Avoiding Potholes

Over the past few quarters, we’ve detailed our process for managing our Dividend Strategies and the impacts of higher interest rates. For this edition of our letter, we wanted to pull the curtain back to highlight our process for navigating the potential “potholes” in our strategies. More specifically, this letter is about how we treat stocks that move against us and, at least for a period of time, go down in value. We’ll detail what goes into our process to determine when to double down on a position, when to cut back, and when to exit completely. We’re by no means perfect, but we’re proud to say that since taking over full management of our two dividend strategies, no company has cut their dividend while we’ve owned it.

If you were to crack open a book on portfolio management, you’d likely see two main schools of thought when it comes to managing a portfolio. The first, would tell you to “cut your weeds and water your roses”. This philosophy calls for cutting bait quickly on positions that go down in value and adding to your “winners” or the positions that are going up in value. While for a trader this can be a good strategy, in many ways it runs counter to a dividend growth strategy that professes low turnover (little trading) and long holding periods. Additionally, when a stock that pays a dividend goes down in price its dividend yield increases all else being equal. As a result, often the most fertile “shopping list” of stocks for us that may have dropped in value recently.

The second school of thought for managing a portfolio, which is often called a “contrarian” approach, is to do essentially the exact opposite. This involves betting on “reversion to the mean” or stocks that have fallen on hard times to rebound. The most extreme version of this approach is called a “Deep Value” strategy, which involves looking at really beaten down companies. Warren Buffett nicknamed this approach “Cigar Butt Investing” and offered the following quote to describe it:

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.” – Warren Buffett

However, just like focusing on just your winners, this approach carries some pitfalls. Specifically, you are almost certain to make some incorrect decisions on which companies to invest in and while they may have low stock prices, the businesses likely offer no margin of safety in terms of quality or balance sheet strength, and as a result one bad call can result in a permanent loss in value.

SO, with these strategies as background how do we approach our Dividend Growth Strategies? When we look at companies there are three things we look at the most:

1. Our Qualitative view of the companies competitive positioning of their products relative to their competitors (i.e. are they gaining or losing market share & is that trend poised to continue)

2. Is the balance sheet healthy? (i.e. is the debt load manageable, appropriate in duration, and generally investment grade)

3. How committed to the dividend is management. (when times get tough some companies double down on commitment to their dividend and some run for the hills. The clues to dividend commitment can often be found in interviews with management like quarterly calls that Dr. Lyle Bowlin listens to for all our companies)

Added together, these steps create a 3-pronged approach for managing positions we own that may drop in value.

Our first step, which is a soft trigger if a stocks experiences a drawdown of 10+% not tied to general market movement, is to have an in depth conversation about whether or not any of our fundamental views on the company have changed. Some times, we feel more convicted than ever in a company, sometimes there may be some competitive decline in the business.

Our second step is to do a deep dive on the financials and dividend payout of the company to analyze the health of the balance sheet and where it fits in our strategy. Is this a low yielding company we’re counting on for growth, or a more mature business we’re mostly focusing on the current income?

Finally, we take a hard look at management to ascertain if there is any wavering in their commitment to paying a growing dividend. When these signs emerge, we go the other direction.

This process has treated our investment committee and our clients well over the past several years, and we’ll continue to refine and improve on this process in 2024.

It is to this end that myself, Dr. Lyle Bowlin, and our entire 6 member Investment Committee Work.

January 2024