In this issue he discusses his investing strategy and also provides 3 specific stock ideas for 2013 that he has determined are likely to be strong investments.
Dave is one of the leading writers of dividend investing articles on Seeking Alpha (see his profile here) with over 30 Editor’s Pick articles.
He holds an undergraduate degree in physics from Holy Cross College and earned his JD from Georgetown University Law Center in 1974. He received formal business training in the MBA program at Rochester Institute of Technology and also in the executive development program at INSEAD in Fontainebleau, France, one of the world’s leading graduate business schools. After a corporate career that included positions with general management and strategy development responsibilities, Dave has been analyzing and writing about stocks since 2001.
Personally, I think his articles on Seeking Alpha are some of the best there are on this subject, and I recommend checking them out. He recently published Top 40 Dividend Stocks for 2013, which is a premium online resource that educates readers about dividend growth investing and then provides 40 specific stock ideas for the year.
How would you describe your investing philosophy?
I am a dividend growth investor. By that I mean that I invest only in stocks that have a history of increasing their dividends each year.
I should back up here and explain how I came to this investing philosophy. I used to be a pretty conventional value investor, then I did “swing trading” for a while. But in about 2007-2008, I realized that my ultimate goal was to have sufficient income for retirement. I am a big believer that one’s investing strategy should be connected logically to one’s goals: Your investing strategy should be custom-designed to achieve your goals. Then you figure out tactics and specific action items that will help you execute your strategy and achieve your goals. It’s all very businesslike and methodical, proceeding from the general to the specific.
Retirement planning, I have found, is “all about income.” That is, you have a budget with your expenses laid out. You need income to cover those expenses. When you are working, your paycheck covers your expenses. When you retire, you need to replace your paycheck with income from other sources. For me, those sources are a pension that I am fortunate to have, Social Security, and income from my investments.
I have found that there are two distinct philosophies about how to generate income from your investments. The traditional one, espoused by most financial advisors, is to save and invest during your working years to achieve “Your Number.” Maybe that is $2,248,575. You’ve probably seen the commercials with people walking around with their Number under their arm.
While the ads don’t go on to spell this out, the idea is that in retirement, you will sell things from your accumulated assets to generate the “income” you need each year. (I put “income” in quotes, because I want to make it clear that what you are really doing is liquidating assets to get your hands on the cash that you need.) The traditional notion is to determine a “safe” percentage of your assets that you can sell each year—usually around 4 percent—so that you don’t run out of money while you are alive.
There are problems with that approach. Two big problems are, first, if there is a bear market just before or just after your retirement, your whole plan can be decimated, as you will be making increasing withdrawals from a declining asset base. A “Number” that was planned to last 30 years may only last 20. And second, you must increase your withdrawals every year to account for inflation. Depending on how the markets are doing, those increases compound every year to put severe pressure on your accumulated assets (which you are selling off).
As I thought about it, I was wondering why the conventional advice is not to accumulate income-generating assets whose income by itself may generate enough cash that you don’t have to liquidate anything. Dividend growth stocks are exactly those kinds of assets. While conventional wisdom is that stocks are riskier than bonds (because of market risk), I think it can be argued that dividend growth stocks are safer, because the income from them (1) comes without having to liquidate them, and (2) grows each year, usually faster than inflation. Of course, you have to manage your portfolio to keep it balanced and to react if there are dividend cuts, but this is not really difficult, and for many people it is a lot of fun. It’s really fun watching that dividend stream increase each year.
If anyone wants to see my demonstration Dividend Growth Portfolio in action, they can view it on my free Web site. It is a real-life, real-money, real-time portfolio. I update its results at the end of each month. Its dividend stream grew 11 percent in 2012.
One last thing. A strategy of living off of income is sometimes criticized as only for the wealthy. People who say that are having trouble with basic math. If you have a portfolio of $800,000 and you withdraw 4% of it in your first year of retirement, that means you get $32,000. Well if you have an $800,000 dividend growth portfolio yielding 4%, you also get $32,000. It’s the same number. Plus in the latter instance, you did not need to liquidate anything to get that cash. Under the 4%-withdrawal rule, you’ve reduced your assets going into Year 2 of retirement. That’s why, under the wrong circumstances, a “Number” portfolio for withdrawals can fail many years before it was designed to run out. A portfolio that generates income—and does not require withdrawals—will never run out.
Do you have a specific method or set of methods for determining a fair price of a stock for a long-term holding?
Sure do. I divide dividend growth investing into three steps: Evaluating companies; valuing their stocks; and managing the portfolio. I consider stock valuation to be an essential step.
My approach is pretty simple to execute, but it is fairly sophisticated in concept. Valuation is really an appraisal process, and as in any appraisal process, reasonable minds can differ. Two of the most common methods for valuing stocks are (1) net present value and (2) valuation ratios. I use both.
For net present value estimations of a stock’s “intrinsic value,” I use Morningstar’s star ratings. Their analysts utilize a proprietary and highly detailed net present value analysis. I like that they don’t just plug numbers into a formula, but they also make judgments on things like whether a company has a sustainable competitive advantage (commonly called “moat”). Their star ratings reflect whether they conclude that a stock is undervalued (4 or 5 stars), fairly valued (3 stars), or overvalued (1 or 2 stars). While the stars appear simple, the work behind them is quite intelligent, in my opinion.
For valuation ratios, I use F.A.S.T. Graphs. These graphs calculate “earnings-justified” prices for each stock, then display that on a graph along with the stock’s actual price. Chuck Carnevale, the creator of F.A.S.T. Graphs, computes the intrinsic value of each stock by using the P/E valuation ratio. He selects the most applicable P/E ratio based on how fast the stock is growing earnings. Most of the time, for typical dividend growth stocks, he uses a P/E of 15, and he plots those fair values over time with an orange line. It is easy to read off the graph whether the stock’s actual black price line is beneath the orange line (undervalued), pretty close to it (fairly valued), or above it (overvalued).
I look at both of these valuation appraisals for each stock. Usually they are in agreement. If not, I blend them or investigate further as to why they are different.
In your opinion, do the ETFs that focus on dividends work as well as a self-made selection of individual dividend growth stocks?
No. I examined about 10 dividend ETFs last year, and I was very disappointed by what I found. The top holding in one of them did not even pay a dividend! All suffered from their cost structures. In an ETF, the costs are subtracted from distributions before the distributions are made. So if a hypothetical ETF contained stocks that each yielded 4.0%, and the ETF had an expense ratio of 0.5%, the distributions to customers would be 3.5%. That may not sound like much, but it actually means that 13% of the income from the stocks never finds its way to customers.
An individual who is willing to make a plan and follow it will do much better on his or her own than with any ETF that I examined. Several of the ETFs had year-over-year distribution reductions in the past couple of years, which is almost unheard of for well-constructed dividend growth portfolios containing individual stocks.
Out of your new Top 40 Dividend Stocks, can you provide three example picks? What makes these three stocks appear to be solid purchases for this year?
Sure. One classic dividend growth stock that has appeared in my eBook every year is Johnson & Johnson (JNJ). This is the world’s most comprehensive manufacturer and distributor of health care products and related services. It is a mammoth holding company, with over 250 operating companies in 75 countries. It is one of the few corporations with an AAA credit rating (higher than the U.S. government). JNJ is widely regarded as having one of the strongest drug development pipelines in the world, and of course they are widely known for their many healthcare and personal care products. They had some manufacturing difficulties over the past couple of years, but those have been addressed. The yield is around 3.4%. They have been increasing their dividend since Kennedy was president; last year’s increase was 7%. The stock has a low beta (about 0.6), and it is fairly valued at the moment.
I like to include a few Master Limited Partnerships (MLPs) in my portfolios. Kinder Morgan Energy Partners (KMP) has made the Top 40 in four years of the six that I have published. It is one of the first and one of the largest MLPs. I like MLPs because they have one of my favorite business models—the tollbooth. They transport oil and other natural resource products, charging regulated rates for doing so. That largely insulates them from the price variations in the products they are transporting. KMP has tens of thousands of miles of pipelines criss-crossing the country, collecting their tariffs as products move through them. The company has stated that it intends to increase its distributions at double-digit rates for the next several years. KMP has increased its distributions for 16 straight years. Last year’s increase was 6%, and their yield is about 5.8%. I view the stock as undervalued to fairly valued at the present time.
My third example is a newcomer to my Top 40 this year: Textainer (TGH). This company is into containerized shipping; they are one of the largest in the world. This stock won’t appeal to everybody’s taste, because it has a high beta (1.7). But it yields about 5.0%, has increased its dividends for 6 straight years, and last year’s increase was a whopping 27%. I am eyeballing this stock for my own portfolios.
Thanks again to Dave for providing the interview. Consider taking a look at his site and his Top 40 Dividend Stocks for 2013.
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Particularly Relevant for this Interview:
Kinder Morgan Energy Partners: Still Poised for Good Returns
Kinder Morgan Inc. Analysis