What does your dream house look like?
Is it a traditional mansion, an ultra-modern house, or maybe a quirky renovated space? You might have already built your dream house, or you might plan on building it one day.
You provide the guiding vision for your dream house, but you also need an architect to create a realistic blueprint for your house.
In creating your dividend growth portfolio, you are the architect. You know where you want to live someday – what your ultimate financial goals are. You have a picture in your mind of what the ‘finished house’ will be – what financial freedom looks like.
The goal of your dividend growth portfolio is to make that dream a reality.
Start With a Strong Foundation
Your investing philosophy is the foundation of your dividend house. The guiding ideas of Sure Dividend are:
- Treat investing in the stock market like investing in a real business (because that’s what it is)
- Invest in businesses with strong competitive advantages
- Invest in shareholder friendly businesses
- Only buy into a business when it’s trading at fair or better prices
- Minimize frictional costs through investing for the long-run
I believe these ideas make a strong foundation upon which you can build your dividend house.
The 8 Rules of Dividend Investing quantify the investing philosophy of Sure Dividend. They create a quantitative system from the guiding ideas above.
Pick Only Quality Materials
Very few people dream of using subpar building materials for their dream house. You don’t want to save a little bit in the short-term only to cost yourself a fortune in repair costs years down the line.
It’s the same with your dividend portfolio. You can absolutely chase higher yields by investing in subpar businesses that have higher dividends. You will probably generate more dividend income in the first few years, but your total returns will suffer in the long run.
Here’s an excellent example of why not to chase yield from Dividend Growth Investor in his recent post Three Investing Lessons I Learned the Hard Way:
“The first lesson I have learned is never to chase yield. I have chased yield in the past, and have gotten burned doing it. The first time I chased yield, I was following a high-yield junk bond closed-end-fund, that was yielding 10-12%. The trust kept cutting distributions, but it kept yielding 10%-12%. As a result I thought I would just keep reinvesting distributions, and make up for the losses in income. Unfortunately, yields stayed the same because prices kept decreasing over time.”
The lesson – don’t skimp. Invest in quality. High quality stocks have outperformed the market by about 3 percentage points a year since the 1950’s. Additionally, quality is persistent; high quality businesses tend to remain high quality businesses for long periods of time. Click here to see 12 high quality stocks examined in detail.
Don’t Waste Money
While quality is important, not overpaying is also important. Quality materials are nice, but not at any price. The ‘quality at any price’ idea was trumpeted in the 1970’s with the ‘Nifty Fifty’ group of stocks.
These were ‘one decision’ stocks with astronomically high price-to-earnings ratios that were allegedly justified because of the tremendous quality and growth prospects of the business. The story of the Nifty Fifty is told below by Jeff Fesenmaier and Gary Smith in the article The Nifty Fifty Re-Revisited:
“A fundamental investment maxim is that, “A great company is not necessarily a great stock.” No matter how good or bad a company’s management, no matter how large or small a company’s profits, no matter how bright or bleak a company’s prospects, the attractiveness of a company’s stock depends on its price. At some price, a great company’s stock is expensive; at some price, a lousy company’s stock is cheap.
To illustrate this fundamental principle, people often recall the early 1970s when institutional investors were infatuated by the Nifty Fifty—a small group of “one-decision” stocks, companies so appealing that their stocks should always be bought and never sold, regardless of price. Among these select few were Avon, Disney, McDonald’s, Polaroid, and Xerox. Each was a leader in its field with a strong balance sheet, high profit rates, and double-digit growth rates.
But is such a company’s stock worth any price, no matter how high? In late 1972, Xerox traded for 49 times earnings, Avon for 65 times earnings, Polaroid for 91 times earnings. When the stock market crashed in 1973, the Nifty Fifty defied gravity for a while, held up by institutional enthusiasm that created a two-tiered market of the richly priced Nifty Fifty and the depressed rest. Then, in the memorable words of a Forbes columnist, the Nifty Fifty were taken out and shot one by one. From their 1972–1973 highs to their 1974 lows, Xerox fell 71%, Avon 86%, and Polaroid 91%.”
The moral of this story is valuation matters. When you build your dividend growth portfolio, don’t ignore value. Click here to see 11 blue chip stocks trading at bargain prices.
Buying quality businesses is great, but not at any price. As Warren Buffet says:
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Finish The Construction Process
A half-built dream house isn’t a dream at all… It’s a nightmare. It’s the same with your dividend portfolio.
When you build your dividend portfolio see the process through. Don’t stop half way because you don’t like one little bit of your design.
Switching strategies results in an excess of frictional costs and a lack of direction in your portfolio. Dividend growth investing works (here’s proof), but only if you stick with it.
Growing your dividend portfolio to reach financial freedom (generally) takes a long time – a lot longer than building your dream house. Rome wasn’t built in a day. Your dividend portfolio won’t either.
When bear markets occur and your portfolio gets beaten down, it can be hard to stay the course. In investing, commitment matters. The better you are able to maintain your investment philosophy and plan in the face of adversity, the more successful of an investor you will be over the long run.