Johnson & Johnson (JNJ) - A must own dividend stock

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. This dividend aristocrat has paid uninterrupted dividends on its common stock since 1944 and increased payments to common shareholders every for 51 consecutive years. There are only fifteen companies in the US which have managed to raise distributions for more than half a century each.

The company’s last dividend increase was in April 2013, when the Board of Directors approved an 8.20% increase to 66 cents/share. Johnson & Johnson's major competitors include Pfizer (PFE), Bristol Myers Squibb (BMY) and Novartis (NVS).

Over the past decade this dividend growth stock has delivered an annualized total return of 6% to its shareholders.

The company has managed to deliver a 5.40% annual increase in EPS since 2003. Analysts expect Johnson & Johnson to earn $5.41 per share in 2013 and $5.78 per share in 2013. In comparison Johnson & Johnson earned $3.86 /share in 2012. The amount was lower due to one-time accounting charges against net income. The company has managed to consistently repurchase 1.10% of its outstanding shares on average in each year over the past decade.

Johnson & Johnson has a diversified product line across medical devices, consumer products and drugs, which should serve it well in the future. This makes the company largely immune from economic cycles. In addition, the company has strong competitive advantages due to its scale, breadth of product offerings in its global distributions channels, continued investment in R&D as well as its stable financial position. In addition to that Johnson & Johnson is expanding into new long term opportunities through strategic acquisitions. Emerging market growth and opportunities for cost restructurings should further help the company in squeezing out extra profits in the long run. Sales in drugs like Simponi, Stelara, Zytiga, Edurant, Incivek, Xaralto and Prezista should more than offset the generic erosion from older drugs which are losing their patent protection. The acquisition of Synthes, which was completed in 2012, is expected to generate significant synergies for Johnson & Johnson.

The company’s return on equity has declined from 30% to 18% over the past decade. Rather than focus on absolute values for this indicator, I generally want to see at least a stable return on equity over time.

The annual dividend payment has increased by 11.70% per year over the past decade, which is higher than to the growth in EPS.

A 12% growth in distributions translates into the dividend payment doubling every six years. If we look at historical data, going as far back as 1972 we see that Johnson & Johnson has actually managed to double its dividend every five years on average.

The dividend payout ratio has increased from 38% in 2003 to 62% in 2012. This was caused by one-time charges against net income. The payout ratio based on forward EPS is standing at 45%. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

Currently Johnson & Johnson is attractively valued at 14.60 times forward 2013 earnings, has a sustainable dividend payout and yields 3%. I recently added to my position in Johnson & Johnson.

Full Disclosure: Long JNJ

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How Warren Buffett built his fortune

Most investors are familiar with Warren Buffet, who is the man in command at Berkshire Hathaway (BRK.B). Buffett is one of the most successful investors of all time, with a net worth placing him somewhere in the top three richest people in the world. His partner in crime was Charlie Munger, who has worked with him for the past 50 years. While most investors are familiar with the story of Berkshire Hathaway, few seem to know how exactly Buffett made his first millions, that catapulted him to Berkshire Hathaway and the companies and stocks he owns through it.

Buffett started several investment partnerships in 1956 with approximately $105,000 in investor money, after his former employer Graham-Newmann investment partnership was liquidated. Buffett had put an initial $700 of his own money, which ballooned to a stake worth $20 million by the time he liquidated his investment partnership in 1969. The assets under managed had grown to $100 million by that time. The Berkshire Hathaway (BRK.A) annual letters to investors have been inspired by Buffett’s annual and semi-annual letters to his limited partners.

Per the Buffett Partners agreement, Buffett as the General Partner received a cut of the profits. For every percentage point gain above 6% in a given year, Buffett collected 25% of the gains. The Buffett Partnership Limited (BPL) was essentially a hedge fund, which pooled investor’s money and invested them at the discretion of the fund manager. Buffett never had a losing year during the thirteen years he ran the partnership, and he also managed to add new investors along the way. In addition, he reinvested any gains he made as a general partner back into the partnership.

Buffett invested in the following types of companies at the partnership: generally undervalued securities, work-outs and control situations. Work-outs included stocks whose financial results depend on corporate actions rather than supply and demand factors created by buyers and sellers. Control situations include occasions where BPL either controlled the company or took a sufficiently large position that allowed it to influence policies of the company.

After the BPL was liquidated, Buffett received shares in Berkshire Hathaway, as well as shares in companies which ultimately merged in Berkshire. And the rest is history.

The lesson to be learned from this exercise is that in order to become rich, Warren Buffett had a scalable business model, with a substantial amount of leverage. Unfortunately, BPL was mostly a one-man operation, although the turnaround expert he employed with Dempster Mill Manufacturing company is a rare situation where he employed others. He did exchange ideas with several of his value investing friends however. Buffett’s investment model worked well when he had $100,000 in the partnership, as well as during the time that he had $100 million. The overvalued market in the late 1960’s however presented a change to his investment strategy. Buffett had leverage to make a lot of money, simply by being the general partner and earning a good cut on any earnings that the partnership generated, without much downside for himself. On the other hand, Charlie Munger made his initial million by using debt leverage to invest and build real estate.

The true genius of Buffett is his complete transformation in the 1970’s, when he started purchasing stock in companies with strong competitive advantages. He essentially held those stocks as long-term investments, and in the event where Berkshire acquired entire businesses, he delegated the whole oversight of day to day operations to skilled management. The companies he invested in the 1950’s and 1960’s represented mostly investments that were one-time producers of substantial gains for BPL. It took Buffett a lot of time to uncover those opportunities, but once they reached full valuation and he sold them, they were no longer producing any benefit for his partnership. He then had to spend more time to find more investments to allocate the now higher cash hoard. However, the companies and securities that Buffett purchased since the 1970’s for Berkshire Hathaway generate recurring cash flow streams to the company. As a result, the effort required to uncover these hidden gems resulted in cash distributions paid to the main holding company for decades. He then used these cash streams to purchase even more cash flow generating assets, which is why I believe that he is a closet dividend investor.

Buffett's operations at Berkshire were further aided by almost cost-free float from insurance operations, which further magnified his investment returns. The float refers to the time period between when premiums are collected and claims paid out. During this time, insurers invest the premiums and generate returns. Buffett only does insurance deals when the pricing is right, and can guarantee that it doesn't result in losses The float further magnified investment returns, therefore leveraging Buffett's investment genius to produce gains for shareholders. For example, if you purchased Coca-Cola at $20 and it doubled in price, you can earn 100% return on your investment. If you put $20 of your money in the stock and invested $20 of cost free float, you would have earned a 200% return on that investment.

The genius of Buffett is that he has been able to uncover undervalued assets, over many different asset classes. Examples include his purchase of silver (SLV) in 1998, real estate investment trusts in 1999, foreign currencies such as the Euro in the early 2000's as well as selling long-dated puts on major market indices. While he has a strategy of always looking for undervalued assets, he has been able to make a fortune for Berkshire by being flexible, and avoiding following a "rigid" strategy. By training himself to spot opportunities when they arose, he has been able to constantly reinvent himself and make money in different environments.

Full Disclosure: None

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This article was included in the Carnival of Wealth

Are dividend investors concentrating too much on consumer staples?

In my dividend investing I focus a lot on diversification. Proper diversification means that an investor owns at least 30 individual stocks, representative of as many of the ten Standard and Poors sectors as possible. Proper diversification also means that investors do not simply purchase stocks in order to diversify their risk however. It means to invest in a diverse number of businesses with favorable economics, which are attractively priced and which also have bright long term prospects. Proper diversification will add an extra layer of protection for an investor’s portfolio when unforeseen events such as financial crises, oil spills and lawsuits affect otherwise stable and profitable dividend paying stocks.

In the world of dividend investing, many claim to be excellent stock pickers, trying to maximize returns by betting on a concentrated portfolio of 10 – 15 stocks. After all, it is easier to find 10 great dividend stocks, than finding 30 or more of them. This sounds like a decent plan if you are already collecting a generous pension and have a decent amount of social security kicking in. Such investors could likely afford to build a concentrated dividend portfolio, and take huge risks in the process. Even if you do a fantastic research, and know the company and industry inside out, you can still lose money on a stock. In general, all the information you have about a stock is based on past data and assumptions based on it. While companies like Coca-Cola (KO) and McDonald’s (MCD) look like long-term winners for the next 30 years, I could see several scenarios where they could go to zero in the process. That being said, this does not mean that they will go to zero, but just that investors might have to regularly monitor the positions in their portfolios. I also believe that investors should not only focus on quality regardless at price. Instead, investors should focus on finding quality stocks at a reasonable price.

If I were to decide between purchasing shares of Coca-Cola (KO) trading at 22 times earnings or Chevron (CVX) at 9.50 times, I would likely choose Chevron. I will still hold on to Coca-Cola for decades, but for new money, I would choose Chevron. Some attractive companies in other sectors include:

Air Products & Chemicals (APD) is a stock in the materials sector, which has boosted dividends for 31 years in a row. This dividend champion company trades at 16.80 times earnings, and yields 3%. Check my analysis of Air Products & Chemicals.

Chevron (CVX)  is a stock in the energy sector, which has boosted dividends for 26 years in a row. This dividend champion trades at 9.50 times earnings, and yields 3.20%. Check my analysis of Chevron.

United Technologies (UTX)  is a stock in the industrials sector, which has boosted dividends for 19 years in a row. This dividend achiever company trades at 14.20 times earnings, and yields 2.20%. Check my analysis of United Technologies.

Aflac (AFL)  is a stock in the financial sector, which has boosted dividends for 30 years in a row. This dividend champion trades at 8.70 times earnings, and yields 2.50%. Check my analysis of Aflac.

One of my favorite reasons and examples on why dividend investors should hold a diversified portfolio is the Financial Crisis of 2007 – 2009. For several decades before that, investors in stable companies such as Bank of America (BAC) collected higher dividends, while also enjoying above average dividend yields.

The current rage is all about consumer staples. While I enjoy the stable nature of many consumer staples companies such as Procter & Gamble (PG) and Coca-Cola (KO), I do not want to place all of my bets on a single sector. It is true that consumers tend to purchase Gillette razors, shaving cream, Coca-Cola drinks repeatedly and they also tend to stick to the products they use for years. However, if companies make a few wrong moves such as making the wrong acquisition and taking on too much debt, not investing enough in the business or simply if company’s products are deemed to be unhealthy for the population, they could lose money and cut the dividends.

When analyzing my portfolio, I noted that Consumer Staples accounted for 36% of it, while Energy, Financials and Healthcare accounted for 22%, 12% and 11% respectively.  After that I have exposure to five sectors, which accounts for a whopping 19% of my portfolio. These sectors include Industrials, Consumer Discretionary, Information Technology, Materials and Utilities. Unlike most other dividend investors, I do not have much exposure to US telecom stocks, since I find their dividend payouts to be too high in general, and thus I do not trust the dividend yields. In addition, I doubt that long-term dividend growth will be more than 3%/year for the largest players such as Verizon (VZ) and AT&T (T). I do have exposure to Vodafone (VOD) however, which accounts for less than 0.60% of my portfolios.

Just because I am underweight Utilities does not mean that I will load up so that I increase my exposure. The stocks in my portfolio are geared towards paying a decent dividend today, with the potential for growing it over time, while potentially delivering strong total returns in the process. Most utilities pay high current yields, but have limited prospects for increasing earnings and dividends over time. In fact, many utilities are actually prone to cutting distributions to income investors. 

Full Disclosure: Long  KO, APD,  UTX, PG, AFL, VOD, MCD, CVX

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Best Income Investing Articles for May 2013

For your weekend reading enjoyment, I have highlighted a few interesting articles from the archives, which I find to be relevant today. The first five articles have been written and posted on this site, while the last five have been selected from other authors. I tend to post anywhere between three to four articles to my site every week. I usually try to write at least one or two articles that contain timeless information concerning dividend investing. This could include information about my strategy, or other pieces of information, which could be useful to dividend investors.

Below, I have highlighted a few articles posted on this site, which many readers have found interesting:

• Attractively valued dividend stocks to consider today
• Procter & Gamble (PG) - A dividend stock to hold forever
• Why would I not sell dividend stocks even after a 1000% gain?
• Should you invest in Wells Fargo (WFC)?
• 2013 Dividend Achievers List Updates

I read a lot about companies, and also read a lot of interesting articles from all over the web. A few that I really enjoyed over the past several months include:

• Two Reasonably Appealing Dividend Ideas
• A Stock Analysis of Disney
• Dividend Stock Analysis of Cisco
• Dividend Stock Analysis of Realty Income
• A Winning Investment Strategy

Thank you for reading Dividend Growth Investor site. I am also on Twitter, if you are interested in following me on another platform, where I post about recent trades I have made.

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Best Brokerage Accounts for Dividend Investors

When I first started dividend investing, I was looking for the lowest commission possible. I ignored any other features of a stock brokerage, since I viewed the brokerage industry as one that provides a commoditized service. Back in 2008 – 2010 I was a big fan of Zecco, mostly for their free trades. Since then I have branched out to other brokers. Before I was a dividend investor, my investing was concentrated on buying mutual funds in a 401 (k).

The chart above summarizes brokers I have personally invested through since I started my site to document my dividend investing journey.  In addition, the information above is not intended to be complete in any means. I have rated the brokers above based on my experience with them, with Schwab being the best, while Sogotrade having room for improvement. Sogotrade charges $5 for trades, but $3/trade if you prepay. The chart shows the commissions for each broker for stock trades, and assumes an individual investor does less than 10 trades/month. It also lists the minimum amounts an investor needs to deposit, in order to open a cash account. The next column shows whether the broker offers dividend reinvestment of partial shares. Tradeking does allow dividend reinvestment per my experience, but not for partial shares. The next to last column shows the length of time that trade history and trade statements are available to the customer. In some cases, the trade history is limited to my own experience with the broker. In other cases, this is based on information available on the broker website. The last column shows that none of the brokers had any inactivity fees at the time I wrote this article.

The story below discusses my experiences with brokers, which could be different than your experience.

I believe that brokers should offer a commission that provides value to customers and also a decent rate of return to the brokerage company itself. A low commission is typically associated with rudimentary platforms which could be very confusing to the investor. Of course, if you are an experienced investor who knows what they need and doesn’t need much hand holding, then you should do fine with simply the lowest cost broker. However, when something goes wrong, and it usually will, you will start regretting your decision.

My experience with Zecco was positive for a few years, while they were offering 10 free trades for accounts whose balance exceeded $2,500. Initially, back in 2006, Zecco offered 40 commission free trades to all customers. In 2009 Zecco changed its rules once again and only provided ten free trades to customers with account balances that exceed $25,000. In 2010, Zecco eliminated commission free trades for everyone except traders who made 25 trades/month. In the meantime, I had a few other brokerage accounts, but was considering Zecco to be my primary individual brokerage account. Then Zecco started going through platform upgrades and changed their clearing firm. In addition, Zecco never offered automatic dividend reinvestment that allowed your investments to compound. This was never an issue for me, since I like to accumulate my dividends and new funds, before I buy a security. The only problems that I had were with companies that were paying 5% stock dividends or companies like Kinder Morgan LLC (KMR) which paid distributions in fractional shares. Zecco used to provide these distributions in cash, thus creating a taxable event and negating any long-term compounding of my investments.

In the meantime, a lot of Zecco investors were unhappy with their platform, because it often crashed during periods of extreme market volatility. Back in late 2008, there were several times when I was unable to log into my Zecco account to place a trade. I was also unable to log into my Zecco account during the May 6, 2010 flash crash. I was able to log into my Schwab account however on both occasions. When Zecco upgraded platforms and changed clearing firms, this created some issues for me. Actually, this created a lot of headaches for me, because some of the shares I owned like Royal Dutch Shell (RDS/B), Brown-Forman (BF/B) and Nestle (NSRGY) were either not showing in my account, or had an incorrect symbol and the position amount was zero. It is a scary feeling to wake up and see that your equity holdings are not correct or simply not there.

A few months ago, Zecco merged with Tradeking. I was afraid that I would still have issues, but luckily this never materialized. The main issue with the merger was that I lost the ability to pull from the broker website all my historical account statements and all historical activity going back to when I first opened the account. Luckily, I keep good records, and have all of this information at my fingertips. However, it is important for long-term investors to choose a brokerage that provides you with all your account activity detail going as far back as possible. Otherwise, when you sell a stock that you have held for 20 or 30 years, figuring out your tax basis would be a nightmare. Tradeking does offer dividend reinvestment, but as I mentioned earlier, I typically reinvest dividends selectively.

As a result, I started adding all new funds to SogoTrade. I kept adding funds, until they made another change in their platform when they were purchased by Wang Investments in 2011. This change did not allow me to log in to my account for a day or two. After that, I was unable to withdraw funds easily. The process is still very cumbersome and one has to enter their account number twice, after they have logged on to the platform, in order to request an ACH transfer. In addition, changing your address is a very difficult thing to accomplish with Sogotrade. It requires you to download a form, fill it out, and then fax or email it to them. If you fax it to them, you run the risk of Sogotrade losing it, which is why it is best to email it. At $3/trade however up until early 2013, you could hardly beat them. Sogotrade does not offer fractional dividend reinvestment, but keeps all monthly statements going as far back as possible. A few weeks ago however, they raised their prices to $5/trade, although investors who pre-pay for trades could still end up paying as little as $3/trade.

For a new investor, I would consider Sharebuilder. They offer $4 trades if it is scheduled on a Tuesday. Sharebuilder provides free dividend reinvestment, fractional shares and offers historical records. Real-time trades used to cost $9.99, although this amount has decreased recently to $6.95/trade. My main problem with Sharebuilder was the fact that commissions were too high for real-time trades, and I didn’t want to be restricted to only trading on Tuesdays in order to get the low commission. Sharebuilder is ideal for someone who is just starting out dividend investing however.

Since my falling out with Zecco and Sogotrade, I have been adding new funds to Schwab. I still kept the old investments in the old brokerage accounts, but since I have new money coming it, that needs to be invested every month, I had to find a reputable broker. I like Schwab because they offer everything an investor can want, including research, a wealth of information, account records, dividend reinvestment and their customer service is very good. However, you do pay a high commission for this privilege. I do like the fact that Schwab is a publicly traded company, and that I can analyze its financials and monitor it closely. With Tradeking, Zecco and Sogotrade, I have no idea whether the companies are on the verge of bankruptcy. I also have an E*TRADE account, which provides a similar level of service as Schwab, but at slightly higher commission prices. I have mitigated the high commissions at Schwab by increasing my purchase or lot size per investment. If I bought shares in $1000 increments at Tradeking or Sogotrade, I now buy stocks in $2000 increments at Schwab.

As I discussed in an earlier article, I try not to invest more than $100,000 per brokerage, in order to add an extra layer of diversification to protect me against broker failures. While brokerage accounts are insured by SIPC up to $500,000, and most brokers also carry additional umbrella insurance, I find having multiple accounts helpful in case assets are frozen due to broker collapsing. Even if your money is SIPC insured, it could still take months before the money is recovered or available. If all of your funds are concentrated in one broker, you might be in a situation where you have a sufficient dividend income to pay your expenses, but you are unable to tap it because your broker failed.

Having many brokerage accounts is not too cumbersome. As a buy and hold dividend investor, I simply add up the total dividend income at tax time. I also try to keep certain securities such as MLPs and REITs in one specific account, in order to make it easier at tax time.

To summarize, while low commissions are important, they should not be the only factor in determining which brokerage to choose. Important factors include providing sufficient data support that would be beneficial during tax time, historical records, as well as a platform that is intuitive and easy to use. Automatic dividend reinvestment is an important feature as well, as is the ability to monitor your broker financial performance. As a result, I believe that Sharebuilder and Schwab are be the best brokers for dividend investors.

Full Disclosure: Long KMR

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Not all P/E ratios are created equal

My favorite companies to invest in are those that have strong competitive advantages, which allow them to have an easily distinguishable product or service. This allows companies to have pricing power. This pricing power comes from the strong brand name associated with the product, and it allows the business to earn high returns on equity, and pass on cost increases to customers. This translates into solid profitability, which enables the business to increase dividends to shareholders over time.

I try to buy stock in great businesses only at attractive valuations. For me this entails a P/E that is lower than 20, an adequate dividend yield, a history of consistent dividend growth and an adequately covered dividend. In the current market environment, most stable businesses are trading at the higher end of what I am willing to pay for. I am planning on holding on to these cash machines, as I expect them to pay much higher distributions and earn much more ten, twenty or thirty years down the road.

However, I am also considering selling a few of those businesses if they trade above 30 times earnings. Brown-Forman (BF-B), Kimberly-Clark (KMB) and Colgate-Palmolive (CL) are a few businesses that would be overvalued at 30 times earnings. Currently these businesses trade at 26.90, 22.60 and 25.50 times earnings. All of these companies have strong brand names, and solid and dependable cash flows, that will only be increasing for the next 20 – 30 years. However, as I like being prepared in deploying cash from stocks I have sold, I have been researching attractive candidates for reinvestment.

I have been able to find plenty of companies with low P/E ratios, which could be fine investments for new capital. However, I am not so certain whether many of these investments have the same characteristics as the ones I am considering selling.

Many of these companies are cyclicals. Their fortunes rise and fall with the economy. Examples include companies such as BHP Billiton (BBL), Caterpillar (CAT), Exxon Mobil (XOM). BHP Billiton trades at 16.50 times earnings, Caterpillar trades at 12.10 times earnings, while Exxon Mobil trades at 9.30 times earnings. If the economy goes through another recession like the one we experienced in 2008 – 2009, commodity prices will plummet, which would depress earnings for commodity producers. It could also negatively affect the three companies mentioned above. Another sector that is somewhat cyclical is the financial one, as recessions could lead to losses in loan portfolios, when borrowers lose their jobs during the downturn.

As a result, one cannot compare the low P/E ratio of a cyclical company such as BHP Biliton to the high P/E ratio to a consumer staple such as Procter & Gamble (PG) or Colgate-Palmolive (CL). The earnings per share of a cyclical company might fall by 50% during the next recession, whereas the earnings per share of a company like Procter & Gamble might stay flat or even increase.

For example, between 2008 and 2009, EPS for Exxon Mobil fell from $8.69/share to $3.98/share, before recovering to $9.70 by 2012. EPS for BHP Billiton fell from $5.50 to $2.11 during the same period, until reaching out $5.77 in 2012. At the same time, Procter & Gamble’s (PG) earnings went from $3.64/share to $4.26/share. From there on they decreased to $3.66 by 2012, although this could be due to one-time items.

Investors should also avoid purchasing shares in companies whose P/E ratios are low today, but which might have issues in maintaining profitability ten years down the road. For example, many technology companies such as Intel (INTC) and Microsoft (MSFT) appear cheap today at 12.10 and 16.70 times earnings. However, if Intel fails to grow earnings over the next decade, the only returns for enterprising income investors might be derived from a flat dividend. If these companies fail to adapt to the ever changing world of technology, where paradigm shifts are the norm every five years or so, their earnings stream might be much lower over time. This could even pose problems for the future stability in dividend payments.

The purpose of this exercise is not to show that Exxon Mobil, Intel and BHP Billiton are bad investments today. The purpose is to show that investors cannot compare P/E ratios in vacuum between sectors. Purchasing a stock at a low P/E ratio is a winning proposition if earnings do not fall during the lifespan of your investment, but increase over time. If earnings fall by 50%, a company that looked cheap at a P/E of 15 might become overvalued all of a sudden.

It is also important to understand the company one is purchasing, how they generate their money, do they have any advantages, and analyze the trends in earnings per share, dividends per share, revenues and Returns on Equity over the past 10 years. I am considering to slowly start accumulating cash in my portfolios as the market continues going higher. However, I might consider adding to some cyclical names such as the oil majors if markets behave like they did in 1995.

That is why selling overvalued companies like Brown-Forman (BF-B) is so tough, and i have been dragging my feet doing it. I see Brown-Forman as a company capable of earning at least $6/share in 2023, and worth $120/share then. I also believe that I would earn close to $20 - $25/share in dividends from the company over the next decade.

Full Disclosure: Long BF-B, CL, KMB,

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Are we in a REIT bubble?

Low rates have made investors hungry for yield. As a result, traditional higher yielding investments such as utilities and real estate investment trusts are getting bid up by investors. If this madness continues, the possibility that many investors will get burned down the road increases exponentially.

Real estate investment trusts (REIT) are required by law to distribute at least 90% of their taxable income to shareholders. The REITs I own typically distribute somewhere close to 80 – 90% of their Funds From Operations (FFO) to shareholders. FFO is a commonly accepted tool to measure profitability for REITs, and is a more accurate indicator than earnings per share. FFO adds back for certain non-cash items such as depreciation, in order to determine the amount of profits that are available. Most REITs that I follow tend to have a FFO payout ratio between 80% - 90%. I own shares of Realty Income (O), Omega Healthcare Investors (OHI), Digital Realty Trust (DLR) and American Realty Capital Properties (ARCP).

As a result, I find it safe to assume that for REITs a low yield usually shows a stock that is overvalued, whereas a higher yield usually shows an attractively valued stock. I define a low yielding REIT in the current environment as a REITs that yields somewhere close to 4% or lower. A higher yielding REIT is one that yields at least 5%. This generalization only includes REITs whose primary business is to own physical real estate.

Some investors believe that current lower than historical yields on REITs are justified by record low interest rates. For example, yields on US 30 year Treasuries are close to 3%. These investors believe that today is the new normal, as low interest rates justify REIT valuations. The mentality that the this time it’s different might be costly to your portfolio.

Investors who purchase a REIT yielding 3% are generally receiving 80 – 90% of cashflows. In contrast, an investor in a typical dividend champion such as Procter & Gamble (PG) or Johnson & Johnson (JNJ) who gets a 3% yield today also gets a 5%- 6% earnings yield.

Even in the current environment however, there are reasonably priced opportunities for investors who are on the lookout for bargains. I have been able to use the weakness in Digital Realty Trust (DLR) to acquire a decent position in the stock. In addition, the following low yielding REITs seem to have very low FFO payout ratios:

Low yields could be justified by the expectation for higher distribution growth down the road. If your REIT slashed distributions to the bone during the 2007 – 2009 recession, they could not yield much today, but could have the potential to yield twice as much in a few years. In addition, REITs in different sectors have different yields. A healthcare REIT that might be overvalued at a yield of 4%, even though a 4% yield would be considered fair for other types of REITs.

Many REITs are able to sell ten year bonds at yields as low as 3-4%. They have particularly benefited from falling interest rates in the past five years. If you re-finance debt that used to cost 6%-7% with debt that costs half of that, the FFO bottom line will be instantly improved. However, the problem that REITs might get to in a decade is if interest rates are substantially higher than interest rates today. Many investors believe that rates will go up, which could be costly to real estate trusts that want to refinance debt a decade from now.

Another risk that we might see is if REITs bid up assets they purchase to yield below 6-7 percent. If the low cost of capital drives REITs to compete aggressively for new assets to purchase, without any regards to quality or future possibilities, this could spell disaster for REIT investors. If rates increase over next decade, this could result in reductions in FFO. This could mean trouble for REIT investors one decade down the road - low property returns relative to high interest rates in 10 years. The mitigating factor here is that interest rates might increase gradually, once they start increasing in 2- 3 years. As a result, REITs will have plenty of time to adjust their debt costs. In addition, many REITs would be able to raise rents if inflation increases alongside with interest rates.

In my personal portfolio, I have replaced National Retail Properties (NNN) with American Realty Capital Properties (ARCP). Check my analysis of National Retail Properties.  I used the fact that investors pushed yields on National Retail Properties below 4% to exit my position. I did not like the slow growth in FFO/share, as well as the slow growth in distributions. The slow growth over the past decade did not justify current valuations. Buying National Retail Properties was justified up until 2010, after which I simply held on and cashed the dividends along the way. In all reality, this REIT could probably go as high as yielding 3%, which translates to $52/share.

Based on FFO/share of $1.77 and annualized dividend of $1.58/share, the forward FFO payout for National Retail Properties comes out to roughly 89%, which is rather high. For American Realty Capital Properties, FFO is expected to be in the range of 91 - 95 cents/share in 2013, and $1.06 - $1.10 share by 2014. The annual dividend is 91 cents/share, which could make up for a forward FFO Payout of 95.80 - 100% in 2013. It looks high, but in reality the company just recently completed the acquisition of American Realty Capital Trust III, which will probably distort how financials look like this year.

I liked the fact that American Realty Capital Properties (ARCP) is a REIT that is trying to make strategic accretive acquisitions in order to expand and increase FFO/share. I view ARCP as a company that could potentially become the next Realty Income (O). Since this REIT has only been publicly traded for less than 2 years, it trades at a premium to more established REITs such as Realty Income (O) and National Retail Properties (NNN).

I also put Realty Income (O) on my watchlist for potential trimming of my position there. I believe that Realty Income is a fine buy at 43/share, which translates to a 5% yield. However, if it trades above 54 it is richly valued. At current valuations, I will consider selling some at the $62-$72/share zone. This is equivalent to a yield of 3% - 3.50%. In the meantime, I will be sitting tight and reinvesting my dividends in other stocks.

I do like the fact that the REIT has managed to maintain and grow distributions. I also like the diversified nature of the tenant base, and stability and quality of cash flows. I believe that Realty Income is the Coca-Cola of REITs, but at yields below 4% it looks overvalued. At yields below 3.50% I am going to start trimming my position in it. My last purchase was in 2011, when my entry yield of 5% made me afraid that I am purchasing at the top. The REIT has managed to boost FFO substantially since then, which is why a valuation in the low 40s is fair.

Full Disclosure: Long O, DLR, ARCP, OHI

Relevant Articles:

- National Retail Properties (NNN) Dividend Stock Analysis
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- The Case for owning Digital Realty Trust (DLR): When Hedge Funds Don't Know What They Are Talking About
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Clorox Hikes Dividends, but is it a buy at current levels?

One aspect of dividend investing that is very appealing to me is the consistency of dividend increases for many of the dividend champions I own. I realize how I take these raises for granted, in the rare event when a stock I own freezes or cuts distributions.

Over the past week, Clorox (CLX) boosted dividends by 10.90% to 71 cents/share. This marked the 36th consecutive annual dividend increase for this dividend champion. Between 2002 and 2012, annual dividends have increased by 11.30% per year. Earnings per share increased by 11.60%/year. Check my analysis of Clorox.

The current yield increased to 3.20%, which is higher than the 2.88% which 30 year US Treasury Bonds offer right now. An investor in a company like Clorox today will likely earn much more in income over the next 30 years, compared to a 30 year US Treasury Bond.  As a result, fixed income allocation might not make sense for investors who look for current income. This would be driven by increases in profits over time, which would likely also result in much higher stock prices. If we experience an annual inflation of 3% over the next 30 years, an investment in Clorox with its rising dividends would essentially provide shareholders with a source of income that is relatively protected against inflation.

It is no surprise that investors are rushing to purchase quality dividend stocks right now, which is pushing valuations to overvalued levels.

The average estimate for 2013 earnings per share for Clorox is $4.30. The estimate for 2014 is $4.63. Based on these estimates however, I would not think it is reasonable to pay more than $86/share. For those investors who have owned Clorox for several years, such as myself however, holding on to this fine consumer goods company is a very good idea that will pay dividends for a long time. In the company’s Centennial Strategy, it targets 3 – 5% revenue growth, and profits above the rate of revenue growth. Given the company’s propensity to repurchase shares, I could easily see earnings per share growth in the high single digits for the foreseeable future. Given that the international segment is only approximately 20% of sales, I see this as a growth opportunity to expand the brand further outside the US.

One concerning factor is the high dividend payout ratio of 66% for 2013. If we use 2014 forward earnings however, the dividend payout falls to 61%, which is borderline high.

Over the past 30 years, investors in Clorox have done very well. The key to success had been investing at P/E ratios below 20, and holding on the position. Selling even after gains of 1000% would have been a mistake, as the company kept earning more income and kept raising dividends. While the next 30 years might not look the same as the past 30 years, this chart illustrates the power of selecting just a few quality stocks like Clorox for your dividend portfolio and then holding them for as long as possible. The data for 2013 assumes two payments at the new rate and two dividend payments at the old rate; it also assumes forward EPS projections for 2013 fiscal year.

Full Disclosure: Long CLX

Relevant Articles:

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Should you invest in Wells Fargo (WFC)?

In order to identify attractively valued dividend stocks, I follow a monthly screening process, where I go through the list of dividend champions and dividend achievers to look for bargains. In addition, I often stumble upon quality income stocks during my review of the dividend raises for the week or on an ad hoc basis through interactions with other dividend investors.

Some investors that I know have been purchasing Wells Fargo (WFC), which is one of the best run large banks in the country. The most prominent buyer of Wells Fargo is Warren Buffett, who has been accumulating the stock for the past four – five years in his personal portfolio and for Berkshire Hathaway (BRK.B). Buffett finds that the key competitive advantage for Wells Fargo is its low cost of funds. The bank took out 25 billion from TARP, and as a result had to slash its dividend and acquire Wachovia.

I had heard only great things about Wells Fargo, which increased my interest in the bank. As a result, I took a look at the financials over the past years.

The financial included Wachovia since 2009. The thing that I noticed was that there was no growth over past four years in revenues. The amounts from non-interest fees have held steady, while the net interest revenues have decreased slightly. Since 2009 however, expenses have decreased from $70.688 billion all the way to $57.615 billion in 2012. The main driver behind the decrease in expenses was due to decrease in the Provision for credit losses from $21.668 billion in 2009 all the way to $7.217 billion in 2012.

At the same time earnings per share increased from $1.75 in 2009 to $3.36 in 2012, while annual dividends increased from 49 cents/share to 88 cents/share. The forward annual dividend payment is $1.20/share. Wells Fargo also increased the number of shares each year since 2009 to 5.351 billion. Since the main reason behind growth has been the reduction in the Provision for credit losses, it seems that future growth would be limited, unless the company either earned more from loans or more from fees.

Actually, net interest income has been declining, while the amount of loans has been slightly up from $783 billion in 2009 to $800 billion in 2012. Securities available for sale have increased dramatically however to $235 billion, up from $173 billion in 2009. At the same time, deposits have increased from $781 billion to $946 billion. The main problem behind lending these days is that it is much tougher to loan money, and interest rates are dropping at the loan rate level. At the deposit rate level, interest rates are essentially zero. As a result, in order to compensate for the decrease in the net interest rate margins, Wells Fargo would have to ramp up its lending. With interest rates projected to be low for the next three years, increasing lending will be the only way out to profit growth in this segment, without sacrificing credit quality however.

The issue with ramping up credit right now however is that when interest rates go up in five - seven years, Wells Fargo might end up owning assets such as 30 year loans at 4% ( I made this number up), when its cost of capital is close to or above 4%.

The mitigating factor however is that the average maturity of loans is under 30 years, and also a portion of Wells Fargo’s loans are floating rate. The company will have almost $300 billion in loans mature within the next five years. Over half of these loans were floating rate ones. New loans will generate more income however.

I like the fact that the company also has a substantial amount of non interest based revenues, which account for half of Wells Fargo’s revenues. Total trust and investment fees and total mortgage activities accounted for over half of those non-interest revenues. The portion of fee income is approximately 59%, with the rest derived from mortgage origination, other, insurance and gains from trading. It is good to hear that the company is able to generate diverse income streams to fall back on. The company is able to cross-sell products to customers who enjoy their banking relationship with it.

One positive could be that the company has a record $945 billion in deposits, and has attracted over $200 billion since 2008. While not all of the funds are allocated to loans, this could be a good indicator going forward, because it means more banking relationships over time. A customer can open a checking account today, then decide to take a mortgage, open a brokerage account or do other business with Wells Fargo. The customer relationship piece is an intangible part of the business, but nevertheless could yield dividends down the road. In addition, with record low interest rates, these deposits are almost not costing anything to Wells Fargo.

Overall I like the fact that Wells Fargo is trading at 10.80 times earnings, yields over 3% and has a sustainable dividend payment. The company has a solid asset base, which will pay dividends for years. However, I am not certain where future growth will come from. The increase in the company’s profit since 2009 has been mostly due to the reduction in the provision for loan losses. At the same time revenues have been flat. Unfortunately, a company cannot grow shareholder value without growing revenues. You can only cut so much expenses. If Wells Fargo were to start loaning out more funds, it would possibly translate into more revenue, as long as borrower quality is maintained and the net interest margin does not drop from here. There is a margin of safety in today’s valuation, but until I can see revenues increasing, I am going to sit this one out on the sidelines.

At the same time, I am a big fan of the five largest Canadian banks. These companies have a dominant position in the Canadian market, and earn very good amount of fees from customers. At the same time they have been able to grow interest and non-interest income, increase number of branches and expand by buying US bank assets. Back in early 2013 I purchased shares in Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Royal Bank of Canada (RY), Toronto-Dominion Bank (TD), Canadian Imperial Bank of Commerce (CM).

Of course, if Canada’s housing market softens, these big five banks would likely perform worse than the likes of Wells Fargo. The table above shows the Net Interest and Non Interest Income trends for Toronto - Dominion Bank (TD). It also shows the trends in the provision for credit losses as well. Canada adopted IFRS accounting standards recently, which is why information for prior to 2011 is under Canadian GAAP. Either way however, the trend in the three pieces of information would be similar under both accounting methods. The trend over the past few years in both interest and non-interest income for the big five Canadian banks is positive. They have been expanding domestically and internationally, which makes seeing where growth will come much easier.

Full Disclosure: Long BMO, BNS, RY, TD, CM

Relevant Articles:

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Why would I not sell dividend stocks even after a 1000% gain?

In a previous article I wrote on when to sell dividend stocks, many investors were absolutely furious that I would not even think about selling after a stock I own goes up 1000% in value. The reality is that this would depend on the circumstances, but since I am a long-term investor, I expect that at least some of the stocks I purchase today would become tenbaggers over the next 30 years or so.

In order to add shares in companies to my portfolio, I go through a quantitative screening process, followed by a qualitative review of the business. The qualitative portion is the most subjective one, and is based on my experiences consulting companies, using products or discussing products with company’s clients etc. As a result, I try to enter companies which I believe would be there for at least 20 – 30 years, when their shares trade at fair prices. If they are undervalued, that makes investing in them much easier. For example, based on my prior experience I would much rather purchase an oil company like Chevron (CVX) or ConocoPhillips (COP), than an individual US oil and gas trust that will be worth zero in a few decades. I could probably write an article about that.

Dividend growth stocks follow a natural progression of slowly increasing earnings and dividends over time. They almost always look fairly valued, which is why the biggest benefit is earned by long-term holders. If I purchase a stock like Chevron today while the annual dividend is $4/share, the current yield is at 3.30%. Chances are that one decade from now, the yield would be close to 3% again. However, the dividend and the share price would have probably doubled along the way.  I say probably in regards to the dividend growth, because things never progress in a linear fashion of course. Using the inputs above however of dividends doubling every decade, and stock prices yielding somewhere close to 3%, it would not be unheard of if an investor in Chevron sits on an 800% – 1000% gain in 30 years. If there isn’t a tectonic shift that would take the world off of oil and gas, chances are that this growth is a very likely scenario that would continue for several more decades.

As a result of focusing on quality companies, there are few things that can make me sell. I view myself as a part owner of a business, and as a result the business fundamentals such as returns on equity, earnings per share and dividends per share are more important than share price fluctuations.

One of the things that would make me sell is a dividend cut. My expectation is that a company would generate higher dividends over time, and thus the inability to do so is usually the last signal of deteriorating financials I am willing to take that shows trouble. I do expect to get a high yield on cost over time, although this indicator is not something i use when evaluating buy or sell decisions. If everything goes well for my investment, I would expect it to generate more dividends over time, which would increase yield on cost, which is an indicator of an increase in dividend income. This indicator always seems to confuse and anger investors for whatever reason. I would not sell a stock simply because it becomes overvalued. For a typical dividend growth stock, if it traded up to 30 times earnings it would be more of a temporary noise, especially if this is backed by serious growth.

Dividend investing is not a black and white strategy however, and as such, a P/E of 30 might cause me to sell some stocks but might lead me to hold on to other stocks. The nuances of holding on to overvalued companies that keep performing will vary for each individual situation. Even if I were to sell a stock with a P/E of 30, then I would have to pay a capital gain tax that would eat into my capital and find a security that is attractively valued. If we happen to have the stock market trading at all-time-highs, and all other quality companies are overvalued, I would have essentially shot myself in the foot.

As an individual dividend investor, I have a limited amount of time that would allow me to identify and invest in approximately 50 – 80 great stocks during my lifetime. Of those, probably 15 – 18 would perform to be once in a lifetime investments. The rest would get acquired, lose focus or outright fail. As a result, my goal is to run with the winners for as long as possible and get rid of the losers as soon as possible.

The number one reason why individual investors fail is because they tend to book small profits. At the same time they keep their losers hoping for a turnaround. Instead, they should focus on identifying quality companies, and then let fundamentals improve and simply hold on to these great ideas. It is difficult to be a long term investor when you are bombarded with stock market information everywhere you go. However if you do not embrace a long-term approach to investing, and do not see shares as ownership in real businesses, chances are dividend growth investing is not for you.

There is a lot of work involved in timing the movements of stocks, and selling a company that might be overvalued today to purchase another company. I have found that there are only so many quality dividend stocks I am willing to consider looking at. Finding the right company trading at the right price narrows the list down even further. Then there are things such as avoiding concentration to specific sectors as well as avoiding concentration in particular individual positions as well. As a result, I buy and hold on to stocks that fundamentally perform well. I could sell the stock and buy another one, but I might increase the risk that I am buying something that could be of lesser quality, despite the high price. For example, I could sell Johnson & Johnson (JNJ) today and purchase NuSkin enterprises (NUS), which have a much lower P/E. However as I mentioned in my analysis of NuSkin, I find it to be of lesser quality than a Johnson & Johnson.

As a dividend investor, I do monitor the positions I have regularly. However, from a psychological perspective I have found that a daily monitoring of my portfolio for major events might increase my chances of doing something stupid such as trading too often. In reality, as a part-owner of a business, there are not many events that would happen every day, which would materially affect the business. Again, this is more of a nuanced approach as opposed to a black and white strategy. I do want to see improving fundamentals over time, as well as catalysts that would bring more income. For example, Coca-Cola (KO) is a brand whose products would likely continue to quench the thirst of consumers, who would only drink the specific products sold by the company. I would never for example drink Pepsi, although I know some individuals who would always drink Pepsi and hate Coke. There are hundreds of millions of consumers who will be entering the middle class in developing markets in Asia, Latin America or Eastern Europe. If people in India and China eventually consume as many servings of Coke per year as Americans do, Coca-Cola will have a bright future ahead.

Back 1988, Warren Buffett began accumulating shares in Coca-Cola (KO) for his holding company Berkshire Hathaway (BRK.B). Currently, Berkshire owns 400 million shares at a cost of $3.2475/share. Berkshire’s stake has increased its value over 11 times over the past 25 years. At the same time, the company has been more valuable, as it has managed to increase profits and dividends. The stock price was overvalued in 1998, seeling as high as $45/share, and having a P/E of 48 by year end and an yield of 0.80%. EPS for 1998 were 71 cents/share. Buffett did not sell his stake, and earnings per share rose to $1.97/share by 2012. The issue was that Coca-Cola was consistently trading above 20 times earnings between 1992 -1998. Since 1995, Coca-Cola traded at a P/E of over 30 times earnings. The stock didn't become attractively valued until 2006. In hindsight, it’s easy to tell when to buy and sell. In reality, it ain’t so. Berkshire Hathaway currently is sitting on more than a 1000% gain in Coca-Cola. Chances are that it would keep on holding the stock, and since Coca-Cola regularly repurchases shares, Berkshire's stake in the company will keep increasing over time.

Buffett did sell another one of his holdings, McDonald’s (MCD) in 1999, when the stock traded around $35 - $40/share. The stock fell as low as $12/share in 2003, before reaching $100 by 2011. The dividend increased each year during the period, although McDonald’s did have some operational issues in 2002 – 2003. In effect, Buffett missed out on this great investment idea.

Full Disclosure: Long CVX, COP, MCD, KO, JNJ, PEP,

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Attractively valued dividend stocks to consider today

With the stock market hitting all-time highs pretty much every day, there are not that many stocks that have low valuations today. Some of my favorite companies such as Coca-Cola (KO) are trading at over 22 times earnings, which is above what I am willing to pay for this otherwise excellent business.

As a result I focused on the list of dividend champions, and uncovered the following attractively valued companies with low p/e ratios. I tried to look for dividend champions with yields above 2%, payout ratios below 60% and P/E ratios around 16 or lower. Despite the fact that current yields on this list are low, these companies offer good values in today’s overheated market. With low dividend payout ratios and attractive dividend growth, these low valuations offer a great entry point for investors who have at least ten or twenty years to let the investment compound.

I also added Ameriprise Financial (AMP) to this list, because I was researching it for inclusion to my portfolio, despite the fact that the company has raised distributions for less than 25 years. As most of these companies yield less than 2.50%, I would monitor them and try to add on dips. For example, back in April, I initiated a position in IBM (IBM) when the stock market punished the stock below $200/share, thus locking a 2% yield for a low valuation business with excellent EPS growth potential. Early in 2013 I was able to add to positions in Yum! Brands (YUM) and Family Dollar (FDO) after investors punished the stocks as well. That is why any type of irrational weakness must be explored by the enterprising dividend investor. Despite the high P/E on Johnson & Johnson (JNJ) today, it looks like the company trades at a P/E of around 15 based on forward 2013 estimates, so it could be one company to check out. The ability to look beyond the numbers could uncover attractively valued stocks in todays market.

While I would not be adding to my positions in Coca-Cola (KO) or Colgate-Palmolive (CL) at current valuations, the 13 companies listed above will be the types of stocks to consider when adding new money to my portfolio on dips. This should be done of course only after thoroughly researching the business, and then paying an attractive entry price.

The traditional blue chip companies I have held on for so many years, such as Coca-Cola, Colgate-Palmolive and many others which have attracted my new capital contributions for the past five years are no longer making sense to buy. As a result, the overvalued markets have caused me to be more creative in uncovering successful businesses, that can deliver better performance in the future. I am willing to purchase a stock yielding 2% today, if the valuation is low at say 15 times earnings and if there are catalysts for future growth. At the end of the day, a company yielding 2%-2.50% that trades at a P/E of less 15 that grows dividends above 7%/year will be more valuable than a company yielding 3.00%, trading at a P/E of over 22 and growing at 7%.

I would try to avoid value traps during the individual analysis I perform. I would try to stay away from known problems that can be disastrous. As a result, I am avoiding technology stocks like Intel (INTC), which might not be able to grow earnings per share over the next decade per my analysis of the situation. In addition, I did not include Cardinal Health (CAH) on this list, because it has been losing customers such as Walgreens (WAG), and has contracts with CVS (CVS) up for renewal in June. That is despite the fact that Cardinal Health has raised dividends for 17 years, trades at a P/E of 13.60 and yields 2.60%

I would much rather avoid losing money, than miss out on the next hot stock. The importance is to focus on quality, which unfortunately usually lies in the eyes of the beholder. A small leak can sink a big ship. Companies which are losing customers, companies that have advantages which are not durable (such as tech companies), or companies which are cyclical are to be avoided. I am not interested in companies which look undervalued today, but whose profitability might suffer, thus making them overvalued in hindsight.

Full Disclosure: Long IBM, KO, CL, AFL, APD, CVX, MDT, UTX, WMT, WAG, AMP

Relevant Articles:

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The Case for owning Digital Realty Trust (DLR): When Hedge Funds Don’t Know What they are talking about

On Thursday, shares of Digital Realty Trust (DLR) fell sharply after hedge fund manager Jon Jacobson discussed their short opinion on the company at an Ira Sohn Conference. I did not attend the conference, and all of my information about the short thesis is derived from outside third-party sources. I have already analyzed Digital Realty Trust (DLR) a few weeks ago, and liked the growth in FFO/share to purchase some shares in the Real Estate Investment Trust (REIT). In this article I will try to rebuff the arguments from the short seller. I am going to use publicly available information in the company’s most recently posted Annual Report for 2012 available on the SEC website. If hedge funds learned about this secret weapon available only to retail investors, they would probably make a killing in the markets.

The thesis behind the short is as followed:

1) The company taps into the capital markets to fund its dividend

This is the point where I realized that this short seller does not know what he is talking about. A real estate investment trust is required by law to distribute over 90% of its earnings to shareholders. In order for REITs to grow, they issue shares and bonds in the markets. I discussed this in my article on the five things to look for in a REIT.

In 2012, the company invested 1.56 billion in properties. The company also put $845 million in Improvements to and advances for investments in real estate.

The company borrowed almost $1 billion and raised $1.04 billion by issuing stock. Given the low cost of dividends at 4.5% - 5% and the low cost of debt at less than 4.50%, these acquisitions should be accretive to existing shareholders almost immediately I also like the conservative capital structure of Digital Realty, where almost two-thirds of investing activity has been financed by equity. That way, when interest rates increase in the future and the real estate investment trust has to refinance those obligations, they would not suffer as much as other companies.

When I look at the income statement of Digital Realty Trust, I see a profit of $171.662 million in 2012. There is a charge of $380 million for maintenance, and also $382 million for depreciation and amortization. These are separate charges. The REIT paid $373 million in dividends.

When you add back depreciation expense and a few minor adjustments, one can see where the Funds from Operation (FFO) is calculated. One can see that the REIT has ample room to pay the dividend. If nothing else, they also have room to increase it over time.

2) Annual cost of maintenance Capex is 40% of revenues

Please refer to last paragraph, that showed a breakdown of revenues and expenses, as well as net income to FFO reconciliation. Digital Realty manages to earn $171 million after subtracting regular depreciation and regular maintenance of approximately $380 million each. In calculating FFO, the REIT adds back only depreciation, to come up with FFO of over $550 million. This makes annual distributions of $373 million paid in 2012 very sustainable. I am not even sure why the hedge fund manager would even bring maintenance expenses, other than as a tactic to scare the weak hands holding Digital Realty Trust stock. Smart dividend investors however know that a high yield dividend growth stock should not be sold, especially when fundamentals are great and business is growing. There are few companies that both yield a lot, and also manage to grow distributions quickly. These are the types of stocks to hold on to.

3) There are no barriers to entry in the business and there is increased competitions

This is a subjective evaluation, that is often prone to investor biases. When a bullish investor who has not done a lot of research on a company tries to justify their position in a stock, they typically claim that a stock has solid competitive advantages. (Of course some investors are right for the likes of Coca-Cola (KO) for example). Similarly, an investor who has not done a lot of original research when making a short sale simply claims that a company does not have any competitive advantages.

I am simply going to put the advantages identified by Digital Realty in their latest 10-K report:

• High-Quality Portfolio that is Difficult to Replicate.
• Presence in Key Markets
• Proven Experience Executing New Leases
• Demonstrated Acquisition Capability.
• Flexible Datacenter Solutions.
• Differentiating Development Advantages
• Diverse Tenant Base Across a Variety of Industry Sectors
• Experienced and Committed Management Team and Organization.

You can read more about those advantages in the 10-K report on page 3.

If only the hedge fund manager had taken the time to read this report through page three, I would not have had to spend my Sunday writing articles, instead of enjoying the nice weather.

The only factor that I found interesting in the short case is the fact about competition. I think that this is the only item that would make me lose sleep at night as an investor. If technology companies decide to buy and operate their own data centers, Digital Realty would lose out. The REIT could also lose out from competitors stealing away business. I find it difficult to believe that a large organization would move their servers every year, simply to save on rent. Anything that involves information technology change in most organization usually is resisted because of the hidden costs of transferring important corporate information. Luckily, the REIT signs long-term leases with its tenants. As of December 31, 2012, their original average lease term was approximately 14 years, with an average of approximately seven years remaining.

If everyone moves to the cloud, Digital Realty might not lose too much, since the cloud is still housed on servers somewhere. Interestingly, one of the companies that was cited as a competitor to Digital Realty, Amazon.com (AMZN) is actually a tenant of the REIT. Digital Realty Trust earns $14 million/year from this tenant.

4)The stock price should be $20/share

I am not in the business of forecasting stock prices. A stock price can fall by 50% or rise by 50% easily from here. If the economy experiences another event like the 2007 – 2009 financial crisis, shares of this REIT could easily fall 50% from here. However, as long as the fundamentals are sound, a stock should be a hold, with additions to existing positions made at attractive valuations. I believe that Digital Realty Trust has been wisely allocating new capital, and as a result has been able to grow FFO/share and the dividend per share nicely over the past seven years. Investing in stocks is risky, and those who cannot sit through a 50% decline in share prices should invest in CD’s instead. If Digital Realty can fall to $62.40/share, which is equivalent to a 5% yield, I would add to my position in the REIT.

Selling a stock short is very expensive. When someone is short a stock, they need to borrow it from a broker, and have to pay an interest rate to the individual who they borrowed the stock from. If a stock is difficult to borrow, a short seller might end up paying a double digit interest rate. In the case of Groupon in 2011, a short seller had to pay an annual interest amount equivalent to 100%. That meant that even if the company went bankrupt in one year, a short seller would still lose money. In addition, when you are short a stock, you are also charged an amount equal to the dividend payment for the security. If we assume a short interest rate of 5%, and a dividend yield of 5% , this would means that this short position is really expensive for the Hedge Fund manager. In addition, the danger behind short selling is that theoretically their risk is unlimited. For example, if Digital Realty fell to zero, all I am going to lose is the money I invested. However, if Digital Realty increased by more than 100%, a short seller would lose more than the money they invested initially.

Because selling stock short is so expensive, the short call by this hedge fund manager looks more like a last attempt to cover their position at a minimum loss. This cry for help from the Hedge Fund manager makes me very bullish on Digital Realty. If it drops to $62.40/share, I would be adding to my position in the stock.

Full Disclosure: Long DLR, KO

Relevant Articles:

- High Dividend Growth REITs: Digital Realty Trust (DLR)
- Five Things to Look For in a Real Estate Investment Trust
- Spring Cleaning My Income Portfolio, Part II
- Four High Yield REITs for current income