DGI Investing: Don't Miss The Forest For The Trees

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Includes: AMZN, FB, GOOGL, MSFT, NFLX
by: Value Prof

Summary

Are rigid DGI rules holding your portfolio back?

As a millennial DGI investor, I like to keep a portion of my portfolio reserved for non-DGI stocks.

Dividends or not, I always look for favorable economic trends, solid moats, and pristine balance sheets.

Some growth stocks may be more defensive than you think.

I often read articles and comments that justify holding companies with lackluster future prospects for years simply because of their fantastic dividend growth or their current yield, or because the investor wanted exposure to a certain sector but couldn't find anything else that met their rules for DGI investing.

While I do make sure that my portfolio has an overall yield and dividend growth rate that exceed those of the S&P 500, I wanted to suggest a less rules-based perspective for dividend investors with a longer time horizon like myself.

I believe that if one focuses on income statements and balance sheets and applies a healthy dose of forward thinking, allocating part of one's DGI portfolio to non-dividend paying stocks can provide exposure to some rapidly growing niches of the market that will play an important role in the future and can improve the overall quality of one's portfolio without adding unnecessary risk.

After all, many of our favorite dividend growth stocks experienced most of their growth before paying a dividend, so I think it makes sense to seek out the best companies first, whether or not they pay a dividend. It's important to have a set of guidelines when investing, but the world is changing so let's embrace it!

Don't Miss The Forest For The Trees

When I started out as a dividend growth investor, I read all of the articles I could find about DGI portfolios and created a list of 10 screens that all of my stocks needed to pass. The Chowder number was my mantra. But as time went on, I realized that my criteria was so strict that a lot of great companies were passing under my radar simply because they didn't pay a dividend. All the dividend growth in the world wasn't going to help me hit my retirement savings goals if I didn't first have the proper sector allocations and an optimal blend of growth and value stocks.

Lost In The Woods

After backtesting many different portfolio models, I discovered that I might get better risk-adjusted returns by being less rigid and more focused on the bigger picture of long-term growth. Rather than adhere to a lengthy set of rules about each stock I own, I want my investing goals to be oriented around creating the best performing portfolio for my family's needs, period. That means only owning high quality, financially disciplined companies that are best positioned to continue growing long into the future. Their income statements and balance sheet should show a history of consistently growing revenues and EPS through a variety of market conditions.

A history of dividend growth is still a huge plus of course, but I don't believe that every position in a successful DGI portfolio needs to pay a dividend, nor that an attractive dividend should justify investing in a company I'm on the fence about. In my own portfolio I aim for a ratio of about 85% dividend payers to 15% pure growth stocks, which seems to give me the best blend between defensiveness and growth.

But before delving into some of the pure growth stocks, I'd like to review some DGI basics to avoid giving the impression that I don't think dividend growth is a crucial part of one's portfolio.

The Upward Price Action Of Dividend Growth

This principle is understood by many investors here, but one aspect of DGI investing that took me a long time to internalize is how dividend growth literally pushes the price of a stock upward over time, separate from the underlying company's fundamentals. Long-term dividend growth investing is so effective largely because of this phenomenon.

DG Price Action

I find that real estate investing is a good analogy. If you own a rental property in an area where rents have risen by ten percent annually for the past ten years and someone approaches you to buy the property, the buyer must factor in future rent increases when deciding on a fair offer price. The property is worth more than its present value because of the relatively predictable rising income stream it produces.

Stocks with a long history of dividend growth offer the same type of value proposition, in that future dividend increases are expected and will produce a growing stream of income that add value to the underlying company's worth. This often makes dividend growth stocks easier to value at a glance, because one can compare the current yield to the historical yield to see if the stock is trading at a discount. Whether or not that discount is warranted is another question, but at least we have a concrete place to start.

Dividend growth also allows one to benefit from both price appreciation and dividend yield without needing to sacrifice one for the other. If the current yield of two companies is 3% and their prices double over the next 5 years, the yield of the company that only maintains its current dividend will be 1.5%, while the yield of the company that grows its dividend at 20% per year will still be 3%. If the price of the first company stayed the same, its yield would remain at 3%, but the dividend grower would now boast a 6% yield! The two companies could have the same market performance, but (all else equal) the latter would be far more attractive to investors given its potential for inflation-beating income production.

The main way a defensive dividend growth portfolio outperforms the market over long periods of time is through the sheer power of compounding. A far greater amount of reinvested income is generated by having a higher initial yield that consistently grows at a higher rate than that of the index. A simple way to visualize this is to compare the reinvested dividend income from a sample dividend growth portfolio (in this case, my 90-position Better Balance Sheets Portfolio, which I will discuss in future articles) to the dividend income from an S&P 500 Index Fund (NYSEARCA:SPY) over the same 10-year period.

Div Growth Portfolio Income vs SPY

Source: PortfolioVisualizer.com

I mention these things only to make clear that I still view dividend growth as central to my portfolio, even though I think an optimal long-term portfolio for millennials should contain a portion of growth stocks. The growth stock component helps increase my chances of performing better during bull markets while limiting taxes (most of my funds are in a taxable account) and raising my exposure to smaller tech and biotech stocks that often don't pay dividends.

Non-DGI Stock Selection

However, companies without a growing dividend can be more difficult to value and often present a few extra risks. Technical analysis can be a useful tool with some of these stocks such as Tesla (NASDAQ:TSLA) or Dexcom (NASDAQ:DXCM), where clear support and resistance levels can be seen over time. But as a buy-and-hold investor, I want to make sure that I'm buying at a great long-term value and not just following market sentiment or betting on price trends.

For non-DGI growth stocks, I aim to find companies with a long streak of revenue and EPS growth, strong free cash flow, little-to-no debt, and a significant competitive moat. Visionary management is also important but can be hard to measure, and I find that the most tangible evidence of exemplary management is a long history of financial discipline as shown on a company's income statements and balance sheet.

Moats for growth stocks can be difficult to determine, so I find that personal experience with a company's products or services often helps when evaluating them. I also want to see high operating margins that can act as a cushion in difficult times as well as macro or industry trends that support a long-term investment thesis. Many of these judgments may be subjective since one needs to make a prediction about the future to some extent, but if you are looking for a relatively safe investment, money should already be flowing in the direction the company is heading.

At the moment, I want exposure to a few niches of the market that I think will grow at a solid rate over the next decade and yet are hard to fully capture within the DGI sphere. These include bendable, ultra-thin OLED displays, direct-to-consumer lab diagnostics, artificial intelligence software, self-driving tech, online gaming and e-sports, Asian e-commerce, digital payments, cyber security, emerging market telecom providers, and veterinary medicine.

To cover these areas in my Best Balance Sheets Portfolio, I've included non-dividend payers such as LabCorp (NYSE:LH), Universal Display (NASDAQ:OLED), Check Point Software Technologies (NASDAQ:CHKP), Baidu (NASDAQ:BIDU), Alibaba (NYSE:BABA), PayPal (NASDAQ:PYPL), and Alphabet (NASDAQ:GOOGL). Others that pay a dividend but don't meet my current yield and growth requirements for DGI stocks include Telefonica Brazil (NYSE:VIV), Telecom Argentina (NYSE:TEO), HDFC Bank (NYSE:HDB), Banco Macro (NYSE:BMA), IDEXX Labs (NASDAQ:IDXX), and Activision Blizzard (NASDAQ:ATVI).

All of these companies have impeccable financials and disciplined management with a long track record of revenue and EPS growth. I plan to write about each of them separately in future articles, but in short I believe that they all enjoy wide moats and are positioned at the forefront of technological advancement and trends in each of their industries. I have no plans to sell any of these names unless there is a major change in their management or business model, and I hope to hold each of them for a decade or more until I transition to a more income-oriented portfolio as I approach retirement.

The New Breed Of "Defensive" Growth Stocks

A final point to consider is that some of the best defensive stocks of the future may very well be the top wide-moat growth stocks of today. Specifically, the FANG stocks: Amazon (NASDAQ:AMZN), Alphabet , Facebook (NASDAQ:FB), and Netflix (NASDAQ:NFLX). One of the goals for a typical DGI investor is to lose less than the market during crashes, and there are a few reasons why I think all of these names may prove to be quite resilient when the next "big one" hits.

This is hardly a new concept, but I think it's one that many dividend growth investors overlook. First, let's take a look back at how well Alphabet (then Google) performed against its DGI peer Microsoft (NASDAQ:MSFT) during the worst of the Great Recession. As you can see, sometimes "losing less" can be less advantageous over the medium-to-long term than "bouncing back faster", which I refer to as resiliency.

SPY Chart

Source: YCharts

Traditionally, consumer staples and telecom have been two of the safest sectors during crashes while technology has been one of the most volatile. People need to buy their basic necessities to live, and they will likely choose to pay their internet and phone bills before making most other discretionary purchases when times are tough.

Up until recently, almost all of these types of stocks have been longtime dividend payers, and investors have flocked to them during uncertain times. But now the biggest staples company in the world is an online retailer, two of the biggest TV substitutes are online streaming services, and the biggest two names in advertising -- another fairly recession-proof industry -- are Facebook and Google.

When unemployment rises and people are spending more time at home with fewer dollars to spend, I think it's highly likely that all four of these companies will see increased usage compared to their "safe" DGI peers. Surveys show that people spend more time watching television as unemployment rises, and given that Netflix, Facebook, and YouTube now comprise such a high proportion of consumers' viewing habits and do so at far lower prices than traditional television, I expect that investors will begin to treat them as defensive holdings during the next economic downturn. Especially considering that traditional TV viewership for people under 50 has been steadily declining over the years.

Traditional TV Viewership Q4 2016

Shopping on Amazon saves time and gas money while often offering lower prices and bulk ordering for staples items, all benefits that will appeal to those being more careful about how they spend their dollars. The addictive loop of social media and online news will only be amplified when users have more time on their hands, for better or worse. And $10/month is a bargain for a slew of on-demand TV shows and movies compared to the price of a typical cable bundle.

It's impossible to know if the FANG stocks will lose less than average during the next market crash or recession, but I think they will hold up better than most and may change the notion that high-growth tech stocks can't also be highly defensive.

Conclusion

I think of my general approach to investing as a "javelin" strategy, with my value stocks, higher-than-average yield, and high dividend growth on one end forming a strong, defensive core that pushes through headwinds and gives the portfolio its upward momentum, and my low debt, disruptive, high growth stocks on the other, acting as an aerodynamic tip that pushes my returns higher and prevents the portfolio from getting too bogged down with debt and moderate growth. A select few cyclical stocks with more erratic balance sheets might reside in between, but in significantly lower percentages than the S&P index. It's not an equal balance between growth and value because I don't want the growth stocks to create too much volatility and risk. I want just enough of a weighting to give me exposure to some promising industries that aren't well represented in the DGI universe.

I'm interested in hearing from the other DGI investors here about your approach to non-dividend payers. Do you leave them out of your portfolio entirely, or do you make exceptions for companies you find exceptional? Has following DGI dogma ever caused you to miss out on a great stock? Let me know in the comments below, and please consider following me if you'd like receive future articles about my portfolio strategy and the stocks I've mentioned above.

Disclosure: I am/we are long OLED, LH, BIDU, BABA, VIV, TEO, CHKP, PYPL, GOOGL, FB, HDB, BMA, IDXX, ATVI.

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.