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

Wednesday, March 4, 2015

Dividend Investing Knowledge Accumulates Like Compound Interest






Dividend investing is highly scalable. This means that the knowledge of how to screen for, analyze companies, and build dividend portfolios is relevant whether someone has to put $10,000 or put $10 million in stocks today. I am also not paying any management fees to someone who simply assembles a portfolio of a random number of companies, but charges me money each year for the privilege of holding several hundred well-known blue chip stocks.

I believe that my effort in gaining knowledge about businesses, which I have accumulated over the past 1.5 - 2 decades has been a good foundation that will pay dividends for hopefully 3 - 4 more decades in the future. Learning about business, stocks, asset classes, valuation, economics, and continuously acquiring company or investing specific information will pay dividends for decades down the road. I believe that the ideas I obtain from different sources, tend to build on existing knowledge, which will again pay dividends for years. This is why I believe that knowledge accumulates like compound interest over time.

Dividend investing works for me, because it is very easy to construct a portfolio that generates a certain amount of income, and match that to my expenses. My goal is to live off my portfolio during bull and bear markets or recessions and economic recoveries. That goal is much easier to accomplish when I live off dividend income. This is because if I relied on traditional asset depletion strategies like the four percent rule, I would risk selling off the stocks or funds in my portfolio during a protracted bear market or flat period for stock prices. This could increase the risk of running out of money, since I will be selling low, and reducing the amount of assets I own. This to me sounds contrary to common sense. I would much rather accumulate cash producing assets,spend the cash they generate, and keep the assets. The asset producing assets for me are dividend growth stocks, but if you don’t know about stocks, you can do it with farmland, real estate in college towns, etc

With dividend investing, I have high certainty on the amount and timing of dividend income I can expect each month, quarter and year. This makes living off my portfolio a breeze, and would be similar to the cycle of regular paychecks one is accustomed to in their workplace. I want to generate cash every month or quarter to live off of, and not have to worry whether the market is up or down, so that I don’t sell my assets at low prices.

I like learning about businesses, learning about companies, and expanding my horizons. I believe in life-long learning. I also know that the knowledge I gain from researching investments has given me the knowledge to stand out from other candidates whenever I have been looking for jobs in the past.

If you are not interested in learning about business, then index funds might be the best bet for you. If you don’t have time for managing investments, then index funds might be for you. However, I can only talk about what I do with my money, and not provide individual investment advice. I would never myself invest in anything, without researching it really well. Only then would I decide whether this investment fits my goals and objectives. If I had no knowledge of investing, I would never put money in mutual funds or index funds. It is very likely that I would not own any stocks. Period. This is because I might do the right thing for years by patiently putting money in funds, and then one day I might hear that the economy is bad and how everything is going down. For someone who has absolutely no knowledge of investments, and who has not done their homework, it would be very easy to panic, and sell at the worst time possible. If someone also doesn't know much about investing, they also risk falling prey to unscrupulous financial advisers who sell expensive products like annuities or loaded or high expense funds.

Someone who is told to buy index funds, but doesn't understand why to buy them, is actually done a disservice. There are no shortcuts to investing, and index investing is not a magic panacea. If you want to live off a portfolio, and the stock market is flat for 16 years, index funds would not save someone’s nest egg after 16 years. In 2008 – 2010, many investors I spoke to were telling how bad stock index funds fared, since they had essentially generated very poor returns in the preceding decade. For someone who retired in 2000, they now have less than half of their money left and only a few years worth of expenses left. In my previous job, I had someone who retired in early 2013. He was not very optimistic about the fact that S&P 500 had reached record territory. The reason was that he had seen the stock market stay largely flat for the preceding 13 - 14 years. This is a lifetime, relative to the average amount of years we put working. This individual used to believe that stocks always go up and should deliver 9% - 10%/year. Unfortunately, the stock market proved that it is indeed a manic-depressive individual, whose goal is to confuse as many people as possible. That's why a strategy that relies on increasing of stock prices is not really taking into account the unpredictable nature of stock price fluctuations. As a dividend investor, one can ignore stock price fluctuations, since I am living entirely off the cash distributed from profitable enterprises, not by selling pieces of business that might go up or down in value.

Indexes are also teaching investors poor behavior such as ignoring valuation. Someone needs to learn about valuation before placing their hard earned money to work. In addition, if someone is a bad investor, they will find a way to lose money, even with the bullett-proof index funds. For example, investors in the Vanguard S&P 500 mutual fund have underperformed the S&P 500 index by 2.50%/year over the past 15 years. If you do not believe me, check this page from Morningstar.

I actually think that if everyone wants to be an indexer that could create a lot of inefficiencies, and could make indexing not as robust as it has historically been. It could also create opportunities for non-indexers. Of course, for those who have the ability to stick to a strategy for 20 - 25 years, it wouldn't really matter whether someone else picked 500 stocks for them, or whether they hand-picked 40 - 50 companies themselves. The caveat is that paying too much for future earning streams could result in much lower returns than in the past. The hand-crafted portfolio stands a better chance in the entry valuation camp.

ETFs are also notorious for their fluctuating distributions, much worse than those on S&P 500. This is because of frequent turnover, and building portfolios without trying to generate stable and growing distribution stream for shareholders. Rules of inclusions in different indexes are very arbitrary as well. For example, the S&P Dividend Aristocrats Index removed Altria (MO) in 2008, after the spin-off of Phillip Morris Internatinal (PM) and Kraft Foods (KRFT). This was a dumb move on their behalf, because Altria did not cut dividends. The dividend seemed lower, mostly because the company had split into three. But the original Altria Group shareholders enjoyed rising dividend income streams in the subsequent years. Unfortunately the S&P committee did a bad job in actually understanding the situation. Rather, they chose to mechanically remove a company whose board of directors had regularly increased distributions every year for close to 4 decades. And luckily for those like myself, who never sold Altria, those boards have kept raising dividends every year.

As you can see, you can learn from any strategy. For example, index investors naively believe that an index such as S&P 500 is "passive". This passive nature of indexing is the main selling point, since it has been documented by academics that individual investors as a group tend to do poorly particularly due to turnover. In reality, the S&P 500 index (which is the most popular vehicle for index investors) experiences turnover each year. According to research by Jeremy Siegel, this turnover has slightly reduced returns for investors. Thus, it pays to hold on to your companies as long as possible. This is why I have held on to Abbvie (ABBV), Abbott (ABT), Kraft (KRFT), Mondelez (MDLZ) etc. It is also one of the reasons why I hold on to companies that have kept dividends unchanged or those that experience temporary setbacks. In fact, when I analyze my results, and the results of other bloggers who publicly disclose their investments, I have noticed that selling is usually a bad idea in 80% of situations. Patience is the main edge I have against Wall Street.

At the end of the day, the goal is to create a portfolio that realistically matches someone’s needs. I say realistically, because if you need $40,000/year to live off for the next 30 years, but you only have $400,000 in your portfolio chances are that you are not ready to retire. However, if you need $12,000 - $16,000 in annual income, that has a high chance of at the very worst maintaining purchasing power over time, there is a high chance that a hand-built portfolio of dividend stocks could do the trick. It shouldn’t matter if you underperform index funds or not, as long as someone is achieving their goals.

In addition, for single people making less than $47,050/year or for Married people making less than $94,100/year, qualified dividend income is essentially tax-free at the Federal level, if that’s the only type of taxable income they earn. Hence, the argument against dividends that they are inefficient, and result in double taxation of income is not really valid for those individuals. Learning about taxation of dividends, and learning about taxation in general, has definitely made my life much easier, and has helped get my whole financial house in a much better order. I do believe that knowledge is power, that provides me with options in life. The more options I eventually have, the better the chances that I may be able to live it on my own terms. And that’s what financial freedom means to me.

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

Relevant Articles:

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Wednesday, February 25, 2015

How to Convert a portfolio of index funds to dividend stocks?


In a previous article, I discussed various ways that investors can accumulate their nest egg. One strategy includes putting a portion in one or a few attractively valued dividend growth stocks every single month, and reinvesting dividends selectively. The other strategy involved investing in index funds, using tax advantaged accounts such as 401 (k) for example.

Traditional vehicles for saving such as index funds and target-date funds work well when you accumulate your nest egg, but could present a challenge if you try to live off them. Many retirees prefer to have a stable and growing source of income, which maintains purchasing power over time, and is not dependent on the manic-depressive swings in stock prices. Therefore, investing in dividend growth stocks is the ideal way to generate income from your nest egg in retirement, due to the stability of dividend income. Therefore, if someone were to accumulate their nest egg in other items such as index funds, but wanted to convert to dividend investing, there are two ways that they can achieve that.

The strategies outlined in this article also work for situations where you have a lump sum amount, and you are thinking of investing it.

The first strategy involves selling all funds in your portfolio, and using the proceeds immediately to create a diversified portfolio of quality dividend paying stocks.

This strategy is quick and easy to achieve, as it involves just a few steps. If you want to make the conversion all at once, and not have to worry about how to invest the amounts for months, this is likely the best deal for you. If you could find 20 – 30 quality dividend paying companies, which are also attractively valued, and your money is spread in several sectors, you could be done with this exercise in one day. After that the only thing to worry about would be to monitor the investments, decide what to do with dividend income, and enjoy life.

Back in early 2013, I converted an old 401 (k) into an IRA, and as a result was able to purchase shares in twenty dividend paying companies. It was somewhat challenging to find twenty dividend growth companies all at once that could be considered quality and attractively valued. Depending on the overall stock market environment, it could be very easy to find plenty of value opportunities or it could be very difficult. Between late 2008 and late 2011, it was relatively easy to find plenty of opportunities, and build a diversified portfolio with them. Starting in early 2013, it has gotten pretty tough to do so, especially if you want to avoid concentrating all your bets on several companies in a few sectors like energy for example.

The second strategy involves selling a portion of your funds every month for a period of at least 12 – 24 months, and then using the proceeds to acquire shares of attractively valued dividend paying stocks.

In my experience building dividend portfolios, it is much easier to build a diversified dividend portfolio slowly over time, rather than all at once. This is because different companies from different sectors of the economy are attractively valued at different times. For example, Walgreens (WBA) met my entry criteria between 2011 and early 2013. The stock wasn’t attractively priced again until a brief period in July - August 2013. Since then, it has been slightly overpriced.

In addition, if you buy a portfolio over time, you also want to avoid the pressure of finding 20- 30 attractively valued securities at the same time. If you get into the mentality of have to put my money in these stocks regardless of availability of quality companies at a fair price, you might be taking on a large risk to your portfolio. With the slow selling of index funds and replacing with dividend stocks, you stand a better chance of getting exposure to different sectors when they are undervalued, and thus having a higher opportunity for exposure to more quality companies to buy.

This strategy is also ideal if you want to convert your taxable 401 (k) into a tax-free Roth IRA. If you convert the whole 401 (k) into a Roth IRA in a single year, all of the amount in the 401 (k) would be considered taxable income, and would likely push your marginal tax rate to the highest levels. However, by slowly converting your 401 (k) into a Roth IRA over a period of a few years, you can make sure to avoid triggering higher taxable income brackets, which would mean paying less taxes on the conversion.

Full Disclosure: Long WBA

Relevant Articles:

How long does it take to manage a dividend portfolio?
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Monday, January 26, 2015

How to never run out of money in retirement

Here is the simple answer: live off dividends

Here is the longer answer –when you live off the income that your portfolio produces, the chance that you will ever run out of money is greatly reduced. If you have to sell portions of your portfolio and thus rely on finding someone else to sell at higher prices than you bought, then you have a higher chance of outliving your money.

It is very easy to monetize a pile of cash, and convert it into a neat dividend machine, which will deposit cold hard cash into your brokerage account regularly. You can then use that cash to either spend or to reinvest into more dividend paying stocks, paying even more cash.

As I discussed earlier, there are largely two types of dividend growth investor investors. The first group are those who have been putting money mostly in dividend growth stocks regularly, reinvested dividends, and maintained their portfolios. The second group include those who are trying to convert a nest egg accumulated over a lifetime of hard work, or an inheritance or another pile of cash received recently as a lump-sum. Those are the ones who want to learn how to pensionize their assets, and live off that pile, while also minimizing the risk of loss to the minimum.

If you are building a dividend growth portfolio from scratch, the first step is to start slow. Get a list of dividend growth stocks and identify the leaders in their industries that also have dividend growth streaks. A long streak of regular dividend increases shows a company which is prospering, as evidenced by the higher amounts of cash it sends to shareholders. A company cannot fake cash for long, which is why many investors consider the proof of regularly increasing cash dividends as proof that earnings are increasing and business is good. It is also important to understand which stage of dividend growth the company is. You are mostly interested in companies that manage to increase dividends because their earnings improved over time. When earnings and dividend growth go in lockstep, you know you have found a candidate for further research.

If that candidate is available at a good price, then it can find a place in my portfolio. I usually try to avoid paying more than 20 times earnings for a company. I also require adequate dividend growth exceeding 6%/year, rising earnings and dividends, and try to understand if the company can continue its growth. Most often, I have found out that a body in motion, keeps its upward trajectory for years to come, until something changes. When something does change, the company cannot fake cash flow anymore, and they either freeze or cut dividends. I am a very patient investor, and will hold even through long periods of time while a company works its issues out, as long as my payout is at least maintained. I won’t add any more funds to this position, and would monitor it more closely, but would not sell it. If however a company does cut or eliminate distributions, I am out one second after the announcement. I can get back in if they start raise dividends again, and I believe earnings can grow and sustain the streak again. Having an exit plan is as important as having an entry plan.

I also try to build my dividend portfolio stock by stock, in an effort to have a diverse stream of cash coming my way. I do not want to be overly dependent on any single company for my dividend income, or a single sector. The nature of dividend growth stocks means that I own too many consumer staples and energy companies unfortunately. It is also important not to diversify just for the sake of diversification, but genuinely look for companies which you believe will be there in 20 – 30 years, and possibly earn more to pay more in dividend income. If there is a high confidence that a company will be there in 20 – 30 years, that increases the chances that it will be hopefully earning more over those years and rewarding that shareholder with more cash. Those growing dividend payments will protect the dividend income of the investor from the destructive power of inflation.

It is also important to dollar cost average my way into those quality companies. Remember, Rome was not built in one day. Your portfolio should not be built in one day either. When I dollar cost average every month, I put money to compound for me in some of the best businesses in the world today. I ignore noise such as “the market is overvalued and will crash” or “the market has crashed and will crash further” and keep buying through thick and thin. That way I have a psychological advantage, because I will be putting money regularly, while everyone else will be panicking and selling during the next bear market or piling most of their money right when the current/next bull market is about to end. I don’t have to worry about ups and down, and I ignore market fluctuations, because I am investing in real businesses, not some lottery tickets. I also invest for the next 30 years, plan to live on dividends that are derived from earnings, which is why fluctuations today don’t really impact me. What impacts me is only how the business does over those 30 years.

This is essentially what many trust funds and some major foundations have been doing for decades. If you look at the Hershey Foundation or the Kellogg Foundation, you will notice that a large portion of their income comes in the form of stock dividends. Those dividends are spent for charitable purposes. Of course, this has not stopped either Kellogg (K) or Hershey (HSY) from prospering as well. You can also look no further than the descendants of Standard Oil, whose trust fund accounts are filled with shares in Exxon Mobil (XOM), or Chevron (CVX) to name a few, which have been able to raise and pay stable dividends for a century. If those foundations or trust fund babies have been able to live off their portfolios using dividend growth stocks, then why can’t someone ordinary like me live off dividends generated by my portfolio for about 30 – 40 years?

To summarize, I plan on creating a diversified portfolio of dividend growth stocks, by slowly dollar cost averaging my way into attractively valued quality companies over time. By only spending the dividend income, I believe I am being more conservative than investors who sell off portions of their assets in retirement, which dramatically the lowers chances of me running out of money in retirement. In addition, I would not be at the mercy of stock market prices and risk selling when prices are low, but I will be getting cash no matter what stocks do. I will be essentially share in the profits of the enterprise and be essentially paid to hold interest in some of the best businesses in the world.

Full Disclosure: Long K, XOM, CVX

Relevant Articles:

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Wednesday, January 21, 2015

Rising Earnings – The Source of Future Dividend Growth

Successful dividend investors understand that a steadily rising dividend payment only tells half of the story. Most dividend paying companies that have been able to consistently raise distributions for at least one decade have enjoyed a steady pattern of earnings during that period of time.

As a dividend growth investor, my goal is to find attractively valued stocks that consistently grow their dividends. I run screens on the list of dividend champions and contenders using my secret entry criteria, and then look at the list company by company. Not surprisingly, I look for a record of increasing dividends. But I look for much more than that in a company.

In a previous article I discussed the three stages that dividend growth companies generally exist in. My goal is to focus on those in the second stage, although I might occasionally select a company from the first phase. However, I try to buy not just companies that have a record of raising dividends, but those that have decent odds of continuing that streak for the next 20 – 30 years. Not every company will achieve that, but for those that do, they would generate the bulk of portfolio dividend growth. The hidden source of dividend growth potential is expected earnings growth.

As you can tell from looking at my stock analysis reports, I look for companies that can increase earnings per share over time. Rising earnings per share can essentially provide the fuel behind future dividend growth. For example, Colgate-Palmolive (CL) has increased dividends for 51 years in a row. Over the past decade, it has managed to increase EPS from $1.17 in 2004 to an estimated $2.93/share for 2014. This has allowed the company to increase annual dividends from $0.48/share in 2004 to $1.42/share. The rest has been invested back into the business, to fuel potential for more earnings growth.

A company that is unable to grow earnings over time can only afford to grow dividends for so long. For example, Diebold (DBD) has managed to increase dividends for 60 years in a row through 2013, and had a very current yield. Unfortunately, the company has been unable to grow earnings as of lately, and the dividend payout ratio is reaching the limits of what a sustainable distribution could be. As a result, the stock has kept dividends flat in 2014, and as a result its streak of dividend growth is over. Therefore, the list of dividend kings will shrink for the first time since I have been tracking it.

Just as with dividend growth, I take past records of earnings growth with a grain of salt. You want to think about catalysts that would help propel earnings higher. For example, in the case of Colgate-Palmolive, the company has strong branded and relatively inexpensive products that consumers buy on a frequent basis. Most of these purchases are repeat business for Colgate – Palmolive, and consumers tend to stick to the brand of say toothpaste they have been using for years. Most consumers will stick to a brand whose quality they trust, and might not even notice a slight increase in prices over time. If you like Colgate toothpaste, and you care for your teeth, you would not substitute it for a generic brand that might be 50 cents cheaper. With this pricing power, Colgate can effectively manage to pass on costs to consumers. This could result in rising profits over time.

You can see that the qualitative analysis is important. If a company has strong brands, and competitive advantages, it can afford to increase prices, and that would not affect profits generated from loyal customers. This can generate profits to fuel dividends for years to come. For example, US companies such as Altria Group (MO) sell an addictive product, whose prices have been increasing for years. Despite the decrease in number of users over time, the increases in prices and constant looking for efficiencies has led to rising profits for decades. This stream of rising profits has fueled the dividend growth behind Altria, which has managed to reward shareholders with higher payouts for over 45 years in a row, adjusting for spin-offs of Kraft and Phillip Morris International (PM).

What you want to avoid is companies that offer commodity type products, companies that could lose leadership positions due to technological change as well as companies that are cyclical in nature. A commodity company is usually a price taker, not a price setter, and therefore does not have the pricing power of a Coca-Cola (KO) or Colgate – Palmolive for example. This can lead to erratic earnings, as prices would fluctuate depending on economic conditions for example. As a result, very few steel companies have managed to maintain an unbroken record of rising dividend payments. The only exception seem to be oil companies, some of which have been able to reward shareholders with rising payouts for over 25 years. This could be due to the nature of oil and natural gas, which once used, cannot be re-used, unlike other commodities such as steel and gold.

You also want to avoid companies which have gotten temporarily lucky. A prime example include some gold companies, which have records of raising distributions for one decade. Unfortunately, this coincides with the boom in gold and silver prices since the bottom in 1999. Even worse, many of these companies have pretty low payouts, which might make it easy to become a dividend achiever, but the paltry yields would be a turn off for investors.

Last, but not least, companies whose products or services could be deemed obsolete by shifts in technology, will not be able to earn sufficient profits to maintain a growing stream of dividend payments. Technology companies seldom have the durable competitive advantages that would make them holds for 15- 20 years. I cannot predict whether Intel (INTC) would still be in a competitive position in 2028 – 2033, or its products would be obsolete. However, I can pretty reasonably expect that people would still eat their favorite potato chips made by PepsiCo (PEP) or drink their favorite Coke or another one of the 500 drinks that the Coca-Cola Company (KO) makes.

In summary, a company that manages to grow earnings over time, should be able to afford to reward shareholders with a growing dividend income stream. Investors should analyze each company in detail, and determine if it has the qualitative characteristics that would allow it to grow earnings. If those characteristics are met, then the job of the investor is to acquire such securities at reasonable valuations as part of their diversified portfolio.

Full Disclosure: Long CL, PEP, KO, CL, MO, KRFT, PM, MDLZ

Relevant Articles:

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Monday, January 12, 2015

How to invest a lump sum

Imagine that you are able to receive a lump sum today, due to an event such as a sale of a business, cashing out of a pension, inheritance or winning the lottery. After you rejoice a little, you start asking yourself what to do with the money. I keep asking myself the same question quite frequently, and think my way through this “problem”.

If I received a lump-sum payment today, I would approach it differently, depending on the level of experience I have, the time I am willing to commit to investing per week, and the level and effort of continuing investing education I am willing to commit myself to. For sake of comparison, lets imagine that I am about to receive $1 million tomorrow.

The easiest option is to build a portfolio consisting entirely of mutual funds, covering indices such as S&P 500, US Total Market Index or a World Total Market Index. This would be in a situation where I didn’t know much about investing, didn’t have the time nor inclination to spend too much time on it, or decided it would have been too big of a hassle for me to pick stocks individually. I would basically put the money in a ladder of Certificates of Deposit first, and have an equal amount of those CD’s expire every month for 24 – 36 months. That way, I am mentally removing the pressure of having to invest all money at once, and I am also removing the opportunity to invest most of the money in my cousin’s business idea of a social network for cats (Catbook anyone?). As an equal amount of money is available each month, I will have it invested in the mix of stock funds. The purpose of dollar cost averaging is to avoid putting all the money at once, in order to avoid the risk of putting the money at the highest prices. By investing an equal amount each month, I am increasing chances that I will get decent prices for stocks I buy, and avoid overpaying. I will also miss out if prices keep going straight up for those 24 – 36 months, but that would be a risk worth taking, since it would also mean I would not put all money right before a major correction. The conventional way of this portfolio is to sell a portion each year to cover expenses. This could work in most situations, unless of course the stock market is down right when you start withdrawing or if the stock market is flat for the majority of time.

The other option I would take if I were willing to put the time and effort into it would be to invest the money in dividend paying stocks directly. I would still start with a CD ladder however, and put equal amounts into attractively valued dividend paying stocks every month for 24- 36 months. I would start by screening the list of dividend champions and dividend achievers every month, identify companies for further research, and put an equal amount of funds into the ten most promising ideas every single month. I would rinse and repeat every single month for 24 – 36 months. Over time, I should be able to gain some sort of understanding behind a large portion of those dividend champions, through regular reading and research about these companies. As the knowledge of each company is accumulated, it would be much easier to act. This process could take a lot of time at first, since it would require spending time researching whether the companies that met a basic entry screen are worth my money. After that however, additional follow-ups on each company should not take that much time each year on average. My goal would be to have a portfolio consisting of at least 40 different dividend paying stocks, representative of as many sectors as possible. That doesn’t mean owning utilities just so you own utilities. It means buying into companies selling at attractive valuation, but also making sure that I do not concentrate too much in a particular sector such as financials for example.

I would also build a portfolio around the three different types of dividend growth companies I have previously identified. The biggest mistake to avoid is focusing only on current dividend yield, without doing much additional work about its sustainability, potential for growth, understanding of the business etc.

Living off dividend income is pretty easy, once a portfolio is set up. When I receive dividend checks directly deposited in my brokerage account, this is cold hard cash I can do whatever I want with. I do not have to stress over whether we are about to enter a bear market, and I would run out of money simply because prices are depressed. I would receive cash dividends, which will get increased above the rate of inflation over time. I would likely accumulate all dividends for a three month period, then spend it equally over the next three monhts. If there is anything left over, I would reinvest it into more dividend paying stocks.

I have chosen of course to focus on selecting individual dividend paying stocks. It is cheaper in the long run to build a portfolio of dividend paying stocks, and rarely sell them. I only sell when dividend is cut or eliminated or when stocks are acquired for cash. I also try to outguess valuations from time to time, but my results have proven that I should not do that. In majority of situations, I am better off just sitting out there, doing nothing. This is the most difficult thing to do in investing.

My portfolio is generating dividends every month, quarter and year. The holdings I own tend to increase those dividends over time, maintaining purchasing power of income, and making my shares more valuable. While stock prices fluctuate from year to year, dividend income is always positive, it is more stable, and thus it is better tool to use when designing a portfolio to live off of. Plus, even the cheapest mutual funds that cost say 0.10% per year are more expensive on a portfolio worth $1 million, since they result in $1000 in annual costs. With brokers such as Interactive Brokers, I would have to make 1000 investments at $1/trade in order to reach the same costs per year. In addition, I would be able to hold on to most stocks and only buy shares in companies which I find properly valued, and possessing the characteristics I am focusing on. I could also avoid selling shares and incurring taxable expenses merely because an index committee decides to remove companies from their lists.

I like the fact that the companies I own provide me with fresh cash in a regular, predictable patterns. This is similar to what my experience is when working – receiving a paycheck at an equal intervals of time. With dividend stocks, I do the work upfront in selection at proper valuation, and then receive the cash for years if not decades to come.

In summary, it makes sense to spread out the investment of a lump sum received in order to reduce investment risks, and reduce the impact of mistakes. The investor who manages a considerable amount of funds should have the goal of preserving wealth first, so that it can last for decades. This will be achieved by spreading purchases over time, diversifying the portfolio in at least 40 individual securities from a variety of sectors, continuing their quest for investment knowledge and requiring quality and attractive prices in the types of investments they purchase.

Relevant Articles:

Why Sustainable Dividends Matter
Dividend Portfolios – concentrate or diversify?
Reinvest Dividends Selectively
Dollar Cost Averaging Versus Lump Sum Investing
Diversified Dividend Portfolios – Don’t forget about quality

Wednesday, January 7, 2015

The dumbest argument against dividend paying stocks

One of the dumbest arguments against dividend growth investing is showing a single investment that failed, and thus implying that the strategy is not good. An opponent of dividend growth investing would usually use a company like Eastman Kodak, General Motors, or one of the major banks like Citigroup (C) as an example of type of stocks that investors believed to be buy and hold forever.

There are several logical flaws with this argument.

The first issue stems from the fact that only some of the banks used in this argument have ever been dividend growth stocks at the time of their demise. General Motors, which was one of the bluest of blue chips for decades, had never been a dividend growth stocks, because of the cyclical nature of its distributions. Eastman Kodak was a dividend achiever once, having raised dividends for 14 years in a row through 1975, when the Board of Directors elected to freeze distributions. This was over 37 years before the company declared bankruptcy. Since 1975, the company had raised dividends off and on, but never for more than five consecutive years in a row. After the company cut dividends in 2003 however, no objective dividend investor should have held on to the stock.

The second issue with the argument assumes that there is a strategy that is better than dividend growth investing, which is why failures are always exaggerated, while dividend growth successes are simply ignored. The thing about every single investment strategy out there is that only a portion of the investments you make will be winners. Even Warren Buffett has not made money on every single investment he has made. The man is happy if he can find a 40% hitter, and stick to them. A rational investor cannot expect to win on every investment he or she makes. However, if they maximize their gains by sticking to their stock holdings that are successful, they would more than make up for the losers over time.

The third issue with this argument is that it ignores how General Motors, Eastman Kodak and the banks such as Citigroup were actually part of the S&P 500 or Dow Jones Industrial's Averages at the times of their dividend suspension or cuts. These companies were once regarded as the bluest of blue chips, and were members of all other major proxies for US stocks. If these are examples that should prevent investors from following a certain strategy, it looks like since these companies failed, the argument should be that investors should not buy stocks or should not buy index funds altogether. If investors are afraid that one or several of the companies in their portfolio will fail at some point in the future, they should never invest in index funds, or follow any stock investment strategy. Now that I have stretched the original argument, hope you can see its ridiculousness.

The other issue with the argument is that it ignores the fact that dividend investors hold diversified income portfolios, consisting of over 30 individual securities. If a few companies that the dividend investor has identified fail, that would surely hurt. However, the portfolio base would not be in dire straits, as the rest of the components would pull in their weight and raise dividend income over time to eventually reach record territory once again.

Another item with index funds is that they are not a magic panacea for poor investor performance. If the investor panics during bear markets, takes excessive leverage, or decides to wait in cash for months or years until the prices get cheaper, they might not make much money. Of course, index funds change approximately 5% of components each year. Those indexes look like daytraders when compared to dividend growth investors, who rarely sell, and hold through thick or thin.

The last issue with the argument is that it never provides alternatives to dividend investing. As a dividend investor I have spent thousands of hours researching and fine-tuning my investment strategy, and by digging through the information about the companies I am interested in. I have chosen to follow a strategy because it fits my goals and objectives. I typically ignore naysayers who tell me my strategy is bad, without providing me any clear alternatives to that.

In my dividend investing I expect that roughly 20% or so of companies I invest in will generate the majority of dividend and capital gain profits. The remaining will either break even or produce net investing losses. If the companies in the winning group go up tenfold in value with dividends reinvested over the next 20 years, with 40% doubling on average, while the companies in the losing group lose 50% of their value, I would expect that I would end up with a portfolio that could triple in value over a 13 - 14 year time period.

You are not going to come up ahead on all investments you make in your lifetime. But if on aggregate the ones you own end up throwing up more in income over time, you should do quite well for yourself.

In order to find quality dividend stocks for my portfolio, I start with the list of dividend champions, take them through my screening criteria, and then analyze each candidate one at a time. I then do the same exercise using dividend contenders/dividend achievers lists and try to make investments every month in those that offer the best values at the moment.

Full Disclosure: None

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Monday, December 22, 2014

Should you purchase dividend stocks at 52 week highs?

Many investors I know follow different investment principles, such as that to "Buy low, sell high" and "Buy and hold forever". To many investors, purchasing dividend paying stocks at 52 weeks highs or all-time-highs seems like anathema, since it would run contrary to their beliefs of buying low.

I expect businesses I own to keep expanding, selling more products, generating higher revenues and earnings, while showering me with more cash dividends each year. In the meantime, those rising earnings and dividend make businesses more valuable over time, as they increase their intrinsic value. Therefore, in a somewhat efficient marketplace for securities, I expect stock prices of successful businesses to follow and keep hitting all-time-highs over time. Of course, I do not focus on stock prices as much, as I do on values. I have found that focusing too much on meaningless short-term stock price fluctuations is not helpful to my long-term wealth building. This is because I feel the urge to do something, which is dangerous to the compounding of wealth. As a long-term investor, the goal is to set-up a portfolio, and look at annual reports, and quarterly press releases as well as major announcements such as dividend increase, mergers & acquisitions to name a few.  I focus on valuation today, compare valuations between different companies between industries, and make estimates of future growth based on sustainability of business model ( does the company have any moat).

Many of the quality businesses I focus on here tend to increase intrinsic value over time. As a result, waiting for the perfect price might let you sitting in the dust. This doesn’t mean to throw all caution out the window and buy regardless of valuation, and without requesting some margin of safety in the event that future is not as rosy as expected. However, if you find a company that sells at an all-time high and say 19 – 20 times earnings, you might have to start accumulating shares if you believe there are good prospects down the road. If earnings per share double in seven years, and the P/E compressed to 15 – 16, the stock could still end up much more expensive in 7 years. If you add in the missed compounding from reinvested dividends, the opportunity cost of sitting in cash might be pretty high.

If you think about it, the all-time high of Coca-Cola from 1987 is much lower than the range it sells for today. In fact, if you purchased Coca-Cola at 52 week highs as long as it sold below 20 times earnings throughout history, you would have done pretty well for yourself. It is true that it is much better to buy quality dividend growth stocks at the lowest prices possible. If you have a long-term horizon like me, that spans at least 15 – 20 years from now, you can afford to view one or two year periods as mere noise.

To me, it is more important to focus my attention on the best values at the moment, and then analyze them for future growth. If the best value today sells at an all-time-high, I would not be worried. I actually read a study, which found that actually purchasing companies that hit all-time-highs has resulted in above-average gains to investors. I know that this was more of a timing strategy than buy and hold, but the results are nevertheless very interesting. The more experience I gain, the more I realize that getting the right entry price is important. However, it is much more important to identify a quality earnings and dividend grower, which manages to earn more money over time, and thus making the business more valuable. If the company has the type of business that sells a unique product, has strong pricing power, and has great earnings growth visibility, then it is fine to pay 20 times earnings for it. This is the type of situation that Warren Buffett describes in his famous saying " It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

My dividend growth strategy is essentially a strategy of following long-term trends in company fundamentals, specifically their dividend rates. Essentially, once I purchase shares in a company, I hold on for as long as the company raises dividends. Even if a company stops growing dividends, I will keep holding on to it, but allocate them elsewhere. It is important to reinvest dividends selectively, into the best values and qualities found at the moment, and not mindlessly reinvest into the same company regardless of valuation. If valuations become too overstretched however, such as in situations where future growth expectations do not justify a P/E of 40, it might make sense to dispose of the security. The situation where I typically have done most of my selling is after a dividend cut. I have found in analyzing my investments that selling a mildly overvalued company to purchase a mildly undervalued is mostly a mistake. If I identify a mistake in the original thinking I may have done, that led me to an investment in the first place, I would sell as well.

On the other side of the equation, just because a company is cheap, and is selling at a 52 week low does not mean it is an automatic buy. Investors who only focus on stock prices, without understanding anything about the business, growth prospects, are probably speculating.

To summarize, just because a company is selling at a 52 weeks high, does not mean that it should not be considered or it should be sold automatically. A new investor should evaluate the value by looking at business fundamentals, catalysts for future earnings growth, and valuation before committing their hard-earned money to work. For those who already hold shares in a company which is hitting a 52 week or an all-time-high,  they should continue monitoring their investment, and check whether earnings are growing and that there are catalysts for further growth. One of the hardest things for investors to do is to just hold on to their best ideas, as they prove them right, and not sell and buy something that appears cheaper but leaves the investor worse off in the long-run.

Full Disclosure: Long KO and BRK.B

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Wednesday, November 19, 2014

Independent thinking for successful dividend investing

I enjoy dividend investing, because it is always challenging but it is also very rewarding. I have a set level of basic guidelines such as my entry criteria I apply on the list of dividend champions and achievers, in order to identify companies for further research. I then maintain a list of companies that I have analyzed, which I monitor very often for any weakness for a buying opportunity. In addition, I also monitor my existing positions in order to identify any laggards that are either cutting dividends or might not deliver as much as previously expected.

My investment analysis goes beyond reading annual reports and research. I also try to learn as much as possible about the stock market, investing and general business knowledge. In other words, I keep learning as much as possible in order to make myself a better and more rounded investor. Most of things I learn go through my filters, and are rejected as unsuitable for my strategy. Some investment gems are tested and a few are implemented in my tools of the trade. I do eat and breathe investing, and the knowledge I have accumulated in the process has allowed me to develop an independent view on the subject, which works for me. I invest my money based on my own analysis, and end up earning dividends and capital gains, although sometimes I generate capital losses in the process. Surprisingly, I have often found that I am usually right when most other investors are opposed to my ideas.

Sometimes, I also learn from the intelligent comments from my readers. A lot of the times however, I end up interacting with investors who clearly should not be putting their money in anything else than an FDIC insured bank account. Many times these investors are arguing with me, and end up informing me that my view is incorrect. After reviewing their objections, I typically find out that these investors are not performing objective analysis of investment situations either because they are blinded by high current yields or because they are not taking into account some other factors. A third scenario that could sometimes include bits and pieces of the items mentioned earlier is the situation where investors are simply following someone else, without doing their own due diligence.

Back at the end of 2012, I posted an analysis of Abbott Laboratories (ABT), right before the company split into Abbott and Abbvie (ABBV). At the same time I also mentioned that I had recently added to my position in the legacy Abbott Laboratories. While many investors had valid comments about this investment, there was one investor whose main concern was very flawed. If they had mentioned that Abbott was not the wisest decision, stemming from the fact that it was not possible to determine if the two new companies would continue the long streak of dividend increases or that synergies between the two companies would disappear after the split, that could have been a concern worth raising. However, the main argument from the investor with the flawed thinking however was that David van Knapp had recommended selling the stock.

I think that blindly following someone’s advice to be the worst sin of investing. If you follow someone’s ideas to purchase a stock, you are immediately at a disadvantage because you would not be the first one to learn about future investment moves. In fact, if the original “guru” ends up selling their position, without notifying the follower, the follower might end up losing money. In addition, if the “guru” buys a stock, which then promptly falls by 50% or more, as plenty of good quality stock prices did in 2008, an inexperienced investor might get scared, and sell at a loss. You might think that only inexperienced investors do this, but in reality everyone is influenced by authority a little bit. I sometimes find myself influenced by authority figures such as Warren Buffett, and thus justifying certain investments with the mere fact that Buffett has purchased them for Berkshire Hathaway (BRK.B). Following a guru however, is never a good reason to purchase or sell a stock. However, performing an analysis of a stock that a guru purchases, and then determining if it is a buy is perfectly fine.

Back in early 2010, I analyzed Realty Income (O), and found it to be a buy. However, many investors dismissed my analysis, because hedge fund manager Bill Ackman was short the stock. Yet, his thesis was flawed, and contained a lot of holes - and the investment has doubled since then. I held on to my stock during that time period, and added to it. Back in 2013, another investor was short Digital Realty Trust (DLR). I called our his manipulations and held on to my position. Someone on Seeking Alpha objected to my analysis, and their primary argument was that I was not a billionaire. Yet the conviction in my own analysis provided me the strength to hold on to my stock positions. If I had merely followed someone blindly into a stock, I would have bailed out at the first sign of trouble.

Another interesting factor about dividend investing is that some investors simply refuse to do their own independent research. One of the questions I always receive from investors is for the list of my current portfolio holdings. I first posted a snapshot of my portfolio four years ago, but since then the page has been out of date. I have since shared my dividend holdings with subscribers of my mailing list. There is a reason why I don't make this list easily available, unlike other sites dedicated to dividend investing. My thinking is that if I posted my holdings, I would actually be doing a disservice to novice investors. I would much rather have patient readers who review my thought process through my regular postings that describe somewhat recent events, from which they could hopefully learn something. If I posted my portfolio and made it easy for anyone to check it, I would usually risk someone seeing what I owned and then purchased it without giving much thought about it. Unfortunately, my portfolio has been built slowly over a timespan exceeding several years. Just because I found Family Dollar (FDO) to be attractively valued in 2008 and initiated a position at $24.99/share, might not mean that Family Dollar is a buy today at $77 - $78/share.

Full Disclosure: Long O, DLR, FDO, ABBV, ABT

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Tuesday, November 18, 2014

What should I do about those non-dividend paying stocks I received in a spin-off?

In a previous article, I discussed the idea of dividend investors holding non – dividend paying stocks. After I wrote the article a few weeks ago, I realized that I have received/am about to receive shares in two companies, after them being spun-off from their parents.

I receive one share in CDK Global (CDK) share for every 3 shares of Automatic Data Processing (ADP). Based on reading the dividend policy of this company, it is unclear whether they will be paying a dividend in the foreseeable future. Based on expected earnings of $1.37 - $1.39/share, the stock is selling for 26.30 - 26.70 times forward earnings, which is pricey. If we get high single digit earnings growth however over the next decade, it could be worth to hold on to this business.

I receive one share of Halyard Health (HYH) for every 8 shares of Kimberly-Clark (KMB). The company has stated that no dividends are expected to be paid. The company earned $154.6 million in 2013, and has approximately 46.5 million shares outstanding, which equates to approximately to an EPS of $3.30/share. Thus, the company is selling for approximately 11.50 times earnings, which is pretty cheap. While revenues have been stagnant for the past 3 years, net income has grown slightly. If they manage to streamline operations, repurchase stock or start growing income organically, shareholders could do pretty well by holding on. If they initiate a dividend and start growing it, I would have less reasons to not hold on to the company.

So I am trying to decide what to do. I basically have two options:

1) Sell

This sounds like a logical option for someone who calls themselves a dividend growth investor. If my goal is to earn more in dividend income from my portfolio, it would seem a waste of capital to hold shares in companies that do not pay dividends. I could essentially sell the shares, pay the capital gains taxes, and reinvest the proceeds in something that pays dividends. Since my goal is to earn more dividend income from my capital, I should not hold on to shares in companies which have mentioned that they won’t continue the legacy of regular dividend growth of their parent companies.
For some investors, having two extra companies in their portfolio would probably trigger a sale, because it would exceed a self-imposed number of companies they want to own. In addition, many index funds that held Automatic Data Processing (ADP) in their portfolios, were selling shares of CDK Global (CDK) merely because CDK was not a member of S&P 500, without questioning whether CDK is a good business to own.

2) Hold

I could also just sit tight and hold on to those shares. This is because stock spin-offs usually do really well, as the new company gets management whose sole focus is on managing it, rather than a division whose goals and needs are lost in a larger company. In addition, I have found through an analysis of the sales I have made that selling a company and buying another one usually results in poor results. This is because I pay capital gains taxes on the gains, which leaves me with less money to reinvest. In addition, I have reinvestment risk if I sold and bought something that doesn’t perform as well. The more time I spend reviewing investments, the more I realize that the biggest risk is not that a company goes to zero, but that I miss out on a potential for large gains.

Conclusion

I believe that I will simply hold on to those shares for the time being. In addition, despite the spin-offs of shares, my total dividend income will be unchanged since Automatic Data Processing (ADP) and Kimberly-Clark (KMB) are holding their dividends per share steady. Update: Actually ADP just increased their dividend by 2% to 49 cents/share, citing the high payout ratio as a reason for the slow increase. This dividend champion has grown dividends for 40 years in a row, and is targeting a dividend payout ratio of 55 - 60%.

The position in Halyard Health (HYH) is really small, since I received 1 share for every 8 shares of Kimberly-Clark (KMB). So the amount I received is roughly equivalent to the dividend from Kimberly-Clark (KMB) for 1 - 1.5 years. Based on my study of historical Kimberly-Clark spin-offs, it might pay off to sit tight, rather than lose capital to taxes and reinvestment risk.

There was a spin-off from Kimberly-Clark in 2005, called Neenah Paper (NP). The company was paying a quarterly dividend of 10 cents/share that was unchanged for about 6 years, until it started raising it to about 27 cents/share in 2014. Thus, if you held for 10 years, your dividend income would have increased by 170%, which is not bad at all. Either way, the investor in the company earned a total return of 7.50%/year since the spin-off. The investor in S&P 500 earned approximately 7.70%/year.

There was another spin-off from Kimberly-Clark in 1995, called Schweitzer-Mauduit International Inc (SWM), which made cigarette paper and related tobacco products. That company didn’t pay a dividend for the first 6 months after spin-off, and started at 7.50 cents/share every quarter in 1996. The dividend was held steady until 2012, after which it has been increasing to 36 cents/share every quarter. This goes to show that the most in profits is made by the patient investor, who holds on to their ownership through thick and thin, and doesn’t get scared away easily. Of course, waiting for a dividend increase for 16 years is a tough proposition. Either way, the investor in the company earned a total return of 10%/year the spin-off. The investor in S&P 500 earned approximately 8.40%/year.

The position in CDK Global is slightly larger, but not by much. A previous spin-off from ADP called Broadridge Financial Solutions (BR) has done pretty well, and has paid and increased dividends to shareholders since 2007. It paid a quarterly dividend of 6 cents/share in 2007, which increased to 27 cents/share by 2014. The company has done much better than an investment in S&P 500 since 2007, by providing a total return of 172% versus 67% for the stock index.

The more important thing is for those companies to be able to grow earnings per share. In addition, it is possible that they pay a dividend at some point in the future. After looking at the sales and earnings trends for the two companies over the past few years, I believe that those would be decent investments. I will wait for one or two years’ worth of performance as separate businesses, and see how promising they are as investments. At that stage I will decide whether it is worth holding on to those companies, based upon their business performance.

Update 11/20/2014: CDK (Name: CDK GLOBAL INC) announced a cash dividend with ex-dividend date of 2014-11-26 and payable date of 2014-12-29. The declared cash rate is USD 0.12.

Full Disclosure: Long KMB, ADP, CDK, HYH

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Wednesday, November 12, 2014

Successful Dividend Investing Requires Patience

We live in a fast paced world, where we are constantly bombarded by information on something that makes us want to act quickly. Unfortunately, that is not the successful set of skills that you need as a dividend investor. The best dividend investors are those who buy a stock, and then let it quietly compound their income and capital over time. I know that many think they can do it, but in reality, few have the stamina to sit through extended periods of “temporary punishment”. Very often, investors give up on a company after an extended period of below average performance. After that happens, the things revert to the mean and the truly patient shareholders with a long-term vision are rewarded.

Those who got scared easily ended up with emotional scars for life and most probably failed to learn the lesson of what successful dividend investing is all about. The secret sauce is that one needs to select a company that fits their entry criteria, research it both qualitatively and quantitatively, and then let it compound their capital without really worrying too much about quarterly noise and even annual noise. You have to be patient, and not be scared by temporary periods of weak performance. Sometimes things look bleakest right after the tide turns positive. If you try to jump in and out of companies, you are very likely to incur so much in investment expenses, tax expenses and lost opportunity costs, that will result in a very poor investment record. The truly successful dividend investor knows they will have some losers, but that their winners will do so much better on average, that they would still generate an adequate portfolio return over a 20 – 30 year period. It is difficult to say whether a problem that everyone is talking about is a temporary or a long-term one that will result in the demise of the company. This is why I ignore most opinions out there, and keep holding and investing. It is tough to say if a weakness is a random item, or a beginning of a pattern until it is too late. I believe that no one can predict the future, which is why I try to ignore speculation which might or might not turn true. The dividend investor will have nerves of steel in their conviction, and hold on through thick and thin, despite the loud noise out there. The dividends they receive will be used to acquire more shares in the best values at the moment, or spent if they are in the distribution phase of their dividend investor lifecycle. Now, if the dividends are cut or eliminated, that itself signals that the reason the company was able to have a dividend growth streak is probably not valid after all. This is the situation when I sell right away, and ask questions later. Until then, I hold on.

We often hear the story of how someone could have put $1,000 in Johnson& Johnson (JNJ) in 1972, then let dividends compound for decades and ended up with a stake worth approximate $97,500. The reality is that in order to earn that handsome return, the investor would have had to sit through difficult periods that would have tested their conviction time and again. For example, it would have been difficult holding a stock through the 1972 – 1974 correction. It would have also been difficult to hold on to Johnson & Johnson through 1983, when the stock price finally exceeded the all-time-highs. It would have also been difficult to hold on to the stock during the Tylenol recalls in 1982, when you are bombarded by terrible news all the time. For me, it was difficult to hold on to shares of Johnson & Johnson in 2010, when I got bad news about recalls. It is difficult for most investors to hold on to a company where prices have gone nowhere for a decade. I got this response a lot when I first started my site and analyzed companies . As a dividend investor, it is rewarding to get paid for waiting, and receive a higher dividend check every year.

Nowadays, it is tough to hold on to shares of McDonald’s (MCD), as the popular opinion discussed how unhealthy the food is, how the minimum wage will rise to $15/hour, how the millennials are not going there etc. The reality is that same store sales have stagnated, and earnings per share growth has slowed down in the past couple of years. It is yet to be seen whether this is a real trend or just a temporary situation. In addition, McDonald’s is often compared to other chains that are relatively new and therefore have a lower base to grow from. And according to the WSJ, most millennials are still eating there, although the amount going to eat elsewhere is increasing from a smaller base slightly quicker. If you stop by your local McDonald’s, you see people waiting in line, going through the drive through, and eating their lunch in. The company is still unmatched in its scale of operations, and still manages to sell its products to millions of customers around the world. The globally recognizable brand name is still there, the premier locations are still there, and the innovation that resulted in the earnings growth that made 38 years of record dividends possible is still there. It is a given that blue chips stumble from time to time. This was true with McDonald’s in 2002 – 2004. It is true again with it in 2014. If you sold then ( in 2002 - 2004), you missed out on capital gains and dividends that were roughly several times more than the amount you had at risk.  I like the fact that I am essentially paid for holding on to my McDonald’s shares, which are attractively valued today. I can and have used those dividends to acquire stakes in other dividend paying companies. This means that if I hold for 20 years, and the dividend increases by just 3% per year, I will likely receive as much money in dividends as I paid for the stock today. Plus, I would still have ownership of McDonald’s (MCD), the results of which can be pretty satisfactory without even considering the dividends. Of course, a 3% annual dividend growth in dividends sounds very low, and I only used it to illustrate the point that shares are offering a good return opportunity today. The lower the shares go, the better the opportunity in my opinion.

It might sound counterintuitive, but companies can provide very good returns to long-term shareholders even if their revenues stagnate. For example, investors in Sears in 1993 did slightly better than the S&P 500 benchmark over the next 20 years. This was due to unlocking value through spin-offs, regular dividend payments, share buybacks, cost cutting and asset sales. McDonald’s (MCD) has a lot of real estate, and a lot of restaurants it can refranchise, thus further increasing the amount of cash it could send the way of shareholders. Imagine how much more dividend income you can receive if McDonald’s spins off its real estate and converts it into a REIT? Even today, if an investor manages to buy the shares at close to a 3.50% - 4% yield, and then earnings and dividends only grow by 4.5% - 5%/year, they should earn a 9% total return. To give you some perspective, the lowest annual dividend growth by McDonald’s was by 4.50% - 5%/year in the late 1990s and early 2000’s. So I am describing again a very conservative scenario from a historical perspective. If that investor reinvests dividends automatically every quarter, their return will be further enhanced if the share price is depressed and thus they earn a higher yield on reinvestment than the above stated one.

Either way, I plan to hold on to my investment in McDonald’s, until management proves me wrong and cuts the dividend. If they freeze the dividend, I would no longer add money to the position (except for my IRA, where it makes sense to automatically reinvest them due to cost/benefit). Furthermore, my downside is protected because McDonald’s has a 2% weight in my diversified dividend portfolio. My largest 40 positions account for 90% of my dividend portfolio value. This helps me sleep well at night even in the highly unlikely scenario that I am wrong. The outcome of this investment will be visible in 2024-2034. Let’s circle back on this article then.

In conclusion, the important thing for investors is to have a strategy for stock selection, and stick to it through thick and thin, while ignoring noise. Investors should also have the patience to hold on to their position as part of a diversified portfolio, in order to let the power of compounding do its magic. Not all dividend investments will work out, but it is tough to say which ones will provide the blockbuster returns in the future. This is why it is a mistake to cut the opportunity for capital gains and dividends too quickly, and disposing of investments.

Full Disclosure: Long MCD, JNJ

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Wednesday, October 29, 2014

Key Ingredients for Successful Dividend Investing

There are four key attributes that need to be considered, in order to be successful at dividend investing. These ingredients include focusing on quality, earnings growth, entry price and sustainable distributions. In this article, I would focus in more detail behind each of these four items.

Quality

I believe in purchasing quality dividend paying companies. This means that I try to focus on companies with strong competitive advantages, strong brand names and/or wide moats. Companies like that offer a product or service which customers desire, and are willing to pay a price which would deliver a fair profit. In addition, companies which offer products which are perceived to have quality characteristics, which typically translates into repeated purchases of the goods or services. In addition, companies that offer a unique product or service are able to compete based upon the added value they bring to the marketplace, and avoid costly price wars with competitors. Furthermore, the company would be able to have pricing power and pass on costs to customers, which will be much less likely to switch to another product. I understand that quality lies in the eyes of the beholder, but through experience, dividend investors should be able to uncover quality dividend paying gems.

Earnings growth

My strategy focuses on purchasing shares in companies which will grow dividends over time. In order to achieve that however in a sustainable manner, companies need to be able to grow earnings. Businesses that manage to grow earnings also tend to become more valuable over time. I also prefer to focus on earnings per share rather than total net income. Companies can grow earnings either by expanding in new markets, introducing new products, marketing existing products to new customers, acquiring competitors, cutting costs or raising prices. I like to read about companies which have specific earnings growth targets. Coca-Cola (KO) is anexample that immediately come to mind when I think about specific growth plans, as I outlined in an earlier article. I also like to see companies riding a long-term economic trend. Many of the companies I own in my portfolio for example will benefit from the increase in number of middle class customers in emerging markets such as China and India. Others like Eaton Vance (EV) or Ameriprise Financial (AMP) will benefit from the increased need for financial products that generate income in retirement by the millions of baby boomers that are expected to retire over the next two decades.

Entry price

The price at which shares are acquired matters a great deal to investors. Even if an investor has identified the best dividend growth stock in the world, with the widest moat, and excellent prospects for earnings and dividend growth, they could still end up losing money for extended periods of time. The reason is that even the best dividend stocks are not worth owning at any price. If you overpay for your stocks, you might end up with losses or not gains to show for your efforts for extended periods of time, even if the underlying fundamentals improve according to your initial plan. In an earlier article I argued that this was one of the main reasons behind the so called “lost decade for stocks” in the US in the early 2000s. Companies such as Coca-Cola (KO) and Wal-Mart (WMT) were grossly overvalued in 2000, which is the primary reason why the stocks didn’t generate much in total returns over the next decade, despite the fact that earnings and dividend increased substantially during the period. I am not proposing that investors time the market and only invest when stocks are super cheap. Instead, I focus on screening the dividend growth lists for attractively valued companies on a regular basis, and then analyze in detail the companies that are spitted out by my screen before adding money to them.

Sustainable distributions

The next key ingredient for successful dividend investing involves the sustainability of distributions. Investors who purchase dividend stocks for income should check whether the company is able to adequately support distributions from current earnings or cash flows for certain entities such as Master Limited Partnerships or Real Estate Investment Trusts. For most corporations, a dividend payout ratio below 60% is generally preferred. A higher ratio could jeopardize the dividend payment even if earnings dip temporarily. That being said, even if a company has a sustainable payout at the time of purchase, over time it could become unsustainable if it grow distributions faster than earnings or earnings decrease due to tectonic shifts in the business model. The best situation I like to observe is when earnings and dividends grow at similar rates. For new dividend payers I typically observe situations where dividend growth is higher than earnings growth up to a certain payout ratio, after which it closely trails growth in profitability.

While investors could argue that one cannot put success in a pre-packaged recipe for achieving it, I have found the four ingredients above to be essential for my income investing strategy.

Full Disclosure: I have a position in all companies listed above

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