Archive for year: 2011

One of the rules of stock investing is that you want to buy a stock at a good price. It’s important to make sure that you are getting a good deal. If you pay too much for a dividend stock – or any stock – it could come back to haunt you, especially if the value doesn’t appreciate as you would expect. An undervalued stock, though, can make a great addition to your portfolio.

An undervalued stock is one that has a price that is considered low as compared to its intrinsic value. This means that a stock might considered “worth” $50 a share, but that, on the market, it is priced at $30 a share. The stock is undervalued, since, if you take into account the possibility of future cash flow, and the growth of the company, it should be priced higher.

Unfortunately, it can be difficult to determine whether or not a dividend stock is undervalued. Just having a low price isn’t enough to say that a stock is undervalued. There are plenty of low-priced stocks that “deserve” those prices. They might be declining in value due to any number of issues, none of them related to the fact that the business is a solid one with good future potential. Buying a low-priced stock just because it is cheap can be one way to see losses down the road. A poor stock choice will continue to lose value, now matter how “bargain” the price appears now.

How Can You Tell if a Stock is Undervalued?

As with most subjects related to investing, there is no sure-fire way to ensure that you are purchasing an undervalued stock vs. a cheap stock. However, there are some clues that, combined, can help you figure out if a stock is undervalued:

• P/E ratio: The price to earnings ratio is a popular measure of stock value. The lower the number is, the better the valuation. So, a stock with a P/E ratio of 5 is better than one with a value of 10. However, you have to dig a little deeper. Why is the P/E ratio so favorable? If the P/E ratio comes as a result of a decline in profitability, or if it is realized through capital gains profits, the stock may not be undervalued after all.
• Good credit rating: While ratings agencies do have their weaknesses, a credit rating can be an indication of the financial health of a company. A company with a good credit rating, and/or low debt levels, could be undervalued.
• Stable earnings history: Many “boring” companies don’t always get the credit they deserve as solid investments. As a result, they might be priced lower than their value would suggest they should be. Look at the trailing three-year earnings, and whether they have risen, on average, over the last 10 years.
• Dividend payouts: You can also look at dividend payouts. Have they been steady over time? If so, it could be an indication of a strong company that is undervalued.

There is no way to guarantee that you are getting the best possible value when you invest in any dividend stock. But you can do your homework and increase the likelihood that you will buy an undervalued stock.

A number of dividend investors become somewhat impatient when building an income portfolio. And with fairly good reason. After all, building a solid income portfolio takes patience and time. In some cases, it might desirable to buy a large amount of stock in a dividend paying company because the price is low, or because you are hoping to kick start matters.

In such cases, some investors decide to borrow in order to invest. While this can be a good strategy – especially in an environment where interest rates are low – it’s important to be aware of the risks.

Advantages of Borrowing to Invest

Recently, The Dividend Guy wrote a post about using leverage to fund your investment purchases. It’s an interesting post about how you can borrow money to be able to make a move right now on solid stocks. You can boost your income portfolio, plus get good deals that are likely to appreciate in the future, providing you with bigger capital gains down the road.

Borrowing means that you don’t have to have the capital sitting in your bank account right now in order to purchase stocks. Plus, with interest rates so low right now, you can borrow at a low rate. Hopefully, your income from dividends, plus the appreciation of the stock, will result in returns that more than make up for the low interest you are paying on the loan. When you use leverage, in many cases you can boost your returns since you aren’t using your own money to make money.

Risks of Borrowing to Invest

Of course, there are risks associated with borrowing to invest. The biggest risk is that your decision will backfire, leading you to magnify your losses. If the stock crashes, you still owe the money, plus interest.

Even if the stock doesn’t crash, it might not gain as much as you expected. As a result, your gains can be reduced by the combination of inflation, taxes, and the interest you pay on the loan. So, even if you don’t lose big time, you could still find yourself without as much as you had imagined. There is a chance that you might have been better off using dollar cost averaging to slowly build a portfolio without paying interest on a loan.

Bottom Line

Leverage can help you magnify your gains – but it also magnifies losses. Before you decide to borrow to invest, consider the investments you want to make, and whether or not you are likely to see returns that will make up for the interest you pay on your loan. If you choose carefully, and get a low-rate loan, you should be able to maximize your investments. Make sure, though, that you will be able to handle the payments, and that you can absorb any losses that do come along.

Hope you have a great Thanksgiving (those of you in the U.S. — we know Canadian Thanksgiving is past). Here are a few blog posts from the past week to give you something to do in between turkey and Black Friday:

1. Implementing a Withdrawal Rate Strategy: Are you looking for a strategy to help you withdraw your money from your retirement account? Oblivious Investor looks at your options, and helps you figure out how to accomplish the best withdrawal strategy for you.
2. Understanding the P/E Ratio as a Valuation: For those who are looking for more valuation tools, you can use P/E ratio. The Dividend Pig takes a look at what the P/E ratio is, and how you can use it as you evaluate stocks.
3. When do you plan to be mortgage free?: The Passive Income Earner takes a look at the idea of becoming mortgage free. Do you have a goal to get rid of all of your debt? This might be a good post to check out.
4. It’s All About the Numbers – Part 2: The Balance Sheet: Dividend Ninja offers a post on how to read a company’s balance sheet. If you want to make the best possible decision when it comes to building your dividend portfolio, the balance sheet is important.
5. Uncommon Portfolio Diversification: Step outside the box when it comes to diversification. The Dividend Guy offers some great information diversification and asset allocation.
6. Dividend reinvestment and rebalancing is easier and cheaper with index funds: Monevator takes a look at how you can use index funds to rebalance and reinvest — without paying such high fees. A great help for those looking to change things up a lot, or tweak a little.
7. Ahead of the Herd with NioGold Mining: Beating The Index shares some ideas about NioGold Mining, and its potential. A information-packed post.

Income investors know about efficiency. They know that income comes from two sources: First, by making their money work as hard as it can and second, reduce commissions and taxes to their lowest possible level.

In the case of the latter, it’s a little more straightforward. Reduce your tax liability by holding on to our positions for at least one year and for long term investors, attempt to minimize your dividend payouts in your taxable accounts. For those with taxable brokerage accounts meant for long term growth, contributing the maximum to a traditional IRA and using that account for dividend names is worth considering.

Reducing expenses is easy compared to maximizing the work load of your money. Think of this illustration. A farmer who has 1,000 acres of land buys a high dollar tractor which will allow him to decrease the amount of workers he has to hire. That’s sounds like a great use of capital but what if he only used his new tractor on 500 of his 1,000 acres? Sounds a bit absurd, doesn’t it? It is, but investors do it with their money every day.

Here’s one example. If you have 100 shares of stock in a high volume, relatively low volatility company, you should be selling covered calls from time to time. There are plenty of articles explaining how covered calls work so we won’t dive too deeply in to the mechanics but if you have a stock that is currently towards the top of its range, consider selling a covered call against your 100 shares.

Let’s say that the stock is currently at $45 and that’s the high end of where it has traded. Why not sell a covered call with a strike price of $47? The worst case scenario is that by expiration the stock is above $47 and you are forced to sell the stock at $47. You made $200 plus the premium you collected when you sold the call. You could always buy the stock back or purchase another 100 shares if the stock goes significantly above the strike price.

Covered call options are a more complicated than simple stock buying but it pays to take the time to learn how they work. You won’t make extra money every month but even after paying short term capital gains taxes on the premium you collected, it’s still more money than what you had.

Another way to maximize gains, besides dividends, is to ask your broker if they have a program where they use your shares for lending to short sellers. Often, you will receive 20% to 50% of the lending fee and in most cases you’re not impacted in any way as long as you plan to hold the stock long term.

Bottom Line

Income investors shouldn’t use dividends as their sole source of revenue. There are other strategies that can be used to produce income with various degrees of risk. Of course it’s always advisable to have a paper account where you can practice these strategies before putting real money to work.