Dividend Investing

My first dividend for the year 2014 was received yesterday. Yeah! It was from Media Chinese International Limited (MEDIAC) for the amount of RM 67.70. Not a big amount (yet) but it is a good start. The next one will be on 29 January 2014 from Pacific & Orient Bhd (P&O).

Dividend from MEDIAC

Dividend from MEDIAC

The total dividend received last year was RM 799.51. This translates to RM 114.21 per month (my first ever dividend was received in June 2013). This year 2014 I hope for at least a total of RM 1400 in dividend income for the whole year. If things go well, it should be more than that since I keep pumping money (small amount but regularly) into the stock market.

Let see how far I can build the monthly dividend income from here. The next big question is when can my dividend income exceed and replace my salary income? Because at that time, I will be financially independent and can afford to retire (if I no longer wish to work) early.

Now, let consider the benefit of doing what I am doing right now from a probabilistic view. The worst case scenario will be the dividend income never exceed my salary. Then I will need to work till I reach the retirement age. In this case, I will just carry on as if I never invested, only lesson learnt.

On the other hand, let think about another case: a slightly better case where the dividend income exceeds my salary and can cover all my living expenses at some point between now and my retirement age. Even just a few years earlier than my retirement age, it would mean a lot to me. It signifies a victory. 🙂

The downside is limited, but the upside opens up to a whole lot more possibilities to my life. It is worth doing it.

My Principles of Dividend Investing

After reading about 25 books (and counting) on investing, mostly about Warren Buffett’s ways of investing, some on index fund investment, some on speculation, … I come out with principles of investing that I am comfortable in.

Golden principle No. 1) invest only in good companies that give consistent, high and growing dividend

Quantitative analysis: Number

The characteristics of good companies are they must be strong financially: have tons of cash, have little or no debt and most importantly, they must make huge profits. These characteristics can be quantified and be assessed via the financial statements and annual reports.

Below are basic criteria for quantitative analysis:

  • ROE (Return on equity) > 15%
  • DE (Debt to equity) < 0.5
  • Gross margin > 20%
  • Average DY (Dividend yield) for 10 yr > 5%
  • EPS (Earning per share) growth for 10 yr > 15%
  • PE (Price to earning) is below avg PE over 10 years

I mostly focus on companies that have at least ten years history so that I can judge whether the dividend payout is consistent. The criteria are not set in stone. You can set your own according to your judgement.

For dividend investing, ROE (Return on equity) plays a big role. The higher ROE means the company is able to generate bigger returns (E.G.: generates more sales) and therefore it will have more cash to pay a nice dividend.

DE (Debt to equity) must be low. A DE of 0 means the company is debt free. Sometimes, it also means the company’s gearing or leverage. A good business does not need too much debt to run.

Gross margin of 20% means for a product that sells at RM 1, your cost of producing it is RM 0.80. Therefore, for every product sold, you earn RM 0.20. Warren Buffett likes companies that have high gross margin or profit margin. The higher the profit margin, the better the competitive advantage of the company because the company can produce at lower cost.

Good to know: net/gross margin and ROE mean different things. High net/gross margin means the company is very competitive but does not really mean it is making money. High ROE means the company is making money but does not mean its products are produced at low cost.

Now, the average DY (Dividend yield) is the crucial part for dividend investing. It shows the average dividend yield of a company. A high average DY means the company is able to pay high dividend consistently over the years.

EPS (Earning per share) growth shows the growth of the company’s earning. A high EPS growth means the company can growth its business at a high rate. It is an important indicator for investors looking for high growth stocks.

PE (Price to earning) is relative to each sector. It shows whether the company’s stock price is cheap or expensive compare to other company in the same industry. A company that has high PE generally means it’s stock price is overvalued. However, that depends on which industry you are talking about. A company in high growth industry will have high average PE.

So, where can you get all these financial numbers? There is a tool that you can use to access all the information mentioned above in a single place. I shared the tool here. There are about 1200 listed companies in KLSE, however, the tool only covers 600 of them. But that are more than enough for me.

Quantitative analysis: Valuation

If you ask Ben Graham, the father of value investing, to summarize the book “The Intelligent Investor”, he will summarize it in three words: margin of safety. Price and value are what matter in value investing. You pay the price of RM 0.50 to buy a business that worth RM 1.00. That is a margin of safety of 50%.

In certain way, the higher the margin of safety, the greater you return will be with the least risk. You can read more on risk and reward of value investing here.

There are several ways or formulas to calculate the value (intrinsic value) of a business. However, all of them are just an estimation. For practical reasons, I don’t take the valuation too seriously. It is just for reference. Note: Normally, a boring, traditional business is easier to value because it is consistent and predictable.

Qualitative analysis: Business

Is the company in a simple business that you can understand? Does it have strong competitive advantage (economic moat, as Warren Buffett puts it) and have an irreplaceable brand? If yes, then you have found a company that is worth investing in.

You can learn more about the business by doing research via trying their products and also study about their competitors, for example.

Qualitative analysis: Management

You would also need to assess the people side of the business: the management. This is the qualitative analysis. Are the management someones who are honest (people you can trust), passionate in running business and lead a modest life (avoid those who live lavishly)? Are their interests aligned with their shareholders? Do they hold they own most of their company’s shares?

You can attend to their AGM (Annual General Meeting) and talk to them personally to get a feel of what kind of people they are, for example.

Quantitative analysis + Qualitative analysis = Fundamental analysis

Both quantitative and qualitative analyses constitute the fundamental study of a company. There is a lot of work involved, but the rewards are high.

Golden principle No. 2) money gets in and only gets out via dividend

Once you have a list of good companies, you can start buying their shares! This is where I get excited. Your money should only gets into the market and never gets out. It should only get out via dividend payment. You ignore the price appreciation or depreciation of the stocks you buy. Never sell a single share. Only buy. That is the only way to accumulate tons of shares until you own the whole company. Yes, the ultimate goal of the principle is to own the whole company. You want to own good companies! Don’t you?

When you own a business that makes money, you want to own it for life. You don’t sell it even when things get tough (E.G.: during bear market). Think your business as your child, you won’t abandon it when catastrophic event comes. This is common sense. The same idea applies to stock owning.

This principle can only be applied if you invest using money that you don’t need. You inject money to help good companies in difficulty especially during bear market. Time is a good friend for good companies. You must have this belief: You can only become wealthy when you don’t need the money.

Golden principle No. 3) try to only average down no matter in bear or bull market

In some ways, it is similar to applying margin of safety to your investment. You average down until you can no longer lower down the average purchase price. From that point onwards, the price can only go higher.

Bear Market?

I think you should not worry too much about bear market and worry that you won’t have enough money when the bear arrives. This is because when the bear comes, it will stay for at least a few months. You will have enough time to accumulate money and apply DCA (Dollar cost averaging) or RCA (Ringgit cost averaging) during that period to average down.

 

It takes time

Dividend investing takes time to bear fruits. It might take decades. Just like growing a durian tree. When I was a kid, I asked my father how long it takes for durian tree to bear fruits. “It takes around 10 years” was the answer. I thought that was too long. Now, the durian tree has grown up and started bearing fruits. 10 years are within a blink of eyes.

Characteristic of Dividend Investing

There are 3 possible outcomes when investing in stocks where (a) if there is no dividend, you will only have price appreciation, (b) if you have dividend, you will have price appreciation + dividend, (c) if you have dividend and reinvest it, you will have price appreciation + dividend + compounding effect. The returns from these three cases vary greatly.

For case (b) and (c), if you are investing on dividend stocks, you dividend return looks like this DY + dividend growth instead of only DY. The dividend will grow if you own the stock of good companies.

Compounding Effect

The famous compound interest formula: b_n = b_0(1 + r) ^ n where  b_n is your final balance, b_0 is your starting balance, r the rate of return and n the number of years.

In order to maximize the total return, you maximize these three variables b_0, r and n.

So how do you maximize each of the variables?

  • b_0: maximize it by saving the most of your salary or income earning. You can only become wealthy when you don’t need the money now.
  • r: maximize it by invest only in good companies. Do your research and think independently.
  • n: maximize it by doing it now! and let your investment grows.

Final thought

How did Steve Job survive with only $1 salary per year? He survived through dividend income by owning a good company (Apple). He received millions and millions of cash from dividend alone.

So, to summarize, the three golden principles of dividend investing are:

  1. invest only in good companies that give consistent, high and growing dividend
  2. money gets in and only gets out via dividend
  3. try to only average down no matter in bear or bull market

It is as simple as 1, 2, 3.