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

Tuesday, June 25, 2013

Rising interest rates affect all businesses, not just dividend paying ones

Ever since the “correction” in dividend paying stocks began five weeks ago, I keep learning that the so-called dividend craze is over. The argument goes that dividend paying stocks are less attractive for investors today, because rising interest rates will make them less appealing.

Before I address this argument on rising interest rates affecting the appeal of dividend paying stocks, I am going to quote Charlie Munger, who has been Warren Buffett’s business partner for half a century.

“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”

Unfortunately, I find that people arguing against dividend investing never get their facts straight, and usually resort to manipulating their examples in order to prove their point. Whether this is based on reality or not, is not important for them.

Over the past 3 months, the yield on the benchmark 10 year US treasuries has increased by 50%. While the term 50% seems like a lot, in reality it is used to describe the fact that yields increased from a low of 1.60% in April to a high of 2.50% in June. To put it in perspective, if you were a retiree with $1 million in cash, who purchased ten year treasuries in April 2013, you would be entitled to receive $16,000 in annual interest income for ten years. If you had waited to invest the money today, you would be entitled to receive a little over $25,000 in annual interest income for ten years. In other words, you went from a situation where your money is not earning too much, to a situation where your money is still not earning enough.

The worst part is that investors in US treasuries are still not earning enough to compensate them for inflation, taxes and to earn a decent livable return. At the end of their maturities in 2023, investors would get their $100 back, but it would likely have the purchasing power of about $74 today, assuming a 3% inflation rate per year. If our enterprising investor instead decides to purchase dividend paying stocks, they would be able to generate distributions which grow at or above the rate of inflation, can also protect principal from inflation, while enjoying a preferential tax treatment. As a result, a a portfolio of dividend growth stocks yielding 2.50% today which grows dividends at 10%/year will generate $25,000 in income today based on a $1,000,000 portfolio. In seven years however, this dividend portfolio will generate an annual dividend stream of $50,000.

As you can see, investors who argue that rising interest rates are bad for dividend growth stocks forget that they are not bonds, and therefore can increase dividend checks to compensate for holding the security. Of course, selecting a quality dividend stock does take some effort, which requires screening, analysis of underlying business prospects and purchasing the security at attractive valuations.

In reality, I think that rising interest rates are really bad for fixed income securities such as treasuries and preferred stocks. The fixed coupons provide an illusory safety that income cannot be cut or eliminated. In reality, the purchasing power of these coupons is decreasing every single year. Dividend stocks are not bonds however, as the underlying business behind the security provides a built in inflation protection in aggregate.

When I invest however, I view shares of dividend paying companies as partial ownership stakes in businesses. I try to invest in those quality companies which I would be happy to hold through several cycles of rising and falling interest rates, economic expansions and recessions and stock market volatility. My holding period is essentially forever. This could range from 20 years all the way to over 50 years ( if I am particularly lucky). As a result, any data point less than one year is viewed as noise in my book.

I have outlined below a few dividend growth stocks which are attractively valued, and have exciting prospects ahead:

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. This dividend champion has managed to boost distributions for 36 years in a row, and has a five year dividend growth rate of 13.90%/year. Currently, the stock is trading at 18 times earnings, yields 3.10% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of McDonald’s.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has managed to boost dividends for 5 years in a row, and has a five year dividend growth rate of 13.10%/year. Currently, the stock is trading at 16.80 times earnings, yields 3.90% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of PMI.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has managed to boost distribution payments for 26 years in a row, and has a ten year dividend growth rate of 9.20%/year. Currently, the stock is trading at 9 times earnings, yields 3.30% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of Chevron.

Aflac Incorporated (AFL) provides supplemental health and life insurance products in Japan and US. The company has managed to boost dividends for 30 years in a row, and has a ten year dividend growth rate of 10.90%/year. Currently, the stock is trading at 9 times earnings, yields 2.50% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of Aflac

To be perfectly clear however, rising yields on treasuries do signal that cost of capital will be higher over time. This does affect corporate profits, as many companies borrow extensively to finance their daily operating needs. The sad part that many anti-dividend arguments miss is that rising interest rates are not good for businesses in general, not just dividend paying ones. However, because the economy is doing better, companies will be able to sell more goods and services, which would offset rising interest rates. However, companies with strong competitive advantages will be able to generate rising profits over time. They can deal with the cost of higher interest rates by passing higher costs to customers who want the products, making operations more efficient by reducing duplicate functions, or working ways to reduce the need for borrowing to finance short-term operations.

Full Disclosure: Long MCD, PM, CVX,  AFL

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Monday, June 24, 2013

Your Retirement Income is on Sale!

Everyone loves a good sale! When you purchase quality merchandise at 50% off, or at everyday low prices, it is considered a bargain and a smart move. When stock prices decline however, investors all of a sudden lose their common sense to become fearful. Lower prices on quality stocks causes investors to shun buying stocks. Higher prices on the other hand, excite everyone.

Stocks have finally began sliding down, and I am starting to get excited. I would love for stocks to get down even further from here. As someone in the accumulation stage of the dividend machine building process, I welcome any price weaknesses with open arms, as it translates into higher entry yields.

The amateurs are starting to get nervous however. They need positive reassurance through rising prices. If they don’t get rising prices, they get scared, and start selling everything. These investors view stocks like lottery ticket substitutes. Many dividend investors, myself included, started their investing journey treating stocks like lottery tickets in their early days. After a while however, it all starts to sync in that stocks are ownership pieces of real businesses, and not just some paper certificates or kilobytes on a computer screen. Success if determined based upon the growth in the underlying business, not because of meaningless short-term stock price fluctuations.

At the end of the day, smart dividend investors view stocks as partial ownership shares of real businesses. They do their research in uncovering those businesses, and then try to buy existing owners out at bargain prices. They can then sit back, monitor their business interests, and collect dividends one check at a time. After all, if you owned an apartment building next to a college that is always occupied, you won’t give a damn if its quoted valued fell by 5% - 10%- 20% in one single day. As long as you can rent your building out, you should do just fine by ignoring “quoted values”.

And what a great time it is to be a collector of business profits, through generous dividend distributions. Corporate balance sheets are flush with cash, more people are going back to work, and that housing market is coming back up. It is even better, when the price of your dividend stream is getting cheaper by the dozen. Just a month ago, everyone was complaining that stocks are overextended, and quality REITs such as Realty Income (O) yielded only 4%. This caused me to ask myself, whether we were in a REIT bubble. Since then, the stock has gone down over 26%, and is yielding a cool 5.30%.

The chicken littles however are scared that the Federal Reserve will stop pumping $85 billion into the economy every single month. However, they seem to be forgetting that the economy seems to be recovering. Most importantly, they seem to be forgetting that most profits in investing are made by the long-term buying and holding, not flipping stocks.

I keep hearing from amateur investors of the world, that the improving economy and the ending of Qualitative Easing by the FED will lead to higher interest rates. Those rising interest rates will be bad for dividend stocks. I usually ignore such talk, not because I am smug, but because I try to look 20 -30 years down the road. I cannot imagine a scenario, where US businesses will not be better off in 20 – 30 years. Businesses will have better productivity, access to more markets, and would have made more in profits. Chances are that we would have new products that few are probably even dreaming of right now. I assume that these products would likely improve lives significantly. I wake up every day, trying to achieve something for myself and my family – I imagine that millions of other people in the US and the Globe are trying hard to achieve just that. Some of these people would be the ones to invent the products mentioned above, that will improve our lives.

In addition, rising interest rates are bad for all stocks, not just dividend stocks. If I had to choose between owning some highly speculative Chinese internet stocks or some blue chip dividend paying stocks that pay me rising dividends every year, I would always go with the dividend stocks. Chances are that the mature dividend stocks will have access to credit at much better terms when things get tough, while the hot growth Chinese internet stocks will get clobbered and many might have to resort to cooking the books to get credit. Again, the goal is to try to select the companies that have what it takes to be here in 20 -30 years, and then try to buy their stock at attractive valuations. You can also call these qualities competitive advantages, wide moats or strong brands. Trying to outguess the economic cycle is a fools game. Even people whose primary job is forecasting macroeconomic trends have trouble getting it right. Your job is again to invest for the next 20 – 30 years, which would cover several economic cycles, and several periods of interest rate fluctuations. In those 20 -30 years, stocks would likely drop by half at least once.

One of the smartest people in the world, who became a billionaire because of his intelligence, once said:

"If you are not willing to hold stocks though 50% loss, you should not be in stocks."

Let that sink in. This person is Charlie Munger, the long-standing business partner of Warren Buffett. If Buffett had chickened out in 1974, when the price of Berkshire Hathaway (BRK.B) had fallen down by 50%, and put everything in Treasuries, he would have never become a billionaire.

When shares of Aflac (AFL) dropped from $25 to $10/share in 2008 - 2009, it was a pretty scary experience. I held on, bought some more, and have been adding to the position and collecting dividends ever since. I am welcoming drops in prices, especially if it would bring companies such as Coca-Cola (KO) to trade at 15 - 16 times earnings. Given forward earnings of $2.14/share for 2013, this would translate into $32.10 to $34.34/share.

Some quality companies like Phillip Morris International (PM) are trading at 16.80 times earnings, yield 3.90%, while having a sustainable distribution. The company is expecting to grow earnings by 9 - 12%/year for the foreseeable future, fueled by its expanding growing operations. Check my analysis of PMI.

Other companies such as Wal-Mart Stores (WMT) are trading at 14.50 times earnings and yield over 2.50%. Wal-Mart Stores has been able to increase dividends for 39 years in a row.Over the past decade, the worlds largest retailer has managed to boost distributions by 18.10%/year. Check my analysis of Wal-Mart.

So back to our Realty Income story mentioned above. If you had $500,000 in May 2013, and you invested the whole stash in realty Income (O), you would have only been able to generate $20.000 in annual dividend income. If you bought Realty Income today, you would be able to make over $26.000. I don’t know about you, but the drop in stock prices is making me feel richer. If I were a rational dividend investor, I would actually hope for lower prices from here. If you get a cash machine that spits out an ever rising stream of dividend income, then wouldn't you want to buy a piece of it at the lowest prices possible?

After all, it would make the cost of your retirement much lower.

Full Disclosure: Long O, KO, AFL, PM, KO

Relevant Articles:

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Wednesday, June 19, 2013

How to crush the market with dividend growth investing

Dividend growth investing is the true underdog of investment strategies. It is not because the strategy fails to generate consistent returns to investors, but because it is not lucrative for the financial industry. It is also misunderstood because it focuses on dividends that grow, not simply yield. Dividend growth investing is a simple investing strategy that focuses on buying and holding quality companies at attractive valuations, which have the potential to increase earnings and dividends along the way. This is do-it-yourself type investing that relies on long-term holding and involves minimal transaction or advisory fees.

What could be simpler that selecting companies with a proven track record of increasing dividends, trading at attractive valuations, that also exhibit the potential for future earnings growth? As long as you monitor your positions, you can essentially set it and forget it and ignore the day to day noise of Wall Street. What critics of dividend growth investing fail to see is that a growing enterprise that consistently earns more, and pays more in dividends is more valuable over time. Thus, dividend growth investors can have their cake ( the dividend stock) while eating it too (receiving growing streams of dividend income).

I have several exhibits, which discuss performance of dividend growth investing over different time frames. The first exhibit below is from an independent study of returns of S&P 500 Index stocks by dividend policy, prepared by Ned Davis Research. The study shows that a $100 investment in dividend growers and initiators in 1972 turned into a cool $4,168 by the end of 2012, compared to $1,622 for an investment in S&P 500. However, the investors that put $100 in 1972 in non-dividend payers and dividend cutters & eliminators ended up with only $193 and $88 after 41 years! This chart shows you that dividend investing provides you with an edge.

The second chart shows the performance of Dividend Champions between 2007 and 2012:

This is my performance since 2007: I achieved this not because I have a magic ball, but because I have a strategy that provides me with an edge against everyone else. As a dividend growth investor, I could care less how I do relative to the market however. Performance relative to a benchmark is not an actionable item, but something that could provide confusion and make otherwise smart investors question their strategy at the worst time possible. Switching strategies at the wrong times because you lack confidence is a sure way to never amass any wealth in the stock market.

Two other investors performance that I am attaching is the one from fellow blogger Dividends4Life through March 31, 2013:

In my investing, all I care about is selecting great companies at attractive valuations, strong competitive advantages, a track record of raising dividends and the potential for earnings increases. The market can fluctuate all it wants, but by ignoring it and focusing on what matters I have been able to crush it since 2008. After all, companies like Coca-Cola (KO) and Chevron (CVX) will satisfy consumer demands for several decades to come. These companies with enduring competitive advantages are much more likely to pump out billions more in profits and afford to pay higher distributions.

Dividend growth investing is not going to outperform the market every single year, but over time it should deliver a performance that should at the very least slightly exceed S&P 500 results. No investment strategy in the world will generate consistent profits all the time, and outperform its benchmark all the time. Investors should have confidence in their approach, and not let temporary underperformance make them switch strategies. The only sure way to lose money in the stock market is to search for a strategy that makes profits all the time, and thus switching strategies often.

By focusing on quality, dividend growth investors uncover value and outperform indices over time, despite not caring about general stock market fluctuations. This is a winning strategy that can not only deliver a growing stream of dividends to live off, but also grow investors income over time.

Another reason why dividend growth investing is perfect for retired investors is because it protects from the variability of year to year returns. The problem with living off of index funds is that you risk having to sell a chunk of your portfolio when stock prices are unreasonably depressed. An index could go up by 10%/year every year on average, but this could mean going down by 50% in year one and being flat in year two. This could cause you to sell at the bottom in order to fund your living expenses, which could leave fewer dollars left to capture any upside in stock prices. It could also leave less dollars to fund your retirement. The growing dividend yield on the other hand provides a baseline that supports the living expenses of the retiree. When everyone else realizes falling stock prices could cause them to go back to work, the dividend growth retiree would care less as they will be drowning in cash from their portfolios. Not surprisingly, the rising dividends  would also provide an income stream that maintains purchasing power against inflation.

Full Disclosure: Long KO and CVX

Relevant Articles:

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Monday, June 17, 2013

Lower Entry Prices Mean Locking Higher Yields Today

The beauty of dividend investing is that once an investor purchases a quality income stock, they can hold on to it for many decades, while patiently collecting cash dividends. The success of a dividend growth investor depends not only on picking the best companies in the world, but also purchasing them at the right price and holding on to them for as long as possible. With the market close to all-time highs, many dividend investors are complaining that it is difficult to find attractively valued stocks to purchase.

I have found that entry price matters when selecting companies. If you pay a cheap price for stocks, you essentially lock in a higher current yield.  In this situation, your margin of safety is higher as well. The advice is usually to buy stocks when there is blood on the streets. In recent memory, the best times to acquire quality stocks on sale was during market crashes such as the ones witnessed in 2001-2002 as well as the most recent one from 2007- 2009. The truth however is that few people have large hoards of cash sitting on the sidelines, patiently waiting to be deployed only at fire-sale prices.

In reality, as an investor in the accumulation phase I have a few obstacles that a retired investor does not have too much of. I get fresh cash contributions every month that needs to be invested. If I chose to wait for perfect opportunities, the risk I am facing is that I might miss out if stocks get even more expensive afterwards. Nobody can say if dividend stocks will rise by 50% or fall by 50% over the next year. No one can even forecast within a reasonable amount of certainty if they are even going up or down. If the market goes up from here, the money in cash represents a lost opportunity.

If stock prices go down, I would buy at lower prices and earn more dividend income. However, I have found that market timing is something that cannot be consistently done by ordinary investors. If I buy now and stock prices tank, I will have more opportunities to buy at attractive prices later on. Even if the stocks I own go down in value, as long as fundamentals are sound and earnings and dividends keep growing, I should be fine eventually. During the financial crisis, shares of Johnson & Johnson (JNJ) fell from a high of $72.76 in September 2008 to a low of $46.25 by March 2009. At the quarterly dividend of 46 cents/share, the differences in dividend yield were between 3.98% in March 2009 and 2.53% in September 2008. I kept holding on to my position, and adding to it as fundamentals were sound, and the dividend was about to be increased in April 2009.

In a study on dollar cost averaging, I found it pays to invest as soon as possible. Over time, companies get more valuable as they service more customers, make more profits and sell new products and expand in new markets. It is great to avoid stocks that are very overvalued, but truth is, there are attractive opportunities even in today’s market. If you invest funds in attractive companies with bright prospects and strong competitive advantages, you are improving your odds of success.

While entry price is important, it is not the only determinant of investment success. A consistently growing company can eventually “bail out” its patient investors, even if they overpaid for it. As earnings and dividends increase, the P/E compression would render the shares more valuable. This, coupled with a higher yield and the prospects for higher dividends down the road, would increase the value of these shares. Maintaining a diversified portfolio that does not use leverage is another important factor to consider. If you are overleveraged, you can still lose your income stream as well as your nest egg during a market meltdown.
As a result, it pays to invest in recession proof stocks, which offer a product or service that customers need no matter what cycle the economy is in. A few such companies, trading at reasonable valuations today

Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus, provides supplemental health and life insurance products. This dividend champion has managed to boost dividends for 30 years in a row, and over the past decade has managed to boost them by 19.30%/year. Currently, the stock is trading at 9.10 times earnings and yields 2.50%. Check my analysis of Aflac.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide.This dividend champion has managed to boost dividends for 26 years in a row, and over the past decade has managed to boost them by 9.60%/year. Currently, the stock is trading at 9.10 times earnings and yields 3.30%. Check my analysis of Chevron.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products.The company has managed to boost dividends every year since becoming independent from parent Altria (MO) in 2008. The five year dividend growth rate is 13.10%/annum. Currently, the stock is trading at 17.70 times earnings and yields 3.70%. Check my analysis of Philip Morris International.

Air Products and Chemicals, Inc. (APD) provides atmospheric gases, process and specialty gases, performance materials, equipment, and services worldwide.This dividend champion has managed to boost dividends for 31 years in a row, and over the past decade has managed to boost them by 11.80%/year. Currently, the stock is trading at 17.30 times earnings and yields 3%. Check my analysis of Air Products and Chemicals.

Full Disclosure: Lon AFL, CVX, PM, MO, APD

Relevant Articles:

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Wednesday, June 12, 2013

How to Generate Energy Dividends Despite the Peak Oil Non-Sense

Peak oil is the idea that the world has reached or is about to reach maximum production of oil either a few years ago or a few years from now. From there on we are supposedly going to experience significant declines in oil production, which would have devastating impacts on the world economy, which would need more and more oil in the future. This would be driven by the emerging economies of China and India, where hundreds of million of consumers will enter the middle class, and demand the lifestyle of your typical American Consumer. This will be bullish for companies like Coca-Cola (KO) as well as energy companies like Chevron (CVX).

I find some of the cheapest stocks in the market today to be oil companies. I own stock in the following three oil companies:

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company trades at 9.20 times earnings and yields 3.30%. This dividend champion has increased distributions for 26 years in a row and has achieved a ten year average annual dividend growth of 9.60%. Check my analysis of Chevron Corporation.

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 trades at 10.10 times earnings and yields 4.20%. This dividend achiever has increased distributions for 12 years in a row and has achieved a ten year average annual dividend growth of 15.10%.Check my analysis of ConocoPhillips.

Royal Dutch Shell plc (RDS.B) operates as an independent oil and gas company worldwide. The company trades at 8.20 times earnings and yields 5.30%. The company ended a 16 year streak of consecutive dividend increases in 2010 by keeping distributions flat, only to start increasing them again in 2012. Check my analysis of Royal Dutch Shell.

I also used to own Exxon Mobil (XOM), but I replaced it with ConocoPhillips. Exxon is the largest oil company in the world. It engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products. The company trades at 9.30 times earnings and yields 2.80%. Check my analysis of Exxon Mobil.

The thing to look for when evaluating energy companies is the reserve replenishment. Oil companies operate wells that will eventually run out of carbons, even if technologies are improved to a point where ALL the oil and gas in a well is pumped out. At some point, this well will stop producing income, and the company needs to move on. The reason why oil companies typically have low payout ratios is because they need to reinvest a portion of profits back into the business in order to find oil or buy assets they can develop.

I have looked at the data, and find that the idea behind peak oil is non-sense. The world is never going to run out of oil. That is, the world is never going to run out of oil during the lifetimes of anyone you meet today. The reason is that consumers will become more energy efficient, and companies will have an enormous incentive to explore and develop oil and gas fields in areas that are very difficult to drill in. The basic economic theory states that companies which see high energy prices will allocate funds at areas that are tough to explore and that make sense if oil stays at high levels for extended periods of time.

Over the past 30 years, the reserve to production ratio has remained above 40 - 50 years. This ratio shows the total amount of estimated oil reserves dividend by the total amount of annual production. If no new oil reserves were discovered ever again, and the world continues to consume oil at the same rate as today, the world would run out of oil in 50 years. It looks like oil reserves have been increasing enough to satisfy future oil demand. Therefore, it looks that for the past 30 years, the world has had anywhere between 50 -54 years’ worth of oil on its disposal. Right now, we have enough oil for the next 50+ years. I am betting ( see below how) that the world would have sufficient oil reserves for next 40 - 50 years in 2020, 2030 and 2040.

The same ratio for Natural Gas is over 60 years. The US is currently experiencing an energy renaissance particularly in such areas like Bakken Shale.

Companies are getting much better at forecasting where to drill for oil, and maximizing their chances of striking energy significantly. By using sophisticated seismic data, energy companies can obtain general reserve estimates for oil and gas wells. In addition, with improvements in technology, companies can now recover much more oil and gas out of the ground, compared to before. When the US experienced its first oil boom in the early 1900s, the primitive technology made it possible to only skim a portion of the oil in oil wells. As pressure in the oil and gas wells decreased, production fell in those wells, and they were then closed out. With improvements in technology however, it is now possible to increase the life of wells significantly, as it is much easier to get more out of each well.

One thing I do avoid is purchasing US oil and gas trusts. While they offer mouthwatering yields today, they are all destined to go to zero. This is because when these trusts were setup, their revenues are set to be generated from a fixed portfolio of assets. They cannot purchase new wells to earn revenue off of, and cannot drill for oil or gas. Even with improvements in technology, chances are that the wells you own will eventually dry up. As a result, the reason why these trusts offer such high yields is because they are essentially returning a huge portion of investor’s capital back. If investors reinvest a portion of these distributions in other oil and gas producing wells, they can extend their income stream. If investors instead spent all of their distributions, then they will not do well in a typical 30 year retirement scenario. BP Prudhoe Bay (BPT) is an example of an oil trust that will go to zero by 2025- 2030. This is the time when the oil royalties will no longer result in distributions, due to costs, declines in production, even if oil went to $200/barrel.

So what is the risk to my theory? If prices rise above a certain threshold, it might be economical for alternative energy sources such as solar and wind to be priced at par with oil and gas. However, oil would still be relevant 100 years from now even if  it no longer were used for energy, because it is used in so many other aspects in everyday life such as chemicals, plastics etc.

Another risk is if the data I am using to base my assumptions is incorrect. The amount in proved reserves is simply an estimate. Actuals could turn out to be much different than estimates. In addition, just because there are proven oil reserves to last for 50 years however, there is no guarantee that all the oil will be available to be pumped out within 50 years, even if estimates were correct. On the positive side however, the reserves to production ratio does not account for undeveloped reserves. With the majority of the world's surface being under water, chances are that high enough oil and gas prices will one day incentivize exploration in the deep sea areas of the globe.Those areas could potentially provide for an almost unlimited amount of energy.

Full Disclosure: Long CVX, COP, RDS/B, KO

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Tuesday, June 11, 2013

Are performance comparisons to S&P 500 necessary for dividend growth investors?

One of the questions I received recently from several readers of my site across platforms concerned my total returns performance and my benchmarks. As a long-term dividend investor, I doubt that sharing performance adds much in value.

My benchmark is S&P 500. I benchmark both my total returns and dividend income relative to this index. However, benchmarking my dividend income is more important to me than looking at my total returns relative to the market. I look at this information probably once an year, if not less often. I believe that focusing too much on comparative total return performance does not add much value to long-term dividend investors.

The stock market can value shares as it pleases, but I cannot control the price it would place on a stock or relative performance versus a basket of other stocks. I try to do the best using factors that are within my control. This includes identifying companies with strong competitive advantages and pricing power, which are able to grow earnings and pay higher dividends over time. I would then try to purchase shares in those companies at what I believe to be attractive valuations. Because my investment thesis relies on long-term momentum in earnings and dividends, I simply hold on to that security for as long as possible. One of the few factors that would make me sell include dividend cuts or an situation of extreme overvaluation relative to the underlying security’s growth prospects.

While I do not care about performance versus S&P 500, I have found that my methods for stock selections have delivered decent results since I started investing in 2008:

As a result, you can see that focusing on items such as benchmarking against S&P 500 for example, are simply items you can put on a checklist, but nothing that is purely actionable. Overall, I expect my portfolios to at least match the total returns of indices such as S&P 500. However, that would mean that I would underperform some portion of the time, and then outperform another portion of the time. I usually outperform during flat or declining markets, as well as situation where stocks as a group are up slightly. During strong up moves when growth stocks are bid up in a frenzy, dividend stocks would likely underperform.

Because I am investing for the long-term, I focus on items that could translate into more profits in one or two decades down the road. Thus, the data points I look at are usually annual fundamental results such as earnings per share, revenues, dividends, returns on equity etc. While the stock price of a company changes every nano-second, the underlying fundamentals are not materially affected that often. As a result, I only look at annual data points, although in rare situations I could look into quarterly sets of fundamental performance. This is why I refer to a period of about one or two years as simply noise. Nothing intelligent could ever come from noise, and most income investors who buy a stock today with the intention of flipping it in five months to an year are mostly kidding themselves.

One thing that intelligent investors should consider is that investment gains come unexpectedly. While it is commonly accepted that stocks have delivered a 10% annual return over the past 80 years or so, it is not commonly known that these returns are not straightforward. You don’t get 10% every year but are signing up for volatility in annual returns. You can as easily lose 50% in one year, and then recover and make 50% more. As a n investor, you need patience and if you do not have it, this could indicate that you didn't do enough due diligence or blindly followed stock tips. Of course, if there was a material change like a dividend cut, or major headwinds that’s ok. For example, neither Procter & Gamble (PG) nor Johnson & Johnson (JNJ) stock moved much between 2010 and 2012. Investors who simply held on to the stock didn’t see much in capital gains during this period. Over the past year and a half however, these companies have delivered very strong total returns. Investors who lost patience in the stock missed out on very good gains and the rising stream of dividend payments.

The other reason why I do not see much value in comparing my total returns relative to S&P 500 is because I find the index to be flawed. First of all, the components of S&P 500 index are subjectively selected by a committee, which considers certain factors such as liquidity, float and market capitalization in their inclusion decisions. If I had the requirements to only include stocks that trade at least 500,000 shares a day and have a market capitalization of $5 billion, I would have missed out on purchasing Hingham Insitutions for Savings (HIFS) at $34.90 in 2010. However, besides these factors, I do not know why they include certain companies, and exclude others. The flaws are evident if you study the history of some components in the index. For example, S&P 500 included a lot of technology companies in the late 1990s, just when they were selling at stratospheric valuations. Herd behavior such as this is destructive to long-term shareholder returns.

Another example as to why S&P 500 might not be the perfect black box to compare your results to is the fact that they didn’t include Berkshire Hathaway (BRK.B) until 2010. Berkshire had been one of the largest US companies for at least 20 years prior to that, which shows you the futility of this index. In addition, did you know that the original members of S&P 500 and their descendant companies selected in 1957 have actually outperformed the “actively managed” S&P 500 over the past 56 years? This means that truly passive buy and hold investing of the major companies without any rebalancing works better than S&P 500 itself.

If I consistently underperform over a period of 4 - 5 years, I would not worry too much, as long as I followed my common sense guidelines to constructing my portfolios. Focusing too much on comparative performance versus the S&P 500 could lead to chasing performance, which is not very smart. After all, a group of sound enterprises that are humming along will likely get ignored by the market at least several times over the next 30 – 40 years in favor of hot growth stocks. This has happened in the late 1960s with the go-go tronics boom, early 1970s with the Nifty-Fifty, early 1980s with technology stocks and the late 1990s with tech media and telecom stocks. An investor who underperformed a benchmark that included hot new issues, would face the psychological pressure that they are missing out. If they sell their portfolio to buy that index, they are essentially shooting themselves in the foot because none of the booms described above turned out well for the frenzied investors. They would have been better off sticking to tried and true dividend growth stocks like Procter & Gamble (PG) for example.

After a hot growth stock frenzy, sooner or later there will be reversion to the mean, which would translate into losses. In other words, one should stick to their strategy, know why they are following that strategy and ignore chasing performance. Chasing performance is counterproductive to your wealth. While you will underperform over short periods of time, over the long term, your dividend investment strategy would pay dividends.

One reason why mutual fund managers underperform is because they have the constant pressure to show results all the time. As a dividend investor, I do not have that pressure and I can afford to sit out periods where dividend stocks are out of style. I actually feel much more comfortable buying quality dividend stocks when no one believes in them than when everyone starts bidding up these fine companies. For example, back in November 2012 I was able to pick up some shares in McDonald’s (MCD) at $85 when there was short-term weakness in the stock.

The main reason why I purchase dividend stocks is to generate a rising stream of distributions that grows above the level of inflation and pays for my expenses. I do quite a lot of work in terms of stock selection, valuation at purchase price, portfolio monitoring in order to ensure that I can achieve this goal. This is why underperforming the S&P 500 over a short period of time does not bother me. This is because there will be fluctuations in performance depending on which sector is hot in the markets. However, the appeal of dividend investing is that your dividend return is always positive and it is more stable, which makes it ideal for someone who wants to live off their nest egg.

Relevant Articles:

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Wednesday, June 5, 2013

Is the Dividend Craze Over?

I read an article from CNN, which discussed how the dividend craze was likely over. In general, I find articles that describe short-term movements of stock prices, and then adding terms like “dividend craze” to be extremely non-productive for dividend investors. The premise of the article was that some dividend stocks like utilities and consumer staples will have poor reception by investors going forward. Others such as banks and cyclical stocks, could do better as the economy improves. As an investor in the accumulation phase, I put money to work every month, but plan to hold for a few decades. This timeframe would encompass several economic cycles. This is why I have found that the best analysis I could do, is to research quality companies that could generate shareholder wealth for several decades to come, and avoid looking for stocks that can do well only in the current cycle.

I buy the stock in companies, which I believe will manage to increase earnings over time, and as a result they will be able to pay me a consistently higher dividend payment. The stock prices could fluctuate, but unless we get to see crazy valuations like the ones we saw in the early 2000s it makes little sense to sell them. At some point on the valuation scale, it does not make sense to overpay even for the best dividend stocks in the world. The near term drop in prices was probably caused by the fact that many stocks reached the high points of their reasonable valuations. To a long-term investor, entry price does matter, but holding on to a company with improving fundamentals is just as important.

Right now, companies such as Kimberly-Clark (KMB) and Coca-Cola (KO) are slightly overvalued trading above 20 times earnings. These are great companies however, which have sticky products that consumers buy repeatedly. I expect that these companies will keep growing over the next 20 -30 years, and expand their brands globally. At the end of the day, this growth will pay higher dividends for me to live off. This is why I plan on holding on to these stocks, even if they trade slightly above fair value right now.

Of course, if they fail to deliver results and are unable to maintain dividend payments at some point over the next 20 -30 years, I would likely part ways with them. In addition, if I get to situations where companies with high yields and low growth get bid up by the market to very low current yields, it might also be a time to part ways. For example, in March 2013 I sold all of my shares of Universal Health Realty Income Trusts (UHT), because the stock yielded 4%, but was growing distributions at a paltry 1%/year.

As an investor in the accumulation phase, who has to put money to work every month, I would be more than happy to buy quality merchandise at depressed prices. Unfortunately, I doubt that things would get so dire for quality dividend paying stocks. I do agree however, that in order to be successful, one does have to focus on buying the dividend growth stocks that are attractively valued. If I had to choose between Coca-Cola (KO) at 21 times earnings and Chevron (CVX) and 10 times earnings, I would always choose Chevron. This is where I agreed with the CNN article.

The article did mention that one of the likely selling triggers behind dividend stocks over the past two weeks might have been the increase in bond yields, and the expectations of further increases in treasury yields. The article didn't discuss this but at this stage, it still doesn't make much sense to buy bonds, despite the increase in 10 years Treasury yields from 1.50% to 2.20%. This is because long-term investors today who sell dividend stocks and buy bonds yielding 2.20% will likely be sorry in one decade. I could argue that we have a Fixed Income Craze, rather than a dividend craze.

Interest rates could and probably will increase over the next decade, as they are artificially kept low by the FED. However, the increase will likely be gradual over time as it would take a few years before we see the 4%- 5% in ten year treasuries. That means that investors buying Treasuries today are essentially locking themselves up to earn only 2.20% till maturity. If inflation and interest rates increase during that time, they will be worse off in 2023 than today. On the other hand, even if you purchase Coca-Cola (KO) today, chances are that ten years from now you will earn more in dividends, as the company would have higher earnings per share. This will protect the purchasing power of your dividend dollars.

Investors should have some fixed income allocation as part of prudent portfolio management. Right now, it doesn't make sense to add to bonds, but if you purchased them anywhere prior to 2010 for example you should be doing just fine by holding on to your bonds. For your stock allocation, you should be doing just fine holding on to your equities as well, assuming you know what you bought and why you bought it in the first place.

What stocks provide investors with is the potential for rising dividend income over time, which maintains the purchasing power of dividends. Before Wall Street became the casino that it is, where hedge funds and investment banks try to outmaneuver each other in the effort to earn a fraction of a cent per transaction, investors bought stocks for the dividend income.  I know that looking for perfection in investing will usually cost a lot in the long-term, which is why I would not sell Coca-Cola (KO) at 21 times earnings, and buy Wells-Fargo (WFC) instead. As a result, I plan on ignoring any mentions of dividend crazes, and hold on to my quality income stocks.

Full Disclosure: Long KMB, KO, CVX, Short WFC Puts

Relevant Articles:

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Monday, June 3, 2013

My Dividend Portfolio Looks Much Better than I Expected

Many of my stocks reached all-time-highs over the past few months. When I purchase my stocks, I usually expect a decent current yield in the 2% – 4%, followed by a P/E of 15 – 20, and a growth in earnings and dividends that averages at least 6%/annually. So far, it has averaged 7% - 10%. As a result, short-term fluctuations in the price of a company which I purchase for say $100/share today which yields 3% and trades at a P/E of 16 would not bother me too much. I would expect such company to realistically trade at about $200/share in a decade or so, still yield approximately 3% and trade at a P/E of about 16. Over that decade, it could trade as high as 25 times earnings and as low as 10 times earnings. The only difference is that its earnings and dividends have doubled over the period. My whole premise of the idea that I won’t sell even at a 1,000% gain is based on this mental model.

Of course, in real life, things never progress in a linear fashion. If you looked at P/E ratios of companies like Wal-Mart (WMT) or Coca-Cola (KO) over the past 10 - 15 years, you would not be surprised to see them over 30 in not one, but at least several occasions. Over the past four years, most of the companies I have usually added to were the likes of Colgate-Palmolive (CL), Johnson & Johnson (JNJ) & Kimberly-Clark (KMB). Right now many of these companies look very overvalued, which is pretty scary. I actually isolated the following companies, whose P/E ratios per Yahoo! Finance exceeded 20. I then excluded MLPs, REITs for whom earnings per share and P/E ratios do not provide comparable results.

Being the lover of annual reports, and digging around data, I went through this list searching for the answer of an obvious question. The question running through my mind was whether it still made sense for me to hold on to these companies. Now, I am not a die-hard buy and hold despite everything type of investor, and a crazy valuation could lead me to sell an otherwise fantastic company. This of course depends on each particular situation. However, I do believe that taking small profits on the few amazing ideas I might be lucky enough to stumble upon in my lifetime would probably be very detrimental to my finances. I could sit-out temporary overvaluations in securities, for which future growth could compensate me well for holding on during a moderate level of craziness. Craziness for a company like Brown-Forman (BF-B) could be a P/E above 30, whereas for a company like Con Edison (ED), craziness could be anything above 18 – 20 times earnings.

However, in my studies of investing, I have learned to dig for information. Most of the information on earnings per share from sources like Yahoo! Finance might be abnormally low, because certain one-time adjustments have reduced it. My next step would be to look at analyst estimates for the current year and the next one, coupled with digging around press releases from the company, in order to evaluate whether those estimates have any merit.

Just by looking at P/E ratios, the stocks in the table look very overvalued. However, if you look at forward earnings, only a couple of those look somewhat overvalued.

For example, looking at Johnson & Johnson (JNJ), it looks terribly overvalued at 23 times earnings. However, by applying forward EPS of $5.41/share, the stock looks much more reasonably priced. While not included on this table, Kimberly-Clark (KMB) looks expensive at 21.06 times earnings and EPS of $4.60. But based on 2013 forward earnings of $5.73/share, it looks cheap at 16.90 times forward earnings. Of course, if analysts are overly optimistic on this company and actual earnings are significantly less, then Johnson & Johnson would be overpriced today.

For those companies that still look overvalued, I am going another step. I estimate what the company is going to earn in a decade, then estimate the total in dividends I will receive over the next decade and then slap a P/E multiple for this time in 2023. My estimates are conservative in regards to growth, although not as conservative in regards to multiples.

For example, Brown-Forman (BF-B) is expected to earn $2.70 in 2013. I believe that by 2023, it could easily earn $6/share and trade at a P/E of 20. In addition, I would expect that Brown-Forman would pay its shareholders approximately $20 -$25/share over the next decade. This means that investors paying $70/share today, might end up doubling their money in a decade. This translates into a return of approximately 7%/year. Those of you reading this article in 2023 would likely use this article as an example of why people should never make predictions. Either way, it is my best case based upon widely available information on consumption on liquor worldwide, historical growth rates, and assumptions for the future revenues, earnings and dividends.

For Automated Data Processing (ADP), I like the fact that it offers business services such as payroll processing to small and medium sized businesses. These businesses outsource certain functions like payroll to ADP, which benefits from scale of transactions processing, constant improvement in technology and depreciation in technology equipment prices. But most importantly, ADP benefits from building and maintain relationships with businesses, which would be less likely to switch processors just to save a few bucks. Over the past decade, EPS grew by 5%/year. If we project this growth forward, this means ADP would likely earn $4.82/share in 2023, which at a P/E of 20 translates into $96.40/share. If dividends also grow at 5%/year, this means that an investor can expect to receive $23 in dividends over the next decade. This translates into a total return of about 6%/year. Check my analysis of ADP.

I purchased Visa (V) in 2011, because I liked the story about credit card processing business, the fact that there are only two major companies in the game, and the opportunity behind growth of cashless transactions worldwide. These were the reasons why I initiated a position in the stock despite the fact that the company has only been publicly traded since 2008. I expect Visa to either double or triple earnings per share over the next decade. This could translate in EPS ranging from $15 to $20 by 2023. At a P/E of 20, this translates into $300 - $400/share. I expect dividends to increase at the high end of these projections, and triple by 2023. Thus, I wouldn’t be surprised if Visa shareholders receive about $25 in dividends over the next decade, with annual dividends reaching $4/share that year.

The return assumptions for the three stocks above, ignore dividend reinvestment, which would likely increase the annual returns slightly.

Nucor (NUE) is the odd one out, as it is a cyclical stock. The demand for steel fluctuates with the cycles in the economy, meaning that profits and revenues are highest at the peak of the cycle, and very depressed at the trough. This is why cyclical companies usually appear overvalued when their stock prices are low, and cheap when their prices are high. During the last boom, Nucor earned $5.98/share in 2008. In addition, the company kept raising its regular dividend even during the lean years after that. The thing that appeals to me is the fact that during the boom years through 2007 – 2008, Nucor paid special dividends every quarter to shareholders. Management was smart enough to realize that this boom in profits would likely be a short term event, yet they still wanted to keep the streak of dividend increases going, and reward long-term shareholders as well. This is why if you simply look at trends in dividends per share, you might see a decrease in 2008. However, the regular dividend amount was never cut, but actually increased. If the US economy keeps expanding, we might see growth in earnings per share, and a lot of special dividends from Nucor. This is the one stock where I cannot provide a ten year guidance of earnings and dividends, but would likely hold on to either way. You get a stable and slowly rising dividend payment, plus a “lottery type” opportunity for special dividends when times are really good. Check my analysis of Nucor.

As a long-term investor, my holding period is in years for some stocks that don’t work out as well, to decades for the ones that keep delivering results over and over again. As such, it was helpful for me to go over my positions above. Overall, when I looked at what seemed to be the most overvalued stocks in my portfolios, I found out that there is nothing to be scared about. Some of the valuations were high either because of one-time events depressing earnings per share, and in those situations forward earnings per share showed a more reasonable valuation. In other scenarios, I reassessed the reason as to why I held on to certain stocks, and whether it still made sense to hold on to them.

Full Disclosure: Long D,V, NUE,TFX, BF-B,K,LOW,CL, EV, ADP, JNJ, YUM, ED, KMB,

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Tuesday, May 28, 2013

Are dividend investors concentrating too much on consumer staples?

In my dividend investing I focus a lot on diversification. Proper diversification means that an investor owns at least 30 individual stocks, representative of as many of the ten Standard and Poors sectors as possible. Proper diversification also means that investors do not simply purchase stocks in order to diversify their risk however. It means to invest in a diverse number of businesses with favorable economics, which are attractively priced and which also have bright long term prospects. Proper diversification will add an extra layer of protection for an investor’s portfolio when unforeseen events such as financial crises, oil spills and lawsuits affect otherwise stable and profitable dividend paying stocks.

In the world of dividend investing, many claim to be excellent stock pickers, trying to maximize returns by betting on a concentrated portfolio of 10 – 15 stocks. After all, it is easier to find 10 great dividend stocks, than finding 30 or more of them. This sounds like a decent plan if you are already collecting a generous pension and have a decent amount of social security kicking in. Such investors could likely afford to build a concentrated dividend portfolio, and take huge risks in the process. Even if you do a fantastic research, and know the company and industry inside out, you can still lose money on a stock. In general, all the information you have about a stock is based on past data and assumptions based on it. While companies like Coca-Cola (KO) and McDonald’s (MCD) look like long-term winners for the next 30 years, I could see several scenarios where they could go to zero in the process. That being said, this does not mean that they will go to zero, but just that investors might have to regularly monitor the positions in their portfolios. I also believe that investors should not only focus on quality regardless at price. Instead, investors should focus on finding quality stocks at a reasonable price.

If I were to decide between purchasing shares of Coca-Cola (KO) trading at 22 times earnings or Chevron (CVX) at 9.50 times, I would likely choose Chevron. I will still hold on to Coca-Cola for decades, but for new money, I would choose Chevron. Some attractive companies in other sectors include:

Air Products & Chemicals (APD) is a stock in the materials sector, which has boosted dividends for 31 years in a row. This dividend champion company trades at 16.80 times earnings, and yields 3%. Check my analysis of Air Products & Chemicals.

Chevron (CVX)  is a stock in the energy sector, which has boosted dividends for 26 years in a row. This dividend champion trades at 9.50 times earnings, and yields 3.20%. Check my analysis of Chevron.

United Technologies (UTX)  is a stock in the industrials sector, which has boosted dividends for 19 years in a rowThis dividend achiever company trades at 14.20 times earnings, and yields 2.20%. Check my analysis of United Technologies.

Aflac (AFL)  is a stock in the financial sector, which has boosted dividends for 30 years in a rowThis dividend champion trades at 8.70 times earnings, and yields 2.50%. Check my analysis of Aflac.

One of my favorite reasons and examples on why dividend investors should hold a diversified portfolio is the Financial Crisis of 2007 – 2009. For several decades before that, investors in stable companies such as Bank of America (BAC) collected higher dividends, while also enjoying above average dividend yields.

The current rage is all about consumer staples. While I enjoy the stable nature of many consumer staples companies such as Procter & Gamble (PG) and Coca-Cola (KO), I do not want to place all of my bets on a single sector. It is true that consumers tend to purchase Gillette razors, shaving cream, Coca-Cola drinks repeatedly and they also tend to stick to the products they use for years. However, if companies make a few wrong moves such as making the wrong acquisition and taking on too much debt, not investing enough in the business or simply if company’s products are deemed to be unhealthy for the population, they could lose money and cut the dividends.

When analyzing my portfolio, I noted that Consumer Staples accounted for 36% of it, while Energy, Financials and Healthcare accounted for 22%, 12% and 11% respectively.  After that I have exposure to five sectors, which accounts for a whopping 19% of my portfolio. These sectors include Industrials, Consumer Discretionary, Information Technology, Materials and Utilities. Unlike most other dividend investors, I do not have much exposure to US telecom stocks, since I find their dividend payouts to be too high in general, and thus I do not trust the dividend yields. In addition, I doubt that long-term dividend growth will be more than 3%/year for the largest players such as Verizon (VZ) and AT&T (T). I do have exposure to Vodafone (VOD) however, which accounts for less than 0.60% of my portfolios.

Just because I am underweight Utilities does not mean that I will load up so that I increase my exposure. The stocks in my portfolio are geared towards paying a decent dividend today, with the potential for growing it over time, while potentially delivering strong total returns in the process. Most utilities pay high current yields, but have limited prospects for increasing earnings and dividends over time. In fact, many utilities are actually prone to cutting distributions to income investors. 

Wednesday, May 15, 2013

Why would I not sell dividend stocks even after a 1000% gain?

In a previous article I wrote on when to sell dividend stocks, many investors were absolutely furious that I would not even think about selling after a stock I own goes up 1000% in value. The reality is that this would depend on the circumstances, but since I am a long-term investor, I expect that at least some of the stocks I purchase today would become tenbaggers over the next 30 years or so.

In order to add shares in companies to my portfolio, I go through a quantitative screening process, followed by a qualitative review of the business. The qualitative portion is the most subjective one, and is based on my experiences consulting companies, using products or discussing products with company’s clients etc. As a result, I try to enter companies which I believe would be there for at least 20 – 30 years, when their shares trade at fair prices. If they are undervalued, that makes investing in them much easier. For example, based on my prior experience I would much rather purchase an oil company like Chevron (CVX) or ConocoPhillips (COP), than an individual US oil and gas trust that will be worth zero in a few decades. I could probably write an article about that.

Dividend growth stocks follow a natural progression of slowly increasing earnings and dividends over time. They almost always look fairly valued, which is why the biggest benefit is earned by long-term holders. If I purchase a stock like Chevron today while the annual dividend is $4/share, the current yield is at 3.30%. Chances are that one decade from now, the yield would be close to 3% again. However, the dividend and the share price would have probably doubled along the way.  I say probably in regards to the dividend growth, because things never progress in a linear fashion of course. Using the inputs above however of dividends doubling every decade, and stock prices yielding somewhere close to 3%, it would not be unheard of if an investor in Chevron sits on an 800% – 1000% gain in 30 years. If there isn’t a tectonic shift that would take the world off of oil and gas, chances are that this growth is a very likely scenario that would continue for several more decades.

As a result of focusing on quality companies, there are few things that can make me sell. I view myself as a part owner of a business, and as a result the business fundamentals such as returns on equity, earnings per share and dividends per share are more important than share price fluctuations.

One of the things that would make me sell is a dividend cut. My expectation is that a company would generate higher dividends over time, and thus the inability to do so is usually the last signal of deteriorating financials I am willing to take that shows trouble. I do expect to get a high yield on cost over time, although this indicator is not something i use when evaluating buy or sell decisions. If everything goes well for my investment, I would expect it to generate more dividends over time, which would increase yield on cost, which is an indicator of an increase in dividend income. This indicator always seems to confuse and anger investors for whatever reason. I would not sell a stock simply because it becomes overvalued. For a typical dividend growth stock, if it traded up to 30 times earnings it would be more of a temporary noise, especially if this is backed by serious growth.

Dividend investing is not a black and white strategy however, and as such, a P/E of 30 might cause me to sell some stocks but might lead me to hold on to other stocks. The nuances of holding on to overvalued companies that keep performing will vary for each individual situation. Even if I were to sell a stock with a P/E of 30, then I would have to pay a capital gain tax that would eat into my capital and find a security that is attractively valued. If we happen to have the stock market trading at all-time-highs, and all other quality companies are overvalued, I would have essentially shot myself in the foot.

As an individual dividend investor, I have a limited amount of time that would allow me to identify and invest in approximately 50 – 80 great stocks during my lifetime. Of those, probably 15 – 18 would perform to be once in a lifetime investments. The rest would get acquired, lose focus or outright fail. As a result, my goal is to run with the winners for as long as possible and get rid of the losers as soon as possible.

The number one reason why individual investors fail is because they tend to book small profits. At the same time they keep their losers hoping for a turnaround. Instead, they should focus on identifying quality companies, and then let fundamentals improve and simply hold on to these great ideas. It is difficult to be a long term investor when you are bombarded with stock market information everywhere you go. However if you do not embrace a long-term approach to investing, and do not see shares as ownership in real businesses, chances are dividend growth investing is not for you.

There is a lot of work involved in timing the movements of stocks, and selling a company that might be overvalued today to purchase another company. I have found that there are only so many quality dividend stocks I am willing to consider looking at. Finding the right company trading at the right price narrows the list down even further. Then there are things such as avoiding concentration to specific sectors as well as avoiding concentration in particular individual positions as well. As a result, I buy and hold on to stocks that fundamentally perform well. I could sell the stock and buy another one, but I might increase the risk that I am buying something that could be of lesser quality, despite the high price. For example, I could sell Johnson & Johnson (JNJ) today and purchase NuSkin enterprises (NUS), which have a much lower P/E. However as I mentioned in my analysis of NuSkin, I find it to be of lesser quality than a Johnson & Johnson.

As a dividend investor, I do monitor the positions I have regularly. However, from a psychological perspective I have found that a daily monitoring of my portfolio for major events might increase my chances of doing something stupid such as trading too often. In reality, as a part-owner of a business, there are not many events that would happen every day, which would materially affect the business. Again, this is more of a nuanced approach as opposed to a black and white strategy. I do want to see improving fundamentals over time, as well as catalysts that would bring more income. For example, Coca-Cola (KO) is a brand whose products would likely continue to quench the thirst of consumers, who would only drink the specific products sold by the company. I would never for example drink Pepsi, although I know some individuals who would always drink Pepsi and hate Coke. There are hundreds of millions of consumers who will be entering the middle class in developing markets in Asia, Latin America or Eastern Europe. If people in India and China eventually consume as many servings of Coke per year as Americans do, Coca-Cola will have a bright future ahead.

Back 1988, Warren Buffett began accumulating shares in Coca-Cola (KO) for his holding company Berkshire Hathaway (BRK.B). Currently, Berkshire owns 400 million shares at a cost of $3.2475/share. Berkshire’s stake has increased its value over 11 times over the past 25 years. At the same time, the company has been more valuable, as it has managed to increase profits and dividends. The stock price was overvalued in 1998, seeling as high as $45/share, and having a P/E of 48 by year end and an yield of 0.80%. EPS for 1998 were 71 cents/share. Buffett did not sell his stake, and earnings per share rose to $1.97/share by 2012. The issue was that Coca-Cola was consistently trading above 20 times earnings between 1992 -1998. Since 1995, Coca-Cola traded at a P/E of over 30 times earnings. The stock didn't become attractively valued until 2006. In hindsight, it’s easy to tell when to buy and sell. In reality, it ain’t so. Berkshire Hathaway currently is sitting on more than a 1000% gain in Coca-Cola. Chances are that it would keep on holding the stock, and since Coca-Cola regularly repurchases shares, Berkshire's stake in the company will keep increasing over time.

Buffett did sell another one of his holdings, McDonald’s (MCD) in 1999, when the stock traded around $35 - $40/share. The stock fell as low as $12/share in 2003, before reaching $100 by 2011. The dividend increased each year during the period, although McDonald’s did have some operational issues in 2002 – 2003. In effect, Buffett missed out on this great investment idea.

Full Disclosure: Long CVX, COP, MCD, KO, JNJ, PEP,

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Tuesday, May 14, 2013

Attractively valued dividend stocks to consider today

With the stock market hitting all-time highs pretty much every day, there are not that many stocks that have low valuations today. Some of my favorite companies such as Coca-Cola (KO) are trading at over 22 times earnings, which is above what I am willing to pay for this otherwise excellent business.

As a result I focused on the list of dividend champions, and uncovered the following attractively valued companies with low p/e ratios. I tried to look for dividend champions with yields above 2%, payout ratios below 60% and P/E ratios around 16 or lower. Despite the fact that current yields on this list are low, these companies offer good values in today’s overheated market. With low dividend payout ratios and attractive dividend growth, these low valuations offer a great entry point for investors who have at least ten or twenty years to let the investment compound.

I also added Ameriprise Financial (AMP) to this list, because I was researching it for inclusion to my portfolio, despite the fact that the company has raised distributions for less than 25 years. As most of these companies yield less than 2.50%, I would monitor them and try to add on dips. For example, back in April, I initiated a position in IBM (IBM) when the stock market punished the stock below $200/share, thus locking a 2% yield for a low valuation business with excellent EPS growth potential. Early in 2013 I was able to add to positions in Yum! Brands (YUM) and Family Dollar (FDO) after investors punished the stocks as well. That is why any type of irrational weakness must be explored by the enterprising dividend investor. Despite the high P/E on Johnson & Johnson (JNJ) today, it looks like the company trades at a P/E of around 15 based on forward 2013 estimates, so it could be one company to check out. The ability to look beyond the numbers could uncover attractively valued stocks in todays market.

While I would not be adding to my positions in Coca-Cola (KO) or Colgate-Palmolive (CL) at current valuations, the 13 companies listed above will be the types of stocks to consider when adding new money to my portfolio on dips. This should be done of course only after thoroughly researching the business, and then paying an attractive entry price.

The traditional blue chip companies I have held on for so many years, such as Coca-Cola, Colgate-Palmolive and many others which have attracted my new capital contributions for the past five years are no longer making sense to buy. As a result, the overvalued markets have caused me to be more creative in uncovering successful businesses, that can deliver better performance in the future. I am willing to purchase a stock yielding 2% today, if the valuation is low at say 15 times earnings and if there are catalysts for future growth. At the end of the day, a company yielding 2%-2.50% that trades at a P/E of less 15 that grows dividends above 7%/year will be more valuable than a company yielding 3.00%, trading at a P/E of over 22 and growing at 7%.

I would try to avoid value traps during the individual analysis I perform. I would try to stay away from known problems that can be disastrous. As a result, I am avoiding technology stocks like Intel (INTC), which might not be able to grow earnings per share over the next decade per my analysis of the situation. In addition, I did not include Cardinal Health (CAH) on this list, because it has been losing customers such as Walgreens (WAG), and has contracts with CVS (CVS) up for renewal in June. That is despite the fact that Cardinal Health has raised dividends for 17 years, trades at a P/E of 13.60 and yields 2.60%

I would much rather avoid losing money, than miss out on the next hot stock. The importance is to focus on quality, which unfortunately usually lies in the eyes of the beholder. A small leak can sink a big ship. Companies which are losing customers, companies that have advantages which are not durable (such as tech companies), or companies which are cyclical are to be avoided. I am not interested in companies which look undervalued today, but whose profitability might suffer, thus making them overvalued in hindsight.

Full Disclosure: Long IBM, KO, CL, AFL, APD, CVX, MDT, UTX, WMT, WAG, AMP

Relevant Articles:

Is Intel Corporation the Ultimate Value Trap for Investors?
How to invest when the market is at all time highs?
High Yield Dividend Investing Misconceptions
My Entry Criteria for Dividend Stocks
Evaluating Dividend Growth Stocks – The Missing Ingredient

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