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This is the sixth piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.

David Van Knapp may be a self-directed individual investor but his impact extends to many members of the Seeking Alpha community and beyond. Starting in 2007, his affinity for value investing gradually gave way to developing his own unique approach to dividend growth investing. The author of five annual eBooks on the subject, Dave assists individual investors who want to take their financial destinies into their own hands by carefully constructing and managing a portfolio of dividend growth stocks.

Dave has been analyzing and writing about stocks since 2001, both on his own site SensibleStocks.com and here at Seeking Alpha. He maintains a public demonstration Dividend Growth Portfolio. His next eBook, Top 40 Dividend Growth Stocks for 2013: A Sensible Guide to Dividend Growth Investing," will be released in January.

Seeking Alpha's Jonathan Liss recently spoke with Dave to better understand why dividend growth investing appealed to him more than other investing styles - and how he would continue to employ this strategy in the coming year.

Jonathan Liss (JL): Please explain how you became a dividend growth investor?

Dave Van Knapp (DVK): After my first general investing book was published in 2007, I did a lot of research into the dividend idea. I studied dividend growth investing, discovered resources such as the Dividend Champions document, and did a lot of reading and thinking. I was a few years into retirement and owned a reasonable facsimile of a traditional asset-allocation portfolio. I was withdrawing 1% from that per quarter, which was my version of the 4% rule. But I had a growing understanding that what I was really doing was creating income from my capital assets. Let’s use a real simple definition of income here: If I move money from an investment portfolio into my checkbook, that is income. The end result was cash that I could spend.

The “aha” moment for me was when I explicitly separated the two components of total return: price changes + dividends. I realized that—in contrast to traditional notions of what investing is all about—the dividend component could be pursued as an end in its own right. That appealed to me, because I wanted to see if I could find a way to produce income—money into my checkbook—organically instead of by selling things off each quarter.

As time passed, my studies continued. Somewhere about the same time, I discovered Seeking Alpha and began to read articles about dividend growth investing. I also ran into articles that derided dividends as essentially meaningless to total return, and I thought long and hard about the points made in those articles. I took the analytical approach that I take to most things, which is that I treated the arguments pro and con as hypotheses (not facts), and I set about trying to confirm or deny the hypotheses.

In the end, most of the points against dividends did not make much sense to me, especially when viewed through the lens that income—a retirement “paycheck”—was the ultimate goal. The study and research helped me to formulate my own hypotheses, which I have been testing and modifying ever since. I became pretty convinced of the efficacy of the dividend growth approach, and I started a demonstration Dividend Growth Portfolio to see how it worked when the rubber hit the road.

Now, five years later, all of our individual stock investments are in dividend growth stocks, and I look at all investment opportunities in terms of their ability to generate income organically.

JL: Let's drill down a bit further here. Why does the dividend growth investing style appeal to you above all others?

DVK: In retirement, income is of primary importance. More specifically, purchasing power is of primary importance. Dividend growth investing builds and maintains purchasing power that keeps pace with inflation. So it strikes me as a natural way to accomplish my primary goal in retirement, which is to have enough cash in my wallet.

Compared to many other forms of investing, dividend growth investing is intuitive and easy. Selecting stalwart dividend growth stocks is not hard. Maintaining a portfolio of them requires attention and monitoring, but I find that to be enjoyable. It’s fun to see the income flowing to me, and it's fun to watch that income rise steadily.

We all know that managing the psychological aspect of our portfolios is a huge part of success. I have found that focusing on the dividend or income side of the equation pretty much insulates me from worrying much about fluctuations in the market. So long as my income generation is safe—which I help insure by monitoring it—I find that I don’t worry about market prices. The acid test was 2008. In 2008, I was buying, not selling, stocks. That’s obviously the opposite of panic selling. (I did make one sale in 2008—Bank of America (NYSE:BAC)—and that is explained later.)

What allowed me to essentially ignore the market crash in 2008 was understanding that I was actually purchasing current and future income, not price-trading slips. I expected that income to remain intact no matter what Mr. Market was doing to prices, and for the most part, that’s the way things worked out.

I now view stock shares primarily as claims on future income that will rise over time. I also know, of course, that those shares can be sold at any time for whatever price Mr. Market is offering that day. But the income rights, not the prices, are my primary focus.

JL: As we approach 2013, are you bullish or bearish on global markets?

DVK: I really have no opinion on global markets. I no longer study them. I focus instead on the prospects of individual companies, and I look at those prospects through the lens of valuation and dividend growth, not through the lens of price changes.

Generally speaking, dividend growth investing largely separates the market’s movements from the income generated, so whether one is bullish or bearish on prices is pretty much irrelevant.

The better question for me might be, am I bullish or bearish on the dividend streams from the best dividend growth stocks? I feel good about those. I anticipate that 2013 will be more or less like 2011 and 2012, namely:

  • Most dividend growth stocks with good business models and strong managed dividend policies will continue those into 2013.
  • As happens every year, a few new businesses will “join the club” of stocks that have raised their dividends for 5, 10, or 20 years or more. And a few others will drop out for various reasons.
  • The average dividend increases for the best dividend growth stocks will be in the 5% to 10% range, with some lower and some higher. Across a portfolio of good dividend growth stocks, the income will probably increase faster than inflation. That’s what it usually does.

With the heightened interest in dividends over the past couple of years (a product of the low interest rate environment), some pundits have declared that dividend stocks are “in a bubble,” meaning that they are severely overbought and overvalued. I haven’t found that to be the case. Because I look at stocks one at a time, I have been able to find a sufficient number of fairly valued or undervalued dividend growth stocks to create or augment a portfolio of them. Whether or not the entire category is overvalued in some broad sense really doesn’t come into play when you think about stocks one at a time.

At the moment, I think these stalwart dividend growth companies are attractively or fairly valued:

  • Kinder Morgan Energy Partners (NYSE:KMP)
  • Chevron (NYSE:CVX)
  • Emerson Electric (NYSE:EMR)
  • Sysco (NYSE:SYY)
  • AFLAC (NYSE:AFL)

JL: What valuation methodology are you using to make that determination?

DVK: There are lots of different ways to appraise valuation. Two of the most common are (1) net-present-value (NPV) methods and (2) valuation ratios, the most common of which is the price-to-earnings (P/E) ratio. I am basing my valuations on both methods by using data from Morningstar and F.A.S.T Graphs™.

Morningstar’s star ratings for stocks (not to be confused with their star ratings for funds) are based on their calculations of fair value for each stock. They use a proprietary NPV approach, then take a ratio of the stock’s current actual price to that fair value price. If the actual price is way under fair value, they award five stars; if the two values are approximately the same, they award three stars; and if the actual price is way over fair value, they award one star. The calculations are complex, but the star system makes them easy to interpret.

F.A.S.T Graphs uses the other method, basing its valuations on P/E ratios, the way Ben Graham did. The graphs themselves are great visual representations of valuation, as they show the actual price as a black line and the “earnings-justified value” as an orange line. It’s pretty easy to see when a stock is undervalued, fairly valued, or overvalued on one of those charts.

In my new eBook, I will use these two methods in combination to arrive at my own appraisals of valuation. Each of the five stocks listed above has three or more stars from Morningstar and appears as undervalued on its F.A.S.T. Graph.

JL: In what ways does your approach to selecting dividend-growth stocks change based on the current market environment and outlook? In what ways does your approach remain constant, regardless of current market conditions?

DVK: My approach doesn’t change depending on market environment and outlook, although the outcomes from that approach might change.

Let me explain. I have one scoring system for evaluating dividend growth companies and a second scoring system for valuing their stocks. I suppose that in extreme market conditions, the scoring systems could lead to finding a lot more or a lot fewer stock candidates than normal. For example, if the whole market were extremely overvalued, dividend growth stocks would probably be overvalued along with them, and thus fewer stocks would emerge as purchase candidates.

But that would be an outcome, not a change in approach. So my overall approach remains the same regardless of market environment.

JL: How are you protecting against potential downside risk in this environment?

DVK: Well, first remember that the “downside risk” that I am protecting against is primarily risk to the dividend stream. I have a pretty well developed tool kit to guard against that risk. Here’s what’s in the kit:

  • Careful stock selection—Risk management begins with what you buy and when you buy it. Both company quality and valuation are important, as are dividend policies and practices.
  • Diversification—I am increasing my attention to what’s been called “the only free lunch in investing.” I try to mix up different industries, yields, growth rates, and so on to create a balanced portfolio.
  • Immediate investigations when “something happens”—Examples would be BP’s oil spill a couple of years ago, Abbott’s (NYSE:ABT) announcement last year that they were going to split themselves up, or a stupid acquisition. While it is rare, it is not unknown for a company to change a 40-year-old dividend policy. So you can get blind-sided by an unexpected dividend cut. I would consider it a difficult year if this happened more than once or twice to stocks that I own.
  • Semi-annual formal portfolio reviews—I look to see whether a stock has become too large in the portfolio, seriously overvalued, reduced its dividend increases to a trickle, developed a negative business outlook, and so on.

One final thought: None of these risk control practices is emotional. I try to run my dividend growth investing as a cold hard business.

JL: Let’s go back to 2008 for a moment. As a result of the financial meltdown that year, stocks of many ‘blue chip’ financials that in all likelihood would have qualified for inclusion in large numbers of dividend growth portfolios, names like Citibank (NYSE:C) and Bank of America (BAC), suddenly cut their dividends all at once – dividends they had been consistently growing for years - while selling off 80 or 90%. Isn’t a recurrence of this type of Black Swan event a potential risk with DGI, where you simultaneously take a large hit to the underlying portfolio while seeing 4 or 5 of maybe 25 names cut their dividends to next to nothing all at once?

DVK: Yes, that is definitely a risk. But it is not a Black Swan risk: The possibility of a business failure or dividend cut is well known, and it can be accounted for.

The risk-management tool kit that I described above is how a dividend growth investor mitigates risks like these. First, stock selection: Some of the banks that failed had never made it onto my radar screen in the first place. They failed various quality tests. Citibank, for example, was never a candidate. If a company scores low on basic tests of business quality, it does not matter how good its yield or dividend history may be. They are not candidates.

Second, immediate investigations when “something happens.” I owned Bank of America. But when they acquired Merrill Lynch, their business model changed significantly, and I could not figure out why they had made that acquisition. That introduction of uncertainty was enough to alert me to the possibility that their whole business might be in trouble. I wrote an article about the situation, and I sold my stock in early October 2008, just as they announced their first dividend cut and before most of the price drop. The article, published here on SA the same day that I sold my stock, concluded as follows:

I hate to lose a stock paying such a high dividend, but the dividend must be considered to be at risk if not outright doomed. It's too bad. BAC seemed to be a great long-term investment. Maybe it still will be for those who can stomach extreme unknowns, price volatility, and the probable dividend cut. But for those looking for a comfortable level of safety and a predictable, growing dividend, it is hard to make the case any more for BAC.

I don’t want to minimize these risks. They exist. But of course risk of loss exists in any form of investing. I don’t think that dividend growth investing is uniquely vulnerable. Since the possibility of unexpected dividend cuts is known, another tool in the tool kit is diversification. The goal is to protect your dividend stream on a portfolio-wide basis. Holding a variety of stocks in different industries and with differing characteristics helps towards that end.

Most of the regular writers and commenters on dividend growth investing report that their total income went up in 2009 over 2008, despite the numerous cuts in big-bank dividends. That was also my own experience. The combination of diversification, portfolio monitoring, and dividend increases from other companies made up for the banks that slashed their dividends.

Perhaps it is not widely known that more than 450 companies increased their dividends straight through the 2008 price collapse (that comes from the Dividend Champions document available from the DRiP Investing Resource Center). Dividend growth investors are accustomed to seeing dividends rise even when market prices are falling.

JL: Are there sectors you are shying away from right now due to particularly worrying headwinds?

DVK: No. I like to say that “dividends are where you find them.”

I put all stocks through basically the same tests. If the outcome of those tests is that some sectors are over- or under-represented at a particular time, that is OK with me. Dividend growth investing is long-term in nature. Building a portfolio over time means that as different sectors provide the best candidates, eventually most sectors will be adequately represented to get the benefits of sector and industry diversification. Even when a sector is “weak,” that does not mean that one or two companies from that sector may not emerge as good investments when you look at them one at a time. You can pick them off when the picking is good.

Getting back to the previous question for a moment, I believe that many dividend growth investors simply exclude big banks from consideration as a result of the financial collapse in 2008 plus banks’ history of disasters every decade or two. The ones that cut their dividends in 2008 are not on my radar screen, as I require five consecutive years of dividend growth for consideration. Any company that cut or froze its dividend in 2008 is not on my list.

JL: What is your ideal allocation heading into 2013 in terms of U.S. vs. foreign-based dividend growth companies?

DVK: I am agnostic on U.S. vs. foreign allocations. All else equal, I tend to favor U.S. companies, as many foreign stocks come with annoyance factors, such as irregular dividend increases, foreign withholding, semi-annual or annual distributions, and the like. But I have purchased foreign corporations in the past, and in a compelling situation I see no reason that I would not purchase a few in the future.

I don’t feel the need to have a certain percentage of my income denominated in foreign currencies. I get plenty of foreign exposure from the types of stocks that I buy. Large multinational companies like Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), and McDonald’s (NYSE:MCD) get over 50% of their revenues from overseas anyway. So even though the companies may be headquartered domestically, they participate in growth in foreign markets by the very nature of their businesses.

JL: How have potential changes to the tax code affected your assessment of dividend-paying investments?

DVK: Currently they haven’t, because until final legislation is passed and signed, I see little use in speculating on what it might turn out to be.

My thoughts right now are that if the net effect on my own taxes is reasonably small, I won’t change my dividend growth investing at all. Reading articles and comments over the past few years has made it abundantly clear that every individual’s tax situation is different. People are in different marginal rate brackets, they hold their investments in varying proportions in tax-deferred and taxable accounts, and so on.

I usually regard taxes as an expense item rather than a subtraction from income. Looking at it that way lets me see the investment performance for what it is and separate out the tax effects. It also places income taxes in context with all the taxes I pay, including sales and property taxes. Thus taxes are a line item in my budget, like gasoline or groceries. The total impact on my budget may be quite small, and easily absorbed at the margins. I might look at a tax increase as a one-time jump in inflation for me. But the main point is that everyone’s situation is different, and each individual investor must figure out what it means to them.

JL: In light of potential changes to the tax code, are there now segments of the bond market such as tax-exempt muni bonds that you feel now have a greater place than they had previously in the ‘current income’ segment of retiree portfolios, or is this unnecessary?

DVK: Again, that is a question for each individual to answer. I have a pension and I draw Social Security, so a good part of my retirement income is fixed. One of the roles of dividend growth stocks is to provide inflation protection that otherwise is not there in fixed-income investments. Bonds are fixed income investments, so it is impossible for their distributions to provide inflation protection.

I am sure that some retirees would give a different answer to this question. It seems probable that if taxes on dividends go up, tax-free investments such as municipal bonds will become more attractive to some investors. Other than a few legacy bond funds that I am slowly selling off and some I-bonds purchased years ago, I own no bonds and do not intend at this time to purchase any. I believe that I have enough fixed income, so my investment focus is on protecting purchasing power with rising-income investments.

JL: Finally, what advice would you offer a ‘do-it-yourself’ dividend growth investor as we approach the new year?

DVK: My suggestions would not change:

  • Buy only at good values.
  • Consider selling and replacing when overvalued.
  • Focus on the dividend income stream, not prices.
  • Look for a minimum yield that is enough for your needs.
  • Look for a managed dividend policy of increasing dividends that seems reliable and woven into the culture of the company.
  • Buy only companies with great, sustainable business models.
  • Use the risk-management tool kit.
  • Think long-term, not short-term.
  • Become accustomed to varying principal and don’t obsess over it.
  • Keep your eye on the ball, which is rising income that beats inflation.

Disclosure: Dave Van Knapp is long CVX, KMP, PEP and MCD.

To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.

Source: Dave Van Knapp Positions For 2013: Tuning Out Market 'Noise' With Dividend Growth Investing