I'm writing this letter to you because I've identified you as someone who is or may be interested in learning more about long-term investing. I have too many friends who have decided that investing is too complex for them, and they either write off investing altogether or pay a mutual fund company thousands of dollars in fees over their lifetime. I have spent the past several years reading everything I can and teaching myself how to be a successful investor. I'm still very much an idiot, but I realize that my knowledge today can help you make better investment decisions for your future.
Someone's sitting in the shade today because someone planted a tree a long time ago. - Warren Buffett
I'd like to start with an introduction about my investing style.Dividend Value Investing
Time is the friend of the wonderful company, the enemy of the mediocre. - Warren Buffett
My investing style closely resembles the value investing style espoused by Warren Buffett mixed with a heavy emphasis on dividends. Value investing is characterized by buying high quality, dividend paying companies at reasonable prices.
How do I ensure a company is high-quality? A high-quality company will have a wide moat, meaning other companies will have a tough time gaining market share from the wide-moat company. An example of a company with a wide moat is Union Pacific Railroad. It is tough if not impossible for a company to come in, buy land, gain permits, purchase cars, and start laying tracks.
I favor boring companies who sell products people will continue to buy 25+ years in the future. People will still need toothpaste, band-aids, and water 30 years from now.
I like companies that generate lots of cash each quarter. High quality companies exhibit stable, 10+ year trends of increasing earnings per share (NYSEARCA:EPS). These companies should have management which uses this cash to make strategic acquisitions or returns this capital to shareholders via dividends (preferably both).
Specific metrics I use to make sure a company is high-quality:
· Dividend Yield > 2% - This is how much the money you invest in a company will earn via dividends throughout the year. I like companies with a greater dividend yield than the general market. The sweet spot for dividend yield range tends to be 2.4-5%. Dividends are passive income currently taxed at a 15% rate.
· Payout Ratio <70% - Tells how much of a company's earnings are currently being paid out via dividends. I want to ensure a company can continue to increase their dividend without eroding earnings.
· Return on Equity (5 year median) > 10% - This formula tells how much net income is returned as a percentage of shareholders equity. This formula is used to measure management's effectiveness of using shareholder's capital to generate earnings. High return on equity = high quality management.
· Earnings Per Share (10 year growth) > 10 - This shows on average how much a company increases its growth rate by over 10 years. I like to see companies who have weathered 10 years of the economic cycle, and still have managed to grow earnings by 10% on average.
· Debt to equity ratio <.55 - Debt to equity ratio is a measure financial leverage. It calculates a company's total liabilities and divides it by shareholder's equity. The lower the number the better as it means a company isn't using debt to finance its assets. A low debt level ensures a company can withstand an economic downturn.Margin of Safety
Rule #1: Don't lose money. Rule #2: Don't forget rule #1 - Warren Buffett
Warren Buffett talks about ensuring your investments have "a high margin of safety". Margin of safety is ensured by making sure the companies you are buying are undervalued, and able to withstand deteriorating market conditions.
An undervalued company is not likely to go down as much during a recession as a highly valued, growth company. Investors get greedy during bull markets. Stocks like Netflix, Amazon, and Tesla get bid up on the expectation that money will keep flowing, and growth will continue forever in the double digits. In a recession, these high growth stocks drop the fastest and hardest. You instead want companies whose value metrics are relatively lower than the general market, as these companies offer safety in case the 7 year bull run goes the other way. Specific metrics I look at to check if a company is undervalued are:
· PE (Price to Earnings Ratio) < market's average - Price to earnings measures the price of the stock divided by the earnings per share. This is a basic way to see how a stock is being valued compared to its past. I look at the forward PE because it takes the current price divided by the future year's earnings estimates. This ratio provides a way to see what a company's PE will look like if they meet their earnings estimates.
· PE< 10 year median PE - A good way to check how PE compares to historical PE for the company
· PS (Price to Sales Ratio) < 10 year PS - Measures current price of stock to current sales. This compares to the historical PS average.
· PB (Price to Book Ratio) < 10 year PB - Measures the price of the stock divided by the book value of the company. This compares to the historical PB ratio.
· PE < Industry Avg PE - We want the PE of the stock to ideally be lower than its industry's PE. Certain industries will usually have a higher PE. Technology companies will usually have higher PE than a paper company.
A favorite method of mine to see if a company is undervalued is comparing the 10 year chart of a company's stock price, with the 10 year earnings per share overlayed. When the EPS is rising , and the share price is down, it's a good indicator that shares are undervalued. This method was popularized in the book, Purple Chips.Dividend Growth
Compound interest is the 8th wonder of the world. He who understands it, earns it…he who doesn't pays it -Albert Einstein
When I buy stock in a company, I plan on holding it long term, ideally 20+ years. It's important to me that a business/company can do well in recessions and bull markets. Slow and steady growth is the name of the game. Dividend growth is extremely important to me. Dividends have accounted for 30% of stock returns over the past 80 years. When management raises the dividend, it is the ultimate signal that management is confident earnings will continue to grow. Dividends cannot be fudged on accounting statements. The money is paid directly to you quarterly, and will be taxed at a 15% rate.
If I buy a company currently yielding 5%, and it raises their dividend 10% every year, after 10 years I will be earning a 10% yield on my original investment, and this doesn't include any stock price appreciation. Earning 10% on your money is unbeatable, even in a high-interest environment. My goal is to generate $80,000 in passive income via dividends to draw upon for retirement by 2036.Market Timing & Greed
Time in the market beats timing the market.
Be fearful when others are greedy, and greedy when others are fearful - Warren Buffett
The biggest mistake people make with investing is letting their emotions of fear and greed interferes with sticking to a sound investment philosophy. Wall Street makes billions each year off naïve investors buying at the top, and then selling when things look like there is no hope.
The fact is the stock market is wildly unpredictable. Like a manic-depressive person, no one truly ever knows whether the market will go up or down. By investing in solid companies that pay dividends, you will make money no matter which way the market decides to go. It helps if your retirement date is 10+ years out. Time is on your side. You can withstand paper losses that recessions will bring. Don't sell and keep reinvesting your dividends and extra capital. Slow and steady will win the race, and you will be rewarded for your patience and steady emotions.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a fly epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497- Warren BuffettCompanies I am Buying or Adding to My Positon:
In order of largest to smallest holding percentage:
1. Johnson & Johnson - JNJ
My largest holding. JNJ is a diversified healthcare company. You probably know them for their consumer health business where they make band-aids, baby shampoo, and Tylenol. Their other 2 businesses include medical devices and their fastest growing-pharmaceuticals. JNJ has raised their dividend for 54 straight years. Their management is top-notch, and they are approaching a reasonable PE ratio of around 19.
2. Lockheed Martin - LMT
Lockheed Martin is an aerospace and defense company who sells stealth jets, missile and radar systems, and space flight vehicles. Their customers are primarily the US government and its NATO allies. Lockheed's price has increased recently with Trump and Republicans winning. People expect the US military to increase spending over the next 4 years. Lockheed pays a nice dividend of 2.8%. Management has grown profits very well over the past 10 years. Do I feel scummy investing in the military industrial complex? Sometimes. I also think there are a lot of bad people out there, and we need advanced weaponry to provide a deterrent against them. I expect Lockheed to do extremely well as governments continue to upgrade against global terrorism.
3. Royal Dutch Shell - RDS.B
Royal Dutch Shell is an energy company selling oil, natural gas, and renewables. Like most energy companies, their prices has dropped significantly since the price of oil dropped from $100 to its current $50 a barrel. Shell has been moving away from oil, and recently spent $50 billion to acquire BG Group, the largest natural gas supplier. Shell's dividend is currently 7%, and they are committed to paying it throughout this oil downturn. Oil may not reach $100 a barrel, but OPEC will not let oil continue to decline as it has over the past year. Since I wrote this, OPEC announced production cuts so that oil-dependent countries like Russia, Venezuela, and Saudi Arabia can stop losing billions of dollars each year. Shell is paying you 7% to wait out this oil decline. The world will continue to need more energy, which is why I am adding to my holding.
4. Welltower - HCN
Welltower is a healthcare Real Estate Investment Trust (REIT) that buys and manages senior housing, post acute care, and assisted living centers. REIT's are required to pay out 90% of its profits in dividends, which is why Welltower is currently yielding 5.5%. Baby boomers are just at the beginning of retiring en masse. Anyone with an older relative realizes how important and necessary senior living centers are. Welltower has been paying dividends for 30+ years. I like Welltower as a stable income producing company who will experience growth for the next 10-20 years as people continue to get old, live longer, and utilize senior housing.
5. Cisco - CSCO
Cisco designs, manufactures, and sells Internet based networking products and services. Their bread and butter are data center and enterprise switches, routers, conferencing systems, and their fast-growing cyber security businesses. They are the market leader in helping computers talk with one another. Cisco current trades at a 12 forward PE, which is significantly lower than the general market's PE of 20. Their PE and price to sales numbers are currently lower than their 5 and 10 year medians. Cisco has a great CEO in John Chambers. They have an operating margin of 25% and current free cash flow of 12b. Their dividend is a solid 3.5%. This is a great tech company to buy and hold.
6. International Business Machines - IBM
IBM is considered a dinosaur in the tech world, and some people foolishly write them off because of this. IBM is in the middle of a multi-year transformation away from traditional businesses like software and IT outsourcing to their "strategic imperative" businesses of big data & analytics, cloud mobile, and social/security. More recently, IBM has developed the AI technology, Watson. You may have seen Watson win the show Jeopardy a few years back. IBM has a low PE, huge cash reserves, and excellent returns on assets/equity. IBM has transformed itself multiple times in its 100+ year history. I will collect their 3.5% dividend yield as they do it again.
7. Abbvie Pharmaceuticals - ABBV
Abbvie is a research based company focusing on treating conditions such as Parkinson's, HIV, cancer, dermatology, cystic fibrosis, and other conditions. Abbvie was spun off from the blue chip, Abbot Labs, in 2012. Abbvie's stock price has remained stagnant over the past year as concerns about its top selling drug, Humira's, patents due to expire. Humira makes up 60% of Abbvie's sales. Abbvie has lawyers upon lawyers to postpone the expiration of its patent. I believe there is too much pessimism about Abbvie's future earnings dropping. They trade at a forward PE of 12 compare to the industry average of 22. They have a return on equity and assets of 118% and 10% respectively. Management raised the dividend last month signaling they expect Abbvie's earnings to continue to grow. They have a 5 year dividend growth rate of over 40%. Abbvie is a rare chance own a great pharma company while collecting a 4.3% dividend yield.
8. Union Pacific Railways - UNP
Who wants to own a railroad in 2016? Union Pacific runs several railways in the Western United States. These railways primarily ship coal, chemicals, and industrial products (do you know a President elect who like coal and building steel walls?). They have a duopoly with Burlington Santa Fe allowing them to command a 37% operating margin. They have grown their income 16% yearly over the past 10 years. Their dividend is currently 2.3%, but they have grown that dividend 16% over the past 5 years. Union Pacific has an extremely wide moat. I used to think of railways as inefficient and non-environmentally friendly. Did you know railways can move freight 436 miles on one gallon of fuel. Try doing that in a semi or 747.
9. John Deere and Co - DE
John Deere is known for their big green tractors, but they also sell dump trucks, loaders, excavators, and anything else to help farmers get better yields. We are currently in the middle of a 5 year lull in corn prices. When corn prices pick up, this gives farmers more money to upgrade their equipment. Deere is an extremely cyclical company, and their price has increased much in the past year as people expect corn prices to rebound. I'd wait for a pullback to initiate a position in them. Still they have an excellent brand, with a long history of rewarding shareholders. They currently yield 2.6% and are increasing their dividend 11% on a yearly average over the past 5 years.
10. Novo Nordisk - NVO
Novo Nordisk is a healthcare company whose two main businesses are diabetes and obesity care. I hope to never have to utilize their drugs and services, but I also understand I'm in the minority. Most people in the US and world are getting fatter. We rely on cars for transportation, sit at desks 8+ hours a day, and are too lazy to exercise. Even worse we have super cheap junk food at our fingertips 24/7. This trend is only continuing as billions of people in China and India enter the "modern world". Sounds bleak, but don't worry, Novo Nordisk is there to get you your insulin and diabetes devices. They are also involved with hormone replacement therapy products. Novo has sold off 40% this year over concerns of drug pricing pressure in the United States. They are at a 52 week low. They generate tons of money, yield 2.6%, and are trading at historic lows.
11. Cummins- CMI
Cummins designs, manufactures, and distributes diesel and natural gas engines. They have a free cash flow of 1.5b, a forward PE of 14, and have grown earnings by 10% each year over the past 5 years. They currently yield 3%, with a long history of paying/increasing dividends. They have a strong brand in a great niche market.
12. Schweitzer-Mauduit International - SWM
This is a new holding for me. SWM is a paper and plastics company. 60% of their business is in producing cigarette papers. Governments around the world mandate cigarette companies use their Lower Ignition Prospensity (LIP) papers. These papers ensure cigarettes do not light on fire when dropped to the ground. This business is slowing as cigarette consumption drops around the world. In 2012, new management came in and changed their strategy to diversify their business away from cigarette papers. They now make water filtration systems, tea bags, and other specialty products. The transformation is working as net income has grown 18% each year over the past 5 years. They have a return on equity /assets of 17 and 8%. Operating margin of 15%, and a forward PE of 12. Their debt to equity ratio is a little high at .51, but management is committed to paying down debt from their recent acquisitions. Even better their dividend yields 4%, and has grown 11% per year over the past 5 years. An upcoming catalyst for them could be selling papers to the marijuana industry. More states and countries countinue to legalize marijuana. These sales can help offset the decline of their cigarette business.
13. TD Bank - TD
TD Bank is headquartered in Toronto, Canada. They have a great steady business with management that pays a dividend yield of 3.5%. Canadian banks are more steady growers than their riskier US counterparts. TD Bank has room to continue growing their earnings and dividend.
14. Visa - V
Visa is an anomaly in my portfolio. They trade at a high PE (29) and pay a paltry dividend (.86%). Visa is a growth stock. Visa runs the world's largest payment network. They do not assume any of the responsibilities with fraud or credit card debt. They just collect their 2.5% on every transaction made when someone uses a card with Visa on it. The world will continue to use less cash as e-commerce grows. Visa has rarely traded at a reasonable PE ratio. This is mostly due to their incredible business. They have an operating margin of 65% with no signs on this slowing down.
15. T Rowe Price - TROW
T Rowe Price provides financial advice and mutual funds. They have grown their dividend 27 years in a row, and currently yield 2.9%. They are currently trading at a forward PE of 16 compared to their 10 year median of 24. Their business and management is truly a blue-chip. They have a return on equity/assets of 24 and 18%, showing that they can invest in themselves and make money.
16. Boeing - BA
Boeing's businesses are airplanes and defense. They are trading at a forward PE of 20.55 compared to a 10 year median of 28. They have 8.4b in free cash flow. Their dividend yield 3%. Their net income and dividends continue to grow. This a blue chip with a wide moat, and 42 years of dividend increases.
17. Tesoro- TSO
Tesoro refines petroleum and bio-fuel products. They also have a great gas station retail business. More and more Americans continue to drive, especially in the Western States where Tesoro operates. They have made strategic acquisitions that will allow them to continue paying a decent dividend (2.5%) and increasing their income.
18. Walmart - WMT
Walmart is like IBM in that they are in the middle of a huge transformation. They were a little late to e-commerce, but concerns about Amazon taking them over were overdone. They have a huge transportation and logistics advantage over every retailer in the world. Their low price model has proven successful in China, Mexico, and India. They have made huge investments in e-commerce to compete with Amazon in the United States. At a PE of 15, and dividend growth for 41+ years, Walmart is still a bargain.
19. Western Digital - WDC
Western digital sells storage hard drives and solid state drives. Their business will continue to grow as more storage is needed for all of the pictures, videos, and data we continue to share. Their forward PE is 9, dividend yield of 3.4%. This is a great tech company that will reap the benefits from their aqusition of Sandisk.
20. Nike - NKE
Nike has been my worst performer over the past year (down 16%). Their PE has gone from 30 to 22, highlighting why it's never good to pay a premium, especially in retail. I still think Nike has a bright future, and this is as good a time as any to buy part of the company. Their dividend was increased so that they yield 1.5%. If you have traveled overseas, you know how popular the brand is abroad. They still dominate in shoe sales. They own the brands converse, who's Chuck Taylors remain popular. Athletic wear is a fast growing market. They recently announced their $700 self-lacing shoe called the HyperAdapt which has been sold out everywhere, and are currently being sold for $5000+ on ebay. I don't like retail stocks, but Nike and VFC are the only companies in the space I would consider owning.
There you have it friends. I'd like to continue writing a letter like this once a year. My wife and I are having our first child next year, so I'm not entirely sure how much time or money we will have to invest. Still, please let me know if you would like to continue receiving these letters. I would love to hear your thoughts. A link to my investment workbook is below. Keep investing for the future. Once you build that nest egg, have a plan to use that money and free time to better others' lives.
2017 Portfolio and Research - https://drive.google.com/file/d/0B1Ol-AIzY-sBa2Z4NzUzbnJPUkE/view?usp=sharing
Note: Please do your own research before investing in the companies I listed, or any company for that matter. Taking stock tips from friends, family, and online strangers can be very dangerous. Although the stocks I listed have been relatively safe over the past decades, there is the chance you can lose your money. Please analyze your own risk tolerance and financial situation before making any investment.
Disclosure: I am/we are long JNJ, LMT, RDS.B, HCN, CSCO, IBM, ABBV, UNP, DE, NVO, CMI, SWM, TD, V, BA, TSO, WMT, WDC, NKE.