Preventing Blind Spots in Dividend Investing

In a previous article I described why dividend investors should look beyond typical dividend growth screens. I am basically finding that investors who take the time to study the numbers for every individual business one at a time, are much more likely to uncover hidden gems. I believe that investors who rely on pure quantitative screens, might develop blind spots that would prevent them from identifying hidden opportunities.

For example, investors who blindly followed the S&P Dividend Aristocrats index in 2007, would have sold their shares of Altria (MO), right before it more than tripled in value. The index committee erroneously thought that when a company splits in three, its past record no longer matters, even if original shareholders were earning higher dividend income from the shares of companies they received. For any smart dividend growth investor, this would not have caused them to sell, but to simply hold on and enjoy the growing stream of cash dividends every year.

In another example, I have the list of stocks in my portfolio input into Yahoo! Finance. When I have spare funds to invest in dividend stocks, I might go to Yahoo! and look at valuation metrics of companies I own. As I was reviewing the valuation of my portfolio holdings, I noticed that some of the companies I own seem very overvalued on the surface.



For example, Kimberly-Clark (KMB) seems to be selling for 61.90 times earnings according to Yahoo Finance. The reason behind these high numbers is because earnings per share is depressed from one-time items such as a $462 million charge (or $1.22/share) to write down balance sheet items that were on the books in depreciating Venezuela currency. This charge is for the remeasurement of its December 31, 2014 bolivar-denominated net monetary assets.  Another example is the $2.23/share charge in the second quarter of 2015, driven by non-cash pension settlement charges. The company basically purchased annuities from two insurance companies for 21,000 of its employees in the US that were covered under a defined benefits plan. This effectively transferred the obligation on to the insurance companies, which cost $819 million. Anyone who simply looks at the 61.90 times earnings, and ignores this and other one-time charges, misses the big picture for a business that is estimated to earn $5.75 in 2015 and over $6.20/share in 2016. Based on Friday's close, the valuations comes down to 18.60 times earnings for 2015. This is not low, but is in fair valuation range. This is why you should not be mechanically looking at screens, but rather review companies one by one.

A few look very undervalued on the surface. For example Chevron (CVX) looks like it is cheap at 12 times earnings. I think the Yahoo feed uses trailing 12 month earnings. In reality, Chevron looks expensive at 22 times earnings, based on 2015 expected earnings of $3.65/share. If you look at estimated earnings for 2016 of $5.19/share, the stock looks fine at roughly 15.50 times earnings. Given the annual dividend of $4.28/share, the company would be unable to cover it in 2015 and would barely afford to cover it in 2016. Of course, forward earnings for 2016 should be taken with a grain of salt, since those are based in large part on oil and natural gas prices in the future. The honest answer is that noone can predict where those will be in 2016, based on the information we have today.

It looks like merely looking at results from a source at face value could impact decision quality tremendously. This is why it is imperative that investors do not merely rely on shortcuts to generate ideas and monitor positions, but to get their hands dirty and research their way to the source. This source could include annual or quarterly filings, press releases to name a few.

In my analysis, I also look at forward average earnings estimates by analysts, as another tool I use in order to gauge whether one-time accounting events have temporarily affected earnings per share. Of course, earnings estimates made by analysts are prone to over-optimism, which in itself is another factor to consider in your stock fair valuation decision.

A third factor you can use in order to come up with a more accurate level of earnings, that you should be using for your P/E ratio calculation, is by studying recent trends in profitability. I usually look at ten year trends in my stock analyses, but for the purposes of researching most current earnings, I would look at the past 4 - 5 years. I essentially try to decipher whether the current trend looks like an aberration or not. If a company earns $3/share for 4 years, and all of a sudden earns $2.50, I would probably spend a few minutes gathering more information behind the variance.

Full Disclosure: Long CVX and KMB and MO

Relevant Articles:

- Dividend Investing – Science versus Intuition
- How I manage my dividend portfolio
- The Energy Company I want to buy
- Dividend Stocks Provide Protection in Any Market
- Why Investors Should Look Beyond Typical Dividend Growth Screens