Legendary Sequoia fund reopened May 1st, 2008 after more than 25 years.  Since closing on December 21, 1982 Sequoia managers Ruane, Cunniff, and Goldfarb claim assets under management have declined from $5 billion to $3.8 billion, prompting the fund to reopen to new investors.  Buffett followers will recognize the Sequoia Fund as being the fund Buffett recommended to to the investors in his partnership after he liquidated it in 1969 due to a lack of bargains in the go-go 60’s stock market.  Short of Berkshire Hathaway stock, Sequoia Fund shares are the closest you can get to Buffett’s unique mix of value and growth investing style.

The Sequoia Fund has consistently garnered above-average returns with below-average risk at a reasonable price.  While a 1% expense ratio may seem a bit steep to passive investors, it’s rare this caliber of active management is on sale at any price.  This reopening represent an excellent opportunity for active investors to get into a winning mutual fund at a fair price.

Former and current employees of Wal-Mart (WMT) last month filed a lawsuit (currently seeking class-action status) seeking $60 million in damages from the world’s largest retailer alleging excessive fees in the company’s retirement plan. As the country’s largest employer with nearly 1.4 million employees and $9.5 billion in 401k assets, the suit alleges Wal-Mart could easily afford to take advantage of economies of scale in its plan and offer lower-cost institutional funds as plan options rather than more expensive retail versions of those funds. This, claims the suit, amounts to a breach of the company’s fiduciary duty to provide adequate investment options and run its 401k plan in the best interests of its investors.

Wal-Mart’s 401K Plan Is Lacking

I certainly agree that Wal-Mart’s 401K plan is sub-par but disagree with the validity of the lawsuit’s claims that it constitutes a breach of fiduciary duty. One example cited by the suit is the 1.59% expense ratio of the AIM International Growth Fund (AIIEX) offered by the plan. While I would certainly never pay that much for a mutual fund, that doesn’t make it an irresponsible fund choice. While 1.59% is an above average expense ratio for an international mutual fund according to Morningstar, it performed in line with the average international growth fund. Yes, the Vanguard International Growth Fund (VWIGX) is cheaper and out-performed the AIM option offered in the plan, but there was no way to know that before-hand. A 3% expense ratio would be irresponsible but 1.59%? That’s not especially egregious.

The suit also alleges there aren’t enough low-cost index fund options in the plan. No arguments here, I love index funds and choose them whenever possible, but the fact is, the vast majority of investors don’t buy index funds if given the choice. Novice investors tend not to like them because they don’t offer the opportunity to beat the market. Sure, the vast majority of actively-managed mutual funds will fail to beat the market and sure the plan participants would likely be better off if only index funds were offered, but is it really Wal-Mart’s responsibility to save investors in spite of themselves? It’s difficult to argue Wal-Mart isn’t giving its participants what they want: actively-managed mutual funds with a chance to beat the market. If investors as a whole eschew index funds in favor of more active investment strategies, I don’t see how you can claim giving investors what they want is immoral or a breach of fiduciary duty. In the end, investors make and are responsible for their own investment decisions.

Besides, I have a better solution to the problem of crappy 401k plans: take companies out of the loop entirely. There is no logical reason why retirement accounts should be linked to employers at all. Allowing employees to open a portable 401k account at the brokerage of their choice would solve a host of problems, which I’ll discuss next week. Stay tuned.

Nobody questions Warren Buffett’s investment ability.  He is a singularly talented investor, business man, and one of the most respected men in the world.  When Buffett talks, people listen.  There are plenty of Buffet-mimickers out there.  When he buys Bank of America, they buy Bank of America.  When he buys railroads, they buy railroads.  That doesn’t mean you should blindly follow his picks, however.  Buying what Buffett buys is a likely path to subpar returns.  Why?  Buffett runs a $200 billion company.  The list of companies he can even consider buying stock in is but a tiny subset of the investable marketplace.  You can bet if he were you, Buffett would be investing quite differently.

Buffett Wishes He Were You

Ok, maybe that’s not entirely accurate.  I’m sure Buffett rather enjoys his billions of dollars and the respect he commands from his peers and rivals alike, but that’s another topic.  Strictly speaking in terms of investing, Buffett is jealous of you.  He’s jealous of your small portfolio (suspend your disbelief, please), of your flexibility, of your ability to take large positions in small companies, and your ability to ignore mundane details such as a stock’s liquidity and treat the market as a black box.  If you want to buy a stock, you buy it.  If you want to sell, you sell.  That’s that.  You don’t have to worry about spacing your activity out over a few days so as to avoid driving up the price of the very stock you’re trying to buy.  You can ply your trade in the less efficient corners of the market, such as small or micro-caps and special situations.  Buffett has none of these advantages.

Warren Buffett is forced by circumstances to invest in large-cap, heavily traded blue-chip companies.  There’s nothing wrong with this, but it’s extremely difficult to generate market-beating returns over the long term when you’re competing with every other institution to buy a stock covered by 40 analysts.  Buffett has been reportedly claimed in the past he could generate returns upwards of 50% per year provided he only had $1 million in order to in micro-cap stocks.  You have a huge advantage over the pros.  Don’t spoil it by copying them.  If you want some Buffett exposure on your portfolio, buy Berkshire Hathaway stock.  But when it comes to your own individual stock selections, you would be better served sticking to areas where you have an advantage.  Buy small companies.  Buy profitable companies with sound fundamentals but that aren’t yet followed by Wall Street.  This is where you’ll make your fortune, not in mega-caps like Coca-Cola or Home Depot.  Don’t try to compete with Buffett because trust me, he’s smarter than you.

Free Cash Flow is a firm’s net income plus depreciation/amortization and all other non-cash charges - minus changes in working capital and capital expenditures.  It may sound complicated at first glance, but all that really means is that free cash flow is the amount of cash left over after paying the bills and making new investments and on-going capital improvements.  Earnings include plenty of non-cash components such as depreciation of equipment, amortization of capital expenditures, provisions for bad debts, and a multitude of other accounting entries which may or may not reflect current economic reality.  Earnings can be easily manipulated through all manner of accounting gimmickery.  Enron was “earning” money right up to the end.  Free cash flow, on the other hand,  is very difficult to manipulate.  You can’t fudge cash in the bank.

The Dividend Coverage Ratio

Last time, we talked about how a low payout ratio can be indicative of a quickly growing future dividend stream.  We’re going to go one step further and examine the dividend coverage ratio as an even better predictor of dividend safety.  The dividend coverage ratio is simply by free cash flow per share divided by cash dividends per share.  There are several reasons to prefer the dividend coverage ratio over the payout ratio.  A  ratio of less than one indicates the company is burning through more cash than it’s taking in and a dividend cut is likely.  A ratio of 2 would be considered acceptable while a ratio of 3 or even 4 would be ideal.

As we saw above, earnings is pretty easy for management to manipulate favorably.  Not only that, but not all earnings are truely available for distribution to shareholders.  All companies need to retain at least some percentage of their earnings to maintain facilities, invest in new equipment, fund research and development, and generally keep things running smoothely.  Were a company to pay out 100% of earnings without reinvesting anything back into the business, its asset base would eventually become obsolete and the company would face bankruptcy. 

By definition, free cash flow is the amount of cash that can be taken out of the business without impairing future results.  Since it takes capital expenditures into account, 100% of free cash flow is available for distribution to shareholders.  This gives you a much better idea of exactly how large a dividend the company can afford to pay than if you rely on earnings alone.

Attributes Of A Good Dividend Stock

Check out  the rest of the series

• Introduction: The Case For Dividends
• Part II: A History Of Rising Dividends
• Part III: A Low Payout Ratio
• Part IV:  Free Cash Flow And The Dividend Coverage Ratio 

Often when speaking of relations with the Soviet Union, Ronald Reagan would toss out the phrase “trust, but verify“.  Reagan reportedly repeated this old Russian proverb (Russian:  Доверяй, но проверяй) at the signing of the INF treaty to which his counterpart Mikhail Gorbachev responded “you repeat this phrase every time we meet”.  Not to be outdone, Reagan replied, “I like it.”

Trust, But Verify

This venerable phrase is just as applicable to investing as it is to international politics.  Many people are prone to taking the advice of market experts when making investment decisions.  “Diversify”, they tell you.  “Value outperforms growth”, they’ll say.  “Own your own home,” is especially popular.  What none of these experts tell you is they have absolutely no idea what’s best for you.  They know nothing about you.  Their goals, risk tolerance, even definitions of success are likely to be far different from your own.  Of course, it’s important to do your own homework to avoid being scammed, but it’s not even a matter of dishonesty or conflict of interest.  Nobody knows your situation and needs as well as you.  Who, then, should be able to advise you better than yourself?

Ignore Steve

Yes, I’m sure your coworker Steve is a great investor.  I’m sure his 401K is up 40% last year while yours is up a paltry 3%.  “He must be doing something right,” you tell yourself.  Consequently, you latch onto his every word as he discusses his newest investment idea (pork belly futures!) over coffee in the break room.  Convinced of the huge investment opportunity in dead pigs, you rush back to your desk to change your 401k contributions to reflect Steve’s brilliant investment tip.  Big mistake.  Pork belly futures promptly plummet and you lose 50% of your money within a month.  The moral of this story is that Steve wasn’t good, he was just lucky.  The correct course of action would have been for you to smile, nod along, and then thoroughly research the actual investment potential of pork belly futures yourself rather than relying on somebody else’s probably uninformed opinion.  Don’t allow yourself to be convinced by somebody else: convince yourself.

Carnival of Personal Finance

This week’s Carnival of Personal Finance #151 was hosted by Kimberly Palmer over at the Alpha Consumer, one of the bloggers at US News & World Report (classy!).  My article on how the CPI is not manipulated was included in this week’s edition.  Here are some of my favorite posts from other bloggers in the carnival. 

Silicon Valley Blogger at The Digerati Life gives a primer on the history and characteristics of recessions and the state of our economy.

Moneyning asks if he should be frugal on his honeymoon.  I wouldn’t recommend it!

G Blogmaster at Can I Get Rich On A Salary asks if men or women are better with money.  That seems like a good topic to start a fight on.

Welcome to part III of my series examining the attributes of good dividend stocks.   When buying a stock for income, the safety of the dividend is of utmost importance.  Dividend cuts are frowned upon because they amount to an admission of defeat by management and show a lack of confidence in the executive suite about future earnings.  Investors usually brutally punish companies that cut their dividend by dumping their stock.  The dividend investor thus suffers a double whammy: a severe decrease in income coupled with a large drop in the stock price.

The Importance Of A Low Payout Ratio

According to investopedia, the dividend payout ratio is merely the yearly dividend per share divided by earnings per share.  In general, the higher the payout ratio the greater the danger of the dividend being cut.  A company paying out 80% of its earnings in dividends every year is in trouble if earnings should drop 20%.  In that case, management will likely have no choice but to either cut the dividend or take on significant debt in order to sustain it, both of which bode poorly for future earnings and thus dividend growth.  If, on the other hand, a company paying out only 20% of earnings hits a rough patch and sees its earnings decline, there is a very good chance management will be able to maintain the current dividend rate.

Low Payout Ratios Leave Room To Grow

In general, corporate management only pays out excess cash it can’t reinvest in the company at a reasonable return out as dividends.  A high payout ratio amounts to an explicity admission by management that future growth prospects are limited.  A company paying out 80% of its earnings as dividends doesn’t expect to grow quickly in the future.  If it did, management would reinvest that cash back into the company instead.  Because of this, buying stocks with extremely high dividend yields is unlikely to pay out the greatest dividend income over time because they will have a hard time increasing dividends by much more than the inflation rate over the long run.  Most income investors with a long time horizon would be better off investing in stocks with moderately above-average dividend yields but with the potential for significant dividend growth over time.  Below I’ve calculated the yearly dividend rates of two hypothetical $100,000 dividend stock investments.  Stock A has an initial yield of only 3% but raises the dividend by 10% per year over the long term.  Stock B, on the other hand, has a large initial yield of 7% but is only able to raise the dividend in line with inflation every year, or around 3%.  Let’s see how they perform over a 40 year holding period.

 As you can see, the lower-yield, high-growth dividend stock begins paying out a higher yearly dividend around the 11th year of ownership.  By year 40, stock A pays out a full 161% of your initial investment in dividends every year.  Stock B, on the other hand, pays out only 23% of your initial investment.  Not a bad return certainly, but it’s obvious which stock you’d want to own.

The State Of The Market

Currently, the S&P 500’s payout ratio stands near historic lows at around 30%, mainly because earnings have been increasing more rapidly than dividends in the recent past.  This means dividends have a lot of room to grow in the future.  As a general rule, dividend paying stocks with a payout ratio of less than 50% and growth rate of at least 10% make the best long-term income investments

Attributes Of A Good Dividend Stock

Please read the rest of the series

• Introduction: The Case For Dividends
• Part II: A History Of Rising Dividends
• Part III: A Low Payout Ratio
• Part IV:  Free Cash Flow And The Dividend Coverage Ratio 

Welcome to part II of my series examining the attributes of good dividend stocks.  The first thing to look for when analyzing a dividend stock is its dividend history.  A long record of rising dividend payments shows discipline, sensible capital allocation, and demonstrates management’s commitment to shareholders.

Earnings You Can Take To The Bank

You might not be aware of this, but *gasp* companies sometimes bend the truth when it comes to earnings.  It would be nice if you could trust management to tell the truth, the whole truth, and nothing but the truth but alas, it is not to be.  From Waste Management to Enron to Worldcom, Wall Street has a long history of accounting scandals.  Sometimes, companies can get away with cooking the books for years before being caught but when it finally comes time to pay the piper, usually it’s innocent shareholders who get stuck holding the bag (just ask anybody owning Enron stock).

Unlike earnings, which can show pretty much anything the accountants want them to show, dividends are real cash payments to shareholders.  Cash can’t be faked, manipulated, or lied about.  If the dividend history jives with the earnings history over long periods of time, you can be reasonably certain those earnings were real and not the resort of accounting gimmickery (after making sure the company wasn’t simply borrowing money to pay those dividends, of course).  If dividends rose 8% per year while earnings rose 20% per year over the last decade, on the other hand, it should immediately raise a red flag in your mind.  Why didn’t management raise the dividend more or less in line with earnings?  Perhaps they couldn’t because those earnings were only on paper.  Of course, there are plenty of legitimate reasons this might happen, but unusual dividend policy is often a good early sign of trouble.

 Dividends Show Management’s Commitment To Shareholders

Steadily rising dividends show management’s commitment to shareholders in a way few other actions can.    Since the management of larger companies tend to be better-compensated than management of smaller companies, company executives have a powerful incentive to grow the company at all costs, even if such growth isn’t in the best interest of outside shareholders.  By paying out excess earnings as dividends to shareholders instead of retaining it to be foolishly squandered on ill-advised expansion projects to serve insider interests, management shows a willingness to reward shareholders even if it might not serve to maximize executive pay.  This is exactly the sort of manager you want running your company.  A good manager knows when to expand and when to return capital to shareholders.

The Mergent Dividend Achievers Index

The Mergent Dividend Achievers Select Index tracks the performance of dividend paying stocks with a record of increasing their regular annual dividend at least 10 years of consecutive and is an excellent starting point when looking for potential dividend stocks.  Its constituents run the gamut from mega-cap consumer staples and financial companies to small-cap manufacturing concerns.  One could easily construct a diversified portfolio based on this index.  Alternately, you could just buy the new Vanguard Dividend Appreciation Index Fund (VDAIX) or its ETF version (VIG), which holds the entire index.

Attributes Of A Good Dividend Stock

Please read the rest of the series

• Introduction: The Case For Dividends
• Part II: A History Of Rising Dividends
• Part III: A Low Payout Ratio
• Part IV:  Free Cash Flow And The Dividend Coverage Ratio 

Dividend paying stocks are the bread and butter of every income investor living off their portfolio income (or aspiring to, anyway).  As far as passive income strategies go, dividend-paying stocks sit at the top of the heap.  After an initial research effort, good dividend stocks can be held for years, even decades, providing a stream of steadily rising inflation-adjusted dividend income, making them ideal sources of passive income.  This is part one of a four-part series investigating the various attributes of good dividend paying stocks.

The Case For Dividends

Since 1930, stock dividends have comprised approximately 50% of the stock market’s total return.  While dividend payout ratios have decreased steadily over the past 30 years, dividends have still comprised a solid 30% of the market’s total return over that period.  Simply put, dividends matter.  Not only do reinvested dividends drive investment returns, they put a damper on price volatility as well.  The owner of a non-dividend-paying stock has nothing to fall back on in a bear market.  With nothing in the way of tangible cash flows, non-dividend stocks tend to exhibit greater price volatility than do their dividend-paying cousins.  Dividend stocks, on the other hand, pay you while you wait.  It’s much easier to persevere through price declines when you’re receiving quarterly cash payments to tide you over.  Furthermore, cash dividends tend to put a floor under stock prices.  If the price declines too much, investors will start buying merely for the high yield.

A Rising Income Stream

Dividends have one especially important advantage over fixed-income investments: they rise with inflation.  If you buy a 10 year bond and hold to maturity, you know exactly how much interest income you will receive every year.  The problem is, the purchasing power of those interest payments may be half what they are today due to the erosive effects of consumer price inflation.  A diversified dividend stock portfolio will tend to generate income at least equivalent to the rate of inflation over the long term, preserving the purchasing power of your portfolio indefinitely. 

Attributes Of A Good Dividend Stock

Now that you know the importance of dividends in a portfolio, we’ll examine a few of the most important attributes you should look for when shopping for dividend-paying stocks for your portfolio.  Tomorrow we’ll examine the first attribute of a good dividend stock:  a long history of rising dividends.

• Introduction: The Case For Dividends
• Part II: A History Of Rising Dividends
• Part III: A Low Payout Ratio
• Part IV:  Free Cash Flow And The Dividend Coverage Ratio 

My 8th grade sunday school teacher was a billionaire, the 380th richest man in America (and 799th richest man in the world), in fact, according to the Forbes 400 2007 list.  With a net worth of $1.3 billion, Truett Cathy knows what he’s talking about and one of the keys to success is learning from those who’ve gone before you.  Fortunately, he’s been kind and humble enough to share a part of his wisdom to a group of 8th graders every year for the last 50 years.

8th grade seems like a long time ago, but what thing I do remember is that Mr Cathy was able to immediately command the respect of the boys in the class.  Nothing inspires respect like success and he was somebody we could genuinely look up to.  After all these years, the one thing that’s stuck with me was something he used to say:  “If it is to be, it is up to me”.  Successful people don’t make excuses.  They take responsibility for their own failures.  Sure, something unexpected may happen that could ruin things, but successful people don’t blame failure on random chance, they blame it on themselves for not being prepared enough to handle all eventualities.  They learn from the outcome and plan better next time.  This goes hand in hand with my rant on blaming others for being broke and having bad credit.  Of course, sometimes things happen that are out of your hands.  You can’t control everything that happens to you, but you can control how you plan for them, how you react to them, and how you learn from them.