It is a common theme among young investors that our portfolios should be based on ‘riskier’ assets. The theory behind this premise is that younger investors have a longer term horizon than their older brethren. Thus, we will be able to absorb greater losses, while replenishing our portfolio with future investments. This is counter intuitive to my investment strategy. Let’s quote the guru Warren Buffett:
· #1 rule of investing is “Don’t Lose Money.”
· Rule #2 is “Don’t forget rule #1.
Obviously, this is easier said than done, but by investing solely in solid, blue chip dividend paying champions you are definitely stacking the deck in your favor. There are many reasons why this strategy will outperform the market over the long run. For one, these companies have paid, and increased dividends for over 25 years. They usually generate large free cash flow and carry low debt/capital ratios. They have low betas, which mean they fluctuate less than the market average. Furthermore, a company that consistently increases its dividend is confident in its business and future outlooks.
Another trait that I look for in a stock purchase is what Buffet likes to call a ‘Competitive Moat’. A Competitive Moat is a distinct advantage that a company has over its competitors. It could be a long term patents, superior brand recognition, manufacturing advantages and superior technology. It is difficult for smaller companies to take market share from companies with a large ‘competitive moat’. Furthermore, the moat dissuades newer companies from even attempting to compete with the older stalwarts.
Next, I will look at dividend yield, dividend growth and their ability to sustain these payments. I look for a minimum dividend yield of 3%. I have made exceptions to this rule in the past, but it is usually a good place to start. Subsequently, I want to make sure the company has the ability to continue paying this dividend. I prefer companies with less than 70% payout ratio. This will ensure that they are generating enough cash to cover the dividend and sustain the business. Ideally, the dividend is growing. This will guarantee that we are keeping pace with inflation.
Finally, I look for companies which I consider have good ‘entry points’. These are companies whose stocks have been beaten down due to current events, but their long-term business outlook remains intact. Anyone one who believes the market is 100% rational is kidding themselves. Maybe over the long term- but there is quality merchandise being put on sale every day.
I am convinced that by creating a diversified portfolio of companies that meet the requirements detailed above is the path to investment success. It minimizes the chances for large losses while dollar cost averaging into companies that have a long history of success. The dividends accumulated by these investments should be reinvested into the company. This will compound your gains. I personally use DRIPS (dividend reinvestment programs) for the majority of my investments. I will cancel the DRIP if the stock has a considerable run up in price, instead using the money to invest in a more beaten down stock.
With these principles in mind companies that I am currently watching are:
DEO, PM, CVX, RDS.B, GIS, JNJ, MCD, INTC, HCBK and ADP.
At their current stock prices, the only companies I would consider opening a large position in are HCBK, RDS.B and INTC. For the others, I will wait for another pullback which I believe is right around the corner.
Young investors should build a solid portfolio of dividend paying companies. This will allow their investment to compound over a longer period of time. Furthermore, with the volatility in the current market, and the direction of the US economy so uncertain, this strategy will provide a cushion for your investments and hopefully keep you in the game longer. Young investors should look at fast growing stocks as well, but I think it is more prudent to exploit the growth companies using option strategies rather than owning the stock outright.
All the best,