Wednesday, July 24, 2013

Frequently Asked Questions (FAQ) About Dividend Investing

I have highlighted below several frequently asked questions about dividend investing. This is not an all inclusive list, but more of a running total of questions I am usually asked about dividend investing, dividend growth stocks and my strategy. The answers pertain to my investing, strategy and experience, and I have tried to respond to the best of my knowledge and intentions. As I get new recurring questions asked, I would add them to this list.

Why should you focus on dividends?

A company that pays dividends is less risky than a company that has never paid a dividend. A company that pays dividends pays with actual cash, which cannot be easily manipulated like earnings. Dividends are a more stable part of total returns, and are always positive, which is what makes them ideal for retirees who want to live off their nest egg. Paying a dividend imposes discipline on management, that makes them evaluate the cash flow impacts of new projects and make them only focus on the best ideas. This dividend payment makes management less likely to engage in empire building, and less likely to simply hoard cash or mindlessly expand/acquire companies which are not accretive to returns. Few US managements are willing to cut a dividend – doing so sends signals that the company is weak financially.

What are you looking for in a dividend stock?

In my entry criteria, I focus on companies which manage to increase dividends over time because they have growing earnings, trade at a P/E below 20, yield above 2.50% and have a dividend payout ratio below 60%. I have violated some of those rules before, but I have also focused on only buying companies that can increase earnings and not paying more than 20 times earnings. I also do qualitative analysis in order to understand the business of the company, whether it has any moat, competitive advantages, strong brands, pricing power and the ability to increase earnings over time.

How to you handle dividend payments?

As an investor in the accumulation phase, I re-invest dividends selectively. This means that I accumulate cash dividends all the way up to $1,000 or $2,000, and then purchase shares in a company I believe to be attractively valued. I am not a fan of automatic dividend reinvestment, unless of course your portfolio is so tiny that the transaction costs would negate any benefit of investing in the cheapest stocks.  I target 6%– 7% in annual dividend growth, coupled with a 3% - 4% yield on my portfolio, for a total of 10% in dividend income increase every year. Once I retire and live off my portfolio, I would spend all of the income, and would rely on organic dividend growth to keep up with inflation.

When would you sell a dividend stock?

I usually sell after a dividend cut, after a company I own is acquired, or if it becomes too overvalued for the growth I expect out of it. For example in 2012, Con Edison (ED) traded at a yield of 4% despite the fact that it was growing distributions at less than 1%/year for the past 16 years. In addition, shares of Universal Health Realty Income (UHT) were similarly overvalued relative to their dividend growth.  I try to buy great stocks that would do great things in increasing earnings, dividends and stock prices, but sometimes life happens and either growth slows down, the stock gets massively overvalued or the financial conditions deteriorate. My expectation is to never sell when I buy (otherwise, why would I buy in the first place), although I monitor frequently my portfolio.  I expect that my best ideas would go up over 1000% in my lifetime, and I would keep holding on to them until I pass them over to my heirs.  These would be the stocks that would generate large portions of my returns. Selling a stock that will go up by 1000% in 20 – 30 years for a small gain without letting it ride out to full potential will likely cost a lot, and could mean you lose money in dividend investing rather than make any.

Don't only companies that do not grow pay dividends? Companies that cannot find anything better to invest money in tend to pay dividends.

It is true that companies like Google (GOOG) have never paid a dividend; nor did Apple (AAPL) pay a dividend between 1997 – 2011, when its stock rose a lot.  However, most companies that do not pay dividends do so because they cannot afford to because they have deteriorating financials or need all of the money to be reinvested in the business, as they are not generating excess cash flows.  If you focus on companies that do not pay a dividend, chances are that few will be the Googles or Berkshire Hathaway’s (BRK.B) of the world, but most might be the Worldcom’s, General Motors, Eastman Kodak’s etc.

Actually, some of the best performing stocks have managed not only to grow business but also pay a rising dividend over time. Such companies include Wal-Mart (WMT), McDonald’s (MCD) and Coca-Cola (KO). My goal is identifying these companies that not only increase earnings and dividends, but also trade at a reasonable valuation. That being said, not all companies that pay dividends are good investments.  Please check above on the factors I look for in a stock.

But Warren Buffett doesn’t believe in paying dividends – Berkshire has not paid a dividend since 1967

Berkshire Hathaway has not paid dividends since 1960’s. However, Buffett does invest in businesses and companies that pay dividends, and he uses these cash flows to invest in other cash generating stocks and businesses. This is similar to what dividend investors do – buy stocks and then reinvest them in other attractively valued stocks if in the accumulation stage. If you are retired, then chances are you still reinvest your excess cash in more dividend stocks. While Buffett is an excellent capital allocator, few other companies can match his expertise. Most companies that invest excess earnings into other relevant businesses or unrelated industries have a poor track record. The sole fact that there is just one Berkshire Hathaway but over 100 dividend champions speaks volumes.

But what about total returns?

As I mentioned above, I focus on companies that I believe will increase earnings per share over time. This is the driver behind dividend growth over time. A company with rising earnings per share would likely increase in price over time. As a result, I do hope that the companies I buy will be more valuable over time, and would generate total returns. However, I focus on dividends because they are a more reliable portion of total return than capital gains for living off your nest egg.

What about taxes?

Qualified dividends derived from US corporations are taxed at a maximum tax rate of 23.80% to US residents. This is much lower than tax rates on interest income, which is taxed much higher at the ordinary income tax rates (except muni-bonds). Unfortunately, if your income is less than $400,000 for single or $450,000 for joint returns, you would pay anywhere from 0% to 15%.

Taxation varies for REITs and MLPs, and is unique to the entity paying them and the personal situation of the individual receiving distributions from these entities. Not investing in dividend stocks and equities in general because they could result in tax liabilities is not a smart strategy to follow. It is possible for US investors to defer/avoid paying taxes on investment income if it is placed in tax-advantaged accounts such as 401(k), IRA, ROTH IRA, SEP IRA etc. If you are a US resident investing in foreign corporations, you might end up paying withholding taxes on dividends received, even if you held them in a tax-advantaged account however.

But is a 2% yield sufficient to protect you against inflation?

I focus on companies which have yields that look low today, but which I believe would increase dividends above the rate of inflation. If this dividend growth is fueled by earnings growth, chances are that stock price will increase as well.  For example, let’s examine a situation where you bought a dividend growth stock that trades at $100/share, earns $5/share and pays a $2 annual dividend. If this company is able to grow earnings and distributions by 7%/year over the next decade, and inflation grows at 3%/year, you will be ahead of inflation. That means that in year two, the company would earn $5.35/share, pay $2.14/share and likely trade around $107/share. In order to maintain purchasing power in year two as year one, the stock would have had to trade at $103/share and would have had to pay $2.06/share.  If you add in that excess over inflation, it can lead to more wealth over time. Since 1920, dividends on the Dow Jones Industrials have increased by 5%/year, which was 2% higher than inflation. As a result, I find dividend growth stocks to be the perfect source of inflation proof source of income.

But I would need $500,000/$1,000,000 invested in dividend paying stocks to make a meaningful amount of dividends to live off?

In order to live off your nest egg, you need to build a nest egg first. I focus on building income, rather than a set amount to invest in. However, if you are just getting started and need $40,000 in annual income, you would likely need to invest about $1 million in dividend paying stocks. However, if you asked a traditional portfolio planner/financial adviser, they would have advised you to have $1 million in your portfolio and follow the traditional 4% rule. As a result, the requirement to have a nest egg to live off of with dividend stocks is no different than what you would need in a traditional index funds/bond fund allocations. The goal is to start as early as possible, in order to get time and compounding on your side. Dividend investing is not a get rich quick scheme.

But doesn’t dividend investing take too much time?

Dividend growth investing does require a time commitment.  The time is spent scanning the market for opportunities, analyzing companies through reading annual reports, analyst reports, and filings. The time is also spent reviewing your portfolio regularly as well. However, once you have a certain level of understanding behind the companies you own, updating that knowledge should not take as much time. In general, you can spend about 10 hours/week easily on average, with a lot of it spent in the February – April period when most annual reports are sent out. If you are unable to dedicate time to managing your individual portfolio, you can outsource it by focusing on stock or bond funds. However, depending on your choices, you might end up paying a steep price every year for this privilege.

What about bonds/real estate/gold?

I believe that a portfolio should be well-rounded with different asset classes that do well under various conditions. I would like to have a 20% - 25% allocation to US treasuries when I retire, which would protect my nest egg for a Depression like scenario like the US experienced in 1929 – 1933 or Japan between 1989 – 2013.

I am not capable of managing real estate myself, but instead focus on Real Estate Investment Trusts.
I do not own gold/silver except for a few coins for numismatic purposes ( I also used to collect stamps at  one point). I do not see much value in it in a typical investment portfolio. I like to own assets that have a productive capacity such as stocks or real estate for example. However, gold has been the asset to own if you were part of a minority that is being persecuted and you need to leave (Jewish community in Poland in 1939).

What are your favorite resources to research dividend investing?

I read annual reports, where I obtain most of my data. I use the Securities and Exchange commission website for this at I also use Yahoo! Finance to keep tabs on my many holdings, in a personalized watch list. I also have a few favorite authors on dividend investing:
Why spend all that time on dividend investing, when no one can outperform index funds?

As a dividend investor my goal is not to outperform the S&P 500, although I do compare increases in my dividend income to increases in S&P 500 dividends. The S&P 500 is a list of stocks which is arbitrarily selected by a committee in Standard & Poor’s according to who knows what criteria – it is not even a list of the 500 largest companies in the US.  The 40 largest companies in the index account for almost half of its weighting. The committee in charge of maintaining S&P 500 included Berkshire Hathaway only a few years ago. During height of the dot-come bubble in 1999 – 2000 they added a lot of so called "new economy stocks", right before they crashed and burned. My goal is to generate a growing stream of dividend income every year, and to achieve that I focus on companies which I believe are undervalued today, have solid competitive advantages that I understand, and will likely increase earnings and dividends over time. I have a friend who owns an auto repair shop.  I never ask him how his business is doing relative to the S&P 500, or else he would think that some of the screws in my head might be failing.

Incidentally however, dividend growth stocks since 1972, dividend champions since 2007 and dividend achievers since 1996 have outperformed the S&P 500 or very closely followed it.

Readers of Dividend Growth Investor website, I would appreciate your feedback on Frequently Asked Questions. If you have input on the existing answers to these questions, or if you could think of any additional ones, I would be more than happy to hear from you here or in my email address. My e-mail is dividendgrowthinvestor at gmail dot com.

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