I talk a lot about corporate business models. I have also suggested frequently that dividend growth investors should treat their investing as a business.
If you combine those two themes, it's fair to ask, what is the business model of the dividend growth investor's own business? "Business model" means simply, how do you make money and sustain your ability to do it?
Here is what I believe is the business model of most dividend growth investors:
Identify, accumulate, and manage a portfolio of stocks that reliably send growing amounts of cash to headquarters.
In other words, the dividend growth investor is like a mini-Buffett: You buy stocks of wonderful companies that send increasing flows of cash up to headquarters (you).
Then you decide what to do with the cash. If you are in your accumulation years, you reinvest it in more wonderful businesses. If you are retired and need the dividend cash to live on, you take it as income and use it for your expenses.
The dividend growth investor is in fact a holding company. What you hold are pieces of outstanding operating companies. Your book value grows over time, and so do the cash flows.
In doing my taxes a few weeks ago, I was struck by how my "stock notebooks" have changed since I became a dividend growth investor in 2008. When I was trading stocks rather than investing in companies, I had to go through all my trade confirmations for the year, matching up buys and sells. There were scores of them. I hated it, because I hate tedium. After finding and collating everything, I had to calculate profits and losses, label each as long-term or short-term, enter them on the tax form, and so on.
That was before I turned to dividend growth investing. Now when I go through my three-ring binders, I have only a handful of trades to match up each year. And at the rear of the binder, behind the tab "Buy Confirmations for Stocks Still Owned," the "buy" confirmations just continue to accumulate. The stack gets thicker every year.
Like Buffett, I feel that I will want to hold these businesses "forever." I intend that they will reward me well into the future - beyond the farthest time horizon that I can imagine.
The dividend growth business model is not about flipping. Rather, you become a stakeholder in each business, because you expect each one to produce more and more money over time. Some of that money will be sent to you.
Don't think of stocks as part of the stock market. Think of them as parts of a business. The market is just the store where you go to make your acquisitions.
Let's break down the business model and see how it works.
"Identify…Stocks that Reliably Send Growing Amounts of Cash to Headquarters"
One core competency needed to execute the dividend growth business model is the ability to identify what companies to invest in. You must make acquisition choices carefully, because you will depend on each company's management to run it. Your competency is not in being able to run each business. It is in identifying which companies are good at making money in their own industries, and that also have the intent and wherewithal to send growing streams of their profits to shareholders.
Here are a few key elements of my own approach.
1. I do not just want to invest in companies that appear on some list of dividend payers or high yielding stocks. It is not hard to find lists of dividend stocks or to run a screen and produce such a list. Usually such simple-minded lists ignore factors like risk, dividend sustainability, business soundness, and even recent dividend cuts. I want to find the best dividend growth stocks, the kind that I can hold with confidence over long periods of time while benefiting from steadily increasing dividend streams.
2. The search must be fact-driven. To promote objectivity, I use an unemotional scoring system for rating companies. I use a few minimum requirements as screens, then rate other factors on a grading scale.
3. The search should use multiple factors. My approach uses four categories of information.
- The company's own business model. I like companies with models that I understand and that suggest that the company has sustainable competitive advantages. Some of my favorite business models are simple: tollbooth; subscription; providing products that people buy repetitively; landlord. Certain businesses are inherently riskier than others, and they generate less confidence in the sustainable economics of the business. Divide the businesses you can reasonably understand from those you can't. The latter go into Charlie Munger's " too-hard" pile. Don't invest in them.
- Dividend fundamentals. These include things like yield, dividend growth rate, and length of dividend increase streak.
- Company financials. I examine EPS growth, revenue growth, ROE (return on equity), debt, and a few others factors. I try to be complete without being duplicative and creating unnecessary work. (As I said before, I hate tedium.)
- Valuation. I prefer to purchase companies when they are undervalued or fairly valued.
What I have found over the years is that using factors like these to judge businesses causes the best ones to rise to the top and the bad ones to sink to the bottom. I have adjusted some factors over the years and tweaked my scoring system from time to time, but usually the same good businesses rise to the top and the same lousy ones sink to the bottom. That's exactly what I want.
The dividend growth investor uses money he or she already has (say from a real job and from incoming dividends) to purchase stocks. You're a little financier. You cannot be like Buffett is today and acquire whole companies, but you can start as he did by purchasing stocks.
The dividend growth investor does not regard his or her stocks as trading slips, but rather sees them as pieces of businesses. He or she is intending to hold and participate for a long time in the success of the businesses purchased. Everything that each business does or accomplishes, you own a little fraction of. The strategy is largely independent from the market, as company profits and dividend decisions are created by the companies themselves, not by the market.
As Buffett says, the ideal holding period is forever. That's the mindset in dividend growth investing. While there will be some clunkers purchased that need to be eliminated, a fundamental principle behind this business plan is simply to accumulate more shares. The accumulation over time causes the dividend stream to go up and up.
Contrary to myth, the dividend growth investor is not passive. He or she is an active manager of the dividend growth business.
Obviously, the investor does not help to manage the individual companies themselves. But the investor fully manages his own investment business. He is the CEO of that business and as such is responsible for all decisions made by the business:
- What and when to buy
- What and when to sell
- How to mitigate risk
- What to do with the cash flowing to headquarters
- Constructing a coherent portfolio of investments
- Intelligently handling the myriad problems and opportunities that inevitably occur in any business
The myth of passivity probably comes from the fact that the dividend growth business model does not usually involve much stock trading. But that does not mean that the dividend growth investor sits idly as the world goes by. He or she is monitoring their portfolio; keeping track of the companies in it; thinking about ways to improve the portfolio; maintaining a list of potential acquisitions; taking advantage of unexpected opportunities; reacting intelligently to unexpected problems; and so on.
For some investors, especially those in retirement, this can be a full-time endeavor. Others spend a few hours per week at it. But all dividend growth investors do it. Most find it is fun. It's fun to run your own business rather than work for others.
The lack of trading has created in some quarters an image of dividend growth investing as being boring. Most dividend growth investors, however, don't see it that way. The excitement of the business model comes from that cash stream flowing to headquarters. Just as payday is not boring to most people in regular jobs, dividend declarations and payment days are not boring to dividend growth investors. Rather, they are the tangible payoffs for the work and thought that the investor has put into the enterprise.
The payoffs happen frequently. Say you own a dividend growth business that has investments in 15 conventional companies that pay quarterly dividends, two MLPs that pay quarterly, plus two REITs that pay monthly. That's 92 paydays per year, almost 8 per month. Not only that, if each investment increases its dividend once per year, that's 19 increases per year. Boring? I think not.
Investors turn to the dividend growth business model to help them reach different goals. It is a large tent. For many, the principal goal is the dividend stream itself. They plan to reinvest the dividends until they retire, then take the dividends as cash and live off them when they retire. For others, the principal goal is total return. That means that they may have certain selling rules - to capture capital gains or avoid paper losses - that income-centric practitioners do not have. So their portfolio management may involve more trading. But for all, this is an active, not passive, strategy.
The dividend growth business model is based on 10-20-30 or more ownership stakes in individual companies. As stated earlier, you are in effect a holding company.
There are a lot of ways to construct a portfolio, and different investors emphasize various factors in constructing theirs. Most consider diversification to be important. This can manifest itself in a variety of ways, including the sheer number of companies owned; coverage of segments and industries; owning both low- and high-yield stocks; owning both slow- and fast-growing dividend payers; and so on.
My own philosophy is stated simply: I want to own a "well rounded" portfolio of dividend growth companies. That takes into account all of the factors just mentioned. For nearly five years, I have maintained a public Dividend Growth Portfolio that I write about frequently and track on my web site. I use it to illustrate one approach (my own) to dividend growth investing. I have guidelines on how many companies I want to own; how varied they should be; and the maximum percentage of the whole portfolio that can be occupied by any one holding.
The business model is: Identify, accumulate, and manage a portfolio of stocks that reliably send growing amounts of cash to headquarters. The key word reliably brings in the subject of risk.
All businesses face risks - from competitors, the general economy, the waxing and waning of trends, technology, even from oddball events beyond their control.
In my own dividend growth investing, I use "risk" to refer to the possibilities of suffering realized loss of capital or unexpected decrease in dividend flow.
I view risk in probabilistic terms. I basically reject the "risk on, risk off" way of looking at the world, as well as simplistic labeling of some investments as "safe" and others as "risky." Instead, working along the spectrum of risk, I try to attain the best probability of accomplishing my goals simultaneously with the least probability of the two negative possibilities that I just mentioned.
Stated another way, I am trying to raise the probability of accumulating stocks of companies that send increasing amounts of cash to headquarters, while simultaneously reducing the probabilities that I will either suffer a decrease in dividend flow or be forced to realize a capital loss.
Fortunately, these are not contradictory goals. They go hand in hand. Decreasing the risks of the two things I am trying to avoid also raises the probability that I will accomplish my principal goal.
These are among the ways that I try to mitigate risk:
1. Stock selection
As described earlier, a core competency required by the dividend growth business model is the ability to identify what businesses to invest in. I have written extensively about the methods that I use, which I summarized above.
Also discussed above was the concept of diversification, which is a well-recognized risk management technique. The idea is to spread your bets around to help protect against bad consequences that can result if any single bet does not turn out in your favor.
3. Immediate investigations when "something happens"
While I expect to sell dividend growth stocks infrequently, that does not mean that I never sell. The presumption that a dividend growth stock will be held for a very long time can be overcome when facts change.
Examples of when I conduct an immediate investigation include:
- a dividend cut, freeze, or suspension;
- a prolonged bubble or serious overvaluation in the stock's price;
- a one-off calamity, such as BP's (NYSE:BP) oil rig disaster;
- an announcement that the company is going to be acquired, such as the recent announcement about Heinz (NYSE:HNZ);
- announced plans by the company to split itself up or spin part of itself off into a separate company, such as Abbott Labs (NYSE:ABT) last year;
- a ballooning or collapsing yield;
- a position's size increasing beyond my stated maximum.
These are not automatic sell situations, but they propel immediate investigation. It could be said that they flip the presumption from hold to sell. The investigation may well lead to a decision to still hold, but the burden shifts to the company to justify continued holding.
4. Periodic strategic portfolio reviews
These are the equivalent of a company's off-site strategic reviews by top executives of macro conditions, competition, the performance of each line of business, and the like.
You are the top executive team of your own dividend growth business. Take yourself "off site." Get your head out of the details for a day or a week and think about large, strategic subjects. Your off-site meetings may result in specific action plans or a project to discover how to improve some aspect of your dividend growth business. I perform strategic portfolio reviews twice per year.
One final note: Risk management is unemotional. All of the techniques described above are based on sound business principles. All decisions should be based on facts and/or reasonable inferences from the facts. So-called panic selling is emphatically not part of this business model. Try to train yourself not to be swayed by the market.