Wednesday, August 7, 2013

Dividend Investing – Science versus Intuition

In many articles on dividend investing, I have typically focused on objective factors that I use to screen for dividend stocks. I typically look for a company which has managed to boost dividends for at least ten consecutive years that trades at a price to earnings multiple below 20 and yields at least 2.50%. I also like to see a sustainable dividend payout ratio. I have come up with this set of entry criteria, after evaluating hundreds of dividend stocks.

However, once this screen spits out a list of companies for further research, I spend hours looking at each individual candidate. I look at trends in earnings, returns on equity, revenues, valuation trends and dividend growth from as far back as the beginning of time. I also try to evaluate whether the company has what it takes to keep earning more for the foreseeable future, and maintain its policy of regularly boosting dividends. The more I research dividend stocks, the more subjective the process begins to look like. For example, my guess as to whether Coca-Cola (KO) will be able to sell more product at higher prices and generate higher revenues and profits between 2013 - 2020 is as good as yours. At the same time, while Intel (INTC) is undervalued right now, and has an above average yield and a sustainable dividend payout ratio, I am still unsure about initiating a position in the company. My guess is that future dividend growth might be limited by the volatility in earnings as the company is struggling to gain market share in the mobile semiconductors market.

At the end of the day, I realize that a large portion of investments I make are based on my personal opinions and biases. These come from years of experience investing, as well as working in different fields such as technology, energy, education, professional services etc. This is what makes investing such a unique and challenging field – at the end of the day there are two people with completely opposite views, who both think they are geniuses, but only one of them is going to make money on the transaction. The point which I am trying to make is that just like any other skill, investing is best learned through practice and not by simply reading about it. After all, I would much rather go to a doctor who has several years of practice than visit a doctor who just graduated from medical school.

In addition, through experience I have been able to learn more about companies business models, gain familiarity with their products, and make an educated guess about their future. For example, I have been able to identify several companies which were outside of my entry criteria and invest in them despite the clear violation with my rules. A very helpful tool I use is the list of dividend increases every week. It helps me identify companies that are exhibiting strong momentum in dividends, fueled by a growth in earnings. That is how I have been able to identify companies like Yum! Brands (YUM), Visa (V), Phillip Morris International (PM), Family Dollar (FDO) and Kinder Morgan Inc (KMI). While these companies either had low current yields or short streaks of dividend increases, the common factor behind each one of them was an attractive valuation, as well as the potential for strong earnings and distributions growth. I liked the prospects for each company after analyzing it, and was able to identify the drivers behind future growth through my analysis.

For example, for Phillip Morris International (PM), I liked the fact that the company had exposure to the growing emerging markets. I also liked the fact that its business was not exposed to the litigation risk in the US. In addition, I liked the fact that company was gaining market share through innovation , strategic acquisitions, and had diversified operations worldwide. Check my analysis of PMI.

With Yum! Brands (YUM) I liked the fact that the company was beating McDonald’s (MCD) in international expansion particularly in China. The company has had some issues in China recently, but I believe those to be temporary.

With Visa (V) I liked the fact that the company is part of a global duopoly with Mastercard (MA) in the global credit card market. In the future, the proportion of cashless payments is going to increase. While the market for credit cards is developed in the US, in emerging markets there is the opportunity for hundreds of million people who will sign up for the first card in their lives over the next decade. In addition to that, Visa was cheaper than Mastercard.

With Kinder Morgan (KMI), I liked the fact that it owned general partner interest in two growing master limited partnerships. This meant that the company was poised to capture much higher distributions growth than the underlying assets, because of valuable incentive distribution rights. I also like the fact that the company's CEO has almost all of his net worth in Kinder Morgan, which aligns his interests with those of other shareholders.

I am not saying that investors should blindly purchase any stock that they think would deliver strong results in the future. What I am trying to depict in this article is the fact that investors need to have some method of identifying strong candidates for further research. However, they also need to be flexible, and identify opportunities which their strategy might not catch. In addition, I do not believe that investing is a black and white process, which is why experience is the best strategy for the enterprising dividend investor for the long term.

Full Disclosure: Long PM, V, YUM, KO, FDO, KMI

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This article was featured in the Carnival of Wealth, Perseid Meteor Shower Edition

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