Monthly Archives: December 2015

Choosing a stock – Part 2: It’s all about the dividend!

Our last post described the first criterion we use when choosing a stock to buy. We stick to companies listed on the S&P 100. These are safe, solid companies that have a proven track record. They’re not going to post meteoric gains but won’t you lose any sleep worrying about the bottom falling out either. The name of this blog is, after all, Passive Dividend Income, so we don’t want to be spending lots of time working on or worrying about our portfolio. Having said that, let’s move on to step 2.

dividendsRemember our analogy of purchasing a piece of camping equipment (or whatever you want to imagine buying)? We decided to buy from a major supplier – one we feel we can count on to be there if we need them. What else do I want from my purchase? I want the equipment to last so I can enjoy it for years to come. I want it to ADD value to my experience. This is like the dividend a company pays – it’s going to add to the value of my portfolio and, when it comes time to retire, is going to provide the income I’m looking for.

Some companies choose to distribute a portion of their earnings to their shareholders. This is called a dividend. Our goal is to build a stream of income from our investment portfolio and this income will be in the form of dividends. That means it’s important to choose stocks that pay the highest rate. As you learn more about companies on the S&P 100 you’ll see that most of them pay a quarterly dividend but you’ll soon discover that the rate of return of those dividends vary considerably from company to company.

For example, on December  AT&T Inc (T:NYSE) closed at 34.64 and paid a quarterly dividend of $0.48 which is a return of 5.5% (0.48 x 4 times/year divided by 34.64). This means for every $1000 you invest in this stock, you’d be paid $55 in dividends. By contrast, on the same date FedEx closed at $149.65 and paid a quarterly dividend of $0.25 which is a return of 0.67%. For every $1000 you invest in FedEx, you’d be paid $6.70 in dividends. As you can see, the stock you choose makes a HUGE difference. The first step in our strategy is to look up the dividend for every company on the S&P 100 and assign a score to each one based on the dividend it pays. While this score is mostly arbitrary, it serves as a means of ranking the companies based on several factors (the dividend is only one of 5 factors we consider) that we use to make a choice. It’s a way of removing emotion and bias from our investing choices. We’ll see the criteria for assigning scores in a later post.

And that’s step 2. Short and simple. Buy shares in companies that pay the best dividends.

Choosing a stock – Part 1: Stick to the S&P 100

A few years ago I realized that I had to change my investment strategy. Until that time I had been playing pretty fast and loose with my investment dollars. I was choosing risky stocks and riding the excitement of the big wins while mostly pretending the big losses didn’t happen. Sure, I was coming ahead overall but I knew one big loser could wipe out my capital. As I got older I recognized that I had less time to take advantage of compound growth to accumulate wealth and I had to start looking for a safer alternative.

stock_marketThat’s when I started working on my own strategy for choosing stocks. I have to disclose that I have no formal education or training in stock investing or financial advice but I do know that nobody cares more about my money than I do! I took it upon myself to start learning everything I could about the stock market and evaluating a stock. Let’s just say that didn’t go well. There were all kinds of factors to consider: beta, price/book ratio, return on equity, net profit margin, EBITDA, blah, blah, blah. When I wasn’t falling asleep reading about all that stuff I was worried about being in over my head and that it would never make sense to me. I quickly realized as an amateur I was going to have to dramatically simplify things so I began trying to figure out what the most important things were.

Maybe I could think about choosing a stock like making any other purchase. What are the factors I consider when buying other things? A car, a TV, a mobile phone, whatever. I like to go backcountry camping whenever I can and that hobby requires some special gear which I’ve slowly acquired over the years. I wondered, when I’m thinking about a new piece of gear, what things do I consider when reaching a decision? First, I want to buy from a company with an established reputation I can trust. I want a company that has proved its longevity and is going to be there if I have a problem. I’m likely going to stick with suppliers like Cabella’s, MEC, or REI and manufacturers such as Patagonia, Marmot, or Arc’teryx.

In the world of stock market investing, we’re talking about the companies on the S&P 100. Companies on that list represent a variety of sectors and account for about 57% of the market capitalization of the S&P 500 (a similar index containing a greater number of companies) and almost 45% of the entire market capitalization of the U.S. equity markets. The stocks in the S&P 100 tend to be the largest and most established companies in the S&P 500. These companies have proven themselves worthy of inclusion on that list and that makes me very comfortable buying them. They’re companies we’ve all heard of. They are Coca Cola, Wal-Mart, Microsoft, AT&T and 3M. Take a look at the list and you’ll recognize many of them. Do I occasionally find a deal so great that I stray from a really well-known camping equipment company and take a chance? Of course! But mostly, I’m sticking with the big guys. That’s also true of picking a stock. Once I gained a little confidence – acquired from seeing the performance of my portfolio – I started to occasionally branch out into companies that aren’t on the S&P 100 if I thought they presented an opportunity. More about that in a later post.

So that’s Step 1. Stick to well-known companies that are listed on the S&P 100. They’re solid, safe, blue chip stocks that have a proven track record.

When doubling a dividend might not be all it seems…

Let’s start out by saying we’re HUGE fans of The Motley Fool. Tom and David Gardner believe in taking a long-term outlook on picking good companies and they’ve done very well at it! On December 10, a post written by Sean Williams recommended three stocks with dividend payments that might double in 2016. That’s right – double! If you’re like us, the thought of a dividend payment from a solid company doubling is pretty exciting. When we took a closer look, however, things weren’t quite as exciting as they first seemed.

The Motley FoolSean’s recommendations were Amgen (NASDAQ:AMGN), Littelfuse (NASDAQ:LFUS) and Allegiant Travel (NASDAQ:ALGT). We’re not disagreeing with any of the reasons for his prediction (you can read those for yourself if you like) but, rather, pointing out why these would not be companies we would pick right now. Amgen is currently trading only 13% below the 52 week high so it’s not at a bargain price right now and it’s current dividend of 2% doesn’t meet our minimum of 3%. Littelfuse is also not on sale as its trading very close to it’s 52 week high and with a current dividend of 1% it wouldn’t make our cut even if it did double – which nobody can say for sure that it will – so it’s out. Finally, Allegiant Travel does offer an attractive price right now at 27% below the 52 week high and even boasts middle of the road P/E and EPS of 17.56 and 9.91, respectively. It falls short of the dividend target though by paying only 0.69%. For a strategy that focuses on dividends, that’s an abysmal choice!

So what, exactly, are we trying to say? Simply, just because you read that a company could possibly double its dividend doesn’t mean you should own the stock. Even if a source you trust – like the guys at Motley Fool – recommends it, take some time to do a little thinking of your own. On these three, we pass.

December’s pick

This month we’re buying International Business Machines (NYSE: IBM). After all the scores had been assigned, there were a couple of really attractive options this month. Williams Companies Inc (NYSE: WMB) and Caterpillar (NYSE: CAT) had scores of 10 each, but IBM came out in the top spot with a score of 13. WMB is trading 41% below the 52 week high which is a great sale, but continued uncertainty in the energy sector means it might go lower still so could be a better buy later. It also offers an awesome dividend yield of 7.1% but we managed to resist that
siren call.
ibmCAT is trading 32% below its 52 week high and the dividend is 4.3%, significantly higher than IBM’s 3.8%, making it another attractive choice.

We don’t always automatically buy the stock with the highest score because there are always other factors, beside the five financials we look at, to consider.

Despite what both WMB and CAT have to offer, we went with IBM for three reasons:

  1. At a P/E of 9.1 it seems undervalued so offers a better buy for the price. CAT’s P/E is 14.8.
  2. The EPS is 14.57 compared to CAT’s 4.82 – a big difference – which means IBM is earning more money per share.
  3. Warren Buffett continues to add to his position in IBM (Berkshire Hathaway now owns over 8% of IBM’s outstanding shares). ‘Nuff said?

Remember, while we favor dividend income, we also want to protect and grow our capital, which is why we chose to go with the promise of growth in IBM’s price over the dividend yield of WMB. I’m sure WMB will remain on our radar and will likely be a strong contender in the months to come.