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A Sweet Tooth For Dividend Growth Investing

|Includes: Colgate-Palmolive Company (CL), PM, TGT, WMT, XOM

Dividend growth investing, DGI, strategy needs no introduction among ardent income investors who are regular visitors of SA. Many have come to embrace the DGI after the great recession. After diligently educating myself about DGI through books like "The Single Best Investment" by Lowell Miller and numerous articles in SA, I have become convinced that this strategy works (for me at least). DGI might seem painfully slow but I find it better to be like a tortoise that sees the end line, albeit slow and steady, than a hare which may get killed during a market like 2008-2009.

Investing in growth stocks seems to be the mantra among many investors & traders alike. Even "if" growth investing yields a better return than DGI, sacrificing a few % in return for the peace of mind DGI offers seems like a great bargain. I am not interested in beating the growth investment return or even beating the market. If so many so called pros can't do it, I don't see me having better odds. One has to be certain of one's investing goals and mine is to get a return better than inflation. If I can protect my savings from loosing to inflation I would be a happy camper.

To find companies than raise their dividends consistently, one just has to look at David Fish's CCC list. Looking at the most recent list (August 2013) there are 469 companies that made the list. All a DG investor has to skim through the list to find the stocks that meet their own set criteria and come up with a well diversified portfolio. That task seems menial compared to a growth strategy where one has to find a few to buy from a sea of stocks. The rules to select the companies to invest from the CCC list will vary from investor to investor. Everyone has to find the right set of criteria that suits their personality.

My personal comfort zone lies in investing in the companies that satisfy the following criteria. These are not a difficult set of conditions to find a basket of stocks that offer diversification.

1. Increased dividends for 10+ years

Personally I am still not okay with stocks that have not raised dividends for more than 10 years. Since there are enough candidates that satisfy this criterion I see no need to go beyond my comfort zone. It gives a sense of security that these stocks have seen 2 recession and market crashes and with stood their divided policy.

2. 1,3,5,10 yr dividend growth rate (DGR) > 7%

I look for stocks whose DGR beats inflation handsomely. When this fed QE policy is finally curbed, inflation is sure to come back, may be even with a vengeance. Better to invest in stocks that will take care of inflation for me than me fighting it.

3. Current yield >2.5%

I prefer 3% or better but 2.5% is okay if justified by a higher DGR. For example, a 2.5% yielder will cross YOC of 3% in less than 2 years with a 15% DGR. And there are quite a few good companies (example: TGT) that yield less than 3% but offer a DGR of more than 15%.

4. Currently not over valued

Over valuation is a relative concept. P/E ratio of 30 was considered undervalued by many at the beginning of 2000. My personal measure is how the current valuation compares with historical PE. I prefer stocks with a forward P/E less than 20, preferably less than 15. Chuck Carnevale's F.A.S.T. Graphs™ can come in handy to analyze how the current valuation fares. It also gives a birds eye view of how investors valued the stock in recent past. For example, analyzing walmart (NYSE:WMT) through F.A.S.T. Graphs™ will show the over valuation during 1999 and consequently trading side ways for next decade, going through a p?E compression.

5. Have a wide economic moat

When I came to USA for my graduate program at the University of Nebraska, little did I know that one of its own alumni, Warren Buffet, would influence me profoundly in regards to investing. Individual investors have much to gain following his valuable insights. One of his principles, investing in business with a wide economic moat, seems like something too obvious that everyone would follow but 2000 crash of Nasdaq says otherwise. I like to invest in companies that rank among the top two in their sector. When the next crash comes, which is not a
"IF" but "WHEN", I am sure the sector leaders will with stand it better than the smaller ones.

6. Low volatility (beta <0.7)

This is a simple rule that does not warrant much explanation. Invest in stocks that don't take you on a wild ride.

7. Dividend payout ratio < 50%

As much as a DG investor likes his/her dividend, it has to be sustainable. When the economy is stagnant, with earnings not improving much, a low pay out ratio comes in handy to keep that DGR well above inflation. I do invest in stocks with a higher than 50% pay out ratio, as long as I understand their business and am confident they will keep their head above water during tough times (example: PM, CL)

8. Decent total return

I am not looking to beat the returns of S&P 500. If so many so called pros can't do it, I don't see me having better odds. One has to be certain of one's investing goals and mine is to get a better return than inflation. What is the benefit of beating a benchmark that may be in a secular bear market? My definition of total return is about 3-5% greater than inflation. I am sure that if the above sets of criteria are followed total return needs will be addressed. Some stocks do share buybacks to boost returns at the cost of low yield, case in point: XOM. I am not a big fan of share repurchases but would rather see a higher dividend that I can reinvest in stocks as I see fit. I don't see it as a negative, but not a positive either.

9. Be fearful when are greedy; Greedy when others are fearful

Again, one of Buffet's quote. The truth behind this is a secret key to better returns. It is easier said than done. I have finally come in terms with this and have taken advantage of general market weakness to accumulate position in some great DG stocks. The key here is to be greedy and buy good companies on sale when general market correction happens, not when a stock falls because of inherent trouble within the company.

10. Using options conservatively

Options trading may scare many conservative investors, particularly income investors. But it is a great boon if used wisely. A DG investor can buy shares in companies they like to own at a price little cheaper than what Mr.Market is willing to sell by selling cash-secured put options. I sell put options ONLY on stocks I like to accumulate and use volatility to my advantage. For example, WMT has fallen about 8% in recent days, but I wanted a better sale so have sold put options for better cost basis. It is akin to having a limit order except I get to own the stock at a price I want even if the price did not go that low. This is a great advantage compared to placing a limit order and waiting for the day to come.

These are the rules that I current follow. They may change a bit, a tweak here, tweak there as I learn and become wiser but the core principles are not going to change. DGI is the way I see myself investing for a long term. Based on these rules I select the companies I want to own. Sticking to a set of well defined principles helps me have a proper business plan to approach investing and retirement. This by no means a buy-&-forget plan but indeed a buy-&-monitor strategy. At least I don't have to monitor aggressively as I would be if investing in pure growth stocks. Will the stocks chosen careful by my method drop in price during next recession? Sure. But I see it as a drop in price but not in value. I don't see a reason to loose my sleep over it. After all, if they do drop in price my dividend dollars will be working hard to reinvest themselves at a cheaper price.

Disclosure: I am long CL, XOM, PM, WMT, TGT. 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 recently initiated a position in WMT & TGT by selling cash-secured puts hoping to get assigned.