I’m joyed to be writing what is only my second book review on Dividend Monk.

The reason I don’t write many book reviews is, the investment strategies that I follow and showcase are rather straightforward, and there’s little reason to ever reinvent this wheel. But Andrew Hallam is a fellow blogger (and on my personal blogroll), and I’ve read his articles for a while now, so I knew his book would be a very worthwhile read, and was waiting to get a copy and write a review. I had the opportunity to get a book before, but I waited, and therefore I just sat around and waited some more for Amazon to get more in stock. (They had been sold out due to the success of the book.)

So without further delay, here’s a review of Andrew Hallam’s Millionaire Teacher.

Overview

Andrew Hallam is an English teacher who became a self-made millionaire in his 30′s. He achieved this by taking his teacher’s salary, frugally saving it, and diligently investing it, year after year, in index equity funds, index bond funds, and some rational individual stock selections. He’s living proof that almost everyone in the developed world can become a millionaire because he led by example.

Andrew’s a smart guy, but he didn’t have to apply some genius stock-picking approach, or take on huge risk to get a huge reward. He merely maintained a balanced portfolio of stocks and bonds, and once in a while he adjusted it to keep it balanced. So for instance, if he had a 65% stock and 35% bond portfolio, and stock prices were rising, he was selling shares while everyone else was buying, and instead was buying bonds to maintain his portfolio balance. Inversely, when stock prices were falling, and everyone was selling stock to buy bonds, he was selling bonds to buy stock at low prices to rebalance his portfolio. It didn’t require market timing, fancy math, or any sort of intellectually rigorous activity; just simple portfolio maintenance and the responsibility to maintain it. It only took him minutes per year. In addition, as a fun side portfolio, he applied fundamental principles of rational individual stock selection. In a noble fashion, he beat the market with his individual selections, but humbly points out that over the long run, it’ll become statistically less and less likely for him to maintain that claim, and that people should index rather than try to beat the market. It’s a rather solid case of wisdom and diligence being a winning combination.

As a teacher, he has witnessed first hand how dismal the financial education is for most students. They learn how to work with quadratic equations, and learn the difference between eukaryotic and prokaryotic cells, but they don’t learn to manage their own money. Recalling my own education, I can literally say that not a single teacher taught me a single thing about investing, valuing a company, corporate structure, or stock indices, except for the simple chapter in a mathematics class regarding the power of compound interest. That was it. Andrew has sought to correct this by educating teachers, educating family members, giving talks, blogging, and now, writing a successful book.

The book is organized as a series of his “Nine Rules of Wealth”.

The Good

The book is excellent, as I expected.

-The organization of the book is well thought-out. He covers the basics, makes arguments, reinforces those arguments, but never becomes tiring or overly repetitive. This is in contrast to the famous book, The Millionaire Next Door, which contains a similar message, but after 50 pages of that book, the reader is like “OK I get it already! You don’t have to say the same thing ten times!” Andrew avoids that problem by providing enough reinforcement of his ideas without tiring them out.

-His set of arguments for index funds over actively managed funds is flawless. He really puts the nail in the coffin of actively managed funds. Not only does he make extremely effective arguments backed up by statistics, history, and reasoning, he even counters the expected counterarguments made by people who wish to sell you those funds anyway. His devastating arguments against the enormous self-serving financial services industry should be clear to any rational mind.

-His final section on individual stock selection uses intelligent principles, and covers a lot of the investment basics. In a few parts of the book, he covers topics of how corporations work, why shares go up in value, differences in company value, and more.

-He gives a definition of “wealthy” that I very much agree with. It’s very straightforward, and in my opinion it’s also accurate. Perhaps just as importantly, it’s reasonably attainable on a regular income with diligent saving/investing habits.

-Andrew is a Canadian teacher that currently lives and teaches in Singapore. So he’s sensitive to global differences, and takes an international approach. There’s a whole section devoted to international indexing. So it doesn’t matter what country you’re from; the truths in this book remain valid.

-The 184 page book is an elegant read. Remember, this isn’t a financial guru writing a book; it’s a self-made millionaire English teacher. It can be read in a weekend, is easily accessible to a multitude of different types of readers, and the nine rules break it up into easily read chunks. He artfully blends personal stories, humor, facts, and images to create a rather effortless reading experience.

-I found myself being unable to put the book down, and finished reading much earlier than I had planned. “Well, I’ll read one more of these rules for now…”, I kept telling myself, until I had read through all of them. It’s not because the book is overly short; it’s because it flows elegantly, and gives the information needed without providing any distracting extras. Andrew’s investment approach is simple, as any effective investment approach should be.

Any Downsides?

Any good review includes some constructive criticism. In this case, it’s not criticism of what he said, or of his arguments; it’s an observation of what he didn’t say, and what most people don’t say.

At one point, when Andrew is explaining how a corporation works (his reminder to readers that indexes are built on real companies, and are not just little lines on a graph that go up and down), he uses the following example: He discusses Willy Wonka starting a public company to raise more capital, talks about the shareholder relationship, talks about growth and dividends, and says that the board of directors is voted in by the shareholders.

All of this is true, and yet with index funds, that’s not what really happens in practice. With index funds, shareholders don’t vote for the board of directors. Instead, they own hundreds or thousands of companies, and can’t pay attention to what those boards are doing. Index investors give their right to vote to the owner of the fund. When Vanguard, for instance, votes on behalf of the millions of investors that gave up their right to vote by buying their index funds, Vanguard sets a very low bar for whether they will vote for a given board member, and they abstain from voting with regard to 94% of shareholder proposals that are related to corporate or social policy.

One can’t really blame Vanguard; they have fiduciary duty to their customers to promote good returns, and they can’t predict how millions of would-be shareholders would want to vote their shares. So they largely stay neutral and abstain from much of the process. I think pointing out the loss of shareholding voting that comes with index funds (as well as actively managed funds), would have been a fair addition in the book.

I believe responsible portfolio management includes treating shares as an owner would, and voting accordingly with regards to board member elections, management compensation, and review of shareholder proposals. It’s the one area where my investing philosophy seems to differ from the book.

Conclusion

Millionaire Teacher is an excellent, easy-to-read book. In my opinion, this should be on the reading list for every high school student in the world. In addition, I suggest that everyone who currently invests in actively managed funds should read this, since I couldn’t agree more that index funds in almost every case are far more rational to invest in than actively managed funds. I offered to let a co-worker of mine borrow my copy of the book after he started talking to me about his mutual funds. Andrew’s arguments are solid, the book is a delight to read, and after having seen him blog for a while now, he certainly is a genuine and honest person.

Disclosure: The book image link is an affiliate link to Amazon, and I only use affiliate links for products I highly recommend.

This is the ninth and last in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

Asset allocation is more important for your portfolio than individual selections. Dividend stocks are not a replacement for bonds, and shouldn’t usually be treated as such. A dividend portfolio with a reasonable allocation towards fixed income securities is important for long-term stability and growth.

Dividend growth stocks, although often less volatile than the market as a whole, still go up and down with economic fluctuations. This isn’t necessarily a problem for long-term investors, but if you want to fully take advantage of these fluctuations, fixed income securities are useful. Bond indices tend to move inversely in respect to stock indices, so when stocks are going down, bonds are often remaining steady or going mildly up. Interest rates tend to be higher during periods of economic strength, which keeps bond prices reduced. When interest rates fall (typically during a period of economic weakness), bond prices increase.

Think of fixed income securities as your “war chest” for recessions or flash crashes.

If you keep, say, a 70/30 allocation of stocks and bonds at all times, then you’ll be prepared for many market conditions. During periods of economic booms, when stock prices are rising fast and perhaps becoming overvalued, your stock percentage of your portfolio will increase to over 70%, and to keep the 70/30 allocation, you’ll either have to sell some stocks and buy some bonds, or preferably, keep the stock holdings you have and use your fresh capital that you regularly put in your portfolio to buy bonds. This is good, because when stock markets are highly valued and you have trouble finding good selections, you’ll instead be putting capital into bonds with solid interest rates.

Then, when a recession comes, and stock prices fall to attractive valuations, your percentage of stock holdings in the portfolio will decrease to under 70%, so you’ll naturally direct new capital towards buying stocks, and perhaps even sell some of your appreciated bonds to take advantage of the undervalued market depending on how big the stock drop was and how imbalanced your portfolio has become from your target asset allocation.

Keeping a consistent allocation of stocks and bonds naturally results in buying at fairly attractive prices, for both bonds and stocks. And note that none of this necessitates market timing. A 80/20 or 70/30 or 60/40 allocation of stocks to bonds can be maintained in all market conditions, so your buying habits are dependent on what your current allocation is rather than directly based on your market predictions.

Suppose I have a total portfolio with the following balance: 20% US Large Cap, 10% US Small Cap, 10% US REITs, 25% International Developed, 10% International Emerging, and 25% Bonds. As they go up and down relative to another, and you rebalance with fresh capital or with annual rebalancing, you harness that volatility by mechanically buying on dips or mechanically buying low and selling high. It can work whether it’s purely indexed or whether substantial portions consist of individual stock selections. Sometimes particular segments might move substantially apart from each other; for instance you could have an emerging market bubble and a US real estate slump, which means you’ll mechanically be selling your emerging market holdings when they are highly valued and buying lowly valued US REITs.

It’s important to pick portfolio segments that have low correlation. It’s useful to have both stable and volatile elements in a portfolio, such as stocks and bonds. Having a bunch of segments that all typically move in the same direction limits diversification. Spreading your assets among geographic locations, market sectors, and asset classes keeps your exposure to a catastrophic loss as low as possible and helps keep a lack of correlation between your portfolio segments. Some rather serious problems can bring down almost all asset classes, but careful selection (certain types of equities, certain types of bonds, real estate, infrastructure, perhaps commodities and cash, etc.) can reduce this possibility.

It’s often reasonable advice to gradually increase the percentage of bonds as you age, so that a large market drop that occurs right when you plan to retire won’t derail your plans, but this would depend on your individual situation and goals. For the most part I agree with the common advice; young people would do well to have a lot of equity exposure, since equities have historically offered the best returns, and those nearing retirement would do well to focus on capital preservation and moderate growth.

Although it can be tempting to think of assets that produce cash flows, such as dividends or interest, as being in the same group, dividend stocks are not a pure replacement for bonds in a portfolio. Maintaining diversification keeps your options open, your risks reduced, and improves the chances of attaining solid long-term returns.

To some people reading this blog, or learning about investments in general, while they are in high school or college, it may seem like a daunting task to start building a serious amount of wealth. But for those readers, you’re in the best position, because you’re interested in building wealth so early.

This post showcases roughly what you need to do to attain a $150k stock/bond portfolio before you reach your 31st birthday, and to also have net worth stored away in retirement accounts and home equity. It’s a simplified and rough presentation, and only one of many ways to do it, but meant to be inspirational rather than thoroughly quantitative.

Prerequisites
Can everyone do this? Only if you strive towards certain goals. The core of the process presented here is dependent on graduating from a fairly high paying major and landing a job within a typical entry level salary range for that major. I base this on the salary that one might expect with engineering, science, software, or certain business degrees- perhaps $50-60k starting out. A major with a lower entry level salary could work out with these as well, if student debt is avoided.

This isn’t to say that students shouldn’t pursue other majors if that’s where their interests are, but it is to say that if one has the goal of building wealth, the facts show that certain majors will give you a much better jump start than others. But, even those who major in lower income fields, with enough frugality, can amass some substantial wealth. Lastly, this presentation doesn’t make allowance for unfortunate events, such as if you had to put a lot of income towards helping parents while still in your 20s, or suffering a major setback in your own personal life. There’s no doubt, building wealth does require a certain component of luck. Most of the results are based on smart effort, but negative circumstances can certainly get in the way.

This also happens to be tailored towards Americans, as that’s the job market and currency I’m most familiar with, but the basics apply in many places.

Tips
Attaining a six figure net worth before age 31 comes around requires a combination of substantial income and lifestyle frugality. Before I present the numbers, here are a few tips to maximize wealth accumulation potential without sacrificing much of anything else.

-Get a job in high school, and try to save some of the income. Have fun of course, since you’re only young once, but it’s best to realize early on that a happy person is typically capable of being happy regardless of the amount she or he consumes, and an unhappy person will typically remain fairly unhappy regardless of how much she or he consumes. Spend money on experiences that truly provide value.

-Work very hard in college to keep your grades higher than average. This will increase your job prospects when you graduate.

-Find a job while school is in session. Whether it’s working in the computer lab, or being a Resident Assistant, if you can find ways to avoid accumulating too much student debt, you’re going to improve your ability to build wealth. Join clubs and groups too, but spending a portion of your time on income generation can be helpful. Certain jobs, like being a resident assistant, can greatly reduce your student loan debt while simultaneously getting you connected with the college experience.

-Try to secure internships. Not only are they a great experience, they typically pay fairly well, and you should be able to save a few thousand dollars in a summer of working, if you are frugal.

-Consider building assets even if you have student loans. It’s important to keep student loans to a minimum, but it’s perhaps even riskier to not have any assets saved away. Rather than focusing on purely debt avoidance, or purely asset-building, I propose a moderate approach of trying to minimize student loans, but also putting some cash away into an emergency fund, and even a starter dividend portfolio, while still in college.

-After you graduate, consider attaining streams of income outside of your primary job if you’re only working 40-50 hours per week. If you find ways to bring in a few thousand extra dollars per year, it can help significantly. For instance, if you make $40k in net income and have $25k in expenses, and save and invest the difference, then although pulling in another $5k in net income only increases your net income by 12.5%, it increases your savings rate by 33% if you keep your expenses static. This is something major to realize- boosting income or reducing expenses moderately has a larger effect on net savings that one might immediately realize.

-Start off frugally pretty quickly. It may be tempting to splurge when you start getting paid higher than you’ve ever been paid before, but there are a lot of ways to save money. You may be able to get furniture for little or no cost from relatives that have extra. If you don’t have a significant other that you live with, you might consider having a roommate for a few years after graduation. By having a roommate, you cut rent in half, and a lot of expenses like power, heat, and internet connection, are divided among more people. Only pay for services you really want; dropping cable tv or land phone lines, isn’t too difficult these days. Try cooking a lot of your own food, and focus on cheaper and healthier meals (moderate or low meat, less junk food, high veggies, nuts, and beans, etc.) Either go carless, or select an inexpensive but reliable used car.

-There are some pretty inexpensive ways to have fun. Go camping, go to the beach, spend time with friends, play sports and exercise, get a quality used acoustic guitar to entertain, and develop hobbies that produce and create rather than consume. Being frugal or a minimalist, especially in your early years, doesn’t mean a lack of fun. Spend money on things that are truly important to you and that create value, but don’t spend money on things to impress, or things to distract, or things that society simply expects you to do that don’t necessarily make sense. Not only will you likely strengthen good character traits, you’ll set yourself up so that you can play with some of your money later when it’s more abundant if you want to.

-Use tax-advantaged accounts if possible. If you’re offered a matching 401(k) or similar at work, at least contribute enough to get full matching. Consider adding to an IRA as well. (Or the equivalent of these vehicles in other countries.)

Let’s Begin
So you’ve graduated college, and you’ve landed a job with reasonable pay. You may have some student debt, but hopefully you’ve kept it to a manageable sum, and you may already have a few grand or even over ten grand in liquid assets that you’ve built from high school through college. In addition, you may or may not have found a way to pull in another few thousand dollars per year. Plus, you have adopted a frugal lifestyle.

-This table assumes 8 years of investment growth at a 7% rate of return after taxes. The 7% rate of return is fairly conservative, and in reality, will be a lot more volatile than in this table, which is why I’ve kept it conservative. Some years may go up 50%, while other years may drop 50%. But by focusing on buying dividend growth companies at reasonable prices, and keeping your portfolio at a certain ratio of bonds/stocks (like 30/70), you can smooth out your volatility and hopefully get a 7% rate of return after taxes.

-It begins at the end of your 22nd year, where you start out without a dividend portfolio and without adding any that year (although as was previously mentioned, you may already have a few grand in liquid assets). During the 23rd year, only $12k is added to the stock/bond portfolio because depending on your initial asset position, starting a healthy emergency fund is wise, so it’s assumed that several grand goes to strengthening what you already have.

-It is assumed that in your late twenties, you purchase your first home with a 20% down payment (either a small condo for a single person or a frugal couple, or a modest home for a couple). If it wasn’t for this, I’d have increased the “fresh capital” column for years 25-28 to more than they are. Instead, it’s assumed that in these years, you’re building up for a down payment in addition to this.

-This post is about how to really have a $150,000 portfolio. Over the 8 year process, if 2.5% annual inflation is assumed, then you’ll need approximately $182,000 in future dollars to have $150,000 worth of today’s dollars. So, $182,000 is the real target, because we’re really going for $150,000 in today’s dollars.

At end of year 30, you have over $182k.

So, you’ve got $182k in the equity/bond account, and on top of this, you’ve got a sizable cash reserve and some home equity. Tens of thousands worth. Hopefully student debt is paid off. In addition, this table doesn’t expressly include 401(k) or IRA contributions (this article was intended as a taxable portfolio that you control completely), so you may and should have a sizable chunk in those other places too. For example, if you put a combined $5k-$7k away in your 401(k) after matching each year (meaning only $2.5k-$3.5k from you), and compound at 10% per year tax free or tax-advantaged, you’ll have $65,000 or so in your 401(k). It’s a similar story for your IRA.

Summing all of this together, it’s not out of the question to have over a quarter million dollars in net worth at age 30, even without a trust fund or college fully paid for by parents. To do it, you would do well to focus early on building wealth, get a job you like with decent pay, live frugally but fully, contribute to retirement plans, to your taxable account, and possibly towards home equity.

This is the eighth in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

Managing a dividend portfolio is a fairly low maintenance activity. The purpose is to have low portfolio turnover to avoid trying to time the market, to avoid unnecessary trading fees, and to avoid unnecessary taxation, while all the while building a larger portfolio and increasing levels of passive dividend income.

But buy-and-hold doesn’t mean set-and-forget. It’s important to routinely review your investments, make note of any changes, and to invest accordingly. Taking time to determine which investments you’re interested in adding more capital to, and which investments are deviating from your investment thesis or not meeting your expectations (of fundamental performance, not stock performance), or becoming overvalued, allows you to streamline and enhance your portfolio and returns.

I spend more time on investing than I would estimate that the average dividend growth investor does (or should), since it’s a hobby of mine, and I write about it. Maintenance for my own portfolio is fairly low, however.

Regularly, give the portfolio a quick check to look for news and updates. Stock price changes matter little for long-term investors, but a large stock price swing either way is an indication of a piece of news that might be worth reading. Google Finance is a good tool for this, because you can scan your portfolio prices and top portfolio news stories on one page, and if you have an email account there, it can all be checked quickly within one log-in. How often one does this is up to the investor (and likely dependent on whether the investor is a hobbyist or if they only invest for the sake of the outcome), but there’s no reason to get too crazy about checking stocks.

Occasionally, give the portfolio a more thorough check by looking through valid news on your investments, and possibly checking various useful sources of opinion (I enjoy Seeking Alpha and Morningstar, in particular, as well as fellow dividend blogs). If possible, add fresh capital to the portfolio on a regular basis, and keep a “watch list” or a “buy list” so that you have stock ideas ready for purchase rather than making up your mind on the spot when fresh capital comes in.

Annually, give each investment a thorough re-analysis. I do this throughout the year, so that once per year, I have analyzed my entire portfolio again to ensure that my companies are still in line with my investing thesis. In addition, I vote in annual shareholder proxies for my holdings, and I particular advocate doing this because healthy capitalism depends on prudent corporate governance. One of my reasons for starting this blog was to hopefully make my time more useful by spreading my discovered facts and opinions with others, to help stabilize my commitment towards thorough stock analysis, and to be part of a community where I can continue to find good ideas. This is a reason why I typically recommend a fewer number of portfolio holdings than some other individual dividend investors might- having a moderate amount of positions makes portfolio maintenance more reasonable, makes voting less time consuming, and allows investors to have a more thorough understanding of their businesses.

Knowing when to sell a stock can be difficult. I keep my portfolio turnover especially low, but still reduce or eliminate a position from time to time. Sometimes my risk preferences change, or a smaller holding is overvalued and I have a significantly better opportunity in mind, or more rarely, a company deviates from my original investment thesis. A little bit of rebalancing to take money from high-performing richly-valued stocks and allocating the capital towards stocks you are currently more favorable toward can be a good idea, but only if the expected rate of return of the new investment is considerable compared to the sold asset, even after fees and taxes are taken into account.

For a more in-depth article on selling stock, see my previous article on the subject: 3 Reasons To Sell a Dividend Stock. When it comes to pruning a portfolio, the saying of “less is more” typically holds true, but failing to prune at all is not optimal.

How much time you decide to spend on investment is up to you, and mainly should depend on your goals and your level of interest. These are my suggestions and experiences. Fortunately for individual investors, dividend growth investing is among the lowest maintenance of all investing strategies, next to pure indexing.

This is the seventh in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

The previous step was about starting small. For long-term investors, rather than jumping completely into an investment with a large single trade, it’s wise to build positions over time, depending on the amount of capital employed. This step is the longer-term extrapolation of this method, and covers two sorts of commitments: commitment of confidence to core holdings, and commitment of continued capital input.

Commitment to Confidence of Core Holdings
As you become very familiar with an investment, and you’ve been adding to your positions, you’ll start to build fairly respectable position sizes.

There are different ideas out there about the optimal position size. Warren Buffett has suggested that 6-7 positions is optimal for a personal investor. Some people suggest 10 or so positions, and others suggest 20+ or 30+ positions. The fewer positions, perhaps the closer you can pay attention and get to know your investments, but the more concentrated the risk is. You’re more prone to outright outperform or underperform the market. The larger number of positions, the harder it is to pay attention to, and really get to know, your investments. It becomes more of an index fund of companies that will likely more closely match the market.

I don’t put forth a claim on what the optimal number of positions is. It likely depends on personal preference, tolerance to risk, portfolio size, life goals, whether you use index funds and how much of your portfolio they make up, and financial obligations and responsibilities.

But I do think it’s worthwhile to really commit meaningful capital to investments that we believe are great choices. When you’ve analyzed an investment to the best of your ability, when you’ve sought out trusted opinions on the company, when you’ve invested in the company and built your position over time, and when you’ve revisited your investment thesis multiple times from different angles with the same conclusion, it can be a good idea to establish “core holdings”. That is, a set of strong companies with large moats that act as foundations for your portfolio that you have high certainty for. It’s a choice that, if your investment thesis is correct, can give your portfolio very meaningful growth and stability. Companies with extremely strong financial positions, a history of strong dividend growth, and that are operating in an industry that won’t be going away any time soon are often good choices for a core holding. The ideal balance is such that if one of your top investment decisions were to be wrong, it wouldn’t devastate your portfolio, but if it were to be right, would give your portfolio a worthwhile boost.

I don’t particularly advocate extremely broad diversification. Apart from diluting core holdings, it makes it significantly harder to consistently vote in shareholder elections, which is something I really suggest doing. It’s good to have diversification, and the level of diversification will vary depending on personal differences, but it makes sense to commit meaningful capital to, and be confident in, your top investment decisions. My personal strategy of dividend investing is to have several (five to ten) primary holdings, and another 10 or so lesser holdings to round out diversification and volatility, plus of course other asset classes such as bonds.

Commitment of Continued Capital Input
Regardless of your chosen position size and level of diversification, the most important aspect of building wealth is to stick with it. A lot of us may know a certain type of guy- the guy at work or the neighbor that “dabbles” in investing. He plays around with a taxable investment account. He may enjoy talking about what positions he is holding lately, how they are doing, etc. He may even do well- making more money than he loses. But as the years go by, he’s still just playing games. He may have a few thousand dollars in there, which he manages to compound a bit from time to time, but doesn’t view it as a consistent wealth-building path and doesn’t diligently add fresh capital to it.

A committed wealth-builder, on the other hand, has the focus on long term wealth accumulation rather than just a few hundred bucks in occasional stock gains. She or he consistently adds money to the portfolio, maybe every month or every other month, like clockwork. This is where the psychological edge of dividend growth investing comes in handy. The focus of this investor is constantly on growth of the passive income stream and on growth of the total portfolio wealth, rather than short term fluctuations. The investor is familiar enough with her financial position, her income, and her investment strategy to make fairly accurate long-term goals of how much passive income she wants by a certain date (five year goals, ten year goals, etc), and then hopes to meet or exceed those goals.

The most important aspects of investing are asset allocation and the discipline to consistently add capital. Individual investment decisions are secondary. To build wealth, one must be the wealth builder rather than the “dabbler”- consistently add money to your portfolio, ensure you have adequate asset allocation and diversification, and think strategically far ahead.

This is the sixth in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

Initiate new positions with a smaller investment

Once an investment has been thoroughly researched and decided upon, it may seem like initiating the investment is trivial. Knowing how much to invest,however, is another significant decision.

This article isn’t about what percentages you should have for individual stocks in your portfolio, or a discussion on what the optimal number of positions is. Rather, this discussion begins after you’ve decided the approximate position size you want in an investment (based on your confidence in the company, the target diversification, and number of positions in your portfolio). Once you know what position size you want, the next question is how to get there.

The “clumsy” way to do it is to take a lot of your available investment capital and immediately enter your full position. Now, this may be appropriate if your positions are small and therefore due to trading costs it makes sense to enter it in one trade. But if you have a larger portfolio, it typically makes sense to build positions over time. The reasons to start small with stock positions are many:

Stock Movements
Large stock swings could give you better opportunities later. Even blue chip companies can have fairly dramatic stock valuation changes over the course of several months, and smallcaps are even more volatile. A long-term dividend investor typically cares little for stock price- save for always being on the lookout for better and better buying opportunities. Entering a position all at once is like putting all of your eggs in one basket; you’re declaring that this is a great value and disclaiming the option to continue to look for better values. In reality, the market is kind enough to give patient investors opportunities to add wisely to their positions.

Familiarization
You may have misjudged your decision, and taking more time to familiarize yourself with the company can help you find faults with your investment analysis, realize things you missed, or perhaps boost your confidence in your initial estimations. Every investor, no matter how experienced and patient, is going to make an investment mistake from time to time. Minimizing the scale of mistakes by starting small and entering positions over time can keep your losses minimal. There’s an element of risk with any investment, and it’s better for a mistake to occur with a small position than with a large position.

Reserves
It’s always a good idea to have sufficient capital available. You never know when you might come across a great investment at a great time. Similarly, you never know when the whole market might retract and give you plenty of attractive buying opportunities across the board.

Efficiency
Breaking an investment up into smaller chunks might sound like it adds a lot of work, but it doesn’t have to be. Once you have a fairly substantial and diversified portfolio, adding to existing positions is a lot easier than initiating new stock positions, as long as you consistently record your investment thesis for each investment. When you’re familiar with a company, and you know the reasons you invested, it only takes a fraction of that information to add to the position. There’s usually no need to start from scratch and analyze the investment all over again (although doing this occasionally isn’t a bad idea either). Instead, you need only take into account any significant changes that occurred since your last investment, including price changes, major business changes, revised outlook, and updated dividend and financial information.

Conclusion

In summary, there are plenty of reasons to build your positions over time. How much you should invest in any one trade depends to a certain extent on your portfolio value, your invest-able income, and your trading costs. It’s best, when possible, to avoid going too far into an investment on a single day, assuming one has a very long-term view of the holding and isn’t looking to cash in on quick stock moves.

This is the fifth in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

Research is where Do-It-Yourself investors really start to get their hands dirty. A certain amount of education is needed to start doing some stock research, and continued stock research will educate a researcher over time to a more thorough degree. In addition, over time, researchers will develop a personalized framework, or efficient series of steps, for screening investments and then looking deeper into some of them.

When looking for potential investments, I approach it broadly and then focus in on specific companies that appear promising.

Screening Process

First, I begin broadly screening large numbers of companies to look for potential gems. Various investing blogs and sites can provide a lot of help here by regularly providing ideas. These can range from analysis articles to lists of potentially good investments under a common theme. In addition, there can be some amusement in perusing these sorts of materials for those that have a genuine interest in business and investing. In addition, some larger entities like Seeking Alpha, Morningstar, or the Motley Fool can provide flows of stock ideas.

Stock screens can also be a big help here. Sites like Google and Morningstar, among several others, offer stock screens. Stock screens are programs that allow you to select certain criteria to limit your search. For instance, you could look for companies with a dividend yield of over 4% with a debt/equity ratio of under 0.5, and a P/E of under 15, and get a list of companies that currently meet that set of criteria. It’s good to try several stock screens to figure out which ones you are most comfortable with, and which ones are the most powerful and precise.

Cursory Glance

Once a potentially interesting company is found, more research is necessary. The 20 Quick Ways to Check a Company are a good start.

Review the company metrics, which can be found on several sites or quickly calculated by other publicly accessible metrics. Ideally, you can quickly eliminate companies from your investing pool that are revealed to be out of the scope of your area of competency, or have a major drawback that goes against your investing style (perhaps too much debt or not enough growth).

Deeper Look

If an investment continues to look appealing at this stage, a deeper look is important. Research the history of the company. Take a look through the company website. Read the annual report and the 10k. I spend a considerable amount of time on the 10k, as information there is presented in an exhaustively thorough way. In addition, take some time to research news articles about the company, with a particular focus on looking for bad news. Also, look for subjective opinions from sources that you trust, and sources that appear legitimately well-researched. It can also be a good idea to look at company investor presentations, but keep in mind that these will generally be biased in favor of the company.

So, to recap the deeper look, be sure to research:
-Various stock and company metrics
-Company history
-Company financial materials, including the 10k, 10Q, annual report, and other materials
-News, and particularly bad news
-Subjective analysis
-Presentations

Finished?

As you do these things and when you are finished, it’s important to document it. Develop an investing thesis, so that much of the information is preserved for future use, either when making an investment or when looking back at why an investment was not made, or when you’ve found a potential investment but wish to wait for a better price.

An investing thesis is also useful because in order to temper emotions, it’s a good idea to put a “hold” on investments after you’ve look through them. Put it down, take some time away, and then come back to it and see if you’re still interested for the same reasons. This helps diminish the emotional element. It can even be a good idea to come back and then try to construct an argument as to why you should not invest in the company. If, when all is said and done, the company remains high on your investment list, then you might have found a gem to add to your portfolio.

Investing research can be overwhelming. This is especially true for novice investors; there are just so many metrics to consider, and they all relate to each other in a large and complex whole, so how can one make sense of a set of investments and compare them?

This article is meant to provide a quick organization viewpoint in regards to scanning companies for investments. It’s not meant to be an all-inclusive guide on how to select a company, but it provides what I consider to be among the most important investing criteria, and how they relate to each other. Some businesses, such as financial companies and partnerships will require a different set of metrics, but these work well for a large collection of dividend stocks out there.

I have broken the metrics down into a few categories: Growth, Financial Strength, Dividend, Subjective Information, and Valuation. Growth metrics are a few ways of analyzing how quickly a company is growing. Financial Strength metrics show how strong a company’s balance sheet is. Dividend metrics are obviously important for those seeking dividends, but also important to gauge overall shareholder friendliness of the company and long-term stability. Subjective Information allows one to take into account non-quantitative aspects of the company, like strength of the moat and quality of the management. Lastly, Valuation metrics are a tool to understand how much investors are currently willing to pay for the company, and this will generally depend on the other metric categories like growth, financial strength, and subjective information.

Generally, things like solid growth prospects, strong balance sheets, and positive subjective information will lead to higher reasonable valuations for a company. So when analyzing a company, I look to find a company with decent growth prospects, a strong financial position, positive subjective information, and shareholder friendly management, and then I look to see if the valuation is reasonable given this total information.

Growth:
Net Income Growth
Revenue Growth
EPS Growth
FCF compared to Net Income
Return on Equity

Financial Strength:
Debt/Equity
Interest Coverage Ratio
Goodwill/Equity
Current Ratio

Dividend Information:
Dividend Yield
Dividend Payout Ratio
Dividend Growth
Share Repurchases

Subjective Information:
Business and Industry Prospects
Economic Advantage
Management Quality

Valuation:
Price-to-Earnings (P/E) Ratio
Price-to-Free-Cash-Flow (P/FCF) Ratio
Price-to-Book Value
Market Capitalization

Growth

A company can grow in many ways, so looking at a variety of growth metrics is important.

Net Income Growth
Income is the bottom line that business owners are after. Companies operate to bring in profits, and profits ideally grow over time. It’s useful to look at net income growth over 3-year, 5-year, and 10-year periods to get an idea of what kind of long-term growth prospects this company may have, and how the trends are changing (is growth slowing or accelerating, or neither?)

Revenue Growth
In many cases, it’s important to look for revenue growth as well. If a company is growing net income but not revenue, it means they are becoming more efficient and therefore increasing their profit margins, but this can only go so far. For sustained growth of net income, sustained revenue growth is required.

EPS Growth
To investors, growth of earnings-per-share is typically even more important than net income growth. If a company grows its net income, while using some of its money to repurchase its own shares, then EPS will grow faster than net income. If, on the other hand, a company is diluting its shares by issuing more shares than it is repurchasing, EPS will grow more slowly than net income. In addition, EPS may be growing even if net income is flat or decreasing, so it’s important to look at both per-share metrics and total company metrics.

FCF compared to Net Income
A company that maintains solid free cash flow numbers is a sign of health and economic advantage. If a company can maintain profitability and growth with minimal capital expenditure, then it’s likely performing quite well. I look for operational cash flow to be substantially higher than net income, and for free cash flow to be either higher than net income, or at least comparable to it, in most investments. It depends to a certain extent on the industry.

Return on Equity (ROE)
When you divide net income of a company by their total shareholder equity, you get return on equity. Typically, higher returns on equity are a sign of competent management and a profitable business, because they are bringing in a lot of income for each dollar that is on the balance sheet. One must be careful, though, because a bad balance sheet can sometimes boost returns on equity. If a company has a large amount of liabilities compared to assets (and therefore a small amount of shareholder equity), then ROE will seem quite high. So it’s important to look at the whole picture, and compare ROE to financial strength metrics.

Financial Strength

A company that is in good financial shape reduces risk, provides opportunity, and shows management responsibility. All else being equal, a company with a strong balance sheet is worth more than a company with a weak one.

Debt/Equity
Debt/Equity is an important metric. Long-term Debt/Equity is calculated by taking the total amount of long-term debt and dividing it by the amount of shareholder equity. The lower the number, the less debt the company has compared to equity. I prefer companies with less than 0.5 debt/equity ratios, or at least less than 1.0 debt/equity ratios, but it will vary to a certain extent in some industries. Companies that necessarily have large amounts of capital expenditure will usually have substantial debt levels.

Interest Coverage Ratio
If a company holds debt, it’s paying interest on that debt. A company with a lot of debt will be paying a lot of interest, but other factors matter too. A company with a strong balance sheet and a good credit rating generally pays lower interest rates than a weaker company, and so a metric is needed to sort out different situations. If you take income before taxes and divide it by the amount the company pays in interest over that time period, you’ll get the interest coverage ratio. I typically look for companies with an interest coverage ratio of at least 3, but prefer to see it over 8 or more.

Goodwill/Equity
Some assets are called “goodwill”, which is an accounting asset rather than a real one. When a company pays more for a company than its book value, they put the remainder on their balance sheet as goodwill, and management is responsible for deducting from it as appropriate. If a company has a lot of goodwill, it can artificially lower metrics like debt/equity. On the other hand, goodwill isn’t necessarily a bad thing if it is accurate. Some companies, especially those prone to making acquisitions, will naturally hold more goodwill than others. Dividing the total goodwill by the total equity shows what percentage of equity consists of goodwill. All else being equal, it’s optimal to look for fairly low or moderate levels of goodwill.

Current Ratio
The current ratio is calculated by taking total current assets (cash, short-term investments, receivables, etc) and dividing by total current liabilities (payables, short-term debt, etc). This should typically be above 1, and I prefer to see a higher number in smaller companies.

Dividend Information

To dividend investors, researching the dividend is obviously of immense importance. One wants a significant dividend yield, a growing dividend, but a payout ratio that is low enough to increase the likelihood that the dividend remains safe and growing.

Dividend Yield
To calculate the dividend yield, take the amount that the company pays in dividends per share each year and divide that amount by the share price. Typical dividend investments typically pay 2.5% to perhaps 7%, with 3-5% being a pretty good area. Yields under that are pretty low, and yields above that may be value traps.

Dividend Payout Ratio
An unsustainable dividend is not a very useful dividend. Divide the total yearly dividend by the EPS to get the earnings payout ratio. This represents the percentage of earnings that the company is paying to shareholders as dividends. It’s also worthwhile to divide the total yearly dividend by the per-share free cash flow to get the FCF payout ratio. Ultimately, it’s cash that determines dividend sustainability.

Dividend Growth
Some companies pay the same dividend each year, some companies grow or reduce their dividends erratically, while others successful grow their dividend year after year. Seeing dividend growth trends can help determine future growth of your passive income and your yield on cost.

Share Repurchases
Some companies repurchase their own shares, which means the existing shares that a shareholder owns are worth a greater percentage of the company (or the company can eventually issue the shares again for an acquisition). Companies typically also issue shares to executives for compensation. Looking at the net share repurchases of a company (repurchases minus issues), shows how much money the company is spending on share repurchases. It’s sometimes useful to compare this amount to how much they are paying in dividends. Share repurchases will boost EPS and fuel dividend growth, but can sometimes be used irresponsibly.

Subjective Information

This is what separates humans from machines. Anyone can plug in the above numbers (and they should), but it takes someone with insight to figure out the rest. This is what separates good investors from mediocre ones, along with discipline and patience. This part of the investment process takes the most work.

Business and Industry Prospects
For long-term investments, it usually makes sense to pick a business that is in an industry that is not going to go away any time soon. A healthy and growing industry makes it easier for a company in that industry to grow and increase profitability. Likewise, even a great company in a struggling industry may find itself in trouble. Even the world’s best horse-and-buggy company will run into trouble if everyone starts driving cars. Sometimes an industry may seem to be in bad shape, but the long term is what’s important. Sometimes great values can be found in industries that are currently out of favor but that have great long-term potential.

Economic Advantage
Some companies have advantages over others that separate them and allows them to achieve and maintain impressive levels of profitability. If companies compete against each other without economic advantages, they are essentially offering commodity products and services, and it often leads to the result that they will not be quite as profitable or have as much staying-power, as those that do have strong advantages. The popular explanation is that an economic advantage is a company’s moat, keeping competitors away with little work.

Examples of Economic Advantages include:
Scale: If a company is larger than others, it likely has more purchasing power, a more effective and efficient distribution network, and the ability to buy-out or out-spend competitors. Companies have trouble competing against scale because they lack scale themselves, and they cannot achieve scale unless they compete well, so it’s a vicious cycle.

Switching Costs:
When it is difficult for a customer to switch to competitor’s product or service, they likely will not. It’s a hassle to change banks, to change infrastructure, and to change computer systems.

Regulation:
Some companies operate in such a way that they essentially have a regulated monopoly. Their risks and rewards are reduced and investments can potentially be more predictable.

Intangible Property: People are willing to pay a little more money for the same product or service when they feel trust towards a brand. In addition, when a person is selecting a product or service seemingly at random, they are likely to pick one they are familiar with. Brand strength is an intangible benefit to many companies. Patent shields are also powerful defenses. When a company can patent its product or service, it keeps competitors away temporarily and allows high levels of profitability.

Management Quality
Lastly, it’s worthwhile to look at management quality. How long has the current CEO been running the company? How have they performed? How much of the company do the executives own? What is the company culture like? Having an outstanding group of individuals running a high-quality business can do wonders for your portfolio.

Valuation

The valuation of a company is the snapshot of what investors are willing to pay for this business at the current time. Fair valuation depends to a large extent on other metrics, and must be considered alongside them.

Price-to-Earnings (P/E) Ratio
The P/E ratio is the price of a share divided by the earnings-per-share. Because price is measured in dollars, and earnings are measured in dollars per year, the units for P/E are measured in years. A higher P/E ratio means that investors are currently paying more per unit of earnings, while a lower P/E means investors aren’t willing to pay very much per unit of earnings. Typically, my investment purchases have a P/E of between 10 and 20 with a few exceptions, and it varies based on a number of factors.

Price-to-Free-Cash-Flow (P/FCF) Ratio
P/FCF is similar to P/E, except free cash flow per share is substituted for earnings. Free cash flow is the total amount of cash brought in by operations minus the amount of cash that was used for capital expenditure. It can sometimes be more truthful than earnings, but tends to be more volatile because management may spend more in capital expenditure in some years than others. Monitoring both income and cash flow is important to get a good grasp on how the company is really performing.

Price-to-Book Value
When you take a company’s total assets and subtract their total liabilities, you get the total shareholder equity, or book value. Book value per share is the total equity divided by the total number of shares. Tangible book value is the same, except it excludes intangible assets such as goodwill. If the company were to go out of business, the tangible book value is the theoretical amount each share would be worth. Different industries have different reasonable book values, because some types of businesses require more assets than others (think manufacturers vs. software).

Market Capitalization
Market capitalization is the total number of shares multiplied by how much each share is currently worth. Theoretically, this is how much the market has decided the entire company is worth. It’s worth looking at, because investors often look to have a mix of big companies and smaller ones.

Conclusion

In conclusion, it takes a lot of work to thoroughly analyze a company. These metrics are a good start, and one will also need to delve into their annual reports, compare the company with competitors, research investing and public commentary on the company, and assess risk and potential growth catalysts.

When looking for a company to invest in, I look for a strong balance sheet, decent growth prospects, competitive advantages, a positive industry, shareholder friendly and competent management, and solid dividend information. I focus on long-term potential and total shareholder return.

This is the fourth in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

One thing to ask yourself when you begin building a portfolio is: What do I feel comfortable owning? Some people only feel comfortable owning stocks that align with their own morality, while others are comfortable owning stocks that they don’t agree with. Whichever kind you are, it’s useful to know ahead of time and to invest accordingly.

Socially Responsible Investing

As a shareholder of a company, you’re a legitimate owner of the companies you invest in. You make profits based on what they do. But at the same time, unless you buy stock in an IPO (initial public offering), you’re not actually funding their activities. You do indirectly assist management by buying stock because you drive the stock price up ever so slightly which generally provides positive feedback for management and their compensation packages and success ratings. (It’s one of those things where you won’t make any noticeable difference, but everyone acting as a whole does.)

Companies dealing with tobacco, gambling, alcohol, big oil, and environmental issues are the ones most commonly avoided by investors that seek to align their portfolios with their ethical preferences. Other examples might be defense companies, or companies that have labor practices that some consider to be unfair, like Walmart with many of its employees on welfare programs, or Exxon which has voted down a proposition to add sexual orientation to the discrimination policy every year since its merger with Mobil, and has long-since undone Mobil’s decision to provide benefits rights to partners of gay employees.

Investors will all have different things that they find to be ethical or unethical. When it comes to the topic of socially responsible investing, I usually break down companies into two categories.

Fundamentally Opposed

Some companies may be fundamentally opposed to your ethics. This means that, the core of the company is dramatically opposed to what you stand for. Perhaps you have family members that died from lung cancer; it’s fathomable you might be fundamentally opposed to Phillip Morris. Maybe you’re a vegetarian, and McDonald’s won’t work for you. Or possibly you’re a staunch pacifist, so Lockheed Martin won’t work for you.

For a company that you are fundamentally opposed to, there’s no realistic possible change that would result in the company’s ethics being aligned with yours.

Partially Opposed

Some companies may have operations that you don’t necessarily disagree with, but you disagree with how they are going about it. For instance, maybe you respect Costco, but not Walmart, because Walmart is known for not treating employees as well as Costco. Or maybe you advocate LGBT rights, and strongly dislike ExxonMobil’s discrimination policy.

The argument to avoid investing in companies that you are partially opposed to is that if you invest in them, you’ll be benefiting from that which doesn’t meet your ethical positions.

The argument to invest in these sorts of companies is that, as a shareholder, you can vote to change their practices. Of course, you can’t do it alone, but if more people who thought like you invested and voted, change could occur. If those who dislike the company’s practices avoid the stock, the situation is unlikely to change.

Voting as a Shareholder

An advantage of owning individual stocks over index funds is that you get to vote your shares. With the proliferation of index funds, people have largely given up their voice while taking the cash and sustaining stock prices. What more could a board of directors ask for?

I promote shareholder advocacy, because I think it’s an essential part of healthy capitalism. People complain left and right about what corporations do, how much CEOs get paid, environmental damage, and so forth, but then they gladly remove themselves from the decision processes.

Conclusion

The takeaway from this article is that, regardless of whatever ethical considerations you take into account with your portfolio, if any at all, make sure you have a game plan. Make note of which business types, if any, are fundamentally or partially opposed to your ethical viewpoints, and forge a conclusion regarding how you are going to go about investing in these sorts of companies. And lastly, for companies that you do own stock in, you can exercise your right to vote in order to shift the company to what your best possible vision of it is. Healthy capitalism occurs when owners take an interest, and owners as an aggregate have a lot of power.

This is the third in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

One of the biggest problems when it comes to investing is confronting our own ego. Just like everyone thinks they’re an above average driver, everyone thinks they’re an above average investor. So, it’s important to make note of what kinds of businesses you readily understand and are capable of making educated long-term investments in, and which you are not. Deciding which companies and sectors to invest in is ultimately a matter that needs to be chosen by the investor, or between the investor and her financial adviser, but there are some things worth considering.

Areas that I particularly recommend caution are:
-International Stocks: Do you know the social issues, geographic risk, and demographics of the areas the company operates in?
-Large Banks: Teams of analysts and economists were unable to grasp the risk of large bank portfolios before the financial crisis.
-Technology: Can you truly predict which tech will catch on over the next five years?
-High Growth Stocks: Are you capable of making accurate long-term predictions of a company’s growth, or do you have to take analysts or management personnel on faith?

This is not necessarily a list of stocks to avoid- just a list of stocks that especially require you to honestly examine what you know and what you don’t know in my opinion. Some investors can target these areas and make good consistent returns. And there are ways of mitigating the risk for less focused investors. For instance, for international exposure, you can invest in companies that have diverse geographic operations. For the finance sector, you can go with smaller banks or more streamlined financial institutions. For tech, there may be some areas you’re knowledgeable enough in to make a substantial investment. For high growth stocks, one can spread out risk into several of them, perform extra diligence, and always invest with more conservative numbers than analysts predict. Index funds and ETFs can also be of help when it comes to diversifying.

A good place to look for investment ideas is to see what products and services you use in your own life. What leads you to them? What stops you from switching to a competitor? How could they be improved?

Sector Diversification

It’s important to be diversified into numerous sectors, but that greatly broadens the circle of competence required. Walking a path between over-diversification (in terms of number of stocks and variety of stocks) and under-diversification is the subjective and difficult part. During market cycles, some sectors will greatly underperform compared to others, so being too concentrated in one or two sectors increases risk. For instance, over these past two years, health care companies have greatly underperformed compared to energy.

The Primary Sectors are:
Basic Materials
Capital Goods
Conglomerates
Consumer Cyclical
Consumer Non-Cyclical
Energy
Financial
Healthcare
Communications
Technology
Transportation
Utilities

One might not necessarily need to invest in all of them, but diversifying into at least several of them is important to reduce overall portfolio volatility and to reduce risk of making wrong assumptions about any given sector. It’s not just about short-term balancing either; some sectors can have very long bouts of poor performance.

A good step to improving your portfolio might be to review each sector, picking out several top companies you are familiar with from each one, and to begin from that reduced list to select investments you think are worthwhile and that you can honestly say are within your field of understanding. Make a note of which sectors you find a lot of familiarity in. There’s no shame in only having a few knowledgeable sectors- even Warren Buffett only invests in a few of them. But it’s important to be fairly diverse, and sometimes broader funds can help your portfolio be more diversified than only your core competencies allow.