Sunday, August 22, 2010

Book Review - The Ultimate Dividend Playbook

Any investor worth his or her salt, who doesn't want to rely on the vagaries of capital appreciation to grow their net worth, and who would readily lean on the best shortcut in the world to wealth creation, dividends, simply must seek to understand them. Numerous studies have shown that dividend paying stocks outperform all other stock classes, and usually by a wide margin of 2% or more annually.

This book, by Josh Peters of Morningstar, helps the investor understand the case for dividends, and how to select individual stocks for a modestly diversified portfolio. While many investors may think dividends are suitable for income investors only, the fact is that dividend paying stocks should be a or the major stock holding style in most investors' portfolios.

Why? Well, as Josh points out, it's very simply because they outperform most other stocks, and generally with reduced volatility. So, it's a more stable, higher-returning investment. What could be better than that?

As Josh points out, dividends are a sign of many things investors like to see:
  • An alignment of managements and the investors interest (return of, and return on, cash);
  • Corporate self-discipline (have to keep grinding out the cash to pay and grow the dividend);
  • Financial strength;
  • And a Valuation basis (dividends can show when a stock is overpriced, and underpriced).
Josh covers economic moats, which he likes all his dividend-paying stocks to have, as well as return on equity (see his book, or mine, on why this is important). He suggests looking at the trend of the dividend (the trend is your friend, in terms of projecting the future), so see how the dividend might grow into the future.

He covers handy items like payout ratios, high yielding stocks (generally, be careful) and high payout ratios (look out if ratio has been continuing to rise).

In the book, Josh covers especially two items that make the book an entirely worthwhile addition to any investors bookshelf: the dividend drill, and the dividend drill return model.

The dividend drill focuses on three items;
  1. Is the dividend safe;
  2. Will the dividend grow;
  3. What does the dividend stream tell me the stock is likely to return to me as a shareholder?
Attempting to answer these questions will help you decide whether or not a prospective stock investment is one that you can or should add to your portfolio.

In relation to #3 above (the total return from the stock), he also introduces one very handy shortcut (and investing is full of them, from PE ratios, to inventory turns, to PEG ratios). Think about the potential of the total return of the stock as the sum of the actual dividend yield, plus the likely growth rate of dividend over the next while, say ten years.

A couple of simple examples showing how the total return might be different for two stocks, is that one might be yielding a 5% return, and has recently been increasing the dividend by about 4% annually. If you think that increase would continue over the next decade or so, then the likely total return on that stock would be about 9% annually (5%+4%). In the case of a stock which has a lower initial yield, but is increasing the dividend more rapidly, the projected return might look like this; a 3% dividend yield, plus expected future dividend increase at 8% annually, suggests an 11% (3%+8%) total return.  The book is full of handy advice like this, written in a straightforward and uncomplicated style.

The book also details the more complicated (but not complex) Dividend Drill Return Model, which encourages you to think more deeply about the company and its prospects. Yes, it's more work, but relies only on elementary/grammar school arithmetic, so it's within the reach of virtually any investor.

I highly recommend this book, and thank Josh Peters for writing it. The information is handy, practical, simple, and timeless.

The Confused Capitalist

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