DivGuy

A lot of investing mistakes can be summed up to one of two things: Overconfidence or Fear. And, despite the fact that these are two sides of the same spectrum, an individual can fall prey to both of them from time to time. In many ways, that’s what the stock market is all about.

Overconfidence

Many investors make the mistake of being too sure of themselves. Overconfidence and exuberance cause bubbles and lose fortunes. This is arguably a huge factor in the cause of this whole global financial crisis. A combination of greed and a sense of not-possibly-being-able-to-do-wrong is what caused once well-respected institutions to collapse. There’s simply no other explanation for the type of leverage that some institutions took on. How can any reasonable collection of individuals set up an investment strategy that completely collapses if it drops by a few percent?

Worse yet, our minds are hardwired for overconfidence. A gambler finds it easier to recall their big wins than their several losses, even if their losses dramatically outweigh their wins. The same can be true for the stock market, especially since for the way that many people approach it, it is gambling.

Most people consider their self to be above average. By definition, only half of people can be above average drivers, possess above average intelligence, or have above average morality, and yet far more than half consider their self to be these things. The same is true for investing: most consider themselves somehow better. I’d wager that such a feeling is hardwired into us for survival, but an investor must take control of it.

Fear

On the other side of the spectrum, fear can cause problems too. As soon as things turn sour, people have a habit of running for the hills and assuming that it’s never going to get any better. It’s not uncommon for a high-quality company to sometimes develop a hefty amount of bad press for one or more things, and then to find that its stock valuation has dropped dramatically. The media needs something to do everyday, and something to scare you with.

Bad press is often legitimate. Large companies do some pretty silly things sometimes, and there are certainly red flags and other warning signs to be aware of. But good companies are built to last through tough times. Bad news is a reasonable cause of a mild stock drop, but usually the market overreacts with fear. When a company is experiencing problems, people seem to expect that these problems will be permanent and that the company is no longer of any use.

Worse yet, fear is sometimes triggered by literally no reason at all. Sometimes stock sell-offs occur seemingly out of the blue, for reasons not related at all to company performance. Fearful investors freak out at their falling paper net worth and they sell sell sell!

The Path

The combination of overconfidence and fear is what causes stock market graphs to look ridiculous. A calm and patient investor, however, uses the absurdity of the market to his or her advantage, by consistently buying high-quality companies at good prices and ignoring short-term market noise.

There’s no silver bullet for developing a successful investor’s mindset, and it can take many mistakes and plenty of experience to learn, but there are some timeless guidelines:

-When you make an investment, write down your investment thesis and save it. When things become questionable, you’ll be glad you have a tangible declaration of why you purchased the stock in the first place and this will allow you to make a more measured decision on what to do.

-Focus on passive income, and the psychological edge that dividends can provide. Dividends provide a huge sense of normalcy and reason in the stock market. They’re declared by the board of directors based on company performance rather than determined by the whims of the market. By focusing on building sustainable and growing dividend income streams, investors should find most of these psychological obstacles of fear and overconfidence removed from their way.

-Focus on company fundamentals. Ignore the stock market and focus on how the company is actually doing. Is the revenue increasing? And earnings and cash flow? Is the payout ratio reasonable, and is the dividend well-covered by cash flow? What are the debt levels like? Are the products and services provided by this company going to be in demand 3, 5, and 10 years from now? Are they growing their number of facilities/locations/volumes? If the company has some bad news, how bad is it? If the stock price got cut in half recently, is it because the company actually made a mistake big enough to cut its company value in half, or did it just spook speculators and institutions with a small misstep?

-Always keep the valuation in mind. You’re buying a business rather than just a stock. It doesn’t matter whether you’re a value investor or a growth investor; the valuation is important. This doesn’t mean to specifically buy cheap stocks or to avoid high P/E stocks, but it does mean to weigh the prospects of the company against its stock price, and determine what kind of company performance would be necessary to justify the current price of the stock. Looking back at the dot com bubble, there was simply no way to justify the stock prices of many companies. Impossible levels of growth would have been necessary.

-Utilize a margin of safety. Once you’ve compared prospective company performance to the current stock price, make sure you leave yourself a margin of safety. To put it simply, our estimations are going to be wrong sometimes, so keep that in mind and focus on buying companies when their shares are cheaper than what you think they are worth. This way, many of your mild mistakes will still be victories.

-Diversify your assets. Invest in several stocks to keep your risks related to any single stock relatively low. Keep some money out of equities so that you can take advantage of undervalued markets when the opportunity arises, either by means of automatic asset allocation or through individual stock-picking.

Dividend Growth Investing is about purchasing dividend stocks that grow their dividends over time, and then holding onto those investments for quite a while as you receive continually increasing passive income from those companies.

Why this strategy? Because it gives you passive income that grows exponentially each year, and simultaneously builds your net worth over the long-term. Wealth is not simply about having a lot of assets, it’s about generating a significant amount of passive income that grows over time. Dividend Growth Investing works to build both your passive income and your net worth, can be more reliable than other investing methods, requires less time, and can be performed by anyone with sufficient discipline and basic math skills.

Dividend Growth Investing is not just about investing in stocks with a high dividend; it’s also about investing in companies that grow their dividends year after year. A passive income stream is typically unimpressive if it doesn’t grow. By investing in dividend growth companies, you’ll be building passive streams of income that grow over time. Each year with this investment strategy, assuming your companies stay healthy and profitable, your dividend passive income will increase. Better yet, unless you’re planning on living off of your dividends right now, you can reinvest your dividends to buy more dividend paying stocks to further increase your passive income. The growth is exponential, and the strategy works over a long period of time to build your wealth.

Companies that Pay Dividends

When a company makes a profit, they have several options for what they can use that money for. They can reinvest it to grow their business, save it for a rainy day or pay off debt, or send it to shareholders as dividends or share repurchases. Many companies use it for a combination of those things. Of the various public companies in existence, a significant subset of them pay regular cash dividends to shareholders. Regular dividends are cash payments that shareholders receive by simply holding the stock. Shareholders can then spend these dividends any way that they could spend any other form of cash income. It can be used as current income or it can be used to reinvest and buy more shares. The share can be held indefinitely, receiving income year after year.

Dividend Terms to Know

Dividend Yield

A share represents a portion of a company, and a dividend represents that shareholder’s portion of distributed earnings from that company. The dividend yield is equal to the annual dividends paid per share divided by the share price. For example, if I buy a share of a company for $50, and that share pays me a $2 cash dividend this year, then my dividend yield is 4%. Using the same math, if I spend $5,000 to buy 100 of those $50 shares, and those shares offer a dividend yield of 4%, then my annual dividends (passive cash income), will be $200.

Dividend Growth Rate

Dividend Growth Investing is not merely concerned with how much passive income your shares give you, but also how quickly that passive income grows. Many companies increase their dividend payments each year, meaning that each year’s passive income is larger than the year before it. Several companies have records of paying increasing dividends for 10, 25, or 50 consecutive years in a row and are still continuing with this trend. Some people look at a dividend yield and mistakenly assume this will be their total rate of return, but that is not the case. Dividend growth must be factored in as well. If a company pays $1 in dividends per share this year, $1.1 in dividends per share next year, $1.21 in dividends next year, then it is currently growing its dividend at a rate of 10% per year on average. If this continues for 30 years, then the company will be paying over $17 per year in dividends per share at that time! Exponential growth is enormously powerful.

Dividend Payout Ratio

The dividend payout ratio is the percentage of per-share earnings that are paid out as dividends each year. So if a company has earnings-per-share (EPS) of $3, and pays out $1 in dividends per share this year, then the payout ratio is approximately 33%. The company is paying out a third of its profit to shareholders as dividends, and keeping the other two-thirds of its profit for other purposes such as growing the business, making acquisitions, reducing debt levels, or repurchasing shares. It’s important to know the payout ratio because it gives you an idea of the growth prospects of the company, and lets you know whether the dividend is safe. If the company doesn’t have enough earnings to keep up with its dividend payments, it will have to reduce its dividend, and we certainly don’t want that.

The Math Behind Dividend Growth Investing

I’ll use a fictional company called Monk Mart Inc. as my example throughout this section. Monk Mart stock currently trades for $30 per share and has a price-to-earnings ratio (P/E) of 12. So, EPS this year is $2.50. Monk Mart currently has a payout ratio of 40%, so the company is paying out $1.00 in dividends to each shareholder this year. Using these numbers, it is calculated that Monk Mart’s dividend yield is 3.33%. Furthermore, Monk Mart currently has plans to increase the dividend by 8% annually by growing its business.

Monk Mart is a stock that increases its dividend approximately in line with its EPS. If the dividend grows by 8% each year, and the payout ratio remains 40% and the P/E remains 12, that means that the stock price will also increase by 8% each year. Of course, in reality, the stock price won’t increase at exactly the same pace as the dividend payments, because the payout ratio or P/E may fluctuate in times of bull markets and bear markets. To keep the calculations for reinvested dividends manageable, I’m going to assume that Monk Mart stock continually has a P/E of 12 and a payout ratio of 40%, along with 8% dividend growth.

In this scenario, I’m going to purchase 100 shares of Monk Mart stock for $30 each, for a total of $3,000. This means that I’ll receive $100 in dividend payments this year. My plan is to reinvest all of my dividends into buying more Monk Mart stock. I have the stock in a non-taxed retirement account, and my broker allows me to reinvest dividends to buy more shares (including fractions of shares) without charge. Let’s see how much much value my Monk Mart stock returns to me.

During year 1, I collect my $100 in dividend payments. I use them to purchase more shares, so at $30 per share I can purchase an additional 3.33 shares and now have a total of 103.33 shares of Monk Mart. My investment is now worth $3100.

During year 2, Monk Mart indeed raises its dividend by 8% from $1.00 per share to $1.08 per share, and because the P/E and payout ratio remained static, the stock price is now $32.40 per share. Since I receive $1.08 per share in dividends this year and have 103.33 shares, my total dividend income this year is $111.60, and I’ll use that money to buy more shares at $32.40 per share. So, I use my $111.60 to purchase 3.44 shares and now have 106.77 shares of Monk Mart. My investment is now worth $3459.35.

During year 3, Monk Mart again raises its dividend by 8% from $1.08 to $1.17 per share, and because the P/E and payout ratio remained static, the stock price is now $34.99 per share. Since I receive $1.17 per share in dividends this year and have 106.77 shares, my total dividend income this year is $124.92, and I’ll use that money to buy more shares at $34.99 per share. So I use my $124.92 to purchase 3.57 shares and now have 110.34 shares of Monk Mart. My investment is now worth $3860.80.

And so on. It may sound like a lot of work, but many brokers allow you to automatically reinvest your dividends leaving very little maintenance for the investor.

After 10 years, the investor owns 134 shares, the total investment is worth over $8,300, and the dividend income is more than $268/year.

After 20 years, the investor owns 186 shares, the total investment is worth over $22,300, and the dividend income is more than $804/year.

After 30 years, the investor owns 258 shares, the total investment is worth over $74,700, and the dividend income is more than $2,400/year.

After 40 years, the investor owns 359 shares, the total investment is worth over $224,000, and the dividend income is more than $7,200/year.

In this scenario, a mere $3,000 turned into more than $224,000 40 years later, and a mere $100 in annual dividend income turned into more than $7000. Both the investment worth and the passive dividend income grew at a rate of return of more than 11%. There will of course be inflation, so the money in the future will have less purchasing power than it does today, but it’s still a whole lot more money than there was to begin with. In addition, stocks are fairly inflation-resistant because a good company can pass the costs of inflation onto its customers. And, this large growth of money only represents a single investment. If the same investment of a few thousand dollars was made each year, then the investment worth would be worth millions by the end.

Notice again that the total rate of return of investment worth in this example was a little over 11% per year. If you add the dividend yield (3.33%) to the dividend growth rate (8%), you’ll get 11.33%, which is the approximate rate of return of this investment. It’s a good rule of thumb that all else being equal, the long-term dividend yield plus the long-term dividend growth rate is what you can expect in terms of total return. In reality, the P/E won’t stay static, and other factors will fluctuate. If you let this work against you, the return may be somewhat less than the yield plus the growth, but if you work it in your favor, the return may be somewhat more than the yield plus the growth.

A huge portion of the returns of this stock were due to dividends. If dividends were not reinvested, then instead of owning 371 shares at the end, the investor would still only own 100. Since each share was worth approximately $600 by the end, the investor would only have had an investment worth of approximately $60,000 rather than $224,000.

Passive Income Growth and Re-Investing

As previously mentioned, the goal of this investment approach is to simultaneously build passive income and a high net worth. A company has control over how much it pays in dividends, but the masses of the market are the ones that determine the stock price at any given time, so the company growth and the dividends they pay are the primary points of focus for dividend growth investors. Stock prices fluctuate all the time, going up and down, but a disciplined company can grow its dividend year after year without missing a beat for decades. It’s important to have a disciplined mindset, because in the real world even if a dividend-paying company provides long-term returns similar to those in my Monk Mart example, the growth will never be that smooth and the market will sometimes reduce the value of your investment. A dividend investor’s job is to pick good companies to invest in at reasonable stock valuations, with both money they put into their portfolio and money they receive as dividends.

To maximize investment returns, the investor should use the dividends they receive to purchase more shares, like with the earlier Monk Mart example. Consider the following chart, which displays a comparison between reinvesting and not reinvesting dividends in a given company. In the chart, two investors start out with $50,000 and keep the money invested for 40 years. The company that they invest in pays out a 3.33% dividend yield and grows its dividend at an 8% rate annually. One of the investors spends his dividends while the other investor reinvests her dividends to buy more shares.

Over time, the investor that reinvested dividends accumulated more shares of the company, so her investment worth increased at a higher rate. She ended up with over $3 million while the investor that did not reinvest dividends only ended up with $1 million.

Eventually, a person can live off of their dividends as current income rather than reinvesting them. If enough value is accumulated, the passive income will be high enough so that no shares ever have to be sold, and so the investor can live off of his or her accumulated wealth indefinitely while continuing to grow, rather than shrink, their net worth.

Characteristics of a Good Dividend Investment

Obviously, the dividend growth strategy takes time and discipline. We need to identify companies that will provide good returns over decades. No single investment must last for the entire span of the investor’s life, because the investor ideally has a diversified portfolio of several dividend-paying companies, but the better the investments perform over the long-term, the lower the turn-over rate of the portfolio needs to be. Some good selections might last throughout the entire span of the investor’s life.

There is no set formula for finding a good dividend growth stock for your portfolio. I leave formulas for the technical speculators. There are, however, general principles that are worth looking for in investments.

-A good dividend growth company has a product or service that you can foresee existing and being relevant for many decades to come. Time is very important to allow passive income to increase, so it’s wise to find a company that is built to last forever.

-The company should have unique aspects that separate it from competitors.

-A strong balance sheet is the hallmark of a good dividend investment, because it increases the chances of your company being able to survive and grow.

-Keep in mind the general estimation that the total rate of return will be equal to the dividend yield plus the sustained dividend growth rate. Some investors like high-yielding stocks with lower dividend growth while others like lower-yielding stocks with higher dividend growth, and some prefer a mix of both, but keep this basic guideline in mind.

-The company’s stock should be reasonably priced. A good company can make a bad stock if it is over-priced relative to its fundamental value. If you buy stock in an overvalued company, your returns are likely to be less than the sum of dividend yield and dividend growth. If, instead, you buy quality undervalued companies, your returns may be greater than the sum of dividend yield and dividend growth.

-You should be able to understand the company. My view of investing is about individuals taking control of their finances, so if they don’t really understand their stocks, they aren’t really taking control of their finances.

I know how hard it is to invest when stocks don’t seem to trade at their fair value

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