The Dividend Monk, Author at Dividend Monk

Anchoring & Recency Bias, Overconfidence and more!

July 4, 2024 By The Dividend Monk Leave a Comment

In this last post about investment biases, I cover the anchoring and recency bias and the overconfidence and self-attribution bias. I also share my tips for overcoming these biases so that they don’t lead to poor investment decisions. If you missed the posts covering the other biases, here are some links:

Recognize and Overcome your Investment Biases

How Hindsight and Loss Aversion Hurt your Investment Decisions

Anchoring and recency bias

The anchoring bias occurs when we rely too heavily on the first piece of information we encounter (the “anchor”) when making decisions.

For example, holding on to shares of Algonquin (AQN) because it was once worth $22 a share; thinking the stock market is going to collapse and never come back by citing Japan; or calling for stagflation because you recall the 70s. Ironically, we had legions of “experts” calling a stagflation period a few years ago. They’re pretty quiet now.

If you look at your portfolio while constantly thinking about the 70s, you might sell a good part of your stocks and buy gold, convinced the yellow metal will make another 900% run. You’ll ignore the particular context in which events occurred in the 70s, which is far from the one we have now; you’ll focus on the “high probability” of seeing gold prices continue to go up. Since gold is on its way to doubling its value in 5 years, why not it at around $7,000 in 5 more years?

While looking at what happened 10 or 20 years ago to draw conclusions will lead you in the wrong direction, so will giving undue weight to recent events or trends. This is called the recency bias. Since there is a limit to the amount of information our brain can properly process, remembering the last important events is often enough to shape an opinion.

Since the economy is always evolving, we must consider recent history. After all, “cloud services” was not in our language back in 1999, it wasn’t even a thing! However, ignoring how events or crises similar to current ones unfolded in the past could also cost you a lot. When you look at the big picture, history does tend to repeat itself almost indefinitely.

Dangerous things happen when you combine the <hindsight bias> with anchoring. With anchoring, you focus on an event believing the same circumstances are happening again. The hindsight bias, which comes from a strong desire to predict the future, will reinforce you anchored belief and push you to take action accordingly.

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Overcome the anchoring & recency bias

When someone asks me about any specific stock, I say to not rate it as a good or a bad investment based on its recent stock performance. When a stock is up, it’s not necessarily a good investment for your portfolio and vice-versa. What matters is why a stock is doing well (or not) on the market. You won’t find the reasons in the media, but rather in the process of reconciling your investment thesis with financial metrics, like those of the dividend triangle (revenue, EPS, and dividend growth).

Will AQN ever trade back to $22? Ask yourself what the narrative was back then. AQN had an aggressive growth-by-acquisition strategy using cheap debt to buy utility assets. It converted those utility assets into renewable energy providers and kept on growing. Today, AQN is selling its renewable assets and has stopped growing by acquisitions. It wants to strengthen its balance sheet and pay off its expensive debt. That is far from the 2021 narrative. To get back to $22, AQN has to write a new growth narrative from scratch. Good luck.

Overconfidence and self-attribution bias

Since we choose to manage our portfolios ourselves, I’d say overconfidence is probably a bias we’re all guilty of. This is the belief that we have an edge over others, a unique ability to understand the market a bit better than everybody else. We don’t have to think we are geniuses; just believe we’re better than the average bear.

I plead guilty to this! Logically, investing with conviction could lead to overconfidence!

When I buy shares of Alimentation Couche-Tard (ATD.TO), I believe it’s the best convenience store operator on the planet. I think its assets are better than gold and that its stock price will go up. The fact that ATD.TO is now in my portfolio makes me think it’s getting better every day. I picked that stock for a reason, right?

The self-attribution bias is slightly different. This is when all success is attributed to our magnificent ability to read the market while all failures are caused by external—and impossible to predict—factors. This protects our ego, enabling us to feel confident again while denying any flaws. This could be highly counterproductive if you can’t own your decisions.

For example, I could say that I went through the 2020 market crash and the strong recovery with great success. I might believe that my rock-solid strategy and my ability to select the right stocks are the only reasons explaining that success. This is only partially right; following a rock-solid investing strategy helps, but it would be dishonest to ignore that about 25% of my portfolio was in tech stocks. This sector thrived during the lockdown and helped my portfolio recover a lot faster than the market. Did I plan to have a quarter of my portfolio invested in tech stocks because it would be beneficial in case of a global lockdown? Absolutely not. We must remain humble when looking at our portfolio returns.

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Overcome the overconfidence and self-attribution bias

When my portfolios increase in value, I usually stay humble and thank the quality of my investing process. I “trust the process”. When my portfolio goes down, I acknowledge my potential losses and try to find where I went wrong. After reviewing my investment thesis for each holding and ensuring it’s backed by a robust dividend triangle, I go back to… “trust the process”.

I reduce the overconfidence and self-attribution bias by making everything about the process and not about me. My goal is to keep a high level of conviction since it prevents me from panicking and selling whenever the market goes down.

How Hindsight and Loss Aversion Hurt your Investment Decisions

June 27, 2024 By The Dividend Monk Leave a Comment

In this second post about investment biases, we explain how hindsight and loss aversion hurt your investment decisions. We also give you tips on overcoming these investment biases to make the best possible investment decisions. In case you missed it, last week, we covered the confirmation and herding biases.

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Loss aversion/regret aversion bias

We all dislike loss and regret. We’d rather avoid both whenever possible. I think loss aversion might be the most powerful investment bias: the pain of losing money is greater than the joy derived from making money.

“In economics and decision theory, loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it’s better to not lose $5 than to find $5.” – Wikipedia

As the market recovered from the March 2020 crash, many investors kept cash on the sidelines waiting for the next dip. They feared entering the market at peak levels would result in severe losses.

When the market recovers, investors are increasingly concerned about losing their money in the coming months. They expect the market to fall any day and would rather wait to invest. When you’re about to invest $100,000, you’d rather earn $100 next month than risk losing $10,000. Often, if you fast forward a year or two, the market is still trading at an all-time high! Again, many investors will think it’s better to wait as a crash must be imminent.

Cost of loss aversion

Loss aversion was widespread among investors at the all-time high in 2017.

Market Total Returns from 2008 to 2017 — Market returns 2008 to “all-time-high” in 2017

Yes, the market was at an all-time high in 2017, but look at the next graph. Clearly, someone sitting on the sidelines, expecting a crash, lost a lot more by waiting than they would have gained by investing. Over the 7 years, their portfolio could have doubled.

Market total returns from 2017 to 2024 — Market returns 2017 to 2024: waiting on sidelines in 2017 proved costly

And here we are today, again, trading at an all-time high…

Nobody knows what the future will bring. Loss aversion is completely non-productive, and often accompanied by choice paralysis. There’s an overload of information that hinders the actual decision-making process.

Regret aversion causes investors to keep their losing stocks forever. Once the paper loss is digested, investors wait to recover that loss. They’d rather keep their losers than sell them now and subsequently see them go back up. This hurts a portfolio more than most people think.

Beating the regret aversion/loss aversion bias

To fight this bias, I’d say there’s nothing like getting additional knowledge and adopting a long-term investment horizon, with which I mean over ten years. If you won’t deplete your portfolio entirely in the next ten years, keep reading 😉.

A J.P. Morgan study shows what happens to a portfolio when investing at all-time highs vs. any other day. Between 1988 and 2020, investing at an all-time high produced better outcomes, with higher total returns after 1 year, 3 years, and 5 years.

Sure, you might indeed suffer for a few months if you invest “now”, but in 5 years? You’ll be golden… most of the time! As I always say… stay invested!

Hindsight bias

The hindsight bias is akin to playing Monday morning quarterback. When you look at what happened in the past you see the reasons for how the market evolved, and find them obvious. It’s always clear when you look in the rear-view mirror.

Everybody should have known the market would crumble back in January 2020 as the virus was spreading everywhere!

Everybody should have seen the financial crisis coming.

Everybody should have bought Amazon 10 years ago because the future of retail is online!

Everybody should have ignored the Blackberry devices; it was obvious Apple would crush them!

Oddly, we even convince ourselves that those moves were obvious back then. This is mostly due to our deep desire to correctly predict the future. By looking at what happened, you select only the factors that contributed to the results, ignoring all the uncertainties at that time. Yet, try to predict the next three months…nothing seems clear in the present.

Also, remember that whatever happened in the past might not happen in the future. Each situation evolves in a different context. For example, the credit bubble burst of 2008 would not have been as damaging in the 80s since mortgage-backed securities, hedge funds, and leverage strategies (including short selling) weren’t as common then. Recalling the 2008 bubble, we might think “Yeah, that was obvious; the market had to implode”. But back then, most people didn’t know what subprime mortgage-backed securities were, and that was the problem!

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Beating the hindsight bias

I don’t think that I should have seen all past events ahead of time. I accept that sometimes I’ll be right and sometimes I’ll be wrong. I’ve been expecting a recessing since the end of 2022. It hasn’t happened, yet! (Haha!).

Most importantly, I don’t trade on hindsight. I trade based on my investment rules. Sure, I could claim that I knew the tech sector would crash in 2022 and that’s why I sold shares of Apple and Microsoft in December of 2021. In truth, I simply followed my investment rule to sell some shares when a position exceeds my maximum weight of 10%. At the end of each year, I trim my highest-performing investments if they exceed that threshold.

Following clear investment rules is much easier than trading based on hindsight.

Recognize and Overcome your Investment Biases

June 20, 2024 By The Dividend Monk Leave a Comment

Investors are rational and make sound decisions based on facts and intricate calculations. Well, that’s the theory. Reality is infinitely more complex. We all have tendencies to deviate from rational decision-making. Recognizing and overcoming your investment biases will lead you to better results.

Our investment biases cause us to make cognitive errors or give in to our prejudices or inclinations. Some of our biases are based on our emotions. Others are due to our brain having learned to cut corners to analyze the millions of data points it’s exposed to every day. Over the years, our brains created patterns. It directs information toward conclusions that are based on older data stored. Since your brain doesn’t consider all data when it’s time to buy or sell a position, it can lead to terrible investing decisions.

Understanding these investment biases will help you develop the intuition to pause and take another look at a situation before pulling the trigger. Here, we look at two biases: the confirmation bias and the herding bias.

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Confirmation bias

When we believe in something, we tend to favor information that confirms this belief, while disregarding information that contradicts it. We enjoy finding people who think like us and avoid those who challenge our thoughts and beliefs.

For example, if I judge that Apple (AAPL) is an amazing company, I’ll likely assign more credibility to an investing firm telling the world this stock should trade at over $200/share than the one saying AAPL is at risk because the iPhone sales cycle will end. If you think Target (TGT) will beat Amazon (AMZN), you’ll probably find bloggers and analysts telling you that TGT is a strong dividend king and ignore articles saying you the opposite. An investor convinced the market is going to crash will only ready or give credence to news stories supporting that conviction.

This behavioral bias affects all spheres of our lives. We look for information and people in line with what we already believe. Our initial belief is reinforced by that new information, and we have more conviction in our decision. Now, having confidence in your decisions is a good thing. Drowning in doubt is unpleasant and can leave us paralyzed, unable to act.

However, repeatedly confirming your belief with new information makes you blind to other investing theories and beliefs. When you are confident about an investment, stop reading stories confirming your decision.

Overcome the confirmation bias

Here’s what I do. After writing my investment thesis focusing on all the great things a company does and why I should buy it, I take a break. A day or two to let that sink in and let the hype go down. The stock will still be available to buy next week!

Then, I add a potential risk section to my investment theses. Knowing what could go wrong with the company is a lot more important than what it does well. To write about potential risks, I search for bearish cases on the internet. I usually start searching with Morningstar and Seeking Alpha, but I also look on YouTube and podcasts and now use ChatGPT to help me narrow down all the risks.

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Herding bias

If most investors around you agree that Johnson & Johnson (JNJ) is a great dividend stock that should be part of any dividend portfolio, you might find it difficult to go against the crowd. The truth is, JNJ might not be such an amazing stock, but it “becomes one” since everybody is going in the same direction.

This is the herding bias. Individuals follow the actions or opinions of a larger group or group of experts, often disregarding their own analysis or opinions. The error here is assuming that the majority is correct. We also fear missing out on potential gains. Oddly, we see that bias even with professionals!

Noise can influence investors very negatively. Whenever market news about a company or a market event gets traction, it creates a global consensus in the media. In early 2021, many discussed a possible deep bull market in the oil industry. As the economy recovered, the oil demand began ramping up. Then, we noticed the lack of investment in exploration/production over the past few quarters.

This narrative became the consensus that we will need more oil for a longer period. It pushed experts to claim that the oil barrel would hit $100 and go beyond. Fast forward to 2024, the oil barrel is still stuck bouncing up and down between $70 and $90 but we are far from trading above $100. Did we increase oil production that much in such a time? Or was it just that the experts were themselves biased into driving a bullish narrative around oil? I remember reading the same narrative (and the same consensus toward oil) after the market crash of 2008-2009…

Overcome the herding bias

Shutting down the noise is a challenging exercise, especially when everybody is singing the same song. It’s easy to pick up someone’s idea but you can’t pick up his conviction. For this reason, I tend to stay away from “trends” in the market by default.

When everyone invests in one direction, I keep my asset and sector allocation intact. It happens that my portfolio is aligned with what people think, but it’s not by design. By keeping the same strategy and the same allocation, I reduce my risk and exposure to a single event.

My sector allocation is decided by:

My investment goal; I want dividend growers, potentially more low-yield, high-dividend growth stocks
My level of knowledge: The largest sectors in my portfolio are those I understand the best

When everybody thinks we should invest in tech stocks and I have some of them in my portfolio, that part of my holdings usually performs well for a while, because demand for the stocks drives prices up. However, I won’t increase my exposure to this sector simply to follow the herd.

Again, know what you own and why you own it.

We’ll explain other investment biases over the next few weeks.

McDonald’s (MCD): In Top Five of my Buy List for June 2024

June 13, 2024 By The Dividend Monk Leave a Comment

New on my buy list for June 2024 is McDonald’s (MCD). It matches my investment strategy perfectly, including a strong dividend triangle showing robust growth trends for revenue, earnings, and dividends. I see MCD as a core holding. Missed our stock pick for May? Read all about it here.

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McDonald’s Business Model

McDonald’s is a food service retailer with over 40,000 locations in over 100 countries. The Company’s segment includes United States, International Operated Markets, and International Developmental Licensed Markets & Corporate.

The International Operated Markets segment operates and franchises restaurants, in markets including Australia, Canada, France, Germany, Italy, Poland, Spain, and the United Kingdom. This segment is over 89% franchised.

The International Developmental Licensed Markets & Corporate segment consists of developmental licensee and affiliate markets in the McDonald’s system. This segment is about 98% franchised. Its menu features hamburgers and cheeseburgers, the Big Mac, the Quarter Pounder with Cheese, the Filet-O-Fish, and several chicken sandwiches like the McChicken, McCrispy and McSpicy.

Approximately 95% of McDonald’s restaurants worldwide are owned and operated by independent local business owners.

MCD Investment Thesis

After seeking ways to generate additional growth for many years, and failing on many attempts, MCD’s CEO finally found a way to succeed. Through a major re-franchising of over 4,000 locations, MCD was able to improve its business model. It increased its earnings, reduced volatility, and won the market’s favor once again.

MCD enjoys strong brand recognition and is the world’s largest fast-food retailer. MCD is attentive to its customers and has made many changes to its menu over the years, adding all-day breakfast and healthier options. Their loyalty program has reached over 50 million customers in top operating markets. The company opened 2000 new restaurants in 2023.

Vintage black and white photo of a McDonald's restaurant, circa the 1950s. — Resilient and adaptable to change over the years

McDonald’s puts a lot of effort into its “Accelerating the Arches 2.0” plan built around four D’s: delivery, digital, drive-through, and development. With more drive-throughs and remodeled restaurants, McDonald’s is well-positioned to take advantage of evolving digital ordering habits. Finally, recent initiatives in mobile ordering and delivery could bode well for continued growth in digital traction, along with consumers trading down from more costly alternatives.

For 2024, MCD expects to open about 2,100 restaurants globally, resulting in a 1,600 net restaurant growth for the year. MCD also expects a free cash flow conversion rate of around 90%. Operating margin is expected to land in the mid-to-high 40% range.

McDonald's dividend triangle. Solid growth trends for revenue, earnings, and dividends. — MCD Dividend triangle – Good growth trends for revenue, earnings, and dividends.

MCD Last Quarter and Recent Activities

McDonald’s reported an “okay” first quarter 2024 with revenue up 5%, but EPS only up by 3%. Revenue growth was driven by solid performance across the U.S. and International Operated Markets (IOM) segments, despite challenging macroeconomic conditions. The continued impact of the war in the Middle East more than offset positive comparable sales in Japan, Latin America, and Europe. Comparable sales in the U.S., up 2.5%, benefited from average check growth driven by strategic menu price increases. The company expects continued moderation in top-line growth due to consumer pressures and a challenging economic landscape.

Potential Risks for McDonald’s

The reduced purchasing power and potential loss of disposable income from customers could bring some choppy quarters. Franchisees are seeking support and MCD will require additional liquidity to provide for its restaurants as the economy stabilizes. Some franchisees may not survive further economic slowdowns, and MCD will continue to face labor shortages and wage inflation, especially in the US.

All fast-food chains compete for the same customers’ dollars. MCD’s debt has decreased but is still significant at $39B with more investments coming. While we await interest cuts, MCD should make a concerted effort to pay down debts.

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MCD Dividend Growth Perspective

MCD has increased its dividend every year since 1977. The company has grown both its cash flow from operations and free cash flow over the past 10 years. Through its re-franchising process, the restaurant chain improved its earnings and shows a payout ratio that is well under control.

The company enjoys financial flexibility, but the dividend growth policy could slow down as the company’s payout ratio continues to rise. In 2020 the dividend increase was only 3%, followed by a more generous 6.98% in 2021. Thanks to stronger numbers, MCD increased its payout by 10% in 2022 and by another 10% in 2023!

Final Thoughts on McDonald’s

There are many compelling reasons to see McDonald’s (MCD) as a good investment. Its global brand recognition and presence in over 100 countries, ensures a steady revenue stream. Its business model, combining company-owned and franchised restaurants, provides stability and growth potential, and transfers some of the risk to franchisees.

McDonald’s resilience through economic cycles, adaptation to consumer preferences, and embrace of technology, such as digital ordering and delivery services, enhance its appeal. Additionally, its strong dividend history and commitment to returning value to shareholders make it an attractive choice for long-term investors seeking both growth and income.

Apple and Microsoft – Enjoying Sticky Business

June 6, 2024 By The Dividend Monk Leave a Comment

Apple and Microsoft are companies that enjoy a sticky business model. “Sticky” means that it’s difficult or costly for customers to change the products or services they use for another vendor. High switching costs/complexity is one type of economic moat that protects companies like Apple and Microsoft.

If half of your home is connected to an Apple product (air pod, iPhone, Mac book, Apple TV, and no doubt others in due time), changing your iPhone to an Android would be difficult. The connectivity of Apple’s product ecosystem is convenient, but it’s also a product prison; you can’t escape without a steep learning curve and significant costs. So, you “stick” with the vendor you know and love.

Microsoft’s suite of products (Windows OS, Office) is deeply embedded in individual and corporate workflows. Imagine a corporation wanting to move away from Microsoft products…the training, the lost productivity during and after the switch, and employee resistance to change are all costly!

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Sticky business models

This sticky business model, or switching cost advantage, exists for many technology companies, but it’s not exclusive to them. Companies in other industries also enjoy this advantage.

Fastenal (FAST)’s strong bond with its industrial customers stems from having its vending machines and even stores on-site at the customers’ manufacturing facilities. Fastenal can provide unmatched speed of service, making it unlikely that customers will sever that relationship. A similar example is Air Products & Chemicals (APD)’s on-site hydrogen connections.

Business models can be sticky due to specialization. Magna International (MGA / MG.TO) builds custom parts to automakers’ specifications. The significant set-up costs incurred, and the long-term relationships built with Magna mean customers don’t walk away easily. Same thing with Equinix (EQIX), the data center REIT and digital infrastructure company. Its co-location services for customers who do business together make its customers stick around.

Apple and Microsoft

Apple and Microsoft are successful in part because of their sticky business models. While both have low yields, they’re superstars for dividend growth investors. Why? They have both offered solid total returns, meaning dividends and stock price appreciation over the years; I feel they are poised to keep on doing so for years.

Dividend growth investing is not centered on high-yield stocks, but rather on strong dividend growers: companies with solid business models, growth vectors, and positive trends for revenue, profit, and dividend growth.

The goal is to create enough income for yourself in retirement. That income doesn’t have to come from dividends exclusively. Dividend growth and stock price appreciation will do just as well. Apple and Microsoft both fit the bill. To learn how to create retirement income for yourself, download our Dividend Income for Life guide.

Now, let’s learn more about Apple and Microsoft’s stickiness.

Apple (AAPL)

The strength of Apple’s business model could be summed up like this: quality products that integrate easily into a user-friendly ecosystem, backed with unrivaled brand loyalty from its customers.

Apple created a tightly integrated ecosystem where devices (iPhone, iPad, Mac, Apple Watch) and services (iCloud, Apple Music, Apple Pay) work seamlessly together. The wide array of applications in its App Store creates more reasons for users to stay within the Apple ecosystem to enjoy the full benefits.

Its high-quality hardware and well-designed software that offers a consistent and reliable user experience across devices are very appealing to its customers. Through its effective marketing, a reputation for innovation, and a premium brand image, Apple has cultivated strong brand loyalty. Loyal customers are less likely to switch to competitors.

If all that wasn’t enough, Apple also provides features and content, like iMessage and iCloud backups, that are exclusive to its devices, creating a barrier for users to move to other ecosystems without losing these functionalities. You see how difficult it is for customers to leave Apple’s ecosystem once they are part of it.

Apple dividend triangle

Below is the 10-year evolution of Apple’s stock price, revenue, earnings per share (EPS), and dividend payments. The last three metrics make up what I call the dividend triangle.

We see steady and strong growth over the years that has slowed down since 2022 due mostly to the economic slowdown and falling revenue in China. AAPL’s first growth vector remains its iPhone. It’s also seeing double-digit growth for its services, which generate higher margins. The company posts solid cash flow generation. Short-term, the concern relates to the technology sector performance as a whole. However, continued interest from consumers of premium products means Apple should continue to perform well long-term.

Don’t be fooled by the low yield; AAPL should double its dividend every 8 years going forward. Both payout and cash payout ratios are very low. The last three dividend increases were more modest (4.2 to 4.5%), but management approved a $100B share buyback program instead of purely increasing its dividends.

Microsoft (MSFT)

Microsoft has made itself indispensable and hard for businesses to switch. It too provides an integrated suite of products (Windows, Office 365, Azure, and Dynamics 365). This makes it convenient for businesses to stay within the Microsoft ecosystem rather than adopting disparate solutions. It has become a leading cloud service provider, and the natural choice for businesses already using Microsoft software.

Through its flexible and attractive licensing agreements, which often include discounts, extended support, and bundled services, Microsoft locks in customers for long periods.

Customers benefit from solutions and specialized applications built and supported by its vast network of developers and partners on Microsoft platforms. The company provides robust enterprise-grade security and compliance solutions that meet industry standards, which is critical for many corporations.

Through its commitment to innovation and continuous improvement, Microsoft ensures its products evolve with the latest technological advancements. This keeps their offerings competitive and appealing to corporations.

All this creates a strong dependence on Microsoft’s ecosystem, making it challenging for corporations to switch to alternative providers without significant disruption and cost.

Microsoft dividend triangle

Microsoft has increased its dividend yearly since 2004. Its yield used to be at ~3%, but the hype surrounding the stock has made it low-yield (~1%). Even a double-digit dividend growth rate wasn’t enough to compensate for the stock price surge since 2015. As you see below, Microsoft shows a perfect dividend triangle. Investors can expect high-single-digit dividend increases for a while.

Can any company enjoy sticky business?

Not really. Industries with many competitors, or whose products are seen as commodities with little differentiation, don’t have high switching costs or strong loyalty from customers. For example, even a loyalty card at a grocery chain store won’t keep me from going to a local butcher shop or to a different grocery.

Building switching costs through a loyalty program can increase stickiness, but it’s limited. These businesses compete on price, operational efficiency, and perhaps convenience of locations.

Visa & Mastercard Unbeatable Business Model: The Network Effect

May 30, 2024 By The Dividend Monk Leave a Comment

Have you ever thought, “Wow, it’s so easy for this company to make money, everyone uses its product or service.”? That’s the network effect. It’s a type of economic moat that protects some companies.

The network effect snowballs as the company offers more value to its customers and its customer base grows.

For example, as more people use Google to search, Google gets more from those searches, which it uses to improve future search results (debatable at times, I know) and to sell ads. As search results become better, even more people use Google. Facebook, or Meta as it is now called also benefits from the network effect. Who would go on Facebook to share their stories or to reach out to others if most of their friends and family weren’t on the platform?

Not all networks are the same

There are three categories of network effects:

One-sided network effects: This relates to a single group of company customers or group of platform users. The more customers or users the company has, the stronger its growth, providing more value and leading to more new customers. Meta and Google fall in this category.
Two-sided network effects: This relates to two groups of company customers or participants. For example, there is a close relationship between the number of people looking for a place to rent and the number of people renting their place on Airbnb. The more sellers there are on a platform, the more choices customers have, leading to more customers coming, which in turn attracts even more sellers. Visa and Mastercard are in this category.
Complementary network effects: This relates to separate companies mutually benefitting from each other’s growth. For example, the more Apple grows its iPhone sales, the more RF filters Broadcom sells, and the more 4G and 5G wireless chips Qualcomm sells.

Today, I want to spend time on my two favorite “network effect” stocks.

Visa & Mastercard

The best examples in the dividend world are probably Visa (V) and Mastercard (MA) who have built a duopoly. In the beginning, not all merchants accepted credit cards and those who did were not accepting all credit cards. As more people started using Visa and Mastercard, more and more merchants accepted their cards. Fast forward: V and MA process billions of transactions per year. The best part is that they earn a fee for each of those transactions. Try to create your own credit card company today and get merchants to accept your card, and you will fully understand the benefit of having developed that network.

Visa (V)

The Visa IPO happened just before the 2008 market crash. V offered a unique opportunity to investors as its stock traded at approximately $11. Today, the stock is trading at approximately $275/share, and it should continue to increase in value for at least another decade.

V’s key to success was building the widest and most secure network in the transfer of funds. Visa partners with major financial institutions across the world, and customers pay a commission for each transaction. Having already established its network, Visa benefits from the strong tailwind that is the clear trend favoring electronic payments.

Visa is one of the few companies that remain insulated from inflationary and macroeconomic concerns thanks to its balanced exposure to payment categories. Visa is well positioned to thrive in a wide array of scenarios. Finally, Visa’s entry into crypto demonstrates that the company is ready to adopt any changes in the industry!

Below, you see the Visa stock price, revenue, earnings per share, and dividend payment trend for the last 10 years. Steady growth across the board, hardly affected even by an event as disruptive as the pandemic.

Find more companies with “unbeatable” business models

At Dividend Stocks Rock, we have a clear strategy: we focus on dividend growth stocks. We handpick companies showing a strong dividend triangle (e.g. revenue, earnings, and dividend growth potential) and make sure we understand their business model.

Using the combination of these dividend triangle metrics, we created the Rock Stars list and we update it monthly. Since we consider other metrics in addition to dividend growth, it’s a stronger list than the dividend aristocrats list.

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Mastercard (MA)

The beauty of Mastercard’s business model is the strength of its brand and its network. When you pull your card out to make a purchase, you certainly don’t want the cashier to question the integrity of your form of payment. For this reason, you use either a Visa or a MasterCard… or both!

MasterCard is a company that focuses on growth and diversification. Management has a robust plan in place, all of it aimed at increasing digital payment services. The current economic slowdown or potential recession will drive consumers to buy online, using their credit cards.

MA has been very generous with its shareholders with massive dividend increases and ongoing share buyback programs. Finally, MA’s volume-driven business acts as a buffer against inflationary pressures and supply chain shortages. It too has a strong dividend triangle.

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Can all companies enjoy a network effect?

Unfortunately, not all companies can build such an impressive business model and generate impressive results!

For example, companies in commodity sectors or those offering undifferentiated products, such as basic materials, traditional manufacturing, and some energy companies, don’t benefit significantly from network effects. If everybody wants to buy gold, gold miners will just sell more of it, but there’s no moat protecting their business.

These businesses compete on price and operational efficiency rather than the increasing value that additional users or participants would bring to a platform or service.

Companies offering services have a better chance of having a network effect. The more the business model can increase the number of users of the services, the larger the network effect will be. Sometimes, the effect is so strong that it creates a business model nearly impossible to replicate such as Visa and Mastercard.

The Dividend Monk