In 1989, Dr. Stephen R. Covey published a book titled The 7 Habits of Highly Effective People. The book was a best seller and became one of the top leadership books of all time. At the time, I was in a managerial role in the company for which I worked and read it from the perspective of becoming a better manager and utilizing it in my profession. Of course it applied to more than just management or leadership and was aimed at helping people become more effective in their business and personal lives. Prior to his death in 2012 Dr. Covey added an 8th habit.
Browsing through it again recently made me think of it from the perspective of investing. I believe much of one's investing success comes not from simply reviewing financial information on particular companies, or buying in at some pre-determined point, but in establishing habits that will ensure investing is done in accordance with certain fundamental principles. With that in mind I thought about what habits dividend growth investors should have to help be successful over the long term. So with a hat tip to the late Dr. Covey along with adapting a couple of his habits, here are the habits that I think effective dividend growth investors exhibit.
Habit No. 1: They Always Use A Road map
It's been reported that everything University of Alabama Football Coach Nick Saban does is part of a process. But in his book "How Good Do You Want To Be?" he states that you need a road map to guide you to where you want to go and what you want to achieve. His process is actually part of his road map. He goes on to say the road map consists of a mission statement, goals, core values, and so forth. Some may refer to this as their business plan or by some other description. By establishing this habit of having a road map or plan, the effective DGI accepts responsibility for his or her own actions, as well as inactions, in following that plan. Once developed, the plan may be (and should be) often reviewed, it may be periodically refined, but it should always be followed.
Saban goes on to say that it's not enough to simply create the road map and then stick it in a drawer, it must be reinforced often enough that it becomes a "sight line" to follow. In addition to the items mentioned above, the DGI's plan should identify the type of investments they'll make, their rules for buying, selling, holding, diversification or asset allocation strategy, and long-term objectives. To use one of Dr. Covey's habits, the plan "begins with the end in mind."
Habit No. 2: They Put First Things First
What I mean by putting first things first is that the effective DGI doesn't let the major things get held up by the minor things. For example, to the dividend growth investor in the distribution phase, income is major, daily stock price movement is minor. Putting first things first means the DGI looks for quality companies as opposed to the popular "stock of the month." Of course that begs the question how does one define quality? I define the word quality as the degree of excellence that a thing possesses so I am looking for companies that have a high degree of excellence in their operations and a high probability of continuing in that regard. That naturally leads to the indicators I use to identify a quality company. They are:
1 - They have a sustainable competitive advantage or economic moat. I also like to look for companies that are recession resistant by which I mean they have products that consumers will still need or desire to buy even during tough economic times. I call these switch hitters. The Coca-Cola Company (KO) and McDonald's (MCD) are both examples of this. They both have strong moats, both brand and size, and while the stock price of both companies dropped during the recession just like every other company, their businesses continued to do well. When the pricing dropped on both of these the DGI looking at valuation would have viewed this as an opportunity to acquire the company at less than fair value. A company like Wal-Mart (WMT) may be an even better example of a switch hitter, since many consumers may do even more business with them during tough economic times. Conversely, a company like Nike (NKE), a quality company which has a brand type economic moat is not necessarily recession resistant. While their brand allows them to charge a higher price many consumers and budget driven teams may hold off on more expensive purchases longer than typical.
2 - They have a strong management team that is stockholder oriented. I try to see if the management team has a long history of managing to grow the company through both good and bad times. What has happened to the company during the current management team's tenure? Are they overpaid, awarding huge stock options and hiding them with share buybacks? Or do they use the share buybacks to increase the value of the company, effectively use cash flow, handle growth well, etc? Much of this evaluation may be subjective but a poor management team can significantly harm a good company. But an excellent team, and especially an effective CEO, can make a tremendous difference. Warren Buffett made a huge difference at Berkshire-Hathaway (BRK.B). I believe Richard Kinder is making a huge difference at Kinder-Morgan as well.
3 - They are financially strong. When I say financially strong I want to look at more than recent history, I want to see a strong financial position exhibited over several years along with the ability to maintain and grow their finances in the future. I look for strong earnings growth accompanied by good free cash flow growth and strong net margins. A quality company should also have low or easily manageable debt and good credit ratings.
4 - The financials have to rhyme. There's an old expression that says "figures don't lie but liars figure." It's been well established that games can be played with the financial numbers of companies to make them look better than they might be. When I say they need to rhyme, over long periods of time if earnings are growing, then revenue and cash flow should also be growing. It's entirely possible that earnings can go down for a short time and dividends continue to grow because of free cash flow. But if over a longer period the dividends and payout ratio continue to grow while earnings, revenue and cash flow are going down then a potential problem is being created. Pitney Bowes (PBI) may be a recent example of this. Looking at their financials one can easily see that their numbers did not rhyme at all. Note that I'm specifically referring to "C" corporations here, not MLPs, REITs, or BDCs that are required by law to pay out higher amounts of taxable income.
You may have noticed I didn't list the payment of a dividend, a certain dividend yield, or dividend growth as an indicator of a quality company. That's because I don't believe it is. A number of companies can pay dividends that aren't quality companies. Additionally, a company may be in a growth stage where they're reinvesting all of their profits back into the company. That doesn't prevent them from being a quality company. To me a dividend is a decision on the part of management to return a portion of the profits to the owners of the company. And as an owner I want my share of the profits. But the company has to have the financial wherewithal to pay it and grow it without harming the company. That's why I check dividend payout ratios. Obviously, as a Dividend Growth Investor I seek out dividend paying companies. But the company didn't start paying dividends and become a quality company as a result. They became a quality company that was making money and then started paying dividends.
Habit No. 3 - They Seek To Understand
The effective DGI desires to understand everything about the investment they're undertaking. This means seeking understanding in 3 different areas as follows:
1. Understanding the company in which they're investing. They seek to know as much as they can about the company's business, its products, its strengths and weaknesses, how it makes money, and how they will keep doing so. For example, knowing that Procter & Gamble (PG) focuses on five core strengths it believes are required for them to be successful in the consumer products industry. Those core strengths are Consumer Understanding, Scale, Innovation, Brand Building, and Go-to-Market Capabilities.
It can include knowing that they have 25 brands that each generates at least $1 billion annually, and the company generates almost $84 billion in annual sales. That they are organized into two Global Business Units or GBU's, Beauty and Grooming and Household Care, and they have five reportable segments which are Beauty, Grooming, Health Care; Fabric Care and Home Care, and Baby Care and Family Care. That 14% of their total revenue in 2012 was from sales to Wal-Mart and its affiliates, that no other customer made up more than 10% of their net sales, and that their top ten customers account for approximately 31% of their total unit volume in 2012. It also includes understanding the not necessarily good, such as that they replaced their CEO recently (that may not be a bad thing), that billionaire investor Bill Ackman recently has been making waves within the company, or that Warren Buffett reduced his position size and was critical of the company management in the not too distant past. The point of understanding the company is that the effective DGI wants to understand the company as a whole, not just the financials.
2. Understanding their own self. The effective DGI makes an honest effort to understand their own investing limitations, whether it be their experience, understanding their emotional tendencies (such as panic/worry on dropping prices), their ability to perform due diligence, their willingness to do the work necessary to be an effective investor, and their mindset (trader vs. investor). They will recognize their strengths and weaknesses, and work to build on their strengths and to improve their weaknesses. As a personal example, I don't understand all the tax implications concerning MLP's, have no desire to learn them, and so therefore don't invest in them except through C Corps structured entities such as Kinder Morgan (KMI). The same thing applies to mREIT's. I don't invest in them but will invest in equity REIT's such as Realty Income (O) and Omega Healthcare (OHI). In understanding their own self the effective DGI will take into consideration where they are in their investment life, such as initial accumulation, accumulating and growing, approaching retirement, or in the distribution phase since these different phases can impact their decision making.
3. Understanding the investment implications. The effective DGI makes sure they know what the specific investments mean in regard to potential consequences if certain things happen, such as a significant event/failure of the company, a BP type of incident if you will. They understand the risk aspects of the investment, consider and act upon ways to reduce the potential risks and prepare for when the unexpected takes place. They understand what buying at over-valuation can do to their long-term results, what buying without a margin of safety means, and what selling too early or too late can do to their long-term results. They strive to keep a big picture view of the investment, not the short term of day to day price movements.
Habit No. 4 - They Practice Patience
By nature I am not a patient person. My wife is much more patient than I am. She can identify an item she wants to buy, say a dress, and then wait for it to go on sale at the price she wants. If I want to buy a tool for example, I'll go to Lowe's (LOW), pick it out, checkout and leave. One and done. Or I'll go online and order, most often from Amazon (AMZN). But I've learned that with dividend growth investing it pays to be patient. Compounding comes through patience. So does success.
By practicing patience I resist the urge to buy an over-valued company and wait until it comes to a point where it's advantageous to establish a position in it. Patience also applies to selling. Take 2 people, one patient and one not, and they both buy Walgreen (WAG) at $32 in November 2012. The impatient one takes profits at $37, buys back in March at $40, sells again at $46, and buys again in early June at $47 only to sell in a panic to protect profits in late June at $45 on an earnings miss, made a total of $9 for each share less commissions (and possible short-term gain taxes), along with missing two dividend payments. And they may still be satisfied that they made a profit of $9 share. The patient one continued to hold, received both dividend payments, will get a dividend increase on the next payment, and currently is up over $18 for each share less one commission fee. Don't think this doesn't happen. The internal argument over realized versus unrealized gains is a frequent event for the impatient investor.
In being patient with investments I've learned to be satisfied with, even have an affinity for, boring companies. High quality companies that slowly but steadily increase in value, continue growing their dividends faster than the rate of inflation and allow me to confidently compound the dividends are perfectly fine with me. Boring is not a requirement though and higher volatility stocks can certainly be held in dividend growth portfolios. But in my case having patience means I don't chase yield but look for under/fairly-valued quality companies and wait for opportunities to acquire them. Patience has allowed me to see that time is on my side when it comes to my DG investments.
Habit No. 5- They Have Conviction
In the book "Golf's Sacred Journey - Seven Days At The Links Of Utopia" by David L. Cook, the young golfer's teacher tells him that in the business of golf there is no model swing, no pat answers, that each person must develop a blueprint for his own style. He goes on to say that his greatest foe would be the casual comment offered up by a fellow player or teacher about how he should be doing it. That every champion has convictions but perennial champions have convictions based on foundations. These foundations become the first line of defense when facing adversity. I believe these lessons directly relate to Dividend Growth Investing.
The effective DG investor must have a strong conviction that DGI is the correct foundation for their investment style and that selecting high quality companies for their portfolio foundation is the correct approach. That casual comment offered by well intentioned people can be harmful if it takes you away from the basic foundation of your approach or style. Having that conviction will help with emotional difficulties during trying times. I'm not saying don't change, but don't be easily swayed by off-hand remarks or comments. For example, those who had conviction that DGI was the correct approach and maintained that conviction when adversity arrived in 2008-2009, held their positions (or added to them) in quality companies that maintained or continued to raise their dividends, were amply rewarded. That conviction can help to view price pullbacks as opportunities rather than problems. Conviction helps you to be disciplined and investing success requires discipline. Peter Lynch said that everyone has the brainpower to make money in stocks but not everyone has the stomach. Having the stomach for those trying times is where conviction comes in.
Habit No. 6 - They Look To The Future
We all use historical data to analyze companies to see how well they've done. But to truly analyze a company and our potential investment success we have to keep our eye on what will happen in the future. And it's more than just estimating a discounted cash flow to calculate a future price and convert it to today's price. Asking future based questions such as will Walgreen still pay their dividend and will they maintain the same rate of growth in 5 years? If not, how will it impact my investment? Will Johnson & Johnson (JNJ) still have an economic moat 5 or 10 years from now? How will Obamacare affect them when it goes into full effect? Can sales remain as strong as they have been? Where are the potential land mines for the company? How can I reduce future risks to the investment? How will rising interest rates affect the company and its potential returns?
Looking to the future also includes our own selves. When will we need to move from an accumulation role to a distribution role? How are my goals doing? Do I need to update my objectives? Do I need to make plans for the portfolio to be managed upon my death, transferred to a trust, sold off, etc? What do I need to improve upon in order to be a better investor? How do I, as Stephen Covey said in his Habit No. 7, sharpen the saw?
Habit No. 7 - They Pay It Forward
After publishing his book Dr. Covey later added an 8th habit. His 8th habit concerned personal fulfillment and helping others to achieve fulfillment. In his words, "find your voice and inspire others to find theirs."
I believe effective DGI's should be willing to help others achieve their goals and dreams, to share what they've learned and to help others in their journey to investment success. In my prior career I taught contracting quite often and I learned that if you really want to understand a subject then teach it. Preparing to answer the unknown question that might arise helps you to understand the subject better. And by helping others you also help yourself. There are other ways to pay it forward as well. It may mean helping our children or other family members, sharing methodologies and information with others, or even making charitable contributions with some portion of our investment proceeds. You might even consider writing articles for Seeking Alpha.
It may seem odd that I've referenced a football coach and a golfing book in an investment article. But I've had a tendency for years to relate observations from one area of my life to other areas. And I've found that many habits are transferable from one part of my life, such as work, to another part such as investing. Investing is not easy ("it's not supposed to be easy" - Charlie Munger) and having good habits will help us overcome some of the difficulties. Your habits may be different than mine but we still need to have and practice them.
I am retired now (and loving it) and don't have to keep any certain schedule or work routines. But that doesn't mean that I don't still care about having good habits, especially in regard to my investments. It's my intent to continue investing and to continue practicing what I believe are the habits required to be successful. The 7 habits listed above are what I believe will make me a better investor over the long term. As the 17th century poet John Dryden said "we first make our habits, and then our habits make us."
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.