How to invest in high quality, dividend paying shares

Transcription

1 asdfblaaasdfdsfh[type text] UK Value Investor How to invest in high quality, dividend paying shares A 10 Step plan for investing in shares for income and growth 2014 Edition Visit: Published by John Kingham

2 How to invest in high quality, dividend paying shares Dear Fellow Investor, If you re like me, then you are mostly interested in high yield, relatively low risk shares. I prefer to put my money into companies like Tesco, Vodafone and SSE, where I can get a good dividend from a proven, high quality business. Whether those dividends are drawn down for income, or reinvested for growth either way, it s a sound and sensible strategy that is popular with many famous investors. I wrote this guide to help investors like you make the most of their investments. I ve heard it said that private investors underperform the market by up to 6% a year. That s a terrible waste, both of the investor s time and their money especially when some of the most successful investors have beaten the market with a relatively simple, common sense and low risk approach. Each step in this guide is designed to help you build and maintain a diverse portfolio of world-class businesses, with market-beating characteristics. Each step is simple, and builds on investment ideas similar to those used by Warren Buffett, Neil Woodford, and more recently, Terry Smith. Together, these 10 steps form a complete end-to-end system for investing in the shares of high quality businesses buying their shares when valuations are low and dividend yields are high, and selling when valuations are high and dividend yields are low. Feel free to use as many or as few of the ideas in this guide as you wish. Yours sincerely, John Kingham Editor, UK Value Investor "The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition." Ben Graham, the father of value investing 1

3 1. Take a long-term view "In the short run the market is a voting machine, but in the long run it is a weighing machine." Ben Graham, the father of value investing It s important to take a long-term view of any investment that you make. Generally long-term is taken to mean 5 years at least, and I think that s a reasonable minimum. Why so long-term? Because of the way the stock market generates returns: 1. Dividend income - Shareholders get paid dividends. If you buy the right sort of companies then those dividends can grow faster than inflation. The average return from dividends is around 3% a year but you will only see a significant return from dividends if you hold an investment for a number of years. 2. Dividend growth The intrinsic value of a company will typically increase with its ability to pay a higher dividend (as long as it s sustainable and supported by growing revenues and profits). The average gain from dividend growth is around 5% a year over the long-term. Again, you will typically need to hold an investment for years before seeing a significant return from dividend growth (and remember, dividends can be cut or suspended too). 3. Valuation changes (such as dividend yield) The current share price of each company is set by the supply and demand pressures of buyers and sellers. In the long-run these investors generally do a reasonable job of valuing companies, assigning them a fair value based on each company s revenues, profits and dividends. In the short-term though investors can be a fickle bunch, either nervous or excitable depending on whether or not today s news about a company is good or bad. This makes share prices highly volatile and unpredictable over the short-term. If you focus on the short-term almost all of your gains (and losses) will come from valuation changes. But these are by their nature unpredictable, and so short-term investing is scarcely different from taking a trip to the casino. Focusing on the longterm instead means dividend income and growth become much more important than the day-to-day ups and downs of the market, and finding a company that can grow its dividend is much easier than finding a share which will go up next week. 2

4 2. Stay diversified Our advice to the defensive investor is that he let it alone and emphasize diversification more than individual selection Ben Graham, the father of value investing No matter how much research you do into a company, you cannot know for certain how it will perform, or what the share price will be in the future. The answer to this uncertainty is to diversify and put your eggs into many different baskets. Ben Graham suggested splitting equity investments across twenty to thirty companies. There are other factors which can be diversified too, beyond just the number of investments; the main ones are industry and geography. Companies within the same industry are often affected by the same kinds of issues, so diversifying across many industries can reduce a portfolio s risk. If a portfolio is diversified across many industries, anything that affects a single industry will only have a relatively small effect on the portfolio. The same thinking can be applied to geography, where a local problem (a recession, earthquake, epidemic, etc.) will have a smaller impact if the portfolio as a whole generates its earnings from across the globe. Risk reduction through diversification is important because investing is a long-term game. If your portfolio is relatively low risk because it is well diversified, you stand a better chance of sticking with equities for the long-haul. 3

5 3. Look for high yield shares A cow for her milk. A hen for her eggs, And a stock, by heck, for her dividends. - John Burr Williams, author of The Theory of Investment Value The 2011 Barclay s Equity Gilt Study showed that 100 invested in equities in 1899 would have grown to 12,655 if dividends had been withdrawn. If dividends had been reinvested then the investment would have grown to 1,697,204. Dividends increased the gains tenfold, and in real terms the gains were an amazing three hundred times better. Dividend income is clearly a very important part of total stock market returns. The obvious way to measure income is by the dividend yield. However, on its own the yield is often misleading. It is just as important that the dividend be sustainable in the longer-term, and that preferably it has a good chance of being increased. That s why yield shouldn t be looked at in isolation, but should instead be considered alongside a company s ability to pay that dividend, consistently, for the long-term - In other words, its quality. There is another problem with a simple dividend yield. By looking at today s yield you could miss situations where a company has cut its dividend for a short period, perhaps because of a one-time, survivable crisis. A better approach may be to look at the share price relative to the company s dividend payments over the last decade. The more dividends that have been paid relative to the current price, the better. 4

6 4. Look for growing companies Purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now Warren Buffett, the world s most successful value investor Growth is the friend of the long-term investor. Without it the value of any business and the income from it will be eroded by inflation. The most important thing is a company s ability to pay a growing stream of dividends in the future, since ultimately the value of all investments is based on the cash that will be paid out. But we cannot know the future, so we have to look to the past for guidance. In simple terms, a company that has produced consistent growth in the past is more likely to continue to produce consistent growth in the future. Growth over a handful of years is not reliable enough to be used as a guide to future growth. The answer is to do what Ben Graham suggested, and look at growth rates over a ten year period. This will pick out those companies that are growing over the long-term. Dividend growth is what we re really after, so it makes sense to look for dividend growth over the past 10 years. Dividends are supported by earnings, and earnings come from sales, so it s also a good idea to look at the growth of sales and earnings over the last 10 years too. All else being equal, a higher growth rate is better. 5

7 5. Look for high quality companies Time is the friend of the wonderful company, the enemy of the mediocre Warren Buffett, the world s most successful value investor The problem with looking back into the past in order to have a clearer view of the future is that the past can be misleading. Sometimes a company will have strong 10 year growth, but it all came in one or two years. This is not reliable, defensive growth. What we want instead is consistent, repeated, high quality growth. Companies that have been consistently successful in the past are more likely to be consistently successful in the future. This in turn means that the past growth rate is likely to be a better guide to the future growth of the company. Companies that consistently produce growing profits and dividends are usually considered high quality companies. To measure a company s quality, look at how often it has been profitable in the last decade, and how often it has paid a dividend; the more often the better. Then count how many times it has increased sales, earnings and dividends in the last 10 years; again, the more often the better. By focusing on high quality, high yield companies that can consistently generate market-beating growth, you will be well on the way to creating an outstanding portfolio.. 6

8 6. Look for low prices relative to earnings Buy stocks like you buy everything else when they are on sale Christopher Browne, author of The Little Book of Value Investing One of the main tools you can use to value shares is the PE ratio. This ratio is a starting point when you begin to think about whether a particular share is cheap or expensive. Valuations cannot go to infinity, and they don t go to zero unless the company goes bust. So in the long-run PE ratios tend to hover around a medium value, typically somewhere in the mid-teens, although of course they can go much higher or lower in the short-term (creating buy-low and sell-high opportunities for sharp investors). The standard PE ratio has its problems though. Earnings from one year to the next can be quite volatile. With large and stable companies, the changes in earnings from year to year are unlikely to reflect the changes to the intrinsic value of the company. Intrinsic value simply means the price that an intelligent, informed and rational investor would pay for the company. A better approach is to compare the share price against an average of the company s earnings over a number of years, rather than just looking at a single year in isolation. This is exactly what Ben Graham suggested. The Graham and Dodd PE (more commonly called PE10) uses the ten year earnings average, which gives a more stable number to compare share prices against. This in turn provides a better guide to whether the shares are expensive or not, relative to the value of the company. 7

9 7. Avoid excessive financial obligations I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt Warren Buffett, the world s most successful value investor No matter how prosperous a business may be, if it has too much debt it can be like a time-bomb waiting to go off when something goes wrong. Debt is one of the main corporate killers. Fortunately, many of the best companies don t need to use lots of debt to generate outstanding returns for shareholders. It s also true that some companies can handle more debt than others. Generally, the more cyclical or volatile a company s earnings are, the less debt it should have. Stable companies, like supermarkets or utilities, can handle more debt. Although this doesn t mean that they should handle more. There are various ways to measure debt in order to find out if a company has too much. You can look at interest payments, to see how well the interest on debt is covered by the company s profits. If interest is more than 10% of profits then it may be a good idea to see if the company needs, or can handle, that much debt. You can also look at the total amount of borrowings and compare it to profits. Some investors look for borrowings to be no more than 5 times the average profit of the past few years. The goal is always to make sure that a company s debts won t become too much of a burden if the company falls on hard times. Another area of concern is pension deficits, and this risk can be reduced by concentrating on companies where total pension obligations are less than the total market value of the company (its market capitalisation). By focusing on consistently profitable companies which are conservatively financed, you will have done more than most investors to avoid debt related problems. 8

10 8. Compare stocks against the market average A wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. To beat the market you have to acquire more value than you can get from the market. Warren Buffett, the world s most successful value investor Most investors who pick their own stocks want to beat the market, either in terms of income, growth or both. To beat the market over the long-term a portfolio must generate more returns from one or more of dividend income, company growth, and valuation changes. It is therefore a good idea to check potential investments against the market. You would generally want to see if a company has a higher dividend yield, lower valuation ratio, and higher, more consistent long-term growth rates than the market. It s a simple case of comparing each of the four factors mentioned previously (high growth, high quality, high yield, and low valuation) to the equivalent values for the market (e.g. the FTSE 100), in order to see how a given investment measures up. A share which has is better than the FTSE 100 in at least three of those four factors will probably be worth taking a closer look at. If it has better long-term growth and better quality than the market as a whole, then it is probably a share from an above average company. But unless it has a better yield or a lower valuation, it may be too expensive. Alternatively, if it has a lower valuation and a better yield, then the shares are probably cheap. But if the long-term growth rate is lower and less consistent than the market s, then the shares may be a cheap because the underlying company is low quality, and therefore unattractive in the long-term. To be a truly outstanding investment, a share should be both cheap and from a high quality company. 9

11 9. Follow a systematic investment plan When surgeons make sure to wash their hands or to talk to everyone on the team, they improve their outcomes with no increase in skill. That s what we are doing when we use a checklist. Mohnish Pabrai, founder of the Pabrai Investment Fund So far we ve looked at companies in terms of the numbers they generate their earnings, dividends, debt levels and so on. But most people wouldn t invest just based on the numbers, and that s sensible. Investors typically want to know something about a company s history, what it does to earn profits, and how the company could develop in the future. When conducting this research, it s important to use a checklist so that no steps are missed out or forgotten. A checklist is also useful so that new ideas and questions can be jotted down, remembered, and included in analyses. If checklists are good enough for surgeons and airline pilots, they should be good enough for investors. There are many things that can be included on a checklist, but the main areas to cover are the company s past, its present situation, and its future potential. Here are some questions you may want to consider in your next investment analysis: Has it been in the same industry, doing the same thing, for a long time? Is the company in the market-leading group? Does it have a highly successful and profitable past? Has it been free of major crises in the last decade (if so, were they successfully resolved)? Does it have any obvious current threats to its economic engine? Does it have any durable competitive advantages? Is there any chance that its economic engine could become obsolete in the next decade, or that its industry could be massively disrupted? 10

12 10. Continually improve your portfolio Our results more specifically attribute much of the advantage of value strategies to the acts of reconstituting and rebalancing and their side effects on dividends. Denis Chaves & Robert Arnott, from Research Associates LLC Once you ve filled up a portfolio with twenty to thirty high yield shares from high quality companies, you might think your job is done - but it isn t. To get the best returns you may want to actively manage the portfolio in the same way that a gardener actively manages a garden. When grass grows up too high, it gets cut back. In the same way, when a company s share price grows more quickly than the company, it may no longer have a low valuation and a high yield. When this occurs it can be beneficial to sell, and reinvest the money into another company where the share price is low, and the dividend yield high. This process of improving a portfolio can easily be achieved by selling the least attractively valued investment in one month, and adding a better investment next month. With 30 holdings this will replace six of them each year, giving a 20% turnover ratio and an average holding period of 5 years. Over time this process of continual improvement can add significantly to returns. Bringing it all together To create and maintain a high quality, dividend paying portfolio you ll need to have a plan for each step, from finding and analysing companies, to sensibly diversifying your portfolio and deciding which shares to hold onto and which ones to sell. Hopefully this short introduction to defensive and income-focused value investing has given you some good ideas. If you want to know more you ll find detailed worksheets and spreadsheets on the web site, and if you re really serious about getting a good return on your investments then take a look at my newsletter, which I publish each month for a select group of investors. 11

13 UK Value Investor The investment newsletter for defensive and income-focused value investors UK Value Investor can help you with each step of the investment process: Find high yield, high quality stocks Each issue contains a stock screen which ranks over 200 FTSE All-Share stocks based on a combination of growth, quality, yield, and value for money. The online version of the screen allows you to sort, select and download data into your own spreadsheets for further analysis. Follow along with a 50,000 model portfolio Stock screens are clinical and mathematical, but investing in the real world is not. It can be messy, exciting and occasionally frightening. That s why each issue shows you how I use the UKVI stock screen and investment strategy to build and maintain this high quality, high yield portfolio. Each month the portfolio is reviewed in detail, including a full review of every buy or sell decision (just one holding is bought or sold each month). I have the vast majority of my own personal wealth invested in exactly the same stocks as the model portfolio, so I take the management of this portfolio very seriously. Get help and support by or phone As a member you ll have priority support from me by or phone. As one member put it, The fact that you always respond in such a timely and considered manner is a very attractive feature of your service. Visit UKValueInvestor.com for more information about becoming a member, or subscribe to the blog for free. 12

14 IMPORTANT DISCLAIMER: The author is not registered as an investment advisor or as an independent financial advisor and does not provide individual investment advice. Neither the author nor this document are regulated by the Financial Conduct Authority. No information provided in this document should ever be construed as investment advice. It is prepared for education and information only. The specific needs, investment objectives and financial situation of any particular reader have not been taken into consideration and the investments mentioned may not be suitable for any individual. The information contained in this document is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities. Readers must not base any investment decision solely on the basis of this document; instead they should seek independent financial advice. The information in this document and any expression of opinion by the author have been obtained from or are based on sources believed to be reliable but the accuracy or completeness of any such sources or the author s interpretation of them cannot be guaranteed although the author believes the document to be clear, fair and not misleading. The author receives no compensation from and is not affiliated with any company mentioned in this document other than possibly receiving advertising revenue via a third party. The views reflected in this document may be wrong and may change without notice. To the maximum extent possible at law, the author does not accept any liability whatsoever arising from the use of the material or information contained herein. INVESTMENT RISK: The value of shares can fall as well as rise. Dividend payments can fall as well as rise. Any information relating to past performance of an investment or investment service is not necessarily a guide to future performance. There is an additional risk of making a loss when you buy shares in certain smaller companies. There is a big difference between the buying price and the selling price of some shares and if you have to sell quickly you may get back much less than you paid. Share prices may go down as well as up and you may not get back the original amount invested. It may be difficult to sell or realize an investment. You should not buy shares with money you cannot afford to lose. 13