Not another article about the market going to crash? Don’t worry; I’m not going to tell you what you already know. I’m not the kind of guy who is passive and cry while waiting. There is an absolute truth that comes with each bull market: it will hit a wall. Market corrections happen all the time. They are especially brutal when it’s been a while. It’s like that time at the party where you thought you could handle a whole bottle of Jack Daniels because you were drinking slowly through the night. The longer the party lasts, the harder it is when you wake up.
As drinking water, taking Tylenols and, most importantly, stopping before it’s sunset will help you recover from your latest party, there is a step-by-step guide you can follow as an investor that will make sure you wake-up without a massive headache once the music is off and the market crashes.
Step #1: Make sure you hold “bonds” in your portfolio
Since I started investing in 2003, I’m a 100% equity guy. This has never changed and most likely probably won’t in the future. Instead of buying fixed income products, I always make sure my portfolio has its shares of “bond type of holdings”. You know, those rock solid companies that have been paying and growing the dividend before fire was discovered? Here are a few examples to help you identify those:
3M Co (MMM). With 50% of its revenues coming from repetitive sales, MMM is the definition of a dividend growth company. It’s business model is built on innovation (where it spends more than any of its competitors) and product quality. This company is always one step ahead of the competition and its clients know it.
Procter & Gamble (PG). PG has 65 brands in which 21 generate between $1 and $10 billion in sales and 11 between $500 million and $1 billion in sales. The company is more diversified geographically than any balanced mutual funds. Owning PG shares is like owning 65 cash flow making machines.
Johnson & Johnson (JNJ). Think of a powerful engine that is continuously being fueled to turn even faster. This is exactly what JNJ is in your portfolio. Johnson & Johnson has an impressive brand portfolio of personal care goods. Most of its brands are either #1 or #2 in their markets and their products are being sold around the world. Finally, JNJ developed speciality drugs that are harder to replicate. This division counts for about 40-50% of its revenue and is the strongest growth vector.
This is the kind of company that will never make your portfolio skyrocket to new highs, but you can always count on them to pay and increase their dividend no matter what happens. Those are the “paid to wait” holdings. The reason why you should have them in your portfolio is to lower its volatility and have the dividend payment compensate for the paper loss during difficult times. Good places to start looking for such companies are the Dividend Kings and the Dividend Aristocrats lists.
Step #2: Clean your portfolio
Ah! That’s easier said than done, isn’t? We all agree that we should get rid of potential losers before the market crash. The tricky part is to identify them. I have developed a few tricks of my own. The first one is to review each holding of my portfolio and answer a simple question:
Does this company meet my investment thesis today?
In other words; does this company still show the reason why I bought it in the first place? If a company continues to meet my 7 dividend growth investing principles, I have no reason to get rid of it. No matter if the stock is +272% or -35%. I take the time to write down all the specific reasons why I make each purchase. The only reason why I sell a stock in my portfolio is if the company doesn’t meet my investment thesis anymore or if I was wrong with my thesis in the first place.
Then, I look at all the high yielding stocks in my portfolio. For me, it takes about 32 seconds since I don’t have any stocks paying over 5%. The reason why I would look out for high yielding stocks is to avoid bad surprises. There is usually a very good reason why a stock pays a 5%+ yield and it’s not because management is overly generous. The reason is because the company shows more risks than others. Therefore, you want to make sure to run the “worst case scenario” on those to see if they can’t continue to keep up their payouts during a recession. Look at both revenue and earnings trends to look where they are headed. Identifying their future growth vectors will help you to know if the company can survive potential bad lucks. Finally, look at their payout and cash payout ratios to make sure management is not squeezed to pay shareholders. A good example of a suspicious holding would be Verizon (VZ) with its rising debt and high cash payout ratio.
Getting rid of weaker positions is not an exact science and you could make mistakes. There is no point of seeing all your stocks as potential losers, but taking off your pinky glasses may not hurt. Avoiding major stock drops is more important to me than hitting home runs. I find it hurts more if a stock loses 80% of its value because it is a bad investment than if it gives a 300% return because it’s a technology breakthrough.
Step #3: Buy Dividend Growth Stocks
The final step to prepare your portfolio for a market crash is to act like there is none. If you know when the market will drop, please let us know. Then, we will all do the obvious; sell, wait and buy again at the bottom. But for those who are like me and don’t have a crystal ball, I think it’s better to continue investing like nothing will happen.
This is the reason why I focus on dividend growth instead of dividend yield for all my picks. Many investors focus on dividend yield or dividend history. I respectfully think they’re making a mistake. While both metrics are important, aiming at companies that have shown the ability to continue raising their dividends by high single-digit to double-digit numbers will make your portfolio outperform others. When a company pushes its dividends too fast, it’s because it is also growing their revenues and earnings. Isn’t this the fundamental of investing – finding strong companies that will grow in the future?
Aiming at those kinds of companies will ensure my quarterly cheques increase when the market goes south. Companies showing high single to double digit dividend growth are confident in their cash flow and in their future growth. They usually have a war chest big enough to survive a recession and gain additional market shares in the process.
As a starting list, I often use the Dividend Achievers. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that have achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.
I’ve accepted a long time ago that I do not have any control over the market or what companies I invest in do. However, I do have control over my holdings and my investing strategy, making sure I hold on to the right companies and get rid of the weaker ones. I achieve this task through a sound investing process and a focus on dividend growing companies.
Disclaimer: I’m long MMM, PG, JNJ