The KISS Strategy (investment rules)

The KISS investment strategy is based on applying DDM to dividend stocks and aiming for meeting or even beating the market performance with lower risk and volatility than is associated with index investing. The strategy follows the following rules:

1. Total dividend return greater than projected return for SP500

Stock market valuation predicts the future returns with great accuracy. Beating the total market with safe dividend stock may be a challenge; however, it is possible to obtain market matching performance with lower risk and volatility than associated with index investing.

Based on current (04/2012) stock market valuation, the annualized return over the next ten years for SP500 is 7.5%. We use this as our minimum discount target for DDM. For example, for a single stage DDM analysis, we want the total return (dividend yield + growth rate) to be greater than r = 7.5%. Currently, large telecoms can be expect to deliver this performance: ATT has yield Y = 6% and the expected growth rate is g = 2%. The total return r = Y + g = 6%+2% should therefore exceed the SP500 over the next ten years.

In summary, the KISS strategy invests stocks where the long dividend return alone will meat or beat the projected return for SP500.

2. Diversification

Invest in at least 10 stocks and in different sectors to reduce risk from a single company. Ideally, the KISS portfolio should include at least 20 different stocks.

3. Size

Large companies have more predictable dividends than small companies whose earnings can vary widely. The KISS strategy invests in companies with the market cap of at least $2B and ideally over $10B.

4. Payout ratio

The payout ratio is generally defined ratio of dividend to earnings. The common recommendation is that the payout ratio should be less than 50% meaning that the company earns $2 for each $1 that it pays out. The theory is that low payout ratio offers “buffer” against earnings drop and leaves the company with money to grow the earnings in the future. This criteria, however, is too restrictive as it excludes some of the best dividend payers.

To see the fallacy, we need to realize that profit is not the same as cash flow: due to tax reasons, even money making companies can report loss. For example, telecommunication companies may write down the assets resulting in paper loss while still bringing in more money than they are paying out.

The KISS strategy seeks to buy stocks where the dividend is supported by the long term cash flow.

5. Debt

From KISS perspective, debt is always bad. High dept means that the company may have trouble raising money when it needs it the most. The most useful ratio for analyzing the company debt is the debt-to-equity ratio. The ratio can be compared to mortgage: If persons assets are essentially a mortgaged house and the debt is 90% of the house, the debt to equity ratio is 90%. Should the housing value drop by 10%, the person would essentially have no equity left and it would be very difficult to obtain additional financing from banks that demand collateral.

Debt-to-equity ratio less that 50% means that the company equity is 2x the debt. For very stable sectors (=utilities and telecommunication), the debt to equity can be larger but it should always be less than 100%.

The KISS strategy invests in stocks where the debt-to-equity is less than 50% (less than 100% for utilities).

6. Minimum dividend yield

Higher dividend yield is better that low. Ideally, most of the return should come from the current dividend yield as it is risky to rely on decades of dividend growth.

The KISS strategy invests in stocks the dividend yield is at least 2x the market yield. Currently, the yield for SP500 is 1.9%. Hence, the yield for dividend stocks should be at least 3.8%.

7. Dividend growth

The dividend growth is not as important as the dividend yield but some growth is always desirable. A company that has not been able to grow dividend in the past may be in trouble and could potentially cut dividend in the future. The KISS strategy invests in stocks the dividend growth rate greater than zero. Zero growth rate may be acceptable if the increased risk is compensated by high yield that leaves room for dividend cuts.

8. Sell criteria

The dividend stock investment is for a long duration and ideally there should be no reason to sell a KISS stock; however, there are two exceptions when the stock should be sold:

a) The dividend is cut unexpectedly. This is always bad news and will most likely result in price decline lasting several weeks. The sooner the stock is sold, the better.

b) The price increases so much that the future return from dividends is no longer attractive. For example, if the stock that yielded 4% at the time of purchase doubles its price decreasing the yield to 2%, it is time to take the profits and find another investment.