The Ultimate Dividend Playbook, a long review

[clifp]

A book review of The Ultimate Dividend Playbook,: Income, Insight and Independence for Today's Investor by Josh Peters, CFA and Morningstar analyst

Let me be upfront, I am a fan of dividend investing in general and Josh’s Morningstar Dividend Investor Newsletter in particular. As an early retiree I have been struggling with a way to have enough income to enjoy life, while protecting my nest egg from the ravages of inflation.

I think this is a valuable book for the intermediate or advance investor to own for two reasons. First, while dividend investing has become somewhat trendy in the last couple of years, there hasn’t been much in depth analysis of why dividends matter. Secondly, the truly outstanding portion of the Dividend Playbook is it teaches the average investor how to search out and evaluate dividend stocks, and figure out which are likely to be good investments. Overall, the Playbook is the rare business book that does a better job teaching you how to catch fish, than making the case why you should eat fish!

Target Audience.
I think anybody who is a current or potential M* Dividend Investor Newsletter subscriber would be crazy not to buy this book, it is a fraction of the cost of the newsletter, and makes the newsletter much more valuable. I’d also commend it to any do it yourself stock picker. I think it would be valuable people looking at purchasing dividend ETF like DVY or mutual funds. A beginning investor who isn’t really comfortable with terms like Return on Equity, or an index fund investor, or 401K investor doesn’t really need it.

Why dividends?
Josh quickly nailed my biggest problem as a retiree depending on an equity heavy (80%) investor. It is awfully hard to figure out when to buy a stock and even harder to know when to sell. I think even for a pure index fund investor with a 50% stock/bond mix who is rebalancing his portfolio in Jan 2008, must be uneasy with recent market volatility. I am sure many ask themselves, do I really want to buy more stocks? They have gone down a lot in the last couple of months. For the individual stock investor figuring out which stocks are overpriced and what is underpriced is way to much work. According to Josh, the beauty of the dividend income approach is by relying on income you are letting the stock do the work for you. As long as the companies keep paying dividends and they continue to grow there is no need to worry about how manic depressive Mr. Market feels about your stocks today or tomorrow.

The first few of chapters make the case for dividend investing being superior. I was most interested in Professor Jeremy Siegel (of Stocks for the Long Run fame) study of the top 100 highest yielding stocks in the S&P 500 earning an average of 14.3% annually while the lowest 100 yielding making only 9.5% annually between 1958 and 2003. Several other shorter term (10-25 years) studies were also cited showing the superiority of dividend investing. One of my main criticism of the book, is I don’t think nearly enough time was devoted (only few pages out of 335) to bolstering Josh’s claim “There’s no good reason an investor needs to own any non dividend paying stock at all”. Not only would Google shareholders disagree but so would Berkshire Hathaway shareholders. I’d love to see a great deal of more effort to examining historical studies of dividend investing.

His philosophical case for why dividends are good for shareholders is quite strong. Imagine a company which makes $200 million in profit. It can reinvest $100 million in it is core business which has historically earn 20% on equity, there is also a $100 million opportunity to acquire another business which if all goes well may earn 15%, In the absence of dividends, both projects are likely to be funded. As we all know the number of can’t miss acquisitions which have flopped is huge. If on the other hand, the company has historically paid out $100 million in dividends management is likely to pass on the risky acquisitions. One particularly interesting insight was the case against share paybacks. All too often management announces buybacks but don’t follow through, even more troubling is share buybacks award EX shareholders not the existing loyal shareholders. If management want to keep stable base of shareholder dividends are a much better approach.

The Dividend Drill
The meat of the book is in Mr. Peter approach to evaluating dividend stocks which he calls the Dividend Drill. The drill is familiar to his newsletter readers, but I never completely understood it until reading the book. The simplest part is the insight that the total return of a stock is equal to the current dividend yield + dividend growth rate. Thus a stock currently yields 4% and has been growing dividends at 6% in the past and is likely to do so in the future its long term total return is 6%+4%=10%. Johnson and Johnson is a classic example with a yield which has been around 2% for most of the last 30 years, but with a dividend growth rate of 14%. The total return on JNJ including reinvesting dividends has been 16% over a 30 year period. Many other stocks have shown strong correlation between dividend yield+growth and total return; examples include Utilities like Con Ed with 5.5% yield and 1% growth rate and Realty Income (O) with a 7% yield and 3.7% div growth rate.

The crux of the dividend drill is evaluating a dividend stock on three critical elements; is the dividend safe, can the dividend grow, and what’s the return? There is high school level math involved and balance sheet 101 knowledge is definitely needed (I have an MBA so I pass!), however it isn’t very complex. Mr. Peters does a good job of providing concrete examples and nice step by step explanation.

Dividend safety is a relatively simple calculation; do the projected earnings exceed next year’s dividend by a comfortable margin? Josh explains that the safety margins (aka payout ratio) for a cyclical industry need to be considerable higher than a natural gas pipeline company. Will it grow is probably the most difficult calculation to make. There are numerous things to consider, management’s commitment to growing dividends, the core potential growth rate, obviously microchip companies have a higher potential growth rate than potato chips companies, and small companies better potential than large companies. Future earnings growth and return on equity are also factors.

Josh then discusses how to calculate total return and emphasis the importance of setting hurdles. In general Josh finds a sweet stock with stocks yielding between 4-7%. Stocks yielding above say 9% are at risk of having a dividend cut, stocks yielding 2% or below require very high growth rates. This sweet spot is important to retirees because a 4% Safe Withdrawal Rate requires growth at the rate of inflation. If Mr. Bear market or Sub prime Scandal comes along and cuts the price of your 4% dividend payer by 25% you can pretty much ride out the market with your income intact. On the other hand, the yields aren’t so high that a dividend cut is likely because of dropping earnings. Overall Josh is looking for companies which will provide a total return in the 9-11% only a couple of percent higher than his 8% total return estimate for the overall market going forward. (FYI, pretty much in line with Buffett and others estimates.) Still a 1-2% reliable return over the market translates into a hefty increase in disposal income for a retiree or near retiree.

The final chapters of the books discuss managing a dividend portfolio. He gives some helpful advice about picking a target income need and designing a portfolio around that. Not surprisingly the portfolio construction is very similar to the M* dividend investor newsletter portfolio. The lack of diversification (e.g. heavy emphasis on financial) could be worrisome to some investor. However, there is something to be said about Mr. Peters, Warren Buffett, and Marty Whitman, argument that it is better to own 10 stocks you know than 500 you don’t know. One of my other criticisms of the book is that the all important discussion of when to sell is definitely glossed over.

Some of the most valuable section of the books is the 6 appendixes, which discuss the mechanism of dividend payments, tax treatments, and investing in Utilities, Master Limited Partnerships (MLPs), REITs, and Bank Stocks, respectively. The last three areas are particularly good places to look to find high yielding dividend stocks. However, they require an additional approach to evaluating the potential returns. I was particular pleased with these appendix, because having learned the basics of fishing, it is very helpful to learn the tricks involved in fly fish, ocean fishing, and bass fishing, because the more you know the less chance you have of going hungry!

Overall, I am much more confident about investing in dividend stocks thanks to this book. I intend to continue to emphasis individual dividend stocks, for the non-index portion of my portfolio.

[terminator]

Nice review. Thanks for posting cliff.

[cute fuzzy bunny]

Or you could just buy vanguards dividend appreciation index and go to another luau.

[terminator]

Quote:

Originally Posted by cute fuzzy bunny Or you could just buy vanguards dividend appreciation index and go to another luau.

I don't think that 1.7% yield would pay for his pig, pineapple and lei.

[REWahoo]

Isn't it illegal to pay for a lei?

[Zathras]

Thanks for the detailed review Clifp, much appreciated

[cute fuzzy bunny]

Quote:

Originally Posted by terminator I don't think that 1.7% yield would pay for his pig, pineapple and lei.

Thats the problem with staring at 30 day yields. 2% of an equity base that grows at an average of 10% a year and increases the yield steadily starts to look pretty darn tasty after 5-10 years. 5% of an equity base that grows at 3-4% a year and holds or lowers its dividends once or twice during that 5-10 year period start looking pretty lousy.

Its more about the full dollar payout of appreciating assets over the long haul than the 30 day percentage and buying in bulk means you're isolated from single issue failure.

[Nords]

Thanks, Clif, it's on my reading list. By any chance did you happen to donate a copy to the state library system yet?

Now to figure out what to do if qualified dividend tax rates go back up to 28%.

Quote:

Originally Posted by REWahoo Isn't it illegal to pay for a lei?

Only if you want more than one a night. But it's OK to trade with your friends and collect the whole set...

[TBPu]

Excellent post. Thanks for the Clif's Notes version, much appreciated. I'm struggling to convince myself that my situation is right for a dividend stock portfolio. You've answered one of my key questions.

Q. Is dividend investing for a person who wants "set and forget".
A. No these stocks require monitoring of company performance.

clifp, do you think it's risky to only have 10-15 stocks? For instance if I had bought Citigroup at 56 in Jan 2007, not only have I lost 50% of equity but also now have lost 40% of the dividend. And same for BAC at 54 now 38 as well as BBT from 44 to 27. So my concern is that without being due diligent I might not be the first person out the door and be stuck with having to bail out with half my money when dividends get slashed.

[terminator]

Quote:

Originally Posted by cute fuzzy bunny Thats the problem with staring at 30 day yields. 2% of an equity base that grows at an average of 10% a year and increases the yield steadily starts to look pretty darn tasty after 5-10 years. 5% of an equity base that grows at 3-4% a year and holds or lowers its dividends once or twice during that 5-10 year period start looking pretty lousy.

Depending on how you measure it (re-investing dividends? just looking at annual income? looking at the compounded dividend rate only? looking at re-invested total portfolio value?) it takes between 16 and 25 years for the dividend portfolio starting at 1.7% and growing 10% per year to catch up to one that starts at 5% and grows at 3.5%. (Funny I was just messing with a spreadsheet to determine whether to buy a high-yield no-growth REIT or a lower-yield growth REIT.)

That's fine for a young buck like me or even a middle-aged one like yourself, but that might be a long time for clif to wait for his . . . luau.

[Running_Man]

Thanks for the heads up on the book just ordered from Amazon, I also believe in the power of dividend investing, but I did find the Cliff notes to show this will be an interesting read.

[clifp]

Quote:

Originally Posted by TBPu Q. Is dividend investing for a person who wants "set and forget". A. No these stocks require monitoring of company performance. clifp, do you think it's risky to only have 10-15 stocks? For instance if I had bought Citigroup at 56 in Jan 2007, not only have I lost 50% of equity but also now have lost 40% of the dividend. And same for BAC at 54 now 38 as well as BBT from 44 to 27. So my concern is that without being due diligent I might not be the first person out the door and be stuck with having to bail out with half my money when dividends get slashed.

TBPu you and I have similar size portfolios ~$2.5 million, so the short answer to your question is no. I would not be comfortable spending ~$200K for 10-15 stocks and basing my retirement on that.

Stepping back I am looking to for portfolio which lets me withdraw 3.5-4.0% a year for the next 40 years (I'm 48 without having to sell stocks each year to fund my expenses.

There are many ways of doing this but all have drawbacks.
The couch potato portfolio with
50% bonds/cash @5 interest = 2.5% income
50% Total Stock Market @ 2% dividend yield = 1% income
This provides an income roughly equal to your desired withdrawal rate. But is hurt by falling interest rates and long term I don't like having 50% in bonds.

A more agressive early retirement is 70-80% equities.
20% bonds/cash @5% = 1% income
80% index funds @2% = 1.6 income
The 2.6% income figure isn't enough so I have to sell 1.5%+ each year of my index funds to fund expenses. In theory this isn't so bad but in practice I along with just about every board member have a lot more than 2 funds. So I have to figure out which stock fund to sell and how much. I don't want to be selling stocks in a bear market or engage in market timing. (I may be deluding myself, but I have some confidence in picking individual stocks I think are undervalued, but I have no confidence in figuring out if the market will be higher or lower in a year much less next month.)

Substituting a dividend ETF, like CFB suggested, does not help much. For instance Vanguard High Yield Dividend ETF has yield of 2.8% this ups my income level to 3.2% The downside is my ER increase from <.1% to .25%. which is $3,000/year on $2 million equity portfolio. $3k is real money in my book.

My solution is to swap out some of the index funds for individual dividend stocks or MLPs.
Eventually my AA will look like this
20% Cash/Bonds @5% = 1% income
40% index funds (15% international) @2% yield = .8% income
40% dividend stocks @4-6% yield=1.6%-2.4% income.
Total income = 3.6-4.2% so my income and desire withdrawal rate are the same. So while I'll be buying and selling individual stocks, I won't be buying or selling my index funds, unless my AA gets seriously out of whack.

So now within the context of the 40% of my portfolio that is dividend stocks, would be I devastate when Citi cut its dividends and BAC, and BB&T dropped like a rock. The answer is no.
Mr Peter's builder portfolio income increased by 9.8% last year due to div hikes. Now even if Citi was 10% of the income, 40% dividend cut means that my dividend income only increase by 5% last year still better than inflation.

FYI, Citi never was on mine or Josh Peters radar screen. Now after all the bad news out the stock maybe a bargain, but it is too complicated for me to pretend to value it. It is also worth noting that even after Citi dividend cut it is paying $.32/qtr dividend in 2003 it was only paying $.20. A 40% BOA dividend cut would make take its payment back to 2004.

Would I be comfortable going on a vacation for 3 to 6 months and never looking at my portfolio yes. Best of all I'd even be comfortable spending every dollar of projected income. Cause odds are in the next 6 months some of the stocks will increase dividends.

The best way of thinking about dividend investing is to think of your stocks as pieces of rental property. If you owned a bunch of rental properties, you don't check the price of your rentals every day. You might pay attention to price trends every quarter but it wouldn't necessarily cause you to do anything different. What you do care about is the rent trends in your city. If rents are going up celebrate by splurging, rents dropping? tighten your belt. If you want to be more hands on try to figure out which neighborhoods provide the best return for future investment dollars. Or if you see a neighborhood deteriorating maybe sell your rentals in those neighborhoods.

[Nords]

Quote:

Originally Posted by clifp So now within the context of the 40% of my portfolio that is dividend stocks, would be I devastate when Citi cut its dividends and BAC, and BB&T dropped like a rock. The answer is no. Mr Peter's builder portfolio income increased by 9.8% last year due to div hikes. Now even if Citi was 10% of the income, 40% dividend cut means that my dividend income only increase by 5% last year still better than inflation. FYI, Citi never was on mine or Josh Peters radar screen. Now after all the bad news out the stock maybe a bargain, but it is too complicated for me to pretend to value it. It is also worth noting that even after Citi dividend cut it is paying $.32/qtr dividend in 2003 it was only paying $.20. A 40% BOA dividend cut would make take its payment back to 2004.

In situations like this my frustration would be figuring out what to sell in order to buy more BB&T, Citi, & BofA...

[terminator]

I went ahead and stopped at B&N yesterday and picked up the book. Read a few chapters last night. Mostly I'm just interested in seeing if he uses any different analytical methods/techniques than the ones I've picked up.

Obviously I agree with a lot of what Peters is saying but I've already come across a couple items where I don't think he's backing up what he asserts very well. I guess I should withhold judgment until I finish it though. I really wonder how "most patents last 17 years" got past his editors though.

[unclemick]

Hmmm - good review but I'm sticking with my - don't read books curmudgeonism. Since dividends were one of the horses I rode in on - I can't get too cranky.

But I'm not going to repost my 2004 dividend stock ladder thread - given the amount of flack I got back then - sour grapes says I ain't gonna read 'that guy's book' . Even if he has some good ideas.

heh heh heh - all of which reminds me - one file cabinet left and 13 DRIP dividend plans to kill before I get all my Norwegian widow stocks to Vanguard.

P.S. January is Moneypaper's twentieth 'Rest Assured' Dividend and Income portfolio of DRIP plans - now that I'm finally swearing off/taking the cure/getting a broker - whatever.

[terminator]

Well, finished reading the main text last night . . . just have those long appendices to read yet. I liked his "dividend drill" as a good, simple way to combine a lot of the data you'd normally review while doing an analysis. Since I own about half of the stocks he lists in the "builder" portfolio I'd say there's a good overlap between his philosophy and mine.

I was surprised he didn't even mention business development companies (BDC's). I'd understand if he didn't like them, but to not even mention them in a book like this is a pretty big oversight IMHO. Especially when he recommends something like CSE which has a similar business model and economics.

[clifp]

Almost there, a sidebar on BDCs appears on page 245. The harvest portfolio purchased ALD at around $22. I'll be buying it (I wrote a put) tomorrow.

One of the weakness of the newsletter is it is limited to stocks Morningstar covers. So while I glanced at ACAS before buying ALD. ACAS was a scary stock with a double digit yield, ALD had a scary yield but Josh said was it safe, and the history looked good so I bought it. For reason which are a mystery M* covered ALD but not the larger ACAS...

[Nords]

Let me bump this thread while I still have the whole screen to work with.

I waited on the local library for a year or so but finally bought the book. If you've ever been intrigued by dividend investing, this is one of the subject's most rigorous analyses I've ever encountered. Thanks for reviewing it for us, Clif!

Now I need to decide if I prefer to continue the hands-off no-brainer approach of dividend ETFs like DVY & IJS, or if I want to go out on my own again with 10-15 individual stocks. But at least I won't be "chasing yield"...

[Gone4Good]

Quote:

Originally Posted by clifp His philosophical case for why dividends are good for shareholders is quite strong. Imagine a company which makes $200 million in profit. It can reinvest $100 million in it is core business which has historically earn 20% on equity, there is also a $100 million opportunity to acquire another business which if all goes well may earn 15%, In the absence of dividends, both projects are likely to be funded. As we all know the number of can’t miss acquisitions which have flopped is huge.

In practice, though, the company would simply issue additional shares to fund the acquisition. A high dividend payout ratio doesn't prohibit value destroying acquisitions . . . just look at the utility industry if you need countless examples.

More likely, the high dividend payout reflects a mature business with a dearth of investment opportunities, and their associated risks.