The Importance of Dividends in a Long-Term Portfolio

05/11/2016 10:00 am EST

Focus: INCOME

John Dobosz

Editor, Forbes Premium Income Report and Forbes Dividend Investor

Income expert John Dobosz explains the importance of dividends in building a long-term portfolio; the editor of the Forbes Dividend Investor also highlights some favorites for value-oriented income investors. The income guru also explains the more sophisticated options strategy behind his Forbes Premium Income Report.

Steve Halpern:  Our special guest today is income expert John Dobosz, editor of Forbes Dividend Investor. How are you doing today John?

John Dobosz:  I’m good, thanks Steven.  How are you?

Steve Halpern:  Very good.  Underlying your investment strategy is an emphasis on dividends.  Could you explain why income plays such a pivotal role in your approach to a long term portfolio?

John Dobosz:  Certainly.  There are periods of time in the stock market when you don’t have much appreciation in stock prices.  You can look back from 2000 through about 2012.  The S&P 500 was flat in terms of price appreciation, but you would have earned some return if you had just collected the dividends.  

Now there’s three ways you can make money stock; either the earnings in the company go up, the multiple that the market’s willing to pay for those earnings goes up, or there’s cash that you get from owning that company’s stock which is of course dividends.  

Like I pointed out there’s periods of time when you will not earn anything maybe for a decade or more if you’re looking just for price appreciation, and you own stock that do not pay dividends.  

If you do get dividends, 3% or 4% a year let’s say, that compounds nicely.  That’s the whole name of the game for long term investing is keeping the compounding effect going.

Steve Halpern:  Well, going hand in hand with these dividends you equally emphasize a stocks valuation. Could you explain how both income and work together in your strategy?

John Dobosz:  Well, if you owned a bunch of dividend stocks that were priced too high those dividends would count for little in terms of the stock price decrease that you would encounter when the market more fairly the value of those companies.  

What I want to see is a company that’s trading at valuations in terms of price to earnings, price to sales, price to book value, price to free cash flow that are less than the valuations on average for the past five years.  

Those are four of the criteria that I use; the price to sales, price to book value, price to earnings, and price to cash flow.

Looking for discounts to the five year average multiples there.  I also require the stocks to produce a positive operating cash flow over the past 12 months because that’s where you get your dividends paid from.  

Actually they’re paid from free cash flow, but if you don’t have operating cash flow your free cash flow probably will be low too.  

I also look for revenue growth, and I kind of ex-communicate any kind of stocks that have had sketchy dividend history, dividend decreases or suspension.  Maybe after about a 10-year period or eight year period you can re-evaluate those.  

A lot of companies did cut dividends in the 2008-2009 recession.  You want to look for companies that are fairly valued because you can’t make money in the stock market, much of it anyway, if you’re buying stocks that are too expensive.  Even if you’re relying on the dividend income.

Steve Halpern:  While you look for income opportunities across a wide spectrum of investment vehicles from individual stocks to REIT to MLPs, in the current environment are any of these specific markets places where you’re particularly finding compelling value?

John Dobosz:  Well, MLPs, the Master Limited Partnerships -- many of which are pipeline companies that transport natural gas, or crude oil, or crude oil derived products -- they took a big spanking in the last two years, no doubt.  

There’s an index called the Alerian MLP Index (AMLP).  You can pull up a two-year chart, and see the gory history there.  I think it was down as much as 75% from its highs.  It’s come back somewhat.  

Nonetheless, there are companies that are engaged not so much in the speculative business of taking crude oil out of the oil fields of places like North Dakota and other places where fracking is going on.  

Companies that transport natural gas, natural gas is at 20-year lows so power plants that are able to run on that stuff are locking in long term contracts, and they need to have natural gas supplied to them.  

One company, Spectra Energy Partners (SEP), is in that business.  We currently have them in the portfolio. You’re getting a 5.1% distribution yield.

And it’s trading at substantial discounts to its five-year average price to sales, price to earnings, and price to free cash flow.  Multiples of the last five years so it meets our criteria.

AmeriGas Partners (APU) has an 8.5% dividend yield.  We do have a few MLPs.  Another one is Tesoro Logistics Partners (TLLP) that’s a 7% yield. They move gasoline around the country and some natural gas.

Then of course you’ve got your old beaten down blue chips, not too many beaten down these days, I guess. IBM (IBM) is one of them -- Big Blue is trading below $150; it is a very compelling stock for a lot of reasons.  It’s been through the jungle before, and it’s emerged successfully.  

You’re getting a 3.8% dividend yield.  It’s a century old company.  Warren Buffet likes it, not that he’s infallible completely, but it’s usually a good mark that the Oracle of Omaha shares your appraisal of value.  

We do see a lot of home building stocks.  There’s one called M.D.C. Holdings (MDC) that we’ve got in the portfolio.  

We’ve got some small cap stocks; one is Douglas Dynamics (PLOW). They make snow plows out of Milwaukee, Wisconsin.  The ticker symbol is very appropriate PLOW.  They’re getting a 4.1% yield out of Douglas Dynamics.  
If you apply this, which is a pretty straight forward formula, companies that are producing cash flow, and that trade at valuations that are less rich than they’ve traded at in the last several years you’re probably going to be right more often than you’re not, and we have been.

Steve Halpern:  Now for the more sophisticated investor, you also offer a newsletter called Forbes Premium Income Report.  Could you share an overview of this service, and the types of opportunities that you uncover there?

John Dobosz:  Yes, sure.  What we do in that newsletter, Steve, is we take a look at the market, find stocks that we would not mind owning so there’s a lot of overlap in the stocks that we choose for the Forbes Dividend Investor, and we’ll either sell puts or we will do buy rights.  

Selling "puts" puts you on the hook literally to buy stock at the strike price at expiration if the stock price is below the strike price.  

Recently we did one, there’s a company Chico’s FAS (CHS), they’re a woman’s clothing retailer.  They also operate the White House and Black Market stores based out of Fort Meyers Florida.  

Chico’s has been a great growth stock for a long time, but it’s kind of stalled.  It came down from $18.  Anyway at just above $12 we sold four contracts of $12 puts for thirty cents apiece.  

Each contract represents 100 shares of stocks.  We picked up $120 in options premium for taking on the obligation to buy Chico’s at $12.  

Actually this one was a two-week trade, the options expire on May 20 so we’ll see where that is.  If Chico’s is below $12 we’ve got to buy it at that price subtracting the options premium that we got we’d own it an 11.70. That’s a way to own a stock cheaper than the market has it today.

The other way to do it is to buy a stock, and then sell "calls".  Calls are just kind of the opposite of puts in that you are obliged to sell the stock if it trades above the strike price at expiration.  

Great way to do this, to really maximize your income to get a multiplier effect is to buy a stock, sell call options against it, and while in that period of waiting for the calls to expire you also get a dividend.  

That’s really nice to do if you look at when the stock is going next dividend maybe about a month before to month and half before you buy it in anticipation of getting that dividend, and right to call option slightly out of the money so that you can get that dividend.  

You could be called away early.  You could be assigned early.  That’s when the holder of that call option decides he wants to buy that stock at the strike price, which is his right until expiration because he wants to get the dividend.  

If that’s the case often you’re not really crying in your beer because you’re getting taken out at the strike price and it’s a nice two-month return.  

You do this again and again and again, and if you sell these covered calls on stocks that you already own you could generate in theory a monthly paycheck, four dividends per year.  Then if you do a month and a half long trade eight times a year, four plus eight is twelve.  

You’re getting 12 little paychecks from your stock.  That’s the way, it’s like the ground game in football, you’re fighting for every two three yards, but you’re making positive yardage each play, as opposed to trying the 80-yard long bombs.  

Not that Tesla (TSLA) and stocks like that won’t eventually probably be very enriching, but this kind of approach where you look for cheap stock that pays dividends, and then look for opportunities to sell options against them.  It’s a very hands on approach, but the results over time pay off.

Steve Halpern:  Again our guest is John Dobosz of the Forbes Dividend Investor.  As well as the Forbes Premium Income Report.  Thank you so much for your time today.

John Dobosz:  Thanks Steven.

By John Dobosz, Editor of Forbes Dividend Investor

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