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The investment psychology

There are different ways to invest depending on your goals and different investment psychologies involved. Value investors with different goals may have to adopt different investment psychologies to achieve their goals. In the majority of my writing in this series the focus will be on achieving financial independence, which requires a return on investment. The investment strategies will align with these goals and will be apolitical, and amoral. To provide an illustration of the psychology of the dividend investment strategy we could take a look at a company such as Altria, which has consistently raised dividends for decades, with a current yield at 4.3%. At the same time Altria is a tabacco company, and many would not choose to buy this stock due to the moral implications associated with the company, but it does not change the fact that Altria pays a yield to holders of 4.3 percent, is offering an addictive product with a strong brand name, is offering a product which is cheap to make and which will likely only become cheaper, the fact that they are global, and you can see by looking at their fundamentals such as cash flow that they'll be able to pay dividends consistently, for a long period of time.

Every investor should have some basic tools, which include an investment psychology, an investment strategy, a spreadsheet, and the ability to analyze each stock and through cost-benefit analysis determine if owning that stock is in their self interest. While the valuation of a stock is an amoral process at times, it is possible that a person analyzing a stock could determine that all things equal, the stock with lower moral costs, are in the self interest of the investor to hold. So it is up to each potential stock holder to determine if the amoral approach to investing is right for them, and in future series we I may dig deeper into concepts like effective altruism for people who would like to take on the moral dimensions.

In this series on passive investment basics I will outline my investment strategy. I describe how to analyze five different stocks, beginning with Altria used in the example. Some of the topics which will be covered include cash flow analysis, dividend payout consistency, market position, regulatory risk, and internationalization. Be aware that this will not be a detailed or actual analysis but merely to inform you of the process involved, the psychological mindset involved, and this will show you what information to look for as a guide or reference.

Table of Contents

  • What is a dividend investor?
  • What is the dividend aristocrats index?
  • What are some examples of dividend ETFs?
  • How to analyze dividend stocks

Altria

  • Cash flow analysis
  • Dividend payout consistency
  • Market position
  • Regulatory risk
  • Technological evolutionary trajectory
  • Internationalization

Coca cola

  • Cash flow analysis
  • Dividend payout consistency
  • Market position
  • Regulatory risk
  • Technological evolutionary trajectory
  • Internationalization

McDonalds

  • Cash flow analysis
  • Dividend payout consistency
  • Market position
  • Regulatory risk
  • Technological evolutionary trajectory
  • Internationalization

AT&T

  • Cash flow analysis
  • Dividend payout consistency
  • Market position
  • Regulatory risk
  • Technological evolutionary trajectory
  • Internationalization

What is a dividend investor?

When most people think of investors they might think of someone such as Warren Buffet, who popularized the concept of “value investing”. Value investing is distinct from dividend investing in that the while both seek a return on their investment the goal of a value investor is to buy a stock when it's below it's “intrinsic value” and then wait until the market reaches it's equilibrium so that the stock eventually is priced at it's “intrinsic value”. Dividend investing is a bit different in that intrinsic value is not necessarily as important, because the goal of a dividend investor is to generate a steady income stream from their investment portfolio.

Concepts like diversification are still important to a dividend investor, because the tactic of a dividend investor is to chase yields but it must also be known that there is a lot more involved than just selecting stocks which currently have high yields in expectation that it will continue. There is a science behind analyzing stocks for growth, and a carefully thought out process should be undertaken when making critical financial decisions.

What is the dividend aristocrat index?

The dividend aristocrats index are a ranked index of stocks which have consistently paid out dividends for at least the past 25 years. When selecting dividend stocks one of the primary criteria of a good stock is it's consistency and this consistency is a requirement to make it on the dividend aristocrat index. 25 years is a very long time to be consistently paying out dividends consecutively so it is not easy to make it onto the index, at the same time it is also possible to find stocks with perhaps higher yields with less consistency, but these stocks also are riskier. The dividend aristocrat index can allow you to easily find the most consistent low risk stocks when it comes to making dividend payments, but if you're chasing higher yields you may want to take calculated risks.

What are dividend ETFs? What are some examples of dividend ETFs?

Dividend ETFs take all the fun out of choosing the dividend stocks, or perhaps if you think about it from another perspective it takes the stress out. The ETF will handle choosing the stocks from a diverse array of different sectors, and you'll also get favorable tax treatment. The reason you get favorable tax treatment with dividend ETFs is because dividend ETFs optimize for tax efficiency, by making the least amount of trades necessary to maintain a reasonable yield. If you're looking for an easy solution, where you can buy it and forget it, the dividend ETFs are the way to go.

An example of a dividend ETF is (Spider) SPDR S&P International Dividend ETF. SPDR S&P is handles all the rough and difficult choice making, handles the tax issues, and focuses on the S&P and as of December 2015 it has a dividend yield of 5.83%. A risk however is the outflow risk where money in 2015 so far has been cashing out. The return for the year is -13.97.

Another example is Vanguard Dividend Appreciation ETF which is one of the more successful and conservative dividend ETFs. Vanguard this year has also suffered from the outflow situation where cash has been flowing out of dividends by the billions. Dividend ETFs are a good choice if you want to have professionals manage your wealth but they also may be conservative in their approach so you might not get the highest yields and you might also not be able micromanage like you could if you can control and manage your portfolio.

How to analyze dividend stocks – free cash flow

When analyzing dividend stocks one of the primary criteria is free cash flow. A company which generates a lot of free cash after it's necessary capital expenditures has the option to give out dividends. Dividends are typically given out when a company doesn't have to invest a lot in R&D due to maturity of their product. For example companies that make tobacco or sugary beverages may not need to put much into R&D or marketing because the product sells itself on it's strong brand recognition. Knowing which companies have the capability to pay a dividend is important and the free cash flow is an indicator of that capability. The free cash flow yield is a metric you can utilize as one of the fundamental indicators of how much free cash flow a company has. To measure the free cash flow yield simply take the free cash flow per share and divide it by the current market price per share for a result which is the free cash flow yield.

How to analyze dividend stocks – consistency

After you've determined that a company has the free cash flow to pay out dividends the next criteria to look at is consistency. Does the company have a track record of paying out dividends over enough of a period of time so that you have an indication of the mind set of the company? Some shareholders may prefer to put cash into R&D, some might prefer to give bonuses to employees or the CEO, but then at other times the shareholders may be of the mindset that the best thing to do with the excess cash is to give it back to the shareholders. If the shareholders have the dividend mind set, and the free cash flow indicates that dividends can be paid for a long period of time, then you have two measures “free cash flow” and “consistency” from which to make your calculated decision.

How to analyze dividend stocks – market position

Market position is an important metric to track. It is important to know if the stock is for a company which is a market leader or if the stock is for a company which is in a very competitive market without a clear lead. In the case where the company is a market leader, or where a company has a monopoly, then you know dividends be paid out for a longer time as long as the company stays in that position. Of course there are other risks such as technological evolutionary changes and the regulatory environment.

How to analyze dividend stocks – regulatory risks

In any industry there are different kinds of risks and one of the major risks are regulatory risks. Regulatory risks are the risk that the political climate can change and as a result the regulatory environment could threaten the ability of the company to continue to make profits. Companies sometimes counter this through regulatory capture, or by placing barriers to entry for their competitors. Barriers to entry act as a moat where startups who want to try to move up the ladder in market position cannot easily do so because the costs of regulations are too high. The financial industry is an example of an industry which has both aspects of regulatory capture and strategically placed high barriers to entry which keep competitors from being able to innovate and move up in market position too fast.

If we used a Bitcoin exchange company as an example then we would see that the Bitcoin exchange might have superior technological innovation, it might be cheaper, more efficient, and better able to evolve, but due to the high costs of various licenses and other legal/professional requirements it might not be very profitable for shareholders. As a result a Bitcoin exchange is not likely to be able to pay dividends to shareholders because so much money would have to be spent dealing with regulations, or on legal fees. On the other hand the financial institutions which are running on old technology also have a risk as well, as eventually newer better technologies could reduce their profit margins. The example for this would be Skype which chipped away at the long distance call market which AT&T where to be a market leader.

How to analyze dividend stocks – technological evolutionary trajectory

In the Skype example we can see how technological evolutionary trajectory can threaten an established company like AT&T. The only way for a company like AT&T to continue to pay dividends is for it to evolve with the technology. Technological evolutionary trajectory is the direction technology is currently moving, and in some cases futurists may try to forecast the direction of this movement whether accurately or inaccurately. Accurately forecasting this movement can allow investors to in the least avoid the stocks which are from companies with obsolete business models, or with business practices which are unsustainable, or which have a technology which has already been shown obsolete.

Certain industries like the technology industry have a very fast moving evolutionary trajectory. Technology can become obsolete almost overnight, new apps can go viral, information flows. When choosing a dividend stock it is important to consider the different technological evolutionary trajectories of the different companies. If the company is a company which can be duplicated relatively easily, because it's relying on some processes which can be decentralized, or relying on keeping a trade secret, or source code closed, then perhaps there is risk in holding the stock of these companies. The source code can be copied, leaked, or reverse engineered. The centralized processes can be crowd funded, decentralized, and crowd sourced, which means the centralized entity might not be able to maintain it's profit in the long term.

How to analyze dividend stocks - internationalization

Internationalization is the ability of the company to operate globally, across multiple cultures, legal jurisdictions, currencies, and languages. The company for example might be a market leader but not internationalized and so another company could simply copy it from another country and compete. An example of an internationalized company would be McDonalds which is in many different countries, languages, with different menus adapted for different cultures. As technology changes with time the process of internationalization will become much cheaper and less difficult, as language will easily be handled by AI, and the Internet combined will blockchains will facilitate many new business models which are global from the very start. The ability of a company to internationalize is an important criteria when choosing a dividend stock and if the company starts out global this can be an advantage.

Conclusion

In this chapter titled “dividend series” I outlined the investor psychology, explained what a dividend investor is, what the dividend aristocrats index is, some examples of dividend ETFs, and how to anylze dividend stocks. This basic outline and these explanations will be useful going forward for future reference. The next chapter will focus on high yield bonds, and will go allow the reader to learn more about how to build a balanced portfolio through diversification. Continue to the high yield bond series.

Financial_independence | Investing | Dividend_investing | How_to | Passive_income


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