Wednesday, June 3, 2015

How to become a successful dividend investor

In order to become successful in any pursuit in life, one needs to define what success means to them. In my situation, I would consider myself successful, when my dividend income exceeds my expenses by a reasonable margin of safety, and keeps growing at or above the rate of inflation. In order to achieve that success, I try to avoid situations which would lead to failure. This is similar to the behavior that Warren Buffett's sidekick Charlie Munger talks about extensively in Poor Charlie's Almanack

The best way to ensure success is to own a diversified portfolio of at least 30 - 40 individual stocks, from as many sectors that make sense. I try to buy quality companies at low to fair valuations. I do not limit the number of companies however - I only invest in companies and sectors when they are available at attractive valuations. Different companies and sectors are available at good prices at different times. If the best values are outside what I already own, it makes logical sense to allocate money in those ideas number 41 and up. Accumulating a dividend portfolio takes several years to build.

This portfolio will likely look differently 30 years later. This is because some of these stocks would end up being acquired. Others will cut dividends at some point, prompting the investor to sell. A third group will freeze dividends, and unfreeze them over time, but never cut them. An example includes General Mills (GIS), which has never cut dividends in 116 years, but has only increased them every year for a decade. Another group would work a couple of years or even decades, and then changes would make the company unappealing and causing you to sell. The last group are the companies that would keep performing as expected, earning more and raising earnings and dividends over time. These will be the companies that would generate gains of several hundred or thousand percent over lifetime of investment. This of course could likely take years or decades.

In the meantime, it is also important to realize that many companies could end up splitting, merging, spinning-off divisions. So even if you build a passive portfolio of 30 securities today, chances are that you might have much more than that in the future. Case in point is Altria (MO), which spun-off Kraft in 2007 and Phillip Morris International (PM) in 2008. Subsequently, Kraft split into Kraft Foods (KRFT) and Mondelez International (MDLZ) in 2012.

Selling these companies would have resulted in much lower total returns and dividend income gains for the investor. It could also be difference between making money and losing money. Lacking patience to see whether the thesis in your fundamental analysis that made you buy pan out, could be the difference between making money or losing money over the course of investment career. Selling the few companies that could result in most profits over time could be quite costly. I have learned that the key to successful investing is to hold on to winners, and dispose off of losers.

Many individual investors are psychologically incapable of sitting on a high profit. They would much rather sell, because of the faulty assumption that "noone went broke taking a profit". They would also rationalize their decisions with the fact that valuations on other stocks are lower. In some extreme cases this is true. If a business you own sells at more than 30 times earnings, chances are that selling it could sound like a wise decision. This is because the money can potentially produce better returns elsewhere. If growth is high enough however, this could lead to P/E compression in a few years, If there are sufficient gains in earnings per share, dividends per share and stock prices, the decision to sell could turn out to be a loser. This loser decision could further be compounded if a company that looks cheap is purchased with the sale proceeds, but then it doesn't turn out to be as good as the original purchase. After an analysis of my sales over the past 7 - 8 years, I realized that in the majority of the stock sales I have done, I would have been better off doing nothing. Actually, going to the movies would have been cheaper, rather than selling, paying taxes and commissions, and purchasing shares in another company that end up doing much worse than what the original investment did in the subsequent periods of time.

I am often wary of trading in exceptional companies at what seems like elevated valuations for merely decent companies selling at what seem like cheap valuations. By engaging in market timing on a longer timeframe, I am enriching my brokers, the IRS etc.

Perfectionism is dangerous for income investing. It is a slippery slope to sell a company trading at 18-19 times earnings for a company trading at 12-14 times earnings. This active trading can lead to a portfolio of dogs that looks "safe" on the outside, but had a lot of risks. For example, companies such as BHP Billiton (BBL) looked very cheap in 2013, while companies like Brown-Forman (BF.B) and Johnson & Johnson (JNJ) looked very expensive. However, this ignored the fact that the latter companies have more stable earnings, strong competitive positions, and pricing power for their differentiated products.  BHP Billiton on the other hand is a commodity producer, which is a price taker, and requires heavy amounts of capital spending. Therefore, its earnings per share are going to fluctuate more, and be more exposed to short-term economic changes and changes to commodity prices.

Therefore, it is important to be aware of situations where an investor is comparing apples to oranges. For example, if you sold a company like Johnson & Johnson to buy a company like BHP Billiton, you are trading recurring earnings per share and dividend per share growth and long history of dividend increases for a commodity company whose profits are dependent on the price of raw materials. These are highly volatile, and vary depending on the cycle the economy is in.

The companies I tend to buy and hold are having competitive advantages, and are able to expand over time. They increase profits and dividends gradually, and stock prices tend to follow that. Very few investors like slow and steady returns, which is why these stocks are always overlooked. They keep producing higher profits year after year. Hopefully your holding period for these companies is forever. Always buy and monitor however, as changes in businesses do happen. It is helpful to avoid micromanaging your investments as well. Just because the dividend growth has slowed down a little or the dividend has been frozen, that doesn't mean the investor should automatically panic and sell out. Of course, if you do miss out on changes, always sell after a dividend cut. I am pretty bad at discerning short-term problems from problems that do matter. This is why I have decided that I am going to stick out with an investment for as long as possible, even if things look ugly for a few years, and would not panic in the process. This is for as long as I believe things could turn for the better eventually. If things get really ugly, my exit will be the second after the dividend is cut. The funny thing is that over the past 8 years, I have had only five dividend cuts or eliminations.

Relevant Articles:

Not all P/E ratios are created equal
Key Ingredients for Successful Dividend Investing
How to be a successful dividend investor
How to monitor your dividend investments
Margin of Safety in Financial Independence

17 comments:

  1. Excellent post, DGI.

    As I have quite a long time scale (I am 27 currently) I am happy to take on a couple of "price takers" over the long haul: BHP Billiton, BP and RDSB. Over the medium to long term they should show a healthy--if wild riding--journey up.

    However, in general my portfolio is bulking up at the consumer defensive end for precisely the reason you suggest. I will be holding for decades so I can wait for that slow, steady growth to really shows its power. However, some of the consumer giants over here are looking a little too keenly priced for me especially as rising interest rates will no doubt see a noticeable amount of cash pull away from them. We will see though.

    Thanks again for the post.

    ReplyDelete
    Replies
    1. Hi DD,

      Thanks for stopping by. You are correct that many consumer companies seem overpriced today. But some are available from time to time - this is why having a watchlist is important. For example PEP has been available at lower valuations (though still not dirt cheap) in the past year, and so has MKC. JNJ is often at fair value territory as well.

      Companies like BHP and RDSB might do well over time. However, they need a lot of capital to reinvest back in order to explore for, and find resources. Luckily, returns are helped by low valuations and high yields over time.

      As for interest rates, rising interest rates will affect all companies, not just dividend paying ones. Furthermore, i plan to hold for the next 30 years. This will include several cycles of rising and falling interest rates. As such, I am indifferent whether the FED raises interest rates in 2015, 2016, or 2020.

      Dividend Growth Investor

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  2. In regards to buying and holding, what are you doing with BAX? It looks like they are cutting the dividend at the spinoff, possibly quite substantially.

    ReplyDelete
  3. Dividend Warrior,

    I am taking a wait and see approach with BAX. When they announce the final stock split/spin off information, as well as final dollar dividend payments for each new company, I will have more factual information to base my decision on. I do think that BAX and anything that splits out of it will do well, at least judging by history.

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  4. Excellent article Dividend Growth Investor. Really enjoyed reading your comparison between BBL and JNJ and why you can't just look at PE alone.

    ReplyDelete
  5. Great stuff as always DGI.

    Just a few general questions for you if you don't mind -

    What are your thoughts on credit ratings? Considering you focus on the long, long-term, how much weight do you put into a company's credit ratings?

    How do you feel about free cash flow payout ratio? I realize that companies can use existing cash or take on debt (especially when money is as cheap as it's been in recent years) to pay dividends, but aren't most dividends covered via free cash flow?

    ReplyDelete
    Replies
    1. The companies I follow, pay dividends out of earnings. So they can afford to pay those dividends out, and still have room to reinvest in the business. For example, Johnson & Johnson earned $5.70/share in 2014, and paid $2.76/share.

      And no. I do not track credit ratings. I do check annual reports, which include the balance sheet, income statement and statement of cash flows. In my analysis I most focus on trends in eps, dps, roe, revenue, valuations, distribution coverage etc. I have found EPS to be more accurate measure of earnings for my analysis and trending. If I were to use FCF however, the long-term trends should be consistent under most scenarios.

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  6. Hey DGI,

    Great article as always. Particularly enjoyed when you said it would've been cheaper to go see a movie than do move around your portfolio, believing another company could perform better when it's actually quite expensive to switch around like that.

    I also agree with you on the dividend cuts being a good point to sell, and had to do that with a company of mine recently.

    Best regards
    DB

    ReplyDelete
    Replies
    1. I think my investment philosophy gravitates more and more towards this saying:

      "An investment portfolio is like a bar of soap: The more you touch/handle it, the smaller it gets"

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  7. Thanks for the article, just out of curiosity, who were the 6 companies over the last 8 years that have cut or eliminated their dividends?

    ReplyDelete
    Replies
    1. I went back, and I can count 5, not six.
      2008 - ACAS
      2009 - STT and GE
      2010 - BP
      2014 - ARCP

      I don't think I had any other dividend cuts.

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    2. Thanks for answering my question, I guess it brings a follow-up. IIRC, you sold ARCP, have you sold the other 4 or do you have a wait and see approach. Peronsally, I purchased BP and GE after their cuts and am hoping to ride them back to CCC status.

      Delete
  8. Hey DGI, thanks for the article, I enjoyed reading it.

    May I ask your thoughts on CVX. Regarded Solutions over on Seeking Alpha recently sold all of his CVX on dividend worries and replaced it with XOM. Looking for your opinion thanks.

    ReplyDelete
    Replies
    1. Who is this Regarded Solutions you keep referring to? And why should I follow him/her blindly?

      Perhaps they read the article I had in February, which discussed that CVX and COP had dangerously high payout ratios, while XOM did not? http://www.dividendgrowthinvestor.com/2015/02/the-energy-company-i-want-to-buy.html

      But no, I would not sell a stock simply because it has "frozen" its dividends. I might not add to the stock, but I would not sell it either. If this Regarded Solutions fellow engages in frequent churning of positions, then it seems they are more of a speculator than a wise long-term business owner. I would not follow such a person too much.

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  9. Great article! Do you think BBL might cut the dividend? Current yield is getting high. Also been looking at WMT as the price has settled down some, even PM. Any thoughts? I worry about currency on PM but that is a temporary thing that could result in a good price to get in.

    ReplyDelete
    Replies
    1. I do not know too much about BBL,. Given the volatile nature of commodity prices, it would be tough to maintain a long streak of dividend increases. Somehow, oil and gas majors have succeeded.

      I have an analysis on WMT that is going live in a couple weeks. Please stay tuned.

      And for PM, I have this article: http://www.dividendgrowthinvestor.com/2015/04/philip-morris-international-pm-dividend.html

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