Friday, May 22, 2020

Electric Utilities Rock


Utilities.  Latin for “not sexy”.  They don’t grow quickly.  They’re for conservative investors in the Greatest Generation only.  Blah, blah, blah…

There are multiple types of utilities.  Water, gas, electric, generation, transmission, and hybrid or multi-varieties come to mind.  As a Dividend Farmer, I like electric utilities for four important reasons.

Barrier to Entry

Warren Buffett likes firms with wide moats.  Companies operating in industry sectors possessing high barriers to entry have wide moats. Consequently, those firms face little to no competitive pressure that can drive down prices, revenue, and profitability.

Electric utilities, particularly those with strong transmission infrastructures, have wide moats. For a given service area like a city, state, or region, the cost of infrastructure is high and the physical space in which to have multiple, competing backbones doesn’t exist.  Consequently, an electric utility established in a particular service area benefits from the prohibitive cost of market entry to competitors and has virtually no chance of facing downward price or market share pressure.

Monopoly

Because of the competitive barrier to market entry, electric utilities are de facto monopolies.  The only thing preventing them from pushing their prices through the roof is regulatory oversight.  This regulatory cap, however, typically allows utilities a reasonable rate of return, roughly in the low double-digit range. 

While such caps limit upside growth potential, the monopolistic nature of a utility nearly guarantees a solid, positive rate of return on an annual basis.  If you could invest in a company sporting a high probability of a 10% return each year or one that might grow 35% one year, then shrink as much the next, which would you prefer?  Dividend Farmers know the answer to that question!

No Substitute

If you consider your home or work environments and the powered devices in them, nearly all are electric.  What’s more, there is no substitute for electricity.  You can’t power the toaster, microwave, laptop, refrigerator, lights, or air conditioner with natural gas, or any other matter, unless you convert it into electricity first.  While several alternatives exist for generating electricity, there is no true substitute for electric power in most cases.

It’s also true to say there are no substitutes for delivering that electricity to homes and businesses.  For 99.9 percent or more of users, the electricity they need arrives through the barrier to competitive entry, infrastructure, discussed above.  Although there may come a day when you can pick up a six-pack of batteries that power the whole house for a week, that day is nowhere in sight.  Super-efficient and low-cost solar cells that deliver all the power a home or business needs aren’t on the horizon either.

Long-term Trend

As growth in the Internet of Things (IoT) and conversion to electric or hybrid vehicles continues apace, the trend in electric consumption is headed in only one direction – up.  It’s true there will be seasonal swings in electric consumption, but the long-term trend for power consumption is positive and will remain so until Armageddon.  As an investor, putting money into an industry with an unstoppable upward consumption trend over a nearly infinite timeline seems like a good play, no?

If you think electric utilities should be a solid block in your portfolio there are 5 utilities among the Dividend Champions growing their dividends annually for 26 to 49 years respectively.  Twenty-one electric utilities are found among the Dividend Contenders growing their dividends in a range of 10 to 22 years and 11 more electric utilities are listed within the Dividend Challengers growing their dividends in a range of 5 to 9 consecutive years.

Not only do electric utilities rock for the reasons noted, there are plenty of quality firms from which to choose.  These utilities pour forth dividends with limited risk allowing you to take advantage of Albert Einstein’s sage advice – he who understands compound interest earns it.



Monday, January 20, 2020

Buy term life insurance and invest the savings

Term or whole life insurance?
Term Life or Whole Life Insurance?

Seed money for a Dividend Farm can come from different sources. It may result from side gigs, pay raises, inheritance, windfalls, or savings from opportunity-cost choices with things like life insurance. How can a decision about life insurance produce seed money? Life insurance is needed to mitigate the risk a family will run out of cash when any of us expire – and we will. Choosing one insurance vehicle or another to mitigate the risk influences availability of savings for investment purposes because of the difference in cost between the two primary options.
   
There are two main types of insurance, term insurance, providing a death benefit only, and whole life insurance that provides a death benefit and may accumulate a cash value over time. Below are three points to consider in the decision about which type to buy:

Premiums:
Whole life insurance premiums can be 10x higher than term life insurance premiums regardless of age or gender. The price comparisons from Good Financial Cents and Nerdwallet offer comparative examples across age, gender, and insurance term.

Returns:
Whole life insurance provides returns of 1.0% to 1.5% for the cash value of the policy with most of that figure occurring late in the policy period. The analyses from Consumer Reports and Investopedia provide detail. However, the short story is that a large portion of your whole life premiums pays commissions and other investment operating expenses instead of death benefits or accruing to you as cash value.

Term life provides zero return because there is no cash value – only a death benefit which is what you need to mitigate risk. Term insurance doesn’t require the commission costs or operational overhead whole life policies do. Consequently, buying term insurance, saving 90% or more on premiums versus whole life insurance, and investing the difference in alternative vehicles may be wise.

Alternatives with reported rates of return as of this writing include:

  • U.S. Treasury Bonds:  2% to 2.4% on 20 and 30-year bonds.
  • S&P 500: 6.6% for 20 and 30-year historical periods.
  • Dividend Champions: Averaging 2.4% with a dividend growth rate of 7.9% over 10 years and increasing dividends 25+ years.

Consider financial options producing returns greater than those of whole life policies when available.

Security:
Whole life insurance proponents claim the cash value is guaranteed while alternative investments are not. The argument sounds logical until you consider the number of insurance carriers that have gone out of business. The probability the United States Treasury or all companies in the S&P 500 Index go out of business at once is approximately zero, but individual insurance companies go out of business more often than thought.

Insurance is necessary to reduce risk. However, Dividend Farmers mitigate risk as efficiently as they can. Whole life insurance is expensive, low performing, and not as secure as sellers claim. Buying term life insurance and investing the premium savings in solid, relatively secure, and better paying alternatives can help you chart a course to a brighter tomorrow.

Thoughts presented are those of the author, who is not a financial professional. Perspectives are not investment advice, but offered for the purpose of discussion and information. For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Wednesday, January 15, 2020

Div Tip #21: Dividend Growth & CAGR


Dividend growth stocks (DGS) are amazing investing vehicles. They become more productive each year while we sit and watch.  Returns are compounded and we benefit from the 8th wonder of the world. But that’s not the end of the story.

DGS drive up the yield on cost of an investment. This means dollars are working harder, the time to double money shrinks, and path to financial freedom grows shorter.

For instance, a stock with a constant 3% yield over 10 years produces a compound annual growth rate (CAGR) of 3%. However, if a similar stock paying 3% when purchased grows its dividend by 3% each year during the same period the CAGR approaches 3.5%. 

The half point difference doesn’t sound like much, but when the two figures are plugged into the Rule of 72 the 3% rate takes 24 years to double the investment while the 3.5% rate takes just over 20.5 years. The half point difference in CAGR reduces the time to double by nearly 25%. That’s a nice reduction for waiting and watching as dividends slowly grow.

If a DGS grows its dividend at the average 10-year growth rate of the 138 Dividend Champions (as of January 2, 2020), the CAGR over the same 10 year period grows to 4.32% and the time to double the money shrinks to 16.7 years. The 1.32% rate advantage offered by DGS generates a 30% reduction in the time to double an investment.

A wise Dividend Farmer harnesses the power of compound interest and consistent dividend growth. Doing so would make Albert happy. Who wouldn’t want to please this guy?

Albert Einstein Quote on Compound Interest.
Add caption
Thoughts presented are those of the author, who is not a financial professional. Perspectives are not investment advice, but offered for the purpose of discussion and information. For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Wednesday, January 8, 2020

The Power of Yield on Cost

Much has been written about dividend growth stocks. Investors are aware of Dividend Aristocrats, Champions, Contenders, and Challengers. They are familiar with the years each has increased its dividend payments. One, three, five, and ten-year dividend growth rates are regularly tracked and reported for these firms and Albert Einstein’s quote regarding the power of compound interest is a common refrain with compound growth curves available demonstrating his point.

However, writers and investors seem to miss an important and powerful factor associated with dividend growing firms: yield on cost. This metric is different than the oft quoted yield on price, but is still important.

I’ll use rental real estate to illustrate the point. If I buy a rental property for $100,000 and generate earnings of $200 per month after expenses during the first year, my return is $2,400 annually or 2.4% of my initial investment. If I raise the rent and potentially reduce costs in year two I might earn $300 per month translating into an annual return of $3,600 or 3.6% of my initial investment. In real estate, this yield calculation does not change if the assessed market value of my rental property goes up or down. My original investment was $100,000 and my earnings yield is computed relative to that investment, not floating market valuations.

The same process holds true of returns on dividend paying firms. If I buy a stock for $50 paying $2 a share in annual dividends the first year I own it, my yield is 4%. If the company increases its dividend to $2.50 in year two, I still paid only $50 for that share. Consequently, the yield on my cost is 5% irrespective of stock price fluctuations along the way. This calculation is true of stocks just as it is rental real estate.

Why is this important for dividend investors? It means yield on the cost of the stock can increase significantly through persistent dividend increases given extended holding periods.  This is true even if those increases are small.

Below are examples culled from the Dividend Farmer portfolio. The yield on price was harvested from Yahoo! Finance in December 2019 and is shown relative to the yield on cost reported by my broker the same month. Obviously, short-term fluctuations cause these spreads to vary slightly, but the variances are minor relative to the spreads shown resulting from long investment periods.

Company
Yield on Price
Yield on Cost
Difference
NNN
3.8%
9.6%
5.8%
MO
6.7%
15.9%
9.2%
T
5.3%
6.2%
0.9%
PFE
3.9%
10.2%
6.3%

The average difference between the yield on investment cost vs current stock market price is 5.55%. Consequently, invested dollars are working harder than given credit when paying attention only to the yield on price. If you had the chance to invest in an opportunity today that paid 3.8% or 9.6% given the same price and risk profile, which would you chose?

Investing $10,000 for 10 years compounded at 3.8% annually results in $14,520 at the end of the period. Conversely, investing the same amount for the same period at 9.6% generates $25,009. The 72% increase in return is compelling and could be yours for staying the course.

Finding an investment yielding 9.6% with limited risk is challenging.  Buying a dividend growth stock today yielding 3.8% gives you the chance to grow it into a future investment paying a much better rate.  This is true only if you have the time and patience to cultivate it.

“Someone’s sitting in the shade today because someone planted a tree a long time ago.”  Warren Buffett

Plant a tree on your Dividend Farm today, watch it grow, and enjoy the shade during retirement. Yield on cost represents the power of dividend growth.  Make use of it when you can.

Thoughts presented are those of the author, who is not a financial professional. Perspectives are not investment advice, but offered for the purpose of discussion and information. For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Tuesday, December 31, 2019

Steady dividends beat investment volatility


Last March I published an article regarding the hazards of volatility in a stock selection.  In that example I compared a 4% annual dividend payer experiencing no growth against a non-div stock that experienced value swings up and down.

This post revisits that exercise but in a slightly different way.  As before, I started with a 4% dividend payer providing no value growth against a non-dividend stock that is uniformly volatile with regard to value.  In other words, the value of the stock increases a specific amount in one year then decreases a specific amount the following year. That pattern was repeated through 20 years.

I was trying to get a sense of how big stock gains have to be to offset corresponding declines over time while resulting in an outcome close to the straight 4% growth path.  The table below, built in excel, shows the results.

Start
 $  10,000.00
Annual Growth
 $     10,000.00
Annual Growth
1
 $  10,400.00
4%
 $     12,000.00
20%
2
 $  10,816.00
4%
 $     10,800.00
-10%
3
 $  11,248.64
4%
 $     12,960.00
20%
4
 $  11,698.59
4%
 $     11,664.00
-10%
5
 $  12,166.53
4%
 $     13,996.80
20%
6
 $  12,653.19
4%
 $     12,597.12
-10%
7
 $  13,159.32
4%
 $     15,116.54
20%
8
 $  13,685.69
4%
 $     13,604.89
-10%
9
 $  14,233.12
4%
 $     16,325.87
20%
10
 $  14,802.44
4%
 $     14,693.28
-10%
11
 $  15,394.54
4%
 $     17,631.94
20%
12
 $  16,010.32
4%
 $     15,868.74
-10%
13
 $  16,650.74
4%
 $     19,042.49
20%
14
 $  17,316.76
4%
 $     17,138.24
-10%
15
 $  18,009.44
4%
 $     20,565.89
20%
16
 $  18,729.81
4%
 $     18,509.30
-10%
17
 $  19,479.00
4%
 $     22,211.16
20%
18
 $  20,258.17
4%
 $     19,990.05
-10%
19
 $  21,068.49
4%
 $     23,988.06
20%
20
 $  21,911.23
4%
 $     21,589.25
-10%
Advantage
1%

If a $10,000 portfolio achieves 20% growth in year one but declines 10% in year two and repeats that pattern through 20 years, the volatile portfolio lags the steadily compounding portfolio by 1%.  This example assumes no money was added or subtracted from the portfolio.

If the value gains  are moved to 21% each year while holding the 10% declines steady, the volatile portfolio outperforms.  However, if value gains fall below 20% while the 10% declines remain constant, the performance advantage offered by the constant growth portfolio widens considerably.
Things to consider given the example above:
  • Gains have to be significantly greater than losses for a volatile portfolio to achieve parity with a constant growth option.
  • Losses should be mitigated as much or as often as possible for a volatile portfolio to achieve parity with a constant growth model.

The effects of volatility perfectly illustrate the following investing wisdom:

"The key to success [in investing] lies in avoiding losers, not in searching for winners."  -- Howard S. Marks

"Avoiding serious loss is a precondition for sustaining a high compound rate of growth."  -- Roger Lowenstein

"Rule #1:  Never Lose Money;  Rule #2:  Never Forget Rule #1."  -- Warren Buffett

Dividend Farmers don’t mind following the lead of successful investors.  On long journeys it’s often better to go with an experienced guide than venturing alone.  With the start of a new year we should keep learning, let the dividends compound, and work on steady growth.

Here’s to a success Dividend Farming effort in 2020.  Happy New Year!

Thoughts presented are those of the author, who is not a financial professional. Perspectives are not investment advice, but offered for the purpose of discussion and information. For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.