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Starting From Scratch: Building Your Dividend Growth Portfolio

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Starting From Scratch:  Building Your Dividend Growth Portfolio by Ben Reynolds, Sure Dividend

I wish someone would have sat down and talked with me about how to invest when I first started out…

I got lucky.  When I first started investing, I didn’t have much money.  The ‘cost of my learning’ wasn’t too expensive.

If you are new to investing, this article is that ‘sit down chat’ about how to invest well.

Investing can seem extremely complicated…

There is a staggering amount of industry specific knowledge in investing.  Case-in-point:  Here are 101 financial ratios and metrics that are important to investing.

Don’t fret, you don’t need to know all 101 to do well in the stock market.

In fact, how to do well as an investor can be boiled down into the following sentence:

Invest in great businesses with strong competitive advantages and shareholder friendly managements trading at fair or better prices.

Buying high quality businesses has historically been a winning strategy, but please do not just take my word for it…

Claims without facts are just baseless opinions.

Here are a few relevant facts:

  1. The Dividend Aristocrats Index is comprised of businesses with 25+ years of consecutive dividend increases. I’d say that qualifies as ‘high quality’.
  2. The Dividend Aristocrats Index has outperformed the S&P 500 by 3.4 percentage points a year on average over the last decade.

Source:  S&P Dividend Aristocrats Fact Sheet

Once you invest in great businesses, do something else.  The benefit to owning great businesses is that they compound your wealth over time.

You don’t have to monitor their price movements – in fact that can hurt your investing performance if it makes you buy or sell to often.  All you need to do is let these great businesses compound your wealth over time.

The bolded statement above covers all there is to know about successful dividend growth investing.  Admittedly, the detail isn’t there.

The rest of this article discusses how to build a dividend growth portfolio, starting with $5,000 or less.

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Should You Build Your Portfolio with Stocks or ETFs?

There is much back-and-forth in the investing industry about what is better:  ETFs or individual stocks.

The truth is that both options have pros and cons.  I personally prefer to invest in individual stocks – systematically.  The 8 Rules of Dividend Investing systemically identify and rank high quality dividend growth stocks over metrics that have historically either improved returns or reduced risk.

I say this so you can understand my bias upfront.  I try to take an unbiased look at the pros and cons of ETFs and dividends.  I can’t help but see through the lens of an individual stock investor.

With that said, take a look at the pros-and-cons of ETFs versus individual stocks summarized from my article on The Best Dividend ETF.

Pro: Investing in dividend ETFs provides wide diversification. This is helpful for investors with small portfolios as they can get necessary diversification without wasting money on multiple brokerage commission fees necessary to build a dividend portfolio of individual stocks.

Pro: Investing in dividend ETFs has a low time commitment. Once purchased, investors can ‘sit and forget’ about their ETF.  No additional research is required.

Pro: Dividend ETFs tend to have lower annual expense ratios than mutual funds. Several dividend ETFs have annual expense ratios below 0.1%.

Con: Dividend ETFs are more expensive than owning individual stocks. Individual stocks will always have an expense ratio of 0.0%. You can’t beat that. Low cost brokerages make buying and selling costs minimal.

Con: You cannot pick what businesses you own with a dividend ETF.

Con: Dividend ETFs give you no control over your portfolio. You cannot buy or sell individual stocks. You cannot fine-tune your strategy to match your specific needs.

There’s nothing wrong with investing in dividend ETFs. For investors with minimal time and/or interest in investing, dividend ETFs are an excellent alternative to mutual funds and individual stocks.

I prefer to invest in businesses, not markets.  The rest of this article will assume you do as well.

Where to Find Great Businesses

To invest in great businesses…  You have to find them first.

The previously mentioned Dividend Aristocrats Index is an excellent place to start your search.  The Dividend Aristocrats Index contains:

  • Contains 50 businesses
  • All 50 have 25+ years of consecutive dividend increases
  • And are in the S&P 500
  • And meet certain size and liquidity requirements

Click here to see a list of all 50 Dividend Aristocrats.

Another great place to look is the Dividend Kings List.  The Dividend Kings list is similar to the Dividend Aristocrats – except it is even more exclusive.  The Dividend Kings list includes just 17 businesses with 50+ years of consecutive dividend increases.  Click here to see all 17 Dividend Kings.

Beyond these 2 lists, you should also visit the Dividend Champions list.  The Dividend Champions List contains well over 100 businesses with 25+ years of consecutive dividend increases.  It is similar to the Dividend Aristocrats Index, except it removes the arbitrary requirement of having to be in the S&P 500 to be included.  Click here to download a list of all Dividend Champions.

The Sure Dividend newsletter lists over 180 businesses with 25+ years of dividend payments without a reduction.  This is a bit more inclusive as it allows a business to freeze its dividend (not raise it but continue to pay it) and still be on the list.

How To Know If A Great Business Is Trading at Fair Or Better Prices

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Finding great businesses with shareholder friendly managements is the first step.

The second is to determine if these great businesses are trading at fair or better prices.

A very quick-and-easy rule of thumb is to look for great businesses trading at or below the S&P 500’s current price-to-earnings ratio.  If a businesses is higher-than-average quality, you would think it would command a higher price-to-earnings ratio than the average S&P 500 price-to-earnings ratio.

Great businesses that trade below the S&P 500’s price-to-earnings ratio are a good place to look into value in more detail.  The S&P 500’s price-to-earnings multiple is currently 22.5.

Beyond that, investors should compare a business current price-to-earnings ratio to both:

  • Its 10 year historical average price-to-earnings ratio
  • Its competitor’s price-to-earnings ratio

It is important to remember to use adjusted earnings when comparing price-to-earnings multiples.  GAAP earnings can be reduced by one time effects such as acquisition costs or deprecation charges that are accounting based, but not reality bases.  It’s more important to understand the long term earnings power of a business.

How Many Stocks Should You Hold?

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There’s a tradeoff with diversification.  The more stock you hold, the safer you are if any one of them implodes.  On the other hand, you have less to gain from the stocks you hold that do well.

Is there a way to get most of the benefits of diversification without over-diversifying into 100’s of positions?  There is.

90% of the benefits of diversification come from holding just 12 to 18 stocks.  Holding a portfolio of around 20 stocks (to be on the safer side) gives 90%+ of the benefits of holding 100+ stocks.

The advantage to holding around 20 stocks is you get to invest in your best ideas.  You can own the businesses you are most comfortable holding that you believe have the greatest total return potential.

Holding a large portfolio of 100 or 200 stocks is virtually impossible to keep up with.  It’s hard to really know 100+ businesses.  Keeping up with the quarterly reports of over 100 businesses would take a serious time commitment.  Much less so for 20 businesses.

Investing in around 20 businesses is the ‘sweet spot’ between investing in only your best ideas while still benefitting from diversification.

You can’t just own any 20 stocks and be diversified, however.

As an example, if you owned 20 upstream oil corporations, you would not be well diversified.  Similarly, owning 20 biotech companies does not a diversified portfolio make.

Dividend growth investors should look to invest over different sectors to gain exposure to different types of great businesses.

The next section discusses different portfolio building strategies.

Dividend Growth Portfolio Building Strategy

There are two types of ‘new’ dividend growth investors:

  • Those that are starting from scratch
  • Those with sizeable portfolios looking to transfer over to dividend growth investing

This article is about starting from scratch.  That’s what will be covered in this section.

Building a high quality dividend growth portfolio is a process.

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The process will take time.  So do most things that matter.

Instead of thinking you will ‘never make it’ because you don’t have $100,000 or $1,000,000 to build your portfolio, focus on saving and investing the same amount each month.

I recommend buying the highest ranked stock you own the least every month based on your specific criteria.  Over time, you will build a well-diversified portfolio of high quality dividend growth stocks.

The longer  you invest, the more money you have to invest, and the more diversified your portfolio will become.

No matter how selective you are when purchasing stocks for your dividend growth portfolio, you will eventually have to trim the ‘dead weight’.

I am a long-term investor.  Once I buy a stock I would prefer to let it compound my wealth indefinitely.

In the real world, things happen.  Businesses that were great at one time lose their competitive advantage.  This can happen by management losing its way, technology changes, or by competitors finding a way to destroy or copy the company’s competitive advantage.

When a business loses its ability to compound your wealth through rising dividend payments, it is time to sell the business.

My primary sell criteria is to sell when a business cuts or eliminates its dividend.  This is a very clear sign from management that either:

  1. The dividend is not important (shareholders don’t matter)
  2. The business cannot sustain its dividend (business is in decline)

In either case, that is not the type of investment likely to generate long-term wealth.  Of course, there are exceptions.  Sometimes businesses rebound after dividend cuts.  The historical record shows that dividend cutters make poor investments, on average.

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Source:  An Economic Perspective On Dividends, slide 7

There is one other good reason to sell a dividend growth stock…

If it becomes wildly and absurdly overvalued.  I will happily sell a business with an adjusted price-to-earnings ratio over 40.  At this level, ‘irrational exuberance’ has clearly taken hold.  It is better to profit from this overconfidence by taking profits than to participate in it.  Profits can be reinvested into dividend growth stocks with sane valuations.

Discipline Is The Key

What sets apart those who will retire wealthy from the rest is the amount of discipline you have to stick with the plan you lay out.

If your investment strategy is sound, and you follow it diligently, you are likely to do well in the market over time.

The stock market does not go up in a straight line.

You can experience losses of 50% or more investing only in stocks.  If you have the fortitude to persevere through market downturns, you can benefit from the compounding effect of owning fantastic businesses over long periods of time.

On the other hand, if you sell when things look there worst – like March 2009, you will likely underperform the market by a wide margin.

Sadly, most individual investors tend to buy and sell far too often.

The study The Behavior of Individual Investors by Brad Barber and Terrance Odean revealed the unfortunate truth about individual investors.

Barber and Odean analyzed data from 78,000 individual investors. They found that when individual investors sell a stock and buy a new stock, the stock they sold outperforms the stock they purchased (on average).

This means we tend to buy and sell at the wrong times…  What’s the solution?

Practice do nothing investing.  Don’t sell stocks without a very good reason. Price declines are not a good reason.

When a stock’s price declines, you can buy more for a better deal (assuming the underlying business has not significantly changed).  This makes stock declines the right time to add to your positions, not sell them.

Final Thoughts:  Why Investing Matters

Why is all of this important?

Because the average retirement age in the United States is increasing.  Both the age people expect to retire and the age at which they actually retire is trending upward.

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Source:  Gallup Polls

This should not be the case.

People should be retiring earlier…  The national GDP has marched upward over the last decade, yet people are not able to retire when they want.

Dividend growth investing will help you build a portfolio that pays growing dividend income during retirement.  This can lead to retirement on time – or even early retirement.

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