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A 5-step approach to investing in dividend stocks

investment strategy Sep 28, 2021
 

In this article, I break down everything I know about dividend investing into five basic steps. These steps then form a solid foundation upon which everything else in my investment strategy is built.

So if you're looking for a high-level overview of dividend growth investing, this is it.

The five steps

Step 0: 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 incredibly obvious, but for many people, it isn't.

For example, when I started investing in the mid-1990s, the only thing I knew was what the evening news told me. So I knew that the FTSE 100 went up and down a bit each day and that occasionally the share price of a big company would take a dive because the company made a loss or had some bad publicity.

So like a lot of novice investors, my focus was on share prices and share price movements from one day, week or month to the next.

I now know that putting share prices front and centre is a very bad idea. It ignores the fact that shareholders are business owners. And I don’t mean that metaphorically. When you own shares, you literally own a piece of a business.

So if you own a few Tesco shares, you literally own a piece of Tesco.

This matters 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 want to know what a random stranger thought M&S was worth? Would you want that random stranger whispering their opinion into your ear on a daily basis?

Well, that random stranger is the stock market. In this example, it’s the M&S share price that gets updated every 15 minutes or so on most stockbroker websites.

If you look at the M&S share price, all it tells you is that some people you don’t know have decided to buy or sell M&S shares at a specific price for reasons you also don’t know.

Perhaps the buyer is an index-tracking fund that knows nothing about M&S, and perhaps the seller is someone who needs the cash to pay their rent.

You have literally no idea why the M&S share price is what it is, so if all you know about M&S is its share price, you know nothing about M&S at all.

When you own a business, listening to the opinions of random strangers (i.e. focusing primarily on share prices) is a bad idea.

if you owned M&S outright, I expect you’d want to know things like:

  • How much revenue it made last year and how much profit;

  • what its strategy is and how it's progressing against that strategy;

  • what return the company is getting on any profits (that belong to you, the owner) that have been retained within the business;

  • what its competitors are up to;

  • what the prospects are for its industry over the medium and longer-term;

  • and all manner of other things related to the company’s ability to generate future profits and dividends.

These business fundamentals are what business owners should focus on. It's how they gauge the progress and success or failure of the companies they own, rather than listening to the opinions of random strangers.

As stock market investors, that means perhaps 95% of our focus should be on the actual businesses we own, and perhaps 5% of our focus, at most, should be used to keep an eye on share prices.

Step 1: Identify quality dividend growth stocks

So our focus is squarely on companies, but what sort of companies should we invest in?

The short answer is that it depends on the outcome you're after. That isn't very helpful, so I'll be a bit more specific.

In my fairly typical case, I want a portfolio that grows reasonably steadily over many years, from a combination of capital growth and reinvested dividends. 

I also want the portfolio to have a high dividend yield, so that when I retire at some distant point in the future my income from the portfolio is higher and/or the capital required to meet my income needs is lower.

I also want the dividend to grow ahead of inflation, at the very least, so that my retirement income keeps up with the rising cost of living.

There are various ways to achieve this outcome, but my approach is to invest in high-quality companies that are very likely to pay a rising dividend over many years and preferably many decades.

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

Identifying quality companies

In a nutshell, a quality company has enduring competitive advantages over its peers. These competitive advantages enable help quality companies to win consistently over long periods, and you can spot most quality companies by looking for the following attributes:

(1) Quality companies generate high profits

The acid test for quality companies is that they produce high returns on capital. In other words, if a company buys a factory for £1 million and that factory produces a profit of £200k per year, then the £1 million 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 money they need to invest in their future success. Without high profits, companies are not able to invest enough into their infrastructure and eventually they will become uncompetitive and eventually fail.

(2) Quality companies generate growth

One way for a company to produce high profits is to put up the price of its products. This will work, but it will also probably lead to fewer sales which will lead to lower revenues and lower profits. So a true high-quality company will typically have both high returns on capital and relatively consistent growth of revenues (sales or turnover), earnings (profits), dividends and capital employed (buildings, machinery, inventory etc).

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

(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 skills, providing customers with a narrow set of products and services.

So key attributes to look for in a quality business are that it's had a narrowly focused core business for at least several decades.

(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 attractiveness of a company's product or service increases as more people use it. A typical example would be Rightmove, which brings together the largest network of home buyers and home sellers in the UK.
  • Valuable and hard to replicate assets: An example here would be Burberry, 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 terminal decline? Eventually, the shrinking market will cause the company to shrink, and that isn’t what I’d call defensive.

So 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

When we buy shares we are buying 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 entirely on its ability to return cash to shareholders. This is typically done by paying dividends although there are other ways that companies can return cash to their owners.

Here’s why fair value depends on future dividends:

Let’s say you’re an omnipotent super-being who can see into the future with 100% accuracy. Let’s also say that you’re thinking of investing in two companies, A and B.

Over the next ten years, you know for certain that Company A will pay a 10p annual dividend while company B will return no cash to shareholders. Both companies will go bust ten years from now and their share prices will go to zero.

Knowing the future with 100% certainty, which is more valuable, Company A or B?

I’m going to assume you said A. Company A at least returns some cash before it goes bust whereas B returns nothing. Your loss with Company B would be total even if you bought its shares for 1p each. 

In other words, a company that will return no cash to shareholders over its remaining lifetime has no economic value.

We can take this idea even further. If a company only has value if it's going to return cash to shareholders, then:

  • The fair value of a business is the sum of all its future cash returns to shareholders

In theory then, if we're going to estimate the fair value of a business, we have to estimate the value of all its future dividends, decades or even centuries into the future.

That sounds a bit extreme, but fortunately, there are various shortcuts we can take so that the task of estimating fair value isn't quite that scary (I’ll cover those shortcuts in a future article).

Even with those shortcuts, we do need to think about future dividends and there are three main factors we need to take into account:

(1) The size of each dividend

Here's another thought experiment:

Company A pays a 100p dividend and Company B pays a 50p dividend. Both dividends are paid annually for the rest of eternity.

Which company is worth more?

The answer is somewhat obviously Company A because its dividend is larger. So the bigger the dividend, the higher the fair value of that dividend and the higher the fair value of the business.

(2) The timing of each dividend

This time, Company A pays a 100p dividend to shareholders at the end of this year and then goes bust. Company B pays a 100p dividend to shareholders ten years from now and then goes bust. No other dividends are paid by either company at any point.

Which company is worth more?

The answer is A because it’s better to receive a 100p dividend this year than having to wait ten years for the same amount.

So the longer you have to wait for a dividend, the less value that dividend has today (in other words, its present value is lower). This also reduces the fair value of the business.

(3) The uncertainty of each dividend

Company A is 100% likely to pay a 100p dividend tomorrow while Company B is 50% likely to pay a 100p dividend tomorrow and 50% likely to pay no dividend. After tomorrow no further cash is returned by either company.

Which company is worth more?

Again, it’s Company A because we’re guaranteed to get the 100p dividend whereas with Company B we might get 100p but we could also get nothing.

So the higher the uncertainty of a dividend, the lower its fair value and the lower the fair value of the business.

To summarise all of that, we can say that:

  • Businesses only have value because they’re expected to pay cash to shareholders in the future

  • The fair value of a business is equal to the sum of all its future dividends, adjusted for their size, timing and uncertainty

Step 3: Buy stocks when there is a significant margin of safety between price and fair value

Let’s say we’ve done some calculations and come up with a fair value for Tesco, based on an estimate of the size, timing and uncertainty of its future dividends (again, this is less scary than it sounds).

Armed with this estimate of fair value, we can now look at the company’s share price and start to form an opinion on whether the share price is high, low or fair.

Having an opinion on whether the price is high, low or fair is important because the gap between price and fair value, often called the margin of safety, is a key driver of risk and return.

Here’s an example of why having a significant margin of safety is so important.

Imagine we’re watching Bargain Hunt, a TV program in which ordinary people hunt for bargains at an antiques market.

The contestants find a painting which they think is very pretty. The seller tells them it’s 100-years old and is in a style that is very popular today. The contestants pay the seller £100 for the painting, so that’s its price on that day at that market.

The next day the contestants show the painting to the TV show’s expert. The expert thinks the fair value of the painting is closer to £20. In other words, the expert thinks a knowledgeable buyer (such as an antiques dealer) would pay around £20 to own that painting, based on economic rather than aesthetic reasons.

Later that day the contestants are taken to an auction where they manage to sell the painting for £40, resulting in a loss of £60 (60% of their "investment"). The buyer is an expert antiques dealer who clearly has a different estimate of fair value than the TV show’s expert.

What does this story tell us?

  • First, that experts can disagree on fair value.

  • Second, the contestants made a 60% loss because the price they paid was well above a reasonable estimate of fair value.

  • Third, if they’d bought the painting for £10, that would have given them a significant margin of safety between price and a conservative estimate of fair value, and they would have made a very good profit

In summary, the gap between the purchase price and fair value determines the expected return of an investment rather than the quality of the item or its fair value.

This applies as much to businesses as it does to paintings. For example, imagine a company that will definitely pay a 10p annual dividend forever:

  • If you buy that company at 100p per share you’ll get a 10% dividend income forever, which is very good.

  • If you buy that company at 200p you’ll get a 5% income forever, which is okay but not as good as 10%.

  • If you pay 1,000p per share you’ll get a 1% income forever, which is terrible.

In each case, the quality of the company, its future dividends and therefore its fair value are the same. The only thing that’s changed is the gap between price and fair value, so that is what has driven the change in returns.

Note: One exception to this is companies that never pay a dividend and then go to zero. In that limited case, the purchase price doesn’t matter as your loss is always 100%. So as a general rule it’s a good idea to try to avoid companies that never pay a dividend and then go to zero.

One final point is that since fair value can only ever be an estimate, we should try to keep our estimates realistic but conservative. If you're not conservative then the margin of safety you thought you had will turn out to be an illusion.

Step 4: Adjust position sizes based on the expected risk and return of each stock

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 you think there is very probably 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?

One answer is to allocate roughly the same amount to each holding. This is a very simple way to diversify and it's more or less how I used to invest, but I now think there’s a better way.

Here’s another thought experiment:

Stock A and B have identical levels of risk, but the expected return of Stock A is twice that of Stock B.

Assuming both stocks are attractive enough to put into your portfolio, would you invest more into A than B, an equal amount in both or more into B than A?

Given that the expected return of A is twice that of B and that the risks are the same, the rational thing to do is to invest more into A.

This is called active position sizing, where the size of each investment is adjusted based on (a) the investment's expected risk, which comes from the quality and defensiveness of the business, and (b) the investment's expected return, which is driven by the margin of safety.

So as a general rule, investors should invest more of their money into stocks with the best combination of quality, defensiveness and margin of safety, which seems very much like common sense.

In fact, if you were an omnipotent super-investor then it would probably make sense to put all your money into the world’s single best investment.

In reality, it rarely makes sense to put all your eggs into one basket, so the idea of concentrating your investments around the best opportunities should be balanced with the need to survive the occasional unexpected catastrophe.

For example, if you put all of your money into one company and it very unexpectedly goes bust, then your life savings will have gone up in smoke.

If you put 50% into one company and it goes bust, you’ll obviously be down 50%. The remaining 50% will have to grow by 100% to get you back to square one, and even with a growth rate of 10% per year that will take seven long years.

If you put 10% into one company and it goes bust, you've only lost 10%. The remaining 90% of your portfolio will have to grow by just over 10% to get you back to square one and, at a growth rate of 10% per year, that will only take slightly over one year.

Of course, diversification can be taken too far, and if you put 1% into 100 companies then it's very unlikely that you'll beat the market. There just aren't that many attractively valued stocks available at any one time.

If you want to have a higher yield and a higher growth rate than the market then you're probably going to have to have a fairly concentrated portfolio, but even with a concentrated portfolio, it's possible to be broadly diversified. 

Step 5: Diversify to reduce risk without reducing returns

Putting an upper limit on position size is an obvious way to reduce risk, but some risks extend beyond a single company.

For example, you might decide that owning one restaurant business is too risky, so you buy 20 restaurant businesses, all of which operate in the UK.

If one of those companies ends up being run by an idiot who drives it into the ground, then your diversification policy has worked and you'll only lose 1/20th of your portfolio.

But what if there's a pandemic? Those 20 restaurant businesses may have to shut for months on end, and that could be catastrophic for your whole portfolio.

So rather than diversifying simply by owning more companies, we also need to think about the underlying risks that we’re trying to reduce.

Of course, there are a billion and one risks so we can’t seriously think about all of them, but we can reduce our exposure to most risks by diversifying along three broad dimensions:

(1) Diversify across multiple companies

We’ve already covered this one and limiting position size is the most obvious and easiest way to begin to diversify.

(2) Diversify across multiple industries

Instead of owning 20 restaurant businesses, there would be a much greater reduction of risk if the investments were spread across multiple industries, such as restaurants, retailers, utilities, technology companies, engineering firms, manufacturers, healthcare businesses 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.

(3) Diversify across multiple countries

Another important way to diversify your investments is to spread them across multiple countries. This can be done even if you only invest in FTSE stocks that are listed in the UK.

Many companies in the FTSE 100 and 250 generate most of their profits overseas, so building a portfolio that is focused primarily outside the UK is relatively easy, even if you only pick companies that are listed on the London Stock Exchange.

Focus on quality dividend growth stocks with a significant margin of safety and diversify to reduce risk

The above heading pretty much sums up these five steps into a single sentence. In other words, I think the foundations of a sensible dividend investment strategy are to:

Think like a business owner, and then:

  1. Identify quality dividend growth stocks
  2. Estimate their fair value
  3. Buy them with a significant margin of safety
  4. Invest more in the most attractive stocks
  5. Diversify to reduce risk

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