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Letting Dividends Do Their Work

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Articles from The Prudent Investor

Dividend Investing Strategies – Dollar Cost Averaging

by George L Smyth

There are numerous strategies for employing dividend investing, which range from the speculative to the conservative.  Dollar cost averaging is a conservative strategy, which I think of as my baseline strategy, and the perfect place for the dividend investor to begin.

“We shall not cease from exploration
And the end of all our exploring
Will be to arrive where we started
And know the place for the first time.”
T.S. Eliot

Long ago I was given a year and a half lead time to prepare for a photographic exhibit that was to be based on water.  For months I would venture from home in search of worthy subjects and make prints with varying darkroom techniques.  A year passed and I felt that I did not have more than a small handful of unconnected pieces, certainly not enough worthy to be shown.  Although I had had direction, I had not had focus.

I decided to toss everything I had done and go back to the beginning, which for me was pinhole photography.  Not only was it a stable starting point for me, but it was also a means to obtain focus.  I found a pinhole sieve that had been given to me and put it in a pinhole camera.  Suddenly it was as if everything had become new.  I very quickly was able to make a dozen prints that hung well together and I still think of it as one of my favorite projects.

Dividend investing using dividend reinvestment programs came to me soon after I started investing.  Over the years I have tried numerous other investing opportunities - some worked well, others not so well.  Having invested in stocks for over two decades I note that I still have a number of the companies I started purchasing in 1997, and they have proven to be excellent investments.  These are the stocks that had been acquired through dividend reinvestment programs, and today about a third of my positions were obtained through the reinvestment of those dividends.

Dollar cost averaging is a baseline for dividend investing not only because it works so well, but also because the basic idea can be used as a launching point for other ideas.  These ideas can be small variations on what I know works through ideas that bring a bit of “spice” to the portfolio.

Dollar cost averaging (sometimes called the constant dollar plan) is a strategy where one breaks up their eventual stake in a company into numerous purchases over a period of time.  This is diametrically opposed to the single purchase, where one immediately places a large bet that the price of the stock will go up over time.

Advantages of Dollar Cost Averaging

The primary advantage of dollar cost averaging can be found in the reduction of risk.  When numerous purchases are made over time, each purchase is made at a different price point.  This means that the exact timing of each purchase becomes less significant.  As one who has seen (all too regularly) an immediate drop in a stock’s price directly after purchase, it can be disheartening to think that had I waited a day or two to make the buy, the eventual gain would have been better.  Dollar cost averaging oftentimes has investors actually hoping for a drop in the price of their own stocks.

A great example of dollar cost averaging is the contribution one makes to their 401(k) plan at work.  From each paycheck a specified amount of money is sent to the plan’s administrator to purchase index or mutual funds.  That amount buys the number of shares that can be bought with the amount applied.  There is no concern for the exact timing of each purchase, just faith that the instrument will increase in value over time, the same faith for all investments.

If one is bought every other week, over the course of the year 26 bi-weekly purchases would be made at 26 different purchase points.  The amount invested when the fund is doing well does not purchase as many shares as when it is not doing well.  This is why those fortuitous and unplanned dips just before a purchase are always welcome.

Of course, the idea is that when the investor wants to move money from the fund that it will be doing well – at least better than it was during the times of those purchases.  This is why I usually suggest that people look at a long term chart for the S&P 500, understand its generally upward trajectory, and consider investing in an index fund that tracks it.

An Example of Dollar Cost Averaging

As an example of dollar cost averaging let’s take a look at Aqua America (WTR), a stock in my portfolio.  Below is a list of the closing values on the first day of the month for the past two years.

Date Close Shares Date Close Shares
1/1/2018

$36.21

2.76

1/1/2019

$35.05

2.85

2/1/2018

$34.19

2.92

2/1/2019

$35.94

2.78

3/1/2018

$34.06

2.94

3/1/2019

$36.44

2.74

4/1/2018

$35.15

2.84

4/1/2019

$39.06

2.56

5/1/2018

$34.70

2.88

5/1/2019

$39.54

2.53

6/1/2018

$35.18

2.84

6/1/2019

$41.37

2.42

7/1/2018

$36.94

2.71

7/1/2019

$41.95

2.38

8/1/2018

$37.18

2.69

8/1/2019

$44.29

2.26

9/1/2018

$36.90

2.71

9/1/2019

$44.83

2.23

10/1/2018

$32.53

3.07

10/1/2019

$45.33

2.21

11/1/2018

$34.29

2.92

11/1/2019

$44.27

2.26

12/1/2018

$34.19

2.92

12/1/2019

$46.94

2.13

Assuming that one had made $100 purchases at the close of each of these dates (in a program that allowed for the purchase of partial shares), the investor would currently have about 63.5 shares of Aqua America, valued at $3,214, with an average purchase price of $38.19.

A single purchase made before April 1, 2019 would have yielded better results for this rising stock, so there is the case to be made that dollar cost averaging may not be using one’s money as efficiently as possible.  However, had I used MMM as an example (another stock in my portfolio) then the opposite would have been the case.  I will look at an actual means of comparing these two strategies in a moment.

The point is that there is considerably less stress when it comes to the issue of timing.  One seldom sees co-workers worrying about when the purchase to their 401(k) will be made, it is something that happens pretty much without notice, so no stress there.  Hoping that a one-time bet works out is great when it does.  But being forced into a long term strategy takes much of the pressure out of the situation.

Dollar Cost Averaging vs. Lump Sum Investing

Of course, this is not a panacea – nothing is.  For one, investing in a lump sum gets the money working more quickly, and if the market is rising then more money can be made than if that money was sitting on the sideline.  That said, if the market falls then losses come more quickly.

This whole subject works on the assumption that one has a large sum of money to invest in the first place.  In the real world not everyone has a spare $5,000 or $10,000, and considerations between dollar cost averaging and lump sum investing are more in tune with hypothetical questions like what one would do were they given $10,000.

But many of us do have a spare $50 or $100, and for those fortunate in their budgeting this is a regular occurrence.  Waiting until one has a large sum of money to invest all at once can take a while to save, and in a market that is rising that is money that is not taking advantage of that rise.  Additionally, there is an even greater stress level for those who have waited months to place their bet all at once than those who are making multiple small purchases.  Simply put, for the majority of people, investing a little at a time is the only option.

The advantage investors have these days is the availability to brokers who allow for investments without a fee.  Examples are Ally, Ameritrade and E*Trade.   This means that instead of 10% being taken away from a $50 purchase, as has been the case in the past, the entire amount can go toward buying the stock.  This has not always been the case and hopefully the trend will remain for a long time.

One can go back and forth with the argument as to whether dollar cost averaging or lump sum investing works better for them.  The bottom line is that there is no absolute answer, as results are dictated by the events of the time.

MoneyChimp has a handy program that allows one to test whether dollar cost averaging or lump sum investing works better. They perform two tests, assuming that $10,000 is invested in the market over the course of a year.  The first section tests a lump sum invested into an S&P 500 index fund all at once, and the second section tests equal amounts invested at the beginning of each month for a year, with the balance of the original amount sitting in an interest bearing savings account.  By entering the bank’s interest rate and the start date (from 1950 to present) the two tests show the amount one would have resulted in a year’s time.  It can be seen that depending upon the date selected and the interest amount entered, each strategy has an opportunity to outperform the other.

Dollar cost averaging is a means of reducing the stress associated with trying to time the market.  It is especially suited to the small investor without large resources, as well as those who enjoy their sleep at night.  It is a powerful tool that provides a system that promotes disciplined investing and should be a consideration for all investors.  This is why I consider it to be the baseline strategy for dividend investing.

Ensuring Dividend Survivability

by George L Smyth

The continuance of a dividend is never assured, but there are a number of things the investor can examine that will offer confidence of the dividend’s survivability, or act as a red flag. We examine these metrics, look at some example companies, and link to sources where this information can be found for any company.

My wife saw an advertisement on television for a peeler.  It showed someone peeling apples, pears, carrots, and on and on.  As this had been one of her frustrations in the kitchen she ordered it, saying that it would change her life.

When it arrived, to be gentle, it did not exactly work as well as advertised.  I tried using it myself with as little success as she had had.  Today it is in the basement, in a box of things we would like to give away, but wouldn’t want to burden anyone with.

Purchasing on a promise is that we do.  We buy things because they promise to help us in some way.  Sometimes they do, sometimes they do not.  When we purchase something with the hope that it will help us and it does not, we know that if we had had that knowledge beforehand we would not have made the purchase in the first place.

Dividend stocks are in the same category.  When researching a company we look at the expectation of future growth, we look at the expectation of stability, and we look at the expectation of the dividend.  As we look at financial statements there are indicators with each of these aspects, and as the first two are outside of the scope of this writing, I will focus on the dividend.

This is essential because if there are red flags implying a possible cut or removal of the dividend, then the only path forward is to value the company without this key aspect.  As dividend stocks rely on this quarterly payout to attract and hold investors, valuation without the expected dividend will almost certainly mark the company as a sale.

There are a number of metrics that we can examine that will give us an indication as to what we should be looking for.  We will also look at a few companies to see how they are evaluated through these metrics.

Dividend Payout Ratio

The Dividend Payout Ratio is the most commonly used metric.  It is expressed as a percentage, and is found by dividing the annualized dividend per share by the earnings per share.  This shows the percentage of the company’s earnings that are shared with the investor through dividends.  (The opposite of this would be the retention ratio, which is the percentage of earnings that are not given to shareholders, but are retained by the company.)

The two obvious endpoints come with payout ratios less than 0% and higher than 100%.  The former can happen if estimates of earnings per share for the next year are negative, meaning that the company is losing money.  If the company is losing money then it has no business going further into debt by offering a dividend.

When payout ratios exceed 100% the company is making money, but more dividends than earnings are going to the shareholders.  This is not a sustainable event.  It is possible that a company with a long history of dividends may not want to cut or suspend the payments, and if a one-time event (lawsuit, catastrophic event, etc.) is the source of payout ratio then they may allow this to happen, but it is not a positive trend.

Payout ratios over 50% are considered to be high.  From the investor’s point of view a ratio this large might be a positive event.  But for the long term investor it means that the retained earnings may not be enough for the company to sufficiently invest in future growth, which could then stunt the ability of the company to increase dividends in the future.

A payout ratio over 75% trends toward the more severe end.  A lack of future growth not only puts dividend increases in the future into jeopardy, but the company’s stock can drop as a result, subjecting the investor to the worst of both worlds.

The Dividend Payout Ratio is easy to find.  NASDAQ.com offers the information on their website – here are links to three companies in my dividend portfolio where I have owned DRiPs an average of 20 years, MMM, Aflac and Johnson & Johnson.  As can be seen from these three companies, the payout ratio is in the area of comfort.

Dividend Payout Ratio

MMM 21.6%
Aflac 12.9%
Johnson & Johnson 22.3%

Cash Dividend Payout Ratio

The Cash Dividend Payout Ratio is similar to the Dividend Payout Ratio, but provides a better analysis of the sustainability of the company’s dividend.  Instead of comparing dividends to earnings, the dividends are compared to cash flow, so the formula looks like this:

Cash Dividend Payout = dividends / (cash flow – capital expenditures – preferred dividends)

Preferred dividends are given to shareholders of preferred stock, which basically means that they have priority over holders of common stock.  If a company is unable to pay all of their dividends then those with preferred shares are first in line to get theirs.

At first glance this may seem to be a number that would pretty much be the same as the Dividend Payout Ratio, and in a perfect world that would be the case.  The difference is that earnings can be manipulated considerably easier than cash flow.

Earnings manipulation is not necessarily intentional fraud, but can be performed through legal accounting tricks that make the company appear to be more profitable than would otherwise be the case.  Obviously, the more earnings a company shows, the more positively it is viewed.  Examples of this manipulation could be capitalization practices, modifying the timing of operating activities, and merger-related expenses.

Cash flow is the movement of money in and out of the business.  While it is possible to manipulate cash flow, it is much more difficult, so using cash flow instead of earnings in the equation can offer a more reliable number.

SeekingAlpha.com offers this information for MMM, Aflac and Johnson & Johnson and again looking at the companies listed above we can record their numbers. 

Cash Dividend Payout Ratio

MMM 61.8%
Aflac 13.8%
Johnson & Johnson 49.9%

For these three excellent companies we see a wide range with the cash dividend payout ratios.  I generally look to the guidance noted above as far as what might be considered to be high and low. 

MMM’s Cash Dividend Payout Ratio appears to be on the high side, but no number should be seen in isolation.  Information of this sort should not be used by itself to make a decision but should be seen in conjunction with additional information to determine its relevance.  In this case MMM’s number is something to note and keep in mind while investigating other information.

MMM has increased their dividend every year since 1959, weathering seven recessions, so it would be extraordinary if they were to decide to end this streak.  As this is a company that has historically placed importance on maintaining their dividend, the expectation is that they will continue to do so.  We need to make sure that they actually will be able to do this.

Financial Debt Ratios

Financial debt is simply money owed by the company that is to be paid back at a future date.  This could include short term debt (due within one year), long term debt, deferred revenues, pension liabilities, and many other items. 

Debt is not necessarily a bad thing, after all one might go into debt to purchase a car, which in turn could make it possible for the individual to travel further for a higher paying job.  The same is true with companies - properly structured debt can be used to the company’s advantage (for instance, paying 4% interest on something that offers 6% in return).

Certainly, too much debt can cause major problems.  The required outflows of money limit the amount that can be used for investing back into the company, as well as dividends.  Understanding the ratio of debt to certain other issues gives us an insight as to how the debt is affecting the company.

Debt to EBITDA

EBITA stands for Earnings Before Interest, Taxes, and Amortization.  While EBITA is not recognized in the generally accepted accounting principles, it is a commonly used number that generally references the company’s operating profitability.  Comparing the debt to profitability gives us an indication as to how much the debt is dragging on a company’s earnings.

Gurufocus.com notes that according to Joel Tillinghast (Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing) a ratio of Debt-to-EBITDA above 4 is a concern unless tangible assets cover the debt.  A ratio under 1 would be considered to be very positive.

Thanks to this Gurufocus, the Debt to EBITA ratio is conveniently located for MMM, Aflac and Johnson & Johnson.

Debt to EBITDA Ratio

MMM 2.49
Aflac 1.44
Johnson & Johnson 1.24

While MMM has the highest in this small group, the Gurufocus’s MMM page also indicates that while MMM’s debt to EBITA ratio is at a 10 year high, this number is ranked lower than 55% of the 1,843 companies in the Industrial Products category, so that should be taken into consideration.

Interestingly, Aflac and Johnson & Johnson both rank higher than 51% and 59% of the companies in the Insurance and Drug Manufacturers industries.

Debt to Assets

A comparison of debt to assets offers an indication as to how much the company’s assets are leveraged after accounting for their securities.  A ratio of 0.5 or larger might be a cause for concern, but the industry in which the company fits under has much to do with this number.  After all, a company that makes products to sell (like MMM) would have many assets, whereas an insurance company (like Aflac) would have considerably fewer.

While I do not consider this ratio to be as significant in terms of a dividend’s stability as the above numbers, it is valuable in that offers an insight to the degree which the company is using debt to finance its assets.  In other words, a number of 0.3 means that 30% of its assets are financed through debt while 70% is owned by the shareholders.

Again, Gurufocus offers this information for MMM, Aflac and Johnson & Johnson.

Debt to Asset Ratio

MMM 0.48
Aflac 0.04
Johnson & Johnson 0.19

Not only is MMM’s number high, but it is also high when compared to other companies in the same space.  As stated above, these numbers should not be viewed by themselves, but in coordination with other numbers.  When looked at together the company’s high Cash Dividend Payout, Debt to EBITDA, and Debt to Asset ratios together must make one take notice of their situation.

Delving further into the numbers, we see that MMM is currently saddled with $14 billion in debt, which even for a company of its size is substantial.  Chances are that this company’s dividend is safe, but the data points noted should make holders of the stock pay closer attention to the quarterly reports.  In this case I would suggest that MMM is neither a green flag nor a red flag, but more a yellow one, or caution.  I have confidence that they will do what they can to continue to increase the dividend well into the future, but need to continue to monitor the situation to make sure that events do not overcome the company’s desires.

Evaluating companies to ensure that their dividend is secure is important and necessary for owners of dividend stocks and those thinking about a purchase.  The company’s dividend is an essential part of the reason for owning the stock, and making sure that the dividend is retained will bring stability to one’s portfolio.



This website is maintained by George L Smyth