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

Wednesday, September 17, 2014

Three Questions That Every Dividend Investor Should Ask Themselves

Investors purchase dividend stocks in order to generate a reliable source of cash that would help them pay for their expenses in retirement. In theory, this is a great idea. However, certain little details could seriously derail the investor’s success. In order to ensure that they will be able to hit their investment goals, dividend investors should ask themselves the following three questions:

1) Is the dividend Safe?

Many dividend investors who are just getting started tend to focus on companies with the highest dividend yields. Noone can blame them for this, as it is every investors goal to maximize their investment returns. Investing purely for dividend yield however, could easily backfire without some basic research. The company with a mouth-watering 8% yield today could end up cutting or completely eliminating the distribution, which could lead to loss in dividend income and huge losses. This could derail anyone’s retirement plan. Investors should instead attempt to understand how the company makes money, and should also calculate whether the dividend is adequately covered. I typically look for a margin of safety in dividend coverage. This means that I typically look for a dividend payout ratio of 60% or less, which means that earnings are roughly 67% higher than the dividend paid. This payout ratio fluctuates from year to year, which is why it is important to look at it for the past decade, in order to gauge the sustainability of dividend payment. While there are no guarantees that the dividend would be paid out, even if it is adequately covered, a sustainable distribution increases the odds that the investor would be able to enjoy an uninterrupted stream of dividends.
For certain entities such as Master Limited Partnerships or Real Estate Investment Trusts, I tend to prefer a stable or declining ratio of distributions to cash flow from operations ( FFO or DCF).

2) Will the dividend grow?

Inflation is the largest enemy of the retired investor. Prices have been on a slow but steady increase over the past century. Even at a modest 3% annual inflation, prices of goods and services will double in 24 years. As a result, investors need to have a stream of income that will increase sufficiently to cover the effects of general price increases. Dividend growth stocks are a perfect investment vehicle for such endeavors. In my portfolio I purchase stocks which have exhibited a strong corporate culture, backed by real profits, which has resulted in long streaks of consecutive dividend increases. Newton’s law that a body in motion will keep being in motion is in full force with dividend growth investing. Just because a company has raised distributions for 20, 30, 40+ years does not mean it is a good buy at the moment however. In general, companies can only afford to grow dividends if they manage to increase profits over time. Investors should thoroughly analyze the company by reading annual reports, analyst reports and keeping up-to-date on any company developments. This is in order to determine whether the possibility of future dividend hikes is higher than average.

3) Will the company deliver solid total returns?

Many investors seem mesmerized only by dividends, do not do much due diligence on growth, and tend to forget about capital gains in the process. This could be costly to your financial well-being. Historically dividends have accounted for about 40% of total returns over the past 80 years. The remainder has been achieved through capital appreciation in stocks. In general, dividend growth companies with moderate current yields in the 2%- 4% range with payouts below 60% stand a very good chance of delivering solid capital gains over time. This is in addition to the rising dividend payment. While, capital gains are not as reliable for retirees as dividend payments, they do ensure that over time the purchasing power of the investor’s capital is maintained and increased. If all else is true, a company yielding 2% - 4% today that also manages to grow earnings and dividends at a healthy clip, should be able to increase in value over time. This again ensures that my capital maintains purchasing power as well. I do not plan on selling most of the holdings I own, however I do want to see increases in networth over time.

Relevant Articles:

Dividend Investing for Financial Independence
Investors Should Look for Organic Dividend Growth
Dollar Cost Averaging Versus Lump Sum Investing
When to sell your dividend stocks?
How to monitor your dividend investments

Tuesday, September 2, 2014

Should I have a minimum yield requirement?

In my entry criteria, dividend yield is the last factor used to select dividend stocks. After I screen the list of dividend champions or dividend achievers, I look at each company in detail.

First I look for growing earnings per share, and attractive entry P/E ratios. Then I check if the dividend is going up above the rate of inflation. Finally, I check if entry yield is above 2.50%.

Using my screen parameters, I sometimes end up missing companies which have low yields but high dividend growth. However, by doing so, I am somewhat protected in the case I purchase a low yield but high growth stock, which subsequently lowers distributions growth or stalls it. I want to avoid at all costs getting carried away chasing dividend growth. Chasing growth could result in overpaying for a low yielding asset that grows earnings and dividends, and my total return ends up being limited to the modest initial yield for several years. My investment philosophy is to avoid losing money, and as a result I am fine missing out on potential gains if that reduces dividend income risk. Winning dividend positions typically take care of themselves, while losing positions are typically the higher risk ones that could make you lose sleep at night.

For example, investors who purchased stock in some great blue-chip dividend payers such as Coca-Cola (KO) or Wal-Mart Stores (WMT) during the 1999 – 2000 period, saw their share prices go nowhere for over a decade. The only return they received was in the form of dividends, which were initially very low. At the same time, both companies managed to significantly increase revenues, earnings and dividends during that time period. The reason behind the lackluster performance was the fact that these stocks were very overvalued in the late 1990’s and early 2000’s. The lesson from this exercise is that even the best dividend paying stocks in the world are not worth overpaying for.

Furthermore, while I may miss out on some companies like Raven Industries (RAVN) or Franklin Resources (BEN), I am going to still be able to select stocks in the sweet spot, which generate best returns for the risk i am taking. A company like Phillip Morris International (PM) or Kinder Morgan (KMI) that provides a good starting yield of 4% which grows at 8%-10% per year, is a much better candidate that a company yielding 1 - 2%, that grows dividends at 12%. The higher initial yield provides a margin of safety for the time in the future when dividend growth stalls. This could be tomorrow, or it could be 20 years from now. The issue with high growth is that it cannot continue forever. At some point, the growth will come down to a more reasonable and sustainable level.

The negative of what I am doing is that I will surely miss out on the next McDonald's (MCD) or Johnson & Johnson (JNJ) dividend growth success story. This is because companies in the early stage of dividend growth typically have low current yields, but manage to grow distributions at a very high clip. Those are the types of companies which will generate outstanding total returns, and double-digit yields on cost for anyone fortunate enough to believe in the company, and put their money there. This is one of the reasons why I purchased Visa (V) in 2011 and recently in 2014, despite the low current yield. I also purchased Casey's (CASY) in 2011 and YUM! Brands (YUM) in 2010 and 2013, when their yields were less than 2.50%. I was betting that above average dividend growth will continue, and I also wanted to beef up my portfolio exposure to the low yield and high dividend growth investments.

In the grand scheme of things, I am starting to believe more and more that initial attractive valuation of less than 20 times earnings is helpful. If this valuation is even lower, that could be very helpful for total returns and future yields on cost as well. The other equally important thing to consider is growth of earnings per share. After all, a quality business that keeps growing over time will eventually bail out the investor who might have slightly overpaid in the beginning. However, if I overpaid for a business that pays a high yield today, but fails to grow earnings per share, chances are that the dividend will not increase above the rate of inflation, and I will end up downgrading my standard of living quite regularly. Therefore, a business which has the potential to earn more in 15 - 20 years, coupled with an attractive valuation, is the type that will deliver investment success to its shareholders. Whether this business pays a 2.50% yield or a 1.50% yield at the time of investment might not be as relevant. However, if I am wrong about my assessment of the business, I will end up losing more under the lower yield scenario, since earnings will not grow by much leading the the price to stagnate, In addition, the business will only pay a paltry yield, that does not grow by much either. Since I use my dividends from companies to buy shares in other companies, this could mean less money to be put to work in the next great dividend growth success story.

This is why evaluating each business one at a time is so important. The investor has to take into consideration valuation, growth prospects, changes in industry or competitive landscape and evaluate that against their unique set of investment opportunities and expectations. Unfortunately, investing is not as black and white as most would make you believe.

Full Disclosure: Long KMI, PM, KO, WMT, YUM, V, CASY

Relevant Articles:

The importance of yield on cost
How to be a successful dividend investor
Types of dividend growth stocks
How to retire in 10 years with dividend stocks
Should Dividend Investors Worry About Rising Interest Rates?

Wednesday, August 20, 2014

How to Invest Like Warren Buffett

Warren Buffett is the most successful stock investor in the world. He made his first $20 million dollars by running a hedge-fund like investment partnership in the 1950’s and 1960’s. However, if he hadn’t changed his investing habits from being a pure value investor to being influenced by Charlie Munger and Phillip Fisher, he would not have been as successful as he is today. Buffett’s earlier cigar-butt investments produced large gains initially, but then he had to do more research in order to find more value investments, and reinvest his money. What he learned from See’s Candies, Berkshire’s Insurance Operations and Newspapers however, shaped the way Buffett invests. By using his investing acumen to identify these superb businesses, his company managed to earn a recurring stream of profits for years to come.

The best lesson that Warren learned happened when he purchased See’s Candies for 25 million dollars in the 1970’s. The business had a strong brand, which was synonymous with quality, and had a loyal customer base. The strong competitive advantages of the business helped it maintain pricing power, and slowly boost prices to consumers over time. When competitors tried to emulate its packaging in order to steal market share, they were sued by See’s and promptly had to stop doing that. At the same time the business did not need to reinvest a substantial portion of earnings in order to increase sales over time. As a result, the business has generated over a billion dollars for the forty years that Berkshire Hathaway (BRK.B) has owned it. In effect, the business has paid for itself almost 50 times over.

The other businesses that Buffett purchased included newspaper and insurance companies. At the time, newspapers had strong competitive advantages in metropolitan areas, which allowed them to serve as the only local exchange of information, services and goods in a given city. All of these businesses were flush with cash, and were spitting excess free cash flows every quarter. They also had strong competitive advantages, and didn’t need all of their profits to be reinvested back in the business in order for it to grow. Unlike the cigar-butt investments that Buffett made earlier in his career, the companies with competitive advantages managed to deliver returns for years to come, rather than deliver a one-time return and then nothing.

Buffett then used the free cash flows from these businesses to purchase more income streams that generated more excess cash flows. This is very similar to what dividend investors in the accumulation phase are doing. They design a dividend portfolio, and then use dividends received in order to purchase more shares of other attractively valued companies. As a result, I have long argued that Buffett is a closet dividend investor. If you read his letters to shareholders closely, one would notice that he keeps reiterating how Berkshire Hathaway’s investments keep producing excess cashflows of staggering amounts every month.

In fact, dividend investors can essentially emulate Buffett’s style by creating their own mini-Berkshire’s using dividend growth stocks purchased at attractive valuations. Some of the most widely-held dividend stocks to serve this purpose include:

McDonald’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. This dividend champion has increased dividends for 38 years in a row. The company has a 10 year average dividend growth rate of 22.80%/annum. Currently, the stock is selling for 17 times forward earnings and yields 3.20%. Check my analysis of McDonald's.

Wal-Mart Stores Inc. (WMT) operates retail stores in various formats worldwide. This dividend champion has increased dividends for 41 years in a row. The company has a 10 year average dividend growth rate of 18%/annum. Currently, the stock is selling for 14.80 times forward earnings and yields 2.50%. Check my analysis of Wal-Mart Stores.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. This dividend stock has increased dividends for 6 years in a row. The company has a five year average dividend growth rate of 14%/annum. Currently, the stock is selling for 16.50 times forward earnings and yields 4.10%. Check my analysis of PMI.

International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. This dividend achiever has increased dividends for 19 years in a row. The company has a 10 year average dividend growth rate of 19.40%/annum. Currently, the stock is selling for 10.60 times forward earnings and yields 2.40%. Check my analysis of IBM.

Exxon Mobil Corporation (XOM) explores and produces for crude oil and natural gas. This dividend champion has increased dividends for 32 years in a row. The company has a 10 year average dividend growth rate of 9.60%/annum. Currently, the stock is selling for 12.80 times forward earnings and yields 2.70%. Check my analysis of Exxon Mobil.

Full Disclosure: Long MCD, KO, WMT, PM, IBM and 1 share of BRK.B

Relevant Articles:

What Attracted Warren Buffett to IBM?
Warren Buffett is now working for me
Why Warren Buffett purchased Exxon Mobil stock?
Warren Buffett Investing Resource Page
How Warren Buffett built his fortune

Wednesday, August 13, 2014

Dividend Investing for Financial Independence

There are millions of Baby-Boomers in the US. Every day, thousands of them retire from the workforce. Most will rely on a mix of social security, company pensions and personal assets for income in their golden years. Fewer employers are offering traditional pensions these days however, and the future of the Social Security system is not as sound as it once was. Depending on who you listen to, Social Security system would either run out of money in 35 years or will be able to continue paying benefits, albeit at a deeply reduced rate. For many investors outside the Baby Boomer generation, the realization is that they would have to provide for their own retirement, and not rely on employers or the government.

The tools that there investors can leverage in order to reach their financial independence goals include time, compounding, capital and smart investing.

One investment strategy that can provide for your own investing is investing in dividend paying stocks. By creating a portfolio that consists of dividend paying stocks, an investor generates income that is paid to them at predictable intervals of time. Having a stream of income deposited in your brokerage account every month or every quarter makes budgeting much easier, and living off dividends a no brainer solution.

I view every dollar I can save as a dollar that can generate income for life. Let’s assume that this dollar is invested in a dividend stock that yields 4%, grows distributions and stock price by 6% annually. After ten years, this dollar will generate 7.16 cents in income, which will increase to 12.80 cents by year 20. In 30 years, this dollar will be generating almost 23 cents in annual income. If distributions are reinvested however, the dollar will be generating 10 cents, 26.70 cents and 71 cents in the next 10, 20 and 30 year periods. One cannot retire on a single dollar alone, but if you keep adding dollars to your investment portfolio and let them compound through dividend reinvestment, our investor can afford to generate enough income to retire.

These dollars need to be invested by designing and creating a diversified dividend portfolio that consists of at least 30 individual stocks. The portfolio should have representation from as many industries that make sense at the time of implementation. This portfolio should focus on dividend growth stocks, which are companies that have a history of regular dividend increases. A company that regularly increases dividends essentially provides investors with a stream of income that keeps its purchasing power over time. Compared to interest income, dividend income looks like a clear winner for preserving purchasing power from inflation.

The element of time is another crucial element in achieving financial independence with dividend paying stocks. Depending on the amount of capital invested initially, as well as the amount of capital added each month, a portfolio would require differing amounts of time to compound before a sustainable amount of income is generated. The portfolio would need more time to compound investment dollars in order to reach the target monthly dividend income if the amount of capital added is not high enough. However, if the amount of capital added to it is large enough, the time needed to reach the monthly income targets would be greatly reduced.

For example, let’s assume that an investor puts $1000/month in the stocks yielding 4% today and achieving a 6% annual dividend growth. If dividends are reinvested, the portfolio will generate over $7,900 in annual dividend income in ten years. However, if our investor put away $2000/month in income stocks with the same characteristics as above, they would be achieving $7,900 in annual dividend income only after 72 months.

Besides diversification and power of compounding, another crucially important factor to building a successful dividend portfolio is stock valuation. Just like a house is composed of many bricks, placed one by one, a portfolio is comprised of many individual stocks which are the building blocks that provide support behind the portfolio. If one or a few companies in a concentrated sector bet crumbles during a recession, it could potentially destroy the whole structure. Having a strong foundation would protect investors’ income portfolios in the event of dividend cuts or eliminations as a result of unfavorable business conditions. Each dividend stock in a portfolio should thus have to be carefully chosen, and should be purchased only at attractive valuations. Purchasing shares when they are cheap maximizes price gains and dividend income for shareholders over time. This further turbocharges the compounding in income stream growth over time. I typically look for companies that have raised dividends for over 10 years, that trade at less than 20 times earnings, have a dividend payout ratio of less than 60% and which yield at least 2.50%. For Master Limited Partnerships and Real Estate Investment Trusts however, the only differences related to how I calculate payout ratios and what minimum yield requirements I selected.

A few companies which are attractively valued today include:

10 yr DG











Full Disclosure: Long ADM, AFL, CB, CVX, JNJ, MCD, MMM, WMT, XOM

Relevant Articles:

My dividend crossover point
Can everyone achieve financial independence with Dividend Paying Stocks?
Margin of Safety in Financial Independence
How to stay motivated on your road to financial independence
Achieve Financial Independence with Dividend Paying Stocks

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