All of us know and love the power of dividend stocks. These companies provide recurring cash flow to investors which is an easy mechanism to exploit when it comes to compound growth – just reinvest your dividends alongside your yearly capital injections and voila! Growth achieved. That’s how Chris Ng managed to become a millionaire – through compounding dividends in a disciplined and systematic fashion.
I initially intended to write about the numerical characteristics of a dividend yielding stock (low volatility in earnings, consistent margins, long enough history of both of the former, etc cetera), but I realised I’d need to do some backtesting to verify my supposition or I’d just be spouting bullshit.
Instead, I’ll take some time today to reiterate some common characteristics of dividend stocks. These are the 4 major qualitative criterias for dividend stocks.
- Recurring Business Model that serves a need not a want
- Free cash flow greater than dividends paid out
- Business not at risk of stagnating or being subsumed by other market competition that can endanger its profits
- Management has Skin in the game – but not too much and not too little
#1 – Recurring Business Model that serves a need not a want
When you break down what Real Estate Investment Trusts are, they’re fundamentally the perfect example of what point #1 is.
REITs are essentially just a bunch of properties stacked together and rented out. Because they have scale, they have better bargaining power for financing and leasing agreements. And they can leverage that for better clientele. REITs also payout 90% of income as dividends, which in Singapore, are NOT TAXED AT ALL, so that’s actually damned useful as an investor.
But the better point of a REIT is often that it
- Locks up rent for years moving forward
- Has a runway of dependable earnings
- Provides a need not a want
So even in the toughest of times, the income source is still highly dependable (since rents are often locked up ahead of time by 6 months-2 years in advance depending on company and size).
REITs also provide a needed services. Most companies larger than 10-15 people require some office space. This should be obvious. I will not get into how or the various angles of weaknesses in a REIT, but suffice to say that you should be thinking about such characteristics when you look at adding a stock to your portfolio for the pure purpose of cash-flow. The cash “pipeline” should be transparent as day and dependable.
#2 Free cash flow greater than dividends paid out
I’ve spoken here at length about the importance of free cash flow for dividend investors, so i’ll simply restate the objective here for posterity.
Your salary = Earnings
Your free cash flow = Your Earnings – bills – savings – monthly expenditures
Free cash flow in other words, is the real “profits made” from a business. Ideally dividends are paid out from free cash flow, and not funded by debt or savings of a company.
If a company starts using debt to pay dividends, or starts paying from savings while facing years of losses, they’ll very quickly lose the ability to pay out dividends and the company could fall into bankruptcy as Hyflux did. Avoid companies that have high payouts with very little free cash flow. These companies will often fall trying and failing and it’s better to not be involved at all.
#3 Business not at risk of stagnating or being subsumed by other market competition that can endanger its profits
Things can change in a fly. Singapore Press Holdings once held a monopoly in the country. They were the country’s premier newspaper distributor, and they used that position to leverage ads revenue. You could list in the classifieds and expect calls because “you were in the papers!”.
But that has changed with the advent of Facebook and Google. Without even trying, they’ve taken over the vastness of ads revenue not just in the country, but in the world. Singapore Press Holdings have suffered ever since. And this is reflected in their share price.
Can they pivot out of this? Perhaps. Only time will tell.
But my point stands. Being a shareholder in SPH has been a miserable proposition – dividend or not, you cannot suffer a 50% share price drop and expect to break even on your investments.
That is why point #3 is particularly important.
#4 Management has skin in the game – just not too much and not too little
I’ve spoken previously about skin in the game, but in this case, let’s apply it towards dividends. Imagine you’re a CEO of a listed company drawing a salary. Now let’s say you own 65% of the company’s outstanding shares.
That’s a nice healthy number, and as a guy looking at your business, I’m happy to note you own so many shares.
How does this affect dividends?
Simple. If management holds a large position in shares, dividends become a form of recurring compensation for them as well. I go over the Hyflux case here quite, but for posterity’s sake, I’ll state plainly.
- Olivia Lum was paid $12 million in dividends across 2013 and 2014.
- She got paid $4,544,970.587 in 2015 and another $1,336,756.055 in 2016.
- Instead, for the period of 2007 to 2016, she received about S$58 million in proportional cash dividends, which were declared and paid to shareholders.
Why is this important? Because management can always enrich themselves by squeezing the company dry using dividends – that’s why we want to watch free cash flow to dividends paid out.
Note I am not saying Olivia Lum did this. She’s just one in a long line of people who committed the basic management mistakes: underestimating project needs and overestimating company financial abilities to sustain large projects. This happens in all companies regardless of size, and Hyflux is not spared simply because its large.
In summary, we want management to hold shares so that they’re incentivised to pay us (because they’d be paying themselves as well) but we should combine watching that with watching free cash flow: dividends paid so that we can be sure management isn’t simply squeezing the company dry as and how they wish.
Conclusion
That’s it! 4 of the main components I think all dividend investors need to look out for. We have an event this coming Saturday where we’ll be going over some of the talking points for dividend investors.
Specifically,
- Real Estate/Publicly available policies/Investing – which one numerically has a higher chance of Early Retirement?
- How do we select dividend stocks?
- How do we balance the risk/reward for students of the Early Retirement Masterclass?
- To date, the XIRR which is the unleveraged internal rate of return across portfolios built by all batches of students is 15.73%.
- In practice, assuming a 3.5% financing fee, returns for the leveraged portfolio is [(15.73% x 2) – 3.5%] or 27.96% – a significant number.
- How do we select portfolios that deliver such returns over the years? How do we understand how to safely leverage a dividend portfolio and then massively propel ourselves forward to retiring earlier and doing what we want in life?
These are some of the questions we will be answering during the seminar. If this interests you, you can register for a seat here. Be sure to come with questions of your own.
If not, I hope the above 4 pointers can help steer you clear of crappy dividend stocks likely to blow up in your face. Cheers.