An Easy Mistake Made by Dividend Investors

Dividend investing can seem deceptively easy. If you want to generate, say, a 5% yield from your dividend portfolio, you only need to buy a group of stocks that provide a weighted average yield of 5%. Then just sit back and watch the money roll in.

Or so the thinking goes.

And, yes, you may indeed receive your desired dividend income if you follow this strategy, but constructing a portfolio in this manner without attention to valuation could end up costing you in the longer-term.

Consider two investors that each invested $100,000 in dividend portfolios with 5% starting yields. Over the course of ten years each investor realizes annual dividend growth of 3%. The first investor (blue line) bought stocks that were considerably overvalued and subsequently lost 20% in capital value in year one; alternatively, the other (red line) invested in stocks that were undervalued and gained 20% in capital value in year one.

After the year one corrections to fair value, both portfolios grow at 8% per year through year 10.

At the end of ten years, both portfolios generated the same amount of dividend income ($57,319), but their ending capital values are nearly $80,000 apart ($159,920 vs. $239,880). It's hard to imagine that the two investors would feel equally good about their performance even though they realized equal dividend income over the ten year period.

To further my point, if both investors decided to liquidate their dividend portfolios in year 10 and invested their capital in bonds with 5% coupons, the first investor would receive annual payments of $7,996 while the second investor would receive $11,994 per year until maturity.

This is an admittedly simple example, but it illustrates an important point about the hidden costs of not paying attention to valuation in income investing. Ultimately, capital growth matters.

Valuation avoidance (Photobucket)

Whether you use relative valuation methods (i.e. comparing P/E ratios, etc.) or absolute valuation methods (i.e. dividend discount models, discounted cash flow models, etc.), the important thing is to fully consider the price you're paying and the value you're getting from each investment. Get to know the businesses you'd like to invest in, understand what drives their performance, and don't rely on a single metric -- in this case, dividend yield -- to guide your buying decisions.

Good dividend investing eschews complexity, but that doesn't mean it's supposed to be easy.

Good reads this week

• Warren Buffett's 1975 letter to Katharine Graham about pensions and investing
• "How I'm Betting Against Neil Woodford" - Monevator
• "Outcome Bias and the Interpreter" - Credit Suisse (Michael Mauboussin & Dan Callahan, CFA)
• The Dividend Compass Cup continues at Total Return Investor

Quote of the week

A mildly non-conventional investment approach, emphasizing a business approach to security selection, gives some opportunity for long-term results slightly above average without corresponding increase in investment risk. - Warren Buffett

If you think this article may be of interest to a friend or colleague, feel free to forward it, and let me know if you have any questions about topics discussed. 

Best,

Todd 
@toddwenning

Neil Woodford is Going His Own Way

There was big news today in the income investing world as UK fund manager Neil Woodford announced he will leave Invesco Perpetual in 2014, after managing money there for 25 years. 

When I first saw the headline, I thought he might be pulling a Peter Lynch and retiring at the top, but no, he's just setting up his own firm. 

Though Woodford is less well known in the US, his track record at Invesco Perpetual is top-shelf by any standard and he's the industry's best-known (and perhaps best overall) income investor. 

As such, I'm looking forward to hearing more from him and learning more about his investing approach once he's established the new firm. 

For now, I've put together a list of some of my favorite Neil Woodford quotes:

• I look to invest in businesses that can provide sustainable long-term dividend growth. If I can invest in a businesses when its growth potential is not reflected in the valuation of its shares, this not only reduces the risk of losing money, it increases the upside opportunity.
• In the short-term, share prices are buffeted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment.
• The economic outlook is tough and will stay so for some time. But the current yield available on selected stocks, combined with dividend growth, can provide decent returns. If you can invest at very low valuations, returns could be even more meaningful. Equity markets offer an attractive yield for investors looking for a better return on capital. This return is not risk free, but a selective and patient approach helps to mitigate risks.
• I am...absolutely convinced that, in the long-term, valuation and fundamentals of a company are the only things that matter and, like gravity, those things will reassert themselves.
• We do not focus on short-term performance issues; we focus on the valuation of fundamentals. Our disciplined approach guides us, we believe, to the best opportunities in the stock market and we are very patient investors. We expect our performance to improve when the market begins again to focus, as it inevitably will, on valuation.
• I am not sure that I have ever really identified a catalyst that has changed anything...the catalyst that I focus on most of all is valuation; valuation is the only catalyst that I really trust.
• The biggest challenge for me, I suppose, is holding my nerve...But I’m afraid you are condemned by your process and what you believe in, and you have to stick to those as a fund manager or you’ve got nothing to hold on to. We believe in what we are doing. I believe what I’m doing,
• When we communicate with our investors, what we’re saying is don’t measure us on the basis of 6 months or a year. Look at us over a 3 to 5 year period. And if we can’t deliver those absolute positive returns, then vote with your feet.

Best,

Todd 
@toddwenning


----- Sources:

http://www.telegraph.co.uk/finance/personalfinance/investing/7995201/Neil-Woodford-be-patient-and-selective.html

http://blogs.telegraph.co.uk/finance/ianmcowie/100008092/10-tips-for-investing-for-income-from-neil-woodford-and-others/

http://www.moneymarketing.co.uk/woodford-confronts-his-critics-the-full-interview/1028943.article

http://citywire.co.uk/money/woodford-to-citywire-i-know-i-must-keep-my-nerve/a360771

http://news.bbc.co.uk/2/shared/spl/hi/programmes/money_box/transcripts/money_box_special_24_july_10.pdf

Successful Investing is About Simplifying

The great architect Frank Lloyd Wright aimed for "the elimination of the insignificant" in his designs rather than try to dazzle the viewer with ornaments, extra rooms, and unnecessary complexity.

Clearly this didn't mean that his work was dull or uninspired.

Fallingwater by FLW. (Photo by K Wenning)

The ultimate aim of the investor should also be to simplify.

I'm not saying investing is simple -- far from it. But as we build experience, improve our skills, and perhaps have a little success, the temptation to make investing more complex increases, and the industry is more than happy to provide you with options to make it more complex than it needs to be.

As Vanguard founder Jack Bogle writes in Enough: "Financial institutions operate by a kind of reverse Occam's razor. They have a large incentive to favor the complex and costly over the simple and cheap, quite the opposite of what most investors need and ought to want."

From the industry's perspective, our strategy of focusing on income, buying good businesses at good prices, and monitoring our positions with the aim of holding for five-plus years might seem quaint, and perhaps even a little naive. We know different, of course, but then again we're not their target customers.

In our quest to become better investors, we should remember Wright's approach of eliminating the insignificant from our work. New research tools and investment vehicles can be great, but they must assist us in simplifying our processes rather than make them more complicated.

Best,

Todd
@toddwenning on Twitter

Better Buying Opportunities Coming for Dividend Investors

In 2005, I distinctly recall perusing the Barnes & Noble business section for a book on dividend investing, only to find just one book that specifically addressed the topic. (There are, um, quite a few more available today on Amazon.com.)

Things changed with the financial crisis, as we know. Interest rates plunged and dividend stocks rapidly became an attractive alternative for income-seeking investors. 

Indeed, the Google Trends chart for the search term “dividend stocks” illustrates the changes in sentiment from 2004 to present quite nicely:

Source: Google Trends

Naturally, the financial services industry responded to strong investor demand for dividends by launching dividend-themed ETFs, ETNs, and funds to attract assets. Some are more creative than others, but when there's a revenue-weighted dividend ETF (not kidding), you know folks are running out of ideas.

Fortunately, it seems we're past the "peak" for dividend valuations, investor interest appears to be turning elsewhere, and more long-term buying opportunities could thus present themselves.

"Non-dividend stocks have outperformed dividend stocks in the S&P 500 over a one year timeframe. Prior to this period, nonpayers had underperformed dividend stocks since late 2009."  - FactSet Dividend Quarterly, September 2013

Just this week, in fact, I started a position in Coca-Cola -- my first buy this year for the dividend sleeve of my portfolio -- and found it interesting that the stock was yielding over 3% for the first time since 2010. 

Though low interest rates may be around a little longer, the prospect of rising interest rates in the coming years should at least limit further multiple expansion for higher-yielding dividend stocks. In the event of a market pull-back and considering the robust dividend growth we've seen in the last three years, I would expect to see more quality 3% to 5% yields coming available. 

Stay focused and patient out there.

Best,

Todd
@toddwenning

Good reads this week

• "Living in a Low Return World" -- Abnormal Returns  
• "Buffett's Folly: The Downside of Compound Interest" -- Monevator
• "Dividend Compass Cup" -- Total Return Investor
• "What Ponds are You Fishing In?" -- Oddball Stocks

Quote of the Week

"My father was very sure about certain matters pertaining to the universe. To him, all good things -- trout as well as eternal salvation -- come by grace and grace comes by art and art does not come easy." -- Norman Maclean, "A River Runs Through It" 

One Way to Improve Your Investment Process

I sometimes think we are too much impressed by the clamor of daily events. Newspaper headlines and the television screens give us a short view...Yet it is the profound tendencies of history, and not the passing excitements, that will shape our future. —JFK

A few years ago, I was speaking with one of my favorite fund managers and asked him why he chose to set up shop in a small town, hundreds of miles from Wall Street. 

His answer was simple: "In order to focus." 

The perfect place to invest?

The more immersed you are in investing, the more distractions there are. It's just that simple. 

Great investors find a way to focus and tune out the distractions. For some, like the fund manager, that might mean living away from the hustle and bustle of major cities.

Before you put up the "for sale" sign...

Knowing how to separate what's important and what isn't partially comes with experience and going through a few market cycles, but investors at any level can dramatically improve their decision-making process by simply not investing with the news cycle.

A few weeks ago, Josh Brown (aka Reformed Broker) had a great post entitled "I Went to Cash Because (Please Check One)". It does a great job of showing that investors who sold their stocks based on passing story lines over the last few years have ended up being sorry. 

The news cycle can be intense at times -- in both up and down markets -- and it's easy to get caught up in it. The key thing to remember is to not make investing decisions based on the news topic du jour. Like the Chicago weather, just wait a few minutes and it'll change. 

What really matters

Alternatively, as JFK's quote suggests, it's the "profound tendencies of history" that really matter in the long-run. JFK was commenting about society and politics, of course, but I believe the principles also apply to investing and business.

Over time, individual companies, sectors, and markets will be shaped by things like competitive dynamics, investment, and innovation. It certainly isn't whether or not Republicans are disagreeing with Democrats at the moment. 

As such, you can dramatically improve your investment focus by paying more attention to factors that affect longer-term profitability. One thing's for sure -- these factors won't be found in the news cycle. 

Best,

Todd
@toddwenning