Saturday, March 7, 2015

Keep It Simple – Part 2

So I recently spoke about keeping it simplewhen it comes to investing in the context of being able to easily decipher what a company does and even going so far as being able to explain that synopsis to a child.
But there are some additional points I wanted to address, as well as explain how this fits within the overall theme of financial independence and living off of dividend income.
Below, I’m expanding a bit on that original article with some additional thoughts which address sleeping well at night, avoiding asset classes and/or investment strategies that may not fit your personality, and being confident in your decisions.

SWAN

When I look at my Freedom Fund, I breathe a deep sigh of relief. I’ve hand picked each and every stock within the portfolio. And almost every company I’m invested in runs a fairly simple business model that’s easy to understand, where those business models are mostly predicated on selling ubiquitous products and/or services. That type of ubiquity and quality provides an enduring nature to operations, where it would take some kind of worldwide calamity on par with nuclear war to wipe them out.
And it’s in this ease of understanding and mostly ubiquitous nature that allows me to SWAN, or sleep well at night.
Look, I sleep like a baby. I promise you that. I’m not up at night worrying about what’s going to happen tomorrow with any of the companies that I’m invested in.
I’m not worried about whether or not Norfolk Southern Corp. (NSC) is going to continue transporting various goods across its rail and freight networks. I’m not worried about whether or not people are going to continue buying Crest toothpaste to brush their teeth, which is manufactured by Procter & Gamble Co. (PG). And I have no concerns over whether or not PepsiCo, Inc. (PEP) will continue selling Doritos chips and Tropicana juices over the next 10 years.
If I were invested in, say, Pandora Media (P), which was a darling growth stock at one time, I probably wouldn’t be sleeping so well. Are people going to find a better/more interesting way to access music? Is a better app going to come out tomorrow? How will this company make money in five years? I have no idea. And watching the stock decline some 58% over the last twelve months would probably have me up all hours of the night.

Confidence

It’s incredibly important to be confident in an investment. Keeping it simple and focusing on quality gives me a ton of confidence. When I understand what a company does, am assured of its quality, and I can reasonably explain it to a child, it gives me the confidence necessary not only to initially invest, but also to invest more down the road, if necessary and applicable.
Take that Pandora example again. Would I be confident enough to buy more stock in the company after a near 60% drop over the last year? Absolutely not, especially when the company isn’t even generating any profit. How can I be confident that they’ll generate a profit in the future? How can I be confident that they’ll still even be around in a decade?
But if Pepsi dropped by 20% or 30%, I’d absolutely be interested in buying more shares. I understand the business model. I get how they make money. And they’re sending me dividends every quarter, reducing the amount of capital I have on the line with every dividend payment. And I’m 100% confident that they’ll still be around tomorrow, a year from now, and 10 years from now. Even better, because a stock’s price and its yield are inversely correlated, a cheaper stock would provide me a higher yield, thus giving me more bang for the buck and more cash flow for the same investment amount.

Keeping Asset Classes Simple

Although I’m going to address this in an entire article at some point, I wanted to make a quick point here about asset classes and how it relates to keeping it simple.
I’m often asked why I don’t invest in real estate via rental properties. And that relates to desiring a simple life.
Rental properties can provide higher returns than the stock market, but it’s certainly not an apples-to-apples comparison and it’s also not a given. Does one have the desire to deal with tenants, credit reports, repairs, maintenance, management companies, banks, leverage, and vacancies? Only you can answer that question for yourself, but I already know that I have no desire for any of that.
I like easy. As I discussed in the original article on this topic, a simple blue-chip stock like Coca-Cola has returned over 10% annualized over the last 10 years, even with all the headwinds it’s dealt with over the last 3-5 years. And guess what? Coca-Cola doesn’t call me when a toilet at headquarters isn’t working. I’m not emailed when a refrigerator or a roof needs replacement. They just send me my cash dividends. And I like cash more than hassles. So that’s a great relationship there.
When thinking about investments, one should heavily consider the “hassle factor”. The higher that factor is, the less likely I’m going to invest in it and the higher returns I’ll need to even consider it. Why hassle oneself when it’s really not necessary? Now, you might love owning rental properties and all of the headachesbenefits that comes with, but you really have to think deep down inside whether that’s right for you.
After all, how do you want to spend your time once you’re financial independence? Maybe you want to spend it managing properties. Maybe you don’t. But stay true to yourself either way.
Although not a separate asset class, options are another subject of interest for some. Again, why bother? If one can return near double digits over a long period of time by simply buying and holding high-quality dividend growth stocks and reinvesting the dividends all the way to financial independence, why complicate matters? And why add fees, turnover, and potentially additional taxes as well? There’s no reason for it.
Now, I’m not saying one can’t do better by trading and adding options to their repertoire. What I am saying, however, is that one can potentially do worse. Furthermore, “spicing things up” just isn’t necessary to attain financial independence in a relatively short period of time on a modest income. Why take a left turn when staying straight will get you where you want to go? Turning left may get you there faster. Or it may put you way behind. I’ve already discussed that your savings rate will matter far more than your investment returns, so I see no reason to overcomplicate what’s a very wonderful and easy system.
I hope to expand my horizons beyond just equities at some point in time, but I can guarantee you it will probably be with high-quality fixed income (when rates are more advantageous). I won’t be complicating things just to add an element of interest or fun. What could be more interesting or fun than collecting cash payouts, especially when these payouts are enough to pay for your lifestyle and likely increasing over the rate of inflation? That’s fun!

How Will The Dividends Continue To Flow?

One final point is this. The big reason I like to keep it simple when it comes to dividend growth stocks and invest in proven businesses that sell products and/or services that are fairly ubiquitous is that I like to be able to have some kind of reasonable assumption about future cash flow.
I plan to become financially independent by 40 years old, living off of the rising dividend income my portfolio generates. The last thing I want to do is not be able to sleep at night because I don’t know if my next dividend is going to hit my account.
I invest specifically in companies like Johnson & Johnson (JNJ)Kinder Morgan Inc. (KMI), and Unilever PLC (UL) because I can reasonably assume that they’ll still be in business a decade from now. And because I can reasonably assume that, I can also reasonably assume that they’ll be even more profitable then than they are today and my dividend income will continue to flow and grow. After all, Kinder Morgan isn’t going to transport energy products across its pipelines for the same amount of money ten years from now as it does today. And Unilever isn’t going to sell Dove soap bars for the same price for the next decade. As well, the odds are high that natural gas and bars of soap will still be in demand over that time frame.
So when I think about cash flowing and growing, I think about good odds. And when I think about good odds, I think about high-quality businesses. And when I think about high-quality businesses, I think about products and/or services that should remain high in demand for years or decades to come. Finally, when you think about great businesses that produce growing cash flow and share that with shareholders in the form of growing dividends, you should think about simple business models.
Look, some of the greatest businesses in the world not only generate the kind of growing profits that are necessary to pay growing dividends, but they also have excellent visibility which gives one the confidence necessary to assume that the cash flow will continue flowing and growing. And it just so happens that these businesses are also fairly easy to understand. What could be more wonderful than that?
Full Disclosure: Long NSC, PG, PEP, JNJ, KMI, and UL.
What about you? Do you have the confidence necessary to sleep well at night and continue adding to your equity stakes? Are you avoiding excess hassle?

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]

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