It's dividend week for Industry Focus! On this episode, we answer a listener question on portfolio construction, explain what to look for in potential dividend investments, and cover mistakes some investors make by focusing on the wrong metric.
As part of dividend week, each Industry Focus analyst picked their favorite dividend stock for 2016, check out our picks at dividends.fool.com.
A full transcript follows the video.
This podcast was recorded on 11/20/2015.
Sean O'Reily: We're talking dividends on this technology edition of Industry Focus.
Greetings, Fools, I am Sean O'Reily joining you from Fool headquarters in Alexandria, Virginia. It is Friday, November 20th, 2015, and joining me to talk dividends, and the worst possible sector for them, is the dependable Dylan Lewis.
Dylan Lewis: I like dependable there.
O'Reily: See what I did there?
Lewis: It kind of feeds into the theme of dividends and reliable payers, and showing up to do the show once a week.
O'Reily: I was saying that, and I actually realized, I think the biotech sector would be worse.
Lewis: Yeah, that would definitely be worse.
O'Reily: So, second-worst sector for dividend discussions.
Lewis: But, they're out there. There are. Apple (NASDAQ:AAPL) might--
O'Reily: We'll get into them. Apple's one, yeah.
Lewis: We might steal a couple companies from CG.
O'Reily: We'll try, yeah.
Lewis: We'll try to curve them into us.
O'Reily: Buffer it a little, yeah. Alright. We're talking dividends because its dividend week on Industry Focus, and we're a tech show. How are we gonna pull this off?
Lewis: I was doing some research on this. You'd be surprised. There are decent amount of dividend-worthy tech companies.
O'Reily: Do not lose heart, dear listener. We promise we will deliver. So, before we dive in, we have a listener question that fits in perfectly with this week's theme. I assume it's John in Columbus, Ohio. Thanks for writing in and go Bucks. I happen to be born and bred in Columbus, Ohio. We moved to Cleveland when I was 13. So John, thank you for the shoutout.
Lewis: [...] was psyched to be getting into--
O'Reily: I was like, "Oh my gosh, Columbus." I mean, there's a Columbus, Georgia, I think. But, anyway. John writes, "I have two questions. I'm looking to start a dividend portfolio. I am 31, so I have plenty of time to build this up. My father, however, will be 60 soon, and he would like to transition to more dividend stocks for income in retirement. I'd like to help him build this portfolio, and maybe mirror it with my own. How should we go about constructing one? Is it's as simple as just buying 5 to 10 good paying companies in a brokerage account? Do you start out with many small positions, or one to two large positions and add to them?"
We're probably going to have to refer back to this. But, Dylan, thoughts?
Lewis: Yeah. A lot to answer there, great question.
O'Reily: What was there, like, five, six questions?
O'Reily: You cheated, John.
Lewis: Identifying dividends, portfolio construction, a lot to digest there. Constructing a portfolio, I think we should start there, is no small feat. I think, when I was thinking about how to answer this question best for our listener--
O'Reily: Disclaimer, neither of us are certified financial planners. We're two guys on a podcast.
Lewis: But I revisit our 13 Steps to Investing Foolishly, which is on fool.com.
O'Reily: Good plug.
Lewis: Excellent resource for people who are looking to get started, or just want a refresher on things to keep in mind. Sometimes, you wind up down the road somewhere, realize that you are super overweight in one sector, or maybe you haven't been dollar-cost averaging well, things like that. It's always nice to get a refresher on the basics. So, I revisited that, and found this great quote: "You want to invest in sips, not gulps." And I think that is -- oh, and Sean is going for the coffee.
O'Reily: I took a sip, Dylan.
Lewis: And you feel like you're comfortable taking a sip.
Lewis: You're not scared that you took too much of a gulp.
O'Reily: I'm going to go invest in my 401K in a sip.
Lewis: So, this is a great way to think about adding to positions, creating positions, and starting out your portfolio. I think there's a couple reasons for this, as just a guiding light. One of the main ones is, it's incredibly tough to time the market. So, if you are investing in gulps, if you're buying very large positions--
O'Reily: Everything today.
Lewis: In one or two companies, you are going to be hit by volatility at some point, or you're going to buy on a very up day. It was maybe a Morgan Housel tweet or something like that that I saw a little while back that was like, "Figure out what you want to buy, commit to a schedule to buying it unless the investing thesis changes," basically. It's like, you led to the position over a period of 4 to 5 months, and you'll regularly buy into it.
So, that's one way to mitigate against some of that timing the market risk. Because none of us can do it. You might look like, "Oh, it looks oversold today, it's a good time to buy," something like that. But if you're long-term oriented, that stuff shouldn't matter. It's better to work toward a better dollar-cost average over the course of a medium-term amount of time, I think.
Another reason that I think this is a great way to think about investing is, you're going to be wrong a lot. So, if you are investing in sips rather than gulps, I think you start to learn quite a bit more about a company after you invest in them, unfortunately. This is something I've found, I don't know about you.
O'Reily: Well, yeah. Even Warren Buffett, I read this awesome thing one time, it wasn't in an annual report, but he said that whenever he was interested in a company, like a couple years ago, he was like, "Oh, I'm gonna plug a tech name, IBM." When he was curious about IBM four or five years ago, I'm sure, he buys a couple hundred shares of the company, they'll send him the annual report, and buying just a small, tiny little stake, it actually triggers something in your mind where, "Oh, I actually have money in this, I should probably look into it more."
So, again, even Buffett sips.
Lewis: Yeah, and that's actually another point that they draw in 13 Steps to Investing Foolishly, is, buy one share to start. If you've never bought any stock before, buy one share in a company, and you'll realize you are now paying attention. Obviously, if you're looking to build out a portfolio, maybe you start to do that at a little bit of a larger scale.
But, I think a case in point as to why you're going to be wrong a lot, in my personal portfolio, if you were to look at this binary up or down, I'm down in like 40% of my positions. I'm very tech-centric. But my winners have proven out, and overall, I'm up. But, if I were to have only invested in two companies, I might be looking at negative portfolio returns.
So, to your question about, is it better to buy 5-10 good companies or build large positions of one to two, I would go with the 5-10 and fully build out larger positions in each of them rather than be highly concentrated in two companies.
O'Reily: Not only that, John, but both you and your dad have nothing but time. He is only 60. In America, the life expectancy is above 80. You're 31. You have plenty of time to do this.
Lewis: I will say, there are two things that are going to tempt you away from this line of thinking, and I think it's good to just air them out now so that you're aware of them and maybe you won't be as biased by them when it's time to actually make moves in your portfolio. One of them is transaction fees. It's something that creeps into my mind. If I'm only looking to invest like $2,000 in a company, or something like that--
O'Reily: And you buy 10 positions, and it's $10 commission that's $100.
Lewis: Yeah, it adds up. So you're like, "Oh, I can just buy once, and it'll be a much lower transaction cost as a percentage of what I own." Again, long-term, is that 1% or whatever going to really matter all that much, over the years of compounding, whether it's dividend income or stock price appreciation? No.
O'Reily: No. Especially if you're buying one position per month, or whatever you're doing. Transaction costs are important, and the best investors in the world talk about them a lot, but they're framing it in reference to not day-trade, not long-term slow position building.
Lewis: Yeah, so don't worry too much about that. I think, as long as it is not eating off a humongous chunk of your actual transactions, it's not something to be too much worried about. And also, I think it's always tempting to want to see immediate returns and hit scale, and the easiest way to do that is buy a lot at once. But, again, knowing that you will be wrong some of the time, and the market will take weird downturns because of macroeconomic factors, or something like the retail industry getting hit really bad, like we saw last week, were you to be buying ahead of something like that, you'd be in a rough position.
So, I think those are some good things to keep in mind with respect to that question.
O'Reily: So, Dylan, are there any good books for John and his dad to read about dividend investing? I have one in mind.
Lewis: One of the things we talked about prior to doing this show was, in dividend investing, there are some unique elements to it. But, really, you're looking for good companies. Everything you look for in a dividend company is something you would want in a regular company, more or less. It's just that, maybe the growth profile is a little bit lesser. So, I'd say, anything that is basic stock-focused that's not super growth-oriented could probably serve as a pretty good intro or guiding light for dividend investing. What about you?
O'Reily: I actually did a search, top dividend stock books. And actually, I found one that I like ...
Lewis: I know there's also, you know the "Little Book" series on investing? I know there's a "Little Book of Dividend Investing." That's a pretty excellent series. They're pretty quick to get through. So, that's something that you might want to consider looking at. I haven't read that one personally, but I've read some of the other "Little" books, and they've been really fantastic primers for getting into some different areas of interesting that I'm not as comfortable with.
O'Reily: Oh, "Dividends Still Don't Lie" by Kelley Wright. It was a follow-up to the 1980s book "Dividends Don't Lie." And basically, it relates to what we're talking about, which was, what you want in a good stock is what you want in a dividend stock -- strong business model, growing, franchises, all that good stuff.
Lewis: Cool. I think one of the interesting things talking about dividends was, what do each of us look for in dividends? We're both young guys, though.
O'Reily: So we don't think, "Oh, I need dividends right now."
Lewis: Yeah, but I will say, I'm trying to build out a larger portion of my portfolio that is dividend-oriented just so that I have that stability. You generally don't see huge swings with dividend stocks, just 'cause they tend to be a little bit more stable, a little bit more established in the sectors that they operate in.
O'Reily: Not only that, history bears us out. What percentage of total returns in the stock market? It was something like 40% of all your returns came from dividends or something.
O'Reily: Yeah, it was something crazy. And it's like, yeah. Every American corporation all lumped in together, that might be true. Anyway, what do you look for, Dylan?
Lewis: So, I like three things as kind of a checklist. I like operating in an industry with high barriers to entry. Not something you're going to be able to find, but if you can, it insulates you from competitive pressure, it makes the next 5-10 years a little bit more foreseeable than if you're in an industry that's very easily disruptable. So, I think that's one thing to watch.
Obviously, you want something that has available growth avenues. So, just because there's been recent great top-line growth and consistent bottom-line results, doesn't mean that something that will continue unless they have a plan to enter new markets or develop new products or something like that. So, you want to see that while they're a strong core business, there's also elements that project out well for the next 5-10 years at least.
And I think something that all dividends investors are very conscious of is the payout ratio. So, that's something you want to keep in mind, how much are they paying out as dividends, both as a proportion of net income and free cash flow. And, is that something that is both sustainable and has room to grow. So, if your primary reason for investing in a company is you like the yield, and all things being equal, the business looks good, then, are they going to be able to continue to grow that yield.
O'Reily: That's the trick.
Lewis: So, those are the three things that I look at. What are you particularly mindful of?
O'Reily: I obviously can't argue with any of those points, because they're spot on. The only thing I would look to add would be that I have two ways of looking at this, and it's basically just through the total return internal capital allocation point of view.
The other thing would be just that, I need income in retirement point of view. In order to make the latter happen, what needs to happen first is the corporation needs to be growing and needs to be doing well. The dividends should only be paid when there are literally no other rational uses for the cash. That's a little trickier in particularly our sector. Even Google, they don't pay a dividend, they're trying to start Alphabet.
Lewis: And Google only recently announced that share buyback--
O'Reily: Which is earth-shattering, yeah.
Lewis: --which is a way to return capital to shareholders, to a certain way. It's part of that capital allocation program and just that general philosophy. But, buying back, I think it was $5 billion worth of shares?
O'Reily: Yeah. So small.
Lewis: It's very different than paying a dividend, because you are on the hook for that dividend consistently. I remember I saw this great quote, it was specific to tech companies and dividends. They said, "Announcing you're going to be paying a dividend is kind of like ditching your hoodie and jeans for khakis and a button-up shirt."
O'Reily: A suit, yeah.
Lewis: And it's something that a lot of tech companies aren't willing to do.
O'Reily: "They're paying a dividend, they're so square."
Lewis: "Yeah, man, they've sold out." It's tough with tech.
O'Reily: It is, yeah.
Lewis: I think there's always this pressure to be growing pretty rapidly. And to your point about capital allocation, you don't see a lot of really gaudy dividend yields in the high-growth tech area.
O'Reily: You don't.
Lewis: Just because the businesses can better invest their money internally and provide better returns for shareholders that way.
O'Reily: Well, not only that, but in order to justify paying a dividend consistently, you need to not only prove that you can't use the money internally better to make an acquisition or something, but you also have to factor in the tax implications of paying out a dividend to shareholders. So, there's a 15-30% tax, and had you just bought back shares, and then theoretically, the value of each share would go up, there's that. I mean, you need to be really, really sure that is the best use for the money.
Lewis: That's a great point.
O'Reily: It's particularly difficult in our industry. But, you'll notice, the people who pay out huge chunks of their profits and free cashflow, what you're talking about, it's Altria, it's Procter & Gamble, these are enormous consumer brands that have made it.
Lewis: Yeah, and you mentioned IBM before. It's like, this is someone that's been in the tech space for a very long time, they're established.
O'Reily: They traded their khaki shorts for suits a long time ago.
Lewis: Yeah, quite a long time ago. So, a lot of up-and-coming names in the tech space really aren't a part of that conversation. That said, you look at space like telecoms, things like that, that's where you start to see some pretty attractive yields, and I think also, a lot of elements of the business that check off some of the bulletpoints that we'd mentioned earlier.
O'Reily: For sure. Before we move on, and going along with this week's income-focused theme, I wanted to point our listeners to a special article written by five Industry Focus contributors, including yours truly and Dylan Lewis, with our top picks for dividend stocks. Just head to dividends.fool.com, you'll learn our picks for the best dividend stocks for 2016. Once again, that's dividends.fool.com. And to make that easy for everybody, I will drop that in the iTunes description of this podcast.
So, Dylan, before we head out of here, I wanted to get your thoughts on what mistakes do dividend investors make, and how they can avoid them.
Lewis: Yeah. I think, with dividend investing, you look quick.
O'Reily: "Oh, I got a 5% yield, awesome!"
Lewis: "I'm gonna be getting that every year!" Right? And you just kind of factor that in as your rate of return if you're doing it quickly. So, I think one of the big things people need to be cautious about is being yield-centric. You might be tempted to use a yield as your screener when you're looking at dividend stocks as potential investments. And I think it's definitely a good place to start, particularly if that's your orientation, but it's something that you definitely need to dig deeper on.
So, some companies in the tech space, other sectors as well, have these really gaudy yields. But you need to read into why that's the case. Sometimes, it's because there's been huge share price depreciation.
O'Reily: Which implies some sort of trouble afoot.
Lewis: Yeah. So, it's easy for a percentage to go up when the denominator goes down. Just as an example, I think Seagate's dividend yield is like 7%. In the last year, the stock has lost half its value. So, that is not necessarily stable.
O'Reily: That is not what you want from that yield, yeah.
Lewis: Yeah. And part of that is because the business is struggling. They've missed on reports recently and some of their quarterly filings, customers seem to be moving a little bit more toward solid state drives than Seagate's flagship, magnetic disk drives. So, there are all these competitive and business elements at play here that ultimately undermine the long-term viability of that dividend, and the yield that it currently is.
O'Reily: On the other end of the spectrum, you picked a couple of names that don't have that sky-high yield, but long-term ...
Lewis: Right. And so, again, only looking at yields might cause you to lose out on some of these best of both worlds growth stocks that also have a nice little dividend as a kicker. No one's going to be surprised to hear this name, but Apple, they make everything, and there are fantastic growth company, they have a great growth profile, and they have a nice little dividend yield. It's like 1.75%, something like that. And I don't think anyone's going to argue. The company's not going anywhere. They're going to be around for a while.
O'Reily: Not only that, but the odds of them upping that just a little bit for the next one to two decades? Probably pretty good. And that's really what somebody who's looking to build a long-term dividend portfolio, like John earlier, should be looking for -- something that's yielding 2% or 3% now and, it's not guaranteed, but it's probably going to up it later.
Lewis: And it's something that you'll probably enjoy some very nice share price appreciation along the way.
O'Reily: Fingers crossed.
Lewis: Because of those growth drivers. I'm a shareholder, so I hope so. Another name, in the same vein, where if you're only looking at 3% above on yield or something like that, you'd miss, somebody like American Tower (NYSE:AMT). So, they're an owner and operator of wireless and broadcast communication sites.
O'Reily: Mildly important today. Huge barriers to entry, who has the money to build those stupid things, right?
Lewis: Yeah. And they lease them out.
O'Reily: Yeah, boom.
Lewis: Yeah, so, huge barriers to entry, capital-intensive business, and you look at the macro factors at play: cell data's huge, it's going to become even bigger in the next decade, so they're well-positioned for that. They only have a yield of like 1.85%, something like that. They're under 2%. So, that's another great business that offers you some growth, also offers you a nice little income on the side, something you would overlook if you were just looking at yields. So, I think that's just another thing to keep in mind.
O'Reily: Cool, very good. Thanks for your thoughts, Dylan.
Lewis: Always a pleasure, Sean.
O'Reily: Have a good one. That is it for us, Fools. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at firstname.lastname@example.org. As always, people on this program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I am Sean O'Reily. Thanks for listening, and Fool on!
Dylan Lewis owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), American Tower, and Apple. The Motley Fool has the following options: long January 2017 $80 calls on American Tower. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.