How To Incorporate Dividends Into A Value Strategy

When I first started investing I thought the idea of dividend investing was amazing. A company actually pays you money to own it? There has to be a catch! Well as it turns out these companies need investors to grow. I even settled on dividend growth investing as a worthwhile strategy to engage in for a little while, but it turns out I was wrong and there is a better form of investing that incorporates dividends.

Value investing and dividend investing are complimentary investing styles. Value investors use dividends to gauge value, reliability and how shareholder friendly management is. Value investors focus on dividends in the 3-6% range to uncover undervalued stocks.

I’ve spent a lot of time perfecting my investing strategy and I’ve settled on a dividend value strategy because it decreases my downside volatility when utilized correctly. It also protects me from fraud and unfriendly management. As it turns out I’m in good company since Benjamin Graham and Peter Cundill both used the same approach.

Dividend Investing vs Value Investing and Complimentary Attributes

In order to properly evaluate the best way to incorporate dividend investing into a value investing strategy we need to understand the attributes of dividend investing and how it assists a value investing strategy.

  • Dividends help generate cash flow during long periods of slow moving value stocks.
  • Dividends identify long term viable businesses and not fly by night heat of the moment stocks.
  • Dividend yields identify cheap stock prices.
  • Long term dividend payers weed out companies with shady financials and dishonest management.

All of the above attributes are complimentary to value investing and help value investors find viable, cheap and reliable businesses. However, not all dividend paying companies are necessarily value stocks.

Dividend Growth Stocks are Neither Value or Growth Stocks

As I mentioned earlier I used to invest in dividend growth stocks. While these types of stocks could also be considered value stocks, more often than not they are typically not very good as pure growth or classified as value stocks.

The reason behind this is that once a stock starts paying a dividend it’s growth has usually slowed down and it has nothing better to invest its excess cash in than returning it to its investors.

Value stocks are also not dividend growth stocks until after operations have improved. Once operations have improved the price typically spikes and the dividend will begin to grow. The key is to find these stocks before the dividend begins growing so that you can reap the quick price appreciation alongside some dividend growth.

Dividend Yield Uncovers Value Stocks

Part of value investing is paying the right price for a stock. Money is made when you purchase a stock, not when you sell it. For that reason it is extremely important to get a stock purchase right. One way of doing this is by looking at a dividend yield.

A dividend yield is merely the percentage that is paid out from earnings compared to the stock price. This means that the higher the yield and the lower the price is, the more undervalued it may be. Unfortunately, the highest yields, over 6%, can come with a lot of negatives.

There are a few things that you will need to look at in order to find an undervalued dividend stock.

  • Payout ratio: This is how much of earnings are paid out in the form of a dividend. The higher the payout ratio the less extra cash a company will have to invest in itself. A payout ratio of over 100% is at extreme risk of the dividend being cut.
  • Previous Dividend Payouts: Its good to look back at whether or not the dividend has been increasing or decreasing. Often dividends that have been cut recently are good investments as there may have been a price overreaction.
  • Debt to Equity: If a company has a high debt load, but is paying out dividends, then that dividend may be fueled with debt instead of the viability of the company. Avoid high debt dividend paying stocks.

When it comes to finding valuable companies to buy I often look for companies that are profitable, trading below book value, and also have a dividend in the range of 3-6%. Oftentimes these companies are paying out very little of their earnings and the dividends are still very high, making these safe undervalued companies.

International Value Investing With Dividends

I used invest in cheap international companies. It didn’t matter if they paid a dividend or not. I was a bit naïve back then and didn’t understand some of the risks I was taking.

One company awakened me to those risks, and I’m happy it happened so early in my international investing career. This was a company called KDM shipping. It was a company that was listed on the Polish stock exchange and operated in Ukraine and the Black Sea.

This stock did not pay a dividend. But it was extremely cheap on paper and its operations were real. What I didn’t realize is that the owners were about to go dark and leave all of its investors with nothing. The Polish stock market tried contacting the owners but to no avail, and to this day the stock sits in my portfolio for pennies. Maybe one day I will see a return or completely erased from my portfolio, but for now it remains as a stark reminder.

This led me to take more of a Peter Cundill approach to deep value net net investing. One of my rules is the stock has to pay a dividend. This is to keep me from investing in companies like KDM, that have no track record or duty to their shareholders.

This is what I imagine their shipping fleet looks like now.

Whether situations like KDM are why Peter Cundill used a value strategy focusing on dividend paying companies is beyond me, but he invested much like Benjamin Graham did, and dividend stocks have a higher chance of working out than non dividend paying stocks.

Deep Value Investors Often Create Dividend Stocks

One of the things I look for in a value stock is lots of cash and hidden assets. These assets and cash are often underutilized and hurting returns on a particular stock. In these types of situations an activist investor often steps in to resolve this market inefficiency.

One situation where value was unlocked and a dividend was created by activist investors was Verso. This was an investment I noticed trading below book value after recently filing for bankruptcy.

After the burden of its debt was alleviated it began to produce ample cash flow and sold off unproductive assets. This was when activist investors fought to take over the company and issued both a one time special dividend alongside an ongoing dividend.

While one of my new priorities is investing in only dividend paying stocks, looking for specific catalysts and the potential for cash being returned to shareholders is always a fruitful endeavor. This is why in American stock markets I may sometimes break my dividend investing rule and look for shareholder activism and hidden assets.

Value Investing vs Ultra High Yield Dividends

In order to properly discuss dividend investing as a complimentary style to value investing we need to discuss ultra high yield dividend stocks. There are a few income stocks that have specific tax advantages and high yields may make sense. These are:

  • MLPs- often associated with resource stocks like oil.
  • Reits – Real estate trusts that focus on commercial residential or industrial buildings.

While the above stocks are typically high yield they also require most of their profits to be paid out, therefore they often take on a lot of debt in order to grow. These stocks are particularly prone to dividend cuts in times of economic downturns.

Ultra high yield stocks that are not associated with the above two classes usually are losing a lot of money and will likely have a dividend cut in their future. The risk associated with ultra high yield dividend stocks often outweigh the benefits.

One counter to the theory that ultra high yield stocks typically don’t do well is corporate bonds. Many corporate bonds may pay a high yield but a company and its prospects may be improving. So thoroughly researching a stock will help uncover these high yield goldmines.

Dividend Investing for Income is Inefficient

Part of the reason I stopped dividend growth investing is because investing for the sake of the dividend is a very slow way to build wealth. A lot of investors mistakenly think great investors became rich because of the dividends their companies pay out, but that is far from the truth.

They made much of their money investing in small extremely cheap stocks with no specific interest into what the dividend was doing, only some like Graham and Cundill considered the dividend, but it was more of an indicator than a specific item to study.

Not only is dividend growth investing and dividend investing slow as far as capital appreciation is concerned, but it does not make you a better investor. Becoming a great investor requires the ability to spot trends and buying at really cheap prices.

If you are investing for income late in life and you don’t have enough principle it becomes painfully obvious that a 4% dividend payout generating your cash flow is not going to cut it. You may be able to add another 4% on top of this with share price appreciation to achieve a 8% per year return, but even then you may still not have enough principle to live a comfortable life.

In fact you will have to be thinking ahead for at least 20 years for dividend growth investing to work and many of us just can’t have money sitting around for that long, especially when you may need it periodically.

This is why dividends are a nice to have but should not take the place of proper value investing. Because in the end value investing will move the needle far more and far faster than just simple dividend investing. However, dividends are the perfect compliment to a value investors arsenal.

Bryan Shealy

Bryan Shealy is an active value investor. He currently focuses on the small and micro cap stock market looking for bargains. He has written content for Seeking Alpha, Net Net Hunter and Broken Leg Investing.

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