Three years ago, I quit my job and decided to pursue my real passion for the investment business by founding my own company – Dividend Stocks Rock. In September of 2017, I received a cheque from my former employer that was for my pension plan fund assets equaling $108,760.02.
I had the choice between letting this money “rot” with my bank pension plan manager or take the money and invest it in a locked-in retirement account. This time was both exciting and nerve wracking for me both personally and professionally. These funds were my pension benefit earned while working for that firm and really did represent the key beginnings to my financial future.
If I invested those funds while the market was at its peak and made mistakes, I may have never seen that money generate satisfactory returns. I’m sure you know the feeling, especially right now as the market’s volatility has substantially increased.
Back in 2017, most people expected the market to crash at any time. We rode a never-ending bull market. This was about to end. Nevertheless, I decided to invest these funds myself. I chose to put all this money into dividend growth stocks. 50% of my portfolio was invested in Canadian stocks and the other 50% in U.S. companies.
This story, however, is not about how successful those investments turned out to be.
It’s about how I developed a methodology that will help you to reach your goals.
For those who follow me, you know I report my dividend income monthly. I use this account as a live case study to show how you can build and manage a portfolio with dividend stocks. You can read my latest update here. It’s the perfect case study since I can’t add more money to the account. All I can do is reinvest the dividends paid. Let’s see how I invested my money before going to the end result. Short-term results are interesting at times, but really don’t matter over the long term as it is all about the process.
I invest with conviction
During this short period of time, I bought into the markets with my pension fund assets, I was confronted with several elements that usually creates many doubts and dilemmas: market swings, major events, strong bull, and bear forces, etc. When such a combination of factors happens, we all tend to up our game and do more research. This leads to hours of reading financial information leading us to more doubts and questions. Many investors get stuck in this paralysis by analysis mode.
- 2017 was clearly not an easy time to make investment decisions.
- 2017 wasn’t a good year to make investing decisions. All-time market highs were being hit routinely, and everyone expected a crash.
- 2018: Same, we even had a “flash bear” market.
- 2019: Same, the market recovered and then exploded. This created even more confusion.
- 2020: Same, COVID-19 + V recovery + election = doubt. How can you invest during times like these?
- 2021? I’ll let you guess…
If you go back in time, you will find many exceptionally good reasons not to invest every single year. I call it the bear song. Many will sing it while waiting for “things to calm down”.
Nevertheless, I took all my money and invested it all in equities. What’s my secret to investing with such conviction? I follow a straightforward process.
I apply a straightforward process
It took me several years, but I have developed clear guidelines. They are so clear and simple that it often sounds too good to be true. But the truth is the best streamlined processes are simple. They make sure you ignore the noise and act. You don’t have to wonder whether it’s time to buy or sell. The process will guide you down the correct path.
I’ll share the big lines of my process with you but note that many other strategies would work well too. The key point is to have it written down and keep following the same steps all the time.
A – Pick the right sector
I believe nobody should ever invest more than 20% of their money in a single sector. The more you add to a sector past 20%, the more volatile your portfolio may be. When the market drops, it affects all sectors. However, each crisis will be particularly hurtful for a few industries. The problem is that we never know which ones will suffer the most. It could be tech stocks (1999 tech bubble), banks (2008 financial crisis), oil & gas businesses (2015 oil bust, 2020 COVID-19) or entertainment, travel, leisure and retailers (2020 COVID-19). The key is to hold some of the best companies from each industry sector.
B – Focus on the dividend triangle
Some investors focus on the dividend yield as they see a genuine source of income. I prefer to pick companies that will give me both dividend growth and capital growth. While I focus on dividend-paying stocks that routinely grow their payouts (I’m the Dividend Guy after all), my goal is to reach the highest total return possible.
For this reason, I’ve come up with a combination of three metrics to initiate any stock research. I call it the dividend triangle:
Revenue growth: A business is not a business without revenues, and preferably growing revenues.
EPS growth: A company cannot pay growing dividends unless their earnings are growing as well.
Dividend growth: Last, but not least, increasing dividend payments are the obvious backbone of any dividend growth investing strategy.
The idea is to find companies that show a strong growth trend over the past 5 years. Let’s just realize that the COVID-19 will make this very difficult for 2021 once we have a full year of bad results included in each company’s financials!
C – Prioritize dividend growth above all
If I have the choice between a few goof companies within the same sector, I’ll pick the one with the strongest dividend growth. In general, a company that can increase its payout year after year has the ingredients to succeed and make me a wealthier investor.
The dividend growth rate is the ultimate measure of a company’s success. It is the confirmation that a company has a robust balance sheet, a growing business, and is cash flow positive. This is what we all want, right?
D – Determine the dividend safety
Once I’ve picked a company showing a strong dividend triangle, I will rate its dividend safety. The point is to track all my holdings with this rating. It helps me identify companies with weaker dividend growth rates. Those companies will inevitably be put on my “sell list”.
You can easily forget about a company offering a decent yield, but “forgetting” to increase dividends for 5 or 6 quarters will land that company on a watch list for potential sale.
Here’s what my rating system looks like:
- 5 = Stellar dividend – Past, present and future dividend growth perspectives are marvelous.
- 4 = Good dividend – The company shows sustainable dividend growth.
- 3 = Decent dividend – Don’t expect much more than a 3-5% annual dividend growth.
- 2 = Dividend is safe but – not likely to increase this year.
- 1= Dividend Trash – It has been cut or is likely to be cut soon.
I usually put my 3s on the watch list and I rarely keep “2’s” and “1’s” in my portfolio. If I had written this article last year, I would have told you that “2s” and “1s” are immediate sells. However, considering the pandemic, keeping a company like Disney (DIS) in my portfolio after its dividend suspension makes more sense. If the cut is not related to the impact of the virus, it is still an immediate sell.
E – Understand the business model
Once I got all excited about a few metrics, it’s time to get down to earth and understand what the business does. There are many companies that have complex business models or that evolve in an industry that is completely unknown to me. I tend to stay away from those.
If I can’t explain to my 13-year-old daughter what the business does and how it makes money, I let it go. The stock market is filled with thousands of stocks. Selecting companies you understand will make you more comfortable during market fluctuations.
F – Discuss upside and downside potential
After defining how a business makes money, it’s time to identify its growth potential and downside risks. Growth vectors are usually easy to find as I’m already getting excited to buy some stocks at this point of my analysis. I look at the dividend triangle and determine the reasons why the company is showing consistent growth. It could be related to merger-acquisitions, a dominant position in the industry, strong innovation, or organic growth. I need to know if those vectors will continue to make the business thrive.
However, identifying headwinds and what could go wrong is probably more important than thinking of growth. Being positive about a company at this state is easy. You already found companies with strong metrics and the ability to increase their dividends. It’s time to put on your “gloom and doom” hat and look at potential downsides for each company you are considering.
My favorite trick to find potential downsides is surfing on Seeking Alpha and reading authors that don’t like the stock I’m about to buy. It helps to take a cold shower and understand what could go wrong.
G – Valuation as a comparison tool
If you have been following me for a while, you will know that I’m not too big on using valuation methods to pull the trigger. They are more often than not wrong and there are often shifts in valuation that happen from time to time for seemingly no reason.
Who knew Apple’s (AAPL) price-earnings ratio would explode like this?
Does it mean AAPL is overvalued now? Or does it mean the market realized the company will generate even more profit going forward? The answer is probably somewhere in between those two hypotheses. Unfortunately, we will only discover the “truth” in 5 years. Then, it may be too late.
I would rather buy shares of AAPL now if it fits my investing model and doesn’t worry about the price I pay. After all, even Chuck Carnevale stated that Microsoft (MSFT) was and I quote ” dangerously overpriced” at $104/share back in July of 2018. I have enormous respect for Mr. Carnevale and my goal is not to point fingers. I just wanted to show that even the best in the game can’t predict the future and give proper valuation to any stocks.
H – Write the investment thesis
There is one thing I always do before I pull the trigger and add a stock to my portfolio: I write down my investment thesis for that security. This may seem to be an innocuous act, but it’s the most important step. In my investment thesis, I’ll include the reasons why I think this company will thrive. I highlight its metrics, its growth vectors and I spend enough time to lay out all the potential risks.
Once this process is completed, I review my thesis quarterly. If I’m proven right, I keep the stock. If I realize that I was wrong, I usually wait one or two more quarters to confirm it’s the case and then I get rid of the stock. It doesn’t matter if I make money or not on the trade, I trust the process.
Now, let’s see how this process fared over the past 3 years.
On September 4, 2017, I deposited a cheque for $108,760.02 with a brokerage house. Three years later, on September 3, my portfolio is now worth $169,423.16 (+55.8%). Is that a good growth rate? Let’s see how markets did in order to compare the results.
This performance compares very favorably to the 19.51% growth of the Canadian market (XIU.TO, total return) and the 47.66% for the U.S. market (SPY). The average index performance is 33.6%. My portfolio outperformed the market by 22.2%. But, that’s not the point.
The point is that I followed meticulously a process that I have spent years to create.
A few bumps in the road
As you can imagine, the past three years weren’t only filled by successful investments. While I was able to avoid the 2018 crash (e.g. I posted positive return during that year), 2020 hit me.
My portfolio showed its lowest point at ~$114K, which was only a few thousands away from my initial investment (and a ~29% portfolio value drop). I’ve also suffered two dividend suspension from Disney (DIS) and CAE (CAE).
Both companies were thriving before the pandemic, but their business model (entertainment and flight simulator) will definitely not bloom with social distancing measures.
I usually sell immediately when one of my holding cuts its distribution. This time, I had to be more lenient and accept to see my dividend income decrease. While Disney has recovered partially since March, I’m still showing a severe loss for CAE and I can’t count on the dividend to relieve the pain. Fortunately, I have other holdings that supported my portfolio during this tough time. This is where diversification shows to be relevant, right?
Many studies (Vanguard, Ned Davis Research, etc.) have proven that dividend growers tend to outperform the market with less volatility. This means more money in your pocket with less stress. It’s not a law of nature, but I can live with that historic trend. This is the reason why I decided to build my investing process around dividend growth.
If I had received my pension plan cheque today instead of three years ago, I would do the same thing. Use the tools I’ve designed to invest it all in dividend growers. I know this is the best course of action to sleep well at night and have a comfortable retirement.
Many investors focus on dividend yield or dividend history. I respectfully think they’re making a mistake. While both metrics are important, aiming at companies that have and show the ability to continue raising their dividend by high single-digit to double-digit numbers will make your portfolio outperform others. When a company pushes its dividend so fast, it’s because it is also growing their revenues and earnings. Isn’t this the fundamental of investing – finding strong companies that will grow? If you are looking for a great combination of dividend and growth, check out Dividend Growth Rocks.
Disclosure: I am/we are long DIS, MSFT, AAPL, CAE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.