Which direction do you take?
I've been asked many times about my investing strategy. Why I put money in stock that doesn't seem to rise, why I put more money in individual companies rather than funds, and why I don't have a lot of capital in the shares that I own that are doing really well.
They are all great questions and there are some cross overs to the answers. I find myself referring back to my 'Investment Strategy' and the two main forms of investing - Income and Growth.
I want to explain the difference between the two forms as I see it, my current strategy, and then I'd like to open it up to you guys on what method you use and why.
The information I provide is at a basic level and is perfect if you're new to investing. If you're more experienced, you might prefer scanning the Income and Growth section (or skipping it entirely) and going straight to my Investment Strategy.
This consists of investing in stocks and shares that pay an above average rate of dividends to their shareholders on a consistent basis. You make your money every time the stocks pay you. Most of them will pay out twice or four times a year, and some pay on a monthly basis.
You can profit from this form of investing in one of two ways:
- Receive a regular high dividend yield.
- Benefit from an annual increase in dividend payments over a long duration - Dividend Growth.
Example 1* - You receive 5% on your investment every year regardless of the share price. You have £1000 invested, and you receive £50 a year in dividends. In 10 years time your investment is still worth £1000 (no growth), yet you've received £500 in dividends.
You can choose to re-invest your income and buy more shares. If that were the case, you could have an investment worth £1,050 after 1 year, which would now receive £52.50 in dividends. After Year 2, the investment would be worth £1,102.50, and you would receive £55.13 income. The process continues and after 10 years of reinvesting your shares are now worth £1,628.89. The dividend in Year 10 has increased to £77.57 (55% increase on £50). 'Compound Interest' is beautiful thing!
Example 2 - The company you invested in have a long history of consistently increasing their dividends by 6% each year. You invested £1,000 in a company and have 100 shares with them (£10 per share). The company pays you 40p per share and you receive £40 (40p x 100 shares). The yield is therefore 4% (pretty good!). The company increases its dividend by 6% the following year = 42.4p per share. You now receive £42.40. The next year it goes up by 6% again and you now receive 44.944p per share = £44.94.
*I've purposely negated charges and commission to simplify things. You could be eligible for both, so please take that into consideration.
In Example 2, I haven't mentioned the share price. If the company wanted to prioritise the dividend growth and keep the 6% increase going, it's likely that the share price will go up with it, but that is not a guarantee. You could receive an increase in dividends of 6% for 10 years and the share price could remain the same value (unlikely, but possible). If that were to happen the dividend yield would increase significantly, but that wouldn't necessarily mean it was good news. It would depend on your strategy.
I've displayed this in a table to help you understand. Using the same example of a £1,000 investment (100 shares), and having a dividend that increases 6% every year (starting from 40p per share). You would receive exactly the same Income on all three examples because the company pays 6% higher dividends every year. Yet the percentage yield would differ based on the price of your investment over time.
||Dividend Payment / Yield
|£1,000 Share Price
||Yr 1 = £40
||Yr 2 = £42.40
||Yr 3 = £44.94
|Stays the Same
||£1,000 = 4%
||£1,000 = 4.2%
||£1,000 = 4.5%
|Increase £100 pa
||£1,100 = 3.6%
||£1,200 = 3.5%
||£1,300 = 3.5%
|Decrease £100 pa
||£900 = 4.4%
||£800 = 5.3%
||£700 = 6.4%
In the top row, where your investment remains the same value for 3 years, the yield has increased from 4% to 4.5%. This is in line with the dividend increase.
In the middle row, your share price has increased £100 each year. This has led to your % yield decreasing over time. Is that a bad thing? Not at all! Your Portfolio has risen from £1,000 to £1,300, and your dividends have increased 6% each year (like the other rows). It's a win/win on Portfolio Growth and Income.
The bottom row shows a decrease in share value from £1,000 to £700. The dividends have continued to increase by 6%, and this has led to an increase in % yield. Is this a good thing? It depends! If your strategy is geared towards share growth then it's not great. If you invest for Income, then you could argue it's positive as you're receiving more income than you did three years ago for the same investment. (This would be a weak argument, and you might need more information to back your point up)
How to Find Quality Income Stocks
If you want to focus more in Income, don't just be sucked in to the % yield. Make sure you review what the company are doing with their dividend payment per share each year. Have they increased every year for 20+ years? Has the dividend decreased at some point during the last 5 years? Ideally, you want a long history of increased dividends per share, with a yield between 4-6%. Average yields will be around the 2-3% mark.
As an income investor, it's important to search for high % yield but it's worth pointing out that extremely high yields (eg. 7% and above) aren't always a good move. The higher the % yield, the harder it is to maintain over time. Large increases in yield over a short space of time, and a lack of dividend increase history should be handled cautiously. It can be considered as a bad sign when a companies yield is over 7% - Like in my table above, it might be down to the share price plummeting. A real time example of this is the UK Supermarkets. Look at the yields of Sainsbury's (6.09%) and Morrisons (7.14%). Sainsbury's share price has fallen 28% in one year whilst Morrisons has fallen 39% in the same time. I invested in Tesco's earlier in the year, as I felt it was the safer of the three supermarkets. It has continued to fall and has also lost 39% of it's value in 12 months.
All three boast high yields, and Tesco recently announced that they were going to slash their dividend later this year. Will the other two follow?
In addition to the dividend per share, and dividend yield, it's worth considering the Earnings Per Share (EPS). Dividends are usually paid out of the companies profits, so when the companies profits increase, it's likely the dividends will too. A sensible benchmark to examine is the annual Dividend Growth should not exceed the annual growth in EPS. If the company continued to pay out more dividends than it could afford, the company would run out of profits. A company without profits can't expand and grow.
If your investment goal is Income, and you've found a company that pays consistently high dividends, that increase each year and don't exceed the growth in earnings - You don't need to concern yourself about the daily or even monthly fluctuations of the share price. You can just wait for the dividend payments to appear in your account and enjoy the continuous flow of money each year.
This involves purchasing shares in companies where the price rises to above average levels over a period of time. You make your money from the increase in the share price.
You can profit from this form of investing in one of two ways:
- Sell part or all of the profit.
- Keep the investment intact and benefit from a higher dividend payment (if it has one).
Example 1 - You buy 50 shares for 100p (worth £50). 12 months later they're worth 200p per share, and your investment is now worth £100. You could sell 25 shares**, reinvest or spend the profit, and you would still have £50 invested in the company with 25 shares worth 200p. As the left over amount is 100% profit, you have a 'free asset'.
Or, you could sell 10 shares for £20 profit (minus charges) and you would have 40 shares worth £80. You have some capital to invest in somewhere else, and your investment is still worth more than it was when you initially invested.
Example 2 - The company you invested in have a long history of consistently paying 4% to their shareholders. You originally received £2 in dividends for your investment when it was worth £50. 12 months later, the value has increased to £100 and you receive £4. You don't sell any stock but you're able to earn more income due to the increase in price.
**If you sell the shares, you're likely to receive a commission charge for doing so. Please take this into account.
It sounds easy right! The trouble is trying to find the stock that will go up in value over time. Predicting the future is never straight forward. Growth stocks can be riskier than Income. They tend to have a higher purchase price than Income and their dividends are lower or in some cases non-existent. The profits are usually reinvested back into the company which help it grow and this generally leads to an increase in share price. The fun begins when you invest in a company that multiples it's share price, like in the example above.
How to identify Growth Stocks?
The Price to Earnings ratio (P/E) helps us to identify share value at a glance. It's calculated by dividing the share price by its Earnings Per Share (EPS). A lower P/E informs us that there is good value for money. Therefore, a high P/E ratio advises us that the stock could be overvalued and at risk of decreasing.
The P/E ratio is not enough on its own to help us identify which companies to invest in, as it doesn't account for growth. A low P/E may look tempting but if a company isn't growing, the stock price isn't likely to either.
The Price to Earnings to Growth (PEG) ratio is ideal remedy for this. I've mentioned a lot of measurements during this post, but I'm a big fan of reviewing PEG. This ratio considers the companies value, earnings, and potential growth! You calculate the PEG by using the P/E ratio and dividing it by the expected 12 month growth rate. Ideally, the growth rate should be the same as the price to earnings. Therefore, a PEG ratio of 1 offers a nice balance of earnings, value and growth. A PEG of 0.5 would highlight an undervalued company, whilst a PEG of 1.5 would suggest it's overvalued.
Using Dividend Yield, EPS, PE, PEG
If this information is new to you, it's likely that it will take some time to digest it. My understanding of these figures was met only by repetition. I kept reading the same paragraphs until they made sense before moving on. I would suggest re-reading this post many times, and from different sources to understand them. The figures on their own do not tell the whole story. The narrative comes to life when you compare these figures between companies in the same sector. For example, comparing the three supermarkets in the UK - Tesco, Sainsbury's and Morrisons.
What can you glean from comparing these ratios? Can you identify any growth opportunities?
My Investment Strategy
Regular readers of this Blog will know that I'm investing money to provide myself an income that will surpass my monthly expenditure on a consistent basis. Therefore, providing me the option of not working again.
That's the basis of my strategy!
I'm not primarily looking for Growth in my portfolio. I desire growth in my Income. I'm an Income Investor.
I look for the following in stocks to represent a perfect Investment***:
- High dividend paying shares which average over 3.5% and under 7.0% yield, over at least a 5 year basis. Bigger doesn't mean better. The yields of 3.5-4.0% are usually the more established and stable companies. I want a blend of these companies with the 5.0-6.0% ones.
- Consistently pay increasing dividends year after year. I look for an annual increase of around 6%. I set a minimum of 5 years here. The longer the increase has run for, the less risk I feel I'm taking.
- Dividend Cover of 1.5 and above, averaged out over 5 years. This is the number of times a companies dividends are covered by it's profits. I want to know that a company can afford to pay it's shareholders.
- A PEG of 1 and below. This represents good value, earnings, and potential growth.
- An increase of EPS over the last 2-3 years.
- I compare the figures above against companies in the same sector to find out which ones stand out.
- I then research the 'standout' companies by reading Broker reports, share news, and company information to see if I'm confident to become a shareholder. If the figures above stand out on one company, I won't tend to do as much research. If it's a bit closer, I'll do a little more reading.
***I have invested in companies that don't fulfill all of this criteria.
I bypassed a lot of the work above when I first started out by looking at what other Income investors had invested in. I wrote down the top 10 holdings for the most popular Income Funds at the time - Vanguard FTSE UK Equity Income index, Invesco Perpetual High Income, Artemis Income, and Rathbone Income. Not too surprisingly, there were a lot of similar names in all the funds. I then checked on the value of these shares at the time I was ready to invest and bought the ones that represented better value to me.
Although I wouldn't recommend solely using the approach above. It helped me to gain confidence in companies I was investing in. If 3 out of the 5 professional investment funds (that were looking for Income) were investing in these companies, why shouldn't I!
I now think it's more important to get an understanding of the ratios/numbers behind the investment before spending your money.
I'm 31 years old, which is still relatively young for a investor. If I'm fortunate enough to live for another 40-60 years, I can afford to take some fluctuations in the market. Eg - Tesco are looking rotten right now, but I guarantee you that their share price will be worth more than it was when I purchased them in 20-30 years time. As will the rest of my portfolio, house prices and gold etc. If you don't believe me, just look back at what the average rates were 20-30 years ago in all of those areas.
The older I get, the less time I have to absorb the market fluctuations. My investment choices will become more conservative as I age.
What's your Strategy?
I've broken down some basics on strategy. I detailed the foundation of my investment strategy, so what about you? What do you do? Are you willing to share how you make your choices?
I would appreciate it if you were willing to take the time and share some of your knowledge and experience so we can all benefit.
Thank you for reading. I hope you found the post useful for either understanding how to invest confidently, or just to comprehend how I personally invest.
Disclaimer: I am not an investment professional or a licensed financial adviser. I am a self-educated investor and the contents of this blog reflect my personal investing strategy, thoughts, and decisions, which may not be appropriate for other investors. My investing decisions do not constitute recommendations or advice. You should consult with an investment professional before making any investing decisions. I am not responsible or liable for any of your investing decisions or the outcomes of your decisions, including but not limited to those that may result in monetary loss or emotional distress. I am not responsible for any of the comments posted by readers or the contents of any linked websites.
Labels: Dividend Income, Stock Purchase, Strategy