CHAPTER 3
THE TECHNICAL KEYS OF DIVIDEND INVESTING
A friend of mine who has a risk-mentality repeatedly tells me that one can either eat well or sleep well, but not both. For him risk is essential for making good money and dining in four-star restaurants. He accepts the hassle that goes with gaining wealth and often cannot sleep. On the other hand, he thinks that sleep may come easily, but wealth is elusive.
Dividend investing raises questions about his philosophy: one can eat well because of dividend payouts, and sleep comes easily because of the safety factors built into the strategy.
When a person adds to his or her investments on a regular basis and reinvests everything earned, profits build quickly. Dividends earned are added to previous dividends, and the entire return again makes dividends. In theory the strategy works, but in fact how well does it work?
Let’s start by looking at what you might expect from investing in dividend stocks. Assume that you invest $1000 a month in dividend stocks and that you receive on the average a 10% annual return on your investments. You’re 17 years of age, to push the example, or at least feel like it, and you hope to retire before you are 50. Below I indicate what returns you could expect. You can avoid a stock broker, but I also add those costs so you can see what you can save by buying direct into a reinvestment program. The table indicates your investments, and returns from reinvesting your contributions during a 30 year period. Of course you may not always get an annualized return of 10%, and your contributions may be smaller, but here is a fair example of the possibilities. Neither am I considering capital appreciation, which would add to the value of your investments.
SYSTEMATIC REINVESTMENT OF CONTRIBUTIONS AND DIVIDENDS
YEARS$ INVESTEDRETURNS $ BROKER FEES
5 60,000 78,082 540
10120,000 206,5521080
15180,000 417,9241620
20240,000 765,6972160
25300,000 1,337,890 2700
30360,000 2,279,3253240
Your total out-of-pocket investments over 30 years is $360,000, and your returns are over two and a quarter million dollars. The English poet Lord Byron, no doubt in a moment of intemperance, said about such gains, “Yes! Ready money is Aladdin’s Lamp.”
You did it with low risk, comfortable sleep, and the knowledge that you would retire before 50 as a multi-millionaire. Note, too, if you bought your stock shares directly from a corporation, bypassing a broker, you saved $3,240. Had you also bought dividend stocks with the amount you might have paid a broker and let the money “ride” as reinvestments, you would have an additional $19,541.89. All this is not as good as you might have done with Aladdin’s Lamp, but it could be a high second best.
There are caveats. The economy may flatten, as it has recently, and the stocks you buy may go down in price. If the dividends are cut significantly by the companies, you have to sell them. But if you bought into the best companies in the world that have paid increasing dividends over many years (and there are hundreds of these), your chances are good that the returns will continue in your favor.
As I write this in April of 2008, almost all stock companies are facing losses of 20, 30, or even 40 percent. Most of these companies did not fail and their management is still top drawer; they simply were caught in a major downturn of the market. The companies still produce needed goods and they will recover. Most are flexible and will adjust their activities until they do. In the meanwhile they will do their best to continue to pay dividends. The yields may drop some, but it is in their best interest to keep old and new shareholders happy.
Think of it this way. If a stock is good enough to buy for a chance of reasonable dividends, it is also one that will probably net you capital appreciation at some later date. My opinion is that now is the time to buy those stocks and use them as a basis of your dividend reinvestment program. The rebound of the market will occur, as it has hundreds of time, and you will make money as a long-term investor. In my mind I hear these great stocks yelling “Buy meand share in the American dream!” These stocks are not merely for grandmothers and children, popping out dividends but not growing, they are truly growth stocks that are cheap and ready to move up.
Clearly, the key for your success begins with choosing stocks that are substantial and have a history of issuing increasing dividends. The Mustang Run to Dividend Investing is designed to show you how to make wise decisions in the choice of stocks or ETFs and exactly how to do that within your budget and lifetime goals.
FIRST STEPS FOR SELECTING GOLDEN COMPANIES
KEY NUMBER ONE: Buy only stocks that show dividend growth.
The table below shows you the annual returns for different classes of stocks over the period of 1972 – 2007 (Mark Skousen: After Ned Davis).
STOCK CLASSANNUAL RETURNS
Dividend Growth and10.9%
Dividend Initiators
Dividend Payers with no 8.9%
Change in Dividends
Dividend Cutters and 3.9%
Dividend Eliminators
Non Dividend Payers 2.5%
Note the wide difference between the extremes. Over the past 35 years non-dividend stocks have only averaged 2.9% annually, whereas dividend-paying stocks have averaged 8,9% to 10.9%. This is a huge difference and one that can mean thousands or even millions of dollars to the small investor. If you had invested $100,000 in non-dividend stocks in 1972 your net return would be $240,000 today. Not bad, but had you invested the same $100,000 in dividend-paying stocks your net return would be $3,223,000 today If you had limited your stock choices to only those that showed both dividends and dividend growth your return would be over $4 million. Now, we’re talking real money.
These are not isolated examples. The average annual return from the S&P 500 for the period of 12/31/1969 to 06/08/2007 (37 years) was about 11% with dividends reinvested, but only 8% without dividends (Investors Business Daily, June 21, 2007).
KEY NUMBER TWO: Use dividend stocks to protect yourself from bear markets.
Even in bad economic periods dividend stock yields increase or remain resistant to market downturns. Dividend stocks climbed from 0.29% in 2003 to 0.37.91, 0.40% and 0.48% in the years following, even though the annual total returns from stocks fell from 32.91% in 2003 to 12.21% and 6.69% the following two years.
In the bear market of 2000-2002 equity income (dividends) lost an average of 21.25%, which was less than half the steep drop of 47.38% plunge by the S&P 500 Thus, losses in the market can be minimized by investing in dividend-paying stocks.
KEY NUMBER THREE: Use dividend stocks to decrease volatility (risk) among your investments.
Volatility, a measure of risk, is lower with companies offering dividend reinvestment plans. Richard Tigue in his informative book, The Standard & Poor’s Guide to Building Wealthwith Dividend Stocks, pointed out that over the past 25 years the return from non-dividend-paying stocks was 50% more volatile than dividend-paying stocks.
KEY NUMBER FOUR: Pick dividend stocks from companies that have large capitalization (cap).
Capitalization refers to the number of outstanding shares multiplied by the current stock price of those shares. It really measures the size, value, and power of the company. The American Association of Individual Investors ( demonstrated in one of many studies that high capitalization is associated with both low volatility and higher dividends. The market cap ($ million) for firms with dividend reinvestment plans was 7,890.4 in contrast to firms without dividend reinvestment plans that had a cap of 352.6. Large cap stocks are often considered to be highly stable, low in volatility, and productive –characteristics of high-dividend paying stocks.
KEY NUMBER FIVE: Strive to select dividend stocks that have a history of at least 10 years of dividend distribution and dividend growth.
You have strong advantages here. Hundreds of so-called dividend-achiever stocks have paid dividends without fail for decades. I’ll try to point you to some of the best. These companies have paid dividends for at least 10 years, and the dividend yield has also increased steadily. The ten longest dividend records are given below.
TEN LONG DIVIDED PAYERS AND DIVIDEND GROWERS
NAME OF COMPANY / TICKER / YEARS HIGH PERFORMAmerican States Water Co / AWR / 53
Diebold Inc / DBD / 53
Procter & Gamble Co / PG / 53
Dover Corp / DOV / 51
Emerson Electric Co / EMR / 50
Genuine Parts Co / GPC / 50
Parker Hannifin Corp / PH / 50
3M Co / MMM / 48
Integrys Energy Group Inc / TEG / 48
Masco Corp / MAS / 48
Mergent’s Dividend Achievers, Winter 2008 (John Wiley & Sons, Inc.) profiles approximately 300 U.S. and Canadian companies each quarter that have increased cash dividends for the remarkable period of over 10 years. These high-performing stocks have outperformed the S&P 500 for the last ten years. I feature 28 of these gems in a later Chapter.Value Line ( profiles 1700 U.S. stocks, identifying the most highly rated dividend stocks, in addition to hundreds of pages of detailed technical analyses. Mergent and Value Line are two of the major sources of superb dividend-paying stocks.
KEY NUMBER SIX: Your dividend stock choices require that the payout ratio be around 50% to 60%.
Joseph Tigue in his book The Standard & Poor’s Guide to Building Wealth with Dividend Stocks (McGraw-Hill, 2006) explains that the payout ratio is a strong indication of how well a dividend stock is doing and if the yields are likely to continue. The payout ratio is measured as the dividends issued as a percent of stock earnings. The level of distribution (the payout ratio) should be at a level that can sustain the yield of distributions year after year. If it is too high, that is, if the dividend distribution is too high it can interfere with the maintenance and growth of the company. Ordinarily it should be in the neighborhood of 50% of earnings. Also, if it is too high, the investor may see this as a signal that the dividend level can not be sustained and may be reduced or abandoned altogether. The stock with an exaggerated payout will probably not survive to be listed as a dividend achiever.
The bottom line is that any stock that has more than doubled its dividends over a 10 year period and still has a low payout ratio has demonstrated strong earnings progress.
KEY NUMBER SEVEN: The dividend should exceed the level of inflation.
There is little reason to invest in a security whose return does not at least pay the investor more than the cost of inflation. With today’s high inflation and relatively low dividend yields, this becomes a challenge. Over time, however, dividend yields increase, offering the possibility that those yields will eventually exceed inflation costs. International securities, especially those of China and India, may add that needed dividend punch, but remember that it is often difficult to judge the risk of foreign funds.
It is essential to choose stocks (or ETFs) that have relatively high dividends to begin with. In today’s market that could be around 3 or 4 percent. Lowell Miller, the author of The Single Best Investment (Independent Publishers Group, 2006), insists that the game is simple: it is to find the best return with the lowest standard deviation (risk). We should remember his formula for success:
High Total Returns = High Quality Stock + High Current Dividend + High Growth of Dividends
KEY NUMBER EIGHT: Pick stocks from “demand” sectors of our economy.
There are certain sectors of our economy that should be avoided like the plague. Housing and Financial institutions are obvious ones. The list of financial companies cutting dividends, or not acting in time, includes Citigroup (C), Bank of America (BAC), Merrill Lynch (MER), Morgan Stanley (MS), Countrywide Financial (CFC) and Bear Stearns (BSC).Others, like Wachovia (WB) and Huntington Bancshares (HBAN) are at risk, and even Wells Fargo (WFC) and Bancorp (USB) may eventually have to reconsider their dividend policies. Unfortunately the Financial sector is one of the highest paying dividend sectors we have. For now it is important to reduce risk as much as possible. The following areas are ones that I am suggesting you look at carefully. They consist of products and services that almost all people demand regardless of troubles in the general economy. We will feature utilities in a later chapter.
1. Utilities: electricity, natural gas, coal, water
2. Consumer Staples: food, fuel, clothing
3. Healthcare: medical equipment, proven techniques, pharmaceuticals
4. Hedonism: beer, wine, fast foods, tobacco, gambling
5. Infrastructure: pipelines, bridges, highways, airports, sewer and water systems
I will give you specific “Demand” stocks in other Chapters of this program, and ways to search out many more.
If you want to consider higher yields and capital appreciation consider commodities – hard assets that people will continue to need regardless of the market fluctuations. Expect these to have high volatility, but also great investor promise. These include the following.
1. Energy: oil, natural gas, coal
2. Precious metals: gold, silver, platinum
3. Agricultural products: wheat, soybeans, rice, corn
4. Alternative energy sources: hybrid cars, solar and wind and water systems, biofuels, thermal
The important characteristics of commodities are that they offer tangible products and services that are needed by almost everyone. With the dollar reaching its lowest levels relative to currencies of other countries, investors want hard assets for their money, not paper money that may quickly lose their entire value. The assets are on the demand side of the ledger, and as supplies diminish, as they certainly are, they become more important and costly. Natural resources are tied to population density and the immediate needs of all individuals. Commodities in general appear to be in a super-commodity cycle that is about ready to explode. Many of the stocks that represent these commodities are bound to show price increases that today are unbelievable. The upswing will not be straight up, as they are subject to environmental, social, and political events, but long-term investors need to consider the potentials as well as the risks and possibly add some of these to their portfolios. Capital appreciation is likely to be high.