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Investing in Dividend Stocks

How to Determine Value

Written by Joseph Cafariello
Posted February 7, 2013 at 4:54PM

Who has not been attracted to discounts? “25% off!”, or “Buy 2 get 1 free!”, or even “$100 cash mail-in rebate!” Savings and rebates certainly make purchases much more enticing.

But when it comes to buying stocks, far too many people walk right past offers of savings and rebates without so much as a glance.

Let’s take a glance at them now… dividends—the stock market’s discounts.

Yet I’d like to present more than just a collection of great dividend stock picks, which can readily be found all over the web. I’d like to highlight two useful trading tools designed to help you get the most of your dividend stock investing: one aimed at all investors both passive and active, and another designed specifically for the more active trading enthusiasts. (This latter one comes directly out of my own playbook. And I simply love it.)

Although it is tempting to scour the many lists of dividend paying stocks and superficially pick the ones that offer the highest yield (dividend payment relative to stock price), doing so can sometimes turn into a futile exercise of paddling upstream.

What good is it collecting 10% per year in dividends when the stock price loses 25% over the same period? Despite all the paddling in the right direction, you still move backwards.

Some stocks have such high yields only because their stock prices recently took big hits. And if this is symptomatic of deeper structural problems within the company, the expectation is quite high that the dividend would soon be cut or even eliminated. Not only would you lose your capital, but you would also lose your dividend income.

One number that can help you avoid such dividend let-downs is a stock’s “liability-adjusted cash-flow yield”, created by John DeFeo, Director of Business Intelligence for TheStreet.

The liability-adjusted cash-flow yield is all about how much of a dividend a company can comfortably maintain going forward. On his website (linked above), DeFeo explains what prompted him to formulate it:

“When the financial crisis came to a boil in 2009, I noticed a funny thing -- companies that paid a dividend yielding more than their LACFY were cutting their dividends with greater regularity than those that did not (notable examples include General Electric and Pfizer). It made perfect sense; debt-laden companies had little recourse if they could not support their dividend with free cash flow and/or couldn't roll-over debt in a drying credit market.”

We now have a means of gauging how sustainable any company’s dividend payments truly are.

Writing for “The Street”, DeFeo uses his LACFY to compile a Top-7-List of blue-chip dividend stocks worth holding:

7. Procter & Gamble (NYSE: PG) – dividend yield 3.18%; LACFY 3.6%

6. Coca-Cola (NYSE: KO) - dividend yield 3.45%; LACFY 4%

5. Home Depot (NYSE: HD) - dividend yield 3.19%; LACFY 4.1%

4. Johnson & Johnson (NYSE: JNJ) - dividend yield 3.63%; LACFY 5.8%

3. Pfizer Inc. (NYSE: PFE) - dividend yield 4.95%; LACFY 6%

2. Exxon Mobil (NYSE: XOM) - dividend yield 3.01%; LACFY 6.3%

1. Intel (NASDAQ: INTC) - dividend yield 3.09%; LACFY 6.6%

Notice that the ratings are based on LACFY percentage and not current dividend yield. Even though companies invariably pay a smaller dividend than the LACFY they could afford, it’s good to know that if the economy were to stumble, it would still have enough sustainable cash flow to continue paying the dividend you are counting on.

OK. Now we present something for the trading enthusiasts who would rather paddle through the volatile rapids of capital gains than simply float along on dividends alone.

In defense of active traders, constantly jumping in and out of fast moving stocks is not a pointless scratching of the stock trader’s itch. It is a sound method of riding a stock’s momentum with the aim of capturing and locking-in capital gains, which can and often do surpass the income provided by even the highest dividends.

What is more, unlike dividend income, capital gains have no withholding tax and are, in most jurisdictions, taxed at a considerably lower income tax rate.

The only problem with such short-term capital gains-based momentum trading is that you can’t really spot momentum until it has already been running for some time. By the time you notice the momentum is real, you have most likely missed the bulk of the move.

And if jumping in at the right time isn’t hard enough, you then have to contend with exiting at the right time, or you risk getting stuck on the rocks with much of your capital immobilized.

The solution? Relative-value trading using solid dividend stocks. Relative-value trades improve your dollar-cost averages without you having to worry about your entry or exit timings.

And because you are using solid dividend stocks, even if markets should stagnate or fall, you still collect a healthy dividend in addition to those relative-value cost-average improvements.

Below is a 2-day intra-day graph of my favorite high-yielding dividend ETFs: SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) (in black) and iShares S&P U.S. Preferred Stock Index Fund ETF (NYSEArca: PFF) (in gold).

JNK PFF ChartSource:

Relative-value trading follows one simple principle: when one stock climbs above the other in percentage terms, you sell a little of the leader and buy a little of the lager.

In the case above, on Monday morning you would have moved some funds from the front runner (JNK) to the trailer (PFF), and the next day moved some funds the other way from PFF back to JNK.

When the round-tern is complete, you will have done more than just soothed that trader’s itch. You will have fruitfully captured some capital gain by improving the dollar-cost average of the two holdings.

And this will also earn you better than the posted dividend yield, for you are effectively increasing your shares for the same amount of total money invested, which in turn pays you a higher dividend yield due to a lower average cost.

Over longer periods of time, the effect is amplified. Notice the following 10-day chart of the same two stocks:

JNK PFF 10 Day ChartSource:

Granted, hindsight allows us to pick the best possible time for a successful relative value trade. But if you do this regularly—say one or two times a week—you are bound to catch a trade like this one rather frequently. Once again, you better your combined cost-average in the process and improve your overall dividend yield.

Sure, relative value trading can be performed between any two stocks, and the greater the volatility of the stocks, the greater the improvement to the dollar-cost-average.

But if you include solid dividend paying stocks or ETFs in your relative-value trading program, you will then be earning on two levels: improving your dollar-cost averages and earning healthy dividends.

Just be certain to keep your eye on your trading costs. Frequent trading can incur so much in commission charges that you completely wipe-out any capital gains or dividend income.

Joseph Cafariello



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