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

Wednesday, July 29, 2015

Dividend Growth Stocks Protect Investors from Inflation

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

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

Wednesday, July 22, 2015

Sector Allocations for Dividend Growth Investors

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

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

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

Tuesday, July 21, 2015

Am I a successful dividend investor?

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

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

Wednesday, July 15, 2015

The biggest investing sin exposed - part II

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

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

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

Tuesday, July 14, 2015

The Biggest Investing Sin Exposed

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

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

Friday, July 10, 2015

Do I need an emergency fund?

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

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

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

Wednesday, July 8, 2015

Dividend Growth Investing – a great strategy for long term investors

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

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

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

Wednesday, July 1, 2015

The most important rule about dividend investing

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

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

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


Monday, June 29, 2015

What drives future investment returns?

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

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

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

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

Wednesday, June 17, 2015

Why Dividend Investors should never use stop losses?

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

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

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

Tuesday, June 16, 2015

The most important metric for dividend investing

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

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


Friday, June 12, 2015

Should Dividend Investors Re-Balance Portfolios?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Relevant Articles:

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

Wednesday, June 10, 2015

How to value dividend stocks



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

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

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

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

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

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

Not all P/E ratios are created equal

Why do I use a P/E below 20

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

How to read my stock analysis reports

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

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

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

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

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

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

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

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

Relevant Articles:

Stress Testing Your Dividend Portfolio
Buying Quality Companies at a Reasonable Price is Very Important
Dividend Investing Knowledge Accumulates Like Compound Interest
The work required to have an opinion
How to never run out of money in retirement

Wednesday, June 3, 2015

How to become a successful dividend investor

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

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

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

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

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

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

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

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

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

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

Relevant Articles:

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

Wednesday, May 27, 2015

Simple Investing Principles to Follow

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

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

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

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

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

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

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

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

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

Relevant Articles:

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

Wednesday, May 6, 2015

How to be an Intelligent Dividend Investor

Ben Graham is one of the most successful investors of all time. He is the father of value investing, and the mentor of super investor Warren Buffett. He is also the author of the bible on value investing “Security Analysis”, as well as the book “The Intelligent Investor”. Ben Graham’s strategy focused on purchasing undervalued companies, and then selling them when prices reached his objective.

Graham was adamant about investing in companies that pay dividends. He believed that conservative investors should only consider companies that have paid a dividend every year for at least the last 20 years. He argued that dividends are a sign that a company is profitable (dividends are paid from profits, after all) and that they also offer investors a return even if the company's stock does not perform well.

Ben Graham quotes in his book "The Intelligent Investor" that:

One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.

Dividends represent a positive return on investment to shareholders. Because they are paid out of real earnings, they are the only fundamental link between company performance and investor returns. This is because stock prices can often ignore fundamental values for extended periods of time.

As a result, dividend investing is the perfect strategy for the intelligent investor to live off their nest egg. It is a nice edge for the investor with the long – term mindset of a business owner, who focuses on business profits, and is not afraid of stock prices that fall by 40 – 50% over a short period of time.

This business owner creates diversified portfolios that hold at least 30 - 40 securities, acquires partial ownership in those businesses over time and tried to pay fair prices for the securities.

What dividend investors do is a variation of value investing, with a quality twist. While Graham would focus on generating one-time profits from buying undervalued securities, dividend investors focus on recognizing value through the receipt of dividends. This dividend income unlocks value in the shares they own, by essentially providing them with a sort of like a cash rebate on their original purchase, while also maintaining their ownership in the asset. This provides recurring returns for the dividend investor who had done all the initial work needed.

Think about this for a second. The strategy Graham and early Buffett used was focusing on spending the equivalent of several full-time employees per week, scanning thousands of opportunities in order to come up with a few undervalued securities. They would purchase them, and sell only after a target price is met. After that, the laborious process continued.

On the other hand, if you spend your time looking for quality dividend paying companies, and find a few at fair prices, your work is essentially done. You will generate a rising stream of dividends over time, in some cases for decades, while patiently holding on to the appreciating stock. If your company manages to grow earnings and dividends by 7 – 10% year, this would quietly compound your investment income and net worth over the years. True, you have to monitor those investments, but let’s be honest, companies do not change that much from year to year. As long as the story keeps up, you can afford to only check the company through quarterly and annual reports. In reality, only a small portion of the companies you own will turn out to grow dividends for a long period of time, and deliver the most in growth for your portfolio. A large part would grow and then freeze and resume dividend growth, while the rest would likely lead to small losses as they cut dividends due to changes in business environment.

In a later version of the Intelligent Investor, Graham discussed how his partnership was involved in acquiring 50% of GEICO in 1948 for $712,000. Later, the SEC required them to distribute the shares to the partners. By 1972, the value of that stock had zoomed to $400 million. Graham later admitted that the profits from this one deal far outstripped the profits of his partnership over two decades from following the laborious value investing principles.

Buffett also purchased $10,000 worth of Geico in 1951, only to dispose at a profit in the next year in order to buy Western Insurance at 2 times earnings. He netted $15,000 from the sale, and notes that in the subsequent 20 years, the value of the sold shares increased to $1.3 million.

This is why buy and hold for the long-term in fantastic businesses is so superior to active trading (the active outguessing of the markets). It therefore seems important to focus on great businesses, which can grow for decades after you purchase them. Such securities can be safely tucked in a vault, and the investor should only be reminded about them four times per year, as the dividends are deposited in their accounts. Check this list of 39 dividend champions I am considering for further research.

Full Disclosure: None

Relevant Articles:

Successful Dividend Investing Requires Patience
How to think like a long term dividend investor
Dividend Stocks For Long Term Wealth Accumulation
Margin of Safety in Dividends
Dividend Stocks Deliver a Return in Any Market Condition

Wednesday, April 29, 2015

What makes Consumer Staples the Perfect Dividend Growth Companies?

Most consumer staples are also called defensive companies, because their earnings and dividends do not decline by much during recessions. During economic recoveries however, their earnings and dividends tend to increase also. Because they are mostly mature and large companies, growth expectations are low, which usually leads to low valuations.

The thing that truly appeals to me in consumer staples includes the recurring nature of their revenues, which are generated from a wide number of products that customers love and buy regularly. Most consumer staples offer products with strong recognizable brands, for which customers are willing to pay a slight premium for. A customer, who is used to Gillette razorblades and shaving crème or foam for years, is not going to downgrade their experience merely in order to save a few dollars, but end up with cuts all over their faces. If you have used Colgate toothpaste for years, chances are very high that you would keep purchasing a tube every month or so. The nature of the products that consumer staple companies offer, satisfy basic human needs, which are satisfied only when the branded product is exhausted. Once it is all used up, the consumer needs to go ahead and purchase the product again, thus ensuring a repeatable stream of sales for the company for decades to come from each consumer it wins over.

Consumer staple companies also benefit from strong distribution networks and economies of scale in production. They have wide moats. The distribution networks help the products to be easily accessible to the everyday consumer, and increase the likelihood of a repeated sale. The economies of scale allow companies to allocate their costs over a larger pool of product, thus resulting in negligible per unit in additional cost. For example, a company like Procter & Gamble (PG) has a better staying power than an upstart consumer-staples company, because P&G can reach out tens of millions of consumers in the US through advertising, as it already generates billions in revenues and already has millions of customers buying its products. The global scale of manufacturing also makes it cheaper to make its products, relative to a smaller competitor.

Furthermore there are always plenty of opportunities for growth, driven either through acquisitions or international expansion. In addition, the general level of increase in populations over time also leads to an organic growth kicker for consumer staples.

The fact that consumer staple products are relatively inelastic, meaning that people use those in good times and bad, translates into a stable stream of recurring revenues for these companies. This translates into stable cash flow generation, that provides the fuel behind dividend payments, share buybacks and acquisitions.

If you think about it, as long as people use hygiene products such as toothpaste and shampoos, eat food like ice-cream, cookies, jelly and canned soup, chances are that consumer staple companies should do well over time. Even if you get a consumer staple company whose customer base grows by 1%/year, you can generate very decent returns over time. This is because the company would be able to pass on rising costs to consumers, deploy some excess cash flows to repurchase some stock on a regular basis, make strategic acquisitions, and make operations more efficient. If you add in a small starter yield of 2 – 3% today, chances are that these factors described previously could easily translate into a minimum very conservative annual earnings per share growth of 6% - 7% for decades.

Some of the huge macro trends that Consumer Staples are riding include the increasing prosperity in the emerging market world, where over a billion people would be lifted out of poverty and join the middle class within a couple decades. In addition, some demographics trends that no one is paying attention to includes the baby boom in the US, as well as the potential for a baby boom in China, as the one child per couple policy seems to be phased out by the government. Even the population ageing in developed countries such as Japan or those Western European ones could be a boom for consumer staples. As people age, they would want to do so in dignity, which could only translate into more sales for the likes of Johnson & Johnson (JNJ), Procter & Gamble (PG) etc.

The time to purchase these companies is when valuations are low, and avoid overpaying, as this would mean that the next decade of growth is already baked in the stock price. The perfect time to purchase could be when there is a temporary snafu at the company, such as the Tylenol scare for Johnson & Johnson in 1983 or the 2010 recalls again at Johnson & Johnson (JNJ). The financial crisis of 2007 – 2009, also created an environment where quality companies such as Procter & Gamble (PG), Clorox (CLX), Colgate-Palmolive (CL) and PepsiCo (PEP), to name a few, were on sale at some of the lowest valuations in years.

After you purchase those companies, your job is to sit patiently and collect those growing dividends. Only if prices become terribly overvalued, north of 30 times forward earnings should you consider thinking about trimming. So far, even if you held on through the 1972 Nifty Fifty bubble, or the 1999 – 2000 bubble, the rising earnings tide on those companies eventually bailed out the long-term investor. Just be mindful that if you sold a company that raises earnings and dividends like clockwork at 30 – 40 times earnings, chances are that any replacements you find might look cheaper, but wont offer the same level of quality.

Unfortunately, many consumer staples companies I like are overvalued. A few which are fairly valued today include:

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 53 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.50 times forward earnings and yields 3%. Check my analysis of Johnson & Johnson 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 18.60 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.

Diageo plc (DEO) manufactures and distributes premium drinks such as Johnnie Walker, Crown Royal, Buchanan’s, J&B, Baileys, Smirnoff, Captain Morgan, Guinness, Shui Jing Fang, and Yenì Raki.. The company has raised dividends for 15 years in a row. In the past decade, the company has managed to boost dividends by 5.80%/year. Currently, the stock is selling for 20.20 times forward earnings and yields 3%. Check my analysis of Diageo for more details.

Full Disclosure: Long JNJ, CLX, PG, CL, PEP, MO, DEO,

Relevant Articles:

Are dividend investors concentrating too much on consumer staples?
Strong Brands Grow Dividends
39 Dividend Champions for Further Research
What dividend stocks would I buy if I were just starting out as a dividend investor

Wednesday, April 22, 2015

How to Make Money in Your Sleep with Forever Dividend Investing

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

Relevant Articles:

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

Tuesday, April 21, 2015

Dividend Growth Stocks Increase Intrinsic Value Over Time

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.

Relevant Articles:

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

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