18 January 2011

Successful investing is simple, isn't it?

Dear Subscriber

You may recall, in Dividend Alerts issue 6, that I referred to comments made by Robert from St Albans, in particular "what would I buy in the current situation?".

I covered this, ultimately sharing my initial thoughts whether there would be demand for a "premium service" that would enable subscribers to track me with regards to which income generating companies I invest in, why, and at what price.

This triggered some further feedback, in particular from John from London, for which my thanks, that he would be interested in specific information - for which he would be willing to pay – that would provide him with ‘safe’ share entry and exit points in order to maximise his total returns, long term.

Now that made me really sit up!

What if one would be able to develop an investment strategy for dividend paying shares that pinpoints exact entry and exit points. What would that entail?

Buy cheap and sell dear that's it?

Generally, most commentators state that the basic secret of successful investing is to “buy low and sell high”. Or, more precise, as per Baron de Rothschild famous saying “buy cheap and sell dear”

The core question for all investors in shares is therefore:

how does one determine when a share is priced
“dear” or “cheap”?

Truly successful investors are 'somehow' able to recognise shares that are undervalued. They buy these shares when they appear to be ‘historically’ undervalued. They also have the patience to hold them when the share price moves upwards over several years - in the meantime receiving a growing dividend stream. Few, however, have the wisdom to sell when the share price has become ‘historically’ overvalued.

The 'trick' to successful long-term investing therefore is to recognise when any of these times have come and to determine where the particular share is in its share price cycle.

Some of you will immediately say that trying to time share purchases is a poor strategy, because how do you know when a particular share is ‘cheap enough’ to buy. Others will say that with long-term investing in companies with high yielding dividends, it doesn’t really matter when you invest as you need to be in the market at all times in order to receive the dividends.

I am afraid, following the various dividend cuts of previous dividend paying companies during 2008/09, I have learned to dismiss the buy and hold investment approach.

The way forward: focus on Value and Dividend Yield?

Unconsciously, many investors ‘feel’ that a company is undervalued when the dividend yield is high. They also ‘feel’ a share price is overvalued when the price rises and the yield becomes low.

Unfortunately, many investors don't recognise or know the low entry points as well as the high exit points when investing in shares thereby not maximising their overall investment returns.

How many times did you not say to yourself:

“The situation is so bad, it can only get worse, so, I’ll wait a bit longer for the share price to collapse further, before getting in”.

And you missed the lowest entry point, as other investors started buying. Or . . .

“But this time it’s different, I am sure the shares will keep rising, so I'll keep them a bit longer”.

Missing out on the highest exit point when other investors pulling out.

Unfortunately, many investors (and, I have to admit, I have been guilty in the past of doing exactly the same) allow their emotions, hopes, greed and, I am sorry to say, sometimes their irrational behaviour to take root when investing, as a result they miss the crucial entry and exit "turning" points.

But, what’s a high or a low yield? By how much is the company under- or overvalued at any moment in time?

In order to make an informed, rather than an emotionally laden or educated guess type of investment decision, whether to buy, hold or sell a share, one needs to determine the real value of a company at a particular moment.

On value, the legendary Charles Dow, founder of The Wall Street Journal and creator of the popular Dow Jones averages, has some great pointers:

”To know values is to know the meaning of the market. And values, when applied to stocks are determined in the end by the dividend yield”

“Value has little to do with day-to-day fluctuations in stock prices, but it is the determining factor in the long term”

I agree with all of this, but just how do you identify value in the stock market?

How does an investor know when a particular share is undervalued or overvalued?

Entry and exit point investment strategy

Recently, I have come across and made contact with the developers of an investment strategy, which calculates specific values for dividend paying shares for when they are historically “undervalued" and therefore can be considered a buy and when they are historically “overvalued” when the shares should be sold.

They are a registered US-based investment advisory firm, which also publishes a regular investment publication. They have developed an investment strategy for US shares, which allows them to pin point specific entry and exit points with regards to dividend paying companies.

As far as I can see, they have a great track record. Their investment advisory publication has been around since the late 1960ties.

While we believe that some of their screening methodologies are not appropriate for UK listed shares, their overall investment strategy appears to be sound. In fact, we have adjusted it somewhat and over the last few weeks, we have tested it on a number of FTSE100 companies. So far, we are very pleased with the results.

Their investment strategy follows a value-based approach to investing, one that uses a share’s dividend yield as the primary measure of value to ascertain if and when to buy, hold or sell a share. Their strategy alerts the investor when a share’s price is genuinely high, low or on the move between those two points.

Understanding quality and recognising value

After almost forty years of investing, having endured and dismissed many investment strategies over the years, I have increasingly come to regard that having a clear understanding of “quality” and recognising “value”, are the two main drivers for successful long-term stock market investing.

The successful investment strategy of the aforementioned US publisher and investment advisor has only further confirmed this even more for me.

Using an adapted version of their investment strategy, our initial research highlights that the highest quality companies have survived numerous economic cycles without them lowering or cancelling their dividends.

Some of these companies clearly have the resources to attract the best managers and to invest in ongoing research and development of new products and services from which additional sales, earnings and ultimately dividends grow. In the main, these company’s products are well known, widely used and perceived as ‘best value’. Their services are regarded as the most trustworthy. Most of them are (increasingly) present in lesser-developed countries, where growth potentials are still extraordinary.

These are also the companies whose sales, earnings and in some cases, dividends grow continuously throughout virtually all economic conditions. More importantly for us, they also recognise the importance of paying dividends, even in periods of major economic and market upheavals when their share prices are ‘depressed’, creating potentially great buying opportunities.

This has then invariably led us to focus solely on relatively few, high quality companies with solid and reliable long term historic track records.

It is telling that there are only five companies listed on the London Stock Exchange with a track record of more than 25 years of uninterrupted dividend increases.

Understanding quality in more detail

Ultimately, quality is revealed and reflected in managements’ ability to grow and guide a company through the inevitable economic up- and downturns as well as the competitive business environments in which their companies operate.

The only reliable way for investors to recognise an excellent management team, is by their long term financial performance and its continuity – in particular by their ability to increase net earnings as well as dividends over long periods.

Financial performance is the obvious measure of quality. This includes measuring a company’s record of earnings, dividends, debt-to-equity ratio, return on equity, dividend payout ratio, book value and cash flow.

Investment performance, as measured in long-term capital gains and dividend growth, is the most important objective of any long term total return investors.

Famous value investor Benjamin Graham, felt that the defensive investor should confine his holdings to the shares of important companies, with a long record of profitable operations and that are in strong financial condition.

By "important," he meant one of substantial size and with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

High quality companies clearly have a reputation for dependability. One that has a long history of corporate excellence.

Paying rising dividends for an extended period of time, plays a very important role in determining a high quality company. Dividends will not be maintained or raised if future earnings are in doubt.

How to recognise high quality companies?

In order to identify fundamental quality, we have adapted the selection criteria of the aforementioned US investment publication as follows:

• dividend has increased five times or more in the past 12 years

• at least five million shares outstanding

• at least 50 institutional investors

• at least 12 years of uninterrupted dividends

• earnings improved in at least seven of the last 12 years

Dividend has increased five times in the past 12 years

Dividend payments are real cash. Dividends provide an element of certainty for investors. A company’s dividend is tangible. In comparison, the probable appreciation of its shares is just that – a probability – or worse, a possibility.

Dividend growth is the hallmark of a high quality company. A company that is making profitable progress should be able to boost its dividend at least five times in a 12-year period.

We would have preferred a longer period of dividend increases as well as the number of times companies should have increased their dividend. Unfortunately, we are limited to the actual dividend track record of London-listed companies.

As mentioned earlier, rather surprisingly there only five companies listed on the London Stock Exchange, including only one FTSE100 company, with a track record of more than 25 years of uninterrupted dividend increases.

At least five million shares outstanding and at least 50 institutional investors

Benjamin Graham felt that large firms have the "capital and brain power" to carry them through adversity and back to a level of satisfactory earnings.

When screening for company size, Graham's focus is on market capitalization (number of shares outstanding times market price), sales, and total assets. In particular, Graham focus is on sales for industrials and total assets for utilities because they reflect company activities and size directly, while market capitalization is tied to overall market levels.

Companies with at least 50 institutional investors and at least five million shares outstanding, leads us invariably to larger companies as institutional investors purchase only companies that are ‘liquid’ enough i.e. those with many shares outstanding.

This will enable an institutional investor to establish an investment position, without disturbing the share price (too much). Also, when they want to sell, they want to be sure that there are buyers.

With enough ordinary shares outstanding, a company is assured of liquidity. Widespread interest in a company is evidenced, when at least 50 institutional investors are holding 50 per cent or more of the shares outstanding.

At least 12 years of uninterrupted dividends

A common test for financial strength over time, is a long period of uninterrupted dividends. Benjamin Graham recommended uninterrupted payments of at least the past 20 years.

While twelve years of uninterrupted dividends sounds great, we would have preferred a much longer period of uninterrupted dividend periods. A longer period of uninterrupted dividend payments would have shown us how companies and their management teams would have performed going through several more business and economic cycles.

Dividends must have been paid long enough for several cycles of undervalue and overvalue to be established, so that extremes of high and low dividend yield can be observed.

Earnings improved in at least seven of the last 12 years

A consistent track record of earnings growth is not only difficult to achieve, but also to sustain over a long period.

Graham liked to look at the historical company performance over an extended period of time. He had a preference for companies that avoided losses during recessionary periods. In his screen for defensive investors, Graham recommended:

• 10 years of positive earnings

• a minimum increase of at least one-third in per share earnings in the past 10 years, which translates into about a 3% annual growth rate

Here, we look for an indication of growth in sales and earnings, but at the same time, with profit margins under control. Earnings do not necessarily have to grow every year, but they should experience growth in at least seven out of twelve years.

Such an earnings record shows that a company has survived the hard times and is able to prosper and grow in the easier times.

In conclusion . . .

If and when a company meets all five criteria above, it merits further investigation into whether it currently represents good value or whether it is overvalued or somewhere in between.

How we establish "true value" will be covered in the second part of this article in a future edition of Dividend Alerts

What do you think so far? As this is still very much 'work in progress' does it make sense to you? Please do let me know It's much appreciated!

Thank you for reading.

Until next time.

Kind regards

Steven Dotsch
Editor
Early Retirement Investor.com

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