Thursday, April 18, 2024

The building blocks of an investing process

The goal of this website is to inspire readers to identify their goals and objectives, and then create a process to achieve them. I shared this article with readers of my Dividend Growth Investor Newsletter a few months ago. 

This process should be able to address the following:

1. What is your investable universe

2. How to identify companies for further research

3. How to evaluate individual companies

4. When to buy them

5. How much to allocate/risk

6. How to monitor investments

7. When to sell

8. How to improve

I will discuss each point in a little bit more detail below (as it pertains to my situation0:

1. What is your investable universe

The investable universe is the total population of companies, that I would leverage to identify companies for further research. My investable universe is the list of companies that have managed to increase dividends for at least 5 years in a row. Most often however, I would start with companies growing dividends for at least 10 years. 

Some good lists include the Dividend Aristocrats and Dividend Champions, all of which look for companies that have increased dividends for at least 25 years in a row. The aristocrats looks for S&P 500 companies only however. Albeit, there are aristocrats lists covering the S&P Midcap sector, so those should be added too. 

A good list is the dividend achievers one, which includes the companies that have managed to raise dividends for at least a decade.

I love the Dividend Champions/Contenders/Challengers list, which is updated here.

2. How to identify companies for further research

The investable universe is about 800 companies in the US. That’s a pretty big number of companies. In general, the investor may want to familiarize themselves with as many of them as possible, one at a time. However, it is much easier to screen out companies, based on parameters set by the investor.

I tend to focus mostly on companies with 25 year track records, though I could occasionally go as low as 5 years, if I see some promising company. There is a trade-off between a short and a long track record of annualized dividend increases, mostly in terms of dividend growth but also how defensible that is. Companies with longer track records of annual dividend increases may turn out to be able to grow dividends for much longer than a company with a shorter track record. That’s because the shorter track records are generally untested, and there’s a high probability of them being cyclical. 

I narrow the list by using a screening criteria. In general I look for:

1) A track record of annual dividend increases

2) Dividend growth exceeding a certain percentage over the past decade

3) Earnings per share growth over the past decade

4) A dividend payout that is sustainable

5) A business I understand

6) Quality – Moat

7) Good valuation

My screening process is a collection of some objective criteria, as well as subjective criteria. Each investor is different, and each investor perceives information differently based on their experiences and knowledge. It’s important to stick to your circle of competence, while also trying to expand it over time however.

I have watchlists of companies I would love to buy at a certain valuation, and I also monitor companies for weekly dividend increases. I am exposed to ideas of other investors and general conditions with major US companies however, which may or may not impact my decision to look at a company.

3. How to evaluate individual companies

The list of about seven items above is a good way of what I look for, when evaluating individual companies. As you can see from my analyses below, I tend to focus on qualitative and quantitative factors.

I look at the latest dividend increase, in comparison with the last 5 and ten years. I like to look at trends in dividends per share to evaluate how things are going. Dividend policy tends to show me how management thinks about the business conditions in the near term, and longer term.

I also tend to review trends in earnings per share over the past decade. Rising earnings per share are the fuel behind future dividend increases and growth in intrinsic value. I like to see how earnings per share did over previous recessions, and I am always on the lookout for stagnating EPS growth. I’m also on the lookout for one-time items as well – I tend to try and normalize things.

The dividend payout ratio is helpful in Identifying whether dividends are safe. In general, I want to see this ratio stuck in a range. This means that growth in dividends per share closely resembles growth in earnings per share – this is especially true for mature companies. Some companies that just recently initiated dividends can afford to grow them faster than earnings, since they start it off a low base. However, once a natural payout ratio is achieved, earnings and dividends should grow at roughly a similar rate. I am on the lookout for dividends growing faster than earnings, because that may be a warning sign of bad things to happen.

I also focus on the absolute number of the dividend payout ratio. Anything below 60% seems sustainable in general. However, a company with a higher payout ratio requires closer monitoring. If it consistently manages to grow dividends and maintain a high payout ratio, that is a plus. However, there is always a higher risk with higher payout ratios that the next recession would result in a lower earnings power, which could result in a dividend cut. This is where it is important to mention that the trend in payout ratio and the absolute value, should also be evaluated relative to earnings per share growth, stability of the business, defensibility and how cyclical it is.

I also like to evaluate companies qualitatively. This means understanding the business, how it can grow, and see how it survived over the past calamities it was exposed to. This is where having a moat or a strong competitive advantage can be helpful. That could mean being part of a duopoly/oligopoly, having an exclusive government license, some unique product/patent, a strong brand name, lowest cost producer, network effects go into effect. This could be a subjective part of the analysis.

4. A dividend payout that is sustainable

Analyzing companies is great. But even the best company in the world is not worth overpaying for. Knowing when to buy an investment is as important as buying the right investment in the first place.

I try to buy companies when I think they are attractively valued. In general, I look at the current P/E ratio, I look at defensibility/cyclicality of the earnings stream, and I look at historical growth and potential growth expectations. I also look at whether I own the company or not already.

If I see two companies with a P/E of 20, yield of 3% and dividend growth rate of 6%, I would prioritize the one that I do not already have a position in. 

I may prioritize a company with a P/E of 20, yield of 3% and growth of 6% over a company with P/E of 10, yield of 4% and growth of 7% if I thought that the latter is cyclical and the former is more defensive and less likely to suffer during a recession. A higher yielding stock is of no use if it cuts dividends during the next recession.

I tend to build positions slowly and over time. I do reserve the right to change my opinion on the stock, if it turns out I was wrong.  Quite often, slowing down in earnings growth and dividend growth may give me a pause.

I also want to have the best odds of building a decent position size. That’s mostly due to the limiting factor of when I have funds available to invest in the first place. I have a set amount to invest monthly, and do not have hundreds of thousands sitting in cash, waiting to be deployed. Hence, when I initiate a position in a security, I try to estimate the odds of being able to deploy money and build a position over time to at least a decent position size.

I also tend to prioritize companies that are rarely undervalued when building positions, over companies that are often attractively valued.

5.   How much to allocate/risk

Risk management is very important to me as an investor. It ensures I live for another day, and another dividend.

I do a lot of analysis on companies I buy, I look at a lot of different data points too. However, life is unpredictable. It’s important to understand and accept that, and have some humility. 

I try to limit risk through diversification. I tend to own a lot of companies from different industries, and even countries too. I also tend to build my positions slowly and over time. I tend to avoid overpaying for securities and I also tend to avoid adding to companies if the story changes ( dividend growth goes to zero for example or earnings start decreasing/flatlining).

I also tend to try and weight my positions as equally as possible. You may have noticed that I equally weighted the positions in my Roth IRA contributions in 2022 and 2023. That’s because I do not really know exactly which of the companies I own will be the best and the worst today. I believe they are all great, but I also know that the conditions over the next 30 years may result in changes, that could render many of my analyses obsolete. That’s ok. The goal is to minimize risk per individual position, and maximize potential for gain. As you know, if I put $1,000 in a stock, the most I will lose is the money I invested upfront, less any dividends received and reinvested elsewhere. However, my upside is unlimited, provided I do not sell early. This is why I rarely sell by the way, because the opportunity cost is usually too high, especially if we are talking about quality cash machines that are dividend growth stocks.

It gets trickier when I invest a set amount each month. However, it is still possible to decide on position limits. I typically try to avoid having more than 5% in a single security or having more than 5% of my dividend income coming from a single stock. I would simply stop adding to it if it got there, but I would not sell. In a portfolio where I plan to add $1,000/month for 15 years (180 months), I expect to put about $180,000. This means that if I end up with say 50 companies, I should plan to put about $3,600 per security. That would be my limit. I may go overboard however. But I should not have more than $9,000 put in a single security. This limit would also be going up over time, but won’t be at $9,000 until much later in the 15 year journey.

If we are talking about having a maximum of 100 companies, that translates into never putting up more than $2,000 in a single security over a period of 15 years. That’s a good risk management idea, which limits the amount I can lose per security to just $2,000. If I stop adding to a stock at $2,000 in cost, then I can also potentially focus on other lucrative opportunities. I also stop adding to a stock if the conditions worsen too, during the accumulation process. That also keeps amounts at risk per security in check. This is why I end up with a lot of small positions, because I take a lot of small risks. Sometimes things just don’t work out during the dating process. The flipside is that if I do not build a high enough position quickly, I may end up missing out on future opportunities. There is a trade-off in everything.

6. How to monitor investments

Monitoring investments can be done in a variety of ways. 

It could include checking out annual report, quarterly press releases, dividend announcements. The goal of course is to avoid being overwhelmed, while still knowing what’s going on.

In general, I try to take a look at existing companies once every 12 – 18 months. I invest in companies that are resilient and have been around for a long period of time. Nothing significant would happen every 3 months, though it is helpful to check once an year. This involves basically updating my analysis/review. 

I give first priority to the companies that seem attractively priced, because that analysis would be my support behind future additions to said investment. I then give priority in analysis updating to companies that do not seem attractively valued, but seem fundamentally sound and promising. For companies that do not seem attractively valued and fundamentally promising, I may skip doing the work. 

My monitoring process does involve looking at dividend increases. That’s because when I buy a quality company at an attractive valuation, I expect to hold on to it for years, and enjoy rising earnings and dividends. For as long as the dividend is not cut, I would hold on to that position. Once the dividend is cut however, that means that my original thesis was wrong. Hence, I sell.

The challenge with monitoring is that it could take a lot of time, but the added benefit may not be worthwhile. A lot of the companies I have bought seem to be the types that can potentially be tucked into a safety deposit box, and forgotten about. That’s my premise or belief at least. While things change, and some of the companies I own would disappoint dearly, chances are that there would be ones that do better than expected. The latter types would likely cover any losers out there, and hopefully propel that portfolio forward. At least that’s my belief/theory.

Hence, the danger of monitoring is that the investor may see one piece of what sounds like negative news to them, and they would sell a potentially promising company. And if the investor sells those promising companies too early, they would be missing out on that future potential that would cover the losers they would encounter in their investment lifetimes.

This is why I believe it’s best to limit amount at risk per company, so if it doesn’t work out, I know how much I would lose at most. That way the downside is limited. But by patiently holding on for as long as possible, I give companies maximum benefit of the doubt to hopefully realize their full unlimited potential.

7. When to sell

I sell very rarely. 

That’s because turnover is costly in terms of commissions, fees and taxes. In addition, turnover is costly in terms of opportunity cost. 

I sell basically after a dividend is cut. That’s because I invest in companies, expecting earnings and dividends to increase over time. I am willing to ride on this long term trend for years, if not decades. A dividend cut is an admission that my thesis is broken. So I sell, clear my head, and allocate proceeds elsewhere. If a company start raising dividends again, and meets my entry criteria, I would consider it though. 

I also sell after a company I hold is acquired. In general though, I rarely have a choice in these matters. I am not as excited when companies I own get acquired, because I always feel like I am being robbed of my future potential. After all, an acquirer is not likely to be buying another company for charity purposes – they probably see the potential like you and me. But they want to get all of it for themselves, and provide us with a pittance of a premium to last Fridays closing price. Sorry, I went on a tangent again.

I have often sold stock for other reasons too. They have been mistakes, but I would mention them, because you may have better luck than me.

Some folks sell after a valuation gets out of hand. Then they buy something else with the proceeds, which seems cheaper. This sounds like a logical approach to many. The pitfalls are that the company you thought was expensive was actually cheap in hindsight. For example, if that stock had a P/E of 30 and a yield of 1%, it looks expensive. But if growth was 15%/year, that stock could quadruple earnings and dividends in 1 decade. So in 10 years that stock could yield 4% on cost, and even if P/E declines to 20, the stock can deliver a 167% return. Of course, if I sell at a profit in a taxable account, I’d also pay taxes on those realized capital gains. Perhaps another reason why I prefer investing through retirement/tax deferred accounts first.

On the other hand, if I bought a stock with a P/E of 10, and a dividend yield of 3%, it may look like I got myself a bargain. However, if earnings and dividends growth turns out to be slower than expected, I may not get myself much of a bargain after all.

Of course, if you are able to spot undervalued gems frequently, it may make sense to sell the least promising companies with the most promising ones. However, those are hard to spot perfectly in advance. There may be steep opportunity costs in the process of replacing one company with another.

8. How to improve

This is the fun part of it all. After investing for a certain period of time, it makes sense to sit back, gather our notes, and see if there are any lessons to be learned. This may involved studying transaction history, studying past analyses/reviews, in order to identify any room for improvement and any lessons that can help with our investing process.

My mistakes made have included:

- Selling due to some “reason”

- Trying to justify a poor performance with verbiage and narratives

- Not using retirement accounts early enough

- Trying to “time” the markets

- Concentrating in “my best idea”

Improving also means observing how other investors operate, and trying to incorporate “best practices”, ideas etc. It’s easier said than done, and it may involve some trial and error.

Looking at strategies that are different than yours, and learning from people who share different opinions from you can be beneficial. I spent a decade looking at ticker tapes, reading books on different strategies before I decided on dividend growth investing. Buying companies with growing dividends is an idea taken from trend following and momentum. Buying and Holding diversified portfolios with low turnover is an idea taken from indexing. Buying companies at attractive valuations, while trying to avoid overpaying is an idea taken from value investing. My edge is in buying a diversified portfolio of quality dividend stocks at attractive valuations, and then holding on to them tightly for decades. In a world where everyone has a short attention span, and everyone is worried about losing a fraction of a penny to high frequency traders, it pays to invest for the long term. Trying to improve can pay off larger dividends and capital gains for you down the road.

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