Wednesday, October 5, 2011

How to choose between dividend stocks?

I invest in several dividend stocks every month. In order to end up with ideas to purchase, I have a rigorous screening process. I have described in detail what my entry criteria is in this article. Basically I look for certain quantitative factors such as valuation, dividend sustainability, return on equity and historical EPS and DPS growth. In terms of qualitative factors I look for competitive advantages, products with lasting impressions in customers and ability to grow earnings and dividends.

After narrowing down the list to a handful of stocks, I might end up with several that might look very similar to each other. While some investors could create an elaborate model using currently available data in order to provide an objective way to screen out candidates, projecting the past into the future seldom produces the desired outcome. At the end of the day one has to use their own judgment in order to select from a list of companies which spot similar characteristics.
Let’s assume that my quantitative screening process eliminated hundreds of dividend stocks from the dividend achievers index and narrowed the companies for further research to six. Let’s also assume that I could only purchase three stocks for whatever reason.

The six stocks I am looking at include:

Johnson & Johnson (JNJ): I have viewed Johnson & Johnson (JNJ) as the perfect dividend stock ever since I started investing in dividend stocks. As such I tend to have an above average position in it. The recent product recalls and the lack of immediate action on behalf of executives are a potential issue for the company, although I doubt it will lead to JNJ’s demise. The company should be able to turn around, and those that entered at current levels will likely generate strong returns in the future. I do have an above average position in the stock however. (analysis)

Procter & Gamble (PG): The company has some of the strongest brands in the world. For example, Gillette is true a wide-moat business brand. Men shave frequently, and the cartridges provide a recurring revenue stream for the company that sells it. Procter & Gamble is a well positioned portfolio of strong consumer brands, and as a result its business is relatively recession resistant, while also capitalizing on such hot trends such as the growing middle class in emerging markets. The issue I have with this company is that I frequently add to it when there are not many other opportunities, which means that I have an above average position in the stock. (analysis)

McDonald's (MCD): The company is one of the world’s most recognized brands. The golden arches has location all over the world. McDonald’s (MCD) has managed to continually reinvent itself and its menu, and delivered strong shareholder returns in the process. However it is lagging behind Yum! Brands (YUM) in China, which is a key market for growth. While the ten year dividend growth rate is at 26%, I expect distribution growth over the next decade to average 10%. (analysis)

Wal-Mart Stores (WMT): I have a below average position in the stock, given the fact that until the most recent dividend increase it was yielding less than 2.50%. While the stock has been able to raise dividends for 36 years, future growth might be harder to realize given the fact that the company already had $400 billion in sales. The company could increase its dividend payout ratio and try to squeeze efficiencies given its scale however, which should aid in dividend growth. Its operations abroad could also be a leading growth indicator for the future. Each share of the company produces a dividend income of $1.46. (analysis)

Coca Cola (KO): I like the product, as do many consumers worldwide. Coke is a stronger brand abroad than PepsiCo. The company is trading at a higher valuation than PepsiCo (PEP). It is a more pure play in soft drinks than PepsiCo, which has its risks however. Coca-Cola (KO) could generate a higher growth in the emerging markets than Pepsi, mostly due to its stronger brand abroad (based on my travel in emerging markets). Both Coke and Pepsi have slowed down the rate of dividend increases over the past few years. (analysis)

PepsiCo (PEP): Unlike its competitor, PepsiCo has a large exposure to the food industry. This has helped the company generate strong performance over the past decade versus Coca-Cola. I personally prefer the taste of Coke over Pepsi however, and many consumers seem to have similar taste buds than me. PepsiCo tends to make large acquisitions, which have worked so far. Sometimes it tends to overpay them, like the recent acquisition of Wimm-Bill-Dann (WBD). PepsiCo (PEP) is cheaper than Coca-Cola, and both have similar near term prospects. (analysis)

I have included my thoughts on each one of these. Given this analysis the end result was PepsiCo (PEP), McDonald's (MCD) and Wal-Mart Stores (WMT). Which three stocks would you have chosen, given the constraints I outlined above?

Full Disclosure: Long All stocks listed above

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