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September’s Pick

Well, the scores have been assigned to identify our stock pick for September and the winner is… General Motors Company (NYSE: GM) or Ford Motor Company (NYSE: F). You choose. Maybe you like a tie and maybe you don’t, but here’s the scoop.

GM earned a higher score (14) than Ford (12) but they both offer strong reasons to own them. GM came out on top for its strong earnings (EPS is 7.82) but is trading at only 14% below the 52-week high. To be sure, that’s a decent discount for a solid company. Ford’s earnings are not as good (EPS is 2.25) but they are currently trading at over 21% below the 52-week high. That’s a much better sale! The dividend yield for the two companies is essentially the same at 4.78% and 4.82% so we left that factor out of our decision. The price of each company has been pretty flat for the last few months so when they begin to recover Ford has a greater potential for capital appreciation. That’s not something to ignore, especially if you get the benefit of the same dividend in the meantime.

Soooo, if you want a company that is earning more per share for you buy GM. If you want to add the potential capital appreciation of Ford to the dividend yield, choose Ford. Our strategy identifies potential stocks to purchase using an objective method of assigning scores for a variety of factors. If you’re a regular reader, you know that we don’t always just simply buy the stock with the highest score. The system identifies potential purchases from which we then make a choice. Because the dividend yields are the same, we’re going to hope for the greater eventual price increase with Ford so that’s our official pick. Honestly, whichever you choose, you can’t lose in the long run with these two.

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July’s Pick

Well, it ain’t GM. After recommending General Motors Company (NYSE: GM) for each of the last four months, we’re offering something different for July’s stock choice. Before we do, it’s important to be completely transparent and let you know that GM was actually tied again this month with another stock at 14 points each. If you’ve already built a position in GM based on our suggestions, go ahead and add to your holdings this month. It’s still a great-looking stock scoring 14 out of a possible 20 points. More on that later.

Our choice this month is MetLife, Inc (NYSE: MET). MetLife is paying a dividend of 4.05%, considerably less than the 5.26% you’ll get from GM. The P/E ratio for MetLife is 8.46 which is nearly double GM’s 4.33, meaning GM could be viewed as being a little better-priced. GM is also more profitable as measured by their EPS of 6.68 compared to 4.67 of MetLife. Ok, you might be wondering, “Ummm, then why are you going with MetLife instead of GM?” One main reason: MetLife is 32% off their 52-week high while GM is only 22% off theirs. That means MetLife is at a better sale price compared to what people were willing to pay over the last year. Put another way, the price of MetLife stock could appreciate more compared to that of GM in the next several months. We think that possibility will compensate for the lower dividend yield. To be clear, we don’t advocate buying a stock just because you think it might increase in value. That sounds an awful lot like acting on a ‘hot stock tip.’ That’s not the case here. We’re simply trying to choose between two solid, reliable companies and we’re using potential capital appreciation to break a tie. It’s worth noting that another minor advantage to buying MetLife this month is that it increases the diversity in our portfolio by adding an insurance company to the mix.

Honestly, we don’t think you could go wrong with either one of these companies. If you prefer the higher dividend yield of GM then buy them instead. Either way, you can sleep at night and that’s a really nice spot for investors like us to be.

Ever Wish You Had More Money?

“If only I had more money…” Ever heard yourself utter those words? If you only had more money you’d… Travel more? Save more for the kids’ education? Invest more? The trouble is, most of us can’t just demand a raise every time we want more money. Well, what if I told you there is a way you could make more money without asking for a raise and didn’t require getting a second job? Would you be interested?

Let’s do some math. Let’s say you live in Ontario and your taxable income is $60,000. That would make your marginal tax rate (the amount of tax you would pay on an additional dollar of income) 31%. That means you would need to earn an extra $1.45 for each additional $1 you want to take home (1.45 x 31% = 0.45). Now let’s turn that around. If you could save $1 it would be like earning an extra $1.45! Get it? You buy things with after-tax dollars which means if you buy something for $100, you had to earn $145 in order to make that purchase. If you can buy things on sale, it’s like earning more money. When you consider your marginal tax rate, it makes waiting for a sale price really appealing. Of course we all know you have more money in your pocket when you spend less, but we rarely stop to consider how much we actually had to earn in order to have that money in our pockets. When you do, it makes your money seem much more valuable.

Now let’s really make things interesting. Let’s see what happens if you take the money you saved and invest it in a tax-sheltered vehicle such as a RRSP. Like lots of men, I love a big screen TV. Basically, the bigger the better. If I’m considering a new TV that retails for $1000 but I wait for a 20% off sale, I save $200. Remember, I had to earn $1630 in order to spend $1000 in after-tax dollars (my marginal rate is 38.5%). The $200 I save during the 20% off sale represents $325 in additional earning.

Ok. If I then invest that $200 in my RRSP, I save $77 in income tax. In other words, I save $200 on the TV but the government gives me a tax refund of $77 which means my actual savings on the TV is $277 and the $200 contribution really only costs me $123! Oh yeah, and that $200 will continue to grow tax-free! Let’s not forget I also have a new TV! If you commit to saving 20% – or more – on everything you buy, it’s not hard to see how it can be an important pillar in your retirement strategy.

The Scoop on Dividend Taxes

Dividends are a great way to build passive income for a few reasons, one of which is the preferential tax treatment they get. Just knowing they enjoy this benefit is enough for some people, but others like to dig into how things work. If you’re a bit of a tax nerd, this post is for you!

dividends_taxRemember that a dividend is a portion of the earnings of a corporation that it pays to its shareholders. Corporations have already paid tax on the earnings they distribute as dividends so governments in Canada and the U.S. give shareholders a tax break on dividend income to avoid it being taxed twice. In Canada, dividends are grossed-up and qualify for a tax credit to “credit” you for the tax already paid by the company. In the U.S., dividends are taxed at a considerably lower rate than regular income to reflect the tax already paid by the corporation.

Here’s how it works in Canada. You have to convert the amount of your dividend to what it was worth before the corporation paid tax on it. This is done by grossing it up by 38% (i.e., multiplying it by 1.38). Next, you figure out how much tax you would expect to pay on that grossed-up amount, based on your marginal tax rate. Last, you subtract the dividend tax credit, which represents the tax already paid by the corporation. The net result is the tax you actually have to pay. For 2015, the federal tax credit in Canada is 15.02% of your taxable amount of dividends while the provincial credits vary by province (find them here). Note that we’re only discussing “eligible dividends;” that is, those paid by public corporations in Canada.

Let’s look at an example for Josh, who lives in Ontario. In 2015, Josh received $3,500 in eligible dividends. His grossed up amount is 3,500 x 1.38 = $4,830. Josh has to report this amount on Line 120 of his tax return. Because of Josh’s employment income, his dividends are taxed at the 22% marginal rate and his provincial tax rate in Ontario is 9.15%. Josh’s federal and provincial tax payable would be $1,062.60 and $441.95, respectively, for a total of $1,504.55. Now he subtracts his federal tax credit of $725.47 (4830 x 15.02%) and his provincial credit of $483 (4830 x 10% – the Ontario rate) to find his actual tax liability is only $296.08. This is an effective rate of 8.4%!!! (296/3500)

The math looks like this:

Dividends $3,500.00 (A)
Grossed up amount (A x 1.38) $4,830.00 (B)
Federal tax (B x 0.22) $1,062.60 (D)
Provincial tax (B x 0.0915) $441.95 (E)
Federal dividend tax credit (B x 0.1502) $725.47 (F)
Provincial dividend tax credit (B x 0.10) $483.00 (G)
Tax payable (D + E – F – G) $296.08

In the U.S. the situation is a little different in that there is a period of time (called the holding period) that you must own the stock before you have to pay tax on dividends you receive. Because we tend to hold shares for the long term we’ll ignore this restriction. Other than that, the calculation is actually easier than is the case in Canada. Dividends are tax-free for amounts in the 10% and 15% brackets, taxed at 15% for those in the 25% up to 35% tax brackets and taxed at a 20% rate for people above the 35% tax bracket.

Here’s an example: Rebecca’s salary puts her in the 25% tax bracket and she collected $4300 in dividends in 2015. While her other income is taxed at 25%, her dividends would be taxed at only 15%.

I should point out that if your shares are held inside a tax-free investment vehicle (like a RSP or TFSA in Canada or an IRA in the U.S.) the tax-preferred status is irrelevant because your dividends are sheltered from tax anyway. The bottom line is that dividends enjoy preferential tax treatment and paying less tax is a great way to build wealth!

The Benefits of Dividends

While there are lots of ways to earn passive income (writing a book, selling a product online, affiliate marketing, real estate, etc.), we prefer dividends for three reasons:

  1. They’re the most passive we can think of.
  2. The benefits of DRIP (or equivalent) investing.
  3. Their preferential tax treatment.

Let’s talk a little about each of these. First, they’re truly passive. Other than a little work a couple of times a year to choose a stock to buy, you shouldn’t be spending any time managing or worrying about your portfolio. We’re buying companies that are stable and we’re in the market for the long term, which means at least five years. Take a look at what the S&P 100 index has done since 1982.

SP100_history

Notice a trend? Sure, there are periods when the index drops significantly (that’s called a correction), but the recovery follows soon after. Check out the Dow Jones Industrial Average over a similar period.

DJIA_history

Same trend! Pick nearly any 5 year period you like and you’d have made money. In other words, if you’re in the market for the long term rather than trying to get in and out at the best times (we call that timing the market) you really can’t lose. Basically, don’t worry about it. Buy a good company and hold it – forever.

Second, the advantages of DRIP investing. A DRIP (dividend reinvestment plan) allows you to use the dividends you receive to purchase additional shares in the company with no trade fee. If you don’t need the cash from the dividends this is a great idea because those additional shares are also eligible to earn dividends in the future. The compound growth that occurs is a powerful way to grow your portfolio. Sometimes, your broker will even offer a discount on shares purchased in a DRIP. These plans are automatic so, again, completely passive. Let’s look at an example. Imagine you have 100 shares of ACME Widgets that are trading for $40 per share and pay a quarterly dividend of $0.50 (5%). In the first quarter, you would be paid a dividend of $50. In a DRIP, $40 of that dividend would be used to buy an additional share and the remaining $10 would be collected in cash. In the next quarter, you’d own 101 shares so you would be paid a dividend of $50.50. Again, you would buy another share in the DRIP and receive the difference in cash. At the end of the fourth quarter, you would own 104 shares and have $43 in cash. If we imagine the stock price was still $40, your effective rate of return for the year would be 5.1%.

Third, preferential tax treatment. Dividends are paid out of the after-tax profits of the company (i.e., they’ve already paid tax on them) so it wouldn’t be fair for the shareholder to also pay full tax. In Canada, dividends are grossed-up and qualify for a tax credit to “credit” you for the tax already paid by the company. In the U.S. dividends  are taxed at a considerably lower rate than regular income. In a later post we’ll describe the preferential treatment of dividends in detail.

So there you have it. The reasons we love dividends. We think you should too!

Choosing a Stock – Part 8: Let’s Practice Scoring

By now, you’re familiar with how we score stocks for our monthly recommendations. In this post we’re going to use General Motors Company to practice scoring so you can see how easy it really is. One of the goals of this blog to empower you to take control of your financial future by investing your money by yourself. It’s really not that scary and, with a few basic rules, pretty safe.

scoring_stocks_gm

This is a screen capture from Google Finance on March 14, 2016 (https://www.google.com/finance). To use our system, this is all you need. No need to worry about complicated stock analysis or expensive “hot” stock tip newsletters. Remember, the companies on the S&P 100 are all big, established companies so they’re all pretty safe. All we’re trying to do is pick the best company at the time from a list of great companies. If we do that we’ll also achieve our other goal – to sleep well at night. Let’s use the data from Google Finance to score GM.

The stock is currently trading at 20% below the 52-week high ((38.99-31.18)/38.99). In other words, it’s on sale for 20% off. It’s only fair to point out that lots of other stocks on the S&P 100 were more than 20% off their high but we’re just using GM as an example and sale price is only one of the factors we consider. We give it a score of 3 for being on sale (Choosing a Stock – Part 3: Buy on Sale). The dividend is 4.87% ((0.38 x 4)/31.18). Most online services calculate that automatically for you which saves some paper and pencil work. It earns a score of 4 for the dividend yield (Choosing a stock – Part 2: It’s all about the dividend!). The P/E ratio is 5.19 and the EPS is 6 which get scores of 5 (Choosing a stock – Part 5: Does the company deserve the price?) and 2 (Choosing a stock – Part 6: How much of the value will be mine?), respectively. Those scores add to 14 (3 + 4 + 5 + 2). On it’s own, that score means very little, but with experience you’ll learn that it’s actually really good – usually the top stocks score between 13 and 16. If you did the same for all the stocks on the list, you’d see that, for March, GM tied with three other companies that month – Potash Corporation of Saskatchewan (TSE: POT), Metlife, Inc (NYSE: MET), and Banco Santander (NYSE: SAN). Of those three, we recommended GM because Potash Corp is experiencing continued uncertainty in the price of potash and Santander is a bank in a foreign market – both riskier than we like to suggest. Neither of those is on the S&P 100 either so we don’t recommend those unless you are able to tolerate a little more risk. While Metlife was a little farther off its 52-week high, it paid a dividend of only 3.74% compared to the 5.2% (at that time) GM offered. BTW, GM is up 6% since we recommended it two weeks ago and Metlife is up 7% so you wouldn’t have gone wrong with either of them. Just sayin’.

We’re convinced (and our track record proves it if you check out our portfolio details) that you could do quite well following our simple system. Of course, if you really like this kind of thing and don’t mind spending some more time you can do more in-depth analyses of stocks but we recognize that most of us would simply rather spend our time doing lots of other things we enjoy. The appeal of our method is simplicity. The idea is passive income, after all.

Choosing a Stock – Part 7: Scoring

If you managed to stay with me through the last 6 entries, you’re familiar with the technique I use for choosing a stock. Now let’s get practical and look at how I actually apply the scoring system.

First, I find the latest price, 52 week high and low, dividend payment, P/E and EPS for shares of each company on the S&P 100. I use RBC Direct Investing (http://www.rbcdirectinvesting.com/) because it’s my online broker but you can use any site that appeals to you. Google Finance (https://www.google.ca/finance) is great and Yahoo Finance (http://finance.yahoo.com/) is another good choice that’s easy to use but there are plenty more.

scoringI have an Excel spreadsheet which lists all the companies on the S&P 100 (including any I’m considering that are not on that list) and has a column for each of the factors we’re using. There are also columns for dividend yield, % below the 52 week high and % above the 52 week low.

Now for assigning the scores. I start by sorting the companies in order of decreasing dividend yield so that I can easily assign the dividend score to each one. I use a simple 5 point scale as in the table below:

Score Yield (%) % below 52 week high P/E EPS
5 6 or greater 30 or greater 10.0 or less 15 or greater
4 4.5-5.9 25.0-29.9 10.1-12.9 10.0-14.9
3 3.5-4.4 20.0-24.9 13.0-14.9 7.0-9.9
2 – 10.0-19.9 15.0-16.9 5.0-6.9
1 – – 17.0-20.0 4.0-4.9

Notice I don’t consider a stock that pays a dividend of less than 3.5%. There are always great deals on companies that pay higher dividends so why choose a lower-paying one? Once this step is complete, I sort the stocks by the % below the 52 week high and assign scores for that. I continue doing this for each factor in turn until scores have been assigned for all the factors, then I simply add up the scores for each stock.

In a perfect world, the stock with the highest score would always be the stock to buy but, unfortunately, we don’t live in a perfect world. Rather, the score highlights the top options but you might need to decide between a few of the top contenders. My preference is usually for a stock which is currently at the deepest discount. Remember, we never consider a company that doesn’t pay a good dividend so it makes sense to take advantage of the potential growth in share price of a stock that is beaten down. I have found that this system really helps to removes the emotional or subjective element in choosing a company by using hard numbers to narrow down the options to just a few.

I don’t always assign a score for the % above the 52-week low. To be honest, that metric only becomes useful when a stock is sliding in price and you want to see if it has started to rebound. A stock that is barely above the 52-week low might still be falling and we want to buy when it is still on sale but recovering. A later version of my system might assign a score based on the 52-week low but for now it’s really not one to worry too much about. Check back for our next post where we’ll use the system to score a real stock to get some practice using the system.

Choosing a stock – Part 6: How much of the value will be mine?

In the last entry we talked about using the P/E ratio to help us determine if the current stock price is overvalued. Let’s now take a look at another measure that lets us see how much of the company’s value will be ours as a shareholder. This is the earnings per share (or EPS).

choosing a stock 6If we think of the P/E ratio as being the number of positive reviews our prospective purchase has, the EPS tells us how many of the total number of reviews these positive ones represent. Think again about online reviews posted by customers. For any product we might be considering, there are generally three categories it can be in (if we ignore bad products with only negative reviews). First, it might have lots of reviews that are all positive. This is a stock that has a great (i.e., low) P/E ratio. We like those. Second, it might have only positive reviews but they have been posted by few customers. This is a stock with a poor (i.e., high) P/E ratio. We want to avoid those. Third, it might have lots and lots of reviews but they’re mixed. In order to make our decision we have to decide what fraction of those reviews need to be positive for us to feel comfortable making the purchase. The EPS can help inform our decision.

EPS tells us the portion of a company’s profit allocated to each outstanding share. In other words, how much money does the company make compared to how many shares are out there. This is like asking “how many of the reviews are positive?” If the EPS of company A are higher than those of company B, company A generates more money per share, and, as a shareholder, you own part of that income. Experts will say that EPS is the single most important factor in determining  a share’s price, but as buyers of blue chip companies on the S&P 100 we needn’t be very concerned about it. It’s more important to institutional investors and speculators who might be making decisions to own a stock for the short term. That’s not us. As with the other 4 factors, I assign a score to each company on the S&P 100 but, admittedly, I put less weight on EPS than the others. These established companies are long-lived because they’ve shown the ability to be profitable. EPS serves as a good tie-breaker if I need it.

That’s it. That’s how I choose a stock. By considering these five factors, each stock earns a score and, often, the stock with the highest score wins. That’s the one I buy. In the next post we’ll look at the scoring system I use and practice applying it using an example.

Choosing a stock – Part 5: Does the company deserve the price?

I have to admit that the metrics we discussed in the previous three posts (the dividend return, whether  the stock is on sale, and the percentage above the 52 week low) are the most important for me and, of those three,  the first two are the most important. When I’m buying my piece of camping gear, I want a trustworthy company that offers a good-quality product and I want to buy it on sale. On sale or not, I also want to know whether the value of the product warrants the price. To help me make the best decision, I routinely read customer reviews online. What better way to judge the quality of something than to read the opinion of others who have purchased the same item. If the item seems a little pricey (even on sale) but lots of people have reviewed it favorably, I might go ahead and spend the money. If, on the other hand, the reviews are positive but only a few people have written a review, I might think twice. Some people might purchase the product at that inflated price based on a handful of positive reviews but, sooner or later, the supplier will realize that shoppers think the item is over-priced for what they’re getting and they’ll have to drop the price.

choosing a stock 5How do we figure this out when it comes to buying stocks? Shareholders don’t write reviews after buying shares but there is a way they indirectly tell us what they think of the value of the company – it’s the price-to-earnings ratio (or P/E). This is the ratio of the company’s share price to its earnings per share. In other words, it’s a way of comparing the ability of the company to earn money (certainly an important way of determining value) to how much people are willing to pay for a share. To calculate the P/E, we take the current stock price and divide by its earnings per share (or EPS). The P/E allows us to evaluate what people are willing to pay for one dollar of the company’s earnings. In the Telus example, the P/E is 15.4 which means you’re paying $15.40 for every dollar of earnings the company generates. We can think of the P/E as a way of asking “does the company make enough money to warrant the price of the stock?” A low P/E is like a product with lots of positive reviews – it’s good quality at a good price.  A high P/E means the stock price could be out of whack with the earnings of the company and, eventually, people will realize that and the price will experience a correction – possibly a major one.

Sometimes share prices are affected by speculation on events which might happen in the company’s future. Maybe they’re releasing a hot new product that is expected to do well and their share price takes off as investors drive it up in anticipation. What if that hot new product turns out to be a dud? We want to avoid buying that stock at an inflated price and then suffering through the correction. Of course, lots of people have made lots of money speculating on future prices but we aren’t interested in risking our money. It`s easy to find headlines online like “5 Stocks Set to Double This Year” or “Stock Secrets Insiders Don’t Want You to Know.” Don’t be fooled – nobody can predict what a share price will do. We want to play it safe by making purchases to hold for the long term and then sleeping well at night. As with the other factors, I assign a score to each stock on the S&P 100 based on the P/E. Remember that a low P/E is good so high scores are awarded to stocks with low ratios.

My strategy makes it unlikely to get fooled by a temporary volatility in a stock price because I’ve already considered the 52 week high and low so we know how the price has behaved recently. Still, it is possible that a stock price was dramatically inflated sometime over the last year (thereby increasing the 52 week high) while being currently well below that (thereby seeming to be on sale) and still be overvalued (i.e., has a high P/E). There are lots of companies on the S&P 100 so why take a chance?

Choosing a stock – Part 4: Don’t buy if the price will be better next week.

So far we’ve looked at two of the five factors I think are important in choosing a stock. Hopefully you agree that the system seems quite simple and requires very little time. Remember, the name of this blog is Passive Dividend Income. I don’t want to spend too much time or effort on this and I certainly don’t want to have to think about my portfolio all the time. I invest a little time in choosing a stock and then pretty much forget about it until it’s time to buy again, letting that small investment pay dividends in the future. Ok, I couldn’t resist that pun. In the last entry we talked about buying a stock that’s on sale. Now let’s talk about making sure there won’t be a better sale on that stock in the future.

Back to our analogy. I’ve picked the supplier I want to buy from, I’ve found the item I want and now I’m checking to see if it’s on sale. I’m in luck! It is. The trouble is, how do I know this is the best price I can get? In other words, what if I buy it now and then it goes on sale the following week at a deeper discount? Oh, the horror! Last time we learned we can determine if the stock is on sale by comparing the current price to the 52 week high. As with the camping gear, how do I know this is the lowest the price will go? I don’t. But what I can know is how the current price compares to the lowest price people have paid in the last year (known as the 52 week low).

picking_a_stock_part_4Time for another calculation. For each company on the S&P 100 I figure out how far above the 52 week low it is. This gives me an idea of whether the sale price is the best price for this stock or if it’s likely to go lower in the future. In the example at the left, we see the stock is 0.8% above the 52 week low. This is exceptionally close to its 52 week low which means that, while it’s still on sale, the price could go lower still. In other words, if the stock were trading at, say, 10% higher than the 52 week low, it suggests that the price is recovering. To be sure, we could simply look at the price history for the last few weeks. Lots of websites provide that kind of information but the charts at www.google.com/finance are especially easy to use.

A stock that is far from the 52 week low is not at the best sale price anymore. Remember, share prices fluctuate between the 52 week high and 52 week low. Our goal is to try and buy when they are far below the high but not yet far above the low. Incidentally, being a little above the 52 week low also suggests the price is recovering and less likely to go lower after I buy it. I’m a little wary of stocks that are at their 52 week low for that very reason.

Of course, lots of things affect share prices but these are big, blue chip companies with high daily trading volumes that are being bought and sold by lots of institutional investors so the prices don’t move very much day-to-day. Lots of people are doing in depth analyses of company valuations which means we don’t have to – thankfully! We can let the price history be our guide to what people are willing to pay now and what they might pay in the future. While our long-term focus is dividend income, we’d like to see growth in the value of the stock too!

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