I 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.

Let us consider that an individual is interested in harvesting profits based on buying undervalued stocks and cashing out after it is has reached its value. In this context, focusing solely on capital appreciation makes sense. Dividends can be considered as misnomer. Here the investor wants to focus on value itself, and given an opportunity, he/she will cash out that value. The objective is not to stick with the business or company. In this case, the buy-and-hold is based on certain criteria (i.e. value).

In my investment approach of buy-and-hold, I am also looking for management to continuously increase the value of its business (and hence my stocks value). I do not plan to cash out my profits (if any). In that context, I only have paper value creation. Unless I cash out, that increased value has no meaning for me. Who knows some nutjob manager will screw things and value is vanished. While I am waiting and continue to trust management, I need management to share some profits with me. That’s rational argument and prudent money management which shows to me company cares for its shareholders. I don’t want 100% profits. I want management to give back 25%-30% of profits as dividends.

Furthermore, if management is confident and company pays increasing dividends, it will be because of increased earnings (and hence P/E ratio). Indirectly, my stocks price valuation will also increase.

Let us take an example:
I start a corner store. I am owner (or shareholder). I want to grow my business. I agree for first few years (say three years) I need to put every penny back into growth. But after three years, I still want to continuously grow it. And I also want to make a decent above average living. It cannot be a one way street forever. I would take some percentage (say 20-30% profits) and remaining plow back into business. That’s what I call prudent management. I am getting something back to wait and continue to do my business.

Other options could be I keep plowing back for few years, say 5 or 6 years, and then sell it completely at higher value. Here my focus would be solely to go after increased value and cash out. I am not worried about whether my business stays to goes.

To summarize…
There has to be balance based on individual’s buy and hold objectives.

• Going after buy and hold approach solely for capital appreciation is a high risk strategy, even when buying at deep value. My view is, until you exit, this value creation has no meaning. And hence, one needs dividends to keep the total returns increasing year after year.
• Individuals wanting to use value investing for capital appreciation alone should always have an exit strategy (it cannot be buy and hold on continued basis). This paper value can vanish at any point in time.

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.

Technology Dividends

In general, the notable positive characteristics of tech titans are free cash flow, low level of debt (zero in many cases), higher gross margins, and cash on balance sheet. In this first group, the prominent one are that have paid consistent dividends. These include AT&T (T), International Business Machines (IBM), Verizon (VZ), Automatic Data Processing (ADP), and Paychex (PAYX). These companies have demonstrated sustainability of dividends and growth of dividends over a period of time. Keen observer will note that these companies are from services sector. All type of dividend investors know these companies very well.

In addition, the second group consists of notable tech titans that have paid or started paying small amount of dividends in last few years. These are Qualcomm (QCOM), Intel (INTC), Microsoft (MSFT), Hewlett and Packard (HPQ), Texas Instruments (TI), and Master Card (MA).

Contrarily, there are few other companies that have not had any favorable dividend policy. The argument for no dividends has been that they need cash for continued innovation and growth. In this third group, the prominent ones that have not paid dividends are Cisco (CSCO), Apple (AAPL), Google (GOOG), Oracle (ORCL), EMC Corp (EMC), eBay (EBAY), and Dell (DELL). Keen observer will note that majority are these companies are from hardware sector.

First group: These companies have demonstrated favorable dividend policy. If not all, then for most of the companies, pricing have come down to an attractive level.

Second group: These companies are the ones that have potential to become dividend champions (and may be dividend aristocrats). The most promising ones are Intel (INTC), Qualcomm (QCOM), and Master Card (MA).

• Intel: Its technological-driven market leadership is so high that it just does not have any significant competitor. It still continues its hunger for more product diversification such as netbooks, WIMAX, etc.
• Qualcomm: Its CDMA technology provides a stable royalty based cash flow, its chipset in CDMA and 3G domain is market leaders, attempting to diversify in netbooks with new platforms, and chipset competitors (Freescale, Infineon, TI, et. al.) falling apart. It would be prudent to say QCOM is soon becoming Google of wireless communication.
• Master Card: Its service based business model and world wide reach makes it a potential dividend investment.
• Microsoft: I did not include it because I am wary of its habit of squandering cash in meaningless acquisitions.

Third group: At the time of this writing, Oracle declared its first dividend. In addition, one other company to watch out for start of dividends is Cisco. It’s chief executive has shown some inclination to start paying dividends. Apple and Google have not shown any inclination to pay dividends. Dividend investors will have to wait and watch until companies in this group have shown some consistency and sustainability.

The first group and second group are where dividend opportunities exist for long term dividend investors.

Full Disclosure: At the time of this writing, long on INTC and PAYX.

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.

S&P500 Potential Dividend Growth Opportunities

Waste Management, Inc. (WMI): It provides integrated waste management services in North America. The company offers collection, transfer, recycling, disposal, and waste-to-energy services.

• Pros: Stable cash flow, dominant market share, per management no planned large capital expenditure in near future, more than 100 year old corporation, stable industry
• Cons: lack of revenue growth

T. Rowe Price Group, Inc. (TROW): It is a publicly owned corporation, a holding group, and an investment manager. The firm provides its services to corporations, corporate, public, and Taft-Hartley retirement plans, foundations, and endowments.

• Pros: Debt free, likely beneficiary of baby boomer driven demographic shift, no direct impact from current financial turmoil, only an investment manager, stable industry
• Cons: recession driven slowing down

Analog Devices, Inc. (ADI): It engages in the design, manufacture, and marketing of analog, mixed-signal, and digital signal processing integrated circuits (i.e primarily high performance analog chips) used in industrial, communication, computer, and consumer applications.

• Pros: dominant market share in key product segments, products sell that 55%+ gross margin, debt free, positive cash flow
• Cons: lack of revenue growth, cyclic industry

Linear Technology Corp. (LLTC): It designs, manufactures, and markets various linear integrated circuits (i.e. high performance analog chips, linear products)

• Pros: dominant market share in key product segments, products sell that 65%+ gross margin, positive cash flow
• Cons: lack of revenue growth, cyclic industry

Qualcomm (QCOM): It manufactures and markets digital wireless telecommunications products and services based on its code division multiple access (CDMA) technology and other wireless communication technologies.

• Pros: Ownership of CDMA technology, high royalty revenue (approx. USD 1 billion), all competitor in its market segment operating at loss, technological leadership in communication market,
• Cons: cyclic industry, engaged in too many legal battles,

Intel Corporation (INTC): It designs, manufactures, and sells integrated circuits for computing and communications industries worldwide. It is the manufacture of microprocessor products used in desktops, nettops, workstations, servers, embedded products, communications products, notebooks, netbooks, mobile Internet devices, and consumer electronics.

• Pros: lone player, no long-term viable competitor, technological leadership
• Cons: cyclic industry, history of squandering cash flow in acquisitions,

CME Group Inc. (CME): It operates two self-regulatory futures exchanges viz. CME and CBOT. The company offers an array of products available across various asset classes, including futures and options on futures based on interest rates, equity indexes, foreign exchange, agricultural commodities, and alternative investments, such as weather and real estate.

• Pros: futures exchange,
• Cons: recession driven slow down in volume

Campbell Soup Company (CPB): This firm together with its subsidiaries engages in the manufacture and marketing of branded convenience food products worldwide. It operates in four segments: U.S. Soup, Sauces, and Beverages; Baking and Snacking; International Soup, Sauces, and Beverages; and North America food service.

• Pros: staples industry, distribution network advantage during recession.
• Cons: prolonged recession affecting revenue, shift to non-branded products, slow dividend growth

Becton, Dickinson and Company (BDX): It is a medical technology company that develops, manufactures, and sells medical supplies, devices, laboratory equipment, and diagnostic products worldwide.

• · Pros: likely beneficiary of baby boomer driven demographic shift, signs of dividend friendliness,
• · Cons: low dividend yield

These are nine corporations that provide a good starting point for additional research. Some the key areas that need further analysis are factors such as cash flow, income, debt level, growth in earnings, and future growth potential. In addition, one another aspect that would need close attention is to understand management’s policy or philosophy vis-à-vis dividends for common share holders. I would like to invest in at least two corporations which have low-to-moderate risk to dividends. I will provide updates as I move forward with the research.

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.

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.