Category: Our Process

Toronto-Dominion Bank: Time To Supercharge Your Dividend Growth Investing (DGI) Returns

Last updated by BM on April 13, 2023

Summary

The banking crisis of 2023 has now spread to global banks.
Are Canadian banks such as Toronto-Dominion Bank vulnerable?
How does Toronto-Dominion’s pending acquisition of First Horizon Corporation (FHN-N) impact our decision?
Our DGI process is simple and intuitive. We review ‘quality’ indicators and ‘valuation’ metrics that are readily available and easy to understand.
In this article, we make the case that an investment in Toronto-Dominion Bank today will help ‘supercharge’ your investment returns in the future.

Source: We Just Bought TD Bank (TD-T) for our MP Wealth-Builder Model Portfolio (CDN)

Background

In mid-March, we sent out a DGI-Alert to all our paid subscribers confirming a transaction. As you may recall, the banking sector faced significant turmoil after Silicon Valley Bank in the United States and Credit Suisse in Europe encountered some issues. We utilize such circumstances to guide our readers through our methodology, ensuring a more rational approach to opportunities when they arise.

This article substantiates our quality and valuation analysis of Toronto-Dominion Bank at that time. We also wanted to give all our readers the inside scoop on our process in action. We used the closing price of $79.65 from last week for our analysis here.

Always be sure that any purchase you make meets your own personal objectives and risk tolerances.

If you have not yet joined as a subscriber of the blog to receive DGI Alerts on the activity in our model portfolio, it’s not too late. Click Here.

Intro

“Be fearful when others are greedy and greedy when others are fearful.”

– Warren Buffett

As we grow older, we tend to accumulate a wealth of experience that we can draw upon. During the first decade of our journey as dividend growth investors, we experienced the ups and downs that are typical of the market. However, we were fortunate to learn from our mistakes and document five valuable lessons in our post, MP Wealth-Builder Portfolio (CDN); The First Ten Years. Recently, we put one of these lessons into practice by purchasing Toronto-Dominion Bank’s stock for our model portfolio.

Lesson #5

Supercharge your returns by having the confidence in a market sell-off to purchase the quality companies on your list. We had a few opportunities over the last ten years to either 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. Have a chat with yourself prior to a sell-off on what your strategy would be and try and eliminate the emotion for when the time comes. Trust the process.

Investment Thesis

Toronto-Dominion Bank’s stock has been impacted by the recent barrage of negative news surrounding the banking industry, credit delinquencies and concerns over the First Horizon Corporation acquisition. In our opinion, Canadian banks are distinct from other banks worldwide. Canadian banks are well-capitalized and enjoy oligopoly power in Canada, with dominant positions in deposit-taking, lending, investment banking, insurance and wealth management.

We also believe that the acquisition or non-acquisition of First Horizon Corporation is only a short-term issue. If the bank can renegotiate the deal to more favourable terms, this could be seen as a positive development and could potentially boost investor confidence in the company. On the other hand, if the bank decides to walk away from the deal entirely, this could also be seen as a positive development if investors believe it will be in the company’s best interest in the long run. Either way, the share price should regain support.

Given the current price, we believe that (TD-T) stock is being unjustly penalized, presenting an excellent opportunity to purchase this quality dividend grower at a discount.

About

Toronto-Dominion Bank is one of Canada’s two largest banks and operates three business segments: Canadian retail banking, U.S. retail banking, and wholesale banking. The bank’s U.S. operations span from Maine to Florida, with a strong presence in the Northeast. It also has a 13% ownership stake in Charles Schwab.

Not only is The Toronto-Dominion the biggest bank in Canada in terms of assets and deposits, but it also ranks as the sixth largest bank in North America in terms of assets and the fifth largest in terms of market capitalization.

TD operates as a global bank, with 60% of its operations in Canada, 37% in the United States, and the remaining 3% overseas. It has a significant presence with 2,220 retail locations in Canada and the U.S. and 16 offices worldwide.

Our Process

The process we use is a ‘rules-based’ process. It is a repeatable process in all markets that tilts the odds of making a good investment decision in our favour. We will review the first two rules in our process to see if now is the time to add Toronto-Dominion Bank to our DGI portfolios.

Quality; only buy large-cap companies with a long dividend growth streak and good financial safety metrics in an industry that is stable and growing.
Valuation; look to buy a company that is sensibly priced or undervalued by looking at a company’s track record. Undervaluation introduces a margin of safety. You are in essence, tilting the odds in your favour that future price movements will be upwards.
Monitor; keep an eye on your dividend growers, especially the current yield; fluctuations in yields send signals. The consistency of a firm’s dividend growth is the best measure of management’s confidence in the long-term growth outlook for a company.

Quality

To assess the quality in the dividend growth stocks we follow, we look at several indicators. A company we invest in rarely satisfies all of our criteria, but the more ‘indicators’ we check off, the higher the quality of the business.

Dividend Growth Streak

We begin assessing quality with a streak of dividend increases of at least 10 years. The longer streak, the higher the ‘quality’.

Toronto-Dominion Bank had a dividend growth streak of 12 years coming into 2022. An increase already in this fiscal year (2023) means the streak will continue.

Growth Yield

Growth yield refers to the yield on cost of a stock, which takes into account the current annualized dividend payments in relation to the original cost basis of the investment. We like the term growth yield better as it proves that growth (a key part of our strategy) has indeed happened and highlights the yield you are now making on dividends alone. The magic of growth yield is typically lost in all statements and conversations about investing. Knowing the subtle difference between a good yield and growing yield is fundamental in what we do.

According to our experience, creating a stock portfolio with an average estimated growth yield and historical growth yield of greater than 7% after ten years has proven to be a reliable indicator of quality.

Historical growth yield calculation for Toronto-Dominion Bank:

Current Dividend / Price Jan. 1, 2013, = Historical Growth Yield

$3.84/$41.60 = 9.2%

Estimated growth yield calculation for Toronto-Dominion Bank:

Current Yield * Average Annual Forward Dividend Growth Rate ^ Period = Estimated Growth Yield

4.9% * 1.08 ^ 10 = 10.6%

In this instance, the Toronto-Dominion Bank satisfies our minimum growth yield criteria regarding historical and projected figures. The historical growth yield was based on a tangible value from an investment in TD Bank ten years ago, whereas the estimated growth yield is a forecasted figure for the next ten years.

Dividend Growth Rates (5YR and 10YR)

We are looking for consistent dividend increases. The lower the starting yield, the higher the growth rate and time horizon required to achieve our income goals.

Toronto-Dominion Bank has a good dividend growth rate for an above-average yielding stock. Toronto-Dominion Bank has a 10YR average annual growth rate of 9.5% and a 5YR average of 8.7%

Recent Dividend Increase

This is a positive statement by management that they have confidence in the business going forward.

The Toronto-Dominion Bank has declared a dividend boost of +7.87% for the year 2023, signifying the bank’s 13th uninterrupted year of increasing dividends and 166th year of maintaining a consistent dividend payment record.

Source: TD Bank Q1 2023 Investor Presentation (March 2, 2023)

Dividend Growth and Price Growth Alignment

Identifying companies whose dividend growth aligns closely with price growth can considerably enhance the predictability of future returns. With the exception of a few abnormalities, such as the pandemic in 2020 and banking concerns in early 2023, the dividend growth of Toronto-Dominion Bank closely corresponds with its price growth. Moreover, the dip in price in 2020 turned out to be a favourable buying opportunity. Toronto-Dominion’s dividend continues to grow. Dividend growth investors know that the dividend drives the price in a predictable way, not the other way around.

Source: YCHARTS

Payout Ratio (Dividends vs Earnings)

Low-payout dividend payers have traditionally done better than companies with high or negative payout ratios. Figure out the industry and company averages and measure against them. Low payout ratios protect your dividend.

Source: YCHARTS

With payout ratios below historical averages, there is ample room for further dividend growth at Toronto-Dominion Bank without adversely affecting financial health even if earnings are impacted in the short term, as its payout ratio currently sits comfortably below its ten-year average.

Independent Research

Although we review the above indicators as they are readily available for all the stocks we invest in, we find the independent research from services that sell information for a living to be the most informative. Value Line (VL) and S&P ratings can typically be found with a little digging.

Value Line’s Safety Rank

Measures the total risk of a stock relative to approximately 1,700 other stocks covered by Value Line. The safest stocks are assigned a rank of 1, whereas the riskiest stocks are assigned a rank of 5.

Toronto-Dominion Bank has a VL Safety Rank of 2.

Value Line Financial Strength

Ratings, from A++ to C in nine steps. The lowest rating is reserved for companies in serious financial difficulty. Factors considered in assigning ratings include balance sheet strength, corporate performance, market capitalization, and stability of returns.

Toronto-Dominion Bank has a VL Financial Strength Rating of A.

S&P Credit Ratings

Help investors determine investment risks. Ratings are either investment grade (AAA through BBB–) or speculative (BB+ through D).

Toronto-Dominion Bank has an S&P Credit Rating of AA-.

Market Cap

Market capitalization is also an important indicator to consider when evaluating a company’s quality. It represents the total value of a company’s outstanding shares of stock and is calculated by multiplying the number of outstanding shares by the current market price per share. Companies with larger market capitalizations generally have more resources, a more established track record, and less volatility than smaller companies. Toronto-Dominion Bank has a market cap of $145 billion dollars making it the second-largest company in Canada.

Quality Summary

Toronto-Dominion Bank is one of Canada’s highest-quality dividend growth companies, ranking highly on almost every quality indicator we use. Quality companies have historically been good investments when purchased at a sensible price.

Valuation

Irrespective of the superior quality of our dividend growers, we exercise caution and do not initiate or augment a position unless the stock is ‘sensibly priced’. To evaluate valuation, we utilize a few different metrics.

Historical Fundamentals

Source: FAST Graphs

When we review the fundamentals FAST Graphs chart of Toronto-Dominion Bank, we notice that Price (Black Line) has historically followed its Normal P/E (Blue Line). Recent price weakness has it separating from its normal trading range. A narrow valuation corridor (a stock price that follows a path that rarely deviates from its trading range ie P/E ratio in this case) shows the predictability of this stock’s price movements.

We are below the Normal P/E of 11.75, which points to undervaluation at the current price. The current level is now ~ 30% below this level, which gives us the margin of safety we are looking for in this market.

Dividend Yield Theory

The 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, this means that if a stock is currently paying a dividend yield above its ten-year average annual yield, there is a higher probability that its price will increase to bring the yield back to its historical average.

Source: YCHARTS

CAPE

The cyclically adjusted price-to-earnings CAPE ratio can assist investors in determining whether a stock is appropriately valued (sensibly priced). By averaging earnings over a longer period, such as ten years, the CAPE ratio helps smooth out short-term fluctuations. It provides a more reliable individual measure of a company’s earnings potential. When the CAPE ratio is low, it may suggest that the stock is undervalued and could be a good investment opportunity. Conversely, when the CAPE ratio is high, it may indicate that the stock is overvalued and could be a potential risk for investors. It is also important to consider the specific industry and market conditions that may affect a company’s earnings potential.

We typically look for stocks with a cyclically adjusted price-to-earnings ratio CAPE under 20. We calculate the CAPE by taking the average of the last ten years of a company’s earnings and dividing it by the current price.

Toronto-Dominion Bank’s CAPE ratio is ~13.8, representing undervaluation at today’s price.

Graham Value

The Graham number is a formula developed by Benjamin Graham, the father of value investing, to determine the intrinsic value of a stock. The formula uses a combination of a company’s earnings per share (EPS) and book value per share (BVPS) to calculate the fair value of a stock.

The Graham value/price we use: square root of (( average of last three years earnings per share * book value per share) * 22.5). The multiplier 22.5 is what Graham believed was appropriate for a company with a price-to-earnings (P/E) ratio of 15 and a price-to-book ratio of 1.5.

According to Graham’s theory, any stock price below the calculated Graham number is considered undervalued and thus worth investing in.

When we compute Toronto-Dominion Bank’s Graham number, we arrive at a price of $94.85. Given last Friday’s price of $79.65, we have a margin of safety here of ~19%, according to Graham, for this quality dividend grower.

Valuation Summary

Purchasing stocks at a ‘sensible price’ is as important as selecting quality companies in what we do. There is no one metric we rely on completely. The primary valuation indicators we use (Dividend Yield Theory, CAPE and Graham Value) all point to the undervaluation of Toronto-Dominion’s stock price at current levels. The historical fundamentals chart from FAST Graphs provides support for our hypothesis.

Forecast

“You can learn from the past, but you make money on the future.”

– Chuck Carnevale

Source: FAST Graphs

Using the “Normal Multiple’ estimating tool from FAST Graphs, we see a normal P/E average over the last five years of 11.21. Based on analyst forecasts for eighteen months out, we estimate an annualized return, based on today’s price, of 27.0% should Toronto-Dominion Bank trade at its five-year normal P/E.

Analyst Scorecard

Source: FAST Graphs

To provide weight to the estimated earnings component of our analysis, we review the analysts’ historical track record covering this stock. You can see from the data that analysts have an above-average record of predicting earnings both one year (1Y) and two years (2Y) out. They have beaten or hit estimates on 1Y estimates 82% of the time and 91% on 2Y timeframes.

Forecast Summary

Due to the predictive power of dividend growth, its narrow historical valuation corridor, its historical track record of analysts’ forward earnings estimates and the conservative assumption that Toronto-Dominion Bank will trade again at its normal (P/E), we believe we have a high probability of above-average returns eighteen months out and beyond on an investment today.

News

TORONTO, March 2, 2023 – TD Bank Group (“TD” or the “Bank”) today announced its financial results for the first quarter January 31, 2023. Reported earnings were $1.6 billion, down 58% compared with the first quarter last year, and adjusted earnings were $4.2 billion, up 8%.

“TD had a strong start to 2023 with Canadian and U.S. retail businesses delivering robust revenue growth and record earnings, demonstrating the benefits of our diversified business mix,” said Bharat Masrani, Group President and Chief Executive Officer, TD Bank Group. “We continued to invest to strengthen our businesses and deliver the legendary customer experiences our customers and clients have come to expect from TD.”

“Yesterday, we announced the close of the Cowen Inc. acquisition, an important step forward in the expansion of our global dealer. TD Securities now has 6,500 colleagues in 40 cities around the world and is able to serve clients with an even broader product and services offering,” added Masrani.

Acquisition of Cowen Inc.

On March 1, 2023, the Bank completed the acquisition of Cowen Inc. (“Cowen”). The results of the acquired business will be consolidated by the Bank from the closing date and primarily reported in the Wholesale Banking segment.

Pending Acquisition of First Horizon Corporation

On February 28, 2022, the Bank and First Horizon Corporation (ׅ“First Horizon”) announced a definitive agreement for the Bank to acquire First Horizon in an all cash transaction valued at US$13.4 billion, or US$25.00 for each common share of First Horizon.

On February 9, 2023, the parties announced they had mutually agreed to extend the outside date to May 27, 2023, in accordance with the terms of the merger agreement. The closing of the transaction is subject to customary closing conditions, including approvals from U.S. and Canadian regulatory authorities, which now are not expected to be obtained prior to May 27, 2023. Regulatory approvals are not within the Bank’s control. If the merger does not close by May 27, 2023, then an amendment to the merger agreement would be required to further extend the outside date. TD and First Horizon are discussing a potential further extension.

Source: TD Earnings Release Q1 2023 (March 2, 2023)

The recent challenges facing the global banking system and the pending acquisition of First Horizon Corporation have harmed Toronto-Dominion Bank’s investors in recent weeks. Although there is an increased likelihood of additional banks being affected by these challenges, we remain confident that Toronto-Dominion Bank will weather the current financial storm and make prudent decisions for investors regarding the First Horizon Corp. acquisition. The bank’s successful track record of sound financial management over three centuries provides us with additional reassurance.

Conclusion

Utilizing our quality indicators and valuation metrics while drawing from our experience as dividend growth investors over the past decade, we have learned the significance of utilizing market sell-offs to acquire high-quality companies at reduced prices. Accumulating this high-quality, sensibly priced dividend grower today is an opportunity that will end up supercharging your DGI returns for years to come.

Magic Pants Process – DGI Real-Time Alerts

Last updated by BM on March 9, 2022

“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”

– Ben Graham, The Intelligent Investor

In our initial article on the Magic Pants Dividend Growth Investing process, we spoke about not getting fixated on the ‘outcomes’ from your investing activities and pay more attention to the process. Although the process in aggregate has worked well for us over the years it wasn’t without a few revisions along the way.

The natural thing to do would be to not dig into our process when we experienced a bad outcome and only show the good ones. The right approach however is to review all outcomes good or bad when they fall outside a ‘band’ of what we view as acceptable. Acceptable to us is an investment that grows its dividend over time and aligns well with an increase in the price of the company’s stock. We would like to achieve a Total Return CAGR (dividends included) in the 10-12% range over a decade.

As part of our ‘soon to be announced’ subscription service, we document all our outcomes (good and bad) to measure our success but also to refine our process and increase the probability we will be right in the future. To better understand our process in action we share our new time-stamped ‘Magic Pants DGI Real-Time Alerts’. The alerts are emailed when we make a trade and can be used as a signaling tool for our subscribers. Once received, subscribers can decide based on their own objectives (income vs capital gain or both) if they want to participate alongside our process. We do the work; you stay in control!

Here is an example of a recent DGI alert email sent out in January this year (Subscribers only).

The alert is sent out based on our own research and is representative of how we build our portfolios over time. Although we follow the position sizing outlined in our blog, understanding your own unique position sizing is also key to building a successful dividend growth machine.

Although not all our alerts turn out to be as successful in the short term, as Franco Nevada did early in 2022, we do have an impressive historical record of purchasing our good dividend growers (at sensible prices) over time.

In the past five years, we are proud to say that out of sixty-two trades in our Wealth-Builder (CDN) Portfolio, only six trades are below their initial purchase price at the time of this article. Of the six currently trading below their purchase price, we have owned five of them for less than a year. In defense of not having a perfect record, our trades typically need time to turn positive and then climb upwards (within 6-18 months).

Going forward we will publish all our trades with subscribers and the reasons we entered positions when we did. We will also review our trades that did not meet our expectations. Full transparency with time-stamped alerts, regardless of the outcome, will help build trust with our subscribers and those looking to get started with dividend growth investing. Stay tuned for a launch date for the subscription service. In the interim, sign up as a reader of the blog and you will still receive our DGI alerts.

MP Wealth-Builder (CDN) Portfolio; The First Ten Years

Posted by BM on February 25, 2022

“Corporations which pay rising dividends are wealth creating machines.” Tom Connolly

A big shout out to one of my mentors, Tom Connolly from Kingston, ON. Thank you, Tom, for introducing me to dividend growth investing (DGI).

Two- and one-half Olympics ago we started the Magic Pants Wealth-Builder (CDN) Portfolio. Most of our research on dividend growth investing was backward looking (historical returns) but the evidence was so overwhelming we decided to take the plunge. Our first DGI stocks were a grocer, utility, pipeline, royalty company and telco. As the saying goes….” the rest is history.”

Here were the total returns generated (dividends included) and the corresponding benchmarks for comparison:

Magic Pants Wealth-Builder CDN Portfolio
Historical Performance
As of December 31, 2021
	MP Wealth-Builder CDN	TSX Dividend Aristocrat CDN Index	TSX Composite Index
Year	Total Return	Total Return	Total Return
2012	29.13%	9.33%	7.19%
2013	15.75%	14.41%	12.99%
2014	25.08%	13.87%	10.55%
2015	-6.63%	10.75%	8.32%
2016	20.21%	21.95%	21.08%
2017	11.15%	5.89%	9.09%
2018	-4.19%	8.28%	8.89%
2019	20.59%	26.29%	22.88%
2020	7.54%	-2.28%	5.60%
2021	28.10%	25.91%	25.09%
10YR Compounded Gain:	146.73%	96.34%	97.26%
Annualized Returns
1YR	28.10%	25.91%	25.09%
3YR	18.86%	15.80%	17.52%
5YR	13.27%	8.56%	10.04%
10YR	12.95%	8.86%	9.14%

Source: Magic Pants Dividend Growth Investing Inc. & S&P Global

A ~13% compounded annual growth rate is over 40% better than the indexes. Compared against the top ETFs and dividend funds in Canada will render similar outperformance.

The reason for our outperformance is clear; ETFs and Funds charge management fees; are less concentrated, contain lower quality companies; have higher turnover due to short-term thinking; are less diversified (40-50% in only two sectors); and do not generate the same amount of income our growing dividend portfolio provides. It is no wonder they were unable to keep pace.

To highlight our outperformance, we looked at 100K invested in all three portfolios starting in 2012 and here is what we found:

The question then becomes, how did we do it?

“We buy quality individual dividend growth stocks when they are sensibly priced and hold for the growing income.”

I know it sounds simple, but it works. It has worked for decades for others and is the reason we started dividend growth investing in the first place.

Lessons Learned:

Although we are proud of our performance, we did learn a lot over the last ten years. Yes, we made some mistakes but thankfully we stuck to our process. We are a lot wiser and less emotional when it comes to our process now. We are excited about what the future holds.

Lesson #1

Only buy ‘quality’ companies. Early on we purchased a few companies that had respectable dividend growth records but were not sufficiently capitalized and when there was turbulence in the market, they suffered more than our high-quality companies did 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 they are in favor but can turn quickly when the cycle trends the other way. Case in point are the pure ‘Energy’ companies in Canada. You need to 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. That way 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 the ones that are essential to the economy (Telcos, Utilities, Banks, Railroads, Pipelines). Determine based on your own comfort level what percentage of your investable capital you are going to allocate to each individual company in each category.

Lesson #5

In summary, it was a good decade for many types of investing methodologies, and we realize that most returns were higher than historical norms. With that said, we still outperformed the market by a wide margin with DGI.

Do you have a repeatable investing process? We prefer dividend growth investing because it 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, give it a try 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 subscribe to the blog and build your portfolio alongside ours.

Position Sizing: It Matters!

Posted by BM on October 25, 2021

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 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.

First, we size our positions based on quality. Our portfolios have a high concentration of high quality dividend growth stocks (as much as 80%) and not as much on quantity (think ETF). Studies have proven that once you get by sixteen stocks you have utilized most if not all the benefit that diversification provides. The added benefit to a concentrated portfolio is that we have fewer stocks to monitor (Step 3 in our process) which takes us less time to stay on top of our portfolios.

Secondly, like the card counting strategy mentioned earlier, we add to our position sizes (increase our bets) when our quality companies are sensibly priced and more aggressively when they go on sale. To dividend growth investors, this is the equivalent of having a lot of face cards left in the deck and increases the probability of better long-term returns.

Getting Started

Let’s say you’ve come up with a sensible estimate of fair value for a company on ‘The List’. Its share price is now below your estimate of fair value, so you think there is very probably a margin of safety between the current price and fair value.

You like the quality of the company (based on our quality indicators), and you like the current price, so you decide to invest. But how much of your capital should you invest into this business?

First separate your quality companies into ‘Core’ and ‘non-Core’ categories. In Canada, ‘Core’ companies are the ones that are essential to the economy (Telcos, Utilities, Banks, Railroads, Pipelines). We then ensure that these companies have high safety and financial ratings from third party sources (i.e. Value Line, S&P). These companies will be the foundation of our Canadian dividend growth portfolio.

Next, we choose our ‘non-Core’ companies. These companies are typically low yield/high growth businesses that tend to be a bit smaller in size but have stability in earnings, good management teams, and a history of paying growing dividends.

Our ‘full’ position size for a company will be about 8% in ‘Core’ companies and 2-4% in ‘non-Core’ companies. We typically, only take the top two rated companies in any given sector. This allows us to hold between 15-20 stocks in our portfolio providing ample diversification across industries.

The logic behind our approach is that we now have greater concentration around the safest opportunities (Core) with some exposure to faster growing companies (non-Core). Our goal is that some of these ‘non-Core’ companies will continue to grow and will become ‘Core’ holdings over time.

If our position sizes grow beyond our initial full position size, we have the luxury of either allocating some of that growth to other areas of our portfolio or letting it run. We typically do not let any one position size grow to more than 10% or our portfolio.

Next, we enter our positions incrementally. This helps us avoid the dreaded price drop in the short term which can discourage those new to dividend growth investing and can supercharge our returns if done properly during times of market volatility. We like to buy in 50-100 basis points at a time when we are entering a position. A basis point is one-one hundredth of one percent so it can take a few trades to get to the position size we want. If the price dops 5% and nothing has fundamentally changed with the company, we will buy more. We usually only buy into a declining stock price three times in a short period of time. If the stock price reverses, we can buy more on the upswing if it remains sensibly priced provided, we have not exceeded our full position size.

I will illustrate how we built a position size using a company from our Canadian Dividend Growth Portfolio, Fortis Inc. (FTS.TO). Both our buying strategies (sensibly priced and on sale) were part of our strategy when building this position. The green dots on the graphic are when we bought a position.

Our historical graph shows that Fortis’ valuation corridor tends to follow its P/E ratio (Blue Line) very closely. The price (Black Line) has periods when it is above the P/E ratio (overpriced) and ones where it is below (on sale). We bought Fortis nine times over the last nine years. On four occasions we initiated a position when the price was at or near the average P/E (sensibly priced) where on five other occasions we initiated a position when the price was well below the average P/E. This is how we win!

The chart below is what we use to quickly monitor how our positions are performing. Dividend growth (DIV UP %) and price growth (PRICE UP %) quickly tell us how our purchases have performed. We like Fortis’ pattern as it seems to align dividend growth with price growth over time when it is purchased at a sensible price. The ‘on sale’ purchases (2016-2018) tend to have higher price appreciation compared to their dividend growth which makes sense given they were a bargain at the time and the price has now recovered.

Summary

We never know if our good dividend growers will go on sale and if they do, how long will it last. Being out-of-the-market for long periods of time will affect your returns so don’t be too cautious with your buying strategy. Entering positions incrementally along the way when our quality companies are sensibly priced and fully taking advantage of a sale when it presents itself increases the probability of above average long-term returns and the best way to use our ‘edge’.

The Drivers of Total Return

Posted by BM on July 19, 2021

“Investor success is driven not so much by picking winning firms, but rather the entry point at which fine companies are purchased.”

-Tom Connolly

Crestmont Research is a site we visit quite often to help better understand investing. The post we share today will help summarize what Ed Easterling calls ‘The Reconciliation Principle’.

Here is the link to the full article by Crestmont Research:

https://www.crestmontresearch.com/docs/Stock-Reconciliation-Principle.pdf

As dividend growth investors we tend to buy and hold our investments if they continue to increase their earnings and pay a growing dividend. Sometimes this can last for decades. Although holding a good company for the long term is viewed as unconventional by today’s standards, it turns out that looking at things in an unconventional manner can increase your Total Returns, especially when you purchase your quality companies when they are sensibly priced (below average P/E).

“Conventional wisdom holds that stock market returns are random. That is true over days, weeks, months, and even a few years. But contrary to conventional wisdom, stock market returns are highly predictable over periods that reflect investors’ horizons–periods either side of a decade. This predictability occurs because stock market returns are driven by component parts.”

– Ed Easterling

In an earlier post we talked about Jack Bogle’s expected return formula when it comes to estimating future returns:

Future Market Returns = Dividend Yield + Earnings Growth +/- Change in P/E Ratio

Ed Easterling essentially agrees with Bogle and then expands on Bogles formula by breaking down the drivers behind the three components.

According to Easterling, …”not only is total return from the stock market driven by the fundamental principle of three components, but also each of the three components is driven by fundamental principles. Not one of the three components is a random element. Each of them has a tangible and definitive driver. This set of relationships further reinforces that stock market returns are not random.

In summary, earnings per share (EPS) growth is driven by economic growth. P/E expansion and contraction are driven by the inflation rate. Dividend yield is driven by the starting level of the P/E ratio.”

If we agree with Easterling, we know that long term returns are not random but short term returns can be because there are so many noneconomic and nonfinancial factors that can affect the markets. Understanding the drivers of long-term returns helps us as dividend growth investors ‘peel back the cloak’ and see the fundamental principles that drive the market so that we can make informed investing decisions.

Let us apply these principles in today’s market. Which of the three drivers do you hear the most talk about?

With the other components (Dividend Yield and EPS Growth) being in the range of their historical averages, I think we can all agree that P/E levels today are the outlier, being substantially higher than average for many stocks. With inflation being the principle that drives the P/E component of Total Return, we need to pay attention to inflation. The market is high right now. It would not be a good time to buy an index fund. Companies whose returns have benefitted from rising P/E’s over the last few years will certainly come under pressure if inflation continues to rise.

One of my DGI mentors, Chuck Carnevale, likes to say that it is a ‘market of stocks not a stock market’, I agree. Not all stocks have higher than average P/E’s. Knowing the components of long term returns and their drivers is empowering to say the least. Be selective when you invest in today’s market and only invest in quality companies that are sensibly priced.

Selling Dividend Growth Stocks

Posted by BM on March 21, 2021

Trees don’t grow to the sky or do they? In my USD portfolio in 2019 last year I sold 1/3 of my position in Microsoft and Visa and more recently in Apple because all three looked to be overvalued. My logic was that the stocks would ‘correct’, and I would be able to buy back in at a lower price. This got me thinking about what a dividend growth investor should do when stocks in their portfolio’s appear overvalued.

In my annual update from 2019 I wrote about my criteria for selling:

“When we make an investment, we take a patient, long term investment horizon and expect to hold the stock for decades, keeping portfolio turnover low. Generally speaking, we will only sell a stock if the safety of the dividend payment has come into question, the company’s long-term earnings power appears to have become impaired, the stock’s valuation reaches seemingly excessive levels, or we find a more attractive idea.”

With the three stocks listed above I chose to sell based on what my process told me was ‘historic’ over valuation. Interpreting the graphs: The ‘black’ line is price; the ‘blue’ line is P/E and the ‘orange’ line is a historical fair valuation metric of 15 P/E.

Apple is trading at a P/E that is 107% higher than its ten-year average.

Microsoft is trading at a P/E that is 80% higher than its ten-year average.

and Visa is trading at a P/E that is 50% higher than its ten-year average.

Warren Buffet probably would have disagreed with my decision to sell.

“Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.” Warren Buffet Annual Letter 2018

I understand with what Buffet is saying about how hard it is to find good businesses. I believe that all three are wonderful companies that are set up for continued growth going forward, but I felt it was time to take advantage of the capital gains being offered to me, and to do some de-risking in my portfolio. Sorry Warren!

Although I left a little money on the table in 2020 by selling some too early, I was still able to participate in the success of these wonderful companies by retaining 2/3 of my original positions in all three stocks. I will most likely trim again as valuations continue to make me uncomfortable and undervalued opportunities in other stocks I follow are revealed.

When to sell is a personal choice for dividend growth investors and one you should take seriously especially if the dividend is still growing. As it turns out I was fortunate to be able to quickly deploy this extra cash generated when COVID hit and was able to reinvest in sensibly priced companies. This has already turned out to be a prudent choice regardless of how these three companies perform going forward.

Trimming your positions due to overvaluations is a good problem to have but, better yet, is redeploying that capital in quality, sensibly priced, DGI stocks that can increase your current income and provide a margin of safety to your portfolio moving forward.

“A company’s valuation level, at time of purchase, significantly influences subsequent returns. As, “risk is more often in the price you pay than in the stock itself”. C.Browne’s Little Book of Value Investing.

Our Dividend Growth Investing Process

Posted by BM on March 1, 2021

Our goal as dividend growth investors is clear, “‘we buy quality individual dividend growth stocks when they are sensibly-priced and hold for the growing income (cash flow).”

The process we use is a ‘rules based’ process. It is a repeatable process in all markets that tilts the odds of making a quality investment decision in our favour.

I like this quote from Annie Duke in her book ‘How to Decide-Simple Tools for Making Better Decisions’. Why does your process matter more than anything else?

“Because there are only two things that determine how your life turns out: luck and the quality of your decisions. You have control over only one of those two things.”

A quick story to demonstrate why a good process is so important.

Being Lucky vs Being Good– Vishal Khandelwal

Let’s say you sponsor a contest to determine the “world’s best coin flippers.” About 100,000 people from across the world come together to participate in this contest. Everyone flips a coin at the same time.

After each coin flip, those who flip “tails” must leave, until the only people left have flipped 10 consecutive heads. Basic statistics suggests that we could expect about 98 coin flippers to remain at the end of the contest.

The odds of flipping heads 10 times in a row are 1/2^10 = 1/1024. So, for 100,000 participants, there will be 100,000/1,024 = 98 people who would have flipped 10 consecutive heads.

Then, these 98 “skilled” coin flippers would get thousands of likes on Facebook, and followers on Twitter. Those with the best smile and social media skills will write bestselling books about coin flipping, sharing their secrets of how to become a world-class coin flipper.

Sadly, most of us most of the times judge the quality of our decisions and actions by one single factor, and that is our one-off good performance that comes easy and at the very beginning of our endeavour.

Investing is not any different. As investors, we often struggle with judging whether a decision was good or not, even in hindsight, because like the winning coin flippers we often only look at the outcome and not the process. The truth, however, is that a good process is the only thing that could help you bring the odds of success in your favour. It’s only with a good process that you stand a chance to do well in investing over the long run.

As dividend growth investors we do things differently. That is how we win!

“I do believe it is possible for a minority of investors to get significantly better results than average. Two conditions are necessary for that. One is that they must follow some sound principles of selection that are related to the value of securities and not to their market price. The other is that their method of operation must be basically different from that of the majority of security buyers. They have to cut themselves off from the general public and put themselves into a different category.”

Ben Graham

By standing on the shoulders of giants, those great investors who came before us, we have come up with a process that is simple to understand with only three basic rules:

Quality; only buy large-cap companies that have a long dividend growth streak and good financial safety metrics in an industry that is stable and growing.
Valuation; look to buy a company that is sensibly priced or undervalued by looking at a company’s track record. Undervaluation introduces a margin of safety. You are in essence tilting the odds in your favor that future price movements will be upwards.
Monitor; keep an eye on your dividend growers; especially the current yield; fluctuations in yields send signals. The consistency of a firm’s dividend growth is the best measure of management’s confidence in the long-term growth outlook for a company.

Our dividend growth magic formula is: Quality + Value + Yield + Growth = Long Term Success

The blog will help those interested in dividend growth investing to better understand how it works and how to use it on their own with a little coaching.

We will also review our outcomes regardless of if they were good or bad. Having a good process means you go back and review your decisions when they fall outside your expectations. We can then make tweaks based on our findings and enhance our process. Only then will we know if we were good or just lucky.

Category: Our Process

Toronto-Dominion Bank: Time To Supercharge Your Dividend Growth Investing (DGI) Returns

Magic Pants Process – DGI Real-Time Alerts

MP Wealth-Builder (CDN) Portfolio; The First Ten Years

Position Sizing: It Matters!

The Drivers of Total Return

Selling Dividend Growth Stocks

Our Dividend Growth Investing Process

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