The process of identifying a great company, and purchasing it at an attractive price is part art, part science. While I have tried to narrow it down to a few quantitative factors, my detailed analysis of each company could bring an unexpected turn of events in determining qualitative nature of things.
In reality, once you have purchased shares of a quality company at fair prices, your job is done. You should stop checking the quote page every five minutes, and turn off your computer. Collect your dividends, and pick up a hobby. And please, listen to your wife and take the Christmas lights off. It is April after all.
This is contrary to what everyone else is telling you to do. You have been told that buy and hold means buy and monitor. And this could be true to a certain extent. However, over the course of a year, there could typically be only a few material events that could impact your analysis of a dividend paying company. One of them would be what is in the annual report, another could be the rate of change in dividends, while a third could be related to corporate events such as mergers, spin-offs, etc.
And then, even if you do monitor those items, and found out something that might make you rethink your opinion on the company, should that be a sell signal? Many times investors see a red flag, and immediately jump for the exits. In reality, the real world is bumpy, and companies, economies and people hit roadblocks all the time. A company that never hit a roadblock is probably really good at cooking the books.
What I am trying to say here is that while monitoring your company is important, in reality, it doesn’t really produce much in actionable information for you. For example, just because cash flows from operations have declined for two years in a row, dividend coverage has been inadequate and dividend growth has stalled, this might not be a reason to sell. A company that experiences those things might also face a falling stock price as well. In reality however, a turnaround could be just right around the corner, which could put it back on the track to dividend growth.
As a dividend investor, your goal is not to obsess over quarterly information or others opinions, as even annual information might end up as “noise” in the grand scheme of things for long-term investors. Your goal is to do a lot of prep work in understanding the companies you are buying, buy them at a decent price, and then be diversified in at least 30 -40 companies representative of as many sectors as possible. Most investors are usually pretty bad at forecasting turns of events. What might look as a flop today, could turn out to be a non-event in the grand scheme of things. Therefore, do not try to compound your mistakes by reading too much into the noise that is all around you.
As an investor, you are your own worst enemy. You are subject to emotions such as fear and greed, which can consume you entirely. Unlike your regular job however, in investing, the amount of time you spend on your portfolio could be inversely proportional to the amount of success you have. This is because the more information you get, the higher the illusion that your decision is better. In reality, because nothing is known about the future of companies with any certainty, more information could usually mean that you simply looked at the facts that you wanted to pick, while ignoring the ones that you didn’t like.
I see investors make rash decisions, because they have too much time on their hands. If a company they hold freezes its dividend, they are thinking about selling right that second. They are not giving the company time to work itself out of a temporary blip. Your goal is to avoid rash decisions, which could be costly down the road. Remember back in 2013 when all dividend bloggers were selling Intel (INTC) because it failed to increase dividends after 5 quarters? In reality, they should have held on, and done absolutely nothing, because the company was doing all the work in quietly compounding their money. Things looked terrible in the short-term, and the level of noise that Intel was going the way of the dodo probably made it safer for those investors to sell rather than hold. Then a few quarters later, Intel raised dividends and is selling at much higher prices today. Activity is bad when it comes to investing.
Which leads me to the most important things about investing in dividend growth stocks: “The money in the stock market is made by sitting, not by thinking”. In other words, time in the market is more important than timing the market.
A good company will grow and compound on its own, even if you do not read its annual report for the next 30 years. The smart investor would hold on to that compounding machine to their grave. Most ordinary investors would not do that however, because they are fearful that their paper gains would evaporate. They are also constantly trying to forecast the turn of events, rather than going along for the ride. When I posted an article on why I would not sell even after a 1000% increase in prices, most responses I received were that it would be silly to not sell after a ten-bagger. In reality, of the 50 or so companies that you would buy in your dividend portfolio, there would be a few exceptional ones that would perform phenomenally. These will be the candidates that would bring a large portion of the gains in dividends and portfolio values for your portfolio. The rest would do just fine probably, while as much as 20% could outright end up failing within a decade or so.
On the contrary, a company that really hits it bad, is going to fail no matter how much you monitor it. You would be unable to determine when to exit the losing company at the time, as some events could mean the end for some companies but not the others. For other companies these same events could mean that the bottom is in and the business is about to turn a corner. For example, I have found that when a company cuts or eliminates dividends, this is a sign that management is really bearish on the business. This is the situation when I sell my shares. If I am wrong and they start growing it again, I will review the situation and get back in. During the financial crisis, several companies that cut dividends such as Washington Mutual, eventually went bankrupt, thus wiping out their sharehoders. Others such as Bank of America (BAC) or Citigroup (C) lost over 90% of their stock value and annual dividend income and haven’t recovered yet. On the other hand however, the perfect time to buy Wells Fargo (WFC) and US Bank (USB) was when the companies cut dividends. At the time of the trouble, you can’t reasonably expect to know if this is a short-term bump or the beginning of the end. Therefore, your monitoring is likely not a value add activity.
I wrote this article, because I have been thinking about the management of my portfolio, should I be unable to manage it any more. After all, there are 62,000 Fedex (FDX) vehicles in the world, so the chance of being hit by one is out there. I know that whoever gets my money ( family, charity etc) is not going to be as knowledgeable about investments as I think I am. Therefore, my goal is to build a portfolio that could last for several decades after I am gone. This means that this is a passive portfolio, consisting of companies which have enduring competitive advantages, that does not need to be monitored or tweaked constantly. The only goal of this portfolio is to distribute the dividends to the beneficiaries, and nothing else.
Looking at my portfolio, I am fairly confident that it can serve its purpose well. I am fairly certain that at least some of the companies I own will be around 30 - 40 years from now, and would be profitable never the less. Therefore, whoever benefits from the dividends from my portfolio, would not even need to know the difference between preferred stock and livestock. My dividend cash machine would work for decades, distributing that income to those beneficiaries, without much need for constant supervision. And no, I do not own any Twitter (TWTR) or Facebook (FB).
I can afford to do nothing, because my portfolio consists of a vast number of reliable blue chip companies from a variety of sectors. These are stodgy, mature companies whose profits are derived from hundreds of products sold across the globe. True, some of them might fail in 5-10-20 years, but the rest would produce reliable long-term growth, that would more than compensate for the failures. The facts supporting doing absolutely nothing are the performance statistics of individual investors, which show that those who trade the most have the lowest returns. This proves that doing nothing could be beneficial to your portfolio results, contrary to ordinary thinking. An investment portfolio is like a bar of soap: The more you touch/handle it, the smaller it gets.
The second fact supporting this strategy is a study by Jeremy Siegel on the performance of the original 500 firms in the S&P 500 from 1957. If you had simply bought all of those 500 corporations in 1957, and then did absolutely nothing other than reinvesting dividends and receiving shares in spin-offs, you would have actually outperformed S&P 500 for 50 years.
The third fact supporting doing nothing is the performance of the Corporate Leaders Trust, which was set up in 1930s, in order to invest in 30 leading blue chip corporations of the time. Approximately 75 years later, it has done pretty well by utilizing a totally passive approach. This so called ghost portfolio held on to the same companies for decades, and selling when dividends were eliminated. A $10,000 investment in 1942 would have turned out to $16.60 million by the end of 2013. This investment would also be delivering annual dividends of a quarter of million dollars. Dividend reinvestment works wonders when placed into practice on a diversified portfolio of blue chip dividend stocks.
To summarize, being a gentleman of leisure is my true calling. Because most of the companies I own are global brands that have recurring revenue streams from hundreds of products sold globally, one can afford to not monitor those if a situation like that arises. That being said, as long as I am in charge, I would likely continue my weekly process of scanning for dividend increases, checking annual reports, looking for undervalued companies to buy, and researching new or existing portfolio components. My goal is to be familiar and keep up with all dividend champions and dividend achievers. That way, I would be prepared to act quickly if the right opportunity arises. For those companies I already own, the goal is to be as passive as possible. Now I have to go out and find a hobby to occupy that extra free time of mine...
Full Disclosure: Long WFC
- The Perfect Dividend Portfolio
- Turbocharge Income Growth with Dividend Reinvestment
- What dividend stocks would I buy if I were just starting out
- How to be a successful dividend investor
- Comparing your results to S&P 500 could be dangerous for dividend investors
Wednesday, April 22, 2015
The process of identifying a great company, and purchasing it at an attractive price is part art, part science. While I have tried to narrow it down to a few quantitative factors, my detailed analysis of each company could bring an unexpected turn of events in determining qualitative nature of things.
Tuesday, April 21, 2015
Dividend growth stocks get no respect. These slow and steady companies tend to produce results for long-term investors, who plan on holding for at least 10 - 20 years. Unfortunately today, the average investor has a much shorter time-frame in mind ( which probably explains why so many fail and never use the stock market for its true potential as a powerful wealth generator for retirement)
Dividend growth stocks are quiet compounding machines, that satisfy customer demands, constantly improve their operations, adapt their offerings to the changing consumer demands, while also innovating and growing their market share in their respective industries.
Over time, those companies manage to increase sales, earnings and dividends, which make them more valuable. This increases their intrinsic value to investors, who generate a rising inflation adjusted stream of income through dividends, and unrealized capital gains to those who are patient enough to sit and wait. Thus those investors end up having their cake and eating it too.
I always talk how I never want to pay more than 20 times earnings even for the best quality dividend growth stock. However, I am willing to hold on to a company I own, even if it sells for 30 times earnings today. This is because I have a long-term mindset when it comes to holding stocks. I know that a company that sells for 30 times earnings today, but manages to grow earnings by 8% – 9% per year for the next 20 years will be able to deliver satisfactory returns for my capital.
This is the reason why my upper limit is always 20 times earnings, and not something like $100/share entry price target ( from a company with $5 in EPS). A quality dividend growth company with $5/share this year, will probably earn much more than that in year two, a higher amount in year three etc. As a result, intrinsic value will be higher, since the business will be generating much more profit, and have the capacity to shower shareholders with a higher amount of cash dividends. Let’s say that EPS grows by 7%/year, and the stock pays a 3% dividend yield. This mean that the intrinsic value will be $100 in year one, $107 in year 2, and $114.49 in year three. Therefore, sitting in cash and waiting for the perfect price might leave the market timing investor in the dust over time.
This could be best explained by looking at Johnson & Johnson (JNJ) shares since 2002. You can see that earnings per share increased from $2.16 in 2002 to $5.70 by 2014. At the same time the share price increased from $53.71 to $104.57. For the patient dividend investor, it made sense to buy the shares since 2005. It also made sense to patiently hold on to the shares, since earnings and dividends increased, which also propelled the intrinsic value higher.
The intrinsic value increased from $43.20 to $114. The intrinsic value is derived by essentially multiplying the annual earnings by a P/E of 20. This is a rough approximation using a limited data set, since I did not want to use too much numbers and assumptions in trying to make a point on intrinsic value.
You can see that the stock has been selling below 20 times earnings since 2005. An investor who bought and held essentially was rewarded with increasing intrinsic value over time, despite fluctuations in the share price. The dividend investor was able to ignore fluctuations in the share price because they were paid a higher dividend every single year. When a company you own increases dividends, you know that its intrinsic value is growing. However, you never know how long it would take for the stock market to recognize that increase in value. If you had to rely only on the judgment of the stock market, and had to sell stock to live off in retirement, you could be in for a big trouble when stock prices are flat or down for extended periods of time. However, if you live off dividends, you do not have to worry about stock markets or price fluctuations. This is because a successful company that manages to earn more over time, will also send you cold hard cash every quarter. This means that you will not have to sell stock, and your ownership stake will not be reduced because of that. In addition, you will not have to speculate and bet your retirement on stock prices increasing every single year.
I believe for my investing that I should put money to work each month. Even if I end up paying high prices, which are not exceeded for 5 – 10 years, I won’t care, as long as the internal compounding is still going on, and there are reasons to believe it will continue. With this disciplined strategy, I might end up purchasing shares at multi-year highs. However, I would also have the discipline to keep purchasing shares of quality companies even when everyone is scared during the next bear market, recession or bank crisis. As you can see from the table above, buying at all time highs is not a problem, as long as someone does not overpay and as long as the business keeps growing. While buying at the depths of the bear market was very smart in hindsight, the investor does not really need to wait for a correction before initiating a position. If they choose the right business, its management will do the heavy lifting by compounding earnings, dividends and propel intrinsic values higher.
At the end of 2014, the shares were selling at $104.57/share and close to 18 times earnings. If someone wants to time the stock to a price of $91.20/share for 16 times earnings, they are taking a risk in lost opportunity cost. This is because if earnings keep going higher by 6%/year, the intrinsic value will increase in lock-step. Therefore, it gets less and less likely with the passing of each year that a price of $91 will be less likely to be seen again. Therefore, if you quibble over a few dollars or cents in share price, you are likely to miss out on the big moves that truly count. In the case of Johnson & Johnson, the big move is 5- 6% annual growth in earnings per share, coupled with a 3% - 3.50% annual dividends.
At the end of the day, if you believe that US will have a better and stronger economy in 30 years, a diversified portfolio of US businesses is the best bet on that prosperity for the average investor. In addition, if we were to get lower prices from here, I would be able to deploy any dividends I receive at much lower prices and valuations than today. I view that as a win-win for the long-term dividend investor. Actually, the best thing that could happen for someone who is just starting their investing journey is to start putting money to work during a period of depressed stock prices. This was the period between late 2008 to late 2012, when a lot of companies were selling for cheap prices, while everyone was waiting for a double-dip recession or hyperinflation.
- Mistakes of Omission Can Be Costlier than Mistakes of Commission
- Opportunity Costs for Dividend Investors
- Why would I not sell dividend stocks even after a 1000% gain?
- Optimal Cash Allocation for Dividend Investors
- Dividend Growth Stocks – The best kept secret on Wall Street
Wednesday, April 15, 2015
One of the biggest misconceptions about dividend investing is that the value of your investment decreases by the amount of the dividend you received. This is a logical fallacy that I hear time and again, and really makes me lose hope in the human race. The origins of the fallacy are that it confuses stock prices with stock values.
There is a difference between price you pay and value you receive. One can easily find stock prices on the internet or in newspapers. Stock prices fluctuate widely, by going from exuberant highs to depressing lows.
The value of companies however does not fluctuate that much on a daily basis. I am referring of course to the intrinsic value of the business, which would be realized in an arms-length transaction involving the sale of the whole company. While it is quite possible to purchase quality shares at a discount to intrinsic value, it is quite rare that a private seller would dispose of his/her total stake in a company at a fire-sale price.
The fallacy about the reduction in prices, that confuses price and value stems from the concept of the ex-dividend day. The ex-dividend date is the first day that a stock trades, at which point the buyer is not eligible to receive the latest dividend payment that was declared. As a result, the share price is cosmetically reduced by the amount of the dividend. If you believe that markets are somewhat efficient, then you should likely also believe that participants expect this dividend to be declared every 90 days or so. In fact, options markets incorporate the level of dividends in the pricing of these derivatives. Therefore, I would think that equity markets incorporate dividend expectations into the current price as well. Shareholders of a company like Coca-Cola (KO) can reasonably expect a quarterly payment of 33 cents/share every 90 days. This translates into an accrual of roughly a third of a cent every single day. I would think that between ex-dividend dates, investors who hold the stock merely accrue that 1/3rd of a cent every single day. On the ex-dividend date, this receivable is recognized in full, which is when it becomes visible to everyone else.
This is how I described this situation in a previous article:
If we make an analogy with bonds, one would note that the prices for both bonds and dividend stocks are decreased by the distribution amount on the ex-dividend date. With bonds however, interest is accrued daily and when you sell the security before the distribution date, you still get a prorated portion of the distribution. For example, let us assume that an investor purchases a 6% bond that pays every 6 months. The bond investor would then receive $30 on a $1000 bond on June 30 and $30 on December 31. By Mar 31, the bond has accumulated an accrued interest amount of 1.50%. If the investor manages to sell the bond at some random price, say 100%, the investor would actually receive the proceeds from the price and the accumulated interest for a total gain of 1.50%. It is interesting to note that dividend haters always focus on the ex-dividend date when discussing their opinions that dividends are a wash, since they give you cash but reduce your stock price. In fact, dividend stocks probably also accrue the dividend amount over time. As a result, investors do not really “lose” anything when ex-dividend date comes. In fact, this is mostly a cosmetic change, since stock prices are not directly tied to fundamentals but to other factors. Because stock prices fluctuate all the time, what truly affects stock prices is earnings, economic expectations, inflation interest rates, investor sentiment. The fact that stock prices are trading “ex-dividend” doesn’t really show on stock prices, unless a large special dividend is being paid out. As a result, stock dividends are already “calculated” by the marketplace and added to the stock’s valuation.
If you still do not believe me, think about the following scenario. A company earns $1/share and sells for $10/share. Now, if that company distributed a $10 special cash dividend, it will not trade at $0. That is because it still has a $1/year in earnings power. Only a fool would sell this stock at $0.
Astute dividend investors know that merely stockpiling cash on a balance sheet does not result in any value for shareholders. If however there is an announcement that a $10 pile of cash will be paid out as a special dividend, this will unlock the hidden value represented on that balance sheet. In the example provided above, that $10 stock will likely sell for close to $20 after that special dividend announcement.
The real reason people get confused and start believing that dividends reduce intrinsic value (besides the fact that they confuse price and value) also stems from the fact that they focus on one event and ignore the whole picture. For example, in Coca-Colas's case, the company earns $2/year, and pays out $1.32 in annual dividends. The rest is reinvested in the business. In a going private transaction at a 20 times multiple, the stock would sell for say $40/share. It is the earnings stream that will provide a source of value for the buyer.
Those who focus only on the ex-dividend, miss the forest for the trees. This is because they ignore earnings power, which is ultimately what drives valuation of a business. Dividends are paid out of earnings. A company like Coca-Cola has a source of cash that is replenished each year at a rate of say $2/share. This means the company can earn $2 this year, then $2 or more next year etc. The earnings power of $2/share is replenishing cash in the corporate coffers each year, and dividends are paid out of those coffers.
A good blue chip business like Coca-Cola will generate excess cash flows to be sent to shareholders. Sure the company can accumulate cash, but then chances are that management will find a way to waste that cash and diworisify. Without the discipline on capital allocation that the dividend provides, shareholders could end up worse off since management will be very likely to squander that cash on corporate jets, golf course memberships, insane bonuses etc. Of course if someone focuses on academic models and chooses to ignore reality, the reality of people behavior in business, then they will keep missing the forest for the trees. And piling that $1.32/year in cash or risky projects might make shareholders worse off than receiving that amount in dividends.
So in essence, shareholders have two options. The first option is to receive a dividend in the amount of $1.32/share. The second option is for management allocate that excess cash of $1.32/share into projects of dubious value, to stockpile cash that might provide incentives for management to diworsify or squander the cash, or to have management pay themselves more because the company has so much cash that nobody knows how to deal with. The sad reality is that no good business can afford to reinvest all of its profits back into operations at good rates of return for extended periods of time. There is a rate of diminishing returns on investment. In Coca-Cola's case, they cannot merely double production and advertising and number of plants and hope that sales will double - it is quite possible that this could actually bankrupt the company. In addition, few companies can expand beyond their core expertise into some other unrelated field or industries. This is why you only have one Berkshire Hathaway but over 100 dividend champions out there.
Actually, the best types of businesses that have delivered the best returns to shareholders are those that distribute that excess cash to shareholders and look like they have a really small book value to outsiders. Those are the businesses that only require a small percentage of profits to be plowed back into operations for future growth. If you don’t trust me look at Clorox (CLX). ( on a side note, if you are reading this site and you don’t trust my work, then you should not read this site anymore)
To illustrate the point that dividends do not reduce the company’s intrinsic value, let’s look at the acquisition of Heinz by Warren Buffett and 3G capital in 2013. Heinz agreed to be acquired for $72.50/share on February 14, 2013. When Buffett acquires a business, he looks for consistent earnings power and then incorporates his assumption on the value of the company earnings estimates from today’s date until the end of time. That is how he probably got comfortable with the price of $72.50. The price of $72.50 represented the intrinsic value of the business to a private buyer. There were no other companies or persons that submitted offers for Heinz, which means that $72.50 was a good estimate of the intrinsic value for Heinz.
The company reported quarterly earnings of 99 cents/share on February 21 and a quarterly dividend of 51.50 cents/share on March 13, 2013. The dividend was payable April 10, 2013 to shareholders of record on March 25, 2013.
On June 7, 2013, Berkshire Hathaway and 3G Capital completed the acquisition of Heinz at the proposed price of $72.50/share. The price fluctuated all it wanted between February 14 and June 7, but this didn’t really affect the value of the business.
In conclusion, when a company pays you a dividend, your investment value is not really reduced by the amount of the dividend, because the earnings power is the same. And company values are based on the discounted amount of future earnings streams from now on up until judgment day.
Dividends come from earnings that the company paying them has generated. As a result, the dividend is directly connected to the company’s fundamentals. The stock price on the other hand is something completely separate from the underlying business in the short run and is determined by investor emotions. This is why most dividend investors ignore stock price fluctuations, and invest in companies they would be perfectly fine holding for ten years even if the stock market was closed for ten years.
Full Disclosure: Long KO, CLX and BRK.B
- Dividends versus Homemade Dividends
- How to never run out of money in retirement
- Dividend Investing Misconceptions
- Four important dates for dividend investors
- Coca-Cola (KO): A Core Holding for Dividend Growth Investors
Monday, April 6, 2015
I love dividend growth investing. I find it amazing that for the price of exchanging my labor for money at my job, and then identifying at least 40 or so dividend paying stocks, I will get paid dividends for decades in the future. This means that in 2044, I will be receiving income because of a decision I had made over 30 years prior to that point.
The reason behind this love for dividend investing is the fact that I like to build things, let them grow, and achieve my desired set of goals and objectives. I know that many investors choose not to do dividend investing, because they lack the patience to sit tight and earn a 3% - 4% yield in a current year. They would much rather trade actively, than wait for the power of compounding to quietly help them achieve their goals over time. On aggregate, those who actively trade end up much worse off than a simple investment in Certificate of Deposit or Treasury Bonds.
Many of those investors tend to criticize the fact that in the initial stages, anyone who puts say $1000, would not earn more than $30 - $40/year in dividend income. Where most others see nothing of interest, but only boredom that is not worth it, I see opportunity. I view each stock in my portfolio as an income generating asset that pays me to hold it, as it transforms capital, know-how, and human ingenuity into products or services that it sells to customers around the world for a healthy profit. Over time, businesses become smarter about processes, and how to do things more efficiently in order to maximize earnings. The people who work in those businesses make decisions every day, so that my interest in the business can generate profits and pay for my dividends. In essence, by being a dividend capitalist, you are having your money work hard for you, so that you don’t have to.
I view each of those dividends as dollars I didn’t need to physically work for. In other words, if you make $20/hour (average wage in the US), for every $20 in annual dividend income you receive, you can afford to work one hour less per year. Of course, this is an oversimplification, because a dollar of dividend income is worth more than a dollar of salary income, because dividends are a more tax efficient form of income. In addition, a dollar of dividend income does not require much time commitment from the dividend investor. Over time, as more income generating assets are added to the portfolio, and dividends grow and are reinvested, the power of compounding eventually reaches a precipitation point in the dividend crossover point. Therefore, one should never despise the days of small beginnings. They should rather start their financial independence journey as early as possible, in order to benefit from the power of compounding to the maximum point.
I love the fact that if I build an equally weighted portfolio today consisting of 40 companies, and putting $40,000, I have a chance of generating over $38,000 in annual dividend income in 40 years. The money generated by the portfolio will be enough to cover the amount invested almost every year. This exercise assumes a 3% starting dividend yield and annual dividend growth of 6%/year.
The cash I earn from the portfolio is also essentially reducing the amount of capital I have at risk. For example, if I invest $1000 in Coca-Cola today, I can reasonably assume that I will receive about $30 - $32 in annual dividend income. If the dividend increases by 7%/year, this means that dividends will double every decade. This means that in 17 years, I would have received dividends equivalent to my entire investment, and I would also still be holding on to the original cash generating asset. Most importantly, over time, the quiet power of compounding would lift the amount of earnings, dividends and values of the average business that I invest in.
I know that of the 40 companies I purchase today, not all will be there in 2044 or 2054. Contrary to popular beliefs however, I expect that only a small percentage of those companies to fail outright. Many will end up merging with competitors, get acquired, change names or do spin-offs. Some will do just fine, while a small number will probably end up delivering outstanding returns to the portfolio, both in terms of dividends and capital gains. As a result, the goal is to do nothing but sit on that portfolio, and reinvest dividends when received in the best values available at the moment. It is important to avoid the temptation of selling
Since most investors I know do not have a lump sum just sitting there, waiting to be invested, the best course of action would be to start dollar cost averaging their way every month. If one gets into the habit of saving as much as possible, and then putting that capital in a broadly diversified portfolio of blue chip dividend stocks, reinvests dividends, and allows themselves a 20 – 25 years’ time horizon, they should do pretty well for themselves over time. This strategy worked even for those who were unlucky to start investing in US companies right before The Great Depression started. I view every $1000 that I save, I can essentially buy more time, and more freedom, that makes me get closer to my dividend crossover point. I love setting cash machines up, and then reinvesting dividends for decades to come.
As a result of all this, I have ended up with several brokerage accounts. I love starting a brokerage account from scratch, and then putting as much as I can save that month into it. The start is always slow, and usually the first dividend checks do not appear for one to three months at first. In addition, they could be anywhere from a few cents to a few dollars. As I keep putting more money to work however, as companies I own increase dividends, and I keep reinvesting those dividends into more shares, the total dividend income starts to reach pretty nice figures. It is absolutely exhilarating to watch the fruits of your regular investing efforts materialize. Once the portfolio achieves critical mass of $100,000 invested, I stop adding more money to it, and move onto my next portfolio building. I merely let the power of compounding do its heavy lifting over the next 30 years, while also remaining under the SIPC insured limits of $500,000 per account, that prevent me from partial loss of capital in case of broker failures.
In order to build wealth, it is important to focus on the big picture. We spend so much time in the present, that we sometimes get to forget that dividend investing is about putting money today, and leaving it uninterrupted for 25 years or so. In other words, the worries of today represent minor fluctuations relative to where things could be in 25 years. Focusing on noise today could prevent the investor from benefiting from the long-term power of compounding, which is what would truly bring success to the patient investor. Remember, time in the market is more important than timing the market.
I am often hearing even today that the stock market is about to crash, so people should wait on the sidelines and accumulate cash. I vehemently disagree with this - it is far better to have the discipline to put some money to work every month, like clockwork, and let that capital compound for 25- 30 years. In 25 - 30 years, it would not matter whether you purchased shares at the high or the low for the year. Even the 1987 stock market crash looks like a minor blip when taken in perspective.
A few companies available at fairly attractive valuations today include:
3M Company (MMM) operates as a diversified technology company worldwide. This dividend king has raised distributions for 57 years in a row. In the past decade, 3M has managed to boost dividends by 9%/year. The stock currently sells for 20 times forward earnings and yields 2.50%. Check my analysis of 3M company for more information about the company.
The Chubb Corporation (CB), through its subsidiaries, provides property and casualty insurance to businesses and individuals. This dividend champion has raised distributions for 33 years in a row. In the past decade, Chubb has managed to boost dividends by 9.80%/year. The stock currently sells for 13.20 times forward earnings and yields 2.30%. Check my analysis of Chubb for more information about the company..
Eaton Vance Corp. (EV), through its subsidiaries, engages in the creation, marketing, and management of investment funds in the United States. This dividend champion has raised distributions for 34 years in a row. In the past decade, Eaton Vance has managed to boost dividends by 12.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.40%. Check my analysis of Eaton Vance for more information about the company.
Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has raised distributions for 45 years in a row. In the past decade, Altria has managed to boost dividends by 11.60%/year. The stock currently sells for 18.30 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.
T. Rowe Price Group, Inc. (TROW) is a publicly owned asset management holding company. This dividend champion has raised distributions for 29 years in a row. In the past decade, T. Rowe Price has managed to boost dividends by 16.60%/year. The stock currently sells for 16.90 times forward earnings and yields 2.50%. Check my analysis of T. Rowe Price for more information about the company.
Johnson & Johnson (JNJ), together with its subsidiaries, researches and develops, manufactures, and sells various products in the health care field worldwide. This dividend king has raised distributions for 52 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.90 times forward earnings and yields 2.80 %. Check my analysis of Johnson & Johnson for more information about the company.
Genuine Parts Company (GPC) distributes automotive replacement parts, industrial replacement parts, office products, and electrical/electronic materials in the United States, Canada, Mexico, Australia, New Zealand, Puerto Rico, the Dominican Republic, and the Caribbean region. This dividend king has raised distributions for 59 years in a row. In the past decade, Genuine Parts Company has managed to boost dividends by 6.80%/year. The stock currently sells for 19.20 times forward earnings and yields 2.70%. Check my analysis of Genuine Parts Company for more information about the company.
W.W. Grainger, Inc. (GWW) operates as a distributor of maintenance, repair, and operating (MRO) supplies; and other related products and services that are used by businesses and institutions primarily in the United States and Canada. This dividend champion has raised distributions for 43 years in a row. In the past decade, W.W. Grainger has managed to boost dividends by 18.20%/year. The stock currently sells for 17.80 times forward earnings and yields 1.90%. Check my analysis of W.W. Grainger for more information about the company.
United Technologies Corporation (UTX) provides technology products and services to building systems and aerospace industries worldwide. This dividend achiever has raised distributions for 22 years in a row. In the past decade, United Technologies has managed to boost dividends by 12.90%/year. The stock currently sells for 16.80 times forward earnings and yields 2.20%. Check my analysis of United Technologies for more information.
Full Disclosure: Long all companies listed above
- How to define risk in dividend paying stocks?
- Stress Testing Your Dividend Portfolio
- Time in the market is more important than timing the market
- Common Misconceptions about Dividend Growth Investing
- Warren Buffet’s Favorite Exercise
Monday, March 30, 2015
As a dividend growth investor, I tend to create diversified portfolios full of companies that regularly raise dividends. I try not to overpay for shares in these companies, when I put my money to work. Dividends are more stable than capital gains, which is what makes them ideal for those who want to live off their nest eggs. The end goal for me is to generate as much in dividends to pay for my regular expenses every month. I expect the forward dividend income generated in my taxable accounts to reach the dividend crossover point at some point around 2018. The stable nature of dividend income makes it easier provides much more confidence in projecting future dividend income at a certain point. On the other hand, I cannot tell you whether the value of the portfolio will be twice as much as today's or half as much.
However, I regularly receive some feedback from new readers, because they might have overheard about the importance of benchmarking against a common benchmark, such as the S&P 500. While I have tracked results versus S&P 500, I think that this is not a value added activity for my strategy and my goals. I believe that tracking my total return performance relative to S&P 500 is not going to add any actionable insights, that would help to me achieving my goals. My goals including reaching a certain target annual dividend income within a certain time period. Whether I do better or worse relative to some random benchmark is irrelevant to my long term goals and objectives.
I monitor the annual operating performance of the businesses I have invested in, as I review them at least once every 12 - 18 months. I also review press releases regarding quarterly results, dividend increases announcements, mergers and acquisitions. I track the organic dividend growth rate for my portfolio. I also track dividend income received, and try to understand whether growth came from organic dividend growth, dividend reinvestment and new cash contributions. As you can see, it doesn't matter for my goals and objectives, if over the next 5 - 10 - 15- 20 years the total return on my portfolio is better or worse than the S&P 500. Not only is relative performance versus a benchmark lacking actionable insights for me, but it could be downright dangerous for dividend investors like me.
The biggest danger in comparing my performance to that of the index, is reaching dangerous conclusions. For example, stock prices do not go up or down in a straight fashion. They move depending on a variety of factors, that few can predict in advance. Sometimes, even quality companies might be under appreciated by market participants, and their stock prices might stagnate for extended periods of time. At the same time stock prices can be increasing, as evidenced by stock indexes. However, if the fundamentals of the underlying businesses are doing well and improving, then holding on to those businesses might still make sense. This is because while their price is doing worse relative to the stock market index, they are getting more valuable, despite being underappreciated by the stock market. It might take the quoted price some time before investors realize this discrepancy and bid up the price. If I sold undervalued shares, to buy something that has done well in price, I would be selling low and buying high. I believe that this is not smart investment behavior. Please remember that the stock market is there to serve you, not to instruct you. The time to sell a business is when it no longer performs to expectations, not because the stock prices a group of other businesses have done better in the past 3 - 6 months.
For example, back in 1999 - 2000, many shares of tobacco companies, financials, utilities and REITs were punished by investors who wanted new economy technology companies. The popular indexes such as S&P 500 and Dow Jones Industrial's Average added technology companies in 1999 - 2000. The performance of those companies was great for a while, as everyone gobbled up those shares in speculative frenzy. The old economy boring companies were not viewed as attractive enough. If a dividend investor had sold their tried and true investments because they underperformed for a short period of time, they would have made a terrible mistake.
If I am impatient however, I would feel like I am missing out by comparing my “slow moving” stocks to the index and chances are I would sell as a result of the exercise. This is usually at the same time that the index would likely start dragging its feet, while the shares of the former “slow mover” finally get appreciation by buyers. I see this happen again and again. This is why most individual investors never make any money in stocks – they go from one strategy to the next, chasing hot strategies and looking for something that magically works all the time. If they stick to a slow and steady strategy like dividend growth investing, they would do very well for themselves over time. This is because rising earnings per share, leads to rising dividends per share, which ultimately makes stock prices more valuable. Plus, the fact that most dividend investors are truly passive, they can compound their capital for decades investing in what they know. Studies have shown that the more passive the investor, the higher the chances for satisfactory long-term performance.
My goal should be to have a portfolio that produces slow and steady returns that I can live off of. If I get scared because my portfolio underperforms for a few years, and I end up switching at the worst possible time, I would likely never make any money investing in stocks. The real lesson here is to have a solid understanding behind my strategy, and then to have the patience to stick to it through thick and thin. If I sold my dividend portfolio holdings today and I invest everything in an S&P 500 fund, my dividend income will drop by 45 - 50%. This will be caused by the fact that I will have to pay capital gains taxes on unrealized capital gains and I will have to accept a lower current yield. This change would actually require me to spend more time working at a job that I might or might not enjoy. Since I am not a robot, I have a limited number of years on this earth that I can spend working, rather than enjoying life. In addition, index funds contain a lot of companies that do not pay dividends. And as we know, relying on capital gains works great during a bull market and prices move up. However, if prices are flat, as they were between 1929 - 1953 or 1966 - 1982 or 2000 - 2012, my portfolio will not last for long if it doesn't yield anything. Selling off stocks in your portfolio results in less stocks available over time. If prices do not grow fast enough, you will deplete your portfolio. Selling off chunks of my portfolio to live off is similar to cutting the tree branch you are sitting on. Why not just pick the fruit from the tree, and let it grow uninterrupted?
When someone tells me they are going to sell securities from their portfolio, they are essentially telling you that they blindly believe the stock market will only go up during their retirement. This flawed thinking ignores past history, and sequence of return risks in the portfolio distribution phase. It also resembles the flawed belief by some homeowners between 2000 - 2008 that they can tap equity from their appreciating homes and spend the proceeds. Treating your house like a piggy bank, and relying on increases in house prices to live off turned out to be a poor choice. Spending too much time comparing yourself to the Joneses, is another folly people do. To me, comparing total returns of my portfolio relative to that of someone else's is a perfect example of keeping up with the Joneses. This can only lead to folly behavior.
I am not a big fan of dividend funds or dividend ETF's either. Even dividend growth funds tend to do bizarre things such as keep companies that have cut dividends for almost an year, as was the case of Citigroup in 2008. Another bizarre thing I have seen is when some companies are not included, or others are taken out, as was the case of Altria (MO) being dropped from the S&P Dividend Aristocrats index in 2007. A third example includes my purchase of Higham Institution for Savings (HIFS) in 2010, which was not covered anywhere else except on the list provided by David Fish. As you can see, indexing does not work for my goals and objectives. However, it could still work for anyone else. Because I am the only one who truly cares about reaching my own goals and objectives, I create my own portfolios by picking individual stocks.
To reiterate the biggest danger in comparing to index funds is that any under or over performance produces no actionable insight for my portfolio management. On the contrary, it can cause me to abandon my strategy at the worst time possible, simply because I “underperformed” the index. With dividend growth investing, I would likely at least match total returns of S&P 500 over long periods of time like 20 years for example. This could include variations in under or over performance over periods of time of varying lengths. However, just because I underperformed for 3 years, it doesn’t mean I would underperform for next 3 years. Because of reversion to the mean, the 3rd year of underperformance might mean that dividend stocks are cheaper than the stock market as a whole. Therefore, they could provide much better returns for the next few years, relative to a market index such as the S&P 500. As usual, past performance is not a predictor of future performance.
The real reason why everyone encourages individual investors to buy index funds in the first place is because some individual investors are horrible at making investment decisions. Not only are they terrible at investing, but they are overconfident and overtrade, fail to stick to a single strategy because they are afraid of missing out on the next big thing. The common fallacy among inexperienced investors is that you need to find the next Microsoft to make money in stocks. Unfortunately, few ever find the next Microsoft, but many lose a lot of money in the process. In fact, these investors would have been better off simply buying and holding on to the original Microsoft in the first place.
(The conclusion that individual investors are terrible at investing is based on data I have analyzed from DALBAR. While I am sure DALBAR is a reputable organization, I have learned to always take information with a grain salt and some healthy dose of skepticism. This is because the information is used by financial providers, advisers and mutual fund companies in order to get clients. Since Dalbar's clients are financial services companies, DALBAR has an incentive to show how bad individual investors do on their own. If you prove to investors that they need help from the financial industry, they are more likely to come and earn money for your company. There is an incentive for DALBAR to not compare apples to apples, in order to make a case against individual investors. So, as Charlie Munger says, "Never ask a barber if you need a haircut" )
The truth is that if you build a diversified income producing portfolio with companies that are purchased at fair prices, and you do little activity every year, you stand a chance to do pretty well over time.
I reached these conclusions after studying the performance of the original 500 stocks in S&P 500 in 1957 versus index, as well as the ING Corporate Leaders fund for the past 50 years. Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index? Did you also know that S&P 500 frequently makes changes to its index methodology, which would have reduced past performance numbers?
In addition, if you study the history of the ING Corporate Leaders fund, you can gain a glimpse of the potential in a truly passive buy and hold portfolio. The trust was formed in 1935 with a list of 30 blue chip dividend paying stocks. Given the mergers, acquisitions, dividend eliminations, the list is now down to 22 companies. Over the past 50 years, the fund has managed to return 10.20%/year, versus 9.80% for the S&P 500. The trust sells when a company eliminates dividends or stock price falls below $1.
To summarize, it looks as if the only way to achieve my goals and objectives is by constructing portfolio myself, by purchasing companies with sustainable advantages at fair prices, and then holding passively for the long run. Being passive should be the goal, as selling is usually one of the biggest mistakes investors make. It is a mistake because few can just sit tight and enjoy the ride while ignoring the noise out there. Frequent churn could be costly. Cutting investment costs to the bone is also very very important. If you have a $1 million portfolio invested in index funds, you are likely paying $500 - $1000 every year. You can easily purchase stakes in 30 – 40 of the largest dividend paying blue chips listed in America, and just hold them for eternity. Some of those will fail in the next 40 - 50 years, others will merge or be acquired or spin off countless subsidiaries. A third group would likely still be around 40 – 50 years later, showering you and your descendants with more dividend income than you ever imagined in your wildest dreams.
Update: I have received a tremendous amount of hate mail from index investors related to this article. One index investor just wished me that my portfolio goes to zero. I wonder if they realize that their wish means S&P 500 will also go to zero.
Full Disclosure: Long MO, HIFS
- Dividends versus Homemade Dividends
- Why I am a dividend growth investor?
- Dividend Portfolios – concentrate or diversify?
- Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
- How to be a successful dividend investor
Tuesday, March 24, 2015
As a dividend investor, I do not really look at stock price charts. The things I look for are trends in earnings and dividends, catalysts for further earnings growth, and whether the security is cheap relative to the other investment opportunities within my opportunity set. In other words, if I expect PepsiCo (PEP) to deliver the same growth as Johnson & Johnson (JNJ), but Johnson & Johnson is available at a cheaper valuation, I would buy Johnson & Johnson (JNJ). It won’t matter whether Johnson & Johnson is selling at a 52 week high, or 52 week low.
However, I know that for a lot of investors, they look at stock price charts for whatever reason. I believe that focusing only on stock price history is misleading, because it doesn’t show you everything you need to know about a security.
The missing link of course are dividends. One of the biggest lies told to investors is that stocks , as measured by S&P 500 or Dow Jones Industrial Average, went nowhere between 1929 – 1954 and 1966 - 1982. It might be true that stock prices were volatile but mostly flat, however dividends provided for a handsome return to those patiently reinvesting them through thick or thin.
For example, if let's look at the annual price performance of the S&P 500 between 1929 and 1954. The price in 1929 was 24.86 points, which was not reached again until some time in 1953. Based on looking at price alone, someone could incorrectly assume that stocks did not provide any returns to shareholders for a quarter of a century.
However, if you add in dividends, and reinvest them, you can see that someone who put money in 1929 broke even by sometime in 1937. This is a very interesting finding, because it shows that even during a period where unemployment was at 25%, industrial and agricultural production fell, GDP fell stocks in the US did well for the long-term shareholder who was not afraid. In fact, during that 25 year period, the whole return on US equities came from reinvested dividends. Over that period from 1929 to 1953, a $1000 investment quadrupled in value.
Dividends usually accounted for 40% of average annual total returns. They are always positive, and more stable than capital gains, which makes them as a reliable source of income in retirement. Interestingly enough, prior to 1994, the yield on US Stocks was averaging around 4%. Incidentally, a researcher found that it is “safe” to "withdraw" 4% of your portfolio in retirement. I say incidentally, because it is clear that this researcher inadvertently makes the case that the safe 4% average annual spending comes entirely from dividends and the high interest income that was prevalent at the times. For those in the accumulation stage, the thing to remember is that reinvested dividends have accounted for 97% of stock market gains since 1871.
The shortcoming of stock charts is also evident when looking at individual companies returns over time. Another thing stock price charts miss is spin-offs. Altria (MO) is a prime example of this, if you look at historical charts on Yahoo Finance. To anyone who only looks at the chart, and ignores everything else, it looks like Altria has done pretty badly since 2007. In reality, the chart fails to account for the fact that Altria (MO) spin-off Kraft in 2007 and Phillip Morris International in 2008.
Those two spin-offs actually have confused a lot of institutions. For example, despite the fact that Altria had a record of consistently increasing dividends for over a quarter of a century, it was booted off the S&P Dividend Aristocrats index in 2007. Anyone who blindly followed the index, likely also sold their shares. In reality, Altria (MO) never cut dividends. Anyone who purchased Altria in early 2007, has been receiving growing annual dividends ever since. The only issue is that those dividends were generated from shares of Altria (MO), Phillip Morris International (PM) and Kraft Foods (KRFT) ( and later Mondelez (MDLZ) as well). This is why I am very skeptical about blindly following indexes - there could be lapses of judgment that stem from mechanical application of rules, without really giving much thought to the reality and facts involved. This is also why I think it is important to analyze every company I own, or expect to own in detail. Luckily, when Abbott split in two in 2013, the mighty S&P Dividend Aristocrats committee decided to keep both Abbott (ABT) and Abbvie (ABBV) in the index. Either way, I focus on the dividend champions index, which is the most complete list of US dividend growth stocks I know of.
The spin-off situation at Altria also confused a lot of "chartists" that appear on CNBC. You might want to check this article - it blatantly ignores the fact that the split from 2007 and 2008 ever happened.
To summarize, stock price charts only show one part of return that investors would have received. However, without taking into accounts dividends, and the power of dividend reinvestment, you cannot understand what the total returns on an investment really are. It pays to research every investment in detail, before putting hard earned money to work there. In addition, it pays to own investments that regularly shower their investors with cash, in order to reduce the risk of outliving money in retirement. As we was above, stock prices can remain flat for extended periods of time - anywhere from 16 to 25 years. If you only rely of capital gains to bail you out, you might be in for some nasty surprises if you happen to invest during one of those periods. An investor who expects to live off the dividend stream generated from their portfolio can afford to ignore stock price fluctuations, and enjoy the retirement that they have worked so hard to achieve. An investor who wants to sell of portions of their portfolio will be in real trouble if that portfolio doesn't pay dividends and share prices fail to increase.
- Altria Group (MO): A Smoking Hot Dividend Champion
- S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors
- S&P 8000 – The power of reinvested dividends in action
- Dow 370,000
- The case for dividend investing in retirement
Monday, March 23, 2015
A few years ago, when I was starting my website, I featured research from Jeremy Siegel on the performance of the original companies in the S&P 500 index between 1957 and 2003. You can find the link in my article titled The Ultimate Passive Investment Strategy. Prof Siegel describes how an investment in the original 500 companies in the S&P 500 would have fared over that 46 year period. My favorite part was about the Total Descendants Portfolio, which assumed a total passive approach, where an investor reinvests dividends, holds on to shares of spin-offs, doesn’t do any rebalancing.
The lessons are very eye opening:
1) Having a totally passive approach has worked great for long-term investors
This is because spin-offs were held, transaction costs and taxes were minimized. It was quite interesting to learn how a totally passive investment ended up outperforming the S&P 500 over that 46 year period.
It is also interesting that only 30 companies failed outright, while 92 were merged and 74 were taken private.
2) The best performers were consumer staples and pharmaceutical companies.
The reason behind this strong performance is because many consumer staples and pharma companies have moats, reinforced by strong brands used regularly by consumers, customer loyalty and pricing power. The combination of competitive advantages, pricing power, brand loyalty which have resulted in above average returns for investors
3) Valuation is important
The most interesting thing is that investors in the so called slow growth companies for which investors have low expectations tend to outperform glamorous companies in new and exciting industries. This is because their valuation is usually low, and because investors in hot industries tend to bid up the valuations in pursuit of growth to the point of low expected returns. If you overpay for future growth, you might not earn a satisfactory return on investment even if your expectations are eventually met.
4) S&P 500 of today is not a passive index
Over the past six – seven years that I have been focusing on dividend growth stocks, I am hearing more and more people talking about index funds like some sort of a magic panacea for all investors. The truth is that S&P 500 is an actively managed portfolio, with frequent turnover, where new companies are frequently added when their valuations are often pretty steep. In addition, index funds have to sell due to adjustments due to buybacks, spin-offs, float adjustments, and other reorganizations. When a new company is added, investors bid up the price before it is added to the index as well, which also causes worse performance. Furthermore, the rules of the index get changes too often and investors who are passive by nature do not probably take the time to learn about them. Needless to say, if you are a terrible investor who makes poor choices, you will not be saved by index investing because it is the lack of education and emotional strength to hold on when things are tough. Plus, if the investor has to select this international index or that other index they heard about on the internet, they are essentially still picking stocks. Only this time the process of picking securities has a fancy named as it is called asset allocation. I have done better than the S&P 500 index since 2007. Of course, if I were a true indexer, I would have also had to own international indexes, which have not done too well. So I have done much better than most indexers out there. And my goal is not even to beat some index either.
However, if I were a busy professional with a family, and no free time or desire to learn about investments, I would invest only in index funds in my 401k/IRA. That describes most individuals out there (roughly 80% - 90%). Therefore, chances are these people are not reading my site. This situation also doesn't describe most of the people reading this site either.
5) Some Industries are built to last
Many investors are afraid of missing the next hot industry. As a result they chase those new industries, because they believe that they would make their big break in investing this way. They seem to forget that just because an industry makes people’s lives better, that doesn’t guarantee profits for investors. As a result, everyone piles in, pays high prices, but doesn’t make high returns. At the end of the day, the slow growth, boring stocks keep producing consistent results to their long-term investors. The important thing, as we mentioned before, is to avoid overpaying.
6) Some companies are built to last
After reading the research again, and also reading about the Corporate Leaders Fund, I am convinced that investing in blue chip dividend stocks for the long term is the best strategy for my portfolio. It is true that investing in 500 stocks today, and doing nothing, could result in a much different portfolio due to mergers and acquisitions, spin-offs, a few failures. However, from the 500 companies from 1957, there were not that many complete failures. This could change in the future, but nevertheless confirms my belief that doing nothing with a portfolio could actually produce the best results in the long-term. For example, one of my biggest mistakes has been selling a company and thinking that I can do better with something else. In 9 out of 10 such circumstances, I would have been better off I had been busy working instead and not fiddle with the portfolio. A portfolio is like a bar of soap - the more you fiddle with it, the smaller it gets.
7) The most important lesson is to be a long-term investor
The best lesson is that success in investing lies down to choosing an investment at an attractive valuation, building a diversified portfolio of those investments, holding through thick and thin, and only reinvesting dividends selectively. The S&P 500 index which constantly added new companies, was very active and failed to do better than a totally passive index. Investors who believe they can outguess the direction of companies and choose to frequently churn portfolios end up doing pretty bad in the future. That’s why it is important to sit on my portfolio for the long term, and do almost nothing. Time in the market is more important than timing the market. Time in the market is important, because it allows your capital to compound quietly. It is important to keep your winners, and not succumb to rebalancing or too much in other activity. It is quite possible that a few of your companies will end up going more than 1000%, which is why selling early because no one went broke booking a small profit is a foolish mistake to make.
- Buying Quality Companies at a Reasonable Price is Important
- The ultimate passive investment strategy
- Should dividend investors invest in index funds?
- Dividend Investing Knowledge Accumulates Like Compound Interest
- How to never run out of money in retirement
Wednesday, March 11, 2015
One of the reasons why some have ventured towards the world of dividend growth investing, is due to the marvelous success stories of the past. If you or someone in your family had put a mere $1000 in Coca-Cola (KO), Procter & Gamble (PG) or a Johnson & Johnson (JNJ) thirty years ago, your stake would be worth a lot, and you would likely be earning double digit yields on cost.
Such examples illustrate the true power of dividend growth investing as a strategy that can provide investors with a rising stream of passive income that is directly tied to the fundamental success of the businesses you are investing in. These examples are very inspiring, and show that a patient dividend investor can do pretty well for themselves if they select companies with the following characteristics:
1) A company with competitive advantages, pricing power and a growing market for its products/services
2) A company that generates so much extra cash, and has such a high return on equity, that it ends up increasing dividends for at least a decade
3) A company that is attractively valued at the time of purchase
If you are a serious dividend investor, I would strongly encourage you to study the history of all the greatest dividend growth stocks. This is in order to learn about the factors that had made these companies successful enough, so that they could afford to increase dividends for 40 – 50 years in a row. The knowledge should accumulate over time, and hopefully help you to spot those existing champions that can keep rewarding you with higher dividends or those emerging dividend achievers that can afford to raise distributions for several decades in the future.
However, there are no guarantees that the past performance will continue. The thing is that the world changes, and evolves over time. The destructive forces of capitalism continuously attack any moat out there, in pursuit of gaining market share and more profits. Technological innovations, changes in competitive nature and consumer habits can alter the business model of the company with the best defended moat of today. As a result, dividend investors should not be blinded and emotionally attached to each individual stock in their portfolio.
A few fallen angels from the list of dividend kings include Winn-Dixie and Masco (MAS). Other fallen dividend growth stocks include Bank of America (BAC) and Wachovia (WB).
While I am a buy and hold forever type of an investor, I realize that I would have turnover in my portfolio. As a result, I have several fail-safe mechanisms, whose goal is to protect me from getting too emotionally attached to a single stock, and failing to see that its business is never going to recover.
My fail safe mechanisms are:
1) Maintaining a diversified dividend portfolio, consisting of at least 40 – 50 individual companies
2) Focus on companies that have raised dividends for at least 10 years in a row
3) Selling a dividend stock after it cuts dividends
4) Reinvesting dividends selectively in other quality companies at fair prices
5) Purchasing companies that have increased earnings and which are not overvalued
In addition, next time you analyze a great company like Coca-Cola (KO), it is important to try and look past the dividend growth history. In other words, do not simply look at the dividend history, and assume the good times would continue indefinitely, without doing any additional research on the company. If the company manages to increase dividends for another 50 years, that is great. However, try to be realistic, and determine if there are growth catalysts that can allow it to keep earning more and paying more in dividends to you. Merely projecting past dividend growth, without doing any due diligence about where future raises could potentially come from, could prove to be costly for your dividend retirement.
In the case of Coca-Cola (KO), the company has hundreds of brands that it sells around the world. In addition, it has a very strong distribution network, and pricing power on its strong brands. The increasing in number of people around the world who can afford the refreshing products the company is offering, will most likely bode well for sales and profits over the next 15 – 20 years.
That being said, even for a great company like Coca-Cola (KO), you should avoid paying more than 20 times earnings at a time. Even for an outstanding company, you need to have a margin of safety by purchasing only when prices are fairly valued. If you overpay for a quality company, and something changes dramatically in a few years, you would lose far more compared to a scenario where you bought at lower prices.
On the other hand however, you should also avoid focusing too much on minutiae, and losing focus on the big picture as well. The worst mistakes I have made involved selling companies because they got a little overvalued, getting impatient because growth slowed down temporarily, and usually purchasing something inferior in the process. There are always reasons not to buy a stock, but unfortunately it would take many years, before you can realistically determine their validity. If you do start with companies that have a proven track record of growing dividends, but then study each company in detail for growth catalysts and fair entry valuations before you buy, you should do well in a diversified portfolio held patiently for the long run.
This is why dividend investing is more art than science. You essentially look for companies that have grown dividends in the past, but need to do your own due diligence in evaluating whether the good times can continue for a couple of decade.
The ultimate goal for you is to generate more dividends from your portfolio every year for the next 20 - 30 years after you retire. In order to achieve your goal, you need to avoid being emotionally attached to the stocks you hold, and be realistic about their position. History doesn’t repeat, but it rhymes.
Full Disclosure: Long KO, PG, JNJ
- Five Metrics of Successful Dividend Companies
- Why Sustainable Dividends Matter
- How to be a successful dividend investor
- Dividend Growth Stocks – The best kept secret on Wall Street
- Emotionless Dividend Investing
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