Avoiding Tunnel Vision In Your Dividend Growth Investing - Part 2 Retirement

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 |  Includes: CVX, KO, MCD, OHI, PG
by: Eddie Herring

In February of this year I wrote an article about Avoiding Tunnel Vision in Your Dividend Growth Investing. In that article I compared Eastman Kodak with Microsoft and made the case that investing is both art and science. I also answered the question as to whether Microsoft had tunnel vision. This article is a continuation of the tunnel vision train of thought in that I want to make sure that as an investor I also don't have tunnel vision. And I'm again using the art and science concept.

I retired in 2008 at the age of 54, two months before I turned 55. At the time retirement had grown to be more frequently on my mind as opposed to, among other things, my job. I had set goals for being able to retire at a certain age and when I achieved those goals, I began to think more and more on taking the next step, which was actually retiring. While I was working and receiving a good salary every two weeks I didn't really think that much about income except for how it related to my goals. But now as a retiree income is much more often on my mind and not just the amount of income, but the safety of it as well. Especially the safety of it.

Using the art and science concept, on the science side it's relatively easy these days to calculate or locate the various measures that we use to determine the financial worth of the companies in which we're considering investing. Using financial websites such as FinViz, Morningstar, Yahoo, etc., you can easily find common metrics such as P/E, PEG, EPS, ROI, ROA, ROE, etc. And if you want to calculate the intrinsic value of a company before you buy, which I believe you should, that has also become relatively simple to obtain. For example, if I was considering adding to my position in McDonald's (NYSE:MCD) on this recent pullback I could simply go to this site hosted by Smart Money and enter the symbol, click submit, and I get the result shown below, which tells me the current valuation is $90.85.

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If I wanted to use a Graham type formula I could go to this Moneychimp site and enter the projected EPS growth rate, which I can get from FinViz or estimate myself, and it will tell me what a fair P/E value would be.

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I can also calculate the DCF rate at another Moneychimp site by entering the EPS for the past 12 months, estimating growth and it tells me that the value for MCD is $92.50.

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If I wanted to verify with other sites if MCD is overvalued, undervalued, or fairly valued at these prices I could also log into my account at Fast Graphs and view the information there or I could simply go to the Morningstar site and see that it is currently listed with 4 stars, which indicates that it is at or near being under-valued. In earlier articles I've included links to other sites that also provide valuation information. Many brokers' websites will also provide analysts reports on various companies, which often provide target prices for both buying and selling, or they may rate simply as a buy, sell or hold. TDAmeritrade for example, shows reports on MCD from Credit Suisse, The Street, S&P Capital IQ, Ford Equity Research, MarketEdge, Jaywalk Consensus, and Research Team. As an alternative to checking these sites I could also calculate the intrinsic worth myself using my own spreadsheets that I keep.

There are a number of other ways to determine the intrinsic value of different companies, and they vary by the type of company. You don't evaluate REITs such as Omega Healthcare (NYSE:OHI) the same way you do a corporation such as McDonald's. The one over-riding thing that this all points out though is that each of these examples provide different estimates of values, which means that although this is part of the science of investing, it's an inexact science. There is no exactly right way to do it, only methods that can get you to a reasonably close value. But if I only concentrate on those numbers or financial metrics, it's very likely that I'm exhibiting the tunnel vision I want to avoid.

As a retiree I seek to invest in companies and in a manner both of which will reliably and safely provide income for my retirement years. With those reliability and safety factors always in my mind, I want to make sure that I don't focus on any one area to the detriment of another. For instance although income is my objective I don't want to overly focus on high yield to the detriment of a safe dividend. Neither do I want to become so impatient to enter a position that I ignore obtaining a margin of safety. I can take the estimates of value from the examples listed above and arrive at a number I consider to be a fair value, and from there arrive at a discounted price that I think gives me a margin of safety at which to buy. By buying at a margin of safety I then have a better "safety-belt" strapped around my income. I also improve my margin of safety through diversification and seeking companies with an economic moat.

But there is also risk on the art side of investing to be considered. The first thing many investors think of as risk is the stock price going down. I tend to think that is a trait or viewpoint too often made worse by the modern emphasis on short-term trading more so than on investing. And as dividend growth investors we often think of risk as the dividend growth slowing down or stopping, the dividend being cut or eliminated, or the yield getting too low. We may also think about the competition to the companies in which we've invested or the economy as a whole. And to be certain these are risks that need to seriously be given due consideration. But the risk I'm speaking of here on the art side is directed more to the management of the company, specifically "how do they perceive risk to their business?"

I think it would be helpful if before I invested in a company I could sit down with management and ask them what they perceive as risks to their business. After all, when I invest in a company I view it as investing in a business of which I am becoming an owner, a minority owner obviously but still an owner. As an owner I want management to tell me what risks the business I own will be facing. In a sense I can do that through the reports they file regularly with the SEC, specifically the 10-K (or 10-Q quarterly) reports, which are submitted annually. There is a standard Item 1A listed in these reports defined as "Risk Factors" that the company uses to list the risks they see facing the business. I use these, along with the annual statements, as the proxy for my interview with management. These are usually easily found on the company websites.

Going back to McDonald's I reviewed both its 10-K and 10-Q. Here are a few of the items it views as risks to the company taken directly from these documents, and edited for length by me:

  • Our business and execution of our strategic plan, the Plan to Win, are subject to risks. The most important of these is whether we can remain relevant to our customers and a brand they trust.
  • We have the added challenge of the cultural and regulatory differences that exist within and among the more than 100 countries where we operate.

The Plan to Win addresses the key drivers of our business and results - people, products, place, price and promotion - and we are focused on our three global priorities that represent the greatest opportunities under our Plan to Win: optimizing our menu, modernizing the customer experience and broadening accessibility to our Brand. The quality of our execution depends mainly on the following:

  • Our ability to anticipate and respond effectively to trends such as spending patterns, demographic changes, trends in food preparation, consumer preferences and publicity about us;
  • Whether we can complete our restaurant re-imaging and rebuilding plans as projected, and whether we are able to identify and develop restaurant sites consistent with our plans for net growth of systemwide restaurants, as well as sales and profitability targets;
  • Our ability to respond effectively to adverse perceptions about our food (including its nutritional content and preparation), promotions and premiums, such as Happy Meal toys (collectively, our "products"), how we source the commodities we use, and our ability to manage the potential impact on McDonald's of food-borne illnesses or product safety issues;
  • The impact of campaigns by labor organizations and activists or the use of social media and other mobile communications and applications to promote adverse perceptions of our operations or those of our suppliers;
  • Our ability to recruit and retain qualified personnel to manage our operations and growth;
  • Our results of operations are substantially affected by economic conditions, both globally and in local markets. To mitigate their impact, we have intensified our focus on value as a driver of guest counts through menu, pricing and promotional actions. These actions have adversely affected our margin percent, and margins will remain under pressure;
  • The impact of an exit from the eurozone by any of the EU Member States, which could entail disruption to our business as the exiting Member State establishes a new currency and we, along with our suppliers, franchisees and others, address the challenges associated with re-denomination;
  • The cost, compliance and other risks associated with the often conflicting and highly prescriptive regulations we face, especially in the United States where inconsistent standards imposed by local, state and federal authorities can adversely affect popular perceptions of our business and increase our exposure to litigation or governmental investigations or proceedings;
  • The impact of litigation trends, adverse results of pending or future litigation, including litigation challenging the composition and preparation of our products, or the appropriateness or accuracy of our marketing or other communication practices;

The trading volatility and price of our common stock may be affected by many factors. The most important of these, some of which are outside our control, are the following:

  • The continuing unfavorable global economic and volatile market conditions;
  • Governmental action or inaction in light of key indicators of economic activity or events that can significantly influence financial markets, particularly in the United States which is the principal trading market for our common stock, and media reports and commentary about economic or other matters, even when the matter in question does not directly relate to our business;
  • The impact of our stock repurchase program or dividend rate;

Scanning through McDonald's' risk factors I saw nothing new that jumped out at me. McDonald's has a strategic plan, it operates in over 100 countries and has to deal with the different cultures in those countries, and is dealing with the demographic and social changes taking place in the U.S. and elsewhere. It is in the process of re-imaging locations and recognizes that menu makeup, pricing and economic conditions are placing pressure on its margins and profits and expects that to continue. What happens in currency issues such as in the eurozone concerns the company, along with the vagaries of regulatory requirements and litigation concerns, which go back I suppose to its experience with Grandma spilling hot coffee on herself. Knowing that it recognizes it is facing margin pressure means that I can possibly expect EPS growth rates to not be as strong as they have been in the past, which I would then take into consideration in estimating intrinsic worth or establishing a buy point at which to add to my position.

Many of these risk factors listed in 10-K reports by different companies consist of what in my previous career I referred to as "boilerplate," which just meant it was standard information applicable to that company. You see a lot of boilerplate from every company in reviewing their 10-K forms. And in reviewing these risk factors I may or may not find anything new, or anything of which I wasn't already aware. But my reason for doing this is that I'm looking for some nugget of information that management is aware of that I hadn't thought of. For example, when I looked at Coca-Cola (NYSE:KO) it commented that it participates in certain multi-employer pension plans that extend into 2017, and if it chooses to withdraw from them then it would expect withdrawal liabilities to negatively impact its financial performance. It also has expansion concerns in countries with poor water quality. While these alone are not enough to prevent me from adding to my position in the company, it is something of which I need to be aware.

Another example is Procter & Gamble (NYSE:PG). I expected its evaluation of risk to be pretty much standard boilerplate material, things such as international environments, currency rates, competition, etc., and it was. But simply doing a search in its latest 10-Q for the word risk I found this statement: "Free cash flow is defined as operating cash flow less capital spending. We view free cash flow as an important measure because it is one factor in determining the amount of cash available for dividends and discretionary investment. Free cash flow is also one of the measures used to evaluate senior management and is a factor in determining their at-risk compensation." It might be easy for me to conclude that since PG has been paying an increasing dividend for 57 years it will continue to do so. And we already know that free cash flow is important to any company in paying dividends. But knowing that it evaluates senior executives as part of their pay package in how well they manage to the free cash flow metric provides additional emphasis to me that those dividends I've been getting from PG are indeed safe.

In its 10-K Chevron (NYSE:CVX), which I recently opened a partial position in, states as one of its risk factors that "The company does not have commercial insurance or third-party indemnities to fully cover all operational risks or potential liability in the event of a significant incident or series of incidents causing catastrophic loss." I perceive this as not being insured against a BP type of incident or other significant hazard. Knowing this in advance as a potential risk, it was necessary to evaluate this as part of the investment process. In essence, Chevron would be self-insured against such an incident, which would in all likelihood affect the dividends, and consequently the income I expect to receive from investing in Chevron. Chevron also acknowledges in the 10-K the high risk countries it operates in, with 21% of net proved reserves in Kazakhstan, and 21% of net proved reserves in OPEC countries including Angola, Nigeria, Venezuela, not exactly bastions of security. Another risk factor for me to consider.

I've heard investors say that going through annual reports and finance statements can be extremely boring, equivalent to watching paint dry. But on the art side of investing you don't necessarily have to read through the numbers as much as you want to read through the statements from the CEOs, CFOs, or other executives that may be providing commentary. The same holds true for quarterly earnings reports where you may be reading the transcript. There are plenty of websites that break down the finance information in a manner that makes it easily digestible. The previous article mentioned did just that. But with the art side of investing it's a different story. Gleaning those little nuggets of gold from the comments of those running the company can sometimes make a huge difference in your investment decisions.

With the art side I want to think deeper about what I expect the company to do, where I want to go with the investment, where the pitfalls are, what the company is doing to make sure it is successful, and what happens if I'm wrong with my investment choice. I believe it takes more time to get better at the art side than the science side, but I also believe it's a necessary and vital part of the investment process. But it doesn't take an excessive amount of time to review 10-K forms, or to browse through annual statements and quarterly reports. With a little practice it can be done very quickly. With CVX, I went to the website, downloaded the most recent 10-Q, which said nothing had changed from the most recent 10-K, so I downloaded it, went immediately to section 1A and browsed through it and found the above statement concerning liability in less than 5 minutes total. Obviously there is more to the art side than just looking at 10-K forms, but it is part of my proxy for interviewing management in regard to risk.

I'm long MCD, KO, PG and CVX, and since I bought them for income, I don't plan on selling them any time soon. In fact my preference would be to never sell them. But that means I have to make sure that the income I expect to receive from them, along with the other positions in my portfolio, is secure. To do that I have to dig in to more than just financial information, I have to do my due diligence on more than just numbers. Like most people, as I've gotten older my eyesight has changed. As an investor I don't want to be like most people, who buy high and sell low. I want to make sure my investment vision stays 20/20. Consequently, as an investor and a retiree seeking reliable and safe income, I need to make sure that the companies in which I invest don't have tunnel vision. And to make sure that I don't have tunnel vision myself, I have to focus on both the science side and the art side.

Disclosure: I am long CVX, KO, MCD, PG, OHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.