The first step you should take before making an investment decision is to lay out your goals. What are you trying to accomplish with your investment? Generally people will say something like "I'm trying to build wealth" or "I want to put away money for retirement" or even "I'm just trying to make some extra money." These represent investing goals. Problems happen when people try to pursue investing goals before thinking about how they will meet these goals. First, you need to have a clearly defined investment strategy.
What strategy is the best for me you ask? Well that depends on your age, risk tolerance, and the amount of time and resources you have at disposal. The two strategies I will focus are dividend investing and growth investing. For the sake of this article I am going to divide dividend investing into three categories. The first is dividend growth, which will be your blue-chip companies such as Johnson & Johnson (NYSE:JNJ) or Proctor & Gamble (NYSE:PG). The second is dividend yield, which will be companies that pay higher yields but are not know for raising their dividends. Utilities like Duke Energy (NYSE:DUK) would be the mainstays in this category. The third is other dividend companies. I generally group REITs, CEFs, MLPs and other specialty and/or holding companies that generate dividends into this category. American Capital Agency (NASDAQ:AGNC) and Kinder Morgan Energy Partners (NYSE:KMP) would be two popular companies that fall into this category. Buying dividend companies is like buying an income stream. As long as the company performs, your dividends will come in every 3 months. If you are a dividend investor, than your #1 goal should be to generate and grow income through an assortment of reliable, diversified companies. You can pick your stocks, reinvest your dividends, and not worry about the fluctuations of the stock market, because they will not affect your income stream.
I believe the core of a dividend investor's portfolio should be dividend growth companies. I love investing in companies with proven records of growing earnings and dividends year in and year out because no matter what the market conditions are, I can be confident that 3, 5, 10 years down the line I will see my investment grow in value. This doesn't necessarily mean the stock price will have appreciated. I can't predict what the stock market is going to do next week, much less years from now, but when I invest in dividend champions that have stood the test of time and continued raising dividends every year, I can at least expect my income stream to increase every year. However even the sturdiest companies can be hit hard by an industry wide decline similar to what occurred in the auto (Ford (NYSE:F)) and financial sectors (Bank of America (NYSE:BAC)). This risk can be mitigated by diversification. A multi-year drought that causes food prices to skyrocket may hurt the fast food industry and companies like McDonalds (NYSE:MCD), but is unlikely to have an impact on medical supply companies such as Becton-Dickinson (NYSE:BDX). We can further diversify by allocating a small percentage of our portfolio to the other two categories of dividend companies mentioned above. A conservative allocation for a divided portfolio would be 80% dividend growth stocks and 20% other, with no one stock accounting for more than 10% of the total portfolio.
Growth investing is investing in any company that is still in the stage of its life-cycle where its main focus is aggressively pursuing top-line growth. A growth company should not pay dividends, because it should be able to funnel every dollar it earns back into its business to generate more than a dollar of return. It does not necessarily need to be a start-up or a smaller company. In fact I will be focusing on large-cap growth companies in part two of this series. Buying solid growth companies is a great way to build income, but it is inherently riskier than buying dividend companies. However with higher risk comes (potentially) higher reward. You are much more likely to find multi-bag winners like Netflix (NASDAQ:NFLX) or Google (NASDAQ:GOOG) with growth companies than dividend companies. The problem is you have nothing to give you solace in the short to medium term if Mr. Market doesn't agree with your assessment of the stock. A company you feel should be trading for 15-20x earning can trade at 10x earnings for a stubbornly long time, and the only way you see a return on your investment is to wait until Mr. Market comes to his senses. Also it is very difficult to accurately value growth stocks because most of their upside comes from future growth, which is predictably difficult to estimate. That being said, as long as you are patient and your investment horizon is long enough you can make a killing in growth stocks. Just ask Peter Lynch.
The two most important factors to consider when choosing a growth stock are revenue growth and economic moat. Revenue growth with flat or rising margins is a great indicator of a winning company. Even if margins are decreasing, as long as revenue is increasing at an acceptable rate and management has solid reasons to sacrifice profits in the short-term (see Amazon (NASDAQ:AMZN)), it is not necessarily a bad thing to have decreasing margins. While revenue is important, a company's moat is what determines if it will be a firecracker or rocket ship. Firecrackers will start off fast and then come back to earth, while rocket ships will just keep on going up. A business must be able to differentiate itself from its competitors in a meaningful way that is difficult to reproduce. Whether it be through branding, superior service, or capital requirements, if a business does not do something that sets itself apart from competitors and that cannot be copied effectively, then there will be a ceiling on how well it can do.
In part two of this series I will put together two competing portfolios and track their performance throughout 2013. My personal investing style leans toward dividend investing, so I will be quite interested in seeing how each of the portfolios performs.