Monday, March 3, 2014

How to think like a long term dividend investor

When most investors watch share prices fluctuate on a screen, it is easy for them to forget there are real businesses behind those share quotes, and not lottery tickets. It is also very easy to forget that price is what you pay, while value is what you get. Just because everyone is willing to pay only $56 for a share of Target, that doesn't mean that the value of the business in a going private transaction is $56. In reality, it could be much higher than that.

An investor should ask themselves the following questions, in order to better understand the business they are thinking of getting into:

1) What does the business do

In order to learn about a business, the logical first step is to realize what this business does. In the case of Target (TGT), you know that the company is a retailer, that sells things in retail stores with various formats and sizes. In the case of Exxon Mobil (XOM), the company owns fully or fractionally oil and gas wells, refineries and carbon transportation assets. Obviously, you need to understand the business and the industry the company is operating in, and take that into account when analyzing companies. When you evaluate Exxon Mobil you want to make sure that the company is able to replace existing reserves, in order to continue production and earn money. All Target cares about is bringing in traffic to its stores, staying relevant and keeping customer loyalty. Thus, always be mindful of industry specifics, when you try to choose between two businesses.

2) Who are the competitors? Are they relying too much on single customer or supplier?

In the case of Target, there are retail competitors all over the place. Wal-Mart (WMT) is a larger competitor, although Target appeals to individuals who earn more than the typical Wal-Mart client. Target also outspends Wal-Mart in the advertising front, in order to create a unique image that appeals to shoppers. The company also competes with the likes of (AMZN). This is one uncertainty that lies ahead for retailers – would their business model become obsolete by the emergence of the web. I think it is doubtful that physical store locations would not be used in the future, but the internet has brought a new threat to traditional retail. Target definitely has potential on the front however, which can mitigate some of those risks.

3) At what price can I snag the business?

It is rare that a business like Target would sell at irrationally depressed price to a private owner. In a manic depressive stock market however, it is entirely possible. As an investor, your goal is to buy shares as cheaply as possible. I usually try to avoid paying more than 20 times earnings, and also look into sustainability and growth prospects when I have to decide between companies. It also helps to acquire positions in businesses when few participants are excited about their prospects. Currently, it seems that many are not so optimistic about Target, given the stolen credit and debit card numbers, and the failure in Canada. While it is quite possible that business deteriorates from here, or that the stock price falls further, I think that now is the time to start acquiring Target for my portfolio. I have been nibbling my way into the stock, and would keep averaging down by adding to my stake approximately in 2014, depending on prices for other securities and prices for Target stock of course. I chose to dollar cost average by making 10 - 12 smaller investments throughout the year, rather than 2- 3 larger ones.

If I can purchase Target at 15.20 times earnings and a yield of 3.10%, that could be a good entry price. Earnings and dividends would likely increase from here, and could easily end up doubling every 9 - 10 years. The fact that Target is smaller than Wal-Mart (WMT) actually creates an opportunity for better future growth, since international is still untapped. This assumes that you are a buyer with strong hands, who is not going to be scared away from stock price volatility or temporary business problems. If you think that the business will not be around in 20 years, then obviously it would not make sense to buy. I believe Target will learn from its mistakes, and will succeed, hence I am willing to put my money where my opinions lie.

Another quality dividend paying stock that many investors own is Coca-Cola (KO). If you buy Coca-Cola at $38, and keep getting a $1.12 in annual dividends that grow by 7%/year, would it matter if market price goes down to $20 or up to $60 in the next 5 years? Unless you plan on putting the dividend and any fresh capital back in the stock, you should pretend like the stock market is closed for the next five years, and spend your time with family, on your day job or your hobby instead. I recommend going to bars or the movies also.

4) What are business competitive advantages

With companies like Wal-Mart Stores (WMT), the competitive advantage is the scale of operations. The company is spending a lot of time with suppliers in order to negotiate lowest prices, and it is continuously investing in infrastructure such as distribution centers and technology, in order to bring costs to the lowest levels possible.

On the other hand, Target stores are cleaner than those of Wal-Mart, and provide a more enjoyable experience to the shopper. This comes at a price however, as prices for the same item are usually slightly more expensive at Target. However, if you want to get fresher fruit and vegetables, do not want to wait in lines that have more than 2 customers, and want a better shopping experience, Target is the place for you. Target delivers on a great store experience and a product that is exciting and unique. Target tries to create excitement in shoppers, and position its products on basis of innovation, on design, and on quality. If you are frugal like me, you would keep going to Wal-Mart to save a few bucks however. However, if you can afford to pay slightly more for a better and friendlier customer experience, faster checkout times, then Target is the place for you.

Customer loyalty is strengthened through the Red Card, which offers discounts to shoppers who frequent the store. It is a win-win for both customers and Target. Target also manages to keep customer loyalty with special discounts and deals from time to time.

Another item that appeals to some shoppers is the fact that Target is active in communities, and provides money to non-profits. Compare this to all the negative publicity that Wal-Mart gets for ruining mom and pop stores.

For companies like Exxon Mobil (XOM) for example, their strength is in their integrated scale of operations. Furthermore, the company is very wise on capital allocation decisions, and tries to generate an adequate return on invested capital for all projects, whether drilling for oil and gas wells, making acquisitions or returning money to shareholders through buybacks. This is an important quality for management to have, because it lowers the risk that they would do something to jeopardize shareholder profits by getting in a bidding frenzy and replacing reserves by paying top dollars for it.

5) Can the business earn more over time - what factors will drive it

The thing is that Target’s market is the US is close to its saturation point. Future growth in the US is still likely, but it won’t be as robust as in the past. Therefore, if it wants to generate more growth in the future, the company needs to expand internationally. The company is eyeing Canada and Latin America as its near term base for expansion. It actually seems to have not done so well with the launch of its Canadian operations, which has led investors to discount future growth prospects through a more skeptical lens. I believe that the company would learn from this experience, and hopefully use that in their future expansion plans abroad.

Full Disclosure: Long TGT, WMT, XOM, KO

Relevant Articles:

How to choose between dividend stocks?
Two Dividend Machines I Purchased Last Week
Dividend Investors Should Ignore Price Fluctuations
Coca-Cola: A wide-moat dividend growth stock to buy and hold
How to retire in 10 years with dividend stocks

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