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Updated: April 19, 2010 18:39 IST

Inflation is investors’ ‘public enemy No. 1’

D. Murali 
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The Little Book of Big Dividends. Author: Charles B. Garlson. cfa
The Hindu
The Little Book of Big Dividends. Author: Charles B. Garlson. cfa

Less is usually more when it comes to formulas, including those for investing, says Charles B. Carlson in ‘The Little Book of Big Dividends’ (www.wiley.com). The fewer moving parts in an investing methodology, the easier it is to implement and monitor, he reasons, and advocates the BSD formula, short for ‘big, safe, dividend.’

The author begins with two premises, viz. a company cannot pay dividends if it doesn’t have the money to pay dividends, and you need to choose stocks that have attractive total-return potential, not just dividend return. Addressing these two points, his formula looks at two data points, payout ratio and overall ‘quadrix’ score.

Safe payout

Payout ratio, for starters, measures how much of a company’s profit is paid out in dividends, and is ‘perhaps the most powerful tool for getting a quick snapshot of a company’s ability to maintain and grow its dividend.’

How much of payout ratio is ‘safe’? Carlson, for instance, gets nervous when payout ratios are north of 60 per cent. He acknowledges that some industries paying out the bulk of cash flows to shareholders in the form of dividends – such as real estate investment trusts, master limited partnerships, royalty trusts, and so on – will have payout ratios well above 90 per cent.

If you use the 60 per cent threshold (0.6) for payout ratios, you would never own those stocks, and that wouldn’t be the worst thing in the world, he assures. “Indeed, these investments, though typically sporting big dividend yields, can have volatile dividend streams.”

Total-return potential

Quadrix, the second data point, is about ‘a stock valuation system that uses over 100 variables in seven major categories to determine the value of a stock. The overall score for a particular stock is determined by a weighted average of all 100 variables,’ as www.investopedia.com explains. “The seven categories of variables used in quadrix are momentum, quality, value, financial strength, forecasted earnings, performance, and volume.”

What happens when you fail to consider a stock’s total-return potential? You’d then pick stocks based on a single data point or a small set of data points that go with your approach, Carlson reasons. “Value investors gravitate toward companies that are most attractive because of their price/ earnings ratios or discounted cash flow. Growth disciples focus on companies with the best sales and earnings growth. Momentum investors look for the strongest stock-price action. And dividend investors focus on yield.”

The problem with such narrow approaches, as the author cautions, is that if your entire strategy is based on a single metric or on a small set of correlated metrics, your portfolio could take a major hit by the time you realise that you’ve bet on the wrong metric and that a change is needed.

Focusing on stocks with payout ratios of 60 per cent or lower, and narrowing the field to stocks with overall quadrix scores of 75 and higher, you can find stocks with safe and growing dividends that offer above-average total returns, Carlson guides. “Don’t look at yield until you’ve analysed the safety of the dividend, the ability for the dividend to grow, and the overall investment merit of the stock.”

How to fight inflation

Investors should watch out for their ‘public enemy No. 1’ which is inflation! How devastating can it be to your nest egg? If inflation averages 3 per cent per year, in 12 years, the purchasing power of your cash flows is cut by 30 per cent, Carlson notes. He urges, therefore, that to fight inflation you must own investments paying higher income every year, stocks that are likely to boost their dividends on a regular basis.

Dividend growth may be the best friend of income investors, but it is often overlooked because income investors focus on today (current yield) and not tomorrow (dividend growth), rues the author. “That’s a mistake, especially if you buy and hold stocks for long periods of time.”

Using the racing parlance, Carlson says current yield is only the starting line. And, what matters is not just how you start a race, but how you finish, he reminds. “Dividend growth hedges against inflation, accelerates your payback on investment, and tends to point you toward stocks that beat the market – three things that will help you cross the finish line a winner.”

Useful ‘growth’ read.

**

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