John (“Jack”) C. Bogle – 10 Investing Principles

One name that keeps consistently coming up in my education as an investor is John C. Bogle, the person who gave us Vanguard and also the concept of index funds. I have been watching/listening to some of his interviews before his death in Jan. 2019. Even at an age of 87, the man was so sharp! And I must say, every single time I listen to him speak, I learn something new.

John’s statements are easy to co-relate with the historical stock market data i.e. passive index investing generally gives the investor better returns at lower costs compared to actively managed funds. It is for this reason that a large portion of my net worth is tied up in low-cost index funds from Vanguard.

Regardless of what your investing strategy is like, it would be wise to listen to experienced heads such as John and adopt those learnings into your overall mindset.

In this post, I wanted to highlight 10 such investing principles that I have heard from his various interviews/speeches/books.

1. Reversion to the mean

Don’t choose funds based on past winners. One way or the other, all mutual funds do badly in one period and do better in another period

This is true of all investments in general. Past performance alone cannot guarantee future results. With every investment, it would be wise to look towards the future and question is the investment makes a good long-term choice.

2. Time is your friend.

Think of the value of compounding. Get yourself a little compound interest table and see that at 7%, money doubles every 10 years and it doubles again and again and again. And by the time you are at your retirement age, it might 35 to 40 times your original investment…maybe more than that.

I demonstrated this very concept in my previous post where I discussed Yield-on-Cost. This is such a powerful concept that can achieved through a simple buy-and-hold strategy with dividend growth investing.

3. Buy Right and Hold Tight

Pick a good fund and hold it through thick and thin. Don’t get despondent when it does badly, because it comes and goes. So don’t let yourself get distracted by changes in the fund performance or changes in the market.

Again, some sound advice about any investment vehicle. During a market correction, it would be wise to disregard all the market headlines and look instead at the fundamentals of the businesses you have invested in. If nothing materially has changed, stay put.

4. Have realistic expectations

I think common stocks should return at a nominal rate, nominal meaning before inflation…at a nominal rate of 7%. The dividend yield is very important in all this. Reasonable rate of return would be 7%, don’t look for 11, don’t look for 15, don’t look for nothing, don’t keep waiting for the next bear market….those are all guesses! Some of these guesses will come good, some not so good.

Several pearls of wisdom in that statement alone. In general, when attempting to draw estimates about projected growth in your portfolio or also things like valuing a business, it is better to remain conservative. Other useful takeaway is to remain invested in the market and not wait on the sidelines.

5. Forget the needle, buy the haystack

You don’t need to take the risk of owning individual stocks, take the market risk, which is high as it is“.

I think I largely agree that for a common individual who is least interested in the stock market news and world of finance, this would be great advice. However, I prefer a slightly hybrid approach where I have a large portion of my net worth invested in low-cost index funds and a smaller portion invested in dividend growth stocks.

6. Minimize the Croupier’s take

Cost is an important factor

Ensure that if you are investing in a index fund, it is low-cost. The expense ratio can add up over time and take away a significant portion of your total return.

7. There is no escaping risk

Think about this for a second..I don’t like the risk of the stock market. I am putting my money in a savings account or certificate of deposit. There is no risk there. Wait a minute! The return there is probably going to be about 1.5% and we are going to have 2.5% inflation. The real return is -1%! So is there any risk in putting your money in a savings account? You better believe it!

Stay invested and stay the course. Obviously, set aside some cash for emergency expenses. But keep the remainder invested. Cash sitting in a bank account will slowly get devalued over time.

8. Don’t fight the last war

Your job is to get the biggest gross return…inflation is going to take whatever it takes out of that. If it is big return, it will take a little of it. But if the gross return is small, it will eliminate it!

Jack was referring to safeguarding against inflation through special funds like “inflation beaters” (his words, TIPS?). In general, my takeaway from this was staying focused on one primary strategy and not making decisions based on problems that existed several years back or that might possibly exist several years into the future.

9. The Hedgehog beats the fox

The fox knows many things. But the hedgehog knows one great thing. In our business, foxes are those harvard business graduates with their fancy computers…armies of them..who know many things. I know one great thing, which is if you own the market in a low-cost index fund, you are guaranteed to earn your fair-share of the market is kind enough to give us, and lets be clear on this, whatever returns a bad market is mean-spirited enough to take from us. So it is the hedgehog who wins ultimately“.

Simple boring strategies ultimately have the highest probability of success, as compared to complicated strategies that involve timing the market.

9. Stay the course

Let me start with this premise…Many investors lose because of their own behavior and not because of how stocks and bonds do. They are trailers…they buy something that has done well and expect it to perform the same in the future, and it doesn’t. A whole lot of bad behavioral patterns…the find a hot stock manager, they jump on the bandwagon and that does not work….that will not work. So figure out a sound program, set the right course and don’t let all these superficial emotional momentary things get in your way! Another way of putting that is, don’t do something, just stand there!

Again, so many pearls of wisdom from the legend. I have previously written about cognitive biases and how that impacts investment decisions. A good investor must be cognizant of these and try their best to avoid such biases creeping in. Another advice is to avoid frequent tinkering with the portfolio based on market news. In fact, I find it easier at times to “zone out” and stay away from the news and headlines and instead focus on big picture and long-term fundamentals.

So there you go! Words from the legendary John C. Bogle. Dear Sir, I thank you humbly for all your contributions to this world. I am a better investor thanks to you.

The Importance of Yield on Cost

Traditionally, the annual dividend yield for any given holding is defined as the annual dividends payed out divided by the current share price for the holding. As an example, at the time of writing this article, Visa (ticker: V) is trading a Price per share (PPS) of $238.47. Currently, Visa pays an annual dividend of $1.28. This gives us an annual dividend yield of 0.53%.

If one were simply looking at that current dividend yield as a screening criteria, 0.53% for Visa does not make it look like an attractive investment from a dividend cash flow perspective. However, throw in the notion of dividend growth from the company and also holding the stock for a really long-term, that initial dividend yield will compound into snowball and start yielding at a much higher rate in a few years. This is through the magic of yield on cost.

Unlike the annual dividend yield, Yield on Cost (YoC) is defined as the annual dividends being payed out currently divided by the original purchase price for the holding.

Let us explain this through a simple example, again sticking with our example for the Visa stock.

For our simple modeling, we will use the current 5-year Compound Annual Growth Rate (CAGR) of 18%. Compound Annual Growth Rate for dividends is defined as follows:

CAGR = [FV / IV]^1/n – 1

where, FV: Final value of the dividend after n years

IV: Current value of the dividend

Assume that you were going to purchase a Visa share today at the current stock price of $238.47. Also, assume that Visa can maintain this dividend growth rate for the next several years. With these assumptions, we get the following results:

YearDividend AmountYield on Cost
0$1.280.53%
5$2.931.22%
10$6.702.8%
15$15.336.42%
20$35.0614.70%
25$80.2233.63%
30$183.5177.0%

So from the table above, we see that the Yield on cost for year 0 starts out at the same rate as the typical annual dividend yield. However, we see that just by holding the stock for several years, and due to the power of compounding, the yield on cost with respect to the initial purchase price after a period of 30 years is a whopping 77%!

Therefore, for the compounding through yield on cost to work, there are the following important considerations:

  • Need to invest early enough to allow for the compounding to do its thing.
  • Need to purchase great companies with solid growth potential at a reasonable valuation (thereby ensuring a great starting dividend yield).

Now, I know the sceptic in you is asking some very pertinent questions about the model above:

Is it fair to assume that Visa will be able to grow at the same dividend CAGR for the next 30 years?

Good question. And most probably not. But it is reasonable to assume that Visa will be growing their dividends at a pretty aggressive rate for the near term and then slow down after that. Playing around with the dividend CAGR rates a little, we arrive at the following results:

5-year CAGR/ Years051015202530
12%0.530.941.662.935.179.1216.08
15%0.531.072.174.368.7817.6635.53
18%0.531.222.86.4214.733.6377
All values for YoC in percentages

Even if we assume a slowing down in the 5 year CAGR rate for the entirety of the 30 years, at a CAGR of 12%, the YoC is still is a respectable 16.08%.

But you have not assumed any re-invested dividends?

That is correct. I am assuming that dividends are not reinvested for the purpose of simplicity.

So does this mean that the current yield is irrelevant and one must always look at the dividend growth rate?

This is a classic question amongst all investors in the dividend growth community. And like with everything in investing, there is no black and white answer here as well.

In my case, I tend to categorize my portfolio amongst a mix of low current yielders with high growth rate, high current yielders with slower growth rate and also some that are in the middle of the road. Why so? Several reasons:

  • The categorization gives diversification to my portfolio: Some companies simply cannot raise their dividends at a faster rate because of the nature of the sector they are in e.g. public utilities, companies in the telecommunication sector.
  • Some companies are lot more mature than others: I hold some classic blue chip companies that have been around for several decades. They have an enormous market cap and will probably not be able to grow aggressively like some of their younger counterparts.
  • Momentum: Yes, I will admit it. Seeing some high yielding stocks now, giving me back good cash flows at present will motivate me to stick to this strategy. This is a strategy that requires enormous amount of patience. Seeing that cash flow working its magic is a re-assurance that this strategy is indeed working and will serve as a momentum boost. While this is more psychological than anything else, there is nothing particularly wrong about the approach.

Like with all metrics, I would recommend using YoC in conjunction with their several other financial metrics to analyze the health of your portfolio, rather than in isolation.

Disclaimer: Long V

Cognitive Biases during Investing

Things have really been getting a lot busy with work and life lately. It is summer time here in the US, and from what I can tell, the general public is out and about, trying to spend a lot of time outdoors. I can see the pandemic restrictions being lifted as well and it seems like things are slowly returning back to some semblance of normalcy. The markets are rallying along as well, and even all this talk of inflation has not really slowed it down. Does this mean that Mr. Market is treating this rise of inflation as a transitory event? Time will tell.

Even with all this news, I am continuing to stick to my strategy. While I tend to my responsibilities of my day job and my family’s needs, my capital deployed in high-quality businesses earns passive income for me in the form of dividends.

In my spare time, I have been binge-reading articles/watching videos on valuation, with an overall goal of adding more tools to my repertoire to analyze businesses effectively. One such person who has been widely quoted on the subject of valuation is Prof. Aswath Damodaran from the NYU Stern School of Business. If you have not checked his website, I humbly urge you to do so, as I think it is a treasure-chest of useful information/tools on the subject of valuation.

One of the topics that I happened to read about is how biases can impact valuations and this subject perked my interest. Here is what Prof. Aswath writes on this subject:

When you start on the valuation of a company, you almost never start with a blank slate. Instead, your valuation is shaped by your prior views of the company in question. The more you know about a company, the more likely it is that you will be biased, when valuing the company…In principle, you should do your valuation first before you decide how much to pay for an asset. In practice, people often decide what to pay and do the valuation afterwards.

Cognitive biases, in general, impact our ability to think and reason logically. Investing is no different. It is important to understand them and ensure that you are avoid them when evaluating businesses. Here are some well known biases that can impact your investment decisions.

Anchoring Bias

We humans tend to rely a lot on the very first piece of information that we receive and use that as an anchor or an initial reference point. As we receive new information, it is processed with reference to this anchor.

Anchoring is used very effectively by folks in the sales and marketing domain. One example that readily comes to mind: if you are ever at a car dealership shopping for a new car, notice how the car dealer will first show you the expensive models before showing you a “cheaper” model, thereby prompting you to buy the latter.

Here is another classic example, this time it is Steve Jobs using anchoring during an iPad promo event.

Anchoring, by itself, may not be such a bad thing in investing, if you are anchoring your brain to the intrinsic value of the investment. However, if your brain fixates on the wrong data point, such as say stock price alone, it can have a damaging effect on your decision making.

Confirmation Bias

Simply put, confirmation bias is a tendency to only search for, favor or interpret proofs that align with our existing point of view. In fact, taken to its extreme, this can result in misinterpreting contradictory evidences to support the current view.

This can be particularly harmful when objectively analyzing a business. If you are approaching the analysis with a “loaded mind” where you already think that “This is a great business“, you will tend to interpret data put in front of you through this prism and simply dismiss other non-conforming data as outliers.

Outcome Bias

This is a tendency to base the effectiveness of a decision through its eventual outcome, and neglecting all the other factors that may have contributed to the outcome. I view this bias through two hypothetical examples:

I bought a stock, and the stock price went higher the next day. Therefore, my decision to buy was correct.

OR

I sold a stock, and the stock price dropped the next day. Therefore, I am right about selling this stock.

Conventional wisdom states that the stock price is probably the worst place to look at when it comes to validation for your decision to buy/sell a stock.

Bandwagon Effect or Herd Mentality

This is a tendency of adopting a specific style or belief simply because others are doing it. In investing, this might be summarized as:

Everyone is buying this stock, therefore it must be a good business.

There is also the common case of FOMO aka Fear Of Missing Out, because you are always wondering about what the other investors know about this business that you don’t.

There are several examples from history to show how this generally does not end well for the investor. One such funny example is quoted by Benjamin Graham, the Godfather of Value Investing, in his famous book titled The Intelligent Investor:

And back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people.” Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in today’s money). For the rest of his life, he forbade anyone to speak the words “South Sea” in his presence.

Availability Heuristic Bias

This is a tendency to place undue importance on events and examples that come readily to mind. This is easily seen in a lot of commentary and analysis on investing. Investors tend to remember the dot-com boom or the Great Financial Crisis in vivid detail and sometimes use that a basis for future investments.

So what does all this mean?

Through this discussion, we can derive the following conclusions:

  1. Your greatest enemy and your greatest friend in all your decisions, investing or otherwise, is your very own sub-conscious.
  2. If you already own a particular stock and think the underlying business fundamentals are sound, one technique that I have found useful while analyzing such a holding is playing the Devil’s advocate i.e. now look for reasons why you would want to sell this stock and be as objective as you possibly can.
  3. Valuation is not an exact science, quite far from it actually. In fact, as a result of these biases and assumptions, there is a good chance that your estimations are completely wrong. It is for this reason that diversification in your portfolio helps to safe-guard against such bets going wrong.
  4. When in doubt, use the philosophy based on Occam’s Razor i.e. the simplest explanation/model is usually the best way to attack an estimation problem. The more complicated your model gets (including more inputs and assumptions), the greater the risk of your biases sneaking in.
  5. Always invest with a Margin of Safety, because at the end of the day, all valuations are estimates and they could be wrong.

That’s it, folks! I hope you found this article useful to read. Please drop a comment below to share your thoughts on this subject.

Until next time…

My Dividend Portfolio Allocation Strategy

I view dividend stock investing as something similar to growing a tree: you initially plant a seedling and do your part by providing it with a lot of care and nourishment. With time and patience, this little seedling will grow into a enormous tree that will eventually pay you back by providing fruits, flowers and also shade. Similarly, with dividend stocks, you simply need to invest in high-quality companies consistently and patiently and with time, through reinvested dividends and also dividend growth, the resulting compounding will blossom into a cash-generating machine that will serve you well for decades to follow.

In one of my earlier posts, I briefly touched upon entry criteria for selecting such companies. But how does one construct a dividend portfolio of such companies? That is the subject that I shall delve into in this post.

Before getting started though, I would like to state a few important background notes regarding my personal situation:

  • My dividend portfolio only represents a certain percentage of my overall investment portfolio (which also includes things such as my retirement accounts like 401(k), Roth IRAs and a HSA).
  • My general strategy is to max out contributions to my retirement accounts. Following that, I will use any remaining funds to invest in my dividend portfolio.
  • I follow a process of hybrid investing: wherein I stick to a mix of investing in low-cost index funds, low-cost ETFs in my retirement accounts and invest in individual dividend paying stocks in my taxable account.
  • I also have a very small percentage of my overall portfolio allocated to growth stocks.
  • For the purposes of reducing my overall taxes, I invest in REITs in only the tax-advantaged accounts (currently Roth IRA and HSA).

With all that out of the way, let me get into the crux of my allocation strategy for my dividend portfolio.

The general idea behind my allocation strategy is two-fold:

  1. Have enough upside such that when the broader market gains, my portfolio not just gains but beats the overall market.
  2. Have enough risk-tolerance such that when the broader market dips, my portfolio does not dip as much.

I attempt to achieve this through categorization based on certain aspects.

Categorization based on My Investment thesis

My general rule of thumb is that for every stock I own, I will have a brief one-pager document explaining the reason why I hold the stock and the associated risks. I refer to this as my investment thesis for the stock. With this in mind, I have categorized my allocation into four broad buckets:

  1. Core stocks: These are my sleep well at night stocks and represent the foundation of my portfolio. These are the classic blue-chip companies that have been around for decades and withstood several economic downturns and come out on top. These holdings offer a decent starting dividend yield but are not going to grow rapidly for the coming decades. However, they are still in the process of innovation and I am very confident that they will remain relevant during my lifetime.
  2. Growth-like stocks: These stocks are in a phase of aggressive growth at this stage. They are relatively younger in their dividend history in comparison to the Core stocks. Their starting yields might be much lower but they have substantially higher dividend growth rates and a lot of runway (in terms of dividend payout ratio) to increase their dividends.
  3. Bond-like stocks: I do not own bonds in this portfolio, but when it comes to de-risking my portfolio, I rely on these type of stocks. Some of these offer a relatively high-starting yield but they are very slow growers.
  4. Speculative stocks: These are the stocks that I have the least confidence in. This is either because of the nature of the sector they are in or because of mixed signals from the management about the commitment to long-term shareholders. I would generally have this as the smallest allocation in my portfolio.

In my view, this categorization provides long-term stability and future growth while also safeguarding against risk during an economic downturn. Each stock has a specific role to play and in conjunction with the other stocks in the portfolio, they form a team to play offense/defense whenever necessary.

Nothing about this categorization is set in stone as such and I may choose to move stocks from one category to another depending on changing trends. In general though, I will skew towards keeping the allocations for the first two buckets (Core and Growth-like) a lot more higher than the last two categories.

Categorization based on Sector

I have split up my allocation across different sectors in the following manner.

The allocation is a reflection of my investment style : very conservative/defensive with a low risk tolerance. I have the highest allocation towards the Consumer Staples & Retail sectors followed by Healthcare. This is mostly with the understanding that regardless of what happen in the stock market, the average consumer is still going to shop daily for consumer products that he/she will use on a day-to-day basis.

Likewise, the healthcare sector is always going to be forced to innovate to remain competitive. A crazy year when the world was grappling with the COVID-19 pandemic has been a testament to that theory. Furthermore, my wife is an engineer with a background in biotechnology, thus bringing this sector in her circle of competence. I have a sizeable allocation the Tech sector since I work as an engineer in the semiconductor industry and understand its intricacies fairly well. This follows my advice from one of my previous posts about investing in what you know.

The least allocation is towards the Energy sector which is mostly composed of Big Oil. While I think the oil industry is going to remain relevant for the remainder of my lifetime, I am also cognizant that there will be a greater push towards use of cleaner sources of energy for large scale infrastructure projects.

As stated before, I do not own REITs in this portfolio to save on taxes (since distributions from REITs are taxed as ordinary income per IRS regulations here in the US). Instead, I own REITs in my tax-advantaged retirement accounts. I will cover my REIT allocations in a future post.

Capital Allocation Strategy

My primary focus is to max out contributions to my retirement accounts for the calendar year. Once I have achieved this, I allocate a fixed amount for contribution towards my dividend portfolio each month. The broker I use (M1 Finance) does not have a traditional DRIP feature, where dividends can be reinvested back into the same stock. Instead, it provides an “auto-deposit” feature which can be used to purchase stocks automatically: generally M1’s algorithm attempts to buy stocks that are currently underweight in your portfolio based on your target allocation. I have mostly not used this feature since I want to be in complete control of what buy orders I am placing rather than rely on any algorithm.

I pool all the dividends that I have received along with any remaining capital and buy stocks that I think are the best value at any given moment. Also, to remove any emotion out of the picture and to ensure that I am consistently dollar-cost averaging into all my holdings, I have a spreadsheet setup that tells me the number of days (configurable for each category of holding) that have elapsed since my last purchase on any given stock. I call these as “staying in the game” purchases, as these purchases are typically for a small dollar amount where the valuation of the stock is not as important.

Dividend Portfolio Revealed

At the time of writing this post, my dividend portfolio contains the following holdings.

Here is an alternative view of the portfolio in a treemap format.

At the time of writing this post, there are reports that AT&T will be cutting their dividend following a spin-off of WarnerMedia and merging it with Discovery. I am planning to continue holding my AT&T shares for now but this reinforces my original thesis of why I put this holding in the “speculative” bucket. Thankfully, I have enough safeguards in my portfolio due to diversification to protect myself against this news.

I am fairly happy with the number of holdings I have in my portfolio (31 at present). Generally, I am not as much focused on this number itself. But I would like to keep this to a manageable number since it would be very difficult to track several companies and periodically research them.

In some future posts, I will dive into the reasons why I hold each of the above stocks.

Summary

So there you go! That is my portfolio allocation strategy and my portfolio. I would love to hear your thoughts on this subject. How have you constructed your portfolio? Do you diversify across sectors like I do? Please let me know in your comments below.

Happy Investing!

Picking good dividend stocks : Fundamentals

Individual stock picking is hard. There are just so many options. Not only is it overwhelming, it is very easy to get it completely wrong. How do you know if a stock pick is really good? What qualifies as “good” in the first place?

Let us first focus on basics.

Peter Lynch, a former manager of the Magellan Funds at Fidelity Investments, is known as one of the most successful investors in the world. I have learned a lot from his writings and talks, mostly because I can relate to how he can simplify investing for average joes such as myself.

Perhaps the best advice I received through Peter Lynch is the quote I have referenced in the picture above. Let me elaborate on that a little more.

Do this exercise for me: Dissect your daily routine by thinking about the stores you shop at, the restaurants you dine at. Look around your office or your home and monitor the products you use on a daily basis. Some of these products are from businesses that you have already heard of. For instance, that post-it note that you are using at office is from 3M (ticker: MMM), a famous company that is known for several such products that you might be using around your office and/or home. That iPhone you are using, is from Apple (ticker: AAPL), another famous company. That Tylenol tablet that you consume when you are not feeling well is from another famous company called Johnson and Johnson (ticker: JNJ).

You get the idea. As a consumer, you already know of several such companies simply because you are buying/using their products. As it turns out, ALL of the above companies also happen to pay cash back to their shareholders, just as a thank you for investing in their business. How cool is that!

So does this mean you should blindly invest in every such company that you can find around you. Certainly not! But you have a better chance of success when investing in a business that you can understand or already know about rather than investing in a business that you have never heard before in your life.

With all that said, in addition to knowing a little bit about the business, I also use the following basic rules to screen such stocks:

  1. Companies with a good starting dividend yield: Typically, I don’t have a cut-off as such here. But an unusually high yield number might be a red flag and point to something wrong with the business.
  2. Companies with a reliable history of growing dividends: I normally look for a history of atleast 5 years.
  3. Companies that have a steady dividend growth rate: I look for Compounded-Annual Growth Rate (CAGR) of atleast 5%.
  4. Companies where the dividends are relatively safe: usually determined by looking at the dividend payout ratio. I look at companies where the payout ratio of less than 65% (Note: The only exception to this rule is when I am considering investing in Real-Estate Investment Trusts or REITs. More on this in a future post).

Note: I highly recommend reading this page on Investopedia to familiarize yourself with the some of the above terms.

This just serves as a starting point. Once I have a filtered down list of stocks that I could potentially own, I begin researching the companies further to see if they are a good fit to my overall investing strategy.

Disclosure: Long MMM, AAPL, JNJ