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Chasing dividend yields on stocks that have been rising fast is a sure fire way to lose principal when a market correction takes place. Since the interest rates had been at historic lows (and the Fed has been keeping them low, albeit in an artificial manner), income investors seem to have an insatiable desire for a higher yield. The problem that income investors don't seem to realize is that when stock prices rise too fast, the true earnings yield (E/P, inverse of P/E ratio) becomes too low, thus unattractive for a value investor. Hence, an interesting scenario could ensue where dividend chasers are pushing the stock price through the moon while value investors are becoming nervous and start creating selling pressure on the stock. This can cause extreme volatility and a hard to predict pattern in stock movement (which we don't recommend you try to predict anyway). Below is the stock chart for Realty Income Corp. (NYSE:O) for your viewing pleasure, which shows such a behavior during the last twelve months.

(click to enlarge)

Source: Yahoo

Although it is not wise to make investment decisions based on the price movements, it never hurts to understand why such gyrations exist. This is the most important concept that yield chasers do not understand and I will make an attempt to clarify this concept at length in below paragraphs.

Before I get into further details, I would like to share with you my methodology for creating a mental model for any particular investment decision. The heart & soul of this method is to look at what I call the 'cake' and the 'icing on the cake' theory. According to this theory, the 'cake' refers to the real reason you are making an investment while 'icing on the cake' refers to the associated benefits that come along with owning that investment. I can assure you that many people often cannot distinguish between the two and inadvertently fall prey to poor investment decisions. So according to this investment style, when you invest in the common stock, your cake MUST be the potential for capital gains while dividends being the icing on the cake. It is a mistake to select securities based on the highest dividend yield (icing) while ignoring underlying fundamentals (Cake). If you buy on dividend yield alone, more likely than not, you will buy an expensive stock which would keep you happy with its dividends for some time before its shares fizzle down to its true intrinsic value. In the end, either you would lose your principal permanently or would have to wait a long time to recoup it.

Being stewards of our investor's capital, we can't lose principal and we recommend that you do the same. Obviously, no one deliberately embarks on a mission to lose money, but if you are not crystal clear in your thinking, you become prone to making expensive mistakes. As a matter of fact when we consider committing capital to a particular investment, we closely look at what is our cake and what is the icing on the cake. This is even more important in private equity, but let's now keep our focus on equities; one thing I can assure you is that this focus has served me well in my investing career.

The purpose of this entire article is to support my argument as follows:

"One should only invest in the common stocks with a desire for capital gains and anything extra (e.g. dividends), though nice to have, should not be the sole consideration for an investment decision"

Now, broadly speaking, there are two schools of thoughts that exist in the investing universe:

  1. First says that since shareholders are technical owners of a corporation, it is this corporation's responsibility to return all profits back to its true owners, which happens via dividends.
  2. Second school of thought that I more tend to agree with, is that although corporations work for shareholders, it also has needs to grow. With this growth comes more rewards for shareholders, so dividends must be delayed or not paid at all

Now income investors need not worry - as there are other instruments designed for their income needs, such as government bonds, munis, corporate bonds and preferred stocks. But looking at the common stock for sole purposes of getting income might not be the best way to go. The problem is that equity investing is usually confused with income investing more often than not. Moreover, what has recently dazzled me is proliferation of portfolio managers who are advising clients to sell call options on the stocks in their portfolio as a vehicle for generating income. Options are beyond the topic of this discussion but my point is clarifying confusion between the capital gains and a desire for income and the correlation between the two. Please note that a common stock, in a more typical sense, should not be looked at as an income vehicle. Now there are some exceptions such as REITs which have to distribute all their income to the shareholders but that is exactly why their share price growth typically lacks other types of securities (think Google (NASDAQ:GOOG)). Think of it this way; paying a large chunk of earnings to owners (aka shareholders) automatically caps the growth of the company to a large extent. Why? Because dividends take away from the pool of money that the corporation can use for growth purposes not to mention it can be retained earnings that alleviates equity capital

Some of you might be thinking that Ben Graham was a dividend champion and he would not invest in something that did not pay dividends, which is true but think about his most prominent disciple, Warren Buffett and his Berkshire Hathaway (BRK.A, BRK.B), which does not pay dividends. So a company as mature as Berkshire Hathaway could still think of itself as a growth company and not pay a dividend. Buffett thinks that he has better uses of capital than his shareholders. Is he acting in the best interest of shareholders by not declaring a dividend? I think so! And this is simply the reason why any corporation could withhold dividends and would still be acting in the best interest of its shareholders.

Also a dividend yield in itself is not a great accomplishment by any measure in absolute dollar terms. Let me explain - Let's arbitrarily consider a company, which trades at $30 per share and has an annual dividend of 5%. It is safe to say that it would be a darling of many dividend investors in today's environment. Now let's take into consideration what kind of price appreciation is required to beat this 5% dividend yield - the stock only needs to be at $31.5 to match the dividend yield in terms of capital gains. And if you are fixated on 5% and stock starts to drop, now you are losing your principal. Either it would be a permanent loss or you would need to wait it out before you can get out. Now contrast this scenario with focusing on a stock that does not pay a dividend and trades at $30. If you calculate it to be 30% undervalued, it only needs to rise to $39 before it's fairly priced. Now there might be some gyrations along the way but sooner or later the stock price will realize its true value. So focusing on the intrinsic value is the key. Now it's true that the stock might drop more and you would have to wait but this is definitely better than buying a stock whose intrinsic value you did not know, and was bought for dividend yield only. My point is that it's much easy to beat the dividend yield by focusing on capital gains if you know what you are doing. Warren Buffett has done this all his life and I think that's why he has never bought "high yielding" REITs in his investment career.

There are numerous academic studies that cite that the stock price must go down when a dividend is paid because potential source of equity has been clipped from the company. By a similar token, stocks can sometimes be punished if they cut off the dividend so that the company could stand back on its feet. Cutting a dividend for future growth or to bring the company back into shape is an intelligent decision, which should be applauded not punished.

A personal life example:

Let me show you how easy it is to confuse the 'cake' with the 'icing on the cake'. Suppose you go to buy a car at a dealership and the price is $25,000. You decide to buy the vehicle and ask the dealer to give you a monthly payment schedule. He comes up with a monthly payment of $483 (based on 5 years term, 6% interest rate, no down payment). You immediately start to negotiate on the payment terms and tell him straight that you would walk away if payments are not reduced. The dealer immediately tells you that he can reduce your monthly payments to $365, which makes you ecstatic. You proudly ride home in your newly purchased automobile.

Now tell me if there is a mistake committed above? In case you are wondering, the price of the car has been completely ignored in favor for the lower monthly payment (icing) and yet you think you got a good deal. What the dealer has done to you is just to change the loan term from 5 years to 7 years. The result is now you will remain longer in debt with two more years of paying $365 a month. What you should have done instead was to pay attention to the price and asked the dealer to reduce it. Let's suppose you could have brought him down to $20K. Now is the right time to focus on loan term (icing on the cake). By pressing the dealer the right way, you very well could have gotten a 7-year term even with this newly negotiated price. And what would be your monthly payment now keeping everything else constant? An affordable $292. Paying attention to the 'cake' has its financial rewards.

Double taxation on dividends:

Many of us know that dividend is paid out of cash coffers of a firm with taxes fully paid. As soon as you get that dividend check as a shareholder, Uncle Sam wants his share. This double taxation is the second reason Warren Buffett has cited for not dolling out dividends, first being that he thinks he has better things to do with your money than you do if you are a shareholder. (Do you agree?).

Can you have your cake and eat it too?

Now let's talk about a dream scenario where you can have your cake and eat it too. So the idea is to find an undervalued security with a healthy dividend yield. There are three securities that we have recently identified and have talked about committing capital so consider this an insider's scoop for being a Seeking Alpha reader. I will not go into intricate details of each issue but rest assured, these have been identified as good investments at current prices with a healthy dividend yield.

Note: This is for information purposes only and should not be considered an investment advice. Please perform your own due diligence before making any investment decision.

Potash Corp. (POT):

Potash is not your typical fertilizer in that it is mined just like metals and looks like a crystallized rock before processing. Potash is unique in the sense that it is only found in significant quantities in Canada, Belarus and the politically unstable Russia, thus putting a supply constraint over the coming years and decades. It is a superior fertilizer such that crops treated with potash are extremely high yielding, provides good crop protection - most importantly in drought ridden countries, and has high water retention. It has a broad use in agriculture products including wheat, rice, sugar, corn, cotton and soybeans not to mention some tobacco products and soap.

Potash Corp. of Saskatchewan is currently trading in the $31-33 range as of this writing. POT currently pays about 4.48% dividend and stock is underpriced by at least 30% in our opinion. There is a strong asymmetric risk/reward scenario here as the Uralkali episode stabilizes as we think there is no long-term merit to their price reduction claims since Potash prices are set via supply/demand equation and not by a single company. The company has inventory reserves in a business where it is not easy to accumulate inventory due to high capital costs. Some analysts consider an inventory pile up to be a bad thing but for Potash, it turns out to be a good thing. BHP Billiton (NYSE:BHP) recently announced that it's going to spend about 2.6B on the Jansen project in Canada, which is expected to complete in 2016 with production expected in 2017. This can give you some idea how long it takes to dig mines let alone accumulate inventories. So Potash Corp. is in an enviable position to benefit from Potash demand in the near future.

Realty Income Corp.:

Realty Income is the best in class Real Estate Investment Trust (REIT), which is required by law to distribute vast majority of its earnings due to the REIT structure. The current dividend yield is 5.50% and the stock trades around $38-39, which is substantially below its high of $55 in May 2013. The reason for this price drop is market's comparison of REITs with bonds, something that we seriously question. This Triple Net REIT (owns single tenant assets) has 3,866 properties in 49 states and Puerto Rico. For those who are new to REITs, Triple Net means that the tenant his responsible for all taxes, insurance and maintenance of the building under lease. Thus Realty Income just collects rents without any ongoing expenses. The flagship tenants include FedEx (NYSE:FDX), Walgreens (NYSE:WAG), LA Fitness, Wal-Mart (NYSE:WMT), Circle K and the list goes on. The company's properties are also well diversified across various industries such as retail, office, industrial, manufacturing etc.

Now the best part is that the company is trading at a discount to its intrinsic value and thus there is a strong potential of capital gains while you collect a 5.5% dividend. And you accomplish this by investing in a first class company with best in class tenants and prime property locations. Can it get better than this?

Exelon Corp. (EXC):

Exelon is a holding company with regulated and unregulated divisions. Its regulated utilities deliver power and gas to 6.6 million customers at Commonwealth Edison (Illinois), PECO (Pennsylvania), and Baltimore Gas & Electric. It owns 11 nuclear plants and has 34 Giga-watts of generation capacity in seven states. It is currently producing 22% of U.S. nuclear power and 4% of all U.S. electricity. Exelon also is the largest power retailer in the U.S., serving about 190 terawatt hours of load. In March 2012, Exelon bought Constellation Energy for $7 billion.

The company's current dividend yield is 5.30% but this is not the best part. The shares are trading around $27-28, while we estimated its true intrinsic value to be in the low 40s, thus the company has 30 to 40% upside, while you collect a 5.5% dividend. The reason for this decline is concerns that the new merger with Constellation is painfully slow. Add lower utility prices to the mix of Exelon's woes and you have got a security unjustly punished by Mr. Market.

Concluding thoughts:

If you think that I attempted to persuade you to stay away from the dividend stocks, you totally got me wrong. My intent was to alert you against a strong bias towards buying expensive stocks just to get a higher dividend yield hence making a poor investment decision overall. While it's natural to want to get paid for your capital, investing in common stocks for the sole purpose of receiving dividends is exactly the wrong reason to do so. Your sole focus should be on acquiring securities with excellent fundamentals, which are trading below their true intrinsic value, and higher returns are guaranteed in the long run. Now it is so much better if an investment comes with a dividend potential, but if it does not, who cares? The best opportunities exist when a dividend stock is available at a deep discount to its true net worth due to the depressed mood of Mr. Market. That's when you could have your cake and eat it too.

According to Warren Buffett, the two most important rules of investing are:

Rule #1:Do not lose money

Rule #2:Do not forget Rule #1

Source: Do Not Chase (Mindlessly) The Dividend Yields