Investing for Capital Appreciation or Dividend Income?

investingI am very sure that every dividend investors would have received this question. While dividend investors can ignore responding to folks with trading philosophy, sometimes it does become difficult to argue with value investors. Value investors who in general are looking to invest below book value sometime have an argument that focusing on dividend is not that critical. Business should be applauded for reinvesting profits back into business to grow. In essence, either create additional value or continuously increase value for their shareholder. That is a good argument. However, the key here is “creating value for the shareholders”.

Each individual will look at this differently. For me, “creating value for shareholder” is how much I am getting back in return. In simplistic terms, what is in there for me? From purely business standpoint, typically, value creation means increasing value of its business (and hence increasing stock value). Managements use combination of funding sources (debt, equity, leverage, etc.) to continuously increase the value of its business.

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Opportunities for Technology Dividends

This article originally appeared on The DIV-Net, March 25, 2009.

Standard and Poor’s “S&P North American Technology Sector Index” (henceforth referred as Tech index) is widely used to benchmark the technology sector in North America. As of February 2008 the Tech index had a weightage of approximately 20% to 23% in overall S&P500 index.

The Tech index represents different sub sectors that include hardware (20 companies), internet (21 companies), multimedia networking (27 companies), semiconductors (43 companies), services (31 companies), and software (40 companies). This is a total to 182 companies in the Tech index. However, similar to any market capitalization based index, Tech index is also top heavy. The cumulative weightage for top 10 companies is approximately 64%, for top 20 companies it is approximately 79%, while top 30 companies it is approximately 86%. The table below shows top 30 companies including the annual per share dividends. There are 17 companies out of top 30 companies that pay quarterly dividends. continue reading rest of the article….

Potential Dividend Growth Opportunities

History shows that it is normal for corporations to change (increase, decrease, or suspend) the dividends paid to the common share holders. These changes take place irrespective of which stage of economic cycle we are in. In last one year, i.e. between March 2008 and February 2009, within S&P500 index, there were 205 corporations that increased their dividends, 63, have decreased their dividends, and 25 have suspended their dividends. I could be argued that all 205 may not have good quality sustainable dividends. However, this list is deep enough for mining potential gems. In general, a typically dividend growth investor will look for a corporation that has increase its dividend consistently for at least last 10 years. It is always good to wait for 10 years worth of dividend history. However, I would like to evaluate corporations that have started showing signs of dividend growth early on, and see how it stands in my analysis.

In this context, I have shortlisted nine corporations (from S&P500) that for the last five years have (1) consistently increased their dividends; and/or (2) demonstrated their inclination to consistently pay dividends. The attached table shows the dividends for last 5 years and corresponding growth in last five years. Note: Year 2003 growth is with respect to Year 2002. 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.


Dividend Portfolio – My Performance Matrices


I have identified my goal and formulated a plan for my dividend portfolio. When I am executing this plan, I need to know exactly how I am doing relative to the overall market. It also helps me evaluate how my strategy is performing. I use few different parameters to measure my portfolio performance.

Benchmark:

I use S&P500 based exchange traded fund, SPY, as a benchmark for my dividend portfolio. I consider the first trading day of the year as starting point, and last trading day of the year as end point. The percentage differential of SPY acts as my benchmark. I compare this value to the value of my portfolio. The performance of SPY ETF is marginally less than actual S&P500 index due to the expense ratio associated with ETF. The expense ratio of 0.10% is very small and I do not believe it will have any significant impact on my comparison. The goal would be to ensure (note: not target) that it is always better than this index ETF performance. Now I do not make any proactive efforts to make this happen. I make investments in good fundamentally strong dividend-based companies and hope that market takes care of the rest.

Cash flow:

This is the sum of all dividends received from all stocks in my dividend portfolio. I am still in the portfolio building and accumulation phase of my life. Therefore, all of the dividends are reinvested back into the same stock. My primary objective for dividend portfolio is to increase this cash flow and maintain sustainability. I target to continuously increase my cash flow by consistently making regular investments. My Year 2009 cash flow goals can be viewed here.

Yield-on-Cost (original investment):

YOC based on original investments is metric that determines the yield I am getting from my input capital. The basis for my yield is sum of all input capital (which could be single or multiple batches). Here, I do not add the dividends that are reinvested. This parameter gives me how much my original investments are compounding.

Yield-on-Cost (including dividend reinvestment):

As the parameters suggest, in this YOC, I include all the reinvested dividends. For this YOC, the cost basis is the sum of all original investments and dividends received. In this way, the YOC gives me a measure of dividend growth. This shows the effect of initial yield and the compound growth of that yield.

Annualized XIRR:

Typically, when we want to calculate our individual portfolio returns, the general practice is to use the percentage value based on differentials of present value of portfolio and original investments. This approach is good for calculating the absolute portfolio values at a given point in time. This method does not provide a time-weighted return for our investments. I make multiple numbers of small investments over period of time. Since I give different timeframes for each individual investment, I need to determine the time-weighted returns. This is also known as personal rate-of-return. It can be easily calculated by Microsoft Excel function XIRR. The way I calculate my XIRR is based on my input investments (-ve values) and output value at a given point in time (+ve values). Although the dividends are output from my portfolio, I do not use them because all of the dividends are reinvested back into the stocks. The final output value includes all these new stocks (or dividends).

Portfolio value:

This is the value of my portfolio at a given point in time. Here also, I do not have any control over my portfolio value. Controlling and/or targeting the value of my portfolio are outside the circle of my influence. However, what I can control is how and which particular investments I make. If my portfolio value is significantly different then market and is not sustainable, then it tells me something is not right with my portfolio management process.

I make investments on continual basis depending upon availability of funds and my watch list. However, I do a formal performance review on calendar year quarterly basis. In future posts, I will discuss (1) above performance parameters using an example; and (2) how I use asset allocation as a portfolio risk management.

Let me know your thoughts, comments, and viewpoint on my performance matrices.

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