Portfolio Five Updated November, 2014

Portfolios Four and Five are each 5 years old, with the beneficiary contributing $3000 and the trustee $6000, for a total of $9000.  The current value is $11,175 for a gain of $2,175 or 24%, or about 6% / year adjusted for the timing of cash flows.  You can see the detailed portfolio here or use the link on the right.

Yahoo and Westpac have been big gainers, and there aren’t any big losers in the portfolio right now.  In the past we sold Alcoa (AA) and since then it went up significantly; Alcoa had slashed its dividend and performed poorly over the years, but since has gotten its act together.


Portfolio Five Updated March 2014

Portfolios Four and Five are both 4 1/2 years old.  The beneficiary invested $2500 and the trustee $5000 for a total of $7500.  The value is $9030 for a gain of $1530 or 20%, which is 6% / year.  See the details on the right or click here.

Portfolio Five now has nine stocks, with some recent sales tied to stop loss orders (Yandex, China Petroleum) and two others that we gave up on in 2013 (Alcoa and Riverbed).  The existing stocks seem well positioned, with 5 overseas and 4 domestic stocks.

Tied to taxes, the portfolio earned $284 in dividends (after foreign withholding).  There was a long term loss of ($493) on sales and a long term gain of $74.

With a recent sale there is $800 cash in the portfolio and we will pick another stock out of the list.

Portfolio Five Updated November 2013

Portfolios Four and Five were both set up four years ago. The beneficiary contributed $2500, the trustee contributed $5000 for a total of $7500. The current value is $9,116 for a gain of $1616, which is 21%, or 6.6% / year over the life of the portfolio. Check results here or in the links on the right side of the page.

Recently two outstanding items in the portfolio were cleared up when we gave up on the metals company Alcoa, which is well run but faces ferocious state-supported Chinese firms willing to work at a loss.  We also sold Riverbed when it bounced up a bit as a raider considered a stake in the company.

The remaining stocks are either brand new (too soon to judge) or doing well.  We will watch Siemens which is near a 5 year high and not ride it all the way back down.  The current portfolio has 9 stocks, with 7 of the 9 being foreign ADR’s (the two recent sales were US companies).

Portfolio Five Updated July 2013

Portfolio Five has 4 years of history. The beneficiary contributed $2000 and the trustee $4000 for a total of $6000. The current account value is $6647, for a gain of $647 or 11%, or 4% / year when adjusted for the timing of cash flows. The portfolio can be found on the links to the right or by going here.

Portfolio five has 2 stocks that we are about to give up on. Alcoa is an integrated US steel company. Alcoa faces sharp pressure from Chinese metals firms (who make up over half the industry, while the US is less than 10% of the market) who are flooding the market with metal, and the dividend isn’t large enough to let us catch up, either.

Riverbed is a company making networking equipment. They recently acquired a cloud based company and is running a loss. Riverbed doesn’t have a dividend at all. I recommend that we sell both stocks and use the proceeds as part of our 2013 new purchases.

The other stocks seem to be doing well and the portfolio is up overall. We have given these two stocks a lot of time to recover / advance and it hasn’t happened so it is time to move along.

Portfolio Five Updated January 2013

Portfolios four and five are both three and a half years old. The beneficiary has contributed $2000 and the trustee has contributed $4000, for a total of $6000. The value of the portfolio is $6848, for a gain of $848, or 14%, which is 5.4% / year when adjusted for the timing of contributions. You can see the detail on the right in the links or go here.

The portfolio is generally doing well. Alcoa, the major US Aluminum company, is down over 25% from our original purchase price and has a relatively small dividend of 1.4% / year. While the company is well run, it faces heavy competition world wide in a very tough market. We will watch the company and sell if it doesn’t improve. Another company on the watch list is Riverbed Technologies, which makes technology security and optimization devices. The company is currently trading at a lower price then we paid for it, although it did spike above for a brief time. Riverbed purchased Opnet for $1B, using cash and debt. Generally Riverbed was thought of as a company that would be a likely acquisition candidate by larger technology companies and to the extent that Riverbed is purchasing other companies, that would indicate that they intend to “go it alone”. We will watch Riverbed and likely sell if it goes above our purchase price or trends down.

There were no sales this year and thus no capital gains or losses, and $190 of dividends were paid.

For both portfolios four and five, since inception interest rates have been remarkably low and the interest that they have earned is minuscule (less than $1). On the other hand, I have been able to use “free trades” for each account and no fees have been assessed on the account, meaning it essentially exists for free. Compared to the earlier portfolios in earlier years, the benefits of “free” trading more than offsets the impact of receiving effectively zero interest on cash on hand.

Portfolio Five Updated December 2012

Portfolio Five is on its fourth year. The beneficiary contributed $2000 and the trustee contributed $4000 for a total of $6000. The portfolio is valued at $6334 for an increase of $334, or 5%, averaging about 2% / year adjusting for the timing of cash flows. You can see the portfolio on the right side or go here.

There are two stocks on watch in this portfolio. Alcoa (AA) faces intense worldwide competition in the metals market. There is over-capacity in this market with new plants coming on line, driven by nationalistic plans for domestic economies worldwide. Alcoa also pays a relatively modest dividend at 1.4%, as opposed for 3.6% for Nucor (which has allowed Nucor to absorb more of the blow of a falling stock price, making it up on dividends). If there isn’t a plan for Alcoa to increase we likely will sell in 2013.

A second stock on watch is Riverbed, a technology company, which is susceptible to changes in stock prices due to small alterations in analysts’ outlook. The stock went down significantly, then above its purchase price, then down again. We will continue to watch as it seems to be in a good portion of the technology business space.

Winners include Westpac banking from Australia and China Petroleum and Chemical (SNP).

Dividend Paying Stocks and Survivorship Bias

Survivorship Bias

One of the most important concepts in all of investing is “survivorship bias”.  Per wikipedia:

In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It often causes the results of studies to skew higher because only companies which were successful enough to survive until the end of the period are included.

You should view any sort of “theory” on stock selection such as value, small-cap, growth, or dividend payers (generally part of the “value” spectrum) as a “sales pitch”.  When someone tries to sell you on something, they will use whatever data that is available to support their pitch.

The data that is generally available is in the stock market “raw” data.  You can see the price changes, the dividends, and compare these against your selected group or theory in a variety of ways.

Valuing Dividends

In general, it is more difficult to determine total stock returns (i.e. how successful your proposed theory is) when you include dividends.  It is easy to look at the “price” of a stock from 10 years ago and the price of that same stock today and said it “went up 25%” or “went down 25%”.  Or, if you owned that stock and are looking for it, that the stock doesn’t exist in the index any more (it went bankrupt, merged with someone else, or went private).  Even large and sophisticated investors sometimes forget to include dividends in their calculations.

Dividends are harder because they are payouts to shareholders and then you need to determine what happened with those dividends.  For my trust funds, for example, the dividends are received in cash.  Then we take the cash and re-invest it periodically, in our case annually.  Thus you don’t earn a “return” on that money, other than interest (which used to be significant, but now can essentially be modeled at zero since interest rates are so low) during that time.

For most models used by analysts, dividends paid are assumed to be re-invested in shares.  Thus if you receive a dividend of 2%, you essentially now own 2% more in shares, and you also earn dividends on those shares going forward, as well.  To make it a bit more complicated, there are taxes that you have to pay when you receive those dividends, so you may want to reduce the effective value of those dividends by 15% (the current taxable rate) or closer to 30% if that exclusion is taken away when the tax laws are changed in 2013.  Here is a wikipedia article that reviews the taxation of dividends for individuals.

Dividends are important.  Per the “dividends aristocrats” methodology used by the S&P 500 and found  here,

Since 1926, dividends have contributed nearly a third of total equity return while capital gains have contributed two-thirds. Sustainable dividend income and capital appreciation potential are both important in determining total return expectations.

For our own portfolios, dividends have brought in a substantial portion of total return.  The impact is largest on our biggest funds, portfolio 1 and 2, since they have more stocks and a longer time frame to accumulate dividends.

How Companies Decide on Dividend Policy

In order for a company to pay out dividends, they must be profitable.  Dividends need to be paid out of profits, or they are essentially a “return of capital” where they are giving back their investors their money received.  While this is not always technically true (you can issue debt and leverage up and then pay yourself) it is a solid rule of thumb that a company must be profitable to pay dividends.

Since a company must be profitable, many start ups are immediately disqualified as dividend-payers.  Once a company is profitable, however, many “growth” companies decide to plow profits back into the business rather than returning it to shareholders (in the form of dividends).  For example, Microsoft did not pay dividends for many years, Amazon pays no dividends (but there is an open question of how profitable their model really is, anyways, regardless of their stock price), Google pays no dividends, and Apple recently starting paying a dividend in 2012.

Thus we’ve already “narrowed” potential dividend paying companies into a smaller subset 1) those that are profitable 2) those that don’t define themselves as “growth” companies (broadly speaking).

Once companies decide that chasing growth isn’t the answer, and they then decide that they want to pay dividends (rather than buy back stock, although it isn’t always  an either / or question), they start notifying investors (and physically paying the dividend).  Investors then incorporate the dividend cash flow into their expectations, and the company is loathe to change these expectations (to reduce dividends once declared).

From the perspective of “expectations”, then, a dividend payer is viewed favorably if they pay the regular dividend they declared, along with continuing to raise their dividend regularly.  A general class of investor seeks out these sorts of stocks, and these investors are usually quite loyal (these stocks can become “widows and orphan” stocks), as defined in Investopedia:

A stock that pays high dividends and is generally considered to carry low risk.

Dividend Policy and Historically Low Borrowing Rates

Today companies can borrow debt at historically low interest rates.  For instance, ITW recently borrowed for 30 years at 4.1%, an historically low number for them and unprecedented in the 2008 stock meltdown when debt could hardly be raised by anyone at any price.  Note that this is for 30 year debt; the equivalent (risk free) yield per the US treasury is 2.8%, for a difference (risk premium) of 1.3%, which is incredibly small.

The equivalent 10 year yield for the US treasury (see table here) is about 1.7% – if you add on the 1.3% premium that ITW pays over the US treasury rate, that is a 3.0% rate.  Why is this rate important?  It is important because the 10 year debt issue would be a roughly reasonable comparison against the dividend rate that ITW is currently paying, which is about 2.6% (the 30 year duration is too far out to be a valid comparison to current dividend policy).

When you factor in the negative tax effect of ordinary income treatment, an adjusted 3.0% interest yield (10 year plus ITW’s risk premium) would receive about a 30% effective tax rate, while that 2.6% dividend payment would be at 15% (see above).  On top of that, the dividend for ITW has been growing over the last 20+ years (over 15% / year for the last 4 years), while for the debt instrument you only get your payment back (no improvement).

Thus for ITW at least, their dividend payment is higher than you can receive as an interest bearing instrument (bond or note), adjusted for taxes.  THIS IS UN-PRECEDENTED in modern times.

Viability of Dividends as an Alternative to Bonds

Due to this historic inversion (companies with solid credit can borrow almost at their dividend rate, adjusted for taxes), companies have new options.  They can choose to borrow money to support items that might have been paid for our of current cash flow and support a higher dividend policy.

While this post is already covering a lot of ground, at this point today high dividend stocks can be treated as a viable alternative to debt in some circumstances.  This is due to the fact that 1) bonds are yielding almost nothing to investors 2) bonds are taxed unfavorably 3) dividends generally increase over time while interest rates are flat.  A major offset is that stocks are inherently more risky than bonds, meaning that they fluctuate in value and a large price “loss” can far and away offset any favorable impact from an increase in dividends (i.e. if the stock drops 25% in value then the dividend policy is mostly irrelevant at that point).

Survivorship Bias and Dividends

When you look at stocks, dividend policy is an ATTRIBUTE.  Thus there is a history of dividend payouts, and you can see the growth in dividends over years for those stocks that are selected.  Based on this historical data, you might infer something about that stock such as

“Company X has paid out a great dividend for 20 years and has raised their dividend 5% / year thorughout that time frame, making it a good candidate for a dividend investor.”

This all sounds rational.  However, let’s think through what (likely) really happened to company X over the years.

1) company X started out as unprofitable, like virtually all companies

2) company X started to earn more money, and re-invested it back in the business as it grew

3) company X then wasn’t a growth company anymore, and started holding cash and giving it back to shareholders

4) once you start paying a dividend and having shareholders EXPECT a dividend, it helps to GROW the dividend which makes your stock more valuable (all else being equal)

5) then the stock really becomes sort of a debt-like instrument to shareholders, and they view it under the lens of a growing return of dividends on their investment

You are looking now at a company in the fifth stage of its life.  What happens next?  Does a company forever stay in the dividend phase of its life, with the dividend growing forever?

This is where the survivorship bias comes in.   Companies that  have grown dividends for many years and managed the transition from a growth company to a value company (and a successful one, on the measure of growing their dividend) now have to continue to grow and support their dividend indefinitely, while the economy goes up and down and new, more nimble competitors enter the market (or giant competitors buy into the market by snapping up other companies).  This is not necessarily an easy thing to do long term or pull off since it is not always an “equilibrium” situation.

For example let’s look at Alcoa (AA).  Alcoa was a “dividend aristocrat” for many years, using its strong position in the US and world wide aluminum industry to pay a steady and growing dividend.  When it started out it needed cash to grow and pay for expensive infrastructure, but then over the years it was able to harvest these investments and throw off cash to investors rather than continuing to make expensive investments for growth. In 2001 they paid a dividend of 15 cents a share (and had been paying a growing dividend on a per share basis since 1988 prior to that, at a minimum) and it peaked at 17 cents in 2009 (they probably held on as long as they could to the dividend after the 2007-8 crash) until they capitulated and reduced their dividend down to 3 cents / share where it is today.  Cutting their dividend corresponded with a significant fall in their share price, as well, dropping from a high of over $40 / share to about $9 / share, a drop of 75%+ in value.

Whether the drop in dividend CAUSED the drop in the stock price or whether the events that made Alcoa less competitive in the global marketplace (overall shrinking demand and tough competition from global players, especially out of China) caused the drop in cash flow which in turn led to the massive drop in dividends paid to shareholders, is tough to tell, but they both contributed to the stock downfall.

You can see the same process happening right now with Telefonica (TEF), the ADR for the Spanish telecom company, as it drops its dividend.  TEF grew its dividends from  41 cents / share in 2007 to $1.05 in 2011, the mark of a “dividend aristocrat” (it had been paying a dividend for a long time previously, this was just the recent growth in dividends per share).  By many metrics this type of behavior would reward them and put them on recommended lists for “widows and orphan” stocks as a steadily growing payer of dividends to shareholders.

Today, however, TEF is facing hard times and cut the dividend back to 35 cents  / share, a more than 2/3 reduction from the 2011 payout.  This also corresponded (but did not necessarily cause, but likely contributed to) a stock price reduction from 22 to 14, an over 40% drop.  One item that partially shields TEF from even greater hardship is the amazingly low interest rates that corporations can now use to borrow funds – per this article (aptly) titled “Telefonica Leads Corporate Bond Rush Amid Record Low Yields”

Borrowing costs are tumbling with average yields on investment-grade securities dropping to 2.58 percent, Bank of America Merrill Lynch’s EMU Corporate Index shows, compared with 4.4 percent at the start of the year.

At this type of rate TEF is roughly able to borrow funds at approximately the same rate as they paid out to shareholders in their last dividend payment in 2011 (35 cents was about 2.84% of the stock price at the time).  Adjusted for the tax deductibility of interest rates to the corporation (dividends are not deductible), the company is able to borrow for LESS than it takes to pay out their dividend, meaning that in some sense on the margin they can borrow money from the bond market and pay it back to the stock market to prop up their dividends.  This isn’t saying that the company is actually doing this, but on the margin for their dividend payout ratio and their most recent debt issuance this could be considered the financial impact overall.


Like most items about stocks, the conclusions are hazy and subject to interpretation.  In general, whether a company pays a growing and steady dividend is more an attribute of its (accidental) place in  its life cycle and overall competition and profitability than a strategy that investors should lock into looking for yield as an alternative to low debt rates.  However, once a company is identified as a growing dividend payer, it becomes loathe to change that strategy because their shareholders view growing dividends as a source of worth for the stock and once the dividend policy capitulates (usually with a strong drop, not a little haircut) the stock is punished (although it potentially could be punished for other reasons, as well).

Buying a stock is a forward looking act and not a backward looking act.   A history of dividend paying growth is one of many signals to look at, although a powerful one because once a company is locked into the “dividend growth” crowd, leaving that crowd will likely take a significant part of the stock price with them (i.e. lead to a big drop in the stock price).

Take the “dividend aristocrats” with a grain of salt.

Cross posted at Chicago Boyz