Saturday, April 21, 2012

Ultra High Yield = Ultra High Risk

The first rule of dividend investing (or at least it should be the first rule) is: If the yield is too good to be true, it probably is.

In an article I wrote last May, I looked into the highest-yielding stocks on the UK FTSE All-Share and found that four names had trailing dividend yields more than twice the FTSE A/S then-average of 3.3%: Cable & Wireless Communications (14.1% yield), Man Group (11.1%), Cable & Wireless Worldwide (8.87%) and Thomas Cook (6.92%).

These ultra-high yields were either implying the market's anticipation of a dividend cut or that the market was missing something really important about the company's prospects. The market is actually a really good predictor of forthcoming dividend cuts (the share price falls and drives the yield upward to unrealistic levels), so I cautioned dividend investors to stay away from those four ultra-high yielders unless they had a really compelling reason to think the market was wrong.

Since that article was published, Man GroupC&W Worldwide and Thomas Cook have each announced changes to their dividend policy, and just this week insiders at Cable & Wireless Communications said the company was considering a dividend cut in the coming year.

By no means am I taking a victory lap -- I never like to see a dividend cut since someone somewhere is depending on it to supplement their income -- but I wanted to reinforce the principle that an ultra-high dividend yield usually means the dividend is at risk.

This is particularly true in a bull market -- if the company was performing well, the market should bid up the share price and drive down the yield closer to the market average. When that doesn't happen, it's time to get suspicious.

Know when to walk away

If you're unsure if a yield is too high, try comparing it to the market average yield. In the U.S., my rule-of-thumb is to be wary of any yield 2.5x or higher than the S&P 500 average; in the U.K., any stock yielding more than 2x the FTSE All-Share average should be approached with caution. For example, the current average S&P 500 yield is 2%, so any U.S. stock yielding more than 5% today should raise the yellow flag.

Rather than rely too much on heuristics, though, let's dig a little deeper into why ultra-high yields are dangerous...

The equation for expected long-term returns from equities is = starting dividend yield + dividend growth rate +/- change in P/E (sometimes called re-rating).

So if you buy a stock with an initial yield of 3%, expect the payout to grow at 7% annualized, and expect no change in the P/E, you can reasonably estimate that your long-term return from the investment will be 10%.

To show how this relationship holds up, consider the return components of the S&P 500 between 1996 and 2011:

Source: Aswath Damodaran data; rates are annualized.

Eerily spot on, huh?

Great, but what does this mean? 

Keeping in mind the expected return equation of "dividend yield + dividend growth +/- PE change", if the current market is yielding 3% and average long-term market dividend growth rate is 5% (the S&P 500 annualized growth rate from 1960-2011) -- and assuming no re-rating -- the market's expected long-term return is 8%. 

If the stock you're researching in that same market has a yield of 14%, then, you need to be able to answer the variables for dividend growth and re-rating and why your expected return should be 600 basis points above the expected market return. 

There's probably a good reason for the discrepancy that can be explained through further research into the business. The odds are pretty strong that such a wide discrepancy  will revert to the market average somehow -- and it's likely to come from a negative dividend growth rate. A meaningful decrease in the P/E ratio is unlikely because a stock trading with a 14% yield probably trades with a single-digit P/E to start with. So again, we're left with a negative outlook on the dividend growth rate.

On the other hand, if you come across a stock yielding 5% in a 3% market, that's not quite as worrisome. It's possible, for example, that the long-term dividend growth rate will be 5% and -- assuming no re-rating -- the expected long term return will be 10%. It's much easier to find a stock that might be slightly underestimated by the market (in this case 100 basis points) than one that's being underestimated by 600 basis points.

Bottom line

It's natural for income-minded investors to get interested in high-yielding stocks, but it's important not to get greedy. The investor's thinking is normally something like "Well, if the company can even maintain that 8% or 10% payout for a few years, it'll be a nice win for me." The market, however, rarely gives away such easy returns and that 8% or 10% yield is probably telling you that the market doesn't think the dividend is sustainable. 

All this is to say...never forget rule #1 of dividend investing -- if a yield is too high to be true, it probably is.

Essential weekend reading:

Have a great weekend!



Sunday, April 15, 2012

How to Identify Dividend Prodigal Sons

Dividend Aristocrats...Dividend Achievers...Dividend Champions. We all know what type of companies are on those lists -- companies that have raised their dividends each year without fail for decades. There's certainly a lot to be said for those companies as they've obviously been doing something right and they almost assuredly have solid competitive advantages. In short, they're a passive dividend investor's dream...when they can be purchased for the right price.

The problem is that investor assets have flooded into dividend-focused ETFs that own these type of stocks. For instance, the SPDR S&P US Dividend Aristocrats ETF raised almost $100m days after it Europe.

As a result of this heightened investor interest in dividend-paying stocks with impeccable track records, the cream-of-the crop stocks may not be great buys right now. Instead, if you're seeking dividend-paying stocks that have a better chance of being undervalued right now, you should also consider looking into dividend-paying stocks that I'll call "prodigal sons". These are stocks that once had sterling dividend track records but fell from grace during the financial crisis by cutting their payouts and are now in the process of rebuilding their dividend reputation.

Hundreds of companies cut their payouts during the financial crisis, but not all of them cut for the same reasons. Some were forced to by regulators (big banks), some levered up and made silly acquisitions at the wrong time, and some simply got caught paying out more than they could afford. The fact that they cut their payouts shouldn't be forgotten, but they shouldn't be written off completely, either. Some of them may be back on the road to redemption.

But how do we begin to separate the Prodigal Sons from the repeat offenders?

First, determine why the company cut its dividend during the financial crisis. Take a look at its financial statements in 2008 and 2009 and read the press release and management comments surrounding the dividend cut announcement. Did the company have the financial resources to continue paying and opportunistically seized the opportunity to reset its payout to a less burdensome level? Did it make some big investments at the wrong time that -- in hindsight -- put the company in a tough spot going into the recession? In some cases, companies should be let off the hook a bit for making the right investments at the wrong time.

Who was running the company when the cuts were announced? Is it the same team today? If it's the same team, look to see if they've learned their lesson -- look for cost cuts, an improved balance sheet, a more focused growth strategy, better returns on capital and equity, and renewed dividend hikes since the nadir. If the team has changed, what is their strategy and how does the dividend fit into it?

Has the company explicitly addressed the future of its dividend? If the company has realigned its dividend policy to be more sustainable (a lower payout ratio/higher cover), that's a positive sign. A company that's hiked its dividend each year since the cut is another encouraging sign. Look for management's comments on the dividend in conference call transcripts and in annual reports. Companies often address their priorities for free cash flow in conference calls or investor presentations -- is the dividend one of the top priorities?

What was the company's dividend track record prior to the cut? A company that increased its payout for 15 years prior to the cut, for instance, likely means that the dividend is part of the corporate culture and management might be eager to regain its reputation as a steady payer.

All this is to say that some of the best longer-term dividend ideas right now might be found in the group of Prodigal Sons. They should be approached with caution and they'll take more research effort, but the payoffs may be worth it.



Saturday, April 14, 2012

Don’t Play the Loser’s Game

In a 1975 article in The Financial Analysts Journal entitled “The Loser’s Game”, Charles D. Ellis wrote:

Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages.

Ellis ultimately contended that the influx of smart and motivated people into the industry led to money management becoming a “loser’s game” -- a game in which you'd be crazy to compete and one that you should perhaps consider surrendering to (i.e. buy an index fund). 

Interestingly, legendary value investor Benjamin Graham voiced a similar opinion in a 1976 interview that was moderated by none other than Ellis. In the interview, Graham lamented that "in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive (research) efforts will generate sufficiently superior selections to justify their cost."

Unfortunately, the rise of the institutional investor has continued unabated in the four decades since Ellis’s article. Today, institutional investors (hedge funds, mutual funds, endowments, etc.) own about 70% of the market -- about twice as much as in 1975. 

*Source: Wall St. Journal

Time to throw in the towel?

If anything, then, Ellis’s thesis that money management is a loser’s game is even more disconcerting to investors today. Nevertheless, the quest for beating the market remains a popular one. A quick search for the phrase “beat the market” on Amazon, for example, turned up 236 books with the phrase in the title, so the quest to beat the market is indeed alive and well.

However, with legions of smart hedge fund and mutual fund managers dominating the market, it’s completely reasonable for investors to conclude that the odds are stacked against them and simply buy an index fund.

But allow me to alter the premise for a moment. Should the individual investor even care about beating the market? In other words, does it have to be an "A or B" situation (try to beat the market or surrender to it)?

Institutional investors don't have much of a choice in whether or not they benchmark performance against the market as it's their primary means of marketing and attracting assets; however, for the individual investor, there are no such obligations.

Indeed, obsessing over short-term relative performance to the market will only lead the individual investor to make more trading decisions, which means higher trading costs and the potential for more mistakes. Instead, investors should think about beating the market only as an afterthought and only over longer periods of time (at least rolling five year periods). 

Out of sight, out of mind.

If you're like me, when you make an investment you don't care so much how your investment is doing relative to the market -- you only care that the investment goes up. If the market goes down 30%, for instance, it's no consolation that my stock is "only" down 15%. As the saying goes, you can't spend relative performance. 

Rather than setting your investing goals against the market, a far healthier approach might be setting a measurable, realistic, and absolute objective for yourself, such as:
  • Avoid permanent losses by demanding at least a 15% margin-of-safety on all investments with a goal of profitably closing at least 75% of all positions.
  • Produce high levels of recurring income by purchasing undervalued dividend-paying stocks with a goal of realizing a 3% initial yield and 7% annualized dividend growth.
  • Aim to own some of the market's best-performing stocks over the next decade by making equal-sized small bets on a wide number of small companies that have at least 15% insider ownership and double-digit revenue and earnings growth rates over the last three years.
These are just examples, but whatever your objective may be, I believe that you'll not only stand a better chance at realizing satisfactory returns if you set yourself a customized objective, but that five, ten, fifteen years from now when you look back at your relative performance versus the market, you'll be quite pleased with the results. 

The sign of a sound investment strategy might just be one in which you can look back and see that the market had very little to do with your success. 

Play to your strengths

To give yourself the best chance at obtaining satisfactory long-term returns, Ellis offers a few excellent tips.

1. Be sure you are playing your own game.

The individual investor’s advantage is not in trading. The hedge funds, mutual funds, and professional traders of the world simply have better data, more advanced trading platforms, and more financial incentive to focus on the short-term. The weekend investor doesn’t stand a chance versus this type of firepower, so trading is a game where the odds are stacked against the individual investor.

David didn't slay Goliath by playing on Goliath’s game on the giant's terms, nor should you play the institutions' game on their terms. Staying patient, keeping a long-term mindset, and establishing an alternative strategy alters the playing field and improves your odds of success.

2. Keep it simple.

The less complicated your investment strategy, the better. As Ellis recommends, "Try to do a few things well." By focusing your efforts on one strategy -- whether it is based on dividends, small caps, deep value, etc -- and consistently sticking to it, you can more effectively tune out distractions and make better decisions. As a result, you'll keep trading costs down and give yourself the best opportunity to realize your return objectives. 

3. Concentrate on your defenses.

Ellis advocates improving your selling strategy because the market’s focus on buying makes it difficult to gain an edge on that side of the equation. It’s a fair point. To figure out how we might improve our selling strategy, let’s answer the question “What’s the market’s selling strategy?” 

The average mutual fund turnover ratio is near 100%, meaning that the average stock in the average fund is typically held for one year. With that in mind, we’re presented with two options -- hold our stocks for less than a year (and we know we’re unlikely to win that game) or hold them longer than a year. 

Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots 30% above your fair value, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.

4. Don’t take it personally.

According to Ellis, the market turned into a loser's game precisely because investors’ "efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem." Resist the temptation to try harder for better returns. In fact, do just the opposite. This doesn’t mean you should pick stocks at random and buy and hold forever. Do your homework, of course, but be deliberate and patient, too. Let the market go through its phases of euphoria and despair and stay your course. Don't try to force returns.

Trying to beat the market is a loser’s game if you make it your primary investment objective, so don’t play it. Instead, redefine the game. Establish your own objectives, stick to your strengths, and stay patient and when you look back at your returns five years from now, I think you'll like what you see. And if you beat the market, all the better.

What do you think? Please post your comments or criticisms below.



Additional sources: 

Sunday, April 8, 2012

5 Rules for Building a Dividend-Focused Portfolio

So you want to build a dividend-focused portfolio...

To borrow a phrase from Dickens, it may be the best of times and the worst of times to do so. You can still build a dividend portfolio with a respectable average yield today, but strong market performance in the first quarter considerably shrunk the pool of opportunities. Since yields and share price have an inverse relationship, suffice it to say there are slimmer pickin's now. With that said, here are five rules for building a dividend-focused portfolio in today's market, or any market for that matter.

1. Build patiently

When you've resolved to build a dividend-focused portfolio, it's natural to want to get fully invested right away and get your money working -- especially when cash and money markets pay you effectively nothing. Resist that temptation.

Remember, patience is the individual investor's greatest advantage over the market.

Unlike a mutual fund manager who may feel compelled to be fully invested at all times to keep up with peers or the market, or may be restricted by the fund's objectives, you have no such pressures or obligations to get fully invested straight away. Only pull the trigger on a new investment when the opportunity is right (see rule #2). If it takes six months or a year to get fully invested, that's better than going all-in on potentially over-valued stocks. A scatter-shot approach to portfolio construction may be effective when the market has been depressed (late 2008/early 2009), but when the markets have been on a run as they have, it's more important to be selective and deliberate.

2. Don't buy for yield alone

A stock's yield can be used as a value indicator, but yield alone tells us very little about a stock's value (think about banks' high yields pre-financial crisis and pre-dividend cuts). As such, investors should consider yield alongside other value indicators when making investment decisions.

Each investor has his or her own way of valuing a stock (DCF, DDM, comparing multiples, etc.), but whatever your preference it's important to estimate a fair value before buying a dividend-paying stock (and any stock for that matter). Repeatedly paying $1.20 for $1, of course, is a quick way to sub-par investment performance. Even if the overvalued stock is paying 3%, with a little patience you'll likely get a chance to buy it below its intrinsic value with a higher yield, to boot. Bottom line: always demand a margin-of-safety before investing -- even in a dividend-paying stock.

3. Stay diversified 

High yield stocks tend to cluster in a few sectors. Utilities and telecoms, for instance, tend to feature higher yields than technology and energy stocks, so they tend to carry more weight in yield-based portfolios than in the market portfolio. It's easy to fall into the trap of loading up on high-yielding stocks in just a few sectors in order to maximize yield.

That model can fall apart quickly, however, if one of those sectors falls on hard times (again, financials in 2008/09). Even if you need to sacrifice a little yield today by investing in some lower-yielding stocks from other sectors, don't be afraid to do so as long as those stocks meet your investment criteria and fit your portfolio objective (see rule #4).

4. Set a portfolio objective

Dividend investors tend to have one of two objectives -- maximize current income or generate a longer-term growing income stream. The former group prefers high-yield today at the expense of income growth potential; the latter willing to sacrifice a little jam today for more jam tomorrow. Both approaches have their merits -- a mix of both is fine, too -- but it's critical to define your objective to help you structure your portfolio to meet your needs. Most importantly, write down your objective, keep it next to your work station, and review it every time you make an investment decision.

Because you're in charge of your portfolio, you can tailor your portfolio weightings to meet your unique situation. Want more current yield? Increase your portfolio weight toward the higher-yielding shares. Want more income growth? Put more cash toward companies growing their payouts at double-digit annual rates.

By setting a portfolio objective (i.e. "Generate a current yield >25% above the market average and grow income three points above CPI inflation"), you'll be more likely to stay the course, make prudent investment choices, and improve your chances of satisfactory returns.

5. Keep track of your income

Most broker websites don't do a great job of tracking portfolio income growth -- normally income growth is lumped in with total returns. If you're building a dividend-focused portfolio, then, it's easy to lose track of your income performance if you rely on brokers to keep records for you. And the whole point of building a dividend-focused portfolio is watching the income flow in. You may need to build your own Excel spreadsheet or manually keep tabs on a notepad, but the important thing is to keep records so you can remain focused on your income. Keep track of quarterly and annual income received and review performance periodically.

Hope this was helpful. More to come.

Happy Easter!