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

Wednesday, August 26, 2015

Do not get emotionally attached to a dividend position

As someone who has been investing in, and writing about dividend paying companies for over seven years, I have accumulated a lot of observations about investor behavior. One of the issues I have observed is when investors get emotionally attached to a dividend stock they owned. While it is important to invest in companies you understand and believe in, it is equally important to also know when a company is no longer performing up to par. It is important to objectively evaluate and identify companies in a portfolio that are no longer pulling their weight, in order to stop adding to those companies and possibly even sell them. Failure to do so could result in permanent loss in capital, and permanent loss in capacity to generate dividend income.

Many investors I have interacted with over the years have liked the types of Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO) to name a few examples of successful dividend growth stocks from the past few decades. And I agree that these companies are great, with wide moats, strong competitive positions and global platforms for selling branded products at a premium price. However, while these companies are great there is not such a thing as a buy and forget investment.

It is important to monitor your dividend stocks regularly. Monitoring is important, because things change and people cannot predict what will happen to a business 20 years from now, using the information of the past or present. A healthy and growing company today might find itself in a declining industry and have its fortunes decimated. Investors should purchase stocks with the intention of holding on for the long run. However, if any warning signs are spotted investors should not add more funds to position, and even consider selling. Newspapers enjoyed an economic moat for decades. The internet ruined the moat of companies like Gannett (GCI). Other companies might decide to change business model and embrace hot growth industries, while disposing of their core stable cash generating assets in the process. Prime case in point is Enron. Another one was french water utility Vivendi, which turned itself into a media conglomerate.

Wednesday, August 19, 2015

Are you ready for the next bear market?

It is not a secret that stock prices have been rising for 6 - 7 years in a row now. This makes it easy to hold on to stocks, and believe that we will have smooth sailing until we reach our goals and objectives.

In my investing, I do like to think about different scenarios. What if my quoted portfolio goes down by 50% in 2016?

I know a lot of investors who are focusing only on total returns would be unhappy. Imagine if you saved for 20 years, and accumulated a net worth of $1 million. Then boom – in one year, half of your net worth, blood,sweat and tears – gone. Would you panic?

I myself would likely be indifferent to a 50% stock price drop. As a dividend investor, I am somewhat insulated from stock price fluctuations. This is because I focus on the earnings power of the business, and the dividend payments that the businesses in my portfolio generates. It is very comforting to keep receiving cash, even when the quoted value of investments throughout the world is falling. When everyone else is hurting, I have the luxury of generating cash from my investments, which I can then deploy at ridiculously low valuations. As long as the underlying fundamentals of the businesses I own are intact, I can ignore stock price fluctuations. This is one of the most important traits of successful dividend investors. Those who do not understand that, are usually the ones that have not made any money in stocks to begin with.

Friday, August 14, 2015

Should companies pay dividends?

As many of you know, I only invest my money in companies which pay dividends. I have made a lot of money that way, and I use dividends as a tool to measure my progress towards financial independence. Currently, I am on track to reach financial independence with dividends around 2018. We all know that dividends are more stable than capital gains. If I had to rely on total returns, and the stock market fell by 50% in 2018, I would have been in a lot of trouble. Since dividends are more stable however, I can ignore stock price fluctuations and focus on enjoying my life.

One of the fundamental questions I hear is whether companies should be paying dividends. The answer of course is that it depends on the company.

Mostly mature companies tend to pay dividends. These companies have an established niche in a market, and earn a lot of excess cashflow that they share with shareholders. Those companies have a lower risk of failure. A firm in the start-up phase will not pay dividends, because it needs all resources to grow or maintain the business. These types of companies are unproven, and therefore more speculative. We often hear about the successful companies that reinvested all profits and ended up being valued for billions of dollars. Google (GOOG) is one such example. The part for Google is that most profits are derived from online advertising. Any money allocated to other projects have not resulted in a meaningful return on investment for shareholders yet.

Wednesday, August 12, 2015

How well do you know your investment strategy?

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

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

Tuesday, August 4, 2015

What should I do with Baxter and Baxalta after the split?

Note: I originally planned to post this article tomorrow, but in light of recent developments about Baxalta being in the process of being taken over by Shire, I am posting it today. I sold two-thirds of my Baxter and Baxalta shares yesterday. 

In early July, Baxter International split into two companies – Baxter and Baxalta. For every share of legacy Baxter, shareholders received a share of new Baxter (BAX) and a share of new Baxalta (BXLT).

A few readers had asked me about the new dividend payments after a press release from late June indicating that there might be a decrease in dividends. I decided to hang on, until both companies formally announced what their dividend policy will be.

Both companies recently announced dividend cuts effective in September. The new payment for Baxter will be 11.50 cents/quarter, while the payment for Baxalta will be 7 cents/quarter. This totals 18.50 cents/quarter, which is much less than the 52 cents/quarter that legacy Baxter paid to shareholders.

My goal as an investor is to generate a rising stream of income from my dividend growth portfolio. As such, I purchase shares in companies that can afford to and do grow dividends per share over time. I have found that it is easier to forecast and rely upon dividend income, rather than capital gains in the retirement years. Therefore, companies that have cut dividends have no place in my portfolio since they are no longer fitting with my overall goals and objectives that made them a purchase in the first place.

Wednesday, July 29, 2015

Dividend Growth Stocks Protect Investors from Inflation

One of the biggest risks that investors in retirement face is inflation. There is a general trend of rising prices over time, which decreases the purchasing power of cash today, as prices on many items slowly increase. A dollar today is going to have a higher purchasing power than a dollar received in 2025.

Dividend growth stocks are the ideal venue for investors in retirement. This is because the dividend income usually rises faster than the rate of inflation, in diversified portfolios of dividend paying securities. For example, historically prices have risen by an average of 3.90% per year between 1960 and 2014. However, annual dividends on the S&P 500 index have increased by 5.60%/year between 1960 and 2014. I have taken the S&P 500 as a proxy for overall dividend growth that could be expected from a diversified portfolio of US stocks.

Wednesday, July 22, 2015

Sector Allocations for Dividend Growth Investors

I am a fan of diversification as a tool to reduce risk. I diversify by buying at least 30 – 40 securities, representative of as many sectors as possible. As I mentioned in an article from last year on diversification, there are 10 11 sectors:

There are ten major sectors as identified by Standard and Poor’s. Those include:

Information Technology
Financials (used to include REITs, now they are their own sector)
Health Care
Consumer Discretionary
Consumer Staples
Telecommunication Services
Real Estate Investment Trusts (REITs)

Tuesday, July 21, 2015

Am I a successful dividend investor?

How do you define success? To me, success is the freedom to do my own thing, and the ability to reach my goals. Given the fact that I am a few years away from potentially reaching out my dividend goals, I would consider myself a successful dividend investor in progress. So how did I get there? The answers are simple – I developed my own approach, stuck to it through thick and thin, kept learning more about investing and kept my emotions at bay. At the same time I ignored the random noise that comes from individuals who do not know what they are talking about, yet scream the loudest.

I kept buying dividend growth stocks in 2008 and 2009, when everyone else tried to make me scared about investing. The economy was supposed to go in the tank, and the Great Depression was coming. Based on my studies of history, the Great Depression was tone of the best times to buy equities. Hence, I continued putting my hard earned cash into dividend paying stocks.

Wednesday, July 15, 2015

The biggest investing sin exposed - part II

In part one, I started talking about the biggest investing sin exposed. This is part two of the series.

My sample of three is not representative at all. These are individuals I have found through my browsing of the internet. If these individuals stick to their new found strategy for the next 20 - 30 years, I believe they will have high odds of succeeding. If they switch strategies however, I would be worried for them.

JLCollins – After reading his investment history, it looks like he jumped from strategy to strategy, selling everything in 1987, getting back in 1989, chasing hot funds like CGM Focus, then admits to chasing dividend stocks. I was surprised how much turnover he had in a single year, when he essentially sold 25% of his portfolio that was in REITs and bought a stock index fund with the proceeds. He is mostly in US stocks, with approximately 20% in fixed income. I think he invested without a clear strategy between 1974 and 2011, before embracing indexing. Since he has only used indexing during a bull market, I wonder whether he will make a switch in strategies again.

Tuesday, July 14, 2015

The Biggest Investing Sin Exposed

One of the biggest sins in investing, is investing money without a clear plan or strategy to accomplish specific goals. This investing sin causes investors to chase unrealistic returns, and to abandon one strategy for the next when things get tough. A common trait of successful investors is identifying their investment objectives, and then devising a plan to accomplish those. The important part after that is patiently sticking to your plan even when things get tough. It is unrealistic to assume that any real strategy can deliver results that are always better than everyone elses, and can also generate consistent profits all the time. Investors who fail to understand this, end up abandoning strategies at their temporarily weak point, and then wasting precious years that could have caused the capital to compound and accomplish their goals.

I believe that in order to be successful in investing, one needs to select a strategy, and stick to it for decades. This allows the power of compounding to do its magic. If you switch investing methods/styles every few years, because you chase what is hot, you are not going to let compounding do the heavy lifting for you. In addition, if you have high portfolio turnover, your compounding will be negatively affected, because you will be paying more in commissions, taxes and fees.

Friday, July 10, 2015

Do I need an emergency fund?

Conventional wisdom states that individuals should have an emergency fund covering six to twelve times monthly expenses. This means that if your monthly expenses are $2000/month, you need to have $12,000 to $24,000 available in your checking/savings account. If you have a sudden one-time expense, you can use the funds from that emergency fund. After that, you can replenish it with monthly income. If you get fired from your job, you know that you will have some 6 – 12 month breathing room, before you land your next job.

I used to subscribe to the idea of the emergency fund. In my article on margin of safety in financial independence I discussed that I keep 3 – 6 months of living expenses. However, I am no longer keeping massive amounts of cash. I would say that I probably have cash covering one or two months expenses at most. Of course, there are a few reasons for that.

The first reason is the fact that I have a decent nest egg saved up over the past 8 years.

Wednesday, July 8, 2015

Dividend Growth Investing – a great strategy for long term investors

I have been a dividend growth investor for over 7-8 years now. The reason why I have somewhere between 85% - 90% of my networth in dividend growth stocks is because of several factors. I have listed those factors below.

1) Dividend growth investing is a simple strategy that is easy to understand by almost everyone.

Essentially I allocate my capital into businesses that send me a portion of their growing profits every quarter. I can then use those dividend checks any way I want to, and they cannot be taken away from me. My investments are working for me around the globe, 24 hours a day, 7 days a week, 365 days an year, finding new ways to increase revenues, profits and dividends. In the case of a company like PepsiCo (PEP), it literally means selling hundreds of snacks and beverage products around the world to hungry and thirsty consumers. I view the dividends I receive from those companies as purely passive income, for which I did not have to work an insane amount of time each week for. The cash is stable and growing, and makes budgeting in retirement a breeze, since I won’t have to rely on complicated mathematical formulas that traditional asset depletion strategies require. The investments are those large blue chip companies whose products I use on a repeated basis, and whose business I understand. As these companies earn more over time, they reward me with dividend raises, which have always been in excess of my salary raises. It is as if my household has an extra worker, silently earning income for me, and sharing all of it with me.

Wednesday, July 1, 2015

The most important rule about dividend investing

As a dividend investor, my main goal is to attain financial independence when dividend income exceeds expenses by an adequate margin of safety. I am going to achieve that by creating a diversified portfolio of attractive dividend paying businesses that are purchased at attractive valuations, reinvest dividends and new capital, and then one day live off these dividends.

Unfortunately, it takes time to accumulate a sufficient stream of dividends, that would allow you to be financially independent. In my case, it would be about 10 years of meticulous saving and investing, through thick and thin when I achieve my target dividend income around the end of 2018. However, the preceding five to ten years were equally important, because I was able to avoid debt whatsoever, which many of my peers were burdening themselves with. It takes and will take a lot of dedication and persistence to eventually reach my dividend crossover point.

Because the fruits of dividend investing take time to grow to a meaningful amount, it can be difficult to stay motivated throughout your dividend investing journey. The human mind can play tricks on you, and you think about shortcuts on how to get there faster. This is a dangerous behavior, which can detract you from your goals. In other words, dividend investing is a great strategy for those who stick to it. But for those who don’t, it is quite possible that you won’t be able to reach your goals. Therefore, I believe that if you avoid big losses, your odds of success increase exponentially.

Monday, June 29, 2015

What drives future investment returns?

There are several factors that drive future investment returns. The important drivers behind future returns on equity investments include:

1) Attractive Entry Price
2) Adequate growth in earnings
3) Dividend Safety
4) Strategic dividend reinvestment

While these are important drivers of future returns, it is equally important to keep as much of any returns as possible. In order to do that, investors need to be mindful of all costs. In order to reduce taxes, it is advisable to place as much shares as possible in a tax-deferred account such as a Roth IRA for example. In taxable accounts, it is advisable to refrain from too much trading, in order to let the power of tax-deferred capital gains on long-term holdings do its magic. The other way to keep costs low is by putting money in the lowest cost broker. In my situation, this is Interactive Brokers, which charges me 35 cents/investment. It feels like a steal.

Let's illustrate the concept with an example from the real life. For example, PepsiCo (PEP) sold at $52.20/share at the end of 2004. The company earned $2.41/share in 2004, and earned $2.39/share in 2005. Therefore, it sold at a trailing P/E ratio of 21.70. The quarterly dividend was increased to 23 cents/share in June 2004, up significantly from the previous rate of 16 cents/share. The stock yielded 1.76%.

Wednesday, June 17, 2015

Why Dividend Investors should never use stop losses?

A stop loss is a price below current stock prices, at which point a sell order is automatically triggered for an investor’s position.

I believe that dividend investors should never use stop loss orders, unless they are considering swing trading or day trading. If you are a swing, day trader or momentum trader, please ignore this article – you will not learn anything new from it. If you are a dividend investor, then you should think twice before using a stop loss. You want to sell shares at your own terms, not because the moody Mr Market triggers a stop loss order, or forces a margin call on you because of a temporary fluctuation in prices.

Investing is a very competitive game. This is why hedge funds and high frequency traders are paying millions of dollars in order to locate their servers as close to exchanges as possible. This is in an effort to front-run orders by fractions of milliseconds and profit in the process. In this competitive game, by placing your stop loss order, you are essentially showing off your hand to hedge funds and high frequency traders. This makes you vulnerable to stock price fluctuations, which temporarily go down, resulting in a sale. As a long-term investor, you do not want to fall prey to the moody Mr Market and sell because of a drop in prices. You want to be able to buy and hold shares at your own terms. You want to take advantage of stock price fluctuations, which make great businesses available at low prices. You do not want to be a victim of unfavorable stock price fluctuations, that would cause you to sell at a loss, due to a stop-loss order or a margin call.

Tuesday, June 16, 2015

The most important metric for dividend investing

When selecting a dividend stock, investors should look at the dividend last. Income investors should first focus on profitability when investing in dividend paying companies. Investors should attempt to gauge whether companies can increase earnings in a sustainable way for the next decade. For master limited partnerships I would focus on Distributable Cashflow per Unit (DCF), while for REITs I would focus on estimated growth in Funds From Operations (FFO). Investors should not focus simply on revenues. They should also be beware of CEO’s who are empire builders or sales groups whose only goal is commissions, not company profitability.

In many cases, investors take into account unimportant pieces of information, which nevertheless influence their decisions. These investors should not focus on news stories and popular opinion, but should instead focus on the cold hard data.

Friday, June 12, 2015

Should Dividend Investors Re-Balance Portfolios?

Rebalancing is the process where investors sell an asset that takes an above average allocation in their portfolio, and use the proceeds to purchase an asset which has a below average portfolio weight. Many investors are told that they need to re-balance their portfolios regularly. The benefit from rebalancing is risk reduction. In my investing, I do not practice re-balancing. This is because I view re-balancing as a perverse process where I end up selling my winners, in order to add to my losers. Re-balancing is a form of market timing, and runs opposite to my belief of letting the best performers run for as long as possible ( until that dividend is cut). I am going to provide more detail below.

I spend a lot of time trying to find attractively valued companies, and then poring through financials, reports and performance statistics in order to determine if I want to purchase them or not.

Even if I do a great job of selecting the best companies, chances are that things will change in some way 1, 5, 10, 20 years down the road. A company can become terribly overvalued, or it could hit some unforeseen/carelessly researched by me event and end up with deteriorating financials. These deteriorating financials could lead the management to cut or suspend distributions to shareholders. I expect that these situations would not be the norm in a carefully selected group of stocks however. At some point, it is important to remain objective, and remove the bad apples. Capital is best allocated outside the bad apples.

Selling companies is the most difficult part of investing. I usually sell after a dividend cut, a cash buyout, or extreme valuation such as a P/E over 30 - 40. However, contrary to what most investors do, I never re-balance.

I expect that the majority of the companies I purchase would slowly improve revenues, earnings and dividends over time, while trading at a reasonable band of earnings multiple and dividend yields over time. For example, a company that earns $1/share this year that trades at somewhere between 15 to 20 times earnings, will trade around the $15 - $20 range within one year. If the company earns $1.05/share in the next year and trades at a P/E of 16 – 20 the range would be from $16.80 to $21. Of course, nothing is certain nor linear in life. Therefore, a company with growing earnings could trade at high or low valuations over time. However, as long the company keeps earnings more each year and it is not too terribly overvalued, I would restrain myself from doing anything. Actually, once I identify a quality company that grows earnings and dividends over time, my job is not to micromanage anything. My job is to sit back, monitor the company, and enjoy the rising wave of prosperity over time.

I usually take dividends in cash, and let them accumulate up to an amount equal to approximately $1000. When I didn’t pay any commission, my lot size was approximately $250/trade. This meant that as soon as I accumulated $250 in cash in my portfolio, I would buy an attractively valued stock. Now the lot size is approximately $1000 - $2000, depending on broker and relative attractiveness of an investment situation. I usually try to allocate equal dollar amounts to my portfolios, but I realize that over time things are going to differ substantially between positions. However, if a company also ends up accounting for an above average percentage of my portfolio, I simply would not add any funds to it. I let accumulated dividends and new cash added to the position in new or existing positions that are cheap. That way, over time, these previously highly weighted positions would fall to normal levels.

Thus, while I do not re-balance, I do manage portfolio weightings. In a portfolio consisting of 40 companies, the average position size could likely be 2.50%. If a certain position exceeds 5%, I would stop adding money to it, even if it is the best dividend stock opportunity at the time. In addition, I would allocate dividends generated from that same company elsewhere. If a position is between 6% and 10% of my portfolio, I would still refrain from "re-balancing" or selling as long as I plan on adding new funds to the portfolio. If I am still adding funds to the portfolio, my portfolio will increase in value, and therefore the relative weight of that top position will decrease over time. Another tool I have at my disposal includes the fact that I take all distributions in cash, and then allocate them in the best opportunities available outside of my largest five or ten portfolio holdings.

Even if I don’t add any more funds to my portfolios, I would still refrain from re-balancing positions back to equal weighting. Selling a company just because it has gone up in value does not sound appealing to me, since it triggers taxable events, costs brokerage commissions, and requires more of my precious time than I can afford to dedicate to mundane tasks at this moment ( and keeping track of taxes which are more complicated as a result of rebalancing is an example of such a mundane tasks). This punishing of companies whose stock go up is contrary to my investment philosophy of buying sound businesses with favorable long-term economics, and then letting the dividends roll into my accounts. Of course, if the companies cut dividends, get bought out for cash or trade at ridiculous P/E’s of 30 or 40 I would probably start selling off slices of my positions. For MLPs and REITs I would look at DCF and FFO multiples. Re-balancing also strikes me as market timing. Few investors are good at timing the markets. Rather, it is time in the market, not timing the market, that delivers the most value to the long-term investor.

You are increasing the amount of work for yourself by selling companies because they moved in price. When you only look at prices, you are essentially speculating. Re-balancing where you sell investments because of price, not because of some change in fundamentals, is market speculation, which will make your broker and your local tax authority better off. You are also taking on added the risk that the companies you added to will do better than the ones you sold from.

Selling overvalued stocks should never be an automatic event either. For one, a company might have a high P/E ratio, because it recognized a one-time event caused by some arcane accounting rules. Or a company might be up in price, but the fundamentals support further growth in earnings and dividends, that might actually make it a steal today. Other times, a company might look undervalued at the peak of the economic cycle, but overvalued at the bottom. Cyclical stocks like oil and gas or metal companies are notorious for this. The other risk I am running is that I sell a company that looks overvalued but prospers in the next 30 years, for a company that looks cheap but doesn't really improve fundamentally in the next 30 years.

In addition, selling a company that has gone up in price to add to a company that has gone down in price might not be a very smart strategy, as you are punishing winners and rewarding losers. Most investors would find that argument not too convincing, particularly since it runs contrary to the popular belief that investors should buy low and sell high. I would let you in on a little secret:

I like to buy high, and then hold for as long as I can collecting dividends, and hopefully never sell. But when I do sell, the goal is to sell at a much higher price, and generate a large amount of cash in the process through dividends. This happens in less than half of investments, but when it does, it will more than compensate for the situations where I bought and lost money, and then some. A much higher price is a result of rising fundamentals. Buying a stock at an all-time high is totally fine with me, as long as the entry price is attractive and fundamentals show a promise. Remember that we are all buying stocks today and hope their earnings and dividends increase from here. As a result, the goal of our dividend growth strategy is to find investments that will frequently be in uncharted waters on the upside. Of course, if I can purchase a stock with improving fundamentals when prices are low that is an added bonus as well. Learning as much as possible about investing, and training yourself to keep an open mind about investing opportunities, could pay off big time for you.

Back when I added to my position in Realty Income (O) at the end of 2011, the stock was trading at all-time-highs. However, the company was adding properties to its portfolio, and was determined to boost FFO/share and dividends/share. I viewed Realty Income as overvalued up until late in 2012, when it announced it was going to purchase ARCT. Then it boosted FFO and dividends per share substantially, and therefore the stock appeared attractively valued at again. Currently, the stock is a little overvalued, but I would hold onto it so long as it continues growing the asset base that will pay rising monthly dividends to shareholders. However, if the stock gets too overvalued and starts yielding 3.50%, I would sell a portion of my holdings. At 3% I would sell more of my Realty Income stock, and would probably be left with 1/3 of the original stock position. If I understand their business model however, I am perfectly fine if the company keeps adding properties from here, and raises dividends in the process, while the stock trades at a band of high and low prices. If I didn't own so much Realty Income already, I might have considered adding to Realty Income if it yields more than 5% again. Because of that, I recently added to my holdings in W.P Carey (WPC), HCP (HCP) and Omega Healthcare (OHI) for a second month in a row.

My models for investing work better with companies which do not experience too much volatility in earnings, and which have the competitive advantages to command premium prices for brand name products and services. As a result, selling a company like Coca-Cola (KO), which grows earnings in the high single digits every year might only be feasible above 30 - 40 times earnings. Holding on to this type of company might be the wise strategy for as long as it makes sense. Selling off Coca-Cola simply because it has gone up relative to another company might not be the most prudent decision, especially if done automatically, without taking into account fundamentals, stability of earnings , and expectations about growth.

As an added bonus, I have included a chart from a Forbes article. The chart shows the results of re-balancing within a portfolio that holds only stocks and bonds. We all know that stocks have higher expected returns than bonds. The financial advising industrial complex sells retirees on the idea of rebalancing in order to reduce risk. The problem, as the chart below shows, is that it ends up resulting in a smoother ride at the expense of much lower returns. This is not difficult to understand, because if the asset that you expect to generate the best returns does indeed end up generating the best returns over time, you have to keep selling it off. You have to keep selling it off in order to maintain a certain target weight of stocks or bonds. Thus, you end up selling your best performing asset, in order to add to the asset with the lower expected returns. Based on the article it was found that re-balancing subtracted from returns.

Full Disclosure: Long O, WPC, HCP, OHI, KO

Relevant Articles:

Should you sell after yield drops below minimum yield requirement?
The Only Reason for Automatic Dividend Reinvestment
Replacing appreciated investments with higher yielding stocks
Three REITs I Picked Last Week
Active Dividend Growth Investing

Wednesday, June 10, 2015

How to value dividend stocks

In my investing, look for businesses I can understand that have some sort of a competitive advantage that translates into consistent earnings power. I try to determine if I believe this business will be around in 20 years, and still have a consistent earnings power, despite obsolescence, competition and regulation. If I believe that to be true, I can then look at trends in earnings, dividends, revenues, returns on equity, payout ratios and make an assumption of what future growth might look like.

This is the part where I also look at valuations. My primary valuation method is often the P/E ratio, relative to 20 times past and/or forward earnings. Of course, regular readers know that this benchmark is not viewed in a vacuum, but in conjunction with past trends in earnings, dividends revenues etc and prospective growth in those earnings and dividends. It is also used as one of the ways I screen for companies for further analysis. P/E ratio is also one of the criteria I use to compare between several companies, before I make my choice.

Over the past few months, I have received a lot of mixed reviews on the type of analysis I perform. I believe the main reasons behind those reviews is the fact that I do a lot of things manually, and have described my outcomes, but never really put everything together in one piece. Actually, a lot of the reasons why I invest the way I invest are also scattered around in a few articles.

Unfortunately, I have found that a majority of readers are not willing to go through the archives or even dig around links provided in an article, in order to find answers to their questions. I know this, because quite frequently I receive questions that could have easily been solved had the reader clicked at a link in the article the hopefully read. In a few scenarios, I have had readers ask me questions that have already been addressed in the article. On the other hand, it is also unreasonable to expect that someone would have the time to sift through 1000 articles I have written on dividend investing.

I think it would be easiest for everyone, if I refer to a few posts I have written on using P/E ratios to value companies.

There are several constraints I face when evaluating a company. I try to discuss them in the following articles:

Not all P/E ratios are created equal

Why do I use a P/E below 20

Why I don’t do discounted cash flow analysis on dividend stocks

How to read my stock analysis reports

As you can see, I use P/E in conjunction with past and projected growth, when screening for and comparing between dividend stocks. This is further complicated by other constraints, such as portfolio weight. For example, I might like Johnson & Johnson (JNJ) or Kinder Morgan (KMI) a lot, but I would not buy more, since they are one of my largest positions. In addition, I am intentionally limiting myself to only companies with P/E ratios below 20 for a reason. The most dangerous thing new investors do is see a company that has done well recently, and project recent successes to the sky. Most often, investors overpay dearly for hot growth concepts and expect trees to reach to the sky. Unfortunately, when you purchase a hot growth stock at 30 times earnings, you are essentially paying for the growth in the next 5 or even 10 years and assuming that things will go smoothly in the future. If there is a slight derailment of plans, you will not earn good returns for as long as the first decade. For example, Starbucks (SBUX) is selling for 38 times 2014 earnings and 33 times forward earnings today. In 2014, the company earned $1.36/share, and for 2015, Starbucks is expected to earn $1.57/share. The projected earnings per share for 2018 are approximately $2.50/share. This means the stock is selling today at 20.90 times earnings in 2018. Even if Starbucks manages to earn $2.50/share in 2018, it could still deliver unstatisfactory returns if the P/E contracts to 20. I would be taking a lot of risk when valuation is overstretched. The risk is that paying a high multiple leaves no margin of safety in case the future doesn't turn out as expected. I also ask myself why should I pay for a company at 30 times earnings that doubles earnings every 7 years, when I can find another company that sells for 20 times earnings. A few potential candidates could include Ross Stores (ROST), TJ Companies (TJX) or Ameriprise Financial (AMP).  As you can see from above, I compare different companies that have a P/E below 20, and pick the ones where the P/E and growth combination is best.

Another constraint I have not really discussed in full is expected investment return. I expect equities to deliver an annual return of 9% - 10%/year for the next 30 years. Therefore, when I select companies, I try to determine whether an investment at today’s prices could deliver a 9% – 10% expected returns. This is something I have not discussed exclusively, because I always assumed that reasonable people would understand that a company that yields 3%, grows earnings and dividends by 6%-7%, could deliver expected annual returns of 9%-10%/year. I also sometimes try to stress test results, in order to see how different outcomes can make or break the returns. Check this article on Hershey from a few weeks ago. Let's take a situation where I pay 30 times earnings today, and the earnings double in a decade. If the earnings stream is worth only 15 times to others, then I have not really earned much in terms of a price return. If the dividend yield was approximately 2%/year, my only return would have come from that small initial dividend yield. Identifying the best quality company is not enough – you also have to buy it at a cheap enough price.

Chasing growth is a dangerous game. What truly matters to the investor is good returns, not overpaying for future growth. Actually, if you pay too much for expected future growth, you might not do too well. For example, between 1957 and 2003, IBM had much better growth prospects than Exxon. IBM had higher revenue, and earnings growth and even dividend growth than Exxon. However, Exxon returned more than IBM, because it always had lower P/E ratios and higher dividend yields. When you have low expectations behind a business, it usually sells at cheaper valuations. This also allows the reinvestment of dividends at those cheaper valuations, which turbocharges returns.

I use earnings per share, but also normalize it for one-time events. For example, in 2012, Coca-Cola appeared cheaper than it was, because of one-time accounting items. In early 2013, Johnson & Johnson appeared more expensive than it really was. For those like me, who like going through annual reports, and press releases, I can identify some of the reasons for annual EPS fluctuations outside the norm. For others, looking at forward earnings and applying a forward P/E ratio could have been a very good approximation of the intrinsic value of the company. In fact, many times I have found that looking at a forward P/E ratio is a good enough shortcut to compare P/E ratios between tens or hundreds of stocks, rather than poring over hundreds of press releases.

For my analysis, it is helpful to look at trends in earnings per share over the preceding decade. However, while I look at the past years earnings, I also look at the prospect for earnings growth in the next two years or so. Purchasing a company at a cheap valuation is helpful, but I also want to see prospects for increase in earnings per share. Otherwise, there would be no future fuel behind future dividend increases. In many cases, looking at the past year earnings and the future year earnings paints a better picture. For example, oil companies like Exxon Mobil (XOM) sell at pretty cheap valuations when you look at past year’s earnings of $7.59/share ( equivalent to a P/E of 11 times earnings). The earnings from 2014 however do not accurately reflect the decline in oil prices. Therefore, one needs to look at estimated 2015 and 2016 earnings per share of $4.26 and $5.34/share ( for an equivalent forward P/E of 20 and 16 times earnings). Those paint a more accurate picture of the near term earnings power for Exxon Mobil. While forecasts are not 100% accurate, I have found them to be close enough for my investing needs. When I buy stocks, I never expect precision. If I demand precision in past and future prospects for earnings and dividends, then I set myself up for disappointment. This is where the margin of safety principle comes in handy.

I apply a set of quantitative criteria on the list of dividend champions. Assuming I have analyzed those companies, I would compare them against each other. I do not assign fair values, like everyone else however. I look at inputs such as P/E ratio, earnings growth, dividend growth, yield, dividend coverage, and my expectations for the future, before choosing an investment from the pack. This is more manual than merely comparing to a calculated fair value, but I think it is easier to think through all the numbers in detail, rather than create a shortcut and miss thinking about an important item.

Overall, screening the list of dividend growth stocks, comparing between dividend stocks, analyzing dividend stocks and hand selecting companies to invest in is a very manual process. Unfortunately, in order to learn how to be a good investor, you need to do the work to have a right to an opinion. In order to succeed in any activity in life, you need to spend thousands of hours and several years learning, perfecting and adapting your knowledge. Continuous learning is important. At the end of the journey however, the reward would be a well maintained dividend machine, which will take care of your needs forever.

Full Disclosure: Long XOM, JNJ, KO, IBM, ROST, TJX, AMP

Relevant Articles:

Stress Testing Your Dividend Portfolio
Buying Quality Companies at a Reasonable Price is Very Important
Dividend Investing Knowledge Accumulates Like Compound Interest
The work required to have an opinion
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Wednesday, June 3, 2015

How to become a successful dividend investor

In order to become successful in any pursuit in life, one needs to define what success means to them. In my situation, I would consider myself successful, when my dividend income exceeds my expenses by a reasonable margin of safety, and keeps growing at or above the rate of inflation. In order to achieve that success, I try to avoid situations which would lead to failure. This is similar to the behavior that Warren Buffett's sidekick Charlie Munger talks about extensively in Poor Charlie's Almanack

The best way to ensure success is to own a diversified portfolio of at least 30 - 40 individual stocks, from as many sectors that make sense. I try to buy quality companies at low to fair valuations. I do not limit the number of companies however - I only invest in companies and sectors when they are available at attractive valuations. Different companies and sectors are available at good prices at different times. If the best values are outside what I already own, it makes logical sense to allocate money in those ideas number 41 and up. Accumulating a dividend portfolio takes several years to build.

This portfolio will likely look differently 30 years later. This is because some of these stocks would end up being acquired. Others will cut dividends at some point, prompting the investor to sell. A third group will freeze dividends, and unfreeze them over time, but never cut them. An example includes General Mills (GIS), which has never cut dividends in 116 years, but has only increased them every year for a decade. Another group would work a couple of years or even decades, and then changes would make the company unappealing and causing you to sell. The last group are the companies that would keep performing as expected, earning more and raising earnings and dividends over time. These will be the companies that would generate gains of several hundred or thousand percent over lifetime of investment. This of course could likely take years or decades.

In the meantime, it is also important to realize that many companies could end up splitting, merging, spinning-off divisions. So even if you build a passive portfolio of 30 securities today, chances are that you might have much more than that in the future. Case in point is Altria (MO), which spun-off Kraft in 2007 and Phillip Morris International (PM) in 2008. Subsequently, Kraft split into Kraft Foods (KRFT) and Mondelez International (MDLZ) in 2012.

Selling these companies would have resulted in much lower total returns and dividend income gains for the investor. It could also be difference between making money and losing money. Lacking patience to see whether the thesis in your fundamental analysis that made you buy pan out, could be the difference between making money or losing money over the course of investment career. Selling the few companies that could result in most profits over time could be quite costly. I have learned that the key to successful investing is to hold on to winners, and dispose off of losers.

Many individual investors are psychologically incapable of sitting on a high profit. They would much rather sell, because of the faulty assumption that "noone went broke taking a profit". They would also rationalize their decisions with the fact that valuations on other stocks are lower. In some extreme cases this is true. If a business you own sells at more than 30 times earnings, chances are that selling it could sound like a wise decision. This is because the money can potentially produce better returns elsewhere. If growth is high enough however, this could lead to P/E compression in a few years, If there are sufficient gains in earnings per share, dividends per share and stock prices, the decision to sell could turn out to be a loser. This loser decision could further be compounded if a company that looks cheap is purchased with the sale proceeds, but then it doesn't turn out to be as good as the original purchase. After an analysis of my sales over the past 7 - 8 years, I realized that in the majority of the stock sales I have done, I would have been better off doing nothing. Actually, going to the movies would have been cheaper, rather than selling, paying taxes and commissions, and purchasing shares in another company that end up doing much worse than what the original investment did in the subsequent periods of time.

I am often wary of trading in exceptional companies at what seems like elevated valuations for merely decent companies selling at what seem like cheap valuations. By engaging in market timing on a longer timeframe, I am enriching my brokers, the IRS etc.

Perfectionism is dangerous for income investing. It is a slippery slope to sell a company trading at 18-19 times earnings for a company trading at 12-14 times earnings. This active trading can lead to a portfolio of dogs that looks "safe" on the outside, but had a lot of risks. For example, companies such as BHP Billiton (BBL) looked very cheap in 2013, while companies like Brown-Forman (BF.B) and Johnson & Johnson (JNJ) looked very expensive. However, this ignored the fact that the latter companies have more stable earnings, strong competitive positions, and pricing power for their differentiated products.  BHP Billiton on the other hand is a commodity producer, which is a price taker, and requires heavy amounts of capital spending. Therefore, its earnings per share are going to fluctuate more, and be more exposed to short-term economic changes and changes to commodity prices.

Therefore, it is important to be aware of situations where an investor is comparing apples to oranges. For example, if you sold a company like Johnson & Johnson to buy a company like BHP Billiton, you are trading recurring earnings per share and dividend per share growth and long history of dividend increases for a commodity company whose profits are dependent on the price of raw materials. These are highly volatile, and vary depending on the cycle the economy is in.

The companies I tend to buy and hold are having competitive advantages, and are able to expand over time. They increase profits and dividends gradually, and stock prices tend to follow that. Very few investors like slow and steady returns, which is why these stocks are always overlooked. They keep producing higher profits year after year. Hopefully your holding period for these companies is forever. Always buy and monitor however, as changes in businesses do happen. It is helpful to avoid micromanaging your investments as well. Just because the dividend growth has slowed down a little or the dividend has been frozen, that doesn't mean the investor should automatically panic and sell out. Of course, if you do miss out on changes, always sell after a dividend cut. I am pretty bad at discerning short-term problems from problems that do matter. This is why I have decided that I am going to stick out with an investment for as long as possible, even if things look ugly for a few years, and would not panic in the process. This is for as long as I believe things could turn for the better eventually. If things get really ugly, my exit will be the second after the dividend is cut. The funny thing is that over the past 8 years, I have had only five dividend cuts or eliminations.

Relevant Articles:

Not all P/E ratios are created equal
Key Ingredients for Successful Dividend Investing
How to be a successful dividend investor
How to monitor your dividend investments
Margin of Safety in Financial Independence

Wednesday, May 27, 2015

Simple Investing Principles to Follow

I have been overdosing on everything about Warren Buffett in the past two-three years. This has spilled over to learning more about Warren’s business partner Charlie Munger. Charlie Munger is big on the so called mental models, which are principles on how to live your life.

In this article, I have outlined several simple principles on investing, which I think should be the foundation of your investment strategy, whether you are a dividend investor or choose to do something entirely different.

The first concept you want to understand is the power of compounding. Compounding is the process where you earn money on the money you invested a certain amount of time ago. You start with an initial amount and have a certain rate of return, and you reinvest gains and dividends back into your portfolio. As a result, you are exponentially increasing your net worth and income.

The second simple principle to take into account is that over the past 200 years, the US stock market has been going up almost every decade. This is a phenomenon not just limited to the US however. A study of most other countries show that equities outperform all other assets over time. This is because stocks represent ownership of real businesses, which over time have more consumers, raise prices, bring new products and gain efficiencies and know-how on how to do things better, cheaper and faster. Reinvested earnings drive growth in the businesses, while reinvested dividends compound your net worth and income even faster. While there are occasional blips that could last for years, equities should be the main cornerstone behind your investment strategy. These occasional declines in share prices, no matter how severe, should not scare the individual investor. On the contrary, they should be seen as opportunities to acquire more equity interests in quality companies at discounted prices.

The third principle to remember is that stocks represent partnership interests in real businesses.  Stocks are not just some blips on a computer screen. While investor sentiment drives stock prices in the short-run, underlying fundamentals drive whether you are going to make or lose money from your investment in the long-run. Over time, growing earnings, dividends make businesses more valuable, hence you will see 52 week highs and all-time highs most of the time. As a result, as a part-owner in a business, your goal is to determine whether the business can earn more money over time. The rise in stock price and dividend will follow if earnings increase.

The fourth principle is diversification. It is important to realize that things can happen to a business that cannot be even considered as a problem today. If you spread your capital in at least 30 – 40 businesses over your lifetime, you would do just fine in the long-run, while protecting your principle in the process. Having exposure to different industries, countries is a must in protecting investment capital from the destructive forces of time.

The fifth principle you need to take in consideration is that increasing investment activity is bad for your returns. The goal of the investor should be to buy or create an equity portfolio, and then sit on it for decades. If you try to time the market by trying to sell at what looks like a top, and try to buy at what looks like a bottom, you might be unable to achieve your investment goals and objectives. In fact, studies have shown that increased levels of activity among individual investors are correlated with extremely low returns relative to their benchmark. In addition, did you know that if you had simply purchased the original 500 components of S&P 500 in 1957, and then did nothing for the next 50 years, you would have outperformed the S&P 500? Therefore, if a company you own spins-off a subsidiary, just hold on to the stock. From a tax efficiency perspective, you should do just fine.

The sixth important principle to ingrain in your memory is to be unemotional about your investments as much as possible. Most investors are terrible at investing, because they lack the emotional characteristics associated with dealing with rising and falling prices. They get excited when stock prices have been rising for a long period of time, but get depressed when stock prices start going down. These investors are always afraid that they are missing out, which is why they frequently change strategies to chase the next hot fad. You should not let emotions run your investments. The successful investor should have a plan, and stick to it through thick and thin. The best plan is to buy, hold and occasionally monitor your portfolio. Remember, it is time in the market that can lead to success, not timing the market.

Another important principal to remember is that entry price does matter. For dividend investors who focus on selecting individual stocks, there are always some attractively valued opportunities available. There were quality companies available at fair prices during the 1972 Nifty-Fifty Bubble, and the 1996 – 2000 Technology Bubble to name a few. Dearly overpaying even for the best companies is a mistake. This is because your initial dividend yield will be ridiculously low, and the price you paid would have all the growth for the next decade already baked into it. In the case of Coca-Cola and Wal-Mart investors, who overpaid in 1999 – 2000, earned low returns over the subsequent decade. This was despite the fact that the underlying businesses produced stellar operating results during the same time period. In addition, one should focus on the current and future ability of the business to generate profits, and not focus on profits that were generated 5 or 10 years ago. In the case of the Nifty-Fifty, the companies generated returns close to that of a stock market index. Of course, investors would have had to patiently hold for a quarter of a century in order to obtain this result. This was difficult, because the first decade was characterized with heavy losses that were more severe than losses experienced by blue chips stocks as a whole.

Relevant Articles:

Buy and hold dividend investing is not dead
Fixed Income for dividend investors
The Pareto Principle in dividend investing
Why dividend investors should never touch principal
Dividend Portfolios – concentrate or diversify?

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