DGI Lesson 12 (Part II): Invest According to a Plan

In Part 1 of this lesson about investment plans, we learned the characteristics of a sound dividend growth investing program. A brief summary of Part 1 would be:

  • Run your investing like a business.
  • You are the CEO of your investing operation. You own it.
  • Establish the primary goal of your investing operation.
  • It is personal to you.
  • Make it realistic for a self-directed individual investor to implement and maintain.

Your Goal
Investors use the dividend growth business model to help them reach different goals. For many, the principal goal is the dividend stream itself. They plan to reinvest the dividends until they retire, then take the dividends as cash and live off them after they retire. For others, the principal goal is total return. For many, it is a combination of the two.

For a complete discussion of your goal, please look back to Part 1. In my Dividend Growth Portfolio, my central goal is this: Generate a steadily increasing stream of dividends paid by excellent, low-risk companies.

Your Business Model = Your Strategies

The strategies that you use to achieve your goal constitute your business model.

In my own dividend growth investing, my business model is to identify, accumulate, and manage a portfolio of stocks that reliably send growing amounts of cash to headquarters. It should be obvious how that supports my goal.

Headquarters is an upstairs bedroom.

On a small scale, I am like a mini-Buffett: I buy stocks of wonderful companies that send increasing flows of cash to my upstairs bedroom.

As a dividend growth investor, you are in fact a holding company.

What you hold are pieces of outstanding companies that send you money.

Like Buffett, the mindset in this business model is that you want to hold these businesses “forever.”

Of course, that does not always work out, but the intent when you make any purchase is that the company will reward you well into the future – beyond the farthest time horizon that you can imagine.

Contrast that mindset to that of a trader, who anticipates short holding periods, buying low, and selling high. The process must be repeated over many years to make it work. The opportunity for error, to make wrong calls, is high.

The dividend growth model is not about flipping properties. Rather, you become a stakeholder in each business, because you expect each one to produce more and more money over time, because these are excellent companies. You don’t want to sell them, you want to keep them.

Further, you anticipate that each one will send portions of their earnings to you, in annually increasing amounts, because you are a part owner of the business, and that is your payoff as an owner.

Parsing Your Business Model

OK, now let’s look at the parts of the business model one at a time and see how they work.

1. Identify stocks that reliably send growing amounts of cash to headquarters

Obviously, you must identify what companies to invest in.

You make acquisition choices carefully, because you will depend on each company’s management to run it. So you need to figure out which companies are good at making money, can do it for a long time, and also have the intent to send growing streams of their profits to you.

In a future lesson, I will go into detail about how I identify such companies. For now, here are a few key principles in the selection process.

  • I do not just want to invest in companies that appear on some list of dividend payers or high yielding stocks. It is not hard to find such lists or to produce one yourself. I want to find the best dividend growth stocks, the kind of excellent low-risk companies that I can hold with confidence for years and years.
  • The search must be fact-driven. This is no time to fool yourself or to approach it like a beauty contest. To promote objectivity, I use an unemotional scoring system for rating companies.
  • I use four categories of information. (1) The company’s own business model. Some of my favorite business models are simple: tollbooth; subscription; providing products that people buy repetitively; and landlord. (2) Dividend fundamentals. These include things like yield, dividend growth rate, and length of dividend increase streak. The best source document is David Fish’s Dividend Champions, Challengers, and Contenders. (3) Company financials. I examine EPS growth, revenue growth, ROE (return on equity), debt, and a few others factors. (4) Valuation. See Dividend Growth Investing Lesson 11: Valuation.

What I have found over the years is that using such factors causes many of the same best companies to rise to the top and the same lesser ones to sink to the bottom every time that I go through them.

That’s reassuring and exactly what I want. Since I want these companies to pay me for years and years, I gain confidence from discovering that the “best” ones tend to stay the best. This is not the NFL, where parity reigns. Some companies are simply better than others, and those are the ones I want.

2. Accumulate

As a dividend growth investor, you use money you already have – say from a real job plus incoming dividends – to purchase stocks. You’re a little financier. You cannot be like Buffett and acquire whole companies, but you can start as he did by purchasing stocks.

This is important: You don’t regard your stocks as trading vehicles, but rather as pieces of businesses that you own. You intend to participate for a long time in their successes. Everything that each one accomplishes, you own a little fraction of that.

The ideal holding period is forever. That’s the mindset. While there will be some clunkers that need to be eliminated, and occasional swaps that are intelligent, a lot of dividend growth investing is simply to accumulate shares over a lifetime of investing. That, along with dividend raises declared by each company, cause the dividend stream to go up and up over time.

As we saw in Part 1, this accumulation mentality also causes your overall wealth to rise, as sooner or later the market usually recognizes the long-term earnings growth of your excellent companies and prices them accordingly.

3. Manage

Contrary to myth, the dividend growth investor is not passive. He or she is an active manager of their dividend growth business.

Obviously, you do not help to manage the individual companies. But you fully manage the investment operation.

In addition to being the CEO, you are the CIO – Chief Investment Officer. As such, you are responsible for all decisions made by your dividend growth business:

  • What and when to buy
  • What and when to sell
  • How to mitigate risk
  • What to do with the cash flowing to headquarters
  • Constructing a coherent portfolio
  • Intelligently handling the problems and opportunities that crop up

The myth of passivity probably comes from the fact that the dividend growth operation does not usually involve much stock trading.

But that does not mean that the dividend growth investor sits idly as the world goes by. He or she is monitoring their portfolio; keeping track of changes to the companies in it; thinking about ways to improve the portfolio; maintaining a list of potential acquisitions; taking advantage of unexpected opportunities; resolving unexpected problems; and so on.

How much time you spend at this will vary from individual to individual. But practically all dividend growth investors do it. Most find it is fun. It’s fun to run your own business rather than work for others.

The lack of trading has created in some quarters an image of dividend growth investing as being boring. Most dividend growth investors don’t see it that way. The excitement comes from that cash stream flowing to headquarters.

Just as payday is not boring to most people in regular jobs, dividend declarations and payment days are not boring to dividend growth investors. Rather, they are the tangible payoffs for the work and thought that the investor has put into the enterprise. They are the point of doing this.

The payoffs happen frequently. Say you own a dividend growth operation that has investments in 15 conventional companies that pay quarterly dividends, two MLPs that pay quarterly, plus two REITs that pay monthly. That’s 92 paydays per year, almost 8 per month. Not only that, if each investment increases its dividend once per year, that’s 19 increases per year. Boring? I think not.

4. Portfolio

The dividend growth model is based on holding 10-20-30 or more ownership stakes in individual companies.

There are a lot of ways to construct a portfolio, and different investors emphasize various factors in constructing theirs. Most consider diversification to be important. This can manifest itself in the sheer number of companies owned; participation in different segments and industries; owning both low- and high-yield stocks; and owning both slow- and fast-growing dividend payers.

My own philosophy is stated simply: I want to own a “well rounded” portfolio of dividend growth companies. That takes into account all of the factors just mentioned.

5. Reliably

The business model is: Identify, accumulate, and manage a portfolio of stocks that reliably send growing amounts of cash to headquarters. The word reliably brings in the subject of risk.

All businesses face risks – from competitors, the general economy, the waxing and waning of trends, technology, even oddball events beyond their control.

In my own dividend growth investing, I use “risk” differently from its usual identity with price volatility. The reason I reject the common definition is that price volatility does not really affect you unless you sell, turning unrealized losses or gains into realized ones. The common definition also ignores income, which seems silly when you are investing for income.

So I define risk as the chance of suffering realized loss of capital or unexpected decrease in dividend flow.

I view risk in probabilistic terms. I basically reject the “risk on, risk off” way of looking at the world, as well as simplistic labeling of some investments as “safe” and others as “risky.” Instead, working along the spectrum of risk, I try to attain the best probability of accomplishing my goals simultaneously with the least probability of the two negative possibilities that I just mentioned.

Stated another way, I am trying to raise the probability of accumulating stocks of companies that send increasing amounts of cash to headquarters, while simultaneously reducing the probabilities that I will either suffer a decrease in dividend flow or be forced to realize a capital loss.

Fortunately, these are not contradictory goals. They go hand in hand. Decreasing the risks of the two things I am trying to avoid also raises the probability that I will accomplish my principal goal.

These are among the ways that I try to mitigate risk:

  • Stock selection. I will write a future lesson about my approach to stock selection
  • Diversification. The idea is to spread your bets around to help protect against bad consequences from any one of them.
  • Immediate investigations when “something happens.” Events requiring investigation include things like a dividend cut, freeze, or suspension; a prolonged bubble or serious overvaluation in the stock’s price; a one-off calamity like an oil disaster; and mergers and acquisitions that may impact business models.
  • Periodic strategic portfolio reviews. You are the CEO. Take yourself “off site” once in a while. Get your head out of the details for a day or a week and think about large, strategic subjects. I perform strategic portfolio reviews twice per year.
  • Staying unemotional. Emotions like fear, panic, and greed are usually useless in a business setting.

The more you treat this like a business, the more businesslike will be your results.

Looking Ahead

Next time, we will discuss some specific strategies to set the dividend growth investing operation in motion. You will be able to see how the specific strategies promote your business plan and your overall objective. You can also “steal” or modify some of them for your own business plan.

Dave Van Knapp