No Risk Stock Market Investing

During the recent market volatility many investors have seen their retirement savings vanish into thin air. With stock markets trading at levels not seen in many years, lots of future would-be retirees are wondering if they could ever stop working. As a result many mutual fund holders are converting the stock portion of their portfolios into fixed income. The selling has left few believers in the stock market’s potential for wealth accumulation. Investors are always reminded that missing the best 10 days of the year in terms of stock market returns will lead to significant underperformance over the long haul, as market timers often fail to predict shifts in market performance.

So how can an investor protect his principle while at the same time also participate in any potential stock market upside?

One answer is purchasing shares in the best dividend stocks for the long run, which I featured in December 2008. By snapping up shares in some of the friendliest corporations for shareholders at bargain prices and then reinvesting the rising dividend income into more stock, investors are more likely than not to achieve superior long-term total returns.

Another answer for investors who do not want to lose ANY of their principle is investing a portion of their capital in long-term certificates of deposit. One of the best 10-year CD rates is currently a 4.00 APY, offered by Discover Bank. If you need $1000 in 10 years, you could simply put $680 in a 10 year CD yielding 4% today, assuming that the money is reinvested.
If you have $1000 to invest today you could simply put 68% of it in CD’s and the rest in stocks. You could either invest in one of the dividend etf’s out there such as SDY, VIG, PFM, PID or simply in one of the ETF’s covering broad market indexes such as S&P 500 (SPY). You won’t lose any of your principal and you would most certainly have much more than $1000 at the end of the decade, if you also diligently reinvest your dividends.

The risks to this strategy could be that 10 years down the road inflation could have eroded a large portion of the purchasing power of your principal. Furthermore, if the stock market has an excellent performance 10 years from now, you’d be kicking yourself for not investing more in it.
If you want to guarantee a 100% return of your principle for period far longer than what FDIC insured Certificates of Deposit offer, you could turn to US treasury zero-coupon bonds with varying maturities up to 30 years.

The zero coupon Treasury bond, maturing on Feb 15, 2029 currently trades at 45.33% of its face value according to Yahoo finance. On the other hand a zero coupon Treasury Bond that matures May 15, 2038 trades at 37.85% of par. Investors who want a full protection of their principal in 20 or 30 years, should invest up to 55% and 62% respectively of their portfolios in stocks.

Full Disclosure: Long S&P 500 Mutual Fund

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Many Dividend Stocks Keep Raising Their Payments

Few investors remember the words of famous value investors Graham and Dodd who wrote that “The prime purpose of a business corporation is to pay dividends to its owners.” Returning money to shareholders prevents managers from wasting it on investments that may not prove profitable for the company. Furthermore according a study by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School found that investors who put $1 in U.S. stocks at the start of the century were paid back $582 with reinvested dividends, adjusted for inflation. Price increases alone would have given an investor just $6 after that span, less than the $9.90 from holding long-term government debt, according to the study.

Dividend Investors have been under fire recently, with a barrage of negative news hitting the wires almost daily now. Friday was especially bad for many dividend investors, when General Electric (GE) announced a dividend cut from $0.31 to $0.10 share. It has been widely speculated that this industrial conglomerate will cut its dividends since early October 2008. Despite the reassurance from the CEO that this won’t happen, dividend investors were disappointed with a dividend cut. This was the fourth dividend cut in the dividend aristocrats index so far in 2009, versus 14 which have increased their dividends.

With dividend payments on the S&P 500 expected to fall by 18% in 2009, it all seems as if dividend investing is a strategy destined to fail in the current market environment. Despite all the gloom and doom, several companies still rewarded their shareholders with an increase in their annual dividend payments. Most notable is the fact that among the main raisers this week there are two dividend aristocrats, one dividend champion and one international dividend achiever.

Colgate-Palmolive (CL), which engages in the manufacture and marketing of consumer products worldwide, announced that its Board has approved a 10% increase in its quarterly dividend from $0.40 to $0.44 per common share. Colgate-Palmolive is a dividend champion, which has consistently increased its dividends for forty-six consecutive years. The stock currently yields 2.70%.

Chubb (CB), which provides property and casualty insurance to businesses and individuals, announced that its Board has approved a 6.10% increase in its quarterly dividend from $0.33 to $0.35 per common share. Chubb is a dividend aristocrat, which has consistently increased its dividends for forty-four consecutive years. The stock currently yields 3.30%. Check out my analysis of Chubb (CB).

Kimberly-Clark Corporation (KMB), which engages in the manufacture and marketing of health and hygiene products worldwide, announced that its Board has approved a 3.40% increase in its quarterly dividend from $0.58 to $0.60 per share. Kimberly-Clark Corporation is a dividend aristocrat, which has consistently increased its dividends for thirty seven consecutive years. The stock currently yields 5.00%. Check out my analysis of Kimberly-Clark Corporation (KMB).

Thomson Reuters (TRI), which provides intelligent information for businesses and professionals in the financial, legal, tax and accounting, scientific, healthcare, and media markets worldwide, announced that its Board has approved a an increase in its quarterly dividend from $0.27 to $0.28 per share. Thomson Reuters is an international dividend achiever, which has consistently increased its dividends for over 6 consecutive years. The stock currently yields 4.50%.

Westar Energy (WR), an electric utility, provides electric generation, transmission, and distribution services in Kansas, announced that its Board has approved a 3.40 % increase in its quarterly dividend from $0.29 to $0.30 a share. Westar Energy has only increased its dividends since 2003. The stock currently yields 6.90%.

PG&E Corporation (PCG), a public utility company that engages in electricity and natural gas distribution primarily in northern and central California, announced that its Board has approved a 7.7% increase in its quarterly dividend from $0.39 to $0.42 per share. PG&E Corporation started consistently increasing its dividends in 2005. The stock currently yields 4.50%.

PepsiAmericas (PAS), which is the world's second-largest manufacturer of Pepsi products, announced that its Board has approved an increase in its quarterly dividend from $0.135 to $0.14 per share. PepsiAmericas has consistently increased its dividends since 2004. The stock currently yields 3.20%.

PPL Corporation (PPL), which an energy and utility holding company,, announced that its Board has approved a 3.00% increase in its quarterly dividend from $0.335 to $0.345 per share. PPL Corporation has only increased its dividends with some consistency since 2002. The stock currently yields 4.60%.

Full Disclosure: Long KMB

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What I learned from Warren Buffett’s Most Recent Letter to Shareholders

Warren Buffett’s iconic letter to shareholders has been published on Berkshire Hathaway's website. The legendary chairman of Berkshire Hathaway has been writing this annual letter for more than 32 years. In it he summarizes the performance of the various businesses that make up the portfolio of his conglomerate. The Oracle of Omaha often gives insight on his decision making process, when making investments.

Of particular importance to me were his words on his reduction of stakes in Johnson and Johnson (JNJ), Procter and Gamble (PG) and Conoco Phillips (COP):

"On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits."

I speculated before that one reason why he might be selling solid dividend stocks such as Johnson & Johnson and Procter and Gamble could be that they haven’t fallen as much as the broader market, which makes them ideal for Buffett to deploy the funds in other beaten down sectors. Another reason could be that he needs to raise as much cash as possible, in order to participate in other preferred stock or fixed income deals, where he could earn a 10%-15% annual dividend yield, with very favorable terms for his company. Ordinary investors do not however have the purchasing power to participate in such favorable deals at this time.

Buffett also spend several pages discussing derivatives and shortcomings of the Black Scholes option-pricing model.

Full Disclosure: Long JNJ, PG

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General Electric (GE) Cuts the Dividend

The big news yesterday was the dividend cut from on of the most prominent dividend aristocrats – General Electric (GE). The company lowered its quarterly payment to $0.10 from $0.31/share for the first time since 1938 in an effort to save 9 billion dollars annually and maintain its AAA rating.

After spending billions on stock buybacks when its stock price was high, the company sold billions in equity to investors during 4Q 2008, including a sale of $3 billion in convertible preferred stock to Warren Buffett.

There had been rumors that the company would cut the dividend payment for over 4 months; every time a rumor of a dividend cut was spreading, Jeffrey Immelt kept reassuring investors that the payment could be maintained well into 2009. Then as more analysts began digging into the company’s financials, it became widely accepted that GE had to either maintain its dividend or lose its AAA rating.

The first sign of trouble came in 2008, when GE reported its 1Q results, which were below the estimates by analysts. The company blamed its poor performance on financial services businesses, which were challenged by a slowing U.S. economy and difficult capital markets.

The second sign of trouble came in September, when the company failed to increase its dividends for the first time in 32 years. At the same time the company suspended its $15 billion stock buyback program, announced in December 2007.

Just a week after GE announced this, the company sold $3 billion preferred stock to Warren Buffett, yielding 10%. In addition to that the company sold an additional 547.8 million shares for approximately 12.2 billion dollars to shareholders.

The CEO kept reassuring investors that everything was ok and that both the AAA rating as well as the dividend could be maintained. The markets didn’t trust him, and GE stock lost almost half of its value in he first two months of 2009.

Another note on the CEO is that he kept buying GE stock all the way down. Many investors viewed his acquisitions of 150,000 GE shares on the open market in the first quarter of 2008 as bullish. This goes on to show that investors should treat insider purchases with caution, and not automatically view them as a bullish signal.

As a result of the dividend cut, I disposed of my whole GE position during the day. The company no longer fits the dividend growth stock characteristics, for which I bought it in the first place. Despite the fact that I am a buy and hold investor, I realize that I would still have a turnover in my portfolio, even if I select my purchases from elite lists such as the dividend aristocrats, dividend achievers and the dividend champions.

I continue seeing a lot of companies increasing dividends in 2009, so I still have a faith in dividend investing.

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Yield on Cost Matters

The bear market has brought many stocks to multi-year lows, pushing their current dividend yields to levels not seen for years. Some dividends got cut in the process, triggering further selloffs in stock prices, which somehow miraculously lead to almost the same current dividend yields. Multiplying the most recent quarterly or monthly dividend payments by 4 or 12 and then dividing the result by the amount of the stock price calculates current dividend yield.

For example if you purchased Bank of America (BAC) stock in September 2008 at $25.60, while the dividend was $0.64/quarter, the current dividend yield would have been 10%. After BAC cut its dividends by 50% to $0.32/quarter, if the stock was trading at $12.80 then the current dividend yield would have been 10% as well. Most investors who chase high yielding stocks blindly would tell you that in both situations BAC was a high yielding stock to consider. There is one difference however – the person that purchased BAC for $25.60 is worse off after the dividend cut, in comparison to the investor who purchased BAC stock at $12.80, since their dividend income is decreased in half.
Astute readers would realize that current yield does not matter much to a long-term dividend investor. What matters is that dividend payments get increased over time.

If an investor purchased stock in Bank of America in 2002 at $30/share, their current dividend yield would have been 4%. As Bank of America kept increasing its dividend payments from $0.30 to $0.64, the current yield on Bank of America was almost unchanged around 4%.

The yield on cost however, which is calculated by dividing the most recent annual dividend payment to the price that you paid for the shares that you own, has been increasing despite the current yield being unchanged.

An investor who purchased 100 shares at $30 in 2002 received $30 every quarter. The current yield and the yield on cost in this scenario were 4%. The amount received increased as the dividend payment was raised to $0.64/quarter in 2007, bringing the yield on cost to 8%. The current yield was almost 5% at the time when the dividend was increased and the stock was trading at $50.

When Bank of America cut its dividend payment to $0.32/share current yields were still in the vicinity of 10%. This affected only new investors however, since they were the ones who might generate a 10% annual return on their investment solely from the dividends received, provided that the payment was not cut again. The investor who purchased BAC stock back in 2002 saw their income fall by half, bringing their yield on cost to 4.3%.

In hindsight, selling after the first dividend cut and allocating the money into another dividend growth stock, could have been a good thing for the investor who purchased BAC stock in 2002. As we later learned, Bank of America cut its dividend payment per share once again to just one penny per quarter.
There are many dividend success stories however, where investor’s yield on cost is in the double or even triple digits. An investment in 3M (MMM) at the end of 1988 at $16 generated a current dividend yield as well as yield on cost of 4%. After 20 years of consistent dividend increases however, the annual dividend payment is increased to $2/share, making for a yield on cost of 12.5%. Check out my analysis of MMM.

Even if you purchased into an S&P 500 index fund in the late 1970’s, you would have seen our yield on cost increase from 5.20% to 26.20% currently.

I hope I have illustrated a point that high current yield is not what dividend growth investors should be looking at when they search for investment opportunities. The thing that matters is finding a solid non-cyclical company with a wide moat, which could increase its earnings over time. Increase in earnings power could lead to increase in dividends over time. As Dave Van Knapp put it in 10x10, the best dividend strategy is to achieve a balance between dividend growth and initial dividend yield.

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