Wednesday, November 12, 2014

Successful Dividend Investing Requires Patience

We live in a fast paced world, where we are constantly bombarded by information on something that makes us want to act quickly. Unfortunately, that is not the successful set of skills that you need as a dividend investor. The best dividend investors are those who buy a stock, and then let it quietly compound their income and capital over time. I know that many think they can do it, but in reality, few have the stamina to sit through extended periods of “temporary punishment”. Very often, investors give up on a company after an extended period of below average performance. After that happens, the things revert to the mean and the truly patient shareholders with a long-term vision are rewarded.

Those who got scared easily ended up with emotional scars for life and most probably failed to learn the lesson of what successful dividend investing is all about. The secret sauce is that one needs to select a company that fits their entry criteria, research it both qualitatively and quantitatively, and then let it compound their capital without really worrying too much about quarterly noise and even annual noise. You have to be patient, and not be scared by temporary periods of weak performance. Sometimes things look bleakest right after the tide turns positive. If you try to jump in and out of companies, you are very likely to incur so much in investment expenses, tax expenses and lost opportunity costs, that will result in a very poor investment record. The truly successful dividend investor knows they will have some losers, but that their winners will do so much better on average, that they would still generate an adequate portfolio return over a 20 – 30 year period. It is difficult to say whether a problem that everyone is talking about is a temporary or a long-term one that will result in the demise of the company. This is why I ignore most opinions out there, and keep holding and investing. It is tough to say if a weakness is a random item, or a beginning of a pattern until it is too late. I believe that no one can predict the future, which is why I try to ignore speculation which might or might not turn true. The dividend investor will have nerves of steel in their conviction, and hold on through thick and thin, despite the loud noise out there. The dividends they receive will be used to acquire more shares in the best values at the moment, or spent if they are in the distribution phase of their dividend investor lifecycle. Now, if the dividends are cut or eliminated, that itself signals that the reason the company was able to have a dividend growth streak is probably not valid after all. This is the situation when I sell right away, and ask questions later. Until then, I hold on.

We often hear the story of how someone could have put $1,000 in Johnson& Johnson (JNJ) in 1972, then let dividends compound for decades and ended up with a stake worth approximate $97,500. The reality is that in order to earn that handsome return, the investor would have had to sit through difficult periods that would have tested their conviction time and again. For example, it would have been difficult holding a stock through the 1972 – 1974 correction. It would have also been difficult to hold on to Johnson & Johnson through 1983, when the stock price finally exceeded the all-time-highs. It would have also been difficult to hold on to the stock during the Tylenol recalls in 1982, when you are bombarded by terrible news all the time. For me, it was difficult to hold on to shares of Johnson & Johnson in 2010, when I got bad news about recalls. It is difficult for most investors to hold on to a company where prices have gone nowhere for a decade. I got this response a lot when I first started my site and analyzed companies . As a dividend investor, it is rewarding to get paid for waiting, and receive a higher dividend check every year.

Nowadays, it is tough to hold on to shares of McDonald’s (MCD), as the popular opinion discussed how unhealthy the food is, how the minimum wage will rise to $15/hour, how the millennials are not going there etc. The reality is that same store sales have stagnated, and earnings per share growth has slowed down in the past couple of years. It is yet to be seen whether this is a real trend or just a temporary situation. In addition, McDonald’s is often compared to other chains that are relatively new and therefore have a lower base to grow from. And according to the WSJ, most millennials are still eating there, although the amount going to eat elsewhere is increasing from a smaller base slightly quicker. If you stop by your local McDonald’s, you see people waiting in line, going through the drive through, and eating their lunch in. The company is still unmatched in its scale of operations, and still manages to sell its products to millions of customers around the world. The globally recognizable brand name is still there, the premier locations are still there, and the innovation that resulted in the earnings growth that made 38 years of record dividends possible is still there. It is a given that blue chips stumble from time to time. This was true with McDonald’s in 2002 – 2004. It is true again with it in 2014. If you sold then ( in 2002 - 2004), you missed out on capital gains and dividends that were roughly several times more than the amount you had at risk.  I like the fact that I am essentially paid for holding on to my McDonald’s shares, which are attractively valued today. I can and have used those dividends to acquire stakes in other dividend paying companies. This means that if I hold for 20 years, and the dividend increases by just 3% per year, I will likely receive as much money in dividends as I paid for the stock today. Plus, I would still have ownership of McDonald’s (MCD), the results of which can be pretty satisfactory without even considering the dividends. Of course, a 3% annual dividend growth in dividends sounds very low, and I only used it to illustrate the point that shares are offering a good return opportunity today. The lower the shares go, the better the opportunity in my opinion.

It might sound counterintuitive, but companies can provide very good returns to long-term shareholders even if their revenues stagnate. For example, investors in Sears in 1993 did slightly better than the S&P 500 benchmark over the next 20 years. This was due to unlocking value through spin-offs, regular dividend payments, share buybacks, cost cutting and asset sales. McDonald’s (MCD) has a lot of real estate, and a lot of restaurants it can refranchise, thus further increasing the amount of cash it could send the way of shareholders. Imagine how much more dividend income you can receive if McDonald’s spins off its real estate and converts it into a REIT? Even today, if an investor manages to buy the shares at close to a 3.50% - 4% yield, and then earnings and dividends only grow by 4.5% - 5%/year, they should earn a 9% total return. To give you some perspective, the lowest annual dividend growth by McDonald’s was by 4.50% - 5%/year in the late 1990s and early 2000’s. So I am describing again a very conservative scenario from a historical perspective. If that investor reinvests dividends automatically every quarter, their return will be further enhanced if the share price is depressed and thus they earn a higher yield on reinvestment than the above stated one.

Either way, I plan to hold on to my investment in McDonald’s, until management proves me wrong and cuts the dividend. If they freeze the dividend, I would no longer add money to the position (except for my IRA, where it makes sense to automatically reinvest them due to cost/benefit). Furthermore, my downside is protected because McDonald’s has a 2% weight in my diversified dividend portfolio. My largest 40 positions account for 90% of my dividend portfolio value. This helps me sleep well at night even in the highly unlikely scenario that I am wrong. The outcome of this investment will be visible in 2024-2034. Let’s circle back on this article then.

In conclusion, the important thing for investors is to have a strategy for stock selection, and stick to it through thick and thin, while ignoring noise. Investors should also have the patience to hold on to their position as part of a diversified portfolio, in order to let the power of compounding do its magic. Not all dividend investments will work out, but it is tough to say which ones will provide the blockbuster returns in the future. This is why it is a mistake to cut the opportunity for capital gains and dividends too quickly, and disposing of investments.

Full Disclosure: Long MCD, JNJ

Relevant Articles:

How to define risk in dividend paying stocks?
Why would I not sell dividend stocks even after a 1000% gain?
Dividends Offer an Instant Rebate on Your Purchase Price
Dividend Investing Is Not As Risky As It Is Portrayed Out to Be
How to become a successful dividend investor

8 comments:

  1. Great post today! (Glad it wasn't one that required going to Seeking Alpha to read)

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  2. Well said but probably preaching to the choir. Looking back at some of my picks, Whole Foods (WFM) comes to mind. It has been a great performer for my portfolio but has had its ups and downs. Long term it has been great. The challenge is to remain a patient, long term investor and not a jumpy, short term trader.

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  3. Good advice, DGI. But are you a buyer of MCD today? I have been considering adding more, and will definitely buy if the price gets close to $90.

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  4. To see the price drop and keep calm is not easy at all. Yes you earn from dividends but the value drops, so mind get busy with many troubled thoughts..

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  5. Great article DGI on a very important topicfor dividend investors. I think one of the keys to successful dividend investing starts at the purchase level. There is a difference between buying a stock that just pays dividend and a long-term, dividend growth stock. I know it probably sounds ridiculous and there is not a difference between the two. However, to me, a dividend growth stock is a company that you can buy, hold, and comfortably know that they will be able to weather the down years. MCD and JNJ, as you mentioned in this article, fall into this class. Sometimes the yield will be higher than the historical average (like MCD right now while the stock is low) and sometimes it'll be lower. If you purchase these kind of companies, I think it will help you develop the patience required to weather the storms that JNJ wentthrough historically and MCD is going through now. However, if you are just chasing yield and investing in a company just because it pays a high dividend, you may be a little more trigger happy selling at any indication the company's stock price is going to drop or the dividend is in danger. Hopefully that makes sense haha

    MCD will be fine in the long run and I am happy we as investors are sticking it out. The company has been through this before and will find a way to make it work. Thanks for a great post!

    Bert, One of the Dividend Diplomats

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  6. I agree, holding onto stocks to collect a dividend is a fine way of riding out downturns. I'm aiming to start my first DRIP soon, so any drop in prices only increases the DRIP power/cash left over to reinvest elsewhere.

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  7. Patience is the most powerful tool while investing bit sadly it is almost always underestimated. I've written about it several times:

    http://www.dividendogma.com/el-mejor-valor-la-paciencia/

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