Foundations (n) – 1.) The load bearing part of a building 2.) An underlying basis or principle for something
I’m a big fan of the concept of foundations in investing. It’s important to have a theory or principle for investing that you stick to. It didn’t take me long to realize that income investing, specifically dividend growth investing was the style that fit for me.
So what is dividend growth investing? It’s investing in companies that consistently and reliably are able to raise their dividend by raising their earnings every year. A lot of times these aren’t the sexiest companies out there. A lot of those “sexy” companies like Amazon (AMZN) or Tesla (TSLA) have never and probably will never pay a dividend. That’s not a bad thing in of itself, but it doesn’t fit with my investing goals. When you are buying any stock that doesn’t pay a dividend, the only way you can make money on it is by selling it a later date (hopefully for a higher amount that you paid for it). Many times there’s nothing wrong with that. There a lot of great stocks like Warren Buffet’s Berkshire Hathaway (BRK.B) that don’t pay a dividend and that you can fairly reliably expect the stock price to be higher years down the line that it is today. But when the stock price doesn’t go up over a long period of time, you have nothing to show for it. What I love about dividend stocks is that you get rewarded for being patient and just holding the stock, regardless of what the price may be doing on any given day.
An important part of your investing foundations are your investing goals. Everyone will have slightly different investing goals based on where they are in life, but all investing goals have the same theme. Make as much money as possible with as little risk as possible. The risk part of that equation is very important and is where people will differentiate. In general the more potential risk you take, the higher your potential reward (and chance of losing money) will be. For those with low risk thresholds, US Treasuries or CDs are the way to go. You won’t earn much, perhaps enough to keep up with inflation and another 1% on top, but your risk of losing money is virtually nil. As of this writing US 10 year treasuries are returning 2.38%. The next level up of potential risk would be an index or mutual fund. These are collections of stocks that allow you to get exposure to the broader stock market. My recommendation for people that don’t feel comfortable with the risk and swings that come from buying individual stocks is to buy a low-cost S & P 500 index fund. This will let you mimic the performance of the stock market as a whole. There is still risk here. The stock market does not go straight up every year, but if you have a long-term horizon, the average annual return of the S & P 500 has been 9.8% over the last 90 years (CNBC). My personal feeling is we are in for a lower number than that for the next 4-5 years because valuation of the S & P 500 is near historical highs, which is why I think the best mode of investment today is selection individual stocks that are trading at fair valuations instead of just buying a collection of all of them which will include some companies that are grossly overvalued.
If you do decide buying individual stocks is right for you, the first thing you need to do is start building your foundations. These are your core group of stocks that you feel comfortable putting your hard-earning money into. For your foundations, quality is better than quantity. Don’t feel like you need to buy 20+ stocks in the name of diversification, especially if you are just starting out. They key attributes I look for in foundational stocks are :
- Earnings/Dividend History – What I look for are companies that have a track record of raising earnings and dividends over long periods of time, paying special attention to how the company performed during recessions. Dividend Champions are the cream of the crop when it comes to this metric. They are companies that have increased their dividend for at least 25 consecutive years. The list of dividend champions is maintained at DRIP Investing.org and is a great resource to identify potential investments.
- Economic Moat – This is what keeps competitors at bay and what allows the company to earn more money every year. Brand recognition (Apple, Pepsi, McDonald’s), high-start up costs (AT&T, Verizon), and economies of scale (Walmart) are examples of moats. The key here is to be able to look forward and determine whether or not the business will be able to continue growing 5, 10, and 20 years down the line. The deeper the moat, the harder it is for competitors to succeed. And when an upstart new company comes onto the scene, companies with large moats have more time to adjust and you have more time to see whether or not adjustments are being made.
- Comfort – This may be the most important aspect of a foundation stock. You need to be comfortable enough with the company that if the price dropped by 20% or more tomorrow, you’d want to buy more as opposed to sell. This is easy to say, but hard to do when you feel the gut-punch that comes with seeing 20% of your hard-earned money disappear. You need to understand the company inside and out and really get how the company is able to turn a profit. If the company’s business model is too complex to understand, pass it by. There are plenty of other options out there.