4 Steps To Better Dividend Growth Investing

by: Kirk Spano

Dividend investing like any other investing starts with minding your asset allocation as that impacts risk management tremendously.

My four-step method to picking dividend stocks takes into account secular trends, government and central bank impacts, fundamental valuation and price trend analysis.

Two stocks worth buying now on multiple strengths.

Dividend growth investing is a fantastic way to build a large chunk of your portfolio. During this bull market, many investors have fared well by owning dividend stocks which got bid up due to low interest rates. However, with valuations very high, and risk rising, it is time for people to look more deeply at the guts of their investment approach.

Asset Allocation Will Control Your Risk

This article is not about asset allocation, but I think it's important to start out with a brief word on the topic. Studies have shown that asset allocation will be the key determinant of the volatility in your portfolio.

We have all heard that asset allocation affects 93% of your portfolio. Many investors assume that means the returns in their portfolio. That's not true. The study that refers to 93% has to do with portfolio volatility.

Carefully considering your asset allocation in order to reduce volatility has more impact on how well you sleep than anything. Wildly volatile portfolios can be (but generally aren't) very profitable, but, if wild volatility gives you sleepless nights and a heart attack, future gains probably don't matter much.

The chart below, pulled straight off of NASDAQ's website, shows that diversification, an outgrowth of asset allocation, requires only small basket of stocks to be diversified. The caveat is that you can't have all of your money in correlated sectors or categories.

Diversification In a special report I provided to Margin of Safety Investing (MOSI) members titled "Intelligent Asset Allocation: Better Returns & Lower Risk," I cover the idea of effective asset allocation. That report is available to you just for taking a free two-week trial.

The key takeaway of "Intelligent Asset Allocation" is that having stocks in at least five sectors of the economy is vital, but so is having assets that are far less correlated to the stock market, like cash, real estate, private equity, currencies, commodities or other alternatives.

For the average investor, many "alternatives" come in the flavor of equities, such as REITs or listed private equity shares. Keep in mind what your money is truly correlated to in order to maintain an effective asset allocation. Being too much in any asset class not only increases your volatility, but also your risk of suffering from a correlated correction. This applies to dividend growth investing too.

For many, having a quarter or half of your money in dividend growth stocks can make a lot of sense, but going much beyond half runs the risk of being too highly correlated, exposing you to massive corrections. That said, let me turn my attention to how I pick out dividend growth investments.

Core 4 Investing Method

Over nearly three decades of financial industry experience (gee, that makes me feel older), I have learned about many different methods of investing. Each has some value, so I decided to create a process for myself that uses the most important ones in my view. I call my process the "Core 4 Investing Method" and am offering a report on it through MOSI as well.

The crux of the approach is that secular trends, government & central banks, fundamental valuation and price trend analysis form the core of what drives asset prices. That holds true for dividend growth and dividend stocks. Here is how I apply my method (which I know several prominent investors use a very similar process). I will use several stocks to illustrate points and then close with two stocks I think deserve your attention now.

Secular Trends

In my recent and highly commented on article, "3 Supposedly Safe Dividend Stocks To Dump Now," I raised the ire of some who didn't like my portrayal of the secular trends negatively impacting companies that they hold the stocks of. My broad brush analysis was that "older economy" stocks suffer from trends that put pressure on revenues, margins, earnings and dividend growth, while "newer economy" stocks face a more favorable outlook.

While the distinction between "older" and "newer" is often subtle, the bottom line is that certain macro secular (long-term) trends will provide headwinds or tailwinds for companies to deal with. An example of this is that telecoms face margin compression due to market saturation and have massive capital obligations to keep up with each other. That was why I recommended selling a particular dividend paying telecom in the linked article.

An example of positive secular trends affecting companies can be found within the technology sector. We are using more and more tech in our lives. From changing the energy sector, to healthcare, to smart homes, to finance and beyond, we can see technology advancements impacting everything. That is why in an article titled "The Only ETF You Need To Start Investing" I made the case for the PowerShares QQQ (QQQ) to be a core holding for those just getting started with investing.

In my mind, QQQ is a core holding for everybody, including dividend and dividend growth investors. Why? Because the big trends towards technology driven companies, certain consumer discretionary stocks and some healthcare stocks are going to last a long time. While I only rate QQQ a hold right now (and it's close to being a sell), I have a buy limit set under the market most of the time. Right now, I have a buy limit at $120 good 'til cancel.

Take a look at how QQQ has performed against the companies I recently recommended selling and a couple popular dividend stock ETFs, the Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Dividend ETF (SDY), as well as, the WisdomTree Midcap Dividend ETF (DON) which I use in portfolios sometimes. I only choose ETFs with ten year track records to show the entirety of the current bull market. These charts assume all dividends are reinvested and that no taxes were collected (which is not true for taxable accounts).

3 Year QQQ compared Over three years QQQ wins.

5 Year QQQ compared Over five years QQQ wins.

10 Year QQQ compared And over 10 years, QQQ wins. It should be clear to folks where to hunt for return. Within tech, consumer discretionary and healthcare, there are several great dividend generating stocks. Few are buys at the moment, but there are some. Just by scouring the holdings of QQQ, you can get on the right side of the big trends and still be a dividend growth investor, so that you can have that cash flow.

Government and Central Bank Influence

The impact of government and central banks on asset prices is monumental. There are several very expensive services I get access to, that focus exclusively on these ideas. Two that are not so expensive, and I get no compensation for saying this, are Stratfor.com and ForeignAffairs.com. If you are looking for great information about what is going on around the world and don't want to spend a fortune (keep an eye out for specials, they both run some), these are two excellent sources that I subscribe to.

The influence that government holds over economic development can be seen in the regulations and taxes that business, investors and especially entrepreneurs have to deal with. And of course, the central banks wield massive power as they largely control currencies and market liquidity. Don't ever forget this classic:

"Don't fight the Fed." ~ A short and eloquent old quote packed with power.

The power of institutions can be seen across energy, healthcare, trade and the value of our currency, among other things. This all has a profound impact on the value of assets.

If a government decides to steer its economy away from a certain product or industry, that can doom companies. In the same vein, if government favors certain products or industries, that can put a significant tailwind behind.

Central banks control of currencies and liquidity is also monumental. The Fed's QE policies have been well chronicled to have helped drive this record long economic recovery and the bull market in stocks.

With record low interest rates, we know that capital intensive businesses have been able to rebound substantially. It's important to consider what happens to those companies when capital isn't so cheap. One reason I recommended selling the telecom in the article linked above is that is will need massive capital to fund a 5G buildout. If interest rates stay low and liquidity stays high, that company will chug along sideways fine. A change in net neutrality, a government impacted issue, could give telecom a boost, but I don't believe it will be substantial. The company discussed is at significant risk of being marginalized and showing no net growth for a long time.

Companies being favored by governments all over the world now include infrastructure and alternative energy companies. The funding for that seems to be tightening, but if there is a recession, I would expect the spigot to get turned back on, even if it requires "helicopter money."

A great case to study is that of General Electric (GE) which is on the MOSI "Very Short List" of stocks to watch. It's share price is down about 20% in the past three quarters for various reasons. If President Trump gets his trillion dollar infrastructure plan and tax cuts for repatriating cash, as well as, continues to lighten regulation on energy production, then GE would be a company to seriously look at. GE is a big in infrastructure and energy, as well as, has billions of dollars held overseas. There are several other companies which pay great dividends that could similarly benefit from such government actions, that I am watching.

Fundamental Business Outlook and Valuation

Here is where most dividend growth investors lose it in my opinion. I believe people glom onto ideas about how a company has raised dividends over 10 years, or 25 years, or longer time frames, and can't let go of what a company used to be. It was a core criticism of mine in the sell three dividend stocks article that I linked (and which you can see in the Ycharts above).

While it is very important to see company management being committed to dividends as a return of capital to shareholders, it is less important to be concerned with what a company did a long time ago. The world has changed and so have a lot of businesses.

The best advice I can give is the best advice that Jim Rogers, co-founder of Quantum fund with George Soros and a probable billionaire or at least nine figure guy, says he ever got about investing:

"The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy. Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything. If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. I realized right away that if I just literally read a company's annual report and the notes -- or better yet, two or three years of reports -- that I would know much more than others. Professional investors used to sort of be dazzled. Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors' annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don't bother even doing the basic homework. And if I did even more, I'd be so far ahead that I'd probably be able to find successful investments."

Now, that's a lot of work and people have time constraints, which is why there are still financial advisors and an increasing number of investment letters. But, the general theory, as far as I can tell, is right. Learn about the companies. Here is Warren Buffett:

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

“Time is the friend of the wonderful company, the enemy of the mediocre.”

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”

Peter Lynch famously said:

"The worst thing you can do is invest in companies you know nothing about. Unfortunately, buying stocks on ignorance is still a popular American pastime."

Buffett and Lynch of course, have books worth of great quotes. But the ideas here are important. Once again I refer to the three stocks I suggested to sell, I called all three mediocre companies now. I didn't say they'd go to zero or even get rid of their dividends, but, I essentially said all would continue to trail the companies with better fundamentals, in better industries, with better comparative advantages.

One key measure of dividend growth is simply the dividend growth rate. The higher that is and the more stable it is, the better the margin of safety for the stock. Assessing stability in a dividend growth rate is a difficult exercise in forward looking analysis that should go far beyond, "well they've done it before, so they'll do it again."

For the dividend investor, finding companies that are truly strong fundamentally is the key to long-term success. Apple (AAPL) is one of those companies in my opinion, and incidentally now one of Buffett's largest holdings despite his concerns over assessing technology companies.

While I think Apple is a hold right now, I'd buy it on any real corrections. It has a quarter trillion dollars on the balance sheet, although much of it is overseas (remember that repatriation thing from the government section) and still offers year-over-year growth rate on its dividend of a hefty 10.1% the past three years after instituting its dividend just before that.

AAPL Dividend Growth What supports that dividend growth, besides the quarter billion in cash and low payout ratio of 27% is the still increasing revenues, albeit, slower than the past. Going forward, due to replacement cycles on phones being every other year, we shouldn't expect every year to show huge revenue gains for Apple. That is, until it finds a way to make money on automobile software, financial payments, AI, smart homes or other technology advancements that it is smack dab in the middle of the secular trends.

Apple still has a PEG ratio (PE divided by growth) of about 1. That is a great ratio. It means that the growth rate of the company is roughly equal to its PE. Couple that with the Rock of Gibraltar balance sheet and it's hard to lose on Apple, which is the margin of safety I like.

One commentator to my last article was critical of my suggesting Apple as a replacement for the three companies to sell. His contention was that Apple was a no growth company with little innovation. I very much disagree with him. Apple is a slower growth company than it was, but has the resources to pursue the massive markets identified above. While they might not succeed in monetizing those markets, it's hard to think they won't have at least some success due to the built in customer loyalty they have with iPhone. All of the ideas above are or can be tied to iPhones. That's a huge potential market expansion someday.

AAPL Revenue Should a dividend growth investor really disqualify Apple because it doesn't have a ten or twenty-five year record of raising dividends. I don't think so.

Price Trend Analysis

Here is where we get into some Voodoo according to a lot of people. The cries of market-timing I can already see in the comments section. Folks, price trend analysis is not Voodoo, but it might be whatever a cousin would be. Here, I'll tell a story to make my point.

Back in the middle 2000s, I was telling folks to sell stocks and their second homes. I even told some folks to sell the homes they lived in because the properties were terribly overvalued and to go rent for a few years. After they ate the steaks I bought them, they said they'll think about it and call later. I didn't get many calls.

Here's what I said in my January 2008 letter to clients:

"2007 was a very eventful and fitful year in the stock and bond markets around the world. Credit markets finally started to shake the fleas that had taken residence over several years of record breaking money creation by government, lending institutions and a quasi-banking system composed of hedge funds and private equity firms. The volatility we saw in 2007 is not likely to subside in the short run. In fact, I believe that the problems at Bear Stearns are the tip of the iceberg regarding problems that are likely to emerge in the financial sector. "

My analysis was fundamental in nature and I was early by about 18-24 months. The financial crisis arrived quietly in early 2008 and hit with a series of punches in the second half of 2008 and Q1 2009.

Who wasn't very early on the financial crisis, but really pretty close to being on time, were some of the quantitative and technical traders. Most of them could care less about secular trends, government and central bank actions or fundamentals ("scoff" they shrug).

Now, a lot of technical guys get things wrong because they just look at the wrong pretty charts or take them out of context. But, some were on the money. Why? I think they used the right type of indicators, quantitative factors - the stuff underlying algorithms.

When my brokerage told me not to short or hold cash shortly before the crisis (I ignored them), I decided it was time to get out of the brokerage biz and learn more about quantitative analysis. So, here I am today using it a bit.

Here's what I know, it's tough to build the next great algorithm. There's always a better one coming and the market is constantly adjusting. And, the algos that serve the biggest piles of money tend to be the most powerful. But, there are a few indicators that are handy for giving us a margin of safety and giving us a heads up on price reversals - either up or down.

What I like to use are longer cycle money flow indicators. Not the day trading stuff. It allows me to see whether or not people are selling in waves or buying in waves (no not Elliott waves, but there are some logical ties I suppose). That's important information since a stock that is being sold tends to go down in price in short order and one that is being bought tends to go up.

Again, I'm not looking for the short-term stuff because I'm a position trader, owning things for years, but if I can avoid stocks in slow distribution patterns, I want to do that. This helps me avoid big companies that are falling out of favor. The selling process for those companies is often slow as sellers fight their emotions because the stock once did them right, then it becomes sudden on some piece of revelationary news. The lesson, get out while the gettin is good.

On the flip side, if I can find companies that are slowly finding buyers, I will want to get in before the big crowd arrives. This is very helpful with small and mid size companies. We can often get in before a company becomes big. As Peter Lynch said:

“Big companies have small moves, small companies have big moves.”

“Look for small companies that are already profitable and have proven that their concept can be replicated... Be suspicious of companies with growth rates of 50 to 100 percent a year.”

Two Stocks to Buy Now for Dividend Investors

I think the stock market is generally overvalued by about 20-30%. I also think that the warnings of secular stagnation are relevant as I've talked about in my "slow growth forever" articles listed at the top of my profile. But, there is literally always something to invest in. Here are two I think can be bought right now.

Buy Intel

Intel (INTC) has a lot going for it. First, it is in the always expanding tech sector. Clearly, the secular trends are on Intel's side.

Intel is a more typical dividend growth stock as it has been paying dividends over two decades now. It has consistently grown dividends in the high single digit to low double digit percentage rate. With a payout ratio a touch below 44%, it is poised for another dividend jump as revenues increase.

The company has also gradually grown revenues since the tech wreck and rebounded well from the financial crisis despite a setback in corporate spending for a few years.

Intel Revs The concern with Intel is that Advanced Mirco Devices (AMD) and Nvidia (NVDA) are going to eat Intel's lunch. While Intel might not maintain such huge market shares in the future as it has in the past, those markets are growing pretty quickly as we connect more and more devices and those devices get smarter.

Intel's acquisition of Mobileye, while panned by some, I think was a move on par with Facebook's (FB) purchase of Instagram. I think many are biased due to some of Intel's other failed takeovers. With Mobileye's tech integrated into Intel's, as autonomous vehicles ramp up, Intel will get a significant portion of that market.

To be sure, Intel has some competition, but they still largely operate in cyclical markets that shakes out competitors from time to time. Intel's fortress balance sheet gives it the ability to survive slow periods and to counter punch the competition. Also, because of the changing nature of the product mixes over time, the company maintains a pretty good profit margin. An easy way to think of it is that they always get branded pricing, there are no generics like in pharma.

Intel Margins From a price trend perspective, Intel has been a laggard lately, trading in a range since 2015. It is now near the top of that range and appears ready to break out. To be sure, nothing is foolproof, but money flow into the stock is positive and that's a good sign.

I would be a buyer of a starter position in Intel here and be ready to buy more if there is a correction towards the lower end of it's range in the upper $20s.

Buy Occidental Petroleum

Occidental Petroleum (OXY) is not a dividend growth stock, however, it pays a high dividend and I think presents a strong chance to see share price appreciation for several years as energy prices rebound. The company is also a rumored buyout target for Exxon (XOM).

The energy sector has been beaten up mercilessly with only a partial rebound in the middle the past few years. Back when I wrote my original "peak oil plateau" piece I discussed the coming changes in the oil industry. I revisited that theme recently in "The Coming 'Peak Oil Plateau' And Higher Oil Prices."

Currently, Occidental's dividend yield is just under 5%, but with basically no dividend growth. I don't expect the dividend to grow, but, with a strong balance sheet and valuable assets to sell, I don't expect it to decline either. The caveat is that if people like Professor Tony Seba are right about oil prices being low forever and I am wrong about there being one more big oil bull market, then all bets are off. An investor in Occidental has to believe oil prices will rise from around $50 per barrel to at least $60 per barrel for an extended period of time.

Here's where Occidental has a few things going for it. First, the trend for energy use globally is still up, including for cars that use petroleum products and Occidental has a great export facility in Texas. The transportation mix will change someday, but not in the next 5 years and maybe not for over ten.

President Trump is also doing what he can to help the incumbent oil producers through regulation, lease rates and I think soon other measures. With a more accommodative government, oil and gas producers with "good rock" will do very well.

As it turns out, Occidental has "good rock" with a huge stake in the low cost Permian Basin. The company also has economically viable properties globally which can be developed further, and as I believe, some will be sold off. The company is a top 40 natural gas producer and pipeline operator as well, which is important as natural gas plays a bigger role in energy versus coal.

The price trend analysis is neutral in the past couple months and given the oil sector with supply and demand in fact balanced now, I believe an upturn is inevitable if not imminent.

Mind the oil price risks, but if you agree with me that oil prices will rise in the next year or so, and be maintained higher, then buy Occidental shares in this price trough.

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Disclosure: I am/we are long OXY. 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.

Additional disclosure: I may take a position in INTC this week. I own a Registered Investment Advisor, however, publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.