In last 10 or 15 years, the meaning of investing has drifted from being part owner of the business to mere buying a ticker stock. Even the concept of value investing, which at core means buying a good business at cheap, has drifted towards using volatility to value or price the stock. The relative basis has shifted from using quality of business to what is the price it is being traded. The fundamental concept of owning a good business has taken a back seat. The ease with which one can buy and sell stocks at a click of few mouse buttons, has distracted us from understanding the business. We have started to believe that buying and selling stocks online is investing.  In my viewpoint, this is what makes us clueless about the stock market. Business comes first and stock market comes later. That’s what is focus of the book I recently finished reading, Why Are We So Clueless about the Stock Market?

In this book Mariusz Skonieczny (the author) provides a very simple and short story of how to understand a business. It is written with the beginning investor in mind.

In first half of the book, the author uses a very simple example to lemonade stand to help explain financial statements and how a business can make individuals wealthy. It discusses various aspects like dividends, share repurchases, equity dilution, debt, reinvestment of earnings, and acquisitions. It helps you understand the fundamental aspect of business and its correlation with shareholders wealth creation.

The second half of the book, the story telling continues grows into how to value the business, differentiate competitive advantages, and scout for bargains. I particularly like the use of example (or analogy) of an elevator rising and descending from different floors to explain on how to value a business, discount the earnings/dividends. The author makes understanding the valuation process very intuitive.

Throughout his discussions, the author keeps us reminding why economic moats and competitive advantage is the key in understanding the business. Once the author provides you methodology for analysis, he uses this framework to apply in four case studies. He applies this framework to companies like Burlington Northern Santa Fe (BNI), Thor Industries (THO), Wells Fargo (WFC), and Moody’s (MCO).

The book touches upon all aspect that a beginner and season individuals can use as a reference for fundamental concepts of classical value investing. However, there are two areas that I believe this book is missing. First, how to understand management actions in new era where they focus is on short term as opposed to long term. All said and done, it’s the management that drives those numbers and how to access the quality of those at helm? Second, is the selection of companies for case studies. In my view using Moody to demonstrate wide moat or competitive advantage is debatable. On a personal note, I would prefer a tobacco company (choice to pick its product knowingly it could harm) over Moody (their ratings/research reports are misguided to borderline hidden agenda). As an owner of a business, I would not like my company to develop competitive advantage on such hidden agenda. In addition, all four case studies focused on positive value analysis. I would have like a couple of case studies on negative value analysis.

Overall, I would recommend this book as a must read for individuals looking to understand the basic concepts of value investing.  The simple story approach makes it easy to understand. It will serve as a very good starting point.

Disclosure: Mr. Mariusz Skonieczny provided me a complimentary copy for this book review. 

The purpose of my starting this blog spot is to share my journey in achieving my investment goals. In the process, I expect to continue my learning process by discussing contrasting views, and hopefully make smaller mistakes. Continuing with my motto of keeping things simple, this page describes my seven step investment process in a broader context. I foresee that over a period of time, this page will act as index page for my complete investment process.

Step 1: My Investment Goals

Here I am discussing and setting my investment target for dividend portfolio.

Step 2: My Investment Principles and Rules

In this post, I describe the rules I use to manage my dividend portfolio. This is a starting point because I do realize that these are intangible rules. In future, I will need to make tangible rules.

Step 3: My Risk Profile

I will discuss about my risk profile with reference to my investment time frame and capacity,

Step 4: My Investment Buckets – An Overview

This is an overview of my complete investment strategy and different investment buckets. I have defined my investment buckets based of my objectives. These are not an asset allocation for my investments.

Step 5: Dividend Portfolio Performance Matrices and Measuring Progress

Here I plan to present the performance measures I use in evaluating my dividend portfolio. I will discuss different matrices such as my benchmark, cash flow, YOC, annualized XIRR, portfolio value, and asset allocation.

Step 6 (a): Dividend Portfolio Building – Generate Watch List

I plan to discuss the parameters I use for stock screening and stock selection. I use qualitative and mild quantitative procedure. I generate watch list based on these screening and selection process.

Step 6 (b): Dividend Portfolio Building – Accumulation

Depending upon the available funds at a given point in time, I start accumulating the security. I can accumulate a new security or add to existing one.

Step 6 (c): Dividend Portfolio Building – Dividend Reinvestment

I believe dividend reinvestment is a lifeline of dividend-based portfolio. I will discuss its significance and how I execute it.

Step 7: My Exit Plan

When I started investing using a dividend-based approach, I had a very fixed view that I will be buy-and-hold investor because it is a long term process. But Year 2008 changed that view. It is prudent to remove an apple gone bad.

This provides a summary-level procedural framework for my investment process. Once I finish writing about each process step, it will provide detailed insight into my investment process for dividend portfolio.

A customary caveat: This is my investment process compatible to risk I am willing to take, the resources I have, and the amount of time I am willing to spend on managing it. I am here to share my journey and hopefully generate constructive critic from the readers (kudos is also welcome – we all need it!).

The third theme in the El-Erian’s market collision commentary is the money flow due to sovereign wealth funds. As per an article on Wikipedia, the top 20 sovereign wealth funds have a total of approximately 2.7 trillion dollars (and up to 3.3 trillions including all SWFs). A major portion of this money, if not all, is invested in safest and most liquid US government treasuries. This is a very large amount of capital and depending upon how it is deployed it can create disruption in world markets. As per author, investors need to understand and watch where this SWF money is flowing. In their quest for higher returns, it is likely that (1) the money will flow in emerging economies; and/or (2) money may be deployed in well know companies with strong footholds in the multiple markets. Unfortunately, this theme does not have a direct bearing on dividend focused investing. This again brings us to the same observation that revenue growth is most likely going to come from emerging markets. Being a long term dividend investors, we will need to figure out how to position ourselves to harvest this dividend for next 25 to 30 years.

To Summarize……

Reflecting back on all three major themes (including Part I and Part II), the message from this book is:

• Risk management is a must. In my dividend portfolio, the risk to dividend (or passive cash flow) is something that I must take into account. I must provide myself a mechanism to measure this risk (infrastructure!) in my dividend portfolio.

• I need to position myself and invest in emerging markets. All of the existing S&P500 dividend aristocrats started raising dividends in 1970s and rode at the back of US economic growth. Similarly, if I can sow dividend seeds in emerging markets now, I can possibly ride the growth story. The challenge is to find the right investment vehicles from a small individual investor perspective.

• The asset allocation model in this book is not oriented towards individual investors. But if I understand the fundamental basis on which it is build, I believe it will provide me good guideline to frame my individual portfolio.

I believe the book was worth a read for these three messages alone. Now the challenge for me is to see, if over a period of time my portfolio reflects these themes. We will see how it goes…

In today’s post, I will discuss how El-Erian’s emerging market theme affects the dividend investors (DIs). Some of the characteristics that we DIs look for in a company are as follows:

• Management’s sincere conviction that shareholders have stake in the business and earnings must be shared with them;
• Dividends are paid from operating earnings;
• Consistent growth in dividends can be maintained only if there is consistent growth in earnings; and
• Dividend focused investing is a long term (i.e. 25-30 years) preposition.

Looking at the dividend aristocrats, one can see that they have had a pretty decent ride for the last 30-40 years on the back of growth in US economy. Along with the US economy, these companies were consistently growing their revenues (and hence the earnings). Managements consistently shared this bounty with the share holders. Now today, in general, dividend aristocrats as a group are struggling to find new source of growth in revenue and earnings. Most of the dividend aristocrats (not all of the companies) are focusing to increase earnings from internal efficiencies or cost reduction initiatives, because they are hard pressed for growth in revenue. How long this can continue? Dividend investing is long term process. Therefore, I foresee that the pool of companies in dividend aristocrat will continue to decrease.

For DIs, this is where the El-Erian’s emerging markets theme comes into play. According to the author, emerging markets will be growing faster and provide higher contribution to earnings in next 30-40 years. In that case, doesn’t it make sense to invest in dividend-based companies in emerging markets? For a moment let us think that international and emerging markets as foreign markets.

One of the issues for DIs is that there is very little public information on companies in foreign markets. If companies do not have ADRs then it is difficult, if not impossible, to find the details of such companies. Additionally, the regulatory framework and governance may not be as advanced as developed world. Here I am comparing the basic minimum requirements and not a full-proof system.

Other way to look at this is US companies or multinationals who get most of their earnings from foreign markets. Such companies have operating history, dividend payment history, management’s performance, presence in US markets, etc. Recently, there was an article on The Div-Net by Dividend Growth Investor which discussed about top 10 companies in S&P500 index and their source of earnings. This article brings out the fact that top 10 companies by weightage in S&P500 index (with approximately 22% contribution to index) derive 44% of total financial contribution from foreign markets. It is likely that if we dig deeper, we will find more such companies and this 44% contribution may even surpass 50% cumulatively for all S&P500 index companies. While we do not have the same investment vehicles as used in El-Erian’s example, the Harvard Endowment Fund, we DIs surely have US-based companies and/or multinational companies. Investing in such companies provide a very good vehicle for investing in international and/or emerging markets.

For us DIs, this is a good fit to El-Erian’s theme of long-term earnings growth in emerging markets. Also it helps us build dividend portfolio using the existing US financial infrastructure.

In the last post, I presented El-Erian’s major themes that are significantly affecting the financial markets. Taking these themes as a framework, the author presents the asset allocation model that was used under his stewardship at Harvard Endowment Fund. The asset allocation model can be found here and here.

The discussion of the asset allocation in this book should be viewed as reflection of author’s understanding of the world of finance. It is the result of author’s belief and conviction on how financial markets are evolving. I do not interpret this as a guideline, framework, or a model that I should follow. With the investment vehicles in this model, how can I?

Among others, one of the key characteristics of dividend-based investing is:

• Management’s sincere conviction that shareholders have stake in the business and earnings must be shared with them;

Now let us compare this characteristics with one of El-Erian’s world colliding themes i.e. use of derivates and lack of financial infrastructure.

It is highly likely that dividend investors (DI) may not invest in funds, companies, and/or institutions that only do business in derivatives domain. Only because they do not have any background history associated with it. DI’s are looking for companies with dividend history and sincere managements. So in 2008 what went wrong with financial companies? Weren’t they good? Some of them had 20+ years of history and dividend growths. It can be argued that at hindsight, it is very easy to say considering what happened in 2008. Quite a few well-known financial institutions imploded due to these derivates. However, when we really put this in perspective, we can see that, in last few years these companies transitioned to greed and excessive use of derivates. Management did not know or understand how to access risk (lack of infrastructure!!). Perhaps, it also failed to communicate to shareholders that their business model has transitioned and they have highly leveraged balanced sheets. In my opinion, I believe management knew about this, but did not communicate due to their short term gains. I believe these folks are smart enough to understand these issues (did anyone make losses?) and were sincere to their own self. They had tight agreements in places to fill their own pockets irrespective of company performance. For example, Citibank CEO Chuck Prince’s famous words on front pages of Financial Times, “when the music stops it will be messy, but as long as it’s playing he’s on the dance floor….” What message was he trying to communicate? Companies such as JPM, USB, WFC, BBT, BAC, etc. also used derivates and got affected by this implosion. These companies are able to digest the loss (and not face extinction) because they managed it as per their risk-appetite. Isn’t that what we call management sincerity towards the company and its stakeholders? Where was risk management?

The author does not comment on whether to use or not use derivatives. All he is trying to bring out is derivatives and their risk management is not supported by existing financial infrastructure and governing mechanism.

In that case, I interpret this as it is acceptable for companies to use derivatives to an extent where risk of loss is understood and manageable. In other words, use it but do not over expose; one of the basic tenets of portfolio managements. So as a dividend investor, it would be acceptable to invest in somewhat riskier groups as long as I understand the downside and its implication on my overall portfolio.

Since the post is becoming long, I will discuss the theme of emerging markets in next post tomorrow.