Over the past decade, our long-term dividend growth investment philosophy has not changed, but we have evolved our risk management framework.
The older I get, the more I believe our primary job as investors is to manage risk on behalf of our clients.
Managing risk will never eliminate risk, of course. There is no such thing as a perfect company or investment case; mistakes are inevitable and humility essential.
Also, some risks (particularly geopolitical and economic risks) are out of one's control. But controlling certain key factors should help a long-term investor to 'stay the course' and minimise the impact of mistakes when they do inevitably happen.
Below are the ten broad categories we use to think about risk at Evenlode.
The first eight are fundamental business risks. The last two - liquidity and valuation - are investment risks.
Economic moat strength
This concept measures competitive strength and pricing power. The harder a business would be to create from scratch, the wider its moat.
A 'wide moat' is created by a network of difficult-to-replicate intangible assets such as brands, intellectual property, distribution networks and, increasingly, digital assets such as proprietary data and software.
These factors, if sustained and renewed over time, typically lead to cash compounding characteristics - such as a low capital intensity and high returns on capital - which are supportive to the long-term dividend growth investor.
Long-term industry outlook
Economic moats can, unfortunately, deteriorate over time. This is often due to industry disruption and product substitution risk brought about by new technologies.
A company could have enjoyed a strong economic moat for many years in say, the buggy whip industry, but when the automobile came along, product substitution would have destroyed its business model.
Time can erode consumer demand for other reasons too, such as changing fashions and habits.
A key thought experiment I like to employ is: "Will society continue to desire and value the products and services this company offers in ten or 20 years?"
Culture and adaptation
Companies with a careful long-term culture and a willingness to adapt and invest tend to be good at consistently turning risks into opportunities.
Conversely, companies that sacrifice long-term investment for short-term profit may jeopardise their long-term future, as may those that make large, ill-conceived acquisitions.
How predictable are the revenues of a business model or the overall portfolio? Given that an investor is unable to control or predict the economic cycle with any degree of certainty, a bedrock of resilient cash generation is crucial, particularly for the dividend growth investor.
Level of diversification
No one knows quite what will happen in the world over coming years and we certainly don't have a crystal ball.
Diversification by business model, sector and category helps to insulate a portfolio and its dividend stream from the inevitable merry-go-round of political and economic risk, including the threat of inflation, recessions and fluctuating interest rates.
Free cashflow strength
Free cashflow is what is left for shareholders at the end of each year after all expenses, interest and capital expenditures. It is a pivotal risk factor for the dividend growth investor. When free cashflow fails to cover the dividend, a business relies on 'the kindness of strangers' (i.e. the debt markets or share issuance) to fund its dividends, which does not tend to end well for income investors.
Balance sheet strength
When a low and deteriorating level of free cashflow coincides with a significant amount of debt, a dividend cut is even more likely.
Strong balance sheets are therefore preferable to the dividend growth investor, particularly for companies such as economically sensitive businesses, whose free cashflow may vary over time.
A strong balance sheet also enables a company to invest in a downturn and strengthen its long-term 'moat'.
Environment and social impact
If a company is doing something detrimental to the environment or society over the long term, society is likely to ultimately punish it.
This punishment may come in the form of regulation, taxes, fines or a shift in consumer demand away from the company or sector.
A key thought experiment we use is: "would you be happy to associate yourself with this business over the next 20 years?"
An essential risk to manage, particularly for the manager of an open-ended portfolio, is liquidity. It is important that liquidity risk should be managed both in terms of individual position sizing and overall portfolio construction.
Even the best business can be a poor investment at the wrong price. There is no way of valuing a share in a company perfectly, but it is helpful to have a consistent framework that helps weigh up the relative valuation appeal of different companies over time.
Dividend yield is also important for the dividend growth investor.It is the balance between initial yield and annualised dividend growth that will produce an attractive income stream for clients over the long term.
Each without the other is not enough.
Hugh Yarrow is co-manager of the Evenlode Income fund