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

Friday, April 18, 2014

Dividend ETF’s Are Bad for Investors: Here is Why

The Exchange Traded Funds (ETF) industry has ballooned since 1993, when the first ETF on S&P 500 was introduced. Currently, there are hundreds of ETF’s covering many investment strategies present. One strategy which is also being covered with dividend etf’s includes dividend paying stocks. In this article I would discuss the positives and negatives of dividend ETF’s, and explain why they are bad for income investors.


Some of the positives of owning dividend ETFs include instant diversification, ability to invest passively and the ability to gain exposure if you do not have a lot of money.

1) Instant diversification,

The biggest allure of dividend ETF’s is the fact that investors can easily purchase a basket of shares with just one trade. This basket of shares would be representative of different industries included in the index, and would reduce the risk that our investor overcommits to a certain sector if they are prone to chasing yield for example. Plus, you get to pay one commission to purchase a whole basket of stocks, or some companies might let you purchase ETF's commission free.

2) Ability to invest passively

Another appeal of dividend ETF’s is that it lets investors purchase a basket of stocks, and then not have to worry about analyzing stocks, monitoring 30 - 40 companies in detail. This is the job of the investment manager in charge of the ETF, who reads annual reports, keeps up with current environment, calls companies and does all the leg work so that the investor does not have to do it. Reading annual reports could sometimes be an intimidating or very boring task for some investors. The dividend ETF is ideal for investors who want to set the investment, and forget it.

3) Good for beginning investors who are still learning and have less than $10,000

The investment in a dividend ETF or dividend mutual fund is probably best for beginning investors who have less than $10,000 to start with. It offers them instant diversification and passive investment at the fraction of the cost of a do-it-yourself portfolio using an online broker. Dividend ETF’s also make it very easy for investors to put additional funds to work, while maintaining sector diversification in the index and without worrying which of the 30 - 40 securities is the best one to buy.


1) Annual costs

While Dividend ETF’s provide investors with instant diversification and the ability to let someone else to worry about the mundane details, the Ivy League investment manager comes at a price. In addition, most companies that offer dividend ETF’s also want to earn a fair profit on this product. As a result, investors in some of the largest dividend ETF’s like SPDR S&P Dividend (SDY) and iShares Dow Jones Select Dividend Index (DVY) pay 0.35% – 0.40% per year in management costs. If the stock portfolios in those ETF's yield 3% on average, this means that 12%-13% of your dividend income will be paid out as an investment tax. If our investor is also in the top bracket, and pays 23.80% federal tax on the income, they would end up with only two-thirds of their desired dividend income. While placing your stocks in a tax-deferred account such as a Roth IRA can eliminate taxation issues, placing your investments in ETF’s would result in recurring annual charges. In fact, investment companies end up charging their fees on a daily basis. This compounding of fees could cost investors large amounts of money over a normal 20 - 30 year investment period. While many ETF’s are now commission free at various brokerage houses, investors would need to pay a commission for most of the dividend ETF’s out there.

2) Investors have no say about which stocks the ETF holds

Another negative of dividend ETF’s is that investors have no say on how these baskets of stocks should be invested. Sometimes, a dividend ETF might hold shares that do not fit in its strategy for months. For example, back in 2008 and 2009, the SPDR S&P Dividend ETF (SDY) held on to shares of companies that cut or eliminated distributions for several months after the fact. As a result, a portion of the capital of this ETF was not properly invested and was not generating much in dividend income for investors. In addition, many dividend ETF’s are placing higher weights on higher yielding stocks, which could increase risk for income investors. This increases exposure to companies with accidental high yields which are large because the dividend is in danger. In addition, some of these ETF’s also tend to focus mostly on higher yielding sectors like utilities and financials, which could increase risk as the portfolios would not be properly diversified.

3) Investors fail to learn about investing

The most successful investors make their own investments, after a careful analysis. If investors simply purchase an ETF, they might not truly get an understanding of what they are buying and could pay a high price over time. Educating yourself on how companies make money, how the economy works and understanding how to value a security would be beneficial to investors who follow stocks, bonds, commodities or real estate. If they blindly buy ETF’s or mutual funds without fully understanding what they are getting into, they might be much more likely to lose money by selling out during bear markets or by getting overly excited about the wrong investments at the most inopportune times.

4) If not enough money is attracted, the ETF could be closed

Another less known risk about dividend ETF’s is that if the fund fails to attract enough investors, it could end up closing and returning money to investors. If our investor is passive and only checks their portfolio once or twice/year, this could mean that they can potentially miss on potential upside by not being invested in the markets. A small ETF size typically also translates into higher bid/ask spreads and higher annual costs.

5) Too much turnover

I am a pretty passive dividend investor, who makes sell transactions very rarely. In fact, I have realized that one of my largest mistakes I have committed in the past few years was selling fine companies in order to get something that I thought is better. The end result of this mistake is that I have ended up with more paperwork, and transaction costs, without really achieving a better benefit. Talk about reinvestment risk. Therefore, I am not a fan of ETFs or Mutual funds that have turnover, which produces capital gains that investors have to foot the bill for, without really getting anything extra. The issue with dividend ETFs is that they contain quite a lot of turnover, and unfortunately the investor does not have any say about it. Honestly, if a company I own froze dividends for a few years, it would not be a strong enough sell signal for me. I also don't want to sell a company when it splits into two after raising dividends for 40 years, despite the fact that the new companies lack a record of dividend increases. This happened with Altria (MO) after it spun-off Kraft (KRFT) and Phillip Morris International (PM) in 2007 and 2008.

For my personal portfolio, I tend to invest in stocks directly, and build my exposure to different sectors from the ground up. I have a direct say on portfolio weights, and selecting only companies whose stocks are attractively priced at the moment. My only cost is the commission to buy or sell securities. If commissions were $5/trade, an investors purchased shares in $1000 increments, then this comes out to a 0.50% one-time cost. This is a much better cost than paying 0.35% – 0.40% every year. During a 20 - 30 year period the costs are going to reduce income over time. In addition, I have flexibility to exit stocks that do not make sense right away, and reinvesting the funds into another security that makes sense. Plus, if you achieve a certain net worth, your investment costs might be close to nill with some brokerage houses.

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

Relevant Articles:

Dividend ETF or Dividend Stocks?
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The ultimate passive investment strategy

Monday, February 3, 2014

How to retire in 10 years with dividend stocks

The goal of every dividend investor is to generate a sufficient stream of passive dividend income, that would adequately cover their expenses. In order to achieve this goal however, investors need to select a strategy and fine-tune it over time to reflect current market conditions. In most of my articles I tend to focus on investing that would generate dividends for several decades to come. But how would someone who wants to retire in one decade afford to retire? Follow the guidelines in this article, and you might end up being one of the lucky ones who can afford to quit the rat race in a decade.

The first guideline is to contribute regularly to your dividend portfolio. This is important, because it allows our investor to dollar cost average their way over many years. This would provide them with the opportunity to build their portfolio brick by brick, without purchasing everything as a lump sum. Many articles on retirement focus on lump sum investing, which is not relevant to most future retirees.

The second guideline is to focus on dividend growth stocks, which are companies that regularly raise distributions. Since our dividend investor is likely to live off distributions for decades to come, they need to overcome the risk of inflation. As a result, they need to invest in stocks that can afford to regularly increase dividends, thus ensuring an inflation adjusted stream of income. Luckily, David Fish has the dividend champions list, which can be accessed from here. Investors can use this list as a starting point to identify dividend growth stocks, and apply their screening criteria.

The third guideline is to buy quality dividend stocks at attractive valuations. This is the step where the savings added to the brokerage account need to be invested. Investors should develop a set of standard screening criteria, in order to narrow down the list of dividend champions or achievers to a more manageable level. I typically look for companies yielding more than 2.50%, which have raised dividends for at least ten years in a row and trade at less than 20 times earnings. I then further avoid companies with high dividend payout ratios, depending on their industry and business form. After I do this, I research each stock in detail, in order to determine if it has what it takes to keep raising earnings and dividends over time. This is the most subjective part of the process. However, if you create a properly diversified portfolio of income stocks as outlined in the next step, you have a very good chance of success, even if you picked average companies.

The fourth rule is to focus on creating a diversified income portfolio, in order to reduce risk. In order to protect yourself, your goal is to have your income stream come from as many companies as possible. Leave the task of outperforming the market each year to the people who want to manage other people’s money or who are trying to sell you expensive newsletters. Your goal is to create an income stream that grows over time, which will support you in your retirement. As a result, in order to have a defensible income stream, you need to own at least 30 individual income stocks representative from as many industries as possible. Ideally, you would own three stocks from each of the ten sectors identified by Standard and Poor's, which comprise the S&P 500 index. In reality however, it might be difficult to achieve this strict diversification. However, since you are building your portfolio over a long period of time, you will likely be able to purchase quality stocks from different sectors, which would be priced right at different times over the next decade.

The fifth rule is to reinvest dividends selectively in these quality income stocks over the next decade. Until you reach your target dividend income, you need to use the power of dividend growth, new capital contributions and dividends received to plow back into your portfolio and turbocharge your dividend income. I typically avoid reinvesting dividends automatically. Instead, I wait for my dividends to accumulate, and then either add to an existing position, or initiate a new position in an attractively valued stock. While some might say I am missing out on compounding my income while waiting for my dividends to accumulate and buy a stock, I disagree. Re-investing dividends in an overvalued stock is a much worse offense than simply patiently accumulating cash in my book, and deploying it in the best values at the moment. This is another tool that will increase your odds of growing your dividend income stream faster.

Now that I outlined a list of few basic guidelines to follow, I will show how an individual can retire in ten years. Let’s assume that our individual manages to save $1,000/month for the next 120 months (10 years). The first month they only manage to save $1000. Let us also assume that our investor invests his or her hard earned money in dividend stocks yielding 4%, that grow distributions by 6%/year. Let's also assume that share prices grow by 6%/year as well (Such linear growth in share prices does not work in reality, but is only used for the model) If the distributions are paid monthly, and are reinvested back in stocks yielding 4% and growing distributions at 6%, our investor will generate $659/month after 10 years. Now granted, they only saved $1000/month for ten years. However, if they saved $2,000/month instead, their dividend income will rise to $1,309/month in 10 years. If your dividend crossover point is around $1,300, then after ten years of meticulously saving and investing $2,000/month, you will be able to retire. The table below shows how investing $2,000/month in dividend paying stocks that yield 4% and grow dividends by 6%/year, can result in monthly incomes exceeding $1,300/month in 10 years, and $2,000/month in 13 years.

As you can see, the second column shows number of shares purchased with the $2000 savings every month, plus the amount of dividends received as well. After the first year, the $2000 buys less than 2000 shares, because the share price goes up in lockstep with the dividend growth.

This spreadsheet is a guideline on the forces that will help someone reach financial independence. Your dividend crossover point will be dependent the amount you can save, amounts you need, returns you can generate, and time to retirement. By carefully managing those variable, the retiree will be able to devise a proper plan that will help them accomplish their ultimate goals of attaining freedom over their time.

Relevant Articles:

Complete List of Articles on Dividend Growth Investor Website
What are your dividend investing goals?
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Dividend Growth Investing is a Perfect Strategy for Young Investors
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Wednesday, January 8, 2014

Achieve Financial Independence with Dividend Paying Stocks

My dividend retirement plan will be achieved at the time when my dividend income exceeds my monthly expenses. In a previous post I mentioned that I am close to covering approximately 50% of my expenses from my portfolio distributions. While achieving financial independence is important, maintaining and growing your dividend income  for several decades after that, is even more important.

In order to achieve and maintain financial independence, I generally try to follow several common sense principles.

1) I try to purchase quality dividend stocks at attractive valuations
2) I try to purchase quality dividend stocks which have sustainable distributions
3) I try to purchase quality companies that will grow earnings and dividends
4) I try to diversify my portfolio by holding at least 30 companies in as many industries as possible
5) I have an exit plan for each stock I purchase
6) I continuously study the lists of consistent dividend payers and analyze potential portfolio additions regularly
7) I analyze the companies I own at least once per year in a great detail

I define quality companies as those that have some sort of competitive advantages or wide-moats with strong pricing power. The companies typically have strong brand names, are market leaders in their niches, have patents or geographic monopoly in certain areas, or are the lowest cost provider of goods/services. Other characteristics of quality companies include high switching costs to move to a competitors.

I typically try to acquire such companies when they have achieved at least a decade of consistent dividend growth and trade for less than 20 times earnings. If their dividend yield is above 2.50% and they have a sustainable dividend payout, that makes me determined to study the company’s financials more in depth. I essentially try to determine whether the company would be able to achieve earnings growth over time, whether organically or through acquisitions. There are several companies in my portfolio such as Clorox (CLX), ONEOK Partners (OKS) and Coca-Cola (KO) which have outlined strategies to hit specific earnings targets within a defined period of time. Once I learn as much as possible about a company, and I have determined that it is a quality company that has a great chance of growing earnings and dividends and which is also attractively priced at the moment, I log on to my brokerage account and buy shares.

I would then hold on to these shares until one of these three events happens. The event that typically makes me want to sell stock has been dividend cuts or eliminations. I automatically sell after an event like that, and try to reinvest proceeds into another company that is attractively priced. This is where my continuous research of the list of dividend growth stocks comes in handy, because it enables me to have a list of 20 - 30 stocks at all times that could fit my criteria for inclusion in my portfolio. The average retirement could last for two – three decades. Over the course of this period, one could reasonably expect that the composition of their income portfolio would be different in year 31 in comparison with the portfolio composition in year one. If a company that I own is not in buy territory anymore, I do not sell its shares, but hold on to them. I would only consider selling if the company is severely overvalued and I have found similar prospects that would provide me with a better income growth over time. One such example was when I replaced most of my position in Con Edison (ED) with shares of ONEOK Partners (OKS).

I try to maintain a portfolio of at least 30 individual dividend paying stocks, which should be spread out between as many sectors that make sense. However, I would not add stocks in a dying sector such as newspapers or cyclical stocks such as General Motors (GM) or Ford (F) just for the sake of diversification. I now hold over 40 individual stocks in a material to my portfolio way. Each of those has varying portfolio weights, because some of the companies have been attractively priced early in my accumulation process, but have been overpriced ever since. As a result, I have allocated new funds and dividends generated by my portfolio into the best picks at the time funds were available. Contrary to popular belief, it does not take a lot of time to keep up with a dividend portfolio consisting of 40 -50 individual issues. This is because as a long-term investor, I purchase shares after doing a large amount of research behind each idea. As a result, I get to update my knowledge through my annual stock analysis of a stock. I gather data by looking at annual and quarterly reports, analysts’ reports and general news. As a long term investor, one notices that there are not a lot of things that materially change from year to year. For example, Wal-Mart (WMT) has been a retailer for over forty years, and McDonald’s (MCD) has been a fast-food company for many decades as well. It is true that each year these companies are facing different challenges ahead, but at their core they are very much unchanged. This is another reason why investors should spend a lot of time upfront educating themselves how a company generates money.

In addition, I also try to diversify, in order to decrease my reliance on the dividend stream from a few bad apples. In a concentrated portfolio of 10 securities which is equally weighted, a dividend elimination by one of the companies will lead to a 10% decrease in total dividend income. In a portfolio of 40 stocks, if one company eliminated distributions, it would result in only 2.50% decrease in dividend income. At the end of the day, even if the remaining stocks managed to grow dividends by 11%, my total dividend income would be unchanged. In the second portfolio, if the remaining companies managed to raise disitrbutions by at least 2.50% my total dividend income would be unchanged for the year. Given the fact that historical dividend growth has been around 5% per year, I believe that it is much safer to assume that 10% growth is too optimistic. As a result, I would much rather have my portfolio generate a stream of income coming from many stocks rather than few.

Full disclosure: Long all stocks mentioned above

Relevant Articles:

Dividend Investing Goals for 2013
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Wednesday, December 18, 2013

Leveraged dividend growth investing

One of the assets that a typical middle class person owns is their house. Houses are purchased with approximately 20% down or less. People usually get a mortgage for the remainder, and they pay the credit off for 30 years. The house provides shelter to the family that purchased it, and hopefully its price keeps up with inflation. Houses however cost a lot of time and money, including renovations, property taxes etc.

With stocks however, regular investors rarely go into debt to purchase partial ownerships of companies. This could be attributed to several factors such as lack of desire to invest in stocks in the first place, the lack of understanding of margin and the higher interest rates paid on stocks with borrowed money. Dividend stocks on the other hand pay you money and you can offset interest expense against dividend income.

Stocks are usually valued mark to market in a brokerage account. If they fall in value the broker would require more money as collateral. This is the dreaded margin call where we either need to add more money or the broker would sell your position. Stock prices fluctuate daily, and as a result if one were to invest $1000 in shares of Procter & Gamble (PG), and bought $1000 more on margin they could end up with nothing if the stock price fell by 50%. If your house value fell by 50%, the mortgage company wouldn't require more money as collateral. They would not repossess your house, unless you are really late on your payment.

Another reason why investing with borrowed money is not popular is because interest rates on margin loans are usually very high. Many brokers charge over 6% presently, which is very high in the current interest rate environment. Only a few brokers, such as Interactive Brokers have margin rates at around 1%. In addition, margin interest rates are also not fixed, but variable. While interest rates are expected to remain low until 2014 - 2015, an increase in the benchmark rate would likely increase the cost of interest rates on margin loans. This could reduce investor returns as a result.

By using borrowed money to purchase dividend stocks, investors can magnify their dividend income significantly. For example, an investor with $100,000 in dividend paying stocks yielding 3% will generate $3,000 in annual dividend income. If they were to buy $100,000 in dividend stocks on margin, they would end up paying around 1.67%/year to a broker like Interactive Brokers, and increase dividend income to $4,330/year. This strategy can work for investors in the accumulation phase, as it could speed up the accumulation of dividend paying shares and compounding of dividend income.

In order to minimize risks mentioned above, an investor should use an adequate margin of safety with leveraged dividend investing. This would means that they should not borrow more than 25% – 30% from their account for margin investments. This would protect the investor from margin calls even if stock prices fell by 50%.

In addition, investors in the accumulation phase should have a plan to pay off their margin loans from their expected monthly contributions to their portfolio within 4- 5 years.

For example let’s assume that our investor with the $100,000 portfolio plans on adding $12,000/year for the next five years. This means that if they purchased $25,000 on margin, they could pay it off within 2 years simply by sticking to their regular investment schedule. However, by using a low cost margin loan, they would be accelerating their dividend compounding process.

In my personal portfolio, I sometimes purchase shares on margin when I see good values in the market. For example, if my portfolio was worth $100,000, and my lot size was $1,000, I might spend $2,000 - $3,000 on 2 – 3 stocks that looked attractive. I would then pay off the margin in a few weeks. I always pay my margin within a couple weeks however, as I use it to scoop up shares that are temporarily beaten down, while waiting for my paycheck to get deposited.

In the past month, I purchased shares of Target (TGT) and Becton Dickinson (BDX) on margin. However, as of this time, the margin has been repaid.

Target Corporation (TGT) operates general merchandise stores in the United States. This dividend champion has rewarded shareholders with higher dividends for 46 years in a row. Over the past decade, Target has managed to raise dividends by 18.60%/year. Currently, the stock is attractively valued at 16 times earnings and yields 2.60%. Check my analysis of Target for more details.

Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. This dividend champion has rewarded shareholders with higher dividends for 42 years in a row. Over the past decade, Target has managed to raise dividends by 16.80%/year. Currently, the stock is attractively valued at 16.70 times earnings and yields 2%. Check my analysis of Becton Dickinson for more details.

I am also playing around with Loyal3, which lets you buy shares with a credit card, commission free. If you time your monthly purchases there, you can essentially get an interest free loan for almost 6 - 8 weeks, while also earning credit card rewards points. In addition, Loyal3 allows investors to buy shares with as little as $10 per each investment.

Full Disclosure: Long TGT, BDX, PG,

Relevant Articles:

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Check the Complete Article Archive

Wednesday, November 20, 2013

International Dividend Stocks – Pros and Cons

Investors are always told to diversify. Diversification is the tool to protect investors from the unknown risks at the time of purchase. In my dividend portfolio, I always try to be diversified, meaning that I hold at least 30 - 40  individual securities representative of as many sectors that make sense. For some reason however, my portfolio only has a few companies traded internationally, which account for about 9% of its value.

International exposure is helpful, because different economies run on different market cycles. For example, if the economy in the US is stagnating, Asian countries might benefit from rise in economic output. In addition, some countries might benefit from increase in number of middle class consumers, which could bode well for earnings and stock prices and dividends.

By limiting themselves to only US companies, US investors might miss on international success stories that could benefit returns. With the increase in globalization, it is possible for a company to start small in one country, but then expand internationally. This could lead to increased profits, and hopefully dividends and stock prices. By increasing the pool of companies to look at, investors increase their chances of finding the next dividend gem for their portfolios.

Another positive fact of international dividend investing is diversifying away from the US dollar. By purchasing foreign assets, US investors will be receiving dividends denominated in Swiss francs, UK pounds, Canadian Dollars and others. This could be viewed as a positive by investors who believe that the US dollar will gradually lose purchasing power relative to these currencies over the long term.

While there are certain advantages to holding international dividend stocks, there are also a few disadvantages.

The first disadvantage includes that foreign stocks pay irregular dividends. Most pay distributions only once per year. Others pay dividends twice per year, by paying an interim and a final dividend. Often the interim dividend is 30%-40% of the total annual distribution, with the final dividend accounting for 60% - 70% of the annual distribution. British based telecom giant Vodafone Group (VOD) is a prime example of this. For 2013, the company paid an interim dividend of 3.27 pence/share, while for the final dividend the company paid 6.92 pence/share, or a total of 10.19 pence/share. This is why calculating the dividend yield could be tricky on a company like Vodafone, especially given that the new interim dividend has recently been increased to 3.53 pence/share.

Other companies like global food giant Nestle (NSRGY) pay dividends once per year, and withhold 15% for US residents. Check my analysis of Nestle.

Another disadvantage of foreign dividend stocks is the fact that few international companies follow a managed dividend policy like US companies. Most US corporations pay a stable and rising dividend, and avoid cutting distributions at all costs. Most foreign companies tend to pay a fluctuating dividend, which could vary greatly from year to year. This variability is caused by the fact that most foreign companies tend to target a certain dividend payout ratio. Since earnings per share fluctuate, so do dividend payments to shareholders of these non-US based companies. Investors also need to be careful in following dividend trends in the local currency, rather than the US dollar converted amounts. For example, for Unliever, it seems like distributions are declared in Euros, and then translated into pounds for PLC holders and dollars for ADR's traded on US markets. Therefore, anyone who followed the dividend trends in pounds or dollars, would be focusing on noise. Focus on the dividend trends in Euro's for Unilever.

Another disadvantage of owning foreign dividend stocks includes steep withholding taxes on distributions. These are typically withheld at source and could vary country by country. These taxes on dividend incomes charged to US investors could vary from 15% to as much as 25%. Investors can usually deduct taxes withheld fully if they are within 15%, using IRS form 1116. US investors who receive foreign dividends in retirement accounts however are still taxed on distributions receive, and cannot get them back. UK is one of the few countries which does not withhold taxes on dividend income paid to US investors. There are several companies which are headquartered in the UK and in another country such as the Netherlands or Australia. As a result, whenever you have a choice between the UK and the other country shares, always select the UK listed one.

Unilever is a prime example of this situation. There are two ADRs trading on NYSE. The Netherland based Unilever N.V. trades under ticker (UN). The UK based Unilever PLC trades under ticker (UL). Investors in both stocks get exactly the same dividends. The only difference is that investors in Unilever NV (UN) are subject to a 15% withholding tax, whereas investors in Unilever PLC (UL) are not. US investors still need to pay taxes on international dividends received however, if paid in taxable accounts.

In addition, some countries do not levy withholding taxes on dividends that are received in retirement accounts, such as Roth IRA's for example. The prime example includes Canada, which usually withholds 15% from dividends paid to US residents at source. However, if you placed those securities in retirement account, Canada would not tax these dividends.

Investors in international equities also need to be aware of the fact that these companies are likely not following US GAAP accounting rules. The whole world seems to have adopted IFRS, albeit it doesn’t seem to have a very consistent implementation. It seems as if each country has managed to implement its own version of IFRS. In addition, investors purchasing foreign shares on international exchanges might find it difficult to open brokerage accounts, wire funds in and out and need to be aware of taxation of dividends and capital gains. For example, Chinese markets are mostly closed to US investors. This means that you cannot go and purchase any Chinese stock that you wish. Other countries have currency controls in place, and might limit the amount of funds you can convert back to US dollars.

In conclusion, while there might be some benefit to receiving international dividends, there are also a lot of cons that investors need to be aware of. In general, I try to purchase US multinationals with long histories of dividend increases, which also have global operations. I have found that a large portion of US dividend companies revenues are derived from international operations, in some cases more than 50%. As a result, I do not have to deal with currency volatility, foreign withholding tax rates, setting up brokerage accounts in 20 different countries and international accounting rules.

For example, when I looked at the ten largest components of the S&P 500 index, I found out that they generate approximately 50% of their revenues from outside the US in 2012. This is significant, and it should probably make you think twice before using measures such as comparing current market capitalization to US GDP to past values of this indicator, as a tool that has any relevant predictive value.

Full Disclosure: Long UL, VOD, NSRGY, XOM, JNJ, CVX, PG, WFC

Relevant Articles:

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Monday, November 18, 2013

How to read my weekly dividend increase reports

As part of my process for uncovering undiscovered dividend gems, I focus on the list of companies that have increased their dividends. I usually look at the list of dividend increases for the week, and try to outline certain basic pieces of information such as amount of new dividend payment, percentage increase in distribution as well as what the new yield is going to be. After I obtain this information, I dive into valuation and trends in earnings per share and dividends per share. In addition, I check length of dividend increases, and rate of dividend increases over the past decade. There are two resources I use to check dividend increases:

Street Insider

WSJ Online

Whenever I review dividend stocks on my site however, I always try to analyze the information at a high level and reach out a conclusion on what to do next. Sometimes however, the conclusions I reach might need a little bit of extra information to be deciphered. Below, I have added a few short outcomes for my high level reviews of dividend increases.

1) Add subject to availability of funds

This is the highest review rating that I would assign to a stock. This means that I find the stock to be attractively valued at the moment and to have excellent future growth prospects. It also means that I have already analyzed the stock. This future growth would likely boost earnings, dividends and share prices. Unfortunately, I have a limited amount of funds to allocate each month. As a result I end up purchasing somewhere between one to three individuals securities per month. As a result, even if I find a stock attractively valued, I would not purchase it if there are other stocks that are cheaper at the moment.

2) Add on dips

This includes situations where I find the company to have excellent growth prospects for earnings and distributions, but the valuation is a little too rich for my taste. I have a strict entry criteria where I would never ever pay more than 20 times earnings for a company’s stock. In addition, I typically try to invest in companies which yield at least 2.50%. Sometimes a stock might yield more than 2.50%, but trade at more than 20 times earnings or yield less than 2.50% and trade at less than 20 times earnings. I typically require that both the P/E be below 20 and the yield be above 2.50%. Sometimes simply by waiting, a company could increase dividends, which would take the stock to my entry criteria. Wal-Mart (WMT) was such example in 2011- 2012. I monitor the shares every week, and would consider initiating or adding a position once the entry price is hit.

For example, in the past week, Automatic Data Processing raised its quarterly dividend by 10.30% to 48 cents/share. This marked the 39th consecutive annual dividend increase for this dividend champion.  Over the past decade, ADP has managed to boost distributions by 13.10%/year. The new yields is 2.50%, but unfortunately it trades at above 20 times earnings. Therefore, I would consider buying it at prices below $63/share, which corresponds to a P/E of 20 times forward earnings of $3.15/share. The company has strong competitive advantages in dealing with small and mid-sized businesses, and should benefit if interest rates increase, as it's float would generate more cash. Check my analysis of ADP for more information about the company.

3) Research

This view covers situations where I find a company which is attractively priced, and has raised distributions for at least ten consecutive years. However, I might not have researched the company in detail yet. I typically like to see not only good valuation, long history of dividend increases and a ten year dividend growth above the rate of inflation, but also good earnings prospects. I like to get a feel of the company’s business, and determine whether the company can sustain future earnings and dividend increases. I try to be a disciplined investor, which is why I require to analyze a company in detail, before initiate a position in it. In addition, if I haven’t analyzed a stock that I already own for about one year, I would likely also put it on my list for further research.

For example, Sysco recently increased dividends by 3.60% to 29 cents/share. I owned Sysco (SYY) for several years, until I decided to pull the plug a couple years ago, since I saw earnings plateaued since reaching a high of $1.81/share in 2008. This meant that most of the dividend growth was running on fumes, meaning through expansion of the dividend payout ratio, which is never desirable. Last time I analyzed the stock in 2011, I still had hopes management can turn the ship around, and increase earnings per share. Shortly after they announced another pathetic dividend increase, I realized dividend growth might be going on borrowed time. I would need to do a more detailed research on the company, and determine if it can increase earnings.

4) Monitor

I usually add a stock on the list for further monitoring if the company has not raised dividends for ten years in a row or if it is too far away from my entry criteria. For example, a company that has raised distributions for 6 years probably has approximately three to four years before I could add it to my portfolio. As a result, I will monitor the rate of dividend increases, and if it gets closer to becoming a dividend achiever, I might add it to my list for further research. Another scenario includes situations where a company yields only 1% or so, and as a result it would not make sense to analyze it or put it on my list to purchase on dips, because it would require a 60% decrease in share price to even get there. A case in point is Costco (COST), which yields 1% and has only raised distributions for ten years in a row. Another company I am actively monitoring is Becton Dickinson (BDX), which yields slightly less than 2%, but has a relatively low P/E ratio of 17.50 times forward earnings and plenty of growth ahead.

5) Hold

I typically tend to avoid the remaining companies that have boosted distributions. I place them under a hold rating, but this is similar to do not touch. Some stocks could move from that hold category into stocks that should be researched. Other stocks could also move from being darlings to being just holds. The world of dividend investing is an ever evolving one, which is why investors need to keep their eyes close to the pulse of the market by following weekly dividend increases.

An example of such a stock is MDU Resources (MDU), which recently increased quarterly dividends by 2.90% to 17.75 cents/share. This marked the 23rd consecutive annual dividend increase for this dividend achiever. Unfortunately, over the past decade the dividend has been increased by 4.90%/year and the current yield is only 2.30%. The companies in this position are decent holds for current income, especially if you bought it at lower prices. However, you might also consider whether you might get better dividend growth and yield prospects elsewhere.

Full Disclosure: Long WMT and ADP

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Wednesday, November 6, 2013

Dividend Investors Should Ignore Market Fluctuations

As a dividend growth investor, my goal is to generate a rising stream of sustainable dividend income, through careful investment in quality dividend growth stocks.

My investing plan is not dependent on market fluctuations. In fact, even if they closed the market tomorrow, I would not care. That is because most my stocks would keep sending me quarterly dividend checks (some do monthly and a few do it annually), with the only issue being that I won’t be able to reinvest distributions into more shares. I am sure I would be able to buy shares directly from other investors however, thus side-stepping the "official stock market". As a result, my dividend income goals are not dependent on the stock price fluctuations.

I simply focus on quality dividend stocks, which I try to purchase them at attractive valuations. I try to focus on companies which have raised distributions for at least ten consecutive years, and which have the capacity to boost distributions over time. I am a firm believer that a management team which focuses on consistently sharing a portion of the profits with investors in the form of dividends will continue doing so, as long as the business is able to support that.

At the end of the day, if you had the chance to purchase a growing quality company like Johnson & Johnson (JNJ) 25 or 30 years ago for example, you would have been exposed to plenty of stock price volatility. You would have witnessed the 1987 stock market crash, the oil shock in 1990 - 1991, as well as the dotcom bubble and the credit bubble implosions. At the same time, earnings per share for Johnson & Johnson increased from 30 cents/share in 1987 to a projected $5.48/share by 2013. The annual dividend is $2.64/share, up from 10 cents/share in 1987. The point of this exercise is to show that you should be focusing on the underlying business strengths, not on stock price fluctuations.

The table below shows that there has been plenty of fluctuations in Johnson & Johnson stock price over the past 30 years.

Of course, a dividend portfolio is not a set it and forget it type of deal. Investors need to monitor the financial health of their stocks regularly. In a previous article I mentioned that once a detailed analysis of a dividend stock is compiled, then any future analyses should not take a lot of time. After all, companies do not fundamentally change every year. Notable exceptions of course include mergers and acquisitions, spin-offs etc.

Market fluctuations should not scare the intelligent dividend investor, but could be used to his/her advantage. A steep drop in prices in quality dividend stocks like Johnson & Johnson or Coca-Cola, like the one witnessed during the 1987 market crash would have provided an excellent entry point for long-term wealth accumulation.

One of the best investors, Warren Buffett is famous for saying :

 ‘‘After we buy a stock, consequently, we would not be distrurbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke (KO)?’’

Dividend investors should also treat investing in quality income stocks as more of a long-term partnership with the business, than stock market speculation. To summarize, dividend investing is as close to Buffett’s long-term investing strategy as possible.

Full Disclosure: Long JNJ, KO

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Wednesday, October 9, 2013

Should Dividend Investors Ever Break Their Rules?

As a buy and monitor dividend investor, one of the items that is presented to me in brokerage statements is percentage gain on each one of my investments. I have noticed that the companies with the best total returns in my portfolio since 2008 included companies which did not exactly fit my strict entry criteria at the time of purchase. These companies were attractively valued at less than 20 times earnings at time of purchase, had adequately covered distributions and had strong earnings and dividends growth. The main criteria that these companies failed was low current yield at the time of purchase and sometimes a streak of dividend increases that was less than 10 years.

The one thing that all of these companies had in common, was the fact that they had the opportunity to deliver strong earnings growth. This strong earnings growth, was noticed by other investors, and led to increases in stock prices. It also didn’t hurt that the strong earnings growth trickled down to investors in the form of higher cash dividends as well. The reasonable price/earnings ratios I paid at the time of acquiring these securities enabled me to generate above average total returns while earnings were rising.  Because both earnings and dividends per share were growing rapidly, and because I was projecting that this could continue happening for the foreseeable 8 - 10 years, I was expecting to generate quite a nice future yield on cost within a decade.

The problem with these companies was that prices started moving up immediately after my purchase. Since these companies were purchased at attractive valuations however, and both earnings and dividends were increasing, substantial declines would have been a welcome opportunity to add to my position in these stocks.

Overall, whenever I “ignore” my entry rules, it is to acquire shares in a company, that is poised to deliver rapid growth. I still expect a rising dividend income stream, although I am willing to accept less than 10 years of dividend increases. In addition, I am willing to accept a dividend yield lower than 2.50%, if I believe that there is a potential for a strong earnings growth. In other words, if I purchase a stock yielding 1.50% - 2% today, which also grows earnings and dividends at 12%/year, I would expect to be earning an yield on cost of 4.50% - 6% in a decade. Ten or twelve percent growth rates per year are not unheard of, and could reasonably be expected to continue. As a result, the 1.5% -2% yielder purchased in year one, would likely still be generating a current yield 1.50% - 2% in ten years. However, if all goes according to plan, I would have tripled my money and earning a much higher dividend income stream.

The only crucial rule that I am not willing to bend is purchasing stocks at or above 20 times earnings. Paying more than 20 times earnings could result in serious losses if earnings do not deliver the expected growth over time. In addition, during bear market declines, high growth stocks tend to fall faster than the market as whole. As dividend investors, we are trained to see market declines as an opportunity to add more to our positions. In the heat of the moment however, losing 40% – 50% on a position could panic both inexperienced and experienced investors alike. In addition, paying too much for a company’s stock could lead to lower returns, even if it deliver the growth, if the market decides that it deserves a more reasonable multiple. An example of this occurred in the early 2000s, when even the most quality dividend stocks such as Johnson & Johnson (JNJ), Coca Cola (KO) and Wal-Mart (WMT) were trading at excessive valuations. This overvaluation was the primary reason for the so called “lost decade” for stocks.

The three stocks I bent my rules for included:

Family Dollar (FDO) had been yielding approximately 2% when I purchased it in 2008. Even during that turbulent time for stocks, the company had been performing impressively, by opening new stores and renovating existing ones to increase their appeal. Given the fact that Family Dollar stores are in smaller communities, and offer low prices to consumers, the financial crisis has been good for business. A consumer that wants to buy a loaf of bread is more likely to stop by a Family Dollar store rather than a Wal-Mart. And we all know that stopping by the store for a loaf of bread might expose consumers to buy something else in the process. I also used the weakness in early 2013 to increase my position slightly.

While I purchased shares of Visa (V) in 2011, I liked the long term growth potential for the company. In addition, Warren Buffett was buying Visa as well. Visa and MasterCard are essentially a duopoly that provides global consumers with the opportunity to do cashless transactions. While consumers would still use cash going forward, I would expect the number of credit and debit card transactions to increase over time not just in the US but globally as well. In fact, credit and debit card usage outside US is not as widespread. This could mean decades of growth for Visa and MasterCard. I also like the toll-booth like business model, where credit card issuers do not take on any credit risk, but simply process information. I purchased the shares at a yield of 1% and a P/E that was less than 20..

What attracted me to Yum! Brands (YUM) was the fact that it was rapidly expanding in China and had more room for future additions of capacity. McDonald’s had not been as successful in China as Yum! Brands, which is due to the fact that the operator of KFC offered something that appeals to the consumers better than burgers and fries. At the time of purchase, current yield was about 2%, although the company had announced plans to hike dividends significantly, and my forward dividend yield was 2.50%. I also used the declines in early 2013 to put another half position in the stock.

This pure dividend growth strategy is slightly riskier than the type where I purchase higher yielding stocks as well as companies in the sweet spot. That is why I only implement it in as one of the strategies in a broadly diversified dividend portfolio. For the three stocks mentioned above, I actually allocated a lower amount of capital than I would for a company like Johnson & Johnson (JNJ), in order to limit risk.

Full Disclosure: Long V, YUM, FDO, KO, WMT, JNJ

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Monday, September 16, 2013

Return on Investment with Dividend Stocks

The goal of every dividend investor should be generating a dependable income stream which grows over time. Dividend investors should not sacrifice the relative safety of their principal. While stock prices fluctuate and stocks do not have a guaranteed maturity price like bonds, investors should not lose track of security of principal in their quest for yield.

Investors are automatically sacrificing the income and principal of their investments by chasing yield, overpaying for the equities they purchase and failing to properly understand the business and its prospects they buy into.

The Dean of Wallstreet, Ben Graham, came up with the following definition of what an investment should achieve: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Dividend investors should thoroughly analyze the companies they invest in, to make sure their financial foundation is sound. A sound foundation such as a plan for growth, can result in increase in earnings and dividends over time. In addition, it is imperative that dividend investors also evaluate valuation of the company whose stock they are purchasing. Even the best dividend paying companies such as Coca-Cola (KO) are not worth purchasing at any price. Investors, who purchased the stock at the highs in 1998, are still sitting at unrealized losses, and the only return they have generated has been from the rising dividend.

Investors should also avoid chasing yield without understanding the reasons behind it. For example, there has been a lot of interest about mortgage REITs such as American Capital Agency (AGNC) and Annaly Mortgage (NLY). Retirees are easily attracted to the mouthwatering yields on these investments. However after observing and discussing investors who own these securities, I have come to the conclusion that many are new to dividend investing in general, they do not understand the risks behind these companies. It is also evident that many probably have not spent the time to understand how these REITs generate these distributions. These observations are not scientific in their nature of course, and I hope I am wrong on them. The reason why I am unsure about these investments is because their distributions fluctuate greatly, as they are affected by the difference between short term borrowing close to the Fed Funds rates and subsequent investment in mortgage backed securities issued by Fannie Mae or Freddie Mac. Forecasting long-term interest rates is an exercise in futility, and so is the exercise of forecasting the spreads between interest rates on mortgage backed securities and federal funds rates.

For example, if I purchased Annaly shares at the end of 2004, I would have paid $19.62/share and expected to earn 50 cents/share every quarter. This was a very nice 10% yield. The company paid $1.04/share in 2005, which is a neat 5% yield, but almost half of what was expected to be paid. In 2006, Annaly distributed 57 cents/share, which represented another 50% decline in distributions, bringing the yield on cost to 3%. Another mREIT, Capstead Mortgage (CMO) decreased distributions from 22 cents/share at the end of 2004 to 2 cents/share for a two year periods between 2005 and 2007. This was down from a high of 53 cents/share earlier in 2004. One typical reason for investing in a high yielding stock like Annaly Mortgage (NLY) is the fact that the retiree did not save a sufficient amount of funds during their working years. As a result, these retirees need a super high yielding stock in order to pay for expenses in retirement. However, by focusing only on the highest yielding stocks, these investors are exposing themselves to wide fluctuations in distributions and stock prices. Overtime, the value of money decreases due to inflation. If our investor takes a 10% yield, and spends all of it, eventually their standard of living will decline. Add in the uncertainty as to the amount of these distributions, and the situation could become potentially very dire. That being said, mREITs could bring in some level of exposure to a dividend portfolio and might work for some investors who thoroughly understand the risks. they are taking

At the same time, investors who focused on traditional dividend growth stocks saw increases in dividend incomes, albeit they received much smaller initial distributions. However, most dividend growth stocks have stable and growing distributions, which do not fluctuate and make living off dividends much easier. In comparison Realty Income (O) traded at $25.29/share at the end of 2004 and paid monthly dividends of 10.90 cents/share, thus yielding 5.20%. The monthly dividend was never cut, and it increased to 11.60 cents/share by 2005 and 12.60 cents/share by 2006. The main difference is that the revenues for Realty Income are coming from recurring rent checks from its hundreds of properties, whereas the distributions from mREITs come from fluctuating spread between short term borrowing and the rates on mortgage backed securities.

Full Disclosure: Long O

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This article was featured in the Carnival of Wealth

Wednesday, September 11, 2013

Three Characteristics of Successful Dividend Investors

Just like practicing skills in any field, Dividend investing takes time to learn. It takes most people several years in college and grad school in order to become good teachers, lawyers, accountants etc. It is no surprise that dividend investing then takes a lifetime of practice to learn and perfect to one’s individual personality.

The first trait of successful dividend investors is realizing why one wants to be a dividend investor. It requires that investors be exposed to other trading strategies, such as market timing, index investing, daytrading, swing trading, options etc. While traders in big banks like Goldman Sachs (GS) can successfully daytrade the market and earn a profit every day, this strategy might not be suitable for a person that just retired and started managing their money. By learning about market strategies, investors could develop a better understanding in formulating their trading plan. By educating themselves about how the market works, investors will develop the hunger for knowledge which would eventually bring them profits. Most important of all is to have the independent thinking to make the decision for yourself. The beauty of dividend investing is that once the perfect dividend stocks have been selected, one can basically collect the rising stream of income with little portfolio maintenance, leaving more time to other activities.

The second trait of successful dividend investors is formulating a strategy which, much like a business plan, outlines how investing should be done. The strategy should be realistically tailored to the investor’s personality, in order to increase the odds of sticking to it. I mention the word realistically, because a strategy whose goal is to generate 20% yields in one year while possible, would be impractical and unrealistic. Sticking to a strategy requires discipline, which would essentially make or break the dividend growth investor’s performance.

The strategy should discuss the following items: (but not limited to them)

- Screening Criteria
- Entry Criteria
- Exit Criteria
- Money Management

The third trait is patience. After an investor has done all the work in screening potential candidates and researching them inside and out, they have a list of stocks to purchase when they trade at attractive valuations. Since not all stocks are bargains all the time, it would take time to build a diversified portfolio of dividend producing investments. It would take a lot of patience to avoid chasing yield, not sticking to your strategy by overpaying for stocks and otherwise avoid any actions that would detract from long-term performance and achievement of investing goals. In the world of dividend investing, sometimes inaction is the best activity for most investors.

In my dividend investing, I have had several examples where not doing anything has paid off. For example, I have been watching shares of Walgreen’s (WAG) for several years. I liked the business; I also like the growth prospects for the business. The problem was that the stock never really yielded much. That was until in 2010 it briefly yielded 2.50%, which is when I loaded up on the stock. Walgreen has essentially been flat over the past decade, with the dividend being a large component of total returns over the period. By having the patience to wait for the right time to initiate a position in the stock, I have avoided several years worth of watching my capital do nothing and earning no income in the process. Check my most recent analysis of the stock.

Another example of having the patience was during the financial crisis of 2008-2009, when stock markets tanked to 12 years lows, unemployment skyrocketed and the overall mood in economies around the world turned gloomy. Many financial stocks cut distributions. Investors who ignored the bleak headlines and held on to those stocks which maintained and even increased distributions should have higher portfolio values than 3 years ago. I was also able to purchase some shares at rock bottom prices:

Chevron (CVX) at 64.35
Aflac (AFL) at 25.24
3M (MMM) at 55
Altria Group (MO) at 14.91

I had researched each of these four companies in detail for many months and years beforehand. Once I saw the low valuations, I immediately loaded up my portfolio with quality income stocks selling at a discount. Unfortunately situations like that are seen rarely, but once they happen, investors need to be able to capitalize on them.

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Wednesday, September 4, 2013

The Tradeoff between Dividend Yield and Dividend Growth

Life is full of trade-offs. One tradeoff includes immediate consumption versus delayed gratification. Essentially, should you save now and bear fruits of your investment 30 years from today or should you spend everything today and rely on pensions and social security later. Both decisions can have impacts on your life, which might not be known for years from now.

Another tradeoff many income investors face is focused on choosing dividend yield and dividend growth. We have similar issues with selecting high yielding stocks today versus selecting high dividend growth stocks which have modest yields today.

On one hand, investors in high yielding stocks are able to generate high dividend incomes on their initial investments. This would allow them to reach the point of financial independence much faster. Investors in higher yielding companies typically spend the dividend checks however, rather than reinvest them.

On the other hand, companies that pay above average yields often do so because their business is not growing quickly. As a result, they pay a large portion of earnings or cash flows to investors in the form of dividend. Since earnings are not rising quickly enough, many high yielding stocks either maintain their dividends flat or increase them barely to keep up with inflation. Utility stocks are a notorious example for this situation. Despite their high current yields, many utilities typically do not grow earnings and dividends above the rate of inflation. Last year, I sold most of my shares in Con Edison (ED), because the dividend had been raised by a mere 1%/year since 1996, which was not enough to keep purchasing power of this dividend income stream. In addition, the low interest rate environment has pushed yields on utilities to levels at which it made sense to switch to other comparable income stocks which offered the possibility for higher dividend growth.

At the same time, dividend growth stocks with more modest current yields are typically purchased by younger investors, who have at least one or two decades before retirement. These stocks are purchased with the intent of holding on and enjoying a rapid growth in dividend income over time. This would be possible from sustained growth in earnings per share, along with a slight expansion in the dividend payout ratio over time, never to exceed 60%. For example, a $1000 investment in a company which yields 2% today but grows distributions by 12%/year, would generate $40 in annual dividend income in 6 years and $160 in annual dividends in 18 years. If the investor also reinvested distributions into more shares, they would be generating an even higher income. In addition to that, a company which yields 2% today would likely yield 2% – 3% in 18 years, assuming that growth rates remain fairly constant. As a result, the rate of increase in the stock price would likely follow the level of increase in earnings and dividends. Our lucky investor would have generated not only a very nice income stream in 18 years, but also pretty sizeable capital gains as well.

On the other hand, maintaining a 12% growth in earnings per share to support a 12% in annual dividend growth is extremely difficult to maintain. Companies can manage to achieve this kind of growth for long periods of time are rare indeed. For example, there are 107 companies in the CCC list maintained by David Fish which have boosted dividends for at least one decade, and have enjoyed annual dividend growth rate of 12%/year. If we require a streak of at least 25 years of consecutive dividend increases however, the number of companies who boosted dividends by 12%/year on average over the preceding decade falls to 28.

The reasons behind decrease in growth are numerous. As companies increase their presence in as many communities as possible, adding extra locations could cannibalize sales from existing locations. In addition, competitors might try to steal market share, or the company could be unable to pass on cost increases to consumers. All those factors and many others could endanger future growth. It is difficult indeed to project historical rates of dividend growth too far in the future.

In my investing I try to focus on companies in the sweet spot, where I get the maximum dividend growth at the maximum possible yield. A few examples 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. The company has increased distributions for 36 years in a row. Over the past decade, McDonald's has managed to raise distributions by 28.40%/year. Currently, the stock trades at 17.40 times earnings and yields 3.20%. Check my analysis of McDonald's.

Phillip Morris International (PM) is engaged in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States of America. The company has managed to boost dividends by 13.10%/year since 2008, when it became an independently traded company. Currently, the stock trades at 16.60 times earnings and yields 4%. Check my analysis of PMI.

Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. Since going public in 2011, the general partner of Kinder Morgan Energy Partners and El Paso Pipeline Partners has increased dividends by 33%. Furthermore, low double digit distributions growth is expected for the next few years. At a current yield of 4.30%, Kinder Morgan looks like a great yield play with a high dividend growth kicker.

Full Disclosure: Long MCD, PM, OKS, KMI

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Tuesday, July 23, 2013

The Importance of Corporate Governance for Successful Income Investing

Everyone’s actions are typically driven by self-interest. That is what has generated strong growth in the world economy over the past two centuries. Sometimes however, different individuals might have actions which might not be in the best self-interest of the people they work for. I am referring to the issue of corporate governance in many of today’s corporations.

The issue is that the goals of managers and shareholders might differ. Managers for example might be compensated based on total profits or total sales. As a result, they might end up pushing for acquisitions of businesses that might deliver short term boosts in these key metrics, but might end up being disastrous for shareholders wealth. Other managers might prefer to allocate excess cash to repurchase stock rather than pay a dividend, in order to increase share prices that would make their incentive stock options more valuable. A third group of managers might even attempt to manipulate accounting records in order to inflate profits and collect their fat performance bonuses.

One thing that could reduce the incentive by managers to do the above mentioned actions is to closely align their performance compensation structure with the actual performance of the business. This is an extremely difficult task to do, and there are countless studies by researchers and highly paid consultants that have spent hours upon hours studying the issue. The answer however could sometimes be very simple.

In my studies of successful businesses, I have noticed one very interesting phenomenon when it comes to corporate governance. This corporate governance situation closely aligns the compensation of managers with the well-being of the enterprise. The situation occurs when a majority shareholder in a company is also in charge of steering the business in the right direction because they are the CEO. Some great examples include Warren Buffett, who took over management of then struggling Berkshire Hathaway (BRK.A) in the 1960s, and then transforming it into a highly successful diversified conglomerate fifty years later. His initial investment of several million dollars has been compounded by the Oracle of Omaha’s investment genius into roughly a fortune worth $40 billion dollars today.

Another example of successful corporate governance by the founder/CEO is Microsoft (MSFT). He had been able to grow the company from a small software start-up in the 1970s, to one of the largest companies in the world by the time Bill Gates retired in 2000. He is a prominent philanthropist these days, but I am not overly bullish on Microsoft's stock.

My favorite CEO currently includes Richard Kinder, who is in charge of managing Kinder Morgan Inc (KMI). All of his wealth is invested and derived from his ownership of Kinder Morgan shares, which own the general partner and some limited partner units in the Kinder Morgan (KMP) and El Paso (EPB) pipelines. Richard Kinder founded Kinder Morgan with assets from Enron in the 1990s, after having a falling out with then managers of the high-flying energy trading company that later went bust. His salary is $1/year. He does however collect millions in dollars in dividends from his investment in Kinder Morgan however.

My other favorite CEO was John D Rockefeller, one of the original robber barons, who founded Standard Oil in 1870. His company was split into several companies in 1911. Many of today’s largest oil companies in the world such as Exxon Mobil (XOM), Chevron (CVX) are descended from these companies. John Rockefeller was famous for saying: “Do you know the only thing thay gives me pleasure? It’s to see my dividends coming in

My third favorite CEO was the founder of Wal-Mart Stores (WMT), Sam Walton. Starting the company in 1962, he revolutionized retail in America. His company managed to beat out larger rivals at their own game, through constant focus on cost containment and trying to become the lowest cost provider in the industry.  By keeping costs low, the company is appealing to customers to the tune of 100 million visits every single week. This repeat business translates into dividend growth for more than 35 years, The company focuses on turnover,  and usually sells most of the merchandise it ordered by the time it has to pay suppliers. Sam Walton thought like an owner however, as he not only expanded at a furious pace, but he also paid an ever increasing dividend only a few years after taking the company public. Check my analysis of Wal-Mart Stores.

To summarize, I have learned that there is often a strong link between having a strong visionary leader at a company, who is also a majority shareholder. This leader usually sees this business as their legacy, and they are very passionate about growing and preserving that legacy. This aligns their goals with the goals of ordinary shareholders to a certain extent. In the cases of the visionary founders listed in this article, shareholders benefited handsomely by the arrangement. By identifying someone who is passionate about their work, and has a majority ownership interest in that enterprise, investors would be wise to buy that stock.

Full Disclosure: Long KMI, CVX, WMT

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Wednesday, July 10, 2013

Business Relationships Can Deliver Solid Dividends to Shareholders

We live in a service- oriented economy. As a result, a large portion of the economic output is based upon purchases of services, rather than the purchases of pre-fabricated tangible products. Using an example from everyday life, a haircut is a service. Many people living in small communities across the United States go to a barber shop or a hair salon every few weeks or so. After a few months of trial and error, consumers generally tend to find a place to have their hair cut and stick with it. The service provider lures in the customer with quality of service, and builds a long-term relationship of repeat purchases that might last for years if not decades. So why should dividend investors care about haircuts and services?

The answer is simple – there are dividends to be made from service oriented companies.

While corporations are not people, they tend to consume services on a regular basis. One of the biggest assets that corporations might have are the intangible relationships that they have built over the years. For example, many public companies tend to keep their audit or law firms for years if not decades, which translates into millions of fees for the latter. The corporations are satisfied with the quality of service offered, and know that the service providers have their best interests at heart. The service provider strives to provide outstanding service, in order to keep the relationship going and generate extra billing opportunities when the right time comes. As a result, it could be argued that offering an outstanding service on a consistent basis could be a source of a wide moat, or a strong competitive advantage.

The areas to focus on include repeat purchases from service providers. A few of those include:

Automatic Data Processing, Inc. (ADP) provide business outsourcing solutions, such as payroll processing. Payroll is an important aspect of a small business. One small error could be bad for business and employees morale. As a result, businesses tend to keep service providers like ADP, even if prices tend to increase over time. The hassle of switching to a new provider makes this service sticky, as long as quality of service is maintained. As a result, this dividend champion has managed to boost dividends for 38 years in a row. Currently, the stock is a little pricey at 23.90 times earnings, although the yield is attractive at 2.50%. Check my analysis of ADP.

International Business Machines Corporation provides information technology (IT) products and services worldwide. The company has transformed itself from a major hardware producer to a service provider. It provides consulting services to clients across the globe. Major corporations are willing to pay large sums of money in order to improve operations, and companies like IBM are there to help. Once companies are comfortable with the services offered by IBM, this relationship will keep on delivering dividends as long as quality of execution is maintained. After all, chances are that a company would ask for IT services only from service providers they are comfortable with. They get comfortable with service provider only after a business relationship is built and maintained over time. A competing firm would have a lot of trouble making a new relationship with an IBM client, since they would have to prove themselves first. Even if they undercut prices, the fears that they might not deliver, since no relationship exists, would likely deter clients from leaving their service providers. This dividend achiever has been able to boost dividends for 18 years in a row, while also being one of the largest and most consistent share repurchasers in the world. The stock is cheap at 13.30 times earnings, although the current yield is low at 2%. Check my analysis of IBM.

One of IBM's competitors is Accenture (ACN), which provides management consulting, technology, and business process outsourcing services worldwide. This international dividend achiever has increased dividends for 8 years in a row. The company has a five year dividend growth rate of 28.70%/year.  Currently, the stock is trading at 16.30 times earnings and yields 2.30%. I would try to post a more detailed analysis of the firm over the next few weeks.

As a result, businesses that manage to build and maintain relationships with clients have an inherent advantage that is as close to a wide moat as possible. It would be very difficult for competitors to steal an existing client, as long as an adequate level of service is offered. This wide moat also provides pricing power, which could translate into higher profits and provide the necessary cash to boost dividends over time.

Full Disclosure: Long ADP, IBM

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