Monday, September 29, 2014

Mistakes of Omission Can Be Costlier than Mistakes of Commission

Warren Buffett is one the best investors in the world. He has coined the term mistakes of commission. Basically, mistakes of omission are those situations where you have identified a company to invest in, but you fail to pull the trigger. As a result, your inability to act results in lost opportunity cost. A mistake of commission on the other hand is the act of buying a security which declines in price, which leads to a permanent loss of capital. Buffett is a very wise and rich person, who is a collector of quality businesses, that throw enough cash for him, that he then uses to buy more income generating assets. This is why I believe he is actually a dividend investor.

With dividend growth stocks, the most one can lose is less than 100% of their investment. This is because if I bought a company like Coca-Cola (KO), and it outright fails in a few years or decades, I would have received enough dividends to recover a big chunk of my original investment. I think it is highly unlikely that Coca-Cola will fail in the next 20 years, although it is possible that its growth will be slower than that in the past 20. Even if the dividend grows a little for the next 10 years, I will be able to recover somewhere around a third of my investment just from dividend income alone. The upside however is virtually unlimited – if the company gets its act together, it can deliver 20 – 30% yields on cost by 2034.

As a dividend investor, I am also a collector of quality assets that regularly pay me more and more cash on a regular basis. My goal is to work hard at saving as much as possible, and use those savings to invest. The reason why I try collect as much in income producing assets as possible is so I can live off those dividends one day. This is the reason why most of you read what I have been thinking out loud about investments over the past seven years.

In order to come up with a list of companies to buy, I go through a rigorous top down approach. I basically start with a list of dividend growth stocks, and then try to narrow it down using some sort of entry criteria. After that I research the most attractively prices companies from that list. Sometimes however I end up missing the forest for the trees.

The recent dividend increase of Lockheed Martin (LMT) increased my mistake of commission. The defense contractor increased its quarterly dividend by 12.80% to $1.50/share. This marked the 12th consecutive annual increase for this dividend achiever. Lockheed Martin has managed to increase dividends by 23.50%/year over the past decade. The lesson to learn from this exercise is that sometimes, you will make mistakes as an investor. I am mentioning this, because the stock continuously appeared on my valuation screens, and my dividend increase monitoring updates in 2011 and 2012, but I did absolutely nothing. I am reviewing this mostly as a way to identify shortcomings in my investment process, and see if I can improve it.

The situation in 2010 - 2012 was very interesting, because the stock of the company was very cheap and yielding a lot. The reason was the near ending of the wars in Iraq and Afghanistan, as well as the US budget issues. The main consensus was that defense contractors were going to face stagnating defense budgets from their largest clients, which was going to affect revenues.

Managements of those defense companies did prove to be good stewards of shareholder capital however. Lockheed Martin managed to repurchase shares at low valuations, reduce its workforce and otherwise maintain its cost base. When your stock sells at 9 – 11 times earnings, you can grow earnings per share in perpetuity merely by repurchasing some of your stock each year. If you contain costs a little as well, this also results in a better growth in earnings per share. Lockheed Martin did just that, by reducing the number of shares outstanding from 410 million in 2008 to 322 million by 2014, through its consistent share buybacks.

I guess, when you have a dividend growth company, which sells at a low P/E multiple, and which grows dividends per share and earnings per share, you can make some pretty decent amounts of money. Imagine if you bought shares yielding 4% - 5%, where dividends increased while the shares outstanding decreased as well, and you also reinvested those dividends. This is some pretty turbocharged compounding of income and capital to me.

While I have been advocating doing qualitative analysis of each company on my screen, I could also be exposing myself to biases that could be costly. As I have mentioned earlier, things are not always black and white in investing. My evaluation of the defense industry was generally correct, but it ignored the fact that earnings could be grown through buybacks and cost containment. Of course, back until late 2012, I didn’t even like stock buybacks. I still don’t like them as much as I like dividends, but I know that companies that consistently do them, and manage to do them while their stock is fairly valued, can improve shareholder wealth.

After analyzing the investments I have done in the past seven years, I have noticed that those that did the best for me were selling for less than 16 – 17 times earnings, and were experiencing growing earnings per share and consistent dividends per share growth. By sometimes listening in to news or other noise, I ended up speculating about the future, without really taking into account that I should merely get on the rising earnings and dividends train. I essentially ignored the fact of rising earnings and dividends per share, and focused on speculating about the future, which is not what enterprising dividend investors do. Worrying about when it is going to stop dividend growt is not really a productive thing to do. This was also the case with Microsoft (MSFT), which was selling at a very cheap price just a couple of years ago, because it was perceived as losing its way. Yet, the company was raising its dividends each year, earnings per share were growing, and the threats sounded scary but also have not materialized yet. Currently, the company that everyone is afraid for is IBM, which sells at a ridiculous cheap valuation, grows earnings per share and dividends, and regularly repurchases shares. This is why I am trying to build out my position in the stock. I am also working my way through increasing my exposure to the much hated Exxon Mobil (XOM) as well.

The mistakes of omission with Microsoft and Lockheed Martin show that maybe I just didn't understand the companies very well altogether. This could be a good reason why I never bought in the first place. I also didn’t buy Bank of America (BAC) in 2008, and also avoided buying Nu Skin (NUS). However, I should be trying to learn more about those businesses (LMT and MSFT), and isolate events that can result in more dividends over time for me, so I can be even more successful. Knowledge is like compound interest – it builds up slowly over time, and results in dividends for years. After this I also learned that the situation with Lockheed Martin in 2010 - 2012 was similar (though not identical) to the situation with General Dynamics in 1993 - 1994, when the company repurchased a large block of stock and sold off businesses to pay more dividends. Warren Buffett made an investment in the defense contractor in 1993, and made a lot of money for Berkshire Hathaway shareholders. It is interesting how the big money in defense companies can be made even after major wars such as Vietnam, The Cold War and the wars in Afghanistan and Iraq were over. It is counterintuitive, yet this is a good thing to have in mind at some point in the future.

Of course one cannot be right 100% of the time either. While I have not been right on all investments I have analyzed ( both through commission and omission), I have achieved solid progress towards my goal of reaching the dividend crossover point. The important thing is to keep learning from your mistakes.

Things are not always black and white, and investing is subjective to a certain degree – I cannot automate and distill it into an investment formula. This is why it is important to evaluate how your companies are doing at least once per year, and decide if you are making some common mistakes. My previous analysis of mistakes showed me that I sometimes sell to buy something cheaper. The end result is worse than doing nothing. The mistake that most dividend investors do is chase yield at all costs, without thinking about sustainability throughout different phases of the economic cycle. They also tend to focus on yield, without taking into consideration growth, which results in decrease in the purchasing power of income over time. If you do not realize you are making mistakes, chances are that you will never learn from them. This is why Buffett is so great – he learned from his mistakes, adapted to the new environment, and kept learning more about business and ways to make money.

You keep hearing about the people who have been calling for a stock market top for 5 – 6 years now. Yet many of those people have been looking for a turn for 20 years. They forget that overall economies improve, earnings improve, productivity improves, which leads to higher valuations in companies and more money for dividends. The fact that those people never learned from their mistakes is really troublesome. If you missed out on the growth in US stocks over the past 20 years, and you still maintain your view, chances are you need some corrective action to do. If you are not objective in the analysis of your investments, you will not be able to identify shortcomings. If you do not identify those mistakes, you are likely to lose on potential gains. This is why it is important to keep learning, and try to improve consistently.

Full Disclosure: Long IBM, KO

Relevant Articles:

Don’t chase High Yielding Stocks Blindly
Never Stop Learning and Improving
How to analyze dividend stocks
Three stages of dividend growth
Should Dividend Investors be Defensive about these five stocks?

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