Category: Finance

A post by Michael James (via Larry MacDonald) on the emotional benefits of dividend investing I thought was very well written.

Dividend issuance is not a valuation metric – although there is high correlation between companies that give out dividends and companies with good cash generation abilities, the issuance of dividends themselves does not cause the investment to be a good value. A company that previously did not declare dividends does not become more valuable the day after they announce dividends (although the market typically treats such announcements favourably in anticipation that dividend funds will increase demand on the stock).

When you isolate all other variables, there is no difference in investing in shares of a company worth $100/share that produces $10/year in earnings and selling $10 worth of shares each year versus that company issuing a $10 dividend each year.

Most dividend-bearing companies are stable simply because they have reached that point in the company’s maturity where they can give off cash without it being adverse to operations.

There are real-life subtle differences between dividends and capital gains which must be considered.

One is that there is a taxation difference between dividends and capital gains that must be considered in an investor’s risk profile – in Canada, lower income individuals would have a preference for dividends, while higher income individuals generally are indifferent. For example, using 2011’s BC tax brackets, a low income bracket individual will have a -9.4% marginal rate on eligible dividend income and a 10% marginal rate on capital gains. A high tax bracket individual will pay 23.9% on dividends and 21.9% on capital gains.

The other salient tax point is that you can choose to defer capital gains by not selling, while dividends have to be taken when declared by a company’s board of directors.

Another consideration is that cash in the hands of management is not equivalent to cash in the hands of an individual. If you believe management is more capable of investing cash, you would want them to retain as much of that capital for reinvestment as possible. If management gives out dividends, they are implicitly stating they are not capable of producing a market-beating return on that capital beyond what they have already invested.

You see this taking effect in companies when they declare large special dividends – the stock price usually increases by some amount because the market is implicitly stating that cash in the hands of management is worth less than the shareholders.

You can also use this to determine the competence of management – if management continues giving out more cash than the company can generate, it is a negative sign.

Ultimately what matters is the total market value of your portfolio increases over time, whether those returns are produced by capital appreciation or by income generation. Sometimes the market has more demand for income and sometimes the market has more demand for capital appreciation – these gyrations in sentiment are what cause opportunities for the neglected part of the marketplace, just as how most non-dividend bearing companies in the marketplace today are somewhat discounted by the apparent lack of income produced.

There is a certain beauty in the premise of dividend investing, but ultimately it is a failed strategy if an investor does not consider the underlying operations of the company and evaluating the company’s ability to generate free cash flow that sustain such dividends. Whether a company gives off dividends in the process or not is a very minor consideration in the valuation process.

The most frustrating experience while trading is setting a limit order for something, having the underlying security trade one penny away from your price, and then have the market move away from you.

On less liquid issues there are usually algorithms that will try front-running your open order for a penny, which is why such orders should be tactically placed. On more liquid orders you can usually keep the orders open and not be prone to sniping.

The first geopolitical detonation has happened in the month of January, primarily the overthrowing of the Tunisian government, and the ongoing attempted ousting of the Egyptian government.

My knowledge of that part of the world is very limited, but I do know that part of Northern Africa should affect Europe much more than it would affect Canada or the USA. However, one has to ask themselves what the secondary or tertiary effects of what we are seeing – and right now, I have no idea other than to watch and wait.

I have sufficient idle cash in the portfolio that if the markets decided to crash, I would be relatively well-positioned to start looking for pricing inefficiencies.

I do note with amusement that a former Member of Parilament’s “real estate bubble” website is advocating some strangely risky financial strategies. Apparently he has forgotten that ETFs derive their value from their underlying holdings, which contain precisely the amount of risk that he declares that people with only a million dollars and above should be engaging in. Here’s my phrase of the day: Diversification is for investors that don’t know where to find value. Diversification also does not mitigate against systemic risk, as most investors in the second half of 2008 discovered.

If your portfolio size is a modest fraction of annual after-tax income, putting all your eggs in a single basket (i.e. putting it all on a very well-researched company) is an acceptable strategy if one believes in maximizing both their risk and reward. As the portfolio size appreciates above annual income, maximum position sizes need to be trimmed down to avoid what I call “blowup” risk, but financial academics call unsystematic risk. With commissions as low as they are, people can invest reasonably with as little as $5k – with $10 commissions, you can diversify into five positions with a 1% expense ratio, or better yet, choose two and keep your expense at that of a typical index fund.

Especially for young people, it is vitally important to learn how to lose money in the public marketplace before making money – making mistakes that cost you 20% of your portfolio means a lot less when you have $5k in the account than $500k. You learn exactly the same lessons, but with a lot less money.

The worst thing that can happen to a beginning investor is that their first three trades are wildly successful.

One of the tricks that you learn in the marketplace over a decade of experience is that you make money by buying when things go lower, and sell when things go higher. It sounds awfully cliche, but doing this correctly is an art and will never be a science – sometimes the markets do something “crazy”, and taking advantage of craziness is how you make a substantial sum of outsized gains – whether it is buying at a crazy low, or selling at a crazy high.

While I would not call present conditions crazy, I do consider them frothy and have been lightening up positions since the beginning of September. Having a high fraction of the portfolio in cash is always boring, but I am fairly firm in my belief that cash will be outperforming most asset classes after the winter is done. There is just not enough reward out there for the risk. I still have enough in the market to participate in further gains and to profit in case if things do become “crazy”.

Until then, I wait. Boring, boring, boring.