Do you invest in Stocks or the Stock Market?

One could rephrase that question:

Do you see yourself as a stock owner or a company owner?

Or even:

Are you an investor or a speculator?

The reason I ask  is because, behaviourally, who you are as capital allocator will probably define your expectations of how that capital is expected to perform. 

My motivation in writing this is to help income investors define themselves accurately (and honestly), and by doing so manage their expectations accordingly.

Controversial as it may sound, I believe many people who call themselves ‘investors’ are in fact speculators. Most people who own stock – individual or index, have an innate expectation that it will increase in price. Why else would you buy it right? But implicit in the expectation is acceptance that all future values of your asset will be determined by other people –  known collectively as ‘the Market.’ As soon as you place the determinant of value in somebody else’s hands you’ve become a speculator. Why?  Because you are expecting someone or something to do something that will fulfil your expectations. You have stopped acting like the part owner of a business. Instead, you are now both participant and spectator in an event that assigns a value to that business each trading day. The process that assigns that daily value may be rational or it may be arbitrary. More likely, those buy/sell decisions that decide the stock’s price have little to do with the outlook of the business itself. The outlook for most established businesses do not change much in the short term, as Daniel Peris points out in his excellent book ‘The Strategic Dividend Investor’:

“The simple fact is that long-term distributable cash flows from large, publicly owned companies don’t vary much day to day.”

But the market’s valuation of those cash flows will.

 If you are truly an income investor – read company owner, rather than a stock owner you will not care how the Stock Market price tags your body of capital each day. What you will care about – and should only care about, is the amount of income that your capital produces each year. Because that is what you would care about if you owned the whole company. And if you owned the whole company its value would not reset each day in a public auction market. Warren Buffett, who prefers to buy whole companies puts it perfectly: 

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

Align yourself with this belief, it will serve you well. Remember, the value of the stock, and the value of the underlying business are not the same thing. The value of a business is its ability to produce growing income streams over time. If you, instead, place significance on the stock market’s daily reset – you are probably at heart a speculator. If an income investor is convinced the underlying business is sound, he will only be concerned with how that business is performing. Is it growing  earnings? Are management passing those increases along to stockholders in the form of dividend increases? And if the business is performing, he should not care how the stock is performing. But.. (and this is as close to a guarantee you will ever get in this business),if your invested capital produces a growing income stream, that capital will naturally be worth more over time. Or as Buffett succinctly puts it, “If a business does well, the stock eventually follows.” You just don’t know when. Neither should you care. But think about the logic of this for a second. If the EPS increases over time, eventually the stock has to increase in price. Otherwise, taken to its logical conclusion the annual dividend and the stock price will eventually reach parity, and all equities trade on a forward multiple greater than 1.

If you see yourself as a Stock Market Investor you will care what the stock market does. If you see yourself as company owner you will care what the underlying business does. Essentially, as an income investor you need that company  to execute on two things: 

1: Grow EPS over time.

2: Commitment from management to pass on the increase in earnings to stockholders in the form of a growing dividend.

It really is that simple. It just takes, discipline and time to let it work. In the meantime don’t get distracted by the market.


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Why US Dividend Income Investors have to go Global.

Home Bias

Most retail equity investors have what is known as a ‘Home Bias’. Simply put, they have an emotional preference for investing in companies that are listed in their home market, and are uncomfortable investing overseas.

This bias hurts all investors regardless of location, but US dividend income investors are especially compromised by staying local.  Since the NASDAQ’s inception in 1971, it would seem that the tech sector payout model has slowly ‘infected’ the broader US equity market.  Tech companies generally reinvest all earnings or distribute negligible amounts to company owners. Unfortunately, over the past 30 years this trend has slowly replicated across the broader US equity market.

Low Payout Ratio. Low Yield

From 1982 – 2011 the S&P 500 Payout Ratio fell from 50 to 30%.As of Q3 2011 it stood at 28%

From 1982 – 2011 Average Yield on the S&P 500 fell from 5.5 to 2%. As I write it is 1.92%

Rebounding from 2008/09, S&P 500 corporations recorded the biggest increase in profitability since 1900*.  The 12-month EPS for the index is $94.77, surpassing the peak of $91.47 set in 2007.  Despite record profits, investors in US corps are not seeing a lot of cash.  They are choosing either to hoard their cash,  pursue  M&A activity, or repurchase their own shares. Their return to profitability has not altered the long term trend of lower payouts and lower yields. The problem is structural, not fiscal. The changing demographic as baby boomers approach retirement may force management to refocus on distributing income, but the 30 year trend will be slow to reverse. Disney(DIS) boosted their dividend by 50% in 2011. Even with the hike, DIS current yield is still only 1.52%**. DIS’s payout ratio?  15.73%.** Wal-Mart(WMT) current yield =2.39%**. WMT payout ratio = 31%,** reflecting the S&P average.  Despite record profitability, large established US corporations with long histories of profitability,  are choosing to retain large portions of their earnings. Compare this to other markets:

Australia ***

ASX 2011 Payout ratio = 70%

ASX 2011 Average Yield  = 4%

UK ***

FTSE-100 2011 Payout ratio = 50%

FTSE-100 2011 Average Yield  = 3.85%

Most other major European markets are in line or exceed UK  levels.  Out of all the developed markets outside the US,  currently only Japan’s yields are lower.  For this reason alone US dividend income investors should consider reaching beyond their home bias for more meaningful yields. The US Bank Sector, formerly a major high yielding sector, has slashed or suspended dividends since 2008, narrowing US equity investor’s  yield search to just a few sectors:  Utilities, Telco’s, Consumer Staples, REITs,  and Pipelines.  To both diversify and increase their yield, US dividend income investors need to go global.

Go Global – What does that mean exactly?

Global in this context does not mean extra yield for added risk, or exposure to emerging markets.  It refers to large companies with long histories of profitability and dividend increases.  It means investing in companies whose management is still focused on redistributing growing income streams to company owners. I am referring to companies listed in the established, highly regulated markets of Europe and Asia.  Fortunately for US investors many of these global titans also have an ADR listing, with many reporting and paying dividends quarterly – in US dollars. Diversifying across market sectors globally also allows income investors to select best of breed stocks. Unlike Verizon(VZ) and AT&T(T), Spain’s Telefonica (TEF) and UK  Vodafone (VOD ) are global Telco’s, deriving their earnings  from a global geographic footprint.

TEF current yield = 10.63%**

VOD current yield = 5.14%**

Diversifying globally can also mean reducing risk non-conventionally. An example of this could be allocating capital to sectors with a higher degree of regulation than available in the US.  Consider the high yielding Canadian banks vs US Banks.  Canadian banks are regarded as the world’s safest ¹,  required no government bailout during the GFC, with 5 out of the 6 largest Canadian banks actually increasing their dividends through 2008/09.  Even with US financials return to profitability compare current yields of BAC (0.57%), JPM(2.68%), WFC(1.57%) to Canadian RY(4.0%),BNS(3.83%), BMO(4.68%).  Diversification across the US bank sector would not have saved a US income investor in 2008/09. Bank stocks got clobbered worldwide in the GFC, but many Australian, Canadian, and Asian banks continued to pay dividends through this period.  By 2011 the same 6 Canadian banks’ payouts had exceeded 2007 levels.  4 out of the six  are currently trading above their 2007 peaks. The US Bank sector has yet to recover fully.

As the above data would indicate the problem at US corporations is not one of profitability – historic or  current . The problems appears to be more one of the management culture embedded in boardrooms. By contrast, large global businesses headquartered in Europe/Asia remain focused on distributing profits to company owners. Home bias can be seen as a kind of misplaced loyalty. But that loyalty is not being rewarded by US corps. US income investors who reject income stock candidates because of a home bias are simply reducing their opportunities by saying no to quality income streams outside their home market. Consider Reckitt Benckiser(RB), the UK based consumer staples giant who derive roughly 50% of its sales outside its European home market. Proctor & Gamble(PG) also gets 50% of its sales outside its home market. What differentiates RB.L from PG?

PG – EPS 5 Yr. Growth Rate: 9.95% / Dividend 5 Year Growth Rate: 11.37%**

RB – EPS 5 Yr. Growth Rate: 18.89% / Dividend 5 Year Growth Rate: 24.14%**

All other things being equal, which one of the above would you choose? RB seems to be growing its EPS/dividend at roughly twice the rate of PG. Would you reject RB on the grounds it is ‘foreign’, even though you may use and trust it’s products every day. It just doesn’t make sense to be global as a consumer and parochial as an investor.

To sum up.

Dividend Income investors in US corporations are naturally disadvantaged by significantly lower payout ratios and current yields than those offered in other developed markets. Further, this phenomenon appears to be structural rather than cyclical.

Diversification across sectors globally can reduce risk and allows ‘best of breed’ selection.

Most overseas large caps have a US ADRs listing. In addition, for transparency,  most of the largest ADRs financials are reconciled to (GAAP), with the SEC as regulator of the Company’s disclosure to investors.

Note: Many countries allow dividends to be paid out free of withholding tax. This includes UK, Brazil, Hong Kong, Singapore, South Korea and India. In addition many Australian dividends are paid out as 100% franked i.e. free of withholding tax for overseas stockholders. This makes high yielding stocks from the above countries ideal for US retirement accounts.

*  Bloomberg

**  Reuters

*** Motley Fool.

¹  Global Finance – WORLD’S 50 SAFEST BANKS 2011

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The importance of Yield on Cost

Yield on cost  = annual dividend/purchase price

It may be a little ironic to talk about the importance of  yield on cost (YOC) in a blog called global dividend growth.

Should not the importance of YOC be a secondary consideration if long term dividend growth increases your income each year?

The answer is that YOC and dividend growth are both vital to long term performance.

How you start out has a large bearing on where you end up.  Let me explain with an example.

You buy two stocks on the same date:

Stock A has a YOC of 5%. Let us assume for the sake of illustration it has zero dividend growth indefinitely.

Stock B has a YOC of 3%, but increases the dividend  5% each year.

One would assume that the dividend grower would quickly catch up and surpass the zero growth stock.  Wrong.  It would actually take Stock B 11 years to match the payout of Stock A.  In addition, Stock A would have generated 25% more hard cold cash than Stock B in those 11 years.  If you add in modest growth of 2.5% for Stock A, that catch up period doubles to 22 years,  with Stock A generating 43% more cash.  I take on board that the above example is an over simplified theoretical example,  but you get the point.  Just 200 basis points of yield difference at the outset can have a huge impact on your long term results.  That is why you have to be patient and only buy when quality, dividend paying stocks are value priced.  I will post some of the parameters I use to determine when a security is value priced  in a future article.

Dividend growth in my opinion is the fundamental argument  for owning equity over debt.  More important than capital appreciation.  With bonds the coupon is fixed at issue.  Your income will not grow. That is why it is called Fixed Income.  But as important as growth in the dividend is, not overpaying to tap into that income stream is equally important to your long term success, as the above calculation illustrates.  That is the take away .

“It could be a great company but it may not necessarily be a good investment if your overpay for it at the outset.”  – Juliette John – Bissett  Dividend Income Fund

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Vale S.A.

Vale S.A. (VALE), the Brazil based miner announced today that it would boost its dividend by $6 billion.

Vale is the world’s largest miner of iron ore.  It has metals & mining interests in ferrous/base metals in 24 countries. It has a market cap of $125 billion, making it the second largest miner.

Mining companies  generally do not make very generous dividend payers,  so the Bloomberg story headline that Vale would boost its dividend in 2012 by US 6 billion caught my eye.

There is plenty for income investors to like about this stock:

Even before today’s announcement, Vale already had a generous current yield of 7.77%

5 year dividend growth = 8.12%

5yr EPS growth = 25.35%

The dividend is well covered.  Price to Free Cash Flow (TTM) = 48.37%

The company also has a modest debt.  Total Long Term Debt to Equity ratio = 31.42

All of the above financials make Vale attractive at these levels.

But the real ‘kickers’ that argue for adding Vale to an income portfolio include:

A very low payout ratio: 23%

The low payout,  despite future commodity price volatility allows Vale plenty of wiggle room to increase the dividend.  In fact, Vale have increased the dividend by an impressive 208%  since 2008 alone.  In addition, Vale periodically makes extraordinary dividend payments which it calls ISE’s (interest on shareholders equity).  Today’s 6 billion announcement exceeded the top end of market expectations.  It confirms that CEO Murilo Ferreira and his management team view returning cash to company owners as a high priority. “I have a huge discipline in capital allocation,” Ferreira boasts. “The most important thing for us is to provide the right return to our shareholders.”  The fact that he has backed these statements with hard cold cash bodes well for income investors.

2.  A  very low earning multiple. Trailing P/E (TTM)  = 5.71

Despite recent earnings growth, Vale is still very cheap,  currently trading at May 2010 levels.  The market’s low valuation simply does not reflect the momentum in earnings growth of 25.35% over the 5 years.

Buying a miner is a commodity play.  Despite being diversified into metals production, coal, fertilizers and logistics, future earnings are tied to metals prices.  I believe current commodity prices levels are structural, not cyclical, with demand only intensifying.  And it is not just about China. Vale is well positioned for the long term to grow their earnings.  Following today’s announcement, Vale is, in my opinion, the best value candidate in the metals/mining sector for income investors.  In short,  it is value priced,  has a great current yield – supported by earnings momentum and a low payout ratio.  In addition, management have indicated they are strongly committed to returning cash to shareholders.

Accumulate at this level.

NB: For retirement accounts there is the added bonus of no Brazilian withholding tax for dividend payments.

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DRIPS – Some thoughts.

DRIPS are a good tool for the passive retail investor to reinvest his income in a market neutral, disciplined way.

“If you take those dividends and run, you can only spend them once. Reinvest them, and they’ll work for you forever” is how someone praised DRIPs recently.

Dividends are reinvested quarterly,  free of commission – if your broker supports DRIPS . You can take advantage of compounding and dollar cost averaging at the same time.

They enable the retail income investor to be both passive and disciplined. Any tool that enables the individual investor to be structured and disciplined in his approach can only be viewed as positive.

I am neither passive nor retail.  I actively manage my dividend income. Here’s how:

Firstly, I view dividend income in the same way as I do new cash coming into the portfolio.  It’s all capital to be allocated – eventually. I should add that I trade infrequently,  so brokerage commissions using this approach v DRIPS are not a significant factor.

Secondly, on the list of income stocks that I monitor there are always some I would like to acquire when they are value priced. Periodically, the market overreacts to some short term event affecting one of the companies on this list and reprices one of these stocks attractively. Some examples:

BP(BP/) after the Gulf Oil spill in 2010  > – 50% of its value in 10 weeks

Tesco(TSCO.L)2012 after a profit warning  -18% in 2 days.

Proctor and Gamble(PG) Q1 earnings shortfall back in 2000  > – 50% of its value

McDonalds (MCD) 2002-2003 > – 50% of its value

As these examples show, periodically, quality names become available at attractive prices. To take advantage of these opportunities you not only have to be disciplined and patient,  you also have to have the cash.  There is nothing worse than seeing an opportunity and not being able to take advantage of it.  Sometimes the whole market is on sale as it was in 2008/09. You also have to able to pull the trigger on these opportunities when they arise, but that’s the subject of another article.

To conclude, I think the biggest drawback with the  passive  DRIP approach is that often you ‘buy’ current yield when it is not value priced.  DRIPing into McDonalds at today’s price of 100, with a P/E of  20 and current yield of 2.79% is not good value. Suddenly, last Thurs (12/01) Tesco’s the UK supermarket giant issued a profits warning.  A day later TSCO was 18% cheaper,  value priced with a P/E of 8.77 and the highest yield (4.65)in 20 years. Almost 200 basis points higher than MCD.

Basically, the approach I outlined not only allows me to consistently apply my buy criteria across all cash flows  in the portfolio, it also gives me extra cash to do it.

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Tesco – Highest Yield in 20 Years

As I write Tesco (TSCO.L) is trading at 313p. TSCO is the 4th largest retailer by sales volume  worldwide.  As a pure supermarket play it is the world’s largest. It has increased its dividend every year for the past 27yrs. With the market’s knee jerk reaction to disappointing UK Christmas sales the stock has lost > 18% of its market value from Wed 11 close.

TSCO’s profit warning represents a major buy opportunity.

Based on the 2011 payout of 14.46p this gives a current yield of 4.6% – 50% higher than the 5yr average of 2.99%. In fact this yield had not been available on TSCO in > 20 yrs.  TSCO has a payout ratio of 40%, so there is plenty of room for management to maintain/increase the dividend.  However, there is plenty of short term noise to ignore in your quest for quality dividend growth:

“Tesco had got too clever,” said Tim Green at Brewin Dolphin Holdings Plc in London,

“The company took its eye off the ball in the U.K.” – Shore Capital.

One bad Christmas season in the UK will not throw this global giant off course. They have economies of scale and size necessary to grow their brand. Fully one third of their sales are outside the UK, and that margin will increase. TSCO’s biggest shareholder Berkshire Hathaway raised their stake in Sept 2011, and have gone on record that they will buy more on price weakness.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”  – Warren Buffett

Accumulate at current prices.  Buy more on further weakness.

At 289p that would yield 5%, again based on 2011 payout.

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