What's Your Story? Dividend Growth Investing's Business Model
- The dividend growth business model is like that of a conglomerate.
- You acquire, collect, and manage properties to grow the business over time.
- If you reinvest dividends, you add a layer of compounding to your growth rate.
In analyzing stocks, I place a good deal of weight on the company's Story. I have a simple rule: If I can't understand the company's Story, I will not invest in it.
The Story explains the company's business model. It answers questions like:
- What does the company do?
- How does it make money?
- What are its competitive advantages?
- Why is it likely to continue to succeed?
I have often suggested that dividend growth investors treat their investing like a business. Think of yourself as running an investment operation in which you are both the CEO and CIO (Chief Investment Officer).
Let's pretend that your investment operation is a public business that others could invest in. They need to figure out your Story. What is it?
Here is the short version of my business model as a dividend growth investor:
Identify, accumulate, and manage a portfolio of stocks in high quality companies that reliably send growing amounts of cash to headquarters.
As CEO/CIO of your operation, you decide what to do with the cash. If you are in your accumulation years, you can add the following sentence to your business model: Reinvest the cash to compound the operation's growth.
If you are retired and need the dividend cash to live on, the reinvestment step is not part of your business model. In all other respects, the model is the same.
Your business model is the same as that of a holding company or conglomerate, like Buffett's with Berkshire Hathaway (NYSE:BRK.A ) (NYSE:BRK.B ). Instead of owning entire companies, you own pieces of them.
Let's break down the business operation and see how it works. It looks like a virtuous circle.
Let's start at the top and work clockwise around the circle.
As a dividend growth investor, you seek out dividend growth stocks.
I use a broad definition of "dividend growth stocks." Some people exclude REITs or MLPs, because of their special structures. I do not exclude them. Some people exclude utilities on the basis that they grow too slowly. I don't.
I use exactly the same definition for dividend growth that David Fish uses for eligibility on his Dividend Champions, Challengers, and Contenders document [CCC]. In compiling his invaluable research tool, David uses a simple requirement: Has the company increased its dividend payout for 5 or more years in a row?
It is hard to get simpler than that. Each C in CCC stands for a level of achievement in compiling a record of consecutive annual dividend increases:
- Champions have increased their payout for 25 or more years in a row.
- Challengers have increased for 10 to 24 years in a row.
- Contenders have increased for 5 to 9 years.
With few exceptions, I do not look beyond CCC to discover dividend growth companies. Currently there are more than 600 CCC companies. Among them an investor can find plenty to populate a dividend growth portfolio.
I do not buy every CCC stock. I analyze them to see how they fit my goals and whether they are good for my investment business.
In my real Dividend Growth Portfolio. my principal goal is this:
To generate a steadily increasing stream of dividends paid by excellent, low-risk companies. The numerical target is for the portfolio to deliver 10 percent yield on cost within 10 years of inception. I am more interested in the ability of this portfolio to produce income than its sheer size.
Clearly I want to:
- Own high-quality companies
- Receive a steadily increasing income stream
- Optimize income in preference to amassing sheer size (often those goals are aligned anyway)
- Hit a 10-by-10 target: Achieve 10% yield on cost (for the whole portfolio) within 10 years
As a conglomerate, you will acquire pieces of companies. You must make acquisition choices carefully, because you will depend on each company's management to run it.
Your competency is not in being able to run each business. It is in identifying which companies are good at making money and have the intent and wherewithal to send streams of their profits to shareholders.
Usually this quest leads you to companies that are in sound sustainable businesses, economically conservative, and committed to prudent growth. The outcome of these characteristics is that the company's own income, from which it pays the dividends, tends to be dependable and growing.
Reasons not to invest in a company include:
- Not understanding its business model
- Low quality of the business
- Poor economics of the business
- Unsustainability of the business; susceptibility to disruption
- Overvalued stock
- Yield and/or dividend growth rates that fall short of minimums that you establish for yourself
On the last factor, I require at least 2.7% yield and 4% annual growth rate (I accept a lower growth rate for stocks yielding over 5%). I believe that these minimums, juiced by compounding (reinvesting dividends), will get me to my 10-by-10 numerical goal.
Needless to say, you need to keep emotions out of your analysis to the extent you can. Emotional responses - like "Coke is a great company and I would never sell it!" - cannot help you to make the best decisions that you are capable of. I own Coke (NYSE:KO ) and probably never will sell it, but there is no upside to being emotional about it.
Buy and Own
For me, dividend growth investing is mostly about accumulating great dividend growth companies and holding onto them. I am a little financier. I cannot be like Buffett and acquire whole companies, but I can start as he did by purchasing stocks. That gives me partial ownership in each company that I choose.
In making purchase decisions, I look for high-rated companies that are well-valued and will improve my portfolio.
As a conglomerate, I try to diversify my holdings. Diversification simply means spreading your investment dollars across a number of different investment types, with a goal of having multiple income streams and minimizing the losses that might occur from a small number of holdings. It is a logical extension of the idea of not putting all of your eggs in one basket.
Diversification occurs along many dimensions. Thus I like to collect companies:
- In different industries and sectors of the economy
- That offer a variety of yields and growth rates
- Which have compiled records of short, medium, and long streaks of annual dividend increases.
There is a danger in stretching to over-diversify. You might inadvertently move outside your area of competence. I like this quote from Buffett:
There's a whole bunch of things I don't know a thing about. I just stay away from those. I stay within what I call my circle of competence. Tom Watson [Sr. founder of IBM] said it best. He said, 'I'm no genius, but I'm smart in spots, and I stay around those spots.'
The dividend growth business model is not based on flipping properties for profit. You may certainly do that from time to time, but mostly you will be aiming to optimize the income from shares that you buy, collect, and hold.
In the buy-and-own process, you will amass dividend rights. These are the rights that you get, as a part owner of great companies, to receive the dividends that they distribute from their profits.
Usually your hoped-for holding period is forever. Of course, things do not always work out that way, but that is the original intent. You will not usually buy companies with the intent of selling them a short time later. There is nothing wrong with attempting to make money that way, but it is a completely different business model from what we are discussing here.
While you will inevitably purchase some clunkers that need to be eliminated, a fundamental principle behind this business plan is to accumulate more shares. Dividends are paid per share. The more shares you own, the more dividends you get. The accumulation of shares over time causes the dividend stream to go up and up, along with the annual increases declared by the companies themselves.
Managing your portfolio involves two things: Keeping an eye on your companies and handling the incoming dividends.
Dividend growth investing, for most, is not a "buy-and-forget" proposition. Instead, "buy-and-monitor" is a better description of what you do. So the dividend growth investor:
- Decides what to buy, hold, or sell
- Keeps track of the companies that he or she owns
- Thinks about ways to improve the portfolio and optimize the income flow
- Keeps an eye on risk
- Reacts intelligently to problems and corrects mistakes
As CEO/CIO of your investment operation, you fully manage the decisions that you make. You own those decisions. You never play the victim card. You know in advance that there is risk, and that some things will not turn out as planned. You are prepared to react in a businesslike fashion when something goes wrong.
I think of risk in probabilistic terms. Risk is not black-white or "risk on/risk off." Risk runs along a continuum of possible outcomes.
No one can predict the future. But anyone can try to get on the right side of the odds. For this business model, that means trying to raise the probability of selecting stocks of companies that will send increasing amounts of cash to headquarters, while simultaneously reducing the possibility that you will suffer a decrease in dividend flow or be forced to take a capital loss.
Risk management is unemotional. You are simply following sound business principals. All decisions should be based on facts and reasonable inferences drawn from the facts. So-called panic selling is not part of your business model. You should know in advance why you might sell anything that you own.
In the business plan for my Dividend Growth Portfolio, I have laid out these reasons to seriously consider selling or trimming a position. Note that these are not hard-and-fast rules, they are simply guidelines:
(1) A company cuts, freezes, or suspends its dividend.
(2) A stock bubbles or becomes seriously overvalued.
(3) You receive news of significant fundamental changes impacting the company.
(4) A company is going to be acquired.
(5) A company announces plans to split itself up or to spin off a separate company.
(6) Current yield rises above 9% percent or drops below 2.5%.
(7) Its size increases beyond 10% of the portfolio.
I present these only as examples. Each investor will want to formulate their own guidelines for considering when to sell. Usually in this business model, not many trades are made, and the default option when faced with an ambiguous situation is simply to hold.
2. Handling dividends
The second part of portfolio management is deciding what to do with the dividends as they flow to headquarters. There are three main alternatives:
- Keep them as spending money. This is typically what a retiree does, although sometimes there is cash left over that can be reinvested.
- Reinvest them automatically back into the stocks that paid them. Many investors choose this option, because it is automatic and free. Over time, significantly large positions can be built by "dripping" dividends back into the stocks that generated them. For more information, see Reinvest Your Dividends Automatically to Build Long-Term Positions.
- Accumulate dividends as cash and reinvest them from time to time in carefully selected dividend growth stocks. See Reinvest Your Dividends Selectively to Enhance Your Returns.
If you reinvest dividends, that means that they will compound, which is an important part of the business model.
It is hard to overstate the power of compounding. The following graph compares the annual income available via dividend reinvestment for a garden-variety dividend growth stock. This stock has a yield of 3.3% and an annual dividend growth rate of 6% per year. The original investment amount is $10,000. The blue line shows the growth in the annual dividend without compounding, the orange line shows it with drip-type reinvestment.
The types of income gains illustrated above are more than theoretical, they can be real. Here are the actual results from my Dividend Growth Portfolio:
The red Goal line curves upwards towards the portfolio's 10-year goal, just as the orange line in the previous graph curves upwards. The Blue line that shows the actual increase in dividends each year is hugging the red line. Progress is not linear, because it picks up speed as time goes on.
Average actual dividend growth in the portfolio is about 14% per year, even though it is uncommon for any individual stock to increase its dividend that much. The gap is made up through reinvesting and compounding.
Not only that, one of the pleasures of this investment model is that the payoffs happen frequently. Say you own a dividend growth business that has investments in 16 conventional companies that pay quarterly dividends, two MLPs that pay quarterly, plus two REITs that pay monthly. That's 96 paydays per year, or 8 per month, or twice per week.
If each investment increases its dividend once per year, that's also 20 increases per year. Some people call this type of investing "boring." It's really not!
Disclosure: The author is long KO. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.Source: m.seekingalpha.com