Investing doesn't have to be complicated.
There. I said it. I know I will get many comments disagreeing with me, but there it is. I'm putting it out there. Investing DOES NOT have to be complicated if you don't want it to be! Of course it can be very complicated if you wish. Extremely complicated! You can study annual reports, study financial statements, listen to earnings conference calls, even do technical analysis. And if you want to do all that, or you enjoy doing all that, and it works for you, then good for you. Go for it. But my position is that it is not necessary. Life is complicated enough. Investing doesn't have to be.
In "What Works on Wall Street" and "Stocks for the Long Run" James P. O'Shaughnessy and Jeremy Siegel show us which investing methods have stood the test of time. And here on Seeking Alpha there are many contributors who have described their methods, have shown that they work, how they work, and why they work. And O'Shaughnessy, Siegel and the authors on SA have shown dividend growth investing (DGI) to be a successful, long-term method of investing. Some people argue that DGI is not perfect, and that other systems will work better. Maybe so. But I have yet to see anybody show, with actual historical data, a well designed DGI portfolio, with well thought out buying criteria, selling criteria, and management rules, that DID NOT perform well over the long term.
So if it's already been shown to work, I figure why not use it? Why try to reinvent the wheel? And that is why I am a dividend growth investor. It is the only investing method I have found that matches my needs, my goals and my desires, and that has been shown to be effective over many decades and market cycles. And one of my desires is to be independent. I don't need a portfolio manager to do it for me. Nobody is more interested in my portfolio doing well than me. So why shouldn't I control it? But you might say that you (or I) don't have the expertise necessary to evaluate stocks, make smart selections, and wisely manage a portfolio. My argument is that we CAN do it ourselves, because many people have already done a lot of the work for us, and we have the opportunity to make use of what they have already done. We don't need to replicate it. We can use their work to our advantage.
If I pay attention to some very basic, but critical ideas, then I can invest safely and effectively, and by using the tools and knowledge others have already developed for me, I can do it fairly easily, and in very little time. The stocks I buy must have financial strength, a strong earnings history, and a strong dividend history. As long as I pay attention to these basics then I should be successful.
Now, what I am presenting here is what I do. In no way am I suggesting that other people should adopt my method. I am not a financial expert and I am not looking to give financial advice or recommendations to anybody. I am simply showing what I do, and how a simple system that only takes about an hour every few months can be just as effective as many of the other more complicated systems you may come across. Is it the best system out there? Will it beat all other systems in terms of dividend income or total return, either in the short term or in the long term? Probably not. But my goal is to produce a stream of dividend income, which grows every year, and will eventually support my wife and me in retirement. It is not necessarily to accumulate as much wealth as possible (or to take all the risks that might entail). And if anybody reading this article chooses to adopt some of my thoughts then I am honored. I wish you well. But make sure you set up a system that you are comfortable with, which makes sense to you, is easy to follow, and lets you sleep well at night. You will need to choose a set of simple buying criteria, each one of which is easy to understand and easy to evaluate, but which when used together create a powerful screen which finds you quality dividend growth stocks. And then set straightforward selling and management rules, and follow them. By creating simple to follow criteria and rules, and by sticking to them, you take emotion out of your decisions, and eliminate one of the biggest reasons (emotion based decisions) why portfolio returns may suffer.
My system is derived from four basic ideas:
- The stock must have the financial strength to pay a good dividend, and to increase that dividend every year for many years to come.
- The stock must have a culture of paying dividends which increase year after year, and of increasing the dividend enough to stay ahead of inflation.
- The stock must not be overvalued when you purchase it.
- Diversification. Since I know I will make some mistakes, the number of stocks I own must be large enough to protect my portfolio from a dividend cut by any one of my positions.
Many people study data such as earnings, book values, short and long-term debt, etc. As a DGIer I focus on the dividend. It is all about the dividend. To me, the reason to study any other financial data would be to try to determine if the company can continue to pay the dividend. But I figure the dividend history speaks for itself. If the company has been raising its dividend every year for the past 5-50 years, then it must have had the financial strength to do so. And if this changes, and the company no longer has the financial strength to raise its dividend, the dividend announcement will tell me that. In my opinion looking at all the other financial data just complicates the issue. I know that many will argue that trying to figure out a pending dividend cut before it happens can save you from a large drop in the stock price. This may be true. But it also can be very difficult. And I think that the most important indicator of what a company will do in the future is what it has done in the past. And in the cases where I turn out to be wrong (and I know it will happen) the size of my portfolio, as mentioned in point D above, will protect me.
I don't worry about capital gains (I'll take it, but I'm not focusing on it). I'm not looking for the stock price to double or triple over a certain period of time. I'm just looking to collect dividends. But I also know that if the dividend growth continues over many years then the capital gains will follow. By concentrating on the dividend I don't have to try to figure out which stocks will double in the next two years. It minimizes the data I have to look at and helps me to screen out companies.
So here are the criteria I use for purchasing my stocks, and the justification for each. In parenthesis are the ideas listed above which are addressed by each of these criteria.
1. The stock must be on the Dividend Champions, Contenders, and Challengers list compiled and maintained by David Fish. The company must have a strong history of paying dividends, year after year, and growing that dividend every year for at least the last 5 years. By limiting myself only to the stocks on this list the number of companies I am considering is immediately cut down to about 400-500. (B)
2. A yield of at least 2.5%. The goal is dividend income, so the yield must be large enough to produce an adequate income. This can be adjusted for each investor's personal situation. I feel that the longer the time horizon you have for investing, the lower the yield you can tolerate, as long as you compensate for that lower yield with a higher DGR. As I get closer to retirement I plan on increasing this minimum yield up to 3% and higher. But for now 2.5% works for me. This cuts the number down to about 250. (A, B)
3. A payout ratio less than 60%. The amount of earnings that is paid out as dividends must not be so large as to be unsustainable. A payout ratio that is too high can be unhealthy and can eventually lead to a dividend cut. By keeping the payout ratio below 60% I try to weed out companies whose dividends are in danger of being cut. This brings the number down to about 100. (A)
4. Chowder number. The Chowder number is the dividend yield plus the five-year dividend growth rate. The Chowder number is listed in David Fish's CCC list. The companies I buy must have a history of either paying a high yield, a history of strong dividend growth, or both. The combination of the two indicates the company's commitment to paying a healthy, increasing dividend. I eliminate any stock with a Chowder number less than 12 (or less than 8 for Utilities, REITs and MLPS). This brings the number down to about 70. I suggest you read Chowder's instablogs to learn more about the Chowder number, and DGI. Much of what I do is based on what I have learned from reading Chowders blogs and comments.
5. S&P quality rating. The company must have the financial strength to continue to increase its dividend payments. Therefore the company must have an S&P quality rating of at least A-. This brings the number down to about 40.
6. A strong earnings history. . Dividends come from earnings. In order to continue to increase the dividend a company must be able to increase its earnings. Nobody can tell what a company's earnings will be in the future. The earnings predictions by different analysts can be different by 20-30% or more. And this is for large cap companies followed by as many as 20 analysts! To me one of the best indications of whether or not a company will increase its earnings in the future, is what is has done in the past. If management has been able to routinely grow earnings in the past then there is a good chance it will continue to do so in the future. Therefore, to make the cut, a company must have a history of steadily increasing its earnings, year after year, with very few down years. I look at FAST Graphs to determine that. As an example, below is the FAST Graph of Wal-Mart (NYSE:WMT). The orange line shows the earnings trend for the past 15 years. This is the kind of earnings growth I look for.
7. I will not pay too much. Even the best dividend growth companies can become overvalued. And if you pay too much your yield and total return will suffer. WMT in 1999 (left side of the above graph) was selling way over its fair value (orange line). For the next ten year the stock price stagnated, even though its earnings continued to rise. Only recently has its price begun to increase again. I use FAST Graphs to check the valuation. If the stock price is at the orange line (as WMT is now), or below, then the stock passes this screen. (C)
8. Diversification. To protect myself from my own mistakes I feel that I should own at least 30 companies, and am willing to own as many as 100 or more. No screening method is perfect. Certainly mine won't be. Some mistakes will be made. As mentioned above, holding a large number of positions protects my portfolio from the affects of any one dividend cut. (D). This is difficult to do when first starting out. It takes a decent amount of money to hold this many positions, or else commission costs will be too burdensome. I want my commission costs to be under 1% of my portfolio. With 50 stocks, and assuming commissions of $10 per trade, I would need a portfolio value of at least $50,000 to keep my initial commissions under 1%. But let me also say that although there may be a large up front commission cost, there should be very little turnover. These stocks are meant to be held for many years. So once the portfolio is set the commissions should be very low. Someone with less money could choose to hold fewer stocks, but I would be uncomfortable holding less than 30. Otherwise I may not give myself enough protection from dividend cuts. When starting out, if unable to handle the costs of buying 30 positions, or more, one might consider a few DGI ETFs to begin with, and over time, as more funds are added, the switch over to individual stocks can be made.
Weighting and Rebalancing
There are many ways to balance a portfolio. Again, to keep things simple, I go with equal weighting of all my stocks. At least as initial positions. You can never know which stocks will perform better in the future, so I figure that by keeping my stocks relatively equal weighted I will have a full position in any stock that does rise significantly. As time goes on and stock values change some stocks will become over weighted. I don't plan on selling shares of any stock that has risen significantly, just to bring it back into balance with the other positions, but I also will not reinvest dividends, or invest new funds, into that stock. By doing this I hope to keep any one position from becoming more than twice as large as any other position. That is the limit I feel comfortable with.
One of the key tenets of dividend growth investing is the reinvesting of the dividends. To be consistent with my plan to keep everything simple, the most obvious way to reinvest dividends would be to reinvest them right back into the stocks that paid them. Dividend reinvestment plans (DRIP) are easy to set up, and have proven to be very effective. Unfortunately for me the trust company which holds my retirement funds does not offer DRIP plans. Therefore I had to come up with my own plan for manually reinvesting my dividends.
I decided that I wanted to reinvest my dividends into the companies in my portfolio that are the most undervalued. I evaluate all my stocks and rank them based on their Percentage Above Average Yield (PAAY). I have already written an article about this so I won't go into the details here. Suffice it to say that stocks that have a yield higher than they usually do, either due to a drop in the stock price, or an increase in the dividend, may be undervalued. I consider the stocks in my portfolio with the highest PAAY to be the most undervalued. Therefore these are the stocks that I buy more of when reinvesting my dividends, or when investing new funds. I have a spreadsheet set up that automatically updates the prices of all my stocks, their PAAY, and their rank compared to the other stocks. So, again, it takes only a few minutes to figure out which stocks I will reinvest in.
Again, I feel there's no reason to get complicated. I will sell if a company cuts or freezes its dividend. It's that simple. I have no other selling criteria. Changes in earnings, changes in stock price, changes in cash flow or debt levels, none of that is important in my decision making. I ignore it all. As long as the dividend grows every year I will continue to hold the stock. But once it violates my rule about raising the dividend year after year it is gone. I receive e-mails from SA every day about all the stocks in my portfolio. All I have to do is look for the dividend declarations to determine what each company is doing with its dividend. Very easy.
Some DGIers will sell a stock if its DGR falls too low (Again, read Chowders blog about this). I may consider doing this in the future but, for now, I have decided that it takes an actual freeze or cut for me to sell any stock.
In my opinion there is no reason not to Keep it Simple! Unless you love spending a few hours every day analyzing company financials, I don't think you have to bother with any of that stuff. David Fish, Chuck Carnevale (the creator of FAST Graphs), and S&P have already done a lot of hard work compiling the data and putting it into easily usable forms. So go ahead and use it! And many others here on SA have already given examples of how they use DGI. Their knowledge and experience is invaluable. Use their examples to come up with your own system. You don't have to use mine. But whatever system you develop, make sure you set down the rules, follow them, and be patient. DGI is a long-term philosophy. Don't break your rules. But if, over time, you find that your rules are not working for you, go ahead and change them.
I'm guessing that some may criticize me for being so simplistic, arguing that it takes a lot of time to effectively evaluate stocks, and that if you're not willing (or able) to put in the time then you should probably let a professional portfolio manager do it for you. My response is take a look at my portfolio. I post an update every quarter. Many of the stocks I have selected with my KISS system are the same ones held in the portfolios of those who do all the extensive research. They spend all that time evaluating hundreds, if not thousands of stocks, and yet we come up with similar portfolios.
Finally, let me say that simplicity is not the goal. I'm not purposefully trying to simplify things. I just haven't found complicated to be better. And it works best for me and my lifestyle. When investing, as with everything else in life, you must be true to yourself. People need to know their own strengths and weaknesses, and they need to do what works best for them. But if you make investing too complicated you will probably end up making many mistakes. Or you may give up and decide to put your portfolio in the hands of a fund manager. I contend that they will not always have your best interest in mind. Stick to the basics, make sure the companies you select are strong financially and have a great dividend history, and protect yourself through diversification.
Thank you for reading my article. I welcome your comments and criticisms.
Disclosure: I am long WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.