Dividend Growth Investor

The Behavior Gap

Thu, 24 Sep 2020 08:00:05 GMT

Your portfolio is like a bar of soap...the more you handle it the smaller it gets.

Fidelity Magellan (FMAGX) was one of the top performing mutual funds in the US between 1977 and 1990. It was managed by legendary investor Peter Lynch, who popularized the concept of investing in what you know. His fund generated an annualized return of 29% during his tenure at Fidelity Magellan.

This means that a $10,000 investment in the Fidelity Magellan at the beginning of 1977 would have been worth $291,782 by June 30, 1990. The same investment in S&P 500 would have been worth $57,524.

His team had calculated that the annualized average return generated by fund shareholders was only 7% during that time period. This means that a similar $10,000 investment would havebeen worth a little less than $25,000 by June 1990.

This is a very big gap between what the investment would have generated, and the actual returns generated by investors. I would refer to that gap as the behavior gap.

You'd think that having a super-star fund manager would have led investors to stick with him through the inevitable ups and downs, and invest for the long term. Of course, we know that today. But investors were not sure at the time.

Perhaps that’s because his investors were not the buy and hold type. They were chasing what is hot, and then selling at the first setback. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.

Perhaps they listened to economists, or perma-bear doom and gloomers, so they could not hold on to their equity fund. Perhaps they traded too much, because they thought they could buy low and sell high. Unfortunately, as a group, investors ended up buying high, selling low, and compounding their mistakes over several corrections.

This is a bad habit to have when you are investing your hard earned money. Noone knows if a stock is about to go up or down in the short-term, which is why it is pointless to even try. Market timing simply does not work, yet people keep jumping in and out of investments, and ultimately doing much worse than if they simple stayed put. Ultimately, it is time in the market, not timing the market that helps you take full advantage of the long-term power of compounding. That’s how you patiently compound dividend income and capital.

I see the same behavior with some dividend growth investors. Notably, they sell too soon at the first time of trouble.

They also sell too soon if the company works in their favor, but gets a little overvalued. In the long-run, I would expect a successful company to grow earnings, dividends and intrinsic value. The stock price of the business would fluctuate above and below that intrinsic value. Since no one can time the markets well enough to make it worthwhile, it is best to just hop on that train and ride for as long as possible.

If you sell when it is overvalued, you may be making an error. That’s because if the business compounds earnings, dividends and intrinsic value over time, you are missing out on all the future growth by selling.

I read academic research that found how trading too much is hazardous to your wealth.

I have studied my investment activity and the activity of other investors who publicly post their transactions. I have found that when individual investors sell stocks, the companies they replaced them with end up doing much worse than the companies they sold. In other words, thse investors on average ended up taking a perfectly good situation and making it worse.

I have found in my investing that selling has frequently been a mistake. I would have been better off just doing nothing. Hence, selling quality dividend growth stocks over a long investing career will most likely be a mistake.

All of this brings me to the very important point of this article.

As an investor, you need to focus on time in the market, not timing the market.

All you have to do it focus on things within your control, such as your savings rate, the strategy you choose to achieve your goals and your temperament. Nobody can time the market, which is why it is fruitless to even try to do it.

Hence, the goal is to diversify, buy quality over time, and patiently wait for the power of compounding to do the heavy lifting for you. Do not strive for perfection, and do not overtrade. When you trade too much, you increase investment costs in terms of commissions, fees and taxes. But even more importantly, you increase your behavioral costs, and ultimately may suffer a behavior gap. That gap is the difference between the return of an asset that a patient buy and hold investor would have achieved, versus the actual return generated by someone with an itchy finger.

Relevant Articles:

- Time in the market is your greatest ally in investing

- How to improve your investing over time

- Should you sell after yield drops below minimum yield requirement?

- Why would I not sell dividend stocks even after a 1000% gain?

What if Altria went to zero?

Tue, 22 Sep 2020 08:00:04 GMT

A few months ago I read an article where someone expressed their hope that tobacco giant Altria goes to zero.

It was a welcome way to look at some key principles of dividend investing, notably the fact that dividends represent a return of investment and a return on investment. It is also a good refresher on my risk management guidelines.

For example, if you bought a share of Altria today for $40/share, you can expect to earn an annual dividend of $3.44/share. This means that as long as the dividend stays constant, the investor receives 8.60% of their original investment back each year. At this rate, the stock will pay for itself with dividends alone within eleven or twelve years. Assuming that the business is still intact, and generating profits, you would have an ownership stake worth something as well. If history is any guide, Altria will likely continue to grow dividends for the foreseeable future, which could translate into high valuations over time. This will all be driven by slow but steady growth in earnings per share. All this growth would result in an even faster dividend payback.

In other words, dividends represent a return of investment and a return on investment in the case of Altria, because just by dividends alone an investor today would recover their purchase price within 11 - 12 years, if not quicker.

However, assuming the company’s business model continues going on uninterrupted, it is likely that the investor would have received dividends and have something of value as well. Assuming that the share price stays at $40 until September 2021, an investor today would generate a close to 8.60% return merely by collecting their distributions.

If Altria keeps growing, and earnings per share and dividends double within a decade, I could reasonably expect that the share price would double. Therefore, the total return would be very good for the patient investor who held through thick or thin. Those growing dividend payments would represent a growing portion of their returns over time. If market participants are less gloomy on Altria in a decade, and P/E expands from less than 10 today to 15 in 2030, that would be an added tailwind behind future stock appreciation.

However, if Altria continues stumbling on, it may do the unthinkable and cut dividends. While I believe that most of Altria's issues are self-inflicted wounds ( as discussed here), it is possible that I am not being objective. Sometimes, early success may make us blind to changes. This is why I always plan to sell after a dividend cut, and then reevaluate with a clear head.

The other notable fact is that dividend investing is almost free, because we do not employ expensive fund managers that charge a percentage of fees under management. We also do not pay money for commissions either. Most dividend investors are the worst clients for brokers, because they buy and hold, and seldom trade actively.

Imagine that you held Altria in a diversified portfolio of 100 individual companies, and the portfolio is equally weighted and worth $100,000 at its inception. If you paid a fund manager a 1% annual fee to manage that portfolio, you are essentially losing one Altria per year in management fees alone. But, if you paid someone to buy stocks for you 1%/year, they would earn that 40 cents on a $40 stock each year that you work with them. If the stock stays at $40/year, and you keep holding for 20 years, you would have paid them close to $8/share.

If that position went to zero, not all is lost in a taxable account. The share that cost $40 can be sold at zero, resulting in a $40 capital loss that can be offset against other gains or against income on the first $3,000 of losses. If you are in the 24% tax bracket, you will save $9.60 in taxes. This means that your loss is never 100%, which is a small consolation. If you managed to collect dividends net of taxes for a sufficient period of time to cover your cost, and sold for a $40 loss, the tax savings alone could have been the determining factor between a gain and a loss.

This is where you need to determine your risk management method. Some investors end up reinvesting dividends back into the same company, which works wonderfully if that company ends up delivering outstanding returns. It doesn't work as well if the company ends up failing.

Other investors take the dividends in cash, and re-deploy them elsewhere. This method works best if the investor deploys the cash into other companies, and the original dividend payer stumbles onto hard times. Redeploying dividends elsewhere doesn't work as well when the original dividend payer is a dividend dynamo, which Altria was between 1926 and 2015.

Relevant Articles:

- Analysis of Altria's Recent Deal Activity

- Dividend Payback from six quality dividend stocks

- Dividends Offer an Instant Rebate on Your Purchase Price

- Risk Management

Buffett on ignoring fluctuations and thinking like a business owner

Mon, 21 Sep 2020 08:00:13 GMT

One of my favorite Berkshire Hathaway letters to shareholders is the one from 2013. It left a very big impression on me, mostly because it discussed some important lessons on dealing with market fluctuations. The lessons were illustrated by two investments that Buffett had made.

The investments were in a farm in Nebraska and a New York property adjacent to NYU.

He made these investments at what he believed to be a low price. In the case of the farm, Buffett tried to estimate how much agricultural products like soybeans and corn can be produced. He looked at estimated costs, and calculated the effect on future productivity improvements. While he knew that there will be disappointing years, he did know that over time, things would be ok. As a result he held on to the farm. It cost $280,000 in 1986 and had an yield of about 10%. By 2013, the farm had increased five times in value, and tripled its earnings. In this deal, he seeked the expertise of his son Howard, who is a farmer.

The other property he invested in 1993 was the one close to NYU. It also had an unlevered yield of 10%, When analyzing the deal, Buffett looked for improvements such as replacing tenants that weren’t charged market rents with new ones as well as leasing vacant stores. He partnered with a couple experienced real estate investors, who knew how to manage the property and unlock value.

As a result of a couple of debt refinancing, expiring leases which were signed at higher rates, and better management of operations, annual distributions increased to 35% of the original equity investment. In addition, he also received several special distributions totaling more than 150% of the original investment. Annual distributions being compared to original cost remind me of the Yield on Cost indicator than many dividend growth investors use.

Buffett used these investments in order to illustrate several fundamentals of investing:

-You don’t need to be an expert in order to achieve satisfactory investment returns

-Focus on the future productivity of the asset you are considering.

-Think only of what the properties would produce and cared not at all about their daily valuations

-If you instead focus on the prospective price change of a contemplated purchase, you are speculating

-Forming macro opinions or listening to the macro or market predictions of others is a waste of time. What the economy, interest rates, or the stock market might do in the years immediately following is of no importance of making those investments.

There was a big difference between investing in businesses and investing in stocks however. Equities offer minute by minute prices. Yet, his farm or real estate do not produce quotes.

Warren Buffett is famous for saying :

‘‘After we buy a stock, consequently, we would not be distrurbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke (KO)?’’

Sometimes Mr Market offers a tremendous bargain and sometimes Mr Market offers a ridiculously high price for an asset. Most of the time, it pays to just ignore Mr Market, unless you want to take advantage of this moody fellow.

People who focus too much on stock price fluctuations, end up being influenced by the manic depressive Mr Market. They feel the urge to do something, which leads to many investors selling low and buying high.

Most of these investors would likely do better by sticking to private businesses and real estate, where they do not get a daily quote. This let’s them focus on the business, its fundamentals and ignore all the noise. For many folks, the instant liquidity that the stock market offers is more of a curse, than a blessing. Perhaps these folks would be better off buying and owning a private business. But if they were to invest in equities, they need to see themselves as partial owners of a business enterprise, and not view stocks as some sort of a lottery ticket. Perhaps that’s why Buffett has stated that you should not buy a business, unless you are willing to hold it for a decade, even if they closed the stock market for ten years.

Thinking like a business owner has a lot of advantages. Mostly, it lets you focus on the business, and ignore noise. Second, it helps you stay patient, when everyone around you is panicking. This was evident during the Global Financial Crisis, and was evident during the Covid-19 crash in 2020. Few investors can sit patiently, when their stocks are going down or even going up.

This is why I try to tell investors to focus on the dividend stream produced by the companies they own, and try to research to see if the payout is adequate and that earnings can grow over time. This lifehack of focusing on the stability of the dividend stream lets the investor avoid being scared away by share price fluctuations. If you are an investor in the accumulation phase, stock price declines should be viewed with excitement, because lower prices mean that future retirement income can be bought on sale.

If you are a retired investor, you should ignore price fluctuations. Instead, focus on the income from your investments.

Both groups should care about prices only when they have money to invest.

Relevant Articles:

- Dividend Investors Should Ignore Market Fluctuations

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- Dividend Investors: Stay The Course

- Dividend Investors Will Make Money Even if the Stock Market Closed for Ten Years

- Dividend Investors Should Ignore Price Fluctuations

Microsoft Hikes Dividends by 10%

Wed, 16 Sep 2020 10:00:04 GMT

Microsoft Corporation (MSFT) develops, licenses, and supports software, services, devices, and solutions worldwide.

The company just raised its quarterly dividend by 9.80% to 56 cents/share yesterday. Microsoft is a dividend achiever which has managed to increase annual dividends for 16 consecutive years.

Annual dividends increased from 64 cents/share in 2011 to $2.04/share in 2020. At the new rate, the forward dividend is $2.24/share.

Earnings per share have increased from $2.69/share in 2011 to $5.76/share in 2020. Microsoft is expected to generate $6.46/share in 2021 and $7.34/share in 2022.

Future growth would be driven by its cloud based platform Azure, as corporations move to the cloud. It would be driven from Office, as more customers move to use software as a service, rather than buy licenses. Linkedin could help growth too, as would Xbox. Windows is essentially a utility, on which a lot of other applications run.

Earnings per share growth has been aided by share buybacks. Microsoft reduced the number of shares outstanding from 8.593 billion in 2011 to 7.683 billion in 2020.

The dividend payout ratio has increased from 23% to 35% between 2011 and 2020.

The stock is not cheap today at 32.30 times forward earnings and a dividend yield of 1.10%.

If Microsoft stumbles over the next couple of years, I would be ready to take advantage of this opportunity at a much better entry valuation.

Relevant Articles:

- Three Quality Companies Raising Dividends and Returns

- Investing in Nasdaq 100 in 2000

- Record Dividend Payments in the US For A Decade

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