Thursday, March 29, 2012

Conditions For Selling a Stock

An important aspect of being a disciplined investor is having predefined conditions for selling stocks. Here I will discuss the conditions under which I would consider selling a stock in my portfolio. Note that the decision of whether to sell would only be made after investigating the reasons underlying the relevant condition(s) for a given stock.

1. The dividend is suspended, cut, or frozen. As a dividend-growth investor, I want the stocks in my portfolio to have sustainable and rising dividends. If a stock has its dividend suspended, cut, or frozen, then it no longer fits the basic definition of a dividend-growth stock and is inconsistent with my investing strategy. It is extremely likely that I would quickly sell any stock that has its dividend suspended or cut. Those are major red flags that are almost always indicative of problems with the company's fundamentals (see the next condition). For a dividend freeze, I would attempt to determine whether the freeze is likely to be only temporary (e.g. for just one year), in which case I might decide to hold or sell a portion of my position. If there is a lot of uncertainty and it looks like the dividend might be frozen for the foreseeable future, then I would probably sell my entire position. I would treat anemic dividend growth (< 2%) in the same way as a dividend freeze. For example, General Mills (GIS) has occasionally frozen its dividend in the past. If it were to freeze its dividend again (ending its current 8-year dividend-growth streak), then I might hold because dividend growth would probably resume at some point in the near future. Moreover, in the company's 113-year history (including that of its predecessor firm), General Mills has never suspended or cut its dividend, which indicates to me that the dividend is a high priority for the company.

2. The company's fundamentals are deteriorating. Dividend growth is powered by earnings growth, which only happens if a company is doing well. If it looks like a company's fundamentals are deteriorating and unlikely to improve in the near future, then I would likely sell. An important consideration would be whether the deterioration appears to be either short term or long term. Short-term deterioration, such as poor earnings for a quarter or two, would not necessarily lead me to sell. Every company has a bad quarter now and then, so I would investigate the reasons for the poor performance and attempt to determine whether it is just a temporary hiccup or reflects a more serious problem. Note that I do not consider missing analysts' estimates to be poor performance. A company can be doing fine and still miss analysts' estimates, which tend to be wrong more often than they are right. Long-term deterioration, such as poor earnings over several quarters, would probably lead me to sell, especially when accompanied by other noticeable problems (e.g., spike in the payout ratio, sharp decrease in revenue, sudden increase in debt, bad news that compromises the company's business, etc.). However, I would also consider macro-economic factors, such as whether the economy is in recession and dragging down the earnings of most companies.

3. The company is changing through a merger, major acquisition, split, or spin-off. These actions are not necessarily negative, but warrant further investigation. For example, if the company I own is merging with or acquiring a weaker company, then I might question the soundness of the decision and decide to sell, especially if the other company is unrelated to my company's main businesses (i.e., I don't want to see what Peter Lynch calls "diworsification" -- a company making itself worse by trying to be too diverse). If the company I own is being acquired, then I would likely sell simply to take advantage of the easy capital gain that would arise from the premium offered by the acquiring company. If I think the acquiring company would be a good addition to my portfolio, then I can always buy it later. Regarding a company split, whether I sell would depend a lot on the specific circumstances of the situation. I would likely hold through the split (unless I am convinced the split is a bad idea from the start), then evaluate each split-off company separately and decide whether I might want to sell one or both of them. For example, Abbott Laboratories (ABT) will be splitting into two companies by the end of 2012. I plan to hold through the split and then evaluate each company on its own afterwards. I would treat a company spinning off a part of itself into a separate company in the same way as a company split.

4. The stock has become extremely overvalued. Regardless of how a company is doing, its stock price might not accurately reflect the company's performance. If I think a company's stock is extremely overvalued relative to its earnings, sales, and other metrics, then I would likely sell all or a portion of my position and then re-establish a position later when the price is more reasonable (assuming the company's fundamentals are still good). What do I mean by extremely overvalued? I do not have a set of strict criteria, but I would be concerned with a P/E ratio above 25 and other metrics that are well above the historic norms for a particular stock, especially if there is no recent growth spurt that justifies the higher metrics. I would also consider whether the market itself seems to be overvalued. A market bubble that pulls several of my stocks into overvalued territory would be motivation for selling multiple stocks, even if it puts me largely in cash for a while.

5. Important information was overlooked when the stock was bought. Although I research every stock before I buy it, there is always the possibility that I overlooked some important information that would have altered my buying decision. For example, maybe I misinterpreted the company's financial condition or dismissed something that initially seemed trivial but later turned out to be a major red flag. Mistakes happen and it makes sense to sell if the company is not in the condition that I originally thought it to be. Hopefully I would be able to detect those mistakes quickly and avoid losing money.

6. A large capital loss can be realized to offset taxable income. Due to market fluctuations, I may have a large unrealized capital loss on a stock even though the company is doing fine. I might consider taking advantage of this situation by selling the stock, then waiting 31 days before re-establishing my position (to avoid a wash sale). Assuming I am able to buy back in at a price similar to my sale price, then the market value of my position would be unchanged. Why would I do this if I end up with the same stock at nearly the same market value? The reason is that I can use the realized capital loss to offset up to $3,000 of my taxable income, thereby lowering my taxes. If the stock rebounds to my original purchase price, then I would have an unrealized capital gain that makes up for the realized capital loss, whereas if I had just held onto my original position, my unrealized capital loss would simply disappear. Thus, in each case I would break even, but by selling and buying back in, I would get a tax deduction. For example, this is sort of what I did near the end of 2011, although it had the dual purpose of offsetting my taxable income and getting rid of a few stocks that I had foolishly bought before I implemented my dividend-growth investing strategy. In that situation, instead of buying back into those stocks later, I used the money from the sales to buy other stocks that fit with my strategy. I am not sure how often I will try this tactic, but it is something I will keep in mind. Of course, this can be done only if I have stocks with unrealized capital losses.

In summary, those are the conditions under which I would consider selling a stock. As I continue to learn more and become a better investor, I may come up with different views of these conditions or add some new conditions to the list. However, I think the present list represents a useful starting point and makes part of my investing strategy more concrete and disciplined.

Saturday, March 24, 2012

Trading Is Hazardous to Your Wealth

An important aspect of investing in the stock market is how often you trade, which can be viewed on a continuum. At the high end of the continuum are day traders, who make several trades each day, rarely holding a position for more than a few minutes or hours. A bit further down are swing traders, who might hold a position for a few days or weeks. At the low end of the continuum are buy-and-monitor investors (which I think is a more appropriate label than "buy-and-hold"), who hold their positions for years or even decades as long as the fundamentals remain sound. Thus, when framed in terms of portfolio turnover, day/swing traders have very high turnover rates, whereas buy-and-monitor investors have very low turnover rates.

What is the effect of turnover on returns for individual investors? I recently came across a study that provides some relevant data. Barber and Odean (2000) looked at the relationship between common stock investment performance for individuals (not mutual fund managers or institutional investors) and the rate of portfolio turnover for a period from 1991-1996, in the midst of a bull market. During that time, the market returned an average of 17.9% per year. How did individual investors do?

Investors were divided into quintiles based on how often they traded. Interestingly, all groups had gross returns (before trading costs) that were very similar to each other and to the market. However, the groups differed in their net returns (after trading costs): The group that traded the least had a net return of 18.5%, which was almost equal to its gross return and slightly better than the market. The group that traded the most had a net return of 11.4%, despite having a gross return that was essentially identical to that of groups that traded less often, which means that a large chunk of their return was lost due to trading costs. Overall, the more that a group traded, the lower its net return. On average, individuals turned over about 75% of their portfolios annually.

These results and related findings show that frequent trading is detrimental to investing performance (in terms of net return). Barber and Odean (2000) suggested that one reason for this relationship is that some people become overconfident and overestimate the value of the news and information they learn about their stocks. This overconfidence compels them to act on their information, leading them to trade more often.

Based on such research, one of the principles of my investing strategy is to keep portfolio turnover at an absolute minimum. Last year I had some turnover because it was not until later in the year that I finally settled on the dividend-growth investing strategy that I now follow. Thus far this year I have had 0% turnover -- I have not sold a single stock (see my Transactions page). To minimize turnover, I adhere to a set of criteria associated with selling stocks that I plan to write about in the future. In addition, I completely refrain from day and swing trading, and I do not follow any sort of market-timing strategy. I think my approach is sensible and will ultimately result in investment performance that is in line with my goals.

Reference: Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55, 773-806. The article is available from Barber's website.

Tuesday, March 20, 2012

Book Review: The Triumph of Value Investing

The Triumph of Value Investing (2010) by Janet Lowe

The purpose of this book is to explain why value investing has been and continues to be a good strategy for the long run. The author addresses many important points about value investing (e.g., margin of safety, valuation measures, earnings growth, etc.) but with the exception of some useful discussion of balance and income sheets, the text rarely goes beyond a superficial level of analysis. That is, I found the book to be more laudatory (highlighting the successes of prominent value investors) than explanatory (showing how to implement a value investing strategy). Throughout the book, the author frequently intersperses interview quotes from Warren Buffett, William O'Neil, David Iben, Charles Brandes, and other investors, which I found to be largely unnecessary. In fact, I consider excessive quotation of this sort to be an indication of a weak writer. I also thought the book was somewhat poorly organized in places, with occasional digressions on topics of questionable relevance. Thus, while I did not find anything wrong with what the author wrote about value investing, there was simply not enough detail for me to gain much of value from this book (pardon the pun).

Note: I read this book in March 2012.

Saturday, March 17, 2012

Stock Thoughts: SYT

As the world population continues to increase, food demand will also increase. This macro-level trend suggests that businesses involved in the agricultural industry may be good long-term investments. My first investment in this area was in Archer Daniels Midland (ADM), a company that buys, transports, stores, processes, and sells various agricultural commodities and products around the world. I started a position in ADM back in January. In my search for other investment candidates I have come across Syngenta (SYT) and I wanted to share some of my thoughts about it.

Company Overview
Syngenta is one of the largest agribusiness companies in the world, employing more than 26,000 people in over 90 countries (the company's headquarters are in Basel, Switzerland). The company was formed in 2000 when the agricultural divisions of Novartis and AstraZeneca were spun off and merged. Syngenta's stated purpose is "bringing plant potential to life," which the company strives to do by conducting biotechnological research and marketing products such as:
  • Herbicides, insecticides, and fungicides for crop protection
  • Field crops, vegetables, and flower seeds
  • Seed care products
  • Turf, garden, home care, and public health products

Recent Performance
Syngenta had sales of $13.3 billion in 2011, with 76% from crop protection and 24% from seeds, and considerable geographic diversification: 32% from Europe, Africa, and Middle East; 26% from North America; 27% from Latin America; and 15% from Asia Pacific. Many product lines and geographic regions had double-digit sales growth. Overall, sales increased 14% compared with 2010 and led to record free cash flow of $1.5 billion. The company has recently initiated an integrated business strategy (combining commercial offers for crop protection and seeds) that appears to be doing well. Based on what I've read, I think the company is well-positioned for future growth.

The biggest risk factors for Syngenta are related to government approval and consumer acceptance of genetically modified (GM) foods. The governments of some countries (e.g., France and Hungary) have banned certain GM foods and there are consumers who avoid GM foods in favor of "organic" foods (even though so-called organic foods are not always what they are claimed to be). Some of these concerns are health-related, although there is not much compelling scientific evidence that consumption of GM food has adverse health effects. There are also questions about whether GM crops yield more than non-GM crops, with various studies producing conflicting results. It is important to be mindful of these risks.

Dividend History
Given that Syngenta was formed in 2000, it does not have a long dividend history. However, management seems to make the dividend a high priority and has generally increased it from year to year (the company pays an annual dividend). Prior to 2007 the dividend was coupled with or replaced by a "par value reduction" which, to the best of my understanding, is a return of capital. However, since 2007 the company has just paid a dividend, making their recent dividend history easier to interpret.

The dividend for the American Depository Shares (ADS) has increased for 6 consecutive years in USD, although it was held constant in the home currency of Swiss francs (CHF) from 2008 to 2009, likely due to the global recession. If one treats the "par value reduction" as equivalent to a dividend, then the streak in USD actually goes back to the company's first dividend for fiscal year 2000/2001. The proposed dividend for fiscal year 2011 (to be paid in 2012) is 8.00 CHF, which is a 14.3% increase over the 7.00 CHF paid for the previous year. The 5-year dividend-growth rate is 16.1% in CHF (even with the dividend being the same in 2008 and 2009); the rate is even higher in USD due to the Swiss franc being a stronger currency. Overall, I think Syngenta has a pretty good dividend history.

Stock Analysis
In the table below I provide some relevant statistics for evaluating SYT. For comparison, I also provide statistics for its closest competitor, Monsanto (MON). PEG ratios are not included because I have seen very different numbers from various sources.

Statistic SYT MON
P/E (ttm) 18.92 24.80
5-yr EPS growth rate 22.22 19.47
P/S 2.25 3.42
P/B 3.99 3.85
ROE 21.40 16.58
Debt/Equity 38.93 19.10
Current Ratio 1.73 1.66
Div Yield 2.41 1.52
5-yr DGR 16.1 23.3
Payout ratio 46 36
% below 52-wk high 8.88 6.12

SYT is a bit pricey but not necessarily overvalued. Moreover, it appears to be cheaper than MON and offers a better yield (even after foreign tax withholding).

Overall, I have a favorable view of Syngenta and I think it might be a good long-term investment in the agricultural industry. I know some investors would be turned off by the annual dividend and foreign tax withholding, but those are inconveniences rather than deal-breakers for me. For the time being I plan to continue watching SYT, waiting for a slightly better valuation before initiating a position. Its ex-dividend date is April 26, so it would be nice to see a dip before that date.

Thursday, March 15, 2012

Milestone: Portfolio Value Reaches $50,000

Today my portfolio's value reached $50,000 for the very first time, closing at $50,018.39. I am pleased that I was able to achieve this milestone about one month sooner than expected. The recent surge in my portfolio's value is attributable to the following three sources (in order from largest to smallest contribution): investment of new capital from savings, capital gains from stock appreciation, and dividends. Given that my portfolio started the year at $42,830.02, in less than three months its value has increased by 16.8%.

The next milestone for my portfolio's value is $60,000, which I hope to reach later this year. At the end of this month I will be achieving another milestone of a different sort, so stay tuned for that announcement.

Sunday, March 11, 2012

Book Review: The Investment Answer

The Investment Answer (2011) by Daniel C. Goldie and Gordon S. Murray

In this very short book (< 100 pages) the authors provide their answers to the following five investing decisions:
  1. The Do-It-Yourself Decision: They argue that the stock market is too complex for the average investor, so they recommend having an independent, fee-only advisor. Not only does this insult the intelligence of many individual investors, but it is inconsistent with their later criticisms about professional money managers (e.g., high fees and sub-par performance).
  2. The Asset Allocation Decision: They give the standard spiel about investing in several different asset classes in a way that purportedly minimizes risk (volatility) while maximizing return. In this chapter they refer to value stocks as "distressed companies" that may have "bleak prospects for the future," yet they present data showing that value stocks tend to outperform growth stocks.
  3. The Diversification Decision: Similar to the previous decision, they advocate investing in a mix of domestic and foreign equities and bonds to balance risk and return. They firmly believe in Modern Portfolio Theory.
  4. The Active Versus Passive Decision: Being strong adherents to the Efficient Market Hypothesis, they argue that it is impossible to beat the market, so they recommend passive investing in various index funds.
  5. The Rebalancing Decision: They suggest rebalancing your portfolio to maintain the desired levels of asset allocation and diversification.
If you were to follow the "answers" given in this book, your portfolio would be comprised of a hodgepodge of index-based ETFs that you would simply buy and hold except for periodic rebalancing. However, you would be paying a financial advisor to manage this portfolio for you. Not surprisingly, I have a low opinion of this book, but at least I did not waste much time reading it.

Note: I read this book in March 2012.

Friday, March 9, 2012

Book Review: Debunkery

Debunkery (2011) by Ken Fisher

The author of this book sets out to debunk 50 myths and misconceptions about the stock market and investing. Each "bunk" is addressed in a 3-5 page chapter that discusses relevant facts and analyses in an understandable and laid-back manner. Some of the bunks covered in the book include: bonds are safer than stocks, age determines asset allocation, beta measures risk, don't fight the Fed, lower taxes help the market, and various factors (high unemployment, high oil prices, big national debts, trade deficits, terrorism) hurt the market. Many of his counterarguments involve presenting historical data that show no reliable relationship where one has been posited (e.g., unemployment rate vs. stock market performance). Overall, I think he succeeds in demonstrating that a lot of the "wisdom" one hears about the stock market has little empirical support and does not stand up to critical analysis.

Note: I read this book in February 2012.

Wednesday, March 7, 2012

Dividend Increase: GD

One of my dividend-growth stocks, General Dynamics (GD), increased its quarterly dividend by 8.5% today, raising the payment from $0.47 to $0.51 per share. This puts the company on track for its 21st consecutive year of dividend growth. Given that I own 20 shares of GD, my quarterly dividend increases from $9.40 to $10.20, which will add an extra $3.20 to my annual dividend income. This dividend increase also boosts my yield on cost to 2.93%.

Tuesday, March 6, 2012

Keeping Things in Perspective

It can be frustrating when you buy a stock only to see it fall in price soon after your purchase. Case in point: My purchase of NSC yesterday.

As I mentioned in my post about the purchase, the stock's price has been declining this year (despite no bad news or change in the company's fundamentals), so I felt compelled to take advantage of it being "on sale." Little did I know that the very next day (today) the market would see its biggest one-day loss thus far in 2012 and NSC would go down another 2.6%.

It is easy to get upset when this happens and I'll admit that I was a bit frustrated. However, at times like this I find it helpful to remind myself of the following points:
  • Short-term price fluctuations are essentially impossible to predict, which is why market timing rarely works. I could not have predicted that the price would drop 2.6% today, so there is little sense in getting frustrated about it.
  • My purchase price was a price at which I deemed I was getting a good stock at a good value, and that remains true. How would I have felt if the price had shot up and I had missed the opportunity to buy the stock when it was on sale? Indeed, I missed plenty of great buying opportunities last fall that would have led to double-digit gains by this time.
  • If the price continues to fall, then I will have the opportunity to buy the stock at an even greater discount. (Whether I do will depend on the availability of cash and how much larger I am willing to make my position.)
  • The purchase is intended as a long-term investment, so years from now I will not care about a price difference of a few percentage points.
  • The price difference amounts to about $30, which is trivial relative to the size of my position and the rest of my portfolio. Moreover, I've spent $30 countless times on far less important things in my life -- and none of those things paid dividends.
  • My primary investing goal is to create a sustainable, rising stream of dividend income, and my purchase is entirely consistent with that goal.
Thus, I think a major psychological aspect of being a good investor is learning to keep things in perspective -- to let rational thinking supplant emotional reactions. It is not an easy thing to do and it is something with which I still struggle, but I think that writing about it on this blog helps my thinking about investing.

Stock Bought: VOD

For my second purchase today I bought shares of Vodafone Group (VOD), a multinational telecommunications company headquartered in the United Kingdom. I particularly like Vodafone's international presence, which I think gives it plenty of opportunities for growth. This purchase complements my position in AT&T (T), giving me some diversification in the telecom industry.

VOD is a good dividend-growth stock. The company has increased its dividend for 12 consecutive years and has stated that its goal is to achieve dividend growth near 7%. The 5-year average annual dividend growth rate is 8.0%. For readers who are curious as to why VOD does not appear as a Dividend Contender (10-24 consecutive years of dividend increases) in the Dividend Champions, Contenders, and Challengers List, it is because the preceding numbers are based on dividends paid in British pounds. Due to exchange rate fluctuations, the dividend paid in U.S. dollars was lower in 2009 compared with 2008.

Some other useful information to know is that the dividend is paid semi-annually in the form of an interim dividend and a final dividend. The most recent dividend payment included a special dividend from Verizon Wireless, which is 45% owned by Vodafone; the other 55% is owned by Verizon (VZ). However, it is unclear whether the special dividend will be a recurring payment. Due to a tax treaty between the U.S. and the U.K., there is no foreign tax withholding on dividends from VOD, which is nice.

I bought 30 shares of VOD at the price of $26.87 per share, giving me a 5.44% yield on cost. At the current dividend rate, excluding the special dividend, I can expect to receive $43.81 in annual dividend income. This purchase represents about half of my desired position in VOD. I plan to buy more shares -- assuming the price remains attractive -- once I add new capital to my brokerage account. (My three purchases this week used up almost all my cash.) This purchase makes VOD the 21st stock overall and the 3rd foreign-based stock in my portfolio.

Stock Bought: UNP

For my first purchase today I bought shares of Union Pacific (UNP), a company that operates a major North American railroad network with over 32000 route miles of track predominantly in the western and central United States. This purchase complements my positions in Norfolk Southern (NSC) and Canadian National Railway (CNI), giving me geographic diversification that spans most of the U.S. and Canada.

UNP is a good dividend-growth stock. The company has paid uninterrupted dividends for 112 years and increased its dividend for 6 consecutive years. The most recent increase was 26.3% in November 2011 and since mid-2010 the company has been increasing its dividend every two quarters (similar to NSC), so the next increase may come in May. The 5-year average annual dividend growth rate also happens to be 26.3%.

I bought 10 shares of UNP at the price of $105.00 per share, giving me a 2.29% yield on cost. At the current dividend rate, I can expect to receive quarterly dividends of $6.00, which would add a total of $24.00 to my annual dividend income. This purchase makes UNP the 20th stock in my portfolio.

Monday, March 5, 2012

Stock Bought: NSC

Today I bought shares of Norfolk Southern (NSC), a major North American railroad company. I wrote about NSC when I increased my position in it at the end of January, so I will merely state that I continue to think it offers great value and will be a good long-term dividend-growth stock.

I bought 15 shares of NSC at the price of $67.62 per share, which is less than the price of my existing position, so I was able to average down. I now have a total of 50 shares at an average price of $71.96 per share, giving me a 2.61% yield on cost. At the current dividend rate, I can expect to receive quarterly dividends of $23.50. NSC will now contribute a total of $94.00 to my annual dividend income.

I had not planned to add to my NSC position, but the stock's price has been declining this year (despite no bad news or change in the company's fundamentals), compelling me to take advantage of it being "on sale." Perhaps it will go down even further in a broader market correction*, but I cannot predict whether or when that might happen, so I decided to buy it now. I find that making regular purchases each month is less stressful than trying to time the market. This purchase makes NSC the third-largest position in my portfolio (after PM and MCD), which is as large as I feel comfortable having it at this time. Thus, my focus will now be on increasing other positions or adding new positions to my portfolio.

* Update (March 6): Of course, that is exactly what happened the very next day; see my post Keeping Things in Perspective.

Saturday, March 3, 2012

Dividend Reinvestment

Investors who do not need to spend their dividend income have two basic methods for dividend reinvestment: automatic and selective. I will discuss each method and explain why I selectively reinvest dividends. I will not cover all aspects of each method (e.g., dollar cost averaging associated with automatic dividend reinvestment), so I encourage readers to do further research if they are interested in knowing more about this topic.

Automatic dividend reinvestment involves passively reinvesting dividends back into the stocks of the companies that paid them. There are two typical ways to implement this method. One way is to enroll in a company-sponsored dividend reinvestment plan (DRIP), which involves buying shares directly from the company or through their agent. Instead of receiving your dividends in cash, they are automatically used to buy more shares of the company's stock at the current market price, although some companies provide small price discounts. Many companies offer no-fee DRIPs (a list of such companies can be found here), although be aware that other companies charge fees (e.g., initial setup fees), so it is important to find out the details of a given company's DRIP before enrolling in it. Many company DRIPs also allow you to make periodic optional cash purchases of stock, usually (but not necessarily) commission-free, although there are often constraints on such purchases (e.g., minimum purchase requirements). Given that the dividends or optional cash purchase amounts are unlikely to be an exact multiple of the stock price, it is typical to get fractional shares of the stock. For example, if you have $187.50 in dividends to reinvest and the stock price is $75 per share, you would get an extra 2.5 shares (assuming no fees). That might look a bit strange, but shares do not have to be whole numbers.

An alternative way to automatically reinvest dividends is to create a synthetic DRIP through a brokerage. If the dividend-paying stocks are held in a brokerage account, some (but not all) brokerages provide the option to automatically reinvest your dividends for free. You should check whether your brokerage has this option. A synthetic DRIP can be more convenient than a company DRIP because you can do it all within a single brokerage account. However, you would not get any price discount that may be associated with the company DRIP and any optional cash purchases would be equivalent to regular stock purchases, so brokerage commissions would be charged.

The main advantage of automatic dividend reinvestment is that it can usually be done for free. The main disadvantage of the method is that because it is automatic, you might be reinvesting dividends in a stock that is overvalued, which may not be the most effective use of that money. That is, you probably would not make a regular stock purchase (with new capital) of a stock that is overvalued, so you probably would not want to see your dividends used to buy overvalued stocks. Synthetic DRIPs do provide the option of temporarily turning off automatic dividend reinvestment and collecting your dividends as cash, in which case you could do selective dividend reinvestment. You can also turn off company DRIPs, but you would have to transfer the cash out of the DRIPs in order to selectively reinvest it.

Selective dividend reinvestment involves actively reinvesting dividends into stocks you select. The dividends are collected in your brokerage account as cash and can be reinvested into any stock in your portfolio (not necessarily the stock of the company that paid them) or you can use them to start new positions. Nothing is done automatically, so you have complete control over when and in which stocks the dividends get reinvested.

The main advantage of selective dividend reinvestment is the control over stock selection. If one of your stocks is overvalued, you do not have to reinvest your dividends in it. Instead, you can reinvest the dividends in an undervalued stock, which may be a more effective use of that money. For example, if you have two dividend-paying stocks that start with similar yields, but then one becomes overvalued due to its stock price increasing (lowering its yield) and the other becomes undervalued due to its stock price decreasing (raising its yield), and nothing else changes (e.g., the dividend rates remain the same), then you will find that reinvesting the dividends from both stocks in the undervalued stock will provide a larger boost to your dividend income compared with reinvesting the dividends in the respective stocks that paid them. That is what I mean when I say that selective dividend reinvestment may be "more effective." The main disadvantage of the method is that dividend reinvestment would be equivalent to a regular stock purchase, incurring brokerage commissions. Investors generally want to minimize such transaction costs because they reduce overall return.

The two methods have complementary advantages and disadvantages, so I do not think one is necessarily better than the other. I think both methods are sensible approaches to dividend reinvestment and the method an investor chooses will depend on his or her individual circumstances. In fact, one does not even need to choose between them; there are investors who have some stocks in DRIPs and selectively reinvest the dividends from other stocks.

Why do I choose to selectively reinvest dividends? The reason is that the main disadvantage of the method -- incurring brokerage commissions -- is a moot issue for me because I buy stocks with new capital on a regular basis (see my Transactions page). Regardless of how I choose to reinvest my dividends, I will always have to pay a brokerage commission when I buy a stock with new capital. Thus, if I selectively reinvest my dividends by combining them with new capital to buy a stock, I do not incur any brokerage commission over and above what I would have to pay anyway for buying a stock solely with new capital. From this perspective, the main disadvantage of selective dividend reinvestment goes away. Moreover, I would still get the main advantage of the method because the dividends would be reinvested in undervalued (or fairly valued) stocks, which is what I typically try to buy with new capital.

I think this approach makes sense and works well for me, but as mentioned above, it may not be suitable for all investors. For example, a retiree or someone who is not investing much new capital would probably be better off doing automatic dividend reinvestment to avoid paying commissions. However, young investors like me may benefit more from selective dividend reinvestment. Regardless of which method you prefer, I think it is a good idea to reinvest your dividends if you do not need them right now to supplement your other income. As discussed on my Strategy page, dividend reinvestment is a key element of the long-term compounding involved in creating a rising dividend income stream, so it can be very beneficial to put that money to work for you.

Thursday, March 1, 2012

Monthly Review: February 2012

Here is a review of what happened in February:

Dividends: I received a total of $85.78 in dividends from the following stocks:
  • ABT: $21.60
  • GIS: $13.73
  • PG: $26.25
  • T: $24.20
This monthly total is very close to what I received in January ($88.74) and results in a year-to-date total of $174.52, which puts me 13.4% of the way toward my goal of receiving $1300 in dividends for 2012.

Dividend Increases: I was pleased to see dividend increases announced for the following stocks (click on each stock to see my post about the increase):
  • ABT: 6.3% increase, $5.40 more in annual dividend income
  • GPC: 10.0%, $9.00
  • KO: 8.5%, $4.80
  • NVS: 5.8%, $3.09 (estimated)
Collectively, these increases will give me an extra $22.29 in annual dividend income going forward. So far in 2012, 7 of my 19 stocks have had dividend increases. The others are CNI (announced in January on the day I initiated my position), NSC (announced in January right before I added to my position), and T (announced last December but effective with this month's payment). The average increase has been 8.2%, which is great.

Savings: My goal for 2012 is to save a total of $12000 (an average of $1000 per month) for investment, which works out to saving 34.2% of the net income from my job. I think this is a pretty good goal considering the average personal savings rate in the U.S. is currently less than 5%. In January I saved $1360 (46.6%) of my net income and I wrote in my monthly review that I would try to beat that amount in February. And I succeeded! This month I saved $1497 (51.3%) of my net income. I am pleased that I managed to get over the 50% mark. This results in year-to-date savings of $2857, which puts me 23.8% of the way toward my goal for 2012.

Transactions: Due to the lack of great buying opportunities, I made only one transaction this month, buying 25 shares of GIS as an addition to my existing position. This purchase will increase my annual dividend income by $30.48. My portfolio remains at 19 stocks with a market value of $46963.71 (including cash).

Looking Ahead: In March I expect to break the $100 mark for dividends in a single month because I will receive them from 8 stocks. March should be similar to February in terms of expenses, so I hope to save a similar amount (perhaps even a bit more). Based on the cash currently in my brokerage account and the pending addition of new capital, I will likely be able to make 2 purchases in March.