High Yield Reads - 8/10/14

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

• Eddy Elfenbein on a topic that's near and dear to many investors - what poolside investing is really all about. I agree with that watchlists trump screens, but I still like to run screens as a way to build the watchlist. 

• My original article related to Eddy Elfenbein's "poolside" tweet - Income Investing by the Poolside.

• Todd Wenning says that mechanical, quant formulas are the opposite of real investing.

• Tim McAleenan on how focusing on Yield on Cost to take the stupid out of investing. Tim uses the same example that originally got me interested in yield on cost - Buffett's Coke purchase which pays him $488M/year in dividends an rising, on an original $1.3 Billion purchase that is good for a 37% yield on cost. Every year. And growing. Its easy to see why academics dismiss yield on cost, if you ignore trading cost, opportunity cost, and assume a spherical cow of uniform density, err I mean perfect market timing, then YOC is irrelevant; however back in the real world its an excellent North Star for individuals, individual investors should embrace it as part of a long term strategy.

• Morgan Housel - How to scare yourself stupid. Innumeracy plus biases make for irrational risk management.

• John Kay - Why mean outcomes are often meaningless. There is no "right" answer when it comes to accounting for uncertainty.

• A Wealth of Common Sense - There's no such thing as precision when it comes to investing. "the data doesn’t really mean anything unless it’s put into the correct context."

• Forever Investor - AstraZeneca rejected Pfizer's buyout bid. It was fair to ask if AstraZeneca's management talk about the pipeline was more narrow self interest or more shareholder friendly. I tended to think the latter at the time, but we got an additional positive developments in that the management wasn't just talking, they were buying north of 3 million pounds of shares. 

• I have a new post Does Caterpillar or Deere Build the Better Dividend Paying Machine? 

Investing Lessons from the Best Trade in NBA History

The sports world is atwitter over Kevin Love joining Lebron James, Kyrie Irving and company in Cleveland. Is this is the greatest trade of all time or is it Red Auerbach getting Robert Parish and Kevin McHale in return for Joe Barry Carroll (aka Joe Barely Cares)?

Actually neither. The best trade by a wide margin involved a team and management that mostly no one  remembers, and no players.

Back in the 1970s, the NBA had a rival basketball league called the ABA. When the ABA folded, four teams, including current champ San Antonio, joined.  Two other teams cut financial deals, one of which proved remarkably successful:

"In the summer of 1976, with the ABA at the point of financial collapse after nine years, the six surviving franchises (the Virginia Squires went bankrupt immediately after the final season) began negotiating a merger with the NBA. But the senior circuit decided to accept only four teams from the rival league: the Nets (the last ABA champion), Denver Nuggets, Indiana Pacers and San Antonio Spurs.

The NBA placated John Y. Brown, owner of the Kentucky Colonels, by giving him a $3.3 million settlement in exchange for shutting his team down. (Brown later used much of that money to buy the Buffalo Braves of the NBA.) But the owners of the Spirits, the brothers Ozzie and Dan Silna, struck a prescient deal to acquire future television money from the teams that joined the NBA, a one-seventh share from each franchise, in perpetuity. With network TV deals becoming more and more lucrative, the deal has made the Silnas wealthy, earning them $186 million as of 2008, according to the Cleveland Plain Dealer, and $255 million as of 2012 according to the New York Times. (The NBA nearly succeeded in buying out the Silnas in 1982 by offering $5 million over eight years, but negotiations stalled when the siblings demanded $8 million over five.) On June 27, 2007, it was extended for another eight years, ensuring another $100 million-plus windfall for the Silnas. In 2014, the Silnas reached agreement with the NBA to end the perpetual payments and take a lump sum of $500 million instead. In the last few years of the deal, the Silnas were receiving $14.57 million a year, despite being owners of a team that hadn't played one minute of basketball in 35 years."

What a deal! The Silnas were clearly in the right place at the right time, no one knew what the future value of the NBA TV contracts would be. The Silnas played their hand well. They did not take a one time payment, instead they looked to the long run, recurring cash payments. 

Most people cannot own a pro sports team, but income investors can learn a lot from this mindset. Instead of looking for stocks that will pop this year, why not look out a decade or so to find opportunities? Sure there are stocks with potential to grow more in the near term than Coca Cola or IBM or Glaxo Smith Kline, but over the long term these companies should deliver income and income growth far into the future. These are three companies with excellent dividend track records.

GSK Dividend data by YCharts

Coke, IBM and Glaxo, all deliver above average dividend yields, all are in a defensible competitive position that can easily last a decade, and have long run dividend track records to demonstrate their moats.

	Fwd Yield	5 yr Avg Div Growth
Coca Cola	3.1%	8.1%
Glaxo Smith Kline	5.4%	6.6%
IBM	2.4%	14.3%

(Source: Morningstar)

These three defensive companies provide deliver decent to excellent current yields; and decent to excellent dividend growth. Its the kind of investment profile the Silnas would love. They turned down offers in the range of one time $3-5 million and were able to instead earn upwards of $750 million through focusing on long run income. In 1987, near the time the Silnas were turning down a $5 million buy out offer, Glaxo Smith Kline paid its shareholders $0.18 in dividends, today that payout stands at $2.40. Thinking in decades pays.

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. 

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."

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

• A Wealth of Common Sense - A Portfolio Premortem, this is one of my favorite concepts, writing down how to deal with adverse events. Its related to the Investment Policy Statement that Jason Zweig wrote about in Your Money and Your Brain.

• Forever Investor has a review of Joel Greenblatt's Little Book that Beats the Market. That along with his first book "You Too Can Be A Stock Market Genius" are two of my all time favorites. He does an excellent job at distilling concepts down in a way they can be applied by a wide array of investors

• Morgan Housel "I Prefer to Keep Things Simple" drills down on how boring Consumer Staples outperform exciting Tech. 

• Foolgirl "Invest Like a Girl, an American Girl" Barbie on decline, but American Girl isn't Mattel looks cheap, and their dividend continues to grow

• My new posts this week - argue that Unilever and Kimberly-Clark are better bargains than Colgate, Statistically Cheap Stocks Can Be Expensive, and Cracker Barrel's dividend growth may be leveling off.  

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

Diversification

Rebalancing

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. 

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.