Seeking Alpha
Profile| Send Message| ()  

Seeking Alpha has quite the collection of dividend growth investors. Though I don't currently maintain a dividend growth portfolio of my own, I am in the process of modeling one and should begin the building stage by mid-2013.

As a result, though I admittedly lack the field experience of most contributors in this investment arena, this series will hopefully generate some quality discussion about the strategy as a whole, in addition to the individual investment ideas.

This article will sum up my views on dividend growth investing while also explaining my personalized strategy. The second installment will consist of my current model portfolio, which I hope will also generate some feedback.

The Method Explained

Dividend growth investing, or DGI, isn't a one-size-fits-all method. There are plenty of decisions that need to be made as investors consider various opportunities and begin the portfolio building process.

For one, dividend growth investors must decide the ultimate goal of their endeavors. Is it to build a portfolio that is mainly expected to generate a large, steady income stream on the basis of spectacular yields on cost? Perhaps the strategy is being utilized to capture outperforming total returns, with an emphasis on company growth prospects rather than dividend potential.

Next, investors must decide on their presumed time frame, since the dynamic of initial yield in combination with annualized dividend growth is a cornerstone of the strategy. This, of course, leads into the next decided variable, which is what kind of initial yield and appreciation combination the investor is looking for. SA contributor David Van Knapp's valuable and oft-utilized "10 x 10 table" is below:

The chart indicates how many years the various combinations would take to produce a hypothetical yield on cost of 10%. The beauty of the strategy begins to appear when we consider what earning 10% per year in dividends alone really means. On a risk-adjusted basis, investors with 10% dividend streams will handily outperform the market almost all of the time, since the dividend component is (essentially) guaranteed and steady, while equity appreciation is not. At the same time, dividend growth should ideally be complimented by quality free cash flow growth, leading to long-term gains in the share price. Stocks that are purchased at fair prices should rise at a long-term, annualized pace in-line with free cash flow growth.

For investors with multi-decade horizons, choosing investments that satisfy the criteria and fall towards the left-center of the chart appears to make the most sense, and produce the best dynamic over time.

As you can see, investments with initial yields of less than three percent take an excruciatingly long time to produce a yield on cost of 10%, unless the annual growth rates are exceptional. Fortunately, one of my favorite companies, Becton Dickinson (BDX), currently only yields 2.40%, but offers a 5 year dividend growth average of 13% annually. Thus, the 11-12 years that it would take me to achieve a 10% yield on cost is very reasonable in the context of a presumed 70-80 year time frame. At that rate, I'd have a YOC of 25% by year 20 (without dividend reinvestment).

But what about stocks with excellent prospects, but that lack a solid dividend dynamic? For example, I believe energy services giant Schlumberger (SLB) has astounding growth prospects courtesy of the natural gas and oil exploration boom, but it only yields 1.50% with a 5-year growth average of almost 13%. These inputs mean SLB would only produce a 10% YOC by year 19.

Of course, I could hold SLB as a smaller part of the portfolio and perhaps offset its lower YOC appreciation with another holding, but I'd be walking a fine line. The yield on cost of SLB by year 10 would be a mere 3.30 -- my psychology for this holding would be far different than the rest of the portfolio. For example, with a near meaningless yield in the context of the entire portfolio, I'll be much more adverse to price declines in SLB, especially since it's not producing much of an income stream.

Lastly, I'd likely be far better off allocating more capital to a company like BDX. I expect to see long-term annualized EPS growth of 6-7%, since I'd be earning annual total returns of 17% after year 10. It would be quite difficult for SLB to achieve those kinds of returns, and it's certainly not worth compromising the portfolio strategy.

Personal Strategy

As a young investor, I have a long investment horizon. While this doesn't change much in terms of execution, I should have the benefit of ultra compounded earnings and dividend growth. The duration of my investing time frame is the key reason that I've become a DGI follower.

As previously mentioned, I also appreciate the liberation that this strategy offers. If there's one thing I've learned during my investment life, it's that crises, especially the ones people see coming, have a way of being mitigated by society. People are always working behind the scenes, and business continues getting done. This reality aligns perfectly with dividend growth investing, since it aims to profit from depressed share prices, thereby increasing the yields on cost and leveraging future returns.

My first goal will be to find companies that fit the following yield criteria:

  • Initial yield upwards of 2%, preferably 3%
  • Payout ratio based on FCF below 60-70%
  • Annual dividend growth sufficient enough to generate yield on cost of 10% by 12-13 years

After doing so, I'll be looking for companies with the following:

  • Unique, non-commoditized products sold by firms that earn sustainable profits above the normal rate of return
  • Strong brand names in its market
  • Good management (this is a major intangible)
  • Strong returns on equity
  • Growth catalysts
  • Minimal "blowout" risk -- Lehman's highly levered exposure to real estate and CDOs comes to mind
  • Predictable cash flows (definitely easier said than done, but is far more realistic in something like consumer staples vs. semiconductors)
  • Economies of scale

One company that I've found meets my criteria with flying colors is Tompkins Financial (TMP). A regional bank operating in upstate New York, TMP yields 3.7% and grows its dividend at 6.5% per year (10-year average), with plans to increase that markedly.

The bank has an established brand name that's been around for 175 years, strong retention rates, and strong cross-selling of products. Management is very shareholder oriented, and recently acquired another healthy regional bank, VIST Financial, at well below book value. Free cash flow has been growing at about 6% per year and the payout ratio is a low 45%.

Tompkins grew earnings right through the recession (quite a feat for a bank), and engages in the "boring" business of genuine banking -- lending depositors money out at favorable rates of return. The company does it well, and investors can sleep at night without having to worry about shareholder lawsuits or CDO holdings.

As for automatic reinvestments via a DRIP plan, I'm all for them as long as you are allocating your capital to the most promising investments. In other words, automatically reinvesting doesn't make sense if you feel the stock's upside is limited, so you'd therefore be better off investing the proceeds of its dividend in an existing or new, cheaper idea.

That leads to the question of whether or not to rebalance the portfolio. Again, my plan is to not worry about industry, macro, etc. exposure. Rather, I'll allocate the majority of funds to my best idea, and the rest to my second, third and fourth best ideas. Diversification beyond that point doesn't make much sense to me. As Warren Buffett says, "no one gets rich on their sixth best idea."

Hedging

I'd imagine that very few focused dividend growth investors care to hedge any sort of macro or "tail-risk" (risk of a major market meltdown). That's fair enough, especially since plenty of long-term investors have done exceptionally well without selling euros or buying put options.

That being said, I know my personality. Unless I feel like I'm covered from all ends, I'm bound to do something stupid with my investments. Additionally, most of my investment background is in trading strategies: futures, options, shorting, commodities, etc.

My plan is to have an excellent portfolio of stocks based around my customized dividend growth strategy, with investments decided by a bottom-up approach. To further leverage risk-adjusted returns, I will "hedge-out" the incurred macro exposure risks.

As an example, though I've recently written articles discussing why gold is likely to drop in the medium-term (don't try and tell the gold bugs this), I feel holding gold is currently an excellent insurance against the ongoing currency debasement and heightened sovereign default risk. Seth Klarman agrees. The way he sees it, while utilizing gold as an insurance holding is no longer a cheap option, it is in fact necessary, given the current environment we are operating in. Negative real interest rates, currency debasement, a limited supply of quality assets, and blowout risk will keep the price of gold elevated until these issues are resolved.

Furthermore, to reduce overall market exposure and gain some uncorrelated returns, I'll continue to sell calls, buy puts, and short stocks that I believe are, as hedge fund manager Dan Loeb has termed, "fads, frauds, or failures."

My personal trading activities may be a bit controversial, since the general consensus among investors seems to be that short-term trading never works. While I definitely disagree with that sentiment, I'd agree that hedging is absolutely not necessary for concentrated dividend growth investors. Rather, I'll continue my trading activities (while I'm young and have the energy), since they align with my personality and investing needs.

In the next article, I'll give detailed descriptions on one of my model DGI portfolios, in conjunction with a hedged portfolio.

Source: My Model Dividend Growth Investment Portfolio (Part 1): The Strategy