Would you rather?

When I’m investing, I’m doing so for my future; for my family’s future; and to assist those in need when I can.  The goal is to grow my resources while mitigating risk along the way.  I want to maximize my return while minimizing the chance I’ll lose part or all of my investment.

In general, this can be accomplished in a couple ways.  I can put compound growth to work or I can depend upon the market valuation of my investment to appreciate through prevailing market mechanisms.  Which path would I rather?

Looking at the numbers helps me decide so I’ll start with a nice round number of $1,000.  This is a number many starting investors can put together, particularly if they’re working their budgets.

    

I’ll review three cases using a 10-year investment period.  In the first case, I’m assuming a 4% dividend compounded quarterly.  The second case assumes a 4% annual rate of appreciation.  The third case assumes a 4% rate of return for the full 10-year period.

 

In the case of the full 10-year period, I assumed a worst-case scenario – getting a total 4% return for the decade.  To run this exercise, I used the Future Value (FV) function in Excel.  The table below shows the inputs for the FV formula, the results, and the percentage change between the starting or Present Value (PV) and the ending or Future Value (FV).

	Quarterly Compound	Annual Compound	Period Compound
PV	$      1,000	$         1,000	$      1,000
iRate / Year	4.0%	4.0%	4.0%
iRate / Period	1.0%	4.0%	4.0%
Years	10	10	1
PMT	0	0	0
PV	$1,488.86	$1,480.24	$1,040.
Increase	49%	48%	4%

• 4% dividends compounded quarterly yields a 49% increase relative to my starting value.
• 4% value appreciation annually yields a 48% increase over my starting value.
• 4% value appreciation for the entire 10-period yields a 4% increase above my starting value.

Compounding obviously has advantages.  The more you do it, the better the outcome.  Understanding this as an investor is straight forward math.

The sticky part is figuring out which method results in the lowest total risk.  Determining this becomes subjective, but I’ll give it a shot.

If I invest in a Dividend Champion with an extended history of dividend payments or better still, growth, there is a reasonably good chance that long history will repeat itself into the future.  Companies with solid dividend histories have a vested interest in continuing the trends and won’t take undue risks to avoid dropping the ball.  They’ve also demonstrated they can generate cash with which to pay those dividends.

Should I invest in a non-dividend payer hoping the market value increases by at least 4% annually, I’m counting on Mr. Market to work in my favor every year for 10 years.  Given Warren Buffet’s quote, I think the probability Mr. Market will come through for me in 10 successive years to be slim.  Even if he does, I’ll still fall 1% short of what might happen by compounding dividends.

As for the third option, it’s a non-starter. 

Although it’s possible non-dividend paying stocks may experience a tremendous increase in some years, it’s also likely they may succumb to a serious decline as well.  The rollercoaster ride can reduce my total return beyond the 1% delta shown between options 1 and 2 above.  While a dividend payer can experience ups and downs as well, their gyrations are relatively subdued. 

Overall I’ve determined the greatest probability of long-term success is found in avoiding big losses while generating small, consistent gains that compound over time.

To be fair, analysts will point out that dividends paid, even if retained and compounded, result in tax bills reducing my return while non-dividend payers can appreciate tax free until they’re sold.  This is true, but I’ll take the relatively sure compounding rate, even with a tax bill, over the ethereal value appreciation approach and no tax bill.  For me, it’s better to have a few bucks and pay pennies on it than having nothing and pay nothing.  Which would you rather?  

The thoughts expressed here are those of the author, who is not a financial professional.  Opinions should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

For safety, bet the average - not the trend

Protecting against loss while generating a satisfactory return is the essence of Value Investing.  As Howard S. Marks, Founder, Oaktree Capital Management, stated:

“The key to success lies in avoiding losers, not in searching for winners.”

Unfortunately, too many investors are driven by sound bites and social media posts.  The goal: find the investment rocket launching their portfolio to galactic heights.  They’re searching for “winners” among IPOs, momentum plays, fads, and who knows what else.  Investment safety is an afterthought – until it’s too late.

One way to increase the safety of my Dividend Farming practice is to look for stability and predictability in investment opportunities.  Strong dividend paying stocks have been a great way for me to do so.

Firms with long histories of dividend payments, particularly firms growing those payments, offer a level of stability non-dividend payers don’t.  They’ve shown an ability to generate sufficient cash to pay those dividends over extended periods.  Cash is fact.  Profit is theory.  Focusing on facts (cash) reduces my risk while being side-tracked by non-facts (profit expectation) increases it.

Consistent delivery of dividends makes estimating future cash flows more reliable which reduces risk.  A company with an unpredictable history of cash generation and market volatility makes accurate forecasting problematic – my guess is as good as the next guy’s.  In such cases, it’s easy to fall victim to trend-itis.  The technical trading crowd takes full advantage.

Trends:

Trends are either up or down; they’re binary.  If I bet the up and it goes down, I lose.  What’s more, a change in trend can be considerable.  The lack of directional predictability and potentially large scale shifts in magnitude increase risk by making it difficult to project where my investments are headed.  It’s akin to driving down the interstate as fast as you can while blindfolded.  It may be exciting, but you increase the probability of going in the ditch – or worse.

Long-term Averages:

Long-term averages can pay off.

Long-term averages, however, smooth the ride.  The binary outcome becomes a range offering greater probability of success.  In other words, results generally revert to the average over time and typically don’t stray far from it.  This fact reduces the likelihood of a large miss in my forward estimation mitigating my risk to a degree. 

Long-run dividend histories offer a readily definable average and target range.  The same can’t be said for momentum investing that simply bets the over / under.  The latter becomes a function of buy low / sell high - market timing.  The timers enjoy limited success.

Looking forward through a stable, predictable lens, improves my investment vision.  The better the vision, the lower the risk.  That’s why I prefer to bet the averages with Dividend Champions and not the trends.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.  

Investing vs Speculating

The Source for Dividend Investors

I’ve been wading into Ben Graham’s book, Security Analysis.  Ben’s the father of Value Investing and mentor to Warren Buffett.  Ben wrote The Intelligent Investor which I’ve referenced before.  His work originated in the depths of the Great Depression and his advice on prudent investing practice was sound then and remains so nearly 80 years later.

According to Graham, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.”

This sounds straight forward, but what does it mean?  And what’s it mean to Dividend Farmers?

Safety, according to Graham, is protection against loss under normal or reasonably likely conditions or variations.  This doesn’t mean elimination of all risk.  That’s not possible.  Instead, it means mitigating risks associated with non-standard, ill-conceived, or otherwise highly improbable actions or events when selecting a stock to purchase.

Satisfactory return is a reference to the rate of return you are willing to accept – not the market, not Uncle Milt, not your broker – you!  This value is subjective but helps bound the degree of risk you’re willing to endure pursuing an investment return.  General wisdom holds that seeking a higher return means enduring greater risk to get it.

Practically speaking, how can Ben’s wisdom be applied?  From my perspective, solid dividend payers e.g., Dividend Champions, provides a safety filter for launching the investment operation.  

Firms in the Dividend Champion class frequently offer long-standing dividend streams, generally supported by healthy cash-flow and strong financials including low earnings multiples, solid price-to-book valuations, and sound debt-to-equity or assets-to-liability ratios.  Seldom are these firms found among volatile momentum categories.  This means my long-term risk is reduced through increased stability and predictability of investment returns.

Selecting from a filtered list like Dividend Champions lets me quickly locate firms meeting my definition of satisfactory return.  For me, that means a firm with an annual yield around 4%, a good possibility of dividend growth, and some probability of valuation growth.  If the yield is near 4% and grows a few percentage points each year while increasing marginally in stock price valuation, I know I have a solid firm with a high probability of delivering a satisfactory return over my long-term horizon.  

Because three components contribute to my satisfactory return, I’m able to mix and match without venturing outside my safety zone.  For instance, I might accept a firm with a 3% yield if I believe the dividend growth rate will be higher than normal.  If an offering has limited potential for growth in its stock price, but offers a higher yield, assuming the financial metrics are sound and its qualitative characteristics are positive, it may provide me a satisfactory return as well.

If I’m mindful of safety, understand my satisfactory return requirement, conduct due diligence on a few financial metrics, and start with firms already possessing some of these important characteristics, I’ll be mitigating risk within normal operations as much as possible.  Doing so means I’m operating according to Graham’s definition of an investing operation and not one of speculation.

Allocating my few dollars this way isn’t flashy.  However, I’d rather make steady progress toward my goal, sleeping well along the way, than hope my future arrives during a bull market vs a bear.  That’s the difference between investing and speculating.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.  

Portfolio: March 2019

The March Dividend Farmer saw a few changes relative to February despite no additions or subtractions to the holdings during the month outside of reinvested dividends.  REIT holdings bumped up nearly one percentage point and continue to lead the portfolio weight.  Conversely, my healthcare issues declined by nearly a like amount in terms of percentage distribution. 

Across the rest of the segments there was a half point movement or less up or down.  Most of the holdings didn’t experience significant events.  However, earlier this week one of my consumer healthcare stocks declined nearly 12% due to an unexpected and large earnings miss so we’ll see how things rebalance in April.  On the bright side, dividends paid now for that holding buy more shares than they would otherwise.   It’s good to be positive about these things, right?

Yield on price:  3.8% - down from 3.9% in February 

Average yield on cost:  4.7% - up from 4.4%   

Average monthly dividend:  $1,170 

Monthly dividend growth rate:  14.8%

Target monthly dividend growth rate:  10%

Time to double dividend stream:  ~4.8 years – down from 5.5 last month 

The growth rates serve as a reminder of the power of compounding given changes in long-term outcomes resulting from small changes in the rate of return.    

Each month adds to the income stream growth through the power of compounding in a slow, steady manner.  The Rule of 72 post offers further detail about the power of compounding.  The remarkable thing about compound growth is that if you’re patient you’ll eventually reach a point at which critical mass is achieved and growth in your dividend stream takes off.  That’s why this Dividend Farmer is an advocate of dividend investing.

The thoughts and opinions provided are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Budget: The Start of Your Financial Future

The last post offered five simple words to help you start your Dividend Farming operation and build financial security:  spend less than you make.  Genius.  There’s gotta be more to it, right?  There is.

Dividend Farming is a navigation problem, as are many things in life.  All navigation problems have three critical components:

1)  The starting point (A)

2)  The destination (B)

3)  The best route from A to B

        a.  Fastest

        b.  Most efficient

        c.  Most enjoyable

You may know your destination.  However, if you aren’t sure where you are, choosing the best route to arrive at your destination will be challenging.  How do you determine your starting location?  A budget is a great way to figure it out. 

Financially speaking, if you don’t know how much you’re spending or on what, you’ve limited your ability to plan a route to a solid financial future.  This is true because you don’t know where you are as you start your journey.

 

One way to address the problem is to build a budget.  A budget is a valuable tool helping you determine your current financial location.  It’s also a great way to gauge your progress along your route of flight. 

Track your expenses.

But budgeting isn’t fun!  Neither is being broke.

Budgeting is hard!  So is being broke.

 

Fortunately, budgeting isn’t as hard as you think.  You can budget on a piece of paper, in a spreadsheet, or in any number of nice software applications built specifically for budgeting.  I’m a fan of the spreadsheet.  I use Excel at work so I’m familiar, spreadsheets are normally free, and I don’t need a pile of erasers or pencils to change or update my budget.

What is a budget you ask?  It’s a list of items or actions and the amount of money you plan to spend money on each during a specific period.  Total expenses are subtracted from your income during the period.  Below is an example of a simple one-month budget.

January 2019	Budget	Income / Spent
Income (Salary or Hourly)	$3,000
Housing (Rent or Mortgage)	$1,200
Groceries	$800
Utilities	$300
Auto	$500
Total Expenses	$2,800
Income Minus Expenses	$200

Your budget should be more detailed and informative than the example above.  For instance, you may want to list separately many of the following items:

Auto Gas	Water / Sewer Utility	Health Insurance or Deductibles
Auto Insurance	Dining Out	Magazine Subscriptions
Cable TV Service	Movies	Gifts / Charity
Cell Phone Service	Coffee	Home Improvement
Electric Utility	Clothes	Yard Improvement
Emergency Fund	Day Care	School Supplies
Credit Card Payment	School Loan Payment	Gym Membership

The above table may not be directly applicable.  Alternatively, you might need to include everything shown here plus additional lines covering all that’s applicable to you.

Try to capture as many expense items as you can then decide how much you need or want to spend on each for the month.  Once your list has been created, tote up the expenses and subtract them from your monthly income.  If the expenses are larger than the income, work through your lines reducing your planned expenses until the expense total is less than the income total.

Once you’ve done this, your budget is built.  For the rest of the month you’ll record your expenses as they’re paid.  Your budget may look like this table part way through the month.

January 2019	Budgeted	Income / Spent
Pay (Salary or Hourly)	$3,000	$3,000
Housing (Rent or Mortgage)	$1,200	$1,200
Groceries	$800	$550
Utilities	$300	$150
Auto	$500	$300
Total Expenses	$2,800	$2,200
Pay Minus Expenses	$200	$600

Budget to save.

The example above could be 20 days into January.  You’ve received all your pay, made your housing and auto payments, and bought most of your groceries as well as part of your utilities for the month. 

In this case, you’re tracking to your budget.  If you maintain course, you’ll have $200 left at the end of the month.  If you don’t have an emergency fund the money should be used to start one.  If you have a solid emergency fund, then $200 can be used as seed money for your Dividend Farm.

 

Each month you’ll go through the same process.  Fortunately, budget building gets easier because many of your expenses won’t change from month-to-month allowing you to copy expense items from one budget to the next.  For instance, your house payment won’t fluctuate monthly nor will things like car payments or insurance in many cases.

Budgets are the secret to “spend less than you make” and the first step on the road to a Dividend Farm and financial security.  Is it magic?  No.  Do you have to use a spreadsheet or pencil and paper?  No.  Some people use envelopes labeled by category.  They put cash in each envelope equal to the amount they plan to spend.  Once a specific envelope is empty, no more money can be spent on that category until the next month when the envelope is filled again. 

Does budgeting require patience and time?  Yes.  Is it worth it?  Yes – particularly when the compound growth of your Dividend Farm kicks in.  At that point you’ll be thrilled you budgeted, saved, and created seed money for your farm.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.