You Need To Watch Out For This – ValueWalk Premium
Dividend Investors

You Need To Watch Out For This

Anne Schreiber was an everyday investor who quietly became a millionaire…

After working in government as an auditor, Anne had US$5,000 in capital plus a US$3,150 pension when she retired in the 1940s.

[REITs]

Q1 hedge fund letters, conference, scoops etc, Also read Lear Capital: Financial Products You Should Avoid?

With that money, she decided to invest in dividend-paying companies and reinvest those dividends.

With this strategy, Anne had amassed a US$22 million fortune by the time she passed away in 1995 – including US$7.5 million worth of pharmaceutical company Schering-Plough shares and US$720,000 worth of Coca-Cola shares.

Anne’s story is just one example of how having dividend-paying investments in your portfolio matter.

The long-term historical performance of the S&P 500 Index is another simple example of the power of compound returns from dividend reinvesting.

Thanks to the decade-long bull market in equities, an investment in the S&P 500 Index back in June 2008, for instance, would have returned 105 percent as of June 2018.

But when we factor in dividends, reinvested over the last 10 years, the total return soars to 152 percent.

That’s a 47 percent total return variance, and it happened during an era characterised by one of the lowest dividend yields for the S&P 500 companies in modern history (an average of 2.1 percent over the last 10 years).

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As you can see from the table, reinvesting dividends over the last six decades has resulted in an average increase of returns of about 95 percentage points every 10 years.

Even during the worst of these periods – from 2000 to 2010 – when the market returned a negative 21.2 percent, reinvesting dividends would have cut those losses down to just 5.6 percent.

So finding investments that pay consistent, predictable yields and harnessing their power — through dividend reinvesting — has been proven to generate substantial returns and true wealth.

But if you’re serious about investing in dividend-paying stocks and harnessing the power of compound returns like Anne Schreiber did, you need to watch out for one important detail.

When it comes to dividends, free cash flow (FCF) — not net income — is king

One fatal mistake investors make when looking for dividend investments is to simply do a search on Yahoo or the Wall Street Journal of the companies with the highest dividend yields, and then add those to their portfolio.

But remember, those yields are usually reflective of the past 12 months’ performance. There’s no assurance that the yield this year will remain the same.

A company’s business can and often does fluctuate. A US$20 stock that paid out US$1.50 in dividends one year might suddenly pay only 15 cents the next.

And while many companies do report a net profit on paper, their ability to pay out dividends consistently can change depending on current and future financial requirements.

This is why it’s important to look at a company’s FCF more than net profits, which are occasionally skewed by non-cash items (i.e. one-time gains from revaluation, stock-based compensations, depreciation, amortisation and others).

A company’s FCF is like an x-ray of a firm’s day-to-day operations. It shows you where cash (the lifeblood of a business) is coming in and where it’s going out. At the end of the day, a company should ideally be generating positive FCF.

Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest in its business, pay expenses and return money to shareholders in the form of dividends.

Sustainable dividends go hand-in-hand with positive FCF

Whenever a company pays out a cash dividend, it reduces its accumulated retained earnings.  But those dividends are paid for with cash.

So unless the company has a strong recurring positive FCF, it’s unlikely that any dividends paid will be sustaintable.

Moreover, if a company doesn’t generate enough FCF and continues to pay out dividends, it increases the likelihood of it having to raise money – like borrowing from a bank – to keep its dividend. Or it will have to cut the dividend, which is usually the case.

If you’re wondering why some very profitable companies (as reported in their income statements) don’t pay out any dividends, poor FCF is a big reason why.

For example, Netflix (Exchange: New York; ticker: NFLX) earned made well over US$900 million in net profits over the last three years combined. Yet, it suffers from a negative FCF averaging a whopping US$1.46 billion million per year.

So Netflix hasn’t paid a dime in dividends. And it has to borrow about US$1 billion a year to make sure its employees and suppliers are paid, as well as finance its breakneck expasion.

Netflix’s soaring stock price has been driven almost entirely on the company’s ability to exponentially grow subscribers, penetrate new markets and take business away from rival video streaming services and traditional cable TV operators.

But when that growth eventually slows and negative FCF continues unabated, Netflix’s stock will likely plummet back to earth.

This contrasts sharply with blue-chip stock McDonald’s (Exchange: New York; ticker: MCD). It generates huge amounts of FCF, averaging about US$4.2 billion a year since 2015. That’s enabled it to pay out US$3 billion in cash dividends per year, at a yield of 2.8 percent.

US$10,000 invested in McDonald’s in January 2008 was already worth US$40,436 by January 2018… for a 304 percent return, after reinvesting dividends.

Now, I’m not saying you should go out and call your broker to buy shares of McDonald’s. It’s a great company in its own right, and will likely continue to do well for its shareholders.

But it’s possible to find similarly well-financed companies that are capable of generating even larger yields to help supercharge your portfolio.

I discovered one of these companies for my readers in March 2008. TravelSky Technology (Exchange: Hong Kong; ticker: 696) had developed the airline ticketing and reservation system that eventually was used by China’s entire domestic airline industry.

The company had no debt, and generated twice as much FCF as it needed to pay its US$65 million in annual cash dividends.

And on the back of China’s domestic air travel market soaring from 180 million passengers domestically in 2008 to 460 million today, TravelSky did even better than McDonalds over the past 10 years – returning 438 percent, including dividends. Every US$10,000 turned into US$50,380.

So if you want to take advantage of the wealth-building power of dividends… find companies with stable or growing businesses that are generating heaps of FCF and paying above market yields.

Good investing,

Brian Tycangco

 

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