Saturday, September 27, 2014

Cocktail napkin math on 5 plus 5 dividend yield and growth

One of the main metrics I use is the simple 5+5 rule that I first came across in Daniel Peris' excellent book Strategic Dividend Investor. The 5 + 5 rule looks for a combination of dividend yield and dividend growth. So the total should equal 10 percentage points, for example 5 percentage points of current dividend yield plus 5 percentage points of annual dividend growth.

Putting this into practice is about a rough separation for high yield and low dividend growth versus lower yielders with high dividend growth. . A company with a 3% dividend yield would need at least 7% dividend growth to clear the bar. Likewise a high yielding company with say 6% would only need a tepid 4% growth to get over the 5+5 hurdle.

GlaxoSmithKline's 5.6% current yield combined with a 6.6% 5 year annualized dividend growth clears the 5+5 hurdle with a total of 12.2. By the same token, IBM clears the hurdle even though it has a much lower yield of 2.3%, IBM sports a 5 year dividend growth rate of 14.3% for a combined 16.6 percentage points.

Before any mathematicians jab a pencil into their eye, the 5 + 5 rule is not about mathematical precision. Its much more about orienting your frame of reference for investment selection and ongoing portfolio management - what am i looking for with this investment? What does "good enough" look like? What are the minimum expected growth rates that are acceptable given the current yield? Is a low yielder with decent growth as good an investments as a high yielder?

I did some cocktail napkin math with four scenarios
• 2% current yield with 8% growth
• 3% current yield with 7% growth
• 4% current yield with 6% growth
• 5% current yield with 5% growth
First cut is income only and 5% current yield wins here, more than double the income at the end of the decade (though not double on cost)

 Yield Plus Growth 2+8 3+7 4+6 5+5 Income - Year 1 2 3 4 5 Year 2 2.16 3.21 4.24 5.25 Year 3 2.33 3.43 4.49 5.51 Year 4 2.52 3.68 4.76 5.79 Year 5 2.72 3.93 5.05 6.08 Year 6 2.94 4.21 5.35 6.38 Year 7 3.17 4.50 5.67 6.70 Year 8 3.43 4.82 6.01 7.04 Year 9 3.70 5.15 6.38 7.39 Year 10 4.00 5.52 6.76 7.76 Total 28.97 41.45 52.72 62.89

For Capital appreciation I tracked the growth of \$100 and assumed that the shares roughly track the dividend growth and so the 2% yield wins here

 2+8 3+7 4+6 5+5 Capital - Year 1 100 100 100 100 Year 2 108.00 107.00 106.00 105.00 Year 3 116.64 114.49 112.36 110.25 Year 4 125.97 122.50 119.10 115.76 Year 5 136.05 131.08 126.25 121.55 Year 6 146.93 140.26 133.82 127.63 Year 7 158.69 150.07 141.85 134.01 Year 8 171.38 160.58 150.36 140.71 Year 9 185.09 171.82 159.38 147.75 Year 10 199.90 183.85 168.95 155.13 Total 1,448.66 1,381.64 1,318.08 1,257.79

Then in the last scenario I combine the income plus capital plus reinvest the dividends each year.

 2+8 3+7 4+6 5+5 Total W Div Reinvested 100 100 100 100 Year 2 110.16 110.21 110.24 110.25 Year 3 121.31 121.36 121.35 121.28 Year 4 133.53 133.53 133.39 133.13 Year 5 146.93 146.81 146.45 145.86 Year 6 161.63 161.29 160.59 159.54 Year 7 177.73 177.09 175.90 174.21 Year 8 195.38 194.30 192.46 189.96 Year 9 214.71 213.06 210.39 206.84 Year 10 235.88 233.48 229.77 224.94 Total 1,597.25 1,591.13 1,580.54 1,566.01

The ten year total returns are for all intents and purposes identical. I think this shows the value of 5 + 5 as a conceptual model. Of course, its a model not reality, but despite it breaking any number mathematical rules it holds up well as a rough guide.

There are a  number of caveats here, first there is no guarantee that share price will track dividend growth, although it usually does over a long enough time scale.  One of my starting points is 5 years annualized dividend growth, but just because IBM and GSK have grown their dividends in line with the 5 + 5 rule for the last five years, the future can be different. Just ask Tesco or Boardwalk Pipeline shareholders.

I still find it interesting to see that in a total return view the 5+5 thinking works pretty well and it confirms to me that both low yielders like IBM and high yielders like GSK can be worthwhile long term holdings when dividends are reinvested.

Friday, September 19, 2014

Bill Gates, Dividend Investor

WSJ Story on Michael Larson who manages investments for Bill Gates mentions the variety of different assets in the portfolio. This includes real estate, hotels, and a lot of stocks, too.

The stock portfolio is interesting to study, as you might imagine its pretty defensive. Berkshire Hathaway is 46% of the portfolio. Clearly follows rule 1 - don't lose money.

There are a number of idiosyncratic ideas in the portfolio like Liberty Global, Grupo Televisa, and Crown Castle.  These things all sound interesting but overall majority of these kind of things just goes into the "too hard" pile for me.

Luckily though, a clear theme emerges in something I can get traction on - over a third of the stock portfolio is high quality dividend growth stocks.

Here is my calculation of dividend income from the top dividend payers in the portfolio.

 Shares Div Income Yield Coca Cola (KO) 34,002,000 1.22 41,482,440.00 3.10% Caterpillar (CAT) 11,260,857 2.8 31,530,399.60 2.8 McDonald's (MCD) 10,872,500 3.24 35,226,900.00 3.4 Wal-Mart (WMT) 11,603,000 1.92 22,277,760.00 2.6 Waste Mgmt (WM) 18,633,672 1.5 27,950,508.00 3.4 Exxon Mobil (XOM) 8,143,858 2.76 22,477,048.08 2.8 Republic Services (RSG) 1,350,000 1.12 1,512,000.00 3 Arcos Dorados (ARCO) 3,060,500 0.24 734,520.00 3.8 Coca Cola FEMSA (KOF) 6,214,719 1.11 6,898,338.09 1.1 BP (BP) 7,315,267 2.34 17,117,724.78 4.7 \$207,207,638.55

The portfolio construction has a couple of patterns. There are blue chip stalwart, dividend champion types - Coca Cola, McDonald's, Wal-Mart, and Exxon Mobil.  The kind of stocks where you buy right and sit tight.

Then there is trash - Waste Management and Republic Services. I really appreciate the static nature of these businesses. Waste Management owns I believe around half the of the landfills in the US, so even if they lose a hauling contract their competition has to pay them to use the landfill. Though I like the model, I could not get the math to add up on the safety of their dividend to get comfortable with WM. Republic Services looked more interesting some years back but the price has really run up.

There is a minor theme in the portfolio - US brands in Latin America. Coca Cola FEMSA is the largest Coke bottler outside the US and distributes products across Mexico and most of Latin America. Arcos Dorados (currently at/near 52 multi year low with a single digit forward P/E and near 4% yield) is the McDonald's franchisee for all of Latin America with over 2,000 McDonald's in 20 countries. These two standout as separate from the blue chip dividend approach and offer a potentially viable way to invest and earn income in Latin America.

Like Charlie Munger says its often profitable to learn from great investors.  With a track record like Michael Larson's where "Mr. Gates's net worth has swelled to about \$82 billion from \$5 billion since he hired the former bond-fund manager and gave him autonomy to buy and sell investments as he sees fit." its for sure that 16x growth with low risk is worth learning from. My takeaways from the stock portion of the portfolio are -

1) Play defense first - 45% in Berkshire Hathaway helps anyone sleep well at night.

2) Generate quality income - boring is beautiful, the dividend championesque list above comprises over 33% of the portfolio and continues to deliver dividend growth

3) Be opportunistic - investments like Canadian National Railway and Liberty Global have paid off big time with each up over 200% since purchase

Reverse engineering those rules sounds just like the philosophy here- Safety, Dividends, Growth - in that order.

Sunday, September 14, 2014

Summary of recent stories of interest, sometimes enduring, to investors.

• A Wealth of Common Sense - "The Best and Worst Things About Investing in Emerging Markets", the growth is there for all to see, but when it comes to picking winners in stocks that is not so easily done "China had by far the highest economic growth rate but also had one of the worst performing stock markets. Mexico, Brazil and South Africa all showed excellent stock returns with only decent economic growth. Other counties, including Turkey and Taiwan, actually showed economic and market performance that were in line with one another
• Morgan Housel doubts there have been 48,000 "perfect storms" in the last month. Bernstein's shallow risk is an annoyance not deep risk.
• Microsoft buying Minecraft and Co. Count me as a believer. Continue to be impressed with Nadella. If you go way back to the 80s, Apple's strategy had at its core a focus on kids and school computing. What are smart, creative kids doing today? A lot are crafting. So in a week that saw Apple introduce a device with three shopworn features presented as innovation, Microsoft gains direct access to waves of the next generations to hit computing platforms for decades to come.
• John Huber on how to be the best plumber in Bemidji. "The good news is that the stock market is filled with opportunities (10,000 opportunities in the US alone), and most people—if they have the will and the work ethic—can carve out an advantage in some small corner of the market not unlike the one that the best plumbing contractor in that small Minnesota town has."

Thursday, September 11, 2014

Book Review - Education of a Value Investor

We live in a categorized, check box kind of world, so Guy Spier's "Education of a Value Investor" is bound to be sitting on a shelf in the Business/Investment category at Barnes & Noble right next to the numerous How To investing guides. But this is not a How To book, its a personal journey of discovery and value investing as conducted by Buffett, Munger, and Pabrai is a North star on this journey.

I received the book today and read it in one go, I suspect others will have a similar experience; find a quiet place and a comfortable chair - Guy Spier's story, told warts and all, pulls you in. Its hard to imagine rooting for a  self admitted Gordon Gekko type, but when he eventually starts to get it and figure out the bigger picture, and helps the reader learn from his own travails its easy to get behind Guy Spier's journey.

The book plainly isn't about the mechanics of investing, there are lots of books that covers these. The main theme is much more fundamental - make sure you spend as much of your time as possible with high quality people. One of my mentors in my own career advised you should always take at least one job in your career simply because of the people you would work with at that company. Guy Spier has sort of adopted this and expanded so its not about one job but a core operating philosophy. He cites a numerous second and third order powerful obliquities that arose out of this mode of operating.

There is another unexpected theme along this journey - gratitude. One of the most compelling parts of the book to me is the description of Guy Spier's devotion to the small, thoughtful kindness of writing thank you notes. To many people. This has the effect of both touching other people and ensuring that you are accounting for what you have received. These are important lessons not to lose sight of in today's world.

Friendships, people, gratitude - there are large parts of the book that are more like a self improvement book, and Guy Spier points to Tony Robbins' and others influences. Lots of people have benefitted from their work to improve their own productivity, health and personally develop, but Guy Spier shows exactly how this plays out in financial markets and in investor psychology which is a unique contribution, especially due to his transparent writing. Its a brave effort to put his mistakes on display and to share the journey at this level.

Value investing is almost like its own character in the book, and in the beginning of his career, Spier is as far from that concept as you could be, but by the end he has fully embraced and internalized the concepts.

Practically speaking there are number of good lessons, too. Spier's discussion of moving his practice from New York to Zurich goes into some detail about his thought process on designing the new space. There is a hard separation between the computer, Bloomberg busy room and a quiet library for reading with no computers. It struck me that Kahneman might call them System 1 room and System 2 room.

Spier stresses the importance of checklists and shares the key insight that checklists are not to tell you what to do, checklists are critical as a mistake avoidance tool. He includes a helpful way to think about processing investment ideas - do your own research first and then read news and other things about companies. Don't be led in by news or analyst reports because your susceptible to seeing things through their lens.

The overall theme is personal growth and connecting on a deeper level with great people (living and dead(through books)) they will help you discover vital things you can't on your own. The personal theme is to be true to yourself, do your research first, or as I say - outsource execution if you want, but never outsource strategy. Guy Spier writes that the "path to true success is through authenticity"and on this measure the book is a Peter Lynch ten bagger.

The real gem is the insight that value investing principles can go well beyond making money in the stock market; Guy Spier shows how value investing principles can be applied to enrich your personal life.

Saturday, September 6, 2014

 Dominion on value of Moats
Summary of recent stories of interest, sometimes enduring, to investors. Note, everyone appears to have got a good vacation, there must be something to taking time off that refreshes you because the first three are as good as any I have read all year:

• My favorite piece from this week is Sanjay Bakshi's lecture notes where takes a walk through the deep woods of second and third order effects of Gary Klein and Daniel Kahneman. There is no simple way to reconcile the two, Klein is focused on gaining insight and Kahneman on mistake avoidance, but lessons from Sherlock Holmes shed some insight.
• Howard Marks Risk Revisited covers a tremendous amount of cognitive terrain, not possible to summarize, just read it, but one nugget I really enjoyed was Marks' inverting Elroy Dimson's "risk means more things can happen than will  happen" to "even though many things can happen only one will."
• John Kay - The Wisest Choices Depend on Instinct and Careful Analysis - "We will never succeed in evaluating works of art, choosing candidates, managing risk, without the skills that can be acquired only through experience; but that experience can always be enhanced by the power of data analysis and the implementation of scientific techniques."
• Todd Wenning documents lessons learned from Tesco's whopper of a dividend cut. Engineers know that you can learn more from failure than success and that makes it important to do a readout when things don't go your way. Yours truly owes Todd a debt of gratitude because running his Dividend Compass on Tesco a couple of times over the years convinced me to steer clear, even though I was intrigued. The dividend is the big enemy for income investors, you lose income and the shares get whacked. As Todd reminds us, no dividend is risk-less, investors should leave the party when the numbers don't make sense. He advises investors to have selling rules, so much is written about how to buy, but selling can be just as important a decision. Emotions are a chief enemy of investment success. If anything, emotions play a bigger role when selling because you become attached and anchored to your years as an owner. Better to have a checklist to buy and a checklist to sell
• Millenial Investor - Beware experts Bearing Predictions - avoid investment decisions based on subjective predictions. he quotes Jiddu Krishnamurti "The primary cause of disorder in ourselves is the seeking of reality promised by another"
• Dividend Mantra - Think Like an Owner - this is an important, oft-repeated concept. This post shows its tie in with dividend investing, namely - if you're an owner expect a paycheck.
• Related to above: Peter Lynch in 1994 on Knowing What You Own, and why its better to make 10x your money in Dunkin' Donuts than swinging for the fences on something you know nothing about.