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How to invest
in high quality,dividend
paying shares A 10 Step plan for investing in shares for income and growth
UK Value Investor
2014 EditionVisit: www.ukvalueinvestor.comPublished by John Kingham
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How to invest in high quality,
dividend paying shares
Dear Fellow Investor,
If you’re like me, then you are mostly interested in high yield, relatively low risk
shares. I prefer to put my money into companies like Tesco, Vodafone and SSE,
where I can get a good dividend from a proven, high quality business. Whether
those dividends are drawn down for income, or reinvested for growth – either way,
it’s a sound and sensible strategy that is popular with many famous investors.
I wrote this guide to help investors like you make the most of their investments. I’ve
heard it said that private investors underperform the market by up to 6% a year.
That’s a terrible waste, both of the investor’s time and their money – especially when
some of the most successful investors have beaten the market with a relatively
simple, common sense and low risk approach.
Each step in this guide is designed to help you build and maintain a diverse portfolio
of world-class businesses, with market-beating characteristics. Each step is simple,
and builds on investment ideas similar to those used by Warren Buffett, Neil
Woodford, and more recently, Terry Smith.
Together, these 10 steps form a complete end-to-end system for investing in the
shares of high quality businesses – buying their shares when valuations are low and
dividend yields are high, and selling when valuations are high and dividend yields
are low.
Feel free to use as many or as few of the ideas in this guide as you wish.
Yours sincerely,
John KinghamEditor, UK Value Investor
"The defens ive investor mu st con f ine h imsel f to the shares of imp ortant
companies wi th a long record of p ro f i tab le operat ions and in st rong
f inanc ia l c ond i t ion . " – Ben Graham, the father of value inv est ing
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1. Take a long-term view
" In the short run the market is a vot ing machine, but in the long run i t is a
weigh ing machine." – Ben Graham, the father of value inv est ing
It’s important to take a long-term view of any investment that you make. Generally
long-term is taken to mean 5 years at least, and I think that ’s a reasonable minimum.
Why so long-term? Because of the way the stock market generates returns:
1. Dividend income - Shareholders get paid dividends. If you buy the right sort of
companies then those dividends can grow faster than inflation. The average return
from dividends is around 3% a year but you will only see a significant return from
dividends if you hold an investment for a number of years.
2. Dividend growth – The intrinsic value of a company will typically increase with its
ability to pay a higher dividend (as long as it ’s sustainable and supported by growing
revenues and profits). The average gain from dividend growth is around 5% a year
over the long-term. Again, you will typically need to hold an investment for years
before seeing a significant return from dividend growth (and remember, dividends
can be cut or suspended too).
3. Valuation changes (such as dividend yield) – The current share price of each
company is set by the supply and demand pressures of buyers and sellers. In the
long-run these investors generally do a reasonable job of valuing companies,
assigning them a fair value based on each company’s revenues, profits and
dividends. In the short-term though investors can be a fickle bunch, either nervous or
excitable depending on whether or not today’s news about a company is good orbad. This makes share prices highly volatile and unpredictable over the short-term.
If you focus on the short-term almost all of your gains (and losses) will come from
valuation changes. But these are by their nature unpredictable, and so short-term
investing is scarcely different from taking a trip to the casino. Focusing on the long-
term instead means dividend income and growth become much more important than
the day-to-day ups and downs of the market, and finding a company that can grow
its dividend is much easier than finding a share which will go up next week.
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2. Stay diversified
“ Our advice to th e defensiv e investor is that he let i t alone and emp hasize
diversi f icat ion mo re than indiv idual select ion ” – Ben Graham, the father
of value invest ing
No matter how much research you do into a company, you cannot know for certain
how it will perform, or what the share price will be in the future. The answer to this
uncertainty is to diversify and put your eggs into many different baskets.
Ben Graham suggested splitting equity investments across twenty to thirty
companies.
There are other factors which can be diversified too, beyond just the number of
investments; the main ones are industry and geography.
Companies within the same industry are often affected by the same kinds of issues,
so diversifying across many industries can reduce a portfolio’s risk. If a portfolio is
diversified across many industries, anything that affects a single industry will only
have a relatively small effect on the portfolio.
The same thinking can be applied to geography, where a local problem (a recession,
earthquake, epidemic, etc.) will have a smaller impact if the portfolio as a whole
generates its earnings from across the globe.
Risk reduction through diversification is important because investing is a long-term
game. If your portfolio is relatively low risk because it is well diversified, you stand a
better chance of sticking with equities for the long-haul.
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3. Look for high yield shares
“ A co w for h er mi lk . A hen for her eggs, And a stock, by heck, for h er
dividends.” - John B urr Wil l iams, autho r of The Theory o f Investm ent
Value
The 2011 Barclay’s Equity Gilt Study showed that £100 invested in equities in 1899
would have grown to £12,655 if dividends had been withdrawn. If dividends had
been reinvested then the investment would have grown to £1,697,204. Dividends
increased the gains tenfold, and in real terms the gains were an amazing three
hundred times better.
Dividend income is clearly a very important part of total stock market returns.
The obvious way to measure income is by the dividend yield. However, on its own
the yield is often misleading. It is just as important that the dividend be sustainable
in the longer-term, and that preferably it has a good chance of being increased.
That’s why yield shouldn’t be looked at in isolation, but should instead be considered
alongside a company’s ability to pay that dividend, consistently, for the long-term - Inother words, its quality.
There is another problem with a simple dividend yield. By looking at today’s yield
you could miss situations where a company has cut its dividend for a short period,
perhaps because of a one-time, survivable crisis.
A better approach may be to look at the share price relative to the company’s
dividend payments over the last decade. The more dividends that have been paid
relative to the current price, the better.
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4. Look for growing companies
“ Purchase, at a rational p rice, a part interest in an easi ly-understandab le
bu siness whos e earnings are virtually certa in to b e material ly high er f ive,
ten and twenty years from now” – Warren B uffet t , the world’s most
successfu l v a lue investor
Growth is the friend of the long-term investor. Without it the value of any business
and the income from it will be eroded by inflation.
The most important thing is a company’s ability to pay a growing stream of dividends
in the future, since ultimately the value of all investments is based on the cash that
will be paid out.
But we cannot know the future, so we have to look to the past for guidance.
In simple terms, a company that has produced consistent growth in the past is more
likely to continue to produce consistent growth in the future.
Growth over a handful of years is not reliable enough to be used as a guide to future
growth. The answer is to do what Ben Graham suggested, and look at growth rates
over a ten year period. This will pick out those companies that are growing over the
long-term.
Dividend growth is what we’re really after, so it makes sense to look for dividend
growth over the past 10 years. Dividends are supported by earnings, and earnings
come from sales, so it’s also a good idea to look at the growth of sales and earnings
over the last 10 years too.
All else being equal, a higher growth rate is better.
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5. Look for high quality companies
“ Time is the f r iend of the w onderfu l comp any, the enemy o f the mediocre ”
– Warren Buffet t , the world’s most successful value investor
The problem with looking back into the past in order to have a clearer view of the
future is that the past can be misleading.
Sometimes a company will have strong 10 year growth, but it all came in one or two
years. This is not reliable, defensive growth. What we want instead is consistent,
repeated, high quality growth.
Companies that have been consistently successful in the past are more likely to be
consistently successful in the future. This in turn means that the past growth rate is
likely to be a better guide to the future growth of the company. Companies that
consistently produce growing profits and dividends are usually considered high
quality companies.
To measure a company’s quality, look at how often it has been profitable in the last
decade, and how often it has paid a dividend; the more often the better. Then counthow many times it has increased sales, earnings and dividends in the last 10 years;
again, the more often the better.
By focusing on high quality, high yield companies that can consistently generate
market-beating growth, you will be well on the way to creating an outstanding
portfolio.
.
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6. Look for low prices relative to earnings
“Buy stocks like you buy everything else – when t hey are on sale” –
Christop her Brow ne, author o f The Lit t le Boo k of Value Invest ing
One of the main tools you can use to value shares is the PE ratio. This ratio is a
starting point when you begin to think about whether a particular share is ‘cheap’ or
‘expensive’.
Valuations cannot go to infinity, and they don’t go to zero unless the company goes
bust. So in the long-run PE ratios tend to hover around a medium value, typically
somewhere in the mid-teens, although of course they can go much higher or lower in
the short-term (creating buy-low and sell-high opportunities for sharp investors).
The standard PE ratio has its problems though. Earnings from one year to the next
can be quite volatile. With large and stable companies, the changes in earnings
from year to year are unlikely to reflect the changes to the intrinsic value of the
company. “Intrinsic value” simply means the price that an intelligent, informed and
rational investor would pay for the company.
A better approach is to compare the share price against an average of the
company’s earnings over a number of years, rather than just looking at a single year
in isolation. This is exactly what Ben Graham suggested.
The Graham and Dodd PE (more commonly called PE10) uses the ten year earnings
average, which gives a more stable number to compare share prices against.
This in turn provides a better guide to whether the shares are expensive or not,
relative to the value of the company.
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7. Avoid excessive financial obligations
“ I do not l ike debt and do not l ike to invest in com panies that have too
muc h d ebt , part icu lar ly long - term debt” – Warren Buffet t , the world’smos t successfu l va lue investor
No matter how prosperous a business may be, if it has too much debt it can be like a
time-bomb waiting to go off when something goes wrong.
Debt is one of the main corporate killers. Fortunately, many of the best companies
don’t need to use lots of debt to generate outstanding returns for shareholders.
It’s also true that some companies can handle more debt than others. Generally, the
more cyclical or volatile a company’s earnings are, the less debt it should have.
Stable companies, like supermarkets or utilities, can handle more debt. Although
this doesn’t mean that they should handle more.
There are various ways to measure debt in order to find out if a company has too
much.
You can look at interest payments, to see how well the interest on debt is covered by
the company’s profits. If interest is more than 10% of profits then it may be a good
idea to see if the company needs, or can handle, that much debt.
You can also look at the total amount of borrowings and compare it to profits. Some
investors look for borrowings to be no more than 5 times the average profit of the
past few years.
The goal is always to make sure that a company’s debts won’t become too much of
a burden if the company falls on hard times.
Another area of concern is pension deficits, and this risk can be reduced by
concentrating on companies where total pension obligations are less than the total
market value of the company (its market capitalisation).
By focusing on consistently profitable companies which are conservatively financed,
you will have done more than most investors to avoid debt related problems.
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8. Compare stocks against the market average
“A wildly fluctuating market means that irrationally low prices will
period ical ly be attached to sol id bus inesses. To beat the market yo u
have to acquire more value than you c an get from the market.” – Warren
Buffet t , the world’s most successful value investor
Most investors who pick their own stocks want to beat the market, either in terms of
income, growth or both.
To beat the market over the long-term a portfolio must generate more returns from
one or more of dividend income, company growth, and valuation changes.
It is therefore a good idea to check potential investments against the market. You
would generally want to see if a company has a higher dividend yield, lower
valuation ratio, and higher, more consistent long-term growth rates than the market.
It’s a simple case of comparing each of the four factors mentioned previously (high
growth, high quality, high yield, and low valuation) to the equivalent values for the
market (e.g. the FTSE 100), in order to see how a given investment measures up.
A share which has is better than the FTSE 100 in at least three of those four factors
will probably be worth taking a closer look at.
If it has better long-term growth and better quality than the market as a whole, then it
is probably a share from an above average company. But unless it has a better yield
or a lower valuation, it may be too expensive.
Alternatively, if it has a lower valuation and a better yield, then the shares are
probably cheap. But if the long-term growth rate is lower and less consistent than
the market’s, then the shares may be a cheap because the underlying company is
low quality, and therefore unattractive in the long-term.
To be a truly outstanding investment, a share should be both cheap and from a high
quality company.
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9. Follow a systematic investment plan
“When surgeons make sure to wash their hands or to talk to everyone on
the team, they improve their outcomes with no increase in skill. That’swhat we are doing when we use a checklist.” – Mohnis h Pabrai, foun der
of the Pabrai Investm ent Fund
So far we’ve looked at companies in terms of the ‘numbers’ they generate – their
earnings, dividends, debt levels and so on. But most people wouldn’t invest just
based on the numbers, and that’s sensible. Investors typically want to know
something about a company’s history, what it does to earn profits, and how the
company could develop in the future.
When conducting this research, it’s important to use a checklist so that no steps are
missed out or forgotten. A checklist is also useful so that new ideas and questions
can be jotted down, remembered, and included in analyses.
If checklists are good enough for surgeons and airline pilots, they should be good
enough for investors.
There are many things that can be included on a checklist, but the main areas to
cover are the company’s past, its present situation, and its future potential.
Here are some questions you may want to consider in your next investment analysis:
Has it been in the same industry, doing the same thing, for a long time?
Is the company in the market-leading group?
Does it have a highly successful and profitable past? Has it been free of major crises in the last decade (if so, were they
successfully resolved)?
Does it have any obvious current threats to its economic engine?
Does it have any durable competitive advantages?
Is there any chance that its economic engine could become obsolete in
the next decade, or that its industry could be massively disrupted?
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10. Continually improve your portfolio
“Our results more specifically attribute much of the advantage of value
strategies to the acts of reconst i tut ing and rebalancing and th eir side
ef fects on div idends .” – Denis Chaves & Rob ert Arnott , from Research
Assoc iates LLC
Once you’ve filled up a portfolio with twenty to thirty high yield shares from high
quality companies, you might think your job is done - but it isn’t. To get the best
returns you may want to actively manage the portfolio in the same way that a
gardener actively manages a garden.
When grass grows up too high, it gets cut back. In the same way, when a
company’s share price grows more quickly than the company, it may no longer have
a low valuation and a high yield. When this occurs it can be beneficial to sell, and re-
invest the money into another company where the share price is low, and the
dividend yield high.
This process of improving a portfolio can easily be achieved by selling the least
attractively valued investment in one month, and adding a better investment next
month. With 30 holdings this will replace six of them each year, giving a 20%
turnover ratio and an average holding period of 5 years. Over time this process of
continual improvement can add significantly to returns.
Bringing it all together
To create and maintain a high quality, dividend paying portfolio you ’ll need to have a
plan for each step, from finding and analysing companies, to sensibly diversifying
your portfolio and deciding which shares to hold onto and which ones to sell.
Hopefully this short introduction to defensive and income-focused value investing
has given you some good ideas. If you want to know more you ’ll find detailed
worksheets and spreadsheets on the web site, and if you ’re really serious about
getting a good return on your investments then take a look at my newsletter, which I
publish each month for a select group of investors.
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UK Value Investor
The investment newsletter for defensive and
income-focused value investors
UK Value Investor can help you with each step of
the investment process:
Find high yield, high quality stocks – Each
issue contains a stock screen which ranks over
200 FTSE All-Share stocks based on a combination of growth, quality, yield, and
value for money. The online version of the screen allows you to sort, select anddownload data into your own spreadsheets for further analysis.
Follow along with a £50,000 model portfolio – Stock screens are clinical and
mathematical, but investing in the real world is not. It can be messy, exciting and
occasionally frightening. That’s why each issue shows you how I use the UKVI stock
screen and investment strategy to build and maintain this high quality, high yield
portfolio. Each month the portfolio is reviewed in detail, including a full review of
every buy or sell decision (just one holding is bought or sold each month). I have the
vast majority of my own personal wealth invested in exactly the same stocks as the
model portfolio, so I take the management of this portfolio very seriously.
Get help and support by email or phone – As a member you’ll have priority
support from me by email or phone. As one member put it, “The fact that you always
respond in such a timely and considered manner is a very attractive feature of your
service”.
Visit UKValueInvestor.com for more information about becoming a member, or
subscribe to the blog for free.
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IMPORTANT DISCLAIMER: The author is not registered as an investment advisor oras an independent financial advisor and does not provide individual investmentadvice. Neither the author nor this document are regulated by the Financial Conduct Authority. No information provided in this document should ever be construed asinvestment advice. It is prepared for education and information only. The specific
needs, investment objectives and financial situation of any particular reader have notbeen taken into consideration and the investments mentioned may not be suitablefor any individual. The information contained in this document is not intended to bean offer to buy or sell or a solicitation of an offer to buy or sell any securities.Readers must not base any investment decision solely on the basis of thisdocument; instead they should seek independent financial advice. The information inthis document and any expression of opinion by the author have been obtained fromor are based on sources believed to be reliable but the accuracy or completeness ofany such sources or the author’s interpretation of them cannot be guaranteedalthough the author believes the document to be clear, fair and not misleading. Theauthor receives no compensation from and is not affiliated with any company
mentioned in this document other than possibly receiving advertising revenue via athird party. The views reflected in this document may be wrong and may changewithout notice. To the maximum extent possible at law, the author does not acceptany liability whatsoever arising from the use of the material or information containedherein.
INVESTMENT RISK: The value of shares can fall as well as rise. Dividend paymentscan fall as well as rise. Any information relating to past performance of an investmentor investment service is not necessarily a guide to future performance. There is anadditional risk of making a loss when you buy shares in certain smaller companies.There is a big difference between the buying price and the selling price of someshares and if you have to sell quickly you may get back much less than you paid.Share prices may go down as well as up and you may not get back the originalamount invested. It may be difficult to sell or realize an investment. You should notbuy shares with money you cannot afford to lose.
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