Taking Your Dividend Growth Strategy To The Next Level

Includes: BIP, DIA, EC, ENB, PM, UGP
by: Bayesian Investing

With the mess in Europe and all of the uncertainty in the markets, let's take a step back and talk - once again - about dividend growth investing: a rather straight-forward investment strategy of accumulating high-quality, dividend paying stocks.

In a recent article, which you should definitely read here, I listed a few tips for dividend growth investors. Today I want to talk about a few ways that more experienced investors can enhance that basic strategy.

Dollar Cos Averaging vs. Valuation

Whenever I am counseling someone who is fairly new to stock investing, I always suggest a blind dollar cost averaging (DCA) strategy. The reason is simple: you can't screw this up. By purchasing equal amount of stocks every month, you will always get the average price. You will never put all your money into a stock when it is considerably over valued. Studies of individual investors have consistently shown that people buy the most stock when it is well above the average price. Simple, but unfortunate psychology primes people to get into the stock market after a great run-up…usually just before a correction.

For example, using DIA as a proxy for the Dow Jones, if you had purchased the Dow in 2007 at the market price of $139 and held until today's closing price of 124 you would be looking at a small loss for your five years of patience. If you have used a monthly blind DCA strategy, however, your average market price would have been $111 and you now have a small gain.

Most investors are burned by their own mistakes, giving into greed or fear, which is why it is important to have a plan - and DCA is a great plan because, again, you can't screw it up. Unfortunately, the flip-side of this argument is true: by using DCA you will always get the average market price of a stock and never any better.

For those who have taken a few laps around the market already, perhaps learned a few lessons the hard way and have the required knowledge and discipline, a valuation based buying strategy will be far superior to a blind averaging strategy. Instead of the average DIA price of $111, how great would it have it been to buy at the 2009 low around $66?

The goal of a valuation based strategy is not to try to pick price tops and bottoms - very, very few people can do that (including myself). What you are trying to do is to allocate your capital as wisely as possible by investing in securities that are at least fairly valued, or preferably, undervalued.

The first step is to assign a fair value to the stocks you are interested in purchasing, which can be expressed as a point value or as a range. There are lots of ways to evaluate value, including more complicated strategies such as Discounted Cash Flow Analyses, but I suggest people start with some simpler metrics such as earnings or dividend yield.

I have a value range for every stock in my portfolio and on my watch list. For example, let's consider Brookfield Infrastructure Partnership (NYSE:BIP), a stock that I am fairly bullish on and have written about in the past. My value range for BIP is 27$ - $30. I will not buy the stock above that range but will consider purchasing it within that range. If we ever get to the low-end or even below my fair value range for this stock then I will make it a priority to pick up some more shares.

Allocating new investment cash is an entirely analytical process for me. I have a simple spreadsheet that calculates where the market prices of my stocks are as compared to my value targets. Every month I then add a few shares in the one or two stocks that are the best value.

If this seems like a lot of work for only a little gain, then I respectfully disagree. Consider the one-year chart of Brazilian energy infrastructure company Ultrapar (NYSE:UGP) below.

(Click to enlarge)

I bought shares twice this year, both on dips, and accumulated my shares at an average price of $15.89. This is very favorable to the average market price last year of $18.67 - a discount of over 17%. Imagine the enhanced returns of even 5% or 10% over your stock's market performance, compounded over your lifetime. Or, to phrase this in a way for the dividend oriented investor, imagine what your ultimate yield-on-cost will be if your initial purchases are always adding 5% or 10% to your starting yield.

An important note is that if all my stocks are near or above the high end of my range, then I buy nothing that month. I believe this is also a very appropriate strategy: when the market seems over valued to you then it is time to raise cash.

Receiving Dividends in Stock vs. Cash

When a lot of investors start out they receive their dividend in stock, whether through DRIP plans or synthetic brokerage DRIPs. This is a very logical way to start as you begin to realize the power of re-investing dividends right away and avoid transaction costs - which is a must! For smaller portfolios, DRIPs are the way to go.

When your portfolio grows to a big enough size - say where monthly transactions would incur transaction costs of less than 1% -- it is time to start taking your dividends in cash. That way you will always have a source of income for new investments, which you can direct toward whatever stocks that you want -- the stocks that are the best value as outlined above.

As a side note, I always shake my head when people claim that dividend growth investing is a passive, almost amateurish strategy. We are taking control of our investments, managing our income streams and are responsible for allocating our capital wisely. Dividend growth investing at its best is an aggressive, active and disciplined strategy that offers the potential for very attractive total returns.

Holding Cash vs. Selling Puts

I collect my dividends in cash and also put aside whatever I can from my weekly paycheck into my brokerage account so that I always have a source of cash on hand. I believe having that dry power on hand is essential in order to take advantage of the inevitable market corrections and crashes.

When you first start out, your dividends will probably be about enough to cover a small cup of coffee. Be patient, though as eventually they will grow to a point that you need to start considering what to do with that cash collecting in your accounts between purchases.

Unfortunately, cash is currently earning interest rates somewhere between diddly and squat. So if you are interested in finding a more productive use for your cash please consider selling cash-secured put options. Even a very conservative short put strategy should yield 4%-5%, considerably better than cash will. Besides, in my humble opinion, the only thing better than buying high-quality stocks at a good price is getting paid to do it.

If you venture down this path, as I occasionally do, there are a few things to keep in mind. First, I never tie up all my cash securing put options. I still want to have the flexibility that only cash can offer, which is essentially a put option on the entire market. Second, be very sure that you would actually be happy to acquire the specific stock at the given price. While the premiums options provided are nice, they are at best only a bonus -- don't jeopardize you're disciplined dividend growth strategy to collect a few extra basis points. If you don't see an option that you feel is attractive, don't write one.

As an example, I sold a Dec 2012 put on Phillip Morris (NYSE:PM) with a strike price of $77.50. I am interested in acquiring more of this stock and would be quite happy to get it at that price. It may not be a fortune, but I figure why not receive the $500 and some bucks from the put option as I wait to see if the stock dips for me.

As disciplined dividend growth investors, we appreciate the long-term value of compounding small gains. Over a couple of decades, adding even a thousand or two dollars to your investment account each year through options premiums will add a very substantial increase to your final portfolio value.

Holding vs. Selling

I know that "sell" is a four-letter word for some dividend growth investors but I want to make the case that there may be times to do just that. I recognize that stocks routinely bounce from under- to over-valued with the random whims of the market, so I certainly don't dump a holding the second it starts to trade at a rich price.

However, I think once a stock goes significantly above your value range, it is time to consider at least trimming your position. If a certain stock is now trading well above your fair value range then you are also receiving a poor dividend yield from that stock. As I have said repeatedly now, the dividend growth investor must wisely allocate capital. It would be wise to reap the gain from that overvalued stock and re-invest it into a more attractive opportunity.

I must admit that I struggle with this one myself at times, as the unpleasant situation can arise when a company you are very bullish on becomes extremely overvalued. This happened to me recently. I have been a very long-time shareholder of Enbridge (NYSE:ENB) and continue to believe the company has a bright future. Unfortunately, the market and I have disagreed on the company's value recently: my fair value range for the company is $28 to $32 - well less than recent prices. I trimmed half my position at $40 and my GTC sell order at $42 was triggered this month and I have now completely exited the position. For some reason, that makes me a little sad.

Still, in my opinion, a pipeline company selling at a P/E of 36 and a PEG of over 3 is a valuation high enough that it should give investors nosebleeds, or at the least, motivation to sell. As a wise manager of my capital, I was unwilling to tie up my money in a now relatively low-yielding stock in a highly regulated sector. I could invest my capital into the aforementioned Philip Morris stock, which would add 80 bps of yield, and which has a P/E less than half of Enbridge despite a similar growth rate.

Another recent position I trimmed was Ecopetrol (NYSE:EC). My fair value range for this stock is $50-$60 (a wider range as I am more uncertain of its true value). As Ecopetrol spent most of the last year hovering around $40, I tended to pick up a few shares each month. Recently, however, the price quickly ran up to almost $68. This is a very risky stock and it suddenly occupied a larger position in my portfolio then I desired while simultaneously having a valuation that left less of a safety margin. So I trimmed the position down to a more reasonable size, pocketing a quick 70% gain and re-investing those gains into a safer and better valued stock.

I do want to point out that I am not advocating for an itchy sell finger here - my broker has probably seen about a dozen sell orders compared with hundreds of buy orders. I am also certainly not advocating a "buy low, sell high" strategy, as that approach almost always fails.

To reiterate, the key determination is value. If a stock is undervalued, I will purchase it and care little if the price continues to go down in the short or even medium term. In fact, I will probably buy more. As well, if that same stock recovers to a fair value, then great: I will continue to capture the growing dividend stream and harness the power of re-invested dividends.

However, if the stock becomes so overvalued I can no longer rationally consider it a good use of my capital then I will sell the stock - even if I am fond of the company. After all, dividend growth investing is a disciplined approach to allocating your capital wisely.

Disclosure: I am long BIP, EC, PM, UGP.

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