Financial Jungle

As mentioned in my High Yielding Dividend Stocks Flexing Muscles post, 12 independent studies concluded that investing in high yielding dividend stocks was a winning strategy for much of the previous century. Despite the overwhelming evidence, all the studies were predominantly US and UK based, so I decided to roll up my sleeves and conduct my own research in Canada.

To begin, I queried for all Canadian dividend mutual funds with at least 15-years of historical data from GlobeFund. I then manually weed out funds with too much bond or foreign content; so, only dividend funds with at least 75% common stocks, and 80% Canadian contents made the list.

Here are the final 7 funds along with their 15-year compounded return and Management Expense Ratio (MER):

1. PH&N Dividend Income (Return=14.28%, MER=1.11%)
2. RBC Canadian Dividend (Return=13.08%, MER=1.73%)
3. Scotia Canadian Dividend (Return=12.03%, MER=1.67%)
4. TD Dividend Growth (Return=11.51%, MER=1.94%)
5. CIBC Dividend (Return=9.37%, MER=1.96%)
6. Investors Dividend (Return=8.27%, MER=2.87%)
7. Mavrix Dividend & Income (Return=8.08%, MER=2.14%)

Not surprisingly, lower MER funds tend to churn out stronger performance over time. However, I don’t see the benefit of paying for MER when an investor can easily emulate these dividend funds with a handful of core holdings, and then build on them as the portfolio grows.

The average annual return for the group is 10.95%, but if I remove the MER component, gross return jumps to 12.87%. It’s worth reiterating that a typical dividend fund has a bond allocation, so a pure dividend play would see over 13% in return. For comparison, TSX’s total return over the same period is 11.27% before tracking error, or a difference of 1.60+% compounded over 15 years. Over the next 3 years or so, I anticipate financial stocks to rebound and resource stocks to cool, which would widen the lead even more.

For other benefits of dividend investing, please check out my post on Top 10 Reasons For Dividend Investing.

The Dividend Guy recently touched on a research paper that revealed a surprising result about dividend investing; stocks that generously distribute larger percentages of their earnings to shareholders tend to outperform their stingy counterparts. This is counter-intuitive considering that the more earnings a company distributes to shareholders, the less retained earnings remain to grow the business. For more on this finding, download Does Dividend Policy Foretell Earnings Growth? from Papers.SSRN.com.

As if that wasn’t a head-scratcher, renowned value-investing firm, Tweedy Browne, compiled a series of studies suggesting another firmly held conventional wisdom is about to come crumbling down. It’s widely believed that one law of dividend investing is to buy lower yielding stocks if you want to accelerate portfolio growth. Beware of such assumption as the paper begins eloquently with a quote from T.H. Huxley.

The deepest sin against the human mind is to believe things without evidence.

As far as I’m aware, this is the very first time that someone gathers not one, not two, not three, but twelve independent research studies using empirical evidence to reinforce the claim that the highest yielding stocks trash their low-yielding counterparts consistently over a variety of periods and geographies.

Here are some quotes from each research:

1. Triumph of the Optimists: 101 Years of Global Investment Returns (2002) - Over 101 years, [Elroy Dimson, Paul Marsh, and Mike Staunton] found that a market-oriented portfolio which included reinvested dividends would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains. (1900 to 2000, US & UK.)
2. Dividends and the Three Dwarfs - [Robert D. Arnott] concluded that dividends were far and away the main source of the real return one would expect from stocks, dwarfing the other constituents: inflation, rising valuations, and growth in dividends. (1802 to 2002, S&P500.)
3. Taxes, Dividend Yields and Returns in the UK Equity Market - Using data from the London Share Price Database (LSPD), [Gareth Morgan and Stephen Thomas] examined the relationship between dividend yields and stock returns from 1975 through 1993 in the UK. Database companies were ranked by dividend yield at the end of each month and divided into six groups, including a zero dividend group (companies that did not pay dividends). … they find a strong [positive] correlation between the size of the dividend yield and the average monthly return. (1975-1993, UK.)
4. Market Anomalies: A Mirage or a Bona Fide Way to Enhance Returns? - Using a sample of 4,413 companies which were listed on the London Stock Exchange during January 1955 through December 1988, Lenhoff ranked all listed companies each year according to dividend yield and sorted the companies into deciles. …there was almost a perfect correlation in the decile returns between higher dividend yields and higher annualized returns. The top decile, in terms of high yield, produced an average annualized return over 34 years of 19.3% versus 13.0% for the Financial Times Actuaries All Share Index. (1965 - 1998, UK.)
5. The Importance of Dividend Yields in Country Selection - Michael Keppler examined the relationship between dividend yield and investment returns for companies throughout the world. … The study indicated that the most profitable strategy was investment in the highest yield quartile. The compound annual investment return for the countries with the highest yielding stocks was 18.49% in local currencies (and 19.08% in U.S. dollars) over the 20-year period, December 31, 1969 through December 31, 1989. The least profitable strategy was investment in the lowest yield quartile, which produced a 5.74% compound annual return in local currency (and 10.31% in U.S. dollars). (1969-1989, world.)
6. Dogs of the Dow - [Michael O’Higgins] discovered that by investing in the 10 highest yielding securities in the Dow Jones Industrial Average of 30 industrial companies, and rebalancing annually, one could substantially outperform the average itself. (1973-1998, Dow Jones Industrial Average.)
7. Triumph of the Optimists: 101 Years of Global Investment Returns - Higher dividend yield stocks outperformed their lower-yielding counterparts and the index by 180 and 160 basis points annualized from year end 1926 to year end 2000 (a basis point is one-hundredth of a percentage point). This translated into 2.29 times the wealth generated by the lower-yielding stocks. (1926-2000, US.)
8. The Future for Investors - In Jeremy Siegel’s study, on December 31 of each year, the S&P 500 stocks were sorted into five quintiles ranked by dividend yield. He then calculated the returns of the stocks and quintiles over the next year, re-sorting at year-end. He found that better results were directly correlated with higher dividend yields. The highest yielding quintile (top 20% of S&P 500 based on yield) produced an annualized return of 14.27% versus an annualized return of 11.18% for the S&P 500 Index, which resulted in three times the wealth accumulation of the index. (1957-2002, S&P 500.)
9. Contrarian Investment Strategies: The Next Generation - David Dreman analyzed the annual returns of price-to-dividend strategies using data derived from the Compustat 1500 (largest 1500 publicly traded companies) for the 27-year period ending December 31, 1996. As indicated in the table below, he found that the highest yielding top two quintiles of the Compustat 1500 stock universe ― as reflected by low prices in relation to dividends ― outperformed the market by 1.2% and 2.6% annualized, respectively, and outperformed the stocks with low-to-no yield by 3.9% and 5.3% annually. (1970-1996, US.)
10. Lehman Brothers Equity Research - High dividend yield stocks were found to have produced more return with less risk than their low-yield counterparts. The Lehman analysts studied the one thousand largest of U.S. firms ranked by market capitalization, and rebalanced these securities quarterly, starting in January 1970. They found that the top-yielding quintile produced a 13.7% equal-weighted total return per year with a 15.5% standard deviation of return. The bottom-yielding quintile, in comparison, returned 9.0% with a 29.1% standard deviation. (1970-2006, US.)
11. High Yield, Low Payout - Over the 26-year period, [Credit Suisse Quantitative Equity Research] found that stocks with higher dividend yields generally outperformed those with low dividend yields, but the highest yield decile did not produce the best overall return. As their chart indicates, deciles 8 and 9 outperformed decile 10, the highest yield decile. … However, the best returns have not come from those with the highest yields ― higher yields coupled with low payout ratios have produced the best returns. (1980-2006, S&P 500.)
12. When The Bear Growls: Bear Market Returns - The Compustat 1500 database (1500 largest publicly traded stocks) was used, and the performance of four value strategies ― low price-to-earnings, low price-to-book value, low price-to-cash flow, and high dividend yields ― were measured and averaged for all down quarters and then compared to the index itself for the 27-year period. All of the value strategies outperformed the market, with the high dividend strategy (low price-to-dividend) performing the best of all the value strategies, declining on average only 3.8%, or roughly half as much as the market. (1970-1996, US.)

Note that the yield is only one facet of a sound stock selection process. Although the typical high-yielding stocks have overwhelming astounded investors with superb total performance, others have slashed or halted their juicy yields due to unsustainable dividend policies.

Just to be on the safe side, we should also examine other financial figures abreast including, but not limited to the price-to-earning (P/E) ratio, free cash flow, payout ratio, debt-to-equity (D/E), return on invested capital (ROIC), revenue growth, and earning growth. One of my favourite sites to look up financial numbers is MSN Finance. Here’s an example link to Saputo’s historical cash flow statements.

The investment saying, “dead cat bounce”, has been thrown around recently to warn investors about the nasty surprises prowling right behind the beguiling recovery of fallen financial stocks.

While I don’t know where the financial sector is headed in the short run, as a dividend and long-term investor, I try to block these little price squiggles off my mind and focus on my long-term views and investment philosophies. Without the benefit of hindsight, no one can predict where the stock market will go over the next few days, weeks or months.

I remember reading a few doom and gloom posts in the Canadian Business forum just days after the near collapse of US investment banker, Bear Sterns. Pundits plead investors to sell financials as the whole sector was being crippled by subprime, ABCP, derivative, credit, and liquidity crisis. Many critics were combing for and cherry picking web articles that supported their point of views. One of the articles even recommended the following:

“If your only nest egg is your IRA, then I suggest taking half of your money out, and paying the penalties, and buying physical silver or gold immediately from your local coin shop.”

Having radical recommendations like this displayed in a public forum is disturbing. I hope no one actually followed up on this recommendation and parked half their nest eggs in one precious metal. That would go against the principle of diversification. A wrong bet could send investors into a financial tailspin.

Sure enough, over the next 2 days, the Vanguard Financial ETF surged 5.6% and gold slid 5.9%.

“Enjoy the dead cat bounce while it lasts !!”, one critic trumpeted.

But, apparently the dead cat had 8 lives remaining as the Vanguard Financial ETF subsequently rose 4.4% and gold fell another 2.9% as of closing today. Even the two most hated Canadian banks, Bank of Montreal and CIBC, jumped nearly 20% since the March 18th low. The other 3 big Canadian banks (RY, TD, BNS) are also up a respectable 7% on average.

I’m not suggesting everyone to flee their gold investments and plunk 100% into financials. That would defeat the purpose of this post. If you believe a particular sector will stumble in the foreseeable future, why not prune gently instead of pulling out the root system entirely? The best way to keep portfolio risks in check is to maintain a reasonably diversified portfolio across all sectors, and avoid keeping a finger on the buy/sell trigger while reading these sensational forecasts from financial forums no matter how convincing or colourful they may be.

By and large, dual-class shares are unloved by investors and PF bloggers because the structure creates a double standard that gives one class of investors unfair voting power over another. ThickenMyWallet recently wrote a post on dual-class shares titled “You’re a fool if you buy…“:

The primary disadvantage of a company with a dual-class share structure is there are no effective checks and balances to management excesses such as excessive executive compensation… The larger issue is that companies with dual-class structures tend to be poorer performing stocks than their single-class structure counterparts (ask someone who invested in shares of Ford).

Yesterday, The Dividend Guy followed up with “Dual-class shares suck“:

From a statistical perspective, it would be better to hold the single-class stock in the industry you are looking at, compared to the dual-class company.

Both bloggers singled out controlling shareholder, Conrad Black, whose extravagant lifestyle single-handedly brought Hollinger International down to its knees. While both bloggers put forth rationales with strong merits, ThickenMyWallet did offer a glimpse of hope suggesting good stocks do exist in the dual-class structure.

Admittedly, I haven’t paid much attention to dual-class structure although I may have to adjust my stock selection process. So far in my endeavor, I’ve found no reasons to shy away from *all* dual-class stocks even though the door is open for management to act in their personal interests. My view is that result should speak louder than share structure, so I tend to stick with management with a strong track record of delivering excellence.

There are many profitable dual-class Canadian stocks with smoking-hot cashflow, and management teams aren’t afraid to share the wealth with generous dividend policies. Reitmans, for example, is a debt-free high quality retailer with a long history of dividend increases. Another one is Teck Cominco which hiked their dividend 10-fold since 2004. AGF Financial also recently boosted their payout by 25%. All three stocks have so much money, at least 3 years worth of dividend is parked in cash or cash equivalents.

Perhaps dual-class structures do raise some eyebrows, but a meticulous screening process should weed out the looters.

Just because the financial sector is ruing Bear Sterns’s stunning collapse doesn’t mean all dividend investors are in dire straits. Smart investors who are surviving this bear market are diversifying into sectors that don’t correlate with the financial sector. Something like the largest pipeline operator in the country, TransCanada (TRP), should fit the bill, because it’s partially immune to both subprime and recession.

TransCanada is a huge conglomerate, but its 2 family jewels are pipelines and energy. Its “network of more than 59,000 kilometres (36,500 miles) of pipeline taps into virtually all major gas supply basins in North America.” The company is also one of North America’s largest providers of gas storage, and a key power plant operator with interests in approximately 7,700 megawatts of power generation.

The pipeline stocks tend to pour in vast amounts of positive cash, but they’re not traditionally known for their growth. However, things are about to change with a glut of crude and natural gas coming on steam in and around Alberta over the next 6 or 7 years. The problem is that the real demand for energy isn’t in Alberta; it’s in Southen U.S. And if crude gets clogged up in Alberta, all producers suffer a phenomenon known as apportionment, where a shortage of pipelines is preventing cruel oil from being shipped to places where it can command top dollars. With producers and refineries crying at both ends of the pipe, companies like TransCanada and Enbridge can come in to relieve the congestion. And to profit handsomely, of course.

Pipelines, are what some people call, a business with strong economic moats. Building a pipeline is tough work. It’s notoriously expensive, complex, and you must wait maybe 2 or 3 years to reap the rewards. On top of that, management must jump through many regulatory hoops, and duke it out with relentless oppositions such as First Nations, farmers, environmentalists and workers unions. The bright side is that all these Mount Everest tall hurdles tend to chase away rookie entrants wishing to duplicate the service. That’s great for long-term shareholders looking to protect their dividend streams.

Here is a map from TransCanada’s annual report showing off their pipelines which span from Canada down to Mexico. Over at the lower right (1) is the recently acquired $3.4 billion 17,000km long ANR gas pipeline system. Next is a 50% ownership in the $5.2 billion Keystone Pipeline (2), which is TransCanada’s venture into the oil pipeline business. This 3,500 km pipeline is currently under construction, and is expected to deliver 590,000 barrels of crude per day. Operation will begin in late 2009. North Central Corridor (3) is a $983 million expansion to the existing Alberta System gas pipeline. The two dotted lines (4) are the proposed Northern Pipelines: the Mackenzie Gas Pipeline and the Alaska Pipeline.

We always think of pipeline stocks as slow moving mammoths, but the company is firing on all cylinders with its numerous growth initiatives, such as the Keystone projects, northern pipelines and expansion to their Alberta system. TransCanada, along with arch-rival EnBridge, are in the most prosperous economical environment possible despite US slipping into a recession. Back-of-the-envelope math suggests that TransCanada is investing at least $11 billion in key pipeline and power projects between 2007 and 2010. (I know I’m underestimating this.) That’s a staggering figure relative to TRP’s $20 billion market cap. In 2008 alone, management forecasts overall capital spending to be $2.9 billion.

Here’s an image of their power plants and gas storages. The key excitement in this area is the refurbishment of Bruce A Units 1 and 2 (9) which is expected to add another 19% of additional megawatt of output in 2010. A couple of other initiatives include the Portlands Energy Centre (11) and Halton Hills Generating Station (10) generating 550MW and 683 MV respectively when they’re complete.

Valuation

At 16 PE, TransCanada isn’t exactly a bargain when compared to the 13.9 historical average. (Financials are still the cheapest.) But the business is investing heavily these days to accelerate revenue, cash flow and earning growths. Given their improved growth profile, I believe buying at historical average PE is a reasonably attractive entry price, or ~$33 with 4.3+% dividend yield. TransCanada closed higher on Thursday at $38.06. I’m keeping an eye on this one.

Disclosure: I have positions in TransCanada, EnBridge and Inter Pipeline Fund.

This is the fifth post on the Dividend Increases series.

It has only been 3 weeks since my previous dividend increases post, but I feel compelled to hurry one in as Boralex Power Income Fund just announced a distribution cut from 90 cents to 70 cents, amidst external headwinds from weaker hydrology and the declining US dollar.

In 2007, BPT.un’s $42-million net cash flow related to operating and investing activities was $9-million short of the $53-million circulated to unit holders, but management has been proactive all along warning investors about the hurdles they’re facing.

Rather than masking the problems and jeopardizing the fund’s long-term health, the new distribution policy will see payout easing to $41-million a year. This is a conservative move considering the fund still has $10-million in the bank. (i.e. the cash could’ve prolonged the current payout by another year while waiting for a turnaround.) If it were an oil & gas trust, management would’ve dug themselves deeper into the hole by (a) issuing new shares, and/or (b) borrowing debts.

Here’s my original analysis on Boralex Power Income Fund:

So why is the trust being punished? The answer likely lies in the unfavourable hydrology in the 3rd quarter. Hydrology is fickle science. Due to unusually low water level, their hydroelectric segment generated 22.8% less than historical average, even though that’s only for one quarter. It was only a year ago when the water current was exceptionally strong, while year-to-date, the segment is down only 6%.
…
Since power trusts are generally considered stable and boring, coupled with Boralex’s conservative balance sheet and high ratings from S&P and DBRS, I feel the distribution is safe, and the higher yield offers a margin of safety in a rare event of a distribution cut.

Obviously I was wrong about the payout being safe. Despite the relaxed distribution policy, BPT.un is still yielding an attractive 11+% based on my average purchase price, and I see the distribution chugging back up as hydrology restores to their historical average. Although I don’t think we’ll see 90 cents anytime soon unless the US Dollar is making a come back.

Disclaimer: I’m not a professional investor. It’s vital that investors perform their own due diligent, and invest accordingly.

On a brighter note, here are my dividend increases over the past 3 weeks:

• Great West - 6.4% (14% from last year)
• IGM Financial - 5.9% (13.4% from last year)
• 3M - 4.2% (4.2% from last year) More analyses from Money Gardener and Middle Class Millionaire.

There are several stable stock markets in which investing through different stock brokerage is very profitable. Several forex companies are doing online trading. The home investment or home building business is on its boom nowadays in different developing countries. If you can invest some thing then investment property is the most favorable option.

I received a few emails from readers singing the dividend investing tune and craving for more out of this blog. As much as I enjoy these praises, most of the ideas don’t originate from me. I certainly don’t live long enough to survive all the experimental mistakes and live to tell about them. Instead, I mimic dividend investors who have succeeded before me: Stephen Jarislowsky, David Dreman, Tom Connolly and bunyip. But the person who really spring boarded my endeavor into dividend investing is Scott M.(a.k.a scomac).

If you don’t know who scomac is, you owe it to yourself to dig up all the little nuggets he left behind in the Financial Webring and Canadian Business forums. In particular, scomac graciously shared this stock picking template, which I adopted and morphed numerous times over the past 2 years to suit my own investment style. His disciplines have also influenced many forum members/bloggers including Brad911 and Investor99.

To my immense delight, Scott visits my humble blog and even agreed to answer a few personal questions! Thank you Scott!

1 ) I remember reading a prior post of yours that you’re semi-retired. What exactly does that mean? How long have you been semi-retired? Are you working your dream job? How do you spend your spare time?

I would interpret semi-retirement to mean working when you want to, as much or as little as you want to and for reasons other than the need of employment income. I have been semi-retired for a little over three years. If working your dream job means not having to do anything, then I’m probably there.

We have a small farm, so that takes up some of my time, but not as much as it used to since our “herd” now consists of only one dog and one cat. Beyond that, I enjoy cooking, cycling, gardening, golf, skiing and….writing.

2 ) At what point financially did you decide it was time to phase in to retirement? Did you wait until your portfolio income covers your essential living expenses?

I just sort of fell into retirement. There was no grand plan. I had originally intended to go back to school and take some training so that I could enter the financial services industry as an advisor. I took the courses, but haven’t bothered to look for work. I doubt I have the personality for that gig. After I had been “semi-retired” for a year or so, we discovered that we had more than enough income as a family unit to continue living the lifestyle that we were accustomed to.

3 ) You’re a pretty young fellow. 47 if I remember correctly. If you were to travel back in time — but without the hindsight of market peaks and valleys — were there anything that you could’ve done to speed up semi-retirement even earlier?

I wouldn’t have done anything differently. The real wealth generator for me was a concentrated investment in personal business assets rather than the traditional savings and investing methods that are discussed in financial forums. We only began investing in the equity markets in a big way in the last 10 years or so.

4 ) You’re a regular at Financial Webring and Canadian Business. Do you think these financial forums are good training grounds for young people looking to shape their financial philosophies? Or, are they better off cutting out these intoxicating noises and sticking with good financial books, such as Personal Finance for Dummies?

I would advise young people to stick with a few good financial texts rather than spending endless hours on financial forums. I don’t want to downplay the value that these forums can have, but it would be difficult, if not impossible for novice investors to separate the good from the bad. They pretty much have to rely upon experienced forum members to correct any errors, poor guidance or miss-information that is posted. This is handled quite well at some forums, but it can be hit and miss at others. Just because an individual can make a convincing case for following a certain course of action, it doesn’t mean that it is the right path for the reader or even the alternative with the greatest probability of success.

My suggestion for a young person looking to get a good basic grounding in personal finance would be to read the following classic texts:

• “The Four Pillars of Investing” by Wm. Bernstein
• “A Random Walk Down Wall Street” by B. Malkiel
• “The Naked Investor” by J. L. Reynolds

5 ) It’s easy to get carried away and spend over 2 hours each day on forums. For someone thinking of participating in a financial forum, what should one do to make the experience more productive?

Limit your time. There’s more to life than sitting staring into a computer screen. If there are some specific things that you want to know about, then don’t hesitate to ask the questions. Remember that the only silly questions are those that aren’t asked. If you stick to specific areas of discussion that apply to your situation and avoid the heated opinion threads, you will likely find that your time spent was well worth it.

6 ) Forum participants often scoff at the “talking heads” from BNN, but come on! Although buying based on the top picks segments isn’t a sound investment strategy, it’s smart to augment their research with ours. And I’m not ashamed of being the first to admit, some of my favourite BNN guests include Norman Levine, Laura Wallace, David Driscoll, Gavin Graham, Bruce Campbell, Ross Healey and all the guys from Sentry Select. Do you have any superstars on your list?

Those individuals that take a balanced, prudent approach are those whose opinions I value the most. Ask yourself which one of these characters you would hand a blank cheque to and you will quickly discover whose advice is worth acting upon. From your list of individuals, the person that I would most likely have to manage our investments would be Norman Levine. Paul Gardner, of Avenue Investment Management, has been quite helpful to me on a personal basis on the fixed income side of our portfolios.

6 ) I believe you’re a hybrid stocks/ETFs investor. Tell us about your investment philosophy. What types of stock and ETF whet your appetite?

That’s correct. You can’t be an expert at everything is an old adage that I take to heart with investing. So, with that in mind, I select individual securities where I feel comfortable and use broad market ETFs to gain exposure to other asset classes.

I can be best described as an income investor. I’ve never been completely comfortable with investing solely for capital gains and having to rely on the greater fool theory where someone else will take my shares off my hands at a higher price. I like to be paid to hold investments and then the market value of these securities isn’t nearly so important to me (unless I’m buying or selling).

Our portfolios, in aggregate, are set-up to mimic a pension plan portfolio, so you could say that we engage in “core and explore” investing with the goal to have only about a third of our investments subject to active management with the other two thirds held in passive investments such as ETFs, a laddered bond portfolio and a few dividend paying stocks. The actively managed third could contain pretty much anything that I deem attractively priced from junk bonds to commodities. At the present time, I’ve been accumulating preferred shares, REITs and O&G shares.

7 ) Which tools do you use to research your potential investments? How do you determine the attractive entry prices?

Over the years, I’ve simplified my approach to researching a potential investment. If I’m not familiar with the company then I will spend a fair amount of time researching the company through resources that are available on the company’s web site and/or SEDAR. Once I’m familiar with a company, I’m quite satisfied to use the free historical data that is correlated on MSN Finance. For ETF research, my first stop is always ETF Connect. All of our various portfolios are tracked on the portfolio tracker at Globe Investor Gold. Globe Investor Gold is also my first stop for business news and I will periodically use the advanced stock/bond/fund screener functions.

I’ve used a commercial spreadsheet in the past, but I’m just as happy doing any calculations with my HP 10BII financial calculator. I think folks can get overly confident with their estimates of future value that some of these sophisticated computer programs produce. We can’t forget that it’s an “estimate”. To determine an entry price, I will use Time Value of Money and Discounted Cash Flow calculations that incorporates dividends, book value, growth of book value, growth of dividends and a discount rate that reflects my required rate of return which is typically 15%/annum. Hopefully this provides an adequate margin of safety to mitigate downside risk. As long as the price is reasonable, I’m more concerned that the company I’m looking at has the characteristics of sustainable long term growth that I’m looking for.

8 ) What are some of the core holdings in your portfolio?

• GoC 2021 RRB
• BLDRS (ADRD, ADRE) for international equity exposure
• SPDR (SDY, DSC) for US equity exposure
• Basket of Canadian dividend payers (BMO, BNS, CNR, MRU.A, PWF, SJR.B, SLF)
• Basket of Canadian preferred shares (mixture of financials and utilities)
• Basket of REITs/trusts/small caps (AP.UN, BR.UN, CUF.UN, CWT.UN, PKI.UN, RET.A, RUS)
• Commodities (CEF.A, ESI, NXY, PCA)
• Canadian pooled funds (bond, dividend income)

9 ) The recent market collapse had rumbled along leaving many road kills behind. Are you picking up any bargains these days?

I’ve been buying on a fairly consistent basis through out January. I’ve been active buying REITs, preferred shares and select stocks most notably in the O&G sector. Astute readers may have noted that I re-entered BMO as well. This was a result of a careful examination of the balance sheet after the release of the annual financial results in December. Whether or not my purchases prove out to be bargains only time will tell, but it is my view that they offer good value at the prices I paid. In the mean time, I’ll be quite content to collect the dividends/distributions.

Sometimes, we just need a hero. This is even more so in the universe of dividend investing, which by nature is a contrarian style. Let’s face it. Dividend investors are always pooh-poohed in a cocktail party because they never share your misery in a market slide, nor your pizzaz in a market frenzy. Want to become a successful dividend investor? Forget about winning the popularity contest.

Instead, follow Warren Buffett’s proverbial mantra:

Be fearful when everyone is greedy and greedy when everyone is fearful.

So, does dividend investing really work? Are there real people who manage to pull this off? Of course we can always point to the foremost Stephen Jarislowsky, author of Investment Zoo, and Tom Connolly of The Connolly Report. But that’s not fair, you may quibble. They are one of a kind. How about someone a little less celebrious? Someone a little… umm… like us?

Folks, meet the retired run-of-the-mill dividend investor, bunyip, whom I met from the Canadian Business forum. Bunyip is a relatively quiet dividend investing veteran, but when this low profile investor speaks, enthralling words flow out of his mouth.

I’m delighted that he gave me the opportunity to interview him three weeks ago, just before leaving for his Central America vacation. Inquisitive readers should hang on to the lessons from his 20-year investing experience.

1) Bring us back to your foray into investing. Did you experiment with various types of style? How did you stumble into dividend investing? What appealed you?

I started investing in the early seventies and made all possible mistakes (never twice). I changed strategies several times and it wasn’t until 1992 that I invested exclusively in dividend stocks and even used to sell half when a stock doubled. Now I rarely sell anything, just reinvest all dividends. I’m retired (freedom 55) but have pension so I probably won’t use non-registered account for anther 10 years. I could have retired earlier but I enjoyed my job and after all debts were paid we had a lot of money to put into stocks.

I bought my first shares in the seventies (20 shares of Simpson-Sears @ around $40). They split 4 for 1 soon after and I used to get a dividend cheque for $10 every few months. I kept them for several years until I bought my first house and sold for a small profit. My next foray into the market was in the late seventies when I was buying small cap mining stocks on the Vancouver exchange and gold coins. Did well with the gold but rather indifferent results with the speculative stocks. It was during this period that I started to read everything I could about the markets and created a starter list of dividend yielding stocks that I wanted to own. By 1992 my mortgage was paid off and I was able to start working my way through the list. It wasn’t until I got a computer and joined TDW that I really developed my own style. At that time I would still sell half of any stock that doubled, a carry ever from the junior resource days, a strategy I came to realize didn’t make any sense. For the last 3-4 years i haven’t added any new funds as I have reach all my targets and average $3000 per month in dividends that i reinvest, mostly in stocks in which i already have a position. Now I rarely sell anything and don’t care about the size of the portfolio, just the year over year increase in the yield.

2) What personal traits are best suited for dividend investing?

Patience for sure, especially in the beginning when increases come so slowly. It is always tempting to go for a “home run” but to build a large dividend stream requires discipline, pick a strategy and stick to it. There are many stocks that have more than doubled their dividends in the last 5 years such as the major banks, ENB, FTS and IGM. I also manage the portfolios of two very old relatives and in one of their accounts it is interesting to note that the dividends paid on several stocks are now higher than the original purchase price. So start young and have patience. I was driving across N. Ontario a few years ago and looking for a radio station to help keep me awake and the only one I could receive was a CBC affiliate doing a phone in gardening show. One of the questions was “when is the best time to plant a tree”. I think the person was looking for an answer like spring or fall. The expert replied “twenty years ago”. That answer could also apply to when is the best time to buy stocks.

3) How do you research your stocks, and what characteristics are you looking for? How do you determine your entry prices? Do you sell after a strong run-up? Do you average down?

Mostly annual reports as I mostly only buy stocks in which I already have a position. Also read both National papers and Globe’s website. I look for a history of dividend increases, ideally a payout ratio of less than 60% and increasing revenues. Entry price? I don’t try and time the market, I buy when dividend revenue is sufficient to buy the next stock on my list. That being said, I’ll buy more if the stock or the market overall drops. I virtually never sell anymore and a strong run-up works against me, it makes everything more expensive. I buy all stocks at market price because all stocks I buy are very liquid and would prefer not to miss a dividend or end up paying a higher price just to save a dime.

4) What stocks are in your portfolio?

Agf.B, Aco.X, Bmo, Bns, Bce, Cm, Ema, Enb, Fts, Igm, Mbt, Mfc, Pow, Pwf, Roc, Ry, Rus, Sap, Slf, Tck.B, T, Td, Ta, Trp, Fap. Trusts- Aet, Apf, Bfc, Cix, Cos, Cne, Cwi, Eit, Mpt, Npi, Pif, Pgf, Prg, Rei, Ylo, Ep. There are several of these that wouldn’t meet my criteria today- Mbt Rus and Tck.

You may have noticed that I hold no mutual funds, just mutual fund companies. I don’t spend any money on MER or even pay for ETFs. They will eat your profits over the long term. My total expenses for a $650,000 account last year were $89.91 representing 9 trades. If this were mutual funds (well you do the math). Mutual funds have to trade often to show gains that they use in advertising, a retail investor in dividend stocks has a huge advantage. A stock that regularly increases it’s dividend and is held for the long term will come out ahead of most mutual funds in the long run.

5) What were some of your best and worst moves? If you were to travel back in time, would you do anything differently?

Best moves- Buying a lot of trusts right after Flaherty’s announcement. TRP@ 11.45 in 2000 after a dividend cut (since restored and then some). Worst- After reading a book on demographics I bought Extendicare and Louwen Group(2nd largest funeral Co in N.America). Both companies were involved in very expensive lawsuits in the US. Exe. survived but Louwen went from $40 to zip. Be diversified.

6) What are you thoughts on investing with borrowed money to enhance return?

Or enhance losses? I think it is human nature to want things to happen faster but it goes back to an earlier question. Patience. Hey but if you are successful, you’ll look like a genius.

7) How do you define financial freedom, and are you financially free?

I am financially free and have been for many years. I probably worked a few years too many because it is very difficult to say when one becomes financially free. I stayed longer so I would have a cushion but realize I don’t need that big a cushion.

I am also a jungle guy and am leaving Friday [FJ: that was 2 weeks ago] for a jungle lodge on the Costa Rican/ Panama border for 2 weeks. No phones, no computers, no stock market. I’ll probably be in withdrawal for a couple of days.

8 ) What stocks appeal you these days? What are you avoiding?

The next three I’m adding to are Fts, Td and Pwf. I’m avoiding anything to do with medicine or aviation, I have never made a cent on either though I tried often enough.

9) Any good books or websites you recommend?

I was impressed with your website. I do a lot of reading but nothing pertaining to the market as my portfolio is becoming less hands-on all the time.

Telly recently left a comment on my Top 5 Reasons Why Dividend Investing Over ETF post expressing her skepticism that anyone can build a diversified portfolio yielding over 4% “without loading up on some income trusts which are not favourably taxed or becoming less diversified by owning only high yielding dividend companies.”

I figure it would be a fun exercise to build this high-yielding diversified portfolio, although I wouldn’t shy away from income trusts. In my opinion, income trusts are an absolute key ingredient to sprinkle over a diversified portfolio. Just because some our best Canadian cash cows are structured as income trusts doesn’t mean we should place them in the penalty box:

• Canadian Oil Sands - a 33 year life reserve of tarsand with no exploration risks like most other energy trusts.
• Consumers Waterheater - Torontans take warm showers recession or not.
• CML Healthcare - a highly profitable diagnostic, laboratory testing and medical imaging services business that is pouring out distributions from its opearational cash, and while paying back debts at the same time.
• InterPipeline - a stable and low payout ratio pipeline trust that’s not sensitive to commodity prices. I covered IntePipeline in a previous post.
• H&R REIT - any diversified portfolio must include real estate. With H&R REIT, you get a little bit of office, a little bit of retail, and a little bit of US. I’ll cover this particular REIT in a future post.

I put this hypothetical 20-stock $100,000 portfolio together based on Friday’s closing prices. I started initially with a list of 30 stocks, and then painstakingly chopping it down to 20, although I’m the first to admit that investors should stick with 30 or more just to spread the eggs around.

As many know, the TSX composite is uncomfortably concentrated in the financial, energy and materials sectors. So, one of my main objectives is to diversify away from these them and place heavier emphasis on real estate, health care, consumer and pipeline stocks/income trusts.

Incidentally, I purposely left out Russel Metals, Manitoba Telecom, CIBC, National Bank or Bank of Montreal as I’m sure many were anticipating. The only high yielding dividend stock is Rothmans, which has a tradition of raising payout and occasionally rewarding shareholders with special dividends. Not to mention the business is recession resistant. But given the portfolio’s lofty 4.69% yield, we still have the buffer to add other lower yielding stocks like Talisman, Shoppers, Research In Motion and Potash without falling short of the 4% target.

I could be tweaking this portfolio all week long, but without further ado…

*** This is just a fun post. Do not interpret this as a recommendation to buy.

All right, that’s it! Those ETF bullies have tormented us dividend stock pickers long enough. I’m retaliating. My headgear is on. My gloves are strapped. Give me your best shot.

1. Less MER - In fact, buy-and-hold dividend investors pay no MER at all. Regrettably, iShares CDN LargeCap 60 ETF (XIU.to) and TD Canadian Index eSeries seize 0.17% and 0.31% respectively. Which means, dividend investors have a 0.17% to 0.31% head start each and every year.

2. More Diversified - Most investors refer to the other types of diversification: by sectors and by geographical locations. This is a non-issue for investors with 30 or more stocks. As long as your eggs are properly spread amongst different baskets, the portfolio will achieve similar volatility as the general market. At least one study found that 90% of the unsystematic risk can be diversified away with as little as 12 stocks.

Sure, diversification does alleviate uncertainties in a portfolio due to particular sectors or countries, but there is a much bigger monster in the room, and that is market sentiment. No matter how much you slice and dice your portfolio, all sectors are still subject to market sentiment. The past few months are a testament of how every sector limps along while the market is howling over its PMS. No one can escape the carnage. The way I see it, dividend investing is the only remedy to help us cruise through the turbulence while remaining fully invested in the stock market. Just look at Bank of Nova Scotia. It’s basically the same old boring bank as yesterday, last week, last month, last quarter and last year, but its 1 year chart resembles 6-flags roller coaster. All that while, their distribution policy is steady as she goes.

So, dividend investing offers you another dimension of diversification by easing reliant on market speculations, and rewarding you with real hard cash straight from the operations of your high-caliber businesses.

3. More Tax Efficient - A $35,000 salaried British Columbian profiting from a $5,000 capital gain must pony up an extra $615 in taxes. The same British Columbian receiving a $5,000 dividend would pocket a $175 tax refund. (That’s almost enough to pick up 4 more BNS shares!) So, ETF investors must overcome both the MER and the tax refund every year.

4. Extended Investment Horizon - Due to market sentiment described in point 2, ETF investors must gradually shift their equity exposure toward bond to protect their nest eggs from market volatility. Consequently, a 25 year old ETF investor may only have a 30 to 35 year weighted investment time horizon before reaching 65. This is a double whammy for them: the investments have less time to compound, and the turnovers create tax-drags against the portfolio return. And don’t forget that bonds are taxed as regular income.

On the other hand, dividend investors can prolong a carefully crafted portfolio because dividends are never at the mercy of market turbulence. By sticking to stocks with a history of rising dividends, or businesses that provide essential goods and services, you can afford to hang on to the portfolio longer. I think the best defense is the best offence. If anyone can prolong a dividend portfolio for 40 years, the dividend compounding coupled with the preferential tax treatment will deliver enough capital cushion to hold to the stocks forever.

5. Less Market Timing - Contrary to popular belief, a thoroughly hands off approach to investing is an illusion. Eventually, a retired ETF investor will have to live off his equities. Unless he turns over 100% of his portfolio to bonds (I smell capital gain taxes), the 4% withdrawal rule is going to pinch during bear markets. If hysteria sinks the market down 15%, can he afford to devour another 4% and erode his already undervalued capital? If euphoria drives the market up 15%, should he take out a little more in anticipation of a trend reversal? You see? There are so many crucial market timing decisions. Doesn’t sound to me like a relaxing golden age.

A retired dividend investor doesn’t need to fiddle with his portfolio whether the market is sad or happy, because the dividend stream is more dependable even when the market is tumbling. And courtesy to points 1, 3 and 4, a dividend portfolio should enter retirement with a much larger base and yield, and be able to outpace inflation and cushion any unforeseen dividend cuts.

Further reading: A brief history of high yield stocks

Psst! Did you know a British Columbian couple can earn as much as $99,200 in dividends and not pony up a dime for income tax? Legally?

BC is truly Canada’s most exhilarating province where the government begs you to splurge on mountain hiking, skiing, fishing, sailing, golfing and urban living, at least in Vancouver. Best of all, you can do all that tax-free with passively generated dividend income from qualified Canadian corporations.

What’s the secret to this tax-free nonsense?

Everyone, please hail to the power of dividend tax credit. Simply put, dividend tax credit (DTC) reduces the amount of tax you pay to the government. You can calculate this tax credit by following my post on How To Calculate Dividend Tax Credits. In a nutshell, all dividend incomes are “grossed-up” to 145% of the actual dividends received. In the eyes of the taxman, you earned 145% of the received dividends for the year. This sounds terrible, because the more money you earn, the more tax you pay. However, the DTC turns around and slashes your tax bill based on a combined federal and provincial rates. The federal DTC rate is fixed at 18.97%. On the other hand, the provincial DTC rate ranges anywhere from 6.65% in Newfoundland to 12% in British Columbia and New Brunswick.

If you’re like me, these calculations make you cross-eyed. To skip this dividend gobbledygook, surf to this online tax calculator from TaxTip.ca. To calculate your total tax payable, simply select your province at the top, and punch in the dividend amount at the “Cdn dividends eligible for enhanced div tax credit (public companies)” field.

I used to believe the first $66,000 in dividends is tax free until confronted with the sneaky Alternative Minimum Tax, which targets high earning individual awash with certain tax advantages. Some web sites are still quoting ~$66,000 as the maximum tax-free dividend earning in BC, but I’d be more than ecstatic if anyone can provide proof.

Probably the most hostile criticism to dividends is the how the 145% gross-up amount robs seniors from certain government supplements, most notably the Old Age Security. Seniors (over 65) can receive up to $502.31 per month from OAS, but problem is the government starts to hold back certain amount for seniors earning above $64,718, and the entire OAS payment vanishes completely by $104,903. The dividend gross-up amount is a real concern because it’d only take $44,634 in dividends to enter the $64,718 territory.

Despite the warning, I believe the pros outweigh the cons. Policies change from year to year, so you never know if OAS is sustainable amidst the dramatic aging population shift over the next few decades. Even then, the prudent course is to clasp the guaranteed tax-savings today, reinvest and compound the profits for years to come.

Reference:
How to optimize dividend tax income by Million Dollar Journey
The other way to retire by Canadian Dream

It seems everyone is busy writing down his/her New Year’s resolutions these days. This is a fabulous idea, and I’m not about to get left out of this party. I’m going to succumb to this boisterous bandwagon, only because publicizing one’s goals and signing them with blood is an effective way to hold oneself accountable, and accountability is what empowers us to make great strides through out 2008 in achieving our goals. I urge everyone to do the same either by conveying your 2008 resolutions to someone other than yourself (or your pets). Hey, be my guest if you’d like to announce them right here at Financial Jungle.

As long-time readers, you may have guessed this year’s theme is dividend investing. For 2008, my goal is to boost our monthly dividend income by $300 — from $1,560 to $1,860. $300 may sound miniscule, but in the context of 1 year, that’s a $3,600 raise, not to mention it’s passive and recurring. This figure is possibly more than my salary raise this year.

What’s my action plan? I anticipate attributing half of this increase to organic growth of dividend increases and smart dividend reinvestments. The other half will come from the sheer power of disciplined saving and investing. I figure the recipe to achieving this goal is to turbocharge our saving rate up from 36% to 43%. This means we must adhere to the following rules:

1. Brown bag our lunches once a week. (Too much of a shock to my system to brown bag every day.)
2. Sniff harder for vacation deals without sacrificing quality.
3. Target those “one-time” discretional expenses that contribute little to the quality of lives.
4. Top up the new RRSP contribution room with tax-inefficient income trusts from non-registered accounts.
5. Pray for decent salary increases.

If 2008 is anything like 2007, this year will again flash by before our eyes. If I squint hard enough, I can almost see the $300 hovering on the horizon. How is that to keep motivation sticky? Yes, living within your means still rocks!

Signed by Financial Jungle Guy, January 8th, 2008.

Let’s round up a few New Year’s resolutions from around the blogsphere.

• Where does all my money go - A New Year’s Resolution for 2008 if you carry high-interest debt
• Thicken My Wallet - 2008 Financial Goals
• Canadian Financial Stuff - Belated Happy and Prosperous New Year
• Million Dollar Journey - Financial and blog goals for 2008