Monthly dividend stocks are mostly gimmicky

Between 2007 and 2009, approximately 34% of American stocks that pay dividends quarterly cut their payout at some point during the recession. The part I find worthy of examination? The fact that 56% of stocks that paid monthly dividends ended up cutting their payout during the recession. The same corporations that suggested you should invest in them for their cash flows had a disproportionately higher likelihood of slashing their payouts than the regular American companies that made no special promises about the future of their dividends.

How should we analyze this?

My view is that many companies have opportunistically recognized that the ability for savers to use their funds to create a meaningful monthly cash flow has been severely compromised in the past decade. There are no savings accounts or U.S. bond investments paying out 5% anymore. Adjusting to the circumstances, many of these investors took up the purchase of things like real estate investment trusts or master limited partnerships. Five years ago, no one outside the most sophisticated investor class had heard of these things, and now mom and pop investors found themselves rushing in with 10% to 15% of their net wealth to try and improve their household’s monthly passive income cash flows.

This created fertile soil for company executives to develop a marketing angle to boost the price of their stock above what a sober analysis of the underlying assets would reveal. How many people in the investor community would pay more to receive ten cents per share each month rather than a lump-sum $1.20 payout each year? Exactly. And therein lay the opportunity.

Sometimes, this just meant getting investors to pay more for an ownership stake in an asset than should be warranted. The theory is that you get investors to bid up the price of a stock to 1.3x compared to the price that existed before the switch to monthly dividends. Aside from the usual reason why businesses like rising stock price, it is permits borrowing at rates because any equity-based financing is an advantage for the company because you are diluting the business when it is trading at a price higher than what it is worth. Basically, using the stock to raise capital is the equivalent to giving up $0.70 in value financiers in exchange for each dollar that they give you in return.

It is also helpful for debt-based financing because the market capitalization of a business is a factor in determining the interest rates that the business must pay.

I mean, look at this list from Lisa Springer of Street Authority in 2013 that gave examples of the 22 best monthly dividend stocks to buy. Only 6 of those 22 companies are paying out monthly dividends right now at rates that are higher or equal to the amount that they were paying in 2013. It hasn’t even been four years, and over 70% of the monthly dividend payers on the list have already failed. And that was from a self-selecting group that she presumably culled for some type of fundamental characteristics that looked good at the time.

An important side note. Realty Income deserves a pass because it actually has real rental income coming in, has been doing monthly payouts since 1994, and was created with stable cash flows in mind out of a sincere desire to address this corner of the income market. This is different from the latest crop that seek to opportunistically exploit the income investor class while interest rates and alternative income investments are lacking.

Stocks that pay dividends each month deserve criticism because they are often preying on you to bid the price up to shore up their own finances. My own research on those 22 stocks mentioned in the Springer recommendation list led me to observe five things: (1) 17 of those 22 stocks had leverage that was greater than 5x the annual cash flows; (2) 15 of them were borrowing at rates greater than 5% at the time the list was created, which is notable because of how low corporate borrowing was at the time; (3) 14 of them had a share count that was at least 25% higher by 2015 compared to 2013; (4) only 3 of them were paying out dividends each month before it became fashionable in the aftermath of the financial crisis; and (5) only 7 of them have higher stock prices than was the case at the time the article was written, which is remarkable because of the general bull market conditions.

Do me a favor and read that paragraph again because it took me almost two hours to tabulate that data.

I know balance sheet analysis isn’t anyone’s idea of a good time. But when it comes to these monthly stocks, you have to do your homework. Check to see whether the dividends are supported by current earnings. See how much greater the balance sheet debt is compared to the cash flows. Find out the interest rates on the existing debt. Make an educated guess as to whether that debt burden will be refinanced at higher rates. Look to see if there has been meaningful dilution in recent year.

Usually, companies become monthly dividend stocks because they “resort to it” rather than have a strong desire to connect with income investors. These payouts are very ephemeral. They might pay the bills for a month or two, or maybe even a year or two. But they can’t withstand recessions. Heck, as the last few years have shown, they can’t even withstand the good times. You’d be much better off stocking up on shares of Johnson & Johnson, ExxonMobil, and Coca-Cola and integrating their quarterly payouts into your budget. Why? Because when the business is built to last, so will the dividend payments.

Full disclosure: Long KO, XOM , O

Oil Stocks: The next hundred years

ant to address one of the more insightful questions that I have received about oil stock investing. It generally goes like this: Does the non-renewable nature of petro-carbons pose a significant risk to the long-term survival of oil majors like ExxonMobil, Chevron, Royal Dutch Shell, BP, Total SA, and ConocoPhillips?

This is a smart risk to consider. If you own an asset, and if you reinvest into it over the course of your lifetime, you should be fixated on the risk of whether there will be something leftover for you at the end of your compounding period. In the past, I have lamented the path of Wachovia investors who receive large chunks of dividend income in the 1980s, 1990s, and early 2000s only to find it all collapse from $40 to $2 in the fall of 2008. All your years of compounding and delaying gratification didn’t mean squat because you ended up multiplying the final figure by a near zero number.

When you think about the future of oil, I want you to first think about its history. What was the precursor to John David Rockefeller’s Standard Oil Trust that was launched in 1882? The answer to that question would be a book in its own right, but he built his wealth by turning gasoline into fuel while his competitors treated gasoline as a waste product to pour into the Cuyahoga River and watch it burn. He manufactured paraffin which we use to make candles. He created benzene, the cleaning fluid and varnish ingredient. And perhaps least known of all, he was the manufacturer of white petrolatum which got marketed under the trade name Vaseline and is now part of Unilever’s multinational empire today.

I mention this because it is important to note that there are plenty of marketable products that arose out of the early gas industry and have served as bridges to the next frontier. The same man who got rich off of petroleum was doing just fine with whale oil. The riches from the latter funded the ownership stake and development of the former.

Aside from the generic PR, there is reason to take it seriously that the major oil stocks have gone to great lengths to rebrand themselves as energy companies. Perhaps this rebranding has been a bit premature, but the industry’s signal that it is moving beyond oil is the right one to convey. ExxonMobil has bought in heavily to chemicals, and Chevron has followed suit. Shell has heavily diversified into natural gas. Total SA is making pledges and setting quotas for the amount of energy it will generate from renewable resources. Conoco dug in even deeper on its commitment to oil, and I suspect the harsh experience during the recent price decline will modify their strategy in the future. And BP has been busy with litigation costs from the 2010 oil spill and maintaining its dividend, and will probably get around to energy-source diversification during year two or three of the next big oil spike.

In years like 2008, ExxonMobil brought in $35 billion while only allocating $20 billion towards stock repurchases and dividend payments to shareholders. Of the remaining $15 billion, some of it went to cash and others went towards investment into new drilling projects.

Fifteen to twenty years from now, that $15 billion in retained earnings won’t go towards new drilling projects. Instead, it will go towards nascent technologies. Maybe it will be wind. Maybe it will be nuclear. Maybe it will Charlie Munger’s favorite energy source—the sun.

You don’t need to predict what will be the next major energy source. Instead, just as whale oil profits provided the “start-up funds” for Rockefeller to develop refineries, I expect that oil and natural gas cash flows will be used to fund the entrance into new markets for the major oil stocks of today.

I should also mention that this transition may still be decades in the offing. Exxon itself doesn’t even imagine that peak oil will hit until the 2040s, and then will gradually taper off thereafter. Energy source changes tend to make place over multi-decades; it doesn’t happen overnight like the iPhone overtaking the Blackberry. My own view is that the pace of technological change will be driven by necessity. If Americans continue to enjoy $2 per gallon-type pricing for much of the next decade or two, the pace of progress will be slow because the status quo will be satisfying enough. However, if the price moves above the $4 mark or so, then innovation will be spurred on faster by discontent with a high gas price status quo.

Despite the low prices of the past few years, oil businesses will see a period of high commodity prices again. This means that there will be a large amount of retained earnings. As surely as Unilever purchased the Dollar Shave Club after its start-up success or Coca-Cola bought a 16.7% interest in Monster Energy or Johnson & Johnson acquired Rydelle Laboratories to get its hands on the Aveeno brand, the major oil companies will see the rising energy firms and acquire them. Waiving around 40% premiums can buy your way to a lot of market access.

If this is something you worry about, I suppose you could mitigate the risk by draining your dividends out of the paying corporation and then reinvest them elsewhere. For instance, if you have built up a sizable position of 3,300 Royal Dutch Shell shares, you could take the $12,400+ in oil dividends and make an investment into a timeless business like Brown Forman, Colgate-Palmolive, or Hershey. You’d effectively milk out all of your initial investment amount within fifteen years and build a standalone diversified portfolio of stocks in case some sort of worst-case scenario plays out that is different from what you had initially planned.

But with mega-cap behemoths, the businesses tend to remain intact after technological change so long as there is an identifiable bolt-on acquisition to make in the sector. I suspect that will be the case with emerging energy technologies. And plus, companies usually run into trouble because they get out-branded or there is a competitor with a lower cost in a razor thin industry. Well, if these firms encounter a solar competitor, they could even fund start-up alternates because wealth in the commodity sector gets created by economies of scale and operating efficiencies which the oil majors already possess in abundance.

In short, I think oil stocks will be fine to buy over our lifetime because the pace of change will take place over decades and these companies have the cash to buy a market position in whatever energy source becomes the next backbone of the world’s economy. And, if this isn’t assuring enough, you could always have oil dividends get paid out as cash and use the proceeds to fund other investments. I don’t know what energy production will look like in 2070, but I suspect the legacy shareholders of Exxon, Chevron, Shell, BP, and Total SA will be the ones creating commodity-sector wealth.

Long: RDSB, XOM

A chicago native donates $2 million walgreen stock to wildlife refuge

eventy years ago, a lawyer in Chicago named Russ Gremel invested $1,000 (the economic equivalent of $13,000 in 2017 purchasing power) to buy shares in Illinois’ pharmaceutical giant The Walgreens Co. Over that time, he collected substantial dividend checks and watched that position balloon into over $2 million in value through 11% compounding from the capital gains exclusive of the dividends.

A few thoughts:

Gremel was able to turn $1,000 into $2,000,000 over seventy years without needing to reinvest the dividends. Had he reinvested into Walgreens stock, his compounding rate would have soured to 14% annualized. That would have turned his $1,000 investment into $14 million.

Am I suggesting that he shouldn’t have spent the dividends? Of course not. As Britain’s distinguished man of letters Samuel Johnson wrote in Rambler #58: “Wealth is nothing in itself, it is not useful but when it departs from us; its value is found only in that which it can purchase, which, if we suppose it put to its best use by those that possess it, seems not much to deserve the desire or envy of a wise man.”

There would be no value in just accumulating wealth for its own sake. By collecting the dividends, Gremel was able to use the Walgreens stock to both support his lifestyle and make a donation to a wildlife refuge.

Specifically, he was able to collect $1,000 in dividends in 1966, $2,000 in 1975, $4,000 in 1982, $8,000 in 1989, $16,000 in 1996, $32000 in 2003, $36000 in 2015.

That may seem low when compared to the final dollar amount that Gremel was able to donate but is not that unusual for a fast-growing company that is trying to rapidly open up new locations by reinvesting earnings into more corner stores rather than ship them off to shareholders. From 1970 through 2015, Walgreens had an average dividend payout ratio of 11.1%. Because he held it for so long, he was able to receive over $732,000 in cumulative dividends during his holding period even paying out cash dividends wasn’t really a party of Walgreens’ strategy.

When reading about Gremel’s investment success, the obvious follow-up question is: Does this have any instructive value? How can you make an analogous decision today that will be as useful to you over your lifetime as Walgreens’ stock was to Gremel?

In an interview discussing his rationale for purchasing Walgreens stock shortly after graduating from Northwestern’s law school, Gremel said that figured “people would always need medicine and women would always need makeup.”

This insight could be validated numerically by paying attention to Walgreens’ same-store sales. From 1970 through 2015, Walgreens saw same-store sales increases of 6% per year. It translated into about 7.5% earnings per share. This means that Walgreens shareholders were able to capitalize on a sort of double compounding—not only did their shares represent new locations that were cropping up across North America, but the existing locations were also adding single digit growth to profits. That combination, sustained year after year, is how you get 14% compounding for over half-a-century.

Qualitatively, an investor could have noticed Walgreens’ moat by paying attention to the fact that Walgreens management was insistent on placing all stores in high-profile locations at intersections and other prominent corner locations such that the immediate visibility would form a competitive advantage with spur-of-the-moment shoppers.

If you wanted to recreate Gremel’s success in your own life, you should pay attention to those “same store sales growth” figures because they often provide an insight into the sustainability of the business model. If a business is under-saturated in a given area, and the existing stores are showing mid-single digit same store sales growth or higher, you have probably found a good buy-and-hold investment candidate assuming the price you pay for the stock is rational. These days, there is a food/beverage company that is trouncing its competitors in terms of same-store sales growth that allows you to create Walgreens-type wealth if you keep your eyes open and pay attention.

Next, it is worth observing that these types of individuals have a deep stealth wealth streak. In Gremel’s case, he said: “I never let anybody know I had that kind of money.” This pattern shows up again and again with individuals that accumulate wealth and don’t purchase luxury goods.

In some cases, this probably comes from a a place of humility. Gremel mentioned that his family lost an extraordinary amount of money in the stock market crash of 1929. The story recounts: “We went from comparable wealth to abject poverty in 24 hours. We had no money. There were no food stamps. There was nothing except your friends and neighbors.” The humility angle is that Gremel could have predicted that another crash would wipe out his Walgreens investment, and would make no sense in treating it as a fountain of power if it could all be gone in an instant.

Or, it could be a self-protective device. As Gremel let on—it was friends and neighbors that provided assistance during the Great Depression. If the community learned of Gremel’s success with his Walgreens investment, then he may have feared that his friends would view him as the small-town piggybank.

There is the old Willie Sutton quote that suggests he responded “that’s where the money is” when being interrogated about why he robbed the bank. Well, if someone in Jefferson Park fell on hard times, who would they ask: They guy they suspect has $2 million, or some other acquaintance whose wealth status isn’t ascertainable?

More benignly, Gremel could have kept his mouth shut to avoid being a robbery victim. After all, if you’re an aspiring Jefferson Park criminal, the phrase “that’s where the money is” could apply to Gremel and banks alike. Though it sounds like Gremel’s wealth remained on his brokerage account and didn’t translate into anything portable, there is no reason for him to expect a potential burglar to know that or rationally process that.

I like Gremel’s story because there are instructive nuggets. Find businesses with a common-sense basis for longevity. Look to same-store sales growth for validation. Receive dividends and enjoy the fruits of some of your wealth today because you’ll never again be as young as you are today. But also, err on the side of humility because wealth can tempt people into unvirtuous behavior and the easiest way to avoid temptation is to resist the first inkling of its encroachment.

Philip Morris Investment: Fayez Sarofim's way

Sayez Sarofim is a Houston-based investor that has seen his fortune climb on the coattails of buying-and-holding consumer stock investments. Coke, Nestle, McDonald’s–you name it–he bought it decades ago and holds it on the balance sheet of his Fayez Sarofim & Co. today.

. To date, Sarofim finds himself sitting on 16,711,214 shares of PM stock.

An aside to precede my commentary: Did you guys see that post on the Mr. Money Mustache website about a year ago when Peter Adeney talks about how it was much easier to build additional wealth once he was financially successful compared to when he was starting out and hungry for it?

It sounds a little bit counterintuitive, but the advantage that comes from pre-existing wealth is that you can afford to take the long view. This advantage was best explained by a character in the Terry Pratchett work “Men At Arms” and is called The Boots Theory of Social Inequity:

“The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money.

Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles.

But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while the poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet.”

Put another way, it is a competitive advantage to be able to act upon your intellect and reason. If you calculate that the up-front costs for something are high but are the best option when measured across the entire contemplated use, you want to be able to have the actual cash on hand to pursue the more intelligent option.

The Vimes Theory and the MMM post express a philosophy that I imagine is executed by Fayez Sarofim in the stewardship of the firm’s assets.

If someone only owns 30 shares of Philip Morris International, the lack of price movement over the past four years might make you anxious and impatient. Everyone is talking about a bull market while that stock seems like the proverbial dead money. I’m sure someone on Seeking Alpha is probably putting it on probation or whatever term they use to say “Bad boy!” to their investments nowadays.

So what impulse does this need to get rich quickly trigger? Sell low!

On the other hand, consider how Fayez Sarofim can approach the lack of price movement.

In the past, Sarofim has said that studies of tobacco industry economics have left him breathless because the torrents of cash flows were so tremendous that it could enable Big Tobacco the cash cushion to purchase America’s leading food stocks (which have since been spun off).

He is already extremely rich, so he can afford the long game. He can enjoy the fact that his experience with the stock from a position of wealth is far more enjoyable. Between 2014 and 2016, Philip Morris International paid out $12.04 in dividends. When you own 16,711,214 shares, you do not view this as a “dead money” operation. You got to collect over $200 million in pure cash dividends as your share of profit from the investment. When your cash dividends are so extreme that you could buy hockey teams just by letting the tobacco dividends pile up for a few years, you are not going to fixate on the share price–no one is cursing at their Bloomberg Terminal when their holdings mail them dividend checks with two commas.

But this situation doesn’t only make Sarofim richer in the here and now. He can also look at the fact that Philip Morris International reduced its share count from 2 billion in 2008 to 1.5 billion in 2013 before the global currencies tightened against the dollar. He can see that this situation will temper or reverse, and within the next twenty-four months, Philip Morris will again have the free cash flow to repurchase its own stock. That, in turn, ought to improve earnings growth from 5.5% to 8-9%. That will bring about commensurate capital gains and dividend growth.

Assume that the future expectations in the paragraph above are held by Sarofim and my hypothetical investor. Who do you think is in a better position to actually be around in 2018 and 2019 to reap those higher returns–the frustrated guy with the “dead money” investment that isn’t permitting him to enjoy lifestyle upgrades or the guy that is collecting $70 million per year as the reward for being patient?