Separation Anxiety

I am often asked what I like best about dividends. I will detail my position here.
In the investing world, there are basically two ways to make money:
a) The first and most popular way is to buy something when it is cheap and sell it at a higher price later (buy low, sell high). This is the method of trying to achieve capital gains through well timed purchases and sales. It is akin to killing off your cattle to sell their beef, or to cut down your trees to sell their lumber.
b) The second way is to achieve cash flow through purchasing productive assets. This can be done in the same way that a dairy farmer milks his cows perpetually to simply sell the milk, or likewise the owner of an apple orchard who collects and sells the apples from his growing apple trees rather than cutting them down for their lumber. Dividends live here.

So, it becomes a matter of Capital Gains vs. Cash Flow (Dividends) – though over time an investor is likely to experience both.

When you own a company whose future prospects you believe in, it is in your interest to want to continue to hold those shares. Wealth builders through history have been “accumulators”. The way to achieve lasting financial strength is to continue to accumulate productive assets over time. This leads me to my first point.
1) Separation anxiety; aligning your interests with your company.
The problem with trying to achieve capital gains with a company that does not pay a dividend is that some day you will need to sell your position in the company to get any benefit from having owned the shares. I view myself very much as a stakeholder in the companies I own. I believe in their future wellbeing. As such, when I buy a company, I hope to never have to sell it. When I am paid my regular dividend, I believe that my interests and the company’s interests are aligned. We are able to grow together over time.
Selling my shares would mean I would have to end my investing relationship with the company (or lessen it, at least, if I sold only some of my shares). With every purchase I make, I genuinely hope that those shares will be in my final Will some day. Though I will indeed sell my shares if the story changes, that is never my intention at the time of purchase.

Over the very long term, companies typically trade in what might be regarded as a fair range as to their value. In the short run, however, the stock market is incredibly volatile and is traded emotionally. So, my second point:
2) Dividends are more stable than share prices.
Dividends are determined by a company’s fundamentals and future prospects while the stock price may be influenced by any number of factors – many of which may have no specific bearing on the particular company itself. Chasing capital gains can be a tricky business as even if you identify that a stock is overvalued, that does not mean it will go down any time soon. Investors trying to buy low and sell high often suffer from the long periods of time that they need to wait to be “proven right” by the market.
The passive dividend investor who is satisfied with the stocks they own is able to sit back and let the tidal wave of the stock market ebb and flow while they collect their money.

From studying businesses over many years, I have seen companies go on countless acquisition sprees to expand their empires. They often reach far beyond their “circle of competence” (as Warren Buffett would say) and try to operate businesses that are distinct from what they currently do. This can be a destroyer of shareholder wealth and brings me to the final reason I will share today that I love dividends:
3) Restraint on management.
Dividends impose restraint on management. Once a company has initiated a dividend policy and increased their payout for a decade or longer, it becomes a part of the culture. It becomes one of the last things that a company would want to tamper with. Knowing that a dividend must be paid and increased annually, management becomes less prone to going on wild expansion ventures and tends to be more careful with investor dollars.
Even with the slew of recall issues Johnson and Johnson (NYSE: JNJ) has had over the past few years, I doubt whether they even considered touching their dividend payout –even behind closed doors.

So, for investors like me who suffer from “separation anxiety”, the best plan of action is to own quality, dividend growth stocks for the long term and collect an ever-increasing cash flow.

Full Disclosure: Long JNJ

Warren Buffett's Letter to Shareholders, 2012

Warren Buffett releases a Letter to Shareholders to those with a stake in Berkshire Hathaway (NYSE: BRK.B) each year. Though this year’s letter was released several months ago, I have been reading through it again recently and I will provide some commentary on sections that have caught my eye.

Outperformance...
Buffett notes at the outset of the letter that Berkshire Hathaway has outperformed the S&P 500 Index in every five-year period since 1965 when he assumed control of the company (Page 3). At the same time, Berkshire Hathaway tends to underperform in a rising market. As such, Buffett indicates that if the markets continue their unprecedented rise that they have been enjoying since the bottoms of 2009, the S&P 500 may actually achieve a five-year outperformance against him.

One thing I enjoy most about Buffett is that he sets a target (such as outperforming the S&P 500 Index) and sticks to it. Year over year, his tune remains much the same and we never need worry about being surprised by him shifting his alleged goals to make himself appear in a better light. This yardstick that he uses is a clear indicator of his job as a manager. In his view, if he cannot beat a simple benchmark index, then the average investor would be no better served by trusting him with their money than simply buying the index.

Due to Berkshire’s financial strength, I would prefer to have a position in it rather than the broader S&P 500 Index. To me, it is how an investor performs in a lagging or declining market that counts most. The comfort of knowing that my wealth will not be wiped out with one catastrophic event is worth more to me than trying to outpace everyone else during a “good” market or rising tide.

Major Acquisitions...
This year, Berkshire assumed a fifty percent stake in a holding company that now owns all of Heinz, which is best known for its ketchup (Page 4). While Berkshire certainly “paid up” for this acquisition, Heinz is a stable business and this meshes perfectly with Buffett’s overall strategy of being willing to pay a fair price for a solid, well-positioned brand.

America’s Future...
Time was spent in this year’s letter with the hopeful note of Buffett offering his view that American business will continue to do well long into the future. Uncertainty will always be there to rear its head at investors, but that is what makes the market. Different parties taking different sides is what moves the ticker, but Buffett is willing to continue to bet on business fundamentals and the American dream of future prosperity. I tend to agree with him.

Railroads...
Buffett discusses the economy of railroads at length, and this section is well worth reading in its entirety. One statistic that truly stands out is that Burlington Northern Santa Fe (owned by Berkshire) actually moves a ton of freight around 500 miles on one gallon of fuel while “trucks taking on the same job guzzle about four times as much fuel” (Page 10). That is certainly efficient both in terms of dollars on Berkshire’s end and also a big plus on the environmental side of things.

Further, once tracks are down, it is very unlikely for new entrants to enter the market and compete. So, once a railroad has their line set, they do not need to fear constant competition eroding their ability to sustain profitability (they have a moat, as Buffett would say).

The railroad business offers one extra advantage to Berkshire Hathaway as well; a place to invest its free cash flow. Berkshire has many businesses that kick off loads of excess cash. Owning a capital-intensive railroad offers the perfect outlet for some of that cash flow.

Changing of the guard...
Berkshire’s stock portfolio, which notably has large stakes in The Coca-Cola Company (NYSE: KO) and the American Express Company (NYSE: AXP), has always been managed by Buffett. Given that Buffett is getting older, Berkshire has taken steps to assure the company will continue into the future on a well-guided path. As such, Todd Combs and Ted Weschler now have been given the reins to make investments of their own, on behalf of Berkshire (Page 15). This is a relatively newer development for Berkshire and one to watch closely in order to discern the money management style of these two investors.

Dividends...
This year’s letter included a section explicitly on dividends and a discussion as to why Berkshire does not pay one. Buffett discusses each of the intelligent uses of capital that a company may employ, including share repurchases, reinvesting in businesses already owned, purchasing businesses outside of their current industries, as well as paying out a dividend.

Buffett ultimately concludes that shareholders of Berkshire are currently best served by the company retaining all earnings to build future growth as they have in the past (Pages 19-21). That said, he leaves the door open to the possibility of future dividends should those within Berkshire believe it to be in the best interest of shareholders at some point in time. Though I am generally largely in favor of dividends being paid, I am willing to grant Buffett the benefit of the doubt given his extensive and successful track record. Without such a dividend, however, I have not yet initiated any position Berkshire – though it is a possibility down the road.

You can find all of these Letters to Shareholders at www.BerkshireHathaway.com. Please read them.

Full Disclosure: Long KO. No position in BRK.B or AXP and no intention to initiate one within the next 72 hours.

Adding To My Bell Canada Position

Bell Canada (BCE) is a Canadian telecommunications company. It is the largest of the “Big Three” comprising Bell, Telus (T), and Rogers (RCI.B).

Already having a sizeable allocation to Bell within my portfolio, I decided recently to add to my position with additional funds as opposed to only the reinvested dividends the company sends me. My current purchase will add roughly 25% more shares to my Bell position.

So why did I do it?
Bell is currently trading at around $42 per share and yields just over 5.5% at the moment in the form of a quarterly dividend. In the current environment, I am quite content to acquire more shares of a very solid performer in Bell with future growth prospects that I believe to be appealing, at a price that is reasonable.

Over time, I expect Bell to continue increasing its dividend at least once per year. With a starting yield of 5.5% and reinvested dividends, even modest annual dividend growth in the 4-7% range will produce a sizeable future cash flow fifteen or twenty years down the road.

In addition, the money I used to increase my position came from dividends that were accumulating in my account already from dividends from other companies. This means that I did not need to add additional funds to my brokerage account to pay for these shares. In effect, this allowed me to “play with the house’s money” while increasing my stake in a quality enterprise.

How did I do it?
Bell had been trading just slightly above the price at which I wanted to pay for it over a period of a few weeks. I wanted a starting yield of 5.5% for my new shares, so I simply set a limit price that would make this possible and waited. I set the expiration on the order a month out, after which time I would re-evaluate if Bell shares never dropped below my target. If the order expired, I would have missed out on acquiring more shares (or I could have just opened a new contract at that time). This was not a real concern of mine, as the stock market tends to gyrate significantly enough to give the patient investor the opportunity to shop at a bargain.

Having now added to my position in Bell, I do not foresee any future additions in this sector for some time. I will allow my dividends to continue reinvesting themselves to passively grow my stake, but new funds will not be provided.

Risks to my assessment?
Verzion (NYSE: VZ), the behemoth telecom from the U.S. has been eyeing the Canadian marketplace. It has expressed interest in purchasing Wind Mobile and Mobilicity here in Canada. Assuming it was able to dip its fingers into Canada (amid protests from Canada’s Big Three), this would be viewed as a serious threat to the current establishment. If Verizon comes to Canada, I would expect each of the Big Three companies to take a hit on the stock market as analysts revise their estimates downward in light of a fourth large competitor in the marketplace.

Even with the knowledge that Verizon may attempt to invade Canada, I still feel comfortable investing in Bell. The thing with the future is that it is always uncertainty. The investor who waits to have all the facts about what is going to happen will live forever on the sidelines. Bell is a solid company now and still would be if Verizon arrives on the North side of the border. If Verizon decides to stay at home, then that will only further strengthen the bet I have made on BCE.

Full Disclosure: Long BCE