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 show 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.
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.
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:
- A reliable income: the income would be independent of the market conditions, always there even during market downturns or recessions.
- 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.
- A lasting income: an income that will last through all of retirement and that can be passed to one’s heirs.
- 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:
- 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.
- 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.
- “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.
- Setting specific goals is the first step to successful stock investing.
- Our goal at SSI is to establish a reliable, ever increasing, well-diversified flow of income.
- To achieve this goal, we rely on the Dividend Growth Investing strategy.
- Dividend Growth Investing is an ideal income replacement strategy that works in all market conditions.