BEGINNER INVESTING LESSONS

BY:DAVID VAN KNAPP

COMPILED BY: VIJAY DAV’E

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Dividend Growth Investing Lessons

(By: Dave Van Knapp)

Lesson 1: What is a Dividend? 2

Lesson 2: Dividend Growth 7
Lesson 3: The 5-Year Rule 11
Lesson 4: The Power of Compounding 16
Lesson 5: The Power of Reinvesting Dividends 21
Lesson 6: Yield and Yield on Cost 27
Lesson 7: Dividends are Independent from the Market 34
Lesson 8: How to Build a High-Yielding Dividend Growth Portfolio 42
Lesson 9: My Top 14 Reasons Why Dividend Growth Investing Makes Sense 49
Lesson 10: Two Ways to Reinvest Your Dividends to Enhance Your Returns 61
Lesson 11: Valuation 68
Lesson 12: Run Your Investing Like a Business 82
Lesson 13: Specific Topics to Cover in Your Dividend Growth Investing Plan 89
Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio 98
Lesson 15: Portfolio Management – How to Decide When to Sell Stocks 117
Lesson 16: Diversification 130
Lesson 17: Dividend Safety 142
Lesson 18: High Yield or Fast Growth? 146
Lesson 19: How to Increase Your Investor Returns 152
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Dividend Growth Investing Lesson 1: What is a Dividend?

I am happy that DTA requested that I renew the Dividend Growth Investing Lessons. Most
of them are now several years old, and while the principles are timeless, the examples need
refreshing, and some technical details have changed.

I will also look for better ways to express the essential ideas about dividend growth
investing.

Each lesson presents a general principle, then fleshes it out with examples, details, and
explanations. Every lesson is presented in plain English and summarizes its key takeaways
at the end.

I would urge you to consider each lesson as a block in a foundation.

After we’ve laid enough blocks, we’ll have a complete understanding of what dividend
growth investing is and how it works.

As you read the lessons, remember that your personal investing is actually a small business,
and you should treat it as such.

That means placing heavy reliance on facts, analyzing them logically, and reaching
intelligent decisions.

It also means removing unhelpful emotions and influences from your process to the extent
that you can.

Many people fear investing, but there’s really no need for that. Basic knowledge goes a long
way to stripping the mystery away. These lessons will help you get started by presenting
basic facts, definitions, explanations, and examples.

OK. Let’s get started with the first lesson. We need to understand what dividends are.

Dividends are distributions by a corporation to its owners.

Usually, what is distributed is money… cash. Occasionally, dividends are paid in shares
rather than cash.
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Here’s how it happens…

A company’s management proposes the payment of a dividend to its board of directors. If

the board approves, a public announcement is made.

The announcement will specify at least 3 things:

• the amount of the dividend;

• the record date, meaning the date on which a shareholder must be registered on the
company’s books to receive the dividend; and
• the payment date.

Here’s what a typical dividend announcement looks like. This one came on January 2, 2018
from Johnson & Johnson (JNJ), a stalwart dividend growth stock that I own.

We can learn a lot from this little announcement…

The Amount of the Dividend — JNJ will pay its shareholders $0.84 in cash for each share
that they own. So, if you own 100 shares of JNJ, your total dividend payout will be $84.

The Frequency of the Dividend — JNJ announced its dividend “for the first quarter.” Most
companies pay dividends on a regular schedule. A quarterly schedule is quite common for
U.S. companies. Some companies pay dividends monthly, while others (especially overseas
companies) pay semi-annually or annually.

The Record Date — In its announcement, JNJ establishes a record date of February 27,
2018. This is the day that you must be on the company’s books as the owner of record in
order to receive the dividend. Companies also use this date to determine who is sent proxy
statements, financial reports, and other information.

The Ex-Dividend Date – Once the company sets the record date, the ex-dividend date is
established based on stock exchange rules. It is usually one business day before the record
date.
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That’s the case in JNJ’s announcement. The ex-dividend date is February 26, and the record
date is one business day later (February 27).

The ex-dividend date is important, because it determines who gets the next dividend.
Beginning on the ex-date, shares change hands without the right to receive the upcoming
dividend (“ex” means “without”).

For the buyer of a stock:

• If you buy before the ex-dividend date, you’ll get the dividend.
• If you buy on the ex-dividend date or later, you will not receive the next dividend. There is
not enough time to get your name on the company’s books as the owner of record, so the
seller gets the dividend.

And if you’re selling a stock:

• If you sell on the ex-dividend date, you’ll get the dividend, even though you no longer
own the stock by the time the payout date rolls around.
• If you sell before the ex-dividend date, you will not receive the dividend. The new owner’s
name will replace yours on the company’s records, and they will get the dividend.

Sometimes the dividend announcement won’t specify the ex-date, because the date is
determined by stock exchange rules once the company sets the record date. Popular
research sites give the ex-dividend date, because it is so important.

Here is how JNJ’s dividend dates appear on Morningstar. Notice that in this summary they
omit the record date, because the ex-dividend date is more important to investors.
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The Payment Date — Quite a bit of time can pass between the declaration of a dividend
and its payment. In our example, JNJ’s declaration was announced on January 2, but the
payment will not be made until March 13.

There is no uniformity to how much time may pass between the declaration and the
payment. Sometimes it is just a week or two, while other times, as in this example, it’s 2-3
months.

Putting all the dates together, this how JNJ’s schedule of dividend events looks. This is a
typical illustration of spacing between dates.

One thing you won’t learn from a dividend announcement is the stock’s yield. The
reason is that the company does not control the yield. The company controls the amount it
pays out. But yield is the ratio of that amount to the stock’s price, which is controlled by the
market, not the company.

For example, say a company is paying $1.00 in dividends this year. If its stock’s price is $10
per share, its yield would be $1 / $10, or 10%. But if its price is $20 per share, its yield
would be $1 / $20, or 5%.

Usually, in a stock summary, its dividend is stated as a yield (like 5%), not an amount (like
$1). Just remember, though, that the yield is a calculated figure that depends on the stock’s
price. That’s why a company’s yield changes every day, because the stock’s price is
changing every day in the market.

And that’s the end of Lesson 1! Now we know what a dividend is.

Key Takeaways from This Lesson

1. A dividend is a distribution by a company to its owners. It’s usually a cash distribution.

2. Dividends are proposed by management and declared by the board of directors.
3. Management specifies the amount of the dividend, the record date, and the payable date.
4. Stock exchange rules determine the ex-dividend date once the record date is known. The
ex-date is important, because it determines who receives the next dividend. If you buy a
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stock before the ex-dividend date, you’ll get the dividend. If you wait until the ex-date or
after to buy the stock, you won’t get the next dividend.
5. A stock’s yield is its annual dividend amount divided by its price. Most yields change
every day as the stock’s price changes in the market.

Coming Up…

There’s a lot more to learn but knowing what a dividend is gives you the first block in the
foundation of dividend growth investing.

In upcoming lessons, we’ll explore why companies declare dividends… dividend

growth… dividend reinvestment… and how to find great dividend stocks.

These lessons give me the opportunity to share the basic blocking and tackling of the stock
investment strategy that I follow. I hope that you, the readers, will find these lessons
helpful and educational in your journey toward generating a lifetime of safe, steadily-rising
dividends.

— Dave Van Knapp

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DGI Lesson 2: Dividend Growth

In Lesson 1, we learned what a dividend is. It is a distribution (usually of cash) that a

company makes to its shareholders.

But beyond merely paying a dividend, the strategy of dividend growth investing requires a
second element: Dividend growth.

Many companies increase their dividends every year. These “dividend growth”
companies form the foundation of dividend growth investing. If you are following that
strategy, these are the companies you want to own.

When I wrote the first edition of this Lesson in 2013, I highlighted 5 stocks to illustrate
dividend growth. I owned all 5 then and still own them today.

They remain as good illustrations of dividend growth stocks.

All 5 companies have continued to grow their dividends since the 2013 article. Their current
dividend growth streaks are shown in the table.

If you are new to dividend growth investing, you might be surprised by how long some
companies have been increasing their dividends every year. Johnson and Johnson’s streak
has hit 55 years. It began in 1963, when JFK was president.

Whether a company is a dividend growth company is a function of whether it has a

history of raising its dividend. As I see it, there are only two requirements to call a
company a dividend-growth company:
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• It pays a dividend
• It raises the dividend regularly

The dividend can be large or small, and its rate of growth may be fast or slow. Indeed,
that’s the central point of this lesson. Dividend growth stocks do not need to sell at a
particular price, have a certain yield or dividend growth rate, or be famous
names. They simply need to have a regular rising dividend.

Whether a company pays or raises a dividend is a matter of corporate policy, not of how its
stock is doing in the market. A stock’s price may go up or down, and that will have nothing
to do with the company’s dividend policy. Thus, dividends and dividend growth are
independent from the market.

The companies we’re interested in as dividend growth investors are companies that have
adopted a policy or follow a practice of increasing their dividend every year. Such a
company’s dividend history will look like a stairway.

This is the dividend chart of a great dividend growth stock, Johnson & Johnson. The chart
shows the past 10 years of dividend growth, and as we saw earlier, its dividend has been
raised each year for 55 years altogether.

Normally, when you look up a stock, you get a price chart. Everyone assumes that investors
are interested in prices. But dividend growth investors are interested in dividends.

Here’s the same chart with J&J’s price superimposed.

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You will notice that J&J’s price has wandered all over the place over the past 10 years. From
2010 to 2012, its price was flat. Not so its dividend. The company raised the dividend each
year.

Dividends tend to be much less volatile than prices. Price is determined by the
market; dividends are determined by company policy. J&J’s policy is to raise its dividend
every year, and that is reflected in the blue line on the chart. Whatever traders are thinking
when J&J’s price plunges or shoots upward has nothing to do with the company’s dividend.

How do you find dividend growth companies? One of the best sources is right here on Daily
Trade Alert: David Fish’s Dividend Champions, Contenders and Challengers, a
comprehensive research document that is updated every month.

If we look at that document, we find (as of the end of January 2018):

• 118 companies have increased their dividends for 25 straight years or more
(Champions)
• 218 companies have streaks of 10 to 24 years (Contenders)
• 508 companies have streaks of 5-9 years (Challengers)

That’s a total of 844 companies that have raised their dividends for at least 5
consecutive years. Isn’t that amazing?

The 5-year lower cutoff that David Fish uses on his “CCC” document is important to me,
because it’s the minimum streak that I require to invest in a dividend growth stock. Next
time, I will explain why.
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Key Takeaways from This Lesson:

1. The only requirements to be a “dividend growth” stock are that a company pays a
dividend and grows it each year.
2. Dividends are determined by company policy and are therefore independent from the
market. A company’s dividend can go up while its price is going down. Indeed, that
often happens.
3. Dividends tend to be more stable than prices.
4. Many companies increase their dividends every year. As of early 2018, over 800
companies traded in the USA have increased their dividends for more than 5 years
straight. More than 100 companies have done it for 25 years or more.

Dave Van Knapp

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DGI Lesson 3: The 5-Year Rule

Welcome back to this series of lessons about dividend growth investing!

Before we get started, let’s briefly review the most important points from the first two
lessons.
In Lesson 1, What Is a Dividend? we learned:

• A dividend is a voluntary distribution by a company to its owners, usually cash.

• The company specifies the amount of the dividend, the record date, and the payable date,
while stock exchange rules determine the ex-dividend date.
• The ex-date is important, because it determines who receives the next dividend. If you
buy a stock before the ex-dividend date, you’ll get the next dividend. If not, the seller gets
it.

Then in Lesson 2, Dividend Growth, we learned:

• The only requirements to be a “dividend growth” stock are that a company pays a
dividend and grows it each year. Nothing about the size of the yield or speed of growth is
implied.
• Dividends are independent from the market, because the companies themselves
determine dividends. A company’s dividend can go up while its price is going down.
• Many companies increase their dividends every year. Some have been doing so for more
than 50-60 years.

Now I want to introduce my first “rule” for dividend growth investing: The 5-Year Rule.

My “rules” are guidelines that I follow. They are not rigid. Over the years, they’ve served
me well, but not every investor does things exactly as I do. You should think about them in
the context of your own needs and investment styles.

As you learn more about the field, you can make up your own mind about what rules and
guidelines are best for you.

The 5-year Rule simply says that a company must have raised its dividend for at
least 5 consecutive years before I consider investing in it for a dividend growth
portfolio.
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The thinking is straightforward. Since the goal of dividend growth investing is to produce
income that grows reliably, I want to select companies that have grown their dividends
reliably.

Of course, no one can predict the future.

Any company can cut, freeze, or eliminate its dividend at any time.
But the past holds clues to the future.
Obviously, a company that has already raised its dividend for 5 years in a row has compiled
a track record that suggests that it might continue to do so.

A 5-year track record is certainly not the only evidence you might seek, but it is an
important part. It is so important to me that I use it as a hurdle requirement. If a
company does not have at least a 5-year streak of raising its dividends, I consider it
ineligible for consideration as a dividend growth investment. I won’t buy it.

Over the years, I have only made one exception to this rule. I bought Apple (AAPL) when
its streak was 4 years. It was obvious that the streak would advance, and it has.

Apple’s streak is now at 6 years, and there should be a new increase for 2018 in a couple of
months.

Five-year streaks are easy to identify. At the moment, there are more than 800
companies traded on U.S. exchanges that qualify under the 5-Year Rule. We know this
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from David Fish’s Dividend Champions, Contenders and Challengers document that is
available here at Daily Trade Alert.

Let’s look at a few examples of stocks that pass this basic test. I own all of the following:

One reason that I like the 5-Year Rule is that the dividend charts of such companies look so
beautiful. They are like staircases.

Those are exactly the way you want dividend charts to flow: Up and to the right, with no
exceptions.
The increases keep marching up straight through recessions (the last recession is shown by
the shaded band at the left) and other difficult events.

The 5-Year Rule is not foolproof. Nothing in investing is guaranteed, and no one can
predict the future. As we learned in Lesson 1, dividends are discretionary. A company can
freeze, cut, or eliminate its dividend no matter how long it has been paying one.
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For example, several “Too Big to Fail” banks cut their dividends during the 2007-2009
financial crisis despite lengthy increase streaks. So, I recommend further analysis beyond
the 5-Year Rule, to buttress the case that a dividend is probably safe.

A company may cut or freeze its dividend not only during times of general economic stress,
but also because of specific difficulties that impact only itself or its industry. For example,
during the oil price drops a few years ago, Chevron (CVX) froze its dividend for almost 2
years until the price of oil recovered. The frozen period is circled below.

But as a company, Chevron was committed to increasing its dividend over the long term.
So, it made a tiny increase at the end of 2016, then in early in 2018 made a more
substantial increase that (hopefully) signals the beginning of many annual increases to
come.

To my way of thinking, a company that cuts its dividend has broken a link in a chain.
Perhaps it becomes easier to break that link again for lesser reasons next time. I want
companies that are clearly devoted to keeping their dividend growth streaks alive
and have the financial strength to do so.

The 5-Year Rule helps me identify stocks that are likely to keep increasing their dividends.
In most cases, longer streaks are even better. Some investors demand 10 years, or even 20
or 25. Again, however, nothing that has happened in the past guarantees the future.
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Key Takeaways from This Lesson:

1. The 5-year Rule is an investing guideline that a company must have raised its
dividend for at least 5 consecutive years before a dividend growth investor considers
it probable that it will continue to do so.

2. A company’s existing dividend growth streak is a track record that gives insight into
its ability and intention to continue raising the dividend each year.

3. The track record is not foolproof. No one knows the future, and even companies with
long streaks sometimes freeze or cut their dividends.

4. For that reason, other due diligence is required to increase confidence. Many
investors require longer streaks like 10 or even 25 years of consecutive annual
increases.

— Dave Van Knapp

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DGI Lesson 4: The Power of Compounding ***

Compounding is one of the most powerful concepts in investing. Compounding occurs

when your money grows at a geometric (exponential) rate rather than a linear rate.

Compounding is especially interesting in dividend growth investing, because it happens at

two levels.

• Companies compound their own value by reinvesting in themselves, thus growing

their revenue, earnings, and dividends. (Lesson 4)

• Investors can reinvest the dividends they receive and compound them in their own
portfolio. That adds a second layer of compounding to the one that occurs within the
company. (Lesson 5)

This lesson is a primer on compounding and also addresses the first bullet point above.
Lesson 5 will focus on the second bullet point.

Let’s talk about compounding in general. Compounding means earning money on

money already earned.
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Great companies compound money within their businesses. They earn money, then take
some of the money already earned (“retained earnings”) and invest it back into the
company to fuel growth.

If the growing company is one that pays dividends, its growth also allows it to increase its
dividends.

Compounding is geometric.

That means that growth occurs not in a straight line (Linear), but in a line that curves
upward, as shown in the cartoon above.

Each year’s growth differs from the prior year’s not by a constant amount, but by a constant
rate.

When applied to dividends, this annual rate of increase is called the dividend growth rate
(DGR).

The difference between straight-line growth and compound growth is startling. Do

you remember the childhood brain-teaser about your father giving you a penny allowance
on the first day of the month and then doubling the amount each day? Most kids think that’s
nothing special.

But they’re wrong. If you double a penny for 30 straight days, the amount your father owes
you on the 31st is more than $10 million dollars!

Let’s relate these principles to dividend growth investing with a simple hypothetical
example.

Say that a successful company raises its dividend by 10% per year. In the first year, its
dividend is $10.00 per share per year. Let’s see how it grows when it’s compounded by a
DGR of 10% per year for 10 years. Look at the blue columns in the following table.
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The table show how powerful compounding is. In 10 years, the dividend increases to
almost 2.6 times the amount of the first year’s dividend.

At first, this might seem impossible. After all, each year’s increase was just 10%. If you add
up 10 years’ worth of 10% increases, shouldn’t that give you a 100% total increase?
Shouldn’t the amount after 10 years be 2.0 times the beginning amount?

No! The reason that the amount after 10 years is way more than twice as much is the result
of compounding. Each year’s 10% increase was tacked onto the prior year’s amount. That
means that each year’s increase is more – in dollars and cents – than the year before.
Compounding is like a snowball rolling down a hill: The bigger it gets, the faster it
gets bigger.

You can see that each year’s increase is bigger in the table above. Look in the 3rd column,
labeled “Dollar Amount of Increase.” Each year, the dollar amount of the increase is larger
than the year before. So, while the dividend growth rate stays constant at 10% per
year, the dollar amount of each increase grows every year. That’s the power of
compounding.

The intuitive doubling of the dividend amount – to 200% of the original – becomes 260% as
a result of compounding. That is a 30% additional boost in dollars (260 / 200 = 30%).

For comparison, in the red column, we show the same dividend increasing by a constant
amount of $1.00 per year. That represents straight-line growth. It matches the intuitive
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result of 100% total increase. In the 10th year, you receive twice the amount as in the first
year.

By the end of the 10 years shown in the table, the annual dividend with compounded
growth has far surpassed the dividend being raised by a constant amount each year.

Let’s see how the numbers in the table look on a chart. The colors on the chart match the
colors in the table.

The first year’s dividends are the same, but by 2025, the compounded dividend is 30%
more. The compounding line curves upward, while the non-compounding growth (Linear
growth) stays straight.

The most common mathematical measure to describe compound growth is compound

annual growth rate (CAGR). The CAGR for the table is 10% per year. When you are
talking specifically about dividends, the term (as noted earlier) is called the dividend growth
rate (DGR).

Are there stocks that raise their dividends by a constant percentage each year? Well, it’s
unusual to find a stock that increases its dividend by exactly the same percentage each
year, but it is not unusual to find stocks that grow their dividends by a significant
average annual percentage for 10 years.

Here are a few real examples taken from David Fish’s Dividend Champions, Contenders, and
Challengers. The middle column shows each stock’s 10-year DGR. The last two columns
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illustrate how those DGRs increased the dollar amount of the annual dividend over the 10
years from 2007-2017.

Each company’s DGR is independent from its yield. Yield, you will recall from Lesson 1,
is the annual dividend payout divided by the stock’s price. The company controls its
payout, but it doesn’t control its price. Price is controlled by the market. That means that
no company controls its yield.

That said, you will often see a loosely inverse relationship between yield and DGR. In the
table above, for example, the lowest-yielding stock – Lowe’s at 1.8% – has had the fastest
DGR at 19.3% per year, while higher-yielding stocks have slower dividend growth rates.

Here are the important takeaways from this lesson:

• Compounding = Earning money on money already earned.

• Companies compound their dividends by raising them each year. The pace of each
year’s raise, or of a series of raises, is called the “dividend growth rate” or DGR.
• Compounding accelerates the rate at which dividends accumulate, like a snowball
rolling down a hill.
• Yield and DGR are independent. The company determines its dividend amount and
therefore its DGR, but its yield also depends on the market price, which the company
does not control. A company with a low yield may have a high DGR, and vice-versa.

Please note that we haven’t talked yet about reinvesting the dividends. The
compounding discussed in this article has been about the impact of the company raising
the dividends that it sends you.

Dividend reinvestment gets into the topic of what you do with that cash once you
receive it. We’ll talk about that second layer of compounding in the next lesson. DVK
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DGI Lesson 5: The Power of Reinvesting Dividends

In our last lesson, we saw how an annual increase in a company’s dividends causes your
dividend income to increase at a growing rate. This is called compounding. It results from
the fact that each annual dividend increase builds upon the rate established by the last
increase.

Compounding is like a snowball rolling down a hill, picking up new snow. As it rolls, it
gets bigger at an increasing rate. Put another way, the bigger it is, the faster it gets bigger.

In dividend growth investing, that snowball effect from increasing dividends is the first layer
of compounding.

You can add a second layer of compounding by reinvesting the dividends. Your
dividend income, which is growing anyway, grows even faster if you buy more
shares with the dividends.

You can reinvest dividend cash into the same stock that issued it, or you can use it to
purchase shares of a different stock. Mathematically, it doesn’t matter, because the effect is
the same: You will accelerate the rate at which your portfolio’s dividend stream grows.

Recall that compounding means earning money on money already earned.

Reinvesting dividends matches that definition exactly. The cash dividends coming in are
“money already earned.” If you use that cash to buy more shares, the new shares will issue
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their own dividends. Those additional dividends are available only because you reinvested
the original dividends.

To review, here are the two layers of compounding in dividend growth investing:

• First layer of compounding: Your dividend stream grows at an increasing

rate, because your companies’ annual dividend increases build on prior increases.
• Second layer of compounding: You take those dividends and reinvest them –
i.e., buy more shares. Those additional shares then generate additional dividends.
Every dividend cycle, the process repeats, and more shares are added to your
portfolio each time.

The end result is a growing snowball of dividends and shares that keep getting bigger at an
accelerating rate.

Simple Example

We can see the impact of both layers of compounding by viewing a chart of dividend dollars
per year that is produced by the calculator at Miller/Howard Investments.

For this simple hypothetical illustration, I input data for a stock that has a 3% yield and
grows its dividend 5% every year. The initial investment is $1000.

The blue line shows your dividend stream if you don’t reinvest the dividends, and the
orange line shows what happens if you reinvest the dividends.
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• The blue line, without dividend reinvestment, curves upward slowly. That illustrates
the first layer of compounding. The rise in each year’s income results from the
stock’s annual dividend increase.
• The orange line shows the accelerating effect of reinvesting the dividends. The
orange line curves up much faster than the blue line. The further out you go in time,
the farther apart the lines get.

The mathematical measure for compound growth is called compound annual growth rate
(CAGR). CAGR is the constant percentage rate of growth that would get you from the
beginning point to the end point of a growth curve.

*** In real life, dividend growth rates vary from year to year. The CAGR pretends that the
growth rate was equal every year, to arrive at the same result years later.

The CAGR of the blue line is 5% per year, which is the hypothetical dividend growth rate
that I put into the calculator. Without reinvestment, the percentage rate of growth stays
constant every year.

I computed the CAGR of the orange line. It is 8% per year. The higher rate is entirely the
result of dividends being reinvested. Each reinvestment buys more shares, which generate
more dividends. That’s why the orange line curves up and away from the blue line over
time.

The analogy of a snowball rolling down a hill applies not only to your dividend stream, but
also to how many shares you own. The orange line in the chart below shows how your
shares increase when you reinvest dividends. In our simple example, 10 original shares
become 30 shares in 25 years.

Without reinvestment, the blue line stays flat – you don’t get any additional shares.

Remember again why the orange line moves up and away. You didn’t add any new money
to the portfolio to get those extra shares. The stocks you already own provided the money.
The new shares came solely from reinvesting dividends that the portfolio produced on its
own.
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Real Example

Now let’s look at a real company.

One of the most common dividend growth stocks is Johnson & Johnson (JNJ). JNJ has been
increasing its dividend for 55 years. We’ll look at the last 11 full years (2007-2017).

Examining a real stock introduces real-world variability into the theoretical inputs that I
used to generate the graphs earlier. Instead of a constant rate of dividend growth, we get
the variable rate that the company actually provided. The shares purchased with reinvested
dividends will come at the stock’s actual price, not a theoretical price.

Nevertheless, the principles still apply. On this graph of Johnson and Johnson, covering
2007-2017, we see JNJ’s real price (the black line) and its trajectory of dividend growth (the
white/green line).

[Graph courtesy of FASTGraphs]

It’s hard to see, but the dividend line is curving upward slightly. That’s the result of JNJ’s
dividend increases each year.

The following display shows how JNJ’s dividend, if reinvested in JNJ’s own shares, caused
the dividend income stream to accelerate. This isn’t hypothetical, it actually happened. The
figures are based on a $10,000 investment in JNJ. I’ve marked the display to identify the
important points to notice.
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Please note the following:

• The red circle shows the number of shares that $10,000 would have bought at the
end of 2006, using JNJ’s actual price at that time: 151.47 shares.
• The green bracket shows JNJ’s dividend increase percentage each year, which varied
between 5% and 11%. The CAGR at the bottom smooths out the different increases
to a single equivalent annual average, which is 7.8% per year.
• The blue bracket shows the growing number of shares that resulted from
reinvestment. Whereas the investor started out with about 151 shares, after 11
years of reinvestments he or she has about 210 shares (39% more shares).
• The gray circle shows the total dividends paid over the 11 years: $4959.53.
• The aqua bracket shows how the investor’s yield on cost (see Lesson 6) went up as
the result of the 2 layers of compounding. By the end of 11 years, the yield on cost
nearly tripled, from 2.5% to 6.9%.

What if the dividends had not been reinvested? The number of shares would have stayed
flat and the income stream would not be nearly as large.

• At the end of the 11 years, the investor would still own the same 151 shares that he
or she started with.
• The dividend increase percentages, of course, remain the same. They were
determined by JNJ’s management (see Lesson 1), not by how many shares you own
or whether you reinvest them.
• The total dividends paid over the 11 years would have been just $4059, compared to
the $4959 that we got with dividends reinvested.
 26

The results absent reinvestment is nothing to sneeze at. Annual dividends more than
doubled. That’s from the first layer of compounding: The impact of the company
raising its dividend every year.

Reinvesting dividends added the second layer of compounding. In 11 years, the

annual dividend flow nearly tripled, as did the yield on cost.

If the table were extended another 10 years into the future, the rate of pick-up of additional
shares and the speed at which the dividend stream grows would continue to accelerate.
Fortunes have been built in exactly this way.

Important Takeaways from This Lesson

1. As we saw in Lesson 4, companies that increase their dividends provide the first
layer of compounding that increases your dividend flow each year.
2. Reinvesting dividends adds the second layer of compounding. The reinvested
dividends buy new shares, which produce their own dividends, in a repeating cycle of
growth and reinvestment that occurs each time you receive and use them to buy
more shares.
3. This additional compounding accelerates the growth of your income stream beyond
the growth that comes from the company’s annual dividend increases alone. The gap
between the two widens as more years pass.
4. Reinvesting dividends also increases the number of shares that you own.
5. If you invest your dividends into the same company that delivered them, your stake
in that company will increase every quarter. If you invest them into another
company, you can start a new position with your dividend dollars. Either way, your
additional shares will produce their own additional dividends.

Dave Van Knapp

 27

DGI Lesson 6: Yield and Yield on Cost

We’ve covered a lot in the first five lessons. The knowledge is piling up.

Here’s a quick review of the most important points.

Lesson 1: What Is a Dividend?

• A dividend is a distribution by a company to its owners, usually in cash.

• The ex-dividend date is important, because it determines who gets the next
dividend. If you buy a stock before its ex-dividend date, you’ll get the dividend. If
you wait until the ex-date or later to buy the stock, you won’t get the next dividend.

Lesson 2: Dividend Growth

• The only requirements to be a “dividend growth” stock are that a company (1) pays
a dividend and (2) grows it each year.
• Dividends are determined by company policy and are therefore independent from the
market. A company’s dividend can go up while its price is going down. It happens all
the time.
• As of early 2018, more than 800 companies traded in the USA have increased their
dividends for 5 years straight or more. Over 100 of them have done it for 25 years or
more.

Lesson 3: The 5-Year Rule

• The 5-year Rule is an investing guideline that a company must have raised its
dividend for at least 5 years straight in order to buy it.
• A company’s track record is not foolproof. Therefore, other due diligence is required
before investing.

Lesson 4: The Power of Compounding

• Compounding means earning money on money already earned.

• Companies compound their dividends by raising them each year. Each raise is on top
of prior raises.
• Compounding causes your income to go up at an accelerating rate each year.
 28

Lesson 5: The Power of Reinvesting Dividends

• Reinvesting dividends adds a second layer of compounding on top of the companies’

dividend increases.
• Reinvesting dividends buys new shares, which produce their own dividends, in a
repeating cycle of growth and reinvestment.
• Reinvesting accelerates the speed at which your dividends compound.
• You can reinvest to add to companies you already own, or to start positions in new
companies.

Now let’s move forward to discuss two essential metrics in dividend growth investing: Yield
and yield on cost.

Yield

Yield is the one-year percentage return on your investment from the dividend.

Yield is measured in percentage, in order to make yields comparable across different stocks.

*** Each company, of course, pays dividends in money – dollars and cents. But knowing
only the dollar amount doesn’t tell you whether the return is low or high, because you don’t
know how much you had to pay to get that dividend.

Yield answers that question.

Say your stock pays a $0.25 dividend each quarter per share. That means that you can
reasonably expect to receive dividends totaling $1 in the next 12 months for each share you
own: 4 quarterly payments x $0.25 each = $1.00.

Is that good or paltry? You don’t know, because that knowledge does not reveal how much
the stock costs. How much are you paying for the right to receive that dividend?

Yield covers this weakness by accounting for price. The formula is simple:

Yield = 12 Months’ Dividends / Price

 29

Let’s say that you paid $10 for that share. With this additional information, now we know
that the $1.00 you expect to receive equals 10% of the price of the share. That’s a 10%
dividend return on your money in one year. So, the yield would be stated as 10%.

Most dividend growth stocks don’t yield that much. Dividend yields are more typically in the
2%-5% range.

Here’s the fine print: There are several ways to compute yield, depending on what 4
quarters of dividends you use.

If you use the past 4 quarters, that’s called “trailing yield.” It’s what has already
happened.

As an investor, you are more interested in what’s happening now and likely to happen going
forward. We want the “forward yield,” which is sometimes known as the “indicated
yield.”

Forward yield is computed by annualizing the most recent dividend payment, as I did
above. I took the most recent quarterly payment and multiplied it by 4. That gives me the
expected next-12-month total (assuming the company doesn’t change its dividend in the
meantime).

So, if the last quarterly payment was $0.25, as in the example above, the expectation going
forward is that the company will pay out that amount each quarter. That is the yield you
are getting (present tense) if you buy the stock right now.

Caution: Not every data source uses the forward yield. For example, Morningstar looks
backward in their main display:
 30

The stated yield for Dominion Energy is 4.8%. But that is actually the trailing yield
discussed above. (Morningstar does not label it, but that’s what is displayed.)

Morningstar shows the forward yield, correctly labeled, further down the page:

Note that the difference is significant. The trailing yield – 4.8% – has already happened. The
forward yield – 5.15% – hasn’t happened yet, but it is what will happen provided that
Dominion doesn’t cut their dividend in the next 12 months.

Let’s look at another common source, Yahoo Finance.

Yahoo is very clear about what they are showing: The forward yield. Note how they
annualized the dividend (to $3.34 per year), which is proper, because yield is an annual
return.
 31

The lesson here is simply to be careful. Find out the calculation method of whatever source
you are using. You want to be consistent in comparing yields, so the same calculation
method should be used whenever you are making such a comparison.

In my writing, I always use the forward yield unless I specify otherwise. The reason is that I
want to know what dividend return I can expect going forward, not what happened last
year.

Yield on Cost

Yield on cost is the yield based on the original price paid instead of current price.

Here is the formula:

Yield on Cost = 12 Months’ Dividends / Original Price

Yield on cost (YOC) can be calculated for an individual stock or an entire portfolio.

Here is an example of an individual stock. In my Dividend Growth Portfolio, I purchased 30

shares of Johnson & Johnson (JNJ) in 2010 at a cost of $58.00 per share. JNJ’s current
dividend is $0.84 per share per quarter, as shown by the red outline in this image from E-
Trade.

I multiply that quarterly dividend by 4 to get JNJ’s annual dividend: $0.84 x 4 = $3.36 per
year per share. Then the yield on cost equation is…

Yield on cost = $3.36 / $58 = 5.8%

 32

That means that I am receiving 5.8% of my original purchase price back from JNJ in the
form of dividends each year.

As shown by the blue outline, JNJ’s current yield is 2.6%. That’s figured on JNJ’s current
price, not the $58 that I paid for it in 2010.

Yield on cost demonstrates that I am receiving a higher dividend return based on the price I
actually paid for my JNJ shares than the current yield would indicate.

Now here is an example of figuring the yield on cost of a whole portfolio. My Dividend
Growth Portfolio began with a value of $46,783 back in 2008. I have never added another
dime, so the original value never changes.

So, as the dividend flow increases over time, the yield on cost goes up
regularly. That’s because the divisor in the equation never changes, while the numerator
goes up when companies raise their dividends or I buy more shares with the dividends I
receive.

As of the end of 2017, the forward 12-month expected total dividend on my portfolio was
calculated (by E-Trade) as being $3836. Therefore, for the whole portfolio…

Yield on cost = $3836 / $46,783 = 8.2%.

That means that I was receiving 8.2% of the portfolio’s original value back from the
portfolio each year in cash.

Caution: Some people criticize yield on cost as just a backwards-looking “feel-good”

number. They say that it simply shows what has already been accomplished via dividend
increases since you paid the original cost.

It is true that YOC is like looking up at a scoreboard, in that it shows what has already been
accomplished. It really does not come into play in making current investment decisions.
 33

However, I don’t find YOC to be useless. Here’s what I use it for:

• Inspiration
• A check on how I am doing

When I began the Dividend Growth Portfolio in 2008, I set its mission to generate a growing
income stream over time. That can be measured either in dollars or by its yield on cost.

I found it inspiring, and still do, to think that 10 years after it started, the portfolio could be
returning to me, in cash, 8% of its original cost each year.

And obviously, since YOC is a “scoreboard” statistic, it’s a fast way to state how the portfolio
is doing on its mission.

Key Takeaways from this Lesson

1. A stock’s yield tells you how much it will return to you in dividends per year,
expressed as a percentage of its current price. Yield = 12 Months’ Dividends / Price.
2. Forward yield – based on a stock’s current annual payout – is more useful than its
backward yield.
3. A stock’s yield on cost (YOC) tells you how much it will return to you in dividends per
year, expressed as a percentage of your original cost for the stock. Yield on Cost =
12 Months’ Dividends / Original Price.

Dave Van Knapp

 34

DGI Lesson 7: Dividends are Independent from the Market ***

Some investors believe that when the market goes up, dividends go up too. And vice-versa:
When the market goes down, dividends suffer.

But those perceptions are not true.

The fact is that dividends and the market are independent from each other.

Indeed, the independence of dividends is one of the reasons to invest in great companies
that pay steady, rising dividends: The dividends continue to flow, and they can help cushion
the fall when stock prices decline. Some call this “getting paid to wait” for the market to get
back on its feet.

There are two sources of return from the stock market:

Total Return = Price Changes + Dividends

We all know that the Great Recession (from late 2007 to early 2009) caused a sickening fall
in the stock market. It took the prices of most stocks down with it.

Here is what the S&P 500 – probably the most widely used gauge of the stock market – did
during the Great Recession. The chart shows the time period from June 2007 to the end of
2009. The gray shaded area is the recession itself.
 35

The Great Recession lasted from December 2007 to June 2009. (11/2 yrs.) As, you can
see, the S&P 500 reached a peak just before the recession started, began to fall, and
bottomed out about 3 months before the recession ended, in March 2009.

The total price value lost from the index – peak to trough – was about 51% over 17
months. It was a hellish experience for many investors.

But many dividend growth investors had a different experience. A wide range of
dividend growth stocks continued to raise their dividends straight through the recession.

Here, for example, is a chart of Johnson & Johnson (JNJ) — a stock that I own — covering
the same time period as above.

This chart shows both components of total return. JNJ’s price is shown by the blue line,
while its dividend is in orange.

Note that the stock price of JNJ plunged during the market crash in 2008, as might be
expected.

In a broad bear market, most stocks are pulled down, even high-quality ones like JNJ.

But JNJ’s dividend kept being raised.

Each stair-step in the orange line represents one of JNJ’s annual dividend
increases.
 36

There is no break in the string of increases.

*** Two raises took place during the recession itself.

In fact, Johnson & Johnson has been raising its dividend for 56 years. We know that from
David Fish’s Dividend Champions, Contenders, and Challengers.

*** Here is how JNJ’s record looks over a much longer term. In the following chart, all of
the gray bands are recessions. All of the little bumps up in the orange line are JNJ’s
dividend increases.

I changed the scale in the 2nd chart to show percentage increases rather than dollar values.
JNJ’s dividend has gone up over 42,000% since the early 1970’s. JNJ has kept increasing
its dividend through 6 recessions – the gray bands – including the big one in 2007-2009.

There are many other examples I could give that would show the same story. Just picking
stocks from my Dividend Growth Portfolio, here are the dividend increase streaks of several
widely held dividend growth stocks.
 37

Here are the same 6 stocks graphed to show dividend growth over the past 10 years.
Basically, they all look the same, the only differences being in rate of growth.

No matter what the market did during the past 10 years, all of the dividend paths were
steadily upwards.

Why Are Dividends Independent from the Market?

Remember from DGI Lesson 1 that dividends are cash distributions by a corporation to its
owners. The company’s management proposes the payment of a dividend to its board of
directors. If the board approves, a public announcement is made, and the dividend is
scheduled to be paid.

That’s the process. Read it again. There’s nothing about the market in the process for
declaring dividends.
 38

Dividends are determined by each company as management decisions. In contrast,

market prices are determined by trades in the market. The processes are completely
independent of each other.

Now it is true that the economy can influence both processes. In a recession, stock prices
often go down, and so may corporate revenues and profits. The latter may influence a
company to slow down, freeze, or even cut its dividend.

But fundamentally, the systems by which stocks are priced and dividends are
declared are separate and distinct from each other. That’s why Johnson & Johnson
continued to increase its dividends through the Great Recession even though its price took a
hit.

Any company with a “dividend increase streak” longer than 12 years (as of this writing)
increased its dividend during the Great Recession. That includes all of the Champions and a
good number of the Contenders.

How Dividend Independence Can Help You as an Investor

One of the findings of Behavioral Economics is that many stock investors hurt themselves by
over-reacting to price drops and market volatility. Average investors often underperform the
very instruments that they invest in.

That may sound impossible, but it happens because they panic and sell during difficult
times, then wait too long to buy back in. Trading in and out quite often lowers returns.

From my own personal experience, dividend growth investing helps keep me away from that
kind of behavior. There are several reasons.

First, as a dividend growth investor, I pay far more attention to income amount,
growth, and safety than prices. In the JNJ charts shown above, my eyes are on the
orange dividend line, not the blue price line.

Second, as you experience rising income over time, you may come to appreciate the
positive feelings of having a growing income stream more than the negative
feelings of having the total value of your portfolio go down.
 39

Third, dividend growth stocks often give you a smoother ride through bear
markets. Their price volatility is often less than average. So, there are fewer and less
severe drops to contemplate. Not only that, the dividends soften the impact of price drops,
and the stocks recover faster.

Let’s look at Johnson & Johnson again, comparing its price (without dividends) to the S&P
500 during the Great Recession. I’ve circled the price peaks before the bear market
pulled both down. Here, JNJ is in blue, while the S&P 500 is in orange.

Notice these things:

• JNJ withstood the recession longer, with its price holding firm well into 2008.
• When its price finally did succumb, it fell far less than the S&P 500.
 40

If we look at total return (with dividends accounted for), JNJ’s resilience is even more
pronounced:

You can see that JNJ’s total returns recovered from the bear market in 2011, much sooner
than the S&P 500.

It is factors like these that may help you to stay invested when others are bailing out. In
JNJ’s case, its price dropped less, the ride was smoother, it kept increasing its dividend,
and it recovered faster.

Many dividend growth investors turn away from price obsession, which means that
they begin to ignore the relentless media coverage of prices.

Instead, dividend growth investors turn their focus to income for the long term,
sustainable company qualities, and company fundamentals rather than price
popularity in the market.

In fact, price drops are often seen as opportunities. In my Valuation Zone series of articles,
it is quite common to see that the month’s well-valued stock has recently experienced a
price drop. That’s why it’s well-valued and worthy of writing up.

Simply staying the course results in better long-term returns, as the market has always
recovered. But that’s hard to do when news outlets are talking about doomsday price
scenarios.
 41

Growing dividends – providing that little bit of positive reinforcement each time you receive
some cash from your investment – can help you stay the course.

So, the next time you read someone equate market slides with dividend slides, or market
turbulence with dividend turbulence, think to yourself that you know the facts. It just ain’t
so. Dividends are independent from the market.

Key Takeaways from this Lesson

1. Dividends are independent from the market.

2. The processes for determining dividends and market prices are completely different
and separate.
3. Dividends can and do often rise even when the market is skidding down.
4. Dividend growth stocks often provide smoother rides through market slides. Their
prices hold up better, the dividends provide positive reasons to stay invested, and
investors become less prone to price obsession.

Dave Van Knapp

 42

DGI Lesson 8: How to Build a High-Yielding Dividend Growth Portfolio

This lesson is about how dividend yields grow in a dividend growth portfolio. It pulls
together principles we have seen in other lessons, including:

• How income goes up over time as stocks raise their dividends (Lesson 2)
• How income also rises as you reinvest dividends to buy more stock shares (Lesson 5)
• How yield on cost reflects your portfolio’s income as a percentage yield based on
original cost rather than current value (Lesson 6)

To refresh, here is the formula for yield on cost.

Yield on Cost = Next 12 Months’ Dividends / Original Price

So, this lesson is about building a portfolio that eventually achieves a high yield on your
original investment from stocks that individually are not necessarily high-yielding
themselves.

Projecting Dividends

The formula above requires that we plug in the next 12 months’ dividends for our portfolio.

How do you know what your future dividends are going to be? Well in actuality, you don’t.
Any of the following may happen:

• A company may cut or suspend its dividend.

• A company may increase its dividend.
• You may add, subtract, or swap out stocks in your portfolio.

But there is a standard way to project the next 12 months’ dividends: Take all current
information, and simply assume that conditions will stay the same for 12 months.

That is, you assume that there will be no dividend increases or cuts. You also assume that
there will be no new purchases or sales from the portfolio. That gives you the best snapshot
of what the next 12 months will look like.
 43

Most brokerages calculate expected dividends for you. For example, here is the calculator at
E-Trade, where my Dividend Growth Portfolio (DGP) resides. This shows their projection of
dividends over the next 12 months for the DGP as of this writing.

Dividends that have already been declared are shown in black. The “Estimated” ones are
shown in purple, and they are based on information known at the time of the calculation.
The calculator makes the assumptions described above:

• No company will cut its dividend

• No company will raise its dividend
• No changes will be made to the holdings in the portfolio

Projected Rising Dividends Are Inspirational

One of my inspirations when I began dividend growth investing was the idea that over time,
I could receive, from my companies, significant percentages of my investment every
year in the form of dividends.

The dividend income would not be generated by selling assets.

I keep all the assets.

The income is generated naturally – organically – by the portfolio.

My thought was that, at some point in the future, I could collect, say, 10% of my original
investment every year in the form of dividends.

Those dividends would replace my paycheck during retirement.

 44

That manner of collecting income without working seemed nearly miraculous then, and
frankly it still does.

After all, if you are retired and selling 10% of your assets each year to finance your life,
your nest egg will last only a few years, because you will run out of assets to sell. But with
dividends flowing in, and indeed increasing every year, you can spend 8% or 10% of your
original nest egg every year and never run out of money.

Dividend Growth Investing Is Like Being a Landlord

The mindset of the dividend growth investor is not unlike that of real-estate investors who
rent out their properties. Most such investors:

• Focus on the rental income from the properties.

• Don’t check the market prices of their properties constantly, because they are not
intending to sell them.
• Don’t panic when the real-estate market softens, so long as their properties keep
producing the income they desire.
• May take advantage of soft markets to buy another property.

Thinking of your investing as a business (see Lesson 12), your business model as a dividend
growth investor includes these elements:

• Find great stocks to own, ones that fit well with your eventual goal of providing
income in retirement. You’ll want to identify companies that are likely to pay
increasing dividends over a long period of time.
• Buy the stocks that you want to own.
• Don’t overpay.
• Don’t put all your eggs in one basket. Diversify across different company types,
sizes, industries, yields, and growth rates.
• Collect and accumulate the assets that you want. Build your portfolio over time.
• Don’t churn it too much. Dividend growth investing is not about flipping assets for
short-term profits. It is based on building a money machine over a long period of
time.
• Manage your portfolio intelligently. This is mostly a collection strategy, but your
business plan should spell out the circumstances under which you will sell or trim a
holding.
 45

• Collect your dividends. If you are accumulating, reinvest them. If you are retired,
spend them.

How Your Portfolio’s Yield Grows

Over time, the cashflow from your dividend growth portfolio should grow. There may be
interruptions and setbacks along the way, but the overall direction of the amount of cash
that the portfolio generates should be upward.

Here is the historical record of my DGP, showing the dividends (in dollars) it has generated
each year.

Currently, the estimate for the next 12 months’ dividends for this portfolio is $3848. When I
started the DGP in 2008, I spent $46,783 to buy the original stocks. I’ve never added any
more outside money.

Using the formula for yield on cost:

Yield on Cost = Next 12 Months’ Dividends / Original Price

Yield on Cost = $3848 / $46,783 = 8.2%

So after almost 10 years of running my little investment business, the portfolio is now
generating 8.2% of my original investment, in cash, per year. And as you see from the
chart above, that amount has grown each year.
 46

How has that happened? It is the result of 3 phenomena that dividend growth investors
experience:

• Companies raise their dividends.

• The investor reinvests those dividends to buy more shares, which create more
dividends, etc., in a virtuous circle of compounded growth.
• The investor makes occasional changes to the portfolio to correct mistakes, take
advantage of compelling opportunities, and the like.

By the way, if I convert the dollars in the above chart into yields, the chart looks the same.
Only the labels change. That is because yield is a percentage, and if we hold the
denominator constant at the amount of the initial investment ($46,783), the resulting
annual percentage yields march upward at exactly the same pace as the dollar amounts
themselves.

In a year or two, if everything continues on the path illustrated by the green bars, my
portfolio will generate 10% cash dividends each year, based on the original amount
invested. My original inspiration will become reality.

Let’s Clarify Current Yield and Yield on Cost

I don’t want the material above to confuse anybody. I am not saying that after a long period
of investment, your portfolio will have a high current yield. Current yield depends on what
the portfolio is currently worth, not what it originally cost.

What I am saying is that after a long period of investment, your portfolio can achieve a high
yield based on what you paid for it.
 47

When you first start a portfolio, its initial yield is the same as its yield on cost. Say
your portfolio has just one stock, and that its current yield at the time that you buy it is
4.0%. Its yield on cost is also 4.0%, because neither the expected dividends over the next
12 months nor the value of the portfolio have changed yet.

Over time, both change. If the stock increases its dividends each year, the expected
dividend payouts go up. And of course, every day that the market is open the stock’s price
changes. So, the portfolio’s yield on cost soon departs from its initial yield.

The initial yield when you first purchase a stock is known at the time you buy it. If
the company does not cut its dividend, your yield on cost will never drop below that initial
amount. Your initial yield on cost is “locked in.”

The company’s future dividend growth rate cannot be known at the time you buy
it. The future is unknowable. You can look at the recent history of a dividend growth stock
and see that its 5-year dividend growth rate has been 10% per year for the past 5 years.

However, if you project that growth rate into the future, you are speculating. No one knows
what the future holds. Remember that in projecting dividends earlier, we did so only for 1
year forward, and we did not presume that any growth would take place in the stock’s
dividend payout.

So, beware of projecting high dividend growth rates into the future. Particularly if a
company has a 5-year dividend growth rate that is quite high (say > 10%), understand that
it is unrealistic to think that the company will be able to increase its dividend that fast every
year. You might want to use a more typical rate, like 6% or 7%, if you feel the need to
make projections several years ahead.

On the plus side, if you are reinvesting dividends, the number of years to hit a
higher yield on cost will be reduced. The additional shares purchased with reinvested
dividends will themselves pay dividends. Thus, you will see a faster increase in the dividend
stream –and in the portfolio’s yield on cost – than if you did not reinvest the dividends.

As of this writing, my portfolio’s current yield is 3.7%. The portfolio’s yield on cost is 8.2%,
which is a full 121% more than the current yield.
 48

Why is the yield on cost so much more than the current yield? The reason is that the yield
on cost is computed on the original investment that I made in the portfolio 10 years ago.

Since then, the yield on cost has ballooned to its current rate for the 3 reasons described
earlier: dividend increases, dividend reinvestments, and occasional portfolio changes.

Key Takeaways from this Lesson

(1) Dividend growth investing is a lot like being a landlord: You own properties not for what
you could sell them for, but for the income that they generate.

(2) Dividend growth investors can maintain a disinterest in day-to-day price changes,
because they are not planning to sell their properties anyway.

(3) Dividend growth investors can create portfolios that generate rising income practically
every year.

(4) Yield on cost can be inspirational. When you are starting out, it helps you imagine a time
in the future when your portfolio may generate annual dividends that are a large percentage
of the amount you invested.

(5) Don’t project high dividend growth rates into the future. Very few companies have ever
maintained high dividend growth rates for more than a few years in a row.

(6) Annual dividends rise for 3 reasons: Companies raise their dividends; you reinvest the
dividends to buy more shares that generate more dividends; and you make occasional
portfolios changes that improve your portfolio’s performance.

Dave Van Knapp

 49

DGI Lesson 9: My Top 14 Reasons Why Dividend Growth Investing Makes Sense

So far, this series of lessons about dividend growth investing has focused on specifics:

• What is a dividend?
• The power of dividend growth and reinvesting dividends
• Compounding
• Yield and yield on cost

For this lesson, we’re going to take a step back and consider broader questions:

• What are the advantages of being a dividend growth investor?

• What is there to like about dividend growth investing?
• Why should anyone do it at all?

My real-money Dividend Growth Portfolio that is updated every month here on Daily Trade
Alert is comprised entirely of dividend growth stocks. In my personal life, both my rollover
IRA and my wife’s and my taxable investment portfolio also contain only dividend growth
stocks and ETFs.

Why do we invest that way? Why are we essentially all-in with dividend growth
investing?

Here are my top 14 reasons why I’m a dividend growth investor.

1. Dividends bypass the market

Market prices and dividends have utterly different mechanisms for converting corporate
earnings into cash in your pocket.

“Mr. Market” translates corporate results into market prices. Here is Warren
Buffet’s timeless description of Mr. Market.

[Y]ou should imagine market quotations as coming from a remarkably accommodating

fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market
appears daily and names a price at which he will either buy your interest or sell you his.
 50

Even though the business that the two of you own may have economic characteristics that
are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has
incurable emotional problems. At times he feels euphoric and he can see only the favorable
factors affecting the business. When in that mood, he names a very high buy-sell price
because he fears that you will snap up his interest and rob him of imminent gains. At other
times he is depressed and can see nothing but trouble ahead for both the business and the
world. On these occasions he will name a very low price, since he is terrified that you will
unload your interest on him.

Mr. Market…doesn’t mind being ignored. If his quotation is uninteresting to you today, he
will be back with a new one tomorrow. Transactions are strictly at your option.

In short, Mr. Market sometimes goes haywire and takes stock prices through irrational
swings that have nothing to do with long-term business performance.

On the other hand, companies themselves determine dividends. Dividends are declared
and paid by corporations, not the market.

Corporate dividend policies rarely go haywire. That means that it is possible to build a
portfolio of companies that will have reliable, growing income – no matter what the market
is doing.

I like that. It suits my goals and my temperament.

2. Dividend investing can relieve obsession over the market

Many dividend growth investors find that the strategy lifts a great worry off their shoulders.

In DGI, you profit from being the owner of a business that sends you some of its earnings
each quarter. You don’t regard stock shares as betting slips or lottery tickets.

Rather, shares are income-producing assets. You own pieces of your businesses,
sharing in their success over the long term.

You don’t care so much about the daily prices offered by Mr. Market for your shares, any
more than a gas-station owner thinks daily about what he could sell his business for. That
helps dividend growth investors take the market’s ups and downs in stride.
 51

In DGI, you do not have to win trading battles against other investors to be successful.

3. Dividends are real cash

Every dividend is a positive return to shareholders. It’s cash in your pocket. Dividends
are completely transparent and immune from accounting manipulation or trickery.

4. Dividend investing provides ongoing feedback about your investment

Because most dividends are paid quarterly and determined by corporate management, they
provide feedback about your investments directly from the companies themselves.

If a company pays and increases its regular dividend according to an established schedule,
that in itself is important information about how that company is performing as a business.
You own a piece of that performance.

A dividend increase can usually be interpreted as a positive sign that management

has confidence in the company’s prospects. As the saying goes, the safest dividend is
one that’s just been raised.

A company with a well-designed dividend policy will look ahead a few years when
considering each year’s increase to see what it can afford, because it knows that an increase
is destined to become permanent under its dividend policy. The company won’t knowingly
bankrupt itself by paying imprudent dividends, so an increase is usually a good sign.

5. The best dividend growth companies are outstanding businesses

Dividend growth companies typically have:

• Proven, time-tested business models

• Steady growth over long periods of time
• Sustainable competitive advantages
• Solid balance sheets
• The strength to survive recessions
• Good profit margins
• Reliable cash generation
• Low debt
 52

It requires an outstanding business to increase dividends for many years in a

row. Weak businesses simply cannot do it.

6. Dividends increase even when stock prices decline

Even when a dividend stock’s price is falling, it still has a positive return component via the
dividends.

For example, below is a 15-year chart of Johnson & Johnson (JNJ). Notice how the
dividend (blue line) has continued steadily upward, with annual increases, while the stock’s
price (orange line) has gone up, down, and sideways.

From 2005-2012, JNJ “traded sideways.” That was Mr. Market talking, and it did not reflect
the success that JNJ was having as a company.

Many price-obsessed investors considered JNJ to be “dead money” for nearly a

decade. Dividend growth investors never saw JNJ as dead money. We saw the blue
line of steadily increasing dividends.

Here’s another chart, from FASTGraphs, that depicts the same timeframe. JNJ’s price is the
black line, while its dividends are the greenish line.
 53

The reason I chose this 2nd display is to show you JNJ’s annual earnings growth. It’s in the
data row near the bottom set off by blue dots at each end.

JNJ’s earnings went up every year during its “dead money” period. In 2005, for example,
JNJ’s earnings per share (EPS) rose 13% while its price fell. If you look across that row of
data, JNJ’s earnings rose every year.

Yet its stock price, determined by Mr. Market, was essentially flat from 2005-2012, before
finally taking off in 2013.

Both dividend growth and price growth come from a common source: profit growth. Mr.
Market, being irrational, often misinterprets a company’s operating results, causing its price
not to reflect its profits.

But the company’s management and board – who make all decisions about dividends – can
execute a managed dividend policy. They deliberately smooth out the flow of dividends
compared to the variations in the company’s earnings. That’s what happened in JNJ’s case.

If a company is committed to annual dividend increases, they can make those

happen, even if they hit a bad patch for a year or two on the earnings front.

That’s why JNJ’s dividend growth more resembles its earnings growth than its market price
does. JNJ’s management, knowing that they had a rock-solid company with a positive long-
term outlook, increased the dividend every year under their managed dividend policy.
 54

7. You do not have to sell the stock to get financially rewarded

If a stock pays no dividends, its total return comes solely from price changes. You
can only realize your profit if you sell the stock. There is no other financial benefit from
ownership.

A problem with confining your returns to stock prices is that they are determined by Mr.
Market, and we know that he’s sometimes irrational. What if you need money and must sell
some shares at a time when Mr. Market is depressive? That’s a real concern for investors.

In contrast, a carefully selected portfolio of dividend growth stocks is pretty reliable about
its dividend returns.

Critics of dividend investing sometimes state that “a dollar is a dollar,” so what difference
does it make if you get a dollar from dividends or a dollar from selling a few shares?

The difference is obvious. In order to get your hands on a dollar of capital value, you
must sell shares. Your wealth is embedded in those shares.

Once sold, the shares are gone. They can no longer benefit you, because you no longer own
them.

So the huge difference between getting a dollar from dividends or from capital is that you
still own the shares in the first instance and don’t own them in the second.

8. Dividend payouts rise over time

Hundreds of dividend companies have a long history of increasing their dividends regularly.
Companies such as McDonald’s (MCD), Coca-Cola (KO), and Johnson & Johnson
(JNJ) have increased their dividends every year for decades. It is logical to expect that they
will continue to do so if they possibly can. (Disclosure: I own all 3 stocks.)

Here is a 10-year chart of those 3 companies’ dividends. To a dividend growth investor, this
is a thing of beauty.
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Reliable, growing income is the most powerful aspect of dividend growth stocks.

• It is why dividend growth investors are often content with stagnant stock prices.
• It is why retirees – seeking income that keeps up with inflation – become attracted
to dividend growth stocks.
• It is why many income investors consider dividend growth stocks to be more
attractive than bonds, whose yields are fixed and whose payouts never go up.

9. Dividend stocks tend to be less volatile

A variety of studies have shown that stocks with a history of increasing their dividend each
year have less average volatility than non-dividend-paying stocks.

For instance, over the 10-year period ending in 2015, the S&P 500 Dividend Aristocrats —
which are stocks within the S&P 500 that have increased their dividends each year for the
past 25 years — produced 7% less volatility. (Source)

If you haven’t perfected the ideal attitude of ignoring Mr. Market’s daily price quotes, the
smoother price ride generally makes dividend growth stocks easier to hold during times of
market volatility.

Dividends have gentle trends that are fairly predictable. For that reason, dividend
growth stocks tend to attract owners who are less likely to panic-sell shares when the
stock’s price drops. That cadre of long-term owners helps to dampen the price volatility of
such stocks.
 56

Indeed, such owners may take advantage of bargain prices to buy more, helping to
counteract the prevailing trend in the market.

10. Historically, dividend growth stocks have outperformed the market in total
returns

Numerous studies have shown that dividend growth stocks have outperformed the
broad market in total returns. The studies differ in their methodology and timeframes,
but the similarity in their conclusions is overwhelming.

One such study was published by Robert Arnott and Clifford S. Asness, “Surprise! Higher
Dividends = Higher Earnings Growth, (December, 2001). This study suggested that in
companies that paid out a low ratio of their earnings as dividends, one often saw inefficient
empire building, the funding of second-rate projects, and poor internal investments. These
money-wasting companies delivered poor subsequent growth.

In contrast, in companies with a higher percentage of earnings paid out as dividends, the
authors found more carefully chosen projects with better returns.

A strong dividend program suggests that management is probably making smart

decisions with the cash remaining after dividends are paid. Some companies
squander their retained earnings. In the best dividend growth companies, management is
disciplined about projects, acquisitions, and costs. The result is a more efficient and focused
business.

The Ned Davis Research Group has had an ongoing study of dividend stocks since 1972.
Their results show that dividend growth stocks have dramatically outperformed other
categories of stocks in the S&P 500 over long time periods.
 57

(Source)

11. You can reinvest dividends to accelerate the compounding effect

Shareholders can do three things with dividends: Reinvest them, keep them, or spend
them.

As we explored in Lesson 5, if you reinvest the dividends (either in the same stock or
elsewhere), the reinvestment brings into play a second layer of compounding. (The first
layer is the rising dividends themselves.)

Dividend reinvestment builds wealth at an accelerating pace. Your share base grows
faster and faster because of the reinvestments. As you purchase more shares with the
dividends, the number of shares you own goes up. Those shares then generate additional
dividends, which can then be reinvested, creating a virtuous circle of
dividends → reinvestment → more shares → more dividends, etc.
 58

12. Rising dividends protect against inflation

One of the risks that we all face is inflation. Inflation erodes the purchasing power of money
over time.

My own studies have shown that the income from dividend growth stocks generally grows
faster than inflation. Speaking personally, sometimes I think that the only benchmark I care
about as an investor is inflation. I don’t care so much whether I beat the market so
long as I beat inflation.

13. You do not need any more wealth to generate 4% income rather than 4% from
sales

One of the rules of thumb in retirement planning is that a safe withdrawal rate in retirement
is 4% of your assets in Year 1, incremented each year afterwards for inflation. Back-tests
show that in most cases, you’ll never run out of money, even in a really long retirement.

It is also commonly stated that to live on income alone in retirement requires a lot of
money, more than if you sell off assets to create retirement “income.”

That second part is a myth. It requires no more money to acquire a portfolio of

stocks that pays a dividend stream of 4% than to acquire a portfolio of stocks that
must be sold piecemeal to generate the exact same 4%.

The point that 4% of organic income from dividends equals 4% of synthetic “income” from
selling assets seems obvious, yet it is missed by many. It’s the same number! And you
don’t have to sell shares to get it.

Even if your portfolio does not yield 4%, and you do sell some assets to fund your
retirement, every dollar that you get from dividends reduces by a dollar how much you need
to sell. The natural, organic income from dividends increases the safety and longevity of
your portfolio.

14. Receiving dividend increases is like investing more, except you don’t have to
invest more

An investor can look at buying an income-producing asset as “buying income,” as if income

were a product that you got off the shelf at a store.
 59

Here’s what I mean. Say you want $1000 per year in income. If you find a bond yielding
3%, that income will cost $33,333. The equation is income = principal x yield. Solving for
principal, we need to invest $1000 / 3% = $33,333 to buy that income from that bond.

Because bond interest stays flat for the term of the bond, if you want more income, you
have to invest more money.

With dividend growth stocks, you don’t have to spend more money to get more
income.

The scenario might start off the same. If you have a stock yielding 3%, it will cost $33,333
to buy $1000 of income from that stock, just like the bond.

But that is just in the first year. When your stock increases its dividend next year, your
income goes up. It is as if you invested more in the stock, but you did not have to.

Let’s use Johnson & Johnson as an example again. I first bought JNJ in August 2010. Here is
my dividend experience with the stock since then.

As you can see, I have received 8 annual increases from JNJ. They raise their dividend in
April each year. During the nearly 8 years I have owned JNJ, my income from them has
increased 67%.

In the bond example, assuming you could find a bond on the same terms as the original
one, in order to get 67% more income, you would have to invest an additional 67% on top
of your original investment.
 60

But with JNJ, to get that 67% increase in income, I have not had to invest anything
more. I got the 67% increase simply by owning JNJ. The company made the decisions to
increase the dividend each year. As we have seen, the market had nothing to do with those
decisions. And as an owner, I didn’t have anything to do with them either. I simply had to
own the stock.

Bonds don’t do that. Each bond payment is the same as the last one. That’s one of the
big differences between loaning your money to a company and owning a piece of
the company. As a part-owner, you get to participate in the company’s ongoing success
without buying additional pieces of the company

So these reasons are why my wife and I are all-in on dividend growth investing.

Key Takeaways from this Lesson

1. Dividends bypass the market. Companies with managed dividend policies smooth
and increase their dividends to reflect long-term earnings performance. They make
these decisions independently from what the stock market is doing to their share
prices.
2. Dividend growth investing can help relieve stress over market drops, because
focusing on your rising dividend stream diverts focus away from price fluctuations. In
addition, many dividend growth companies are less volatile than the market,
because their price changes are dampened by the dividends, and they often have
more committed owners.
3. The best dividend growth companies are outstanding businesses. Mediocre firms
simply cannot maintain long streaks of annual increasing dividends.
4. You don’t have to sell stock shares to get the dividends. The companies send you
dividends in cash, and you still own all your shares of stock to provide future returns.
5. Rising dividends help protect against inflation.
6. With dividend growers, you don’t have to invest more money to get more income
each year.

Dave Van Knapp

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Dividend Growth Investing Lesson 10: Two Ways to Reinvest Your Dividends to
Enhance Your Returns

Note from Daily Trade Alert and Dave Van Knapp:

This 2018 revision of DGI Lesson 10 condenses the original two-part Lesson into a single
lesson that discusses both ways of reinvesting dividends: Selectively and automatically. The
segment on automatic reinvestment was originally written by the late David Fish, who
created the wildly popular Dividend Champions, Contenders and Challengers (CCC) list in
2008 and maintained it until his death in 2018. Much of David’s original discussion of drip
investing remains in this revised lesson. The dividend investing community owes a great
debt of gratitude for David Fish’s expertise, his willingness to share it, and his creation of
the CCC.

In DGI Lesson 5, we discussed the power of reinvesting dividends. We saw that:

1. Reinvesting dividends adds a layer of compounding to your dividend stream. Reinvested

dividends buy new shares, which produce their own dividends, in repeating cycles of growth
and reinvestment that cause your ownership stakes to rise.
2. The compounding from reinvestment accelerates the growth of your income stream
beyond the growth that comes from the companies’ annual dividend increases alone.
3. Compounding from reinvesting dividends causes your dividend stream to rise
geometrically. The gap between reinvesting dividends and not reinvesting them widens as
more years pass.

In this lesson, let’s come down from the mountaintop and talk tactically about the two ways
that you can reinvest your dividends. You can:

• Collect dividends in cash and then selectively target reinvestments. I do that in

my Dividend Growth Portfolio.

• Have your brokerage automatically reinvest each dividend as soon as it’s available. Each
dividend goes to buy more shares of the company that paid it. That’s what Mike Nadel does
in DTA’s Income Builder Portfolio. My wife and I also do it with some positions in our private
investments.
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Method 1: Selective Reinvestment

I should note at the outset that selective reinvestment is probably the less-used way to
reinvest dividends. The method used by most dividend growth investors is automatic
reinvestment, which will be discussed later in the article.

To illustrate selective reinvestment, here is how I do it in my Dividend Growth Portfolio

(DGP).

1. I allow dividends to accumulate in my brokerage account to a certain amount that I have

predetermined. Currently that amount is $1000, which is about 1% of the DGP’s size.
2. When the $1000 threshold is reached, I go shopping for more shares. I might look for a
new stock, or I might add to an existing position.
3. I put as much thought into what to buy with the accumulated dividends as I would put
into buying shares with new outside money coming into the portfolio.

There is nothing magic about $1000. It is just a nice round figure. Since my DGP has a
current yield of just under 4%, that means that it currently delivers about $3900 per year in
dividends. Thus I can go shopping (with $1000) about 4 times per year.

For an example of how it works, let’s look at my most recent reinvestment: I bought 19
shares of Altria (MO) for $1053 in May, 2018.

The main reasons I selected MO were these:

1. It allowed me to start a new portfolio position in an iconic dividend growth stock without
adding new money to the portfolio. All the dividends used to buy MO came from other
companies.

2. MO is a high-yield stock (5.1% when I bought it) that immediately added significantly to
the DGP’s income stream.

3. For the first time in years, MO was decently valued. I didn’t have to over-pay for it.
 63

I purchased MO by entering a simple market order, using the dividend cash already in the
account to pay for it.

Method 2: Automatic Reinvestment

This is the more common way to reinvest dividends. You set it up with your broker to
reinvest dividends automatically, as soon as they are credited to your account, into the
same stock that issued them.

Automatic reinvestment is usually called “dripping.” A little background helps explain that
term. The acronym DRIP stands for Dividend Reinvestment Plan.

There are two basic types of DRIP. If you look back 25 years or more, DRIP primarily
referred to company-sponsored Dividend Reinvestment (and Stock Purchase) Plans.

These were arrangements set up directly between companies and investors.

Under these DRIP plans, an investor had shares registered in his or her own name, rather
than in “street name,” which describes stock ownership in a brokerage account.

One benefit of the original DRIPs was that individuals could own stock in various companies
without needing to open a brokerage account.

What’s more, company-sponsored plans allowed participants to make additional (optional)

cash purchases, a benefit that exists to this day.
 64

So, for example, a small investor could invest (via check and later, electronically) $10, $25,
or $50 in dividend growth companies like 3M Company (MMM) or Johnson & Johnson (JNJ).

Beginning in the mid-1990s, the major brokerages launched programs to rein in as much of
those assets as possible. The primary pitch was that investors could reinvest their dividends
– usually for free – in their brokerage accounts, so dealing with all that paperwork was
unnecessary.

As time went on, the brokerages’ drip plans gained increasing acceptance. Meanwhile, some
companies began adding fees to their DRIP plans. Naturally, these added costs led to a
decline in the popularity of company-sponsored DRIPs, to the point where many people are
unaware of their existence.

Nowadays, most brokerages make it as easy as checking a box to initiate a free dividend
reinvestment plan. I have accounts at E-Trade and Schwab, and with each it’s just a matter
of checking the right box.

At E-Trade, they state that when a stock you own and have enrolled in a DRIP pays a
dividend, those funds are automatically invested in additional shares of that company’s
stock instead of being deposited into your account as cash. They explain how the purchase
date and share pricing are determined.

This display, from my Dividend Growth Portfolio account, illustrates how easy it is to check a
box and enroll your shares in their DRIP program:
 65

I could check any box, or all of them, and those stocks would immediately be enrolled in E-
Trade’s DRIP program.

At Schwab, where my IRA resides, they ask you one security at a time:

Both brokerages allow you to select dividend reinvestment at the time you buy a security,
as well as later after you already own it. You can switch back and forth whenever you want.
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Comparing the Two Methods of Reinvesting Dividends

There is no “right way” to reinvest dividends. Selective reinvestment and automatic

reinvestment are two ways to skin the same cat: You want your reinvested dividends, over
time, to accelerate the building of:

• your asset base;

• your wealth;
• your dividend streams.

Whether you choose selective reinvestment or automatic reinvestment of

dividends, the result is that your portfolio consistently increases the number of
shares of companies that you own.

Let’s compare the two methods:

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Many dividend growth investors use both methods within a single account. They
drip some stocks or ETFs while just collecting the cash from others. Some turn
drips on or off as the valuations of individual stocks change.

Either way, reinvesting dividends causes share counts to rise, and since dividends are paid
per share, it causes your dividend stream to rise too.

Key Takeaways from this Lesson

1. There are two ways to reinvest dividends: Selectively and automatically.

2. In selective reinvestment, you collect dividends in cash until a certain “trigger” amount

(of your choice) has been accumulated. Then you select a stock to buy and enter a purchase

order for it.

3. In automatic reinvestment – also known as “dripping” – you check a box that instructs

your brokerage to automatically reinvest dividends in the stocks that paid them.

4. You can switch back and forth between the methods whenever you want.

5. Within a single account, you can employ both methods at once: Some stocks can have

the drip turned on, while others can have it turned off.

6. No matter which method you use, you will get the universal benefit

of compounding. Compounding means to make money on money already earned.

The “money already earned” is the dividend stream. You compound it by

reinvesting the dividends to purchase more shares and get more dividends. Either

method accomplishes that.

— Dave Van Knapp

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DGI Lesson 11: Valuation

When evaluating stocks, there is a difference between the value of a company and its price.
In this lesson we want to understand that difference, and then demonstrate methods by
which you can estimate a stock’s value.

Once you know a stock’s value, you can compare that value to its actual market price. Then
you can decide for yourself whether the stock is overpriced, underpriced, or selling for a fair
price.

What Is Valuation?

Valuation is the process of determining the current worth of a company’s stock.

Valuation is an assessment or appraisal of what the stock is worth as an investment.

If you have ever had a home appraised, stock valuation is similar.

Just as a home appraisal would help you understand whether a seller’s asking price is fair or
too high, stock valuation helps you understand if a stock’s price is fair, too high, or a
bargain.

The idea behind valuation is that each stock has an intrinsic value, meaning a fair,
true, or inherent value.

You cannot measure intrinsic value with a ruler or gauge. It is not a physical quality. Rather
it is an assessment based on facts and logic.

Warren Buffett has said, “[I]ntrinsic value is an estimate rather than a precise figure….Two
people looking at the same set of facts…will almost inevitably come up with at least slightly
different intrinsic value figures.”

Value vs. Price

In contrast to the range of fair values that can exist for a stock (depending on who
appraised it), its market price is an exact number that you can look up at any moment.
Price is determined minute-to-minute by the stock market.
 69

As I write this, here is Johnson and Johnson’s (JNJ) exact price as shown on
Morningstar:

As you can see, on that day JNJ’s price was up $0.22 about 40 minutes after the market
opened. Every quotation service, like Morningstar, tracks the price continuously, because
stock prices change with every trade in the market.

In contrast to JNJ’s constantly changing price, do you believe that JNJ’s intrinsic
valueas a company changes every minute? I don’t, and neither should you. Its true
value changes more slowly, as it conducts its business, carries out strategic programs,
introduces new products, and so on.

We value a stock so that we can understand how its price relates to its intrinsic value: Is the
actual price higher, lower, or about the same as its intrinsic value?

If all you know about a stock is its price, you do not know whether the stock is
fairly valued. Here are two common ways that the concepts are mixed up.

• The fact that a stock has pulled back from a recent high does not necessarily
mean that it is well valued. The price may have fallen for an important reason.
Maybe the company issued a bleak earnings outlook or suffered a disaster like an oil
spill. Or maybe the stock was way overvalued to begin with, and it remains
overvalued even after losing a few bucks off its price.
• Similarly, a sudden or prolonged price increase does not necessarily mean
that a stock has become overvalued. There may be good reasons for a rise in
 70

price, and the stock may still be a relative bargain even though it is selling for more
than it was a few months ago.

Valuation allows you to interpret the actual price in light of all relevant factors when you are
considering whether to buy, hold, or sell a stock. It takes you beyond simply comparing a
stock’s current price to a recent price or to its 52-week high or low. Those don’t really tell
you about valuation.

Why Consider Valuation?

Valuation gives you a reference point to answer whether a stock is:

• Fairly priced, or selling at about its intrinsic value;

• Underpriced, or selling at a bargain; or
• Overpriced, selling for more than it is worth.

We want to buy stocks in the first two categories and avoid stocks that are overvalued.
There are two main reasons.

(1) Better yield

As we saw in DGI Lesson 6: Yield and Yield on Cost, a stock’s dividend yield mathematically
moves in the opposite direction of its price. Yield goes up when price goes down and vice-
versa. That is plain from the definition of yield:

Yield = 12 Months’ Dividends / Price

So buying at a better valuation (lower price) means that you get a higher yield
right out of the starting gate. If you lower the value of “Price” in the equation above, the
value of “Yield” goes up.

You can see that inverse relationship on any graph that plots yield and price on top of each
other, such as this one:
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JNJ’s price and yield are practically mirror images of one another. When price goes up, yield
comes down, and vice-versa.

In the short 6-month timespan covered by the chart, JNJ’s yield varied by about 0.6%.
That’s a significant difference when compounded over many years of ownership. If you’re
investing for cash flow, you would much rather buy JNJ when it’s yielding 2.9% than 2.3%.

Assuming that your stock never cuts its dividend, your initial yield is the
lowest yield on cost that you will ever experience for that purchase. It’s locked in. A
higher initial yield will benefit your income stream for as long as you own the stock.

(2) Lower price risk

Most investors want their stocks’ prices to rise over the long term. If you can purchase a
stock at less than its intrinsic value, you are tilting the odds in your favor that
future price movements will be upwards.

The larger the gap between the price you pay and the stock’s intrinsic value, the larger is
your margin of safety that future price trends are likely to be positive.

Nobody can predict the future, but part of being a good investor is putting the odds in your
favor whenever you can. Good valuation will not shield you from short-term price declines.
Mr. Market moves prices up and down all the time, and you cannot control that.
 72

Nevertheless, knowing that you bought at a good valuation should provide some comfort
from the stress of falling prices. You can think of such price drops as short-term aberrations
rather than fearsome “loss of money.” You don’t lose any money unless you sell at the
reduced price.

Valuation Is Not the Same as Company Quality

Valuation has little to do with company quality. Both lousy companies and excellent ones
can be undervalued or overvalued.

Let’s consider overvaluation first. An excellent company can have its price bid too high.
Investors may be exuberantly chasing a “hot” company, or perhaps they emotionally
overpay when chasing yield. The whole market may be rising as a result of irrational
demand for stocks. Those kinds of things happen in markets.

So please remember: No matter how excellent a company is, its price can be too
high.When that happens, it probably is not a good time to buy shares in that company.

On the other hand, an excellent company can have its price fall below its true worth.
Perhaps the entire market is in a slump, taking all stocks down with it. Or a company may
suffer a temporary setback that will make no difference in the long term, but which causes
traders to run from the company, causing its price to fall temporarily.

For the long-term investor, price drops like that can present buying opportunities for
excellent companies.

• Over the long term, the odds are that the highest quality companies will recover
faster than the market as a whole. The phenomenon is called flight to quality. If you
purchased a high-quality company at a good price, you will benefit from this.
• As we have already seen, a price decline causes a company’s yield to increase. If you
can buy a dividend growth company at a better price, you are rewarded with a
higher yield. Your dollars buy more income from that company than they would if
you paid a higher price.
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Four Steps to Valuing a Company

I use a four-step approach to valuing companies. None of them takes very long. I can value
a company in 10 minutes, and with a little practice, you can too.

(1) FASTGraphs Method 1

In this first step, I compare the stock’s valuation to the historical average
valuation of the market as a whole.

I use FASTGraphs in this step, specifically the “Forecasting Calculators” that are a short
scroll down from the main graph at the top of the page. FASTGraphs plots Price-to-Earnings
(P/E) ratios on the same chart as price itself. The comparison between the two is
enormously helpful in visualizing valuation.

FASTGraphs allows you to turn some portions of the display on or off. Here is an example of
the graph as it appears with all features turned on:

I used to use this display, because the “channels” created by the blue and orange dashed
lines were handy indicators of valuation. In this display, Starbuck’s price (the black line) is
in the 5th channel above the fair-value reference line (heavy orange line). That suggests
that Starbucks is extremely overvalued.
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Nowadays, I usually turn off all the display features except for EPS and price. This
eliminates everything but the heavy orange and black lines. I like the cleaner look, and I
still have all the information needed to assess the stock’s valuation.

I use the stock’s actual P/E ratio (circled in blue) to calculate the degree of overvaluation or
undervaluation.

Here’s how to do it. The orange line is drawn using a P/E ratio of 15. That’s the historical
long-term P/E of the stock market itself, which is used as a “fair value” reference line.

The black line shows the stock’s actual price.

In this example, Starbuck’s actual P/E at its current price is 22.0 (circled in blue). We use
that to calculate a simple valuation ratio:
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Valuation ratio = Current P/E / Orange-line P/E

Valuation ratio = 22.0 / 15 = 1.47

The valuation ratio tells us that Starbucks is overvalued, because its actual P/E is way
higher than the reference value of 15. More specifically, it suggests that JNJ is overvalued
by 47%, because 1.47 is 47% higher than 1.

We can use the valuation ratio to calculate a fair price for Starbucks.

Fair price = Actual price / Valuation ratio

Fair price = $52 / 1.47 = $35

Starbucks is trading for $17 more than its fair price. It’s far overvalued as estimated by this
first step.

Note that I round off dollar figures to the nearest whole dollar. I do that to reinforce the
idea that valuation is an estimation or assessment process. There’s no use introducing false
precision into it.

When I do valuations, I use the degree of overvaluation or undervaluation to rate the

company on each step. I use 10% “zones” above and below fair price to characterize its
valuation.

As you can see, my “fairly valued” band is wide: +/- 10% of fair value in either direction.
Again, that is a way to avoid presenting a picture with false precision.

In Starbuck’s case, using this first step, the stock is in the red zone, meaning extremely
overvalued.

But wait, there’s more.

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Step 2: FASTGraphs Method 2

In this next step, I compare the stock’s price to its own long-term average P/E
ratio.

This step “normalizes” the valuation estimate: It’s based on the stock’s own long-term
valuation instead of the market’s long-term valuation that was used in Step 1. The idea is
that some stocks “always” seem overvalued, usually because they are expected to have fast
profit growth. Others seem perpetually undervalued, usually because they are perceived as
slow-growing.

To find the stock’s historical P/E ratio, I select the “Normal Multiple” tab at the top of the
Forecasting Calculator.

The graph changes so that the reference line (now drawn in blue) uses the stock’s own
historical P/E ratio rather than the stock market’s historical average of 15 used in Step 1.

The pull-down menu at the lower left normally displays the 5-year “normal” P/E ratio of the
stock. I usually use that 5-year average, although with the menu, you can pull it down and
choose other lengths of time if you like.
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I’ve circled the long-term P/E multiple in blue. It turns out that Starbucks is one of those
companies that the market has been valuing highly: Its 5-year average valuation has been
30.0 rather than the 15 used in the first step.

Using 30.0 to draw the fair-value reference line changes the picture enormously. Now the
stock looks undervalued.

By how much? We compute the valuation ratio exactly the same way as before:

Valuation ratio = Current P/E / Blue-line P/E

Valuation ratio = 22.0 / 30.0 = 0.73

Fair price is also calculated the same way as before:

Fair price = Actual price / Valuation ratio

Fair price = $52 / 0.73 = $71

So in this step, Starbucks calculates out to be extremely undervalued. Its actual price is
27% under its fair-value price.

The two steps so far have painted completely different pictures of Starbucks’ valuation. Let’s
move along and see if we can get to a more consensus point of view.

Step 3: Morningstar Star Rating

Morningstar approaches valuation differently. They use a discounted cash flow (DCF) model
for valuation. Many investors consider DCF to be the best method of assessing stock
valuations.

Warren Buffet has said, “Intrinsic value can be defined simply: It is the discounted value of
the cash that can be taken out of a business during its remaining life.”

The DCF model ignores P/E ratios. Instead, it requires the analyst to model all of the
company’s future profits (year by year out to infinity), then discount the sum of them back
to the present to reflect the time value of money. That gets you to Buffett’s description of
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fair value. (If you want to learn more about DCF, I recommend this readable explanation at
Moneychimp.)

Morningstar presents the results of their calculations in summary form. First they give the
stock a star rating. They use a 5-star system where 1 star = extremely overvalued and 5
stars = extremely undervalued.

As of this writing, Morningstar calculates that Starbucks is undervalued (4 stars).

They also present their fair price:

Morningstar calculates a fair price of $64. That means that they think that the stock is
selling at a 19% discount to fair value.

Step 4: Current Yield vs. Historical Yield

My last step is to compare the stock’s current yield to its historical yield.

This is yet a different approach to valuation. The idea is that over long periods of time, the
market will tend to price a stock so that its yield stays within a typical range for that stock.
The closer you are to the top of this range (i.e., the yield is higher than usual), the more
desirable the stock is at today’s price.

If the yield falls toward the bottom of the historical range (yield lower than usual), it is likely
that the stock is overvalued. History suggests that you will be able to get it at a better yield
if you wait for the market to bring the price back to a more normal valuation for that stock.

Historical yields are available from a variety of sources. One easy way to visualize this
valuation approach is to use Simply Safe Dividend’s historical yield display.
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In this case, Starbuck’s yield (2.8%) is much higher than usual (5-year average is 1.5%),
suggesting under-valuation of the stock.

Again, we use a ratio to compute the degree of undervaluation.

Valuation ratio = 5-Year average yield / Current yield

Valuation ratio = 1.5% / 2.8% = 0.54

When using this method, I cut off the valuation ratio at 0.8 (using nothing below that),
because this is an indirect valuation method, and it can be swayed by things like recent
large dividend increases. So in this case, I would use a valuation ratio of 0.8.

Fair price is computed as in the first two steps.

Fair price = Actual price / Valuation ratio

Fair price = $52 / 0.8 = $65

Averaging the Four Estimates

To finish up, I simply average the 4 valuation methods.

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Thus, I would conclude that Starbuck’s current price is 12% below its fair price. That means
it is undervalued, and if you like other things about the company, now would be a good time
to buy it. It’s selling at a bargain price.

It is unusual to see such a wide variation in fair price estimates as we see in Starbucks’
case, but it is not unusual to get different assessments from different methods. To quote
Buffett again: “As our definition suggests, intrinsic value is an estimate rather than a
precise figure.”

Some investors might steer away from Starbucks because of the wide disparity in
valuation estimates. They might figure that Starbucks simply cannot be valued
with any degree of confidence. (That would not be my conclusion.)

What About Other Valuation Methods?

I selected the four methods that I use based on my experience over the years. I have
developed confidence in them, and I also want to combine different approaches to arrive at
a conclusion.

That said, you may develop other sources and methods. For example, most brokerages give
free access to a variety of independent stock analyses. “Independence” is important in my
book, because I wouldn’t trust valuation estimates from someone who is being paid to push
a particular stock or point of view.
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Such trusted sources might include CFRA (formerly S&P Capital IQ); Thomson Reuters; and
Credit Suisse.

Key Takeaways from this Lesson

1. Valuation is a way to determine whether a stock’s current price is fair, a bargain, or

too high.
2. Valuation is different from price. If all you know is a stock’s price, you don’t know
whether that is a good or bad price.
3. Valuation is also different from company quality. A high-quality company can be
undervalued, and a low-quality company can be overvalued.
4. Different valuation methods yield different results. It is a good idea to use several
valuation methods and average them or compare them so that you understand a
stock’s valuation.
5. If you can buy an excellent company at a bargain price, you benefit in two ways. You
get a higher yield, and you improve the odds that its price will not hurt you over the
long term.
6. Using tools and sources available on the Internet, you can derive valuations from
several methods in just a few minutes.

— Dave Van Knapp

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DGI Lesson 12: Run Your Investing Like a Business

One of the great things about investing is that you are in charge.

In your job, you have a boss, who also has a boss. You have colleagues with expectations.
To get your paycheck, you have to do things that other people want you to do.

But in investing, you are the boss. Your investing, in fact, is your own little
business. The assets that you invest in are like employees, there to work for you.

The goal of your investing business is to make money. The investing legend Benjamin
Graham often referred to this as an “investment operation.” Here’s what he said:

An investment operation is one which, upon thorough analysis, promises safety of principal
and an adequate return. Operations not meeting these requirements are speculative.

A self-directed dividend growth investor should treat his or her “investment operation” like a
business. Give it a name. Have a plan. Create rules, procedures, and even a culture that
give your business its particular character and keep it on track.

Keep emotions at bay. Anticipate changes in your business environment and how you will
react. Constantly learn: You should be better at your business after five years than when
you started.

You are the founder, CEO, and Chief Investment Officer of your business. You want to run it
well. Every well-run business has:

• a primary goal;
• strategies designed to achieve that goal; and
• tactics, programs, and activities to execute the strategies.

I urge you to create a document that sets forth at least the first two of those
elements. Write down your goal and high-level strategies. They form the core of your
business plan.

Throughout this lesson, I am going to use the business plan for my Dividend Growth
Portfolio to illustrate how you can construct your own business plan.
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Your own plan, of course, will be customized to your goals and circumstances. But the
general concepts of having a plan, identifying your goals and strategies, and the like, are
universal ideas that can be applied to any business plan.

Why Are You Investing?

Start your business plan with your goals. Why are you investing?

Here’s the Goals section from my own business plan:

As you can see, the goal statements are simple. KISS: Keep It Simple, Stupid.

But that simplicity masks the thought that went into them. The simple words are the
distillation of much consideration about what I really want to achieve in my own investing.

For example, you will note that I do not say that I want to “maximize” my income stream.

The reason is that, upon consideration, I realized that trying always to maximize an income
stream might mean taking risks that I am not comfortable with.

High-yield investments (say those yielding 9%+) are often risky ventures.

They have to be watched like a hawk. That’s not the way I want to live.

But different investors might have different views of what they consider the best dividend
goal.

For example, you may want to have a few really high yielding stocks, and be willing to
tolerate occasional dividend cuts, so long as the portfolio’s overall long-term trend is up.
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You might reason that you can use the high income from riskier stocks to fund the purchase
of more dependable stocks that will become your core portfolio down the road.

I urge you to give your goal(s) considerable thought. But don’t stress out over them.
You don’t have to get everything right the first time. This is your business plan. You can
change it whenever you want to.

You can adjust your goals as you gain experience, enter different phases of life, and
encounter life changes such as marriage, divorce, births, deaths, retirement, and so on.
Your primary goal undoubtedly depends on your age, financial situation, stage in life,
tolerance for risk, and a host of other factors that are important to you.

As those factors change, feel free to change your goal. Think it out and write it down.

You can have hybrid goals. “Growth and income” is a common approach. Many investors
want some of each. As you can see in my own case, I do have a secondary goal of achieving
total returns that are competitive with the broad market.

The main reason to give your goals thought and be comfortable with them is that they form
the foundation for your investment strategies, tactics, and day-to-day decisions. Reaching
your goals is why you are investing. So knowing your goals will determine how you will
invest.

One last point about your goals: Stating them clearly can help you guard against mission
creep – a gradual shift in objectives and practices that ends up taking you into unplanned
territory.

Mission creep can cause an investing operation to spiral out of control. Adhering to your
plan helps you put the brakes on when you are considering a “hot tip” or other decision that
really does not fit with your long-term goals.

What Are Your Strategies?

After goals come strategies.

Here is a diagram I devised to show how goals, strategies, and tactics relate to each other.
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The umbrella at the top is your overarching vision. It could be something like, “I want to
retire at 55.”

Beneath that umbrella aspiration, your goals, strategies, and activities depict how you will
get there.

Strategies are the general plans that you will use to achieve your goals. Your
strategies sum up the business model of your investment operation. They state how you will
invest so as to accomplish your goals.

You want your strategies to provide a logical roadmap for how you will achieve your goals.
Strategies are pretty general in nature. For example, they don’t tell you what stock to buy.
Rather they tell you how to select what stocks to buy.

Strategies don’t change much, unless your goal(s) or circumstances change dramatically.
But as you gain experience, you may well add, drop, or refine a strategy as you learn more
about investing and absorb new ideas about it.
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Your strategies should always be designed to achieve your goal(s). To illustrate, here are
the strategic headings from my own investment plan, along with summaries of what is
under each heading.

Selecting Stocks

In this section, I describe the methods that I use to select stocks. I have links to articles or
examples that show how I do it. I evaluate companies not only for their suitability to my
goals, but also for good valuation.

Reinvesting Dividends

Since I am building an income stream for future use in retirement, the dividend revenue
from my enterprise is invested right back into the enterprise. In this section, I describe how
I reinvest dividends.

Because I reinvest dividends, I don’t hold cash in efforts to time the market, because cash
does not generate dividends, and therefore it does not advance my goals.

Portfolio Characteristics

In this section, I describe what I see as the ideal portfolio for my goals:

• It has 20-30 stocks.

• It is well-rounded, meaning that it is diversified across economic sectors, industries,
yields, and dividend growth rates.
• I expect the portfolio’s income to go up 6-8% per year on average.
• The maximum size of any one position is 10% of the portfolio.
• I don’t rebalance the portfolio on any set schedule.

Selling Guidelines

Here I lay out the reasons why I might sell a stock. Selling is rare, as I consider dividend
growth investing to be mainly a strategy of buying, collecting, and holding good stocks for
long periods of time. The businesses themselves do the work; I try to stay out of their way.

In my strategies, I don’t go into deep detail about how the strategies will be
executed. Strategies are not to-do lists. I would suggest that you guard against getting
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bogged down in operational details when you are formulating your strategies. Strategies are
best stated at a high level and from a long-term perspective.

The business model for any company answers this important question: How does the
business make money? In running your investment business, you should demand of
yourself that you understand your own business model as an investor: How do you make
money?

In my own case, I make money by buying and accumulating stocks in high-quality

companies that send me annually increasing dividends, and reinvesting the dividends to buy
more of them. That’s my simple business model: I’m a holding company. I hold the stocks
of great businesses that pay increasing dividends.

I would suggest that a good business model for an individual dividend growth investor has
these characteristics:

• It is realistic for a self-directed investor to implement and maintain.

• It provides sufficient and reliable cash flow from dividends.
• The cash flow grows steadily, at a rate that beats inflation over long periods of
time.
• The operation provides peace of mind and psychological relief from market
volatility.

How Do You Implement Your Strategies?

Strategies are implemented through tactics, to-do lists, and day-to-day activities.

I don’t include tactics and tasks in my business plan. They are too detail-oriented, would
lengthen it by several pages, and by their nature require frequent adjustments.

I prefer my business plan to be a relatively brief document that I can consult for high-level
guidance when I forget what I am doing, find myself straying from my principal goal, or get
stuck between incompatible choices.

That’s why I have the business plan: To remind me of my goals and strategies, so
they can guide me through difficult situations.
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Obviously, in your investment operation, you do not help to manage the individual
companies in which you own stock. But you fully manage the investment
operation. Your business plan helps you to do it.

Most individual investors find that it is fun. It’s fun to run your own business rather than
work for others.

Key Takeaways from this Lesson

1. Run your investing like a business, because it is. It is designed to make money.
2. You are the CEO of your investing operation.
3. Write out your business plan. Your business plan states how you will make money.
Writing it out “forces” you to organize your thinking, reconcile contradictions, and
integrate ideas.
4. Start out with the primary goal of your investing operation. Feel free to modify your
goal as you gain experience, enter different stages of life, and encounter new
circumstances.
5. Make your business plan realistic to implement and maintain.
6. Keep your business plan at a high level. Don’t clog it up with day-to-day tasks and
activities.
7. Modify your business plan whenever you want – as you learn how to be a better
investor or encounter life changes that impact your goals.

Dave Van Knapp

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DGI Lesson 13: Specific Topics to Cover in Your Dividend Growth Investing Plan

The best investors have a plan.

In Lesson 12, we covered the importance of running your investing like a business, and
noted that a best business practice is to have a written plan. If you haven’t read that
lesson, it would be a good idea to read it before this one.

Why have a plan? When conditions are ambiguous, or your emotions are getting the
best of you, you can refer back to your plan. That will help you recall how you viewed
investing issues when you were thinking straight.

The purpose of this lesson is to discuss major topics that you should consider covering in
your plan. Examples are drawn from:

• The business plan for my own Dividend Growth Portfolio

• Mike Nadel’s plan for Daily Trade Alert’s Income Builder Portfolio

Give Your Plan a Name

Give your investment plan an inspiring name:

• Retirement Millionaire
• Free at Fifty-Five
• FIRE at 40 (where FIRE = Financial Independence, Retire Early)
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The idea is to inspire yourself with a name that suggests a goal that you know is
achievable. The planning process leads to a road map that will get you from where you are
to where you want to be. The roadmap needs a name.

My wife and I own two dividend growth portfolios. They both have boring names:

• Dividend Growth Portfolio

• Perpetual Dividend Portfolio

My portfolios were created many years ago. The names were inspiring to me then, but now
they seem boring. If I start another one, it will have a snazzier name.

State Your Goal

Your goal says what you want to accomplish.

Why are you investing? The answer to that question is your goal.

For example, here is the primary goal from my Dividend Growth Portfolio:

Build a reliable, steadily increasing stream of dividends over many years that can eventually
be used as income for retirement.

And here is the primary goal from Mike’s Income Builder Portfolio:

Build a reliable, growing income stream by making regular investments in high-quality,

dividend-paying companies.

The goals are similar. They differ only in emphasis. My DGP goal states what the income will
be used for, while Mike’s IBP goal indicates how he will accomplish his objective.

Both of our portfolios have secondary goals that address total returns.

DGP: Deliver total returns that are competitive with the general stock market as measured
by the S&P 500 with dividends reinvested.

IBP: The secondary goal is to build a portfolio that will experience solid total return,
something we believe will occur organically because of the excellent companies owned.
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In one way or another, most dividend growth investors share the goal of building
a large, reliable stream of “passive income” that they can live off of.

In most cases, something along those lines will be your primary (or only) goal.

Don’t set goals that are not realistic and achievable. If you earn $40,000 per year and have
nothing saved, don’t set a goal of creating a $70,000-per-year passive income stream in 5
years. Subconsciously, you will know that is impossible, so you probably won’t even bother
to get started.

Write Out Your Strategies

Strategies are your plans, policies, and methods for how to achieve your goals.

Your strategies state how you will invest so as to get from where you are now to where you
want to be financially when you reach your goals.

I suggest that you keep your strategies pretty general in nature. For example, your
business plan shouldn’t name a particular stock to buy. That’s a to-do list item. Rather, your
business plan should describe how you will select what stocks to buy.

The following sub-sections cover particular topics that you may want your business plan to
cover. Feel free to “steal” any of these ideas for your own business plan. That said,
ultimately the business plan is your own, and it needs to align with your personal goals,
capabilities, and resources.

1. Income Goal

You may want to state a specific goal for the income that you want your portfolio to
produce. Here is how Mike handles that in the IBP business plan:

Build a portfolio that will produce at least $5,000 in annual dividends within 7 years of the
IBP’s inception.

His plan goes on to illustrate how he expects the income to grow year by year. His income
goal is realistic, because he is funding the Income Builder Portfolio with $2000 per month to
make stock purchases. By the end of 7 years, he will have invested $168,000. His $5000
annual goal amounts to a 3% yield on the total amount invested. That is completely
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realistic, given typical yields on dividend growth stocks and the fact that they grow their
dividends every year.

2. How the Portfolio Will Be Funded

Having cash to invest means that you must save. It is an unavoidable truth that if you
want financial independence in retirement, you will need to save money while you are
working.

Obviously, how much you can save is personal to you. But set a goal and then “pay yourself
first.” That means to set the savings aside every payday before you blow it on stuff.

Can you save $500 per month? $200? Write that down. Whatever the amount may be, the
time to start doing it is now. Because of compounding, the earlier you get started saving,
the better.

When you get a raise at work, increase your savings by the same percentage or more.

3. Stock Selection

My DGP’s business plan includes, by reference, a separate document in which I describe

how I select stocks. That document is presented here on Daily Trade Alert as DGI Lesson
19: Grading Dividend Growth Stocks to Find the Best Ones.

That lesson covers such subjects as these:

• The minimum yield for stocks I buy, which currently stands at 2.0%. (Earlier in the
DGP’s life, I required 2.8% minimum yield.)
• The minimum dividend growth rate (DGR) that I require, which is 2% per year. In
practice, I seek higher DGRs unless the stock has a very high yield (say >4-5%).
• Dividend safety.
• Company quality, including the use of quality and credit ratings from companies such
as Morningstar, CFRA, and S&P.
• Company financials, including earnings, cashflow, and debt.

In a similar vein, Mike’s IBP business plan states this about stock selection:
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Assess each company’s business model; dividend growth history; “moat” (competitive
economic advantage); financial strength (through metrics such as earnings, revenue and
free cash flow); and other readily available data.

A good place to start your stock hunt is the Dividend Champions, Contenders, and
Challengers list. It shows every stock that has been raising its dividend continuously for 5
years or more. For many investors, appearance on that list is the minimum qualification to
call something a “dividend growth stock.”

4. Valuation

Under valuation concepts, paying too much for even a great company is not a
promising way to invest.

As Warren Buffett has put it:

Our…approach [to investing] can be continued soundly only as long as portions of attractive
businesses can be acquired at attractive prices…. For the investor, a too-high purchase price
for the stock of an excellent company can undo the effects of a subsequent decade of
favorable business developments. [1982 Berkshire Hathaway Letter to Stockholders]

As discussed in DGI Lesson 11 on valuation, I want to buy companies when they are fairly
priced, or better still when they are on sale.

For my own investing, I only buy stocks at Fair valuations or better. This is a hard and fast
rule for me. If I am tempted to stray – the temptation to buy an excellent company at a
too-high price can be strong – I look back at my investing plan to remind myself of what I
am doing.

5. Dividend reinvestment

In DGI Lesson 10, we reviewed the two ways to reinvest dividends: By dripping them back
into the companies that distribute them, or by accumulating them and then making targeted
purchases.

As it happens, the two portfolios I am using as examples in this article – the Dividend
Growth Portfolio and the Income Builder Portfolio – employ these two approaches. I
accumulate dividends and reinvest them in chunks, while Mike Nadel drips them.
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Over the years, you will reinvest lots of dividends. The total you reinvest may well
exceed the amount of “new cash” that you use to establish your portfolio in the
first place. In a little over 10 years, I have reinvested almost $27,000 in the DGP
compared to $46,783 that was in the portfolio when I started it. In a few years, the
dividends collected and reinvested will be more in total than the amount I started with.

Just because the dividends arrive in small amounts should not lead you to be careless with
how you reinvest them.

Give the subject some thought and choose whatever’s right for you. Many investors do
both: Drip some stocks but accumulate the dividends from others. It’s totally up to you.

Of course, once you retire, you will probably stop reinvesting, or you will only reinvest part
of what you receive and spend the rest. That will be because Financial Independence has
arrived: You can live off your dividends and not have to work at a job any more unless you
want to!

6. Number of stocks and diversification

Different investors have portfolios of different sizes, and they take various approaches to
diversification. Your business plan should address what you want your portfolio to look like
as it gets established.

How many stocks to own is a function of factors like these:

• how many companies you can keep track of;

• how much income you want to have at risk from any one company;
• whether you want a “core and satellite” type of portfolio;
• to what degree you want to diversify across economic sectors; and so on.

Here is how I state my policy in the DGP:

1. The portfolio will normally contain 20-30 stocks.

2. The portfolio will be well-rounded. It is diversified across economic sectors and
industries. It is also diversified across a variety of yields and dividend growth rates.
3. The portfolio is meant to be a straightforward illustration of all-purpose dividend
growth investing. It will not be unduly tilted either toward fast dividend growth or
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high yield stocks. The DGP’s yield will usually be in the vicinity of 3.5%. Its annual
dividend growth rate is expected to be in the 6-8% range per year.
4. The portfolio will normally hold no more than 10% of its total value in a single stock.

My target of 20-30 companies would be too concentrated for some investors. I

know many dividend growth investors who want at least 50, or even 100, companies in
their portfolio. They see the higher number as a risk-control tool, spreading out their bets.

The math is easy: If you own 50 companies in equal amounts, only 2% of your portfolio is
at risk from any one of them. If the number of companies drops to 33, the amount at risk
rises to 3% for each one.

But this is not completely a math question. How many companies to own is a personal
question. Base your answer on your own comfort level with a larger or smaller number of
companies.

When you are first starting out, you’ll own a small number of companies by necessity. Use
your business plan to describe the building process as well as what your portfolio will look
like after you have built it out.

7. Rebalancing policy

Connected to the question of how many stocks to own is how much weight each carries in
your portfolio.

Position sizes can wander over time as the result of price changes in the market. Also, if you
drip dividends, some positions will grow faster than others, because they will be receiving
more dividend reinvestments.

Some investors want an equal-weighted portfolio. Therefore they rebalance regularly.

Other investors don’t care as much about having equal weights, preferring instead to have
more money in certain companies that they call “core” positions.

I have seen research supporting frequent rebalancing, occasional rebalancing, and no

rebalancing. It’s up to you.
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Say you own 20 stocks, and your target is to own them about equally, meaning that each
position represents 5% of your portfolio. There are several ways to look at a rebalancing
policy:

• You could rebalance by the calendar, say every 6 months or 12 months. If you do
this, be aware that you will incur trading costs to make small adjustments, so you
probably want to build some leeway into the equal-weight goal.

• You could rebalance only when positions get way out of whack. For example, you
could accept any position that falls within a 4-6% range, and reweight only when a
position gets outside that range.

Of course, you can reject rebalancing except if a position grows beyond a specified
maximum size. That’s what I do in the DGP:

The portfolio is not rebalanced on any set schedule. However, occasionally a large position
may be trimmed, with the money used to purchase or build up other positions

8. Selling policies

Most investors find it harder to decide when to sell than what and when to buy.

The urge to sell is often emotional, especially when the market is falling. Human nature
induces many investors to flee to cash, but that is often a self-defeating action. Investors,
on average, sell too soon and then buy too late, missing the run-ups when the period of
falling prices comes to an end.

Risk tolerance is all about psychology. In investing, you are not running from a sabre-tooth
tiger. Fight-or-flight responses generally do not help you toward long-term success. You are
dealing with the market. Do it rationally.

Here are my selling policies:

1. This portfolio is expected to have a low turnover rate. Unless there is a strong reason
to sell or trim a position, the default action is to hold. The underlying strategy is to
buy, collect, and hold good dividend growth stocks for long periods of time.
2. However, selling or trimming will be seriously considered if any company/stock:
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(a) Cuts, freezes, or suspends its dividend.

(b) Bubbles or becomes seriously overvalued.
(c) Is impacted by significant fundamental changes.
(d) Is going to be acquired.
(e) Announces plans to split itself into 2 companies or spin off a significant portion of its
operations.
(f) Sees its current yield rise above 9% or drop below 2.0%.
(g) Grows to where it is beyond 10% of the portfolio.

Those are my selling guidelines. They are not hard-and-fast rules. The language “seriously
consider selling” is carefully chosen. Even if a stock freezes its dividend, I want the flexibility
not to sell it. Maybe the company has a good reason, and it is clear that dividend increases
will resume shortly.

Guidelines (2)(b), (f), and (g) interact. If a stock’s market price shoots way up, its valuation
may deteriorate. Since yield = dividend / price, its yield may fall way down. And the price
increase may cause its weight in the portfolio to go beyond my 10% maximum.

Key Takeaways from this Lesson

1. If you intend to run your investing like a business, a best practice is to have a written
business plan.

2. Your plan should spell out your investment goals and strategies. It’s a roadmap for
success.

3. Topics to cover include:

§ Your income target

§ Saving for retirement
§ How to select stocks
§ Dividend reinvestment
§ Number of stocks and diversification
§ Selling guidelines

4. Consult your business plan when you’re in a confusing situation or you feel that you are
straying from the path you chose. Its purpose is to guide you without being a straightjacket.
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DGI Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your
Portfolio

Important Note from Daily Trade Alert: For dividend growth investors, the following
lesson from Dave Van Knapp could be the most important information we publish this year.
In short, it lays out the key steps you should take when deciding what stocks to buy and
when to buy them. Our suggestion is to print out this lesson, keep it close by, and review it
before you buy your next stock.

Why Grade Stocks?

When I am selecting stocks to invest in, I grade them.

Here’s why.

1. There is no perfect stock. When you examine the details of individual companies,
different pieces of information tell different stories. Sometimes the stories conflict.
One metric will be positive (like a high yield), but another will be negative (the
dividend is at risk). Grading helps pull together a unified view about the company’s
prospects.
2. Avoid overlooking anything. I grade a variety of metrics about every company.
The system acts as a checklist of what to look at. Following each step insures that
you won’t overlook anything important.
3. Save work. Some of the grading factors act as screens. For example, for me a stock
with a lousy dividend safety grade is not a candidate for purchase. If you spot a
disqualifying factor early, you can drop further research and save a lot of work.

I have experimented with a lot of systems over the years. What I present here is a
distillation of what I have learned about scoring dividend growth stocks. Consider it as a
basic system to start with, one that you can adjust and improve as you learn about stocks.

In your own work, you may want to weigh some factors more heavily than others. You will
also certainly want to apply the scoring factors differently when you encounter special
situations.
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So use your judgement. Add or drop factors. Change weights. Customize it however you
wish. But at a minimum, I would suggest that you use it as a checklist of things to look at
when you are considering a stock.

I use a “stoplight” system for issuing grades: Green means go (good), yellow means
caution, and red means stop (bad). The colors alone provide a great visual for the potential
investor. If there’s lots of green, you’re probably looking at an excellent company. If you’re
seeing lots of orange and red, it might be one you want to skip.

One thing I have observed over the years is that whatever the details of the
system you use, the cream always rises to the top. The best companies emerge,
and weaker companies sink.

The grading system has 18 factors divided into 4 categories:

1. Dividend resume
2. Company quality
3. Company finances
4. Miscellaneous

Category 1: Dividend Resume

1. Yield

I use yield as a screening factor as well as a metric to be graded. In other words, it can
eliminate a stock all by itself if the yield is too low.

As you can see, the cutoff for minimum acceptable yield in this chart is 1.0%. In my own
personal investing, I require stocks to have minimum yields of 2.0%. Set your own
minimum to suit your style and needs.
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2. Years of Consecutive Increases

In order for a stock to be recognized as a “dividend growth stock,” I require a minimum of 5

straight years of increases (see Dividend Growth Investing Lesson 3: The 5-Year Rule). If a
company is just initiating a dividend, that first year counts as Year 1 of the increase streak.

All qualifying stocks can be found on the Dividend Champions, Contenders, and Challengers
(CCC) document available here on Daily Trade Alert.

3. Dividend Growth Rate

I judge dividend growth rates (DGR) in relation to the stock’s yield.

A stock with a high yield – for example >4% – does not need as fast a growth rate to be
valuable as a stock with a low yield.

The following chart divides stocks into 3 categories: Low Yield, Medium Yield, and High
Yield. Then it suggests grades for various DGRs.

So a stock with a high yield (say 5%) is OK with me if it has a slow DGR (say 2% per year).
A stock with a low yield (say 1%) would be disqualified if it had a DGR that slow. Stocks
with high yields often have slow DGRs, and vice-versa.

I usually judge DGRs over multiple time frames: current year, last year, and the last 5
years. That triple coverage means that DGR is heavily weighted in my analysis.
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4. Dividend Growth Trend

I usually don’t like to see a pattern where the DGR has been continually declining: That
would look like this: 10-year DGR > 5-year DGR > 3-year DGR > 1-year DGR > this year’s
increase. Every shorter interval has a smaller DGR, meaning that the average annual
increases are going steadily down. They’re still increases, but getting continually smaller.

There are exceptions.

For example, a stock that is new in its dividend growth life often has a declining pattern. Its
first dividend (which is an increase from zero) is actually a DGR of infinity. Then maybe
there’s a 30% increase followed by a 20% increase, and so on as the company finds its
footing as a new dividend growth stock.

I would not penalize such a company for its declining DGR. It may be a gem in the making.
In recent years, we have been seeing this with established tech companies, former high
fliers that one-by-one are initiating dividends as they mature.

Here is Microsoft’s (MSFT) record, for example (it paid its first dividend in 2003). Its DGR is
slowing down, but that’s no reason to penalize it.

[Source]

At the other end of the spectrum, some high-yield stocks have reached a stage of maturity
that they just raise their dividend the same dollar amount each year, typically a few cents.
Mathematically, this causes the percentage rate of increase to decline a tiny bit each year.

An example would be AT&T (T). Since 2009, its annual increase has been 4 cents each year.
Obviously, as the base amount rises, the percentage increase is slightly declining every
year.
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But AT&T’s yield is large, currently over 5%. So, I would not penalize it for tiny increases or
the declining percentage rate each year. Its main value is in the size of the dividend, not its
growth rate.

5. Dividend Safety

I consult Simply Safe Dividends for these grades. They grade dividend safety on a 0-100
scale.

I convert
that system to my own scoring like this:

Note that I have no “orange” category. I consider any dividend safety rating below 40 to be
unacceptable. This is another example of using the results in a category as a screen. If I am
researching a stock and its safety rating is 25, I just stop. No use looking further.

Category 2: Company Quality

This group of factors considers the quality of the company. Obviously, we want to invest in
excellent companies and eliminate companies that are poorly run or are facing difficult
problems.

Here are the factors that I use.

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6. S&P Credit Ratings

S&P’s credit ratings range from AAA (the best) to C (the worst). The ratings can be further
nuanced by a plus or a minus (as in A+).

The lowest “investment grade” rating is BBB-. Ratings below that indicate significant
speculative characteristics. I require all qualifying stocks to be investment grade.

This display from S&P defines how they grade companies. Investment grade issuers are in
the top 4 lines, from AAA to BBB.

[Source]
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I convert S&P’s credit ratings to my own scoring like this:

Here again, I use the credit rating as a screen: I won’t invest in “non-investment-grade”
companies.

7. Moat

A company has a moat when it has sustainable competitive advantages.

Morningstar assigns moat ratings based on their analysis of how long a company’s
competitive advantages can last. Here’s how they assign rankings:

A company whose competitive advantages we expect to last more than 20 years has a wide
moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with
either no advantage or one that we think will quickly dissipate has no moat.

I don’t automatically eliminate a company with no moat, because I take a look at its
business model myself. A no-moat company has a tough hurdle to overcome, however,
before I would consider it investable.

8. S&P Global Market Intelligence Quality Ratings

S&P is one of many information providers that grade companies on various factors. I like to
use their ratings, because (like Morningstar) they are independent information providers,
not “sell-side” analysts.
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Their Quality ratings are now known as S&P Global Market Intelligence’s Quality Rankings
(formerly they were called S&P Capital IQ Quality Ratings). They appear in CFRA stock
reports, which are available from many brokerages.

Here is how they describe their rankings:

Here’s how I convert them for my own scoring.

Again, I don’t use this as a screen, so I don’t let even a red rating disqualify a stock. I’ll
make my own judgement based on all the factors.

9. Value Line Safety Rank

If you have access to Value Line (many libraries do), they have a Safety rank that implies
company quality. It looks like this on their stock research pages:
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Here’s how they describe it:

[The Safety rank] measures the total risk of a stock relative to the [other stocks that Value
Line covers]…. Safety ranks are…given on a scale from 1 (Highest) to 5 (Lowest) as follows:

-Rank 1 (Highest): These stocks, as a group, are the safest, most stable, and least risky
investments relative to the Value Line universe.
-Rank 2 (Above Average): These stocks, as a group, are safer and less risky than most.
-Rank 3 (Average): These stocks, as a group, are of average risk and safety.
-Rank 4 (Below Average): These stocks, as a group, are riskier and less safe than most.
-Rank 5 (Lowest): These stocks, as a group, are the riskiest and least safe.

Stocks with high Safety ranks are often associated with large, financially sound companies;
these same companies also often have somewhat less-than-average growth prospects
because their primary markets tend to be growing slowly or not at all. Stocks with low
Safety ranks are often associated with companies that are smaller and/or have weaker-
than-average finances; on the other hand, these smaller companies sometimes have above-
average growth prospects because they start with a lower revenue and earnings base.

I convert Value Line’s Safety rank to my own grades as follows:

10. Company Business Model – What’s the “Story”?

The Story is a few paragraphs about the company as a business.

I write it out to make sure I understand it. If I can’t understand in general how a company
makes money, I won’t invest in it.
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As the famous investor Peter Lynch said:

If you’re prepared to invest in a company, then you ought to be able to explain why in
simple language that a fifth grader could understand, and quickly enough so the fifth grader
won’t get bored. [Source]

That simple explanation is often called the stock’s Story. The Story answers questions like
these:

• What does the company do?

• How does it make money?
• Does it have coherent strategies to protect its earnings and to grow them?
• Why is it likely to continue to succeed?

Look for companies that are dominant in their fields. If a company is riding a long-term
mega-trend (demographic, technological, etc.), that’s a plus.

Other good signs are:

• legal monopoly
• company not hindered by regulation (or actually assisted by it, like utilities)
• coherent strategies and growth plans that sound sensible to you
• great brands
• record of innovation and adaptability to changing conditions
• production efficiencies or cost-saving programs
• timeless and everyday products and services that people need
• sustainable competitive advantages (moats)
• proven shareholder orientation

We want companies that are relatively immune from technological disruptions, product
obsolescence, or shifting tastes, fads, and fashions. Whether any company can retain
industry leadership is impossible to know, but you want to find evidence to help you answer
that question.

Explain the company’s Story to yourself in simple language. Be crystal clear in

describing what the company does, how it makes money, and why you think its
business is sustainable. This is no time to delude yourself.
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This exercise may sound tedious, but it will help steer you away from unsound companies.
If you find yourself with seeds of doubt when trying to write the company’s Story, that may
be a clue that the company really isn’t very good or that you don’t understand it. Don’t
force it.

If you don’t understand it, don’t invest in it.

Obviously, the Story is somewhat subjective. Someone else may understand a company’s
business model that you just don’t get or trust. Stay near your areas of competence and be
comfortable with the companies that you own.

I score company Stories on this scale:

Category 3: Company Financials

The third group of factors delves into the company’s financial situation. I want to find
companies that are profitable, growing, efficient, and have strong balance sheets.

Again, if you have access to Value Line, they have a Financial Strength Grade rating that
summarizes and scores a company’s overall financial situation, such as this:

Their grades vary from A++ (the highest) to C in 9 steps. I don’t use their rating directly,
but I like to look it up and then see how I rate the company’s finances based on my own
methods. I usually agree with Value Line’s overall rating, but sometimes I think it’s a little
too generous, other times a little too harsh.
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In the Company Financials category, I do not use failing (red) grades as screens, because I
want to get a total picture based on the variety of metrics that I use. All of the metrics are
easy to find on standard financial websites such as Morningstar.

Here they are.

11. Return on Equity (ROE)

Return on Equity is a standard measure of efficiency in a company. It indicates how

much return a company is generating per dollar invested in it.

The average ROE among Dividend Champions is 16%, and for S&P 500 companies it is
about 13%. I score the company’s trailing 12-month ROE as follows.

A company’s ROE will be artificially inflated if it carries lots of debt. We will take care of that
later by downgrading companies with high debt loads.

ROEs often vary from year to year. Therefore, in addition to the current ROE, I also look at
the company’s ROEs over the past 10 years to look for consistency. I score the record as
follows:

12.Debt to Capital (D/C)

A company’s Debt-to-Capital ratio measures its financial leverage: How much do

they depend on borrowed money to finance their activities?
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Most companies carry debt. They borrow money routinely, financing their operations
through a mixture of debt, equity (money invested by shareholders), and their own cash
flows.

Even companies that could be self-funding often borrow money instead. The reason is that
they can make more money on the borrowed money than the borrowing costs. That’s
called leverage.

That said, debt repayment obligations are a constant drain on a company’s resources. While
leverage can help a company grow faster, too much debt can weaken a company or even
make its financial structure untenable.

The D/C ratio gives insight into whether a company is depending on debt too much. It
compares the company’s debt to its total capital. Total capital, in turn, is all the capital the
company has.

The D/C ratio shows what percentage of a company’s total capital structure is debt. A ratio
is used, rather than the dollar amount of debt, to allow us to compare companies of
different size. $10,000,000 in debt might cripple a small company but be only a rounding
error for a large company.

All else equal, the higher the D/C ratio, the riskier the company is. Companies that are
highly dependent on debt to fund themselves are more likely to have trouble when business
conditions weaken or a recession strikes.

A high debt load can give a company an artificially high ROE number. We credited high
ROEs earlier. So if the company is achieving a high ROE via high debt, we penalize it here
for the high debt to balance things out.

In the low-interest-rate world of the past few years, many companies have taken on more
debt because it has been so cheap to do so. Average D/C ratios are often in the 50% range,
meaning that half the company’s total capital is debt.
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Here’s how I score debt.

I also look at the 10-year trend.

13.Operating Margin

Operating margin is a measure of profitability. It measures what percentage of

revenue is turned into profit after subtracting cost of goods sold and operating expenses.

Per a report from Yardeni Research published in 2018, the operating margin across S&P 500
companies is around 11%-12%, as shown in the following graph.
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Research has shown that profitability is positively associated with long-term stock returns.
Here’s how I grade this metric.

I also look at the 10-year trend.

14. Earnings

There are 2 basic ways to measure the money flowing through a company: Earnings and
cash. Both begin, of course, with revenue from customers, which then goes through the
company’s financial “machine” to produce earnings and cash.

Earnings are the officially reported profits calculated according to Generally

Accepted Accounting Principles (GAAP). There are a couple of important points to
remember about GAAP.

• GAAP occasionally counts as “money” things that are not cash. A simple example is
goodwill. If an acquiring company pays more than book value for an acquired
company, the difference is called goodwill. That is a way of monetizing the brands,
expertise, and other intangibles that the acquiring company receives, even though
the intangibles have no cash value.
• GAAP requires accountants to shift the timing of cash flows. Cash inflows and
outflows are not always recognized at the time of actual receipt and disbursement,
but rather when the events associated with the cash take place. An example would
be a subscription business that takes in cash when subscriptions are paid for, but
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counts them as revenue only when content is sent to the subscriber. Another
example would be when a company pays for equipment with cash, but GAAP requires
the cost to be depreciated over the useful life of the equipment (several years).

I look for earnings per share (EPS) that have been consistently positive, with extra points
for a general pattern of growth.

The above looks backward in time. To look forward, analysts project EPS growth, typically
over the next 3-5 years. Averages are collected and published. Recent average analyst
growth estimates for CCC stocks have been about 11% per year. Therefore my rating scale
is arranged around that average, with higher grades for faster estimated growth rates and
lower grades for slower growth rates.

15. Cashflow

Cash for a company is like gasoline for a car. It keeps it running. Cash is used to cut checks
for salaries, bills, debts, and dividends. There has to be enough cash flowing on a real-
time basis to keep the company operating.

Remember that with earnings, money is sometimes time-shifted under GAAP rules.
Cashflow is not time-shifted. If the payroll is due this Thursday, the company must have the
cash to cut the checks on Thursday. If the dividend is to be paid next week, the cash must
be ready on the payable date. Debt payments must be made on time.
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As investors, we want companies that are not only profitable under GAAP but also have
strong cash flow. I will omit the gory details, but a company can be GAAP-profitable but
strapped for cash. And vice-versa: A company can have sufficient cash to run itself but be
unprofitable under GAAP rules.

There are various flavors of cash flow. I use free cash flow (FCF), which is what is left after
a company has paid all of its bills and reinvested to maintain and grow its business.

I find a graph or chart of the company’s FCF and make an assessment.

Category 4: Miscellaneous Factors

Finally, we look at a few things that don’t fall neatly into the earlier categories.

16. Beta

Beta measures a stock’s price volatility vs. the S&P 500’s volatility. 1.0 is defined as the
stock being equal to the index. So if a stock has a beta of 0.7, its price tends to move only
70% as much as the market, on average.

Generally, I prefer lower-volatility stocks, because they tend to give you fewer reasons to
worry about price swings. Not only that, but there is also research that suggests that low-
volatility stocks produce higher total returns over the long haul.
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17. Share Count Trend

Some companies buy back their own shares regularly. They may retire the shares, and
when they do, it makes each remaining share more valuable. They are able to do this
because they have money left over every year after paying all their bills and dividends.

You cannot assume that because a company buys back shares that it will retire them. Some
repurchased shares aren’t retired at all: They are used to pay executive compensation. So
beware of companies that equate buying back shares with “returning money to
shareholders.” I consider that to be disingenuous. The only value to shareholders comes if
the company retires the shares.

At the other end of the spectrum, many companies issue shares regularly. Issuing new
shares or debt to raise capital may be the only way to finance growth initiatives. Real estate
investment trusts (REITs), for example, must by law pay out most of their profits to
shareholders as distributions. They can’t use that money to help finance growth. Thus they
must issue more shares and/or borrow money to fund their growth.

All else equal, a declining share count is preferable. For one thing, it means that the annual
dividend pool is spread over fewer shares, so it’s easier for the company to pay and raise its
dividend per share as the number of shares shrinks.

I assess the share count trend over the past 10 years and score it along the following lines.

18. Analysts’ Recommendations

Sell-side analysts constantly issue stock reports and recommendations. Some information
providers poll analysts and report their average recommendations.
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I use the summaries that CFRA (formerly S&P Capital IQ) puts into their stock reports. They
normalize the different systems used by various analysts into a standard scale of 1-5, where
1 = strong sell, 3 = hold, and 5 = strong buy.

Valuation

The above scoring system is about evaluating the excellence of a company as a business.

Even a great business, though, may not be a great investment if its stock is overvalued. A
company may be the best in its field, but if its stock is overvalued, it may not be a good
investment proposition at its current price.

So I check valuations separately. Valuing stocks is easy. I laid out my system in Dividend
Growth Investing Lesson 11: Valuation. When you are making investment decisions, I
suggest that you rate both the excellence of the company and the valuation of its stock.

Key Takeaways from this Lesson

1. The myriad quality and financial aspects of a company can be sorted into a logical,
step-by-step grading system.
2. Divide the grading components into bite-size chunks:

• Dividend record and outlook

• “Story” – how does the company make money, and why is it likely to continue to be
successful?
• Financials, with focus on profitability, earnings, cashflow, and debt

3. Pull everything together into a coherent thesis on why the company is a good one or
not for the type of portfolio you want.
4. Consider valuation separately. A great company may not be priced well enough to
buy. - Dave Van Knapp
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DGI Lesson 15: Portfolio Management – How to Decide When to Sell Stocks

Introduction

In most of the other DGI Lessons, we’ve talked about reasons to buy a stock:

• Matching up companies with your investment goals

• Company quality and business model
• Dividend record and outlook, including yield, growth, and safety
• Valuation

For many investors, buying is the easy part. Knowing when – and whether – to sell is
harder.

Once you have a portfolio established, how do you decide whether to hold or sell
(trim) a particular position?

When buying, you are taking action. Buying is a proactive step, and it is human nature to
take action. That is what most of us are wired to do.

However, once you already own stocks, taking furtheraction may not be helpful.

Some investors have great difficulty keeping their hands off their portfolios, wanting
constantly to tinker with them.

But messing around with your portfolio is often the wrong thing to do.

Studies have shown that most investors underperform the very securities that they invest
in. How is this possible?

Because they trade too much.

The field of behavioral finance has demonstrated that many investors trade at the wrong
times. They sell, emotionally, when prices are falling. By selling, they often lock in a loss.

Having sold, they wait too long to buy back in (because they fear the market), and thus
they miss some gains that the actual securities make. When they finally decide to get back
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in, they are too late. They may pay a higher price to get back in than the price at which
they sold.

Thus they underperform the security that they invested in. They would have been better off
leaving it alone. Their emotional reaction to price changes ends up costing them money.

Dividend Growth Investing Can Help Behaviorally

Dividend growth investing turns your attention from prices to cashflow. It is a

collection strategy where you benefit from buying and then holding onto what you
already own.

Unlike other styles of investing, dividend growth investing is not about buying low and
selling high. You are not trying to make money by flipping the stocks. Instead, you
are trying to make money by collecting an ever-rising stream of cash dividends.

• First you collect shares of stock in excellent companies by buying them.

• Then you collect ever-rising streams of dividends from the companies that you own.
• Then you reinvest those dividends to collect more shares of stock.
• And then you collect dividends from them too.

Dividend growth investing is like being a landlord. A landlord buys properties so that he can
rent them out. He makes money by collecting rents. He doesn’t flip the properties.

Dividend growth investing is similar. You are not buying stocks with the intent of selling
them for a profit. You want the stream of dividends.

Don’t get me wrong. As life events happen, you will sell some of your stocks. But that is not
your intent when you buy them.

In the rest of this lesson, we will presume that you have already built a portfolio of great
companies. You are collecting the dividends and reinvesting them (or spending them).

Why might you consider trimming or selling any holding? That’s what we will explore in the
remainder of this article.
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Treat Selling in Your Business Plan

You have a business plan, right? We talked about running your investing like a business
in Lesson 12and constructing your business plan in Lesson 13. In my opinion, every serious
investor should have a business plan.

Your business plan should contain guidelines for when you will consider selling a
dividend growth stock.

Why? Because we always strive to make our investing activities rational. We don’t want to
sell in a panic, churn our accounts, or over-trade. That is self-defeating behavior.

So as we talk about reasons to consider selling in the remainder of this article, think about
incorporating the concepts that make sense to you into your own business plan.

Reasons to Consider Selling

Remember our basic business model: As a dividend growth investor, the goal is to
collect, over time, stocks that pay a rising stream of dividends. The end-game is to
live off those dividends in retirement.

Most of the time, that business goal is best served by buying, holding, and collecting stocks,
not by selling them. Your account transactions do not include many sales. Most of the
account activity is to collect dividends, add money, and buy more shares.

Here’s 3 recent months of activity in my Dividend Growth Portfolio:

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All the transactions are dividends coming in, plus one purchase (marked by the red dot).
There are no sales.

But there will be times when selling or trimming a stock advances your business
model better than just continuing to hold it.

Here are a few suggestions for situations when you might consider selling.

1. A stock cuts, freezes, or suspends its dividend

The logic here is obvious. Your goal is to own stocks that give you a reliably increasing
stream of dividends. If one of your stocks cuts its dividend, it is not a “dividend growth
stock” anymore.

Famous recent examples of such stocks include:

• The many banks that cut their dividends in the financial crisis of 2008-2009.
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• General Electric (GE), a former reliable dividend-growth stalwart that cut its dividend
in 2009 and again in 2017.
• Kinder Morgan (KMI), a pipeline company that was long a darling of dividend growth
investors, but which got caught in the oil squeeze and cut its dividend 75% in 2015.

I held both GE and KMI in my Dividend Growth Portfolio when they cut their dividends. I
didn’t see the cuts coming, and in each case the dividend cut was accompanied by steep
price drops. In the graph below, the 2009 GE experience is circled in blue, and the 2015
KMI experience is circled in red.

Unfortunately, in both cases major price damage had already occurred by the time of the
dividend cuts. Selling locked in losses in both cases.

But I sold out of my positions, and the sales were not made in fear of further loss. The
reason to sell in each case was the dividend cut. The reduced dividends for GE and KMI
were inconsistent with my goal, which is to have increasing dividends.

As I look back on those decisions to sell, they were the right thing to do. Neither company
has recovered either in share price or dividend payout. I deployed the money from the sales
into other (better) companies, and the dividend cuts have been made up by the growing
income streams from other companies in my diversified portfolio.
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2. A stock bubbles or becomes seriously overvalued

I discussed how I value stocks in Lesson 11. In my Dividend Growth Stock of the
Month articles, I summarize valuation in a table like this.

But what if the valuation summary looked like this?

You might want to consider selling or trimming – especially if:

• You have an alternative company to invest in that is of equal quality, fairly valued,
and paying a larger yield.
• The position you are considering trimming is excessively large.

You could increase your income flow instantly by making the swap. And increasing your
income flow aligns with your goals.
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Selling on the basis of severe overvaluation is something that I do seldom, but I have done
it. One way to look at it is that by selling (or trimming), you may collect in profits
the equivalent of several years’ worth of dividends.

If you can turn around and invest that money into a good company at a better valuation
with a much better yield, it’s something to seriously consider doing.

Here is an example of making such a swap in my Dividend Growth Portfolio. In 2017,

McDonald’s (MCD) had grown to occupy >12% of the portfolio. This happened because MCD
had been on an upward price tear for 2 years.

One result of that price tear was that the stock became seriously overvalued. As shown on
the next chart, McDonald’s valuation had levitated beyond historical norms for both the
market (orange line) and McDonald’s itself (blue line).

Because yield and price are inversely related (see DGI Lesson 6: Yield and Yield on Cost),
MCD’s yield had fallen to 2.2%.
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So I had a situation where the McDonald’s position was overvalued, oversized, and yielding
a low percentage.

So I decided to trim the position and put the money to work elsewhere. Here’s what I did.

• Sold $3300 of McDonald’s to bring it back to 9% of the portfolio.

• With the $3300, bought shares in two other companies with better yields, one of
which was new to the portfolio, and both of which had better valuations.

With this simple swap, I accomplished several goals.

• Reduced portfolio risk by trimming the oversize McDonald’s position.

• Improved the portfolio’s diversification and balance by adding a new position and
bringing McDonald’s back into line with other positions.
• Increased the portfolio’s annual income stream by >1%.
• Kicked up the portfolio’s yield from 3.5% to 3.6%.

3. A position’s size increases beyond the maximum size that you allow in your
portfolio

The example above illustrating overvaluation is also an example of keeping position sizes
down where you want them. Doing so decreases “concentration risk,” which is the risk that
a disaster with a single stock will have an outsized impact on your portfolio.

Many dividend growth investors do not tolerate position sizes as large as I do. I will let a
position become 10% of my portfolio. From reading articles and comments around the Web,
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I have learned that many investors prefer to limit maximum position sizes to 5% or less of
their portfolios.

Notice that as you reduce your maximum allowable position size, you must by simple math
increase the number of stocks in your portfolio.

I consider the choice of maximum position size and number of stocks to be a personal
decision. Obviously, the more stocks that you own, the less damage any one of them can
cause if it blows up.

On the other hand, the more stocks that you own, the more there is to keep track of., and
the less benefit you will get if one of them does really well.

A very common approach would be something like this:

• Maximum position size = 4% of the portfolio

• Target number of stocks = 25-30

Another approach that some investors use is to limit position size by the percentage of
income that each position is responsible for, rather than by its market value. So, for
example, an investor might say that no single position will be responsible for >10% of the
portfolio’s income.

Both approaches are used in the Income Builder Portfolio that Mike Nadel manages for Daily
Trade Alert.

4. The company’s dividend safety falls to an unsafe level

Many investors gauge dividend safety by looking at its payout ratio.

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Payout Ratio Calculation

Based on earnings: Dividend per share / Earnings per share

Based on cash flow: Dividend per share / Cashflow per share

These numbers are easy to look up, and indeed some data providers display the payout
ratios for you. Here is how they are portrayed for Johnson & Johnson (JNJ) at the Simply
Safe Dividends website:

Payout ratios of <60% or <70% are usually considered to be safe, depending on industry.

Unfortunately, payout ratios by themselves may be too simple to judge dividend safety.
They may lead you to think that company’s dividend is safe when in fact it isn’t, and vice-
versa.

Therefore, I utilize the service that Simply Safe Dividends provides. They calculate a
Dividend Safety Score for each stock based on a variety of factors, more than a dozen in all.
These factors include:

• Payout ratios
• Debt levels and coverage metrics
• Recession performance
• Dividend longevity
• Industry cyclicality
• Free cash flow generation
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• Recent sales and earnings growth

Scores range from 0 to 100:

In my own investing, I won’t consider buying a stock whose safety score is below 41, and
indeed I usually buy stocks that are in the two green ranges.

If I already own a stock, I will consider selling it if its score drops below 41, especially if I
have an ideal replacement on my watch list.

As you examine stocks, you will find that eye-catching high yielders often have wobbly
dividend safety. Here is an example, GameStop (GME):

GameStop’s dividend yield is sky-high at >10%, but its dividend does not look sustainable
upon an in-depth look.

In contrast, stocks with more reasonable yields, in the 2.5% – 5% range, often have
dividend safety scores that inspire more confidence. Here’s the well-known consumer giant
Kimberly-Clark (KMB):

KMB’s yield is 3.6%, which may not sound all that exciting, but it’s very safe.
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Other Reasons to Consider Selling

I have highlighted four reasons to consider selling above. You should also consider other
reasons that make sense to you. Here are a few more suggestions:

• The company’s dividend growth rate (DGR) is in long-term decline.

• Its current yield rises above 9% percent or drops below 2%. The idea is that at 2%
or less yield, the company is not paying me enough, or that at 9%+ something risky
is going on that I ought to investigate. Sound reliable companies normally do not
have yields over 9% in this day and age.
• Significant changes impact the company. Examples could be that it is going to be
acquired; or it announces plans to split itself into two or more companies; or it
announces plans to spin off a separate company.

Guidelines, Not Rules

When I first began as a dividend growth investor, I treated my selling guidelines as

automatic rules. For example, if a company froze its dividend, I automatically sold it.

I have since decided that it’s better to consider these as guidelines rather than rules. The
way I word them is, “Seriously consider selling or trimming if….”

The reason is that sometimes you may have a situation where the best decision, all things
considered, is to hold.

For example, during weak economic times, a company may temporarily freeze its dividend.
Many companies did that in 2008-09, and it was a prudent move. Then after the economic
crisis and recession passed, they resumed their annual dividend increases. Obviously, such
situations require case-by-case analysis.

Another example would be where a severe overvaluation does not take your position
beyond your maximum size guideline. You may decide just to let the market do what it does
(go up and down) and leave your holding alone as long as it is doing what you primarily
want, which is increasing its dividend every year at an acceptable speed.
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Even if a stock freezes its dividend, I want the flexibility not to sell it. Maybe the company
has a good reason for the freeze, and it is clear that its dividend increases will resume
shortly.

If you want to see how selling guidelines can form a part of an investment business plan,
here are two examples:

• Dividend Growth Portfolio Business Plan

• Income Builder Portfolio Business Plan

Key Takeaways from this Lesson

1. Deciding whether and when to sell are often more difficult decisions than deciding
what and when to buy.
2. Many investors shoot themselves in the foot by trading too much.
3. Dividend growth investing can help guard against over-trading, because you are
primarily watching your growing dividend cashflow rather than prices that hop all
over the place. Cashflow is positive and usually growing, so it doesn’t create fear of
market volatility.
4. Dividend growth portfolios normally do not have a great deal of turnover. You are a
collector of income-producing stocks rather than a trader.
5. Nevertheless, there will be instances where the best thing to do to reach your long-
range goals is to sell or trim a position rather than hold onto it.
6. Articulate your selling guidelines in your business plan. Then you can consult your
plan to remind yourself of how you analyzed these issues when you were calm rather
than just reacting when a situation pops up.
7. Realize that studying a situation and deciding to hold is an active step. That will help
if you feel like you have to “do something” with your portfolio. That something is to
investigate and reach a decision based on sound principles. It’s still an active
decision even if it results in no changes to your portfolio.

Dave Van Knapp

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DGI Lesson 16: Diversification

Introduction

In investing, one often hears that they should be “properly diversified.” What does that
mean?

Diversification is a simple concept. At its most basic level, it means not keeping all of your
eggs in one basket. The reason is obvious: If you have all of your eggs in one basket, and
the basket falls, you will lose all of your eggs.

Thus, being undiversified is risky: A very bad outcome can result from just a single bad
event. For example, say you had all of your assets in a single stock, and that company
suddenly fell apart, eventually going bankrupt. Your asset values would fall, eventually
becoming worthless.

Most investors want to avoid that kind of risk, and therefore they diversify their holdings.

Instead of putting all of their money into a single security, they spread their money into
multiple securities and/or multiple asset classes.

That ensures that if one investment flops, they won’t lose everything.

Diversification is a risk coping tactic by which you mix a variety of investments into a
portfolio.

You do it to minimize the impact of any single security on the portfolio’s overall
performance. The resulting risk reduction is often referred to as the only free lunch in
finance.

Diversification can help to smooth out performance. As time goes on and prices go up and
down, the positive performance of some investments will neutralize the negative
performance of others. The performance of a diversified portfolio will always be better than
the performance of its worst stock and less than the performance of its best stock.
Diversification thus narrows the range of possible outcomes.

Diversification has some special nuances for the dividend growth investor. Let’s explore
them, beginning with an examination of risk itself.
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Risk

What is “risk”?

The answer may seem obvious at first. Risk = losing money, right? Well yes, the possibility
of losing money is certainly a risk. But for the dividend growth investor, that is too narrow a
definition. Let’s expand it so that it is more helpful.

The most common definition of investment risk is price volatility: How much do the
prices of your investments vary – day to day, month to month, or year to year? When you
read that an investment is “risky,” what is almost always meant is that its price is volatile.

This view of risk was established decades ago by the terminology used in academic papers.
The reasoning behind it is that if you have a highly volatile security, there will be lots of
times when the price of that security is down. During those periods of time, you have an
accounting loss (that is, it’s a loss on paper).

If you were forced to sell at that moment, you would turn the accounting loss into an actual
loss. Your risk would have been realized. You would lose money.

While this risk may be important to guard against, most dividend growth investors find that
the traditional definition of investment risk is too narrow. I agree with them, because (1) it
only refers to price variations, (2) people are not often forced to sell when prices are down,
and (3) if your main concern is income, temporary variations in price are not much concern
to you.

Therefore, I use a more sensible definition of risk. My definition of risk includes not only
the potential loss of money, but also things that threaten income and income
growth.

So, in dividend growth investing, things like this fit the broader concept of risk:

• An investment’s return will be less than expected

• Some or all of the original investment will be lost
• The dividend gets cut or suspended
• The annual increase in the dividend is less than expected
• The overall dividend returns fall short of what you need
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Risk to Income

The basic goal for most dividend growth investors is to optimize their income.

Let’s say that you’re 52 and plan to retire in 10 years. You estimate that you will need
$45,000 per year to cover your normal expenses: food, shelter, gas, travel, hobbies,
medicine – everything that comprises your life and lifestyle.

Your estimate will become more refined each year as you get closer to actual retirement.
But currently it is your best projection, and so you use it for planning purposes.

From the Social Security (SS) statements that you receive, you believe that you will receive
$22,000 per year when you begin receiving SS, and your spouse will receive $11,000. So
SS will cover $33,000 of the $45,000 that you think you will need.

That means that your investments will need to generate $12,000 per year to fill the gap
between your fixed sources of income and what you think you will need. You would like to
have more retirement income, of course, but you really do not want to have less.

Plus, you know that each year, inflation will erode the purchasing power of your income.
Social Security is indexed to inflation, so you want to be sure that the gap-filler income also
grows at least as fast as inflation too, preferably faster.

As a dividend growth investor, you plan to fill the gap with income from stocks that you
own. Therefore, you are more concerned about risk to the dividends, and to your
portfolio’s dividend growth, than you are concerned about price fluctuations. The
dividends represent your gap-filler income. Prices do not.

That is why you cannot limit your definition of “risk” to potential loss of principle. That
would be very misleading. It is a fact that dividend income can go up even when stock
prices are falling.

Consider this 15-year chart of a common dividend growth stock, Johnson and Johnson
(JNJ), a company that I featured as the Dividend Growth Stock of the Month for June,
2018.
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The orange line represents JNJ’s dividend, and the blue line shows its price. I have circled 3
periods when JNJ’s price fell back by a considerable amount.

Despite those periods of negative price volatility, you can see that JNJ’s dividend went up
like clockwork every year. (JNJ has increased its dividend for 56 straight years.) JNJ’s
dividend did not go down even when its market price fell. The risk to JNJ’s dividend has
been significantly different from – and smaller than – the risk to its price. In other words, its
dividend has been far less volatile than its price, and all of the dividend’s volatility has been
upward.

Dividends are independent of price. (See DGI Lesson 7: Dividends Are Independent
from the Market.) So, if the most important thing to you is filling the gap to complete your
retirement income, you can see why the risk that you are most concerned about is not risk
to price. Rather, it is risk to your portfolio’s income.

How Does Diversification Help?

Diversification helps by spreading single-stock risk among many stocks.

Risk is based on probabilities. It’s the product of the probability of bad things happening
times the magnitude of damage if they occur.
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Say that you have decided that, in your dividend growth portfolio, there is a 3% chance
each year that one of your stocks will cut or suspend its dividend. That’s just a guess, but
it’s an educated guess.

What you don’t know (and cannot know) is which stocks will cut their dividends
nor when they will do it.

Let’s run some simple numbers. Your estimate of a 3% chance that a single stock will cut its
dividend in any year leads directly to planning that over 10 years, 30% of them will cut
their dividend.

But you don’t know which ones will cut nor when they will do it. In a 30-stock portfolio, your
3% educated guess would mean that over 10 years, you expect that 9 of the 30 stocks will
cut their dividends. In all likelihood, the bad events will happen unevenly:

Year 1: No cuts

Year 2: No cuts

Year 3: 2 cuts

Year 4: No cuts

And so on. After 10 years, there have been 9 cuts, but they occur unevenly. Until they
happen, you don’t know which companies will be the culprits.

Diversification helps by making those unknowns less important, almost to the point that you
don’t care. You have created a diversified portfolio of 30 stocks. If each one contributes
equal income, then each of your 30 stocks is responsible for 3.3% of your total income.

In a year when there are no dividend cuts, there is no negative effect on your income. But
even in a bad year when there are, say, 2 cuts, only 6-7% of your income is affected. You
can easily work around a 6% cut to your income.

In fact, you probably do not suffer a 6% income cut at all, even if those 2
companies eliminate their dividend entirely. That is because the other 28 stocks raise their
dividends that same year.
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Say the average increase for the other 28 stocks is a modest 5%. If your income the year
before was $12,000 (the gap-filler amount), your income the next year (trust my math)
would be $11,760.

You can live with that result. Besides, as part of normal portfolio management, you will
replace the 2 stocks that eliminate their dividends with 2 others that pay something.

How Do You Diversify?

I want my portfolios to be “well rounded.” That means that I try to diversify along multiple
dimensions. I want a variety of income streams that are different from each other, so that it
is less likely that more than one will suffer a negative outcome at any one time.

I will use the holdings in my Dividend Growth Portfolio (DGP) as examples of diversification
across multiple dimensions.

Economic Sectors

There is a standard classification system called GICS, which stands for Global Industry
Classification Standards.

Different sectors – and asset classes – have their up and down years. In the following table,
each color represents a different economic sector. (White indicates the average, and gray
indicates the S&P 500, which is diversified but not equal-weighted.) The table covers the
past 10 years.
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[Source]

The chart is filled with fascinating facts:

• 6 different sectors led at least 1 year.

• 5 different sectors were worst at least 1 year.
• Equal weighting all sectors invariably turned out around the middle; so, did the S&P
500 in most years.
• Individual sectors often went from best to worst or vice-versa. Examples: Utilities
was worst in 2012-13, then vaulted up to best in 2014. Energy was worst in 2014-
15, best in 2016, then worst again in 2017.

Here are the 11 economic sectors, with examples of stocks that I hold in my portfolio:

o Communications Services – AT&T (T), Verizon (VZ)

o Consumer discretionary – Hasbro (HAS), Lowe’s (LOW), McDonald’s (MCD)
o Consumer staples – Altria (MO), Coca-Cola (KO), PepsiCo (PEP), Phillip Morris (PM),
Procter & Gamble (PG)
o Energy – Chevron (CVX)
o Financials – None at this time
o Health Care – Amgen (AMGN), Johnson & Johnson (JNJ)
o Industrials – Boeing (BA)
o Materials – None at this time
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o Real Estate – Digital Realty Trust (DLR), Realty Income (O), Ventas (VTR)
o Technology – Cisco (CSCO), Microsoft (MSFT), Qualcomm (QCOM)
o Utilities – Alliant Energy (LNT), Southern (SO)

As you can see, even in a relatively small 23-stock portfolio, I am able to have pretty good
diversification across different economic sectors. Nine of the 11 sectors are represented.

Diversify across industries and sub-industries too, because they can have their ups and
downs within a single sector.

In my Consumer Staples stocks, you can see how different industries are represented: My 5
companies cover the beverage, snack food, cigarette, and household goods industries.

Yields

I like to mix things up with low-yield, mid-yield, and high-yield stocks. Across my whole
portfolio, the average yield is usually in the 3.5%-4% range, but the lowest might be below
2% (such as Lowe’s) while the highest may be 6% or more (AT&T).

Dividend Growth Rates

Often (but not always), lower-yielding stocks have higher dividend growth rates (DGR) and
vice versa. So, in addition to diversifying by yield, I diversify by DGR.

So, my portfolio has room both for a stock like AT&T, with a high yield but only a 2% per
year DGR, as well as Microsoft that has a sub-2% yield but a whopping 14% per year DGR
over the past 5 years.

Size of Company

While many of the best dividend growth stocks are huge “Blue Chip” companies, not all of
them are. In my own portfolio, for example, both Hasbro (Consumer Discretionary) and
Alliant Energy (Utilities) are mid-size companies. REITs (Real Estate) are often smaller
companies too.
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How Many Stocks Should You Own?

Obviously, diversification implies that you own more than one stock. But how many is
enough?

We know that the fewer stocks you own, the greater is your risk. You have more exposure
to single-stock risk – the impact of bad things that might happen to an individual holding.

Say you hold X number of stocks in equal amounts. This table shows how much of your
wealth/income is at risk from a bad thing happening to each individual stock, as a function
of how many stocks you own.

Remember, the risk referred to in the second column includes risk to income, not just price.
The table clearly implies that the lower your tolerance for risk, the more stocks you should
hold.

That said, the table also shows that there are diminishing risk-reduction benefits from
continually adding new stocks to a portfolio. The 50% risk reduction that you get from
adding 1 stock to a 1-stock portfolio drops to 1% risk reduction from adding 5 stocks to a
20-stock portfolio. At some point, adding more stocks confers almost no statistical benefit
and increases your work.

Ultimately, in my opinion, it becomes a matter of personal preference and comfort. When I

began my Dividend Growth Portfolio, it had 10 stocks, and I allowed any of them to be
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worth up to 20% of the portfolio. (Obviously, I did not anticipate having an equal-weighted
portfolio.)

In the 10 years since, I decided that was too risky for me. Therefore, I have changed my
guidelines a couple of times. Currently, I am aiming for 20-30 stocks and a maximum
position size of 10% of the portfolio. (To see the complete Business Plan for this
portfolio, click here.)

My 10% allowable maximum position size would still be too risky for many investors. I think
that 5% or 4% is more typical. If positions are equal weight, that would imply portfolios of
at least 20-25 stocks.

As we often see, there is a tension between the math and the psychology of investing. The
bottom line is that you should design your dividend growth portfolio to meet your unique
goals and tolerance for risk. There is no one-size-fits-all answer to the question of how
many stocks to own.

Diversification is Not the Only Risk-Control Technique

Just as a reminder, diversification is not the only way that you can keep risk to a level that
you find acceptable. Other techniques include:

• Valuation (see Lesson 11)

• Selecting quality companies (see Lesson 14)
• Dividend safety (see Lesson 17)

Also, remember that your tolerance for risk will be favorably impacted by the degree that
you understand your investments and construct a portfolio that specifically targets your
unique goals. To read more about setting goals, designing strategies, and writing your own
business plan, see Lessons 12 and 13.

A Word about Asset Allocation

This article is specifically aimed at the subject of diversification in a dividend-growth

portfolio.

Diversification writ large is a much broader subject. Dividend growth stocks are only a niche
selected from all of the possible investments that are available.
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In Modern Portfolio Theory, diversification includes the idea of investing in different asset
classes. The 3 main asset classes are stocks, bonds, and cash. There are innumerable sub-
classes, such as large-cap U.S. stocks or municipal bonds.

Obviously, a dividend growth portfolio is made up only of stocks. Therefore it is inherently

undiversified in the sense that other asset classes are omitted.

When I write about dividend growth investing, I never mean to imply that all of one’s
investments should be in stocks or in dividend growth stocks. Every investor must decide
for himself or herself how to allocate assets across different asset classes and sub-classes.

My articles about dividend growth investing relate solely to the equity portion of your
portfolio. The focus is on how to construct a stock portfolio that is designed to meet specific
goals, has acceptable risk and reward characteristics, and makes sense to you.

Even though all the assets in a dividend growth portfolio are in the single asset
class stocks, we saw above how you can mitigate risk to your capital and dividend stream
by diversifying among a variety of economic sectors, industries, companies with different
dividend characteristics, and the like.

A Word about Price Volatility

Earlier, I explained why the common definition of risk – variation in an asset’s price – is too
narrow. A dividend growth investor needs to expand the definition to include risks to the
dividend stream.

Nevertheless, portfolio volatility is important. Even the most income-centric investor may
become unnerved if his or her portfolio drops 20% or 30% in a bear market – even if the
income from the portfolio continues to grow.

Therefore, many dividend growth investors are at least a little interested in the beta of their
portfolio. Beta is a measure of price volatility compared to the market.

If “the market” is defined as the S&P 500, then by definition the S&P 500 has a beta of 1.0.
An asset whose price tends to move less than the S&P 500 has a beta < 1.0, while a
portfolio with more volatility has a beta > 1.0.
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My own Dividend Growth Portfolio has a beta of about 0.7, meaning it moves up and down
at about 70% as much as the market.

You can compute the beta of your portfolio by taking the average of the betas of the stocks
in it. If every stock is equal weighted in the portfolio, then the beta of the whole portfolio is
the simple average of betas. If the stocks have different weights, to get a precise result you
would weight the beta of each stock before calculating the average.

I use beta as a minor factor in my write-ups of Dividend Growth Stocks of the Month. I
consider a low beta to be a “plus factor,” because stocks with lower volatility are less likely
to cause emotional reactions when the market is volatile. That helps you stick with your
plan.

Key Takeaways from this Lesson

1. Diversification means owning multiple assets, as distinguished from putting all your
eggs in just 1 or 2 baskets.
2. Diversification is a risk-control technique. While you never have total control, and
certainly can never eliminate risk when you invest in stocks, diversification holds risk
down by spreading your bets among different stocks with different characteristics.
3. Construct a portfolio with enough stocks to provide sufficient diversification, but not
so many that it’s too much work to keep track of them. Both of those judgements
are up to you. Many investors find that their sweet spot is in the 20-30 stock range.
4. Diversify your portfolio in ways that make sense to you. Buy stocks that differ in:

• Economic sectors and industries within sectors

• Company size
• Yield
• Dividend growth rate

5. Remember that dividend income can (and often does) go up even when stock prices
are going down. That knowledge can help you stick with your investing plan even
when others are panicking.

Dave Van Knapp

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DGI Lesson 17: Dividend Safety

One of the most important factors in dividend growth investing is dividend safety.

The reliability of a company’s dividend payments is crucial, whether you are depending on
dividends to provide growing income or to contribute to good total returns. The reason
should be obvious: If you cannot rely on a dividend’s safety, you can’t rely on the other
elements of the dividend growth process:

• Growing income
• Reinvesting
• Compounding

Dividend safety is even more important if you are retired and using dividends as cash
income to live on. You must be able to rely on the dividends being delivered and growing at
the approximate rate you expect.

How do you know if a dividend is safe?

In one sense, you cannot know if a dividend is safe: No one knows the future.

You can never be 100% sure that every company you own will increase or even maintain its
dividend every year.

Sometimes things go wrong. Unexpected things happen.

But being unable to be 100% sure of the future is not unique to dividend safety. It applies
to all of life.

Therefore, I suggest that you take a probabilistic view of investing.

That means that, using information and analysis, attempt to tilt the odds in your favor
whenever possible.

So in analyzing stocks, examine the available evidence for clues about what is likely to
happen. As the maxim says, “History doesn’t repeat itself, but it rhymes.”

When analyzing a stock, look at things like:

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• How many years a company has been increasing its dividend. See Lesson 3: The 5-
Year Rule. The longer the better.
• Whether a company has frozen its dividend or is overdue for its annual increase.
Check the most recent Dividend Champions document.
• How financially sound the company is, with particular attention to its debt and credit
rating.
• Whether the size of annual increases has been trending up or down. Again, see the
Dividend Champions document for a nice summary.

The dividend payout ratio

Many dividend investors only look at a single metric – the payout ratio – to assess dividend
safety. The dividend payout ratio divides the dividend (in dollars) by an amount, typically
the company’s earnings.

Payout ratio = Dividend per share / Earnings per share

Since companies need to retain at least some earnings to grow and improve, investors don’t
want to see all earnings paid out as dividends. So often, a payout ratio of 50% will be
considered safe, while a payout ratio of 70% might be considered risky.

But dividend safety requires deeper analysis. The safe amount of dividends to pay out varies
by company. One company may starve itself if it pays out any earnings as dividends, while
another company may be fine paying 70% or more of its earnings to shareholders.

Not only that, earnings may not be the right number to get a meaningful ratio. In real
life, dividends are paid in cash out of the company’s cash flow. Therefore, dividends-
to-cash flow may be a better measure of how safe a dividend is, rather than the percent-of-
earnings ratio commonly used.

Cash payout ratio = Dividend per share / Cash flow per share

Cashflow and earnings are not usually the same in any company. They can be especially
wide apart in companies that make a lot of capital investments, such as telephone
companies, REITs, and others that are constantly building or purchasing more
infrastructure.
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Dividend safety services

Because dividend safety is of such importance, I augment my own analysis of companies on

the subject.

To do that, I consult the services of an organization that focuses especially on dividend

safety: Simply Safe Dividends.

Simply Safe Dividends (SSD) was formed in 2015 by my Daily Trade Alert colleague Brian
Bollinger, who was previously a partner and equity research analyst for a large investment
manager in Illinois.

SSD computes Dividend Safety Scores and offers a suite of online portfolio tools, stock
analyses, and data for individual dividend investors.

SSD’s Dividend Safety Scores range from 0 to 100, and they take a long-term, conservative
view with their ratings. Specifically, dividend risk is assessed over a full economic cycle –
not just next quarter. Here is the scoring system.

Brian suggests that conservative investors stick with companies that score at least 60 for
Dividend Safety.

In my Dividend Growth Stock of the Month and Valuation Zone articles, I use SSD’s scores
to help make sure that a stock is worthy of even researching in depth.

Brian told me a little about how he arrives at his scores.

I believe that companies most at risk of cutting their dividends emit a number of warning
signs well before a reduction is announced – sales and earnings are usually falling, the
balance sheet is overleveraged, payout ratios are unsustainable, management hasn’t shown
to be overly committed to maintaining the dividend, and the company needs to preserve
cash.
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SSD’s Safety Scores are designed to be a comprehensive measurement of dividend risk.

They take into account more than a dozen key factors that influence a company’s ability to
continue paying dividends. The factors include:

• Debt load
• Interest coverage
• Industry cyclicality
• Free cash flow generation
• Profitability
• Earnings and free cash flow payout ratios
• Business model quality
• Performance during past recessions
• Dividend longevity
• Near-term sales and earnings growth

The predictive power of SSD’s scores has been impressive. At this page, there is a
compilation of dividend cuts since the system was introduced in 2015. An investor who
stuck to stocks with scores 60 or above would have avoided 98% of them.

Dividend Safety Scores are updated weekly. A detailed explanation of how they are
calculated can be found here.

Key takeaways from this lesson

1. Dividend safety can be measured. Not exactly measured, of course, because risks to a
dividend involve the future. But probabilities can be placed on the likelihood that a
company’s dividend is safe and not likely to be cut.

2. The safety of a company’s dividend depends on its means to pay the dividend and
increase it, as well as on its policies to do so.

3. Over time, companies build up dividend resumes that show their means and intentions
with respect to dividends, including dividend growth.

4. By examining a variety of financial factors, you can tilt the odds in your favor of owning
companies that are less likely to cut their dividends. Stick to companies with safe dividends,
even if that means giving up a little in yield.
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DGI Lesson 18: Which Is Better: High Yield or Fast Dividend Growth?

Some dividend growth investors believe that a fast-growth stock is “better” than a slower-
growing stock.

For example, they would consider Starbucks (SBUX) to be better than AT&T (T), because
Starbucks has a much faster rate of dividend growth. Its dividend growth rate over the past
5 years has been more than 24% per year, while AT&T has been plodding along at 2% per
year.

Other dividend growth investors think that high yield trumps a fast dividend growth rate.

They would say that AT&T is better than Starbucks, because it has a much higher yield. Its
yield is nearly 7%, making it a true high-yield stock. (Disclosure: I own both stocks.)

But does either characteristic, by itself, make Starbucks or AT&T “better”?

It depends. “Better” is subjective. Whether a high-growth or high-yield stock is

better for you depends on a multitude of factors, including your goals, age,
and situation in life.

Let’s Check the Math

To get started, let’s look at the math. Here is the tale of the tape for these two stocks. You
can see that they are different breeds of DG stocks.

In evaluating stocks, sometimes it can be tempting to gloss over yield in favor of dividend
growth rate, or vice versa. But to decide what’s “better,” you have to look at both metrics,
particularly how they play out over time.

These two stocks provide stark examples of the extremes. Starbucks is a low-yield, fast-
DGR stock. AT&T is the opposite: High-yield, slow-DGR.

Here’s the key: Both yield and DGR impact how many dollars you receive over time
from each stock.
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To illustrate the interplay between yield and dividend growth rate, I like to use the
calculator at Miller/Howard Investments. Let’s plug Starbucks’ and AT&T’s stats into the
calculator and see what we get.

Here is Starbucks, showing scenarios both with (orange) and without (blue) dividends being
reinvested:

In the input section, I entered Starbucks’ 2.1% yield. I also input Starbuck’s 24% DGR, but
the calculator limits DGR to 20% maximum per year in drawing the graph.

For the orange inputs, I had the dividends reinvested (note the checkmark in the box).

The blue version does not reinvest dividends.

I used a $1000 initial investment for simplicity.

So both graphs represent Starbucks – with dividends simply collected (blue) and with
dividends reinvested (orange).

As you would expect, the orange version with dividends reinvested pulls away from the blue
version, especially after Year 13 or so. (See DGI Lesson 5: The Power of Reinvesting
Dividends.)

How do these results compare with AT&T?

To make the comparison, we will focus on the scenario with dividends reinvested, since this
is what most investors do before they retire and need the income for expenses.
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So, in the next graph, I will plug AT&T’s stats into the blue input area, with dividends
reinvested. Starbucks remains the orange stock, also with dividends reinvested.

At a glance, this looks like a laughable mismatch. Starbucks wins spectacularly.

Or does it? Look closer. Through the first 9 years, AT&T sends you more dividends than
Starbucks every year. Here are the dividends by year (based on the $1000 initial
investment).

AT&T starts out with a sizable advantage, paying you more than 3x Starbucks in the first
year alone.

While Starbucks is growing its payout much faster, AT&T’s annual payout begins much
higher and is more than Starbucks’ payout in each of the first 9 years. AT&T’s higher yield
gives it a giant advantage out of the starting gate in terms of total dividends delivered.
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After 9 years, AT&T has paid out 1.6x Starbucks’ dividends in total, although Starbucks’
annual payment has finally caught up with AT&T’s.

The degree of AT&T’s annual advantage, of course, declines each year, because Starbucks’
dividend is growing much faster. Starbucks finally passes AT&T in Year 10. Then the
annual gap widens in Starbucks’ favor each year.

After 9 years, the total dividends paid are $894 for AT&T vs. $566 for Starbucks. AT&T has
paid out 58% more dividends than Starbucks through the first 9 years. Not only that, since
the initial investment was $1000, AT&T has practically paid you back your entire initial
outlay after 9 years. You’re basically playing with house money after that.

It will take another 6 years for Starbucks to catch up in terms of total (cumulative)
dividends delivered. Here is the rest of the table illustrating that.

So, Starbucks’ higher growth does eventually win out in both dividends per year (Year 10)
and cumulative dividends (Year 15).

I have compared numerous pairs of stocks along these lines. Crossover points of 10-12
years for annual dividends, and 15-17 years for cumulative dividends, are typical when
comparing a high-yield, slow-growth stock to a low-yield, fast-growth stock.

Those are significant chunks of an investor’s lifetime. What you term “better” may thus
have a lot to do with your age when you start, and/or your need for immediate
income. A retiree may view the question quite differently from a 30-year-old.
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Dividend Growth Predictability

There’s another factor to think about: What is the chance that Starbucks will maintain a
DGR of 20% each year for 20 years or more?

Let’s put it this way. It hasn’t been done yet. According to the excellent Tesselation website,
no company with a DGR as high as 20% each year has maintained that pace for at least 10
years, let alone 20.

The highest DGR that has been maintained each year for at least 20 years is 12% per year,
and only one company has done it. That company is Ross Stores (ROST), whose dividend
yield is only 1.0%.

So, the almost certain scenario is that Starbucks’ DGR will gradually come down. It is
foolish, in my opinion, to project that Starbucks (or any company) will maintain a dividend
growth rate anywhere near 20% per year for a really long term.

That likely slowdown in annual growth, of course, would lengthen the timeframes that we
discussed above. It is likely that it will take Starbucks more than 10 years to surpass AT&T
in annual dividends, and more than 15 years to surpass it in cumulative dividends.

In fact, it is possible to construct a scenario in which Starbucks’ cumulative total dividends

never passes AT&T’s, because Starbucks’ growth may slow enough that it never overcomes
the early lead that AT&T gained from its higher initial yield.

The Bottom Line

Remember, when comparing dividend growth stocks, to look at both the initial yield and
the historical dividend growth rate. Consider how long the faster-growing company can
maintain that rate of growth. You won’t be able to pinpoint that exactly, but you can make
an educated guess.
My own approach to this question is that I like to have a mixture of both kinds of stocks in
my portfolio. Mixing them up is a form of diversification. See DGI Lesson 16: Diversification.

This table shows how I divide stocks into 3 categories based on yield (low, mid, and high),
and then interpret their dividend growth rates in ways that are sensible for each yield
range.
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As you can see, I consider 2% per year to be an OK dividend growth rate for a stock with a
yield of over 4%, but it would take a 9% per year DGR to be OK for a stock yielding less
than 2%.

Key Takeaways from this Lesson

1. Never assume that a faster-growth dividend stock is automatically better.

2. For that matter, never assume that a high-yield stock is better either.
3. Instead, examine the interplay between yield and growth rate for both stocks.
4. A stock with a high yield at the time you buy it gets a significant head start in
delivering not only dividends per year, but also cumulative dividends for many years,
compared to a stock with a low initial yield.
5. “Better” is subjective. It may depend on your age, current income needs, and
other factors.
6. Don’t project high DGRs infinitely into the future. Every company’s dividend
growth rate eventually reverts to a level similar to its earnings growth rate.
7. Consider owning both high-yielders and fast-growers to help diversify your
portfolio.

— Dave Van Knapp

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DGI Lesson 19: How to Increase Your Investor Returns

Investors Often Make Less Than the Stocks They Invest In

Did you know that many investors’ returns are a lot less than the returns of the stocks they
invest in?

That’s why you see graphs like this:

[Source]

That graph shows us that “average investors” in 1993-2013 gained far less than practically
anything they might have invested in.

More recent studies show that little has changed since then.
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[Source]

When I first saw charts like these, I thought it was impossible: After all, everyone’s money
is somewhere, and the charts list practically every place it could be. How could the
average investor underperform everything?

Well, if you look closely, there’s one giant asset class not listed: Cash.

So, what the graphs really tell us is that many investors hold lots of money in cash, which
earned little during 1993-2013 and today earns even less.

And that brings us to the difference between investor returns and investment returns.

Investor returns are what you, as an investor, actually receive.

Investor returns differ from stock returns in this way: Investor returns take into account
your own behavior.

Remember in DGI Lesson 12: Run Your Investing Like a Business, we said:

You are the founder, CEO, and Chief Investment Officer of your business. You want to run it
well. Every well-run business has:

• a primary goal;
• strategies designed to achieve that goal; and
• tactics, programs, and activities to execute the strategies.
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Running your investments like a business helps remove behavioral quirks and emotions
from your investment decisions. That way, your investor returns will more closely match the
returns of what you hold.

That’s what we want, because in general, studies have shown that investor returns usually
trail investment returns, often by large amounts. The reason universally identified by
these studies is that investors trade too much and time their trades badly.

Specifically, they sell out in fear during market downturns (going to cash), then they wait
too long in cash to get back into the market when it’s going up. Their money earns nothing
in cash.

Why do investors behave like this?

• Fear. Selling in a panic when the stock market drops.

• Greed. Buying when the market has been going up or topped out, based on short-term
euphoria (recency bias).
• Impatience. Short-term view rather than long-term view. Hopping around from idea to
idea rather than giving an investment thesis time to play out.
• Lack of discipline and over-emotionalism. Being triggerd into action by today’s news,
especially breathless stock-market reports. Trading based on tips or superficialities.

Dividend Growth Investors Have Another Behavioral Factor

Dividend growth investing (DGI) includes all of the above factors that could negatively
impact investor returns.

But with DGI, there’s another factor as well: Dividend reinvestment.

We saw the math behind dividend reinvestment in DGI Lesson 5: The Power of Reinvesting
Dividends.

But reinvesting dividends is a behavioral issue too: Dividend reinvestment is controlled by

you, the investor. You have to decide to do it, and then you must execute your decision(s).

If you owned a business like a construction company, much of your success over time would
result from how you allocated capital. Capital comes into such a business via payments for
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jobs completed, business loans, and the like. What you do with that capital is called capital
allocation.

As a stock investor, running your stock-investing business, you make capital allocation
decisions too. You decide what stocks to buy in the first place, how to manage your
portfolio, and what to do with dividends.

Thus, your investing operation is itself a growth business. That is true even if you
invest in slow-growth dividend-paying companies.

To see this more clearly, break down the sources of return to the stock investor. There are
more sources than simply the growth of the businesses that you own.

The Layers of Returns for The Stock Investor

Viewed from the perspective of the investor’s investing business, here are the five
components of return.

1. Results of trading in and out

We saw above that many investors sabotage themselves by trading in and out of stocks,
trying to catch high points and get out at low points.

That usually backfires, because no one has a crystal ball. Sells made at perceived highs
often cause the investor to miss still higher highs that come later. And buys made at
perceived lows often cause the investor to be stuck in cash, rather than invested, when the
market reverses and the stock’s price starts going back up. By the time the investor decides
to re-enter the market, much of the runup has been missed.

So, the first layer of investor returns is under the investor’s control: Don’t trade
too much, and don’t try to time the market.

2. Earnings growth

It is axiomatic in stock investing that stock prices follow earnings.

But a footnote to the axiom is: But not always and not consistently. Let’s be sure we
understand the relationship between a company’s earnings and its stock price.
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Stock prices are determined in the market. The market is an auction house: Potential
buyers make bids, and potential sellers set their asking prices.

The stock’s multiple – price divided by earnings, or P/E ratio – reflects this fact. Market
participants place a value on earnings and the expected growth of earnings. The market’s
valuation of a stock is reflected in the P/E ratio at any given time.

As I write this, Johnson and Johnson (JNJ) has a multiple of 24.59, circled below.

JNJ is one of my favorite stocks for illustrating investment principles. One reason is that it
suffered through a strange flat period in the 2000s where its price hardly moved for a
decade even though its earnings increased steadily.

The following chart shows July 1999 through March 2009. JNJ’s earnings rose every year, a
total of 180% (see the orange line), while the stock’s price (blue line) hardly changed for a
whole decade.
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During that decade, the market did not reward JNJ’s continual earnings increases by upping
the share price. JNJ was called “dead money,” and investors were often advised to avoid
the stock.

An over-reactive investor might have followed such triggers and sold the stock. As we’ll see,
that would have been a mistake.

Why didn’t JNJ’s price rise with its earnings? Because for 10 years, while JNJ’s earnings
rose every year, the market steadily devalued those earnings. JNJ had a high P/E ratio at
the beginning of its dead-money era, but that ratio fell for 10 years even as the company
was growing its earnings.

At the beginning of the period, JNJ’s P/E ratio was over 40. At the end of the decade, it was
under 11.

A stock’s P/E ratio is determined by the market, not by the company. Why did the market
devalue JNJ’s shares when the company was doing such a great job?

Markets can be irrational. We can surmise that at the beginning of the period, owners of
JNJ had bid up its price “too high,” cresting in a euphoria of over-valuation. The valuation
of JNJ was irrational at 40.

But the market self-corrected, as it often does over long periods of time. A decade later,
JNJ’s shares were, if anything, undervalued at 11.
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Then the market turned around and reversed itself again. Over the next few years, JNJ’s
price climbed back faster than its earnings grew.

If you look at enough price charts, you’ll see that that is typical behavior for stocks,
although market irrationality it rarely lasts for 10 years. Stock prices often climb above fair
value, then fall back below fair value, then climb back up again. A stock’s price is
rarely right on its fair value.

Over the long term, the stock’s price will approximately track its earnings growth. Over
shorter time frames, its price might do anything, including move in the opposite direction of
earnings.

Here’s my point: The axiom that stock prices follow earnings is true in general, but
sometimes it takes years for the thesis to play out.

In any event, that is the next layer of returns: Stock prices directionally tend to
mirror growth in earnings over long periods of time. This layer of returns is not in the
investor’s control: Earnings are a function of how the company is performing.

3. Multiple expansion or contraction

We just saw that over long periods, earnings and stock price tend to correspond to each
other. But we also saw that over shorter time periods, they often do not.

Many times, a stock’s P/E ratio is around 15, and that is often viewed as a fair valuation
estimate for most stocks most of the time.

But the exact P/E ratio changes constantly in the market, as buyers and sellers complete
transactions.

Let’s look at JNJ again, this time using FASTGraphs. On the following chart, the orange line
is drawn at a constant P/E ratio of 15. That provides us with a generic fair value for JNJ’s
stock. It moves with earnings, because it is a constant multiple of earnings.

The black line is JNJ’s actual price, reflecting what traders are actually doing in the market.
This chart covers more than 20 years.
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You can see that over that long a period, JNJ’s price has sort of generally followed its
steadily rising earnings. Its price has stayed within about 50% of the orange line at all
times, indeed wandering through it in both directions a few times.

I put maroon dots at the beginning and end of the 10-year dead-money era on this chart.
Note that from one dot to the other, JNJ’s fair price (orange line) went up steadily – due to
JNJ’s earnings success – but its price zig-zagged up and down, ending up just about where
it began.

The orange fair-value line is nice and smooth (drawn at a constant P/E of 15), but the black
price line is volatile and has sudden directional changes. Note also that at the beginning of
the dead-money decade, JNJ’s price was quite a bit above its fair price (orange line), but
by the end of the decade, it was quite a bit below its fair price.

For the JNJ investor, the outcome was this: During its dead-money decade, the JNJ
shareholder did not receive price returns commensurate with JNJ’s earnings growth. Even
though JNJ was steadily increasing its earnings every year, the market was relentlessly
reducing the value that it placed on those earnings.

But then, in 2011-12, the market’s devaluation of JNJ’s earnings reversed, as investors
began to value JNJ’s earnings more highly, and JNJ’s P/E ratio steadily rose. The result has
been that in recent years, JNJ’s price has grown faster than its earnings.
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So, while JNJ’s really long-term shareholders have received price returns that roughly
correlated with JNJ’s earnings growth, the degree of correlation has varied markedly over
shorter time periods.

So that is the third source of stock returns: Market valuation. As an investor, you
have no control over the market’s raising and lowering of the stock’s P/E ratio. You just
have to accept it.

And also note that if you tried to trade in and out of JNJ, it would be all but impossible to
time your trades correctly. The price line simply zig-zags too much. If you are truly a
dividend-growth investor, my advice is simple: Don’t do that.

4. Dividends

Dividends are cash sent to you by the company. (See DGI Lesson 1: What Is a Dividend?)

Dividends are added to price returns as part of the return equation. Your return from a
stock in a given period = price change + dividends.

*** So, while dividends do not represent growth in the compa*ny, they certainly represent
growth to you as an investor in the company.

*** Over time, in the whole market (as measured by the S&P 500), dividends contribute
about 30-40% of the stock market’s return, although that varies by year and by era.

[Source]

Dividends are the fourth layer of shareholder returns. You have no control over dividends.
Dividends are declared by the companies themselves.
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5. Reinvestment of dividends

The chart just above does not account for the reinvestment of dividends. The 30-40%
contribution of dividends to investor returns only accounts for receiving the dividends.

Note that the chart is labeled “total return.” That’s only half-correct. What the chart depicts
are price returns + dividends if you do nothing with the dividends. The label is misleading.
(I encourage you to always check what a “total return” chart is actually displaying. There is
no consistency.)

You own an investing business. Your business has revenue coming into it in the form of
dividends. What you do with them has a great impact on your total investor returns.

If you reinvest dividends, that triggers compounding. Compounding means making money
on money already made. The dividends are money already made. If you reinvest them, you
position them to make still more money.

Reinvesting dividends is central to the difference between stock returns and

investor returns for the dividend growth investor.

Here is a simple generic example of a dividend being reinvested. The dividend is 3.5% yield
growing at 6% per year. On the chart below, the blue line shows the growth in the annual
dividend if it is not reinvested, while the orange line shows the effect of reinvestment back
into the same stock. The chart assumes an initial investment of $10,000.
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The blue line illustrates simple 6% per year growth. The orange line shows what happens if
you leverage that 6% annual growth by reinvesting those dividends. As you can see, the
impact of dividend reinvestment is enormous, especially after the first decade or so.

Here’s the same example in table form. It shows the Yield on Investment (usually called
Yield on Cost) of the blue and orange lines. YOI = the current yield calculated as a fraction
of the original costof the investment.

I call the impact of reinvesting dividends the “Multiplier Effect.” It grows every year. If you
reinvest your dividends regularly, they grow faster and faster compared to not reinvesting.
That is why the orange line of dividends received curves up so much more dramatically than
the blue line.

Not only that, the reinvestments buy more shares too. Therefore, the investor gets the
benefit of price returns from the “extra” shares as well as the rising dividends from those
shares on top of the shares originally purchased.

Just focusing on the dividends alone, the multiplier effect after 10 years is 1.34. That means
that the investor will get 34% more dividends in Year 10 than he or she would have
received if they hadn’t invested dividends along the way.

The Multiplier Effect does not show up in any chart of the stock itself, unless you find a
“total return” chart that includes dividend reinvestment. (Remember that the “total return”
chart shown earlier did not include dividend reinvestment. You have to be careful
interpreting chart labels.)

The multiplier effect of reinvesting dividends – which is the fifth layer of investor
returns – is not the result of anything done by the company. It is the result of
decisions made by the investor to reinvest those dividends.
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Summary of Layers of Investor Returns

The discussion above explains several ways that investor returns differ from the company
and market performance, with emphasis on how your behaviors and decisions affect your
returns.

The total return of your investment business is determined by all the layers of
returns, not just by what the companies and markets do.

Total Shareholder Returns

That gets us to total returns experienced by the investor, which result from the combined
impact of all the elements just described:

• Investor’s behavior
• Company earnings growth
• Valuation
• Dividends
• Dividend reinvestment

Let’s use Johnson & Johnson again as an illustration. Despite its decade-long dead-money
period, JNJ delivered positive investor returns during that time because of its dividends,
which grew every year throughout that decade.
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Not only that, if the investor reinvested the dividends back into JNJ, he or she received
more shares, which generated more dividends, in a virtuous circle of rising share counts and
dividends.

Those extra shares eventually benefited from the price runups that finally happened when
JNJ shook off its market slump at the end of the dead-money decade.

These graphs illustrate the total returns that an investor would have received from JNJ with
and without reinvesting dividends over the past 20 years, starting with an initial investment
of $10,000.

Note that the $10,000 initial investment bought 205.13 shares of JNJ 20 years ago. Without
dividend reinvestment, that’s how many shares the investor would still own today.
But with dividend reinvestment, the investor’s stash would have risen to 337.83 shares
today – 65% more shares.
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Since dividends are paid per share, that represents a 65% increase in annual dividends,
without the investor having done a thing other than (1) hold on, and (2) plow the dividends
back into JNJ.

Plus, those new shares rose in price. Subtracting out the initial $10,000 investment, the JNJ
investor who bought, held, and reinvested dividends would have made 38% more profit
than the investor who did not reinvest dividends.

Let’s go over the layers of shareholder returns and see how they relate to JNJ’s performance
over the past 20 years.
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Key Takeaways from This Lesson

1. Investor returns differ from the market returns of the assets invested in.

*** 2. The differences result from investor behavior. There are five layers of investor
returns, and investors are in complete control of two of them. The decisions you make in
these two layers can have an enormous impact on your returns.

3. One layer that investors control is their frequency of trading. Many investors trade too
much, and they often hurt their own results by doing so. Through over-trading, they shoot
themselves in the foot from fear, greed, or trying to outwit the market.

4. The other layer that investors control is whether they reinvest their dividends. While
some investors need their dividends to live on, and therefore can’t reinvest them, dividend
growth investors can significantly multiply their returns by reinvesting dividends.

— Dave Van Knapp