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