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

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