My 5 Simple Rules For Investing Stability

Includes: CVX, GIS, JNJ, KO, NLY, PG, WBA, XOM
by: Eddie Herring

In my former career, I periodically taught contracting classes to other contract personnel in the organization. One of the things I liked to do was to open a class with a test, the purpose of which was to test assumptions about certain issues relating to contracting. I'll use the same concept in this article and hopefully it will test some assumptions.

The Yield Test

Pictured below are several charts and graphs, all on the same two companies. For the test, I'll refer to them as the orange company and the blue company and provide the actual names later. However, both companies are well known within the dividend investing arena. Here is a 1-year chart of dividend yields from the two different companies. The test is simple, which company would you prefer to own?

You may say that 1-year is too short a time frame and there isn't enough information to make that decision, and I would agree. Here is a 5-year dividend yield chart of the same two companies.

As you can see the orange company has yielded anywhere from 11% up to 17% over a 5-year period whereas the blue company has yielded from 2% to about 4% over the same time frame. You might assume that the higher yield stock would be more risky. But if you're an income investor would you think an average yield of around 14%, with its potentially sizable income over that time frame, might be worth the risk? On the other hand, you may say that less than 3% yield is too low and have a rule that prevents you investing in companies below a certain yield.

If I said that $10,000 invested in each company 10 years ago would have provided the total dividend payments as shown in the following chart would it affect your decision in which one to invest?

The orange company would have paid $10,438.68 in dividends whereas the blue company would have paid $3,348.18 over the same time period, both based on investing $10,000 in each company in December 2003. Is it now more attractive and would you now consider investing in the orange company? $10K would have bought 578 shares at $17.28 in the orange and 209 shares in the blue at $47.66 each share. Here is a spreadsheet of each payment you would have received, without reinvesting dividends.

Would it make a difference if I told you that over the past 10-year period the orange company has returned 5.4% per year and the blue company 8.3% per year? Would you think I'm getting considerably more yield with the orange company and the additional $7,100 in dividend income would outweigh the 3% difference in total return assuming the same amount invested?

Here is a 10-year price chart on the same 2 companies.

Would this chart now make a difference in your thinking, with perhaps the trend over the past 2 or 3 years changing your mind? Perhaps the high dividend yield might not be worth the potential risk. Or you might be confident of your ability to buy when the price is low and sell when the price is high, even though market timing has proven extremely difficult for most investors. But then again, maybe you're dependent upon the income from your investments and you place a higher emphasis on dividend yield so you're willing to take the risk. Or you might think price volatility is simply a consequence of receiving the additional income.

Here is a chart illustrating the actual dividend payments. It's easy to see that the dividend payments received from the orange company fluctuate quite a bit whereas the blue company is very consistent, especially with growing the dividend. Would that change your thinking about the additional income available from the orange company considering equal investments in each?

Perhaps the chart below, which shows the percentage increase/decrease in the dividends of the two companies, provides a better picture of the difference.

Over a 10-year span the dividends from the orange company actually declined 30% whereas the blue company increased theirs by 124%. Which company would you choose now? Is the amount of the additional income received because of the higher dividend yield from the orange company still more attractive?

The Simple Test Results

Here's one last look at the two companies side by side using data from the "longrundata" website.

This indicates what the total value of the $10,000 invested in each company would be as of December 9th, 2013. As can be seen the investment in the blue company, which provided $7,100 less in total dividend payments over the 10-year period, is actually still worth more than the orange company. You might be thinking "but I'm an income investor, I don't care about the capital appreciation, I only care about the income."

If that's so, and you selected the orange company for the dividend yield, you would have seen your dividends start at $0.47 per share (quarterly) but then drop to $0.10 per share, climb to $0.75 cents per share, and then drop back to $0.35 per share by Dec 2013. In other words the dividend income is less than it was 10 years earlier. And that doesn't even consider inflation.

In my opinion the typical dividend growth investor who bought the orange company for the income probably wouldn't have held past the first or second dividend cut, which took place 15 and 18 months after the purchase in 2003. And quite frankly this is not a rare occurrence with high yield stocks. Having quarterly income drop from $272 to $75, or 72%, from one company is a significant hit to the budget for a retiree dependent upon the income.

Obviously, there are other things to consider in making purchase decisions in which companies to invest. But the point of this simple little test is that many investors, and especially those concerned with income and yield, tend to place more importance, perhaps too much importance, on high yields rather than solid sustainable yields from high quality companies. While my focus as a DGI is on income, the reliability and stability of that income is of more importance to me than a higher yield. And both income and total returns are important to me as a dividend growth investor.

It's my belief that if one is going to be a dividend growth investor, or an investor dependent upon income, then that person will be better off seeking stability in their investments. By stability I mean companies that reliably pay and grow their dividends year in and year out, that consistently show growth in earnings, sales, cash flow and other important metrics. Companies like the blue company.

I built and continue to orient my portfolio with an eye toward stability. That doesn't mean that I won't invest in companies that are more volatile than others, but it does mean that I limit their size in the portfolio, which limits the damage they can do to it. For the most part though I simply choose the tortoise over the hare.

My 5 Simple Rules For Stability

I try to follow 5 simple rules for building and managing a stable portfolio. They are:

1 - Avoid speculation;

2 - Stay within my circle of competence (I must completely understand the investment/business/company);

3 - Manage my emotions (price volatility doesn't equal risk to me);

4 - Buy only when a company is at a fair or undervalued price level;

5 - Place proper importance on the appropriate metrics.

While I have other rules in my investing plan these 5 simple rules help me insure that I am constantly working toward a stable portfolio, a portfolio that is somewhat resistant to the whims of the market and the fear and greed that is often rampant.

My portfolio currently contains boring but stable companies like Johnson & Johnson (NYSE:JNJ), Chevron (NYSE:CVX), General Mills (NYSE:GIS), Walgreen (WAG), Procter & Gamble (NYSE:PG), and Exxon Mobil (NYSE:XOM), among others. These 6 companies exhibit stability in dividend growth as illustrated by this chart.

I currently have 33 companies in my portfolio. It is predominantly made up of stable dividend paying companies, of which many are shown on David Fish's well known CCC list. I make it a point to avoid speculative stocks, which means I won't invest in IPO's such as Facebook or Groupon. I won't invest in mREITs either since not only are they not in my circle of competence but I consider them too risky as well as speculative. By buying at fair or undervalued levels and managing my emotions I don't get easily shaken out of positions. And placing importance on metrics such as earnings, free cash flow, profitability, dividend payouts, etc., and not just yield or price, I place myself in a position to not only improve my stock selections but to better understand how well an investment is actually doing.

In other words I haven't and won't invest in the orange company, which is Annaly Capital Management (NYSE:NLY), an mREIT, but I will and have invested in the blue company, which is the Coca-Cola Company (NYSE:KO), currently my largest position. And I've found that by doing so it makes for fewer surprises and better results.

Disclosure: I am long CVX, GIS, JNJ, KO, PG, WAG, XOM. 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.