Investing


Table Of Contents

Introduction
Quotes Online
Investment Philosopohy
Dividend Yield vs. Dividend Growth
Dividend History
Retirement Withdrawals
Definitions of Terms
Investing Forum

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Introduction

These pages relate to Steve and Sharon's investing ideas.

The sections on Quotes Online, Investment Philosopohy , and Dividend History are not suggestions on how to invest. They are merely descriptions of how we think about investing. Even if the ideas turn out to be good for us, they probably don't fit anyone else's situation exactly.

Please do not construe anything you see on this web site as investment advice. We are certainly not qualified to be giving advice. Remember that any ideas you see on this site are probably not worth any more than the price that you paid for them. The same can be said for the accuracy of the data that you see.

In other words, always do your own due diligence (DYODD) before making any investment decision.

If the preceding comments have not made a strong enough impression on you, then read the first two paragraphs of this story by Michael Lewis.

This page was last updated on October 06, 2012 16:22:46 EDT (GMT-0400).

This page has been read 8019 times from 3675 internet addresses.

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Quotes Online

Here is a more detailed view of stocks to watch. The ones up through WEC are in our portfolio. The others we once owned or were interested in.

Here are the mutual funds and indices to watch. The first and second entries are the mutual funds that we own.

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Investment Philosopohy

For retirement, we have chosen an investment philosophy that Steve learned at a Portland, Oregon local chapter meeting of AAII (American Association of Individual Investors).

The presenter at the March 18, 2003 meeting was Bruce C. Miller, CFP.

A very brief summary of his idea is to change the way you look at your portfolio in retirement. What is important is to generate a stream of dividend payments on which you can live now and in the future. Your future requirements are that the dividend stream must grow to offset the mounting effects of inflation.

To get the dependable dividend stream, invest in companies that have a long record of paying increasing dividends.

When you look to replace an investment in your portfolio with another investment, the process is fairly simple. Once you have selected an investment that meets the criteria for paying a dependably increasing dividend, you must decide if it should replace an existing investment.

Determine your net proceeds from selling the investment you want to replace. The net proceeds account for transaction costs and taxes you will owe. Next determine the dividend income stream that would result from investing the net proceeds in the new investment. Take into account the transaction costs for the new investment and any tax consequences for the kind of dividend it pays compared to the kind of dividend the original investment paid.

If the new investment gives you a significant increase in your net dividend income, then it is a good candidate for your portfolio.

Using this philosophy of investing, you no longer need to be too concerned about the prices of the stocks in your portfolio. These prices will go up and they will go down, but as long as the dividend stream is reliable, you can sleep comfortably at night. Be sure to keep your eyes and ears open to any possibility that a dividend may be reduced or interrupted.

Stretches of 8 quarters or more of no increase in the dividend is something to take notice of. Also keep track of payout ratios for early signs of unsustainable dividends. Some stocks like royalty trusts are not expected to have a monotonically increasing dividend. While these may be good investments at times, you obviously cannot use the exact same rules about dividend changes.

By the way, keep the amount invested in any single stock to 5% or less of your portfolio. That way, even a disastrous mistake on any one stock won't be catastrophic for your portfolio.

The secondary effect of using this philosophy is that you tend to buy stocks when they are cheap and you tend to replace them when they get overpriced. (You can't beat buy low and sell high.)

I just realized how another tenet of Bruce Miller's applies. He subscribed to the old adage, "First, don't lose money." His whole strategy of living off the dividends presupposes that you are not investing in a stock whose price trend is continuously downward. When a stock is paying a very high dividend, it may be that you are receiving large returns of capital. I found it hard to know if I was getting ahead or falling behind when this happened. It just dawned on me that the history plot of split and dividend adjusted stock price is a useful tool. This is described in the Dividend History Section below.

The plot for FRO is a case in point. On August 31, 2005, the closing price was $46.76. At the time of the plot, March 27, 2007, the adjusted closing price for August 31, 2005 was $30.72. The closing price on March 27, 2007 was $35.07. So FRO has made me money even though the current closing price is lower than my purchase price. At some point I need to calculate the net yield in order to derate the dividend yield which appears to be quite high. Yahoo was showing 23.2% as of April 20, 2007.

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Dividend Yield vs. Dividend Growth

There is some controversy about how one should account for a stock's history of dividend growth versus its level of current yield. Should you choose high dividend growth instead of high current yield because the dividend growing stock's dividend will soon surpass the dividend of the stock with high current yield?

This section of my investing web site was written in response to an article on June 20, 2011 Dividend Growth vs. High Yield: Some Surprising Findings whose findings were not so suprising to me given this plot that I had derived in October, 2010.

To answer the question of the tradeoff between dividend growth versus high yield, I made the following plot.

Dividend Growth versus Current Yield plot

The plotted results are totally hypothetical. They do not represent the history of an actual stock investment. After all, at the beginning of the investment period when you want to make the tradeoff between dividend growth and high current dividend yield, you cannot predict how any of these numbers will behave in the future. In order to derive this plot, I have made certain assumptions which should be reasonably fair way to judge all high quality stocks.

The isometric lines are of constant total gain (dividends plus capital gain) over five years for various starting dividend yields and constant dividend growth rates. The gain is expressed as a fraction of the initial investment. For example, a gain of 1 means the total gain was equal to the initial purchase meaning the value of the investment doubled.

The investment web site Investment Quality Trends has determined that high quality, dividend paying stocks go through repeatable cycles of dividend yield. The peaks and valleys of yield vary for each individual stock. For the sake of simplicity in deriving the plot, I assumed a constant dividend yield. You can sort of think of this as the yield averaging out over the long term. A crude assumption, but a useful simplification for seeing how to trade-off high current yield with predicted dividend growth.

The implication of a constant dividend yield for a stock with a growing dividend is that the price of the stock will increase along with the dividend. So your investment grows in two ways with a dividend growth stock, the dividends are harvested and the value of the stock grows. I have assumed that the dividends are not reinvested in the hypothetical stock under consideration.

Let us examine one of the isobars in the plot. For a 20% total gain over 5 years, you could invest in a stock with a 4% yield and no dividend growth. For a stock with a 10% dividend growth rate it would have to have an initial yield of only 3% to have the same total gain. In other words, you would need an increase in 10% for dividend growth rate to trade off a 1% lower initial yield.

For a 100% total gain over 5 years, you could invest in a stock with a 15% initial yield, but even it would have to have a dividend growth rate of over 10%. If the dividend growth rate were higher at 15%, you would only need an initial dividend yield of a little over 13%. In other words you would need a 5% higher growth rate to compensate for a 1.5% lower yield.

Without this plot, I bet you would have been unlikely to make a correct estimation of the tradeoff between dividend growth and high initial yield.

Of course, you have to make your own judgment on how to compensate the calculations due to any deviation from the assumptions. You could do your own plot if you wanted to assume dividend reinvestment. The tradeoff would also be different for a different assumed holding period (the 5 years I assumed.)

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Dividend History

At about the same time that Steve learned about Bruce Miller's investment philosophy, he also learned about the Investment Quality Trends (IQT) newsletter and methodology.

The IQT method emphasizes using dividend yield as a way to estimate whether a stock is undervalued, overvalued, rising, or declining.

IQT plots a stock's price history over time relative to changing thresholds of undervalue and overvalue. (See the link to their website above.) Steve's dividend yield history plot is an alternative way of looking at the stock price history. From the dividend yield plot you may be able to figure out what are the undervalue and overvalue thresholds, if such a concept applies.

The IQT method focuses on maximizing total return as the primary driving factor. The Bruce Miller methodology focuses on producing a reliably increasing dividend stream.

In retirement, we have shifted methodology from IQT to Bruce Miller. Nevertheless, IQT gave Steve some ideas on how to look at the readily available stock price and dividend history of a stock. Be advised that IQT focuses on Standard & Poor's A rated stocks. Keep in mind that the IQT strategy may not be completely valid for stocks that have a lower rating and/or a shorter history.

Table 1 contains the links to the stocks in our portfolio. There is no guarantee that inclusion in this list means that the stock meets all of Bruce Miller's or IQT's criteria. Neither the data nor the plots come from IQT.

The directory of plots has a complete list of links to all stock plots available on this web site.

Table 1: Links to Dividend History Plots for Our Stocks
Ticker Stock Name
ADP Automatic Data Processing, Inc.
AINV Apollo Investment Corporation
BMO Bank of Montreal
BMY Bristol-Myers Squibb Company
BOH Bank of Hawaii Corporation
EPD Enterprise Products Partners LP
EXC Exelon Corporation
FE FirstEnergy Corp.
INTC Intel Corporation
JNJ Johnson & Johnson
KMB Kimberly-Clark Corporation
MDP Meredith Corporation
MMP Magellan Midstream Partners LP
PFE Pfizer Inc.
PG Procter & Gamble Co.
PPL PPL Corporation
PSEC Prospect Energy Corporation
SYY Sysco Corp.
T AT&T, Inc.

Below are the explanations of the five plots that are shown for each stock.

The price history plot
shows the split and dividend adjusted price. In other words the most recent price of the stock is unadjusted. Historical prices are adjusted downward to account for dividends paid or stock splits. This gives a better picture of how you would have done had you owned the stock through its history. If you do not include the dividends in the calculation, then you will seriously underestimate the performance of these high dividend paying stocks.

The dividend history plot
shows the split adjusted dividend. In other words, each dividend is divided by the cumulative split ratio reaching back from the most recent plot date to the date of the dividend. This gives you a better picture of how the dividend has progressed had you started with a single share and held it up to the present time. There are some difficutlies in interpreting the plot. Extra dividends look like a sudden drop in the dividend. To try to understand whether the sudden drop is not bad because it is an extra dividend or whether it is bad because it is a real drop, refer to the dividend frequency plot as described next. Flat stretches of no dividend growth that are longer than 8 quarters have been deemed by Bruce Miller as something to be concerned about. The green line on the plot is a least-squares fit of a straight line to the data plotted by the red line. If it is a good fit, it might make it easier to calculate the rate of growth of the dividend.

Washington Mutual shows an extreme case. Look at the Dividend History plot to see the sudden sharp drop in dividends in early 2008. This was the indication to get out of this stock immediately. Maybe the previous price drop could have been ignored as long as the dividends were still coming in. Although, the payout ratio was probably an indication of trouble long before the dividend cut. However, the cut was certainly the last straw.

We learned on 12/13/2007 that the divided would be cut to $0.15. At that rate it would be yielding 3.8% at the then current price of $15.59. We sold out on 12/14/2007 at $15.45. We replaced the stock with Nustar Energy, L.P. paying a dividend of 7.27% at the time. The actual Washington Mutual cut dividend wasn't paid until 01/29/2008 as shown on the plot.

There were capital losses (37% in 4 years offset by 27% accumulated dividends) for waiting for the dividend cut to get out of the stock, but at least we got out 9 months before the dying breath on 09/26/2008. Washington Mutual had actually reached as high as $21.75 between the time we sold it and the eventual fall to $0.16 on its last day of trading.

The dividend frequency history plot
shows the number of times per year that a dividend was paid. In other words a quarterly payment is made 4 times per year and a monthly payment is made 12 times a year. The frequency is derived solely by looking at the dates of the dividends. There is hardly any more intelligence in the calculation than that. If the frequency suddenly changes from one number to a hugely different number, then it is probably a sign of a special dividend payment. These plots could be more meaningful if artificial intelligence were used in producing them. For now, the reader of the plot must supply human intelligence to draw any meaning from the plot.

The dividend growth rate history plot
shows the history of the growth rate of the annual dividend. This is not the yield history as described for the next plot. We want the dividends to grow over the years so our income will keep up with inflation. It is easy to see on the dividend history plot whether or not the dividend is growing, but it is not immediately obvious if it is growing fast enough. On this, the dividend growth rate history plot, you can see the actual rate of growth that you can compare to inflation or to the growth rate of other stock dividends.

I started making this kind of plot in July 2009. For some of the example stocks that I mention that no longer existed on this date, this plot will not be present. This plot may also be missing for some stocks in which I had a brief interest before July 2009, but am no longer actively tracking.

The yield history plot
shows the dividend yield over time. This is calculated as the actual dividend most recently paid at the time divided by the actual price at the same time all annualized. This is kind of tricky to produce. As explained above, calculating the frequency of the dividend to get an annualized yield is not easy. If a split occurs between the time a dividend is paid and the time the yield is calculated, then this must be taken into account. Who knows if this has been done correctly. Also the calculations are no better than the underlying data from which they were done. Errors in the data have been found in the past. Hopefully, by applying human intelligence to the interpretation of the plot, you will be able to detect any serious anomalies. Any repeating patterns that you think you see are solely a figment of your own imagination. Even if the patterns were real, there is no guarantee that history will repeat itself.

If there were one or more outliers in the data, they would have a huge impact on the scale of the vertical axis of the plot. This would make it hard to see the patterns in the more normal data. In order to ameliorate this situation, the top of the vertical axis is not allowed to go above 20% yield. Yields higher than 20% are most likely uninteresting outliers.

Remember, we told you this information was not worth more than the price you have paid for it.

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Retirement Withdrawals

Originally, I felt constrained that part of my income was coming from tax deferred accounts. I had to pay tax on the withdrawals, and I was losing the tax deferment on any gains that the withdrawn money would have earned.

The solution may be obvious to you, but it took me a few months to figure it out.

Now, if I need some cash from the dividends in a tax deferred account, I sell enough stock in a non-deferred account to raise an amount of money to equal the dividends I want to withdraw. I then invest the dividend sitting in my tax-deferred account into whatever stock appears to be the best investment to make at the current time. I usually pick a low yielding stock to sell and a higher yielding stock to buy. If the stock I sell is at a capital loss, I even get tax benefits from the transaction instead of a tax loss from withdrawing from the tax-deferred account.

Also, If I decide to sell a stock in my taxable account, I take an equal amount of cash that has built up from dividends in my tax deferred account and invest it in another stock. That way I am raising the fraction of my net worth that is tax deferred and I am not paying taxes on money I might otherwise have withdrawn from the tax deferred account. The new investment gains the tax deferred treatment by being in my deferred account instead of in my taxable account. I am also building the amount of cash that I can withdraw without paying taxes on what should remain tax deferred.

I use the proceeds from the stock sale in my taxable account for my retirement income. Effectively, I am still only using dividends for income, because of the offsetting investment in my tax deferred account.

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Definitions of Terms

Here are some sources for financial definitions of terms:

Investopedia
Financial Dictionary at thefreedictionary.com

Here are some definitions that are significant for securities in our investment portfolio or considered for our investment portfolio.

CDO - Collaterized Debt Obligation
A debt security collateralized by a variety of debt obligations including bonds and loans of different maturities and credit quality.

LEAP - Long-Term Equity Anticipation Securities
Publicly traded options contracts with expiration dates that are longer than one year. Structurally, LEAPS are no different from short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts. The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.

LEAPS are an excellent way for a longer-term trader to gain exposure to a prolonged trend in a given security without having to roll several short-term contracts together. The ability to buy a call/put option that expires one or two years in the future is very alluring because it gives the holder exposure to the long-term price movement without the need to invest the larger amount of capital that would be required to own the underlying asset outright. These long-term options can be purchased not only for individual stocks, but also for equity indexes (such as the S&P 500).

MTM - Mark To Market
The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

This is done most often in futures accounts to make sure that margin requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call.

One can also contrast the current market value to the value at purchase or the value of the item when it was used as collateral. This issue is important to any loan that has a maximum loan to collateral value ratio. When the MTM price causes the maximum ratio to be exceeded, then the borrower must come up with additional collateral. This is similar to the margin call in a futures account as mentioned above, but the idea is extended to other types of loans.

RDY - Relative Dividend Yield
From the book of the same name:
Note: There are two ways of doing Relative Dividend Yield. One is ratio -- the stock's yield divided by the market's yield. But you can also do it on a spread basis by looking at the difference -- between the stock yield and the S&P 500 (market index) yield. Until six or eight years ago, both kinds of RDY tended to move together. But as yields dropped in the 1990s, the two ways of measuring RDY began to show some divergence.
TruPS - Trust Preferred Securities
A Trust preferred security is a security possessing characteristics of both equity and debt issues. A company creates trust-preferred securities by creating a trust and issuing debt to the new entity, while the trust issues the trust preferred securities.

The security is similar to debentures and preferreds in that it is generally longer term, has early redemption features, makes periodic fixed or variable interest payments, and matures at face value.

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Investing Forum

To participate in the discussion of ideas on investing go to Steve's Investing Forum.

You can read about Steve's description of his retirement investing strategy before going to the forum.

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