Wednesday, June 24, 2015

A Dozen Things I Learned from Todd Wenning About Investing

Todd Wenning is leaving Morningstar for another post in the investing world. Not sure if he will be able to post as much going forward, so this seems a good time to summarize the lessons I, and I am sure many others, have learned from his work.

1. Importance of Dividends
Dividends are everywhere now, but Todd has been writing about dividends for a long time. A lot of what I learned about the importance of dividends comes from Todd's work. These include focusing first on the moat, which is more important than the dividend itself, signs of what companies to avoid, and minimizing transaction costs.

2. Think Different
Most guidance on dividends includes the safety check for how sustainable the dividend is. These guidance pieces almost always point you in the direction of the Payout Ratio. This is a good indicator to check, but its based on earnings. Todd points out that free cash flow is the more important metric for dividend investors.

"Many companies and investors primarily focus on earnings cover (earnings per share/dividends per share or net income/dividends paid). As such, earnings cover is also important to consider, but "earnings" are simply an accountant's opinion of the company's profits and not necessarily a good measure of cash flow. In fact, a company can have sufficient earnings cover but negative free cash flow cover.

Because dividends are paid in cash, we want to use a metric that helps us measure cash inflows and outflows. That's what the free cash flow cover metric can do.

Free cash flow is how much cash flow is left over each year after the company has reinvested in its business. Think of it as spare or surplus cash flow. It's from these surplus cash flows that dividends, buybacks, debt repayments, etc. are funded."

3. Think Small
Morningstar is a great service with a lot of useful information. However it has one gap - lack of small cap coverage. The fundamental construct that Morningstar uses to assess companies' durability is the economic moat. For sure, there is a good case to be made that the moat concept is just as relevant to a small cap as it is to J&J. Todd wrote a series on Small Cap Moats, that uncovered lots of interesting smaller companies from WD-40 to Badger Meter, there are a lot of interesting ideas in this space.

The goal of the Small Cap Moat series is one that resonates with individual investors:

"identifying smaller firms that exhibit moatworthy characteristics and are run by skillful management teams. This is a promising combination for any company to have, but it’s particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time."

4. Look Outside the US
Investors should not limit their holdings to the US. Many companies in general, and dividend payers specifically exist out side the US. Go where the opportunities are.  Further some of the more interesting investors to follow are outside the US, for example Neil Woodford. Todd uncovered a number of Woodford quotes I really like this one:

"In the short-term, share prices are buffeted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment."

5. Make Tools  
Churchill said we make our buildings and then they make us. The same is true in investing. We make our analytical tools and our tools make our portfolios. Todd published the Dividend Compass tool which is a great way to analyze the key data to dividend investors and monitor changes.

6. Separate Income Investing from Value Investing
Like a lot of people, I came into dividend investing thinking about it as a subspecies of value investing. I like both styles of investing, but unless we are talking about 2008-11 timeframe its pretty hard to find great bargains on dividend payers.

Todd's post Income Investor Manifesto gets to the heart of this distinction:

"a high yield can sometimes be indicative of an undervalued stock, but the objective of a pure income strategy differs from value investing in that its primary focus is to generate a growing and sustainable stream of dividends. Capital gains are an important, yet secondary concern. For value investing, the opposite is true -- indeed, companies don't necessarily need to pay a dividend to make it an attractive investment to a value investor.

Further, income investing has a distinct research process that focuses on a company's ability to sustain and increase its dividend. Where value research typically begins with a company's balance sheet and growth research starts with the income statement, dividend research commences on the cash flow statement.

From the cash flow statement, for instance, we can determine free cash flow coverage, earnings coverage, how the company approaches dividends versus buybacks, debt repayment trends, acquisition trends, and more.

This analysis is critical in determining a company's dividend health and therefore the cash flow statement is the necessary starting point for dividend research."

7. Be Long Term
Lots of people "talk" long term, but its even more important for dividend investors. Further, individual investors do not have many advantages, but the ability to be long term is one absolutely one. Buying high quality + high yield and holding for the long term really works. Todd says it well-

"Individual investors, on the other hand, don't have to worry about underperforming in a given year and can thus maintain a patient and long-term focus. You can hold a large cash position or take a contrarian position, for instance, and give your thesis a few years to play out without worrying about investors pulling money out of your fund."

8. What to Avoid
Todd advises to ask yourself these questions before investing:

  • What do I know about this stock that other investors don't? 
  • Does this company have a sustainable competitive advantage? 
  • If the stock loses 50% of its value over the next three years, what happened? 
  • In two minutes, can I explain to a friend how this company makes its money?
  • When will I sell this stock?

Not only are these solid questions to ask, they also get to get to a critical issue - mistake avoidance. Asking these questions helps to ensure that that you have a margin of error in your own thinking process.

9. Learn from Your Mistakes
Mistakes are inevitable, learning from them is not. One way to try and learn is to first recognize your mistakes and identify where it went wrong. Todd revisited his purchase in Tesco that did not work out.  Buffett also got burned on Tesco. Interestingly enough I was looking at Tesco around the same time, and the thing that convinced me not to invest was the metrics that Tesco showed on Todd's Dividend Compass tool.

Suffice to say, the world in general and investment world in particular is rife with people talking about their success and ten baggers, but the mistakes get somewhat less review.

In the case of Tesco, Todd summarized the key lessons learned:

  • When you find yourself making a lot of excuses for a company’s missteps, it’s time to reevaluate your investment thesis. Remember, you don’t work for the company and there’s no reason to spin bad results in a positive light. Call them as you see them. 
  • If a company holds its dividend flat after years of steady growth, it’s likely a sign that the competitive landscape and/or company’s strategy has changed. The board and management are clearly not confident in their medium-term outlook. Something is up. 
  • When figuring out when to buy or sell a stock, don’t concern yourself with which investors are also buying or selling the stock. Fund managers with large assets under management can have very different investment criteria and objectives than you and I do. They can also make mistakes like anyone else. 
  • Forget the price you paid for the stock. The question you need to answer is, “Would you buy the stock today?” Anchoring is a powerful behavioral bias. To combat anchoring, write down your original thesis and periodically review it and update your assumptions. Has anything materially changed? 
  • Even a solid research process can have a poor outcome. On average and over time, a good process should yield better results, but on a case-by-case basis this isn’t always true. Learn from the poor outcome and move onto the next investment.
10. Share Ideas
Harold Edgerton developed a number of ground breaking technologies, including high speed strobe, and ran one of the major labs at MIT. His motto was ""Work like hell, tell everyone everything you know, close a deal with a handshake, and have fun."

There are a lot of investment analysts out there, but not many share as much insight and tooling as Todd has. I suspect that like Shelby Davis observed years ago, there is a lot of value to the person sharing because it forces more rigorous thought. Virtuous cycle.

11. Process Matters
I think processes are unlikely to automagically turn up huge ideas, but what processes are very good at is mistake avoidance. That matters in any kind of investing, but mistake avoidance matters even more in dividend investing. If you are a biotech investor you know going in that you will flame out half the time, but you have some huge upside on the ones you are right on. In dividend investing, you are not going to see the huge upside this decade, so you have to stay in the game and avoid losers.

Todd's good process traits:

Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.

Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 

Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 

Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.

Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 

Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.

12. Simplicity and Patience Win
Processes are great at limiting errors, but what about finding excellent ideas? Search strategy should seek out different ideas. But what are we really searching for? The answers have less to do with advanced math and more to do with investor behavior:

Investment + good company + right price + patience

Without the investment, for instance, nothing else happens. I know this is obvious, but bear in mind that only about half of American households own stocks at all. Not everyone is taking that first step and planting the seed.

It's also a matter of where the seed is planted. Just as rocky soil wouldn't allow a tree to grow to its full potential, investments in poorly run companies will likely struggle over long periods of time. Instead, look to own good companies -- that is, firms with durable competitive advantages and strong financials that are run by able and trustworthy management teams. It's these companies that will give your investment the best chance to grow over the long-term.

Good companies should also be purchased at the right prices, of course, just as an apple tree needs to be planted in the right type of climate. As I noted in this post, an investment can be made in a good company and held patiently, but if it was bought at too dear of a price, it won't yield as much as the same company bought at a discount.

The final step is the trickiest one of all. Having the patience to hold a single investment for more than a few months isn't easy, let alone a few decades, yet you wouldn't tear down a tree for not producing bushels full of fruit right away, would you? It's only over longer periods of time that both yield great rewards."

As Todd is moving on to other things, I am glad I took the time to distill a lot of lessons I have learned from his work. I am also glad that even though he may not post as much, these are lessons that do not have an expiration date and so individual investors like me can leverage them for a long time down the road.


  1. Excellent list of lessons, Gunnar. I really enjoyed them (and found them enlightening). I have not read a lot of Wenning, chiefly picking up the little I know through your site. But clearly the thoughts he put to paper are well-considered, intelligent and built on--sometimes bitter--experience.

    I will return to this post periodically, I think!

    Thanks again!

  2. Good job, of telling me who a safe value investor is

  3. Great post – I’ve submitted it to the UKFinanceOver30 sub-reddit.