Commentary and Opinion By Henry G. J. G. Godzik
Henry taught in the TDSB Learn4Life Dividend investing for Income and Building Wealth the Dividend Way programs. You can find part 1 of this articel in the Spring issue 2022.
When deciding on a particular stock to add to a portfolio, understanding the definition of what “stock valuation” is and how it is calculated should be a priority consideration. First of all, stock valuation is divided into two streams namely; Absolute Valuation which involves deriving specific financial information from the company’s financial statements and running an analysis on items such as cash-flow, dividends, earnings, revenues etc and Relative Valuation which involves comparing similar companies and their key ratios to the target company. The primary purpose of stock valuation is to determine whether a stock is overvalued, undervalued or at fair market price. Conducting these valuations enables the investor to better understand their level of risk, whether it be conservative, moderate or aggressive. Companies that are “overvalued” provide a large downsize risk, whereas, a company that is “undervalued” reduces the risk. Basically, stock valuation is determined by its “intrinsic value”, or in other words its philosophical or theoretical value based on financial models analysts create by using components of a business such as qualitative, quantitative and perception factors.
Qualitative factors (unquantifiable) include items specific to a business such as intangible factors; branding, intellectual property, senior management, legal issues, employees etc. Quantitative factors are derived from the fundamental analysis of the company including the financial statement and financial ratio analysis, profit margins, earnings multiples etc and Perceptual factors which include the investor’s idea of what a specific security’s value is, stocks perceived market price and technical analysis.
Some notable financial models include the Dividend Discount Model (there are a number of variations) which looks at dividend paying companies intrinsic value of their stock and the dividends that are paid to the shareholders to determine the company’s ability to pay cash. The Dividend Cash Flow model is used by analysts to determine a valuation of a stock based on cash – flow projections, more specifically free cash flow. This model uses the “time value of money” calculation to discount the future cash flow to its present day value. The Residual Income Model is a valuation method of deriving a stocks value from the difference between its EPS and its “book value per share”. Subjective measures are reduced when analysts are constructing these models and the end result is to compare the models value with the current market price to establish whether the asset is over or undervalued. The discrepancy between the market price and what the analyst calculated through the intrinsic model becomes a measure for an investor seeking an investment opportunity. Remember that there are no guarantees whether an investor buys growth or value stocks that their price will go up in value. You might consider adding less stress to your life and think about purchasing a mixture of growth and value stocks provided that it fits the portfolio construction strategy.
As you continue conducting a stock valuation analysis, pay less attention to where a stock price has been and focus on where the price might go. For example, just because a stock was priced at $20 and now it’s $10 doesn’t necessarily mean that it’s a better time to buy it now. It also doesn’t mean that that stock won’t go higher or lower than it is now. All it shows, is that it’s lower than before so don’t presume that the stock will rise to its former glory. You may end up holding on to a stock longer than you should. There should be a provision in your D.I.M.S. that references this issue.
Balance Sheets, Income Statements and the Cash Flow statements
Financial Statement analysis is another important area to understand when making investment decisions. What financial statements are is a set of documents prepared by the company’s senior management team showing a company’s current financial status and performance at a point in time. Financial statements are audited for financial accuracy, tax and investment purposes by accounting and legal firms, gov’t agencies and creditor reporting agencies.
Financial statements consist of 3 main areas namely, the Balance Sheet, Income Statement and the Cash Flow statement.
The Balance Sheet provides a financial “snapshot” of what the company owes and owns at a point in time, typical at the end of each quarter. The Income statement details the company’s revenues and expenses and once the various results have been tabulated, will indicate whether the company made a profit. The cash flow records the actual movement of cash in the company, showing which of the company’s areas generated inflows of cash and what was paid for in the quarter. The cash flow statement provides specific details about where the cash came from, what it was spent on and whether the company spent more money than it generated.
Investors should not get discouraged by these documents because proficiency in financial statement analysis can takes years of experience and analytical practise. That is one reason why investors become intimidated by the sheer number of facts, figures, footnotes and complex explanations contained in the company’s quarterly and annual reports. Financial statement analysis is usually the domain of accountants so as with other areas that investors find challenging, seek the help of these financial statement specialists.
Another crucial component of the stock analysis process is having a fundamental understanding of how financial ratios influence the decision making process as it pertains to stock selection.
Becoming familiar with some basic ratios derived from the financial statements, is important when deciding which equities are best suited for your portfolio. Understanding where the ratios actually come from makes the equity choice easier when deciding the strategic exposure of the investment as well as its placement in the portfolio and business cycle. Ratio analysis is used to evaluate various aspects of a company’s financial performance and operating efficiency, liquidity, profitability and debt management. Ratio analysis helps to assess whether a company can continue to grow or shows signs of aging and deterioration, by using current and historical data derived from the company’s financial statements.
Ratio research can be very time consuming, and in some cases prove to be an unproductive exercise. Focus on the specific ones that are unique to your D.I.M.S. program. For example, the following should be considered when doing further ratio research as it applies to dividend investing: EPS, earnings per share; P/E, price/earnings ratio; P/EG, price earnings and growth ratio; P/EGY, price earnings, growth and yield ratio; Debt equity ratio; Dividend payout ratio, which varies depending on industry sector; Dividend yield ratio; ROE, return on equity; ROI, return on investment; Book value per share; Cash flow per share, to name a few. Information on how to perform the calculations and exactly what they represent can be found on many investment sites online. Peter Lynch, a former top ranking mutual fund manager stated that “all the math you need in the stock market, you learned in fourth grade…” he also stated, and was insistent that private (retail) investors can outperform professional fund managers by developing basic insights such as common sense, doing some research, and sticking with companies that you may have some familiarity with.
Technical Analysis is another tool that’s available for investors to investigate. Technical analysis is fundamentally the relationship between trading volumes and price movements to determine the supply and demand for specific securities.The focus is on the company’s historical stock price movements and the trading volumes of the stock in relation to those of the market.Technical Analysts are of the belief that past trading activity and stock price changes are valuable indicators of the securities future price movement. It’s also the study of market movement by analyzing stock charts relative to their price and volume movement. Various stock charts help to identify specific price patterns to determine future price movement. Stock charts illustrate the volumes of shares traded daily/weekly, help to assist in interpreting supply and demand of a stock and whether the stock is trading higher/lower than “normal volume”. Some common stock charts include the following: Line Charts which plot successive stock prices connected by a line over time; Bar Charts which plot high/low closing prices over time; Point and Figure Charts utilize columns consisting of stacked X’s and O’s and plots price against changes in direction by plotting a column of X’s as the price rises and a column of O’s as the price falls; and Candlestick Charts which display the high and low, opening and closing stock prices and indicate whether the opening price ends up higher or lower than the closing price. Although the general consensus assumes that technical analysis is the exclusive domain of traders and day traders, investors, once they’ve decided to buy into the market, use technical analysis to help identify quality, low-risk securities at a good price level. As with fundamental ratio analysis, technical analysis takes serious time, commitment, learning and practice to fully understand its contribution to the stock analysis process.
Another very popular technical tool used by investors is what is known as Moving Averages. Moving averages show the value of a securities price over the duration of 20, 50, 100, 200 days. If for example, the stock price “crosses” above a 200 day average, it’s a signal to either hold or purchase more of that security and if it crosses below the moving average, it’s a signal to sell. When the market crosses the 200 day moving average in either direction, it is considered a major signal.
Moving averages are calculated by including the most recent stock price and eliminating the earliest price before computing the average. Sir John Templeton said…” the best time to buy a stock is when its reached its maximum level of pessimism…”.
Relative Price Strength is a technical tool used by investors to show what value the market itself places on a stock. It’s simply calculated by taking the stocks price a year ago and its price today, calculating the percentage change and comparing it to similar stocks over the same period. The general consensus is to look for stocks that have a relative price strength rating of 70% or over. Now comes the time where some serious decision making needs to be done to determine which companies will become a part of the portfolio building process. When looking for companies to add to the Dividend growth portfolio:
DO Look into the “story” of the company. Is it ranked in the top 2-3 in the industry?
DO Look for companies with historical growth and prospects of moderate, consistent earnings growth
DO some historical research on the dividend payments and stock price over the last 5-10 years. Are the growth rates the same?
DO Look for a company that offers a good dividend yield (3+%), but do not let yield be the driving force behind your decision. Companies that pay “rich dividends” (8-10-12%) need further research to determine the sustainability of the dividend and whether it’s in jeopardy of suspension/cancellation.
DO Look for companies whose stock/bond rating is BBB+/A. Companies are required to pay the companies bondholders first before paying preferred/common dividends. Companies that default on making bond interest payments – red flag.
DO Look for companies that have potential for future growth. Will their products/services be in demand 10-20 years from now? Is the size of the market growing? Does it dominate?
DO Look for companies with a strong senior management team; i.e. knowledgeable, experienced, educated in the business they are running. Check to see if senior mgmt. executives are buying/selling stock in the company.
Why? A company’s long-running success in the midst of a poor economic environment is a positive sign.
DO Look at the company’s fundamental/technical analysis (moving averages, relative strength index). Does the company fit into your D.I.M.S. profile?
DO Look for companies that are leaders in their industry/sector. Have they formed partnerships and/or acquired competitors? Do they continue to develop a strong economic “moat”?
DO Look for companies level of innovation and rate of new product expansion. Are their current lineup of products still in demand? How difficult (if at all) would it be to diversify and grow into new markets; both domestic and foreign.
DO Look for companies that have adopted ESG strategies. What % of earnings are dedicated to the “greening” of their business/industry/sector? Is their workplace environment favourable to various diversity groups?
D.I.M.S. Method Revisited
The D.I.M.S. dividend growth formula is committed to helping design, construct the implementation process of the portfolio itself. This is accomplished by understanding the importance of asset allocation, diversification and rebalancing, when deciding the appropriate mix of assets, the risk associated with each group and strategies to mitigate any significant downside to the portfolio.
Asset allocation is the process of determining which of the asset classes i.e. stocks, bonds and cash is best suited to your individual investment needs. Asset allocation should be largely driven by your time horizon and risk tolerance. It is crucial to select the right asset mix according to your needs, since statistically, studies have shown that 60-70 percent of your investment return will come from the portfolios asset allocation. Further research has also clearly shown that asset allocation is the biggest determinant of gains and losses which explains more than 90 percent of the variation in a portfolio return. The relationship between risk and reward are closely linked and the reward for taking on more risk is the potential for a greater investment return. All investments involve some level of risk and the possibility of losing some or all your invested dollars is real. That is why it is important to include different asset classes in the portfolio.
In order to manage, monitor and administer the dividend portfolio; the investor should be familiar with the concepts of Asset Allocation. A helpful solution is to build a spreadsheet which has graphing capabilities as well as math functions to group the investments under the appropriate allocation. You may elect to group the investments by allocating according to, investment types, sector/industry, geographic location, market capitalization or whatever other classification you deem important to include. This information would be referenced from your D.I.M.S. layout.
Investors who are properly DIVERSIFIED and have broad exposure across various sectors, industries, asset types and countries enables the investor to build a portfolio with generally less risk than the combined risks of each individual stock. The purpose of diversification is to mitigate the risk of potential portfolio loss by mixing a wide variety of investments within the portfolio. Diversification also strives to decrease the effects of “Systematic Risk” within the portfolio so that the positive performance of certain investments counteracts the negative effects of other securities. Systematic Risk is risk that investors have no control over i.e. interest rate risk, inflation risk, market risk etc and is unpredictable and cannot be diversified out of a portfolio. Investment portfolios are not immune from its effects and even specialized stock diversification cannot fully protect portfolios from it. Various studies have concluded that maintaining a well-diversified portfolio of 25-30 stocks delivers the most cost-effective level of risk reduction. When picking stocks for the portfolio, also be aware of high yielding securities whose stock price has decreased and the market interprets this issue as an indication of a possible dividend cut. Stick with dividend stocks that pay a moderate yield of 3+ percent and are expecting approximately the same percentage in their dividend growth.
There are times when experienced investors aren’t actually all that diversified because they are very confident in their portfolio choices. Their portfolios consist of no more than 15-20 stocks and they focus on owning concentrated industries that they understand, and pay less attention to industries that they do not. It minimizes the portfolios ability to be perfectly correlated to the flows of the market. Of course there will be times when specific stocks will not perform as anticipated and should not create any major damage to a properly positioned portfolio. It’s important to understand that disturbances in the marketplace have happened in the past and will continue to do so in the future. These disruptions will indeed continue to be facts of life for investors. Savvy investors recognize these disruptions as buying opportunities and take full advantage of these chances. Negative events will impact portfolios in the short-term, but history has taught us that markets are resilient and that a recovery will take place in time. When constructing the dividend portfolio, investors need to be familiar with Concentration Risk. This type of risk occurs when insufficient diversification leads to an investment portfolio’s heavily concentrated by industry, geography, market cap or other factors and there is a negative change to those factors. Sir John Templeton, the legendary investor and founder of the Templeton Growth Mutual Fund stated that. “the only investors that shouldn’t diversify, are those that are right 100% of the time…”. Ideally, dividend investors will be better off maintaining a diversified portfolio that can weather different economic storms and at the same time being able to take advantage of investing opportunities suitable for the D.I.M.S. investment philosophy. Ultimately, a sign of a well constructed and diversified portfolio is how well the asset classes and securities held within it have performed overall.
Portfolio REBALANCING is another important component of the D.I.M.S. strategy. Basically, the process of rebalancing is to return your asset mix to its original asset allocation by either selling some of the top performers, and/or selling over-weighted asset categories and using those funds to shore up the under-weighted percentage of the portfolio. The goal is to bring the portfolio holdings back to the ideal mix initially set out in your D.I.M.S profile, taking into account changes in investment goals, income needs, risk tolerance, time horizon etc. There are many opinions as to when to conduct the rebalancing process i.e every 6-12 months or when a specific asset class has decreased more than the percentage initially allotted to that class.
Rebalancing various types of accounts such as RRSP’s, TFSA’s and Non-Registered accounts can be complicated and challenging since they need to be treated differently for tax purposes. Remember not to inadvertently jump in and rebalance every time certain components of the portfolio underperform. Even a well- balanced portfolio will inevitably have some stocks that either under or outperform others. As one asset class continues to outperform, the bigger percentage of the portfolio it makes up, thus creating an unbalanced portfolio. If you are still not sure when you should conduct an asset rebalancing analysis, seek the advice of a financial advisor who can guide you through the initial process before you venture out on your own and possibly create some unnecessary portfolio trauma. Also, there are various methods of rebalancing, so whichever one you choose to use, make sure to account for any transaction fees and tax consequences that might arise from such actions.
Stock buybacks are another investing arena that dividend investors are encouraged to explore. When companies buyback their shares, it results in a reduction of the number of shares outstanding while still maintaining the same level of profitability, thus increasing the company’s earnings per share EPS. Buybacks tend to boost share prices in the short-term because of the reduction of available shares. Shareholders that are eager to purchase stock start to bid up the price of the securities in the market. With the decrease in shares available, owners of these shares are now in possession of shares that represent a higher percentage of ownership at a higher price per share. Ideally, companies will buyback their shares when it’s trading at a bargain price.
One drawback of the buyback strategy is that any increase in the share price tends to benefit the short-term investor than to necessarily benefit the long-term investor. As a result, buybacks are sending a signal to the market that the increased earnings may not be the result of a company’s growth and reinvestment strategies. That is why investors should investigate the company’s reasoning for initiating the buyback process. Buybacks shouldn’t jeopardize a company’s ability to take advantage of good investment opportunities nor place them in a highly leveraged position that lacks capital discipline. There have been incidents whereby buybacks have been used to manipulate earnings i.e. temporarily, suspending a dividend in order to use the dollars to buyback stock and increase the EPS for that reporting period. The company’s senior executive’s bonus is often tied to the EPS performance. Although many company share buyback programs are not conducted in this fashion, it’s a quick way to lower share count and fabricate positive company performance which isn’t based on factual information.
A properly diversified portfolio can withstand the shock of a stock’s volatile behaviour. If a stock suddenly drops in price, find out why without allowing your emotions to compel you to sell prematurely. Studies in Behavioural Finance has shown that investors have often let their emotional state dictate how they make their investment decisions in the midst of a market crisis, resulting in an underperforming portfolio relative to a given index. Take time to process the information before deciding to pull the plug. You may ask yourself if you are more worried about the company or the markets overall volatility. Even well established companies stock will decline when the market heads south unless there is some damaging fundamental issues within the company. Strong companies will likely bounce back affording you the luxury of purchasing more shares at a bargain price.
Sometimes, the tendency of investors is to sell winners far too soon, while holding on to “stinkers” (stocks that have outlived their usefulness in the portfolio) far too long. Don’t let the profits earned by your winning stocks be eroded by the non-performance of the stinkers (losers). Also, has the price of these losers dropped more than what you initially paid for them? Don’t assume that they may return to their former value. Breaking-even is not a D.I.M.S. investment strategy to embrace at any time. The goal of your strategy is to make money, not get back the same amount of capital. If your losers have fallen out of the D.I.M.S. favour, sell them and reallocate those funds into another quality dividend paying company that meets the D.I.M.S. criteria. However, before acting too hastily, put in place a selling strategy to avoid stocks that could torpedo into the depths of investment despair. If a company fundamentals are deteriorating an investor may execute a stop-order to set a selling price, but watch for warning signs before selling to make sure that the investor is making the proper choice. Some signs to be aware of include, weak earnings reports, negative earnings revisions (EPS) drops, significant competitor pressures, senior management shuffle (top mgmt get fired, executives leave unannounced, CEO passes away), federal investigations and legal issues, insider trading prior to the release of bad news and dismal earnings reports and if the dividend is in jeopardy of cancellation, suspension or if there has been no increase in the dividends over the last year without any explanation. On the other hand, selling a stock that can be traded for a similar company that provides a better yield and growth prospects and a dividend that is more sustainable can also be an advantageous strategy, but always verify and validate the sources of company information before acting prematurely on the selling decision.
With all this being said, if dividend investors still find the D.I.M.S. or other investment strategies intimidating and complicated, one possible solution to address this investment paralysis is to consider the purchase of Exchange Traded Funds (ETFs) which are similar to mutual funds in that they invest in a fixed basket of securities. ETFs trade like stocks on a stock exchange and with greater transparency, the investor knows exactly what is held in the ETF. This enables the investor to avoid stocks that may not be of interest to them as well as not doubling up on stocks already owned. Everything is spelled out in the ETF prospectus including all the holdings, fees and other applicable information. ETFs enable the investor to have easy access to various asset classes because many of the ETFs available in the market today cover a host of different sectors, countries, indices and industries. If the investor wants exposure to a specific industry, but doesn’t want the challenge of picking individual stocks, buying the ETF is a better choice. Not only can ETFs be an important addition to a dividend portfolio, but investment portfolios can be constructed using only ETFs.
Another very important ETF item to understand is how ETFs are taxed and being able to choose the most tax-efficient solution available. Deciding which type of account (RRSP, TFSA, Non-Registered, RESP) the ETF is held in and which country the ETF is domiciled in will impact the amount of withholding tax the investor is subject to. As with other investments, if you are not sure what to do, seeking the advice of a financial professional will help to ease the burden of making decisions that you’re not comfortable with.
Watch for the thrid part and conclusion in our Fall issue 2022 where this article will be continued.