Published August 4th, 2016
Do you remember the first time you purchased a stock or mutual fund?
I can look back on when I first started investing – and how little I knew. Investing knowledge isn’t inherited, it is learned.
Wise men and women learn from other people’s mistakes. Better that than learning from your own mistakes. Investing can have very high learning costs.
This article has 10 important tips for first time dividend investors. I wish I had known these 10 tips when I first started investing.
Even if you are not a first time investor, these tips will help reinforce your dividend investing knowledge and help prevent against future behavioral investing errors.
Table of Contents
Each of the 10 tips are listed below:
- Don’t Chase Yield
- Look for Quality Dividend Stocks
- Understand Valuation
- Focus on the Business
- Invest for the Long Run
- Don’t Obsess Over Returns
- Be Prepared to Lose Money When The Market Falls
- Know Why You Will Sell
- Stay In Your Circle of Competence
- Have an Investing Plan
One of the most common mistakes that first time investors make is chasing yield.
Dividend investors are looking for dividends. That means a higher yield is always better, right? That is not always the case.
The highest yielding stocks are often very risky. Ultra-high yield is there to compensate investors for the extreme risk. Taking big risks is not a good way to create stable, growing dividend income.
It also doesn’t produce the highest total returns…
One of the biggest misconceptions in investing is that risk is always directly related with return. The idea that riskier stocks must somehow return more sounds like it makes sense. But the real world data does not validate this hypothesis.
Low volatility (and the very similar low beta) stocks have historically outperformed high volatility (or high beta) stocks.
This phenomena is not just observed in price volatility. More to the point for dividend investors, the highest yielding stocks don’t produce the highest total returns.
The 2nd highest yielding quintile (stocks between top 20% and top 40% in yield) have actually produced the best returns on both an absolute and risk adjusted basis.
You can see how to quickly find dividend stocks in this quintile here. Stocks in the second quintile of yield currently have a yield of between 2.9% and 4.5% in today’s market.
If you are looking for sustainable and growing dividends, don’t invest in stocks with 10% or 20% yields (I am sure there are a few exceptions, but in general). Instead, focus on quality with a ‘good enough’ yield.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
Saying you should look for quality dividend stocks is like saying you should buy a good car… It doesn’t mean much. What exactly is quality?
It’s difficult to accurately pin quality down quantitatively. Does it mean a high profit margin? If so, are Amazon (AMZN) and Wal-Mart (WMT) low quality businesses? I don’t think so.
Does it mean a low stock price volatility? If so, is Archer-Daniels-Midland (ADM) a weak business? I don’t think so.
Does it mean a long operating history? Then I suppose Google (GOOG) is not a quality business.
Finding the ‘perfect’ metric for quality is impossible. Finding a good metric that excludes most ‘low quality’ businesses (and some high quality businesses) is about the best we can hope for.
As a dividend investor, I prefer to use a long history of steady or rising dividend payments to greatly narrow the search for high quality businesses. Specifically, I use the cut off of 25 years.
For a business to have paid steady or increasing dividends for 25 years it must have (or at least very recently had) a strong competitive advantage. There’s no way to produce reliable results over a long period of time without having some insulation against competitive forces. I would call this a ‘quality’ business.
Businesses with long histories of rising dividends have historically performed very well. The Dividend Aristocrats Index is comprised of 50 businesses with 25+ years of consecutive dividend increases. You can see the excellent historical performance of the Dividend Aristocrats over the last decade below:
Source: S&P Fact Sheet
The aforementioned stock price volatility also makes a decent proxy for quantifying quality. Businesses with stable outlooks tend to see their stock prices bounce around less than businesses with higher risks, all other things being equal.
Quality can be observed qualitatively as well. It is something that is rather difficult to pin down. Being familiar with a business helps to determine its level of quality. For example, anyone familiar with Coca-Cola (KO) could easily say it has a stronger competitive advantage than a startup in the beverage space.
Thinking about how difficult it would be for a competitor to beat a company in a competitive environment is a good way to think about the quality of a business. How hard would it be to go head to head with Coca-Cola? You’d need billions in advertising spending every year. That alone forms a strong competitive advantage.
Quality is important, but not at any price.
The Warren Buffett quote from tip 2 also applies to tip 3. Buffett likes quality when it is marked down.
This means, look for quality businesses that are trading below their fair value. Like saying ‘invest in quality’, saying to invest in ‘undervalued’ securities is easier said than done.
Every business has an intrinsic fair value that is the sum of its future cash flows discounted to present value using an appropriate discount rate.
The problem is, we don’t know the sum of future cash flows or the appropriate discount rate to use. This makes finding the true intrinsic value impossible.
Looking at price-to-earnings ratios is a good substitute. The price-to-earnings ratio shows how much people are willing to pay today for a dollar of earnings. The higher the price-to-earnings ratio, the faster earnings are expected to grow. Higher price-to-earnings ratios also imply a greater degree of safety; a higher probability that earnings will occur.
In short, higher price-to-earnings ratios mean people have higher expectations of a business in the future. Lower price-to-earnings ratios show general pessimism about the future.
The S&P 500’s average price-to-earnings ratio is 15.6. The lowest it has ever been is 5.3 (in 1917). The highest it has ever been (excluding periods when earnings dropped precipitously, throwing off the usefulness of the ratio) is 32.9 in January of 1999 (during the tech bubble).
These are valuation levels for the whole market. Looking at individual stocks shows a different perspective:
- Netflix (NFLX) has a price-to-earnings ratio of 289.1
- General Motors (GM) has a price-to-earnings ratio of 3.9
It doesn’t take a genius to know that Netflix has better growth prospects going forward than General Motors. Investors have bid up the price of Netflix because they expect great things from it. Very little is expected of General Motors going forward.
Interestingly, General Motors is one of Warren Buffett’s highest conviction dividend holding. He owns no shares of Netflix.
Stocks with a low price-to-earnings multiple have historically outperformed high price-to-earnings ratio stocks. Stocks with low expectations outperforming is known as the ‘value effect’.
People tend to overestimate. Stocks with high price-to-earnings ratios tend to underperform because they (on average) fail to live up to such lofty expectations. Stocks with lower price-to-earnings ratios tend to outperform because so little is expected. A bit of good news can revise expectations upwards, resulting in capital gains for value investors.
The first 3 tips discuss what type of dividend stocks to invest in. Investing in stocks in general can feel like gambling. Constantly updated stock prices and the sensationalist financial media certainly don’t help matters.
What gets lost in the mix is what actually happens when you buy a stock…
Buying a stock means you own a small fraction of a real business. The only difference between owning 1 share of McDonald’s (MCD) stock and owning a 35% share of an individual restaurant is a matter of degree (and, to be fair, the amount of control you have over how the business is run).
Buying stock gives you fractional ownership of the underlying business. This puts investing into perspective.
Investing is not gambling. It is not a virtual casino or a game. It is real money being exchanged for a small share of a real business.
Just because the transaction is streamlined and can be done quickly on line does not make it any less real.
Focusing on the actual business rather than the stock price is advantageous in both selecting and holding your dividend stock investments.
When you realize you are owning shares of an actual business, you realize you have the choice of what type of business you want to own.
You can invest in overpriced businesses, or you can wait for the right opportunity to buy into quality dividend paying businesses at a discount.
Investors should think of themselves as business owners. You get to pick what type of businesses you want to own. If selected wisely, the time to trade in one business for another comes very rarely.
“The Single Greatest Edge an Investor can Have is a Long-Term Orientation”
– Seth Klarman
Seth Klarman is one of the world’s greatest investors. He is the billionaire manager of the Baupost Group hedge fund. When Klarman says a long-term orientation is the single greatest edge you can have in investing, you should listen.
Klarman is not alone in his opinion that investing for the long-run is of critical importance.
“Our favorite holding period is forever”
– Warren Buffett
Investing for the long-run has several advantages over rapidly turning over your account.
The most obvious advantage is holding for long periods of time reduces transaction costs and other frictional costs like taxes. Minimizing frictional costs is discussed later in this article. Simply put, the less often you sell, the less often you pay your brokerage a commission – and the less often you pay Uncle Sam capital gains tax.
When you invest in a high quality business, the best thing you can do is… Nothing. You let the business compound your money for you as it grows over time.
This gives you the advantage of maximizing total returns for each of your ideas. The hard part is finding great businesses that can compound your wealth over long periods of time that are trading at fair or better prices. Once this type of business is found, the worst thing you can do is sell it after a year or two to ‘lock in’ your gains. This prevents you from reaping the full rewards of the business’ long-term growth.
All businesses go through ups and downs. Even great businesses will lag the market some years. That’s why it’s important to be confident in the long-term growth prospects of your investments and to not obsess over returns.
There is no strategy that outperforms the market 100% of the time. Even Warren Buffett does not outperform every year. No investor can.
Dividend investing is no different. Will some of your investments underperform the market? Yes, absolutely.
Don’t worry about short-term performance.
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine”
– Benjamin Graham
Benjamin Graham (Buffett’s mentor and father of value investing) says that the market is a voting machine in the short run. Over the course of any give quarter, month, or year returns are largely driven by changing investor sentiment.
Guessing at the changes of investor sentiment beforehand is virtually impossible. It’s a game that’s difficult to when. It’s also a game you don’t have to play.
Instead of focusing on guessing ever-shifting investor sentiment and comparing your short-term returns to a benchmark, look to long-term returns instead.
How long is ‘long-term’? Return data means very little unless you have at least 3 years of returns to go off. Five or 10 year return windows are better to compare performance.
Don’t obsess over short-term returns. This will just cause anxiety and frustration which lead to additional portfolio churn and higher investing costs. It isn’t worth it.
This isn’t to see total returns aren’t important. Checking returns over short periods of time is impractical because you cannot draw meaningful conclusions from it. Checking performance over very long periods of time is more helpful because it can show if the strategy you are employing is ‘worth it’. In the final analysis, what matters most is that you reach your investing goals, not that you chase returns.
You can’t always have positive returns. Be prepared to lose money when the market falls.
The long-term trend of the market is up. Investing in stocks is a rigged game… It’s rigged in your favor. Market’s average positive returns over long periods of time as businesses grow and technology makes us more productive.
That’s in stark contrast to casinos where the odds are stacked against you. It’s also in contrast to ‘zero sum’ games where you can only gain at other people’s expense.
But stock market gains don’t accrue equally every year. Some years the market surges upwards, and other years it declines substantially.
Source: Image from Google Finance
As you ca see tremendous wealth is created over the long run, but only if you can hold through the down periods. If you sell when markets collapse and then wait to ‘jump back in’ the market, you aren’t going to generate favorable (or maybe not even positive) returns.
Unfortunately, many individual investors do just this. Individual investors have historically significantly underperformed the market because they buy high and sell low. In short, too many individual investors buy because other people are buying and sell because other people are selling.
The way to beat your instincts and stay the course when stock prices fall is to be prepared ahead of time.
Remind yourself that stock prices rise and fall in the short-run, and this has very little to do with the underlying strength of the business.
No recession lasts forever. Even if a high quality businesses sees a temporary decline in earnings from a recession, that doesn’t mean earnings are permanently impaired or that the business has lost its competitive advantage. If you can hold (or better yet, continue buying) through market dips you will very likely end up far better off than the investor who panic sells.
To avoid panic selling, you should know ahead of time why you will sell one of your dividend stock holdings.
Having a plan of why you will sell a stock beforehand is absolutely critical in avoiding the mistake of selling because of price declines rather than fundamental business reasons.
There are 2 sell rules in The 8 Rules of Dividend Investing:
- Sell when a stock becomes extremely overvalued (adjusted price-to-earnings ratio above 40)
- Sell when a stock loses its competitive advantage (judged as a cut in dividend payments)
You will notice that both of these rules have strict quantitative requirements. ‘Extremely overvalued’ is objective. A stock can be extremely overvalued with a price-to-earnings ratio of 20, there’s no question about that. By using a strict rule, there is no second guessing about when to sell. The high quality dividend growth stocks typically recommended by Sure Dividend would all be overvalued at a price-to-earnings ratio of 40. That’s why this number is used. There are no ultra-rapid growth stocks in the Sure Dividend database that would justify holding at a price-to-earnings ratio of 40.
A similar approach would be to look at a fair valuation multiple for each of your holdings and then come up with the price-to-earnings ratio at which you’d sell, no questions asked. This way, you will not trick yourself into believing hype surrounding a stock once its price-to-earnings ratio reaches very high levels. You can benefit from irrational exuberance rather than participate in it.
The second reason I have for selling a stock is when it loses its competitive advantage. Again, this is a qualitative measure that is debatable for each individual business. To cut through the confusion, I use a dividend cut to signify the loss of a competitive advantage.
Businesses that cut their dividends have either completely lost their competitive advantages or are in serious danger. As a dividend growth investor, the reason to own the stock (stable, growing dividend income) has been violated.
Like any rule, this isn’t perfect in identifying businesses losing their competitive advantages, but I believe it to significantly reduce behavioral errors that result from tricking yourself into believing a business you want to sell has lost its competitive advantage, or believing that a business you hold hasn’t lost its edge (when it has).
The specific rules aren’t as important as knowing what will trigger a sell for you beforehand. I believe that rules based on fundamental data of the business rather than the stock price are more appropriate for sell rules – as we are investing in the business, not the stock price.
Looking for reasons to sell a business involves analyzing and understanding the business. Everyone has different strengths and weaknesses. It’s important to stay in your circle of competence.
You don’t have to be an expert in every stock or industry to find great dividend paying businesses suitable for long-term holding.
Less complicated investments have less room for error. It’s easier to understand the risks and rewards Coca-Cola (KO) faces than to accurately value the prospects of a pre-revenue biotech startup.
Investing in businesses that you understand well is called staying in your ‘circle of competence’. One of my favorite Warren Buffett quotes on the subject is below:
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
– Warren Buffett
Knowing the boundaries of your circle of competence is critically important. It’s better to miss an opportunity (and wait for the next one to come around) than it is to make a mistake and suffer a permanent loss of capital.
Humility is a rare virtue. Who doesn’t want to ‘know it all’? You can expand your circle of competence through research over time. But it is not a good idea to bet large sums of money on businesses that you aren’t really sure how they operate.
Sadly, many investors do just this. There are no bonus points in investing for degree of difficulty. Investing in businesses you don’t understand is like playing poker without looking at your cards. You might get lucky, but you probably won’t.
The previous nine tips have broadly defined how to invest in high quality dividend stocks for the long run.
The final tip is to invest with a plan. The first step in creating your investing plan is to understand what you are investing for.
Are you saving for retirement, or for a down payment on a new house, or for something else? Understand when you will need the money you are investing. If the majority of it is needed in a short period of time (certainly anything under 5 years), then your money should not be invested in stocks.
Income is also an important consideration. Will you need your portfolio to produce income in retirement? If so, how much? You should invest accordingly. Investing for retirement creates different circumstances than other goals. You can see 10 of the best stocks for retirement here.
After the reason why you are investing is in place, it’s time to pick the investing vehicle that will accomplish your goals.
If you decide to invest in individual businesses then you should define the type of business you are looking for. From the tips in this article, that would be high quality dividend growth stocks trading at fair or better prices.
When to buy and when to sell should be determined. This will determine how infrequently you trade (the less the better).
Like most things in life, thinking through your investment decisions ahead of time will increase the likelihood that you accomplish your investing goals by making intelligent investing choices suitable to achieving your goals.