More on How Jason Invests in Dividend Stocks

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Jason’s Random Words

On this past week's episode, Jeff and I talked pretty in-depth about dividend stocks, what they are, and made the case for owning them. But we didn't really spend a lot of time talking about how we each think about them and use them in our own investing strategies and portfolios. And while I've written about my barbell approach in the past, I haven't really broken down more about my specific approach to dividend stocks, what I look for, and what I own. 

So here goes. 

Let's start with my portfolio. Some of this will be repetitive to what I wrote in "Jason's Barbell," but I will attempt to discuss more about my thought process and strategy around the dividends side specifically. Let's start with the thought process.

Simple is as Jason Does

I attempt to keep my investing process as simple as possible, and the barbell is based on taking two slightly different strategies to do the same thing: Create the most long-term wealth I can. The growth side of the barbell is pretty straightforward, where I'm simply attempting to buy businesses that I expect will grow their earnings and cash flows per share very quickly, and faster, over the long-term, than the S&P 500. If I can't pick better stocks than just buying the index, I'm wasting a lot of time that I could be putting towards earning more money or going fishing. 

I've made plenty of growth stock mistakes. Seeing 90%-plus losses on bad picks like Clean Energy Fuels (CLNE), Teladoc (TDOC), SunPower (SPWR), and plenty of others is painful. I've also been lucky enough to see small investments many years ago in now-household names like Nvidia (NVDA), and Intuitive Surgical (ISRG) turn into more than 10-fold winners, as well as a handful of more obscure companies like Trex (TREX) and Chart Industries (GTLS) do the same. It's cherry picking, I know, but the 2,900% in gains from my earliest investment in Nvidia means that I could have 28 other stocks go to $0 and I would still have made money. 

Enough about growth investing. That's for another day. Here's how I think about dividend stocks, and why I want to own them. 

In short, they are a headstart on the point in time when I need to turn the businesses that I own into money, and a check against my (in)ability to pick the best growth stocks, and/or a protracted period of below-average stock market returns. As I wrote in "Jason's Barbell," dividend stocks are more about a higher floor than a higher ceiling. 

Yield Ain’t the Main Thing

The road of investing failure is littered with many a sprung yield trap. Occasionally there are mispriced businesses where the yield is high because of a concern that the market may be overstating (Jeff and I both think that EPR Properties (EPR) is one of those right now), but for every EPR (and it remains to be proven if we are right about it or not) there are a dozen Walgreens (WBA) or 3Ms (MMM) that end up slashing their dividends and causing permanent capital losses for a lot of investors. 

Don't get me wrong: Part of my dividend investing process is indeed buying dips. And I think that it's a more useful approach for many dividend investments than with growth stocks where a rising stock price is often a signal that the business is winning. Many dividend stocks have moved inversely with higher interest rates, on concerns that rising rates mean higher expenses for companies that use a lot of debt, and general concerns that economic growth could be affected and company earnings will get squeezed because of both. And I think that this has created a lot of opportunity to buy some very good businesses at better valuations. For example, companies like Hershey (HSY) have always been on my radar, but have only more recently fallen what I consider fair value. 

I have also found that, in general, paying a good-to-cheap valuation is far more important for dividend stocks. If you're going to overpay, it should be for a company that's growing its cash flows (or high-margin revenues that will drive future cash flows) at very high rates, and in a very large, fast-growing market. That's the margin of safety. For most dividend stocks, their growth rates just won't be as high, and overpaying will almost always result in below-average returns. 

So buying dividend stocks forces me to be more disciplined as a buyer, and that behavior carries over to my growth investing. I'm far less likely to fall in love with a story and YOLO into some growthy idea because I regularly exercise my valuation muscles on my dividend stocks. It's helped me increase the effectiveness of my bullshit detector, too. 

Avoiding Messed-Up Expectations

Owning dividend stocks also helps me stay more patient and be a little more humble. I can't assume that we will continue to see the exceptionally high returns from the stock market that we have enjoyed over the past 15 years for the next 15 years. History says we won't get 14%-plus CAGR from here, and I think it's possible we see something closer to half of that, and that's before the spending-power-destroying impact of inflation. So if I'm earning 3% in average yield – and those companies are growing their payouts – from a sizable portion of my portfolio, I'm raising the floor of what I can expect my portfolio will deliver in base-level returns. 

What is the basis for my expectation of low market returns? Ben Carlson recently wrote about rolling two-decade periods of market return, and it resonated with me. I want to be clear: I am not predicting below-average returns. But I do see some factors that could cause below-average returns. To start, the S&P 500 is expensive, trading for more than 27 times earnings, versus a long-term average of closer to 24 times. The dividend yield of the S&P is 1.3%; for the 20 years prior to 2020, it was closer to 2%. 

Now, a few major factors why this is the case. First, we've seen margins improve, and investors have proven willing to pay higher multiples. This has been especially true for the mega-cap tech stocks that have driven a large portion of the market's gains over the past 15 years. The six largest stocks in the S&P trade for an average of almost 40 times their trailing 12-month earnings. These six companies make up more than 25% of the S&P 500 all alone. And with the exception of Amazon (AMZN), they also all pay a dividend, and only Microsoft (MSFT) yield is even half the S&P's average. 

These mega-caps have done a tremendous amount of lifting, are still growing their earnings at high rates, and investors are paying up to own them. 

Combine the possibility that these mega-caps start to revert to longer-term valuation means if their growth rates slow with higher debt costs for the hundreds of other companies that don't have the cash-rich balance sheets of Microsoft and its ilk, and you get lower profits, higher expenses, and below-average returns. 

Very high-quality dividend stocks help bridge the total returns gap if we do see weaker stock price appreciation in the future. 

Jason’s Portfolio Today 

I'm going to cheat a little bit. The reality is, the difference between a dividend stock and a growth stock isn't binary. For instance, Nvidia pays a dividend, as does MasterCard (MA) along with some of my best growth investments like Kinsale Capital (KNSL) and Live Oak Bancshares (LOB). So for the sake of clarity, I will include very-low-yield payers that my thesis was about stock price appreciation with the growth stocks, while including stocks that my original thesis of growth has changed as they have matured and made dividends a bigger part of their return profile, like Meritage Homes (MTH). 

As of market close on July 26, here's how my portfolio is divided between growth-focused investments and dividend stocks:

• Dividend stocks: 35% of invested portfolio; 27% of cost basis.

• Growth stocks: 65% of invested portfolio; 73% of cost basis. 

If you've been paying attention, this is a big cost basis shift over the past few months, but it's really just a change in reporting metrics. 

Remember when I said I was going to cheat? The difference in the shift is that I'm describing my portfolio about how I think about specific investments. In my prior screed, I included Kinsale and Live Oak and MasterCard in the dividend stocks column; technically, they belong there, but philosophically, they're growth investments. 

Some Final Thoughts

If I were to tell you why I own dividend stocks in a single sentence, it's because the best ones have historically been better investments than non-dividend-payers, especially ones that have generally grown their dividends. The dividend isn't the reason why they're better investments, but it is underpinned by the "why:" These are superior, profitable businesses that have strong and durable moats that protect their cash flows and allow them to grow. And paying dividends helps keep managements from wasting the money on bad investment ideas they wouldn't have made otherwise. And owning them is a hedge against me. 

I think more investors should use a similar approach. It helps instill a more disciplined approach across my entire portfolio, and can act as ballast and a starting point for future cash generation when you'll need it. It's made a huge difference in how I invest and in my success. I hope by sharing more about it with you here, it helps some of you invest better, too. 

You can do it,

Jason