annually was $3.36/share prior to the oil Spill in the Gulf of Mexico. I believe that this could easily be achieved by the end of this decade, especially if oil prices keep steady.

British Petroleum owns 19.75% of Russian Company Rosneft, which is the largest energy company in the world by reserves, and has a market capitalization of over 80 billion. BP also received a sizable cash consideration in the process, and will be using $8 billion from that to repurchase shares over the next 12 – 18 months. This would offset the reduction in earnings following the sale of its stake of BP –TNT to Rosneft for the cash and stock consideration.

In addition, BP has managed to replenish its reserves continuously over the past two decades. This is an important metric for oil companies, because it shows that they can replace the oil and gas extracted from developed fields through exploring for or acquiring fields that hold an equivalent amount or more of these precious carbons it sells worldwide.

Just like all other integrated energy companies, BP could suffer if oil and gas prices fall and stay low. However, I think that in the long-term, energy demand is only going higher from here. For example oil has so many uses outside of energy, that even if the whole world was running on solar and wind, there would still be a massive need for oil and gas. Even if the whole world used renewable energy to power the economy, realistically this is at least a couple decades away from it becoming mainstream. In the meantime, you can use the sizable dividend from BP as a sort of “rebate” to lower your cost basis in the stock.

Overall, I don't think I can go too wrong on a company like BP, which is cheap but has room to grow over time, offers a good dividend and buys back its cheap stock.

I would hate to turn this site into a stock picking service, but if there is interest, I would keep posting recent investments. As was the cash with my Roth IRA investments, I am going to post those in a couple weeks. I do post the tickers on Twitter, the day I make the transactions in that portfolio.

Please remember that I am making investments in my own accounts with my own money, based on information, estimates and biases (or experience) I have. These are not investment recommendations for you, but merely examples of the end result behind my investment philosophy and strategy in action. Do your own research before putting your money to work.

Full Disclosure: Long O, BP, RDS.B

Relevant Articles:

Ten Dividend Paying Stocks I purchased in September.
Realty Income (O) – The Monthly Dividend Company
Is BP’s dividend safe?
Royal Dutch Shell – An Undiscovered Dividend Gem
Three Dividend Stocks to Capitalize on BP’s weakness

Friday, September 20, 2013

Looking for Advertising Dividend Paying Stocks

One of my favorite shows is Mad Men. The story depicts life in an advertising agency in Manhattan in the 1960's. I was intrigued by the portrayal of the advertising business, since it involved maintaining client relationships for long periods of time if successful. I also wanted to look for ideas beyond the usual investment targets.

Advertising agencies have a very interesting business model. Businesses have to advertise their products or services, even during a recession. The business of advertising agencies is not characterized by heavy capital investment, typical to most other professional service organizations. However, because few of the companies have raised dividends for at least ten years in a row, they are not found on typical dividend growth screens.

The business is characterized by having strong relationships with clients, who trust their agencies with everything related to the advertising process. This includes the creative process of making the actual ad across different channels such as print, TV or web, to purchasing ad space across multiple platforms. Once a client is working with a particular agency, chances are that the relationship can last for many years. After all, by working with clients for many years, advertising agencies know their business, their executives, and the needs of the business better than what a newcomer would do. As a result, big accounts stay with their agencies for many years, which could translate into a steady stream of profits for those agencies.

Advertising companies also have the scale to implement the ads using a variety of channels within their control, either print, TV, radio, web or other channels. As new channels to reach the consumer like web and mobile are developed, there is an even higher opportunity for advertising companies to offer more services. The repetitive nature of advertising virtually guarantees revenues and profits for ad companies even during a recession.

Some pundits claim that the business of advertising agencies is threatened by online and mobile advertising. However, digital is not a threat but rather an opportunity, because it merely represents another channel through which to reach out to consumers. A company like Coca-Cola cannot advertise solely online. Thus, companies need someone like WPP Group or Omnicom to execute a marketing strategy consistently across different channels.

The business also has some float as well, which is created by the timing of payments from client to advertising agency and from advertising agency to media publisher. Because of their scale, advertising companies can negotiate much cheaper rates with media companies than those which the clients pay. Many share a portion of the savings back with the client, which creates a mutually profitable arrangement.

Revenue for creating ads is usually billed by the hour, plus a profit and overhead. In addition, most contracts allow for an incentive to be paid out to advertising companies if specific qualitative or quantitative results are hit.

Advertising agencies essentially have a toll-bridge type business model, that connects customers with TV, print, radio and online companies.

The market is dominated by a few large players such as Omnicom, Publicis, WPP, Interpublic. Unfortunately, none of them has a history of regularly raising dividends.

WPP plc (WPPGY) provides communications services worldwide. The company seems to have frozen its dividend in 2009, which ended its streak of consecutive dividend increases. WPP was dropped from the list of international dividend achievers after the dividend freeze of 2009, although it would likely be added back in 2014 if it maintains a five year streak of dividend increases. I reviewed the company site, and could find raises starting in 1995. This is the advertising company I would likely consider for inclusion in my dividend portfolio if it trades at attractive valuations.


Currently, the stock is slightly overvalued at 20.90 times earnings and yields approximately 2.30%. I would need to research the company in more detail and analyze it, before I initiate a position in it, but I usually require at least a 2.50% entry yield coupled with a P/E ratio below 20. The company might not end up delivering dividend growth every year, but over time, I expect it to grow dividends above the rate of inflation.

Omnicom Group Inc. (OMC), together with its subsidiaries, provides advertising, marketing, and corporate communications services in the Americas, Europe, the Middle East, Africa, and the Asia pacific. While the company has not raised dividends every year, over the past decade it has managed to quadruple the quarterly payment from 10 to 40 cents/share. When I initially started researching the basics of the advertising companies, I found Omnicom to be a company I would consider owning one day. Unfortunately, with the announced merger with french company Publicis (PUBGY),  there are some changes to take into account. It looks as if the new company will be based in the Netherlands, which could pose issues for dividend investors from a tax withholding standpoint. In addition, companies that merge might lose focus on their brands, as Interpublic did in late 1990's. I also do not like the fact that the combined Omnicom/Publicis will have both Coca-Cola and PepsiCo as clients. I am not sure if these clients would be happy if their business is handled by the same advertising agency. Currently, Omnicom trades at 17.70 times earnings and yields 2.50%.

The third advertising company I reviewed was Interpublic (IPG), which provides marketing and advertising solutions worldwide. While it does not have a consistent history of raising dividends, the company could well be an acquisition target itself. The company went on a major acquisition spree in the late 1990's, lost focus, and eventually cut dividends in the early 2000's. It reinstated it a few years ago, and currently trades at 18.90 times earnings and yields 1.80%. Warren Buffett used to be a shareholder in Interpublic between the bear market in 1972 - 1974 and the mid 1980's.

Full Disclosure: Long KO and PEP

Relevant Articles:

Why do I keep talking about the same companies all the time
The ten year dividend growth requirement
International Dividend Achievers for diversification
My Entry Criteria for Dividend Stocks

Monday, September 9, 2013

Should dividend investors hold non-dividend paying stocks?

I have spent several years writing about dividend investments, and why I consider them superior for most investors . However, I do understand that dividend investing might not work for everyone.

For investors who have little or no time to focus on managing their portfolios, it is actually preferable that they put their money in index funds and fixed income. As I had mentioned in earlier articles, dividend investing could easily take approximately 10 - 15 hours/week on average. If you have a demanding career, and a growing family, your time could be better spent being invested in index funds, while learning about investments in your free time.

For those who have the time, it is important to have a strategy that identified great investment opportunities, no matter whether they pay a dividend or not. It is possible that there are many outstanding businesses that do not pay dividends. For once, Berkshire Hathaway (BRK.B) is one such business. The story of Warren Buffett, who is the current CEO of Berkshire Hathaway is legendary. While he has been dubbed a “value investor”, since the early 1960s, he has been able to make hundreds of investments which are outside of the box for value investing. In essence, the Oracle of Omaha has been able to continuously learn more about business, in order to respond to the changing environment quite accurately. This has resulted in him having a strategy whose goal has been to simply uncover attractive investment opportunities, regardless of investment classification. Buffett changed course from buying undervalued securities, to buying great businesses with long lasting competitive advantages. Unfortunately, there is one Warren Buffett, but over 100 dividend champions. In addition, while Buffett does not let Berkshire pay a dividend, he routinely invests in companies that distribute their excess cash flow back to corporate headquarters for reinvestment.

The investor that uncovers companies with durable competitive advantages, will likely do very well over time, especially if acquired at attractive valuations. A portion of the returns will come through capital gains, which would defer taxable liability for years. However, it would be difficult to live off such a portfolio if prices are flat or decline over time. Usually, markets might fail to appreciate a company’s growing earnings for several years, which could result in your selling great companies at low prices, simply to meet the everyday expenses of your demanding life. Of course, if you can afford to hold on to appreciating stock for years if not decades, you will likely do very well for yourself.

There are companies which are great, but might not be paying a dividend for a different reason. Sticking only to a dividend strategy might cause an investor to miss such opportunities. For example, Starbucks (SBUX) didn’t pay a dividend until 2008. Another company which I like is Buffalo Wild Wings (BWLD), but it doesn’t pay a dividend either.

There are many growing enterprises which reinvest all money back into the business in order to grow it. As a result, many are able to grow at a rapid pace for several years. Rapid growth does not last forever however, which is why investors need to avoid overpaying for expected growth today.

Investors need to understand what their investment style is as well. I have an acquaintance who worked at one of the fastest growing technology companies in the US. Being on the ground floor of this rapidly growing company, he saw that there were tremendous opportunities for years to come in the US and internationally. As a result, he has been able to deploy a large portion of his investment dollars into the company stock, and has made plenty of money. Of course, my acquaintance is at least 30 years away from retirement, which is why risky technology stocks work as his method of accumulating wealth. It is very difficult to live off a nest egg whose sole source of returns is the fickle nature of Mr Market.

One reason why income investors should keep buying dividend paying stocks is because this is what they know. If you have spent your time analyzing streaks of consecutive dividend increases, projected dividend growth, and understood the underlying fundamentals behind those outcomes, you would be effectively specializing in a strategy that you can do better than the average investor. If you are able to identify businesses with strong competitive advantages, and can buy them at reasonable valuations, you can generate respectable returns over your investing career. Knowing your strategy, and having a conviction in it based upon years of experience, would make it that much easier to stick to your equities when prices go down during the next bear market. For example, I am pretty familiar with the business model of Coca-Cola (KO), which has managed to raised dividends for over 51 years in a row. It is not difficult to understand that a company that sells its branded concentrates to bottlers and other middle-men, would earns high margins on that activity. It is also not difficult to understand that a company that sells differentiated branded products, will earn a lot of money when a growing number of global consumers are exposed to it.

A second reason to hold on to dividend paying stocks is because dividends provide a component of total returns that is more stable than capital gains alone. When you need to live off your portfolio in retirement, you need to generate a stream of income which is relatively predictable in a manner of timing and amount of income. This makes relying on dividend checks superior to relying on selling off stocks to meet your expenses. A diversified portfolio of dividend paying companies with strong fundamentals, and a history of raising dividends for at least a decade will be much more likely to generate a rising amount of dividends even during a recession. You have to remember that you need to eat and live even during a bear market. Flat or declining stock prices are terrible news for investors who sell off stocks in retirement in order to cover expenses. This is because they would have to sell off ever larger amounts of their portfolio just to maintain the same standard of living, if stock prices stagnate or decline. With dividend paying stocks, you get a cash return on your investment, while still maintaining the same amount of share ownership. In addition, if you have excess dividend income, you can redeploy it back into quality companies at depressed prices during the next flat or declining markets. For example, shares of Procter & Gamble (PG) have decreased by 50% at least several times over the past 50+ years. However, the company has raised dividends for 57 years in a row to its loyal shareholders.

A third reason for holding dividend paying stocks is if these companies fit the investment goals and objectives in your retirement plan. The goal of my retirement plan is that my diversified portfolio generates a sufficient stream of income to cover my expenses after I stop working. Because dividend income is more stable than capital gains, it is a safer alternative that can deliver cash to pay for expenses on a timely and predictable pattern. As a result, the transition from being paid twice/month to receiving multiple dividend checks every month is easier on your personal finances. Therefore, if your monthly expenses are $1000 month, and your portfolio generates at least $1000 in monthly dividend income, you have achieved your objective. It is much easier to keep investing in income generating assets until you reach $1000/month in dividend income than worrying about accumulating a certain amount of funds first, and only then worrying about how to convert that into meeting your expenses. I find dividend investing to be a much easier approach compared to withdrawing 3% - 4% of my net worth every year.

A fourth reason to keep dividend paying stocks is because they are more stable and mature than non-dividend paying ones. Only a company that generates excess cash flows that are above and beyond its needs to grow and maintain the business, will be able to pay a growing dividend to shareholders. The growing dividend is an indication of a business model that has the competitive advantages to throw off so much cash. Most companies that do not pay dividends do so because they cannot afford to pay distributions. The ones like Berkshire Hathaway (BRK.B) are the more like an exception, rather than the norm.

Another reason to buy quality dividend paying stocks is because they are typically cheaper than some of the great growth stories out there. The growth stocks typically plow back every single penny back into building the organization. There is usually a lot of hype associated with many of those companies, which makes them sell at ridiculous valuations. If a company like Tesla (TSLA) sells at $150/share, this is because market participants expect it to earn several dollars/share in a few years. Given the company’s low current earnings, it seems that most of the valuation is dependent on future expectations, which can vary a great deal away from reality. If the expectations do not materialize, stock prices could be lower, and sources of return would be just from capital gains. It can work for many, but not for my style of investing. Most dividend paying stocks are usually cheaper because a regular 6 – 9% growth is seen as unexciting by market participants. This is ok, because a low entry price, coupled with modest but consistent growth can result in compounding miracles decades down the road. For example, if you can purchase shares of a dividend stock like Chevron (CVX) at nine times earnings, 9% earnings and dividend growth, and a 3% yield, you can do very well for yourself over time. Of course, if you can purchase the shares of a quality company that doesn’t pay dividends, you can also do well over time. However, your total source of returns would be capital gains. In my life, I prefer the diversified nature of both dividends and capital gains.

Overall, an investor would do great for themselves if they focus their energies on purchasing quality companies at attractive valuations. The vast majority of such enterprises are dividend paying ones, although there are some exceptions. In my stock portfolio, I hold only quality dividend paying companies, because I like the consistency in the nature, timing and amount of dividend payments. Therefore, I mostly focus on the dividend contenders and dividend champions list of companies for research. As a result, despite the exceptions, I do not believe that focusing only on dividend paying stocks is limiting me in any sort of way.

Full Disclosure: Long CVX, KO, PG

Relevant Articles:

How long does it take to manage a dividend portfolio?
How Warren Buffett made his fortune
How to accumulate your nest egg
Common Misconceptions about Dividend Growth Investing
Frequently Asked Questions (FAQ) About Dividend Investing

Wednesday, August 21, 2013

The predictive value of rising dividends

Newton’s first law states that a body in motion at a constant velocity will remain in motion in a straight line unless acted upon by an outside force. While Newton lost a lot of money during the South Sea bubble in 1720 chasing hot stocks, he could have made a lot more simply by applying his findings to the world of investing in dividend stocks instead.

In my years of investing in dividend stocks, I have noticed that companies which consistently raise dividends every year tend to keep raising dividends going forward. Companies which sporadically boost dividends for short periods of time, only to freeze or cut them later tend to repeat this activity over and over throughout their corporate histories. Unfortunately, many dividend investors fail to learn from history. As a result, these investors hope for the best when dividends are kept unchanged or cut, and predict dividend cuts as the distribution is raised to record levels for many years.

The companies which tend to consistently raise dividends tend to have business models that deliver the type of sustainable earnings growth that supports dividend growth. These companies manage to expand their businesses by creating a plan and sticking to it, while capitalizing on long-term economic trends and keeping their business vibrant and innovative. In addition, many companies that have managed to achieve long streaks of dividend increases are owners of strong global brands, have strong competitive advantages and are able to deliver value added products or services, which are characterized by high quality. As a result, it would be very difficult for a competitor to steal away customers based on price alone. In order to steal customers away, a competitor would have to spend years losing money, before carving out a profitable niche in the industry. The high returns on equity result in businesses that generate so much in free cash flow, that they have to return some to shareholders. The high return on equity also translates into lower capital requirements to stay relevant or expand the business over time.

For example, Wal-Mart Stores (WMT) is known for its low prices. If another retailer tries to steal customers away, they would have to beat the efficient distribution network, scale and long-term relationships/deals that Wal-Mart has with suppliers. In addition, because Wal-Mart has so many locations, it can afford lose money in a given market in order to eliminate competition there.

Another example includes Colgate-Palmolive (CL) toothpaste. Customers who purchase this product do so in a repeatable manner, because they like the quality of the toothpaste. People’s teeth are important to them, which is why they would likely keep on purchasing the same brand of toothpaste even if prices were going up, rather than save money and purchase a cheaper product. That is especially true if the quality of the cheaper product is not perceived to be as high. In order to increase consumer awareness, marketers for the cheaper toothpaste would have to spend large sums of money convincing customers of the positive effects of their products. The cheaper toothpaste company would keep losing money for long periods of time, because people’s tastes do not change overnight. A company like Colgate-Palmolive (CL) would maintain its competitive position if it innovates constantly and betters its products, and mint cash along the way to distribute to shareholders.

The repeatable nature of the transactions for companies like Wal-Mart and Colgate-Palmolive is occurring millions of times every week. Because they are providing products to use in peoples every day’s lives, many such companies are able to predict how much they are going to sell within a few percentage points. As a result, the Boards of Directors are able to predict with a reasonable amount of certainty the amount of funds the company would be able to sustainably allocate in order to pay dividends over the next year. In addition, many companies in the US pride themselves on their long records of dividend payments or dividend increases. The dividend is typically seen as a “sacred cow”, and would only be cut or eliminated under dire circumstances. In addition, companies like Coca-Cola (KO) and Johnson & Johnson (JNJ) which have the culture of consistently boosting distributions, would continue doing so, as long as the business fundamentals support this move. Even short-term weaknesses in earnings would not lead to elimination of the dividend growth culture in such companies. A dividend freeze or a dividend cut however would probably mean that the wheels of fortune are turning at these companies. As a result, these companies would likely avoid taking such actions, unless absolutely necessary.

Full disclosure: Long  WMT, CL, JNJ, KO

Relevant Articles:

Ten Dividend Stocks with High Returns on Equity
Dividend Stocks for the next decade and beyond
Strong Brands Grow Dividends
Seven wide-moat dividends stocks to consider
Avoid Dividend Cutters at All Costs

Wednesday, August 14, 2013

Why Investors Should Look Beyond Typical Dividend Growth Screens

In my early days as a dividend growth investor, I focused exclusively on the list of dividend aristocrats. It included 50 or so solid blue chips, each of which had managed to boost dividends for at least a quarter of a century. I liked the fact that this was a short list, which made screening for potential candidates for inclusion in my portfolio very easy.

As I kept digging however, I learned more about the historical changes in the S&P Dividend Aristocrats Index. I was very surprised to learn that some companies had been eliminated from the index, despite the fact that they kept increasing distributions. I also noticed that there were many companies which had raised dividends for over 25 years in a row, yet they were never included in the index, for whatever strange reason. Luckily, I had found the dividend champions lists, maintained by David Fish. While his list is as complete as possible, I would still advise income investors to get their hands dirty with as much information as possible, before eliminating an idea from their list for further research due to a low streak of consecutive dividend increases.

For example, I have noticed that a few companies were booted out of the Dividend Aristocrats index because of spin-offs or because they split into two or more separately traded companies.

Altria Group (MO) was able to spin-off its Kraft Foods division in 2007. Shareholders in Altria received shares in Kraft for each share of Altria stock they held. In 2008, this was followed by the spin-off of Phillip Morris International (PM), which represented the international tobacco business of Altria Group.

Shareholders of the legacy Altria Group received one share of Phillip Morris International (PM) as well as a share of the new Altria Group (MO), which focused exclusively on the domestic cigarette business. The legacy Altria Group has managed to boost distributions for over 42 years in a row. After the two spin-offs however, the company was eliminated from the dividend aristocrats and the dividend achievers indexes.

However, shareholders who purchased Altria in early 2007, and went through the two spin-offs actually enjoyed increases in their total dividend incomes in every year since then. The growth in total dividend income was helped by annual dividend increases by Phillip Morris International (PM) and Altria Group (MO) in every year since 2008. Kraft Foods stopped boosting dividends in 2008 however, and maintained them flat for a period of 3 years, before the company itseld split into two separately traded parts – Mondelez International (MDLZ) and Kraft Foods Group (KRFT). In general, Altria Group (MO) should have never been removed from any of the lists of dividend growth stocks. I was positively surprised by the fact that Dave Fish had included the company in his list of Dividend Champions. The point of this story is that investors should not use a mechanical approach to screening for stocks, but utilize their knowledge in order to identify opportunities that others less knowledgeable investors might have missed.

In May 2012, ConocoPhillips split into two separately traded companies: ConocoPhillips (COP), which focused on Exploration and Production for Oil and Natural gas and Phillips 66 (PSX), which focused on Refining and Marketing for crude and natural gas. The legacy ConocoPhillips company was paying a quarterly dividend of 66 cents/share, and had raised dividends since 2002. On the surface, through June 2013 it seemed that the company had not raised distributions since the 20% boost payable in March 2011. Shareholders as of April 30, 2012 received one share of the new upstream focused ConocoPhillips (COP) as well as half a share of the downstream focused Phillips 66 (PSX). However, although the new ConocoPhillips maintained its quarterly dividend of 66 cents/share, this was technically a dividend increase, since it was coming from a lower base. Some dividend investors didn't see it that way however, and worried about the perceived "lack of dividend increase". Most recently however, ConocoPhillips raised quarterly distributions to 69 cents/share.

Abbott Laboratories is another company that recently split into two separately traded companies - Abbott (ABT) and Abbvie (ABBV). It seems that as of this writing, the Dividend Aristocrats index has not removed both companies from its ranks. However, I cannot find any mention in the Dividend Champions list. Dividend growth investors should keep both companies on their radars, and add to their portfolios under the right circumstances.

Full Disclosure: Long MO, PM, KRFT, MDLZ, COP, ABT, ABBV

Relevant Articles:

Check Out the complete Archive of Articles
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
Dividend Aristocrats List
Dividend Champions - The Best List for Dividend Investors
Should dividend investors hold on to Abbott (ABT) and Abbvie (ABBV) following the split?

Monday, July 29, 2013

Looking for dividend bargains in an overheated market

With prices on many stocks I follow reaching new highs, it is getting more difficult to find attractive places for my investment dollars. Because of the above factors, I have ventured into modifying my entry criteria slightly, in order to adapt to the current environment in 2013. I definitely feel out of step with the current market however.

I usually screen the list of dividend champions and dividend contenders about once every month using my entry criteria, in order to find attractively valued securities. In addition, I also review dividend increases every week, in order to uncover hidden dividend gems.

After I come up with a list of cheap companies, I try to perform a more detailed review of financials, business prospects and competitive strengths, in order to gain a more thorough understanding of the company’s business model.

In most cases however, chances are that I have analyzed before the companies on the dividend champions and dividend contenders lists. As a result, I just check the last time anything material happened between my analysis time and the purchase date. The beauty of dividend investing is that knowledge is cumulative – if you understood the business model of Coca-Cola in 2011, along with risks and opportunities, your knowledge is most likely still relevant. Things could change over time of course, as Coca-Cola (KO) acquired North America bottling operations from CCE in 2010. For most of your dividend champions, there are not going to be changes in the business model over several years. By reviewing the annual reports, one can easily keep up with any other annual changes like new markets, new products as well as obtaining information about the most recent trends in fundamentals.

Unfortunately, most of the companies I usually focus on have been overpriced. For the companies that I find attractively priced today, I already have an above average allocation to them. Unfortunately, my principles of holding a diversified portfolio prevent me from concentrating my holdings too much. For example, I find Phillip Morris International (PM) and Chevron (CVX) to be attractively priced today. Unfortunately, all two of these companies are in the top five of my holdings. As a result, I would need to look elsewhere for opportunities.

There are also many opportunities with the oil and gas majors these days, many of which trade under 10 times earnings, and offer above average yields. However, investors should avoid concentrating portfolios too much in a given sector. This is because oil and gas companies earnings could suffer if commodity prices dropped from here. If your income portfolio has more than 15 - 20% in a given sector, chances are you might be overly concentrated to it.

Another attractive factor behind dividend investing however is that once you select a great company at a good price, you can simply hold on to it. You can choose to perform small portfolio tweaks here and there, but even if you don’t you should still do just as well doing little. Monitoring your positions is important as well however, as things do change over time.  If I were retired and living off my portfolio, I would not really care whether stocks are up or down, as long as fundamentals are intact and companies are showering me with cash on a recurring basis. As an investor in the accumulation phase however, the problem is that while you would benefit from dividend growth, you would fail to turbocharge your income growth because you are not reinvesting your pile of growing dividend payments.

I have been able to identify several companies with low price/earnings ratios, adequate dividend coverage and yields, which have good long-term business and dividend growth prospects:

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance products. The company has raised distributions for 30 years in a row, and has a five year dividend growth rate of 10.90%/annum. Currently, the stock is trading at 9.70 times earnings and yields 2.30%%. Check my analysis of Aflac.

Ameriprise Financial, Inc. (AMP), through its subsidiaries, provides a range of financial products and services in the United States and internationally. The company has raised distributions for 9 years in a row, and has a five year dividend growth rate of 20.60%/annum. Currently, the stock is trading at 17.20 times earnings and yields 2.40%. Check my analysis of Ameriprise Financial.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised distributions for 26 years in a row, and has a five year dividend growth rate of 9.20%/annum. Currently, the stock is trading at 9.60 times earnings and yields 3.10%. Check my analysis of Chevron.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised distributions for 5 years in a row, and has a five year dividend growth rate of 13.10%/annum. Currently, the stock is trading at 17.30 times earnings and yields 3.80%. Check my analysis of Philip Morris International.

Target Corporation (TGT) operates general merchandise stores in the United States. The company has raised distributions for 46 years in a row, and has a five year dividend growth rate of 20.50%/annum. Currently, the stock is trading at 16.80 times earnings and yields 2.40%. Check my analysis of Target Corporation.

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company has raised distributions for 39 years in a row, and has a five year dividend growth rate of 13.50%/annum. Currently, the stock is trading at 15.40 times earnings and yields 2.40%. Check my analysis of Wal-Mart Stores.

ConocoPhillips (COP) explores for, produces, transports, and markets crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids on a worldwide basis. The company has raised distributions for 13 years in a row, and has a five year dividend growth rate of 13.10%/annum. Currently, the stock is trading at 10.70 times earnings and yields 4.20%. Check my analysis of ConocoPhillips.

McDonald’'s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has raised distributions for 36 years in a row, and has a five year dividend growth rate of 13.90%/annum. Currently, the stock is trading at 18.20 times earnings and yields 3.10%. Check my analysis of McDonald’'s.

In modifying my entry criteria, I can accept a shorter streak of dividend increases, and even a lower current yield. However, I would never sacrifice on company quality, and I would not purchase shares trading above twenty times earnings.

Full Disclosure: Long AFL, CVX, PM, TGT, WMT, COP, APD, KO

Relevant Articles:

Check Out the complete Archive of Articles
How to invest when the market is at all time highs?
Is the Dividend Craze Over?
The World’s Best Dividend Portfolio
Lower Entry Prices Mean Locking Higher Yields Today
- Carnival of Wealth, Back to School Edition

Wednesday, July 24, 2013

Frequently Asked Questions (FAQ) About Dividend Investing

I have highlighted below several frequently asked questions about dividend investing. This is not an all inclusive list, but more of a running total of questions I am usually asked about dividend investing, dividend growth stocks and my strategy. The answers pertain to my investing, strategy and experience, and I have tried to respond to the best of my knowledge and intentions. As I get new recurring questions asked, I would add them to this list.

Why should you focus on dividends?

A company that pays dividends is less risky than a company that has never paid a dividend. A company that pays dividends pays with actual cash, which cannot be easily manipulated like earnings. Dividends are a more stable part of total returns, and are always positive, which is what makes them ideal for retirees who want to live off their nest egg. Paying a dividend imposes discipline on management, that makes them evaluate the cash flow impacts of new projects and make them only focus on the best ideas. This dividend payment makes management less likely to engage in empire building, and less likely to simply hoard cash or mindlessly expand/acquire companies which are not accretive to returns. Few US managements are willing to cut a dividend – doing so sends signals that the company is weak financially.

What are you looking for in a dividend stock?

In my entry criteria, I focus on companies which manage to increase dividends over time because they have growing earnings, trade at a P/E below 20, yield above 2.50% and have a dividend payout ratio below 60%. I have violated some of those rules before, but I have also focused on only buying companies that can increase earnings and not paying more than 20 times earnings. I also do qualitative analysis in order to understand the business of the company, whether it has any moat, competitive advantages, strong brands, pricing power and the ability to increase earnings over time.

How to you handle dividend payments?

As an investor in the accumulation phase, I re-invest dividends selectively. This means that I accumulate cash dividends all the way up to $1,000 or $2,000, and then purchase shares in a company I believe to be attractively valued. I am not a fan of automatic dividend reinvestment, unless of course your portfolio is so tiny that the transaction costs would negate any benefit of investing in the cheapest stocks.  I target 6%– 7% in annual dividend growth, coupled with a 3% - 4% yield on my portfolio, for a total of 10% in dividend income increase every year. Once I retire and live off my portfolio, I would spend all of the income, and would rely on organic dividend growth to keep up with inflation.

When would you sell a dividend stock?

I usually sell after a dividend cut, after a company I own is acquired, or if it becomes too overvalued for the growth I expect out of it. For example in 2012, Con Edison (ED) traded at a yield of 4% despite the fact that it was growing distributions at less than 1%/year for the past 16 years. In addition, shares of Universal Health Realty Income (UHT) were similarly overvalued relative to their dividend growth.  I try to buy great stocks that would do great things in increasing earnings, dividends and stock prices, but sometimes life happens and either growth slows down, the stock gets massively overvalued or the financial conditions deteriorate. My expectation is to never sell when I buy (otherwise, why would I buy in the first place), although I monitor frequently my portfolio.  I expect that my best ideas would go up over 1000% in my lifetime, and I would keep holding on to them until I pass them over to my heirs.  These would be the stocks that would generate large portions of my returns. Selling a stock that will go up by 1000% in 20 – 30 years for a small gain without letting it ride out to full potential will likely cost a lot, and could mean you lose money in dividend investing rather than make any.

Don't only companies that do not grow pay dividends? Companies that cannot find anything better to invest money in tend to pay dividends.

It is true that companies like Google (GOOG) have never paid a dividend; nor did Apple (AAPL) pay a dividend between 1997 – 2011, when its stock rose a lot.  However, most companies that do not pay dividends do so because they cannot afford to because they have deteriorating financials or need all of the money to be reinvested in the business, as they are not generating excess cash flows.  If you focus on companies that do not pay a dividend, chances are that few will be the Googles or Berkshire Hathaway’s (BRK.B) of the world, but most might be the Worldcom’s, General Motors, Eastman Kodak’s etc.

Actually, some of the best performing stocks have managed not only to grow business but also pay a rising dividend over time. Such companies include Wal-Mart (WMT), McDonald’s (MCD) and Coca-Cola (KO). My goal is identifying these companies that not only increase earnings and dividends, but also trade at a reasonable valuation. That being said, not all companies that pay dividends are good investments.  Please check above on the factors I look for in a stock.

But Warren Buffett doesn’t believe in paying dividends – Berkshire has not paid a dividend since 1967

Berkshire Hathaway has not paid dividends since 1960’s. However, Buffett does invest in businesses and companies that pay dividends, and he uses these cash flows to invest in other cash generating stocks and businesses. This is similar to what dividend investors do – buy stocks and then reinvest them in other attractively valued stocks if in the accumulation stage. If you are retired, then chances are you still reinvest your excess cash in more dividend stocks. While Buffett is an excellent capital allocator, few other companies can match his expertise. Most companies that invest excess earnings into other relevant businesses or unrelated industries have a poor track record. The sole fact that there is just one Berkshire Hathaway but over 100 dividend champions speaks volumes.

But what about total returns?

As I mentioned above, I focus on companies that I believe will increase earnings per share over time. This is the driver behind dividend growth over time. A company with rising earnings per share would likely increase in price over time. As a result, I do hope that the companies I buy will be more valuable over time, and would generate total returns. However, I focus on dividends because they are a more reliable portion of total return than capital gains for living off your nest egg.

What about taxes?

Qualified dividends derived from US corporations are taxed at a maximum tax rate of 23.80% to US residents. This is much lower than tax rates on interest income, which is taxed much higher at the ordinary income tax rates (except muni-bonds). Unfortunately, if you income is less than $400,000 for single or $450,000 for joint returns, you would pay anywhere from 0% to 15%.

Taxation varies for REITs and MLPs, and is unique to the entity paying them and the personal situation of the individual receiving distributions from these entities. Not investing in dividend stocks and equities in general because they could result in tax liabilities is not a smart strategy to follow. It is possible for US investors to defer/avoid paying taxes on investment income if it is placed in tax-advantaged accounts such as 401(k), IRA, ROTH IRA, SEP IRA etc. If you are a US resident investing in foreign corporations, you might end up paying withholding taxes on dividends received, even if you held them in a tax-advantaged account however.

But is a 2% yield sufficient to protect you against inflation?

I focus on companies which have yields that look low today, but which I believe would increase dividends above the rate of inflation. If this dividend growth is fueled by earnings growth, chances are that stock price will increase as well.  For example, let’s examine a situation where you bought a dividend growth stock that trades at $100/share, earns $5/share and pays a $2 annual dividend. If this company is able to grow earnings and distributions by 7%/year over the next decade, and inflation grows at 3%/year, you will be ahead of inflation. That means that in year two, the company would earn $5.35/share, pay $2.14/share and likely trade around $107/share. In order to maintain purchasing power in year two as year one, the stock would have had to trade at $103/share and would have had to pay $2.06/share.  If you add in that excess over inflation, it can lead to more wealth over time. Since 1920, dividends on the Dow Jones Industrials have increased by 5%/year, which was 2% higher than inflation. As a result, I find dividend growth stocks to be the perfect source of inflation proof source of income.

But I would need $500,000/$1,000,000 invested in dividend paying stocks to make a meaningful amount of dividends to live off?

In order to live off your nest egg, you need to build a nest egg first. I focus on building income, rather than a set amount to invest in. However, if you are just getting started and need $40,000 in annual income, you would likely need to invest about $1 million in dividend paying stocks. However, if you asked a traditional portfolio planner/financial adviser, they would have advised you to have $1 million in your portfolio and follow the traditional 4% rule. As a result, the requirement to have a nest egg to live off of with dividend stocks is no different than what you would need in a traditional index funds/bond fund allocations. The goal is to start as early as possible, in order to get time and compounding on your side. Dividend investing is not a get rich quick scheme.

But doesn’t dividend investing take too much time?

Dividend growth investing does require a time commitment.  The time is spent scanning the market for opportunities, analyzing companies through reading annual reports, analyst reports, and filings. The time is also spent reviewing your portfolio regularly as well. However, once you have a certain level of understanding behind the companies you own, updating that knowledge should not take as much time. In general, you can spend about 10 hours/week easily on average, with a lot of it spent in the February – April period when most annual reports are sent out. If you are unable to dedicate time to managing your individual portfolio, you can outsource it by focusing on stock or bond funds. However, depending on your choices, you might end up paying a steep price every year for this privilege.

What about bonds/real estate/gold?

I believe that a portfolio should be well-rounded with different asset classes that do well under various conditions. I would like to have a 20% - 25% allocation to US treasuries when I retire, which would protect my nest egg for a Depression like scenario like the US experienced in 1929 – 1933 or Japan between 1989 – 2013.

I am not capable of managing real estate myself, but instead focus on Real Estate Investment Trusts.
I do not own gold/silver except for a few coins for numismatic purposes ( I also used to collect stamps at  one point). I do not see much value in it in a typical investment portfolio. I like to own assets that have a productive capacity such as stocks or real estate for example. However, gold has been the asset to own if you were part of a minority that is being persecuted and you need to leave (Jewish community in Poland in 1939).

What are your favorite resources to research dividend investing?

I read annual reports, where I obtain most of my data. I use the Securities and Exchange commission website for this at SEC.gov. I also use Yahoo! Finance to keep tabs on my many holdings, in a personalized watch list. I also have a few favorite authors on dividend investing:

Why spend all that time on dividend investing, when no one can outperform index funds?

As a dividend investor my goal is not to outperform the S&P 500, although I do compare increases in my dividend income to increases in S&P 500 dividends. The S&P 500 is a list of stocks which is arbitrarily selected by a committee in Standard & Poor’s according to who knows what criteria – it is not even a list of the 500 largest companies in the US.  The 40 largest companies in the index account for almost half of its weighting. The committee in charge of maintaining S&P 500 included Berkshire Hathaway only a few years ago. During height of the dot-come bubble in 1999 – 2000 they added a lot of so called "new economy stocks", right before they crashed and burned. My goal is to generate a growing stream of dividend income every year, and to achieve that I focus on companies which I believe are undervalued today, have solid competitive advantages that I understand, and will likely increase earnings and dividends over time. I have a friend who owns an auto repair shop.  I never ask him how his business is doing relative to the S&P 500, or else he would think that some of the screws in my head might be failing.

Incidentally however, dividend growth stocks since 1972, dividend champions since 2007 and dividend achievers since 1996 have outperformed the S&P 500 or very closely followed it.

Readers of Dividend Growth Investor website, I would appreciate your feedback on Frequently Asked Questions. If you have input on the existing answers to these questions, or if you could think of any additional ones, I would be more than happy to hear from you here or in my email address. My e-mail is dividendgrowthinvestor at gmail dot com.

Note: This article was included in the Carnival of Wealth, Hunter Mahan Is Too Rich Edition

Wednesday, July 17, 2013

Dividend Investors Should Ignore Price Fluctuations

In this day and age we are bombarded with stock market information anywhere we go. You can find stock prices on many TV channels, newspapers, the internet and mobile phones or tablets. This excess of information creates information overload which creates the urge to buy and sell stocks in nanoseconds. This could prove hazardous to your wealth however. Research has shown that investors who actively trade the markets generate lower returns that index funds. In fact, investors would be better suited to just ignore price fluctuations and simply focus on fundamentals.

Investors should focus on company fundamentals in order to profit in the long run. Focusing on long term business performance would be helpful if the investor takes the time to understand the business, and determine whether the company has a chance of growing earnings over time. If earnings are increasing, chances are that the market will reward the company’s stock with a higher price, and that the company will be able to reward its shareholders with higher dividends. At times stock prices get detached from fundamentals however, which is when the patience of dividend investors is tested. During stock market euphoria, investors who own dependable dividend stalwarts tend to feel out of sync with the rest of the market, as high growth stocks tend to deliver double digit returns easily. During market corrections however, these same growth stocks tend to give up almost all of their returns, and then some. It is during market corrections that investors in sound companies continue generating a return on their investment. This return is in the form of cash that is directly deposited in investors brokerage accounts every quarter. Investors following the four percent rule of dividend investing in retirement do not worry about whether market is up or down, because their dividend checks pay for their expenses. They are essentially getting paid to hold their dividend stocks.

As dividend investors however, we should be ready to embrace periods of time where stock prices decline. I view these as opportunities to add to my existing positions and to buy stock in companies which have always been overvalued before. After that, I just sit patiently while the companies execute their strategies and prosper, even if the stock market does not recognize that for years. As long as the fundamentals are sound, and as long as the dividend is not cut or eliminated, I will hold on to my dividend stocks.

For example, between 1972 and 1985 shares of Procter & Gamble (PG) were flat. The only return that investors realized came from dividends. The reason behind this underperformance was due to P&G stock being overvalued in 1972, yielding only 1.30%. By 1985, the dividend had increased by 233%, and the stock was yielding 4.30%. For original investors who held P&G stock at lower entry prices however, their yield on cost continued to increase despite the overall stagnation in stock prices. Despite the fact that the stock price was flat for 13 years, earnings were increasing, and therefore the business was becoming more valuable.

Unfortunately investors never learn, and by late 1999, Procter & Gamble (PG) was trading at $55, and yielded only 1.20%. The stock fell on negative news all the way to $27/share, and it took four years before the stock reached its year 2000 highs. The dividend had increased by over 50% during that time period. For investors who purchased Procter & Gamble stock in the 1980s however, they were already generating high yields on cost. This meant that the volatility in stock prices should not have scared them away, as their dividend incomes continued to increase. New funds should not have been added to their P&G positions at the time however.

Other notable dividend stock declines included the decrease in McDonald’s stock price between its 1999 high of $49/share and its 2003 lows at $13/share. This was caused by overvaluation in the stock, although investors kept receiving distributions during that period. Albeit, dividend yield was less than 1% at the time, so it probably didn’t deliver much in terms of returns to shareholders.

On the other hand, some attractively priced companies became even cheaper to buy during the financial crisis of 2007 – 2009. Shares of Johnson & Johnson (JNJ), Abbott (ABT) and McDonald’s (MCD), which provided shareholders with a rising stream of dividend income, were trading at even more attractive valuations. Investors were essentially paid to hold during this tumultuous period, and could have reinvested distributions at the low prices that existed. At the same time fundamentals were improving, and investors could sleep at night with these investments, despite the fact that it seemed as if the whole world was breaking apart.

To summarize, long term dividend investors should expect to see price volatility, even if the fundamentals of their income stocks are doing fantastically. As a result, it is important to have entry criteria which would deliver some sort of return even if fundamentals do not pan out as expected. In the case of Procter & Gamble in 1972, 1999 and 2007, despite the fact that fundamentals were solid, the company’s stock price was overpriced, which led to high volatility while new investors did not see much in terms of dividend yield. Same was the result for investors in Coca Cola (KO), Wal-Mart Stores (WMT) and McDonald’s (MCD) in 1999.

The subsequent improvements in stock valuations over time should have prompted investors to add or initiate positions in these stocks. For example, right after the crash in 1987, Warren Buffett began accumulating Coca Cola stock, and by the time he was done, he had an average cost of $3.2475/share. For long term investors such as Warren Buffett, the stream of dividend income kept increasing, his yield on cost kept going up, and he kept reinvesting it in more cash flow generating assets for his company Berkshire Hathaway.

Full Disclosure: Long KO, WMT, MCD, JNJ, ABT, PG

Relevant Articles:

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Buy and hold dividend investing is not dead
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Lower Entry Prices Mean Locking Higher Yields Today

Tuesday, July 2, 2013

Common Misconceptions about Dividend Growth Investing

There are many misconceptions about dividend investing. I have tried itemizing several of them, outlining them, and providing a brief commentary. Dealing with viewpoints that are different from yours is very important, because it opens you up to new ideas, and tests your strategies against scenarios that you might not have thought about. Unfortunately, most of the time I deal with viewpoints which are against dividend investing, I often find the authors are only providing their opinions, without ever bothering to examine any factual evidence on the subject. It is very dangerous to have an opinion on a subject, without knowing it inside out, but sticking to your original viewpoint, even if the evidence refutes your original ideas. As Charlie Munger says " “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.” 

The misconceptions are summarized below:

- One misconception about dividend investing is that it is not a good strategy because one needs a high amount of funds in order to generate a meaningful amount of income to live off. For example, high amounts such as $500,000 or $1,000,000 are often used as some sort of an arbitrary yardstick that somehow is the main requirement to use dividend investing. In reality this is nonsense, as investors can start dividend growth investing with as little as a few hundred dollars per month, and then reinvest dividends and keep adding funds to their portfolios. Of course, the less money you can afford to put in your portfolio, the more time you would need to achieve your target monthly dividend income. In addition, in order for any investor to live off their nest egg with any strategy, they do need to accumulate somewhat of a sizeable portfolio. If you decided to live off your rental properties, or sell off index funds, chances are you would need a portfolio size equivalent to a dividend portfolio. It is obviously important to be diversified, and pick quality like Coca-Cola (KO) or Johnson & Johnson (JNJ). The reason why dividend investing shines is because dividend income is more stable than capital gains, and therefore it is easier to live off of. In addition, a regular addition to a healthy mix of dividend growth stocks every month, can turn into a substantial income stream a few yeas down the road.

- Another misconception is that the only return dividend investors receive is the dividend payment. In reality, for many investors their returns are not limited to dividend yields only. Dividend stocks are not bonds, but represent ownership interests in real businesses that earn profits. If these businesses have the characteristics that will allow them to earn more profits over time, they can afford to pay higher distributions over time. The rising dividend payments can generate significant yields on cost over time. The rising earnings can also lead to the potential for capital gains as well. For example, companies like Procter & Gamble (PG) have been paying distributions for over one century, and raising them for 57 years in a row.

- Many investors mistakenly believe that somehow dividend stocks are similar to bonds. In reality dividend stocks are proxies for stocks and they are not a separate asset class. That means that dividend paying companies are real businesses, which generate profits from selling products and services, and therefore are more likely than not to earn more over time and pay more in dividends in the process. With dividend stocks, you can get both a very good total return, and a portion of your returns will always be positive. Stability in total returns is what would provide you the positive reinforcement to stick it out through thick and thin. When your growth stock collapses in the next bear market, the chance of a silly move that involves panicked selling at depressed prices increases exponentially.

- Another misconception is that dividend stocks are only for older investors. In reality, dividend stocks are great for investors regardless of their age – although older investors usually focus on higher yielding companies. There are also different life-cycles of dividend stocks. You can get the low yielders with high dividend growth like Visa (V), which is in the initial phase of building out a dividend growth history. You also get the stocks with yields and dividend growth in the sweet spot like McDonald’s (MCD), which are maintaining their streak of consecutive raises. A company with a slow and steady approach of increasing earnings and gradually increasing dividends is ideal for building wealth. Over time, the growing amount of dividends that is reinvested at attractive valuations will mushroom into a cash machine that is able to provide for in retirement.

- Many investors still believe that it is better to focus on growth companies which reinvest everything back into the business. However, they fail to mention that such pure growth stocks are often overvalued, and your only source of return is dependent on the mercy of Mr Market. You can get quite the ride in the process. Taking risk in your younger years is fine, although gambling your money away is stupid. If you graduated college in 1994, and gambled with internet stocks in the 1990s and lost it all by 2001, you essentially lost on the first 7 years of compounding. You lost the most important period of compounding. In hindsight, you would have been better off just doing index funds because the contribution from the amount of funds in those first few years grows out to be the same as contributions for the next 30 years. Crazy, isn’t it?

There are no short-cuts to learning investments. If you take too much risk, gamble with Chinese internet stocks or the Tesla's of the world in an effort to generate very high returns, you might end up burning yourself. The reason so many investors underperform is because they are gambling, trading in and out of stocks. They pay a lot in commissions, taxes and fees. That’s not the way to build wealth for you – although it’s a great way for your broker to send their kids to private schools. Also if you pick growth stocks, you won’t be only selecting the Tesla's (TSLA) of the world.

- Many investors believe that dividends are a sign of inability of management to invest back into the business. The saying says that there will be no future growth in the company, which is why the stock should be avoided. The problem with this statement is that a company does not need to reinvest all its earnings in order to grow. A company that retains all earnings to fund internal growth might be masking the fact that it cannot earn an economic rate of return for shareholders. A technology company reinvests all profits to be number one in the field, but then it risks being the leader in buggies one day, at which point it will have to reinvest any remaining profits in other businesses to stay afloat. In addition, it could be because a company is cooking the books. Wolrdcom never paid a dividend, which made it very easy to generate great EPS gains on paper. Other stocks like Tesla (TSLA) are speculative companies, that has never turned a profit.  They cannot afford to pay a dividend, as their product is still unproven to generate earnings. The stock price depends on investor expectations – what is fashionable today might be obsolete next year.

On the other hand, companies like Wal-Mart Stores (WMT) have paid dividends since 1974, and raised them ever since. This was 4 years after going public in 1970. Somehow they managed to grow into the largest retailer in the world. An investor who put $1000 in 1974 would be sitting at a neat $ 2.44 million today. This would be generating a neat $61,600 in annual dividend income. I guess dividend investors can have their cake and eat it too.

To Summarize:

- Dividend stocks are great vehicles to build wealth and to live off your nest egg. It is best to start investing in dividend stocks as soon as you have some meaningful savings, in order to start the knowledge accumulation process early. You learn a great deal of knowledge when you are just starting out dividend investing, so as you get promotions and save more money for your dividend portfolio, you can be ready to accumulate your nest egg. Thus, dividend stocks work for all investors.

- A dividend stock portfolio can easily yield 3%-4% today, but this income stream will increase over time, thus protecting you against inflation. You will also generate capital gains in the process, as the companies earn more and become more valuable to investors. When growth stocks are down 50 - 60% from their highs during the next bear market, your dividend stocks will be down, but the level of income will likely remain the same and even increase. It is much easier to get scared and sell everything when your stocks are down 50% if all you rely on is growth and capital gains. During a recession you get none! With dividend stocks at least you get some return on investment that is positive at all times. During a bull market you get cap gains and dividends and hence you have your cake and eating it too.


Full Disclosure: Long V, MCD, WMT, JNJ, KO, PG

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