Best Practices For Dividend Growth Investors

by: David Van Knapp

When I was working, my little company was bought out by a great big international company. Consultants swarmed all over the place, outsiders who knew nothing about the business were placed in positions of power and started making bad decisions, and it was a bad time.

But the business was so basically good that it survived and eventually thrived, which is why the big international company bought it in the first place. As Peter Lynch put it, "Go for a business that any idiot can run - because sooner or later, an idiot probably is going to run it." As time passed, some of new management's ideas actually became helpful, and today the little company I worked for is much farther along than it would have been had it remained privately held.

One of the new ideas that I gravitated to was "best practices." In a far-flung organization, there are often different people or units working on identical or similar issues without knowing that others are working on the same thing. My company made several efforts to set up "knowledge sharing" mechanisms to help people find other people who were working on the same things. I often view Seeking Alpha as a massive knowledge-sharing enterprise for individual investors.

For knowledge sharing to work, people have to contribute what they know so that it is accessible to others. Keeping things secret defeats knowledge sharing. In that spirit, I offer up some of what I consider "best practices" for dividend growth investors. It'd be cool if others added more of their own in the comments, or elaborated upon or criticized these.

  1. Know your goals. Begin with a goal statement. Your investing goals should be compatible with your life goals. If your goal is retirement, think about what you would like your retirement to be like and how you can make it happen.
  2. Become comfortable with thinking in very long time-frames: 10 years, 20 years, or more. You won't hold every stock you buy for that long, but your portfolio will be working for you for that long and longer. Think of your portfolio as a wall built of stones, with each stock being one of the stones. The stones are different shapes and sizes, and they must be pieced together to create a strong wall. Each stone has a role and a place. That's a good way to regard your stocks. In addition, thinking in long-term time-frames will help you ignore short-term noise and volatility in the market, which can lead "impulse" investors to make bad decisions.
  3. Build sensible strategies to attain your goals and write them down in a strategy document. Dividend growth investing is a coherent set of strategies for investing your capital wisely. Learn from your own experiences and mistakes and from those of others. Strategies are broad approaches. They don't specify individual decisions, but rather they inform and guide how you will make such decisions. Consider your strategies document to be a work in progress; it is never finished. Here is a visual of how strategies and tactics relate to each other:
  4. Follow your strategies. If you find yourself constantly making exceptions, that means that your strategies are too narrow. Update them to encompass similar situations in the future. That usually means broadening your strategies to recognize that unusual situations will come up and provide guidance as to how you will handle them when they do.
  5. Learn basic concepts such as compounding, the CCC document (David Fish's Dividend Champions), valuation, the interplay of initial yield with dividend growth, the mathematics of making up for losses, and the like. Learn about the basic kinds of dividend growth instruments: "regular" corporations, Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), and Business Development Corporations (BDCs).
  6. Dividend growth investing involves selecting individual stocks. It is not asset-class investing in the sense of Modern Portfolio Theory. It requires making individual selections from within a single asset class (or two, if you consider REITs or MLPs to comprise separate classes). Understand the risks and rewards associated with investing in individual stocks. Develop methods to minimize the risks and maximize the rewards.
  7. Measure performance in ways that make sense for your goals. If your goal is to maximize an income stream for some future point in life, such as retirement, focus mainly on that. If your goal is to maximize total returns, focus on that. Those two goals are not incompatible, in fact they usually go hand-in-hand. But sometimes one focus or the other may lead to subtle differences in stock selection or portfolio management practices. Try to learn what those are and to understand why the differences exist.
  8. Decide if there are any "must have" characteristics for stocks that you will consider. Examples might be a minimum initial yield (meaning the current yield at the time you buy it); a minimum dividend growth rate; or a minimum number of consecutive years of dividend increases. I use a minimum 2.7% initial yield and require at least a 5-year dividend increase streak. Eliminate from consideration any stock that does not meet your minimum requirements; this makes further stock selection much easier. In fact, learn to enjoy eliminating stocks for the work it saves you rather than worrying that you might be missing out on something. You can always reconsider later.
  9. Working from your strategies, develop your tactics and procedures for stock selection. Settle on fundamental financial metrics that you will use to judge every company. These fall into two categories: Operating metrics and dividend metrics. Operating metrics include factors such as revenue growth, ROE (return on equity), earnings growth, operating margins, and the like. Dividend metrics include consecutive years of dividend increases, current yield, dividend growth rate, and the like. Try to use enough metrics to allow you to "score" companies in a sensible and consistent way, but not so many that the task becomes unwieldy or the metrics overlap a lot. You will find that the mere effort to evaluate companies fundamentally puts you far ahead of many investors who react more to emotions and impulses rather than to data and information.
  10. Understand how any company you are considering actually makes money. Write out its "Story" such that a high-schooler could understand it. The Story is different from the basic thumbnail sketches found everywhere. Rather, it is about the company's business model: What is its business? What makes it successful and profitable? What are the company's competitive advantages? Are they sustainable? What gives the company pricing power? Why would an intelligent person think that the business model makes sense? If you cannot truly understand how the company makes money, don't invest in it! Many successful business models are simple. A few of my favorites are subscription models; toll-booth models; and businesses that produce must-have products and market and distribute them effectively. I'm always looking for sustainable competitive advantages, commonly called "moats." I love it when law or regulation creates a legal monopoly, as it does with utilities, for example.
  11. Resolve not to purchase any stock that is overvalued. Valuation is different from price. The mere price of a stock tells you nothing about its valuation: A $10 stock might be overvalued while a $50 stock is undervalued. Rather, valuation is price related to a fundamental. So valuation ratios include price-to-earnings (P/E), price-to-sales (P/S), price-to-earnings-growth (PEG), and so on. Decide how you will value stocks. There are lots of ways. Morningstar's star ratings are based on their reckoning of valuation. Many SA readers use Chuck Carnevale's FAST Graphs, which provide a great visualization of valuation (see the sample below...when the black price line is beneath the orange fair-value line, the stock is undervalued). A bonus for dividend growth investors in their accumulation years is that when valuations improve, yields usually improve too. Lower price means higher initial yield. Just in the past few weeks, stocks such as McDonald's (NYSE:MCD) have seen their yields improve from perhaps too low to acceptable (over 3%). The companies haven't changed. What changed are their market prices. Some dividend growth investors use current yield as a basic way to judge valuation itself.
  12. Decide how diversified your portfolio should be. Diversification can be measured in many ways: Sheer number of stocks; coverage of sectors or industries; varieties of yields and dividend growth rates; and so on. Decide what dimensions make sense to you and build your portfolio to satisfy them. Know why you make these decisions; the parameters should be spelled out in your strategy document. Should you own both Coke (NYSE:KO) and Pepsi (NYSE:PEP)? Why or why not?…you should be able to articulate that answer. Remember that each stock is a stone in your wall. Why is it there? What is its best place?
  13. Dividend growth investing is buy-and-monitor, not buy-and-forget. Establish a system for monitoring and managing your portfolio. Your system should include some method for keeping up with important news about the stocks you own combined with regular portfolio-wide reviews from a broad strategic perspective. I do my portfolio-wide reviews twice per year.
  14. Establish selling rules or guidelines. Many dividend growth investors sell any stock that cuts its dividend, or whose dividend growth rate slows to some unacceptable snail's pace. Your selling guidelines should be spelled out in your strategy document. Here are mine: I investigate and strongly 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 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.
  15. Become accustomed to varying principal. A good portion of the growth in dividend growth investing comes from compounding, which takes two forms: Companies raising their dividends every year, and you reinvesting those dividends during your accumulation years. You won't get the advantages of all the compounding if you keep interrupting the process by selling during market downturns. Keep your eye on the ball, which is the ever-rising income stream. Notice that none of the selling guidelines above call for selling because a stock's price drops. So long as it is fundamentally sound and keeps raising its dividend, price volatility is not a reason to sell, because price consistency was not the reason you bought. You bought to get your hands on rising dividends.

Disclosure: I am long MCD, PEP.