Dividend Investing Safety Buffer
John McGuinness who holds the current TT lap record at an average speed of over 129mph, reported to the BBC. “On Bray Hill, you go from 0-180mph down a straight. On a normal road elsewhere, you would immediately go to jail or kill yourself. It looks ridiculously fast and mental and insane, 200mph on a road looks like absolute madness. But I leave a little bit, my safety buffer.”
Investing though certainly not implying any of the physical risks of the TT does by its very nature carry financial risk. Actively managing the downside risk against various return expectations is vital. Just as John McGuinness leaves a “safety buffer” when riding in the TT, in the words of Benjamin Graham the founder of value investing, an investor should build in a “margin of safety” when seeking investment opportunities.
A “margin of safety” in the context of value investing refers to the difference between the price a security can be purchased and its intrinsic value. Where the intrinsic value is a value assigned to a security in accordance with your analysis. Value based investors will use a variety of indicators such as the PE ratio, price-to-book, replacement value or dividend yield, in order to ascertain a securities intrinsic value. However, the application of these metrics is only a reliable approach if the metrics you base your model are at worst stable, where ideally the move in your direction.
Dividends offer such a metric and as a source of return are historically much more predictable than capital growth. Capital growth depends on the behavior of other market participants, but dividends depend solely on cash flow and company policy. Executives will generally lean on the side of caution when deciding on the dividend level to ensure that they can be reliably paid and reliably increased. The most likely reason for this is that any dividend cut generally results in senior management being relieved of their posts.
In the main dividends are reliable and consistently increased but even in the most difficult operating environments the exhibit exceptional defensive qualities. For example, in the 2000-2003 bear market when earnings collapsed, the FTSE All-Share index dropped around 50 per cent the aggregate dividend yield only dropped 7 per cent.
For these reasons, the valuation metric of dividend yield and the associated dividend investing strategy where one buys into stocks with a high and sustainable dividend yield is an approach offers a generous “margin of safety”.
Just as John McGuinness’s “safety buffer” does not prevent him from setting lap records, dividend investing with its “margin of safety” does not exclude the possibility of obtaining exceptional returns. Which leads us to next weeks column where I will detail a ‘dividend investment’ I have just exited which provided a return over the one year holding period of almost exactly 50 per cent.