Investment Moats

5 steps to make the power of compounding work in dividend income investing

by 23 Comments

A question on many investors mind is that we always say that we invest because we want to make our money work harder. Working harder here is to make use of the power of compounding over time.

However, how do we relate this to dividend income investing? What are the things we need to watch out for? Today we will fit this into our action plan to compound dividends.

Power of compounding

Power of compounding over time in layman terms is to earn on an investment, put that earnings back into the investment or another investment to earn more and continue to do that.

If you invest $1000 in Singapore Press Holdings (SPH) and you invest in SPH knowing it will earn you $60 for a 6% yield per year.

If you take the $60 out of your portfolio to buy some other things you want, in 20 years you will earn:

$60 x 20 = $1200

Compare this to if you take all these dividend cash earned from SPH back into SPH, your returns will be $2399.56 (computations below)

End of YearAccumulated ValueReturnsReturn difference from principal
0$1000.00$1000.00 x 1.06 = $1060.00$60
1$1060.00$1060.00 x 1.06 =  $1123.60$123.60
2$1123.60$1123.60 x 1.06 =  $1191.06$191.06
3$1191.06$1191.06 x 1.06 = $1262.48$262.48
4$1262.48$1262.48 x 1.06 = $1338.23$338.23
5$1338.23$1338.23 x 1.06 = $1418.52$418.52
6$1418.52$1418.52 x 1.06 = $1503.63$503.63
7$1503.63$1503.63 x 1.06 = $1593.85$593.85
8$1593.85$1593.85 x 1.06 = $1689.48$689.48
9$1689.48$1689.48 x 1.06 = $1790.85$790.85
10$1790.85$1790.85 x 1.06 = $1898.30$898.30
11$1898.30$1898.30 x 1.06 = $2012.20$1012.20
12$2012.20$2012.20 x 1.06 = $2132.93$1132.93
13$2132.93$2132.93 x 1.06 = $2260.90$1260.90
14$2260.90$2260.90 x 1.06 = $2396.58$1396.58
15$2396.58$2396.58 x 1.06 = $2540.35$1540.35
16$2540.35$2540.35 x 1.06 = $2692.77$1692.77
17$2692.77$2692.77 x 1.06 = $2854.34$1854.34
18$2854.34$2854.34 x 1.06 = $3025.60$2025.60
19$3025.60$3025.60 x 1.06 = $3207.13$2207.13
20$3207.13$3207.13 x 1.06 = $3399.56$2399.56

 

However, it is even more crazy if you can consider that the 6% dividend grows at a conservative 2% per year. Instead of returning $2399 the return now is $3445 from the original capital. Your original yield on cost increases from 6% to 8.92%.

The lesson here: To make more money do not take your money out of your portfolio. Re-invest in it.

The important aspects of compounding in dividend income stock

Based on the compounding example above it is easy to see where are the flaws of this when we realistically talk about compounding of a dividend stock like SPH

Growth rate is important. Stock’s dividend yield do not grow consistently at 6%. Some bad years it may be 2%, some years it will give special dividend, thus your yield will be 12%.

Do not underestimate the importance of special dividends. This article shows you that special dividends, bonus shares and spin offs can determine a lot of the astronomical returns.

In some years they do not pay at all. In some years you may even lose money if the growth rate is negative!

Failure for stock to maintain or grow their dividend payout at the required growth rate could ultimately make this stock less appealing then another stock on the market.

Dividends are pay out of profits and cash flow. Many look at dividends at the be all end all but to pay out a sustainable dividends, the stock needs to be not just profitable but earning enough to pay for it.

At Investment Moats, we define a sustainable dividend payout either as a dividend payout less than free cash flow or net profit. [Explaining free cash flow and net profit >>]

A sustainable and growing free cash flow and net profit is important to the sustainability of a 6% dividend yield.

Choosing the right dividend stock is important. Many a time we buy a stock for its dividend only that it turns out to be a dud

  1. Unable to continue paying 6%. Some companies business model gets eroded by competition, substitutes that what used to enable them to be lucrative just ain’t that good anymore
  2. Take on more debts to pay dividends, which will eventually proof to be unsustainable. (Think Willas Array)
  3. Cook their books by using dividends to entice investors only the cash to pay dividends is not there at all (Think fraudulent S-Chips)

It is important to evaluate the business of a dividend stock to see whether it can continue to pay the dividends that you require. To guard against fraudulent risks or imperfect knowledge holding a portfolio of dividend stocks is important rather than concentrate on 1 or 2 stocks.

Your Action Plan to Compounding Dividends

Taking into considerations the important aspects mentioned, how should you go about compounding through dividend investing?

To put it simply, put the following widgets into your action plan:

  1. Identify a list of reliable dividend paying stocks. Know their economic moat, strength and weakness, their risks and their profit and cash flow sustainability and growth capability.
  2. From this list, evaluate which of them are beaten down or presents a good value proposition.
  3. Invest a comfortable amount of your “Investment Warchest” into them.
  4. Collect your dividends, capital returns and together with your additional savings set aside for investments, put it into an “Investment Warchest”.
  5. Periodically review Step 1 and 2 and invest your “Investment Warchest” or prune your existing holdings.

1. Identify a list of reliable dividend paying stocks

To reinforce and to guard against what was outlined in the importance aspects of compounding in dividend income stock, always treat it as an exercise to understand the companies you currently invest in, do want to invest in, or do not want to invest in.

Understand their

  1. Economic moat. What makes this business a better business then the rest. What is the edge of this business model.
  2. Strength and Weakness. How it measures up versus its competition or why this business is not good to invest in.
  3. Sustainability of profit and cash flow. Is the cash flow growing? Can it sustain the dividend payout? Is this huge cash flow a one time event? Is this loss a one time event?
  4. Risks to operability and going concern. Can this company pay off its debts? Is it holding too much debts? Does the company have a law-suit or major impairment that would impede profitability currently or in the long term. Can it get its loans refinance?

2. Evaluate the value proposition

Its important to know how the business or how the stock generates the dividends. However, it doesn’t mean a good company is a good investment.

Total access communication which I identified in June this year was paying a dividend yield of 9% in March 2011. Buying the stock then would be a great proposition.

Since I identified it late and was waiting for it to come down it has ran up almost 50%. The current yield now is only 5%.

9% versus the average REITs listed on my Dividend Stock Tracker is great, but 5%? I think we can spot many better stocks with higher yields.

Of course dividend yield versus the prevailing market dividend yield is only 1 metric. It is a long topic which we will discuss more in the future and this goes hand in hand with Step 1, which is very important for this step.

Ultimately we hope to uncover fifty-cent dollar. This means that you get to buy 1 dollar for only fifty-cent.

3. Invest a comfortable amount of your “Investment Warchest”

I like to term my cash holdings set aside for investing as my “Investment Warchest”. To guard against things you cannot control, it is advisable to not concentrate your initial buying all at once and in only 1 or 2 stocks.

While step 1 and 2 when done right can weed out the duds, ultimately there are certain businesses that cook their books so well that even the pro analyst who are in constant contact with management cannot see it.

In some other cases, they are not fruadulent, their models are just breaking down. When you review it, your portfolio is already down a lot. Diversification ensures that it is not a sizeable chunk.

The key here is also not to over-diversify, such that it takes too much effort to monitor them. You are not a full time investor with the time to do that. I suggest not more than 20 stocks. Use Step 5 to prune when you have to.

4. Collect dividends, savings and add to “Investment Warchest”

The problem with starting small is that your dividends might not allow you to re-invest readily. Imagine your dividends from SPH being only $120. What can you buy with that?

The key is to pool your dividends together. That way you can invest in a stock that enables you to put your money back to work.

Now, most likely as part of a sound financial plan you will pay yourself first and set aside money for wealth accumulation and preservation. Collect them in this “Investment Warchest” as well.

5. Review Step 1 and 2. Continue to invest and prune your portfolio

Step 5 is the recurring step. It is also the one that demands you to be discipline and industrious. You are not going to collect dividends only for 1 month but through out the year and for many years.

Every month you will add savings to your “Investment Warchest”, you will need to put it to work as well.

To re-invest that, and the rest of the cash in your “Investment Warchest”, you will have to consistently take a look at prospective stocks and the stocks you own.

  1. Most of your holdings may hum along nicely.
  2. Some of them may have grown well.
  3. Some of them may be in trouble for a while or for a foreseeable future.
  4. There may be great stocks that suddenly appear to be at great prices

The important thing is to weed out those that are in (3). If they have fallen but you know their business is strong and it’s a short term problem, your next investment prospect could be this.

Those in (1) may still look very valuable even if they had grown with the general market. Some checkmarks here is compare to other stocks on your prospective list, they appear to be of higher value then the others.

In contrast, there could be those bargain dividend stocks in recession or sharp corrections that you want to buy but they were at $1. Now you get to buy them at $0.80 or $0.50.

The key is to develop investing, valuation and portfolio management as a lifelong hobby.

Conclusion

I hope that I have highlight to you folks how compounding in dividend investing comes into play. There are some caveats to it compare to what we normally know like bank interest rate and bond interest rate. This happens because stocks do fall or rise in value. Compounding is not so visible.

As such the key is for cash flow of the stocks to grow and re-investment. I hope that through my five step plan it makes it simple for you guys.

Do let me know if you have any questions.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.

China Merchant Pacific (CMHP): Dividend yield on track

by 9 Comments

We profiled and introduce SGX listed chinese toll road operator China Merchant Pacific (CMHP) recently stating that this could become a good dividend income stock. [Analysis >>]

This week its Q3 2011 report was out. Specifically, they had a major acquisition and so we have speculated that it can pay out a good 8-9% dividend income annually on a 50-60% net profit payout.

[SGX Q3 2011 Results >>]

CMHP pay out SGD 0.045 in 2011 and at current share price of SGD 0.60 that works out to a 7.5% yield. The guidance for 2012 onwards is to pay out SGD 0.055 which comes up to a 9.1% yield on 50-60% payout.

Profit Composition Analysis

We have the maiden contribution from Yongtaiwen expressway (51% owned by CMHP)

In an additional information summary, CMHP showed the figures for its underlying assets.

  1. Traffic was up for all 4 toll roads QOQ and YOY.
  2. The greatest traffic growth being Guihuang and Yuyao.

Here is the profit contribution break down by toll roads

  1. Yuyao although there are traffic growth but profit was down 15% due to higher direct expenses.
  2. You can see how important Guihuang was to CMHP as it is this toll road that provides the biggest profit contribution. It should be noted that currently CMHP receives 100% of Guihuang’s profit contribution which will revert to its 60% share of the joint entity in 2014. We want to see this continue to grow as after 2014 we should see profit of Guihuang go down by 40%.
  3. The maiden contribution from Yongtaiwen was inline and gives CMHP a huge income boost. Yongtaiwen have thus become CMHP’s most important profit contributor.
  4. 2010 profits was boosted by the disposal of Luomei expressway to the tune of HKD 40 mil. Without this, this years result will see a more significant improvement from 2010.

Question: How much have Guiliu and Guihuang grown since 2004? What is the expected growth rate of Yongtaiwen?

 

The thing about toll roads is that they grow as the population, affluence and trade between inter joining places increase. We have seen substantial growth in both Guiliu and Guihuang.

The annualized growth rate for Guiliu and Guihuang’s traffic since 2004 was 7%. Do I expect it to continue growing? It depends. There is only this much traffic the roads will be able to take and at some point growth has to taper off.

But the surprising thing is that Guihuang is on track to grow massively this year on estimation from 3 quarters.

In comparison, Yongtaiwen’s traffic does not seem to change much since 2010. I suspect CMHP bought into a very mature toll road that have already grown quite a fair bit.

Question: How will full year 2011 profit contribution from toll roads look?

We use a 7% annualized growth rate for both Guiliu and Guihuang and a conservative 2% annualized growth rate for Yongtaiwen.

Since Yongtaiwen will only contribute 2 quarters, the estimated total profit contribution for 2011 will be 94+175+146 + 22 (Yuyao not on table above) = 437 mil

Question: How will full year 2012 profit contribution from toll roads look?

With a full year of contribution from Yongtaiwen with the same annualized growth rate, the estimated total profit contribution will be 100 + 187 + 297 + 20 (Yuyao not on table above) = 604 mil

Question: How will full year 2015 profit contribution from toll roads look?

In 2015, Guihuang will contribute 60% instead of 100%. We do expect that perhaps, Yuyao will be sold. There could be further acquisitions to augment the earnings.

But lets assume Yuyao is still around but declining at 10% per year.

The total profit contribution from toll roads will be 122 + 137 + 315 + 14 = 588 mil

Possible dilution

The current outstanding number of shares is 718 mil. CMHP additionally have 135 mil redeemable convertible preference shares (RCPS).

Should these be converted it may mean a possible 19% share dilution. How this will impact current share holders is that current share of earnings and dividends will be diluted.

CMHP is likely to convert in the future should they need to free up cash to make further acquisitions.

The total enlarged (diluted) number of shares is therefore 854 mil.

Interest Expense

CMHP was previously unleveraged, but with the purchase of Yongtaiwen they will be taking on HKD 1.4 bil in debt.

I enquired and got wind that the likely interest rate for the debt will be around 3%-4%.

This will work out to an annual interest expense of 1400 * 0.04 = 56 mil per year.

Dividend Sustainability

In the past CMHP have paid out 4 amounts of dividends, SGD 0.04, 0.045, 0.05, 0.055. The guidance is SGD 0.055 for next year.

Based on existing number of shares of 718 mil, to pay out these dividends, CMPacific will need at least

  • 0.04: 176 mil (current yield based on SGD 0.60):  6.66%
  • 0.045: 198 mil (7.5%)
  • 0.05: 220 mil  (8.3%)
  • 0.055: 242 mil (9.1%)

Should we estimate based on dilution, where all RCPS be converted, CMHP will need at least

  • 0.04: 209 mil
  • 0.045: 235 mil
  • 0.05: 261 mil
  • 0.055: 287 mil

All other things being equal, we are concern about 3 different profitability period, FY2011, FY2012 and FY2015.

Taking our previous profit from toll roads contribution above deducting interest expense from debt servicing

  • FY2011: 437 – 56 = 381 mil
  • FY2012: 604 – 56 = 548 mil
  • FY2015: 588 – 56 = 532 mil

Safe to say whether it is diluted or not diluted, CMHP will be able to pay out any of those dividends. The question is how much will be paid out.

We know that CMHP do not pay out 100% as dividends. I am supportive of this policy if

  • Cash is used to make accretive acquisition
  • Cash is used to pay down debt
  • Capital Replacement. Do note that toll roads have a concession and are thus self-liquidating assets so you have to build up capital to buy more toll roads or renew existing toll roads
    Based on undiluted number of shares (718 mil), the earnings yield is
  • FY2011: 381 mil / (718 * 0.60 * 6.13) = 14%
  • FY2012: 548 mil / (718 * 0.60 * 6.13) = 20%
  • FY2015: 532 mil / (718 * 0.60 * 6.13) = 20%

Diluted number of shares (854 mil), should CMHP convert the shares tomorrow at SGD0.60, the earnings yield is

  • FY2011: 381 mil / (854 * 0.60 * 6.13) = 12%
  • FY2012: 548 mil / (854 * 0.60 * 6.13) = 17.4%
  • FY2015: 532 mil / (854 * 0.60 * 6.13) = 16.9%
    If we estimate that CMHP pays out  55% of their earnings and keep 45% as retained earnings, CMHP will be able to pay out
  • FY2011: 381 mil * 55% = 209 mil
  • FY2012: 548 mil * 55% = 301 mil
  • FY2015: 532 mil * 55% = 292 mil

We can conclude that all assumptions taken into consideration, CMHP can probably cover

  • FY2011: undiluted dividend of SGD 0.045 and diluted dividend of SGD 0.04
  • FY2012: undiluted dividend of SGD 0.055 and diluted dividend of SGD 0.055
  • FY2015: undiluted dividend of SGD 0.055 and diluted dividend of SGD 0.055

That works out to a pretty good 7.5% yield for FY2011 and anywhere between a 9.1% yield for FY2012 and FY2015 should you buy it now at SGD 0.60.As usual the devil is in the detail. The assumptions are:

  • Guiliu and Guihuang no impairment. Annualized growth rate at 7%
  • Yongtaiwen no impairment. Annualized growth rate at 2%
  • Yuyao not sold. Annualized growth rate at –10%
  • No acquistions

Servicing the HKD 1.4 bil of debt

Some how or rather, the debts on the balance sheet will need to be cleared.

Assuming FY2012 CMHP retained 45% of profits, CMHP will be able to use 246 mil to clear its debt.

That would mean they can clear the debt in 5.6 years.

Alternatively, should share price trade above NAV, they can choose to do a rights issue to convert the debt to equity.

Debt on underlying toll roads

A worry from my past experience with MIIF is that the underlying assets are heavily funded by debt and could be a problem during periods where refinance is an issue.

For CMHP, only the recent acquisition have debts. The other 3 do not. The current profile is that Yongtaiwen have 500 mil in cash and 1.7 bil in interest bearing debt.

Based on the interest expense, we estimate the interest rate to be around 5.8%

Since there is depreciation accounted under Yongtaiwen, it is safe to say that this depreciation can be used to pay down the debts.

The profit we compute should be net of this depreciation and based on the third quarter reported Amortization of intangible assets, this amounts to a full year depreciation of possibly 62 mil * 4 = 248 mil.

To clear the net debt of 1.2 bil, Yongtaiwen could probably take 4.8 years to clear it.

Conclusion

All in all we are pretty satisfied with this results. I wouldn’t say this is a solid yield stock but toll roads are pretty defensive. It is even better if its not very levered and we can see the underlying assets have the ability to pay down debts.

A 55% payout is good for a company with many self-liquidating assets. It allows for rejuvenation provided the 45% retained is put into good use.

The caveat is always the growth or impairment of the underlying assets. We have to be aware that like all infrastructures there run the risk of major natural disaster catastrophe.

This asset in the long run I am expecting it to yield like First REIT which is around the 8% to 9% region. It has the same geographical risks yet with a defensiveness during recession.

Currently invested with a small position, but I was hoping to collect it cheaper but it didn’t even drop back to the SGD 0.46 level. I have a feeling that it will trend back to NAV of SGD 0.80.

The future growth comes with more acquisition and the caveat is to monitor to see if the assets are quality and not an asset dumping exercise from parent CMH.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.

Quick Take on Pertama Holding:Delisting Fails

by 4 Comments

We mention this great stock called Pertama Holdings that runs the Harvey Norman chain in the past [Analysis here >>]. First spotted at 47 cents, its majority share holder Harvey Norman Group wants to take it off the market. However it looks like they have failed in their effort.

  1. Harvey Norman Group raise their stake to a formidable 83.15%
  2. The recent purchase was done at 65 cents.
  3. Proposed delisting of Pertama was shot down at an EGM.
  4. Under SGX rules, the controlling shareholders of PErtama were not required to abstain from voting. The largest minority investor in Pertama is US based fund management Fidelity International, which holds over 22 million shares, or 9.1% of the company. The exit offer lapsed on Sept 26.
  5. Pertama Shares advance as much as 75 cents on the back of a special 1.4 cents special dividend.
  6. Revenues remain strong growing at 5.6% and a 32.5% rise in profits.
  7. NAV is at $107 mil or 44 cents per share.
  8. Based on current DPU of 6.4 cents which includes a special dividend of 1.4 cents, the yield is 9.84%
  9. A more reasonable estimate is 5 cents, which will yield 7.7%

Quick take from recent 2011 Annual Report

  • Latest outstanding number of shares is 242 mil
  • Gross Profits grew 17%. This shows growth in core business
  • Inventories, Receivables stayed the same while Payables were higher. This indicates a good maintenance of cash conversion cycle [Definition here >>]
  • Cash holdings remains steady at 78 mil. But it is likely it will be down owing to this 1.4 cents of special dividend payout
  • A 1.4 cents additional payout should drain 3.38 mil from this cash holdings
  • Zero debts
  • Free Cash Flow improve from 7 mil to 11 mil
  • Out of Free Cash Flow, 12 mil was paid as dividends (2011). This is higher than free cash flow but still within acceptable limits
  • Compare to 2010 where on a free cash flow of 7 mil they paid out 5.8 mil in dividends.This should be equivalent to 2.4 cents in div. At 65 cents, the yield is 3.7%
  • Since 2007, Pertama have been paying out 2.4 cents in div for the 3 years before the ramp up
  • The main growth area was the contribution in Malaysia which went up from 1.3 mil in gross profit to 5 mil in gross profit. Singapore profits stayed largely consistent

For investors hunting for yield, I missed out entirely on this because I though I could get it cheaper. The buy up from the owner have indicated they value Pertama at 65 cents. Obviously Fidelity International likes the business a lot and think it could be value at more.

This stock is very very very illiquid so you may be trap in this stock should you get invested and not exit at a price you want. That said it may mean the stock will hold up well in these volatile times.

For investors like me,

  1. We want to see that since this recent developments, whether the earnings are due to very favorable demand that will not be repeated.
  2. Whether the potential to grow even more is there. What will be the key drivers.
  3. A DPU of 5 cents on current share price looks a good yield.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.

Quick Take on HPH Trust: Analysts touting 9% yield

by Leave a Comment

We did an article some time back on HPH Trust. [Analysis here >>] Since then the price went down to a low of 59 cents and came back up at 68 cents. Why is this stock continue to be weak? Analyst are still thinking that there is a good risk versus reward for this.

  1. The general consensus during IPO was that HPH will grow 8.5% in 2011 and 8.4 in 2012. Turns out instead of growing based on GDP growth, volume have fell 4.6% instead.
  2. DMG Analyst think that the port assets owned by HPH are relatively mature and unlikely to deliver much more than single digit growth even if economic situation improve.
  3. CITI Analyst says the original estimate DPU was 5.9 US cents (45.88 HK cents) for 2011 and 6.59 US Cents (51.24 HK cents) for 2012 could be in jeopardy. He estimate that it may be 34 HK cents and 45 HK cents instead.
  4. CITI Analyst thinks HPH relatively expensive at 20 times earnings versus Cosco Pacific and China Merchant International Holdings.
  5. Analyst have indicated that the problem for HPH is that volume and export slowdown cannot be anticipated easily.
  6. Several trustee manager believe that the stock price have factor in a lot of the bad news.
  7. Analyst think that the support is at 60 US cents. They are forecasting DPU of 5.5 US cents for 2011 and 5.9 US cents for 2012.  That’s 8% and 8.6% yield based on share price of 68 US cents.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.