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Tunnel vision is defined as a restricted field of vision in which peripheral vision is severely limited. It is also defined as a very limited viewpoint or conception of things. I tend to think tunnel vision is a common danger in investing and as a dividend growth investor I believe I need to make sure that I don't have it as well as ensure the companies in which I invest don't have it. How can I have it? By having a tendency to overly focus on the dividend, the dividend yield, and the growth of the dividend. I realize these 3 things may be considered sacred to dividend growth investing, but before you write me off for blasphemy bear with me a moment. The more experienced dividend growth investors already know there is much more to choosing the right dividend growth company than those three metrics. But since there are many new investors who have decided to take their investments into their own hands, I thought I would address how I deal with this potential tunnel vision issue.

Based on commentary to many of the DGI articles, it appears many of the newer DG investors place their focus on the 3 metrics mentioned, along with whether it's on the CCC list and what the value area might be at which to buy. I believe the more important thing is to look at what the genesis of the dividend is and what sustains it. Since I believe the object of dividend growth investing is to generate income, and if in retirement I'm going to be depending on that income, then it becomes imperative to me to make sure that the dividends, and their growth, will keep on keeping on. And while I may think I've invested in a great company that pays a solid growing dividend and has a dependable history of doing so, I still need to make sure the company is being managed in a manner that provides appropriate financing for the dividend and that company management is not developing tunnel vision as I call it. I'll first give an example of a company which I believe exhibited a classic case of tunnel vision.

Classic Tunnel Vision

Brownie Pic

In 1975 a team of Eastman Kodak engineers led by Steve Sasson invented digital photography. Sasson presented the idea of a "filmless camera" to the Eastman Kodak executives and at the presentation his report stated that "The camera described in this report represents a first attempt demonstrating a photographic system which may, with improvements in technology, substantially impact the way pictures will be taken in the future." (emphasis mine) The executives couldn't understand why anyone would want to look at images on a TV screen when they could hold them in their hand on paper.

At the time film and paper for printed pictures were the Kodak cash cows with a whopping 90% market share of photographic film sales in the U.S. Kodak paid an annual dividend in 1975 of $0.91 and at the end of the year with a stock price of $37.30 yielded 2.4%. Kodak was such a well-known company with a dominant product that one of the more familiar phrases in the American lexicon was when a special event was described as a "Kodak moment." Company management was hesitant to do anything that would impact that business, especially when they could see no future use for what was being proposed. However, other companies were not so hesitant or concerned with the impacts to Kodak's business.

Fast forward to today and almost everyone is using digital photography. But Eastman Kodak declared bankruptcy in January 2012 and their stock, which in 1997 had risen to over $94 per share, is today being traded over the counter under the symbol EKDKQ.PK for $0.20 per share. I believe Kodak's demise was brought about by its failure to think outside of its own paradigms, which is a fancy way of saying it had a bad case of tunnel vision. By the time it attempted to become a dominant player in the digital photography market it was too late.

It would be easy to say that 1975 to 2012 is a long time and any dividend growth investor would have had plenty of time to see the writing on the wall and get out. That pre-supposes having and using the relevant information at that point in time. Since Kodak hit all-time highs as late as 1997, how many dividend growth investors would have seen it as a buying opportunity when the stock price started dropping? One of the underlying philosophies of dividend growth investing is that we invest for the long term, and just like rain, snow, sleet, or gloom of night won't keep the U.S. mail from going through, neither will price fluctuations drive us out of our positions (did I mention the Post Office isn't exactly on firm financial foundations?). So would we have been driven out or stayed in?

Both Art and Science

I'm in the camp of those that believe investing is partly art and partly science. Dependent on one's own natural inclinations one side may be more difficult than the other, or they may be equally difficult/easy. Either part though, in my opinion, requires the individual investor to utilize the single biggest asset he or she brings to the table, which is the ability to think. I may or may not have seen things differently than the Kodak executives 38 years ago, but I've learned the hard way to keep an open mind about the companies in which I'm investing. You don't have to be Nostradamus or a Mayan to make a reasonable judgment on whether a company has tunnel vision and is limiting its future, or has a big picture view and is improving its future. Starting with what I consider the science side, I'll use Microsoft (NASDAQ:MSFT), one of the dividend growth holdings in my own portfolio, as an example.

The Science Side

Starting with the criteria I noted above that is popular with newer DG investors, MSFT would look like this:

(click to enlarge)

While this is all important information, absolutely none of it tells me if it is sustainable, although the growth rate certainly appears to be pointing in that direction. But the dividend and its growth are only as strong as the underlying company. To find out how sustainable the dividend is my rule of thumb is to practice the old adage to "follow the money." To do that I go to Morningstar.com and pull up the key ratios tab which looks like this:

(click to enlarge)MStar

All of this is free information on their site. I start with earnings. Checking the earnings rate, most commonly noted with the EPS Ratio, is probably the most widely used and accepted metric for measuring a company's success from quarter to quarter. Meeting or exceeding the analysts' expectations on the earnings can greatly affect the price movement of a stock. And while an earnings miss can be an opportunity to grab a good company at a better price and yield, I need to determine before that point if I want to grab it. Earnings can be fuzzy and even somewhat manipulated to make the earnings look better than what they actually are before reporting. Microsoft's earnings have trended upward over the past 10 years except they took a hit in 2012. They had to write down their purchase of aQuantive 2012 and took a $6.2 billion loss. No wonder EPS dropped. Still EPS grew at a 9.01% rate over 10 years.

Since I don't completely trust earnings numbers, I follow the money trail to see where the earnings come from, which is sales, often called revenue on financial statements. If earnings are truly growing then sales should be growing. I look at the trend on both of them to verify it matches. A quick calculation tells me CAGR on the top revenue line over 10 years is 9.65%. So earnings are in line with sales. But sales has its weakness as a metric as well. Companies can record revenue that hasn't been received and may never be. So continuing down the money path I look at actual cash coming into the company.

While earnings and sales can be tweaked to make it look better, cash is either there or it's not. With that in mind, I look at cash from operations or operating activities. This tells me how much money the company actually generated or brought in. What it doesn't tell me though is how much of that cash it had to use to maintain or grow the business, such as new manufacturing plants, equipment, etc. So I take capital expenditures or Capex out of that and I'm left with free cash flow. Free cash flow is the amount of cash that's left over after everything it takes to run the company is removed, and I view it as the money that belongs to me as a shareholder. If it's in good shape then I feel better that the dividends generating the income I'm expecting to receive are sustainable and stable. I also compare the free cash flow line to the free cash flow per share line. Over 10 years the free cash flow CAGR is 7.81% whereas the FCF per share CAGR is 10.77%, which tells me they've been buying back shares. The other thing this growing free cash flow indicates to me is that they have an economic moat.

While I'm at that page I also look at the other information. For example, I can see the payout ratio is healthy, averaging well below 50%, their gross margins are good, and I can see that Morningstar has valued them at 4 stars, meaning they're currently under-valued. I'll scroll down the page and check the ROA, ROE, ROIC, and current ratio (debt). The key takeaways I'm looking for are that revenues are growing, they're profitable (managing expenses), are financially healthy (low debt), and that the dividend growth is sustainable.

There are other things to look for if doing an initial evaluation for purchase, but this short exercise helps me to check that I don't have tunnel vision in regard to the dividend yield and growth. But that still leaves me to deal with what I called the art side.

The Art Side

I refer to it as the art side since I can't sit down and ask questions of management directly, and analyzing data will only go so far, so I have to look within the company and make a best guess determination as to how management is responding to external forces, economic factors, competition and trends. Quite frankly, I picked Microsoft for this because I thought there were some natural similarities between them and Kodak. Microsoft's cash cow has been its Windows and Office Suite of business applications and, just like Kodak's film and paper business in 1975, has held the predominant market share for the past several years. But with the popularity of tablets such as the iPad and more mobile computing, the question in my mind that needed to be asked was if the Windows and Office business is headed to the same dustbin as film photography and if Microsoft is the next Eastman Kodak?

You could be living in the Amazon jungle or Antarctica and still know that computing is going more and more mobile. With that in mind, my objective is to make sure Microsoft doesn't have tunnel vision and that the income I'm expecting is safe. Bill Gates stated in an interview recently that both he and CEO Steve Ballmer were dissatisfied with Microsoft's performance in the mobile computing arena. If that's true then what are they doing about it? Here's what I found.

Microsoft is segmented into five operating divisions. They are:

Windows & Windows Live Division - Windows & Windows Live Division offerings consist of the Windows 7 (and now 8) operating system, software and services through Windows Live, and PC hardware products. FY12 Revenue was $18.8 billion.

Server and Tools - Server and Tools product and service offerings include Windows Server, Windows Azure, Microsoft SQL Server, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. FY12 Revenue was $18.7 billion.

Online Services Division - Online Services Division offerings include Bing, MSN, and advertiser tools. FY12 Revenue was $2.9 billion.

Microsoft Business Division - Microsoft Business Division offerings include Microsoft Office, SharePoint, Exchange, Lync, and Microsoft Dynamics business solutions. FY12 Revenue was $23.9 billion.

Entertainment and Devices Division - Entertainment and Devices Division offerings include the Xbox 360 entertainment platform, including Kinect for Xbox 360, Skype, and Windows Phone. FY12 Revenue was $9.6 billion.

(click to enlarge)DivRev

About 58% of Microsoft's revenue comes from the Windows and Office products. But over the past several years, they have expanded in other areas and built a diversified infrastructure that is growing. More and more is being done in the "cloud" and Microsoft's Server and Tools division is growing in that area. Their Windows Azure was recently rated the top performer in cloud storage beating out Amazon, Google, HP, and Rackspace. They've recently starting making an aggressive effort with Outlook.com to take on Google's (NASDAQ:GOOG) Gmail and reportedly are having some success. Skype continues to grow and Yammer, their social network for business, is growing extremely fast. In looking at their Devices division, I believe their Xbox and Kinect consoles will continue to do well. I read an article where they're looking at expanding the technology in the Kinect, which was originally Microsoft's answer to the Nintendo Wii, into non-gaming areas. One use was in grocery stores where the shopping carts would have Kinect technology that would automatically price the items placed in the carts so a shopper would know exactly how much they had in their cart at any given time, and then could be used to check out to avoid standing in line. Future stuff.

Microsoft also has a "Tag" group which you can read about here. In essence their Tag group is into new barcodes for mobile marketing. They released a very interesting infographic that provides information on where mobile computing is headed and gives usage statistics. For example, these new tags are being used in magazines. Golf Digest places these tag barcodes next to articles so that readers can view video golfing lessons and tips from the pros on their mobile phones. In the future, I can see someone putting tags next to stock symbols and being able to pull up a report and evaluation on investing in that particular company on their phone while browsing through a magazine. Review an annual report and check financials while waiting in the doctor's office or getting the oil changed.

A quick visit to netmarketshare.com showed that desktops are still the primary device for Internet usage, at least for now.

Device Share

And while Microsoft is still king of the desktop operating systems and browsers,

(click to enlarge)OS Browser Share

they are trailing badly when it comes to the mobile arena.

(click to enlarge)Mobile Share

Microsoft is spending on average a little over $9 billion a year on R&D, which I view as a good thing. They recently released Windows 8 which is intended for mobile computing, and also released the Surface RT and Surface Pro as their tablets. It's probably still too early to determine the success or failure of either but early indications are they're headed in the right direction. So back to my original question, does Microsoft have tunnel vision? I believe the answer is no, they don't. But they have been slow out the gate in the mobile arena and are now having to play catch-up. Only time will tell if they will be successful or not. For now though I view the dividend as safe.

As a dividend growth investor I want to make sure that the income from those investments will continue. As I said I picked Microsoft to review because it had so many similarities to Eastman Kodak. But tunnel vision can pertain to many different companies in different sectors. A utility company that insists on continuing to utilize coal as its primary generation fuel as opposed to switching to natural gas might be an example. I have Southern Company (NYSE:SO) so I keep an eye on them. A big box store that didn't see the future of online shopping, or was late entering that arena, would be another. Could that be why Best Buy (NYSE:BBY) has been struggling for the past few years? I recently decided I needed a new desktop. I browsed both Best Buy and Sam's Club stores locally, checked their websites, didn't really see what I was looking for and wound up ordering online directly from Dell, and was able to customize it for my specific uses, with the latest bells and whistles at a price less than what I would have paid for an off the shelf model. This is the kind of reality that companies such as Best Buy must face and establish a business plan to deal with.

It doesn't take much time to do a quick review of a company in this manner. Most of the time was spent on simply searching for relevant information on mobile computing, scanning the articles, and browsing through Microsoft's annual report. Total time for everything was less than 2 hours. I view it as time well spent and it keeps me informed on those companies for which I'm looking to provide future income. So I try to keep a watchful eye on the companies that I have in my portfolio to make sure they're not getting tunnel vision. And when I'm confident those companies are doing things right, it helps me close my eyes and sleep well at night.

Source: Avoiding Tunnel Vision In Your Dividend Growth Investing