January 24, 2007 Letters to the Editor

Updated: March 31, 2007.

Dividend Growth Strategy

I received this from Atul.

I am enjoying your M* posts & this site, while learning a lot.

I'm interested in: How to implement a Dividend Growth Strategy for myself.

Do you provide services or any suggestions?

HERE IS MY RESPONSE

Thank you.

I do not provide financial services as such. I do not recommend specific investments. I am engaged in research. I investigate the S&P500 and a handful of other specific investments for the purpose of gaining insights. This site is where I report my findings.

Dividend Growth Strategies are at an early stage. I believe that a dividend investor will produce an income stream better than that of the S&P500 index simply because his stocks pay dividends. Many companies in the S&P500 pay little or no dividends.

Use the S&P500 as a baseline for comparison. Expect to do better.

I have recently looked into Investment Returns. This is the portion of the Total Return that is independent of stock prices.

My investigations reveal that we have overestimated the long-term return of stocks going forward. Looking backward, the long-term total return of stocks, after adjusting for inflation, has been around 6.5% to 6.7%. But this includes a small, but persistent, 0.7% Speculative Return. It extended over the last century. Looking forward, we cannot depend upon this 0.7%. In addition, it is not part of the income stream unless we liquidate some of our holdings.

I can only provide coarse confidence limits for these numbers. Excluding the bubble, I reported the Speculative Return at Year 10 in “Disturbing Numbers Follow On.” It ranged from (0.75)% per year to 0.98% per year when using averages and from 0.09% per year to 1.17% per year when using medians. Applying these numbers to 6.7%, the range of the Investment Return has been from 5.7% to 7.5% using averages and 5.5% to 6.6% using medians.

I recommend planning for an Investment Return ranging from 5.5% to 6.6% for stocks in general (i.e., the S&P500). I would use 6.0% for the most likely outcome.

These numbers do not tell us the full story. We need to make an additional adjustment for today’s prices. Stocks currently sell for about twice as much as they have historically. We need to make a downward adjustment to the initial dividend yield in the Gordon Model.

One way of doing this would be to cut the normal 4% dividend yield in half, down to 2%. This is close to today’s S&P500 dividend yield of 1.7%.

I prefer an alternative. I would balance the effect of today’s high prices with the implementation of a dividend strategy. Simply by using DVY’s 3% dividend yield as a floor, we can bring today’s Investment Return within 1% of the historical levels. With care, an actual implementation should recover the remaining 1%.

This simplifies our calculations. Simply use the 5.5% to 6.6% Investment Return for planning purposes with a possible downside limit at 1.0% less. Use 4.5% to 5.6% as an absolute worst case.

All of these approaches generate perpetual income streams. All of these percentages are in real dollars (that is, after adjusting for inflation). Add about 3% per year inflation to calculate nominal returns.

These numbers are much better than the 4% (plus inflation) for 30 years associated with traditional studies.

It is OK to expect better returns. There is a good chance that you get them. Just use the more conservative numbers for income that you need as opposed to income that you want.

I defer to others when it comes to specific investments.

Always pay careful attention to the rationale and whether it makes sense. You are responsible for your own decisions.

I believe that you can find quality advice on the Morningstar Income & Dividend Income discussion board.

For income oriented investors, I recommend Ben Stein and Phil DeMuth’s book “Yes, You Can Be a Successful Income Investor!” because I have confidence in their judgment. They make specific recommendations about securities which I know nothing about. For dividend oriented investors, I recommend Lowell Miller’s “The Best Single Investment.” For investors in general, I recommend David Dreman’s “Contrarian Investment Strategies: The Next Generation.”

I recommend that you pay special attention to Russ's (Sirschnitz) remarks about how he converted his portfolio to an income strategy. Patience pays handsomely.

A great deal of traditional research is misleading because it ignores price discipline.

Pay very close attention to prices. Selecting a quality investment and buying it are two distinct actions. Identify a list of worthwhile investments. Wait for attractive prices. Use limit orders. Allow investments to get away from you if they do not meet your price goals.

You can determine the reasonable range of prices easily. Look at a graph of prices over the last two or three years. Stocks usually revisit levels close to their recent highs and lows.

NOTE: The Investment Return = Initial Dividend Yield + Dividend Growth Rate (annualized)

Stability of Dividends

I received this from Rob Bennett of PassionSaving.com.

Here are two sentences from your article "Gentle Failure Mechanisms":

"There were more severe cuts prior to the 1950s. But those were at much higher payout ratios than we have experienced for decades."

Does it make sense to think of lower dividends as being generally more stable than higher dividends?

I see the case for buying stocks of companies that pay high dividends. I see high dividends as being preferable even if they are less stable (I presume that the lack of stability is not enough of a negative to counter the positive of a high dividend). Intuitively, though, I view relatively high dividends as being less stable than relatively low dividends. I'm not sure that I am right to see things that way, but that is the direction in which my thinking is pulled by my intuitive take on this.

HERE IS MY RESPONSE

Thank you.

The payout ratio is dividends divided by earnings. The dividend yield is the dividend amount per share divided by the price.

Dividends are more secure when the payout ratio is low. There are more earnings to support them. As a rule, however, dividends with payout ratios up to 60% are secure and, when earnings are stable enough, a payout ratio of 80% can be secure. This is the first step in identifying high dividend stocks.

Dividends are safest when backed by dependable earnings. Back when they were regulated, utilities could offer high payout ratios since public utility commissions guaranteed profits. Today’s unregulated utilities still offer higher than average dividends, but not as high as before. They are still close to being monopolies that satisfy a need.

The next step is to look at prices. All stock market sectors fall into disfavor at times. Their price to earnings ratios fall. Their dividend yields increase.

The third step is to look at the predictability of earnings. Cyclical companies get penalized. There is an opportunity if you can handle volatile earnings and its affect dividends.

The final step is to assess the quality of earnings. This involves a series of checks. Many people look at Value Line in their library. Others check out the details on the web.

One thing to look at is smoothed earnings. Find the annual report and learn how well earnings have behaved. Average over 8 to 10 years and over the last three years. Make sure that the latest three years of earnings (averaged) are higher than the average of the last ten years. If so, the company’s earnings are growing. Good. If not, look more carefully. The dividend may be in danger.

Another thing to consider is the company’s credit rating.

Size matters. As a rule, larger companies are better able to sustain earnings during hard times than smaller companies. Diversification is much more important with smaller companies.

Look for dividend related accounting gimmicks. It is very bad news when a company borrows to meet its dividend.

Beware of stock buybacks. Too often, buybacks are abusive. As a rule, if a company has a history if treating its shareholders well, as reflected in its dividend policy, stock buybacks are good. Management thinks that the current stock price is too low. But if a company does not have a shareholder friendly dividend policy or if the stock price is above bargain levels, look elsewhere.

An example of when a buyback makes sense is when a cyclical shareholder friendly company is at the peak of its earnings cycle. If prices are low and the dividend yield is high, a share buyback can be an attractive tax free alternative to a special dividend.

In terms of the market as a whole, a lower payout ratio translates directly into safer dividends.

In terms of individual companies, however, a low payout ratio often identifies an inferior choice. Management may be unsure about future earnings. Management may be using its money inefficiently.

A high payout ratio often accompanies quality. High quality companies generate enough earnings to fund their internal needs fully. They pay generous dividends as well.

An excessively high payout ratio, above 60% to 80% depending upon industry, signals danger.

REITS and Master Limited Partnerships have special tax and accounting features. They require special treatment. I recommend looking at what Phil DeMuth and Ben Stein have written in “Yes, You Can Be a Successful Income Investor!” In addition, I recommend visiting the Income and Dividend Investing discussion board at Morningstar.com.

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005