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

Wednesday, April 16, 2014

When to sell your dividend stocks?

Ideally, your holding period should be forever. Investors who purchase shares in prominent dividend paying companies with the intent of flipping them within a few months are likely to make a lot of mistakes. This is because by frequently buying and selling stocks, investors incur costs such as taxes and commissions, which drain their capital. Studies have shown that the investors who make the most trades per year tend to earn mediocre returns at best. This is because a successful investment would likely pay in rising dividends over many decades to come. A lousy investment would be one where dividends are cut or eliminated as earnings per share decline. Even the best businesses can experience such adverse situations a few times during their lives. A patient investor should let the company work its problems out, especially given the fact that they are in it for the long haul, as long as dividends are at least maintained. You have already delegated your investment in the hands of company management indirectly, who work to increase earnings and pay you the dividends. Thus, micromanaging business conditions does not strike as particularly rewarding. Many times companies fall onto hard times, and keep a dividend frozen, only to resume increases in a few quarters or years. Just think of General Mills (GIS), which has paid dividends for over 115 years, and has never cut it. There have been times where it achieved a streak of 30+ years of consecutive dividend increases, followed by a few years where dividends were frozen.

An impatient investor who sells after dividend freezes might increase portfolio turnover dramatically, increase their investment costs, and sell securities which have experienced temporary turbulence. For example, in 2009, Hershey (HSY) froze dividends, thus ending a 30 year streak of dividend increases. Selling would have been a mistake, as the company resumed increases a year after it kept distributions unchanged. The dividend has since increased by over 60%, which is not too bad for a five year holding period.

When a dividend is cut or eliminated however, this is management’s way of saying that things are indeed bad. Dividends are a sacred cow, which might be frozen from time to time, but very rarely cut or eliminated. As a result, a dividend cut shows that this business is likely in trouble. As a dividend investor, this is when I decide to sell my position automatically. This safeguards the capital left, and provides a fresh perspective after the sale is done. The reason for this automatic sale is to prevent me from being overly emotionally attached to a stock, and rationalize my holding until it is too late. For example, dividend investors in Bank of America (BAC) enjoyed a rising dividend for 30 years in a row, before the dividend was cut two times between 2008 – 2009. This took the quarterly dividend from 64 cents/share to 1 cent/share If you sold right after the first announcement, you could have managed to get out around $29 - $30/share. If you held BAC stock for the past 20 years however, and you rationalized that the bank would eventually bounce back, you suffered from no dividend income on this portion of your portfolio for 5 - 6 years in a row. Sometimes, admitting mistakes is difficult, but costly if nothing is done about it.

If the dividend cut is reversed and the company initiates or increases dividends, you can get back in. In a typical dividend growth portfolio consisting of 30 – 40 securities, I would expect a dividend cut to occur at least once per year. On the bright side, if 39 portfolio holding raise distributions by at least 2.50%, and one completely eliminated distributions, your income will stay flat. Chances are however that the 39 companies will increase dividends by 6%/year, and the capital you deploy from the dividend cutter will generate some return when invested elsewhere.

Full Disclosure: Long GIS

Relevant Articles:

- How to Manage Your Dividend Portfolio
How to analyze investment opportunities?
When to buy dividend paying stocks?
Where to search for investment opportunities?
How to identify your dividend investment goals

Monday, April 14, 2014

How to monitor your dividend investments

Once an investment is purchased, it has to be monitored frequently. While monitoring is important, it is also important to avoid too much action with your investments. The hardest part of dividend investing is sitting and doing nothing for years if not decades. The good businesses will usually take care of themselves, while the bad businesses may produce some dividend payments for you for a few quarters before cutting them or eliminating them completely.

The way I monitor investments is by focusing on annual reports and maybe quarterly reports and press releases. I usually update my stock analysis about once every 12 – 18 months as well. I do this mostly to aide me when deciding to buy a stock or not. I discuss the conditions that would cause me to sell in the next chapter. An investor should apply extreme caution to dealing with information that is noise, and does not really present you with material information about the business you own. Examples include analyst opinions on stocks, news articles from mainstream media sources or TV commentary from the likes of CNBC. You should apply your judgment in determining whether you would benefit by listening to this noise.

In the analysis, I look for rising earnings per share, dividend per share, sustainability of distributions and how the business is doing. If you have spent a lot of initial time learning about the company, there would not be much to learn from year to year. For a period of several years however, you might learn about new acquisitions, divestitures, and plans on how to grow the business. You should be careful if management focuses too much on growth at any price, as this could result in poor performance in the fundamentals that matter to you as a dividend investor. For example, if a utility company you own is trying to revolutionize energy market by trading energy, electricity and internet bandwidth, without focusing its attention to actual profits, this could be a red flag. This is Enron of course, which was a sleepy company until management got crazy in the 1990’s and eventually bankrupted shareholders and left thousands of employees without a job.

Investors might also monitor investment for extreme overvaluation. For example, a business that is ridiculously overvalued might be better off sold, although this could be evaluated in light of the steep tax liabilities it could produce. Sometimes it might make sense to hold on to a temporarily overvalued business, merely because the investor expects the improving fundamentals will “bail them out” eventually. For example, Coca-Cola (KO) and Wal-Mart (WMT) were terribly overvalued in 1999 – 2000. However, the improved fundamentals eventually bailed investors out. Of course, the capital invested in Coca-Cola and Wal-Mart didn’t deliver much in terms of dividend income, and could have been invested somewhere else. However, if significant unrealized profits were generated, selling and buying something cheaper could have been an exercise in wealth destruction. This is because there are no guarantees that the undervalued security in an overheated market is not a value trap. Therefore, investor would have been better off simply holding off, and reinvesting dividends elsewhere.

One should also monitor positions that go above a certain pre-set threshold. For example, if you hold 40 individual securities in your portfolio, each position would account for 2.50% in an equally weighted portfolio at the start. Over time however, it would not be unreasonable to have a position or two which turn out to be outstanding winners, and prove to be multi-baggers ( they increase in price several times above your purchase price). If such a position now accounts for 10% of portfolio value and dividend income, it produces a larger strain on portfolio income for diversification purposes. If you are in the accumulation stage, you can simply add new funds and dividend payments received and apply them to other attractively priced securities. As a result, the overall weigh of the multi-bagger would decrease. In the retirement phase, you can simply reallocate dividends towards other securities. The main idea is to try to let your winners run for as much as possible, and not tinker with your portfolio too much, unless there is extreme overvaluation, dividend cut or a fundamental shift in fundamentals. The only reason why I would always sell is included in the next chapter.

Full Disclosure: Long WMT, KO

Relevant Articles:

How to Manage Your Dividend Portfolio
How to analyze investment opportunities?
When to buy dividend paying stocks?
Where to search for investment opportunities?
How to identify your dividend investment goals

Friday, April 11, 2014

How to deal with new cash from dividend payments

As a dividend investor, you have the luxury of receiving regular cash infusions into your portfolio on a regular basis. During the accumulation stage, you will also have extra cash that you would need to deploy on a regular basis. Even once you become retired however, you might still find a trickle of excess cash finding its way to your bank accounts, that you might decide to put to work in your dividend portfolio. You then have the opportunity to deploy this cash in one of two ways that you believe are the most optimal for your portfolio. The two options are to reinvest automatically (DRIP), or reinvest manually. Another option could be to mix and match both strategies.

Each of those strategies has its pros and cons. The major negative about DRIPing is that investors risk reinvesting distributions into shares without regards to valuation or opportunity cost. It could be very costly in the long run, if you mindlessly allocate dividends received into the overvalued companies that generated them, particularly if more attractive places for this cash are available. This is one of the reasons why I usually combine new cash with dividends received every month, and then make a purchase in my best ideas at the time.

One of the positives of DRIPs is that you are taking immediate advantage of the power of compounding, by putting cash dividends received into more shares right away. That way, you are not wasting time trying to accumulate enough cash so that it is cost effective to make an investment. Plus, you can set it and forget it, and take a more passive approach to compounding your wealth and passive income.

Another advantage of automatic dividend reinvestment is that you are not charged a commission when putting money back into the same stock that distributed cash for you. I do not advise anyone to pay more than a 0.50% in commissions before investing in dividend paying stocks. If you lose a portion of dividend income to excessive brokerage fees, you are shooting your compounding process in the foot. This is why automatic dividend reinvestment is ideal for situations where your dividend income is low, or you cannot add money to this account, in order to justify waiting for a set amount of capital to accumulate in cash.

I only reinvest dividends automatically for my Roth IRA account, which I started in 2013. This is because I can only put $5,500 per year in it, and the amount of dividend income generated per year is a couple hundred dollars. Therefore, it is not cost effective to wait for cash to accumulate and pay an exorbitant commission of over 2%, which would stump the turbocharging effect of growing dividends that are being reinvested. It is much better to reinvest dividends back into the company that paid them for free, rather than taking the time and paying a steep fee in order to reinvest elsewhere. Manual dividend reinvestment is quite inefficient for smaller portfolios with no new additions of capital. For my taxable portfolios, which are the lions share of everything however, dividends are reinvested selectively.

Full Disclosure: None

Relevant Articles:

How to be a successful dividend investor
How to identify your dividend investment goals
Where to search for investment opportunities?
When to buy dividend paying stocks?
How to analyze investment opportunities

Wednesday, April 9, 2014

How to Manage Your Dividend Portfolio

The hardest part about investing is sitting down, and not doing anything. Just monitoring your portfolio even when its quoted value drops by 50% in a given year, is something that only a very small number of investors can achieve. Studies have shown that the most investors usually perform very poorly when making investments. Those that buy and hold on, are a very rare breed. However, these are the types that save a ton in commissions, taxes and have the best chances of generating the most bang for their investment bucks.

Wall Street makes its money if you actively buy and sell stocks. It nickels and dimes you in commissions, bid/ask spreads, annual fees etc. The hedge fund managers and high speed computers are all operating at a day to day or minute to minute time frame. They see orders from small investors as prey. However, as dividend investor, you should not care whether you paid $37 or $37.01/share for Coca-Cola. Your edge lies in the fact that you would hold the stock for as long as it maintains and raises its dividend. This is where your edge against the Wall Street types comes from.

Your other edge as a long-term investor comes from deferring taxes paid to the IRS. If you bought Coca-Cola in 1988 for a split-adjusted $3/share, you are now sitting on an unrealized capital gain of $35 - $36. At 15% in taxes, this is more than what you paid for the stock. Those who buy and sell securities frequently, end up paying a ton to the tax man. Of course, if they are really bad at investing, they can generate a lot of tax deductions for themselves to use for years against taxable incomes.

Your other edge comes from the fact that you should not care how you are doing against a benchmark like S&P 500. Many mutual fund manager are evaluated based on how they did against a benchmark within a 3 month period. This is non-sensical – as quotations in the short run are just noise. You can’t judge the performance of an investment strategy based on short-term period of less than one year. You also have a much better chance of succeeding, if you have a strategy that fits your investment goals and objectives ( see first article in the series). If your goal is to generate a rising stream of income, that would pay for your expenses in retirement, you should not worry that the quoted value of your dividend stocks is down by 50%, as long as the underlying fundamentals are still intact.

What I am trying to show with those examples above is that your portfolio management should be very passive in nature. You should sit tight, and watch your dividends deposited in your accounts.

I usually sell only after a dividend cut. I have modified my criterion of selling if I thought stock was severely overvalued, but so far my results are pretty mixed with that. In retrospect, I would have been slightly worse off sticking with the original investment I sold. Therefore, you should be very careful about selling securities. This is because a factor that might influence you to sell could seem important at the time of sale, but in reality could be just noise in the data. With long term buy and hold investing, you stand the greatest chances of earning the most in dividends and capital gains. The best results are probably still ahead for you. If you think about it, if you focus on strong franchises such as Coca-Cola (KO), Wal- Mart Stores (WMT) and McDonald’s (MCD), chances are that 20 years from now, your investment would likely be worth several times your initial capital outlay. If history is any guide, you can likely expect an annual dividend income stream which is equivalent to approximately 20% yield on cost. Therefore, while your amount at risk is fixed, your upside is virtually unlimited.

There are a few more traps that suck investors into selling their stock prematurely, and therefore not participating fully in any dividend upsides:

- Do not sell simply because you have a huge gain

- Do not sell if your stock trades at a P/E of 23 and replace with a stock with a P/E of 20

- Do not sell because of dividend freeze

- Do not sell because of spin-offs

The most important thing about investing is to be patient. It is true that you won’t make money on all of your stock selections. A portion of the businesses you purchase today would likely be obsolete in 20 -30 years, thus cutting or eliminating distributions, while another portion would likely be mediocre dividend growers. The dividend growth from the remaining winners however would likely more than compensate for the lost dividend income from the losers.

As a result, it is wise to accumulate dividends in cash, and use it to buy the most attractive securities at the time. If a position accounts for more than 5%, do not add to it. Unfortunately, if it becomes 10%, determine if new cash added over next year to other positions can lower positions weight in portfolio. Otherwise, you might need to trim it.

Full Disclosure: Long KO, WMT, MCD,

Relevant Articles:

How to be a successful dividend investor
How to identify your dividend investment goals
Where to search for investment opportunities?
When to buy dividend paying stocks?
- How to analyze investment opportunities

Monday, April 7, 2014

How to analyze investment opportunities?

I have discussed before my criteria for screening dividend stocks. The screen narrows down the list of companies to look into more detail, to a more manageable level. In addition, it makes you focus on a set of companies with minimum set of earnings and dividend growth characteristics which are cheaper. Therefore, you would avoid looking at Automatic Data Processing (ADP) at 26 times earnings that yields 2.50%, and instead focus on researching the likes of Chevron (CVX) at 10.70 times earnings that yield 3.40%.

However, it is very important to avoid being short-sighted in regards to stock screens. This is due to the fact that data could not be fed correctly, or it might be misrepresented in the database you are using. For example, some companies usually record one-time adjustments to earnings. Any astute dividend investor should know to exclude these one-time items from the calculation of price earnings ratios. Back in 2010, Coca-Cola had to record a one-time gain on the acquisition of Coca Cola Enterprises North American Bottling Operations. As a result, the stock appeared as a much better bargain in comparison to PepsiCo (PEP). However, this was an illusion, made possible by the one time gain discussed earlier.

The opposite also happens, where a onetime adjustment could push earnings so low, that the P/E ratio and dividend payout ratios scream avoid. In reality, if a one-time adjustment should be taken out, it would usually show that the stock might be a good opportunity.

This is why simply relying on a stock screen to find ideas is not sufficient. This is also why astute dividend investors should research every prospective buy candidate one at a time.

For every company I look at, I focus on several quantitative factors to begin with:

1) Rising earnings per share over the past decade
2) Rising dividends per share over the past decade
3) A stable and sustainable dividend payout ratio
4) Returns on Equity that are stable over time

I also try to read the annual report, and quarterly press releases from the company. There is usually a lot of information, but not all of it can be actionable. I usually try to understand the company’s business while reading reports. However, the thing I am most interested in is trying to determine if there are catalysts for growth in earnings. Only a company that manages to grow earnings per share over time, will be able to afford to increase distributions for its loyal shareholders.

Companies can grow earnings by selling more products, creating new products and services, expanding in new markets, increasing prices, cutting costs, squeezing out inefficiencies, buying back stock, acquiring competitors to name just a few ways. Sometimes, companies can manage to grow earnings per share through a combination of all of the above. For example, Coca-Cola (KO) can earn much more per share, if it manages to convince the average consumer in China and India to drink as many servings of its product as the average US consumer. The average US customer consumes 401 servings of Coca-Cola product every year, compared to 39 in China and 14 in India.

I usually like to see companies which offer a product or service which is unique, and results in repeatable sales to consumers. I also look for companies that have strong brand names for products or services, which are pursued by a fan base of loyal customers. If the customers really like your product or service, and cannot get it anywhere else due to various reasons, you can have very good pricing power. This could be extremely profitable, if there is a limited amount of government regulation. This is referred to as the business having a moat, or strong competitive advantages.

For example, consumers who like Coca-Cola, would be much less likely to buy a Pepsi (PEP). Therefore, if a store does not offer Coke, customers are likely to go to another store to purchase their daily fix. The same is true for other branded products like Hershey (HSY) bars for example.

Full Disclosure: Long KO, PEP, CVX, ADP

Relevant Articles:

How to be a successful dividend investor
How to identify your dividend investment goals
Where to search for investment opportunities?
When to buy dividend paying stocks?
Check the Complete Article Archive

Friday, April 4, 2014

When to buy dividend paying stocks?

Dividend investors should not view every stock they purchase as a price that fluctuates on a computer screen however. On the contrary, they should view each stock purchased as a share in a business. Therefore, the most important thing to focus on is the underlying strength of the business you are investing in, and not day to day fluctuations in security prices.

Once an investor has a list of quality businesses, he needs to be able to decide at what prices to purchase them.

Fluctuations in security prices should be utilized by the enterprising dividend investor to his or her own advantage. In order to be rational and allocate their money in the most efficient manner, the intelligent dividend investor should have devised a system for buying. This system would allow the investor to acquire shares of quality companies at a reasonable price.

The intelligent dividend investor should know that even the best company in the world, is not worth purchasing at any price. Therefore, they should realize the value of being patient, and only buy securities when they are available at attractive valuations. The number of quality companies selling at cheap prices would vary depending on the conditions on the stock market. During times of Irrational Exuberance, it would be almost impossible to find securities, whose prices are not bid up in the frenzied environment. The opposite happens during stock market panics, when doom and gloom circles the common psyche of scared investors, who rush to unload their holdings at rock bottom prices. During these panics, the number of bargains could typically be overwhelming.

However, these environments on both ends of the spectrum of extreme circumstances are relatively rare in occurrence. An investor is much more likely to experience an environment which is somewhere in the middle, with quality securities being available from some sectors, but not in others. Again, having the entry system and the patience to wait for those opportunities is of utmost importance.

For example, I usually run a screen at least two times per month on the list of dividend champions. I use the following parameters:

1) A company raising dividends every year for at least a decade
2) A price to earnings ratio of less than 20.
3) Annual dividend growth exceeding twice the annual rate of inflation
4) A dividend yield that exceeds 2.50%, which is slightly higher than the yield on S&P 500
5) A dividend payout ratio below 60%, in order to ensure sustainability of distributions

Note: For REITs and MLPs, I look for FFO and DCF information, rather than earnings. As those as more advanced securities, they are not the point of this article.

The output of this screen only provides with a quantitative view of a list of businesses. It should not be an automatic signal to buy, especially if the investor knows nothing about the businesses that are produced by that screen. If the investor has analyzed the companies that are on the screen already, he or she can put their money to work by acquiring shares in these enterprises.

It is important to also take into account existing portfolio weights and holdings, after screening for attractively valued quality dividend growth stocks. When presented with the results of the screen, investors should first always initiate positions in quality companies that are rarely undervalued. Then, they should add to existing positions, as long as they are not taking a prohibitively high portfolio weight. Again, this paragraph assumes that the investor already has knowledge of the company they are buying, and finds it to be a quality company.

It is very common for the investor to see the same companies on the screen for months or even years to come. Therefore, it could be wise to be on the lookout for candidates that are new to the screen results. In addition, it might also be important to get into the habit of monitoring companies you are interested in for steep drops on negative news, which could also present an opportunity to buy a quality company at a bargain price. Unfortunately, these usually do not come out with a consistency that a twice monthly regular screen would produce. Therefore, keeping an open view could prove to be profitable.

In addition, I also like it when the companies I am investing in have a plan to grow earnings per share. Examples include IBM’s (IBM) strategy to grow earnings per share to $20 by 2015.

Full Disclosure: Long IBM

Relevant Articles:

How to be a successful dividend investor
How to identify your dividend investment goals
Where to search for investment opportunities?
Diversified Dividend Portfolios – Don’t forget about quality
Not all P/E ratios are created equal

Wednesday, April 2, 2014

Where to search for investment opportunities?

There are thousands of companies in the world, who have chosen to list their shares on a stock exchange. It would take a lifelong journey, in order to learn everything there is about every one about these publicly traded companies. Fortunately, out of that large universe of investments, less than 300 represent that investment universe of dividend growth investors.

As a dividend growth investor, your goal is to select investments that can afford to increase distributions every single year. The three lists I focus my attention on include:

Dividend champions: This list is maintained by David Fish. It includes all companies which have managed to increase dividends for at least 25 years in a row. In addition, David's list also includes Dividend Contenders, which are companies that have managed to increase dividends for at least ten years in a row. The champions and contender lists are superior to the dividend aristocrats and dividend achievers lists, because they are not excluding companies based on superficial criteria such as market capitalization or average trading volume. Therefore, they provide a more complete population of potential investment ideas for the enterprising dividend investor.

International Dividend Achievers: This list includes companies which are domiciled outside of the US, which have managed to increase dividends for at least five consecutive years. It is generally helpful to be aware of international companies which have achieved a track record of consistent dividend increases, since those are not followed by many income seeking investors. However, you should also be aware of the pros and cons of investing in international dividend stocks.

I require at least 10 years of consecutive dividend increases, in order to weed out companies that simply got lucky in a positive economic trend. I do not believe in a business model that has not gone through the average of two economic cycles, which the decade is equivalent to. I want high odds that the business earnings power will be immune to shocks during the next recession, in order to ensure uninterrupted and growing distribution payments to shareholders.

You should learn as much as possible about these companies, even if they are always overvalued. If you can track all 300 of them, you would have the knowledge necessary to act, should the right but brief opportunity arrives.If you gain that knowledge, you would be able to specialize in a strategy you know very well, and earn good returns on your capital. Over time, this knowledge will accumulate like compound interest, and lead to better outcomes for your portfolio.

Full Disclosure: None

Relevant Articles:

International Dividend Stocks – Pros and Cons
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
Dividend Champions - The Best List for Dividend Investors
The case for dividend investing in retirement
The World’s Best Dividend Portfolio

Monday, March 31, 2014

How to identify your dividend investment goals

You have saved up some money after working hard for many years, and now you have decided to put it to work. You see hundreds of articles on investing online, and hundreds of strategies that promise you everything. You are getting information overload. How should you select your strategy?

The first goal when selecting your strategy is to determine what your desired end result should be. For most investors who want a strategy that would help them in accumulating a certain level of target monthly income, dividend investing might be the best solution. The goal should be very specific, and should incorporate as much information as possible to fit the objectives of the investor.

As a result, the goal of earning $1000/month in dividend income is more specific as accumulating a nest egg of $300,000. This is because accumulating a nest egg of $300,000 does not automatically translate into the desired target monthly income to meet expenses, and does not discuss how to pensionize this asset.

For example, my goal is to generate a sustainable level of dividend income, which maintains its purchasing power over time, at the minimum. This would be achieved by creating a diversified dividend portfolio, consisting of quality dividend growth stocks that I try to acquire at attractive valuations over time.

Your dividend investing goals should take into account things like amount you can put to work every month, the time until you retire, as well as make reasonable assumptions about investment returns (initial yield, earnings and dividend growth).

For example, if you put $1000/month in a portfolio of dividend paying stocks that yield 4% and grow distributions at 6% per year, you can expect to earn $1000 in monthly dividends in 12.5 years. If you increase your contributions to $2000/month, you will be able to generate $1000 in monthly dividend income in only eight years.

The types of dividend paying stocks, which could be part of such a portfolio could include:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products.The company has managed to boost distributions from 46 cents/share in 2008 to 94 cents/share presently. Currently, the stock yields a very reasonable 4.60%. Check my analysis of Philip Morris International.

Unilever PLC (UL) operates as a fast-moving consumer goods company in Asia, Africa, the Middle East, Turkey, Russia, Ukraine, Belarus, Europe, and the Americas. The company has increased dividends for at least 15 years in a row. The stock yields 3.65%. Check my analysis of Unilever.

Kinder Morgan, Inc. (KMI) operates as a midstream and energy company in North America. The company has managed to boost distributions from 30 cents/share in 2011 to 41 cents/share presently. Currently, the stock yields 5.30%.

In addition, that investment plan should discuss more issues, such as where to start your search for investment opportunities, how to analyze them, when to buy, how to manage your portfolio and when to sell. Over the next few weeks, I would discuss each one of these bullet points, and walk you through the complete dividend plan, from beginning to end.

Full Disclosure: Long PM, UL, KMI

Relevant Articles:

My Dividend Goals for 2014 and after
Why do I keep talking about the same companies all the time
How to retire in 10 years with dividend stocks
How to accumulate your nest egg
Warren Buffett’s Dividend Stock Strategy

Sunday, March 30, 2014

How to be a successful dividend investor

There are several guidelines about becoming a successful dividend investor. They are centered around several key points I am going to be discussing in the next three weeks. I will be updating this post with links to articles on the process of becoming a successful investor.

The series of articles over the next three weeks will be a high level summary of my dividend investment plan today. If I were to start dividend investing today, I would find the collection of posts to be of tremendous value. In other words, the articles I will be posting are similar to a free course on dividend investing.

Lesson One: How to identify your dividend investment goals?

Lesson Two: Where to search for investment opportunities?

Lesson Three: When to buy dividend paying stocks?

Lesson Four: How to analyze investment opportunities?

Lesson Five: How to Manage Your Dividend Portfolio

Wednesday, March 26, 2014

Four companies paying dividends for over 100 years

The world is changing at a rapid pace. Some technologies such as the internet and smartphone apps have redefined the way we work and live. Despite all the change, I keep focusing my efforts on companies which have managed to keep their status quo for years, and have a high chance of continuing their quest for higher profits in the future.

The companies I tend to focus on tend to be stodgy corporations that have strong competitive advantages that allow them to keep customers happy and protect their business from competitors. They are characterized by wide moats, or strong competitive advantages such as geographic monopolies, strong brand names, strong customer relationships, economies of scale or the ability to consistently reinvent themselves.
These companies have managed to boost distributions through two world wars, the cold war, several oil price shocks and countless recessions. Their strong business models have helped them to consistently find new ways to increase sales, pass on cost increases to consumers and gain market share, that has resulted in higher profits and dividends over the past century.

Investors should study each of these companies, in order to identify the characteristics that have enabled them to pay dividends every year for over one century. This list is by no means a complete one of course, but it includes those rare companies that have listed their complete dividend histories, spanning back over one century:

International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. The company operates in five segments: Global Technology Services, Global Business Services, Software, Systems and Technology, and Global Financing. The company has raised dividends for 18 years in a row, and has consistently paid them since 1913. The company sells for 12.40 times earnings  and yields 2%. Check my analysis of IBM.

Exxon Mobil Corporation (XOM) engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products, as well as transportation and sale of crude oil, natural gas, and petroleum products. The company has raised dividends for 31 years in a row, and has consistently paid them since 1911. The company sells for 12.70 times earnings  and yields 2.70%. Check my analysis of Exxon-Mobil.

The Bank of Nova Scotia (BNS), together with its subsidiaries, offers various personal, commercial, corporate, and investment banking services in Canada and internationally. It operates through four segments: Canadian Banking, International Banking, Global Wealth Management, and Scotia Capital. The company has paid dividends since 1892, maintained its distributions dyring the crisis of 2007 -2009 and has bee boosting them again over the past few years. The company sells for 10.80 times earnings  and yields 4%.

Edison International (EIX), through its subsidiaries, engages in the generation and distribution of electric power. It operates in two segments, Electric Utility and Competitive Power Generation. The company has raised dividends for 11 years in a row, and has consistently paid them since 1910. The company sells for 18.60 times earnings and yields 2.70%.

An honorable mention goes to Kellogg (K), which has paid dividends for almost 90 years in a row, and has a listing of all the payments since 1925. Kellogg has also raised dividends for 9 years in a row. The company sells for 12.50 times earnings and yields 3%.Check my analysis of Kellogg.

Full Disclosure: Long XOM, IBM, BNS, K

Relevant Articles:

A long streak of dividend growth is an indication of a business with exceptional fundamentals
Historical changes of the S&P Dividend Aristocrats
Where are the original Dividend Aristocrats now?
Dividend Champions Index – Five Year Total Return Performance
Seven wide-moat dividends stocks to consider

Tuesday, March 25, 2014

Should dividend investors invest in index funds?

Index funds are perfect for most people who don’t want to bother about managing their finances and retirement. If your goal is to accumulate a certain amount of net worth in the future, and do not want to spend any time learning about investing, index funds could be your best solution. Therefore, index funds are great for 80% - 90% of the population out there, particularly if coupled with the tax advantages of 401 (k), Roth and Regular IRA’s etc. I own index funds in my 401 (K), because I cannot buy anything else there.

However, if your goal is to generate income in retirement, index funds might not be most optimal use of your resources. If your goal is to generate a positive stream of income that is not dependent on market fluctuations and grows faster than inflation (dividends), then index funds like the S&P 500 might not be for you. Dividend investing is probably practiced by less than five percent of the investing population, although it should be higher. Of course, do not take my word for that, as this percentage might be even lower than that. But this article is written for the dividend investor, who is willing to do some work, and not let their retirement in the hands of Wall Street.

With dividend growth investing, you put a portfolio of 30 - 40 equally weighted individual securities, from as many sectors that make sense, which are attractively valued at the moment. After screening for your entry criteria, you construct your portfolio, and sit on it, while receiving a rising stream of dividend income. You monitor your portfolio regularly, and only sell after a dividend cut or a crazy overvaluation. I have been doing this since 2008, and have experienced one cut in 2008, two in 2009, one in 2010 and none between 2011 and 2014. The proceeds from the sale of the stock which cut dividends is put to work in another company that fits your entry criteria. Typically, dividends are either spent or reinvested into more quality dividend paying stocks in the accumulation phase, in order to compound capital faster. The reason why relying on dividend income for retirement is superior to index investing is because dividends are more stable than capital gains, and are always positive. Therefore, if stock prices fall and stay down, the dividend payments will provide positive reinforcement to the investor, who would be motivated to keep holding and ignore market fluctuations. Otherwise, investors could panic during a market correction, and probably sell at the worst time possible. In fact, many investors do sell at the worst times possible. It is very difficult for the ordinary uninformed investor to see their portfolio being down 30% - 40% - 50%, and them losing several years worth of contributions in one bad year for stocks. Therefore, a lot of investors sell in order to stop the pain and stop their nest egg from dwindling down even further.

In addition, with dividend stocks, you are a buy and hold investor with a long-term view. You are not switching money from one company to another. Therefore, you are reducing reinvestment risk due to transactions, and have a much lower chance of generating lower returns that come out of frequent portfolio churning.

One reason against index funds, is that they include a lot of companies which do not pay ANY dividends. Therefore, the yields on index funds are very low, and not sufficient to live off of today. That’s why in order to live off this nest egg in retirement, you need to sell of a chunk of it every single year. This leaves you with a shrinking asset base, which is relying on continued growth in prices. Without the increase in stock prices, you are shrinking your asset base even further. If you retired at the end of 1999, you would have experienced stagnating stock prices, and as a result, you would have “eaten” more than half of your portfolio by now. I would not want to face the stress of eating into my capital when I retire. If I have $1,000,000, and I sell $40,000 worth of securities each year, I would be out of money in 25 years, assuming no inflation and no stock price growth. If the first five or ten years produce no increase in stock prices, then I face a high risk of running out of money. The last few years of living in such conditions would likely be horrible, as I would be counting every penny twice, and stressing over, while counting the days until I have to get a Wal-Mart job as a greeter out of necessity. The thing is that noone can tell you in advance whether the year you retire with index funds will be similar to 1972 or to 2000.

There are many flaws with index funds, particularly those on S&P 500, which make them poor choices for the enterprising dividend investor. The first is that there is a lot of turnover every single year, which is not good for wealth building. In fact, the turnover is approximately 3% – 5% per year on average. This means that every year anywhere between 15 and more than 25 companies are added and replaced by the benchmark, incurring fees for the investor. Buying and selling of stocks is the reason many investors underperform their benchmarks. For indexes like S&P 500, this frequency of asset turnover has lead to underperforming a purely passive portfolio of stocks. Did you know that the original 500 stocks of S&P 500 from 1957 outperformed the S&P 500 index by 1% point for 50 years? My previous article on the topic discusses research done to prove this.

The second flaw is that index funds are weighted based on float and market capitalization. This is to serve the mutual fund industry, not the investor. If you are a big shot mutual fund, and you want to raise 100 billion from investors, you cannot follow a passive strategy that requires you to put money equally between 500 companies, because for some the total amount of stock available to purchase might be less than $200 million. Therefore, some companies are ignored, at the expense of focusing on the biggest. In reality, the equal weighted S&P 500 has done better than the market cap weighted S&P 500 over the past decade.

The third flaw is that I do not know what criteria the index committee uses to include stocks in the S&P 500. Sometimes, they (just like any normal investor) follow the crowd into irrational exuberance and doing stupid things. For example, back in 1999, a lot of old economy stocks were thrown out of the index, and substituted for red hot technology stocks such as Yahoo! I would let you figure out for yourself how that worked out. The other sin of the S&P index committee is that it didn’t include Warren Buffett’s Berkshire Hathaway in the index until 2010. With my strategy, I can select the securities that fit my criteria, and live or die by their performance, as I am the one in charge of capital allocation in the family.

The fourth flaw with index investing that they are not a magic panacea for sure stock market profits. An investor who doesn’t know anything about investing, and is passively saving in index funds, can still lose money. They can lose money if they panic at the wrong times such as in 2008 – 2009 and sell everything. They can also lose money if they put money to work without taking valuation into account. The ordinary investor can find a way lose money even with idiot-proof index funds. In fact, according to Morningstar, most investors in the Vanguard 500 index fund have underperformed the index by 2% per year over the past 15 years. The investor also needs to focus on valuation at the time of investment. You should not just blindly put your money in the market to work, without taking valuation into account. For anyone who bought S&P 500 index funds in the late 1990s, they were simply chasing market returns. This was not a smart decision, and the subsequent decade of low returns proved that ignoring entry valuation at the time of investment is not a good strategy.

The other thing is that while index funds have rock bottom expenses, they could still add up over time. For example, if you have a portfolio worth $100,000, you will end up paying $100/year in management fees. If your portfolio is worth $500,000, you will be paying $500/year for life.

In contrast, if you built a portfolio of 40 individual dividend paying stocks, and paid a $5/commission for each trade, you would pay $200 in total. If you never sell, you would never have to incur commission expenses again. Therefore, with a $100K portfolio, you are better off cost wise in 2 years. For the larger portfolios you are better off in individually selected stocks on your own, rather than index funds. That is one of the reasons why people who have several million in equities always pick their own securities, rather than rely on index funds. Why pay someone else thousands of dollars in fees per year for passive investments, when you can simply create a portfolio of the largest blue chip stocks, and do nothing after that?

Over the past decade, more and more investors are beginning to embrace passive index investing strategies. I am just wondering to myself, what if everyone is in index funds one day? I wonder what the consequences and inefficiencies that could arise from this phenomenon of people believe you do not need to know what you own, as long as it is an index fund.

If at one point everyone is invested in index funds, this could create all sorts of inefficiencies in the market. For example, if a company asks shareholders to vote on certain issues that could be otherwise profitable, noone would vote, since conventional efficient market theory says all information is already priced into the stock. As a result, index fund managers might not even bother voting, as they won’t believe their vote counts. Next, since these fund managers might not vote, because they probably haven’t done any research to know enough about the companies they hold for investors in the first place. Therefore, corporate managers at those large companies would face few consequences from angry shareholders. I think that one of the reasons why CEO’s are earning such high compensations is because ownership is being delegated to mutual funds, and not individual shareholders. If Warren Buffett owned 30% of Berkshire Hathaway, and he let his son be the CEO, you could be 100% sure that he would fire Howard on the spot if he paid himself an exorbitant amount of compensation while not furthering shareholders’ interests. This is the reason why as dividend investors, it pays to have your interests aligned with management, especially when management has an ownership stake.

In conclusion, there are a few main ideas that enterprising dividend investors should take from this article.

The first idea is to buy and hold, and not engage in active trading. If you slowly built a portfolio of 30 blue chip stocks, from as many sectors that made sense, and you HELD ON, for several decades, you should do very well for yourself.

The second idea is also to educate yourself about money and investing AS MUCH AS POSSIBLE. The main idea is that you are the one responsible for your retirement future. You are the one whose retirement is at stake, and the only one who cares about succeeding. Therefore, you should be personally involved in the process, educate yourself and determine the best way to achieve your goals. Whether you end up buying dividend paying stocks, index funds, or daytrade internet stocks online, you are the person who will benefit or  lose from your actions. Therefore, do not outsource your retirement goals and dreams to a third party, whose only goal is to generate a commission or annual fees from you. Take your dream in your own hands, and get at it!

Full Disclosure: Long S&P 500 Mutual Fund

Relevant Articles:

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Wednesday, March 19, 2014

Why Did I Purchase This Dividend Paying Company For a Third Month in a Row?

I added to my position in Target (TGT) for the third month in a row, using my no cost brokerage Loyal3. Basically, I am evenly spreading my equal dollar purchases in the stock every month throughout 2014, rather than making two or three larger purchases. By now you probably also know that Target is a dividend champion which has managed to increase dividends for 46 years in a row. The company sells for 14.40 - 15.50 times forward earnings for 2014. The forward earnings range is $3.85 - $4.15/share.

Everyone is familiar with issues in Canada and the credit card breaches, so I am not going to keep repeating those. This has made many investors nervous about the company. Many seem to be going to the extreme, and projecting the recent news about the retailer onto the future. This is called recency bias, and is quite common among investors. It could also prove costly to you down the road.

It is very fun to watch the behavior of investors during tumultuous periods. During the declines in stock prices between 2008 and 2009, many investors were forecasting the end of the world. Few took advantage of the cheap prices at which many high quality companies were selling for. Now Target has stumbled, and the weak hands are forecasting the actual demise of the company. When investors become emotional about a topic, they can get greedy or fearful, which leads them to make ridiculous forecasts based on those irrational emotions.

In reality, Target’s operations are doing just fine. The company can still achieve some growth in the US, but international is really the place to go. Management has previously stumbled before on big initiatives, but they have always seemed to learn from them. This is a short-term issue, and years from now, investors would look at 2014 with regret that they failed to capitalize on the weakness in stock prices. I would say that the company will likely achieve its goal of $8/share in earnings by 2018. This is a year later than what was originally planned a couple months ago. If you demand perfect precision in growth, then chances are investing in the stock market is not for you. Of course, it is tough to be a long-term investor, when you get scary headlines every day. Unfortunately, this is what separates winners from losers in the long-term investing game.

Of course, it is quite possible that growth for Target slows down over the next few years. This could lead to a slowdown of dividend growth. However, I am hopeful that management will learn from the Canada expansion, and use those lessons when they decide to expand to other countries as well. In addition, the common sense approach is that credit card breaches have happened before, and will happen again. Either way, this is not something that will kill a retailer. At least it didn't kill T.J. Maxx in 2007.Of course, if they fail to show confidence in the business, and do not increase dividends in 2014, then I would stop adding funds to the stock. If they cut the dividend, I will be out the door a second after the announcement. While I am optimistic for the company, I also know when to cut my losses and move on. In addition, I keep a very diversified portfolio of dividend paying stocks, which mitigates the negative effects of dividend cuts stemming from onebad apple.

Either way, many investors I have been interacting with have given me 100 reasons why Target is a poor investment today. Either way, I do my own analysis, which is why I try not to get influenced by others.

One of the risks to retailers is that a portion of shoppers will convert their spending online. This is already happening to a certain degree, and has produced “winners” like Amazon.com. The thing is that online sales growth could be an opportunity to reach out to new and existing customers for the likes of Wal-Mart (WMT) and Target. However, I do not believe that consumers will do all of their retail business online. There are certain categories, where customers are always going to prefer the convenience of going to a retail location, and selecting their items to buy right away. For example, if you want to purchase clothes, you need to try them on. It is much easier to buy a TV or a book online, since you are getting the same level of product experience online or offline. If you bought a book, you know it will “fit” your needs, which is why it won’t matter how you bought it. The only difference is how long are you willing to wait before receiving the book.

The thing is that online shopping has been around for over 17- 18 years now, and it has not eliminated the need for brick and mortar retailers. While having exposure to online and offline channels could only help, I am not so sure that people will be buying everything online in the future. If you think so, then ask yourself why didn’t the mail order catalog result in the obsolescence of the retail store decades ago?

Of course, the major question I ask myself is “ Do I see Target around in 20 years?”. For me the question is yes, and thus I would keep sticking to my plan.

Full Disclosure: Long TGT, WMT

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Tuesday, March 18, 2014

Richard Kinder: The Warren Buffett of Energy

Warren Buffett is the most successful investor in the world. If someone had put $10,000 in his partnership in 1956 and stayed with him, approximately 57 years later their stake would be worth almost $1 billion. I have been on a mission to learn as much as possible about this successful investor, and hopefully implement some of those lessons to improve my own investing. In the process of my reviews, I noticed some striking similarities between Warren Buffett and Richard Kinder, who is the CEO of Kinder Morgan Inc (KMI).

I have owned Kinder Morgan Management LLC (KMR) for a little over 5 years, and Kinder Morgan Inc (KMI) for over 3 years now. In my research of the Kinder Morgan Companies, I have uncovered striking similarities between the founder and main shareholder of Kinder Morgan and investing legend Warren Buffett. Of course, correlation is different from causation, but never the less I think it pays to pay attention to certain traits of successful CEO’s. I believe these characteristics could pay dividends for shareholders for years to come.

The first striking characteristic is that both men have the majority of their net worth in the stock of the companies they manage as CEO’s. Buffett has a 21.40% economic interest in Berkshire Hathaway, while Richard Kinder owns 23.30% of Kinder Morgan Inc. I really like to see when CEO’s have most of their net worth in the company they manage, because this shows that their interests are aligned with the interests of ordinary shareholders. What can I say, I admire investors with skin in the game.

In addition, both men take nominal salaries from the companies they manage, compared to other CEO’s. Warren Buffett earns a $100,000 annual salary from Berkshire Hathaway (BRK.B), while Richard Kinder earns a mind-boggling $1/year. Of course, they are not relying on these salaries, which are pitiful compared to the gargantuan packages that executives earn these days. Buffett has approximately 1% of his net worth in various investments, which earn him a high enough dividend income to pay a lower tax rate than his secretary. Richard Kinder on the other hand derives most of his income from dividends paid by Kinder Morgan Inc to shareholders. With over 240 million Kinder Morgan Inc (KMI) shares, Richard Kinder makes approximately $400 million in annual dividend income. You can bet that he would do anything within his control to ensure that his stream of dividends increases over time, and that his stake becomes more valuable. Because qualified dividend income has preferential tax treatment, Richard Kinder would not pay more than 23.80%.

Both Buffett and Kinder seem to be focusing their best efforts on activities they like, which are also within their circles of competence. Buffett has been a student of business and investing for almost his entire life. Richard Kinder has had a career in law, followed by working at Enron until 1996. At one time, he was one of the most likely to succeed Ken Lay to the CEO position at Enron. Unfortunately for Enron, the company did not promote Richard Kinder, which is why he left in 1996 and started his journey as the Buffett of Energy. He purchased pipeline assets from Enron, and started acquiring more pipelines and other energy gathering assets in order to gain scale. In addition, he took advantage of the master limited partnership structure for tax purposes, which was not common at the time.

The thing that really strikes a resemblance between the early days of the Buffett partnership and Richard Kinder is the smart use of leverage. For example, Warren Buffett earned as a performance fee a quarter of all partnership returns above 6% in a given year. He then plowed most of those fees back into the partnership as limited ownership stakes. Because Buffett’s investment partnership routinely made more than 6%/year, he ended up collecting millions in fees, while allowed him to end up with a high net worth by the time he wound the partnership down in 1970. Richard Kinder on the other hand owns a large stake in the general partner of Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB). The general partner earns incentive distribution rights, which essentially allow them to a greater share of incremental growth in cash flows from the limited partnerships. In addition, the general partner also owns portions of the limited partners.

Either way, my highest portfolio position is Kinder Morgan Inc (KMI), as it offers a high current yield, plus solid dividend growth. I also own a pretty size-able chunk of Kinder Morgan Management LLC (KMR), where instead of distributions I receive more shares. This is also a great way to gain exposure to MLPs in a tax-deferred account, particularly if you are afraid of the UBTI. Therefore, the growing distributions are automatically reinvested, thus further turbocharging the compounding effect there. Once I retire however, I would likely convert those shares into partnership units of KMP, so that I can live off the income. Hopefully the spread between KMR and KMP narrows by then. Otherwise, if you are a long-term investor who wants to purchase KMP units, but don’t need the cash for years, I would strongly suggest KMR instead.

Full Disclosure: Long KMI, KMR, BRK/B

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Wednesday, March 12, 2014

I admire Investors with Skin in the Game

Anytime I study companies for a potential investment, I always try to do plenty of research on the company, reading annual reports, analyst reports and articles on the firm. Many times I end up reading very positive articles where owning company’s shares is mentioned as a no-brainer decision. After reading the articles however, I am always surprised when authors are not owning shares in this otherwise slam-dunk investment.

That being said there are valid reasons for not owning a company's stock, such as waiting for a pullback or due to conflict of interest. Either way however, I prefer to listen to an investor who has skin in the game. Authors who are good at writing articles, have very little to teach me about investing, where the major part of success is based on investor psychology, rather than neatly organized content. I believe in learning from those who practice their skills, not those who claim to have knowledge of it. After all, if you went for a surgery, would you go for the person that has all the theoretical knowledge, or would you go for the person who has actually practiced their skill?

I do not trust financial advisers whose goal is to sell you products you do not need. I cannot trust a college kid with a degree who has never dealt with psychological dilemmas of investing decisions. I enjoy reading articles written by authors who talk about their own experiences as investors.

I also prefer books from authors who have made it in the investing game, or at least discuss a particular topic from their own experiences. If they failed that is fine with me as well. Sometimes you increase your chances of success and gain more knowledge on a given topic when you learn what not to do, rather than what you should be doing. If you narrow down investing books to only those based on personal experience, rather than the academic ones describing your hypothetical returns, you are only left with a handful.

The reason why I prefer following investors with skin in the game is because you view situations differently when money is on the line, rather than using statistics and pie in the sky models. That is why I respect individuals with stake in the game. Warren Buffett for example, the world’s most renowned investor and the chairman of Berkshire Hathaway (BRK.B) is the epitome of an individual with a stake in the game, who have always treated investors that have trusted him with their money as partners, and looked after their best interests. He made a lot of money for himself in the process as well.

Richard Kinder, the CEO of Kinder Morgan Inc. (KMI) is another individual that I greatly admire. His interests are aligned with the interests of Kinder Morgan (KMI) shareholders and Kinder Morgan Energy (KMP) limited partners. The higher the distributions that Kinder Morgan Energy Partners achieves, the higher the dividends that this CEO with the sky-high salary of $1/year will receive. Compared to Richard Kinder, even Buffett's $100,000/year salary looks excessive.

Compare this to the typical CEO compensation however, which runs into the millions of dollars, no matter what the financial performance of the company they are heading. Some CEO's spend more time gaming the system, and wasting shareholders' money on ill-timed ego boosting acquisitions or share buybacks, while collecting big paychecks. For example, in 2009 I posted a chart of the CEO's that collected enormous bonuses, while their companies were struggling and had to cut distributions to shareholders.

Full Disclosure: Long KMI and KMR

Relevant Articles:

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The work required to have an opinion
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Tuesday, March 11, 2014

How to invest for dividends when markets are overvalued?

As someone who been dedicated to my dividend investing since 2008, I get to interact with a lot of individual dividend investors. Since the beginning of last year, many of those investors have been unhappy that stock prices on many quality companies are overvalued. As a result, some investors are accumulating cash, waiting for lower prices. Others are expanding their search, and leaving no stone unturned, in their quest for dividend bargains.

In a previous article, I explained why I am not in the camp of accumulating cash and waiting for lower prices. That is because I am in the camp of leaving no stone unturned looking for quality bargains. While the stock market is slightly overpriced, I am not too worried. This is because I focus on evaluating the valuation of individual companies rather than make evaluation decisions on the overall US stock market. I am lucky that I buy individual dividend paying stocks in my taxable accounts, because I only purchase securities when I find them to be fairly priced. I believe that one can always find enough quality dividend paying companies in almost any stock market environment. Plus, I always keep a list of companies to accumulate on dips.

Every month, I add new funds to my portfolio. In addition, I also let dividends accumulate in cash. I prefer to invest my funds as soon as I reach my minimum lot size. Luckily however, I always find several quality dividend stocks to purchase. In fact, I can always find anywhere between 15 – 20 companies that are attractively valued and I like, that are competing for my investment dollars. I then have to check my portfolio allocations, and pick one or two that I like best. As a result, I typically end up purchasing the same stock mostly once or twice a year.

Finding quality dividend stocks on sale is not that difficult, even during periods of market excess such as the 1990’s. Despite the fact that markets were overvalued in 1999 for example, there were some pockets of opportunity. There had actually been some great bargains such as REITs, Financials and many old economy stocks, which otherwise were perceived as boring. Despite this perception, those companies managed to grow profits and distributed higher dividends every year since then. It is important that the investor maintains a regular screening process, and develops a list of companies that would be attractive to consider on dips. It is also important that the investor thoroughly analyzes as many companies as possible, in order for them to be able to pull the trigger at a moments notice.

I also keep a dividend wishlist, where I list out companies I would like to purchase on dips. During the next market correction or if any of these companies misses earnings projections by a quarter of a penny, I might get lucky and snap up some shares to increase my position. Throughout my tenure as a dividend investor, I have had my fair share of wins and losses. One manages to learn from both outcomes, and manage those risks when outcomes are unfavorable. Some of my best winners have been companies which have been overvalued forever, but through careful monitoring, I had been able to buy a small stake in them. Companies like Yum! Brands (YUM), Family Dollar (FDO), Visa (V) come to mind. Unfortunately, my position in each of these companies is really low, because I tend to build my positions slowly.

Dividend investors are lucky, because most of them tend to focus on growing their passive income stream. They ignore short-term price fluctuations, and focus on selecting the fundamentally sound corporations, that will deliver the profits growth that would ultimately lift stock prices and annual distributions. Dividend investors do not purchase a market index, but focus on building a portfolio of quality income stocks by patiently allocating funds every month. By layering their portfolio brick by brick, these investors are creating a solid foundation for long-term results.

So to summarize, no matter what environment you are in the stock market for shares, a dividend investor should not worry because they are purchasing individual businesses. Investors are not purchasing pre-determined baskets of securities, regardless of valuation. A dividend investor shouldn't abandon their approach, especially when speculators are temporarily making a lot of money with riskier investments. The reality is that there are always dividend bargains out there, which require some good work to be identified. In addition, one needs to closely monitor companies on their wishlist, in order to capitalize on any short-term weakness caused by short-term noise, such as an analyst downgrade for example.

Full Disclosure: Long V, FDO, YUM

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Monday, March 10, 2014

Why do I use a P/E below 20 for valuation purposes?

Long time readers know that I use a price earnings ratio of 20 as one of the parameters in my set of screening criteria. In addition, anytime I analyze a company, I always end up with a conclusion of whether I find it overvalued or undervalued in terms of P/E relative to the benchmark of 20.

A common question in my mailbox concerns the reasoning behind using this variable, and the reason why I don’t look at historical P/E ranges or industry P/E ranges when looking at companies.

A P/E of 20 implies an earnings yield of 5% by the way. I set this parameter back in 2007- 2008, when yields on treasury bonds were about 5%. If yields on treasury bonds increase above 6 – 7%, I would likely require a P/E of about 15 for screening purposes.

The reality is that I use that P/E of 20 as a way to screen out companies that trade at a higher P/E than 20. I am not willing to pay for a high valuation above 20 times earnings, especially for mature dividend growth companies. However, I do not use this P/E in a vacuum to select companies. Instead I use it as one of the tools to compare individual companies that are valued attractively at the present.

I use this criterion for screening purposes, as a way to narrow down the list of qualified opportunities to a more manageable level. I also use other criterion in my screening, such as requirements for minimum yield (2.50%), 5 and 10 year annual dividend growth (6%/year), and dividend sustainability (payout ratio below 60%). However for the purposes of this exercise, I am not going to go into much detail on those.

I applied those results to the list of dividend champions, and received the following output:


After I narrow down the list of prospect to a more manageable level, then I compare companies listed in the output. I try to determine which one/ones to buy – based on valuation, earnings stability, growth prospects, portfolio weight. I analyze each company on the list for qualitative factors as well, such as moats, competitive advantages, brands, pricing power etc. For me earnings stability and opportunities for future earnings growth are paramount. You cannot simply look at yield or P/E ratios without gaining some comfort on stability of earnings and dividend payments, and prospects for future growth in both.

As you can see, I try to allocate my funds in what I believe to be the best ideas at the time. I do not believe in the strategy of accumulating cash, and waiting for lower prices from there. I try to balance obtaining the most earnings yield, with the highest probability of growth, for every dollar I put to use today. However, I also face the constraint that I can make only 24 – 36 purchases per year, and that I want to have a diversified portfolio of securities.

If you look at the screen, Chevron (CVX) is on the top of the list by valuation. Therefore, if I was just starting out, I would analyse and potentially buy Chevron in the first month, then maybe analyse and buy some Exxon Mobil (XOM) the next, followed by some Helmerich & Payne (HP) in the third month. If I had not analyzed Helmerich & Payne (HP) and Weyco Group (WEYS) before, I would need to add them to my list for further research, before I allocate any capital to them. I have done what I describe in this article for the past 6 years, and it has worked fine for me.

I do not look at P/E ratios for industry and in terms of historical ranges. To understand why, let’s walk through an example where you have two companies, one which typically sells at 8 – 12 times earnings and another which sells at 18 – 24 times earnings. Both grow dividends at 7%/year, and both yield 2.50%. We would also assume that earnings are relatively stable in both, there is an equal history of dividend growth, and both companies have some sort of durable competitive advantage. Company A trades at the top end of its P/E valuation range (P/E of 12), while company B trades at the low end of its valuation range (P/E of 18). If I was just getting started investing, I would choose company A any time over company B. This is because I am getting more earnings yield for each dollar I invest. This also provides the company with certain options such as share buybacks to boost earnings per share. This could be more accretive to shareholders of company A than for those of company B. It doesn't matter that the P/E is at the top of the range for company A, because I am getting more value for my dollars invested.

Of course if I already have exposure to company A, I would then start allocating funds to company B, which is the next best thing to put my money in. I will also do it because I like to be diversified and not keep all my eggs in one basket.

So as you can see, my method of screening provides a very good launching pad for evaluating opportunity cost, and selecting the most optimal investments at the time. It is superior to looking at past P/E ratios and industry P/E ratios, because it focuses on finding value today, relative to the rest of the market opportunities of the day.

To summarize, I use the P/E as one of the tools to narrow down list of prospects to a manageable level, and then help me to choose between dividend stocks. This low P/E, coupled with my qualitative and quantitative analysis of companies, helps me identify and purchase shares in the best bargains at the present moment. I have money to invest every month, so this P/E of 20 helps me avoid overvalued securities, and helps me to find the best bargains in the market at the time I have to allocate my capital.

Full Disclosure: Long CVX, XOM, WMT, MCD, PEP, JNJ, KMB & TGT

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