For The Contrarian Investor

If you are the type of investor who likes to "go-it-alone" as opposed to "running with the herd," then you may find much to interest you in several Web sites that are specifically geared toward the independent-minded investor.

Contrarian Investing Association is an independent network of contrarian investors who all participate in the upkeep of the site. Members are encouraged to post commentary and articles they find interesting as well as discuss their current stock holdings and those they are considering for future purchase. Basic membership is free with registration.

The site also allows members to post their own stock tips and ideas as well as read others' suggestions. Members can discuss these ideas via a message board. Lists of articles posted by other members can be accessed as well as a monthly update with commentary, market news and an article of the month.


Bearmarketcentral.com is a site devoted to bear-market-minded investors and supports a contrarian investing style. Periodically, an updated commentary is posted on the home page that discusses the current market in relation to the bear market philosophy. Archived commentaries are available as well.

The site's Bear Cub section offers a free financial education center presented by Online Trading Academy that is geared toward individual investors of all skill and knowledge levels. Links to useful Web sites and answers to commonly asked bearish investing questions are given as well. The site also offers links to bearish and contrarian investing articles and commentary, free quotes and charts, and related books. The "Fotley Mule" offers daily jokes and cartoons poking fun at contrarian and bearish investors.


Contra the Herd calls itself "an information service for independent individual investors." The site gives its stock-picking philosophy which includes statements like, "concentrate on turnaround situations and stocks that are currently unpopular but are likely to regain their luster in the near future" and "analyze management's ability to achieve stated goals."

Subscribers have access to buy and sell information while non-subscribers can learn only about the sells. When a stock is bought or sold, subscribers receive an E-mail or a fax with the necessary information. Contra the Heard is a 16-to-20-page newsletter that includes a commentary on the market and analyzes portfolio performance; it is published quarterly.


PrudentBear.com offers up-to-date market commentary and news as well as articles, presentations and arguments for a current bear market. Commentaries are updated almost daily. Current news is broken into sections that include market movers, the economy and the Federal Reserve, market and finance, company and industry, and international.

The Bear Case section offers a slideshow presentation called "A Bear Tour," which explains why investors should take a long-term bearish stance in the market. The site also includes a mutual fund section that shows performance data and other information on mutual funds in the Prudent Bear family. Access to the site is free.

You can find these contrarian sites listed in our "Links" section.

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Investing Terms You Should Know!

Financial Hedges

Like their trimmed namesakes that surround your home, financial hedges serve as protection - not from prowlers, but against losses and potential losses in your portfolio. The term hedge was originally adopted by the financial world in the 1600s. It has come to refer to investors protecting themselves, or hedging, by acquiring stock options or other instruments that bet on movement contrary to their core strategy. In other words, when an investor purchases stocks he wants to go up, the investor can hedge by obtaining options that allow him to profit if prices go down. Though in theory it seems a pretty simple, even logical way to cover your bets, buying into hedge funds isn't necessarily safe, since they often engage in speculative investing.


Bubble

When investors put money into instruments based more on hope than sound business practice, their gains may disappear as quickly as a soap bubble. And that's the basis for the contemporary definition of bubble, used to describe a market whose sentiment has little to do with economic or business reality. In the 1700s, "to bubble" meant "to cheat," but recently it has been given its less base, though no less ominous, meaning. Today, analysts are concerned about a bubble that has driven the stock market to record highs, despite the Fed's belief that earnings aren't strong enough to support such values. If corporate profits don't meet expectations, the market may drop sharply - bursting the bubble, and slowing the longest peacetime expansion in history.


Bulls & Bears

Even those who infrequently follow stocks know that a bull is a market optimist and a bear expects prices to soon head south. So the statue of a bull on Wall Street in Manhattan could well be seen as a monument to the financial markets' enduring optimism. Perhaps because history shows that up markets outpace down markets, no bear statues are in sight. In any case, these most famous of financial terms derive from an 18th-century English proverb that warned against "selling the bearskin before catching the bear." That referred to hunters who collected their fees before setting out into the wilderness, then died before delivering the goods. As for bull, it may have been paired with bear simply because of the ancient sports of "bear and bull baiting." Those popular matchups, combined with the bull's aggressive nature, made it a label for the bear's opposite: an investor who sees prices rising.

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An Investor's Best Friend

One of the best tools available to every investor is the SEC's Website (found in our list of Links). At this Website, an investor can obtain a wealth of free information on any publicly traded company.

One document that you should always review when considering a stock is the firm's 10-K report. This report, provided in conjunction with the firm's annual report each year, provides a wealth of information on a company.

The 10-K is especially useful in providing background information on the company's business. The 10-K also contains all financial statements and, more importantly, the footnotes to the financial statements.

A company's 10-K is must reading before investing in any company. That's because by reading a 10-K, you will develop a much stronger impression about a particular company. You'll also remove a lot of the guesswork that goes with picking stocks. And you'll have stronger conviction in your opinion.

In short, you'll make much smarter investment decisions.

You can depend on the fact that spending time with this 10-K document will help you become a better investor!

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Three Questions That Count

Note: This is taken from an article by Kenneth L. Fisher appearing in the October 17, 2005 edition of Forbes magazine.


You want to maximize your chances of getting good results from stock picking? Here is a system, and it boils down to focusing on just three big questions. They aren't what you might expect - like questions about the market's price/earnings ratio or interest rate forecasts. Rather, they have to do with your own psyche. Overcome your psychological failings and you can be a better investor.

First question: What do you believe is true that's actually wrong? If you are captivated by some market myth, other investors probably are, too. Figure out what that popular but wrongheaded belief is and you can disassociate yourself from it. You can bet against it.

Example: Most investors believe that years when the market is trading at a high multiple of its collective earnings are bad years in which to invest and low-P/E market years are good times. This popular belief is contradicted by the evidence. Yes, there are some high-P/E years that turned out to be disasters (2000 and 2001, for example). But there are just as many occasions when buying into a high-P/E market was the right thing to do, for example 1932, 1998 and 2003.

So when you see folks freaked out by high-P/E markets, you can bet against them. You know something they don't know. You can invest knowing the market P/E is irrelevant. (And it should be.)

Question two: Can you fathom the unfathomable? If you have the right instinct for turning market statistics into buy-and-sell signals, you seek correlations first, then causal relationships that would explain them.

For example, the main force driving cycles when growth stocks do well versus value is time-lagged shifts in the yield curve. The yield curve plots the yield on Treasury notes and bonds against their maturity dates. The historical pattern has been this: About 9 to 12 months after the yield curve gets flat, growth stocks start beating value stocks, and they continue to beat value until the curve gets very steep again. The causal relationship is very simple. A flat yield curve reflects a reluctance of banks to lend to commercial borrowers. And value stocks are very borrowing-dependent, while growth stocks aren't.

At the moment (October 17, 2005) the yield curve has gone close to flat - the yield on ten-year Treasurys, 4.1%, is not much more than the yield on two-year Treasurys, 3.9%. So mid-2006 is the time to prefer growth to value.

Question three: What is your blind spot? Investors suffer from self-blinding psychological traits like confirmation bias and reframing; fear of heights, myopia, and Stone Age hardwired thinking. It takes time and effort, but you can learn. For example, if you are myopic and suffer confirmation bias, you are a trend-follower and will miss upcoming changes like the capital expenditure and agricultural booms starting in 2006.

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Emotional Investing

Are you a bull or a bear? A tortoise or a hare? Your answer is not as important as how you arrived at it. The investment world's biggest divide these days is between two competing interpretations of reality: the efficient market theory and behavioral finance. The University of Chicago is home to two of the most distinguished champions of these beliefs: Eugene Fama for the efficient market approach and Richard Thaler for behavioral finance.

Efficiency theorists argue that markets are completely rational and stocks are priced to reflect all information known to investors. If there's a piece of news about a stock, investors will act promptly and adjust the share price. If the market is efficient, you can't beat it. At least not consistently and over a long span of time. The only exception is small and mid-cap stocks that are generally less followed.

But while the market efficiency theory is useful, it doesn't convey the whole story of how people invest. Human emotions, such as fear and greed, drive investor decisions. Behaviorists hold up studies showing that the cheap shares, those with low price/earnings ratios, beat expensive (high price/earnings) offerings, over time. Value trumps growth, in other words. If share prices are completely rational, then how can one type of stock outperform another?

Behavioral academics cite the 'madness-of-crowds' phenomenon by pointing out the fact that most people make the same mistakes over and over. The most prevalent one is to pile in at the peak with everyone else. Since fitting in is easier than sticking out, investors tend to flock together even when the results turn out bad.

Harvard professor Jeremy Stein explored the complexities of behavioral science, and he explored a behavioral quirk known as the "recency effect." That's when people overweight current information and assume that the future will follow the present. So they buy what's hot and they avoid what's not.

Another behavioral quirk is overconfidence. A word to the wise: People rarely know as much as they think - creating still more price inefficiency.

Behavioral finance substantiates many of the core tenets of value investing - chief among these is buying great businesses when they are out of favor and selling below their intrinsic worth.

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Blogging For Dollars

The Blogosphere provides a feast of investment Web sites - some of them are quite good while others may be only half-baked. Here, we've identified some of the most worthwhile investing blogs that you can find in our "Links" listing. And to make them easier to spot, I have set each one apart by placing an asterisk (*) at both ends of the respective names. Now here are a few words about some of them"

*Accounting Observer* - this is a respected research service aimed at serious investors. The author blogs about accounting topics in the news such as the financial restatements of Health South or the woes of public pension funds. The sophisticated analysis can be dense for casual readers, but is top-notch.

*The Asset Allocator* - Packed with links, charts, cartoons, and pithy comments about the markets and economy, this site is fun, newsy, and entertaining. The author doesn't offer much concrete investing advice, but his site does link to some of the best blogs.

*The Big Picture* - This author mixes technical analysis with macroeconomics to come up with some insightful calls on the direction of the stock market.

*Footnoted.org* - This author scours through SEC filings to find juicy items like relatives on a company's payroll, how often execs are using the company jet, and many otherwise hidden tidbits. You can search by company, plus there is a "cheat sheet" for interpreting filings.

*Free Money Finance* - This Blog offers an inspiring mix of timeless investing wisdom and money-making ideas.

*The Kirk Report* - Here is where an individual investor chronicles his stock trades from his living room in a small Minnesota town. He provides market and economic commentary as well as "Random Thoughts & Readings," packed with interesting links. Many Wall Street pros check out what he has to say.

*Random Roger* - This author writes a few posts a day about investing strategies, with emphasis on asset allocation, foreign stocks, exchange-traded funds, and options.

*The Wealthy Blogger* - Written by a two man team, who say they started this Blog to teach people how to get out of debt, plan their futures and eventually become millionaires. They also run stock contests and discuss ways to reduce debt.

So there in brief is a glimpse into some of the interesting WeBlogs that can be found with just a tiny effort. I hope that you can learn something of value by checking out several of these sites.

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Thoughts of Chairman Buffett

ON STICKING WITH WHAT YOU KNOW

"Invest within your circle of competence. It's not how big the circle is that counts, it's how well you define the parameters."

-Warren Buffett

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How Your Money Builds A Business

Smart business owners commit their capital only to projects that promise to sweeten their bottom lines. Smart shareholders can do the same, by buying only into companies that use their equity efficiently in order to grow earnings.

The measure of how effectively a company deploys its shareholders' money is its return on equity (ROE). Return on Equity = net income divided by shareholder equity, and it reflects the success of management decisions about issues like pricing strategies, asset purchases, and capital structure.

The art of this investing approach lies in selecting the companies that will continue or increase their efficient use of shareholders' equity. And your homework as an investor involves getting convictions that the companies you have selected can sustain those numbers.

But how do you know that they can? One way is to look at the numbers behind the numbers. For an idea of where a company's ROE growth is coming from, analysts often factor that ratio (net income/equity) as the product of three other ratios: profit margin (net income/sales) x asset turnover (sales/assets) x financial leverage (assets/equity). This works both mathematically and financially, tying ROE not just to a company's net income and equity but also to other elements of its balance sheet (assets), and income statement (sales).

Profit margin is the percent of each dollar of sales the company actually ends up with. The more money it can get for its products relative to the cost of making them, the higher its margin will be and the better its prospects of continued growth. However, product pricing depends on how much competition the company faces in its market segment now and in the future.

A firm's asset turnover indicates how efficiently it uses its assets. As with profit margin, higher is better. But you have to look at a company's ratio relative to its industry norm, since businesses that require more capital investment will generally generate lower turnovers. Financial leverage tells you how much debt a company has on its books. Keep it low. Some debt can fuel growth; too much may stunt it in tough times.

With all these ratios, focus on trends rather than on the most recent figures, and dig for explanations beyond the financial statements. Accepted accounting principles allow great leeway in reporting the numbers, and the rules are subject to change, which affects consistency. Mergers and write-offs can also throw a monkey wrench into your analysis.

To interpret the figures you find, study the people responsible for them. Read management's discussion and analysis in the annual report, and go back a couple of years to check for consistent focus, because some managements seems to crank out a new set of goals each year.

Those companies that have used equity well in the past, despite industry changes and business cycles, have good odds for continued success in the future!

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Investing Hall of Fame

Hard work, shrewd judgment, self-discipline, and the belief that excellent investments are to be had overseas have made Sir John Marks Templeton a great investor, while optimism and a deep faith have made him one of the most generous philanthropists of our time.

Templeton learned thrift and enterprise early. Growing up at the turn of the century in Winchester, Tennessee, he started his own business at the age of four, growing beans in a corner of his mother's garden and selling them at the local store. As a teenager, Templeton and a group of friends bought two dilapidated Fords for $10 each and combined their parts into one operating vehicle.

Templeton's approach to investing was just as practical. He honed bargain hunting and stock picking to a science, and devoted every available moment to the research of companies and industries. His search for good buys was what led him to international stocks, the area that he pioneered. Personally, Templeton was so thrifty that in 1969 he moved to the Bahamas, renounced his U.S. citizenship, and became a British subject - all to avoid paying taxes.

Still, his 15 rules for investing are tried and true, to this day. Among them: "Buy low. So simple in concept, so difficult in execution. When prices are high, a lot of investors are buying a lot of stocks. Prices are low when demand is low. Investors have pulled back, people are discouraged and pessimistic. But if you buy the same securities everyone else is buying, you'll have the same results as everyone else. By definition, you can't outperform the market."

His value approach proved quite successful. If dividends were reinvested, an initial investment of $10,000 made when he founded the Templeton Growth Fund in 1954 was worth $3 million - much of that made by investing in unfashionable foreign markets - when the fund was sold to Franklin Resources in 1992.

In 1984, he endowed Templeton College at Oxford University (which he attended as a Rhodes scholar); the graduate program focuses on international business and management.

In 1987, he founded the Templeton Foundation "to encourage a fresh appreciation of the critical importance - for all peoples and cultures - of the moral and spiritual dimensions of life." The Foundation awards grants to researchers studying religious or spiritual subjects, publishing books and newsletters, and cohosts conferences with medical institutions. The Foundation also oversees the Templeton Prize for Progress in Religion, which has been given annually since 1973 to a living person who has deepened the world's understanding of God, spiritual life, and service. The cash part of the prize is greater than that of the Nobel Prize.

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Watch That DRIP!

Dividend Reinvestment Plans, or DRIPs, are a great way to build wealth. They allow you to use the quarterly payments to acquire more shares in a company, and odd amounts are no problem since the plans buy fractional shares. But before you buy, be sure to look at the details. Of the roughly 1,100 DRIPs, approximately half of them charge fees to invest the dividend, and they can be deceptively steep.

The biggest offenders are direct purchase plans, a type of DRIP that lets you invest in a company even if you don't already own any shares. Most charge 1% to 5% of the value of the investment, and sometimes a per-share fee to cover brokerage costs. IBM's direct purchase plan levies 2%, up to a maximum of $3. Campbell Soup and FedEx both add on a 5% reinvestment fee, up to $3 - plus commissions. That can add up, especially on small accounts.

Fees up to 2% are acceptable, but if you already own stock in a high-fee plan, you would be better advised to take the cash and divert it into another DRIP with lower, or better yet, no fees. Spending $5 to invest $100 in dividends is no way to get rich!

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Investment Terms That You Should Understand

Blue Chip Stock

This is perhaps one of the most familiar of Wall Street's terms. Blue chip describes companies that have operated through good times and bad, retaining their value and paying dividends. The term dates back to the early 1900s, when the most valuable chips used in an alternative financial pursuit, namely poker, were blue. Today, the expression may be out of date, since gamblers favor multicolored chips now. Similarly, some believe that blue chip stocks are no longer the market's driving force, or even an indicator of its overall trends and performance.


10-Bagger

If you buy a stock at $5 and stick with it as it rises to $50, you've got a 10-bagger. A relatively new term usually attributed to fund manager Peter Lynch, "10-bagger" describes a stock whose value has increased 10 times. The word construction is often applied to other notable rises, as in 30-bagger or 100-bagger (think Yahoo! since it began trading in 1996). Lynch says the term has its origins in baseball, where a home run is dubbed a "four-bagger." Whatever its origin, 10-bagger now generally refers to a stock that has shown remarkable gains. To achieve this kind of performance, investors must not only find and purchase good stocks, but hang onto them as well.


Tombstone

When a new stock is issued, its birth announcement carries the ironic name of tombstone, which are those staid, simple advertisements seen in financial newspapers like The Wall Street Journal or the Financial Times. The label was applied by printers, around 1880, who described such ads as "tombstone style." The term also captures the hostility between underwriters over the order in which their names are listed. Government regulations require that tombstones avoid the flash of mainstream advertising, so they simply cite the amount of stock offered, its price, and the underwriters and dealers who have it for sale. Still, tombstones are often misunderstood by individual investors. By the time an ad hits the newspaper, the first shares are already in the hands of investors.

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How to Make Buying Bonds Easier, Safer and More Rewarding

Let's say you wake up one fine day with an urge to buy a bond or a bond mutual fund. It could happen to you for any number of reasons. And whatever the reason you want a bond, being a diligent investor, you look at all the things you are supposed to: yield, maturity, and credit rating.

But if you don't examine the bond's duration, you could be in for a nasty surprise. Understanding duration can make buying bonds safer, saner, and more rewarding - whether you buy individual issues or a bond mutual fund.

Pure and simple, duration tries to estimate the potential price volatility of a bond due to a change in interest rates. It would be the equivalent to what stock market investors try to estimate with beta. So just as beta measures the price volatility of one stock compared with another, duration compares how much one bond is likely to move in price versus another, as interest rates change. The two concepts differ in that a stock's beta is based on past performance, while duration is based on what will happen in the future.

Specifically, duration seeks to measure how long it will take, through the combination of interest and principal payments, before you recoup the money you invested in the bond. The longer the duration, which is another way of saying the longer your money is at risk, the more volatility you must expect along the way. The shorter the duration, or the quicker you get your money back, the less volatility you can expect.

Volatility isn't bad per se. High volatility means bigger losses when interest rates rise and prices fall, but bigger profits when the opposite occurs. Low volatility limits losses, but also dampens potential gains. It's your choice, but you want to know what you're getting before you buy.

Why, you might ask, do you need to worry about duration at all? Why not just concentrate on the bond's maturity date? The maturity date, after all, tells you when the repayment of principal will eliminate all risk. If it's a 20-year $1,000 bond, you will get your $1,000 back in 20 years, after which your risk of losing money is zero.

The trouble is, by using maturity alone, you are saying a 20-year bond is a 20-year bond is a 20-year bond, whether it is a U.S. Treasury issue, a junk bond, or a zero-coupon bond. Common sense tells you that can't be the case. A junk bond and a zero-coupon bond can't behave the same way even if they have the same maturity. Some other measure must differentiate bonds in the eyes of investors. That's where duration comes into the picture.

Duration's key measure is the cash flow the bond throws off, year after year, until it matures. Here's how it works.

Say you pay $1,000 for a 12%, 20-year junk bond from XYZ Corporation. On day one, you have $1,000 at risk. In six months time, you'll get a $60 semi-annual interest payment. Now $60 of the $1,000 you put at risk has been repaid. Each incremental interest payment further reduces the amount you have at risk. After 8-1/2 years, you will have received $1,020 in interest, which is more than the $1,000 you invested originally. Thus the maturity of the bond may be 20 years, but the duration is about 8-1/2 years.

Now compare that 12%, 20-year junk bond with a 20-year zero-coupon bond, bought at a discount and paying nothing until it matures. Because there is no cash flow from the zero, its maturity and its duration are both the same: 20 years. The junk bond throws off lots of cash, which reduced its duration to 8-1/2 years. Since the potential for price volatility increases with a bond's duration, the zero-coupon figures to be more than twice as volatile as the coupon issue.

That may come as a shock if you have socked away zero-coupon bonds to pay college bills on the assumption that zeros are the most stable things around. They are stable, if you can hold out until the zero pays off. But if you find it necessary to sell before maturity, you could be in for a rude awakening.

A zero-coupon bond is far and away the riskiest security an investor can own, because its duration is very long. A 100-basis-point [one percentage point] rise in rates on a 20-year zero will chop off about 20% of the value of that security. That's a huge change in the price of a security with a fairly small overall change in interest rates.

Obviously, that makes the zero-coupon bond volatile. But how volatile is volatile? That's easy to figure out.

Duration, multiplied by the change in interest rates, equals change in price.

Let's say that a bond mutual fund has a five-year duration. Then, if interest rates rise two percentage points, that's going to mean a 10% loss in the price of this fund. That's the strategic view of duration.

So what are the tactics to be used when buying individual bonds or bond funds?

You want a bond's duration, and its accompanying price volatility, or lack thereof, working for you. The more you believe that interest rates are heading lower, the longer the duration you want. The more you believe that interest rates are heading higher, the shorter the duration you want.

Two things happen with a long-duration bond when interest rates fall, both of them good:

The longer the duration, the more time before you must reinvest your money at lower interest rates. And the more the price of your bonds will climb as interest rates fall. As an example of how this works, let's say your bond has a five-year duration. Each 1% drop in interest rates means a 5% gain in the bond's price. That price gain jumps to 15% if the bond has a 15-year duration.

If you think rates are heading higher, then you want to buy short-duration issues, since the value of long-duration bonds plummets when rates rise. A 1% rise in rates will knock 15% off the price of a bond with a 15-year duration. The same increase will knock only 2% off a security with a two-year duration. The shorter the maturity, the narrower the gap between maturity and duration. That makes sense given the formula: Change in interest rates multiplied by the duration equals change in price.

When in doubt about rates, pick duration securities that are more in the middle of the road. That gives you a strategy to use through both the bull and bear phases of the market.

If you are going to use duration as a buying tool - a way to eliminate the risk of rising interest rates on bonds - then there are three things to keep in mind.

First, you must make your own interest rate forecast. Duration can only tell what will happen to the price of a given bond if interest rates move as you expect them to.

Second, the duration figure may not always be readily available. If you buy an individual bond, your broker should be able to tell you its duration. But in the case of a bond mutual fund, there is at best a 50-50 chance of learning the duration of the portfolio of bonds in any mutual fund, so you really should never invest in any bond mutual fund unless you can know with certainty the bond fund's duration.

Thirdly, remember there are many ways of measuring duration. Do you count duration to final maturity, or to first call date, or what? However you choose to measure duration, it's important to use the same method of calculating duration when comparing one investment with another.

Duration isn't perfect, but then you wouldn't buy a stock based solely on its beta. But duration is one more tool for making wise fixed-income investments.


NOTE: Be sure to also check in our "Archive" for my January 12, 2005 posting titled, "Getting Good Bond Prices" - which can save you from making a very expensive mistake when buying individual bonds.

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NEXT MEETING: Thursday - November 17, 2005

If you attended our meeting last month then you are aware that our scheduled speaker, Mr. Jim Bittman, failed to show up. It turns out that he simply neglected to check his schedule for that date, and he was most apologetic about this fact, and said so in a telephone conversation that I had with him the following week.

So as it turns out, Mr. Bittman will be our guest for this November 17th meeting, and he also stated that to make up for his absence last month, he plans to do something extra special that will benefit everyone who attends this meeting. And our topic once again will be Covered Calls.

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We meet at DePaul University, which is located at 150 West Warrenville Road in Naperville, Illinois. Our meeting begins at 7:00 PM and ends at 9:00 PM. The room number for this meeting will be posted on the easel standing near the reception desk in the main lobby.

We do have a $15.00 yearly membership fee and we meet on the third Thursday of each month. These meetings are open to anyone who shares our interest in learning more about investing, and non-members may attend for a donation of $5.00 per meeting.

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Some Risks Inherent To High-Dividend Paying Stocks

The Morningstar Dividend Investor recently advised about five risks that you should pay close attention to when investing in high-dividend paying stocks.

1. Pay attention to payout percentages.

The payout ratio is, by definition, the ratio of dividends to earnings. And danger looms if company earnings drop while the company is paying at a higher dividend rate. Any company that distributes more than 80 percent of its earnings as dividends should immediately raise a red flag.


2. Be very cautious about borrowing.

Whenever a firm is taking on debt in order to keep dividends high, it's a signal that management is gambling that operating cash flow will bounce back. But what if it doesn't?... All the more reason for an investor to be cautious about borrowing!


3. Seek steady growth.

The ideal business is one in which revenue and income from the company's core businesses will be growing by at least 6 percent a year on average. And any company that isn't keeping pace with major factors in the economy such as inflation and/or the long-term U.S. GDP growth rate, is a company that will not be around to pay out dividends in the long run.


4. Learn to appreciate uniqueness in a business.

Warren Buffett uses the term "wide economic moats" to describe uniqueness in a given business. This refers to advantages that are difficult for competitors to copy - like strong brand names and proprietary processes - which can help to insulate a business from competitive threats and economic recessions.


5. Watch closely any expansion costs.

The more a company spends on growth, the less money it has available for paying dividends. So whenever you subtract capital expenditures from the operating cash flow, the resulting number should exceed the amount that was paid out in dividends. If it does not, the company may not be able to finance future growth and also reward its shareholders - and do both things at the same time!

The 2003 change in the tax laws have made high-dividend paying stocks more attractive, but never invest without first paying close attention to the five risks as noted above.

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