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Long-term horizon, dividend investing, long only
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Sometimes people ask for my advice on investments: What kind of companies do you like? Why focus on dividends? Can a payout ratio be too low? - That sort of thing. But never has anyone ever asked me whether or not they should buy a cup of coffee each morning, whether they should continue to smoke or if they should lease their car. And I wouldn't expect them to; these are personal finance opportunities and as such they should remain largely personal. However, I believe this scenario depicts a tangible disconnect that the middle-of-the-pack American has between finances and investments.

When prompted with an investment question, my first instinct is to ask: 'How are your personal finances looking?' Usually I'll take a moment to listen and the answer invariably finds its way out. Often it's choosing between investing versus paying off student loans or simply finding an extra percentage point or two in yield. Surely these questions are important, but fundamentally they're not really "investment questions."

For example if you have loans or credit card debt, with say 10% interest, then paying this off is the effective equivalent to earning a 10% risk-free return. Even if you had a 10% stock market gain, this would not be risk free. Likewise, once a person has his/her optimal mix of securities he cannot simply find more yield without taking on additional risk. A simpler way to reach the enhanced financial goals would be to reduce an expense and reallocate the saved capital back into the portfolio.

The over-aching message is to make sure one's financial house is in order before looking to invest. Impulsively combining the two can have unwanted consequences. Normally I wouldn't spend any time at all on such a subject; as I expect to focus on "real investment questions" with a captive audience that has a corresponding "real investment" knowledge-base. However, I was simply shocked about something the other day and felt it necessary to precursor the example.

I was flipping through the T.V. channels, perhaps the day before last, and I happened to stop on one of those advertisements for a quick-money loan. It wasn't necessarily over-the-top nor inherently cheesy sounding, but I did happen to catch the fine print: APR on a $5,000 loan = 116.73%, 84 monthly payments of $486.58. I was amazed first by the insurmountable interest rate and next by the mere fact that such businesses are operating. I could go on and on about the irrationality, but I think it's best just to show you their table of interest rates:

Loan Product

Borrower Proceeds

Loan Fee

APR

Number of Payments

Payment Amount

$5,075 Loan

$5,000

$75

116.73%

84

$486.58

$2,600 Loan

$2,525

$75

139.22%

47

$294.46

$1,500 Loan

$1,000

$500

234.25

24

$198.19

Source

Astonishingly, 117% is on the low end of the spectrum. The pure economics of having to pay $40,872.72 over seven years to borrow $5k, $13,839.62 over three years and 11 months for $2.5k and $4,756.56 over two years to borrow $1k is in a word insurmountable. The lender doesn't even need 25% of its 'clients' to pay back the loans in order to make money.

I know people can shrug off extremes like this as 'never-going-to-happen' scenarios, but to me this example is no different than using a credit card to pay $2,000 for a $1,000 computer that will be worth $200. Debt is a plea to sanity amongst investors and too often its toll finds deaf ears. I realize that the investing community on Seeking Alpha is apt to 'have its financial houses in order.' However, I believe that a parallel can be drawn. Much in the same way of excusing the 'pay-day advance' type of loan as extreme, while still carrying a credit card balance, investors can become overly concerned about day-to-day market fluctuations.

Here's an example. If you told me today that you held: Coca-Cola (KO), Procter & Gamble (PG), PepsiCo (PEP), Johnson & Johnson (JNJ), McDonald's (MCD), Colgate-Palmolive (CL), Exxon Mobil (XOM), Wal-Mart (WMT), AT&T (T) and Kimberly-Clark (KMB). I would tell you I like your holdings even before you told me what you paid. I realize price is extremely important, however if you're a dividend growth investor, searching for long-term sustainability coupled with increasing payouts, you're more apt to care about what you're in as to when you're in.

As Warren Buffett says about Coca-Cola or any other formidable company:

If you're right about the business, you'll make a lot of money. The timing part of it is a very tricky thing. So I don't worry about any given event if I've got a wonderful business... You can figure out what will happen, you can't figure out when it will happen. You don't want to focus too much on when; you want to focus on what. If you're right about what, you don't have to worry about when very much.

For some investors it's easy to distinguish the 'what.' For me, first you have to have your personal finances in order. Next, you can go on to investing or "building your financial house of cards." This sounds dangerous, and to be honest it is, so approach it with caution. After all no additional reward is given without added risk. In creating the financial house of cards, I would want the basement level to be inherently stable in that it is effectively 'glued-down.' No leaks, no mold, perhaps some remodeling from time to time, but the classics rarely go out of style.

To accomplish this I would look for fundamental businesses with growing payouts that can increase earnings over the long term. To accomplish this, I would start with exactly the same 10 stocks that I mentioned previously:

Coca-Cola - 49 consecutive years of increased dividends, 2.8% current yield, 8.7% 5-year average dividend growth rate

Procter & Gamble - 55 years of increasing dividends, 3.2% current yield, 11.1% 5-year div growth rate

PepsiCo - 39 years of increases, 3.2% yield, 11.4% 5-year div growth rate

Johnson & Johnson - 49 years of increases, 3.5% yield, 8.7% 5-year div growth rate

McDonald's - 35 years of increases, 2.8% yield, 22.9% 5-year div growth rate

Colgate-Palmolive - 48 years of increases, 2.6% yield, 12.6% 5-year div growth rate

Exxon Mobil - 29 years of increases, 2.2% yield, 8% 5-year div growth rate

Wal-Mart - 37 years of increases, 2.5% yield, 16.8% 5-year div growth rate

AT&T - 28 years of increases, 5.9% yield, 5.2% 5-year div growth rate

Kimberly-Clark - 39 years of increases, 3.8% yield, 7.4% 5-year div growth rate

Obviously I would not recommend holding just these 10 stocks, as the issue of alleviating diversifiable risk becomes problematic. However, I would suggest that these are the types of companies that a solid portfolio is built upon. A much more complete list of similar opportunities can be found in David Fish's wonderful Dividend Champion, Contender and Challenger spreadsheets located here. Some might suggest that there is an issue with monitoring a portfolio of say 30 stocks. After all, even the analysts who spend their lives on the stuff can only focus on a sector or collection of companies.

But for the dividend growth investor, the monitoring doesn't have to be that difficult. If you make sure your foundation is solid, that is you know both why you bought the company and why you paid what you did, there isn't much legwork left. You check in. Did earnings increase? Did the dividend increase? Were there any fundamental changes to the company or its environment where it will be doing something different 10-20 years from now? If the answers are satisfactory, then we're good.

In building your house of financial cards I wish you two things. First may you make more than you spend, live simply and invest wisely. Second, when in doubt or question, brush off your foundation and make sure of its fundamental strength.

Source: Building A Solid Foundation For Your Financial House Of Cards