How to buy Kinder Morgan at a discount

Back in August, Kinder Morgan Inc (KMI) announced that it was going to simplify its structure by acquiring the limited partner interests in its pipelines. The company expects plenty of benefits, which would enable it to pay close to $2 in annual dividends per share in 2015. After that, the company expects that dividends will grow by about 10%/year for five years.

As a result of the deal, unitholders of Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) are going to receive shares in Kinder Morgan Inc, as well as some cash consideration. KMP unitholders will receive 2.1931 KMI shares and $10.77 in cash for each KMP unit. EPB unitholders will receive .9451 KMI shares and $4.65 in cash for each EPB unit. Limited partners are receiving some cash, because the act of exchanging their units for Kinder Morgan shares is a taxable event, which could trigger some tax liabilities to the IRS.

The holders of Kinder Morgan Management LLC (KMR) will receive 2.4849 KMI shares for each share of KMR. This will be a tax-free event, because those holders are exchanging one asset type for another.

The deal has to go through some regulatory hurdles, but I doubt it would not finish. The timeline is somewhere by the end of 2014, although in my opinion it might close by the first half of 2015.

Ticker	Price	KMI Shares	Cash	Value of bounty	Spread	Discount
KMP	$    93.60	2.1931	$  10.77	$                   95.27	0.9825	-1.75%
EPB	$    40.34	0.9451	$    4.65	$                   41.06	0.9824	-1.76%
KMR	$    94.50	2.4849		$                   95.74	0.9870	-1.30%
KMI at $38.53/share

At the closing prices on Monday, it seems like there is an arbitrage opportunity for investors. It seems that if one believes that the deal in its current form will ultimately be consummated, they could purchase limited interests in KMP, EPB or shares of KMR, and then have those converted into KMI shares when the deal does close. Going forward, I will use the word investor, even though technically, the holders of KMP and EPB units are called limited partners. As a result, those investors will be able to effectively purchase KMI shares at a discount, when all is said and done. You might want to read this article, if you are unsure how each of those tickers differs from each other.

It looks like there is an arbitrage opportunity for those who wish to purchase shares of Kinder Morgan Inc at a slight discount today. If I were to do it, I would go for KMR, since it presents a complete tax-deferral of the arb opportunity. If I went with KMP or EPB, I would have to deal with partnership taxation, and K-1 forms, which scare the hell out of most dividend investors. Or at least the ones that have talked to me over the past seven years.

If I already owned enough Kinder Morgan Inc (KMI) stock in a tax-deferred account, I would simply sell it, and purchase shares of Kinder Morgan Management LLC (KMR). This of course assumes that my position is big enough, so that the commission does not erase the arbitrage opportunity. I would also not do this in a taxable account, because the capital gains taxes will make this arbitrage play not worth it. If you however expect to be in the 10 – 15% bracket for Federal tax purposes, this could mean that your dividends and capital gains will be taxed at zero. State taxes of course could apply however. So here is how it goes: If I had 1000 shares of Kinder Morgan Inc (KMI) in an IRA, I would sell it, and put the proceeds into Kinder Morgan Management LLC (KMR). Whenever the deal is closed, I would end up with approximately 1013 shares of Kinder Morgan Inc.

If I wanted to purchase 100 shares of Kinder Morgan Inc with new money however, I would put the money in Kinder Morgan Management LLC instead, and convert my stake in Kinder Morgan Inc when the deal closes.

The amount of 1.30% might not seem like a lot. However, this line of thinking ignores the basic truth that even a small seed can turn into a mighty oak. In other words, for those who have 1000 shares of Kinder Morgan Inc, the 13 shares could produce a lot of wealth over 40 or 50 years down the road. If you manage to compound those $500 at 10% for 50 years, this could turn into a cool $50,000 that produces $2,000 in annual dividend income at a 4% dividend yield. Those of you who train your minds to search for small, accretive investments, that improve your portfolio outcome, you will do really well over your investment career.

The added bonus in this exercise is that investors who purchase KMR rather than KMI, will likely be eligible for a $1.39 quarterly distribution paid in stock somewhere around November 15, 2014. This would be a tax-deferred dividend reinvestment, which would leave the investor of KMR today with more shares to tender for KMI stock. The tax-deferral of those reinvested distributions is really nice, and could widen the spread and potential accretion effect for those enterprising dividend investors. The yield on KMR is higher than KMI, and the KMR yield is entirely tax-deferred (until you sell KMR). The fact that dividends were automatically reinvested for me with KMR, the fact that distributions didn't cause any tax headaches and the fact that KMR always sold at a discount to KMP, made KMR an ideal investment for me. Unfortunately, once the acquisition closes, I will end up with a lot of Kinder Morgan Inc stock, the dividends of which would be fully taxable under the preferential tax rates for qualified dividend income. Hence, I do not plan on adding new cash to this position for the foreseeable future.

Since I hold most of my Kinder Morgan Inc in a taxable account, and since my dividends and capital gains will likely not be taxed at 0% in the foreseeable future, I would not do this exercise. I also do not plan on adding to any of the Kinder Morgan entities, given the fact that this is my largest position. I present this exercise not to provide you with specific investment advice, but to get you thinking about opportunities to increase wealth. This information is not advice for you to act on. The information I used is believed to be accurate, but could be incomplete. Therefore, please do your own analysis before you make an investment.

Full Disclosure: Long KMI and KMR

Relevant Articles:

- Do not despise the days of small beginnings
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Mistakes of Omission Can Be Costlier than Mistakes of Commission

Warren Buffett is one the best investors in the world. He has coined the term mistakes of commission. Basically, mistakes of omission are those situations where you have identified a company to invest in, but you fail to pull the trigger. As a result, your inability to act results in lost opportunity cost. A mistake of commission on the other hand is the act of buying a security which declines in price, which leads to a permanent loss of capital. Buffett is a very wise and rich person, who is a collector of quality businesses, that throw enough cash for him, that he then uses to buy more income generating assets. This is why I believe he is actually a dividend investor.

With dividend growth stocks, the most one can lose is less than 100% of their investment. This is because if I bought a company like Coca-Cola (KO), and it outright fails in a few years or decades, I would have received enough dividends to recover a big chunk of my original investment. I think it is highly unlikely that Coca-Cola will fail in the next 20 years, although it is possible that its growth will be slower than that in the past 20. Even if the dividend grows a little for the next 10 years, I will be able to recover somewhere around a third of my investment just from dividend income alone. The upside however is virtually unlimited – if the company gets its act together, it can deliver 20 – 30% yields on cost by 2034.

As a dividend investor, I am also a collector of quality assets that regularly pay me more and more cash on a regular basis. My goal is to work hard at saving as much as possible, and use those savings to invest. The reason why I try collect as much in income producing assets as possible is so I can live off those dividends one day. This is the reason why most of you read what I have been thinking out loud about investments over the past seven years.

In order to come up with a list of companies to buy, I go through a rigorous top down approach. I basically start with a list of dividend growth stocks, and then try to narrow it down using some sort of entry criteria. After that I research the most attractively prices companies from that list. Sometimes however I end up missing the forest for the trees.

The recent dividend increase of Lockheed Martin (LMT) increased my mistake of commission. The defense contractor increased its quarterly dividend by 12.80% to $1.50/share. This marked the 12th consecutive annual increase for this dividend achiever. Lockheed Martin has managed to increase dividends by 23.50%/year over the past decade. The lesson to learn from this exercise is that sometimes, you will make mistakes as an investor. I am mentioning this, because the stock continuously appeared on my valuation screens, and my dividend increase monitoring updates in 2011 and 2012, but I did absolutely nothing. I am reviewing this mostly as a way to identify shortcomings in my investment process, and see if I can improve it.

The situation in 2010 - 2012 was very interesting, because the stock of the company was very cheap and yielding a lot. The reason was the near ending of the wars in Iraq and Afghanistan, as well as the US budget issues. The main consensus was that defense contractors were going to face stagnating defense budgets from their largest clients, which was going to affect revenues.

Managements of those defense companies did prove to be good stewards of shareholder capital however. Lockheed Martin managed to repurchase shares at low valuations, reduce its workforce and otherwise maintain its cost base. When your stock sells at 9 – 11 times earnings, you can grow earnings per share in perpetuity merely by repurchasing some of your stock each year. If you contain costs a little as well, this also results in a better growth in earnings per share. Lockheed Martin did just that, by reducing the number of shares outstanding from 410 million in 2008 to 322 million by 2014, through its consistent share buybacks.

I guess, when you have a dividend growth company, which sells at a low P/E multiple, and which grows dividends per share and earnings per share, you can make some pretty decent amounts of money. Imagine if you bought shares yielding 4% - 5%, where dividends increased while the shares outstanding decreased as well, and you also reinvested those dividends. This is some pretty turbocharged compounding of income and capital to me.

While I have been advocating doing qualitative analysis of each company on my screen, I could also be exposing myself to biases that could be costly. As I have mentioned earlier, things are not always black and white in investing. My evaluation of the defense industry was generally correct, but it ignored the fact that earnings could be grown through buybacks and cost containment. Of course, back until late 2012, I didn’t even like stock buybacks. I still don’t like them as much as I like dividends, but I know that companies that consistently do them, and manage to do them while their stock is fairly valued, can improve shareholder wealth.

After analyzing the investments I have done in the past seven years, I have noticed that those that did the best for me were selling for less than 16 – 17 times earnings, and were experiencing growing earnings per share and consistent dividends per share growth. By sometimes listening in to news or other noise, I ended up speculating about the future, without really taking into account that I should merely get on the rising earnings and dividends train. I essentially ignored the fact of rising earnings and dividends per share, and focused on speculating about the future, which is not what enterprising dividend investors do. Worrying about when it is going to stop dividend growt is not really a productive thing to do. This was also the case with Microsoft (MSFT), which was selling at a very cheap price just a couple of years ago, because it was perceived as losing its way. Yet, the company was raising its dividends each year, earnings per share were growing, and the threats sounded scary but also have not materialized yet. Currently, the company that everyone is afraid for is IBM, which sells at a ridiculous cheap valuation, grows earnings per share and dividends, and regularly repurchases shares. This is why I am trying to build out my position in the stock. I am also working my way through increasing my exposure to the much hated Exxon Mobil (XOM) as well.

The mistakes of omission with Microsoft and Lockheed Martin show that maybe I just didn't understand the companies very well altogether. This could be a good reason why I never bought in the first place. I also didn’t buy Bank of America (BAC) in 2008, and also avoided buying Nu Skin (NUS). However, I should be trying to learn more about those businesses (LMT and MSFT), and isolate events that can result in more dividends over time for me, so I can be even more successful. Knowledge is like compound interest – it builds up slowly over time, and results in dividends for years. After this I also learned that the situation with Lockheed Martin in 2010 - 2012 was similar (though not identical) to the situation with General Dynamics in 1993 - 1994, when the company repurchased a large block of stock and sold off businesses to pay more dividends. Warren Buffett made an investment in the defense contractor in 1993, and made a lot of money for Berkshire Hathaway shareholders. It is interesting how the big money in defense companies can be made even after major wars such as Vietnam, The Cold War and the wars in Afghanistan and Iraq were over. It is counterintuitive, yet this is a good thing to have in mind at some point in the future.

Of course one cannot be right 100% of the time either. While I have not been right on all investments I have analyzed ( both through commission and omission), I have achieved solid progress towards my goal of reaching the dividend crossover point. The important thing is to keep learning from your mistakes.

Things are not always black and white, and investing is subjective to a certain degree – I cannot automate and distill it into an investment formula. This is why it is important to evaluate how your companies are doing at least once per year, and decide if you are making some common mistakes. My previous analysis of mistakes showed me that I sometimes sell to buy something cheaper. The end result is worse than doing nothing. The mistake that most dividend investors do is chase yield at all costs, without thinking about sustainability throughout different phases of the economic cycle. They also tend to focus on yield, without taking into consideration growth, which results in decrease in the purchasing power of income over time. If you do not realize you are making mistakes, chances are that you will never learn from them. This is why Buffett is so great – he learned from his mistakes, adapted to the new environment, and kept learning more about business and ways to make money.

You keep hearing about the people who have been calling for a stock market top for 5 – 6 years now. Yet many of those people have been looking for a turn for 20 years. They forget that overall economies improve, earnings improve, productivity improves, which leads to higher valuations in companies and more money for dividends. The fact that those people never learned from their mistakes is really troublesome. If you missed out on the growth in US stocks over the past 20 years, and you still maintain your view, chances are you need some corrective action to do. If you are not objective in the analysis of your investments, you will not be able to identify shortcomings. If you do not identify those mistakes, you are likely to lose on potential gains. This is why it is important to keep learning, and try to improve consistently.

Full Disclosure: Long IBM, KO

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Chevron (CVX) Dividend Stock Analysis 2014

Chevron Corporation (CVX), through its subsidiaries, is engaged in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company operates in two segments, Upstream and Downstream. This dividend champion has paid a dividend since 1912 and increased it for 27 years in a row.

In April 2014, the Board of Directors approved a 7% increase in the quarterly dividend to $1.07/share. 

Chevron’s peers include Exxon Mobil (XOM), ConocoPhillips (COP) and British Petroleum (BP).

Over the past decade this dividend growth stock has delivered an annualized total return of 14.40% to its shareholders. Future returns will be dependent on growth in earnings and dividend yields obtained by shareholders.

The company has managed to deliver a 12% average increase in annual EPS over the past decade. Chevron is expected to earn $10.81 per share in 2014 and $11.37 per share in 2015. In comparison, the company earned $11.09/share in 2013.

Chevron has a consistent history of share repurchases. The company has been able to reduce the number of shares outstanding from 2.197 billion in 2006 to 1.915 billion in 2014.

The company is also working towards increasing production from 2.6 million barrels of oil equivalent per day (MMBOED) to 3.1 MMBOED by 2017. The company actually decreased this projection from 3.3 MMBOED originally expected at a price of $79/barrel. However, it also increased the expected price to $110/barrel.

Chevron is strategic about its exploration and production, and focuses on areas where it has above-average odds of achieving financial success. As a result, Chevron is able to earn more per barrel than Exxon Mobil, BP or Total (NYSE:TOT). In the past decade, Chevron has also managed to achieve a reserve replacement rate exceeding 100%, which means that it has added more oil and gas resources than it pumped out of the ground. The company believes that it already owns the assets that will enable it to generate growth in production for years into the future.

Oil companies need to continuously explore for production, since the amount of oil and gas pumped from wells decreases every year. Even with improvement in technology for oil and gas recovery, future exploration is important. This is why companies need to be very careful about their capital allocation strategy, since they want to generate the most profit at the least cost, avoid overruns and still manage to reward their shareholders with a dividend and share buybacks. Unfortunately, oil and gas companies are price takers, and are subject to wild swings in prices. However, for integrated companies like Chervon, they can add value across the chain and extract more in profits. Of course, the problem arises if oil prices decrease for extended periods of time, which would mean that many unconventional oil and gas wells will be uneconomical to operate, which could decrease supply and also reduce incentive for further development of drilling technology in hard to reach places like deep seas, for example.

However, I believe any drops in price will be temporary, since that would decrease supply and thereafter increase prices. In addition, the demand for energy is expected to increase through 2030 by approximately 2%/year. While renewables will likely capture a higher share in satisfying the world's energy needs in the future, they are intermittent sources and are more expensive relative to conventional energy sources. Therefore, I believe that while the percentage supplied by traditional oil and gas will be lower in 2030, the overall amount of consumption will be much higher. We have all heard how emerging markets need energy -- well, if they are truly to embrace capitalism and grow their middle classes in the future, then rest assured that demand for energy will increase.

The annual dividend payment has increased by 10.50% per year over the past decade, which is lower than the growth in EPS. Future growth in dividends will likely match rate of increase in earnings per share.

A 10% growth in distributions translates into the dividend payment doubling every seven years on average. If we check the dividend history, going as far back as 1984, we could see that Chevron has actually managed to double dividends every ten years on average.

In the past decade, the dividend payout ratio increased slightly from 25% in 2004 to 35% in 2014. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

The return on equity has decreased from 29.40% and 15% over the past decade. I generally like seeing a high return on equity, which is also relatively stable over time.

Currently, Chevron is attractively valued at 11.80 times forward earnings, and has a dividend yield of 3.30%. Overall, I believe that oil companies like Chevron have the quality of assets that generate strong cash flows, and quality of a management team, coupled with a dedication to sharing the wealth with shareholders through a commitment to dividend growth and share buybacks. While dividend growth rates might fluctuate from year to year, I am firmly believing that the investor with a 20 year horizon, who patiently accumulates and reinvests dividends, will reap the rewards in the future.

Full Disclosure: Long CVX, XOM and BP

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Never Stop Learning and Improving

Some of my readers know that I own a lot of stocks. I even dedicated a whole article on the topic.

Readers also know that I have more than one brokerage account. I also dedicated another article on the topic here.

What can I say - I try a lot of different things. I think I do all of that because I like tinkering, and testing in real time what happens, and see how I react to it. Investing is all about having a method, and then trying to improve it, drop things that don't work. The lessons from all that have been invaluable, and have shattered my beliefs time and again. But as a result, I have become much more successful.

One account I own has exclusively low yield, high growth securities in the initial stage of dividend growth. An example includes the company Visa (V). From time to time, I also do something else, like participate in merger arbitrage, or buy a really under loved and undervalued security like I did with Gazprom in 2013 and early 2014. This portfolio has a myriad of small positions, which could mushroom to very big opportunities, particularly if they grow at mid-to-high teens for long periods of time. I believe it is important to try and monitor the dividend growth universe for the next big dividend growth story.

Another account is used exclusively for selling long-term puts. Check this article on selling puts if you are unsure what this means or how I approach that strategy. The account can have up to 25% of value in naked long-term puts I have sold. Meaning if account value was $100,000, I have sold puts on securities I like. If those puts are exercised at the same time, I would have to buy $25,000 worth of securities. Usually this would occur at lower prices, and into the future, matching expected inflows with future outflows. Too bad most long-term puts expire in Jan 2015 or Jan 2016. There aren't any long-dated put options on companies I am interested in going beyond that yet (unless you want to invest in ETFs like SPY, which goes as far out as December 2016). The main portfolio is fully invested, and the options expirations are layered into the future, so that they do not occur at the same time. This means that the $100,000 is invested in dividend paying stocks, and in addition, I have sold puts which would trigger a purchase of $25,000 worth of stocks, if puts are exercised. The put selling is a way to mostly try and buy certain companies at a discount, and generate some float in the process. I only do companies now, although for a while I sold puts on S&P 500. A recent example is the sale of puts on Hershey, which would result in an entry price of approximately $84/share, provided that the stock price is below $90 by January 2016.

Another account has up to 15% of value on margin. Check this article on leveraged dividend investing. Meaning if account is $100,000, I have bought 15,000 worth of securities on margin. I have figured out that this margin would be paid off by my dividend income within 3- 4 years. At the current time, the interest rate is a paltry 1.09% - 1,59%/year. Actually, several of the purchases I have made in 2014 occurred in this account at Interactive Brokers. I am also considering moving some of the options selling to this account as well, given the low commissions and super low margin rates I enjoy at this broker. However, I might need to beef up the equity there first before I combine both activities. I find investing using borrowed money to be a very interesting exercise, which could be disastrous however. This is why I am only doing this with one of the accounts, because the risks are high. However, I strongly doubt that it is that risky to buy shares on margin today, which would be paid off by my dividends alone in three to four years, while paying a very low margin rate.

A third account has some CD’s, which will likely expire in 2015. I had high hopes of putting approximately 20% of my portfolio in treasury bonds, and CD’s, but the low interest rate environment means this would be unlikely. This account used to be very high in 2007 and 2008, but has been steadily decreasing since 2008. I used to own a ladder of CD's, which have been expiring since 2008. I also owned some Treasury Bonds at one time a few years ago, but I sold them all in 2010. As those remaining CD's have expired, I allocated the proceeds into dividend paying stocks.

Another account simply collects all dividend, interest and other portfolio income received. It then distributes the cash to the account which I am trying to build up. I do not automatically reinvest dividends, but allocate them in the best values at the moment. This is honestly a very important account.

Over time, the activities in those portfolios have added to cash flow, and provided extra power to deploy in dividend paying securities.

I am not going to even list the retirement account such as 401 (k), which lets me defer taxes today, and which I hope to convert to a Roth IRA tax free when or if I drop out of the rat race, and reduce my effective taxable income to the lowest brackets possible. Nor am I going to discuss the SEP IRA, Roth IRA, Rollover IRA or Employer Stock I hold. The retirement accounts are mostly a cash outflow right now, since they are being built out and limited by the maximum contributions by our friends at the IRS. The employer stock plan provides the opportunity to buy shares at a discount, which are then hedged, and sold at the first possible opportunity. Small investors have opportunities to generate "alpha" all the time, particularly those employed at companies with benefits.

All of these accounts holds a purpose, despite the fact that the picture looks complicated on the surface. The retirement accounts are essentially taking care of themselves, and so are most of the other accounts I hold that are fully built up. A lot of the work involves having a list of holdings in a spreadsheet, and then monitoring the actual holdings and overall allocation to those. The rest is covered in my monitoring process, which involves researching companies to invest, looking at dividend increases, checking material company information such as quarterly or annual financials as well as other major items such as mergers and acquisitions. Those might or might not be driven by tax inversions.

At tax time, each brokerage account generates a 1099 that is just inputted into the tax form, and it is sent out to our friends at the IRS.

I often get asked why don't I simply buy 20 dividend stocks, and concentrate myself to those. The things is, if I had limited myself to a set number of companies, without looking for my own strategy that fit my way of investing, I would not have been as successful as I have been today. Investing environments change, which is why you need to be adaptable to the situation, and not impose your own set of values on the environment. If you place self-imposed limits on your growth as an investor, you are wasting your potential.

Full Disclosure: Long V

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Three Dividend Stocks With Consistent Dividend Hikes

As a dividend growth investor, I value consistency in the types of companies I own. When I buy shares, I view myself as a partial owner in a business. My success is therefore dependent on the ability of that business to earn more money over time, in order to pay me more dividends in the future. In my experience as a dividend investor over the past seven years, I have found that the companies that earn a repetitive stream of sales to a loyal set of customers are the ones who end up with reliable revenues and earnings to pay the dividend to me as a part owner. From time to time even the best business experiences temporary weakness, which is usually an opportunity to increase my stake, after careful analysis of the situation.

I do have safety in numbers however, as the majority of my total dividend income is generated by approximately 40 – 50 companies. Therefore, even if I made one bad decision, my total dividend income keeps coming, and keeps growing. Most regular readers are keenly aware that one of the methods I use to monitor dividend growth stocks is to regularly check the list of dividend increases for the week.

Over the past week, the following dividend growth companies I monitor announced increases in their dividends:

McDonald’s (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company raised its quarterly dividend by 4.90% to 85 cents/share. This marked the 38th consecutive dividend increase for this dividend champion.

Per the words of the CEO “McDonald's global growth priorities – providing great-tasting food and beverages, creating memorable experiences, offering unparalleled convenience and becoming an even more trusted brand – focus on what matters most to our customers and serve as the foundation to building our business over the long term. Today's dividend increase reflects the continued strength and sustainability of our cash flow and our commitment to enhancing shareholder value. We expect to return $18 to $20 billion to shareholders between 2014 and 2016 and have returned $3.2 billion year-to-date August toward that target”

This was the slowest dividend increase since the late 1990s. The stock sells for 17.50 times forward earnings and yields 3.60%. Check my analysis of McDonald’s for more details on what my take on the company is.

W.P. Carey (WPC) invests in commercial properties that are generally triple-net leased to single corporate tenants including office, warehouse, industrial, logistics, retail, hotel, R&D, and self-storage properties across the globe. This REIT hiked quarterly distributions to 94 cents/share. This dividend achiever has increased distributions for 16 years in a row. Over the past decade, it has managed to hike distributions by 6.30%/year. W.P. Carey yields 5.50% after the hike. This REIT is one of my mistakes of omission. I have monitored it for several years, and missed out on the opportunity to acquire a stake in 2012, when the plans for conversion to a REIT were announced. I then continuously decided against investing in the company, “because the price went too high”. I believe that investors in W.P. Carey today would likely do slightly better than investors in Realty Income over the next 10 years. Maybe one of these months I will admit I was wrong and initiate a position, using the dividends I receive from Realty Income (O) and American Realty (ARCP).

Microsoft (MSFT) develops, licenses, markets, and supports software, services, and devices worldwide. . The company raised its quarterly dividend by 10.70% to 31 cents/share. This marked the twelfth consecutive annual dividend increase for this dividend achiever. Over the past decade, Microsoft has managed to boost dividends by 15%/year. The stock sells for 17.30 times forward earnings and yields 2.70%. I have analyzed the company before, but never really did anything about initiating a position. The company has a strong brand, and a business model I understand very well. However, I am not sure what the future of computing will be in 20 years, and how Microsoft will fit into it. Hence, it is on the too hard pile – meaning it is probably outside my circle for now.

That being said, I value each one of those companies for their consistency in dividend increases. To arrive at this list, I focused on companies that announced increases in dividends in the past week, and then focused only on those that have grown them for at least a decade.

Full Disclosure: Long MCD

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How to analyze dividend stocks

Most dividend investors tend to have a screening criteria which helps them narrow down the investable universe of income stocks to a more manageable list. This screen could include criteria such as profitability, valuation, as well as other characteristics that are tailored to the individual’s strategy. Once a list of potential candidates is presented however, investors need to create an additional set of parameters that would help them to identify the best investments for their money.

In my investment process, I apply my entry criteria to the list of dividend champions and dividend achievers. I tend to perform this exercise once a month, but might perform it more often if stock prices decline. After I have a manageable list of investments to dig into, I often dig into them one by one. The items I look for might seem highly subjective, and based on my personal experiences. Therefore, they should not be a be it all inclusive list to copy and mindlessly replicate.

In general, I typically look for increases in income over the past decade. It does not have to be a stair step increase, although a period of flat or declining earnings of five or more years is typically a red flag for me. After past earnings are analyzed, I tend to research how exactly the company is making money. This is typically found in the first few pages of an annual 10-K filing, and it typically makes for a fascinating read. The next step after that is determining if the company has any formal plan or goals for growth over a given time period.

For example, IBM has a plan to earn $20/share by 2015. If a company does not have a formal plan written down, I tend to analyze factors that could allow it to grow profitably for the next decade and hopefully beyond that. In general companies can grow earnings by expanding in new markets, acquiring competitors, increasing sales volumes, introducing new products, raising prices or cuttings costs to name a few. For example, companies like Coca-Cola (KO), which are expanding rapidly overseas, could generate increases in earnings over the next several decades. This would be fueled by the increase in the middle-class worldwide, introductions of new healthier beverages as well from strong pricing power coming from strong brand name that the company owns.

For a company like Wal-Mart (WMT), it could expand its presence overseas in key markets such as China, while also maintaining its position as the lowest cost retailer, due to its scale. If Wal-Mart can successfully renovate a large portion of stores and manages to make and keep them cleaner and more appealing to the types of shoppers that tend to frequent Target (TGT), it could increase sales for years to come. Of course, by simply maintaining its grip on retail sales by negotiating favorable terms with suppliers, squeezing out inefficiencies from its value chain and passing off savings to consumers, it should continue to dominate in the US retail market. The problem that Wal-Mart is facing is that its size is a major impediment to fast growth in the future; moderate growth in earnings per share however could still be expected over time.

I typically also look at the return on equity, in order to determine whether the dollars which had been reinvested back into the business have generated any value to the company. In general, if there has not been a major acquisition, ROE would be a helpful factor to analyze. Companies need to invest in the business in order to keep their edge and also to increase profitability over time. Not all new projects are going to add to the bottom line immediately, but on aggregate, I would expect that a reasonably capable management team would deliver the kind of organic earnings growth that would pay dividends for years to come. Chasing hot or exciting projects that make news headlines might not be helpful for operating performance, since it would likely result in overpaying for assets. For example, back in the early 2000s, European Telecom’s spent billions for 3G wireless spectrum, which was more than they could swallow. This resulted in increased debt levels, and the big winners ended up being the governments which sold licenses at high prices.

Another thing I tend to look for includes trends in dividends and dividend payout ratios. If companies are able to generate rising profits over time, I generally tend to like those that raise distributions in tandem with increases in profits. A company with the culture to reward shareholders with more cash as the business grows and profits are rising are definitely a plus in my book. However, I tend to closely monitor the dividend payout ratio, in order to determine whether dividends are being increased on borrowed time. In other words, if dividends are rising faster than earnings, chances are that sooner or later both of these indicators have to converge their growth rate. Otherwise, the company would end up with an unsustainably high dividend payout ratio. Without a margin of safety in dividends, any short-term dip in profitability could result in steep dividend cuts, which could end long records of consistent dividend increases.

Companies like Chubb (CB) have been able to raise dividends at a rate that has been very close to the increase in earnings over the past decade.

In addition, I also look for companies which can deliver meaningful dividend increases for years to come. In general, utilities have been plagued by dividend cycles of increases followed by dividend cuts. Other utility companies such as Consolidated Edison (ED) have managed to eke-out minimal dividend raises of 1%/annually for the past 16 years. Given that inflation is typically 3%/year, this minimal dividend increase is not sufficient to maintain purchasing power of our dividend dollars. In general, I recognize that there is a trade-off between current yielder with low growth and a low yielder with high growth. However, investors should select the option that shows them the best potential from growth in earnings and dividends, rather than impose their own personal situation on the world.

This would mean avoiding a high yielder like Con Edison (ED), despite its mouth-watering yield and sticking to a company like Kimberly-Clark (KMB). Chances are that a high yielder could generate a high level of dividend income for years, which would decrease its purchasing power over time because of low growth rates. In addition, a high yielder would likely deliver lower total returns, since it would not be able to grow earnings as quickly as a low yielder.

Many of the companies I hold are defensive in nature, and sell products or services sold to millions of consumers and businesses worldwide. Many of those sales represents recurring transactions, which repeat every so often. Finding a business model that I can understand is definitely a plus. I believe that most ordinary investors can understand how Colgate-Palmolive (CL) or Procter & Gamble (PG) or PepsiCo (PEP) earn their money. This is the type of "qualitative" analysis which could be subjective, but important. In the case of those companies listed in this paragraph, I doubt that their profits will decline by much during the next recession.

In conclusion, investors should take into consideration the performance of the companies in which they plan to invest their money in, and estimate whether they stand a decent chance of continuing that performance in the future. If the answer is yes, and the dividend paying stock is attractively priced, then chances are that it would be a decent addition that would bear fruit for years to come.

Full Disclosure: Long KMB, KO, PEP, APD, WMT, CLX

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Wal-Mart (WMT): The Time To Buy Is When No One Likes A Quality Dividend Company

Wal-Mart Stores Inc. (WMT) operates retail stores through three segments: Walmart U.S., Walmart International, and Sam’s Club. This dividend champion has paid a dividend since 1974, has consistent history of share repurchases. and increased it for 41 years in a row. Wal-Mart is also one of the companies, which could be purchased commission-free using Loyal3, with as little as $10.

The most recent dividend increase was in February 2014, when the Board of Directors approved a 2% dividend increase to 48 cents/quarter. This was the slowest dividend increase ever for Wal-Mart Stores. It is likely that management does not expect high earnings growth in the next couple of years.

Wal-Mart has delivered a 9.10% average increase in annual EPS over the past decade. It is expected to earn $5.16 per share in 2014 and $5.64 per share in 2015. In comparison, the company earned $4.85/share in 2013.

Currently, Wal-Mart is attractively valued at 14.40 times forward earnings, and has a dividend yield of 2.60%. I believe that Wal-Mart has what it takes to be successful, and endure changes over the next 20 years. Unfortunately, the company is so large that its future profits growth might not be that high. The valuation is compelling, but the expected earnings per share growth is not going to exceed 6% - 7 % per year. That being said, I will hold on to my existing position, and might consider adding a little more this year, subject to availability of funds and other ideas.

Check the full stock analysis at Seeking Alpha

Full Disclosure: Long WMT and TGT

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Three Questions That Every Dividend Investor Should Ask Themselves

Investors purchase dividend stocks in order to generate a reliable source of cash that would help them pay for their expenses in retirement. In theory, this is a great idea. However, certain little details could seriously derail the investor’s success. In order to ensure that they will be able to hit their investment goals, dividend investors should ask themselves the following three questions:

1) Is the dividend Safe?

Many dividend investors who are just getting started tend to focus on companies with the highest dividend yields. Noone can blame them for this, as it is every investors goal to maximize their investment returns. Investing purely for dividend yield however, could easily backfire without some basic research. The company with a mouth-watering 8% yield today could end up cutting or completely eliminating the distribution, which could lead to loss in dividend income and huge losses. This could derail anyone’s retirement plan. Investors should instead attempt to understand how the company makes money, and should also calculate whether the dividend is adequately covered. I typically look for a margin of safety in dividend coverage. This means that I typically look for a dividend payout ratio of 60% or less, which means that earnings are roughly 67% higher than the dividend paid. This payout ratio fluctuates from year to year, which is why it is important to look at it for the past decade, in order to gauge the sustainability of dividend payment. While there are no guarantees that the dividend would be paid out, even if it is adequately covered, a sustainable distribution increases the odds that the investor would be able to enjoy an uninterrupted stream of dividends.
For certain entities such as Master Limited Partnerships or Real Estate Investment Trusts, I tend to prefer a stable or declining ratio of distributions to cash flow from operations ( FFO or DCF).

2) Will the dividend grow?

Inflation is the largest enemy of the retired investor. Prices have been on a slow but steady increase over the past century. Even at a modest 3% annual inflation, prices of goods and services will double in 24 years. As a result, investors need to have a stream of income that will increase sufficiently to cover the effects of general price increases. Dividend growth stocks are a perfect investment vehicle for such endeavors. In my portfolio I purchase stocks which have exhibited a strong corporate culture, backed by real profits, which has resulted in long streaks of consecutive dividend increases. Newton’s law that a body in motion will keep being in motion is in full force with dividend growth investing. Just because a company has raised distributions for 20, 30, 40+ years does not mean it is a good buy at the moment however. In general, companies can only afford to grow dividends if they manage to increase profits over time. Investors should thoroughly analyze the company by reading annual reports, analyst reports and keeping up-to-date on any company developments. This is in order to determine whether the possibility of future dividend hikes is higher than average.

3) Will the company deliver solid total returns?

Many investors seem mesmerized only by dividends, do not do much due diligence on growth, and tend to forget about capital gains in the process. This could be costly to your financial well-being. Historically dividends have accounted for about 40% of total returns over the past 80 years. The remainder has been achieved through capital appreciation in stocks. In general, dividend growth companies with moderate current yields in the 2%- 4% range with payouts below 60% stand a very good chance of delivering solid capital gains over time. This is in addition to the rising dividend payment. While, capital gains are not as reliable for retirees as dividend payments, they do ensure that over time the purchasing power of the investor’s capital is maintained and increased. If all else is true, a company yielding 2% - 4% today that also manages to grow earnings and dividends at a healthy clip, should be able to increase in value over time. This again ensures that my capital maintains purchasing power as well. I do not plan on selling most of the holdings I own, however I do want to see increases in networth over time.

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High Yield Companies for Current Income

I monitor my portfolio holdings quite regularly, looking for material events concerning the companies I hold. As a dividend investor, the best news is when a company I hold raises dividends. This is a confirmation that the analysis I had done in the first place was valid, and that the decision to purchase a stock in a company after that painstaking process is indeed paying higher dividends. Rising dividends are important, because they ensure that the purchasing power of my income is at the very least maintained if I were to drop out of the rat race and retire tomorrow.

With dividend investing, success is very tangible, one dividend check at a time. Dividends represent money I earn without having to be physically present at a location or answer to a boss. Thus, with each dividend check I am getting one step closer to retirement.

Two of my holdings raised their dividends in the past week. Those include:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company raised its quarterly dividend by 6.40% to $1/share. This was the slowest dividend increase since PMI was spun-off from Altria (MO) in 2008. The company is facing some headwinds worldwide, but despite those is still able to generate strong cashflows to pay increasing dividends and repurchase shares. I would probably have to lower my earnings and dividend growth expectations to 6% - 7%/year for the foreseeable future. However, a 6%-7% annual growth in dividends from a company yielding almost 4.80% is a pretty good achievement. The shares are still attractively valued at 16.30 time forward earnings. Check my analysis of PMI.

Realty Income Corporation (O) is a publicly traded real estate investment trust. The REIT increased its monthly dividend slightly to $0.1831/share. This was less than 1% higher than the monthly amount paid at the same time in the preceding year. Realty Income has managed to increase dividends by 6%/year over the past decade. This dividend achiever has also managed to boost distributions to its patient long-term investors for 20 years in a row. This includes a 20% increase in dividends in 2013, which is probably one of the reasons for the slow raises in 2014. Going forward, I would expect this REIT to manage to grow distributions to match or slightly exceed the rate of inflation. Since the company is already a high portion of my income portfolio, I do not plan on adding any more funds there. Check my analysis of Realty Income.

While I am not a big fan of looking for high yields  for the sake of looking for high yields, I understand that some investors who are retired need above average yields today. I believe that companies like the above mentioned could be the types of companies to research thoroughly, before you decide if they are a good fit for your portfolio or not. The two are a good fit for my portfolio, and provide quite a nice stream of growing dividend income, which is then reinvested into other attractively priced income producing assets.

As an added bonus to my readers, I am also going to mention another recent dividend increase, which is not from a high yield company. However, I believe that this company can achieve the type of dividend growth to reach high yields on cost in the future for those who manage to acquire the shares at attractive valuations. The company is Yum! Brands (YUM), which operates quick service restaurants in the United States and internationally. It operates in six segments: YUM Restaurants China, YUM Restaurants International, Taco Bell U.S., KFC U.S., Pizza Hut U.S., and YUM Restaurants India.

The company raised its quarterly dividend by 11% to 41 cents/share. This marked the tenth consecutive annual dividend increase for this dividend achiever. The stock is overvalued at 21.30 times forward earnings, but it does have potential for a lot of international growth. I hold a small position in it, and would like to add some more at 2.50% entry yields. Check my analysis of Yum.

Full Disclosure: Long PM and O, YUM

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Walgreen: A High Dividend Growth Champion To Consider

Walgreen Co. (WAG), together with its subsidiaries, operates a network of drugstores in the United States. This dividend champion company has paid a dividend since 1933 and increased it for 39 years in a row.

The most recent dividend increase was in August 2014, when the Board of Directors approved a 7.10 increase in the annual dividend to 33.75 cents/share. The largest competitors for Walgreen include CVS (CVS), Wal-Mart (WMT) and Rite-Aid (RAD).

Over the past decade this dividend growth stock has delivered an annualized total return of 9.10% to its shareholders.

The company has managed to deliver an 8.40% average increase in annual EPS over the past decade. Walgreen is expected to earn $3.32 per share in 2014 and $3.87 per share in 2015. In comparison, the company earned $2.56/share in 2013. In the press release from Walgreen from yesterday, the company mentioned that it expects earnings per share to hit $4.25 - $4.60 by 2016.

Selling Puts: Pros and Cons for Dividend Investors

Last week, I sold some puts on British Petroleum (BP), right after the judgment that opened the door for a potential $18 more billion in liabilities stemming from that Gulf of Mexico oil spill from 2010. The stock price sold off sharply on those news, and I decided that this was an opportunity to add to my existing position. Since I am low on investable funds, I decided to sell some puts on British Petroleum. I posted this over the internet, and had a reader ask me exactly what that means. As a result of this question, I am going to try and respond to this request.

A put is an options contract, that allows the options buyer to sell a number of shares at a given price at a given date in the future. The number of shares per each options contract is 100. People buy put options in order to protect themselves from a decline in prices, and thus they want to limit their losses. Those who purchase put options are therefore either hedging their exposure, or outright trying to place a bet that prices are going to decrease. For the right to sell a number of shares at a given price into the future, the options buyer pays the options seller a premium. This is essentially the cost of the bet behind the option. The premium is essentially the price that the put options buyer pays to the put options seller.

The put options seller receives the premium, and has a few potential outcomes for him. In my case, I sold a put option on BP at a strike of $44, which expires in April 2015. I received an options premium of about $2.25/option. This means that the options buyer ( the person I sold the option to) paid $225 for the right, but not the obligation, to sell me 100 shares of British Petroleum at $44/share in April 2015.

I essentially have two potential outcomes from this transaction:

The first outcome is that shares of British Petroleum sell for more than $44/share by the time the options I sold expire in April 2015. As a result, those options contracts expire worthless, and I end up with the $225 in premium in my account. The downside in this outcome is that I missed out on all potential gains above $44/share, if the put is never exercised.

The second outcome is that shares of British Petroleum sell for less than $44/share by the time the options expire in April 2015. As a result, I would have to purchase 100 shares of BP for every options contract I sold to the buyer of the put option. If shares of British Petroleum sell for $40/share in April 2015, I would knowingly buy shares at around $4 lower than then present prices. All is not bad however since I received $2.25 per each share, which essentially lowers the cost to about $41.75/share. In addition, buying at $41.75 sure beats buying at $44 or $45/share outright. The share was selling around $45 immediately after the unfavorable court ruling.

In both first and second outcomes, I am not eligible to receive any dividends on British Petroleum, since the buyer of the put option holds those shares in their own brokerage account. If exercised under the second scenario, I would own some shares in the British oil giant, and receive those fat dividends ( assuming they are not cut or suspended). Astute readers can see that as long as the stock price is flat or up, I get to keep the premium. If the stock price is down, I get to buy shares in a company I am interested in, but at a lower price. It is a win-win for me, that slightly tilts the odds of success in my favor.

However, I used the premiums from the puts I sold to purchase shares in British Petroleum. This means that for every put contract I sold, I was able to buy 5 shares in British Petroleum. I will be earning a nice dividend check on those shares for years to come, since I rarely sell those companies that at least maintain their dividend payment. If shares sell for more than $44 in April 2015, I will have essentially earned 5 shares for every options contract I sold on BP. The nice part is that I would have earned those shares only because I have good credit with my brokerage. Even if I have to buy BP at $44, my entry price would be much better compared to buying the stock outright today. Hence, I view selling puts on stocks I want to buy either way as a type of “heads I am better off than before, tails I am even as before” strategy.

Here comes the danger in selling puts however – the possibility for wipeout risk due to overleveraging. Let’s assume that my portfolio was valued at $10,000, and I sold a put on BP with a strike of $44. If the value of BP stock decreased by 50% in April 2015, and I needed $4,400 to buy BP stock, while the value of my overall portfolio dropped by 50% through April 2015, I would be almost wiped out (assuming other shares in my portfolio also decrease by 50%). This is why it is important to be very careful when playing with leverage, which is akin to playing with fire.

I only sell puts sporadically, and only do it on companies I would like to buy outright, but whose prices are little too rich for my taste today. In addition, I make sure that the potential outlay if all puts are exercised does not exceed 25% of the account value on the stock account through which I do that options trading. Long-time readers also know that I have more than one stock brokerage account, which further reduces wipeout risk.

Full Disclosure: Long BP and short BP puts

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