The Dividend Growth Strategy: Should even young people bother doing it?

Should young people do it? Or should they just go for index and growth stocks (more risky stocks) and then when they’re older, switch over to dividend growth stocks? 

Why Dividend Growth Investment: Presentation at the Norwegian School of Economics

This week I held a presentation about Dividend Growth Investment at the Norwegian School of Economics (NHH). Since I  know that many of my readers are still in the beginning of their investment career, I’d like to share my slides with you guys!

So I’ve been investing since around 2010. Like many others, I struggled a bit finding my way at first, switching between trading, speculation, long-term investment that turns to speculating, index which turns into speculating and so on. It took about 4-5 years before I understood that dividend investing was my thing, and even further a year before I understood that I wanted to do the “Dividend Growth strategy”

I’ve been fortunate enough to get more and more readers. Something that I highly believe in is that quality matters. This is why you don´t see me writing blog post every day, or maybe not even every week. If I don’t feel that I have something to say, I don´t.

Mark twain has a pretty cool quote about this:

“It’s better to keep your mouth shut and appear stupid than open it and remove all doubt”

Compound interest

As dividend Growth Investors, it’s essential that you understand the effect of compound interest. If you don’t, there is no way to stay long term and you will fail at holding your companies for a long time.

What I like to do is to try to thing like a business owner. What this means is that there isn’t necessarily a strong correlation (=1 or close) to how the stock price move and how the company is doing. In the long-term the stock price should follow the company, but in the short-term, this doesn’t have to be the case.

Real Effect of Compound Interest

The slide above is a illustration of Warren Buffet’s net worth and you can see that in the beginning, it barely moved. Most of his fortune is made in his 70’s and 80’s. Of course, some might say that “what’s the point of having so much money when your old?”. Yes, I get that. The point of this illustration is to show you the effect of compound interest. It’s up to you to choose how you want to spend your money and at what time to do so.

Dividend Growth

What this table shows it the effect of CAGR (compounded annual growth rate). If you start of by about $850 in annual income, and you hold that for income for 10 years while getting a 10% CAGR, you will get $2292 in annual income. Pretty nice right?

The importance of using Total Return


I’ve stressed this before, but I will do this again. As dividend investors, we should focus on total return and not just price return. Why? Well, in reality, you can have a stock that has no change in price in a whole year, giving 0 %price return. But, when using total return, you see that you have actually earned 5 %, not 0%. I would suggest that you find a way to track your total return ASAP.


Dividend Growth Stock VS High Yield Stock

The slide above shows us the difference between a high yield stock and a DGI stock. HRL is a very nice DGI stock, but has a pretty low yield. SO on the other hand has a pretty high yield but low growth. We can see that in year 15, the compounded returns are even. We also notice that after year 15, HRL really takes of and the returns are amazing. By comparing SO and HRL we see that fater 30 years, HRL has returned 1000 % more than SO.

However, the numbers presented are very unsure because we are talking 30 years head and a lot can happen then. Having 15 % CAGR for 30 years would be amazing, but who knows? The point is that you can see the effect of DGI.

People often ask me how I find stocks, so I thought I should share some thoughts. First, most of the companies that I´m interested are presented in my Watchlist World

Also, these are some of the criteria that I use. (I do more, and I also try to calculate fair value based on different valuation methods, but this is my framework)

About the MOATs

  • Brand
    • Apple can charge 15% higher prices that their peers because of a strong Brand MOAT
  • Switching Costs
    • If you run a company, changing the software from Excel or Word to something else would be so bothersome that you just keep the same software.
  • Establishing Costs
    • Say that you want to enter the norwegian food market. Competing against the big chains is very though, and most likely, you will fail due to higher marginal cost.

REITs

As most of you know, I love REITs. If you don´t know what a REIT is, I suggest you read my post about REITs here:

Recommendations

Every presentions about stocks should include some kind of recommendation.  You should know about these companies, but don’t read this as a buy rec. It’s just information about two great companies.

Now that you have an idea about my strategy, it’s time to figure out my goals for my investments. It’s not just about money! It’s about Financial Independence

What’s High Quality?

One of the most common questions I get is what do I mean by high quality? When I held the presentation about Dividend Growth Investment at The Norwegian School of Economics, I outlined a few factors which I focus on. Still, there is so much more to the term quality.

In the book Zen and the Art of Motorcycle Maintainance the author tries to figure out what quality really means. How do you know the difference between a bad poem and a good poem? Is it the rhythm that makes it high quality? The complex vocabulary? Most likely, you will say that it’s the combination of many factors and that’s how it is with high quality companies too. It’s not just about a wide moat, a great brand, a strong track-record and a visionary CEO. It’s the total package and in this post, I’ll show you what I mean by high quality.

The Four Factors I Look For

  • Profitability
  • Management
  • Financials / Debt
  • Dividend Growth

Enduring Competitive Advantages

By Enduring competitive advantages, I mean either a wide or a narrow moat. Buffet uses the word economic moat and explains that a company can have different kinds of moats

  • Brand Moat such as Apple making them able to charge 15 % higher per phone even though the software is pretty much the same
  • Switching Cost such as Microsoft were so many companies have the Microsoft Package that it’s almost impossible to go to something else or at least the struggle isn’t worth it unless there’s a product which totally disrupts the business.
  • Establishing Costs such as AT&T or Dominion Energy were the cost of building the infrastructure needed to operate is so high that it’s basically impossible to enter the segment.
  • Patents such as J&J where they have the only permission to sell a drug, causing them to have a short-term monopoly.

A great way to see if a company has any kind of moat is to look at the return of equity (ROE). Imagine that someone opened a store selling hot-dogs and you can get 30% return on your invested capital. In just a couple of years, you would have doubled your money and each year you’d earn more and more. Surely someone else would find a way to sell hot-dogs, causing prices to drop. New companies would start to compete and the new mission would be to try to find the perfect balance between price and quantity.

But if a company can operate for a long time without having any significant competition, we might be talking about a company with a strong moat. An example would be my favorite company, namely Rollins (ROL). For decades they have been able to maintain a ROE close to 30%. Btw, Rollins is the first company I’m going to buy in a recession.

Long Operating History

By long operating history I want to able to check that the management has shown great leadership in depressed times as well as times with high growth (like now). I want to know that they have been smart with their money and invested in a proper way. As for management, I check that the Return on Invested Capital (ROIC) has been high for a long time. If it turns out the ROIC has been high for a long time, it shows that the management can find ways to inject capital and earn more money / profits. Again, if we use Rollins they have had ROIC above 40% since 2008. Simply astonishing.

Shareholder-Aligned Management

By shareholder-aligned management I mean that I want the company to pay respect to me as a shareholder. In many ways, this is where most dividend investors fail. They think that management should pay a dividend no matter what, and they also want it to be as high as possible. Probably, many would prefer two digit yield. The problem is that a dividend payment isn’t something magical. A company can choose to spend the capital from the positive revenue on new assets such as machine,  creating even grander growth in the future. They can choose to reduce debt which might not be a bad idea in a super low-interest rate environment. Lastly, they can choose to pay a dividend to shareholders.

For stocks such as AT&T, where the market is very saturated and there aren’t many ways to grow, I want to have a high dividend as my return for taking risk in this company instead of just owning a bond or placing my money on a saving account. For REITs it’s quite different since they are by law forced to pay most of their earnings as a dividend to shareholders. Still, I want to see that the company don’t have to increase debt in order to pay me. That might be sweet in the short-term, but it will surely end up bad. For stocks such as Visa, Medtronic or Hormel, I want a combination of high debt control, yield above or close to inflation as well as investment in growth-opportunities.

So, in total I want management to be risk-averse, not paying me a dividend just because people want them to pay. In USA, they operate with dividend aristocrats and dividend kings. Sure, many of these companies are great, but one need to notice and be aware that they have a high pressure of not freezing the dividend or cutting the dividend. Many people invest in those lists without having a clue what the company do and demand money even though the company would be better of holding the dividend payment for a while.

As for reasonable payout ratios, consistent free cash flow and healthy balance sheet, I normally aim at a payout ratio for American firms at maximum 70%. For REIT’s I look at the industry standard and the sector standard, but I’m not too eager when I see payout ratios above 100%. Since the free cash flow is in some ways the tool for a company to operate smoothly, being able to grow, invest and pay dividends, I want this to grow over time. Nothing is better than a consistent free cash flow year over year. It basically means that they get more and more money after paying their expenses to increase shareholder value.

As for balance sheets, I’m mostly focus on short-term debt, not that much on long-term debt. Debt is necessary to grow, but not being able to pay the short-term debt is dangerous. Here I want to current ratio, which is the total assets divided by liabilities to be above or close to 1. A current ratio less than 1 means that the company might find other raise money to pay the debt.

When I have a general idea of how the company might be, I perform a risk rating

The Stockles Risk Rating is created with the purpose of getting to know the business. I think that the best way to stay rational and calm in a stressful market is to know what you own and know what it’s good for. This Risk Rating is not absolute and a company can fit my portfolio even if a few questions are negative. I do this Risk Rating every time I buy a new company to make sure I know what this partnership truly means.

About the Company

  1. Geopolitical Risk: Is this company free of meaningful geopolitical risk?
  2. Market Cap: Is the market cap greater than $1 billion?
  3. Repeat Business: Does the business have high repeat customer usage?
  4. Brand 1: Does the company have brand strength with passionate advocates?
  5. Brand 2: Does the company’s business rely on recognizable branding truly valued by its buyer base?
  6. Safety: Is the safety score from SSD more than 75?
  7. Growth: Is the growth score from SSD more than 75?
  8. Yield: Is the yield score from SSD more than 75?
  9. Is the company recession proof?

Financials

10. Does the company have a good recent record of revenue growth? (Revenue CAGR)
11. Growth: Did the company increase its sales by 10% to 40% annually in the previous three years?
12. Profitability: Was the company profitable during the past year? 
13. Consistency: Has this company shown consistent profits each of the last five years? 
14. Cash Flow: Was the company cash-flow positive for the previous quarter, the last 12 months? Two of the last three years? 
15. Diversification: Is the company free of any customer or supplier that accounts for more than 10% of sales? 
16. Independence: Can the company execute its business plan without relying on external funding? 
17. Leverage: Is the company’s debt-to-equity ratio less than 1.0? 
18. Current Ratio: Is the current ratio more than 1.0? 
19. Net debt / EBIT: Is the net debt / EBIT lower than 2.0? 
20. Financial Transparency: Are the financials easy to understand? 
21. Return on Equity: Is the ROE/ROIC greater than 12% each year for the past five years?

Dividend

22. Yield: Does the company yield more than inflation?
23. Dividend CAGR: Is the CAGR more than 5%
24. Payout Ratio: Is the payout ratio less than 70%?
25. Dividend status: Is the company a king, aristocrat, contender…?

The Competition

26. Underdog: Is it free from stronger competitors?
27. Goliath: Is it free from disruptive upstarts?
28. Moat: Are there signs of strong competitive advantage?
29. Is the company likely to avoid disruption and see most of its key markets continue?
30. Is the company Amazon Proof?

The Stock

31. Market cap: Does the stock have a market cap of more than $750 million?
32. Beta: Is this stock’s beta less than 1.3 for the past 12 months?
33. P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30?
34. Forward P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30?
35. P/B ratio (financials): Does the stock have a price-to-book multiple around 1?
36. Forward P/B ratio: Does the stock have a price-to-book multiple around 1?
37. P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 – 2 or less than 1?
38. Forward P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 – 2 or less than 1?

Management

39. Insider Stake: Do founders and top executives have at least a 5% stake in the company?
40. Management: Is the management trustworthy? (Do as they say, ROE, ROIC, Capital Structure, Long-term Stock Price growth and Risk Controll)

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