Dividend Tree Potpourri – January 31, 2009


During the week, I read articles from fellow bloggers and participate in blog carnivals. Once a week I highlight some of the articles that I enjoyed reading. I have named this section as Dividend Tree Potpourri. Similar to a potpourri, this section is a collection of posts from fellow bloggers which will spread the constructive scent of differing viewpoints. continue reading rest of the article….

Analysis Parameters for Dividend Stocks


The objective of my dividend portfolio is to make investments that result in continuously increasing cash flow. My expectation is that the capital allocated to this portfolio will not be required for a long period of time (i.e. 12 years or more). This objective and methodology allows me to make investments in individual stocks and take higher risk relative to the market. Prior to year 2008, my stock selection process was primarily driven by trend analysis and quality of dividends. Determining fair value and risk factors were very much subjective and based on qualitative viewpoint. I now use little bit more quantitative process. The parameters I use in my evaluation are as follows:

Trend Analysis

The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends for past 10 years.

  • Revenue
  • EPS from continuing operation
  • Dividend per share
  • Cash flow from operations
  • Income from operations

Quality of Dividends

This section measure the dividend growth rate, duration of growth, consistency over a period of past ten years.

  • Dividend growth rate: This should be consistent with growth in earnings per share.
  • Duration of dividend growth: Dividends should have grown continuously for past 10 years.
  • 4 year rolling dividend growth rate for past ten years: It is preferred to be greater than 10%.
  • Payout factor: It should be less than 50%.
  • Dividend cash flow vs. income from MMA: Dividends should be more than income for 10 years of time period.

Fair Value Calculation

This sections determine the what price should I pay to buy a given stock

  • Net present value (NPV) price based on 20 year Discounted Cash Flow (DCF)
  • Average high yield price calculated based on past 10 years
  • Pricing based on past 10 year relative price-to-earnings ratio
  • Pricing based on price-to-earnings ratio of 12
  • Graham number

Risk Parameter Calculation (and what-if pricing)

I have recently added this in my stock evaluation process. Here, I use the corporations financial health to assign the risk factor or based on risk factor what should be pricing. This is calculated as:

[Price + Yield + Payout Factor + Gross Margin + Operating Margin + Financial Leverage] / 6

I am in process of calculating this risk parameter for all of my existing holdings. I will discuss this in more details in next week’s posts.

Qualitative Analysis

I make qualitative judgment of a given stock based on management’s action, roadmap, business environment, position in market, etc. This is a subjective observation.

Acknowledgment: The “4 year rolling dividend growth rate” and “dividend cash flow vs. MMA income” was inspired by methodology used by Dividends4life. These two parameters significantly enhance the quality of dividends from a given stock. My thanks to Dividends4life.


International Equities in Dividend Growth Portfolio

I have discussed about my investing approach with respect to commodity asset class and investment vehicles. International developed/emerging equities are another asset class which dividend investors should include in their portfolios. I have spent some time to read and understand the characteristics of this asset class. In this asset class, i.e. international developed/emerging equities, there are three significant differences when compared to North American domestic equities. These differences are:

  1. Frequency of Dividends – Majority of the domestic equities pay dividends four times a year. The frequency of dividends paid by international equities is less than domestic equity class. At most, these equities provide two dividends per year (and only one in some cases). The implication is it slows down the dividend compounding growth of investments.
  2. Tax Structure – Depending upon the country, the taxation structure is different for each country. In most cases, the tax is deducted at source i.e. at the time of dividend payment. This tax deducted at source can be accounted during US tax returns. Nevertheless, the dividend payment is reduced by that amount. This again slows down the compounded dividend growth.
  3. Currency fluctuations – This is another factor that affects the dividend payment. The dividend may appear to be varying over a period of time, but could be due to currency fluctuations. For true reflection of dividend policy, individual investors should look at the company’s annual reports or dividend information section on website.

 

In general, as with any other asset class, here also I found the usual suspects of investment vehicles such as mutual funds, closed end funds, exchange trade funds, and individual stocks. The fund fees range anywhere from 0.3% to 1.1% (more in case of some mutual funds). One of the common issues that I found with most of these funds is that they use ADR listed on US-based exchanges. To put it mildly, I find this very perplexing, intriguing, and disappointing. If these institutional funds with large resources use the ADRs instead of actual currency in the corporation’s native country, then why should I pay unnecessary fees? What benefit do I have to buy their funds? In addition, in most cases, these funds consists of a more than 60 companies, which range from good to moderate to bad to worse. Investment in these funds essentially means covering the full quality spectrum.

 

Some funds from Wisdom Tree’s ETF portfolio are exception to above observations. Many of Wisdom Tree’s ETFs actually hold equity in corporation’s native currency. However, my concern about fees and capturing full spectrum of quality of corporations still remains.

 

At the time of this writing, I have investments in PID and AOD. While PID is meeting my portfolio requirements, I am not too happy about AOD. When I had initiated my position in AOD, it was an international focused (with 65%+) closed end fund. It changed its allocation to domestic stocks (65%+) over the period of last four months in 2008.

 

If I have to invest in ADRs, then why not invest in individual companies. The three characteristics that I have listed above remain same whether it is fund based investment or individual ADRs. As I mentioned in my earlier post at Dividend Tree, it is not necessary to invest in many corporations for diversification. The diversification can be achieved with few good quality individual equities also. Since the capital allocation to dividend portfolios are for 10+ years, investors should be willing to take relatively higher risk. For my dividend portfolio and individual investor looking for international exposure, I have a shortlist of following international equities (which pay dividends) for further analysis:

  • Unilever PLC (UL) and/or Unilever NV (UN)
  • Cadbury PLC (CBY)
  • ABB Limited (ABB)
  • National Grid PLC (NGG)
  • Nestle (NSRGY)
  • Siemens AG (SI)
  • Vodaphone PLC (VOD)
  • BT Group PLC (BT)
  • CPFL Energia S.A. (CPL)
  • China Mobile Limited (CHL)
  • ICICI Bank Ltd. (IBN)

Individuals should perform further analysis (based on their risk profile) to evaluate how above equities fit into their dividend portfolios. Individual investor’s end goal should be to invest in at least five to six good quality international dividend growth equities.

 

Pfizer and Wyeth: A Marriage of Short Term Convenience

Pfizer (PFE) is cutting the dividend, primarily driven by their need to allocate cash for Wyeth (WYE) buyout.

The marriage between PFE and WYE is not a union of two love birds. It’s just a short term convenience driven by PFE’s need to soar the bottom line. In fact, I would send kudos to WYE management who has wrestled out good value for WYE shareholders. So why do I think it’s not a good union? continue reading rest of the article….

Expected Return Based Asset Allocation – A Dividend Portfolio Perspective


Let me open today’s post with a question. How do we decide what is an effective asset allocation for us?

As individual investors we all know that we need to maintain a diversified asset allocation in our portfolios. We are also aware of different types of asset class and investment vehicles. Unfortunately, for most of us individual investors (note: individual investors) that’s where we hit dead end on asset allocation discussions. We really do not know how to engineer a portfolio that has optimum asset allocation for our risk profile.

Theoretically, asset allocation is a risk management methodology driven by relationship between expected return and risk. Can we use this classical approach of asset allocation to dividend investing? It can be argued that the inclusion of dividends in ‘expected return’ captures the dividends, and hence, it can be applied. My viewpoint is, these asset allocation methodologies are driven by expected return on capital. We dividend investors know that in short (3 to 5 years) to intermediate (5 to 8 years) term the dividends have a small contribution to the total return. The significant contribution of dividends starts to accelerate after 10 to 12 years. In addition, the dividend investors would find that asset allocation becomes very challenging, particular with reference to foreign (developed and emerging) asset classes.

In this context, I looked at David Swensen’s work with Yale Endowment Fund (source). This is an institutional fund, therefore, may not have a direct bearing on individual investors. I am including it in this discussion to highlight how the fund’s asset allocation is managed by using ‘expected real return’ and ‘standard deviation of the returns’. The table below shows the different asset classes with expected real return and standard deviations.

In this table, we can see that every asset class has its own expected return and its corresponding standard deviation. In general, I was quite surprised by the single digit expected real return and higher percentage of standard deviations (in 20s). The expected real return excludes inflation, but still it appears to be quite different than the generally purported value of approximately 10% (domestic equity) and 10+% (foreign equity).

The interesting point in this asset allocation methodology is the use of concept of expected return. Keeping with this methodology, as a dividend investor, I have recently started doing following:

  • Looking at my asset allocation from the viewpoint of risk-to-dividend (referenced in Dividend Tree Holdings)
  • Use of ‘expected dividend return/growth’ instead of expected return (will discuss in future posts).

How do you decide what is a good asset allocation for you?
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