Johnson & Johnson (JNJ) Dividend Stock Analysis

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide.

Johnson & Johnson is a major component of the S&P 500, Dow Industrials and the Dividend Aristocrats Indexes. One of the company’s largest shareholders includes Warren Buffett. JNJ has been consistently increasing its dividends for 46 consecutive years. From the end of 1998 up until December 2008 this dividend growth stock has delivered a 5.60% annual average total return to its shareholders.

At the same time company has managed to deliver a 13.40% average annual increase in its EPS since 1999.

The ROE has remained largely between 20% and 30%.

Annual dividend payments have increased by an average of 14.10% annually since 1999, which is much higher than the growth in EPS. Analysts are expecting flat EPS for 2009 compared to 2008, given the state of the economy and the erosion of market share by certain products losing patent protection. The strong US dollar could potentially hurt sales, as over 50% of Johnson & Johnson’s revenues are derived internationally.
A 14% growth in dividends translates into the dividend payment doubling almost every five years. Since 1974 JNJ has indeed managed to double its dividend payment almost every 5 years.
The dividend payout has remained in a range between 35% and 45%. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

JNJ is attractively valued. The stock trades at a price/earnings multiple of 12, has a low DPR and the current dividend yield is the 3% minimum threshold that I have set.
I do not see the recent reduction in Berkshire Hathaway’s stake in JNJ as a negative. Buffett has sold at the wrong time before as well. Furthermore he could afford to invest his proceeds in preferred shares with warrants, which deliver him 10%-15% dividend yields.

Full Disclosure: Long JNJ

Relevant Articles:

- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates

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The Testimony Of Benjamin Graham - Part II

Last Thursday I posted on testimony that Benjamin Graham gave to Congress in the early 1950's. While some would consider this to be ancient history, I found a passage that is applicable to the situation today, as it pertains to the sentiment and psychology that is gripping the market.

"With respect to the causes of the rise in the market since September 1953, my statement indicates I would emphasize very much the change in investment and speculative sentiment, more than any change in basic economic factors. I wanted to point out that that carries an element of danger because a change in of sentiment for the better may be followed by a change in sentiment for the worse."

We are certainly seeing a change in sentiment for the worst, and if you listen to some commentators, we are heading for the end of civilization. This is nonsense, of course, and represents nothing more than the opposite of what Greenspan called "irrational exuberance."

Turn your TV off and start looking for stocks that will get through the next few years unscathed and make you rich.
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Cable TV & Coffee

Yes, some firms are still raising dividends and it is up to me to keep DIV-Net readers informed. Despite the economic crisis, Rogers Communications (RCI.B) and Tim Hortons (THI) are still getting paid and ensuring that their shareholders are getting paid.

Rogers Communications, which is actually part of my Future of Canadian Dividend Growth series hiked their dividend by 16%. The stock now yields about 3.8%. Rogers is well positioned to grow their dividend in the years to come.

Tim Hortons, the iconic Canadian Coffee and Doughnut chain, raised their dividend by 11% and now yields about 1.3%. I also like Tim Horton's prospects for dividend growth going forward.

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What Being On Vacation Taught Me About Investing

Ok, this is going to be a real short post from me on The DIV-Net as I am currently living it up in the Canary Islands on a bit of a vacation with some good friends and family. As I sit here and log into one of the slowest Wi-Fi services I have experienced in a long time I once again have been reminded about what is important in life.

It is very easy to get sucked into watching the markets all the time - listening to CNBC and reading newspapers about how bad things are and how they are going to only get worse. That may be true, and it is not a good situation we are all in right now. However, as a long term investor what happens day to day and even month to month does not really matter. In 25+ years this too will seem like a blip in the historical investment timeframe - even if it isn't then all we can do is build a core portfolio to meet the market performance and hope for the best.

While on vacation, it has been good to be disconnected from my portfolio. I hope that I can do it more in the future.

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

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Stock Analysis: Parker Hannifin Corp (PH)

Linked here is a detailed quantitative analysis of Parker Hannifin Corp (PH). Below are some highlights from the above linked analysis:

Company Description: Parker-Hannifin Corp is a global maker of industrial pumps, valves and hydraulics. Its products are used in everything from jet engines to trucks and autos and utility turbines.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
   
2. 20-Year DCF Price
   
3. Avg. P/E Price
   
4. Graham Number
   

PH earned two Stars in this section for 3.) and 4.) above. PH has paid a cash dividend to shareholders every year since 1949 and has increased its dividend payments for 52 consecutive years. It's one year dividend growth rate exceeded its 5-year growth rate. This could indicate the growth rate is accelerating.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
   
2. Dividend Growth Rate
   
3. Years of Div. Growth
   
4. 1-Yr. > 5-Yr Growth
   
5. Payout 15% of avg.
   

PH earned two Stars in this section for 3.) and 4.) above. PH has paid a cash dividend to shareholders every year since 1949 and has increased its dividend payments for 52 consecutive years. Its one year dividend growth rate exceeded its 5-year growth rate. This could indicate the growth rate is accelerating.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
   
2. Years to > MMA
   

PH earned one Star in this section for 1.) above. The NPV MMA Diff. of the $2,839 is in excess of the $2,500 minimum I look for in a stock that has increased dividends as long as PH has. If PH grows its dividend at 8.0% per year, it will take 7 years to equal the cumulative earnings from a MMA yielding an estimated 20-year average rate of 3.42%.

Other: PH is a member of the S&P 500 and a member of the Broad Dividend Achievers™ Index. PH's industrial and aviation businesses are highly cyclical. They operate in a competitive environment and are sensitive to energy costs. With the recent economic downturn, manufacturing firms (much of PH's customer base) are extremely cautious on spending. This is likely to continue until the global economy shows at least some signs of recovery. Risks include continued declines in global economic growth, an extended downturn in the aerospace market and the potential for production problems.

Conclusion: PH earned one Star in the Fair Value section, earned two Stars in the Dividend Analytical Data section and earned one Star in the Dividend Income vs. MMA section for a net total of four Stars. This quantitatively ranks PH as a 4 Star-Buy.

Using my D4L-PreScreen.xls model, I determined the share price would need to decrease to $37.23 before PH's NPV MMA Differential fell to the $3,000 that I like to see. At that price the stock would yield 2.69%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the needed $3,000 NPV MMA Differential, the calculated rate is 9.9%. This dividend growth rate is above the 8.0% used in this analysis. PH has a risk rating of 1.50 which classifies it as a low risk stock.

PH is a world-class industrial company with a favorable earnings and dividend track record. It's valuations are near all-time lows. Currently, PH's NPV MMA Differential is not enough to justify its current risk. I would give PH consideration at prices below $37.23, but would not give strong consideration until the price hit $32.17. For additional information, including the stock's dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I did not have a position in PH (0.0% of my Income Portfolio).

What are your thoughts on PH?


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Johnson & Johnson Rundown

Berkshire Hathaway's 13-F revealing a big sell off of JNJ, has created a huge wave of news about whether Buffett has gone sour on the business. Without hearing from the man himself, we will never know. With everyone offering tremendous terms to Buffett in order to borrow from his hoarde of cash, I wouldn't be surprised if he is getting better deals from these American icons than what JNJ is offering.

Rather than getting swamped with the noise, analysing the numbers itself reveals that JNJ is in fine condition.

I think it is safe to say that JNJ requires no introduction. Here are some points to note regarding JNJ from the following PDF analysis.

Quick Look at the Financial Statements

• Gross profit maintained at 70%
• SG&A steady at 33%
• Slight reduction in R&D
• Larger than usual Other expense (requires digging into footnotes)
• Decline in net margin to 17.3% which is around the same level during the previous recession
• Steadily increasing accounts receivables, inventory and other assets
• Doubled intangibles in 2006
• Tripled long term debt from 2006 but still capable of paying it off easily
• Other long term liabilities doubled
• FCF growth maintained more than 10 years

Quick Valuation

• Very good, strong and consistent numbers but the increase in debt should be looked at
• Bottom line margins declining. JNJ is still subject to a recessionary environment. We think that people will still maintain their baby powder, band aids and shampoos, but when it gets tough, most resort to the cheaper and generic brands.
• DCF values JNJ at $71 which is the peak price from 2008
• Plenty of FCF to cover debt
• Ben Graham formula values JNJ at $108 which is overly optimistic
• JNJ has always been trading close to its intrinsic value but the recent dip is the biggest stray from the intrinsic line to date
• Compared to its competitors, JNJ is not trading at a premium. A very respectable PE of 12.
• Highest earnings yield in a long time of 13%

Johnson & Johnson still remains to be a solid company. Whether Buffett himself or his subsidiaries sold it or not, the business continues to pump out cash. Just the way I like it.Download the PDF.

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Weekend Reading Links - February 21, 2009

For your weekend reading pleasure, the articles listed below contain some of the best dividend and value investing insights found on the web. They were written by various members of the Dividend Investing and Value Network (DIV-Net) over the past week:

Articles From DIV-Net Members

• Dividends Value presented Ten Dividend Stocks With 50+ Years of Consecutive Increases
  
• The Dividend Guy presented A Really Long Term Dow Jones Chart to Put Things in Perspective
• Dividend Growth Investor presented Should you follow Warren Buffett’s latest moves?
• the moneygardener presented good financial government
• The Div Guy presented The 20 Best Dividend Plays for 2009
• Disciplined Approach to Investing presented Investor Bullish Sentiment Continues To Fall
• Living Off Dividends & Passive Income presented Is A Global Financial Meltdown Imminent?
• Old School Value presented Reward-Risk or Risk-Reward?
• Triaging My Way To Financial Success presented Mail Bag: Manulife (MFC)
• Dividend Money presented The Misery Index
• Barel Karsan presented Protectionism In Recessions
• Everyday Finance presented GM - Not One to Say "I Told You So"
• Contrarian Value Investing presented Readers Of CVI Somewhat Bullish
• Buy Value presented Buffett's Biggest Mistake

There are some really good articles here, please take time and read a few of them.

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Yield on Cost Matters

The bear market has brought many stocks to multi-year lows, pushing their current dividend yields to levels not seen for years. Some dividends got cut in the process, triggering further selloffs in stock prices, which somehow miraculously lead to almost the same current dividend yields. Multiplying the most recent quarterly or monthly dividend payments by 4 or 12 and then dividing the result by the amount of the stock price calculates current dividend yield.

For example if you purchased Bank of America (BAC) stock in September 2008 at $25.60, while the dividend was $0.64/quarter, the current dividend yield would have been 10%. After BAC cut its dividends by 50% to $0.32/quarter, if the stock was trading at $12.80 then the current dividend yield would have been 10% as well. Most investors who chase high yielding stocks blindly would tell you that in both situations BAC was a high yielding stock to consider. There is one difference however – the person that purchased BAC for $25.60 is worse off after the dividend cut, in comparison to the investor who purchased BAC stock at $12.80, since their dividend income is decreased in half.

Astute readers would realize that current yield does not matter much to a long-term dividend investor. What matters is that dividend payments get increased over time.

If an investor purchased stock in Bank of America in 2002 at $30/share, their current dividend yield would have been 4%. As Bank of America kept increasing its dividend payments from $0.30 to $0.64, the current yield on Bank of America was almost unchanged around 4%. The yield on cost however, which is calculated by dividing the most recent annual dividend payment to the price that you paid for the shares that you own, has been increasing despite the current yield being unchanged.

An investor who purchased 100 shares at $30 in 2002 received $30 every quarter. The current yield and the yield on cost in this scenario were 4%. The amount received increased as the dividend payment was raised to $0.64/quarter in 2007, bringing the yield on cost to 8%. The current yield was almost 5% at the time when the dividend was increased and the stock was trading at $50.

When Bank of America cut its dividend payment to $0.32/share current yields were still in the vicinity of 10%. This affected only new investors however, since they were the ones who might generate a 10% annual return on their investment solely from the dividends received, provided that the payment was not cut again. The investor who purchased BAC stock back in 2002 saw their income fall by half, bringing their yield on cost to 4.3%.

In hindsight, selling after the first dividend cut and allocating the money into another dividend growth stock, could have been a good thing for the investor who purchased BAC stock in 2002. As we later learned, Bank of America cut its dividend payment per share once again to just one penny per quarter.

There are many dividend success stories however, where investor’s yield on cost is in the double or even triple digits. An investment in 3M (MMM) at the end of 1988 at $16 generated a current dividend yield as well as yield on cost of 4%. After 20 years of consistent dividend increases however, the annual dividend payment is increased to $2/share, making for a yield on cost of 12.5%. Check out my analysis of MMM. Even if you purchased into an S&P 500 index fund in the late 1970’s, you would have seen our yield on cost increase from 5.20% to 26.20% currently.

I hope I have illustrated a point that high current yield is not what dividend growth investors should be looking at when they search for investment opportunities. The thing that matters is finding a solid non-cyclical company with a wide moat, which could increase its earnings over time. Increase in earnings power could lead to increase in dividends over time. As Dave Van Knapp put it in 10x10, the best dividend strategy is to achieve a balance between dividend growth and initial dividend yield.

Relevant Articles:
- Don’t chase High Yielding Stocks Blindly
- 10 by 10: A New Way to Look at Yield and Dividend Growth
- Bank of America (BAC) might have to cut dividends
- Bank of America (BAC) Dividend Analysis

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The Testimony Of Benjamin Graham

I came across a copy of testimony that Benjamin Graham gave to the Senate Committee on Banking and Currency back in 1955. This was the old name of current Committee on Banking, Housing, and Urban Affairs that is Chaired by Senator Chris Dodd, a Democrat from Connecticut. The subject of the hearing was “Factors Affecting the Buying and Selling of Securities.”

The full transcript is available here:

Under the Buttonwood Tree

Click the second link.

The most interesting part of the testimony is the overall tone. The politicians are actually trying to get information and learn something rather than grandstand and try to get a few headlines on the local news showing them bash some rich Wall Street fellow.

Graham started his partnership in 1923 with $500,000. If you adjust this for inflation using the CPI, that comes to around $6 million.

I am still wading through the 34 pages and will post more next Thursday.
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10 Steps to Improve Your Financial Future

One of the podcasts I listen to every week is Sound Investing. As I was searching through You Tube the other week for investment related materials, I came across a number of video posts that have done summarizing their investment approach. This particular video I am posting here describes 10 steps to improve your financial future. I think it is a pretty good summary of things that a lot of people need to do now, especially in light of this crazy market we are going through. Here is the video:



As a summary, here are the 10 steps deiscussed in the video:

1. Focus on you and your need for a return on your investments
2. Understand your risk profile
3. Be diversified
4. Reduce expenses
5. Unload bad assets
6. Add good assets
7. Balance non-correlated funds
8. Add fixed income
9. Get your spouse involved
10. Confirm with a pro

Now, I do recognize that it is a bit of a sales pitch for their firm - point 10 pretty much confirms that! However, as far as the basics of investing goes I think it is pretty hard to refute steps 1 through 9 as something to do to create a strong portfolio into the future.

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

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Stock Analysis: 3M Co. (MMM)

Linked here is a detailed quantitative analysis of 3M Co. (MMM). Below are some highlights from the above linked analysis:

Company Description: 3M Co. is a diversified technology company with a presence in various businesses, including industrial & transportation, healthcare, display & graphics, consumer & office, safety, security & protection services, and electro and communications.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
   
2. 20-Year DCF Price
   
3. Avg. P/E Price
   
4. Graham Number
   

MMM is trading at a discount to 1.), 2.) and 3.) above. If I exclude the high and low valuations and average the remaining two, MMM is trading at a 41.2% discount. MMM earned a Star in this section since it is trading at a fair value.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
   
2. Dividend Growth Rate
   
3. Years of Div. Growth
   
4. 1-Yr. > 5-Yr Growth
   
5. Payout 15% of avg.
   

MMM earned one Star in this section for 3.) above. MMM has paid a cash dividend to shareholders every year since 1916 and has increased its dividend payments for 51 consecutive years.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
   
2. Years to > MMA
   

MMM earned both of the available Stars in this section. The NPV MMA Diff. of the $4,687 is in excess of the $2,500 minimum I look for in a stock that has increased dividends as long as MMM has. MMM's current yield of 4.08% exceeds the 3.42% estimated 20-year average MMA rate.

Other: MMM is a member of the S&P 500, a Dividend Aristocrat and a member of the Broad Dividend Achievers™ Index. The company has enjoyed strong historical earnings, dividend growth and free cash flow. In addition, the company has relatively low debt and a strong balance sheet. MMM's has demonstrated the ability to generate strong returns on capital and free cash flows, and will likely continue to do so. Risks include slowing growth in most of MMM's business units from the current economic situation, lower growth in the optical display business, integrating business acquisitions and less than planned cost-saving initiatives

Conclusion: MMM earned one Star in the Fair Value section, earned one Star in the Dividend Analytical Data section and earned two Stars in the Dividend Income vs. MMA section for a net total of four Stars. This quantitatively ranks MMM as a 4 Star-Buy.

Using my D4L-PreScreen.xls model, I determined the share price could increase to $55.76 before MMM's NPV MMA Differential fell to the $3,000 that I like to see. At that price the stock would yield 3.59%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the needed $3,000 NPV MMA Differential, the calculated rate is 2.4%. This dividend growth rate is below the 4.2% used in this analysis. MMM has a risk rating of 1.25 which classifies it as a low risk stock.

The above information is based on dividends paid through 2008. Earlier this month MMM incresed its quarterly dividend 2% to $0.51/share. Using a dividend growth rate of 2% and holding all other thing equal, MMM's NPV MMA Differential would drop to $2,723, which is below my required $3,000. At a 2% dividend growth rate, MMM drops to a 3 Star-Hold and my adjusted buy price would be $47.84.

I consider MMM to be an excellent long-term dividend stock and will continue to watch for opportunities to initiate a position below my buy price. For additional information, including MMM's dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I did not have a position in MMM (0.0% of my Income Portfolio).

What are your thoughts on MMM?


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Sustainable Dividends

Last week I wrote a post titled Leveraging Dividends where I provided tips for using conservative leverage in a dividend growth portfolio. This week I want to expand on what I deem to be conservative income for any investor looking for companies that pay dividends.

There have been a number of dividend cuts announced over the past 12 months and many investors are speculating on who could be next or how far further dividend cuts could go. As a dividend investor you have to develop a discipline that prevents you from chasing yield and allows you to look at the operations of the company with an unbiased view. There are a number of public corporations whose operations aren’t sustainable and neither is their dividend.

How does an investor identify what is a sustainable dividend?

You need to look at the operations of the business, examine the business model, assess their earnings strength and determine the payout ratio of the company.

Yield isn’t the sole factor that should set off alarm bells in the minds of investors; the payout ratio is more important. The payout ratio is the amount of earnings that are paid out as dividends to investors; the higher the payout the less sustainable a dividend potentially becomes.

For a company with high growth and a capital intensive business the payout should be relatively low; below 50%. The reason for this is because the company needs to re-invest earnings back into the business in order to continue growing and maintaining their strong financial position. For a company with low growth and limited capital requirements the payout can be slightly higher; above 50%. The reason for this is because the company can afford to pay out more in dividends to investors since its operations don’t require the majority of earnings to be re-invested back into the business. A company always needs to retain some portion of earnings, but determining what is appropriate depends on the business model and life-cycle of the business.

Many investors have chased yield over the past year and been burnt badly when the company’s dividend has been subsequently slashed.

What companies have sustainable dividends?

I’ve included a list of 25 companies whose payout ratios range from a low of 14.4% to a high of 66.5%. They include companies from different industries, with different business models and different demands for re-investment of their earnings.



I consider each to have sustainable dividends and each should have the ability to endure this difficult economic period with their dividends intact or higher. They aren’t the most exciting companies, but they provide something that many investors lack in their portfolios at this time: consistency & sustainability.

I own shares in BAX, BDX, KO, CL, GIS, SJM, JNJ, KMB, PG, SNY, WMT, CNR, ACO.X, ENB (via ENB.PR.A), FTS, RCI.B, SJR.B & X.

This article was written by Triaging My Way To Financial Success. You may email questions or comments to me via my contact page.
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Weekend Reading Links - February 14, 2009

For your weekend reading pleasure, the articles listed below contain some of the best dividend and value investing insights found on the web. They were written by various members of the Dividend Investing and Value Network (DIV-Net) over the past week:

Articles From DIV-Net Members

• Dividends Value presented The Best Dividend Stocks In The World
  
• The Dividend Guy presented The Dividend Guy Investment Process Part 11: Things I Won’t Do
  
• Dividend Growth Investor presented Seven Notable Dividend Increases in the news
  
• the moneygardener presented teenage dirtbag
  
• Stock Market Prognosticator presented Beating A Dead Horse
  
• The Div Guy presented The Tortoise Wins Again
  
• Disciplined Approach to Investing presented Near The Bottom If History Repeats Itself?
  
• Living Off Dividends & Passive Income presented Faber And Einhorn on Inflation and Gold
  
• Old School Value presented Mead Johnson Nutritionals Spinoff IPO
  
• Triaging My Way To Financial Success presented Always Coca-Cola
  
• Barel Karsan presented UTS Energy
  
• Everyday Finance presented 3 Corporate Bonds Yielding Over 10% that Aren't Financials!
  
• Contrarian Value Investing presented Magic Formula Stocks On The Move 2-07-09
  
• Buy Value presented The Best Month To Buy Stock

There are some really good articles here, please take time and read a few of them.

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Stock Screen: Oil and Gas Transport Plays

BusinessWeek has a great screen of oil and gas transportation stocks by Beth Piskora. These stocks have held up well over the last couple of years and have been my top performers.

Stock Screen: Oil and Gas Transport Plays
Quick: name an industry group where the average dividend yield is hovering around 11%. If you guessed utilities, real estate investment trusts (REITS), or banks, you're wrong. But if you guessed oil and gas transportation companies, that would be correct.

Most oil and gas pipeline companies are set up as Master Limited Partnerships (MLPs), which means they must, by law, distribute their earnings, just like REITs do. That makes them good choices for income-focused investors, in our view.

"The distribution—or dividend—level is a very important driver of investor interest in this group," explains Tanjila Shafi, a Standard & Poor's equity analyst. "The companies know this, so they are working very hard not to cut the payouts. They are doing other things like cutting capital expenditures to preserve capital, just to maintain the distribution levels."

Shafi recommends only six MLPs, and believes all six should be able to maintain their distribution levels this year. She also believes that they, as a group, are the strongest companies in the industry, have good balance sheets, and are more likely to be able to tap the capital markets. She notes investors may find other MLPs with higher dividend yields, but recommends for purchase only these six, each of which carries an S&P investment ranking of 4 STARS (buy) or 5 STARS (strong buy).

Company Ticker S&P STARS Rank (2/12/09)
Energy Transfer Partners ETP 4
Kinder Morgan Energy Partners KMP 5
Magellan Midstream Holdings MGG 4
NuStar Energy NS 4
Oneok Partners OKS 4
Plains All American Pipeline PAA 4

Disclosure: The Div Guy owns shares of KMP and OKE which owns part of OKS at the time of this post.

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IBM Dividend Stock Analysis

International Business Machines Corporation (IBM) develops and manufactures information technologies, including computer systems, software, networking systems, storage devices, and microelectronics worldwide.

IBM is a major component of the S&P 500, Dow Industrials and the Dividend Achievers Indexes. IBM has been consistently increasing its dividends for 13 consecutive years. From the end of 1998 up until December 2008 this dividend growth stock has delivered a zero annual average total return to its shareholders. At the same time company has managed to deliver a 9.00% average annual increase in its EPS since 1999.
The ROE has remained largely between 25% and 40%, with the exception on 2008.

Annual dividend payments have increased by an average of 16.80% annually since 1999, which is much higher than the growth in EPS.
A 17% growth in dividends translates into the dividend payment doubling almost every four years. Since 1997 IBM has actually managed to double its dividend payment almost every 5 years.
The dividend payout increased slightly for the majority of our study period, by rising from 11% in 1999 to 21% in 2008. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

IBM is not yet attractively valued. The stock trades at a price/earnings multiple of 10.7, and has a low DPR. However the current dividend yield is below the 3% minimum threshold that I have set. As a dividend growth holding IBM is a buy on dips below $67. Big Blue has cut its dividend previously in 1993.

Relevant Articles:

- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates

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Charlie Munger Speaks

Charlie Munger has always taken a backseat to Warren Buffett in the pantheon of Value Gods, not because of ability, but perhaps out of a lack of ego or some other reason. He penned an editorial in the Washington Post yesterday morning that made some interesting points.

The full editorial is here.

This editorial has been well covered so I won't go over each point, but the most interesting part to me was the last paragraph:

"...officials might want to consider a precedent that helped establish our republic. The deliberative rules of the Constitutional Convention of 1787 worked wonders in fruitful compromise and eventually produced the U.S. Constitution. With no Marshall figure, trusted by all, amid today's legislators, perhaps the Founding Fathers can once more serve us."

If Munger calling for a constitutional convention to solve our problems? This would, of course, be unprecedented in our history. Our constitution has been amended many times, but only by Congressional action, not through a convention which must be called for by two-thirds of the states. If a convention is called, then everything is on the table, not just the Financial system. This might be a little too radical a solution as the partisanship fighting would explode to new levels at such an event.

Read more on Article V
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These Firms Shouldn't Cut Part II

In last Wednesday's post I isolated what I think are the two most important questions to ask about a firm to decipher the changes of a dividend cut. I'll expand on why I believe these questions are crucial in today's post.

1. How Does This Company Make Money? This is important. Does the company offer a product or service that is unlikely to be sacrificed during recessionary conditions. In other words, how stable are it's cash flows?

Examples:
Campbell Soup (CPB) - Manufacturer of soup and other basic foods
Clorox (CLX) - Manufacturer of cleaning products, kitchen bags, etc.

2. What Is The Payout Ratio of Dividends on Earnings? What is the ratio of dividends paid per share divided by earnings per share. If you feel good about the answer to question number 1, a pay out ratio of less than 50% is ideal and increases the likelihood that this firm will not cut it's dividend.

Examples:
Procter & Gamble (PG) = 37%
Wal-Mart (WMT) = 28%

This is not a be all and end all, however asking these two questions is a good start towards selecting a dividend investment that is unlikely to chop their dividend in the future.

This article was written by the moneygardener. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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The S&P Indices Versus Active Funds Scorecard

There is a huge and constant debate in the investment world concerning active versus passive investing. As I am sure most of our readers know, passive investing is simply investing in a series of stock market indexes. Active investing is buying individual stocks and bonds to try to beat the indexes. Standards & Poor's conducts a study of active mutual funds versus the index called The S&P Indices Versus Active Funds (SPIVA) Scorecard (pdf). From this report it is very easy to see that active mutual funds do not stack up well against the indexes, even if 2008 was a better year than most.

The image below presents the results from the study. Each number listed is the percentage of actively managed mutual funds that did not manage to beat the index. As you can see, the majority of mutual funds are not able to beat the index. The real challenge for an investor however, is how to know which of the over 2,000 domoestic funds are going to be the one that manages to post better than average performance.



The other main takeaway from this information is the fact that investors are paying huge fees to mutual fund companies to support marketing and broker commissions when most of the time these funds cannot even keep up with the indexes. This argument is starting to sound like a broken record, however it is what it is. Mutual funds cannot meet their goals and investors should stop getting ripped off by them. I will get off my soapbox now!

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

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Stock Analysis: Paychex Inc (PAYX)

Linked here is a detailed quantitative analysis of Paychex Inc (PAYX). Below are some highlights from the above linked analysis:

Company Description: Paychex, Inc. provides payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the United States.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
   
2. 20-Year DCF Price
   
3. Avg. P/E Price
   
4. Graham Number
   

PAYX is trading at a discount to 1.), 2.) and 3.) above. Since PAYX's tangible book value is not meaningful, a Graham number can not be calculated. If I exclude the high and low valuations and average the remaining two, PAYX is trading at a 51.9% discount. PAYX earned a Star in this section since it is trading at a fair value.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
   
2. Dividend Growth Rate
   
3. Years of Div. Growth
   
4. 1-Yr. > 5-Yr Growth
   
5. Payout 15% of avg.
   

PAYX earned all available Stars in this section for the four valuations above, [5.) is a deduct only]. Rolling 4-yr Div. > 15% means that dividends grew on average in excess of 15% for each consecutive 4 year period over the last 10 years (1999-2002, 2000-2003, 2001-2004, etc.) I consider this a key metric since dividends will double every 5 years if they grow by 15%. PAYX has paid a cash dividend to shareholders every year since 1988 and has increased its dividend payments for 17 consecutive years. It's one year dividend growth rate exceeded its 5-year growth rate. This could indicate the growth rate is accelerating.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
   
2. Years to > MMA
   

PAYX earned both of the available Stars in this section. The NPV MMA Diff. of the $248,717 is in excess of the $7,500 minimum I look for in a stock that has increased dividends as long as PAYX has. PAYX's current yield of 4.77% exceeds the 3.42% estimated 20-year average MMA rate.

Other: PAYX is a member of the S&P 500 and a member of the Broad Dividend Achievers™ Index. The company has a strong balance sheet and the nature of the business provides for regular cash inflows. With the economic downturn leading many companies to layoff employees, PAYX’s earnings could be adversely affected in the short-term. However, over the long term the company should benefit from a solid management team, higher retention rates, falling attrition and strong profitability. Risks include economic uncertainty in the small-to medium-sized business segment, pricing and margin pressure from Automatic Data Processing (ADP).

Conclusion: PAYX earned one Star in the Fair Value section, earned four Stars in the Dividend Analytical Data section and earned two Stars in the Dividend Income vs. MMA section for a net total of seven Stars. Since my scale tops out at five, this quantitatively ranks PAYX as a 5 Star-Strong Buy.

Using my D4L-PreScreen.xls model, I determined the share price could increase to $81.45 before payx's NPV MMA Differential fell to the $7,500 that I like to see. At that price the stock would yield 1.47%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the needed $7,500 NPV MMA Differential, the calculated rate is 4.3%. This dividend growth rate is substantially below the 17.8% used in this analysis, thus providing a margin of safety. PAYX has a risk rating of 1.75 which classifies it as a medium risk stock.

PAYX is trading substantially below my calculated buy price of $55.94. I will continue to cautiously add share as PAYX's price and my allocation allows. For additional information, including PAYX's dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I was long in PAYX (1.9% of my Income Portfolio).

What are your thoughts on PAYX?


Recent Stock Analyses:

• Stock Analysis: BP Plc [BP]
  
• Stock Analysis: Lowe's Companies, Inc. [LOW]
  
• Stock Analysis: Legg Mason, Inc. [LM]
  
• Stock Analysis: Procter & Gamble Co. [PG]
  
• More Stock Analyses

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Warren Buffett's Bad Deal

Much has been written about the success of Warren Buffett, but little on his failures.I think a great deal can be learned by analyzing the failures of successful people. By studying these failures hopefully we can avoid them ourselves.

The Deal

Buffett purchased preferred shares in US Airways in the early 1990's, and later remarked that this was one of his biggest mistakes. Now before getting to far into this it is worthwhile to comment that Buffett did in fact end up making a profit on his holdings of US Airways but Buffett certainly cannot claim credit for this. In his own words:

"Two changes at the company coincided with its remarkable rebound: 1) Charlie and I left the board of directors and 2) Stephen Wolf became CEO. Fortunately for our egos, the second event was the key..." Warren Buffett, Bershire Hathaway Letter 1997.

A few years after purchasing Buffett had pretty much written off the investment and had tried to sell out of the stock numerous times at a substantial discount. The investment had essentially become out of control and Buffett wanted out. Luckily he wasn't able to sell until sometime later when the company had started to rise again.

What Went Wrong?

So what did Buffett do so wrong? Lets look at the principals that Buffett uses for analyzing an investment:

"Charlie and I look for companies that have a) a business we understand; b)favorable long term economics c)able and trust worthy management d) a sensible price tag." Berkshire Letter to Shareholders 2007

Understandable Business

Looking from the outside the airline business is fairly easy to understand. Money is made by moving customers and packages from one location to another. But behind the scenes the airline business is a huge gamble with 183 airlines having gone bankrupt since 1978. So much of the business is frozen in the assets in the business that any turn in the economy can destroy it over night.

Sustainable Competitive Advantage

Part of the reason that so many airlines have gone out of business is that consumer's are essentially unable to determine the difference between one airline and another. The planes are all the same make and model, you leave from the same airports, the pilots are all trained by the same schools and military, the food is very similar and they show the same movies. For the consumer in most cases it comes down to a question of price- who can get me there cheaper. Did US Airways have a way to keep their costs under any better control than their competition? No, unfortunately they shared several of the same unions as other airlines and were being charged the same airport fees as others also. It is difficult then to see the sustainable competitive advantage that US Airways had.

Able & Trustworthy Managers

Within a year of purchasing the preferred shares in United Airways the CEO Ed Colodny had been replaced and the stock price had gone into a deep dive. While Buffett still remarks that he has the utmost respect for Colodny he obviously could not get the job done and was on his way out as Buffett was coming in. In terms of Able then US Airways appears to fail this criteria.

Bargain Price

A bargain is only a bargain if you get something of value. While the preferred divided Buffett was to receive was an appealing 9.25% he was unable to collect that for 2 years. Several other ratios were also appealing; if the market teaches value investors anything its that sometimes things appear cheap because they, in fact, garbage.

Analysis Conclusion

Buffett failed to enforce his own rules of selection and got wrapped up in a bad decision. As he put it:

"I liked and admired Ed Colodny, the company's then-CEO, and I still do. But my analysis of USAir's business was both superficial and wrong. I was so beguiled by the company's long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir's revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline's past record might be." 1996 Letter to Shareholders, Warren Buffett

What Can We All Learn From This?

Buffett has a good system, when he settles on an investment choice he writes down the reasons that he feels it is a good investment. If he can't persuade himself to buy based entirely on what he writes down on the paper then he walks. This would have been one of those times he should have looked more carefully at the paper.

We can all learn from this mistake; do your homework and, most importantly, stick to your principals. If you have rules for investments make sure you are sticking to them. What went wrong here then is that Buffett stopped using his rules and veered off the track- don't make the same mistake in your investing.

This article was written by buy value. You may email questions or comments to me at buyvalue.investor@gmail.com

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Weekend Reading Links - February 7, 2009

For your weekend reading pleasure, the articles listed below contain some of the best dividend and value investing insights found on the web. They were written by various members of the Dividend Investing and Value Network (DIV-Net) over the past week:

Articles From DIV-Net Members

• Dividends Value presented The Dividend Stock Life Cycle
  
• The Dividend Guy presented Top 50 Investing Blogs
• Dividend Growth Investor presented My take on State Street’s dividend cut
• the moneygardener presented energy dividends going by the wayside
• Stock Market Prognosticator presented What Is The Real Story With The Senior Loan Officer Opinion Survey
  
• The Div Guy presented Stock Screen: Low-Beta Dividend Stocks
  
• Disciplined Approach to Investing presented Investor Sentiment Continues To Decline And Market Grinds Higher
  
• Living Off Dividends & Passive Income presented Peter Schiff: Dollar Is The Next Bubble To Collapse
  
• Old School Value presented Odds Update for EMAG Arbitrage
  
• Triaging My Way To Financial Success presented The Return of Capital
  
• Bullish Dividends presented Dividend Stock Analysis: Royal Bank Of Canada (TSE: RY)
  
• Barel Karsan presented Buffett's Stock Market Indicator
  
• Everyday Finance presented Caps on Wall Street Compensation - Dumb and Ineffective
  
• Contrarian Value Investing presented Why Wall Street Will Never Get It Right
  

There are some really good articles here, please take time and read a few of them.

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Are Dividends in Dire Straits?

BusinessWeek has an interesting article on the state of dividends by Ben Steverman. Are Dividends in Dire Straits?

Many companies, especially banks, have had to slash or eliminate payouts. How low will dividends go?

Companies continue to slash dividend payments to shareholders, as firms rush to hold on to capital amid the continuing credit crisis and deteriorating economy.

The latest to slash its payout is financial firm State Street (STT), which on Feb. 5 dropped its quarterly dividend from 24¢ to 1¢ per share. On the same day, auto and truck dealer Penske Automotive Group (PAG) suspended its dividend.

In the past two months, corporate boards have cut dividends by half or more at Macy's (M), Pfizer (PFE), and Constellation Energy Group (CEG). Dividends have been eliminated—or nearly so, with payouts slashed 96% or more—at Bank of America (BAC), Motorola (MOT), and Citigroup (C).

The trend is disturbing to investors, who especially appreciate dividends at times of economic uncertainty.

"Investors are really looking for yield, and they're looking for safety," says Bruce Bittles, R.W. Baird's chief investment strategist. "Companies that cut their dividend take away both."

Howard Silverblatt, Standard & Poor's senior index analyst, says actual dividend payments by firms in the S&P 500 index plunged 23.9% in January. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).) "It's going to be a bad dividend year," he says, predicting 2009 will be "the worst in at least 50 years."

Financial Crisis Is a Huge Blow
Thanks to the financial crisis, it's no surprise that many of these dividend-cutters are banks. To make up for large losses and shore up their capital, financial firms aren't just cutting dividends but also taking federal government bailout money.

Dividend cuts may actually be a positive for already-battered financial firms. A dividend cut can help avoid other less attractive options for raising cash, such as issuing new stock, which dilutes current shareholders' stakes. "It's the lesser of two evils," Plesser says.

The S&P Dividend Aristocrats is a list of 60 large-cap U.S. firms that have raised dividends every year for the past 25 years. The list will look very different next year. By announcing dividend cuts, several prominent firms, including Bank of America, State Street, Fifth Third Bank (FITB), and Pfizer, are set to break their streaks. Newspaper firm Gannett (GCI) is also likely to lose its crown; on Jan. 30, the firm said its board would consider a dividend cut later this month.

Still, many less troubled firms are hanging on. A healthy number of firms continue to raise dividends, even if shareholders are seeing smaller increases. AT&T (T) claimed its 25th annual dividend increase in December, when it inched up its payout by 2.5%. The year before, AT&T's dividend had risen 12.7%.

In this environment, any increase in dividends, no matter how small, can help inspire the confidence of market players desperate for some safety and stability. However, the overall trend of falling dividends gives investors one less reason to get excited about stocks these days.

Disclosure: The Div Guy owns shares of BAC, PFE and C at the time of this post.

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Barron's Dividend Aristocrats Video

Barron's has an interesting video about the Dividend Aristocrats. Thanks to Disciplined Approach to Investing for psting the video on his blog in the first place. It definitely seems that Barron's is indeed reading my blog. If you scroll to 21st second of the video you will see a snapshot of a table that I originally posted on my blog in this post from June 2008.



Other than that my blog has been featured on several prominent sites from time to time including but not limited to WSJ, The Street (here, here and here) and Motley Fool. Most of my articles also appear regularly on Seeking Alpha, which is the best blog aggregators on the net.

The best publicity that I have received so far however comes from TheDiv-Net and its members.

Relevant Articles:

- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates

This article was written by Dividend Growth Investor. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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Quote Of The Day

The quote of the day comes from Martin Lipton, a partner at Wachtell, Lipton, Rosen & Katz. He was attending a conference about shareholder activism in the new age.

He decided to unload some buckshot against the Hedge Fund strain of this peculiar form of investment management.

"One of the most significant problems caused by activists is their method of attempting to force companies to focus on short-term stock gains rather than long-term value, which could entail pushing for share buybacks or possible special dividends to create a quick profit for shareholders."

I wonder how many companies are on the brink of bankruptcy who wished they had never bought back billions of dollars worth of stock during the good times. I remember many years ago some activists trying to get Ford to pay a special dividend because its cash hoard was too "large." Recent events have shown that no amount of cash is too large.

Read the full article here.
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These Firms Shouldn't Cut

I can't help but notice that in this environment many companies are electing to cut dividends in an effort to cut costs and return to profitability. Staying away from investments in these stocks before the cut is probably a good idea. Is there a simple method of determining which companies will be able to retain their dividend?

Asking these two simple questions are a great start to determining if a company is likely to maintan it's dividend.

1. How Does This Company Make Money?
2. What Is The Payout Ratio of Dividends on Earnings?

I believe that these are the two key questions and in next week's post I explain how you can use these two questions to shield yourself from firms that might cut their dividend.

This article was written by the moneygardener. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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Six Lessons from John Bogle of Vanguard

I am a big fan of John Bogle. He is on a mission to expose the scams perpetuated by the mutual fund and institutional investment firms and the fees they represent. A few weeks ago Mr. Bogle wrote a piece in the Wall Street Journal that covered six lessons individual investors need to be aware of. In my opinion, these a very important and I have considered how they have impacted my own portfolio. I would suggest that we all do the same - it sounds cliche but it is times like these that investors learn the most and hopefully will be more successful in the future. However, if human nature is any guide, then we will all probably just continue on the path of least resistance and not put these lessons into effect. I hope to not be that guy!


So what are Bogle's six lessons. Here that are in the order that were presented in the article. I encourage you to check out the full article as there are examples of what he is getting at with each lesson.

1. Beware of market forecasts, even by experts
2. Never underrate the importance of asset allocation
3. Mutual funds with superior performance records often falter
4. Owning the market remains the strategy of choice
5. Look before you leap into alternative asset classes
6. Beware of financial innovation

Not to sound like I am kissing Bogle's butt here, but these are a really important summary of what will make an investor successful. The theme of these IMHO - keep it simple and don't get fancy. Pick a simple asset allocation and stick with it through thick and thin.


This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.

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Stock Analysis: BP Plc (BP)

Linked here is a detailed quantitative analysis of BP Plc (NYSE:BP). Below are some highlights from the above linked analysis:

Company Description: This supermajor integrated oil company (formerly BP Amoco p.l.c.) is based in London and is the world's second largest publicly owned oil company and the fourth largest U.S. refiner.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
   
2. 20-Year DCF Price
   
3. Avg. P/E Price
   
4. Graham Number
   

BP is trading at a discount to all four valuations above. If I exclude the high and low valuations and average the remaining two, BP is trading at a 52.0% discount. BP earned a Star in this section since it is trading at a fair value.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
   
2. Dividend Growth Rate
   
3. Years of Div. Growth
   
4. 1-Yr. > 5-Yr Growth
   
5. Payout 15% of avg.
   

BP earned both of the available Stars in this section. The NPV MMA Diff. of the $68,347 is in excess of the $10,000 minimum I look for in a stock that has increased dividends as long as BP has. BP's current yield of 7.73% exceeds the 3.42% estimated 20-year average MMA rate.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
   
2. Years to >MMA
   

BP earned both of the available Stars in this section. The NPV MMA Diff. of the $68,347 is in excess of the $10,000 minimum I look for in a stock that has increased dividends as long as BP has. BP's current yield of 7.73% exceeds the 3.42% estimated 20-year average MMA rate.

Other: BP is a member of the International Dividend Achievers™ Index. Some analysts believe that BP's crude oil production will decline over the next two years. That along with with projected lower prices, refining restructuring project and the impact of new management will likely take its toll on near-term earnings. However, new projects coming on-stream in 2009 should allow the company to maintain production at 4 million barrels of crude oil per day. Risks include the standard operational and geopolitical risks, unsuccessful replacement of reserves and a continuation of crude oil prices falling.

Conclusion: BP earned one Star in the Fair Value section, earned one Star in the Dividend Analytical Data section and earned two Stars in the Dividend Income vs. MMA section for a net total of four Stars. This quantitatively ranks BP as a 4 Star-Buy.

Using my D4L-PreScreen.xls model, I determined the share price could increase to $91.03 before BP's NPV MMA Differential fell to the $10,000 that I like to see. At that price the stock would yield 3.63%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the needed $10,000 NPV MMA Differential, the calculated rate is -0.96%. This dividend growth rate is substantially below the 9.1% used in this analysis, thus providing a margin of safety.

BP has a risk rating of 2.25 which classifies it as a medium risk stock. In October 2008, BP said it will maintain its current dividend this year [2008] and anticipates growing it, deciding to distribute more money to shareholders via dividends than buybacks. BP's CEO indicated that the company's robust financial position should allow it to do this even if crude oil prices decline further, and despite the market turmoil.

As noted above, I anticipate 2009 and 2010 will bring earnings challenges to BP, but long-term BP's reserves offer substantial upside for the patient investo. BP is trading substantially below my calculated buy price of $88.44. I ill continue to add share as its price and my allocation allows. For additional information, including BP's dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I was long in BP (2.8% of my Income Portfolio) .

What are your thoughts on BP?


Recent Stock Analyses:

• Stock Analysis: Lowe's Companies, Inc. [LOW]
  
• Stock Analysis: Legg Mason, Inc. [LM]
  
• Stock Analysis: Procter & Gamble Co. [PG]
  
• Stock Analysis: PepsiCo, Inc. [PEP]
  
• More Stock Analyses

This article was written by Dividends4Life. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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Leveraging Dividends

Leverage Killed companies in 2008 and investors need no other indicator of the success that leverage played in the demise of so many companies than to look at their investment returns from the past year, those of the broader market and at companies continuing to have problems right now with heavily levered balance sheets.

There are clear lessons that can be learnt from how leverage poisons companies but borrowing money to invest under the right conditions can be a prudent investment decision for an individual investor.

I certainly don’t advocate that investors eager to invest in the current market go out and do so blindly with borrowed money but for the long-term investor an adequate amount of leverage can enhance returns if properly allocated and managed. Not only is the amount of leverage used important to consider but how that capital is allocated into investments to best position an investor for success.

An obvious strategy for using leverage when investing is to focus on dividends. Dividend paying stocks are often sought after with a leveraged investing strategy because of an investors’ ability to pay down interest and/or principal of borrowed funds with the cashflow provided from monthly or quarterly cash payments. The danger is that many inexperienced investors look at dividend paying stocks that yield 5% and with borrowing costs as low as 3-4% come to the immediate decision that borrowing to invest in such a company is a no-lose situation or risk-free.

I utilize leverage in my dividend investing activities because under the proper conditions and with a conservative approach I believe that borrowing to invest offers a disciplined investor an ability to accelerate returns over the long-term. What I don’t do is ever lose focus of the risk I expose myself to and consistently monitor the amount of risk I’m taking versus the perceived reward of my activities.

I want to provide four key concepts I use for any investor who might want to use leverage or is considering leverage for a dividend growth portfolio.


I – Conservative Amount

For an investor considering leverage I would first advise you to identify a sustainable amount of leverage for your investing strategy. There is speculation in the market that some hedge funds and investment banks were leveraged as much as 30:1 (or higher) entering into 2008 and this was clearly not sustainable under any market conditions. Borrowing $30 for every $1 committed to an investment strategy is sheer insanity and how this was sustained for any length of time goes beyond simple logic. To put this type of leverage into perspective: would you buy a $600,000 home with only a down payment of $20,000?

Fiscal mismanagement should not be tolerated and I certainly don’t advocate it for the individual investor. While only you know the amount of leverage you can handle I would politely advise that whatever your intended target (10%, 20% or higher) you first start with half. The threshold for my portfolio isn’t a percentage, but a dollar amount which I will touch on in section IV.

The important lesson is that whatever amount you intend to borrow, start with half and work from there. You might not find a happy medium right away but it’s always better to start from a conservative footing than finding yourself out too far on a cliff without anything stable beneath your feet. It’s only after you begin losing money when investing that you realize your risk tolerance is well beneath what you originally thought it would/should be.


II – Conservative Stocks

For an investment strategy where you intend to leverage your returns you want to be diversified against all types of risks. If you intend to create a leveraged portfolio of stocks for a medium to long-term portfolio try to include a balance of financials, consumer staple/discretionary, utilities, energy, real estate and industrial stocks in the portfolio.

I would initially target companies who aren’t leveraged heavily because this helps an investor avoid double leveraging your investments (your leverage plus theirs). Companies with solid business models, strong cashflows, fiscally conservative management teams and products/services in sustainable demand are key candidates for a leveraged investing strategy. If you have an opportunity to add stocks with distinct competitive advantages in their operations I would strongly consider those as primary investments.


III – Conservative Income

A collection of low yielding stocks likely won’t pay your bills and a collection of high yielding stocks may spell disaster for your portfolio in short order. Achieving a balance of income produced by the stocks in your portfolio goes a long way to making your strategy viable in all market environments. Stocks with high dividend yields above their historical average may be at risk for dividend cuts. For balance target a collection of low yielding companies who increase their dividends consistently at a high rate and medium-high yielding stocks who increase their dividends consistently at a conservative rate.

Conservative leverage in the beginning is key for the success of your strategy in the event of unexpected events. If you start with an amount of leverage beneath your targeted threshold and one or two of your dividend stocks cut their payout by 50% you haven’t over extended yourself on the basis of risk. It’s much easier to go up in leverage than down.


IV – Conservative Payment

Each investor should have a specific target for the amount of leverage they want to use in their portfolio. Some of my peers use anywhere from 30-45% as their basic benchmark for the amount of money they borrow to invest; for every $1.00 in their portfolio they use $0.30-0.40 of borrowed money to invest. My approach is slightly different since I take the ultra-conservative approach of using borrowed money when I invest and anticipate a worst case scenario.

The basic principle is this: Can my internal cashflow from the portfolio cover my costs?

When an individual or institution provides you with borrowed money they expect it back with certain terms and a timeline. Often a line of credit, loan or margin has a minimum requirement to repay over a set time period. This can be solely interest or interest and principal depending on the terms of your agreement and it is very important to understand these terms prior to investing borrowed funds. If you’re using a margin account this is a little different, but for this example I’ll simply use an investment line of credit (which I use).

My belief is that internal cashflow from my portfolio should cover my interest and 2-3% repayment of the outstanding principal in any given month. That’s my threshold for how much I will borrow in my leveraged strategy.

My reasoning is very straight forward: if I don’t have enough money coming in from my investments each month to pay the interest and repay a portion of the principal I owe I feel that I am taking on too much risk for my individual tolerance.

Example:

If my monthly cashflow is $200 in dividends and my interest rate is 4% I want to know how much leverage I can use to repay the interest plus 3% of my principal.

In really simple math if I were to borrow $6,000 I would pay approximately $20 in interest and my repayment on the principal (3%) would come to $180. On a $48,000 portfolio yielding 5% ($2,400 per year in dividends) this would put my leverage ratio at only 12.5%. I would be borrowing $0.12 for every $1.00 invested and able to manage the leverage adequately without committing any new money of my own on a monthly basis.

Obviously if you are adding savings to the portfolio on a regular basis you can afford to borrow more, but setting a target threshold for your monthly payment (interest + % of principal) helps you to stay conservative in your investing strategy and not overextend yourself with unnecessary risk.

Leveraging Dividends Review:

• Understand how leverage can enhance/diminish returns
• Understand the risk
• Begin by using a conservative amount of leverage
• Target a diversified group of stocks with higher margins of safety in their operations and financial health
• Target safer sources of income
• Set a payment plan that targets repaying both interest & a certain percentage of your outstanding balance from your monthly cashflow

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