Should Dividend Investors Ever Break Their Rules?

As a buy and monitor dividend investor, one of the items that is presented to me in brokerage statements is percentage gain on each one of my investments. I have noticed that the companies with the best total returns in my portfolio since 2008 included companies which did not exactly fit my strict entry criteria at the time of purchase. These companies were attractively valued at less than 20 times earnings at time of purchase, had adequately covered distributions and had strong earnings and dividends growth. The main criteria that these companies failed was low current yield at the time of purchase and sometimes a streak of dividend increases that was less than 10 years.

The one thing that all of these companies had in common, was the fact that they had the opportunity to deliver strong earnings growth. This strong earnings growth, was noticed by other investors, and led to increases in stock prices. It also didn’t hurt that the strong earnings growth trickled down to investors in the form of higher cash dividends as well. The reasonable price/earnings ratios I paid at the time of acquiring these securities enabled me to generate above average total returns while earnings were rising.  Because both earnings and dividends per share were growing rapidly, and because I was projecting that this could continue happening for the foreseeable 8 - 10 years, I was expecting to generate quite a nice future yield on cost within a decade.

The problem with these companies was that prices started moving up immediately after my purchase. Since these companies were purchased at attractive valuations however, and both earnings and dividends were increasing, substantial declines would have been a welcome opportunity to add to my position in these stocks.

Overall, whenever I “ignore” my entry rules, it is to acquire shares in a company, that is poised to deliver rapid growth. I still expect a rising dividend income stream, although I am willing to accept less than 10 years of dividend increases. In addition, I am willing to accept a dividend yield lower than 2.50%, if I believe that there is a potential for a strong earnings growth. In other words, if I purchase a stock yielding 1.50% - 2% today, which also grows earnings and dividends at 12%/year, I would expect to be earning an yield on cost of 4.50% - 6% in a decade. Ten or twelve percent growth rates per year are not unheard of, and could reasonably be expected to continue. As a result, the 1.5% -2% yielder purchased in year one, would likely still be generating a current yield 1.50% - 2% in ten years. However, if all goes according to plan, I would have tripled my money and earning a much higher dividend income stream.

The only crucial rule that I am not willing to bend is purchasing stocks at or above 20 times earnings. Paying more than 20 times earnings could result in serious losses if earnings do not deliver the expected growth over time. In addition, during bear market declines, high growth stocks tend to fall faster than the market as whole. As dividend investors, we are trained to see market declines as an opportunity to add more to our positions. In the heat of the moment however, losing 40% – 50% on a position could panic both inexperienced and experienced investors alike. In addition, paying too much for a company’s stock could lead to lower returns, even if it deliver the growth, if the market decides that it deserves a more reasonable multiple. An example of this occurred in the early 2000s, when even the most quality dividend stocks such as Johnson & Johnson (JNJ), Coca Cola (KO) and Wal-Mart (WMT) were trading at excessive valuations. This overvaluation was the primary reason for the so called “lost decade” for stocks.

The three stocks I bent my rules for included:

Family Dollar (FDO) had been yielding approximately 2% when I purchased it in 2008. Even during that turbulent time for stocks, the company had been performing impressively, by opening new stores and renovating existing ones to increase their appeal. Given the fact that Family Dollar stores are in smaller communities, and offer low prices to consumers, the financial crisis has been good for business. A consumer that wants to buy a loaf of bread is more likely to stop by a Family Dollar store rather than a Wal-Mart. And we all know that stopping by the store for a loaf of bread might expose consumers to buy something else in the process. I also used the weakness in early 2013 to increase my position slightly.

While I purchased shares of Visa (V) in 2011, I liked the long term growth potential for the company. In addition, Warren Buffett was buying Visa as well. Visa and MasterCard are essentially a duopoly that provides global consumers with the opportunity to do cashless transactions. While consumers would still use cash going forward, I would expect the number of credit and debit card transactions to increase over time not just in the US but globally as well. In fact, credit and debit card usage outside US is not as widespread. This could mean decades of growth for Visa and MasterCard. I also like the toll-booth like business model, where credit card issuers do not take on any credit risk, but simply process information. I purchased the shares at a yield of 1% and a P/E that was less than 20..

What attracted me to Yum! Brands (YUM) was the fact that it was rapidly expanding in China and had more room for future additions of capacity. McDonald’s had not been as successful in China as Yum! Brands, which is due to the fact that the operator of KFC offered something that appeals to the consumers better than burgers and fries. At the time of purchase, current yield was about 2%, although the company had announced plans to hike dividends significantly, and my forward dividend yield was 2.50%. I also used the declines in early 2013 to put another half position in the stock.

This pure dividend growth strategy is slightly riskier than the type where I purchase higher yielding stocks as well as companies in the sweet spot. That is why I only implement it in as one of the strategies in a broadly diversified dividend portfolio. For the three stocks mentioned above, I actually allocated a lower amount of capital than I would for a company like Johnson & Johnson (JNJ), in order to limit risk.

Full Disclosure: Long V, YUM, FDO, KO, WMT, JNJ

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