Tuesday, July 29, 2014

Buy a High Yield Portfolio and Hold Forever

In a October 2008 article, Todd Wenning described the High Yield Portfolio approach this way - "Buy 10 to 15 high-yielding large-cap stocks today and hold them -- forever."

Todd Wenning used a ruleset from Stephen Bland writing at the Motley Fool UK back in 2000 to select a basket of high yielding companies. The ruleset is as follows:
  • Large-cap stocks,
  • With a history of increasing dividends,
  • Relatively low debt levels, and
  • Sufficient dividend coverage,
  • That hail from diverse industries.
These are to held, basically forever, "the only permissible reasons to sell or remove a stock from the HYP portfolio are (1) the dividend is halted or cut, or (2) the company is acquired."

In the research article, Todd Wenning highlighted seven stocks:

Original dividend yield
Nucor 3.5%
Sysco 3.4%
Eli Lilly 5.5%
Caterpillar 4.1%
UPS 3.5%
Northrop Grumman 3.4%
Reynolds American 7.3%

The blended portfolio came in around 4.5% yield at time of purchase, so an investor who put in $1,500 in each company could realize over $450 in annual income. 

Fast forward to today, we are in a global yield famine. Its actually somewhat painful to look at the yields available circa 2008, but moving along how would an investor have done buying this HYP? I ran some numbers over on Longrundata.com.

Value of $1,500
is now worth
Annualized Total Return
Nucor $2,662.28 10.5%
Sysco 2,917.15 12.2
Eli Lilly 3,958.58 18.3
Caterpillar 5,466.24 25.2
UPS 3,939.37 18.2
Northrop Grumman 5,885.32 26.8
Reynolds American 5,202.26 24.1

The net result here is that from the time that Todd Wenning wrote this article on HYP to now, the value of those seven stocks with $1,500 in original (For a total of 10,500) plus dividends reinvested is worth $30,031.20 today. The average annualized return is 17.8%. 

Those are stellar results, but that's not the best part. The High Yield Portfolio concept is about Yield. Otherwise why hold forever? Turning to the current yield in those companies

Value of $1,500
is now worth
Current Yield Current Income
Nucor $2,662.28 2.9%$77.21
Sysco 2,917.15 3.1 90.43
Eli Lilly 3,958.58 3.2 126.67
Caterpillar 5,466.24 2.6 142.12
UPS 3,939.37 2.6 102.42
Northrop Grumman 5,885.32 2.3 135.36
Reynolds American 5,202.26 4.3 223.70

So with an initial investment in the fictional HYP in October 2008 of $10,500, this group of companies not only delivered capital gains; it now yields $897.92. This equates to a 8.6% yield on original cost, closing in on a holy grail of income investors - a double digit yield on cost. This where a very good return goes to great.

Notice that there was no massive risk taking here, no ground breaking discoveries, no impossible to predict outcomes. Its as dowdy a group of companies as you are likely to find.. The idea of a HYP is sound in principle, and examples like Todd Wenning's show how well it can work in practice. 

Monday, July 28, 2014

Why Moats Matter

I read Why Moats Matter while on Martha's Vineyard. This felt especially appropriate. The moat concept that Morningstar pioneered is all about different kinds of structural competitive advantages. When you are on an island like Martha's Vineyard, there is no bridge to the mainland, only a ferry or a plane. If you need anything you better hope you brought it with you or prepare to pay a rich price to acquire it on the island. The only thing better than a moat is an ocean.

Heather Brilliant, Elizabeth Collins, and an all star cast of Morningstar analysts provide a detailed analysis of the Morningstar analysis framework. The book opens with the five kinds of moats that Morningstar uses - Intangible Assets, Cost Advantage, Switching Cost, Network Effect, and Efficient Scale. The rest of the book could just as easily be called How Moats Matter since it really focuses more on how to analyze moats and use them in your investing analysis.

The chapter on moats trends breaks down the competitive landscape by sector. That's interesting because looking at the positive and negative moat trends shows which spaces are more hotly contested

Todd Wenning's chapter is on How Stewardship affects economic moats. Morningstar's view is that its more about the horse than the jockey. Todd writes "Management itself can't make a moat, but a company can enhance or establish a moat resulting from its management's skillful effort to allocate capital toward moat-widening projects. On the other hand, poor stewards of shareholder capital that consistently invest in competitively disadvantaged projects for the sake of short-term growth and destroy long-term shareholder value in the process would likely see moats erode over time."

One of my favorite parts of the book is the many real world examples. The stewardship chapter lists detailed examples for each sector of exemplary standouts (like consistently shareholder friendly IBM) and poor standouts (like Dean Foods).

Josh Peters' chapter on using moats with dividend investing has several useful nuggets, several of which are gleaned from the real money portfolio that he runs. The first is on the importance of avoiding dividend cuts. In the real money dividend portfolio, that Josh Peters runs at Morningstar, they have experienced negative total returns in 81% of the companies where the dividend was cut. For companies that held the dividend flat, they earned a positive return 67% of the time, and for the dividend growers it was 89% positive. Simply avoiding dividend cutters makes a huge difference in total returns, So how can moat analysis help? The business' moat is an important safety measure.

Moat Frequency of Cuts Avg Cut Size
No moat 7.4% 69.8%
Narrow Moat 5.3% 66.8%
Wide Moat 3.0% 66.0%

Wide moat companies are more than half as likely to undergo a dividend cut. That's a factor that should be considered right alongside traditional dividend safety metrics like dividend coverage, payout ratios and so on.

Long run total returns and wide moats work well together, Josh Peters writes "An attractive and sustainable dividend policy can create a "clientele effect" in which shareholders, amply rewarded through dividends, are less likely to dump their shares and hurt the stock price on the basis of short-run fluctuations in profits. This in turn may give management a freer hand to concentrate on long-term initiatives, even at the expense of near-term profits or cash flow." The ability to think longer term than your competition is a very rare thing, this strikes me as a huge advantage when an investor can find wide moat, dividend paying companies.

The first half of the book is on the conceptual, analytical framework. Just as useful is the second half which shows how the analytical tools are put to use in each sector. Like Pat Dorsey's book, this sector by sector view is very helpful because it shows how to apply moat analysis in different segments. What you look for in energy is quite different than technology or industrials. Further, the authors describe their view as to what kind of moats you are likely to find in each of the major industry sectors.

The book works well on two levels - as a guide for how moat analysis helps investors, and how these apply in sectors. For me, the most fruitful insight is the intersection of wide moats and dividends, which can result in, as Josh Peters writes "a sound provider of income and total returns."

Saturday, July 19, 2014

High Yield Reads - 7/19/14

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

  • Two good pieces in Barron's this week first up - Quite Contrary. I am always struck by virtually every fund manager and finance pro that I see interviewed characterizes themselves as "contrarian." Pretty sure for that to be valid the number needs to be below 50%. The Barron's story sums up today's conundrum well - "So when everyone appears to be a contrarian, what's a stockpicker to do? Perversely: Follow the consensus view"
  • The Worst May Be Over at IBM - IBM is a company with great fundamentals, R&D, and best of all a fantastic score on Todd Wenning's Dividend Compass. its also a hated stock selling for less than 10 times earnings. Personally, I agree with Buffett and see a lot to like at IBM. They've been beaten up by the market due to Cloud and Mobile trends, but that's missed a lot of their pluses (which I will cover in a future post). On top of that, this week the Apple-IBM partnership puts IBM in a great position, best in class back end (Websphere, Mainframe) for the best in class front end (Apple). Smart deal right out of Ricardo

Why We Write - Anecdote from Davis Dynasty Book

There is a great anecdote in The Davis Dynasty that I think resonates well with anyone who writes. As I mentioned in my full review of The Davis Dynasty book, this is a different kind of investing book. There are tons of business books about how one person or another climbed the ladder, found a way to make a fortune. Those are great, but the Davis Dynasty shows more of the effects on the personal side through three generations, which is pretty unique.

Towards the end of the book, the third generation Andrew Davis and Chris Davis are establishing themselves in the investment world. Chris Davis is working for Shelby Davis the patriarch, then in his 80s, who is at the tail end of his career. Shelby Davis specialized in investing in insurance companies, and he had published a weekly insurance newsletter. One of Chris (his grandson's) jobs was to help with publishing the newsletter, which in the age of computers was not really read by anyone outside their family office any more:

"Why do we bother this?" [Chris] asked Davis, "when nobody reads it."

"It's not for the readers," Davis said. "It's for us. We write it for ourselves. Putting ideas on paper forces you think things through." 

That's an excellent insight and applies well beyond investing. In the realm of investing, I have followed Jason Zweig's guidance in Your Money and Your Brain, where he advises that investors write out an Investment Policy Statement (IPS). Zweig says "The best way to prevent yourself from being knocked off track by your emotions is spell out your investment policies and procedures in advance in an IPS"

From Zweig's book and IPS should include:

"Purpose of Portfolio

Return Expectations

Time Horizon



Benchmarks and Review

Frequency of Evaluation

Adding and Subtracting

We Will Never..."

I think the last category is the most vital, because the IPS is essentially a mistake avoidance tool. The We Will Never rules to avoid act as guardrails. And writing them down is the first step. 

Monday, July 14, 2014

What Will Visa's Dividend Look Like in Five Years?

Tim McAleenan has a new post that Visa is only expensive if you can't think 5 years ahead. Its certainly expensive on conventional metrics. Visa's P/E sits at 26, which is pretty far beyond any territory a dividend seeking investor is likely to tread. In addition, the forward yield is 0.7%. Basically it has all the markings of an easy pass.

I think there is some merit to Tim McAleenan's view that five years out things could be different. First off, Visa's payout ratio is 17%, the company has the ability to pay a much higher dividend.  Visa is debt free with 44% net margins, and has earnings per share growth averaging 24% over last three years.

So how long will it take an investor in Visa today to exceed the S&P 500 1.9% dividend yield? I used the S&P 500 average 5% average dividend growth which gets you to a 2.4% yield on cost by 2019. For Visa the assumptions are a little trickier. The company has a  38% three year dividend growth rate. Its possible that continues, but that seems a little rosy. Instead I assumed that dividends will grow more in line with earnings and so I used the 24% EPS three year average, which is still pretty optimistic.

S&P 500 Visa
2014 1.90 0.74
2015 2.00 0.92
2016 2.09 1.14
2017 2.20 1.41
2018 2.31 1.75
2019 2.42 2.17

Using those assumptions, Visa's yield on cost does not exceed the market's current yield until 2019.  Assuming the trends stay in tact, there is good news in 2020 where the S&P moves up to 2.55% and Visa passes it with 2.69. I think its pretty realistic to think that Visa can get their yield into that range in 5-6 years, but a lot depends on if they want to. Does Visa have the inclination to increase the payout ratio or will they continue to prefer buy backs?

As always these assumptions are pretty basic, but the low starting point on Visa's dividend yield mean that continuing excellent operations are required to beat the plain, old vanilla index yield. 

Sunday, July 13, 2014

High Yield Reads - 7/13/14

Summary of recents posts and pieces of interest, sometimes enduring, to investors:

  • Josh Peters on dividend and buyback debate: the record for buybacks was set in 2007 near previous market highs, then when prices improved companies were concerned with the financial crisis and couldn't buy at attractive prices. Buy backs are great in theory, but  its not reasonable to expect management to be excellent at running their business and be the second coming of John Malone, too. 
  • Lou Ann Lofton: Invest Like a Girl. Words of wisdom; women "tend to think longer term, take much less risk, and just generally view investing more as a means to an end (security for their families, for example) than a game or a way to keep score." 
  • Meet the new fund holdings (mostly) the same as the old fund holdings - Forever Investor - checks in on Neil Woodford's new fund and finds it similar to his previous fund. It was an interesting parlor game to figure which ones he would buy. The qualities were still there on many holdings (Like AstraZeneca, Roche) but the prices had run up. Good signal to see them in the new portfolio (bought in June) as well.

Monday, July 7, 2014

The Davis Dynasty Book Review

The Davis Dynasty is a different kind of investing book. Its part biography, part history of investing business, and part how to succeed as a long term investor.

The Davis Dynasty tells the story of three generations of investors - Shelby Davis, Shelby Cullom Davis and Chris Davis. The latter still actively engaged at the Davis Venture Fund.

One of the common threads that run through the three generation is a substantially longer term focus this side of anyone outside of Omaha. This pays off in the long run. All investors know the power of compounding, but long term focus means that you are positioned to improve with age- 1 to 2 is nice, 2 to 4 is better, and when you get to 4 to 8 that is really great.

The end of the book summarizes the Davis principles of investing:

1. "Avoid Cheap stocks"

2. "Avoid expensive stocks" - the combined effect of rule 1 and rule 2, means that the Davis' occupy a middle ground between classic growth and classic value. When I look at the holdings of the Davis Venture Fund - Wells Fargo, Costco, Google, Bank of NY Mellon, Amazon, Berkshire, CVS -  I am left with the impression that its a quality at a reasonable price focus. Avoiding expensive stocks is obvious, but rule 1 is counterintuitive. I agree that most of the time stocks are cheap for a reason.

3. "Buy moderately priced stocks in companies that grow moderately fast"- look for companies that grow faster than the earnings multiple. That way you lock in a good chance for the Davis double play - higher earnings plus higher valuation. This takes time.

4. "Wait until the price is right" - as the Davis saying goes - "you make most of your money in bear markets, you just don't realize it at the time." Many investors from 2008 and beyond can relate to this. A corollary rule here is that you want to avoid losing most of your money in bull markets (not realizing you lost it until later).

5. "Don't fight progress" - seems obvious, but doubly important once you realize the time component. Progress can grind down your competitive advantages, to give the double play a chance to materialize you cannot swim against the tides for long periods.

6. "Invest in a theme"

7. "Let your winners ride"

8. "Bet on superior management"

9. "Ignore the rear view mirror'

10. " Stay the course"

Overall, its a very interesting read if you like market history. The book will not likely add new tactics to your investing toolset, but it does a good job of reinforcing long term investing principles and shows how these principles interact with real world markets through many decades of gyrations.