Monday, September 22, 2014

How to analyze dividend stocks

Most dividend investors tend to have a screening criteria which helps them narrow down the investable universe of income stocks to a more manageable list. This screen could include criteria such as profitability, valuation, as well as other characteristics that are tailored to the individual’s strategy. Once a list of potential candidates is presented however, investors need to create an additional set of parameters that would help them to identify the best investments for their money.

In my investment process, I apply my entry criteria to the list of dividend champions and dividend achievers. I tend to perform this exercise once a month, but might perform it more often if stock prices decline. After I have a manageable list of investments to dig into, I often dig into them one by one. The items I look for might seem highly subjective, and based on my personal experiences. Therefore, they should not be a be it all inclusive list to copy and mindlessly replicate.

In general, I typically look for increases in income over the past decade. It does not have to be a stair step increase, although a period of flat or declining earnings of five or more years is typically a red flag for me. After past earnings are analyzed, I tend to research how exactly the company is making money. This is typically found in the first few pages of an annual 10-K filing, and it typically makes for a fascinating read. The next step after that is determining if the company has any formal plan or goals for growth over a given time period.

For example, IBM has a plan to earn $20/share by 2015. If a company does not have a formal plan written down, I tend to analyze factors that could allow it to grow profitably for the next decade and hopefully beyond that. In general companies can grow earnings by expanding in new markets, acquiring competitors, increasing sales volumes, introducing new products, raising prices or cuttings costs to name a few. For example, companies like Coca-Cola (KO), which are expanding rapidly overseas, could generate increases in earnings over the next several decades. This would be fueled by the increase in the middle-class worldwide, introductions of new healthier beverages as well from strong pricing power coming from strong brand name that the company owns.

For a company like Wal-Mart (WMT), it could expand its presence overseas in key markets such as China, while also maintaining its position as the lowest cost retailer, due to its scale. If Wal-Mart can successfully renovate a large portion of stores and manages to make and keep them cleaner and more appealing to the types of shoppers that tend to frequent Target (TGT), it could increase sales for years to come. Of course, by simply maintaining its grip on retail sales by negotiating favorable terms with suppliers, squeezing out inefficiencies from its value chain and passing off savings to consumers, it should continue to dominate in the US retail market. The problem that Wal-Mart is facing is that its size is a major impediment to fast growth in the future; moderate growth in earnings per share however could still be expected over time.

I typically also look at the return on equity, in order to determine whether the dollars which had been reinvested back into the business have generated any value to the company. In general, if there has not been a major acquisition, ROE would be a helpful factor to analyze. Companies need to invest in the business in order to keep their edge and also to increase profitability over time. Not all new projects are going to add to the bottom line immediately, but on aggregate, I would expect that a reasonably capable management team would deliver the kind of organic earnings growth that would pay dividends for years to come. Chasing hot or exciting projects that make news headlines might not be helpful for operating performance, since it would likely result in overpaying for assets. For example, back in the early 2000s, European Telecom’s spent billions for 3G wireless spectrum, which was more than they could swallow. This resulted in increased debt levels, and the big winners ended up being the governments which sold licenses at high prices.

Another thing I tend to look for includes trends in dividends and dividend payout ratios. If companies are able to generate rising profits over time, I generally tend to like those that raise distributions in tandem with increases in profits. A company with the culture to reward shareholders with more cash as the business grows and profits are rising are definitely a plus in my book. However, I tend to closely monitor the dividend payout ratio, in order to determine whether dividends are being increased on borrowed time. In other words, if dividends are rising faster than earnings, chances are that sooner or later both of these indicators have to converge their growth rate. Otherwise, the company would end up with an unsustainably high dividend payout ratio. Without a margin of safety in dividends, any short-term dip in profitability could result in steep dividend cuts, which could end long records of consistent dividend increases.

Companies like Chubb (CB) have been able to raise dividends at a rate that has been very close to the increase in earnings over the past decade.

In addition, I also look for companies which can deliver meaningful dividend increases for years to come. In general, utilities have been plagued by dividend cycles of increases followed by dividend cuts. Other utility companies such as Consolidated Edison (ED) have managed to eke-out minimal dividend raises of 1%/annually for the past 16 years. Given that inflation is typically 3%/year, this minimal dividend increase is not sufficient to maintain purchasing power of our dividend dollars. In general, I recognize that there is a trade-off between current yielder with low growth and a low yielder with high growth. However, investors should select the option that shows them the best potential from growth in earnings and dividends, rather than impose their own personal situation on the world.

This would mean avoiding a high yielder like Con Edison (ED), despite its mouth-watering yield and sticking to a company like Kimberly-Clark (KMB). Chances are that a high yielder could generate a high level of dividend income for years, which would decrease its purchasing power over time because of low growth rates. In addition, a high yielder would likely deliver lower total returns, since it would not be able to grow earnings as quickly as a low yielder.

Many of the companies I hold are defensive in nature, and sell products or services sold to millions of consumers and businesses worldwide. Many of those sales represents recurring transactions, which repeat every so often. Finding a business model that I can understand is definitely a plus. I believe that most ordinary investors can understand how Colgate-Palmolive (CL) or Procter & Gamble (PG) or PepsiCo (PEP) earn their money. This is the type of "qualitative" analysis which could be subjective, but important. In the case of those companies listed in this paragraph, I doubt that their profits will decline by much during the next recession.

In conclusion, investors should take into consideration the performance of the companies in which they plan to invest their money in, and estimate whether they stand a decent chance of continuing that performance in the future. If the answer is yes, and the dividend paying stock is attractively priced, then chances are that it would be a decent addition that would bear fruit for years to come.

Full Disclosure: Long KMB, KO, PEP, APD, WMT, CLX

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