In dividend-growth investing, there are as many dividend-growth investing strategies as there are investors, each uniquely suited to the given investor’s personality, risk tolerance/profile, skills, and interests. However, the degree to which these varying investing approaches deliver long-run success is directly tied to the foundation upon which they are built. In this article, we will introduce three essential investing principles that should underpin all investing strategies—universal, core principles that will maximize your potential for long-run success!
As a life-long student of investing, I feel strongly that we can all learn a lot from studying the greats—whether through books, articles, or videos. After all, investing, at its core, is not complicated, nor has it changed over time.
One such person is Warren Buffett—who, in turn, built much of his investing foundation on the wisdom of Benjamin Graham. His decades of annual letters to the Berkshire Hathaway shareholders represent a treasure-trove of insightful investing wisdom—as do his discussions at their annual shareholder meetings.
This article is predicated on a short but profound answer Buffet provided to a question asked of him at the 1995 Berkshire Hathaway Annual Meeting. I feel it reveals the three fundamental principles that underpin all dividend-growth investing success—regardless of your unique strategy, style, or goals.
We’ll examine Buffett’s three investing principles in this article:
The first principle for investing success is to ensure you always have a proper market mindset.
We must always recognize and accept that the market is a probabilistic system—meaning unpredictable volatility is a given. While we may have greater certainty about an outcome over a long time-frame, there can be quite a bit of volatility over shorter periods of time.
The market will swing. In fact, in a five-year period, it is not uncommon (and you should expect it) to see 30-50% price swings in a given stock.
These swings are the result of short-run catalysts and the herd mentality—combining to generate overreactions in both directions… and opportunities for savvy, principled investors!
We should be taking advantage of these swings—not the other way around!
One of the most important quotes from Benjamin Graham’s The Intelligent Investor (chapter 8) is:
“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage [emphasis added].”
Failing to grasp this concept and market mindset is one of the fundamental contributing factors to retail-investor failure! They fail to expect volatility and cave to the herd mentality—emotionally selling when they should be confidently buying or at least holding fast.
Graham continues to expound on this principle by writing, “That man [or woman] would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement.”
Dividend-growth investing requires a contrarian mindset—one that embraces volatility and capitalizes on short-run overreactions by the markets (i.e., “other persons’ mistakes of judgement”).
As Buffett has aptly noted, the market is the perfect mechanism to transfer money from the impatient to the patient!
Where and when there is no fundamental reason to justify a price move or swing, we need to have the confidence (intestinal fortitude) to stick with our underlying investment thesis. When price drops below our estimate of intrinsic value or current yield rises above our yield-on-cost (YOC), we need to seize the opportunity and be buyers.
Success comes from buying when others are headed for the exits and there’s blood in the streets. By doing so, we embrace the opportunity the market is providing us with and transfer the herd’s money into our patient pockets—meaning those folks who weren’t prepared for such price swings and have the wrong mindset!
Embracing a market mindset allows us to take advantage of unjustified price swings—not the other way around.
To learn more ways that you can employ the market mindset, I encourage you to read my articles The Paradigm Shift: Embracing the Dividend-Growth Mindset and Investing Zen: 6 Ways to Win the Dividend-Growth Investing Mental Game.
The second principle for investing success is to always invest with a margin of safety.
A stock’s price at any given point in time does not necessarily equal the actual value of the underlying company.
For example, Let’s take a look at the recent price action for Facebook (FB). Over a one-year period of time (364 days), the stock went from a high of $218.62 to a low of $123.02… and then back to a high of $208.66.
That’s a drop of -$95.60 (-43.7%) and a subsequent rise of +$84.64 (+69.6%)!
What was the real value of Facebook? $525 billion, $295 billion, or $501 billion???
Did the value of the company really change that much over the span of just one year?
First, this is a perfect illustration of why having a market mindset (Principle #1) is so important. This is an example of that 50%+ price swing (volatility) you have to expect. This wasn’t a one-time event or something exclusive to Facebook… it happens all the time across the market!
It is also an example of herd mentality. Clearly the value of the company didn’t change that much. Rather, short-run news catalysts started a stampede and the herd plunged off the cliff together—as irrational as that might sound. Then, once the sky appeared to stop falling, the herd picked-up steam in the other direction.
We don’t want to run with the herd! We want to have a contrarian mindset that zigs when the market zags.
As dividend-growth investors, once we identify a quality company we are interested in, we need to determine our estimate of intrinsic (or fair) value for the underlying company in order to exploit market opportunities (e.g., when the herd plunges off the cliff) to acquire it.
We base our investing decisions on that valuation—not the actions of the herd.
Unless the long-run fundamentals of the company materially change, our valuation remains valid.
When the price falls below that value, we should be buying. How far below that value we chose to buy at is referred to as our margin of safety.
The larger your margin of safety is, (1) the less risk of principal loss and (2) the higher potential for future returns you have. However, the larger your margin of safety is, the less opportunities you will have to buy and/or add the holding.
It’s a balancing act. But—to whatever degree you decide on—you need to employ a margin of safety.
I personally like to identify a fair value range and start buying/adding when the price exceeds a 10% discount to (a) my average fair value (more aggressive) or (b) the low end of my fair value range (more conservative).
I also increase my margin of safety if (a) the risk is higher or (b) my level of confidence in the valuation is lower.
Finally, I utilize a discounted cash flow model to estimate my fair values. As such, my margin of safety is factored directly into the calculation. To learn how you can easily use a DCF valuation model, I recommend reading my article How to Easily Value Dividend Stocks Using Discounted Earnings.
One of the most prevalent myths in investing is the notion that the market pays for risk. In other words, less risk equals less reward or more risk equals higher potential reward. This couldn’t be further from the truth!
By employing a margin of safety in your dividend-growth investing, you actually reduce your risk… while increasing your potential return!
It’s the best of both worlds… but it requires the right mindset (see Principle #1) and a margin of safety!
The third principle for investing success is always remembering that stocks represent a business.
Stocks are not just a not just a piece of paper—they represent fractional ownership in an actual business.
As such, you should act like a business owner and evaluate/manage your position in the same way you would evaluate/manage that business.
You wouldn’t manage that business based on short-term price movements in the stock… so why would you manage your stock position like that?
Instead, you should focus on the long-run fundamentals of the underlying business—the business you are a part owner in!
Focus on forward-looking growth and cash flow. You have locked in a certain amount of passive income (your yield-on-cost); therefore, your investment decisions should focus on whether your cash flow will increase (dividend growth) or decrease (dividend cuts) over the long run.
Dividend-growth investing—like running a business—is all about managing cash flow (aka your passive income).
It makes no difference what the price is trading at today, next week, or next year. All that matters is how the company is positioned to perform over your investing time-horizon (which should be a long, long time—if not forever).
In fact, as we learned in Principle #1 and #2, price volatility is actually a positive for dividend-growth investing because it provides you with more opportunities to buy below your intrinsic value (and margin of safety) and/or at a current yield above your YOC!
In other words, it provides you with a basic advantage to profit from other persons’ mistakes of judgement!
To do this requires a long-term orientation. This is why quality matters far more with dividend-growth investing than with a pure value (net-net) approach that is focused on a shorter timeframe.
Don’t focus on price—focus on company fundamentals and performance. After all, you’re a partial owner who’s in it for the long run!
Price determines opportunities to buy… fundamentals determine what to invest in and when—if required—to sell. Don’t get the two confused—selling based on short-run price action leads to long-run investing failure.
There are many ways to approach value investing—even under the dividend-growth umbrella. However, the degree to which these styles and/or strategies will enable you to achieve long-run success is largely driven by the quality of the foundation you build them upon.
Without a strong investing foundation, even the best of strategies is likely to ultimately fail.
Regardless of your particular approach, there are three essential investing principles that should form your foundation:
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