Methodology I Use To Build Outperforming Portfolios

by: The Dividend Guy

Originally published on July 19, 2016

When I started investing, I was young and reckless. I enjoyed the opportunity to start my investing journey at a relatively young age (23) and make my mistakes with smaller numbers. My first three years in the investing world were crowned by success. I rapidly built a $50,000 cash down payment to buy my first house. However, the risk I was taking and the lack of diligence in my investment methods finally hurt me in 2006-2007. Then, 2008 arrived and it wasn't the time to change anything, since everything was falling apart. However, I realized that losing money on trades was the red flag which told me I was doing something wrong.

At this time, I started to do more research and decided to change my investing strategy. In 2010, I decided to select dividend growth investing as the basis of my holdings. Between 2010 and 2012, I worked on building a complete investing process that will guide me during good and bad times - an investing process that will guide my buying, selling and holding decisions when the horizon gets darker. I wish I could tell you that I started this investing strategy in 2003 and give you 13 years' worth of results (and I eventually will), but in the meantime, I still wanted to share my methodology with you, as it has been proven successful so far. Here's what I've done as yet.

#1 Identify your investing goal

It may sound stupid and simplistic, but the very first thing I did was to establish my investing goal. Some people just invest with the hope of making money. I don't think this kind of goal is well defined. As investors, we obviously want to make more money. What can we hope for if we invest $100,000 and withdraw $74,000 from it?

If you want to reach the $1,000,000 million dollar bar before turning 55, you already have a better goal. This goal definition implies that you will have to investing X per year at a rate of Y during Z number of years. Then, you start by having something tangible.

Since I knew my savings capacity was going to be hectic in my 30s (notably because I have stopped working for 12 months in order to travel the world), I couldn't reach such a defined investing goal. So far, my investing goal is to be able to build a portfolio that will generate an ever-increasing dividend income, while beating my benchmarks (a Canadian and a US dividend ETF). The reason why I aim to beat my benchmarks is simple; if I don't beat them, I should rather simply invest in those 2 ETFs and never spend more than 30 minutes per year on my portfolio! I would save lots of time, and could use it to make more money working on something else.

#2 Build an investing process

The biggest advantage of building an investing process is that you will avoid doubting your decisions all the time. I've discussed this with many investors since I started running this blog, and the same questions come up often:

When should I buy?

When should I sell?

When should I enter the market?

When should I exit the market?

Is there a bull market coming or another bubble crash?

I've personally found the answers to all these questions by defining my own investing process. Based on academic studies and tested on my own portfolios, I've built 7 investing principles:

Principle #1: High Dividend Yield Doesn't Equal High Returns

Principle #2: Focus on Dividend Growth

Principle #3: Find Sustainable Dividend Growth Stocks

Principle #4: The Business Model Ensures Future Growth

Principle #5: Buy When You Have Money in Hand - At The Right Valuation

Principle #6: The Rationale Used to Buy is Also Used to Sell

Principle #7: Think Core, Think Growth

The rationale and financial research used to build these principles can be found here. These rules have helped me to shape a long-horizon dividend growth portfolio that has been performing very well. In addition to my own portfolios, I've also built 12 real-life portfolio models applying the same rules. These 12 portfolios are doing very well compared their benchmarks. You can get my portfolio return details here, if you are curious.

By the simple fact of applying these 7 principles to my investing decisions, I skip emotional mistakes and doubt. I never have more than 2-3% of my portfolio sitting in a cash account, as I can always find a good opportunity. At the beginning of this year, I even decided to build my children a tuition fund portfolio based on the same principles, and I've never been worried even if the US economic numbers weren't as good as expected or when Brexit shook the market not so long ago. This portfolio has been built on solid ground, and I will not change my mind, since I know I'm doing the right thing. Without having solid background checks and a real set of rules, I would be less confident in my investing decision.

#3 Build a solid asset allocation

It is very possible to find several interesting companies in the same sector while pulling stock filters. It is without surprise that all the oil & gas and railroads companies are showing numbers that are slowing down at the moment. Does this mean all of them shouldn't be on your buy list? Nope, it simply means that these specific sectors are going through a tough time. The same thing happens the other way. Not so long ago, dividend-paying stocks in the consumer sector were showing very strong numbers before 2013. If you pick all of them thinking you have built a solid portfolio, you will be left with a bitter taste in your mouth later on. We saw exactly the same thing happening in the financial industry between 2003 and 2008.

This is why it is important to make sure you don't own too many stocks from the same sector. I always try to have less than 20% of my money invested in the same sector. The more sectors you have, the better your asset allocation will be. This will greatly help you to even out your investment performance year after year.

#4 Review holdings quarterly

During each earnings season, I take a pause to read about my holdings' results and what the future looks like. The point is not to trade any of my holdings based on a bad quarter or a bad series of quarters. Unfortunately, it is impossible to hold companies that show growth each quarter. Currency headwinds (I'm sure you read that one a lot!), challenging economic news or new factors are coming into play each year for each type of business. What is interesting is to see from one quarter to another how management reacts in front of a changing environment. What do they do to ensure the future of the company? How they will modify their course of action in order to pursue stronger dividend payments. This is the type of information I'm looking for.

If, for many quarters in a row, the company shows its inability to reverse an obvious trend, or it simply doesn't meet my reasons to buy shares in the first place, this is when I sell.

Final Thoughts

I don't think all the specifics of my methodology are unique. I think I've done an honest job in finding key metrics and ratios to follow. However, I think the real success of this methodology, as with any other successful one, is that I never twist or replace my investing principles for others. I follow my strategy no matter if the market goes up or goes down. I think to be successful and achieve your investing goal, you must stick to your investing rules and never change them.

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