A 5-Step Strategy for Investing in Dividend Stocks

investment strategy Sep 28, 2021
5-Step Dividend Investing Strategy

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

Note: If you're new to dividend investing and aren't sure if it's right for you, you may want to read this post first: The pros and cons of savings vs. dividends for retirement income.

The five steps to investing in dividend stocks:

Step 0: Think like a business owner

I'll begin 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, 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 fallen 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 terrible 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.

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

Business owners focus on the businesses they own

Let's say you win the lottery, and in a moment of madness, you buy Marks & Spencer outright. Now that you own M&S outright, what information would interest 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 (because 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 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 profit and dividend growth can the company 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 companies 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 stocks

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

Most dividend investors are after a good combination of dividend yield and growth, so my approach is to focus on high-quality companies that are 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 consistently take market share or expand into new markets repeatedly over many decades.

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

(1) Consistently strong profitability

The acid test for quality companies is that they generate consistent profits and consistently high returns on capital, where "capital" is funding provided to the company by investors (in the form of shareholder equity), lenders (as loans) and landlords (as leased property). 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 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 making 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 allows quality companies to fund their growth with lower-risk retained profits rather than higher-risk debt. The best companies can fund consistent strong growth with little debt while paying a consistently growing dividend.

Related articleHow to find quality companies with consistent profits and dividends

Related articleFind quality dividend stocks using these profitability ratios

(2) Consistent inflation-beating 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 a quality company takes market share from weaker competitors or moves into adjacent markets closely related to its core business.

Related articleHow to identify stocks with high-quality dividend growth

(3) Focused core businesses

If you want to win at the highest level in any sport, it will 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 limited set of products and services.

So, if 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.

Related articleHow to find quality dividend stocks with enduring core businesses

(4) Durable competitive advantages

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

  • Market dominance: 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.  
  • Brands or reputation: This includes (1) loved consumer brands, where customers choose the brand first and worry about price second, and (2) trusted suppliers of critical components, where the cost of a component failure is high (e.g. medical devices), so customers are willing to pay more to buy from a trusted supplier.
  • Unique business model: Some companies benefit from a unique business model. Common examples include (1) vertical integration (such as a car insurer that also repairs cars) and (2) horizontal integration (such as a retailer that sells a broader range of goods than any of its competitors).
  • Long-term focus: Some companies are able to ignore the pressures of short-term investors and focus on developing a business that can thrive over the long term, even if that hurts short-term results. These companies typically either have strong founder ownership or they're able to develop their own CEOs who put the company's long-term interests far ahead of their own.
  • 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).
  • 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 for a long time.

Identifying defensive companies

A high-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.

RelatedHow to avoid dividend traps with excessive debts

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

If we're going to invest in businesses, then we should have at least some opinion about what those companies are worth so that we're less likely to overpay for them.

Unfortunately, a company can be worth different amounts to different investors, so there is no single "correct" figure for what a company is worth. However, there is a generally accepted concept of fair value or fair price, which is the price at which an investor could expect to receive a return in line with the historical market average (about 7% per year in the UK).

Of course, the investor won't get exactly 7%, but that would be their central expectation if they purchased a stock at its fair price.

There are two main approaches to estimating a company's fair value. One is simple and looks backwards, while the other is complex and looks forwards. Both approaches are based on the same underlying theory, which is that a company derives its value from the dividends it is expected to pay in the future.

How companies derive their value from future dividends

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

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

Company A pays a dividend this year and goes bust next year, taking its share price down to zero.

Company B doesn't pay a dividend this year and then goes bust next year, taking its share price down to zero.

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.

Once we realise that a company's value comes from its future dividends, the next obvious question is, how large will the company's future dividends be?

We cannot know the future precisely, but we can make intelligent estimates that are good enough to base investment decisions on. This is where the simple and complex methods mentioned above come into play. I'll start with the simple approach.

Estimating fair value from historical earnings and dividends

Large, stable, high-quality companies tend to produce fairly steady earnings and dividends that don't change dramatically from one year to the next, at least most of the time. This becomes even more true if we look at the average earnings and dividends produced by a quality dividend stock over, say, five or ten years.

For example, I think it is very likely that Unilever will earn larger profits and pay larger dividends over the next ten years than it did over the last ten years. There are no guarantees, but I think the odds are very good that I will be right.

So, a very simple way to estimate a company's future dividends is to simply look at its past dividends. If we're looking at a high-quality dividend stock, we should be able to assume that its dividends over the next ten years will be larger than those of the last ten years.

Rule of thumb: Only invest in companies where it is virtually certain that earnings and dividends over the next ten years will exceed earnings and dividends over the last ten years

To estimate fair value, we just take those historical ten-year average earnings and dividends and apply a prudent price-to-earnings and price-to-dividends multiple. I call these the PE10 and PD10 ratios.

The appropriate multiple will vary from one company to another, but in my experience, the following rules of thumb are applicable to most high-quality stocks:

Rule of thumb: Fair value is likely to be less than 30 times the ten-year average earnings (PE10 below 30)

Rule of thumb: Fair value is likely to be less than 60 times the ten-year average dividend (PD10 below 60)

Given that fair value implies market-average returns, I usually sell stocks when the share price reaches those levels.

Let's turn our attention to the complex method, where we try to estimate the company's likely future dividend payments in some detail.

Estimating fair value by building a discounted dividend model

Discounted dividend models are made up of two components: (1) An estimate of the company's future dividends and (2) a discount rate, which calculates the present value of those future dividends (in other words, we discount the future because a £100 dividend paid today is more valuable to most investors than a £100 dividend paid 100 years from now).

My preferred approach to estimating future dividends is to treat a company like a savings account. For example:

  • If a savings account contains £100 and pays 10% interest, it will pay out £10 in year one
  • If I reinvest half of that (£5) back into the account, it will contain £105 and pay interest of £10.50 in year two
  • If I keep reinvesting half the interest each year, the money in the account, the annual interest, the amount reinvested, and the amount withdrawn will all keep growing by 5% every year

We can apply a similar model to companies by estimating their capital base (the amount in the “savings account”), their net return on capital (the “interest rate”) and their dividend cover (the amount paid out vs. the amount reinvested) over the next ten years.

My default approach is to assume that a company will (a) continue to earn historically average net returns on capital and (b) maintain a historically average level of dividend cover. These models often need to be tweaked to take into account a range of other factors, but in many cases, the simple default is good enough.

Once we've estimated the company's future dividends, we can calculate the present value of those future dividends by discounting them by the market's long-term average rate of return, which is 7% per year in the UK. 

Once we've discounted the future dividends, just add them all up, and that gives us our fair value estimate for that company. 

This is obviously a more long-winded approach than using the simpler approach of comparing price to past earnings and dividends, but it does have value because building a dividend model forces you to quantify your thoughts about a company's potential future.

Related articleHow to Value Shares with a Dividend Discount Model (link goes to my old website)

Resources: If you want to build a dividend model, use the spreadsheet on the Free Resources page.

Step 3: Demand 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 and estimated 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). 

Calculating the margin of safety using PE10 and PD10

Using the simple valuation method, where a PE10 of 30 and a PD10 of 60 are probably at or above fair value, we would achieve our 30% margin of safety by following these rules:

Rule of thumb: Only invest in a quality dividend stock when the PE10 ratio is below 20

Rule of thumb: Only invest in a quality dividend stock when the PD10 ratio is below 40

I use one additional rule of thumb, which limits the price I'll pay for a company while also ensuring I earn a reasonable dividend yield from every investment.

Rule of thumb: Only invest in a quality dividend stock when the dividend yield is above 3%

Calculating the margin of safety using a discounted dividend model

If you estimate fair value using a discounted dividend model, the easiest way to calculate the margin of safety is to just measure the gap between the current share price and your fair value estimate.

If, for example, fair value is 100p per share and the current share price is 80p, then the margin of safety is 20%. Again, I would suggest a minimum margin of safety of 30%.

Over the last few years, I have been trialling a more complicated approach that uses two discounted dividend models; one to estimate fair value using a 7% discount rate and one to estimate a good value price using a 10% discount rate. The margin of safety is then based on where the share price is between fair and good value.

If the share price equals fair value, the margin of safety is zero (as it would be using the simpler approach), and if the share price equals the good value estimate, the margin of safety is 100%. And, of course, between those two extremes, the margin of safety varies proportionately.

It isn't 100% clear that this more complex approach is any better than the simpler approach, so in general, I would suggest using the simpler approach of just comparing the current share price to your fair value estimate.

Step 4: Diversify 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 portfolio should you invest in 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

The whole point of diversifying is to reduce risk, so the first thing to think about is how much risk you're willing to take with any one company. In other words, how much could you stomach losing if one of your investments went to zero?

In my case, if one of my investments went bust, then I would want the rest of the portfolio to be able to fully recover within one year, assuming it was a year of normal returns.

The UK stock market's average rate of return is 7% per year, so that is the maximum I'm willing to put into any single holding.

  • Rule of thumb: Don't invest more than 7% into any one company

In practice, this would mean starting new investments off with a position size closer to 5% and then trimming any holdings back if they grow to the point where they exceed 7%.

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%, which hardly seems worth the effort.

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

If a position falls below 2%, I will either top it back up to 4-5% (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.

Having chosen your maximum and minimum position sizes, you have effectively already put an upper and lower limit on the number of holdings you can have.

Choosing the number of holdings

With maximum and minimum position sizes of 7% and 2% (in my case), the average position size would be 4.5%, and that would leave the portfolio with somewhere between 20 and 25 holdings.

This is good because 20 to 25 holdings falls into the Goldilocks zone between concentration and diversification for a portfolio of individual stocks.

benefits of diversification

Source: How Many Stocks Should You Own In Your Portfolio?

The problem with having a lot more than 25 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 a lot more than 25 stocks significantly increases the amount of time and effort needed to stay up to date with your holdings.

  • Rule of thumb: Optimise concentration and diversification by holding 20 to 25 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

Investing in 20 to 25 companies is a good way to begin to diversify a portfolio, 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 10% of the portfolio's holdings (e.g. 2 out of 20) operating in the same sector

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 store 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 revenue should be generated in any one country 

Step 5: Rebalance 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, and to top up undersized holdings and trim back oversized holdings. This is a very simple but effective approach to rebalancing.

A more complicated approach involves calculating target position sizes for each holding based on their risk profile (whether they're cyclical or defensive) and their valuation (their margin of safety).

There are various ways to do this, but one approach is to start off with a default size, say 4.5% (using the average position size from the previous example).

That default would then be adjusted up for defensive stocks (because they're lower risk) to, say, 6% and down for cyclical stocks (because they're higher risk) to, say, 4%. Putting this very simply:

Rule of thumb: Give defensive holdings larger position sizes than cyclical holdings

Those target sizes could then be further adjusted based on the gap between price and fair value (the margin of safety).

If the margin of safety is wide (the price is a long way below fair value), then the target size could be increased even further to take advantage of the stock's higher yield and higher expected return. On the other hand, if the margin of safety is small, the target size could be adjusted downwards to move the portfolio away from holdings with the lowest yields and lowest expected returns.

Rule of thumb: Invest more into those holdings that have the widest margins of safety

As before, positions could then be rebalanced if they move too far away from their target position size, perhaps using a rule along these lines:

Rule of thumb: Rebalance holdings when they move more than 2% from their target size

One final important point is to be wary of repeatedly topping up a holding that just keeps going down and down. There is a risk that you could invest an excessively large portion into one stock which eventually goes to zero (I did exactly that many years ago). So, here is one final rebalancing rule of thumb:

Rule of thumb: Don't top up a holding if its cost size is above its target position size

Note that cost size is the holding's position size using the cost of the shares (the total amount you've invested so far), not their market value.

A 5-step approach to investing in dividend stocks

This has been a fairly detailed overview of the approach to dividend investing that I've been developing from real-world experience for more than ten years. Hopefully, you've discovered some practical ideas that will help you avoid some of the most common investing mistakes.

If you'd like to learn more about this approach to investing in quality dividend stocks, please visit the Free Resources page, where you can download my Dividend Investing Guide, Dividend Investing Checklist and a collection of other useful tools and resources.

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