Category: MP Market Reviews

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

This week, I was reading a white paper by one of my mentors, Tom Connolly. He posed an intriguing question: Would you purchase an apartment building if the tenants did not pay rent?

At first glance, the answer is obvious: of course you wouldn’t. But isn’t that what most investors do when buying a stock that doesn’t pay a dividend?

Our strategy focuses exclusively on companies that pay dividends and, even better, those that offer growing dividends. The more income our quality dividend growers produce, the higher another investor is willing to pay. This growing income is the secret sauce in our strategy and what sets us apart.

It might take a few years to see how a growing dividend drives the price forward in your Dividend Growth Investing (DGI) portfolio, but when it eventually happens—and it will—you’ll wonder why it took you so long to figure it out.

As a bonus, this week, we’re offering free subscribers a snapshot of all the trades in our model DGI portfolio since its inception on May 1, 2022. The model portfolio is an example of our strategy and process in action. Although we are only a couple of years into our business plan, the chart clearly shows that, on average, dividend growth (DIV UP %) and price growth (PRICE UP %) are in sync.

Ideally, you will have created a Dividend Growth Investing (DGI) business plan that outlines your objectives and how you are going to deploy your hard-earned capital. Next, you will have a list of companies that meet your investment criteria and will select from this list when they are sensibly priced. Finally, you will be patient and build your portfolio over a few years, as not all quality companies will be sensibly priced at the same time.

Our blog follows this process with our model dividend growth portfolio. Paid subscribers can build their portfolios alongside ours, saving time on research and eliminating much of the emotion of investing. We send alerts for every buy or sell action and conduct quarterly performance reviews to track our progress.

But what if you’re new to the blog, have a lump sum to invest, and want to start quickly? The answer is simple: invest in our All Canadian ‘No-Look’ DGI Portfolio. This portfolio is a streamlined version of ‘The List’ we follow, featuring a diversified selection of the top twenty Canadian stocks, rated for quality by reputable third-party agencies (Value Line and S&P) as of January 2024.

By investing equal amounts in each of these twenty companies, you’re on your way to building a robust DGI portfolio. For more details on how we manage risk and determine when to buy or sell, read the business plan in the premium content section of our site.

                                            All Canadian ‘No-Look’ DGI Portfolio                                                                                                     (As of July 19, 2024)

Weeks like the one we just experienced remind me of the benefits of our dividend growth strategy. As retirees, we invest in quality companies, allowing us to generate income without the need to buy and sell frequently. Our approach is backed by decades of data demonstrating the challenges of timing the market.

Consistently timing the market is impossible. There literally is no human being who can claim that he or she has been successful at that task with any degree of honesty. However, timing the market is not only unachievable, attempting to time the market can lead to poor investment returns.

The next chart, taken from CNBC, gives insights into the impact on a portfolio when an investor misses the 10 days in each decade when the market registers the largest gains.

It’s been a few months since we last reviewed our ‘Timely Ten’ dividend growth stocks. For those new to the blog, these are the ten most undervalued stocks on ‘The List,’ determined by one of our key valuation metrics, dividend yield theory.

This latest update of the ‘Timely Ten’ reveals a fascinating trend: a significant number of companies from ‘The List’ are signalling undervaluation. Fourteen stocks meet the criteria based on dividend yield theory—representing half of the companies on ‘The List.’ Even more encouraging, some of our highest-quality companies are now meeting our threshold, making our investment decisions even more straightforward.

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’.

Not every stock on ‘The List’ ends up in our dividend growth investing (DGI) portfolio. ‘The List’ is a teaching tool that screens for candidates based on a set criterion across the universe of dividend growth stocks in Canada. To end up in our portfolio a candidate would need to score high on ‘quality’ using our many quality indicators. Then and only then would we look at valuation.

Despite the superior quality of our dividend growers, we exercise caution and do not initiate or augment a position unless the stock is ‘sensibly priced.’ Here are the four methods we use to assess valuation. 

1. Historical Fundamentals
2. Dividend Yield Theory
3. CAPE Ratio
4. Graham Value 

In today’s post we will review the ‘historical fundamentals’ method of arriving at a sensible price using Fortis Inc. (FTS-T), one of the highest quality candidates on ‘The List’. 

Historical Fundamentals 

A company’s operating results will determine its stock price in the long run. Analyzing a company’s historical fundamentals provides insight into how the business has been valued over an extended period. Many of the stocks we invest in have a ‘narrow valuation corridor,’ meaning the stock price follows a path that rarely deviates from its historical trading range. A company’s P/E (Price to Adjusted Operating Earnings), OCF (Price to Operating Cash Flow), EBITDA (Price to Earnings Before Interest, Taxes, and Amortization), and Sales (Price to Sales) ranges tell us a lot about how a company has been traditionally valued.

Purchasing at the bottom of these ranges or selling at the top has helped us manage our entry and exit points to enhance returns.

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 has traded in different economic cycles.

FASTgraphs – “FG” 

The following colours/lines on the “FG” 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

Our strategy and the safety of our capital hinges on the growing income generated by a select group of quality companies. While stock prices may vary, our overall income consistently increases. The downside is the need for patience for this growth. What are we waiting for? The dividend, the income, the yield.

Our strategy and our safety depends upon the growing income from a few leading companies, not the market, not a fund, nor over-diversification.

A quick test I like to perform is our “7% in 10 Years” test. This test helps identify dividend growth stocks that are attractive investments today. If your income stream (without reinvesting dividends) is projected to grow to a yield of 7% in ten years, then it has the potential to be a good investment opportunity.

In monetary terms, if you invest $10,000 today, you can expect to receive $700 annually from dividends alone within ten years. How does an investment bought today generate a 7% return on dividends alone ten years from now? The answer is that the dividend grows!

One reason I use 7% as my numerical goal is that equities have historically provided around 7% returns over the last 100 years. Generating a return within a decade equal to the stock market’s historical total return from the dividend alone demonstrates the magic of dividend growth investing.

Another advantage of using at least a decade as your investment horizon is that the distance between your purchase and current prices is typically significant.

Let’s look at an example of growing yield and its effect on price using a company on ‘The List’:

As we approach the midpoint of 2024, it’s the perfect time to start scouting candidates for next year’s list. Monitoring potential additions closely allows us to evaluate how they compare to our existing list of members.

While we’re comfortable building a portfolio of quality dividend growers from our current list, we always keep an eye on potential future candidates. This forward-thinking approach has paid off in the past, as evidenced by our early additions of TFII-N and MFC-T before launching our public-facing model portfolio in 2022, both of which have proven excellent choices.

Identifying Potential Candidates

We’ve identified six companies on the TSX that will meet our first two criteria for inclusion on ‘The List’ in 2025:

Dividend Growth Streak: At least 10 years.

Market Cap: Minimum of one billion dollars.