Business Model For A Dividend Growth Investor

Includes: INTC
by: David Van Knapp

I all but preach that a self-directed investor of any persuasion should treat his or her investing like a business. Give it a name. Have a plan. Create rules, procedures, even a culture that give your business its particular character and keep it on track. Define goals and strategies to reach them. Keep emotions at bay. Anticipate changes in your business environment and how you will react. Constantly learn: You should be better at your business after five years than when you started.

In dividend growth investing, stock selection is required. In evaluating stocks, I place great emphasis on understanding the company's "business model." That means how does the company make money? For example, Intel's (NASDAQ:INTC) actual product-microprocessors-is very complex. But you don't need to understand how a microprocessor works to understand Intel's business model. In a nutshell, their business model is based on-

--designing, fabricating, and selling microprocessors;

--constantly improving the performance of their products to keep ahead of the competition;

--creating and using economies of scale to hold their costs down and keep their margins high;

--encouraging the design of products that utilize their microprocessors;

--marketing not only to their direct customers (the makers of electronic equipment), but also to the public ("Intel Inside") to create demand pressure for Intel products that their direct customers must respond to.

Intel does those things very well, and following that business model has made them one of the most successful companies in the world.

My last few working years were spent in strategy development. Here is a diagram that I devised and have since adapted to illustrate how goals, strategies, and tactics relate to each other for an individual investing business:

To illustrate how this works, I will use as an example one of my own investing businesses, namely my public Dividend Growth Portfolio.

Business Name: Dave's Dividend Growth Portfolio

Business Goal: Generate a steadily increasing stream of dividends paid by excellent, low-risk companies. Numerically, the target is to deliver 10 percent yield on cost within 10 years of inception.

Business Model (Strategies):

Stock Selection:

  1. Use the current Top 40 Dividend Growth Stocks as the Shopping List.
  2. [Alternative: Select stocks from the Dividend Champions document. Require the following from any stock selected:
  • Price at least $5 per share.
  • Minimum projected yield at least 3.0% (occasional exceptions allowed for stocks with high dividend growth rates).
  • Dividend growth rate over past 5 years at least 4% annually (occasional exceptions allowed for stocks with high yields).
  • Positive annual total returns in three of past five years (2007-2011).
  • Annualized average total return at least 1% over past five years.
  • Increased dividend payout in each of past 5 years.
  • An understandable and sustainable business model with meaningful competitive advantages.
  • Good fundamental business metrics. ]

Stock Valuation:

Buy only stocks with "Fair" or better valuations.

Portfolio Construction:

  1. Aim for well-roundedness in the portfolio. Diversify across sectors, industries, geographies, and different ranges of yields and growth rates.
  2. Limit the number of stocks owned to a maximum of 20.
  3. Be agnostic on position sizing. Investing an equal initial amount in each stock is fine. Adjustments in proportion will occur as prices change, dividends are reinvested, and perceptions of risk and reward change.
  4. Hold no more than 20 percent of the portfolio's value in a single stock. If a position exceeds 20 percent, sell the excess and re-deploy the proceeds.
  5. Make opportunistic switches from one stock to another if such a swap will upgrade the portfolio. The expected frequency of such exchanges is low.
  6. Since the major focus is on dividends and not share prices, the portfolio will usually be 100% invested (except for accumulating dividends). Don't "sit out" bear markets. Cash does not generate dividends.

Dividend reinvestment:

  1. Reinvest dividends, but not automatically in the company that issued them. Rather, collect the cash and reinvest when it accumulates to $1000, selecting the best candidate at that time.
  2. When reinvesting dividends, try to improve the portfolio along some dimension: yield, dividend growth, diversification, and the like.

Selling Guidelines:

1. Investigate and seriously consider selling any stock for these reasons:

  • It cuts, freezes, or suspends its dividend.
  • It bubbles or becomes seriously overvalued.
  • You receive news of significant changes impacting the company.
  • It is going to be acquired or merged.
  • It announces plans to split itself up or to spin off a separate company.
  • Its current yield rises above 9 or 10 percent or drops below 3 percent.
  • It underperforms the market in total returns (price + dividends) for three years running.

2. Conduct a thorough Portfolio Review twice per year. At these times, measure the Portfolio's overall progress toward the overall goal and consider selling or upgrading any stock for the reasons listed above.

As you can see, the business model has five basic elements:

  • Rules for stock selection
  • A requirement not to overpay for any stocks
  • Guidelines for portfolio construction
  • A plan for reinvesting dividends
  • Guidelines for selling

Let's look at these elements again and compare them to analogous elements of a "real" business model or plan for a company such as Intel:

My Business Model

Intel's Business Model

Rules for stock selection

Product choice: What particular kinds of devices Intel intends to make. Intel selects certain devices-and importantly, rejects others-based on where it sees business opportunities that also fit well with Intel's expertise. Mistakes can be made: Intel's forays into consumer goods have not worked out well. My own rules attempt to focus me on particular kinds of stocks that are well-suited to my overall goal and that I have expertise in picking.

A requirement not to overpay for any stocks

Cost controls. Any good business controls its costs. Costs saved fall right to the bottom line. A caveat is not to cut costs so much that quality suffers. My own rules are straightforward attempts to not overpay for stocks, as this increases not only my initial yield on cost but also improves the odds of making money through capital gains.

Guidelines for portfolio construction

Lines of business. The selection of business lines or product lines-importantly, creating a rational set of offerings with synergies-is one of the most important elements in a good business plan. My own guidelines help me establish a portfolio that is decently diversified and synergistic in pursuit of my overall goal.

A plan for reinvesting dividends

What to do with profits. Profits can be retained, hoarded, used to fund new projects, used for acquisitions, used to expand operations when a particular product is a "hit," paid out as dividends, used to buy back shares, and for scores of other uses. I use my own profits (incoming dividends) to either expand ownership of a "hit" stock or make acquisitions of new stocks. Either course helps me build my asset base.

Guidelines for selling

Discontinuation of product lines. Intel abandons products as they replace them with better (faster) products, demand slackens, or products bomb. My guidelines have essentially the same goals.

As this document is not only my business model but also my business plan, I review it every year and modify it to reflect new realities and things that I have learned. In my old corporation, we had periodic strategy review meetings and of course produced a new business plan every year.

I hope that this gives some insights into how you, as an individual investor, can treat your investing as a business. I think that the best results come from approaching investing this way. In particular, this approach helps to ward off self-defeating emotions and also helps you put the brakes on when you are considering a "hot tip" or other decision that really does not fit with your long-term goals.

Disclosure: I am long INTC.