The Way of The Value Investor (Part I Dividends)

Personally, I recommend beginning your investment portfolio in a diversified, age appropriate mix of low cost index funds. Normally, this process would start in tax favored retirement accounts such as 401 (k), 403 (b), traditional IRAs, and Roth IRAs. Once you have that foundation in place, consider the way of the value investor. The definitive text on this subject is The Intelligent Investor by Benjamin Graham.

The value investor attempts to buy (and occasionally sell) stocks just as he would make any other purchase, the highest possible quality at the lowest possible price. Almost all products follow an S shaped price performance curve. Consider: You can purchase a car that can go 60 mph for $300. You can purchase a car that can go 100 mph for maybe $6,000 or $7,000. If you want to drive on the Interstate at 160 mph, be prepared to part with over $60,000. If you want a car that is capable of 200 mph, you will need more than $300,000. What is your top speed on that morning commute, 80 mph while passing a truck on the Interstate? How much did you pay for 350 hp under the hood? How often will you actually need to use that kind of power?

Always start with quality. Look for the “wide moat.” How difficult would it be for someone to start a business in competition with the stock under consideration? A wide moat is an economic advantage that is very difficult to overcome. Imagine building a new railroad to compete with the Union Pacific Railroad out in California. That is a wide moat. Coca Cola (KO) is an obvious example. They have the most valuable trade name on the planet. Dasani, Coca Cola’s bottled water, is a popular brand in India, because people trust their products. A wide moat is not limited to large companies. I once met a man who owned a small company that produces specialty products for use in deep oil wells. In his colorful Texas vernacular he informed me patents weren’t worth a damn. His goal is to produce the highest possible quality then sell for a price that is so low, no one will dare compete with his products.

Next, look for a righteous dividend. “Righteous” will vary from industry to industry and will depend on the size and age of the company. Be careful to compare apples to apples and oranges to oranges. Buy things that pay you to own them. Try to avoid wasting money on things that cost to own. This is one of the key principles to building wealth. Consider: A smart phone might cost $500 plus $100 a month. What do you really do with that thing? If you use it as an important tool in running your business, more power to you. If you use it to surf the web and update your facebook page while at work, consider a better way. Verizon (VZ) pays a 4.19% dividend and offers some possibility of future capital gains. At 4.19% without any capital gains a $500 initial purchase of VZ shares plus a $100 a month over ten years will amount to $15,620.58. Can you live with a less expensive phone? Can you invest the difference? Hopefully, dividends will be the number one source of your income in retirement. Studies have shown that over half of your total investment returns will come from dividends.

Yield, the return on your dividend, consists of two parts the price of a share of stock and the dividend per share. If a share of stock costs $50.00 and the dividend is $2.50 per share, the yield is equal to 5%. That money is paid out to you. Every quarter (usually) the company deposits an amount equal to the number of shares you own multiplied by the quarterly dividend into your brokerage account. That money belongs to you. You can take that money off the table if you need the income or you can chose to automatically reinvest that money in more shares of the same stock without any brokerage fees. This is called DRIP (Dividend Re Investment Program) investing. It is a simple potent way to put the power of compound interest to work for you.

There is another component to determining what constitutes a “righteous” dividend. Is it sustainable? If you are lucky enough to buy an undervalued stock paying, let’s say a 3% dividend, and it doubles in price; you are effectively receiving a 6% dividend. The first quarter of 2009 was a perfect opportunity for this kind of bargain hunting. However, bottom fishing is not without its risks. Sometimes that stock is undervalued for good reasons and that juicy dividend is not sustainable. Watch the cash flow. Dividends should not be consuming too much of a company’s profit. The dividend payout ratio is the amount of money distributed to the shareholders divided by total earnings. If a company paid out $1 Billion in dividends from total profits of $4 Billon, the payout ratio would be 25%. Various rules of thumb have been proposed to define a sustainable dividend. If the payout is over 60% you are in a danger zone. Such a stock might be a “value trap.” If you choose to buy such shares, understand the risk. Between 40% and 60% watch not only the number, but the direction of that number over time. If a dividend payout ratio is 50% and climbing that is not a good thing. If it is 50% and falling it is probably a better deal. Under 40% you are probably OK. Again, an acceptable number varies from industry to industry. Be sure to compare a potential investment to its peers.

A good place for the value investor to start his search would be with a list of Dividend Aristocrats. These stocks have increased their dividends every year for at least 25 consecutive years. Once a company makes it on to this list, it is going to try to remain on the list. Even for a company that is not a dividend aristocrat, cutting dividends is a sign of weakness that often results in bloodshed on executive row. These are the stocks you can ALMOST buy and forget. Sometimes they are called widow and orphan stocks. Dividend aristocrats are good candidates for your core equity holdings. Unfortunately nothing is perfect. GE was a dividend aristocrat until it wasn’t. I took a beat down on that one. Various advisors would also include regulated utilities, consumer staples, and other “wide moat” companies as possible candidates for your core equity holdings.