Quality Takes The Cake! Valuation Adds The Icing!

Quality Investing Takes The Cake

Photo by Deva Williamson on Unsplash

When it comes to success in investing there is no finer path than focusing on quality!

Take the 25 companies included in the High Quality Dividend Growth Portfolio as an example. Between 2017 and January 2024, collectively, they have crushed the return of the S&P 500, delivering a cumulative gain of 362.29%, relative to just 143.78% for the S&P 500. And I’ll admit, measuring this return is playing Monday Morning Quarterback. I selected these 25 companies in January of 2024 and not January of 2017. However, the reason I chose these 25 companies and not other companies was in part due to their wonderful track records. All of these companies have at least a decade of success under their belts, and it is highly likely that had I followed a similar process in 2017, it would have led me to consider many of the same companies. Unfortunately for me, in 2017 my process was not as refined as it is today. But what’s done is done and there is no sense dwelling on things we didn’t do. It’s better to focus on today and position ourselves properly for the future.

History can be a great teacher, as George Santayana told us “those who cannot remember the past are condemned to repeat it.” I like to look back at the history of the market and individual stocks, to find what worked and what didn’t, but most importantly to figure out why. And what has worked the best historically is buying quality companies and owning them for a very long time. Terry Smith of FundSmith sums this process up very well.

1. Invest in good companies

2. Don’t overpay

3. Do nothing

Plain and simple, and simple is a very good way to approach investing. When you simplify your strategy it becomes much easier to follow. The first part of Terry’s process is simple, figure out how to find great businesses, because quality investing takes the cake! The second step is a little harder, figuring out the fair price for a stock can be challenging. Not only are there many ways to tackle this problem, they all require you to make some assumptions about the future. If you’re too optimistic you may overpay and if you’re too pessimistic you may miss out on a great opportunity.

Fortunately, getting the valuation component of the equation right is just icing on the cake. As I mentioned earlier, by simply investing in quality companies you can easily outperform indices like the S&P 500 over a long enough period of time. If you purchased all 25 stocks in my High Quality portfolio a mere 6 years ago, regardless of their individual valuation at that time you would have beaten the S&P 500 by a factor of 2.53. This could have been achieved by simply following Terry Smith’s first and third rule. The third rule is also very important, it sounds easy to “do nothing”. But if you’ve been investing for a few years I think you’ll agree with me that doing nothing sounds easier than it actually is. We are constantly bombarded with information that is difficult to ignore. There is always someone talking about the next market crash being upon us, or the next hottest thing you must invest in or you’ll be left in the dust. These catchy phrases are hard to ignore because we humans are curious creatures. It takes time and practice to become a patient investor, one that waits for great returns to come to them rather than constantly chasing returns on the open market.

Once you’ve mastered the art of finding great businesses and learned to be a patient investor. The next step is to tackle Terry Smith’s second rule, not overpaying for the companies you invest in.

Icing On The Cake

What if I told you there was a simple way to turn the 362.29% return from the 25 high quality companies into 415.84%, that’s an extra 53.55%! All you had to do was follow a simple valuation technique that would tell you which of these 25 companies to purchase in any given month. That valuation technique was dividend yield theory. It’s a less commonly used valuation technique as it solely applies to dividend growth stocks, and it works more effectively for companies with a strong track record of growth. It almost sounds ideal for a quality dividend growth strategy.

Dividend yield theory works on a simple premise, that dividend yields revert back to long term averages over time. Hence if a stock currently pays a dividend yield that is higher than its long term average, the stock looks attractively valued and vice versa. The premise here is that you purchase the stock with an above average dividend yield, relative to what it paid historically, and when the dividend yield reverts back to the mean (long term average) you benefit from the share price appreciation. Its a win win when it works out. It is also a long term strategy as it may take months or years for yields to revert back to trailing averages, and just like with any type of investing there is no guarantee that this will actually happen.

Let me tell you exactly how I applied dividend yield theory to improve the cumulative return of the 25 stocks in the High Quality Dividend Growth Portfolio.

I backtested all 25 stocks in this portfolio, applying a rolling 5-year dividend yield to measure the attractiveness of each stock at the start of each calendar month since January 2017. Each month, I took an equal sum of money ($1,000 in my test example) and I invested it in the stocks that appeared to be undervalued or fairly valued (fairly valued = less than 5% overvalued), splitting the invested sum equally amongst all stocks that fit the bill. During some months this worked out great, and not so great during others, but over the long term the results were beautiful. When this strategy worked out great, it really worked out great and more than offset some of the bumps caused by the not so great months. Ultimately this simple strategy led to an additional return of 53.55% over dollar cost averaging into all 25 stocks each month.

During these 85 months, on average, about 12 out of these 25 stocks were undervalued or fairly valued each month. The highest count of undervalued and fairly valued stocks was 23 (in January 2019) and the lowest count was just 2 (in September 2021).

The stock that was purchased the fewest times was KLA Corporation (KLAC) as it appeared undervalued or fairly valued during just 9 out of the 85 months. The stock that was purchased the most times was Home Depot (HD) with 67 months.

Test Number 2

Fortune favors the bold! A minor tweak to this strategy led to another improvement. Version two of the backtest eliminated the fairly valued stocks and solely focused on just the undervalued stocks. This more concentrated strategy led to the average number of stocks purchased each month dropping from 12 to just shy of 10. KLA Corporation and Home Depot were still the lowest and highest purchased stocks, but the count of months each stock appeared undervalued declined to 4 (from 9) and 60 (from 67), respectively. The final result of this backtest yielded a cumulative return of 462.35%, a 46.51% improvement over the first backtest that included fairly valued stocks, and a 100.06% improvement over owning all 25 stocks.

The reason I said fortune favors the bold is because investing in a more concentrated portfolio is inherently associated with more risk. But that isn’t actually true. Yes, a more concentrated portfolio may see higher volatility than a larger portfolio because each component will have a larger weight and will pull and tug at the portfolio return with a larger force. But volatility, that is often times referred to as “risk”, can be a good thing if it works out in your favor. I would much rather be invested in 25 companies that I believe are of high quality, with proven track records of success, than in 100 companies that give me the illusion of safety (less volatility and tracking error to the market).

I understand that higher volatility isn’t for everyone. It all depends on your goals, your timeline and your risk appetite.

If you want to improve your investing strategy, I would recommend following a version of Terry Smith’s investing framework. Learn how to find great businesses, don’t overpay, and do nothing. Be patient and wait for great returns to come to you rather than chasing them up and down with the stock market. This may not look pretty every day but it will pay off in the long run.

Portfolio Return Update

And to wrap up, here’s a quick update on how the High Quality Dividend Growth Portfolio is performing.

In February (2/1 - 2/28 price only)

Portfolio: +5.36%

SPY: +4.84%

SCHD: +1.56%

Year-to-date through 2/28/24

Portfolio: +6.75%

SPY: +6.51%

SCHD: +1.70%

And the valuation tilted portfolio.

In February (2/1 - 2/28 price only)

Portfolio: +4.88%

SPY: +4.84%

SCHD: +1.56%

Year-to-date through 2/28/24

Portfolio: +5.06%

SPY: +6.51%

SCHD: +1.70%

Dividend Growth

Since the last update, one of these 25 stocks has announced a dividend increase. Domino’s Pizza (DPZ) bumped its dividend from $1.21 to $1.51 or by about 24.7%. This brings the 2024 dividend growth for the portfolio up from 8.00% to 8.99%.

Special Edition

Would you like me to issue a special edition of the newsletter at the end of each month to share with you the valuation update for all 25 stocks? If so, please let me know in the comments.

I hope you all have a great Thursday afternoon!