Investing in a rising interest rate environment – Part 1 : Dividend Stocks

PART 1 : DIVIDEND STOCKS

To be honest we’ve been reluctant to submit any post regarding how we invest in the stock market with valuations currently being at such high levels. The idea that someone would pick up an investing thesis from us and then decide to run headlong into the current market seemed like a recipe for disaster.

The good news as we see it is that with the Fed unwinding it’s balance sheet and increasing interest rates we have recently started to see volatility in a few quality stocks. It makes us a little more confident that we might be seeing some very early signs we can resume slowly making purchases in the future. We’ve been starved of business as usual for so long we thought it was never going to happen.

Background

As far as the stock market is concerned we mainly invest in dividend stocks, the beauty of these type of stocks is that they pay us to own them. Most of them pay us on a quarterly basis, some on a monthly basis, some on a bi-annual basis but they pay us to own them and they continue to pay us even if the stock price rises or falls. Each of these carry a percentage yield of anywhere between 2% and 12% but mainly fall into the 3-4% range on average.

To clarify we aren’t talking about Apple, Facebook, Amazon, Netflix, Twitter or Google here. Those companies currently pay barely anything, if anything at all to own them so it isn’t worth it to us. People who invest in these companies are reliant on increases in valuation at which point they sell and make money through capital gain. This to us is very stressful and we don’t really have the stomach for it, it bears similarities to gambling in that we are putting our money into a company and in the hope it will gain in value and praying it won’t lose value.

Even in the current rising interest rate environment as dividend investors we very rarely make a sale of any of the portfolio as valuations fall. Since they are constantly delivering us income at a yield of 3-4% there is really no real reason to unless our opinion of the stock changes and we are no longer confident in the payment of the dividend. This could be due to red flag warnings such as long term earnings growth declines, sudden unexplainable growth in debt, or a change to the company story that we are no longer comfortable with.

This is the reason we focus our thesis so heavily on investing in companies with good dividend growth history, payout ratio (dividend payout to earnings) cashflow and manageable debt to equity. We like to see a company growing it’s earnings steadily over the years and increasing it’s dividend accordingly. The best indicator for this is to research the dividend growth history which is the company’s dividend track record over as long of a lifespan as possible. If there is a long unbroken history of increases including through the 2008 financial crisis then we can have some confidence that it will continue through good and bad times.

We also like to see that the dividend payout isn’t hurting the company bottom line so we can look at the payout ratio to get an idea of this. The payout ratio is basically the dividend payout to earnings ratio and we like to see it less than 75% where possible, anything above that might mean that the payout could be in jeopardy at some point as the company doesn’t have sufficient earnings to cover it. If it goes over 100% then the company is spending more on the dividend than it is taking in earnings, making it vulnerable to elimination.

The final two critical metrics are cashflow since we need to see that the company has strong consistent cashflow to cover the dividend, so we like to see consistent increases in cashflow year-on-year in line with dividend increases. Secondly that the company is not continually running up higher and higher debt to sustain itself. This may be being used to pay us the dividend, companies sometimes run up debt to produce unsustainable high yields known as sucker yields. We therefore like to see debt slowly decreasing year-on-year unless there is a good reason for the debt increase such as a major acquisition which could be incremental to earnings.

Examples

So what type of industries are we interested in when we look for our purchases of dividend stocks? Well we are really looking for what we call “bread and butter” companies that produce products that we need on a daily basis and have been around long term. For example telephone companies that have been around for decades like AT&T. Similarly healthcare companies like Johnson and Johnson or Procter and Gamble, also utilities such as Duke Energy and Southern Company. These are they type of companies that we use the products of on a day to day basis through good and bad times. During the financial crisis we didn’t cease to use electricity or our cellphones, neither did we forego the toothpaste or clothes washing products of Proctor and Gamble because the market went south. These companies continued to make profit and paid us our dividends during these periods so these are the type of companies we like to look for at the right price.

An excellent place to start a search for dividend companies is the David Fish list of Dividend Champions, Contenders and Challengers. This is a comprehensive list of all the companies that have historically raised their dividends and is available at dailydividendalert.com under david-fishs-dividend-champions-contenders-and-challengers. This doesn’t mean we automatically go and invest in each and every one of the these companies as their current valuations could be too high after the stock market run over the last decade. It just gives us a good start point for companies to put on our watchlist for potential purchases on market pullbacks.

Interest rates and the FED

Our focus right now is on the US interest rates that are progressively increasing and studying companies that are likely to see their valuations negatively affected. Companies such as Real Estate Investment Trusts or REIT’s whose business model relies on taking out debt to purchase property are generally badly affected by rate rises because when they refinance their repayments are higher which hurts their bottom line. Same situation for utility companies and telecoms with their bond proxy status. Their values also tend to drop with higher interest rates because safe haven bonds start to look more attractive, so these companies are also worth watching for price drops.

Rule making

The rule making should work similarly to the way it did back investing at crisis levels in 2008, slow and steady. So that we don’t get too far ahead of ourselves when we start to see the new lower values, we tend to set limits on our purchases. We only ever invest in the stock market with money we accept we could lose, so we won’t invest any of our rainy day funds and taking out finance to purchase or leverage is a definite no no. In the world of lower prices it is definitely a marathon not a sprint so we only ever enter a new position with a figure of about $250 and then sit back and watch. This initial cool off period gives us time to collect our thoughts and track our new investment progress adequately so that we aren’t rushing the process. If we can gain a little confidence in the fear-filled volatile environment after this time period then we might start to look at adding to the position very slowly as and when interest rate rises are accompanied by pullbacks. We are basically trying to buy in slow increments as we head down the down-slope, don’t panic too much if you miss a plunge as there will be other opportunities.

Our maximum investments for most stocks is only ever $1000 when we are fully committed. If we have a reason for considerably more confidence then we might go above our $1000 limit but these instances only ever represent less than 5% of our entire stock portfolio and are truly one-off instances where we monitor the stock like a hawk. Try to remember we don’t know where the final interest rates will settle so we need to be patient as the new environment unfolds.

Conclusion

In the end this type of investment strategy in the current environment comes down to personal risk tolerance. Right now stocks are still at an all time high despite the recent pull backs. Patience is the name of the game and watching the Fed for signs of further rate increases as it tries to hold back inflation. As the saying goes, don’t fight the Fed. With gradual interest rate rises and the effects of the unwinding of the decade of abundant free money for the banks we think pullbacks and volatility will become more common. We are therefore preparing for a long, slow and gradual transformation to a bear market over the next few years that could take valuations a lot lower than where they are today. Particularly as interest rates hit a high enough yield that encourages retirees to take all their risk off the table and head for the relative safety of bonds.

We plan to also run future posts regarding products such as Preferred shares, CD’s and bonds. These are also perfectly good investment income vehicles even if they are not as inflation friendly as stocks but also have their pitfalls in the rising rate environment. Our aim is always to invest as diversely as possible to keep our income sources balanced.

We are long T,PG,DUK,JNJ and SO.

Thanks for reading.

DN

 

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