A simple calculation that could help you thrash the Footsie in 2020

One of my favourite British outperforming and well-known investors is Lord John Lee. And in his book, How to Make a Million – Slowly, he revealed to us that he believes “most” investors and analysts are inclined to over-complicate matters.

Lee reckons he aims to focus on just two yardsticks when investing in a trading company – the earnings multiple and the dividend yield. The payment of a dividend, he says in his book, acts as a “significant” discipline for the directors of a company because they must find the cash each year to fund those dividends.

And for shareholders, there is an obvious attraction in receiving dividends from an investment, so I reckon the dividend is a jolly good place to start when searching for new investments.

Increasing dividends

Lee looks for companies with the potential to increase their dividends and profits each year. If they manage to do that, and if the earnings multiple is low, there’s often a good chance that the stock market will re-rate the valuation upwards when dividend-raising has been confirmed. And Lee reckons that in such situations, a firm could double its profits while seeing its share price quadruple.

Lee’s focus on dividends chimes with the approach that Neil Woodford took to post his market-thrashing returns before he went ‘rogue’. It’s a source of some bemusement to me how Woodford went from being an ultra-safe, dividend-focused investor with a knack for getting the big calls correct, to a hapless, trigger-happy speculative investor with a scatter-gun approach – but that’s a subject for another day!

However, when Woodford was at his best and building his awe-inspiring reputation, he also advocated a simple approach to investing that focused on the dividend. And it served him very well for decades. I once read the transcript of an interview in which Woodford revealed that he used to start off his analysis of a potential investment with a basic calculation for judging a firm’s attractions. His technique boiled down to expecting a return from a stock to be its “dividend yield plus the anticipated rate of dividend growth.”

Capital gains a bonus

Focusing on the dividend like that meant that Woodford considered any capital gains that materialised through a rising share price to be a bonus. And we’ve seen with Lee’s explanation that buying a rising dividend and a low valuation often can lead to rapidly increasing share prices. No doubt such rises powered a big portion of Woodford’s impressive returns during the 25 years he was with Invesco.

And the simple calculation that could help you thrash the Footsie in 2020 is taken from vintage Woodford philosophy – judge the potential of a share by calculating the dividend yield and adding it to the anticipated rate of dividend growth.

Of course, that’s best used as starting point for your research and not the entirety of what you should look at when evaluating shares. But whatever you do in 2020, don’t toss the approach out the window entirely like Neil Woodford did when he started his own fund management firm. Be more like Lord John Lee instead!