Wednesday, June 10, 2015
How to value dividend stocks
In my investing, look for businesses I can understand that have some sort of a competitive advantage that translates into consistent earnings power. I try to determine if I believe this business will be around in 20 years, and still have a consistent earnings power, despite obsolescence, competition and regulation. If I believe that to be true, I can then look at trends in earnings, dividends, revenues, returns on equity, payout ratios and make an assumption of what future growth might look like.
This is the part where I also look at valuations. My primary valuation method is often the P/E ratio, relative to 20 times past and/or forward earnings. Of course, regular readers know that this benchmark is not viewed in a vacuum, but in conjunction with past trends in earnings, dividends revenues etc and prospective growth in those earnings and dividends. It is also used as one of the ways I screen for companies for further analysis. P/E ratio is also one of the criteria I use to compare between several companies, before I make my choice.
Over the past few months, I have received a lot of mixed reviews on the type of analysis I perform. I believe the main reasons behind those reviews is the fact that I do a lot of things manually, and have described my outcomes, but never really put everything together in one piece. Actually, a lot of the reasons why I invest the way I invest are also scattered around in a few articles.
Unfortunately, I have found that a majority of readers are not willing to go through the archives or even dig around links provided in an article, in order to find answers to their questions. I know this, because quite frequently I receive questions that could have easily been solved had the reader clicked at a link in the article the hopefully read. In a few scenarios, I have had readers ask me questions that have already been addressed in the article. On the other hand, it is also unreasonable to expect that someone would have the time to sift through 1000 articles I have written on dividend investing.
I think it would be easiest for everyone, if I refer to a few posts I have written on using P/E ratios to value companies.
There are several constraints I face when evaluating a company. I try to discuss them in the following articles:
Not all P/E ratios are created equal
Why do I use a P/E below 20
Why I don’t do discounted cash flow analysis on dividend stocks
How to read my stock analysis reports
As you can see, I use P/E in conjunction with past and projected growth, when screening for and comparing between dividend stocks. This is further complicated by other constraints, such as portfolio weight. For example, I might like Johnson & Johnson (JNJ) a lot, but I would not buy more, since it is one of my largest positions. In addition, I am intentionally limiting myself to only companies with P/E ratios below 20 for a reason. The most dangerous thing new investors do is see a company that has done well recently, and project recent successes to the sky. Most often, investors overpay dearly for hot growth concepts and expect trees to reach to the sky. Unfortunately, when you purchase a hot growth stock at 30 times earnings, you are essentially paying for the growth in the next 5 or even 10 years and assuming that things will go smoothly in the future. If there is a slight derailment of plans, you will not earn good returns for as long as the first decade. For example, Starbucks (SBUX) is selling for 38 times 2014 earnings and 33 times forward earnings today. In 2014, the company earned $1.36/share, and for 2015, Starbucks is expected to earn $1.57/share. The projected earnings per share for 2018 are approximately $2.50/share. This means the stock is selling today at 20.90 times earnings in 2018. Even if Starbucks manages to earn $2.50/share in 2018, it could still deliver unstatisfactory returns if the P/E contracts to 20. I would be taking a lot of risk when valuation is overstretched. The risk is that paying a high multiple leaves no margin of safety in case the future doesn't turn out as expected. I also ask myself why should I pay for a company at 30 times earnings that doubles earnings every 7 years, when I can find another company that sells for 20 times earnings. A few potential candidates could include Ross Stores (ROST), TJ Companies (TJX) or Ameriprise Financial (AMP). As you can see from above, I compare different companies that have a P/E below 20, and pick the ones where the P/E and growth combination is best.
Another constraint I have not really discussed in full is expected investment return. I expect equities to deliver an annual return of 9% - 10%/year for the next 30 years. Therefore, when I select companies, I try to determine whether an investment at today’s prices could deliver a 9% – 10% expected returns. This is something I have not discussed exclusively, because I always assumed that reasonable people would understand that a company that yields 3%, grows earnings and dividends by 6%-7%, could deliver expected annual returns of 9%-10%/year. I also sometimes try to stress test results, in order to see how different outcomes can make or break the returns. Check this article on Hershey from a few weeks ago. Let's take a situation where I pay 30 times earnings today, and the earnings double in a decade. If the earnings stream is worth only 15 times to others, then I have not really earned much in terms of a price return. If the dividend yield was approximately 2%/year, my only return would have come from that small initial dividend yield. Identifying the best quality company is not enough – you also have to buy it at a cheap enough price.
Chasing growth is a dangerous game. What truly matters to the investor is good returns, not overpaying for future growth. Actually, if you pay too much for expected future growth, you might not do too well. For example, between 1957 and 2003, IBM had much better growth prospects than Exxon. IBM had higher revenue, and earnings growth and even dividend growth than Exxon. However, Exxon returned more than IBM, because it always had lower P/E ratios and higher dividend yields. When you have low expectations behind a business, it usually sells at cheaper valuations. This also allows the reinvestment of dividends at those cheaper valuations, which turbocharges returns.
I use earnings per share, but also normalize it for one-time events. For example, in 2012, Coca-Cola appeared cheaper than it was, because of one-time accounting items. In early 2013, Johnson & Johnson appeared more expensive than it really was. For those like me, who like going through annual reports, and press releases, I can identify some of the reasons for annual EPS fluctuations outside the norm. For others, looking at forward earnings and applying a forward P/E ratio could have been a very good approximation of the intrinsic value of the company. In fact, many times I have found that looking at a forward P/E ratio is a good enough shortcut to compare P/E ratios between tens or hundreds of stocks, rather than poring over hundreds of press releases.
For my analysis, it is helpful to look at trends in earnings per share over the preceding decade. However, while I look at the past years earnings, I also look at the prospect for earnings growth in the next two years or so. Purchasing a company at a cheap valuation is helpful, but I also want to see prospects for increase in earnings per share. Otherwise, there would be no future fuel behind future dividend increases. In many cases, looking at the past year earnings and the future year earnings paints a better picture. For example, oil companies like Exxon Mobil (XOM) sell at pretty cheap valuations when you look at past year’s earnings of $7.59/share ( equivalent to a P/E of 11 times earnings). The earnings from 2014 however do not accurately reflect the decline in oil prices. Therefore, one needs to look at estimated 2015 and 2016 earnings per share of $4.26 and $5.34/share ( for an equivalent forward P/E of 20 and 16 times earnings). Those paint a more accurate picture of the near term earnings power for Exxon Mobil. While forecasts are not 100% accurate, I have found them to be close enough for my investing needs. When I buy stocks, I never expect precision. If I demand precision in past and future prospects for earnings and dividends, then I set myself up for disappointment. This is where the margin of safety principle comes in handy.
I apply a set of quantitative criteria on the list of dividend champions. Assuming I have analyzed those companies, I would compare them against each other. I do not assign fair values, like everyone else however. I look at inputs such as P/E ratio, earnings growth, dividend growth, yield, dividend coverage, and my expectations for the future, before choosing an investment from the pack. This is more manual than merely comparing to a calculated fair value, but I think it is easier to think through all the numbers in detail, rather than create a shortcut and miss thinking about an important item.
Overall, screening the list of dividend growth stocks, comparing between dividend stocks, analyzing dividend stocks and hand selecting companies to invest in is a very manual process. Unfortunately, in order to learn how to be a good investor, you need to do the work to have a right to an opinion. In order to succeed in any activity in life, you need to spend thousands of hours and several years learning, perfecting and adapting your knowledge. Continuous learning is important. At the end of the journey however, the reward would be a well maintained dividend machine, which will take care of your needs forever.
Full Disclosure: Long XOM, JNJ, KO, IBM, ROST, TJX, AMP
Relevant Articles:
- Stress Testing Your Dividend Portfolio
- Buying Quality Companies at a Reasonable Price is Very Important
- Dividend Investing Knowledge Accumulates Like Compound Interest
- The work required to have an opinion
- How to never run out of money in retirement
Monday, June 8, 2015
Lowe’s Delivers Consistent Dividend Growth to Investors
Lowe’s Companies, Inc. (LOW) operates as a home improvement retailer. Lowe’s operates approximately 1,840 home improvement and hardware stores in North America. The company also sells its products through online sites comprising Lowes.com, Lowes.ca, and ATGstores.com, as well as through mobile applications. I last analyzed Lowe's a couple of years ago, so I decided to do a quick update on it.
Lowe’s recently announced that it was raising its quarterly dividend by 21.70% to 28 cents/share. This marked the 53rd consecutive annual dividend increase for this dividend king. As we have discussed the dividend kings before, this is an elite group of companies that have raised distributions for at least 50 years in a row. It is a rare feat when a company has managed to grow dividends every year for over half a century. It is an even rarer accomplishment when that company is firing up on all cylinders, and keep growing dividends at the rate of Lowe’s.
The ten year dividend growth rate for Lowe’s is an impressive 25%/year. The company managed to grow earnings per share by 7.10%/year. Therefore, a large reason behind the high dividend growth is due to expansion in the dividend payout ratio. However, you should not forget that the past decade also included one of the worst housing crises in the US and the recession of 2007 – 2009. One of the main reasons I picked up Lowe’s after the housing crisis is because management kept raising the dividend. When they raised the dividend, this showed me that they had confidence in the long-term sustainability of the business.
Competitor Home Depot (HD) on the other hand stopped raising dividends in 2008.
As I mentioned above, earnings per share grew at a respectable 7.10%/year over the past decade, which included a terrible housing crisis. Lowe’s earned $2.71/share in 2015. The company is expected to earn $3.29/share in 2016 and $3.95/share in 2017. Lowe’s also has had an aggressive share buyback policy over the past decade. As a result, the company has reduced its share count from 1.606 billion shares in 2006 to 990 million shares in 2015. While I would prefer special dividends to share buybacks as a stockholder, I would get what I can.
The company’s fortunes are tied to the fortunes of the housing market in North America. As the US housing market bounces back, this could translate into more traffic to home improvement stores, and to high growth in same store sales. As the housing market improves, there will be more remodeling, and more need for store trips to Lowe’s or Home Depot to accommodate for that remodeling. An up-tick in new home construction could also provide another source of growth. The company focuses on do-it-yourself, do it for me customers as well as commercial customers.
Research shows that renovations tend to accelerate for homes older than 25 years. According to latest Census, 71% of homes in the US have been built more than 25 years ago. As a result, homeowners will be much more likely to participate in do it yourself home renovation and upkeep projects, in order to try to increase the value of their home, to make it more marketable or just to make it a better place to live.
A further source of growth will be the opening of new stores. Unfortunately, the level of new store openings has slowed down to 15 – 20/year. In the long-term, the company can capture growth by expanding internationally, beyond North America. This could be an interesting development to check. Currently, it has operations in US, Canada and Mexico, as well as an Australian Joint-Venture with Woolworths where Lowe’s has a one-third share of the ownership. I like the fact that the company is only interested in expanding in international markets after intense analysis, and only if their research determines that expansion will support compelling long-term returns.
Being the second largest home improvement retailer, Lowe’s also has scale and strong purchasing power. This bargaining power translates into lower costs, and higher profits. Another important characteristic for Lowe’s and competitor Home Depot is the fact that their knowledgeable staff can deliver quality level of service, and the knowledge to address the specific customer needs. This is something that is difficult to maintain in a purely online shopping experience. The company is aiming to enhance its relevance to customers through omni-channel retailing and differentiate itself through better customer experiences.
The company is continued focus on developing its omni-channel retail capabilities. Thus it is ensuring Lowe's meets customer needs whenever and wherever they choose to engage with the company, whether in store, in home and on the job, online and through contact centers. The company is also focused on further building customer experience design capabilities that differentiate Lowe's from other home improvement providers, improving its offering for Pro customers and continuing to improve productivity and profitability.
Currently, the stock is overvalued at 21.20 times forward earnings and a current yield of 1.60%. While I do not believe that the company is a buy at present levels, it is definitely a hold. I think it is important to keep companies purchased at attractive prices, and to monitor them at least once every 12 – 18 months. I do not subscribe to the theory that I should sell a company, merely because the price is a little on the high side, and buy something “cheaper”. I believe holding on to a company like Lowe’s, which grows intrinsic value over time is a wise decision. However, wise investors will know that Lowe’s is exposed to the cyclical nature of the housing market, which is why its results are not going to look pretty during the next recession. This would be the time to scoop up more shares of the retailer, provided the fundamentals are still intact.
Full Disclosure: Long LOW
Relevant Articles:
- Let dividends do the heavy lifting for your retirement
- Dividend Growth Stocks Increase Intrinsic Value Over Time
- Dividend Kings List for 2015
- Price is what you pay, value is what you get
- Rising Earnings – The Source of Future Dividend Growth
Lowe’s recently announced that it was raising its quarterly dividend by 21.70% to 28 cents/share. This marked the 53rd consecutive annual dividend increase for this dividend king. As we have discussed the dividend kings before, this is an elite group of companies that have raised distributions for at least 50 years in a row. It is a rare feat when a company has managed to grow dividends every year for over half a century. It is an even rarer accomplishment when that company is firing up on all cylinders, and keep growing dividends at the rate of Lowe’s.
The ten year dividend growth rate for Lowe’s is an impressive 25%/year. The company managed to grow earnings per share by 7.10%/year. Therefore, a large reason behind the high dividend growth is due to expansion in the dividend payout ratio. However, you should not forget that the past decade also included one of the worst housing crises in the US and the recession of 2007 – 2009. One of the main reasons I picked up Lowe’s after the housing crisis is because management kept raising the dividend. When they raised the dividend, this showed me that they had confidence in the long-term sustainability of the business.
Competitor Home Depot (HD) on the other hand stopped raising dividends in 2008.
As I mentioned above, earnings per share grew at a respectable 7.10%/year over the past decade, which included a terrible housing crisis. Lowe’s earned $2.71/share in 2015. The company is expected to earn $3.29/share in 2016 and $3.95/share in 2017. Lowe’s also has had an aggressive share buyback policy over the past decade. As a result, the company has reduced its share count from 1.606 billion shares in 2006 to 990 million shares in 2015. While I would prefer special dividends to share buybacks as a stockholder, I would get what I can.
The company’s fortunes are tied to the fortunes of the housing market in North America. As the US housing market bounces back, this could translate into more traffic to home improvement stores, and to high growth in same store sales. As the housing market improves, there will be more remodeling, and more need for store trips to Lowe’s or Home Depot to accommodate for that remodeling. An up-tick in new home construction could also provide another source of growth. The company focuses on do-it-yourself, do it for me customers as well as commercial customers.
Research shows that renovations tend to accelerate for homes older than 25 years. According to latest Census, 71% of homes in the US have been built more than 25 years ago. As a result, homeowners will be much more likely to participate in do it yourself home renovation and upkeep projects, in order to try to increase the value of their home, to make it more marketable or just to make it a better place to live.
A further source of growth will be the opening of new stores. Unfortunately, the level of new store openings has slowed down to 15 – 20/year. In the long-term, the company can capture growth by expanding internationally, beyond North America. This could be an interesting development to check. Currently, it has operations in US, Canada and Mexico, as well as an Australian Joint-Venture with Woolworths where Lowe’s has a one-third share of the ownership. I like the fact that the company is only interested in expanding in international markets after intense analysis, and only if their research determines that expansion will support compelling long-term returns.
Being the second largest home improvement retailer, Lowe’s also has scale and strong purchasing power. This bargaining power translates into lower costs, and higher profits. Another important characteristic for Lowe’s and competitor Home Depot is the fact that their knowledgeable staff can deliver quality level of service, and the knowledge to address the specific customer needs. This is something that is difficult to maintain in a purely online shopping experience. The company is aiming to enhance its relevance to customers through omni-channel retailing and differentiate itself through better customer experiences.
The company is continued focus on developing its omni-channel retail capabilities. Thus it is ensuring Lowe's meets customer needs whenever and wherever they choose to engage with the company, whether in store, in home and on the job, online and through contact centers. The company is also focused on further building customer experience design capabilities that differentiate Lowe's from other home improvement providers, improving its offering for Pro customers and continuing to improve productivity and profitability.
Currently, the stock is overvalued at 21.20 times forward earnings and a current yield of 1.60%. While I do not believe that the company is a buy at present levels, it is definitely a hold. I think it is important to keep companies purchased at attractive prices, and to monitor them at least once every 12 – 18 months. I do not subscribe to the theory that I should sell a company, merely because the price is a little on the high side, and buy something “cheaper”. I believe holding on to a company like Lowe’s, which grows intrinsic value over time is a wise decision. However, wise investors will know that Lowe’s is exposed to the cyclical nature of the housing market, which is why its results are not going to look pretty during the next recession. This would be the time to scoop up more shares of the retailer, provided the fundamentals are still intact.
Full Disclosure: Long LOW
Relevant Articles:
- Let dividends do the heavy lifting for your retirement
- Dividend Growth Stocks Increase Intrinsic Value Over Time
- Dividend Kings List for 2015
- Price is what you pay, value is what you get
- Rising Earnings – The Source of Future Dividend Growth
Friday, June 5, 2015
Norfolk Southern (NSC) Dividend Stock Analysis
Norfolk Southern Corporation, together with its subsidiaries, engages in the rail transportation of raw materials, intermediate products, and finished goods. As of December 31, 2014, it operated approximately 20,000 miles of road in 22 states and the District of Columbia. Norfolk Southern Corporation is a dividend achiever, which has raised dividends for 14 years in a row.
The most recent dividend increase was in January 2015, when the Board of Directors approved a 3.50% increase in the quarterly dividend to 59 cents/share. This was the second increase in a year however, and represented a 9.30% dividend growth over the same time in 2014.
The company’s largest competitors include CSX Corporation (CSX), Union Pacific (UNP), and Burlington Northern Santa Fe which is part of Berkshire Hathaway (BRK/B).
Over the past decade this dividend growth stock has delivered an annualized total return of 15% to its shareholders. Future returns will likely be lower, and will be dependent on growth in earnings and starting dividend yields obtained by shareholders at time of investment.
The company has managed to deliver a 10.70% average increase in annual EPS over the past decade. Norfolk Southern is expected to earn $5.94 per share in 2015 and $6.84 per share in 2016. In comparison, the company earned $6.39/share in 2014.
Earnings per share have also been aided by share buybacks. The number of shares outstanding has decreased from 412 million in 2005 to 312 million by 2015.
Railroads are an oligopoly in the US, as 80% of industry revenues are generated by BNSF, Union Pacific, Norfolk Southern and CSX. The first two operate largely on the west coast, while the last two operate largely on the east coast. Railroads compete for customers, but also share assets as well. They compete with trucks, pipelines, ships and aircraft for hauling goods. Trucking provides more flexibility in transporting goods, though they are more expensive. It makes sense to transport goods on long distances using a combination of rail and other modes of transport for maximum cost savings when moving goods.
Long-term growth for Norfolk Southern will be driven by the growth in US economic activity. When economic activity improves over time, this would translate into more goods being shipped in the country.
The railroad's best prospects are long-term. As Warren Buffett put it, an investment in railroads is an all-in wager on the economic future of the United States. Over time, the movement of goods in the United States will increase, and railroads like BNSF, Union Pacific, Norfolk Southern and CSX should get its full share of the gain. Railroads move goods across longer distances in a much more efficient way that long-haul trucks. This provides railroads a cost advantage.
Today, the United States has half the usable track it had in 1970, though companies like BNSF are hauling much more freight than they did back then, and the American Association of Railroads estimates that freight loads will nearly double by 2035. That congestion—a signal of demand—means opportunity: Improve existing tracks and add new ones, and boost sales.
The economic moats around railroads are the billions of dollars it costs to build them and the fact that the rights of way they need are all but impossible to obtain today. Therefore, it is unlikely that a new railroad will be created, though other modes of transportation could chip away market share. However, given the fact that it costs 3 – 4 times lower to transport goods through a railroad than truck, railways have inherent cost advantage. This cost advantage could also allow railroads to raise prices, and still remain competitive. Railroads have some geographic advantage as well.
Furthermore, rail companies can increase profits by improving productivity. For example, using smart systems to optimize speed depending on terrain could generate significant fuel savings over time. Reducing the amount of time railcars sit idle, could also improve profitability (since using those assets more effectively reduces the need to buy too many railcars to begin with). Raising the length of trains could further boost productivity. Improving productivity reduces cost, and increases profitability over time.
Norfolk Southern transports raw materials, intermediate products and finished goods classified in the following commodity groups (percent of total railway operating revenues in 2014): intermodal (22%); coal (21%); chemicals (16%); metals/construction (13%); agriculture/consumer products/government (13%); automotive (8%); and, paper/clay/forest products (7%).
Growth in Norfolk Southern will be aided by increase in intermodal traffic and chemicals. It will likely be hurt by decreasing demand for coal, which will decrease the amount of coal transported by rail. The company has invested heavily in intermodal operations. Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes.
The thing to consider with railway companies like Norfolk Southern, Union Pacific or BNSF is that their fortunes are exposed to the cyclical fluctuations in demand for transportation. The downside is that these companies have substantial needs for capital, in order to comply with new regulations, replace track, locomotives and railcars and maintain their rail networks along the way. Maintaining their tens of thousands of miles of track is a cost that trucking companies do not have.
The annual dividend payment has increased by 17% per year over the past decade, which is higher than the growth in EPS. This was possible mostly due to the increase in the dividend payout ratio. Future rates of growth in dividends will be limited to the rate of growth in earnings per share.
A 17% growth in distributions translates into the dividend payment doubling almost every four and a quarter years on average. If we check the dividend history, going as far back as 2002, we could see that Norfolk Southern has actually managed to double dividends almost every four and a quarter years on average. The item to add however was that in 2000 the company did cut its dividends by more than 50%. Therefore, just like we saw with Union Pacific, while the dividend is likely sustainable, this is a cyclical company which is more likely to cut distributions than your typical consumer staples or healthcare dividend stock. So even if you plan on holding for the next 100 years, there will be hiccups and dividend cuts are likely every one or two decades.
In the past decade, the dividend payout ratio has more than doubled from a low of 15.40% in 2005 to 34.70 in 2014. The high percentage in 2009 was mostly an aberration, as earnings seem to have been hit by the Great Recession. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.
Norfolk Southern has managed to grow its return on equity a little over the past decade, from 14.80% in 2005 to 16.80% in 2014. I generally like seeing a high return on equity, which is also relatively stable or rising over time.
Currently, Norfolk Southern is attractively valued at 15.80 times forward earnings, and it has a decent current yield of 2.50%. I initiated a small position in the railroad, because it is easier for me to track companies when I have skin in the game. I am interested in Norfolk Southern on dips below $95/share. I recently also initiated a small position in Union Pacific (UNP), to which I also plan on adding on dips below $90/share.
Full Disclosure: Long UNP, NSC
Relevant Articles:
- Union Pacific (UNP) Dividend Stock Analysis
- The Value of Dividend Growth
- Dividend Investors have an advantage over everyone else on Wall Street
- How to be a successful dividend investor
- How to get dividend investment ideas
The most recent dividend increase was in January 2015, when the Board of Directors approved a 3.50% increase in the quarterly dividend to 59 cents/share. This was the second increase in a year however, and represented a 9.30% dividend growth over the same time in 2014.
The company’s largest competitors include CSX Corporation (CSX), Union Pacific (UNP), and Burlington Northern Santa Fe which is part of Berkshire Hathaway (BRK/B).
Over the past decade this dividend growth stock has delivered an annualized total return of 15% to its shareholders. Future returns will likely be lower, and will be dependent on growth in earnings and starting dividend yields obtained by shareholders at time of investment.
The company has managed to deliver a 10.70% average increase in annual EPS over the past decade. Norfolk Southern is expected to earn $5.94 per share in 2015 and $6.84 per share in 2016. In comparison, the company earned $6.39/share in 2014.
Earnings per share have also been aided by share buybacks. The number of shares outstanding has decreased from 412 million in 2005 to 312 million by 2015.
Railroads are an oligopoly in the US, as 80% of industry revenues are generated by BNSF, Union Pacific, Norfolk Southern and CSX. The first two operate largely on the west coast, while the last two operate largely on the east coast. Railroads compete for customers, but also share assets as well. They compete with trucks, pipelines, ships and aircraft for hauling goods. Trucking provides more flexibility in transporting goods, though they are more expensive. It makes sense to transport goods on long distances using a combination of rail and other modes of transport for maximum cost savings when moving goods.
Long-term growth for Norfolk Southern will be driven by the growth in US economic activity. When economic activity improves over time, this would translate into more goods being shipped in the country.
The railroad's best prospects are long-term. As Warren Buffett put it, an investment in railroads is an all-in wager on the economic future of the United States. Over time, the movement of goods in the United States will increase, and railroads like BNSF, Union Pacific, Norfolk Southern and CSX should get its full share of the gain. Railroads move goods across longer distances in a much more efficient way that long-haul trucks. This provides railroads a cost advantage.
Today, the United States has half the usable track it had in 1970, though companies like BNSF are hauling much more freight than they did back then, and the American Association of Railroads estimates that freight loads will nearly double by 2035. That congestion—a signal of demand—means opportunity: Improve existing tracks and add new ones, and boost sales.
The economic moats around railroads are the billions of dollars it costs to build them and the fact that the rights of way they need are all but impossible to obtain today. Therefore, it is unlikely that a new railroad will be created, though other modes of transportation could chip away market share. However, given the fact that it costs 3 – 4 times lower to transport goods through a railroad than truck, railways have inherent cost advantage. This cost advantage could also allow railroads to raise prices, and still remain competitive. Railroads have some geographic advantage as well.
Furthermore, rail companies can increase profits by improving productivity. For example, using smart systems to optimize speed depending on terrain could generate significant fuel savings over time. Reducing the amount of time railcars sit idle, could also improve profitability (since using those assets more effectively reduces the need to buy too many railcars to begin with). Raising the length of trains could further boost productivity. Improving productivity reduces cost, and increases profitability over time.
Norfolk Southern transports raw materials, intermediate products and finished goods classified in the following commodity groups (percent of total railway operating revenues in 2014): intermodal (22%); coal (21%); chemicals (16%); metals/construction (13%); agriculture/consumer products/government (13%); automotive (8%); and, paper/clay/forest products (7%).
Growth in Norfolk Southern will be aided by increase in intermodal traffic and chemicals. It will likely be hurt by decreasing demand for coal, which will decrease the amount of coal transported by rail. The company has invested heavily in intermodal operations. Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes.
The thing to consider with railway companies like Norfolk Southern, Union Pacific or BNSF is that their fortunes are exposed to the cyclical fluctuations in demand for transportation. The downside is that these companies have substantial needs for capital, in order to comply with new regulations, replace track, locomotives and railcars and maintain their rail networks along the way. Maintaining their tens of thousands of miles of track is a cost that trucking companies do not have.
The annual dividend payment has increased by 17% per year over the past decade, which is higher than the growth in EPS. This was possible mostly due to the increase in the dividend payout ratio. Future rates of growth in dividends will be limited to the rate of growth in earnings per share.
A 17% growth in distributions translates into the dividend payment doubling almost every four and a quarter years on average. If we check the dividend history, going as far back as 2002, we could see that Norfolk Southern has actually managed to double dividends almost every four and a quarter years on average. The item to add however was that in 2000 the company did cut its dividends by more than 50%. Therefore, just like we saw with Union Pacific, while the dividend is likely sustainable, this is a cyclical company which is more likely to cut distributions than your typical consumer staples or healthcare dividend stock. So even if you plan on holding for the next 100 years, there will be hiccups and dividend cuts are likely every one or two decades.
In the past decade, the dividend payout ratio has more than doubled from a low of 15.40% in 2005 to 34.70 in 2014. The high percentage in 2009 was mostly an aberration, as earnings seem to have been hit by the Great Recession. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.
Norfolk Southern has managed to grow its return on equity a little over the past decade, from 14.80% in 2005 to 16.80% in 2014. I generally like seeing a high return on equity, which is also relatively stable or rising over time.
Currently, Norfolk Southern is attractively valued at 15.80 times forward earnings, and it has a decent current yield of 2.50%. I initiated a small position in the railroad, because it is easier for me to track companies when I have skin in the game. I am interested in Norfolk Southern on dips below $95/share. I recently also initiated a small position in Union Pacific (UNP), to which I also plan on adding on dips below $90/share.
Full Disclosure: Long UNP, NSC
Relevant Articles:
- Union Pacific (UNP) Dividend Stock Analysis
- The Value of Dividend Growth
- Dividend Investors have an advantage over everyone else on Wall Street
- How to be a successful dividend investor
- How to get dividend investment ideas
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
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
Monday, June 1, 2015
Dividend Investors have an advantage over everyone else on Wall Street
I believe that dividend investors have an inherent edge against everyone else on Wall Street. This comes down to several traits, which set them apart from the crowd.
1) Dividend Investors are patient
Dividend investors have a long-term horizon. As a result, they invest for the next 20 – 30 years, not for the next quarter or year. You can afford to be patient, focus on what matters in the long run, and ignore short term noise. If the company you invested in suffers a temporary set-back in price, you can double up, and get more stock for your buck
Wall Street, meaning mutual funds, or hedge funds, invest with an eye on short-term performance. If you manage money, and you do worse than your benchmark for a quarter or two, you might get fired. This is even if you get the stock ultimately correct. If you bought Berkshire Hathaway (BRK.B) in 1998 - 1999, you would have been fired by early 2000, since you “underperformed the market”. About 15 years later, you would have crushed that ‘market”. But you would have been unemployed long since. This is because everyone else focuses on irrelevant short term noise – stock price fluctuations, earnings misses of one penny per share, and tries to outguess everyone else. At the same time active investors end up paying steep commissions and fees and taxes in the process, and essentially killing their compounding process in its infancy.
I like the fact that as a stock picker, I can afford to hold my stocks essentially forever. I also can afford to pass up on investments that are overvalued, and would likely generate poor returns. It is well documented that turnover is bad for investment portfolios. The funny story is that even so called passive index funds have high turnovers, as they constantly add and remove companies, purge spin-offs or carve-outs, adjust their weightings due to share repurchases or sales by founders, or due to arbitrary changes in rules. As a stock picker I do not have to follow rules that make me sell investments for no good business reason. For example companies like Unilever (UL) and Royal Dutch (RDS.B) were removed from S&P 500 in 2002, because of a rule against including foreign companies. Surprisingly, those were successful enterprises, which had contributed to the index by outperforming it since they were included 50 years ago. However, a company like Phillip Morris International (PM), which does all its business outside the US, is kept in the index. Other changes include weighting based on free float, implemented in the middle of last decade. The most eye-opening experience is that the investors of the original S&P 500 companies did better than those who held the index between 1957 and 2003. I also do not need to re-balance my portfolio or add shares in companies with no earnings, just because their market capitalization is high enough. Indexing is still a great way for a large portion of savers to accumulate retirement nest eggs. However, it is not perfect, and too frequent changes or too widespread of an adoption and ignoring valuations could deliver poor returns going forward. On a side note, I allocate a large portion of my annual savings to index funds, as I max out my 401 (k) and ultimately the HSA accounts each year. The tax-deferred nature of those accounts make it a no-brainer to use them, even if I have to place the money in index funds.
2) As a dividend investor, you don’t have to suffer from investment myopia.
- You don’t have to care about meaningless short term fluctuations
- You are not going to fire yourself because of meaningless comparisons to a benchmark ( see point 3 below)
- You also won’t have to pay 1- 2% in fees per year that most mutual funds and investment advisers charge or the 2/20% that hedge funds charge.
Most importantly you have the patience to stick to your ideas for the long term, and avoid overtrading. Overtrading and lack of diversification are the number one reason for the mediocre performance of ordinary investors in general.
Many of the companies I have purchased have done relatively fine in terms of dividend increases over time. However, if I had myopically focused on earnings per share every quarter, or if I have ran away the moment stock prices fell or “underperformed” an arbitrarily chosen index, I would have made a grave mistake. The thing is, many companies I buy can stay flat in stock price for a long time. As an accumulator of assets, this is not a problem, because it allows me to buy more stock with less dollars. Only after a few years do those companies start producing the type of long-term capital gains and increased dividends that make investors want to salivate. For example, Johnson & Johnson (JNJ) was difficult to own in 2010 when it sold for $60/share and was involved with recalls. Fast forward four years later and it is selling at a much higher price, and most importantly earns more and pays a much higher dividend per share.
In another example, I held Kinder Morgan Management LLC (KMR) between 2008 and 2014, before it was acquired by Kinder Morgan Inc (KMI). There were some hedge funds that were short Kinder Morgan which were attempting to manipulate investors into panic selling in 2013 - 2014. While the position was flat for a while, and did worse relative to others, I stuck to my guns and were rewarded. The reason I stayed with Kinder Morgan LLC (KMR) is because it was cheap, delivered the results I purchased it for, and was compounding my capital tax free in the process. I do not let fear or greed dictate what I do.
If I were a mutual fund or a hedge fund, I would suffer from capital redemptions when things are tough. For example, many investors ask for their money back during bear markets and during periods of relative underperformance. This does not allow any time for investment ideas to work out. Therefore, the edge that I have against others is the fact that I have permanent capital. The money I put to work in the stock market will likely never be withdrawn. This is because I plan to live off dividends, and never tough principal. If I touch the principal, chances are I have a rare disease and a short amount of time left anyways, so stock market performance would be the last thing on my mind. And long-term would likely be less than a couple of years anyways in that case.
3) As a dividend investor, you work towards your own goals and objectives
Many are surprised by the fact that I do not find benchmarking my portfolio to an index like S&P 500 to be relevant. The truth is that my investing tries to accomplish a set of goals and objectives I have set for myself. My goal it to be able to generate a certain amount in passive dividend income before the end of this decade. ( roughly around 2018). As a result, I save money each month and invest them in the best dividend stock ideas I could find at the time. I look for:
- Companies with a proven track record of dividend growth,
- Available at attractive valuations
- With rising earnings and prospects for rising earnings
I then add those shares to my portfolio, reinvest dividends selectively and hold for as long as the fundamentals still make sense. I try to maintain a diversified portfolio, which is why I avoid adding to the ten largest positions I have. With each $1000 that I invest in a stock yielding 3% today, I generate $30 in annual income that will grow above the rate of inflation and will support me in retirement forever. As long as that income grows over time and dividends are not cut, I will hold forever. I could not care less whether the price of this investment is down to $500 or up to $5000, as long as my dividends are neatly deposited in my brokerage account in a timely manner.
You can see that whether my portfolio does better or worse than some benchmark is irrelevant for my goals and objectives. In fact, Certificates of Deposit have beaten the S&P 500 since the end of 1999. Everyone is focused on beating the market. I am not, because to me beating the market doesn't mean anything to me. My goal is to achieve my goals and objectives, not to beat some benchmark. I would accomplish my goals by generating returns, not by obsessing over returns relative to others. Let's assume that my goal is to generate $2,000/month in retirement income. If I retire on $2,000/month or $3,000/month, and this is less than the $5,000/month that another investor needs, I would consider myself a success, not a failure. Anyone who believes that as a failure probably needs to get their brain wiring examined by a licensed professional.
4) As a dividend investor, you are a long-term investor
In this day and age, everyone is mesmerised by instant news covering economics, stock markets etc. The average holding period of securities is in months these days, rather than decades ( like it were 50 - 60 years ago). There is high amount of activity among mutual funds and other "sophisticated" investors. There is an entire industry of high-frequency traders, which skim a portion of a penny any time a stock is traded. As a dividend investor, my goal is not to profit from meaningless short-term price changes. As a dividend investor my returns will be dependent on the fundamental success of the companies I ultimately end up investing in. In addition to focusing on quality, minimizing risk of failure, and focusing on prospects for growth, I also need to make sure I do not overpay too much for those companies. As a result, my ability to profit will be dependent on the success of the enterprises I pick. If Johnson & Johnson (JNJ) keeps growing over the next 30 years, I will be able to earn a higher amount of dividends almost every year for those next 30 years. In addition, if Johnson & Johnson manages to grow earnings per share over those next 30 years, chances are that the intrinsic value of the business will grow significantly in the process.
Johnson & Johnson (JNJ) is expected to earn $6.14/share in 2015, and pay $3/share. Let's assume that the company grows earnings per share and dividends per share by 5%/year, and that it will sell at a P/E of 16 for the next 30 years. This means that by 2045, earnings per share will reach $26.50 and dividends could reach close to $13/share. The shares could fetch $424. If we reinvest those dividends in a tax-deferred account, this $98 investment today could mushroom to over $1046.
Therefore, the largest amount of profits will be generated by those who identify an asset with a good prospect, and then purchase it at fair valuations. The big return will be generated by sitting on this asset for decades, and quietly compounding income and capital. Having the patience to allow the power of compounding to do its simple magic, and the permanent capital to implement it with, is your edge against everyone on Wall Street.
Full Disclosure: Long JNJ, KMI, and BRK.B
Relevant Articles:
- Dividend Growth Stocks are Compounding Machines
- Successful Dividend Investing Requires Patience
- Let dividends do the heavy lifting for your retirement
- How to retire in 10 years with dividend stocks
- Dividend Growth Stocks Increase Intrinsic Value Over Time
1) Dividend Investors are patient
Dividend investors have a long-term horizon. As a result, they invest for the next 20 – 30 years, not for the next quarter or year. You can afford to be patient, focus on what matters in the long run, and ignore short term noise. If the company you invested in suffers a temporary set-back in price, you can double up, and get more stock for your buck
Wall Street, meaning mutual funds, or hedge funds, invest with an eye on short-term performance. If you manage money, and you do worse than your benchmark for a quarter or two, you might get fired. This is even if you get the stock ultimately correct. If you bought Berkshire Hathaway (BRK.B) in 1998 - 1999, you would have been fired by early 2000, since you “underperformed the market”. About 15 years later, you would have crushed that ‘market”. But you would have been unemployed long since. This is because everyone else focuses on irrelevant short term noise – stock price fluctuations, earnings misses of one penny per share, and tries to outguess everyone else. At the same time active investors end up paying steep commissions and fees and taxes in the process, and essentially killing their compounding process in its infancy.
I like the fact that as a stock picker, I can afford to hold my stocks essentially forever. I also can afford to pass up on investments that are overvalued, and would likely generate poor returns. It is well documented that turnover is bad for investment portfolios. The funny story is that even so called passive index funds have high turnovers, as they constantly add and remove companies, purge spin-offs or carve-outs, adjust their weightings due to share repurchases or sales by founders, or due to arbitrary changes in rules. As a stock picker I do not have to follow rules that make me sell investments for no good business reason. For example companies like Unilever (UL) and Royal Dutch (RDS.B) were removed from S&P 500 in 2002, because of a rule against including foreign companies. Surprisingly, those were successful enterprises, which had contributed to the index by outperforming it since they were included 50 years ago. However, a company like Phillip Morris International (PM), which does all its business outside the US, is kept in the index. Other changes include weighting based on free float, implemented in the middle of last decade. The most eye-opening experience is that the investors of the original S&P 500 companies did better than those who held the index between 1957 and 2003. I also do not need to re-balance my portfolio or add shares in companies with no earnings, just because their market capitalization is high enough. Indexing is still a great way for a large portion of savers to accumulate retirement nest eggs. However, it is not perfect, and too frequent changes or too widespread of an adoption and ignoring valuations could deliver poor returns going forward. On a side note, I allocate a large portion of my annual savings to index funds, as I max out my 401 (k) and ultimately the HSA accounts each year. The tax-deferred nature of those accounts make it a no-brainer to use them, even if I have to place the money in index funds.
2) As a dividend investor, you don’t have to suffer from investment myopia.
- You don’t have to care about meaningless short term fluctuations
- You are not going to fire yourself because of meaningless comparisons to a benchmark ( see point 3 below)
- You also won’t have to pay 1- 2% in fees per year that most mutual funds and investment advisers charge or the 2/20% that hedge funds charge.
Most importantly you have the patience to stick to your ideas for the long term, and avoid overtrading. Overtrading and lack of diversification are the number one reason for the mediocre performance of ordinary investors in general.
Many of the companies I have purchased have done relatively fine in terms of dividend increases over time. However, if I had myopically focused on earnings per share every quarter, or if I have ran away the moment stock prices fell or “underperformed” an arbitrarily chosen index, I would have made a grave mistake. The thing is, many companies I buy can stay flat in stock price for a long time. As an accumulator of assets, this is not a problem, because it allows me to buy more stock with less dollars. Only after a few years do those companies start producing the type of long-term capital gains and increased dividends that make investors want to salivate. For example, Johnson & Johnson (JNJ) was difficult to own in 2010 when it sold for $60/share and was involved with recalls. Fast forward four years later and it is selling at a much higher price, and most importantly earns more and pays a much higher dividend per share.
In another example, I held Kinder Morgan Management LLC (KMR) between 2008 and 2014, before it was acquired by Kinder Morgan Inc (KMI). There were some hedge funds that were short Kinder Morgan which were attempting to manipulate investors into panic selling in 2013 - 2014. While the position was flat for a while, and did worse relative to others, I stuck to my guns and were rewarded. The reason I stayed with Kinder Morgan LLC (KMR) is because it was cheap, delivered the results I purchased it for, and was compounding my capital tax free in the process. I do not let fear or greed dictate what I do.
If I were a mutual fund or a hedge fund, I would suffer from capital redemptions when things are tough. For example, many investors ask for their money back during bear markets and during periods of relative underperformance. This does not allow any time for investment ideas to work out. Therefore, the edge that I have against others is the fact that I have permanent capital. The money I put to work in the stock market will likely never be withdrawn. This is because I plan to live off dividends, and never tough principal. If I touch the principal, chances are I have a rare disease and a short amount of time left anyways, so stock market performance would be the last thing on my mind. And long-term would likely be less than a couple of years anyways in that case.
3) As a dividend investor, you work towards your own goals and objectives
Many are surprised by the fact that I do not find benchmarking my portfolio to an index like S&P 500 to be relevant. The truth is that my investing tries to accomplish a set of goals and objectives I have set for myself. My goal it to be able to generate a certain amount in passive dividend income before the end of this decade. ( roughly around 2018). As a result, I save money each month and invest them in the best dividend stock ideas I could find at the time. I look for:
- Companies with a proven track record of dividend growth,
- Available at attractive valuations
- With rising earnings and prospects for rising earnings
I then add those shares to my portfolio, reinvest dividends selectively and hold for as long as the fundamentals still make sense. I try to maintain a diversified portfolio, which is why I avoid adding to the ten largest positions I have. With each $1000 that I invest in a stock yielding 3% today, I generate $30 in annual income that will grow above the rate of inflation and will support me in retirement forever. As long as that income grows over time and dividends are not cut, I will hold forever. I could not care less whether the price of this investment is down to $500 or up to $5000, as long as my dividends are neatly deposited in my brokerage account in a timely manner.
You can see that whether my portfolio does better or worse than some benchmark is irrelevant for my goals and objectives. In fact, Certificates of Deposit have beaten the S&P 500 since the end of 1999. Everyone is focused on beating the market. I am not, because to me beating the market doesn't mean anything to me. My goal is to achieve my goals and objectives, not to beat some benchmark. I would accomplish my goals by generating returns, not by obsessing over returns relative to others. Let's assume that my goal is to generate $2,000/month in retirement income. If I retire on $2,000/month or $3,000/month, and this is less than the $5,000/month that another investor needs, I would consider myself a success, not a failure. Anyone who believes that as a failure probably needs to get their brain wiring examined by a licensed professional.
4) As a dividend investor, you are a long-term investor
In this day and age, everyone is mesmerised by instant news covering economics, stock markets etc. The average holding period of securities is in months these days, rather than decades ( like it were 50 - 60 years ago). There is high amount of activity among mutual funds and other "sophisticated" investors. There is an entire industry of high-frequency traders, which skim a portion of a penny any time a stock is traded. As a dividend investor, my goal is not to profit from meaningless short-term price changes. As a dividend investor my returns will be dependent on the fundamental success of the companies I ultimately end up investing in. In addition to focusing on quality, minimizing risk of failure, and focusing on prospects for growth, I also need to make sure I do not overpay too much for those companies. As a result, my ability to profit will be dependent on the success of the enterprises I pick. If Johnson & Johnson (JNJ) keeps growing over the next 30 years, I will be able to earn a higher amount of dividends almost every year for those next 30 years. In addition, if Johnson & Johnson manages to grow earnings per share over those next 30 years, chances are that the intrinsic value of the business will grow significantly in the process.
Johnson & Johnson (JNJ) is expected to earn $6.14/share in 2015, and pay $3/share. Let's assume that the company grows earnings per share and dividends per share by 5%/year, and that it will sell at a P/E of 16 for the next 30 years. This means that by 2045, earnings per share will reach $26.50 and dividends could reach close to $13/share. The shares could fetch $424. If we reinvest those dividends in a tax-deferred account, this $98 investment today could mushroom to over $1046.
Therefore, the largest amount of profits will be generated by those who identify an asset with a good prospect, and then purchase it at fair valuations. The big return will be generated by sitting on this asset for decades, and quietly compounding income and capital. Having the patience to allow the power of compounding to do its simple magic, and the permanent capital to implement it with, is your edge against everyone on Wall Street.
Full Disclosure: Long JNJ, KMI, and BRK.B
Relevant Articles:
- Dividend Growth Stocks are Compounding Machines
- Successful Dividend Investing Requires Patience
- Let dividends do the heavy lifting for your retirement
- How to retire in 10 years with dividend stocks
- Dividend Growth Stocks Increase Intrinsic Value Over Time
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