Despite Mistakes, A Dividend Growth Investor Retires Early, Part II

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Includes: AAPL, ADM, CMI, CSCO, CVX, DEO, DIS, EMR, GE, GIS, HP, HSY, IBM, JNJ, KHC, KMB, KO, MCD, MMM, MSFT, NSRGY, ORCL, PEP, PG, PM, T, UL, UPS, UTX, VZ, WFC, WMT, WPC, XOM
by: Skip Kapur

Summary

I explain what I have learned about investing for retirement.

I provide my thoughts both on investments and behaviors.

I discuss things I plan to do over the next two to three years in order to improve my portfolio performance.

In part I, I walked through my journey towards becoming an early retiree. I emphasized the successes, failures and course correction I needed to make in order to achieve my goal. In this article, I explain my investing philosophy. Reasons to read this article are centered on the fact that I'm actually living off these beliefs. Enough dividends come in for me to spend my days as I wish. Conversely, I am not a professional, so readers should take what I share as a point-of-view. Even better, use this perspective as part of your triangulation as you devise your own strategy.

Quality Investing

For me, investing starts with quality. Quality companies tend to get stronger over time. This means that marginal errors in over-paying for the company are recoverable errors. As earnings per share increase over time, prices tend to reflect this fact in the long term. All my future portfolio moves are driven toward improving the quality of my portfolio. All my current portfolio challenges are based on holdings that I bought when I was not as focused on quality as I am now.

To me, hallmarks of high quality include:

- The simplicity and durability of the business model,

- the history of earnings and dividends growth,

- free cash flow (FCF, cash left over after CAPEX) and,

- use of financial leverage (less debt is better).

Over time, I have realized the importance of FCF, which gives companies tremendous optionality when dealing with crisis including recessions. It also is a demonstration of the strength of the business model and management's ability to use leverage wisely. Companies that are highly leveraged are fraught with risk, and FCF is a simple way to understand this risk.

If I cannot understand the business, I will not buy the company. Even more crucial, when researching a company, I look for reasons NOT to buy. I use a checklist. If a company does not get past the checklist, I simply move on to another company.

I create a handwritten page for every company in which I write down the following metrics:

- The business model of the company, including how the company makes money, and why I believe that the model is sustainable,

- years of earnings and dividend growth,

- earnings per share (EPS) and free cash flow (FCF) payout ratio,

- S&P credit, S&P quality, and Morningstar moat ratings,

- FAST graph valuation for 10, 15 and 20 years (FAST Graphs is a subscription-based service which is invaluable for determining valuation as part of a larger evaluation of a company),

- dividend yield and Chowder score (the Chowder score is the sum of dividend yield and the five-year dividend growth rate).

- I also visit Robert Allan Schwartz's site to see the dividend growth rate of the company. In addition, I visit longrundata to evaluate long-term stock performance. Both sites are free and a valuable service and I didn't know about them until reading SA.

I typically buy companies when FAST Graphs indicates fair or great valuation, and usually the associated prices tend to be close to 52-week lows. I review each company's investor presentations and look for several critical clues about their culture and strategy:

- What is the company proud of? Their operational excellence? Serving their customers? Providing dividends to their Investors? Their balance sheet quality?

- What they do with their FCF. Are they buying back shares? How committed are they to dividends?

- How sticky is their business, and how much of their business is repeatable (from existing customers).

- I write a couple of sentences on how the company makes money and why they will do well in the future.

- Lastly, I list the single biggest risk the business faces. If I struggle with this, I pass on the investment. If I cannot articulate the risk that a business faces, it means I simply don't understand its business model adequately.

The following are two examples of summaries I have written. (Management quality is a rating I've created for myself.)

United Technologies (NYSE:UTX): This is a conglomerate with four businesses (engines, aerospace, elevators and climate controls). In every case, they are either doing business as oligopolies (e.g., where they provide Boeing (NYSE:BA) or Airbus (OTCPK:EADSY) with engines) or are dominant (e.g., elevators, climate controls).

A wide moat rating coupled with an S&P IQ score of 100 and an S&P credit score of A- means that third party analysts are comfortable with the sustainability of the business. Repeatable service revenues are a considerable feature for ALL their business. The single biggest risk UTX faces is lower air travel and/or urbanization. Given secular trends, this is a risk worth taking. Management quality: A.

IBM (NYSE:IBM): A technology systems software and services provider, IBM does business with almost ALL of the largest businesses in the world. 65 percent of revenues and 75 percent of income are recurring. Companies of a certain size are practically forced to conduct business with IBM. The single biggest risk is that revenues have not grown in approximately 18 years. However, their base revenue is approximately $81 billion, giving it a lot of maneuvering room.

Large FCF has allowed them to buy back shares, 3 percent per year, a good thing that allows EPS to increase. Their emphasis on moving to leveraging Watson (cognitive solutions) and providing the cloud platform has a reasonable chance at success. Large customers will continue to provide stability. The largest risk IBM faces is technology disintermediation. The reason I am not too concerned is because they are at the forefront with new technologies due to their close relationships with large customers. Management quality: B.

My Investments

My top 37 holdings provide approximately 75 percent of all my dividends.

My top 37 holdings, in descending order of size, are Proctor & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), United Technologies, Verizon Communications (NYSE:VZ), Coca-Cola (NYSE:KO), AT&T (NYSE:T), Exxon Mobil (NYSE:XOM), Diageo (NYSE:DEO), Hershey (NYSE:HSY), Kimberly-Clark (NYSE:KMB), Unilever (NYSE:UL), Kraft Heinz (NASDAQ:KHC), McDonald's (NYSE:MCD), International Business Machines, Cummins (NYSE:CMI), PepsiCo (NYSE:PEP), Chevron (NYSE:CVX), Emerson Electric (NYSE:EMR), Wal-Mart (NYSE:WMT), Microsoft (NASDAQ:MSFT), Disney (NYSE:DIS), General Electric (NYSE:GE), Philip Morris (NYSE:PM), Altria (NYSE:MO), Nestle (OTCPK:NSRGY), Cisco (NASDAQ:CSCO), 3M (NYSE:MMM), Helmerich & Payne (NYSE:HP), United Parcel Service (NYSE:UPS), Boeing, General Mills (NYSE:GIS), Wells Fargo (NYSE:WFC), Apple (NASDAQ:AAPL), Archer-Daniels-Midland (NYSE:ADM), Oracle (NASDAQ:ORCL), Union Pacific (NYSE:UNP) and W. P. Carey (NYSE:WPC).

All but three are rated by Morningstar as narrow or wide moats. My fondest hope is that this list puts you to sleep by the tenth name. If it does, then I have achieved my goal of buying the most boring high quality companies that simply keep increasing earnings (and hopefully dividends) year after year.

The remaining companies in the other 25 percent are categorized as follows:

- Real Estate Investment Trusts (REITs). I consider the 10 or so REITs I own as one virtual company. I am unwilling to hold more than a quarter of a full position in any one REIT. My primary reason for this is that my experience with REITs is fairly recent and I don't have a feel for this sector as I do others. When the prices of Colgate (NYSE:CL), Pepsi or Automatic Data Processing (NASDAQ:ADP) go down, I have no problem adding to them as I've watched and owned them for years. The REITs I own include Armada Hoffler (NYSE:AHH), Chatham Lodging (NYSE:CLDT), HCP (NYSE:HCP), Lexington Realty (NYSE:LXP), National Retail Properties (NYSE:NNN), Ryman Hospitality (NYSE:RHP), STAG (NYSE:STAG), Store Capital (NYSE:STOR), Urstadt Biddle (NYSE:UBA), W.P. Carey and Weingarten Realty (NYSE:WRI). I intend to buy Realty Income (NYSE:O) and Digital Realty (NYSE:DLR), which I previously sold, and plan to now buy back at lower prices.

- Lower quality companies that I do NOT consider being long-term investments as they do not NOW meet my definition of quality. Examples include Baker Hughes (NYSE:BHI), BHP Billiton (NYSE:BHP), Coach (NYSE:COH), Devon Energy (NYSE:DVN), Ensco (NYSE:ESV), Murphy (NYSE:MUR) and Marathon Oil (NYSE:MRO). These will be liquidated over time and the funds reinvested into the companies listed in the next section.

- High quality companies that I don't own enough of either because I didn't have enough cash at the time (e.g., BTI, CSX, KNYGY, NSC, PH, PNR), or their yields were not high enough (e.g., MA, V, CL, BF.B, ADP, TDG as examples). I'm adding to this last group with funds left over when dividends received exceed expenses each month.

When I'm done with eliminating the lower quality companies (second section above) in the next two to three years, I expect to have no more than 50 companies in my portfolio. Remember, I count all my REITs as one holding and they represent less than 4 percent of my portfolio.

I hold only C corporations, I stay away from Gold, MLPs, M-REITS and BDCs, and I own very few non-US companies. I believe that U.S. reporting standards are the highest in the world and that is important in terms of risk mitigation. With two exceptions, I do not own closed-end funds or mutual funds. I sell Puts (but rarely) and stay away from selling Calls. My portfolio is entirely equity. My portfolio is diversified, but not asset allocated.

I own no bonds, but will consider buying bonds if 30-year yields exceed 6 percent. In other words, I probably will not own them in my lifetime.

While I keep up with the news, my understanding of the macro-economic environment does not DIRECTLY impact my buy or sell decisions. Coca-Cola or Pepsi or Nestle are impacted by so many forces, globally, that I find it impossible to possess any value differentiating information. Offer them to me at 3.5 percent yield, and I'll take them any day, all day.

Because prices fluctuate significantly in any given 12-month period, I find that I never keep cash for long. My typical cash position is less than 1 percent. Note that CL's 52-week high and low are $50-$75, EMR's is $41-$56, JNJ's is $82-$126, and these are all dividend aristocrats! My contention is that your cash does not need to wait more than six months in order to purchase a high quality company at a somewhat reasonable valuation.

My brokerage accounts are with Merrill Edge and Wells Fargo. Both provide zero cost trading. Wells Fargo has stopped zero-cost trades for new accounts but Merrill Edge still offers them. Their service is excellent. Through Merrill Edge, I get access to Morningstar and S&P reports. I subscribe to Fast Graphs and I download David Fish's CCC list every month. I believe in karma and I know that David's account increases every month!

I consider Seeking Alpha not only to be a valuable source of information but a true community (at least the DGI component). The amount of time people take to teach and answer questions is simply breathtaking. I read anything put out by Chuck Carnevale, Mike Nadel, Chowder, Part Time Investor, Dividend Sleuth, Dividend House, Simply Safe Dividends, Bob Wells and Sure Dividend amongst others. I think of Tim McCaleenan as a particularly gifted thinker and writer.

I have concluded that the past record of companies provides the best possible correlation to future performance. Reference Jeremy Siegel's seminal work "why the tried and true triumph over the bold and new." I have learned that companies make their greatest profit during their cash cow phase. That most industries are oligopolistic (i.e. typically two to three companies dominating their space), thus, providing some degree of revenue stability. References one and two of oligopolies.

Investment Behaviors

Based on my own experience and those of colleagues, I am convinced that our biggest obstacles to achieving investment success are our own paradigms and behaviors. We trade too much. We cannot bring ourselves to buy good quality companies when prices go down because it is difficult to go against the grain. We sell to take small one-time gains instead of letting compounding to occur.

We buy junk at low prices and think we got a bargain. We earmark portions of our portfolios for speculation wherein we agree to lose that portion of our portfolio. We forget that as equity investors we are getting PAID for dealing with volatility. That is the agreement: Handle the emotions that come with volatility; keep higher returns in the long term.

Possibly the single biggest behavioral failure is to see investing as a form of gambling. With friends I see an attitude of swinging for the fences. Many want 100 percent and 200 percent returns, quickly. They subscribe to expensive newsletters that know of some pharmaceutical company that with just this one successful trial will own the world's supply of a much-needed cure.

They have no idea whether or not the company has cash to last the quarter. Even worse, they seem resigned to the fact that investing in stocks means accepting large losses. As Buffett says "Rule No. 1 Never lose money. Rule No 2 Never forget rule No 1." It took me years to understand this simple concept. This means no swinging for the fences.

So this brings us back full circle. Since safety of principle is paramount, one must buy high-quality companies at reasonable value. By necessity this means buying "safe" companies. Doing so is "boring" because your wealth, under such an approach, builds gradually - slowly, but surely. That is the experience I went through, and want to share. Want excitement? Join a poker tournament; at least your losses are limited to the entry fees.

I have realized that buying and holding is a viable option for long-term wealth creation. My doubles and triples are companies that I have simply left alone.

Working for the Future

On May 1, 2016, after 32 years of working and 2 million miles of air travel, I retired at age 57. I live off dividends. My income buffer is 20 percent. Dividends received could decrease by 20 percent and we'd still be able to get by. I also have 18 months of expenses in cash. I aim to keep my life as simple as possible with the fewest possible complications and possessions.

I spend one to two hours a day monitoring and reading up on companies and investor psychology. I love doing this by the way. About as much time each day as I spend exercising or reading or bothering Dearest. One of my goals is to become as good at investing as I was at my profession. Another is to take as many road trips as I can while I have my health. Yet another is to spend time with family and friends, and give back as much as I can.

Conclusion

To summarize Parts I and II of this article, the four stages of my evolution to early retirement were:

- Stage 1 (17 years): I contributed the maximum to 401(k) and IRA, and invested all of it in equity index mutual funds. I also invested taxable savings in high-quality dividend-paying stocks.

- Stage 2 (2 years): I incurred significant losses because I invested new taxable savings into momentum stocks.

- Stage 3 (11 years): I reverted back to stage 1.

- Stage 4 (3 years): I transitioned from ETFs and equity mutual funds to an all-individual-stock portfolio over a three-year period.

My key learnings are as follows:

- Owning individual dividend growth companies is a viable strategy to generate income to live on.

- Buying quality companies is critical. As Buffett says, it is better to pay a fair price for a great company than a great price for a fair company. This emphasis on quality has been my greatest improvement as an investor in the last three years.

- Diversify to reduce risk.

- Valuation matters. But I don't go crazy about it.

"Retirement, a time to do what you want to do, when you want to do it, where you want to do it, and, how you want to do it." Catherine Pulsifer

My questions to you are:

- Have you documented your strategy for achieving retirement? Remember, simply stating the goal and describing your strategy is perhaps the most important step you can take. Bob Wells has written extensively about the value of conducting this valuable exercise.

- Are you happy with the quality of your holdings? If not, are you willing to sell poor quality companies, at a loss in order to buy higher quality ones?

- Are you trading too much?

- What actions can you take to improve diversification (by either lowering or increasing your holdings) and quality?

Thank you for reading this article. I intend to respond to every comment.

Disclosure: I am/we are long PG, JNJ, VZ, KO, T, UTX, XOM, DEO, KMB, HSY, KHC, MCD, PEP, UL, CVX, WMT, EMR, IBM, PM, CMI, GE, NSRGY, DIS, MSFT, CSCO, MMM, HP, GIS, UPS, WPC, WFC, ADM, ORCL, AAPL.

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.