The Only Way To Invest

When you dumb it down, investing should have one clear objective, to grow the value of your capital. As a dividend investor you may have secondary and tertiary goals focused around dividend income and dividend growth, but these should compliment the primary objective but not be the primary objective. If dividend investors make dividend income or dividend growth their primary objective, they may find themselves running into unexpected surprises. Let me unpack this a bit more.

Which of these 3 factors do you consider to be the most important?

1. Fundamental Growth and Quality of the Business

2. Dividend Yield

3. Dividend Growth

You could argue that each of these 3 factors may be of equal importance to you. What if I ask the question in a different way to help you decide, which of these 3 factors do you look at first when you review a stock?

What if I told you that the order in which you review these factors matters more than you realize. If a dividend yield is the first piece of information you consider before looking deeper at a stock, it is more likely to drive your ultimate decision of whether or not to invest. This is due to the primacy effect or primacy bias which is the tendency to place more emphasis on information learned early on opposed to information learned later. So, if you do in fact look at the dividend yield before considering any other information about a stock you are more likely to find yourself justifying rather than reviewing that stocks business fundamentals. Of course you’ll do this subconsciously so you are unlikely to realize it is happening but empirical evidence tells us that is exactly what is taking place.

I, personally, want to see the value of my capital increase over time and I want my dividend income to grow as a byproduct of wealth creation. That is why my primary investing objective is investing in High Quality dividend growth stocks, emphasis on the “High Quality”!

Perhaps its worth reviewing what is most important to you and adjusting your investing research process accordingly.

High Quality Stocks in February

The 14 Highest Quality dividend growth stocks in my investable universe, on average, performed well last month, seeing a positive total return of +1.46%. This was superior to the S&P 500, measured by SPY 0.00%↑, that posted a loss of 1.27%. Schwab’s U.S. Dividend Equity ETF SCHD 0.00%↑ also had a great month and outpaced my quality stocks with a total return of +2.55%.

Year-to-date, my quality stocks are up +4.64%, SPY 0.00%↑ is up +1.39% and SCHD 0.00%↑ is up +4.47%. A rather promising start to the year for SCHD 0.00%↑ and my quality stocks.

Individual performance breakdown for February:

• Ferrari RACE 0.00%↑ +8.41%

• Visa V 0.00%↑ +6.29%

• Rollins ROL 0.00%↑ +6.18%

• Nvidia NVDA 0.00%↑ +4.04%

• Automatic Data Processing ADP 0.00%↑ +4.02%

• Mastercard MA 0.00%↑ +3.76%

• Cintas CTAS 0.00%↑ +3.65%

• Intuit INTU 0.00%↑ +2.05%

• MSCI MSCI 0.00%↑ -0.74%

• Badger Meter BMI 0.00%↑ -1.51%

• Zoetis ZTS 0.00%↑ -2.14%

• Monolithic Power Systems MPWR 0.00%↑ -4.14%

• Microsoft MSFT 0.00%↑ -4.16%

• Lam Research LRCX 0.00%↑ -5.32%

These are the 14 quality stocks that all have a long-term quality score above 90%.

In my secondary group of stocks to keep an eye on, those that have a quality score above 85%, the performance results were not so great. Collectively, the 26 stocks on this list, posted a total return of -4.07%. Some of the notable gains were:

• Brown and Brown BRO 0.00%↑ +13.42%

• Heico HEI 0.00%↑ +10.77%

• Moodys MCO 0.00%↑ +1.09%

• Texas Roadhouse TXRH 0.00%↑ +1.65%

• W.R. Berkley WRB 0.00%↑ +7.22%

I also maintain a third list of stocks that all have an excellent short-term quality score with a mixed long-term history, these are stocks to keep on my radar for the future. The 18 stocks on this list also did not perform well when measured collectively, with a total return of -4.12%. Here are some notable gains:

• Novartis NVS 0.00%↑ +4.13%

• Oil-Dri Corporation ODC 0.00%↑ +5.35%

• Universal Display Corp OLED 0.00%↑ +2.47%

• Selective Insurance Group SIGI 0.00%↑ +2.75%

• Verisk Analytics VRSK 0.00%↑ +3.29%

These short-term gains or losses are a bit meaningless to me personally as I have a long-term focus when it comes to investing. What I am more interested in is whether any of these stocks are attractive buying opportunities today.

What Is An Attractive Opportunity For Me?

I like to keep my investing strategy very simple by focusing on 3 things.

1. Do I think the business is of High Quality

2. Does the stock present a lucrative expected rate of return

3. Is the stock attractively valued

If a stock meets all 3 of these parameters I invest and patiently wait to see if my outlook will pan out in terms of total return. Let me break down each parameters to better explain my investment philosophy.

1. High Quality Business

I look at the following 6 metrics to help me determine whether or not I believe any given company is of High Quality.

1. Revenue Growth

2. Free Cash Flow Growth

3. Gross Profit Margin

4. Return on Invested Capital

5. Dividend History

6. Payout Ratio

The final 2 metrics are less focused on business quality and more so geared towards my preferred investment strategy, dividend growth investing.

I like to see strong and consistent growth for each metric and I use my custom “Quality Score” to help me quickly determine which companies will likely look attractive to me.

2. Lucrative Expected Rate of Return

Since my primary investing objective is to grow my capital I want to invest in companies that have the potential to offer lucrative rates of return in the future. I do this by calculating the expected rate of return for each of the high quality stocks I identify. My expected rate of return is calculated using the following 3 inputs:

1. Forward dividend yield

2. Projected earnings growth rate

3. Return to Fair Value component (Free Cash Flow valuation model)

The expected rate of return is a 3-5 year estimate and I typically look for stocks that have at least a 10% ROR.

3. Attractively Valued

Given that the prior parameter already considers valuation you may be wondering why I look at the valuation again. Even though the valuation, and a return to fair value component is built into the rate of return estimate, it does not directly imply that all stocks with an attractive ROR are also undervalued. A stock may be growing at such an attractive rate that it may still have an attractive ROR and be overvalued. Ideally I prefer to invest in stocks that are undervalued or fairly valued to increase my margin of safety in the event that my outlook proves to be incorrect. Think of this as another lever in the belts and suspenders investing philosophy.

My preferred valuation methodology is the custom Free Cash Flow valuation model. The tool runs a 12 year historical free cash flow analysis and determines the fair multiple of free cash flow any given stock should trade for today. Then it simply compares the current free cash flow multiple to the fair multiple, and viola we have our valuation rating. I share this tool with my paid subscribers in addition to 2 other valuation tools.

I use parameters 2 & 3 to help me determine a rating for each stock in my investable universe.

A “Strong Buy” rating is assigned to stocks that have an expected rate of return of at least 10% AND are undervalued.

A “Buy” rating is assigned to stocks that have an expected rate of return of at least 10% Regardless of their valuation.

A “Hold” rating is assigned to stocks that do not have an expected rate of return of at least 10%.

When I add capital to my portfolio I will scan the “Strong Buy” rated stocks first and add capital to any underweight or interesting suggestions. On occasion I will consider looking at the “Buy” rated stocks as well, especially if not too many stocks are rated as a “Strong Buy”.

Paid subscribers can see my valuation ratings for all of the high quality stocks in my investable universe. These ratings are updated live when the stock market is open.