A Brilliantly Simple Investment Idea

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

“Simplicity is the ultimate sophistication.”

--Leonardo da Vinci

You don't need a complex investment strategy to do well in the markets over the long term. In fact, the most simple and easy-to-understand investments are usually the most profitable. Buying companies with rock-solid competitive advantages and a long-term trajectory of rising dividend payments can be a very effective and straightforward way to achieve superior returns in the long term.

Dividends are transparent cash payments, as opposed to earnings which are more susceptible to accounting manipulation. When a company has generated increasing cash flows for long periods of time, investors can sleep soundly at night knowing that the business is strong enough to withstand macroeconomic headwinds or increasing competitive pressure.

Dividends also provide income in case prices remain uninspiring for some time. In the current scenario of ultra-low interest rates around the planet, high-quality dividend growth stocks look like an interesting alternative for those who want higher returns than those offered by fixed income markets but still want to keep risks under control.

One very interesting vehicle to implement this strategy is the Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) which tracks the Dividend Achievers Select Index, consisting of stocks which have increased their dividends in each of the last 10 years. This is a relevant time period, since it includes the historically deep recession and financial crisis of 2008-2009; companies which have been able to raise dividends during this complicated timeframe have earned their right to be considered materially different from the rest.

This instrument pays a 2.1% dividend yield, which is not very big in comparison to other alternatives, but we should keep in mind that the criterion for inclusion in the ETF is not the size of the dividend; quality – as expressed by the dividend growth trajectory – is the main consideration here. With a 0.18% expense ratio, VIG provides exposure to a diversified group of securities at a conveniently low cost.

The ETF invests in a basket of more than 130 companies, holding mostly high quality names with indisputable competitive advantages: market leaders like: Wal-Mart, Coca-Cola, Chevron, Exxon, Procter and Gamble, McDonald's, Caterpillar, Pepsico, Nike and IBM are some of the highly recognizable names in the portfolio.

Diversification helps reduce the risks for VIG investors, both in terms of company-specific factors and industry considerations. Coca-Cola (NYSE: KO) and Pepsi (NYSE: PEP) are both part of the portfolio, so investors don't need to worry too much about what happens with  the cola wars, as one company's losses are usually the other one's gains.

Over the last few years, Coke has been gaining share in the competition for the carbonated drinks market in the US and Europe, which is a gigantic but quite stagnant market. Pepsi, on the other hand, has been focusing more on healthy drinks and food products, a potentially more dynamic segment, but the strategy hasn't yielded the expected financial results so far.

Coke has made more efficient decisions from an economic point of view over the last few years, but Pepsi seems more oriented for growth in by betting on healthier consumer habits. Both companies have raised their dividends consecutively for decades, 50 and 40 years for Coke and Pepsi respectively, so they are unquestioningly high quality businesses. By betting on these two archrivals at the same time, investors reduce their risks in an efficient way.

A similar example is the inclusion of both Exxon (NYSE: XOM) and Chevron (NYSE: CVX) in the portfolio of this ETF. The two biggest integrated energy producers in the planet actively compete to get access to big sized highly profitable projects, which are getting scarcer by the day. Also, while Exxon has gained more exposure to natural gas in the last years, Chevron is still more oriented towards oil.

Investing in the two energy giants means protection from the competitive risks coming from project sourcing, and it also guards investors from the very important aspect of oil versus gas competitiveness as an energy source. But energy is still  energy after all, and that's when the industry diversification provided by VIG becomes more important.

In a scenario of high economic growth and rising inflation, energy stocks will almost certainly perform better than more stable companies like Coke and Pepsi. In fact, commodities are an input which could have negative effects on profit margins for consumer staples stocks in an inflationary environment. On the other hand, when economic growth is lackluster and energy prices are suffering from low demand, the safety provided by Coke and Pepsi can compensate for the volatility generated by Exxon and Chevron.

Vanguard Dividend Appreciation provides access to a diversified portfolio of high-quality dividend growth stocks for a conveniently low expense ratio. This is the kind of brilliant simplicity which characterizes the best investment ideas.

acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of PepsiCo and ExxonMobil. Motley Fool newsletter services recommend Chevron, PepsiCo, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus