A 5-Step Approach to Investing in Dividend Stocks

investment strategy Sep 28, 2021

In this article, I break down my strategy for investing in dividend stocks into five basic steps. These steps then form a solid foundation upon which all of the finer details are built.

The five steps to investing in dividend stocks

Step 0: Think like a business owner

Think like a business owner

I'm going to cheat a little bit by starting with step zero, which is to think like a business owner. This isn't really a step at all; it's more of a philosophical bedrock that underpins the five steps.

If you've been investing for a while then the idea of thinking like a business owner may sound obvious, but for less experienced investors, it isn't.

For example, when I started investing in the mid-1990s, the only thing I knew about the stock market was what the evening news told me. And what the news told me was that the FTSE 100 had gone up or down a bit that day, or that the share price of a big company had taken a dive because the company made a loss or had some bad publicity.

So, like most novice investors, my focus was on share prices and their movements from one day, week or month to the next.

Eventually I learned that putting share price movements front and centre is a very bad idea because it ignores the fact that shareholders are business owners. And I mean that literally, because if you own shares in Tesco, you literally own a piece of Tesco, or if you own shares in Next (as I did when I wrote this) then you literally own a piece of that clothing retailer.

This is hugely important, because thinking of yourself as a business owner should fundamentally change the way you think about investing.

Business owners focus on the businesses they own

Let’s say you win the lottery and you decide to buy Marks & Spencer outright. Now that you own M&S outright, what information would be of interest to you? Would you spend most of your time worrying about the share price?

The answer is that you wouldn't, because if you owned M&S outright, you would own all of its shares and there would be no share price (prices only emerge when there are buyers and sellers, and if you own all the shares and aren't looking to sell, there is no seller to negotiate a price with).

If there is no share price to worry about, what would you focus your attention on instead?

You would probably want to know things like:

  • How much revenue did M&S make last year? How much profit?

  • What is its strategy and how is it progressing against that strategy?

  • What return is it getting on profits (that belong to you, the owner) retained within the business?

  • What are its competitors doing?

  • What are the prospects for its industry over the medium and longer-term?

  • What sort of profit and dividend growth is the company likely to produce over the next ten years?

These business fundamentals are what business owners focus on, because it's how they gauge the progress of the companies they own. These fundamentals also help business owners value their businesses, just in case someone wants to acquire the business from them (I'll have more to say about valuing businesses in a later step).

As stock market investors, we are business investors. On that basis, almost all of our focus should be on the fundamentals of the businesses we are invested in, rather than the short-term ups and downs of their share prices.

Step 1: Identify quality dividend growth stocks

identify quality dividend stocks

If our focus is squarely on businesses, but what sort of businesses should we invest in?

Most dividend investors are after a good combination of dividend yield and dividend growth, so my approach is to focus on high-quality companies that are very likely to pay a rising dividend over many years and, preferably, many decades.

Not all companies can produce long-term sustainable dividend growth, and those that do usually have two key features: Quality and defensiveness.

Identifying quality companies

In a nutshell, most quality companies have durable competitive advantages over their peers. These competitive advantages allow them to take market share or expand into new markets, consistently, over many decades.

You can find quality companies by looking for the following attributes:

(1) Quality companies generate consistently high profits

The acid test for quality companies is that they have a consistently high return on capital, where capital is funding provided to the company by investors (in the form of shareholder equity), lenders (in the form of loans) and landlords (in the form of leased property or other assets). That capital is then used to fund offices, stores, warehouses, technology, vehicles and so on, and the aim, of course, is to generate attractive returns from those assets.

As a very simple example, if a company buys a factory for £1 million and that factory produces a profit of £200k per year, then the £1 million of capital invested in the factory is producing an annual return of 20%, which is good (it's a bit more complicated than that, but that's the general idea).

High profitability is essential as it gives quality companies the ability to fund their growth with lower risk retained profits rather than higher risk debt. The very best companies are able to fund consistent strong growth with little debt, all while paying a consistently growing dividend.

I have a couple of rules of thumb that relate to profitability:

  • Rule of thumb: Only invest in companies where return on capital is consistently above 10%
  • Rule of thumb: Only invest in companies were return on sales (profit margin) is consistently above 5%

(2) Quality companies generate consistent growth

As I just mentioned, quality companies produce high profits which can be used to fund dividends and growth, so quality companies usually have long track records of relatively consistent growth across revenues (sales), earnings (profits), dividends and capital (buildings, machinery, inventory etc).

This growth often occurs when the company takes market share from weaker competitors, or when it moves into adjacent markets that are closely related to its existing core business.

Here are my related rules of thumb:

  • Rule of thumb: Only invest in companies that have grown ahead of inflation over the last ten years
  • Rule of thumb: Only invest in companies where dividend growth over the next ten years is extremely likely

(3) Quality companies are masters of their trade

If you want to win at the highest level in any sport, it's going to take a combination of talent and many years of specialist training. Winning in business is no different.

Quality companies that consistently win over time have, in most cases, spent decades focusing on a narrow set of capabilities, providing customers with a narrow set of products and services.

So, when you're looking for a quality company, you should look for a business that has had a narrowly focused core business for at least a decade.

(4) Quality companies have durable competitive advantages

There are many different types of competitive advantage, but most quality companies have at least one of these four:

  • Network effects: This is where the functionality of a company's product or service improves as more customers use it. A good example would be Rightmove, which improves as more buyers and sellers use it (this often leads to monopoly-like market dominance).
  • Valuable and hard to replicate assets: An example here would be Burberry (which I sold in 2021), which has 100-plus years of heritage. That heritage is attractive to customers and is virtually impossible to replicate.
  • Market leadership: It's often very hard to beat market leaders as they benefit from economies of scale and brand strength, both of which are useful for attracting both talented employees and customers. 
  • Switching costs: This is a weak competitive advantage but it's still useful. Think of how hard it is to switch bank accounts, or to move a business from one computer operating system to another. This is why Barclays and Microsoft have been around a long time.

Identifying defensive companies

A quality vase should be worth a lot of money, but if it’s so fragile that the slightest touch causes it to crack, then it's likely to be in pieces and worthless by the time you get it to an auction.

The same can be said of quality companies. If a company is so fragile that it breaks when the economy hits a bump in the road, its durable competitive advantages are ultimately worthless.

So, in addition to quality, I’m also looking for companies that are robust, or defensive, in three ways:

(1) Defensive companies operate in defensive markets

The most obvious form of defensiveness is that the company operates in a defensive market. In other words, it operates in a market that is relatively insensitive to economic ups and downs. Just think how bad the economy would have to be before you stopped buying toothpaste. On the other hand, if there’s any sign that the economy may be slowing, it’s very easy to not buy a new car or a new house.

(2) Defensive companies operate in growing markets

Imagine a highly competitive, high-quality company operating in a market that is immune to economic ups and downs. That sounds great, but what if its core market is in long-term decline? Eventually, the shrinking market will cause the company to shrink, and that isn’t what I’d call defensive.

Because of that, it’s a good idea to focus on companies operating in markets with long-term growth potential.

(3) Defensive companies are robust

Like the vase I mentioned above, some companies are just fragile. This usually happens because they have too much debt, but there can be other reasons, such as a pension scheme that is too large, or perhaps they rely too heavily on a single client, supplier or superstar employee. Or perhaps they’re exposed to abrupt technological or regulatory change.

In summary, the ideal dividend growth stock combines quality (enduring competitiveness) with defensiveness (robustness), and the combination of those two factors should make long-term dividend growth the likely outcome.

Step 2: Estimate fair value based on future dividends

estimate fair value

When we buy shares, we are buying a piece of a business, and if we’re going to buy a business then we should have a good idea of what that business is worth. In other words, we should have a good idea of its fair value.

The first thing to know is that the fair value of a business depends solely on its future cash returns to shareholders.

Cash is usually returned to shareholders as dividends, but the principle applies to other types of cash return such as share buybacks (when the company pays you cash in exchange for your shares). To simplify things, I'll lump all cash returns together and just call them "dividends".

Some people have a hard time believing that companies derive their value purely from their future dividends, so I'll try to explain with a thought experiment:

Imagine we have two companies, Company A and Company B.

Company A will pay a dividend this year and then go bust next year, taking it share price down to zero. Company B will not pay any dividends and it will also go bust next year.

Given that scenario, which company would you rather invest in: Company A or Company B?

The answer is obviously Company A, because although both companies eventually become worthless, at least you'll get a dividend out of Company A before it goes bust.

In fact, you would be crazy to pay anything for Company B because no matter how little you put in, you won't get any of it back.

This tells us that a company gets its value from the cash it returns to shareholders, and from nowhere else.

So even if a company doesn't return cash to shareholders today (like most high-growth tech companies) investors must be assuming that those companies will, at some distant point in the future, start paying dividends or buying back shares.

Once we realise that a company's value comes from its dividends, the next obvious question is, how much is a particular company worth? 

To answer that, we need to think about the two variables that affect the fair value (or present value) of future dividends:

(1) The size of each dividend

This one is very simple. If you have the choice of being given £10 or £100, which would you prefer (in other words, which do you think is more valuable to you)?

The answer, of course, is £100. So bigger dividends have a higher present value.

(2) The timing of each dividend

If you had the choice of being given £100 today or £100 in a year, which would you choose?

Again, it's obvious. Money today is worth more than money tomorrow, so near-term dividends have a higher present value than far-future dividends.

With these two variables in hand, we can then estimate a company's fair value using a discounted dividend model.

Using a discounted dividend model to estimate fair value

This isn't necessarily as complicated as it sounds, because all we need to do is come up with a realistic and conservative estimate of the company's future dividends.

Once we've done that, we can calculate the present value of those future dividends by discounting (reducing) them by the market's long-term average rate of return. 

If that sounds like gobbledegook, here's another way of thinking about it:

Remember that a dividend today is worth more than an identical dividend a year from now? This is basically what we mean by "discounting".

The present value of future dividends reduces in proportion to the time we have to wait for the dividend to be paid. The discount rate simply tells us how much we need to reduce a dividend by, for each year we have to wait for it.

And for UK stocks, the fair value discount rate is the UK market's long-term average rate of return.

Once we've discounted all the future dividends (using an investment spreadsheet), we can simply add them all up and that gives us our fair value estimate for that company. 

This is obviously much more long-winded than using simplistic valuation metrics like PE or dividend yield, but building a dividend model has real value because it forces you to quantify your thoughts about a company's potential future.

Also, fair value estimates based on discounted dividend models are much more robust than simplistic measures like dividend yield, and I wouldn't value companies any other way.

Step 3: Buy when there is a margin of safety

Invest with a margin of safety

Here's the story so far: We are thinking like business owners, looking to acquire quality companies with long track records of dividend growth. We've analysed a particular company, estimated its future dividends and used those as a basis to estimate its fair value.

We can now look at the company's market value (its share price) and compare it to our estimate of fair value.

If the share price is below fair value, the share price is said to have a margin of safety. Having a margin of safety is important because it protects us, to some degree, from mistakes and unexpected events. The future is, after all, highly uncertain and we are by no means all-knowing, so we should expect our fair value estimates to be wrong.

We can, to some extent, protect ourselves from our ignorance by (a) making conservative estimates of future dividends and (b) buying shares only when there is a significant gap - a significant margin of safety - between the share price and our estimate of fair value.

This is where the old mantra of buy-low and sell-high comes in. If we buy low (relative to fair value), we can reduce risk and increase expected returns at the same time. Risk is reduced because buying low will give us a wider margin of safety, and expected returns are increased because the dividend yield will be higher.

How big should this margin of safety be? That's up to you, but in my experience, a margin of safety of 30% is a bare minimum, while the best investments tend to occur when a company's share price is 50% or more below a conservative estimate of fair value (which doesn't happen very often). 

Step 4: Diversify wisely to reduce risk

diversify your investments wisely

Let's say you've come up with a realistic but conservative estimate of fair value for a company. Its share price is well below your estimate of fair value, so there seems to be a significant margin of safety between price and fair value.

You like the quality of the company and you like the current price, so you decide to invest. But how much of your precious savings should you invest into this business?

You could put all of your money into that one company, but most people would (quite rightly) say that was crazy. Alternatively, you might decide to invest 1% into it. But what would be the point of that? If the share price doubled, you would make a measly 1% capital gain.

So, as with most things, there is a sensible middle ground that we can aim for.

Limit your maximum position size

In terms of maximum position size, it's really a question of how long it would take the portfolio to fully recover from the total loss of any one investment.

For example, my target rate of return is 10% per year. If I put 50% of my portfolio into a company that subsequently goes bust, I'll obviously be down 50%. More importantly, the remaining 50% of the portfolio would have to grow by 100% to get the portfolio back to square one.

With a growth target of 10% per year, that 50% loss could take seven long years to recover from, which would be seven years of growth and income lost to a single mistake.

I don't want to suffer that much of a setback from a single mistake, so here's my rule of thumb:

  • Rule of thumb: Don't invest more into one company than the portfolio can recover from within one year

With a target rate of return of 10% per year, that means my maximum position size is 10%. If I had 10% in a company that went bust tomorrow, the remaining 90% of my portfolio should be able to fully recover from that loss in just over one average year.

If a position exceeds 10% (perhaps because the share price shoots up unexpectedly), this can easily be fixed by trimming the position back to something more sensible while taking some early profits.

Having put a limit on the maximum size of any one holding, the next thing to think about is minimum position sizes.

Limit your minimum position size

Given that it takes time and effort to analyse and value companies, it's reasonable to expect each of our investments to pull its weight. If, for example, we have a 1% position in a particular company, a doubling of that company's share price will give us a capital gain of just 1%.

So, in addition to having a maximum position size, I also have a minimum position size:

  • Rule of thumb: Top up or sell any positions that fall below 2% of the portfolio

2% is of course a subjective and personal limit, but for me, I don't see the point of owning something that makes up just 2% of my portfolio. If a position falls below 2%, I will either top it up (if I still like the valuation and the company) or sell it. The only exception would be if I wanted to top it up, but didn't have the spare cash available to do it. In that case, I would leave the position in place but top it up as soon as cash was available.

With these maximum and minimum position size limits in place, the next task is to choose how many holdings we want in total.

Limit the maximum and minimum number of holdings

With maximum and minimum position sizes of 10% and 2% (in my case), there is already a limit on the number of holdings, going from 10 (where each would have a position size of 10%) to 50 (where each would have a position size of 2%).

10 to 50 is a pretty wide range, but research shows that the optimal number is probably somewhere in the lower half of that range.

More specifically, something in the region of 15 to 20 holdings seems to be the Goldilocks zone between concentration and diversification for a portfolio of individual stocks.

Source: The Dangers of Over-Diversifying Your Portfolio

"The magic is that you only need to do this simple thing. This simple thing is to find 15 or 20 good uncorrelated return streams" - Ray Dalio, Founder of the world's largest hedge fund

The problem with having more than 20 holdings is that it doesn't meaningfully reduce risk, but it does reduce the expected return as you have to add in increasingly less attractive stocks.

Perhaps more importantly, owning much more than 20 stocks significantly reduces the amount of time available for analysing each holding, and that can reduce the quality of your analysis.

  • Rule of thumb: Optimise concentration and diversification by holding 15 to 20 companies

The next step towards wise diversification is to make sure we aren't over-invested in any one industry.

Diversify across a wide range of industries

It's all well and good investing in 15 to 20 different companies, but if they all operate in the same industry, they'll be exposed to similar industry-related risks.

There would be a much greater reduction of risk if the investments were spread across multiple industries, such as aerospace, retail, utilities, technology, media, chemicals, healthcare and so on.

These industries have different industry-specific risks, and by spreading your investments across many different industries you can materially reduce the impact of those risks.

In fact, if you do this well, you'll often find that what is a disaster for some holdings is good news for others, so this is a simple way to hedge your bets without having to invest in a hedge fund.

Again, the exact level of industry diversification is up to each investor to decide. Some insist on having each holding operate in a different sector, but I'm willing to be slightly more concentrated than that:

  • Rule of thumb: Don't have more than two holdings operating in the same industry with very similar business models 

Diversify across a wide range of countries

Another important way to diversify your investments is to spread them across multiple countries. After all, nobody knows for sure what the future has in hold for the UK, the US, China or any other country.

Many companies in the FTSE All-Share generate much of their revenues overseas, so building a portfolio that is internationally diverse is relatively easy, even if you only invest in UK-listed companies.

  • Rule of thumb: No more than 50% of the portfolio's revenues should be generated from any one country 

Step 5: Rebalance regularly to improve returns

rebalance holdings regularly

The final step on our journey to a well-managed portfolio of dividend stocks is to understand the power of rebalancing.

Perhaps the easiest way to understand rebalancing is to look at the classic 60/40 portfolio, which is 60% invested in equities and 40% in bonds.

If stocks have a fantastic year and bonds a terrible year, the portfolio could easily end up with an asset allocation split 80/20 between stocks and bonds. If that happens, the portfolio is no longer set up the way the investor wanted, because it's far too heavily exposed to risky equities and underexposed to lower risk bonds.

The simple answer is to rebalance the portfolio by selling some of the portfolio's equities and using the proceeds to top up the bond holdings.

This does two things. First, it brings the portfolio's expected risk/return profile back to target by bringing its asset allocation back to target. Second, and just as importantly, it automatically leads the investor to sell whichever investment has performed best (selling high) in order to top up whatever performed worst (buying low).

If rebalancing is carried out consistently over a number of years, it can have a meaningful impact in terms of both reducing risk and improving returns.

The good news is that rebalancing works just as well with a portfolio of quality dividend stocks.

As I've already mentioned, it's a good idea to have maximum and minimum position targets.

One simple way to implement rebalancing is to trim back any positions that have exceeded your maximum, with the proceeds being used to top up any positions that have fallen below your minimum target size.

That's a step in the right direction, but we can do much better.

Here’s a quick thought experiment:

Holding A and Holding B have identical levels of risk, but the expected return of Holding A (based on your calculated margin of safety) is twice that of Holding B.

Which one of these two holdings should have the largest position size?

Given that the expected return of Holding A is twice that of Holding B, for the same level of risk, the rational thing to do is to invest more into Holding A.

"The question is always, 'How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?'" - Warren Buffett, probably the best known and most revered investor on the planet 

This is called active position sizing, where the size of each investment is adjusted based on its expected risk and return, both of which are driven by the quality and defensiveness of the business and the investment's margin of safety.

  • Rule of thumb: Invest more into stocks with the best combination of quality, defensiveness and value

In my case, I use my investment spreadsheet to calculate a target position size for each holding, based on a combination of the company's defensiveness (whether it's defensive or cyclical) and its margin of safety.

Here's one final thought experiment to illustrate how it works in practice:

Let's say I hold two defensive stocks (among many others), where my estimate of fair value is 100p in both cases. Let's also say the share price of both companies is 60p, so there is a good margin of safety in both stocks. Because their margins of safety are the same, each holding's position size is an identical 5%.

Over a period of several weeks, Holding A faces some bad news and the share price halves to 30p. At the same time, Holding B has a run of good news and the share price goes up by 50% to 90p.

At this point, I review both companies again and come to the conclusion that the good and bad news are largely irrelevant. My estimate of each company's future dividends remains the same and my fair value estimate remains unchanged at 100p.

So, Holding A's share price is now 30p against a fair value estimate of 100p, while holding B's price is 90p versus an identical 100p fair value estimate.

Clearly, Holding A is the more attractively valued of the two, by a wide margin. But thanks to its falling share price, its position size has halved to 2.5% while Holding B's position has gone up by 50% to 7.5%.

How can it possibly make sense to have three-times as much in Holding B compared to Holding A, when Holding A is by far the most attractively valued?

Of course, It doesn't make any sense, but we can rectify this situation by trimming Holding B in order to top up Holding A.

However, given that Holding A has a much wider margin of safety than Holding B, we don't just rebalance them back up to their original position size of 5%. Instead, we go further, trimming Holding B all the way back to 2.5% and topping Holding A all the way up to 7.5%.

As a result, we now have more invested into the more attractive holding and less invested in the less attractive holding. Just as importantly, the discipline of rebalancing and active position sizes forces us to sell high in order to buy low, and that is pretty close to the definition of sound investing.

A 5-step approach to investing in dividend stocks

This has been a fairly detailed overview of an approach to dividend investing that I've been developing from real-world experience for more than ten years. Hopefully you've found some useful ideas in there and hopefully those ideas will help you avoid some of the mistakes I've made over the years.  

In summary then, the fundamentals are to always think like a business owner, and:

  1. Identify quality dividend growth stocks
  2. Estimate fair value
  3. Buy when there is a margin of safety
  4. Diversify wisely to reduce risk
  5. Rebalance to improve returns

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