Dobosz on Dividends

02/12/2016 10:00 am EST

Focus: STOCKS

John Dobosz

Editor, Forbes Premium Income Report and Forbes Dividend Investor

John Dobosz—editor of Forbes Dividend Investor and the Forbes Premium Income Report—discusses his strategy and the importance of income as a component of the investing process, and highlights some favorite stocks offer value and yield.

Steven Halpern: Joining us today is John Dobosz, editor of Forbes Dividend Investor and the Forbes Premium Income Report. How are you doing today, John?

John Dobosz:  I’m doing great Steven, thank you. How are you?

Steven Halpern:  Very good. Thanks for taking the time. Dividends play a critical role in your investment strategy.  Could you briefly explain the importance of dividends to long-term investors?  

John Dobosz:  Well, Roger Ibbotson, former professor at the University of Chicago, who started Ibbotson and Associates, they put out the famous Yearbook of bonds, bills, notes, and stocks—and going back to 1926—showed essentially you have three sources of earning money in the stock market.  

There’s growth of earnings. There’s growth of the PE ratio used to value those earnings. And then there’s dividends.  

Ibbotson says that, since 1926, that about 51% of growth in stock market value has come through dividends and you go through periods of time where the market is flat and that percentage goes up a lot more because…take for instance 2001 to 2010, market was basically flat, but you would have pocketed dividends along the way.

Essentially, they also provide a great measure of reassurance that there’s actually cash in the business. When you go to buy the stock, you can’t really fake dividends for a long time.  

There are other ways we find out if those dividends are going to be secure because that’s at the heart of it. The goal is to buy a stock that’s cheap, collect dividends, never have to sell it, pass it on to your heirs.

Steven Halpern: Now, many novice investors make the mistake of just looking for the highest yields, but you emphasize that you’re looking for above-average dividend yields. Could you explain the difference?  

John Dobosz:  Well, right now if you bought the SPDR S&P 500 Trust (SPY) you could actually earn a 2.2% dividend yield. I was kind of shocked. I looked that up the other day.  

It was down below 2% for a long time, but the market has come down so much. What I’m looking for are yields that are above the market.  Right now it’s 2.2% for the overall market.  

What you want is a dividend that’s not necessarily the highest out there because a high dividend could, in fact, signal trouble with the company, but you want to have a dividend that grows over time and grows every year, keeps up with inflation.  

You want to see companies that can comfortably pay that dividend so you have to look at the cash flow. You have to look at the free cash flow and the operating cash flow, make some assumptions about the future if those levels of cash flow will continue and then look at the dividend and see how much coverage you have.  

If it’s a 30% payout ratio that’s probably sustainable, although different industries have different payout rates. A high yield, a lot of energy stocks right now, you’ll look at the yields and they’re very, very high, but some of these companies may be going out of business.  

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What you want to do is you want to buy a stock when it is out of favor, not on death’s doorstep, but out of favor so you’re paying cheaply for it and you lock in a yield that is a bit higher than you could if you had bought it when it was more fully valued.

Steven Halpern: Now, as you alluded to, a dividend stock is only worth considering if the stock itself is undervalued. Could you briefly highlight some of the criteria you consider in making that determination?   

John Dobosz:  Well, what I like to do is I like to look at the long-term five- or ten-year average of multiples on the stock, various metrics.  

You want to look at, as I mentioned before, free cash flow.  There’s the thing called price to free cash flow per share.  Look at the average over time.  Look at where it is now.  If it’s below, you’re trading at a discount on that.  

I also look at price-to-sales ratio.  Price-to-sales, sales is about the rawest financial metric out there. You really can’t fake it.  Same thing, look at the five-year average of price-to-sales ratio.  Look at where it is now.  Do you have a discount?  If so, go on.  

Same thing for earnings, price-to-earnings ratio, but earnings are manipulatable by management so you can’t fully go on earnings.  The cash flow and the sales are perhaps the two most important, although I’d throw in enterprise value (EV) to EBITDA, that’s the debt and the equity value of the company divided by the earnings before interest, taxes, depreciation, and amortization.  That takes account of debt.  

What you want to see is discounts on as many of those as possible and if you do and you see that the cash flows cover the dividend and that the dividend has risen over time, you’ve probably got a great stock.

Steven Halpern:  You recently recommended Nordstrom (JWN) in our 2016 MoneyShow annual Top Picks report and while the market’s down over 6% since then, your selection of Nordstrom is actually showing gain.  Are you still comfortable with the stock’s outlook?  

John Dobosz:  I mean, they do report earnings on February 18 and so that’ll be the first look at how the past three months have gone.

But yes, I am, because as I just alluded to with all those various metrics that I look at—price-to-cash flow, price-to-earnings, price-to-sales, EV to EBITDA—you’re looking at big discounts on Nordstrom’s current price and revenue has actually held up and their dividend has risen over time and it’s grown.  

It’s something like a 15% annualized rate over the last ten years. That’s fantastic dividend growth.  Yes, I’m still comfortable with Nordstrom. I mean, the overall stock market, keep in mind, will drag 75% of the stocks in the market with it.  

If the market tanks, Nordstrom could feel some pressure, but again, over time I think if I have a long enough holding period if I were Rip Van Winkle I could wake up and be very happy with Nordstrom and I’d love the dividend checks.

Steven Halpern:  Now, perhaps you could walk us through a couple of new investment ideas that would help our listeners better understand your stock selection process.

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John Dobosz:  Sure, yeah.  One of the other stocks that…there’s a lot of opportunity to be had in late January when the market sold-off.  I was a little bit early, but we turned out doing very well with Cummins (CMI).  

Of course, that’s a big diesel engine maker in Indiana. Cummins was around $85, $84.  We got into it.  It’s around 90 now. You’re getting a nice yield.  They pay $4 per share on let’s say a $90 stock so with that kind of payout you’re getting a 4.4% dividend yield.  

They trade at a discount of price-to-free-cash flow, price-to-earnings, price-to-sale, and EV to EBITDA, so Cummins is definitely worth a look.  

One thing I’d like to point out, Steven, is that number, 4%.  You hear that a lot in financial planning.  If you have a portfolio and you take 4% withdrawals from it each year over a 30-year period, your chances are virtually nil of running out of it.

Imagine if you had a portfolio you didn’t even need to take the money out of.  You could get it in dividend checks. You could keep your principal intact and keep earning that 4% or whatever you need to retire. That 4% I think is a sweet spot.  

When you get a stock that’s got quality fundaments underneath it that has a yield north of 4%, that’s like a rare opportunity to get into a long-term position that you’ll be happy with for a long time.  

Steven Halpern:  You’re also the editor of Forbes Premium Income Report and hopefully we’ll be able to discuss that more in depth in a full interview next time we speak, but before you go, we’ve got a minute, could you share a brief overview of this service and perhaps highlight an example of the type of recommendations that you make there?

John Dobosz:  Sure.  What we do is we sell options.  We don’t buy them.  It’s fun to speculate with options, but it’s better to sell them because most of them do expire worthless.  You have puts and you have calls.  

With the calls, if you already own the stock, you can sell a call option against, meaning you have to sell it at expiration if the stock is above it, but if it’s below it you just pocket that premium and do it again and again in about a 30- to 45-day cycle.  

With puts, if you sell a put you are literally put on the hook to buy that stock at the strike price if it’s below that at expiration.  

I’ll give you a good example of that.  Exxon Mobil (XOM) reported horrendous earnings, down 58% from a year before. The stock dropped to around $74 so I thought, well, how about a $67.50 strike price for a put that expires in 45 days?  

It would have to drop 10% more to make me have to buy it and if I did have to buy it we’d be getting a dividend yield of like 4.3%.  It’s a way to put in a low ball offer on a stock to sell a put.  

I do it every Tuesday and Thursday, two trades a day and we will talk more about it in the future, but it’s really a great way, and then when you combine that with dividends, if you do that with dividend stocks, you can really turbocharge your income component of your stock portfolio.

Steven Halpern:  I look forward to talking more about that.  Again, our guest is John Dobosz of the Forbes Dividend Investor.  Thank you for your time today.

John Dobosz:  Thanks Steven, good to talk to you.

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