New year, new opportunities! Now is the ideal time to review my investment results and ensure they align with my investment strategy.
As stock pickers, we are at a disadvantage
Especially as active investors, as I am, we should take this step regularly. Unlike ETF investors who invest capital in a broadly diversified ETF on a monthly basis, we face some systemic challenges. ETF investors benefit from the long-term nature of the stock market: losers are weeded out, while winners automatically remain in the basket. This is true even for last year’s weirdest bull markets of all time.
A basket of losers due to cheap valuation and high dividend yield
As active investors, on the other hand, we bear the risk of filling our basket with losers. This may be due to the fact that we focus too much on cheaply valued shares. Of course, the big discounts are mainly for junk stocks on the shelf, and this does not necessarily mean a long-term increase in value.
A high dividend yield should also not be seen as the sole signal to buy. Why should a high dividend yield or a favorable valuation guarantee outperformance compared to the broader market?
The facts are painful but let’s encounter them
There is empirical evidence that active investors underperform compared to the MSCI World. The MSCI World or the S&P 500 give a damn about the valuation of the shares or their dividends. Last year, for example, seven stocks were responsible for a large part of the S&P 500’s performance that can hardly be described as value stocks by conventional valuation standards.
Many factors can justify a favorable price, from short-term market fluctuations to industry-specific challenges. However, quality stocks often fall less than the average stock during broader market fluctuations. This tempts investors to invest in the average share rather than the quality share, as the quality share still appears too expensive on paper.
A high dividend yield can also be deceptive. While many investors appreciate high dividend payments, one should ask whether they are sustainable. Companies with dividend yields of 10% or more may struggle to maintain them. It is important to look at the company’s financial health and ensure that it will continue to generate enough cash flow to cover dividends in the coming years.
So if the superior investment strategy in broad index funds such as the MSCI or S&P 500 does not rely on specific valuation criteria, why should they help individual investors to achieve an above-average return?
Growth is more important than value
It sounds tempting to receive only 10 dollars for an annual profit of 1 or even 2 dollars. However, it is crucial to question what will happen to this profit over the next five to ten years. Will the profit increase? With a low valuation, this is rather unlikely, as the share would otherwise already be more in the focus of investors. Instead, the share could sit on the shelf like poison, and there are reasons for this.
In the long term, paying 20 dollars for an annual profit of 1 dollar is often wiser when the profit doubles every two or three years.
When looking at the next five to ten years, it is crucial to consider whether the expected profit will increase. A favorable valuation alone is no guarantee of this. The same applies to the dividend yield.
I am now focusing more on annual dividend increases and low payout ratios. A consistently rising dividend often signals financial stability and shows that the company can increase its profits. Companies that regularly increase their dividends are attractive long-term investments and get the snowball rolling.
IBM and Cisco are dividend growth losers
I recently compiled an overview of my shares and current monthly savings plans. It became clear that I invest monthly in stocks whose dividends have risen by less than five percent in the last two years, such as IBM and Cisco. This may not seem dramatic at first glance, but it was a wake-up call for me. It clarified that these companies might not offer the long-term dividend growth potential I was looking for.
Although I was aware that the increases were not exceptionally high, it was still helpful to recognize these underperformers in the big picture. Why should I continue to invest capital in IBM when other stocks from my holding have similarly high dividend yields but higher growth rates, such as the European insurance companies Allianz and Munich Re, or my REITS, such as Extra Space Storage? I, therefore, decided to terminate the savings plan for IBM.
Portfolio hygiene is part of the investment strategy and the hobby
It is important that investors regularly review their portfolios and make adjustments as necessary to ensure that their investments are in line with their long-term goals.
In the world of stock picking, there are no hard and fast rules that apply to all situations (only realities). Every investor has their own strategy and risk appetite. While broadly diversified index funds provide a solid foundation for many investors, active investors can achieve solid results through thorough research and wise selection of individual stocks.
Ultimately, it’s about being aware that a successful investment strategy requires more than just favorable valuations or high dividend yields. An in-depth analysis that focuses on long-term growth, financial stability and dividend history can help to make successful long-term investments.
But sad truth be told: Even then, there is no guarantee but only a 90 percent probability that stock pickers will underperform the broad market in the long term. Period.