Wednesday, May 6, 2015

How to be an Intelligent Dividend Investor

Ben Graham is one of the most successful investors of all time. He is the father of value investing, and the mentor of super investor Warren Buffett. He is also the author of the bible on value investing “Security Analysis”, as well as the book “The Intelligent Investor”. Ben Graham’s strategy focused on purchasing undervalued companies, and then selling them when prices reached his objective.

Graham was adamant about investing in companies that pay dividends. He believed that conservative investors should only consider companies that have paid a dividend every year for at least the last 20 years. He argued that dividends are a sign that a company is profitable (dividends are paid from profits, after all) and that they also offer investors a return even if the company's stock does not perform well.

Ben Graham quotes in his book "The Intelligent Investor" that:

One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.

Dividends represent a positive return on investment to shareholders. Because they are paid out of real earnings, they are the only fundamental link between company performance and investor returns. This is because stock prices can often ignore fundamental values for extended periods of time.

As a result, dividend investing is the perfect strategy for the intelligent investor to live off their nest egg. It is a nice edge for the investor with the long – term mindset of a business owner, who focuses on business profits, and is not afraid of stock prices that fall by 40 – 50% over a short period of time.

This business owner creates diversified portfolios that hold at least 30 - 40 securities, acquires partial ownership in those businesses over time and tried to pay fair prices for the securities.

What dividend investors do is a variation of value investing, with a quality twist. While Graham would focus on generating one-time profits from buying undervalued securities, dividend investors focus on recognizing value through the receipt of dividends. This dividend income unlocks value in the shares they own, by essentially providing them with a sort of like a cash rebate on their original purchase, while also maintaining their ownership in the asset. This provides recurring returns for the dividend investor who had done all the initial work needed.

Think about this for a second. The strategy Graham and early Buffett used was focusing on spending the equivalent of several full-time employees per week, scanning thousands of opportunities in order to come up with a few undervalued securities. They would purchase them, and sell only after a target price is met. After that, the laborious process continued.

On the other hand, if you spend your time looking for quality dividend paying companies, and find a few at fair prices, your work is essentially done. You will generate a rising stream of dividends over time, in some cases for decades, while patiently holding on to the appreciating stock. If your company manages to grow earnings and dividends by 7 – 10% year, this would quietly compound your investment income and net worth over the years. True, you have to monitor those investments, but let’s be honest, companies do not change that much from year to year. As long as the story keeps up, you can afford to only check the company through quarterly and annual reports. In reality, only a small portion of the companies you own will turn out to grow dividends for a long period of time, and deliver the most in growth for your portfolio. A large part would grow and then freeze and resume dividend growth, while the rest would likely lead to small losses as they cut dividends due to changes in business environment.

In a later version of the Intelligent Investor, Graham discussed how his partnership was involved in acquiring 50% of GEICO in 1948 for $712,000. Later, the SEC required them to distribute the shares to the partners. By 1972, the value of that stock had zoomed to $400 million. Graham later admitted that the profits from this one deal far outstripped the profits of his partnership over two decades from following the laborious value investing principles.

Buffett also purchased $10,000 worth of Geico in 1951, only to dispose at a profit in the next year in order to buy Western Insurance at 2 times earnings. He netted $15,000 from the sale, and notes that in the subsequent 20 years, the value of the sold shares increased to $1.3 million.

This is why buy and hold for the long-term in fantastic businesses is so superior to active trading (the active outguessing of the markets). It therefore seems important to focus on great businesses, which can grow for decades after you purchase them. Such securities can be safely tucked in a vault, and the investor should only be reminded about them four times per year, as the dividends are deposited in their accounts. Check this list of 39 dividend champions I am considering for further research.

Full Disclosure: None

Relevant Articles:

Successful Dividend Investing Requires Patience
How to think like a long term dividend investor
Dividend Stocks For Long Term Wealth Accumulation
Margin of Safety in Dividends
Dividend Stocks Deliver a Return in Any Market Condition

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