Thursday, December 9, 2021

Skate to where the puck is going

As a dividend growth investor, my goal is to buy stock in a company that fits certain criteria.

In general I look for:

- A streak of consecutive annual dividend increases

- Rising earnings per share over the past decade

- A dividend payout ratio that is not too high 

- An attractive valuation

Once I see this, the goal is to accumulate a position, and sit tight. In a way, I am a long-term investor and will hold on for a long time for as long as the dividend is growing. In a way, I follow long-term trends for as long as they persist. The second they are over however, I exit and look for greener pastures. If the trend resumes, I will get back in.

A lot of investors tend to focus on narratives, which are stories told to defend ideas. Narratives can be helpful, but only if supported by objective data behind them. Otherwise, they are fairy tale stories. As an investor, I am always on the lookout to determine if the story is still ongoing and thesis is still accurate. While I like looking at historical research, I also need to be aware that things may change. If they do, then I need to recognize this and allocate funds elsewhere.

I’ve made some changes over the past 15 years at Dividend Growth Investor, albeit gradually. I started off with a fairly fixed screening criteria. I had been lucky, because my strict criteria helped me find a lot of great companies at attractive valuations in the beginning of my journey. They did well subsequently for the most part. But I've had to adapt over the years, due to many changes.

I have since relaxed the need for a minimum dividend yield. I have also relaxed the need to look for companies with a P/E of less than 20. Now I look at P/E and growth and quality and defensibility of the earnings stream together. This is driven by the changes in the marketplace today, the availability of quality companies at bargain valuations, and the decline in interest rates. Most importantly, it is driven by my research on historical dividend growth success stories, and not wanting to miss out on the next Wal-Mart for example. But change is a given, not just for my strategy, but the world at large.

There are a lot of changes over time, as the world evolves. Some of these changes however are trends within long-term cycles. For example, over the past 40 years, companies in general are not as focused on distributing dividends to shareholders as they once were. I do focus on the companies that still pay and grow dividends however, but I do recognize that things may change in the future. There is a need to be flexible in my approach. In the current version of my approach, I do look for companies that can grow earnings and dividends for decades down the road, while also compounding future net worths. A long streak of consecutive annual dividend increases is the signal I used to identify such companies for research. However, if companies stopped raising dividends, and focused on buybacks instead, I may end up with a much smaller sample size of an investing population from which to source ideas for my portfolio.

For example, in the past 40 years, companies are more prone to pay buybacks than dividends. These days, companies are paying more in buybacks than dividends. 

Source: Standard & Poor's

When share prices are rising, shareholders usually do not care about dividends, as their portion of total returns seems insignificant. This has increasingly been the case in the current bull market. If a stock keeps rising by 15%/year, a shareholder is not going to be impressed by a 2% or a 3% dividend yield. The same thing occurred in the 1990s.

Of course, when share prices refuse to go up, only then do shareholders realize the value of dividends. This happened between 1966 – 1982 

It also happened between 2000 – 2013. 

We know that reinvested dividends account for a large portion of total returns over time. But with investor time horizons shrinking, they are more focused on share price movements. Long term investors are more focused on the longer term. I find a plan focusing on dividends much more robust, because I get to focus on the fundamentals, and the dividend income alone is enough to help pay expenses in retirement after the crossover point is reached. I can afford to avoid worrying about stock prices going nowhere for extended periods of time, as long as the fundamentals as sound, precisely because dividends are more stable, reliable and predictable. 

During those secular bear markets, you see growth companies initiate dividends. This was the case with Wal-Mart stores in 1974, which initiated a dividend after a monstrous 50% decline in the stock in a brutal bear market. This was also the case for Microsoft in 2003, which initiated a dividend after the implosion of the dot-com bubble.

I find dividends to be a decent indicator of valuation, albeit not perfect of course. Lack of dividends definitely makes it harder to evaluate things on my end. Particularly if we are analyzing the broader US markets, where companies have had the proclivity to raise dividends annually for years.

Low yields have historically marked stock market tops. For example, in the 1980s, the Japanese index Nikkei 225 rose from 8,000 to 39,000 points in the span of a decade. Dividend yields, which were historically low for Japanese stocks, were down to 0.50% by 1989. A dividend investor that was close to retirement could have just expected to live off the dividend, but at 0.50% that’s not much. Investors who viewed capital gains as free money however, and expected to live off future gains would have run out of money by the late 1990s as Nikkei fell by 50% - 75%. This is just a reminder that valuations can get out of hand, people would lose their minds in a speculative fervor, but when the clock strikes at midnight the party may end. 

Source: "Japanese Finance in the 1980s: A Survey" by Jeffrey A. Frankel

At present times, we have the so called FANG companies like Facebook/Metaverse, Amazon, Netflix and Google growing share prices, but not really paying dividends. At this pace, only Metaverse and Google are doing some notable share buybacks, but they are not really paying a dividend. Google has always looked like a company that can grow and support dividends, and it is a company I understand and have been really close to buying. However, I never did, mostly to my own detriment.

I have used Google for about 20 years now, so I definitely failed my inner Peter Lynch. I was also one of the first group of users for Facebook since 2005, so I failed Peter Lynch there as well. And I have used Amazon since 2004/2005 as well. I have even generated revenue from Amazon and Google. In fact, one of my mistakes has been that I never invested in them. If I had invested that modest revenues into the stocks, I would have made a pretty dime. I did recognize and invest in other companies within the dividend growth investing universe that did well, so for the time being, the dividend growth investing universe did its work. 

 I have been spoiled in the past 10 - 15 years, because I had the ability to buy quality dividend aristocrats, dividend champions and dividend achievers t attractive valuations, and watch them continue growing earnings and dividends for the most part ( and share prices too). But the future may be different, so I need to understand that if things change, I should be able to recognize it. So while I am fine with the fact that I will miss out on some great companies in my lifetime, I also need to think about risks to my strategy too. If promising companies I understand are out there, but they do not pay and grow dividends, I may be at a disadvantage.

I am pretty confident however, that at some point all of these companies (FAANG types) would initiate a dividend to shareholders. Perhaps that would happen during the next big and pro-longer bear market, just like was the case for Wal-Mart or Microsoft. Of course, I may have to wait for years, before this happens, missing out on potential gains. There are always going to be trade-offs, no matter what I do of course. If I had decided to buy Oracle or Cisco in 1999 for example, it would have been a poor choice. Buying Cisco or Oracle when it initiated a dividend would have been a better choice.

One way that I have somewhat reconciled with the fact that I will miss out on companies is that I own them indirectly through my 401 (k) plan at work. It is basically invested in S&P 500 and an international fund at an 80/20 split. Google, Amazon, Facebook and even Tesla are some of the largest holdings. In a way, this fund portfolio is a good hedge for the companies I will end up missing out on.

But still, it is a good reminder that things can change and evolve over time. The future is never written in stone, and anything could happen really. This helps us stay humble, and open the where things are today, not where we thing they should be.

We need to be cognizant for the potential for change. A decade ago, I believed that companies that do not pay dividends are doing so, because they cannot afford to pay dividends. The success of companies like Google have definitely shown that this is not always the case.

This is why investing is part art, part science. I always keep asking myself if I am being prudent or stubborn.

What is the point of this article?

Notably, trying wrap a few ideas together. Basically we also want to stick to long-term trends, like rising dividends per share, and stick to them for as long as they are present, without second guessing too much.  But, we also need to recognize that things change, so we need to be adaptable. Ultimately, the best idea is to try and improve and focus on quality companies that can grow earnings and cash flows over time and can afford to grow dividends.  That being said, you will miss some companies, as its part of the game. Others that seem like can’t miss investments that you invest will disappoint. Having a fail-safe mechanism, like a 401 (k) retirement fund at work is a good hedge.

Of course in a perfect world, we would have companies like Google, Facebook, Amazon initiating  dividend soon. Microsoft and Apple already did that, so this shouldn't be a foreign concept. But I am actively monitoring the situation.

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