Home Depot's Dutch Auction

Mr. Market sometimes makes little sense. Take Home Depot, for example.

They just completed a Dutch Auction where they bought back 289 mil shares, all acquired at the low end of the price range. This was more than the 250 mil shares estimated. So let's see...it is a bad thing that they have removed more shares from circulation and at lower prices than estimated?

Yes, it means more people were willing to part with their shares since they got acquired at the lowest prices. And, it must mean there are more sellers out there who didn't get their shares bought. Does this mean they will end up selling their shares? Could it represent latent selling pressure? I'm not so sure about the logic. Isn't the whole point of the Dutch Auction for investors to offer their shares based on what they thought it was worth? Since 289 mil shares reportedly got offered and accepted at $37, the low end of the range, one can say shareholders were more willing to part with their shares for a lower price. Since yesterday's price was well above the $37 range, we have tankola.

But, doesn't it also mean that the company got a better deal in the process, and it's financial results will only be better, having acquired more shares and for lower prices?

To add to the market pessimism, Raymond James indicated in a Wall St. Journal article that the share buyback will cause stock index funds to reduce their holdings to adjust for the lower share count, which will also lower the share price short term.

Is it just me or does all of this seem like really, really short term thinking?

Home Depot's performance is tied to the housing market in that it sells to homebuilders, and subprime is usually the prime reason given for selling the stock. But, HD's market isn't just new home construction. Also, when people decide not to, or can't buy a new home, I would imagine many compromise by fixing up their existing home. Isn't that somewhat of an offset?

The company is on sound financial footing. S&P maintains a "strong buy" rating on the stock, and they rate their financial stability as an A+.

Some have expressed criticism that HD's selling off their wholesale distribution business was shortsighted, that it was the best future growth driver, but HD retained a 12.5% stake in that operation. The reason for it is to allow them to focus on their retail operations. Sounds like a smart move to me.

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Ignoring the Trees...and the Lemmings

You've probably heard someone proclaim they "can't see the forest for the trees." We are human, so this cliche has a ring of truth to it. Often it is easy to lose sight of the 'big picture.'

It is especially hard when you follow stocks. When markets are volatile stock quotes have a real hypnotic quality. It's like watching a suspense thriller - you can't take your eyes away because you just know something very important is about to happen.

Yet, when you look at the 'forest' - the portfolio level - individual stock price movements become just a lot of noise, because at the portfolio level everything hums along very nicely or ugly just like the overall market.

During the last few weeks, stock prices have been all over the map, and the Vix (volatility index) has been spiking higher and higher. But, it hasn't made very much difference when you look at just the bottom line performance of the portfolio.

What has your portfolio done vs. the overall market? Does it really matter if you lost three percent if the market is down four or five? I suppose it matters if you need the money now, but that kind of money should never be in the market in the first place. That argument doesn't make much sense to me.

If you are properly diversified across economic sectors, and you have selected quality stocks, chances are that you will at least pace the market's performance. In our case, we have always been slightly overweighted in defensive stocks, but not excessively so. This approach is ok with the fact that we may lag a bit during bull markets but outperform (catch up) during corrections. The reward is less volatility.

If, over time we don't meet our performance goals, we will go easy on ourselves. Performance in the stock market is not a verdict on your intelligence, or even your skill as a 'finance wizard'. It only is how you view risk versus value. In the end, it doesn't even matter what the market 'thinks.' At least when you view it from the time horizon Warren Buffet and others do. Now that is what I call seeing the forest for the trees. The smart guys use diversification, quality, and most importantly - time, to their advantage.

Now certainly we invest for a reason, and it is usually to buy some freedom, wealth, security, charity, etc. for those we love - and, o.k. some for us, too. And, we'd like it during our lifetime, thank you.

This is pretty much the entire basis for the concept of asset allocation. And it's why investment people tell us to adjust it as we grow older. It does makes sense, and we should understand this approach, but it is not Gospel. It is advice intended to get us to think in terms of what we invest in, how we manage risk, and why. For example our portfolio is "under-weighted" in fixed income investments, but our philosophy considers defensive stocks to be equivalent to bonds, at least the ones we have. Why? Becasue they grow their dividends. And we can choose to do this because we have the luxury of time. If you ask me when I am 65, or if you ask someone else with a lower tolerance for risk, you may get a different answer.

If we decide to look at any trees, they ought to be the individual payout ones - meaning the dividends of the companies, not their daily stock price movements. It doesn't mean that you don't monitor the company's ability to continue paying and increasing dividends, and then make prudent decisions accordingly. It does mean you effectively decide where your time and energy is most productively focused. And my energy is not focused on what the lemmings say one of my individual stocks is worth today.

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Some Minor Adjustments

Since Nuveen (JNC) is getting fairly close to its buyout price, and since S&P indicates that it is not likely to get a sweeter offer, it was sold, and purchased was VF Corp (VFC), a company that has been on our radar for a long time. It is still somewhat a risk in this market climate, but not as overvalued as it was. It is an excellent dividend grower, and it's a quality company. Another purchase, Entergy (ETR), is filling the void we have had ever since we sold PPL Corp (PPL). Now we finally have a utility stock again. Both PPL and Entergy are utilities that have a non-regulated growth component to them. I think Entergy is the better value at this point, although PPL could continue to appreciate from here as well. We also sold a third of our position in Chevron (CVX).

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Why Dividends Are Important

1. Issuance of dividends usually means the company has significant positive cash flow.

2. The consideration of payout ratio and rate of dividend growth when viewed together are a good measurement of the company’s health.

3. They motivate management to focus on generation and growth of both earnings and cash flow.

4. Income investors enjoy less volatility with little to no sacrifice of total return vs. non-dividend stocks. Dividend stocks tend to have lower betas.

5. For now, there is a tax advantage for dividends over capital gains.

6. Investors can generate growing cash flow at a rate far exceeding inflation by careful selection of stocks with increasing dividends.

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Volatility Rules

Well, besides Home Depot (HD) announcing a major share buyback and asset sale, Nuveen (JNC) getting a buyout offer, and the Wilshire 5000 dropping 200 points in one day, it's really boring out there.

Throughout all of this fuss, the portfolio keeps plugging along, and even with all the turmoil, we are still beating the Wilshire by around 2%, not counting dividends. I suppose we could do worse...

More Changes

Made a number of portfolio adjustments. Added were Home Depot and Intel. Sold were PPL (could not pass by a quick 40%+ gain), CHT, BLK, and a little of KTC.

On a net basis I have been raising some cash hoping for some decent entries later.

TCHC is bouncing back some today after losing almost half its value. Management announced a share buyback today.

That's all for now...

Taxation of Dividends

A friend recently told me that the capital gains rate is actually lower than the the tax rate for ordinary income. This is true. I goofed on the explanation in my first blog post, but the tax benefit of dividends remains. Here is the correction:

Most people in middle tax brackets or higher want their dividends taxed at the capital gains rate, which is 15%, not the ordinary income rate, which varies but is roughly in the 24-28% area for middle to upper brackets.

However, almost all dividends paid to holders of individual stocks are "qualified dividends."

What is a qualified dividend? It is simply a dividend that "qualifies" for taxation at the lower capital gains rate. There are three criteria for this treatment:

1. The dividend must have been paid by an American company or a qualifying foreign company.
2. The dividends are not listed with the IRS as dividends that do not qualify.
3. The required dividend holding period has been met.

Although most dividends paid on individual stocks are "qualified," be careful about ETFs and mutual funds, because these are more likely to issue "ordinary dividends." Recently more funds are being marketed as "tax efficient" and these are more likely to issue qualified dividends.

The tax law providing this favorable treatment was going to be sunsetted (is that a word?) at the end of 2008, but Congress recently extended it to 2010, so (for now) the tax break is safe.

Congress ought to make this treatment permanent and provide the nation's taxpayers a real incentive to save. The savings rate in the USA is abysmal, and punitive tax law is in part to blame.

More Dividend Hikes

We have a number of dividend increases announced this week - Microchip (MCHP) which also surged around 7% Friday, Johnson & Johnson (JNJ), and a slight increase from Meridian Bio (VIVO).

Current buy candidates with great QDV are RVSB, FNLC, CGI, PCU, ROH, IEX, and RY. I am waiting for a pullback for better prices. I wonder if we'll get one?

Quite a few changes

Many portfolio changes to report - Most changes were made to improve the overall QDV, yield, or both.

One shift was made to sell Metlife (MET) and replace it with Chubb (CB) insurance. Why the switch? Both insurance companies are excellent stocks, both are highly rated by S&P, and both have good dividend growth. But Chubb's yield was higher, and it pays the dividend quarterly, while Metlife only pays annually. It was a tough decision to sell MET, since it a great stock, but I decided that Chubb was a smarter choice, and I wanted to stay with Allstate and Chubb. I didn't want a third major insurer now.

Last week I had made plans to buy Yum! Brands (YUM), 21st Century Holdings (TCHC), and Commerce Group (CGI). Unfortunately I waited one day too long to buy CGI, since yesterday it went up over 8% in one day. This surge was due to its shares just being added to the S&P 400 Midcap index. It was down a little today, but not enough to get me to buy just yet. I did pick up the other two though. All three have excellent QDV.

Proctor & Gamble (PG) Dividend increase

PG announced that they upped their dividend by around 13% today. It's been awhile since the last announcement was heard for our overall potfolio holdings.

Citigroup beat earnings expectations today as well.

Quarterly Dividend Velocity (QDV)

We already know what dividend growth is. If a stock's dividend goes from $1.00 to $1.10, the dividend growth rate is 10%. That doesn't tell the whole story.

Let's compare two fictional stocks, ABC Corp and CDE Corp. Both companies started the year with a $0.25 quarterly dividend, or a $1.00 per-year indicated rate, and both increased their dividend to $1.40 indicated rate by the end of the year - a 40% increase, right?

Let's look at the total payout of the two stocks:

ABC - Qtr 1: 0.25, Qtr 2: 0.31, Qtr 3: 0.33, Qtr 4: 0.35
CDE - Qtr 1: 0.25, Qtr 2: 0.25, Qtr 3: 0.25, Qtr 4: 0.35

Both stocks ended the year with a indicated annual dividend of $1.40, but ABC actually paid more (ABC paid $1.24 while CDE paid only $1.10). Why? Because ABC's quarterly dividend velocity (QDV) was higher.

The first lesson is that the indicated rate doesn't tell us everything we need to know about a company's rate of dividend growth.

So, how do we go about measuring and thus capturing the difference? In other words, how do we go about calculating QDV?

If we just ignored the indicated rate and looked at what was actually paid out each year, would that do it? Let's see. If both companies actually paid out $1.00 total over the previous four quarters, then ABC's actual increase in payout for the following 12 months was 24% ($1.24 vs. $1.00), while CDE's was 10% ($1.10 vs. $1.00). That doesn't really tell the story either, but it is way better information than what the indicated dividend 'increase' of 40% tells us.

Yahoo! Finance seems to 'get' there is a difference. They cite in their "Key Statistics" section both the "Trailing Annual Dividend Rate" (for our ABC example, $1.24) and the "Forward Annual Dividend Rate" ($1.40 for both of our examples).

So to summarize, it is pretty obvious the trailing dividend information is important, not just the forward rate.

Still, if we are trying to develop a better measure of growth - one that would tell us ABC corp is a better investment (from a dividend growth point of view) than CDE, we need to capture the trailing dividend values for each over time (something Yahoo does give us but we have to work for it) and then compare the historical growth rate in dividends.

If you have studied finance, you know it is better to get $50 today than $50 a year from now. Therefore, we also need to take into account the 'quarterly timing of payments' in the QDV calculation (their net present value).

The easiest way I have found to take all of this into account is to calculate a 'rolling historical annual payout' then look at the 'average annual rate of change'.

Here's the QDV calculation for Pepsi:

Date	Dividends	Avg Qtrly Div	Avg Qtrly Increase	Annual Increase (QDV)
6/5/2002	0.15
9/4/2002	0.15
12/4/2002	0.15
3/12/2003	0.15	0.15
6/11/2003	0.16	0.1525	1.67%
9/10/2003	0.16	0.155	1.64%
12/10/2003	0.16	0.1575	1.61%
3/10/2004	0.16	0.16	1.59%	6.51%
6/9/2004	0.23	0.1775	10.94%	15.78%
9/8/2004	0.23	0.195	9.86%	24.00%
12/8/2004	0.23	0.2125	8.97%	31.36%
3/9/2005	0.23	0.23	8.24%	38.01%
6/8/2005	0.26	0.2375	3.26%	30.33%
9/7/2005	0.26	0.245	3.16%	23.63%
12/7/2005	0.26	0.2525	3.06%	17.72%
3/8/2006	0.26	0.26	2.97%	12.45%
6/7/2006	0.3	0.27	3.85%	13.04%
9/6/2006	0.3	0.28	3.70%	13.58%
12/6/2006	0.3	0.29	3.57%	14.09%
3/7/2007	0.3	0.3	3.45%	14.57%

As you can see, the dividend went up around 1.6% quarterly, on average, to start. The last column is the annualized rate of dividend growth. Happily, Pepsi shareholders are seeing double digit annualized increases in the rate of average quarterly dividends. The annual has backed off from the quarter ending Mar 2007 compared with Sept 2005. Quarterly Dividend (growth) Velocity, or QDV, has declined to 14.57% from the 23.63% level in Sep 2005. In summary, the rate of change is declining over that period, however dividends are still being increased at a double digit average rate.

The take-away is that you can use the 14% figure to estimate future growth, but you need to consider the 'velocity effect'. If you look at the most recent quarters, QDV has started going back up (from 12.45% Mar 2006 to 14.57% today), so in this example, I might estimate 15% growth, or 3.5% average quarterly growth, over the next four quarters for PEP. This is the best way I have found for measuring dividend growth, and best for use in forecasting.

GE Gives a Market Signal

I think GE is a pretty good barometer of the overall market environment. After all, it is this huge mega-conglomerate that is in probably every economic sector imaginable. Anyway, they were quite optimistic that their numbers would be on track for the year, and that probably lent a lot of support to markets.

Made a lot more changes - I 'cried uncle' on the short hedge. That China sell-off fooled me but good. Also, took the opportunity today to get some picks I've been eyeing for some time, like Health Care Services Group (HCSG), Meridian Bioscience (VIVO) and Waste Management (WMI), and also added to the 'spun-off' shares of Kraft gotten from the Altria spin-off.

Hope you haven't been getting too whipsawed!

Spin-Off Monday Coming Up

Just so you are not surprised, the portfolio numbers will not look right on Monday (and maybe Tuesday as well) due to two spin-offs, Altria (MO) spinning off Kraft (KFT), and Automatic Data Processing (ADP) spinning off Broadridge Financial (BR).

This is an interesting piece on how dividend growers outpace the rest of the market.

I made quite a few changes on Friday - bought were Allstate (ALL), Nuveen (JNC), Jabil Circuit (JBL), and Pacer Tech (PACR). I eased up a little on SDS (Double Short S&P), but remain defensive and expecting more pain.

Hope this finds you without pain. Till next time...

Altria's Kraft Spin-off finalized

It's finally set: Altria will spin off Kraft on Mar 30th

Meanwhile, I have been raising more cash (by selling a bit of TTH, MCHP, and JNJ) and sticking to a hedged position. I know this doesn't look very smart with the last two day's rallying going on, but the technicals rarely lie, and they are saying that drop awhile back 'ain't no blip.'

I do think oils are due for better action, so I picked up Total SA, which, contrary to Yahoo Finance, actually pays around a 4% yield, before foreign taxes.

Eaton Vance Tax Advantaged Global Dividend Opportunities Fund (ETO) got away from me before I could get it, and I am not chasing it now. If it pulls back I would reconsider another try. Also, I found a couple more ETFs that take a 'dividend growth' approach. The expense ratios are much lower than ETO, although the expected dividend isn't as rich (because these aren't leveraged). They are Wisdom Tree Mid Cap Dividend and Small Cap Dividend. I was troubled by the prospectus initially because it was not clear on the frequency of dividend distributions, so I asked. They replied that domestic funds are quarterly, foreign is annual. The funds have a short history, but they claim to match their dividend growth index in yield and performance. The index yields are in the 3.75-4.0% range.

See I Told You So

As mentioned last Friday, the correction was not likely over. Today was rather devastating, but looking at the big picture, not so bad considering SDS was there to bear hedge the portfolio. The result was that on a day when the Wilshire 5000 lost 2%, our portfolio lost "only" 0.95%. Painful, to be sure, but much less so than for those who did not prepare for a storm that you could see coming.

The financial press is getting almost hysterical about its claims that the subprime meltdown does not affect the overall economy much. Fair enough, but tell that to the financial sector, which comprises a very large percentage of the S&P 500 (and of this portfolio as well) and is getting unmercilessly hammered by the fallout.

Anyway, I'll reiterate that when things start settling down, it'll be time for snatching up shares at bargain prices, and the beauty of hedging a portfolio is that it provides you cash to help build it back up without excessive pain.

Until then, we will continue to grin and 'bear' it...

Continuation of Volatility?

Sorry, but I am not buying that the rally we got this week marks a resumption of the bull - at least not yet. I won't go so far as to say the bull is dead, but this ain't no "pause" either.

It doesn't take a chart expert to see that the ferocity of last week's decline - specifically the 'velocity' of the decline and associated volume - looks to me like the sudden drop was not based on a 'fluke' or happenstance.

Besides the China explanation - why did it happen, and what happens next?

First theory - Alan Greenspan implied a recession is just around the corner. If you go by the 'six month rule' which is that the stock market discounts a recession six months in adavance, then a recession should hit around the first of September.

Second theory - A normal correction is overdue, since we've been getting a more or less non-stop run since around Aug 2006. Markets never go up in a straight line. The bull is intact, but a 10% correction now is normal and maybe even expected at this point. Load up after the next wave down.

Third Theory - The bull is officially dead. Although it is an election year, the bull market has been going since March of 2003. We just hit the four year mark. It's not unusual to get a bear market after this long. The 1990s were a fluke.

Fourth Theory - The drop is over and it will be remembered as just a blip in the continuing bull market.

Which theory will bear out is anyone's guess. If I knew I would already be retired.

In dividend news...Colgate Palmolive just increased their dividend 13% - I like it!

What to do?

I bet that Wednesday's rally was simply a reflexive bounce, and that we could have more pain to come, and judging by Friday's action it looks like that is the case.

That is not to say it is my philosophy to bail out of the market whenever it catches a cold, but some smart adjustments are in order. First, you may have noticed my caution a couple weeks ago. Wednesday I used the lukewarm rally to take a short position in SDS which is an ETF that is 2X short the S&P 500.

It certainly won't eliminate portfolio losses in the event of a major correction, but it will certainly make sleeping at night easier while I am waiting it out. Ideally this will provide a nice pile of cash to buy cheaper stocks when the dust clears.

See my last few posts for the companies on the radar as buy candidates. Also, I like Eaton Vance Tax Advantaged Global Dividend Opportunities Fund (ETO). Although ETFs are not better than proper stock selection, this fund has a low turnover rate, and its selection of holdings are complimentary rather than redundant to my individual stock holdings. It currently yields around 6.2% and has growing dividends.

Oh, also Bank of Montreal just increased their dividend by over 22%.

Market Gets Hammered

The markets were roiled by China and a number of other reasons domestically, but Black Rock upped their dividend around 60%. Kinda puts things in perspective, doesn't it?

PPL Corp. (PPL) Raises Dividend

Wouldn't it be nice if we got these announcements every day? In any case, it happens more often when you select companies with a track record of upping dividends. Today it's PPL Corp

Lazy Investing?

You may have heard the term "Lazy Investing" before. If not, it means selecting a group of different ETFs or mutual funds in such a way that the combination gives you diversification against the entire universe of asset classes. Some good ETFs that apply to our dividend growth approach are iShares Dow Jones Select Dividend Index (DVY) and SPDR S&P Dividend (SDY)

Although you may want to consider having one of these along with individual stocks, I would argue that it is usually worth the 'extra' effort to focus more on individual stocks, particularly those that are managed with shareholder interests in mind. It's really not that much work anyway to find quality companies that have good earnings growth and that regularly increase their dividends. While you are doing that, you also need to pay attention to selecting companies across all sectors, including foreign ADRs.

What about bonds? Don't you need them to have proper diversification? The textbook answer is "yes," but my view is that unless you are very near to your retirement date (within a few years), consider that proper selection of these kinds of stocks will pay a yield far better than bonds after a 3-6 year holding period. Better yet is the yield increases with each succeeding year, at least at the portfolio level. If you select right, it will happen on each holding as well.

It takes a mental adjustment, but start thinking of stocks not as a price appreciation vehicle per se, but as a cash flow machine that rewards you with more and more cash with each year you hold it.

That is not to say you should 'just set it and forget it'. Look at the market for dividend candidates better than what you currently have, and don't be afraid to upgrade.

For example, today I sold a number of stocks. One was Pfizer, which S&P now only rates a hold (3 stars). They paid a good dividend and have been growing dividends for a number of years, but there is concern over how long earnings growth can sustain the dividend growth. The others were Rohm & Haas (ROH)(3 stars), Cato (CTR)(not covered by S&P), Southern Copper (PCU)(not covered) which had a nice gain of 35%+, and Eaton (ETN)(3 stars).

Considering the nice run the market has had, it a good idea to trim the lower ranked stocks and prepare to buy some better quality alternatives when we get a real pullback (it could be soon).

I'm looking at Yum! Brands, rated 5 stars with a 2% yield, Tsakos Energy (TNP), rated 4 stars with a 5.4% yield, Taiwan Semi (TSM), rated 4 stars and a 3.3% yield, and Eni Spa (E), rated 4 stars and a 4.7% yield. All of these have good dividend growth as well.