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8 Rules Of Dividend Investing

Apr. 04, 2014 1:48 PM ET4 Comments
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Summary

  • Quantitative strategies outperform qualitative strategies.
  • Common-Sense rules help prevent investing errors.
  • High quality growing dividend stocks have historically performed very well.

The 8 rules of dividend investing are based on common-sense principals that come from many of the greatest investors of all time. The 8 rules of dividend investing are academically substantiated. They are quantifiable hard rules, not fuzzy guesswork approaches.

The first 5 rules govern what stocks you should invest in. Rules 6 and 7 detail when to sell. Rule 8 guides you on portfolio management. Without further ado, the 8 rules for dividend investing success:

Rule 1 - The Quality Rule

Quote - "The single greatest edge an investor can have is a long term orientation" - Seth Klarman
Common Sense Idea - Invest in great businesses that have a proven long-term record of stability, growth, and profitability. There is no reason to own a so-so business when you can own a great business for a very long time.
Financial Rule - Invest only in stocks with 25 or more years of consecutive dividend increases
Evidence - The Dividend Aristocrats (stocks with 25+ years of rising dividends) have outperformed the S&P500 over the last 10 years by 2.88% per year.
Source: S&P 500 Dividend Aristocrats Factsheet, February 28 2014, page 2

Rule 2 - The Bargain Rule

Quote - "Price is what you pay, value is what you get" - Warren Buffett
Common Sense Idea - Invest in businesses that pay you the most dividends so you can increase your cash flow from your investments.
Financial Rule - Rank stocks by their dividend yield.
Evidence - The highest yielding quintile of stocks outperformed the lowest yielding quintile of stocks by 1.76% per year from 1928 through 2013.
Source: Dividends: A Review of Historical Returns by Heartland Funds, page 2

Rule 3 - The Safety Rule

Quote - "The secret of sound investment in 3 words; margin of safety" - Benjamin Graham
Common Sense Idea -If a business is paying out all their profits as dividends, they will have nothing left to grow the business. When a downturn in the business occurs, they will have to cut the dividend. Invest in businesses that have much higher profits than they do dividend payments so your dividend payments are secure.
Financial Rule - Rank stocks by their payout ratios.
Evidence - High yield low payout ratio stocks outperformed high yield high payout ratio stocks by 8.2% per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Rule 4 - The Growth Rule

Quote - "All you need for a lifetime of successful investing is a few big winners" - Peter Lynch
Common Sense Idea - Invest in businesses that have a history of solid growth. If a business has maintained a high growth rate for several years, they are likely to continue to do so. The more a business grows, the more profitable your investment will become.
Financial Rule - Rank stocks by their long-term revenue growth.
Evidence - Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4% per year from 1972 to 2013.
Source: Rising Dividends Fund, Oppenheimer, page 4

Rule 5 - The Peace of Mind Rule

Quote - "Psychology is probably the most important factor in the market - and one that is least understood" - David Dreman
Common Sense Idea - Look for businesses that people invest in during recessions and times of panic. These businesses will have a relatively stable stock price that will make them easier to hold for the long run.
Financial Rule - Rank stocks by their long-term volatility.
Evidence - The S&P Low Volatility index outperformed the S&P500 by 2.00% per year for the 20 year period ending September 30th, 2011.
Source: S&P 500 Low Volatility Index: Low & Slow Could Win the Race, page 3

Rule 6 - The Overpriced Rule

Quote - "Pigs get fat, hogs get slaughtered" - Unknown
Common Sense Idea - If you are offered $500,000 for a $250,000 house, you take the money. It is the same with a stock. If you can sell a stock for much more than it is worth , you should. Take the money and reinvest it into businesses that pay higher dividends.
Financial Rule - Sell when the normalized P/E ratio is over 40.
Evidence - The lowest decile of P/E stocks outperformed the highest decile by 9.02% per year from 1975 to 2010.
Source: The Case for Value by Brandes Investment Partners, Page 2

Rule 7 - The Survival of the Fittest Rule

Quote - "When the facts change, I change my mind. What do you do, sir?" - John Maynard Keynes
Common Sense Idea - If a stock you own reduces its dividend, it is paying you less over time instead of more. This is the opposite of what should happen. You must admit the business has lost its safety and reinvest the proceeds of the sale into a more stable business.
Financial Rule - Sell when the dividend payment is reduced or eliminated.
Evidence - Stocks that reduced or eliminated their dividends had a 0% return from 1972 through 2013.
Source: Rising Dividends Fund, Oppenheimer, page 4

Rule 8 - The Hedge Your Bets Rule

Quote - "The only investors who shouldn't diversify are those who are right 100% of the time" - John Templeton
Common Sense Idea - When you go to invest, buy the highest ranked stock of which you own the least. You will be spreading your bets over different businesses as time goes by. Better yet, you will still be investing in great businesses.
Financial Rule - Buy the highest ranked stock of which you own the least.
Evidence - 90% of the benefits of diversification come from owning just 12 to 18 stocks.
Source: Frank Reilly and Keith Brown, Investment Analysis and Portfolio Management, page 213

Real Life Examples

To get an idea of exactly what businesses fit the rules above, I have selected 5 of the top 10 for April 2014 below:

  • Coca-Cola
  • Wal-Mart
  • Kimberly-Clark
  • McDonald's
  • Exxon Mobil

The majority of stocks that the 8 rules find are well known businesses that have been around for a long time. They are household names that many people are very familiar with. This is because they have been so successful, for so long.

Disclosure: I am long WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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