Thursday, July 9, 2015

The Power Of Dividend Investing [Part 2] - Choosing the right stocks for dividend investing

Dividend investing helps us create passive income so we can achieve financial independence. In my previous article, I wrote on the benefits of dividend investing and how we can essentially get more than 10% yield on our investment. You can read part 1 here: The Power Of Dividend Investing [Part 1]

Credit: Wikipedia

The question now would be, how do we pick the right dividend stocks for successful dividend investing? Let's take a look at some criterias for dividend investing in part 2 of this series. But before we get right into it, let me show you the pitfalls to avoid using the story of this once hot stock listed on the Singapore exchange.

Pick the wrong stocks and suffer

As with all investments, if we do it the wrong way, we would lose money. This is the same for dividend investing. Not only do we get lesser dividend if we pick the wrong stocks, some stocks will also cut out dividends totally.

Creative Technologies - The Once Hot Stock

One example of such a company which performed poorly over the years is Creative Technologies. You may remember the sound blaster sound card which used to be popular for PCs and the many breakthrough sound technologies which they have. However, in the end, Creative did not manage to keep up with the competition and the technology changes and fell behind over the years.

Let's take a look at its stock price from 1998 to now:

Image from Yahoo Finance (Click to enlarge)

Creative Technologies share price was once at a high of $59.50 in year 2000. The share price now is only $1.37 cents. This is a scary drop and those who bought it at a high would have got their fingers burnt badly.

As for dividends, Creative paid a stunning 50 cents dividend in 1998 which consist of a special dividend of 25 cents. In 1999, dividends paid was 25 cents. That was probably about 10% yield when its share price was about $20 before year 2000. What about the dividends now? Creative, although has a net loss reported year after year, still pays dividend to its share holders. Dividends paid is only 4 cents in 2014. That is a stark difference from the 25 cents and 50 cents dividends paid last time.

When choosing stocks to invest, we should not just look at dividend yield. Even with a 10% dividend yield, dividends could drop and we could lose money.

Choosing the right stocks for dividend investing

Each of us have our own different ways of choosing stocks. We also have our own different strategies for building our investment portfolio. Some may invest more into growth stocks, some practice value investing while others go into dividend investing. No matter what, there are always some basic criteria or check list which we can look at.

1. Look for Businesses with Strong Competitive Advantage

We always need to ask ourselves why is the firm suitable for investing? Are profits still coming in and if so is there a threat that competitors can steal away its customers?

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." -- Warren Buffett

When we invest in stocks, we have to think like a business owner. Investing in stocks is owning a part of a company. When we have this mindset, we would want to invest in a company that can probably survive as long as possible.

It is not easy to find stocks with competitive advantage. Some industries such as utilities and energy have greater competitive advantage as compared to industries such as F&B. Technology companies such as Creative could not create a strong enough competitive advantage to keep competition out. Once another company which has another breakthrough technology comes, Creative losses a big portion of its business and its profits slumped.

A business with strong competitive advantage can stay ahead of times and keep competition away. It is like the game of monopoly where the purpose is to dominate the entire market by buying as many properties as possible so your chances of getting money from other players is higher. If businesses can monopolise their market and keep competition out, then they have a greater competitive advantage.

2. Look for Undervalued Business

No matter how good a business is, we should not overpay for it.

"Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." -- Warren Buffett

Everyone loves discounts. If we can buy a great company at a discount, it is a good deal. During the 2008 financial crisis, stocks were trading at extremely attractive valuations. Many blue chip companies had a PE ratio of less than 10. PE ratio is the number of years needed for investors to get back their initial investment assuming all things remain constant.

We can use Price to Earnings Growth ratio (PEG) to determine if a company is undervalued or at fair value. This is mostly useful only for small companies. The formula for PEG is PE Ratio divided by compound annual growth rate. At the end of the calculation, if PEG is 1x, it means the stock is trading at fair value. If PEG is 0.5x, it is undervalued and we can say this stock has a margin of safety of 50% (less than 1 is undervalued). If PEG is 2x, it is a sell signal. Take note again that PEG is useful only for small growth companies.

Next, we can use the discounted earnings model or discounted cashflow model to calculate the intrinsic value. This is suitable for blue chips or mature companies. There is a free intrinsic value calculator which you can download from a fellow blogger's site here. There are instructions for you to follow there. If intrinsic value is $1 and stock price is trading at $0.50, this stock is said to be undervalued with a margin of safety of 50%. However, do note that blue chips companies normally trade at a fair price rather than a bargain price.

For companies which relies on its assets to generate income, such as REITS and property counters, we can look at it net asset value or price to book ratio to determine if the company is trading at a discount or otherwise. If a stock price is at $2 and its net asset value is at $4, then the company is deemed to be trading at a discount of 50%. This seems like a good buy at first glance. However, it is always not that simple as companies would include assets, such as development properties, as part of their assets. We should exclude the development properties and assume they are not sold. A company's assets will be further broken down under the notes to financial statement.

Below shows the balance sheet of Capitaland:

Click to enlarge

In the balance sheet, we can see current assets and non current assets. Development properties is listed under current assets which we may exclude. If we want to look deeper into the types of assets, for example under the property plant and equipment, we can go to note 3 as stated in the balance sheet. When we go to the notes to financial statement under point 3, we will see the below information:

Click to enlarge

The break down of Capitaland's property plant and equipment can be seen under the notes to financial statement. To analyse companies at a deeper level, it is essential to refer to the notes at the back of an annual report. 

If you're unsure of how to read financial statements, you can refer to my guide below:

3. Beware the temptation of high yields/dividends

When investing for income, we like to see good dividends which translates into high yields on our investment. Imagine if the yield is 10%, every $10,000 invested will give you $1000. It is really tempting to go for high yields. However, as investors who invest for income, even though high yields seems attractive, we should not jump straight into in.

Jumping straight into a high yield stock is like jumping into an ocean without knowing if its water is shark infested. It all seem good from the outside but if we look deeper, there may be dangers lurking ahead. A company which pay out high dividends have to get the money from somewhere. It can be paid from its income or it can be paid from its existing cash.

There are a few questions we need to ask ourselves when investing into stocks for passive income.

  1. Where does the company pay its dividends from?
  2. Are the dividends sustainable? Will the company continue to grow?
  3. What's the trend of its past dividend payouts? Is it increasing or decreasing year by year?

Since we're investing for income, we want that income to be sustainable and even better if its increasing yearly. Look at the company's business structure for clues on where they derive its income. If income is not stable, most likely the high dividends are not sustainable as well. This is especially so for REITS where their income is derived from rental collected.

4. Understanding The Risks of a Company

Sometimes, companies can take on a huge amount of debt in order to expand the company and drive up profits. It is crucial to understand any risks which might come from taking on too much debt and keep track of how a company is performing by reviewing its financial results as and when available. A business with a strong competitive advantage can use debt to its advantage while a business which is cyclical in nature may succumb itself to danger when situation turns bad for them.  

Also, companies may have a high dividend payout ratio to attract investors when they just started out but this dividend may not be sustainable. A lower dividend payout ratio is generally preferred as these companies can still raise its dividends even if its profits drop later. On the other hand, a company which has a high dividend payout ratio will suffer cut in its dividends when profits drop. However, this will not apply for REITS which have to payout 90% of its net income after tax to shareholders. 

I hope the 2 part series on dividend investing has given you some insights on how it is possible to generate passive income through it and also the strategies in selecting dividend stocks. Market has been volatile recently. Dividend investing is still a better choice as we shareholders get dividends even during a bear market. Nevertheless, do invest safely in the right stocks!

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  1. Hello,

    Hmmm I would say invest in companies 'with a sustainable competitive advantage that is fairly priced' than a 'strong competitive advantage' (play of words here haha) cos I feel that at that point in time, Creative, in the eyes of many, had a strong competitive advantage - think about the MP3 player and how we were mad over it (or at least I was lol) - but it wasn't sustainable. This is because tech companies have to constantly innovate to stay ahead of the game. Creative probably was overpriced at that point in time too. So I would phrase it another way instead. Just something that came to my mind :)

    1. Hi Matthew,

      I would think the industry that creative is in generally doesn't have a strong competitive advantage. That's why Warren buffett said before that he don't really like tech companies. Yes we shouldn't buy any companies when its overpriced even when it has a very strong competitive advantage.

    2. Speaking of competitive advantage on Tech companies. No amount of advantage in supply chain, low cost leader, good management, good product, great strategic potion or even innovation can be construed as competitive advantage.

      The only thing that can be a competitive advantage for tech companies is Constant Innovation.

      Is not just creating something special but the ability to constantly create something special.

      Losing this ability, everything just fall apart. Nothing matters.

      We have seen many tech companies with great economic moat and still die like files when confronted by smaller companies who possess the ability to innovate constantly.

      So the question is how to find companies that possess such ability.

      The answer is finding companies with great culture. Culture matters the most when comes to constant innovation.

      Unfortunately we can't find it in finance statement nor in AGM. We can only know the culture when we work with them.

      Hence it's still best to stay away.

  2. Hi , just interested whether does this apply to students studying and working right now that doesn't have much money to invest on

    1. Hi Wei Hao,

      Dividend investing definitely applies to everyone. But take note that if we have lesser capital, the dividends we get will be lesser too. It is still better to save up more so that we can have a bigger capital and thus larger dividend size.

  3. Hi there ,
    Thanks for the reply , i found your blog post interesting .. But maybe , you can write up on how do we start in investing dividends? Just a heads up

    1. Hi Wei Hao,

      I do have an article which I wrote on how to start investing. Its on the right side bar of my blog and you need to switch to desktop version on your mobile or use to desktop/laptop to see the side bar of my blog. Any other specifics on what you want to know? It'll be a good feedback on how i could write it to cater to students. Thanks!

  4. Will let you know once i have the specifics idea on how to cater to student ,

  5. Hi SGYI ,
    What do you think on the blue chips investment ?

    1. Hi,

      Blue chips do give out dividends too so its definitely one of the choice in dividend investing.