Thoughts on Investing

Thoughts on Investing—Lessons from a Dividend Investor #2

Lesson 2: Dividend Investing Is Its Own Thing

This lesson might seem a bit like inside baseball, but it's still one of the most important conclusions I've drawn over the course of collecting our first 1,000 dividends. Investing for dividends is not really a subset of value investing, or what most people think of as value investing. Dividend investing doesn't fall into the growth or momentum styles, either, though growth of dividends is a critical part of our approach. Dividend investing is its own thing.

I've always believed dividends were the most important aspect of our investment strategy, but I've always been something of a cheapskate, too. I don't like paying full price for anything if I can help it. In the first year or two of DividendInvestor'srun, I brought this impulse to my stock-picking, but I was often disappointed. In the banking industry, for example, I originally passed on top performers like  M&T(MTB) and gravitated toward statistically cheaper names like National City and First Horizon (FHN). I also dabbled in a few straightforward value plays that, at least in hindsight, really didn't have much to do with their dividends ( Sonic Automotive(SAH) and Tuesday Morning (TUES) come to mind). The results from these stocks were mediocre at best; worse, they kept me the sidelines as best-in-class issues like  General Mills (GIS) and  Southern Company (SO) kept raising their dividends.

It didn't take too long for me to recognize these mistakes. I managed to sell those four stocks before their dividends were cut, and our portfolios performed well overall. But it still took several years for me to take a key piece of Warren Buffett's advice to heart. Starting in the late 1970s, Buffett realized that it was better to pay a fair price for a great business rather than a great price for a fair business. The best-of-the-best dividend-paying stocks are rarely cheap, and when they are, it's usually because the whole market has been crushed and most other stocks are cheaper still.

At the same time, I can't endorse paying any price to buy a high-quality dividend-paying stock. You might say experience has turned my approach into DARP: dividends at a reasonable price. I still demand margins of safety, principally through economically defensive and competitively advantaged businesses, strong balance sheets, and manageable payout ratios. But if you start your search for dividend-paying stocks by looking for cheap valuation metrics rather than the best businesses, you're prone to make a mistake Ben Graham identified in his final (1973) edition of The Intelligent Investor:

The risk of paying too high a price for good-quality stocks--while a real one--is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions....These securities do not offer an adequate margin of safety in any admissible sense of the term.