To make sure the companies I invest in are able to provide a constant stream of increasing dividends I need to understand the underlying business model. The company financials should reflect the business model. Both the business model and the financials are presented in the annual report, in which I need to trust. I trust only in companies that have a positive corporate governance and report with generally accepted account standards. Some investors take this for granted, but it is not!
I consider stocks e.g. in the regions of North America, Western and Nothern Europe, Japan and Singapore as adequate secure. However, the recent example of ARCP (a US REIT) shows that an investor cannot be certain at all. That’s when diversification jumps in!
Investment criteria I follow
1. Companies with increasing dividends >15 years (no reductions)
Paying an increasing dividend for the past 15 years is especially impressive because the company was able to master two crisis (in 2001/2 and 2008/9) while still increasing its dividend. Making it only 10years, would leave the millenium crisis be unconsidered. That dividend is a strong signal for a strong business model with a competitive advantage and make me confident that I will receive increasing dividends also in the next crisis, that will come for sure.
2. Companies with a share price that implies a dividend yield greater than its last 5-year average
In the first step I look at the last 5 year dividend yield chart of my target company by using either S&P Capital IQ or YCharts. It is actually pretty simple to use YCharts as you just need to type in google: “ycharts dividend yield + (company name)” to get a 5 year chart. I roughly aim at identifying tops in dividend yield (that mostly correspond to stock price dips) to determine my required yield. Having the yield and the dividend per share (DPS) enables me to determine the purchase price (if the dividend remains the same): DPS / Yield = Target share price. Buying at a yield > last 5 year average ensures I buy the stock at least at a fair yield level.
3. Companies with a Chowder Score >12% (>15%)
The Chowder Score was invented by the seekingalpha contributor “Chowder”. The score is determined by adding together the (i) last 5 year dividend CAGR (compounded annual growth rate) of a stock and its (ii) current dividend yield. A Chowder Score of 12% or greater is required when the current dividend yield is 3% or greater. If the current dividend yield is less than 3%, it must have a score of 15% or higher. With this rule Chowder adresses the investment trade-off between high yield / low growth and low yield / high growth companies.
4. Companies with low dividend payout ratio (margin of safety)
As dividend investor I want to make sure my dividends can be sustained even in severe crisis situations. The lower the companies dividend payout ratio the better is the ability to sustain the dividend in times when EPS fall (payout ratio increases). I consider a dividend payout ratio (=DPS / EPS) below 50% as good to have and below 60% as acceptable. A dividend payout ratio of 50% leaves a fair amount of 50% of net income to be used within the company for future growth. A higher payout ratio could hamper growth prospects of the company as less capital is at the companies disposal.
5. Companies with growth of >5% in revenues (L5Yr), EPS (L5Yr), and EPS (Next5Yr)
The last five year period (L5Y) from today (Nov ’14) started back in Nov 2009 when we had already seen the stock market lows of the financials crisis at the beginning of the year 2009. Since then, the broad market rallied north together with an improving economic environment. I would expect a company to swing back from negative growth to positive after the crisis and continue its inherent growth path. Further, increasing revenues (L5Y) support my going concern assumtion. Increasing revenues will ceteris paribus increase EPS and my dividend income at the end. Companies with decreasing revenues in the long-term usually have their business model under pressure, putting the dividend sustainability at risk. The combination of both >5% revenues (L5Y) and >5% EPS (L5Y) growth indicates a stable business model as operational margins, and financing remains the same (assuming positive EPS). I would also accept less positive revenue growth and higher EPS growth. EPS growth > revenue growth could e.g. indicate i.a. operational and/or financing improvements. The estimate for the EPS (N5Y) indicates a general positive growth assumption by analysts covering the stock which supports my thesis of positive future EPS growth.
6. Companies with fair value or cheaper (multiples below 5 year average)
The fair value of a company is difficult to dertmine with various techniques available for application (e.g. DCF, Multiples, EVA, etc.). Whether you believe the market is efficient or not, you recognize that using market implied valuation techniques (multiples) over a period of time indicates periods of high and of low relative valuations of a stock. I use EV/ EBITDA and the common P/E multiple as my single valuation criteria. EV/EBITDA is a very famours valuation multiple within Investment Banking and Private Equity. It values the Enterprise Value (EV) relative to its operational earnings before interest, taxes, depreciation & amortization (EBITDA). In his book “What works on Wall Street” O’shaughnessy determines this ratio as the most potent. The P/E ratio is a commonly used ratio putting stock price and EPS in a relationship. The benefit from using ratios is, that they are (mostly) independed of monetary expansion (QE).
As a (dividend) investor I am not so much concerned about capital gains. Time in the market is better than timing the market! However, I do not want to overpay for a stock and pay”the right price”. Paying a fair price ensures that in potential crisis situations, the stock will (hopefully) come back to its average valuation levels, reducing my risk of capital losses. The fair price I consider to be the average of the last five years of the the EV/EBITDA and P/E multiple valuation or cheaper.
7. Companies currently oversold (RSI below 35)
The RSI (=Relative Strenght Index) is a technical indicator (oscillator) ranging from 0 – 100. A stock having an RSI below 30 is regarded as oversold and above 70 as overbought stock. I know, this investment criteria is a timing rule and of rather technical nature. Also in downward trends the RSI seems of limited usability. However, in sideward- or upward trends it gives an indication of buying stocks “on a dip”, adding some extra yield to my dividend portfolio.