Over the past year, I’ve had many great conversations with our Dick Davis Digest contributors, as part of our Contributor Interview Series for Investment of the Week. In today’s Dividend Edition, I thought I’d collect some of the best income investing advice these experts shared with me. Together, their advice provides a pretty good road-map for choosing good dividend-paying investments.
Some of the best advice we’ve gotten this year came from Harry Domash, editor of Dividend Detective. Domash focuses totally on dividend-paying stocks, so he shared some great guidelines for analyzing them. One of his most important points, I thought, was that investors must analyze and treat dividend investments differently from growth investments. As he said:
“Dividend-stock investing requires a different mindset than growth investing.
“For growth stocks, the main thing is a firm’s market position in its industry. Growth investors must know if their stocks are gaining or losing market share vis-à-vis their competitors, or if their products are saturating their markets. This is critical since any slowing of growth vs. expectations will crash growth stock prices. For instance, today, growth investors are pondering how well Apple’s new mini iPad will sell compared to the new Windows tablet.
“Dividend stocks, by contrast, have already been around that block. They have survived the fast growth, young upstart phase and now are one of a handful of players with more-or-less stable market shares in relatively slow growing industries such as food product makers, shopping center operators, hotel property owners or utility companies. So, dividend investors don’t spend much time analyzing stock price charts, changes in stock analyst earnings forecasts and the like searching for clues pointing to faltering growth. Instead, they pay attention to long-term trends and economic forecasts signaling whether market conditions for their stocks are likely to improve or decline in coming months.”
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Several of the other contributors I’ve interviewed have also emphasized the importance of taking a long-term view when investing for income. As John Buckingham, editor of The Prudent Speculator, told me in March: “I very much believe that a long-term-focused strategy based on planting and patiently harvesting a broadly diversified portfolio of undervalued stocks is the key to success in the equity markets.”
He went on to explain the advantages of buying at low valuations, a habit that is especially helpful to yield-hungry income investors: “As value investors, we seek to buy stocks that are on sale, similar to what most folks do in their everyday lives. Whether it is a box of cereal, a washing machine or a new car, most of us prefer to pay as little as possible and we generally walk away if we think that the price is too rich.
“On the other hand, the stock market, as the old adage goes, is the only place where they hold a sale and few people show up. Though we find this puzzling, given that history shows value stocks outperform growth stocks, we are grateful that investors often overly punish companies for short-term transgressions while they drive ‘hot’ stocks to unreasonably high levels. It is this dynamic that allows us to implement our strategy as we are able to make a reasonable assessment of fair value based on a variety of historical valuation ‘norms’ for each company, its sector and the overall market. When a stock is priced at a significant discount to that determination of fair value, we buy. When it approaches fair value or when we find another stock with much better reward to risk potential, we sell.”
Finally, Buckingham added, you have to take dividend income into account when considering a stock’s potential return. As he said, “[Since] 2002, we have augmented our analytics by explicitly including dividends and the income they generate into our decision-making process. Market history shows that anywhere from 25% to 40% of total return has been derived from dividends, so we think that there is strong evidence to support their inclusion in the analytical framework.”
Bob Brinker, editor of Brinker Fixed Income Advisor, also emphasized the importance of considering dividend yield in your investment decisions, but he added another caveat: make sure you’re considering the correct yield. He said: “Another important point I emphasize is to focus on real return, not nominal return. Earning 7% in a 4% inflation environment is not better, in real terms, than earning 4% in a 1% inflation environment.”
In addition to calculating the real yield of your potential investment, consider the safety of that yield. Vivian Lewis, editor of Global Investing and my first interviewee, told a cautionary tale of high but unsafe yields:
“The most important thing to do now is to be sure the yields you buy are secure and real. Very high payout levels usually mean there is something amiss with the company paying them. Just looking at a chart won’t tell you what is wrong.
“Here is an example: Banco Macro trades as BMA and has an 8.4% yield. I get an inquiry about this stock about once a month. BMA is Argentinian. Argentina in 2003-04 blocked bank accounts denominated in U.S. dollars to devalue the currency. People couldn’t get their funds out of the ATMs of Argentina. So Argentinians are trigger-happy and more likely than other people to start a run on their friendly local bank at the first sign of another grab by the Peronist government (and there have been several, including faking inflation to cut pensions).
“So Banco Macro’s high yields depend on depositors staying put in their bank accounts. I cannot figure out when the Cristina Fernandez government next decides to do something awful to savers. My Latin American reporter, Frida, agrees. This is the Wild South. Remember, Butch Cassidy and the Sundance Kid wound up in Argentina.”
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Two more factors to consider when analyzing yield investments came from Harry Domash. In addition to the macro factors in Lewis’ example, consider the safety of the dividend based on the company’s own finances.
Domash said: “It’s the earnings per share that gets the headlines when firms report quarterly results. But most high-dividend stocks have large investments in physical assets such a factories, office buildings, pipelines, etc., that must be depreciated when computing earnings, even though the assets may be increasing in value. Further, depreciation costs are bookkeeping entries only; no cash changes hands. Thus, for high-dividend payers, reported earnings are not relevant to a firm’s ability to pay its dividends. Instead, dividend investors must focus on operating cash flow, which is the amount of actual cash that flowed into or out of a firm’s bank accounts related to its basic business operations. Fortunately, that number is easy to find and you won’t need to turn on your calculator to do the analysis.”
And once you’ve established that a firm’s dividend is safe, Domash suggests considering its growth prospects:
“To paraphrase an old adage, the three most important factors for evaluating dividend investment candidates are dividend growth prospects, dividend growth prospects and dividend growth prospects. That said, if a stock is already paying double-digit yields, you might be satisfied just if the dividend remained steady. The main factors that determine future dividend growth are:
1) ability (will the company generate enough cash to fund its dividends),
2) desire (does the current management want to continue raising their dividends?) and
3) industry and global economic factors (is the company in a shrinking industry such as magazines, or a growing industry such as healthcare, are we heading into a recession or economic growth phase, etc?).”
Finally, even if an investment is well-priced, in a growing industry and has a secure-looking real yield and dividend growth potential, consider one more factor: how well does the investment match your risk tolerance? Bob Brinker explained, “In the end, each investor needs to balance their need for yield versus their risk tolerance. It makes no sense to me when I see investors who have plenty of money take unnecessary risk. If you can provide an income that meets your lifestyle in U.S. Treasuries and CDs, do it! Do not take risk just to earn more money that you do not need. Only take on added risk if you need to in order to generate additional income.”
In short, when considering dividend-paying investments:
• Buy established companies in stable industries.
• Buy at low valuations.
• Consider dividend yield as part of potential total return.
• Calculate the investment’s real yield, given taxes, inflation and all other factors.
• Be skeptical of very high yields; check for risk factors.
• Look at actual cash flow to see if the dividend is well-covered.
• Consider potential for dividend growth.
• And finally, don’t take on any more risk than you need to.
Wishing you success in your investing and beyond,
Chloe Lutts
Editor of Dick Davis Digests
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