Month: August 2024

While preparing the latest quarterly report for our model portfolio, I was struck by a quote from Roger Federer. It reminded me of the ‘Timestamps’ chart I include each quarter for our paid subscribers. This chart tracks the performance of our original stock purchases based on their end-of-quarter prices. We derive our portfolio’s winning percentage by calculating the percentage of purchases currently above their original cost.

Federer’s insight is powerful: despite winning 80% of his matches, he only won 54% of the points. This mirrors our experience when investing.

As of July 31, 2024, our winning percentage also stands at 80%. This means that twenty-four of our thirty purchases for the model portfolio are now higher than when we originally bought them. However, this wasn’t always the case. Many of our purchases initially declined before they rose in value, and at times, our winning percentage was barely above 50%.

Like Federer, we focused on the long game and did not get caught up in short-term market fluctuations. We held onto our strong dividend growers and often added to our positions when prices dipped below our initial or second purchase. This confidence in our process, combined with our incremental buying strategy, not only improved our winning percentage but also contributed to higher overall returns in our portfolio as stock prices eventually recovered.

The ‘Timestamps’ chart below illustrates our winning percentage on purchases made in the model portfolio as of July 31, 2024.

This month’s edition of the ‘Timely Ten’ brings both familiar names and a notable newcomer to our lineup of the top ten most undervalued companies from ‘The List,’ as determined by dividend yield theory.

While many of the ‘Timely Ten’ remain unchanged from last month, there’s a significant switch: Canadian National Railway has replaced TC Energy Corp., which surged 18% recently and dropped out of the top ten. For those who conducted their due diligence and invested, it’s been a rewarding journey. We strategically added TC Energy Corp. to our model portfolio following our three-dot rule, exercising patience as the market eventually caught up to our insights. The wait was worth it.

Among the group, Canadian National Railway and TD Bank stand out as the highest-quality companies deserving of further analysis. Both are currently navigating short-term challenges, yet their strong historical fundamentals suggest they are poised for long-term success. We have used two dots on each, so we are being a bit more selective as we consider our final allocation.

The rest of the ‘Timely Ten’ have been regulars on the list, indicating that their challenges might take longer to resolve. This reinforces our commitment to continuously monitoring all companies on ‘The List,’ as we aim to avoid tying up capital for extended periods in favor of seizing better opportunities in quality companies that have temporarily fallen out of favour.

Here’s a recap on how we select our ‘Timely Ten’:

Step three in our process involves monitoring our quality dividend growers regularly, which can become quite challenging depending on the number of companies we track. Fortunately, we rely on ‘The List’ instead of the vast array of stocks in the index, which streamlines our task. Nevertheless, we continually seek methods to enhance our efficiency. Through dividend yield theory, we’ve discovered an approach that has proven remarkably effective in aiding us with our efforts over the years.

Dividend yield theory is a simple and intuitive approach to valuing dividend growth stocks. It suggests that the dividend yield of quality dividend growth stocks tends to revert to the mean over time, assuming that the underlying business model remains stable. In practical terms, if a stock pays a dividend yield above its ten-year average annual yield, its price will likely increase to return the yield to its historical average. Knowing that price and yield go in opposite directions, this theory helps us find stocks poised for a positive price correction.

We have pre-screened our candidates using the criteria we initially laid out in building ‘The List’. This helps us considerably narrow the universe of investable stocks.

1. Dividend growth streak: 10 years or more.
2. Market cap: Minimum one billion dollars.
3. Diversification: Limit of five companies per sector, preferably two per industry.
4. Cyclicality: Exclude REITs and pure-play energy companies due to high cyclicality.

Next, we rank ‘The List’ by how significantly each stock is priced below its fair value (Low Price), as calculated using dividend yield theory. To determine fair value, divide the current dividend by what you consider to be the stock’s historically high yield.

All companies above the thin black line have a current price below fair value (sensibly priced). The stocks above the thick black line make up our ‘Timely Ten’.

The recent market volatility made me think about the lessons I have learned over the last fifteen years that make periods like last week less emotional than before I discovered dividend growth investing.

Although we are proud of our performance, we have learned a lot over the last fifteen years. Yes, we made some mistakes but thankfully we stuck to our process. Here are five lessons that help us stay calm when the markets are volatile.

Lesson #1

We only buy ‘quality’ companies. Early on, we purchased a few companies that had respectable dividend growth records but were not sufficiently capitalized. When the market turbulence occurred, these companies suffered more than our high-quality companies and were slow to recover. In the end, we exited our positions at a loss and chalked one up to experience.

Lesson #2

Do not buy cyclical companies. Cyclicals can do very well when in favour but can turn quickly when the cycle trends the other way. Case in point are the pure ‘Energy’ companies and Real Estate Investment Trusts (REITs) in Canada. You must incorporate ‘market timing’ into your process and hold on for the ride if you want to add cyclicals to your dividend growth portfolio. For most investors, the emotional rollercoaster is too much.

Lesson #3

Rarely sell your good dividend growers. Early on, we sold some companies too early when they appeared overvalued. They continued to go higher, and we were unable to participate. If you must sell due to perceived overvaluation, sell some and take your position size down but don’t exit totally. If they continue higher, you still have some skin in the game.

Lesson #4

Have a position sizing strategy. First separate your quality companies into ‘Core’ and ‘non-Core’ categories. In Canada, ‘Core’ companies are essential to the economy (e.g., telcos, utilities, banks, railroads, pipelines). Determine, based on your comfort level, what percentage of your investable capital you will allocate to each company in each category.

Lesson #5

Take advantage of market sell-offs. By having confidence in a market sell-off, you can supercharge your investment returns by purchasing more of the quality companies on your list. Over the last fifteen years, we have had a few opportunities to initiate or add to our core positions at a steep discount. We ended up being too conservative when the opportunities presented themselves, and our returns were not as good as they could have been. Chat with yourself before a sell-off on your strategy and try and eliminate the emotion for when the time comes. Trust the process.

Wrap Up

Lesson five resonates with me now, particularly given the recent market volatility. Having weathered many similar weeks over the past decade and a half, we’ve come to recognize the value of seizing opportunities to acquire more of our quality dividend growers at discounted prices. Our confidence in this strategy remains steadfast, and we will continue to act decisively whenever such opportunities present themselves.

Do you have a repeatable investing process? We prefer dividend growth investing because it is less active than other forms, does well in both bull and bear market cycles and no matter what, we always have our growing income to fall back on. If you are still unsure, try it with a percentage of your portfolio and track your performance against other strategies you believe in. If you are like us, you will like what you see.

For those of you who need a little more help, you can always become a paid subscriber to the blog and build your portfolio alongside ours.

In 2016 Michael J. Mauboussin wrote a paper titled ‘Thirty Years: Reflections on the Ten Attributes of Great Investors’. One of those attributes deals with position sizing.

Mauboussin writes, “success in investing has two parts: finding edge and fully taking advantage of it through proper position sizing. Almost all investment firms focus on edge, while position sizing generally gets much less attention.”

He uses the example of card counting in blackjack as a means to finding an edge and incorporating a betting strategy that takes advantage of it when the cards are in your favor.

As dividend growth investors we already know what our ‘edge’ is…buying quality individual dividend growth companies when they are sensibly priced and holding for the growing income. Our strategy for taking advantage of our ‘edge’ requires further explanation.

Three-Dot Rule:

In our business plan, we detail how we use position sizing to give us an edge with our strategy. We set minimum and maximum sizes for each company on ‘The List’ allocating a higher portion of our portfolio to the highest quality companies, ensuring a solid foundation. However, we avoid reaching the maximum allocation for any position immediately, opting for a more gradual approach.

How we enter/exit positions can be critical to our investment returns in the long term. We prefer to enter our positions incrementally to avoid short-term price drops that can discourage new dividend growth investors and can supercharge our returns if done correctly during market volatility. We like to buy incrementally when entering a position. If the price drops 5-10% and nothing fundamentally changes with the company, we will buy more. If we do decide to sell, we exit gradually: sometimes this leads to an entire exit, sometimes only to a partial exit. We typically apply the three-dot rule, where we only buy a declining stock three times within a short period or sell an overvalued stock three times as its price increases.

Having the discipline to buy/sell more during market inefficiencies is a lesson we learned early on and is truly one of the best ways to outperform the markets over time with our dividend growth investing process.

Three-Dot Example (TRP-T):

Our entry into a full position size at TC Energy Corp. is detailed below.

We use the Fundamental Analyzer Software Tool (FASTgraphs) to visualize how a company has been historically valued. We like to see it trading within its typical ‘valuation corridor’ based on a ten-to-twelve-year timeline. This gives us a clearer picture of how the stock is traded in different economic cycles.

Using Adjusted Operating Earnings as our valuation metric. 

The following colours/lines on the FASTgraphs chart shown below represent: 

Black line: Price

White line: Dividend

Orange line: Graham average of usually 15 P/E (price/earnings) for most stocks

Blue line: Normal P/E

Dashed or dotted lines: Estimates only

Green area: Earnings

Green dots: Purchases