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

Monday, November 17, 2014

Should Dividend Investors own Non-Dividend Paying Stocks?

Dividend growth investing is the strategy I have been using for several years in order to reach my retirement goals. In order to be successful with a strategy and stick to it through thick and thin, investors need to understand its positives and limitations. One of the disadvantages of investing purely for dividends is missing out on spectacular price gains of hot new technology stocks. On the other hand, everyone can pick the best hot stock only after the fact. Most investors who look for the best growth stock are very often very wrong at the end. This is why I stick to the tried and true dividend champions and dividend achievers.

Apple (AAPL) is one of the best performing stocks over the past decade. The stock rose from a low of about $4/share in November 2004 to a high of about $100/share in 2012. If you look at any of the top performing stocks from ten years ago, one could notice that few of them even paid dividends, let alone maintained a streak of dividend increases. Opponents of dividend investing often use this fact as an argument against the merits of dividend investing. While as a dividend investor I am going to miss out on the next Apple, I also know that I am going to miss out on the next technology bubble, the next MCI Worldcom or the next company that will try to be the next Apple (or Google, Microsoft etc) but fail in the process. Most companies that are touted to be the "next something" end up failing, losing money for their investors and their worthless shares get delisted. Since those losers are not in the plain sight of ordinary investors, the lessons from their failures are soon forgotten by investors.

The world of technology changes very fast, which is why it is so difficult to maintain an economic moat that lasts for several decades. The companies that try to become the “next” Google, Apple or Microsoft often end up being nothing more than pipe dreams, which end up costing investors many dollars. In addition, the chances of selecting the best growth company over the next five years are really slim, unless you are a seasoned and well-connected Silicon Valley venture capitalist.

Looking at the best performing stocks over the past decade and then invalidating dividend investment altogether is not a very smart way of looking into things. This is because one is not comparing apples to apples. If instead we compared the results of dividend paying stocks to the results of non-dividend paying stocks, we could notice a stark contrast. Over the past years, dividend stock have consistently outperformed non dividend paying stocks.



The reasons behind this out-performance are somewhat counter-intuitive:

1) Dividend paying stocks are typically mature companies, which generate excess cash flows that they do not know what to do with. As a result, these companies return this excess cashflows to shareholders in the form of dividends. Some, like Procter & Gamble or Coca-Cola have increased dividends for over 50 years in a row each.

2) The boards of these dividend paying companies realize that companies cannot reinvest new money at the same rates of return. Investing new funds is important to maintain and grow the business, but unfortunately there are physical limitations to expanding business indefinitely and forever. Due to laws of diminishing returns, once you add in an extra dollar of investment that does not result in much profit, you should be better off doing something else with the money. In other words, if you are Starbucks (SBUX) and you already have four coffeehouses on a busy intersection, chances are the adding a fifth one is not going to result in a 20 – 25% automatic increase in total sales.

3) Because dividend companies are mature enterprises, their growth prospects are not going to be very high. As a result, these stocks are often trading at low price-earnings multiples. This allows investors to purchase these quality companies at a discount, and thus enjoy better compounding of capital. The companies which have very high earnings growth projections often sell at a premium price, which has high earnings growth already baked in to the stock price. The reason why Altria (MO) (which was called Phillip Morris back then) was the best performing stock between 1957 - 2003, was because it grew earnings and dividends while shares were always cheap, and thus shareholders were able to consistently reinvest dividends at low valuations. This turbocharges dividend income and capital growth.

4) While the growth prospects for mature dividend paying stocks are not as high as the prospects for a hot new IPO, they are more dependable. Many of these mature companies tend to deliver a small but consistent growth, which makes them clear winners over time. Many of these stodgy dividend champions tend to sell a similar type of a branded product or service that your parents or grandparents have used and which you and your children would likely use for decades to come. The consistent growth translates into consistent profitability, which coupled with the relative undervaluation when compared to the stock market makes investment a very good idea.

5) The dividends that these companies pay to shareholders represent a return on investment which is always positive. A company can see its stock price rise quickly to new highs or fall precipitously to all-time-lows, leaving investors with rapidly fluctuating capital gains or losses. At the same time however, income investors receiving a dividend would be essentially paid to hold on to the stock of their choice, and would be less likely to panic and sell at the worst time possible. The dividend payment, if sustainable, would thus be a factor that could keep the stock price from losing too much, since value oriented investors would step up and provide support behind the stock by purchasing it at attractive valuations.

6) The dividend payment provides a regular stream of income, which investors could use to either spend or invest in stocks that fit their entry criteria. Dividend reinvestment allows investors to compound their capital over time, through the systematic accumulation of undervalued assets over time using dividend income. This strategy has helped famous value investor Warren Buffett to accumulate a fortune worth over $60 billion. By focusing Berkshire Hathaway’s capital on income producing investments, and then reinvesting excess capital into other income producing assets, Buffett has transformed the sleepy textile company into a diversified conglomerate with a market capitalization of over $200 billion.

The article discusses dividend paying stocks and non-dividend paying stocks in general. While there could be dividend paying stocks which have failed, as well as non-dividend paying stocks which have been wildly successful, this does not change the overall conclusion that dividend paying stocks have historically done better than non-paying ones. The probability that your average blue chip dividend stock provides better returns is much higher than the probability of good returns by your average non-dividend paying stock. In order to further increase your chances of achieving your goals, one also needs to further screen out investments and evaluate the final list of candidates for inclusion one by one.

Full Disclosure: Long KO, PG, MO, PM,

Relevant Articles:

Another reason for companies to pay dividends
Why Dividend Growth Stocks Rock?
What is Dividend Growth Investing?
Should dividend investors hold non-dividend paying stocks?
The predictive value of rising dividends

Wednesday, October 15, 2014

Top Dividend Growth Stocks of the past decade

Dividend growth investing is sustainable when derived from consistent earnings growth. In its true form, successful dividend growth investing is characterized by instances where annual earnings and dividend growth are almost identical. In addition, companies that exhibit such traits tend to have their current yields being in the same range of 2% - 3% during prolonged periods of time. Ordinary yield chasing investors tend to ignore such companies, because they lack the patience or forward thinking to care for high future yields on cost or strong total returns. As a result, many of these companies offer low current yields, which tend to stay low for extended periods of time. The lucky investors who purchased such securities however are able to generate high yields on cost over time.

I selected the fifteen dividend champions which have achieved the highest ten year dividend growth rates:

Name
Ticker
Yrs Consecutive Div Increase
10 Year Annual Div Growth
P/E Ratio
Yield
Div Payout Ratio
Stock Analysis
AFLAC Inc.
AFL
31
16.8%
8.90
2.60%
23%
Becton Dickinson & Co.
BDX
42
17.6%
20.50
1.70%
35%
Computer Services Inc.
CSVI
43
17.0%
19.30
2.30%
44%

Donaldson Company
DCI
28
18.4%
21.70
1.70%
37%

Helmerich & Payne Inc.
HP
42
23.3%
13.10
3.10%
41%

Lowe's Companies
LOW
52
29.2%
22.40
1.70%
38%
McDonald's Corp.
MCD
39
22.8%
16.70
3.70%
62%
MSA Safety Inc.
MSA
43
16.5%
22
2.50%
55%

Nucor Corp.
NUE
41
22.1%
27.20
3.00%
82%

Raven Industries
RAVN
28
19.2%
21.10
2.20%
46%

T. Rowe Price Group
TROW
27
16.2%
17.40
2.30%
40%
Target Corp.
TGT
47
19.8%
19.00
3.30%
63%
W.W. Grainger Inc.
GWW
43
17.2%
21.60
1.70%
37%

Walgreen Company
WAG
39
22.0%
17.50
2.20%
39%
Wal-Mart Stores Inc.
WMT
41
18.0%
16.10
2.50%
40%

High dividend growth does not make companies automatic buys. Investors need to evaluate each company in detail, and understand where future growth will come from. A solid plan with concrete deliverables communicated from the company is just one instance of something that could propel solid dividend growth going forward. Other variables that could translate into high earnings and dividend growth include taking advantage of favorable demographic trends in healthcare, baby boomers needs for retirement saving, and the rise of the emerging markets middle class.

Investors should also take with a red flag companies whose dividend growth has been slowing down considerably in the past five years or less. Nucor (NUE) rode the boom in steel prices in the first half of the decade, only to reach a plateau at the onset of the financial crisis of 2007 – 2009. The dividend growth has been miniscule for the past five years.

Investors should also look into the valuation of each company, prior to investing. Purchasing even the best company in the world that is guaranteed to boost earnings and dividends for the next 10 years could still lead to losses, if investment is made at very high valuations. Investors in Wal-Mart Stores (WMT) in 1999 and Coca-Cola (KO) in 1998 can certainly attest to this fact.

However, a booming business can be rewarding eventually even for the most unlucky investors, provided they are true long-term investors. Great businesses like Wal-Mart and Coca-Cola are attractively priced today, and have managed to record better sales, profits and dividends since hitting all-time-highs at the end of the last millennium. If they can continue pushing forward, their investors will eventually make good profits.

Full Disclosure: Long WMT, KO, NUE, LOW, AFL, BDX, MCD, TGT, WAG

Relevant Articles:

The Tradeoff between Dividend Yield and Dividend Growth
Why Dividend Growth Stocks Rock?
Four Characteristics of The Best Dividend Growth Stocks
Living off dividends in retirement
Four Percent Rule for Dividend Investing in Retirement

Wednesday, October 8, 2014

Is international exposure overrated?

International diversification has always been sold on individual investors, as a means to reduce volatility in returns and enhance their portfolio returns. In essence, when US markets zig, the international markets would zag and vice versa. This might have been a great strategy a few years and decades ago, but in out globalized society, it might be less of a factor. Presently, global markets are increasingly moving at same pace, because of globalization. This correlation was evident during the financial crisis of 2007 – 2009, when all global markets tanked.

In a previous article I discussed the pros and cons of international diversification. I came up with more cons for dividend investors than pros. I tried to look at international exposure using another angle, and calm down US dividend investors that increased international exposure would not really add that much to the stability of their dividend incomes.

In the table below, I have listed the ten companies with the highest weight in the S&P 500. In addition, I have also listed the percentage of revenues that each one of these companies derives from their international operations. The ten companies with highest weight in the index accounted for approximately 18% of S&P 500. On average, these global companies derived 48% of their revenues from international operations.

Name
Ticker
Sector
Weight
International Sales
Apple Inc.
AAPL
Information Technology
3.46
61%
Exxon Mobil Corporation
XOM
Energy
2.3
64%
Microsoft Corporation
MSFT
Information Technology
2.18
52%
Johnson & Johnson
JNJ
Health Care
1.69
55%
General Electric Company
GE
Industrials
1.46
53%
Berkshire Hathaway Inc. Class B
BRK.B
Financials
1.45
16%
Wells Fargo & Company
WFC
Financials
1.41
5%
Procter & Gamble Company
PG
Consumer Staples
1.3
65%
Chevron Corporation
CVX
Energy
1.29
59%
JPMorgan Chase & Co.
JPM
Financials
1.28
45%

Each of these companies has different year-end dates. I tried to analyze the latest annual reports and other publicly available corporate information out there, which was 2013 for the majority of situations. 

If we were to extrapolate the results from this sample to the whole universe of stocks in the S&P 500, one can conclude that a large portion of revenues for US companies is derived from international operations. As a result, US investors who purchase shares in US multinationals such as Procter & Gamble (PG) or Johnson & Johnson (JNJ) can gain international exposure simply by investing in these US stocks. These global conglomerates operate businesses in many countries, and generate diversified streams of income from these international locations. These cashflows are then used to grow the business, with the excess distributed to shareholders as dividends.

As a result, I believe that adding internationally listed stocks would not dramatically improve the performance of a dividend portfolio. By purchasing US stocks with global operations, the domestic US dividend investor gains exposure to global income streams, without the hassle of international taxation or learning international accounting rules.

Full Disclosure: Long XOM, JNJ, GE, BRK/B, WFC, PG, CVX

Relevant Articles:

International Dividend Stocks – Pros and Cons
Dividend Investors Should Ignore Market Fluctuations
Dividend Growth Investing Works for Everyone Willing to Put the Time Into It
My Retirement Strategy for Tax-Free Income
Do not despise the days of small beginnings

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