Minimize Losses: Maximize Long-term Gains

"Avoiding serious loss is a precondition for sustaining a high compound rate of growth."  -- Roger Lowenstein, Financial Journalist and Director, Sequoia Fund

Dividend Farming is an investing practice extended into a future horizon.  It’s not a “get rich quick” activity doubling your money in six months, a year, or even two.  It relies upon the reinvestment of dividends to compound growth and that requires time.

If Dividend Farming investments are compounding at 4% annually, how do we expect them to perform better than alternatives that may be enjoying double-digit growth today?  How can I believe that a lowly 4% return will get me where I want to be in 20 or 30 years?  Answering that question means investigating two scenarios.  The first involves a steady-eddy dividend play while the second is a high-flying investment that is volatile over time.

Both examples start with a single share of stock priced at $50.  Each share is held for 20 years.

The stock paying a dividend offers a steady, 4% annual dividend. 

The alternative offers no dividend, but a cyclical trajectory of increases and decreases during the 20-year period.  Within that timeframe the stock enjoys two years of 30% growth, two years in which it declined 30%, two years of zero growth, and the balance at 7% growth which is the historical market average.

Year 0	$   50.00	Annual Growth Dividend Stock	$   50.00	Annual Growth Non-Dividend Stock
1	$   52.00	4%	$   53.50	7%
2	$   54.08	4%	$   69.55	30%
3	$   56.24	4%	$   74.42	7%
4	$   58.49	4%	$   79.63	7%
5	$   60.83	4%	$   85.20	7%
6	$   63.27	4%	$   59.64	-30%
7	$   65.80	4%	$   63.82	7%
8	$   68.43	4%	$   68.28	7%
9	$   71.17	4%	$   73.06	7%
10	$   74.01	4%	$   94.98	30%
11	$   76.97	4%	$ 101.63	7%
12	$   80.05	4%	$ 101.63	0%
13	$   83.25	4%	$ 108.74	7%
14	$   86.58	4%	$ 116.36	7%
15	$   90.05	4%	$   81.45	-30%
16	$   93.65	4%	$   87.15	7%
17	$   97.40	4%	$   93.25	7%
18	$ 101.29	4%	$   93.25	0%
19	$ 105.34	4%	$   99.78	7%
20	$ 109.56	4%	$ 106.76	7%
Advantage	3%

At the end of the 20-year holding period, the dividend paying steady-eddy outperformed the volatile non-dividend payer by 3%.

This is a hypothetical exercise; the kind of which academics are fond.  It’s clean, clear, and unencumbered by things like the real world.  Although neither stock is guaranteed to grow exactly as shown, the exercise is helpful in four ways. 

Dividends Roll Up Over Time

First:  It shows what can happen when a dividend payer with a long history of payments, that is likely to continue, can do.  Moreover, it does so with better forecast accuracy.  Investing in a dividend champion helps reduce your risk.  Firms with growth and decline that cycle unexpectedly and abruptly are difficult to count upon to deliver the returns you need over time.

Second:  The consistent progression of the dividend payer also means that if you need to take money from your investment you’re less likely to do so at a significant low point in the market.  Investments that swing up and down like that of the alternative mean you could be forced to take a distribution during a market decline.  If that happens you may not be able to make up the loss, particularly if your investing horizon is short.

Third:  The average yield during the period for the first investment is 4%.  However, the average yield for the second investment is 5%, yet comes up short.  The reason is that the compounding effect is diluted by the years of large losses.  This is the essence of Lowenstein’s quote above.  If you don’t understand how this can happen, consider this example.

Fourth:  3% outperformance is a win.  Better performance with less risk is what margin of safety is all about.  It may not be glamorous, but who cares?  You still win.  See a couple of the dividend articles linked here for more about the performance of dividend stocks over time. 

Getting to your horizon with the money you need, sleeping soundly along the way, is the essence of Dividend Farming.

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.

Margin of Safety

Benjamin Graham, father of value investing, once distilled the practice of sound investing into three words:  margin of safety.

Margin of Safety in Flight

Margin of safety isn’t unique to investing.  The aviation industry is steeped in margin of safety practices.  Manufacturers build aircraft designed to fly within a specific range of maneuvers imparting stress on the airplane.  These maneuvers and associated stress limits are established and documented by the Federal Aviation Administration.  

Aircraft are built and certified to operate well beyond these limits to account for unexpected weather conditions and poor pilot decision making.  Building to withstand more than the published limits of the airframe imparts a margin of safety to flight operations. 

Airlines, corporate flight departments, charter operators, and flight schools are conscious of margin of safety as well.  Aviation firms use decision tools and training methods to help ensure flight crews conduct operations within safe limits.  Best practice includes risk assessments prior to takeoff to thoroughly documented and verified procedures used during each phase of flight.  Standard practice focused on safe flight operations add a margin of safety to any flight.

From the time pilots begin their initial flight training, nearly everything they work through is designed to build a foundation of good aeronautical decision making and safe operating practices.  Pilots learn about the design limits of their aircraft and how to fly within those limits.  They build skill through regular simulator sessions providing the repetition and critique unavailable in an actual airplane.  These activities are required of all airline flight crew on a regular basis.  Good decision making with highly developed skills built through repetition and critique add yet more margin of safety to flight ops.

What’s aviation got to do with investing?  Dividend Farmers want to build a margin of safety into our investing the same way aviation firms build margin of safety into their operations.  We look for well designed and built firms in which to invest.  Our target companies are large, have long records of cash generation, don’t carry far more debt than equity, and aren’t priced too far above their intrinsic value.

These firms exhibit logical, easily repeatable operating practices that don’t expose investors to undue risk.  Management teams make logical decisions, don’t gamble, and take only well calculated risks.  Firms headed in such fashion are likely to produce reliable results while avoiding big losses.

Investors who understand these factors, know the fundamentals of investment analysis, and practice their craft regularly, build investing skill through repetition.  As our skills build so does our ability to develop margins of safety within our investment choices.

The first rule in aviation is to not lose life – yours or anyone else’s.  In investing, the first rule is  to not lose money.  The second rule in both is the same – remember rule #1.

Although few people become pilots, millions become investors in one way or another.  Creating a margin of safety is a priceless activity regardless of the industry.  You expect a healthy margin of safety whenever you board an airplane.  Why not expect the same with your investing?

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.

Dividend Farming Scorecard: NACCO Industries (NC)

Earlier this month I summarized Top 10 Dividend Champions that ranked among the ten best in multiple investment metrics.  NACCO Industries was among the Top 10 firms in three different categories: Price-to-Earnings, Price-to-Book, and low Payout Ratio.  I thought it would be a good exercise to see how NC performed across the board.

The table below provides a summary of factors I consider as applied to NACCO Industries on March 17, 2019.  Laying out my analysis like this helps me quickly benchmark against my target metrics and compare this firm to alternatives.

FACTOR	METRICS	COMPANY
CCC List	Champion	Champion
Current Yield	4.0%	1.8%
Company Profile	Red Flags?	Primarily coal mining and related services
Industry Leadership	Top 10	7th
Market Cap	$10 B+	$267 M
P/E	< 20	7.6
P/B	< 2	1.05
Debt / Equity	< 1	.33%
Dividend History (Years)	25	33
12 Month Price Range	Lower Half	Top 20%
Dividend Payout Ratio	< 75%	13.2%
Portfolio Weight	Slightly Over	Under

CCC List: The DRIPinvesting.org web site provides the list of Champions, Contenders, and Challengers which is where I normally start.  NACCO industries has a substantial record as a Dividend Champion which bodes well out of the gate. 

Current Yield:  NC’s yield is 1.8%, less than half my target, paying $0.66 annually.

Company Profile:  NACCO is a mining company specializing in production of bituminous and lignite coal for power generation.  Power generation requirements won’t disappear in the foreseeable future.  However, I’m not as sure about fossil fuels that supply it e.g., coal.  While barriers to entry are high for competitors, I’m not sure the future for coal producers is sunny.

Industry Leadership:  The U.S. Energy Information Administration lists NACCO as the 7^th largest coal producer in the U.S.  That’s a nice stat but it must be paired with market capitalization and other factors to gain a clear picture.

Market Capitalization:  With a grand total of $267 million, the market cap for NACCO falls far below the desired minimum.  The size of the firm makes a number 7 ranking within the industry dubious.

Price to Earnings:  The trailing P/E of 7.6 is among the best I’ve seen in several months. Daily volumes are light and the firm small which may explain as much about the low P/E as would the firm’s business operations.

Price to Book:  P/B at $1.05 for every $1.00 purchased.  There’s no good will on the books and little in the way of intangible assets.  If the firm was liquidated, I would get back most of my money in which case the risk appears low.

Debt to Equity:  Debt is roughly a third of all assets owned so that’s a definite plus.

Dividend History:  A dividend growth history spanning 33 years is sound.  Better yet, the dividend growth rate over the past 10 years has been in the solid double-digit range.

Price Range:  The price is within 20% of its high during the trailing 12-month period.  I wouldn’t call it a bargain based on the range alone, but its volatility is such that it may be possible to buy into a position on a future dip.

Payout Ratio:  The payout ratio at just over 13% is about as low as a dividend payer may get.  There is plenty of room to run up that ratio and it appears NACCO has been working on doing that over the past 1 to 3 years.  However, the cash flow appears cyclical in which case I wonder how long an aggressive div growth practice may continue.

Portfolio Distribution:  NC would be my only coal producer if I were to add it to the farm. Energy is a great sector, but I question whether coal production is the best play.

Analysis  

NC misses on only 3 of my primary benchmarks.  At first blush, the opportunity looks sound, particularly considering the important financial ratios.  However, the size of the firm, health of the industry, and political climate in vogue leads me to believe NC wouldn’t be as sound a long-term investment as downstream energy plays in the sectors of generation or distribution.  Given the number of substitute fuels available for electricity generation, parking cash in a coal producer for the next 10 to 15 years isn’t a fit for this Dividend Farmer.   

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.