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

How I Beat the Market Over the Past Five Years

I don't make a habit of checking my portfolio's performance, but it being a new year and all, I decided to log onto my U.S. broker's website and check on my performance as of the end of 2012.

Over the past 1, 3, and 5 year periods my mutual fund investments were just slightly ahead of the market average. I was okay with that, however, since I own mutual funds (and a few ETFs) primarily as an insurance policy on my stock-picking efforts (if I royally mess up, the thinking goes, at least I'll earn the market return elsewhere) and to fill in any gaps in my portfolio.

Fortunately, the performance of my brokerage (non-fund) holdings was pretty good:

As of Dec. 31, 2012; Personal rate of return via broker's website; S&P data from Reuters

Admittedly, the one year figure is nothing to write home about, but I'm more focused on the five-year returns, which I consider to be a better length of time for evaluating investment performance* as it greatly reduces the effects of chance in results.

As such, I thought this was a good opportunity to review what worked and didn't work for me over the past five years.

What worked

Keeping transaction costs to a minimum: Over the past five years, I made fifty transactions in this account -- most of which were buys. Transaction costs were well below 1%, leaving more money in my pocket and less in my broker's.

Regularly reinvesting dividends: In most cases, I automatically reinvested dividends back into the stocks that paid them. There's some debate about whether you should automatically or manually reinvest dividends, but automatic worked best for me. I might have been able to redirect dividends to better opportunities elsewhere in my portfolio, but I could have also misallocated the money or waited too long. Looking back at my reinvestment prices, I picked up some additional shares at really good prices during the financial crisis, Greece worries, etc. when I might not have otherwise.

Buying from forced sellers: Unsurprisingly, some of my best performing picks came during the financial crisis of late 2008 into 2009 -- among them, Philip Morris International, Home Depot, Kinetic Concepts, and AmTrust Financial. The pickings during that time were, in hindsight, incredible and I wish I had invested more aggressively. I don't think I did anything special during that period other than put money to work in quality names and let them take care of themselves.

That was a rare market, however, and it's not often that we can buy from forced sellers. The key, then, is to always have some cash ready to take advantage of those opportunities. Fortunately, I did have a good amount of cash available during the financial crisis, having sold a few big winners in mid-2008 such as Core Labs and Sun Hydraulics (I own SNHY again today).

Being opportunistic: While forced selling situations don't come around often, I took advantage of a number of opportunities where the market soured on specific names or sectors. In fact, I love it when the market gets down on a competitively advantaged company due to either a temporary setback or another reason outside the company's control.

For example, I picked up shares of Tradestation in August 2010 at a time when the market was down on brokers due to the low rate environment and depressed trading revenue. (Indeed, many broker share prices remain depressed today for the same reason.) However, TRAD had some special assets that the other brokers didn't -- an advanced trading platform that catered to active traders, as well as a deep database of derivatives pricing history. It also had a great balance sheet and was small enough to potentially be a nice bolt-on acquisition for a larger company. Fortunately, TRAD was acquired in 2011 to register a 60% gain in my portfolio.

Focusing on singles and doubles, not home runs: While it's true that a few big winners can make up for a lot of losers, taking flyers on speculative companies just doesn't fit with my investing temperament. If I tried to employ such a strategy, I would have probably made many more mistakes along the way, getting nervous if the investment went against me, etc. and realized more permanent losses of capital.

Instead, I focused on buying companies with substantial competitive advantages that had temporarily fallen out of favor. When the market corrects its mistake, the quality companies may generate a 50-100% return as opposed to being a multi-bagger as a speculative company might, but I also don't lose any sleep in the process.

Not being afraid to take gains: Two of my stocks were acquired at nice premiums over the past five years, but I also made it a practice to sell stocks that shot 15%+ beyond my fair value estimate. It's true that you shouldn't cut your winners and water your weeds, but it's also true that a paper gain is just that until it is sold and turned into cash. Don't be afraid to prune a little where necessary and put the cash to use elsewhere.

What didn't work

Before this spirals too far into becoming a self-congratulatory piece, I did make some significant mistakes along the way that I think diminished my five-year results.

I made some emotional decisions: I bought Home Depot around $24 in 2008 for the right reasons, but sold it for a 30% gain in 2010 after I'd had a bad experience shopping at Home Depot. Though Home Depot may have terrible customer service -- and it certainly does most of the time -- American homeowners don't have much choice when it comes to shopping for home improvement goods, as the scale advantages that HD and Lowes have keep competition at bay. Poor customer service doesn't matter all that much if there aren't many other places to take your business. Had I held on through today, I'd be sitting on at least a 160% gain. Stupid. Whatever I rolled those proceeds into hasn't performed nearly as well.

I didn't invest enough in my high conviction ideas: Great ideas don't come around often, and when they do, it's important to take advantage and invest more capital than you normally would in other stocks. Over the past five years, I missed some opportunities to do just that. While there's surely some hindsight bias there, there were few massive surprises in my portfolio -- my best ideas generally outperformed my good ideas -- and I should have invested more in my best ideas.

I bought some things for the wrong reasons: In early 2009, I was convinced that we were headed for rapid inflation, so I bought the iShares TIPS ETF. Trying to be clever with a macro-call here backfired. While I generated a ~10% return from that investment, I could have done better in just about any stock at the time given it was near the nadir of the bear market.

I also bought shares of Pfizer in 2008 primarily because it had a very high dividend yield and a long track record of making payouts. Unfortunately, the company cut its payout in January 2009 after it acquired Wyeth, quickly souring my investment thesis. Getting burned here did inspire me, however, to dig deeper into why companies cut their dividends and probably saved me from future mistakes. A small price to pay for a good lesson, I guess.

What matters now

Hopefully my results show that a) individual investors can, in fact, beat the market in the longer-term, b) that you don't need a complex algorithm or be a professional trader to do so, and c) that a conservative and patient approach can deliver great results.

That's said, what's done is done. The past is the past. Though I'm very pleased with how my portfolio performed over the past five years, I'm more focused on not repeating the same mistakes over the next five years. If the market teaches us anything it's that past performance is not indicative of future results, so I'm reminded not to get lazy or cocky, but rather to stay focused.

Hello 2013!

I hope everyone had a happy and relaxing holiday season. The Mrs., the hound, and I spent our holiday driving nearly 2,000 miles across seven states to visit friends and family in Virginia and Ohio.

It was close quarters in the rental car, for sure. :)

Backseat driver

Here's to a great start of 2013. As always, please post any comments or questions you might have in the comments section -- or better yet, on our Google + community page on dividend investing.

Best,

Todd
@toddwenning on Twitter

*On the importance of using five-year returns as a means of evaluating investment performance: Diamond Hill Investment Group

Why Tax Increases Could Lead to More Buybacks

(Note: Since this article was published, dividend tax rates were increased as expected, but in-line with long-term capital gains. This is a more positive outcome than the one described in the article where dividends and capital gains were taxed at different rates.)

It now seems certain that dividend tax increases are on the way starting in 2013.

The point of this post is not to argue the wisdom (or lack thereof) of a dividend tax increase from a fiscal standpoint, so I won't add to that discussion here.

Instead, I want to explore how tax rate changes could affect corporate distribution policies, especially if dividend tax rates end up being higher than long-term capital gains tax rates.

Even things up

Recall that in 2003, tax rates on qualified dividends were lowered to 15% and, more importantly, were brought in-line with long-term capital gains tax rates for the first time in many years.

Source: LMCM.com

The initial effect of the equalized tax rates, according to a paper by the National Bureau of Economic Research, was that "firms adjusted their distribution policy (specifically, dividends versus share repurchases) in a manner consistent with the altered tax incentives for individual investors."

Indeed, it stands to reason that another tax change in 2013 would similarly impact buyback and dividend policies.

Buybacks still surged

Despite the reforms that reduced the tax disadvantage of dividends, buyback activity has actually surged since the end of 2003 and has trumped dividend payouts 1.68-to-1 through 2011.

Source: Birinyi Associates and FRB Z.1.

We've previously discussed the reasons why buybacks can be more attractive to management teams, but investor preference for lower tax rates on capital gains cannot account for the boom in buyback activity since 2004 as tax rates have been equal over that time period.

That might change starting next year if no legislative effort is made to keep dividend and long-term capital gains taxes the same, as it would re-establish the tax disadvantage of dividends.

Source: Goldman Sachs

A tailwind for buybacks

Don't get me wrong -- I do not think that companies will stop paying dividends or stop increasing their payouts in a higher and unequal tax rate environment. Far from it.

It's entirely possible in such an environment, however, that relatively lower taxes on capital gains could add more fuel to buyback activity. If that's the case, dividend growth rates may be lower than what they might have been in an equal tax environment.

It's also possible that some younger companies that might have considered paying a small dividend in an equal tax environment may opt to focus on buybacks instead.

It will be interesting to see how it plays out, but unless Congress keeps tax rates on dividends and long-term capital gains the same (even if they are both increased) I expect to see buybacks continue to account for the bulk of total distributions.

Source: Birinyi Associates and FRB Z.1.

What do you think? Please share your thoughts below.

Thanks for reading!

Best,

Todd
@toddwenning on Twitter

Should We Do Away With Dividend Yield?

We may not like it, but buybacks are here to stay. Management teams prefer buybacks for a number of reasons, even though those reasons may not always be in the best interests of their shareholders.

So ingrained are buybacks in today's market that some have called for an end to the classic definition of dividend yield (dividends per share / share price) to be replaced with a "modified" or "total" yield that includes buybacks ( (dividends + buybacks per share) / share price). 

Indeed, Standard & Poors now includes a "dividend & buyback yield" column in its quarterly update on S&P 500 distributions. Ready or not, it's becoming a more commonly-used metric.

The game has changed...

The total yield approach is somewhat instructive as it helps explain a number of things that we've seen in the 30 years since Congress (via rule 10b-18) allowed companies to make greater use of buybacks. 

The major thing total yield helps explain is why dividend yields over the past 30 years remain well-off historical averages. The chart below shows the dividend yield of the S&P 500 between 1960 and 2011 and compares it with the total yield of all U.S. companies since 1985 when buybacks started becoming a meaningful way of returning shareholder cash. 

Source: S&P (via Aswath Damodaran) and Birinyi Associates and FRB Z.1. (via Michael Mauboussin) 

Recognizing there's only a slight difference between the 1960-2011 and 1985-2011 data, the major difference between the red and blue lines is buyback yield. Put in this perspective, the decline in dividend yield can be rationalized as a paradigm shift toward alternative ways of returning shareholder cash.

In fact, it shows that companies have become even more generous with distributions than in the past. 

(Don't break out the party hats just yet...)

The next chart provides more granularity for the total yield period and shows the rise of buybacks as the primary means of returning shareholder cash between 1985 and 2011.

Source: Birinyi Associates and FRB Z.1.  

As you can see from these two charts, buybacks have only recently become a truly driving force in the total yield equation. Until 2004, dividends had accounted for the majority of distributions -- even during the dotcom boom.

Predictably, the buyback trend since 2004 has largely followed the market. When the market has been good and companies feel flush, buybacks have increased, and vice versa. Curiously -- and sadly -- as Michael Mauboussin points out here, M&A activity has generally followed this path, as well:

Indeed, M&A and buybacks follow the economic cycle: Activity increases when the stock market is up and decreases when the market is down. This is the exact opposite pattern you’d expect if management’s primary goal is to build value.  (His emphasis)

One shining example of this principle in action has been Hewlett-Packard, which repurchased $36 billion of its stock between 2008 and 2011.

Its current market cap is $28 billion.

Long-term HPQ shareholders certainly don't feel any richer despite the $36 billion buybacks that should have been used to enhance shareholder value -- or in part distributed to shareholders as special cash dividends. Worse, most of the buybacks were fueled by borrowings and HPQ's debt/equity ratio increased from 13% in 2007 to 76% in the most recent quarter.

...but common sense remains common sense

There are companies that make prudent use of buybacks and no, I'm not completely opposed to them; however, general market data shows that, on average, buybacks are value destructive.

For this reason alone, I cannot accept the idea that we should do away with dividend yield and replace it with a total yield metric that includes buybacks. The two types of returning shareholder cash are simply not apples-to-apples. 

The total yield metric is certainly instructive, but given the differences between dividends and buybacks and the track record of companies destroying value using buybacks, it's critical to keep dividend yield and buyback yield separate.

Hope you're having a great weekend! Thanks for reading.

Best,

Todd