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A Common Sense Approach to Building Wealth with Dividend Growth Stocks

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Dividend Growth Investing and the Formula for Success

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Introduction

Previously, we covered how Dividend Growth Investing fulfils all the requirements of an ideal income replacement strategy. This approach offers:

  1. a safe and reliable income
  2. a revenue stream that increases every year, offsets inflation and even increases your buying power
  3. an approach allowing you to preserve your capital
  4. an easily applicable method.

In this post, the formula for success will be revealed and explained. Its components will be covered individually. This will set the stage for future discussions on how to apply the method concretely.

 

The Formula for Success

When it comes to investing, our formula for success states:

High Quality Company + High Combination of [dividend yield and dividend growth rate] = Safe Increasing Income + High Total Return

Component 1: High Quality Company

Buy quality

The cornerstone of our DGI strategy is investing in high quality companies. By investing in those companies, we become business partners with their management team. As business partners, we benefit from the future success of these companies when some of their cash flow is distributed to us, shareholders, in form of a dividend.

The importance of choosing high quality businesses cannot be overstressed! In Finance (as it is also the case in many other spheres of life), the strong often gets stronger. Investing in the strongest companies is therefore a wise bet.

High quality, financially strong companies are better able to strive in all market conditions. During recessions, they have the financial means to buy struggling competitors that are selling at a discount. The high-quality companies thus emerge from recessions even stronger while their competitors either go bankrupt, are acquired or come out crippled. [1] [2]

When facing headwinds, companies with strong finances have more maneuverability and are better able to weather difficulties. They have a buffer that allows them to turn the ship if needs be, such as trying new strategies, developing new innovative products or acquiring other companies.

Examples of a high-quality companies overcoming headwinds abound. Let’s look at Microsoft Corporation (NASDAQ:MSFT), a company well-known for its operating system. This company was at the center of much negative news in 2013. To make a complex story short, its earnings had missed Wall Street’s estimates. In fact, its operating earnings had been decreasing since 2012. With the increasing popularity of smartphones and tablets, the market for personal computers was showing weakness. According to several newspapers and analysts, such change in consumers’ interest spelled doom for the company. [3] Microsoft attempted to compete with Apple’s iPad with its Surface RT, which proved to be a complete blunder. Similarly, it had not been able to make significant foray in the smartphone market. To add insult to injury, Google was becoming a serious competitor. It had recently come up with its Chromebook (released in 2011, [4]), its vision of the laptop. It was also offering for free its own version of office through its integrated online Google Apps.

Although Microsoft was facing several headwinds, it was still at the time an exceptionally high-quality company. It was one of the very rare companies boasting a AAA credit rating. It was still a cash printing machine with a very well covered dividend; the payout ratio was 34%. At the end of 2013, it had more than $77B in cash and short-term investments, which amply covered its ~$15B in short and long-term debts. [5] This financial flexibility gave ample leeway for the company to restructure and reinvent itself. Microsoft has been transitioning towards cloud-based software and services. Fast forward to 2017, this bet seems to be bearing fruit as its revenues have grown to $89B, from $77B in 2013. [6] Similarly, since 2013, its earnings per share have grown 25% (from $2.65 to $3.31) and its dividends an impressive 69.5% (from $0.92 to $1.56).  This case exemplifies how investing in high-quality companies and being patient during difficult times can work out. And while you allow the management team to carry its turn-around plan, you collect your income in form of dividends.

In Bear markets, by definition the whole market falls at least 20% over at least a two-month period. [7] Although the stock price of high-quality companies will also stumble, that fall is often mitigated especially if these companies are part of more defensive sectors. This phenomenon occurs due to the flight-to-quality behavior of investors who shun riskier investments in favor of safer ones during more pessimistic times.

We can easily find examples of this flight-to-quality behavior by looking at the most recent bear market that occurred during the Great Recession. First, let’s look at the overall stock market. We will use the S&P 500 ETF (NYSEARCA: SPY) and the Vanguard Total Stock Market ETF (NYSEARCA: VTI) as proxies.

SPY went from a high of $158 in 2007 to a low of $67 in 2009 for a negative return of -57%. If dividends are considered, $4.9 were paid in those years, and the return was -54%. Even the dividend payout dropped 20% (from $2.72 to $2.18). [8]

VTI did even worse! It went from a high of $78.25 to a low of $27.76, giving a negative return of -62%. With dividends accounted for, that return was slightly better at 59%. The dividend payout sustained an important decrease between 2008 and 2009 of 43%! [8]

Let’s examine now one high-quality stock for each of the defensive sectors, namely Healthcare, Utilities and Consumer Staples and see if they fared better than the overall market.

Johnson & Johnson (NYSE:JNJ) is a Healthcare behemoth that has been sporting a AAA credit rating from S&P since 1987 [9] and that has been increasing its dividend yearly for 55 straight years. It went from a high of $72.7 to a low of $46.2, leading to a negative return of -36%. Not too shabby compared to the -62% of VTI! With dividends, that return climbed to -31%. Even better, the dividend payout increased 8% between 2008 and 2009. (from $1.79 to $1.93) [8].

Dominion Energy Inc. (NYSE:D) is a well-known utility with a BBB+ credit rating [9] that’s had been increasing its dividend for 14 years. Its return during the Great Recession was -45% when considering price alone ($49 to $27) and -38% when taking into account dividends. Similar to JNJ, its dividend payout increased 11% between 2008 and 2009.

For our final example, we will look at Costco, a multinational wholesale company with a credit rating of A+ and a dividend increase streak of 14 years. It sustained a -49% and -47% loss without and with dividends, respectively. Similar to JNJ and D, its dividend increased by 12% during that recession.

These examples clearly show how stock prices of high-quality, dividend growth, companies tend to fall less than the broader market during bear markets. In addition, if one was invested in a broad market ETF like SPY or VTI during that recession, one could rely neither on price nor on dividends as both decreased substantially! On the other hand, although prices of financially strong companies did drop, their decrease was much less than the overall market, and more importantly, their dividend payouts kept rising.

What is a high-quality DGI company?

To apply our Formula for Success, we need to clarify the characteristics of a high-quality stock. When we talk about quality in the world of stock investing, we are referring to the fundamentals of the underlying business that renders it particularly successful. Ultimately, the notion of quality is subjective. Nonetheless, one can examine several criteria, some quantitative and others more qualitative:

  • Financial strength:
    Indicators of financial strength include increasing revenues, earnings and cash flow. Another very important indicator is creditworthiness, which reflects the ability of the company to service its debt.

 

  • Business model
    The business model of strong companies exhibits certain characteristics. These companies offer products or services that are in demand and that surpass their competitors’. They show diversification of their customer base and of the geographic locations where they do business.

 

  • Economic moat
    Economic moat refers to how difficult it would be for their competitors to replicate their business model and to steal market shares.

 

  • Corporate management/stewardship
    When looking for high-quality companies, it is important to determine if the interests of the management team are aligned with the best interests of the company and of its shareholders. The following are some aspects of corporate stewardship that should be considered:

    • How well does management allocate capital?
    • Does management rely on excessive debt?
    • What is the vision of the leadership and has it showed proper execution?
    • What are the dividend and share buyback policies? Have they been respected so far?
    • Does management show exemplary integrity? Has management team stood by its words? Have there been any unusual accounting practices?

Component 2: High Combination of [dividend yield and dividend growth rate]

The second component of our Formula for Success is the combination of dividend yield and dividend growth rate. Both, the yield and the growth rate are important. They must be evaluated together, not individually.

Dividends are important to consider not only because they constitute the main income in the Dividend Growth Investing strategy, but also because they can be viewed as implicit signals from the management team about how the company is expected to do.

Dividends as Income

When looking at dividends from the income perspective, the ideal combination would be a high dividend yield coupled with a high dividend growth rate. This situation is more easily encountered during a bear market where the market as a whole has fallen, taking with it high-quality, dividend growing companies.

For example, Automatic Data Processing Inc. (NasdaqGS:ADP), a human resources management company boasting a AA credit rating [9] and a dividend growing streak of 43 years, saw its price drop to $28 in 2009 while paying a $1.32 dividend. ADP yield was 4.7%, almost 50% higher than the S&P 500 yield when the market reached bottom (SPY yield was 3.2%). Not only that, but ADP saw its dividend increase by 26% in 2008 and 13.7% in 2009.

In a bull market, high yield and high growth rate may be a combination more difficult to find, especially when companies are more richly valued. In that case, you must determine what your needs are. Do I need income today or do I need it several years down the road? Answering that question will determine if you go with a higher current yield and lower future dividend growth rate or vice versa. Nonetheless, it is still possible to find high-quality stocks trading in a sweet spot with current dividend yield higher than that of the broader market and a high single-digit/double-digit dividend growth rate.

 

Dividends as Signal        

As important as the income they provide, dividends are also extremely useful for the information they imply regarding the financial health of the company and where management believes the business is heading.

Notion 1: The number of consecutive years dividends have increased is a major indicator of quality and of the strength of the company’s underlying business model.

Let’s stop and think about it.

A company must be darn strong to not only pay but increase its dividend every year for 15, 20 or more years despite all that can go wrong in the world. Dividends are not something virtual but real cash that the company must pay somehow.  Some companies have managed to increase their dividends despite wars, recessions, natural disasters or other unfortunate events thanks to their phenomenal profitability.

Notion 2: By announcing a dividend increase, management signals that profits are expected to increase in the not-too distant future.

Since dividend cuts are viewed so negatively by investors, management teams usually try their best to avoid them. Company leaders showing good stewardship therefore do not announce a dividend increase if they believe their company cannot support it.

 

Conclusion

We have covered several important aspects of our Dividend Growth Investing approach.

  • I will state again the DGI Formula for Success:
    High Quality Company + High Combination of [dividend yield and dividend growth rate] = Safe Increasing Income + High Total Return
  • Successful dividend growth investing relies on high-quality companies with a long history of yearly dividend increases.
  • The dividend yield and growth rate must be considered together. The optimal combination is a high current dividend yield and a high expected dividend growth rate.
  • Dividends are important as they are the fundamental income in DGI. Their growth rate can be viewed as an important signal from management regarding the expected profitability of the company.

 

References

  1. S. Thurm, “For Big Companies, Life Is Good,” The Wall Street Journal, 9 April 2012. [Online]. Available: https://www.wsj.com/articles/SB10001424052702303815404577331660464739018. [Accessed 22 December 2017].
  2. S. Rajan, “Recessions can present rare M&A opportunities,” Bain & Company, 16 April 2009. [Online]. Available: http://www.bain.com/publications/articles/recessions-can-present-rare-ma-opportunities-mint.aspx. [Accessed 22 December 2017].
  3. N. Wingfield, “Microsoft’s Profit Falls as Sales of Personal Computers Shrink,” 18 October 2012. [Online]. Available: http://www.nytimes.com/2012/10/19/technology/microsoft-profit-falls-as-pc-sales-shrink.html. [Accessed 23 December 2017].
  4. Wikipedia, “Chromebook,” 15 December 2017. [Online]. Available: https://en.wikipedia.org/wiki/Chromebook. [Accessed 24 December 2017].
  5. “Earnings Release FY13 Q4,” Microsoft Corporation, [Online]. Available: https://www.microsoft.com/Investor/EarningsAndFinancials/Financials/fy13/q4/BalanceSheets.aspx. [Accessed 22 December 2017].
  6. “Annual Financials for Microsoft Corp,” MarketWatch, [Online]. Available: https://www.marketwatch.com/investing/stock/msft/financials. [Accessed 12 22 2017].
  7. “Bear Market,” Investopedia, [Online]. Available: https://www.investopedia.com/terms/b/bearmarket.asp. [Accessed 22 December 2017].
  8. Fidelity, [Online]. Available: https://www.fidelity.com. [Accessed 22 December 2017].
  9. S&P Global, [Online]. Available: https://www.standardandpoors.com/en_US/web/guest/home. [Accessed 22 December 2017].

Our strategy for success: the power of dividend growth investing

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Introduction

This post discusses the fundamentals of our investing strategy.
Before addressing our approach to stock investing, we will review the importance of setting concrete goals when investing, how these goals guide our stock selection process and which objectives we have set for ourselves here at SSI.
Next, we will describe the basics of the dividend growth investing strategy and give you a foretaste of how powerful this strategy really is.

 

Setting Investing Goals

As legend baseball player Yogi Berra put it:

“If you don’t know where you are going, you’ll end up someplace else.”

Setting goals is often the first step to achieve success. This concept is even more true in the world of stock investing. Defining precise goals encourages you to think about the long-term while staying motivated and focused in the short-term.
When difficult situations arise or when confronted with a dilemma, one can always go back to these goals to help choose the next course of action. Following this principle, each investing decision must be made in relation to your pre-defined goals.
Setting investing goals is an essential step that helps filter the information we read about companies. Today’s world is often described as the Information Age where access to information has never been easier and more liberal. This is particularly true regarding stocks. There is a plethora of websites that relate news or analysis for most publicly traded companies. However, the downside has become information overload. For the same company, it is often possible to read half a dozen articles encouraging you to buy it and as many articles arguing the contrary. Your pre-defined investing goals help you analyze all this information, and act as filtering lenses through which you examine each new information and decide how it impacts your decision.

When setting objectives regarding stock investing, we recommend using the S.M.A.R.T. goal template. It stands for Specific, Measurable, Achievable, Results-focused and Time-bound. We encourage you to write your goals on paper. This step is often overlooked but helps concretize your ideas.

 

What are our investment goals at SSI?

We have organized our goals as primary and secondary. Each and every investment decision we make gets us closer to our goals.

 

Primary Goal

The primary goal of our investment strategy is complete income replacement. We want to achieve it through a reliable, ever increasing, diversified flow of income that will stay ahead of inflation.
Once the income we derive from our investments equal the income we make at our job, we essential achieve financial freedom and working becomes an option rather than a necessity.
This goal is measured by recording and following our monthly income from dividends.

 

Secondary Goal

We want to achieve that income replacement while having a long term total return on par or better than the broad market. This goal is monitored by comparing our portfolio to exchange traded funds (ETFs) that follow major indices and that offer similar yields.

 

Dividend Growth Investing and the Formula for Success

Simply put, we invest for income.
Before explaining what Dividend Growth Investing is and why it is our preferred approach, let’s first discuss some characteristics of the perfect income replacement strategy. Ideally, that perfect strategy would have the following characteristics:

  1. A reliable income: the income would be independent of the market conditions, always there even during market downturns or recessions.
  2. An increasing income: we would like that income to increase yearly at the same or at a faster rate than inflation as to preserve, and ideally improve, our buying power.
  3. A lasting income: an income that will last through all of retirement and that can be passed to one’s heirs.
  4. Be easily applied by the common investor: the strategy should be simple enough to understand and practical enough to be applied by non-professional investors who lead a busy life like yourself.

 

Now, let’s briefly review different strategies that can be used for income replacement and some of their advantages and limitations. This will help us realize the strength of the Dividend Growth approach. These strategies include:

  1. Earning interests from a savings account, certificates of deposit or bonds:
    This approach is simple to follow, and the capital is usually safe. However, all these options tend to offer low interest rates and a very large capital is necessary. There is also the risk of losing buying power over time as inflation is usually higher than interest rates. Moreover, except for some types of bonds, interests are usually taxed at the same level as income.
  2. Selling stocks for capital gain:
    On the plus side, the price of the stock market has historically increased at a rate higher than inflation over the long term. Also, capital gains benefit from better taxation rates than professional income or interests. However, stock prices can fluctuate significantly, and one must be able to stomach this volatility. Moreover, that active strategy requires good timing. There is the risk of having a bears market or a recession just as one enters retirement, which could bring down significantly the value of the portfolio at the worst possible time. In turn, that situation may lead to faster depletion of capital. The main fear would be having our capital not last throughout retirement.
  3. “Generic” Dividend investing:
    It is a more passive approach compared to selling stocks for capital gain. It can also enjoy a better taxation rate than interests. However, in this generic version of dividend investing, less emphasis is put on safety and growth of the dividend. In turn, there is a risk of having the dividends not increased or even cut. That can occur especially if one is chasing high yields in weak or distressed companies.

Here comes Dividend Growth Investing.

This strategy is based on the observation that there is a small subset of companies that have not only paid dividends for several consecutive years, but they have also increased it every single year. This ability to consistently increase the dividend even during the worst possible times, such as recessions, political instability or even wars, is a direct result of the financial strength of these companies and a testament to their strong business model.

Let’s look at an example, Johnson & Johnson (NYSE:JNJ). Johnson & Johnson has increased its dividend every single year for 55 years. Think about it, that’s more than half a century! A lot has happened in the last 5 decades: several wars, the oil crisis followed by the energy crisis in the 70’s, the dot-com bubble and more recently the Great Recession. And yet, JNJ has managed to pay an ever increasing dividend to its shareholders during all these times! Now you can see how having a portfolio made up of companies of the same caliber as JNJ paying an ever increasing dividend would provide a safe, reliable income stream and, even more importantly, peace of mind.

Now, the crucial concept that makes this strategy work:
The amount of money you receive when a company pays a dividend is based on the number of shares you own. It is completely independent of the daily fluctuations of the shares’ price.

Let’s go back to Johnson & Johnson.
The following graph shows price fluctuation from 1998 to now (line in black) and below it the amount of dividend paid per share (green-white line). The dollar amount of dividend is also written on the last row. As you can see, the dividend payout amount (in $, not the yield) has increased every year while the price has fluctuated, and sometimes, quite a bit. In 2008-2009, the price dropped from approximately $70 to $50, a 29% drop while the dividend increased from $1.79 to $1.93, a 7.8% increase!

Imagine now you have a million-dollar portfolio of strong companies paying let’s say $30,000 in dividend for the year. If a severe recession occurs such as what we experienced in 2008, the overall value of the portfolio may fall by 50% to $500,000. However, your portfolio will still give you the same income (assuming none of the companies cut it, as you may expect when investing in financially strong companies). That fall in share price and the resultant virtual capital loss is not affecting whatsoever the income you are receiving from these stocks.

The Dividend Growth Strategy gives you peace of mind and confidence. It is a strategy that works in all market conditions, be it in bull, bear and sideways markets and even during severe recessions. It fulfills all the criteria of the ideal income replacement strategy: the income you derive from high quality dividend growth stocks is reliable. By definition, it increases every year, often at a faster rate than inflation. Since you are not selling stocks, your capital is preserved, and the income is long-lasting. Finally, that strategy is not difficult to implement, as I will show in future posts.

Conclusions

  1. Setting specific goals is the first step to successful stock investing.
  2. Our goal at SSI is to establish a reliable, ever increasing, well-diversified flow of income.
  3. To achieve this goal, we rely on the Dividend Growth Investing strategy.
  4. Dividend Growth Investing is an ideal income replacement strategy that works in all market conditions.

Fundamentals of stock: The “What” and “why” of stocks

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What is a company

Before delving into the world of stocks, you need to understand the basic definition of a company. At its most fundamental level, a company is an entity whose primary goal is to make money by offering something in exchange, be it a product or a service. That realization is important because, ultimately, the price of a stock is based on this ability to generate a profit.

It is also helpful to understand how companies make money these days and what their business models are. This helps determine if the teachings of earlier finance books are still relevant and how they can be applied today.

For example, how companies do business has shifted over the past decades in the United States. The economy has slowly evolved from a manufacturing to a service economy.

 

This realization helps us put into historical context landmark books that were written about investing.

Here’s an example of what I am talking about when I state we need to have some historical perspective on earlier writings:

The “Intelligent Investor”, originally published in 1949 by Benjamin Graham, is considered by many as the bible of value investing. The central theme of the book is to compare the intrinsic value of a company to the actual price of its stock to find bargains. It reaches these intrinsic value estimates by analyzing balance sheet metrics, such as book value. However, with the change in business models over the past century, companies see today much higher returns on capital than in the early 1900’s. Companies now tend to trade above book value, and balance sheet analysis has become less helpful.  In other words, there is much less use for the book value metric than when the “Intelligent Investor” was originally written.

My hope with this site is to eventually show you what metrics make most sense to consider today and where you can easily look them up.

What is a stock

A stock is NOT simply a 1 to 4 letter ticker that goes randomly up and down throughout the day.

A stock ticker represents something real. Under a stock ticker lies a real company, doing real business with real people.

Owning shares in a company gives you 3 rights:

  1. A right to vote at shareholder meetings when decisions need to be made regarding the direction of the company
  2. A right to sell your shares to someone else
  3. A right to receive dividends
  4. The right to receive dividends really means that you have a right on a portion of the profits of the company

 

Why do companies go on the stock market

The main reason for companies to go on the stock market (ie. “going public”) is to raise money outside of the banking system and without the need to take additional debt.

Other advantages include:

  • Decreasing the risk of the original owners by spreading ownership over a larger number of stock holders
  • Getting more visibility
  • Having more leverage when obtaining loans from banks and other financial institutions

Does that mean each time you buy shares on the stock market, the company receives a portion of it? No, companies obtain money only when they issue new shares. Most buying that we do is on the secondary market when shares only exchange hands between the buyer and the seller, and the company does not get any money from these transactions.

 

How do you make money with stocks?

The 2 simplest ways to make money with stocks are:

  • Selling shares at a higher price
  • Receiving dividends from the companies in which you have invested

Our strategy is based on that second bullet. More on that later.

 

Stock Market vs a Market of Stocks

On the one hand, you often hear or read on the news that the stock market or that major indices like the Dow Jones or the S&P 500 increased or decreased by so many points.

On the other hand, there are people who say “it’s not a stock market but a market of stocks”.

When media talk about how much major indices move, they are referring to the behavior of an collection of companies. This is useful mainly when you are planning to buy exchanged traded funds (ETFs) that represent/follow these indices.

When you are planning to buy individual stocks, then the expression “it’s not a stock market but a market of stocks” applies to you. Individual stocks may or may not follow the trend of the general market. So it does not make any sense to be obsessed by how the general market is doing when your strategy is to buy individual stocks that meet your criteria.

Conclusion

  • The primary goal of companies is to make money, and the price of their stock reflects that ability .
  • The fundamental business model of companies affects how we should analyze them. It helps put into perspective the teaching of earlier books.
  • Stocks represent real companies, not just some tickers that fluctuate randomly.
  • Companies decide to go public on the stock market usually to raise money. When you buy shares outside of the period of first issuance, you are buying from the secondary market. Companies do not receive money when you buy their shares from the secondary market.
  • To make money from stock investing, you either sell the shares at a higher price or receive dividends from the underlying companies.

Disclaimer

We are not licensed professionals, registered investment advisers, brokers/dealers, or tax professionals. Before you invest any of your money, please perform your own research and due diligence and consult an appropriate professional. Unless your investments are FDIC insured, they may decline in value. Any information about particular stock transactions and/or analyses we publish must not be considered to be investment recommendations. We are not liable for losses or suffering experienced by any party. We do not make any representations, warranties or guarantees regarding the completeness or the accuracy of the information presented on this site or transmitted by emails.