Monday, October 8, 2018

My screening criteria for dividend growth stocks

Screening is part of my process for identifying quality dividend growth stocks. For over a decade, I have managed to apply my screening criteria against the universe of dividend growth stocks I am interested in. This helps to narrow down the list of companies I am looking at. I use these parameters as a cornerstone in my dividend growth newsletter as well. However, I also tweak them in order to identify quality companies for further research.

The criteria I use are listed below:

1) A P/E ratio below 20

I have a set limit where I am not willing to pay more than 20 times earnings for a company. A P/E ratio of 20 translates into an earnings yield of 5%. This helps me avoid getting excited about chasing future growth opportunities and buying shares that are overvalued. I want to avoid situations where I buy a stock at inflated growth expectations, which do not turn out as expected. I also use this P/E ratio as a way to compare between dividend stocks. If I overpay dearly for a stock, my long-term returns may be lower than the returns of a company with better entry valuations. Dividend investors instinctively understand valuation, because overpaying for a stock results in buying future income at an inflated price; whereas buying a stock at a better entry valuation results in purchasing a future stream of income at a discount. Of course, valuation is a tricky subject, where P/E ratios should be taken into consideration while also evaluating the growth expectations of the business.

2) A dividend payout ratio below 60%

A quality dividend company reinvests a portion of earnings back into the business, and distributes the excess earnings to shareholders. This criterion ensures that I focus on the dividend payments which are sustainable. I want to have a margin of safety in case earnings temporarily decline during a recession. This goes back to my objective to generate dividend income that I can count on throughout the economic cycle. By focusing on companies with lower payout ratios, I reduce the risk of dividend cuts during the next recession. I also look for a dividend payout ratio that is sustainable, while also looking for growing earnings over time.

3) A dividend streak of at least 10 years

I have found that companies that manage to grow dividends for at least a decade are likely to have the business model and the corporate culture that rewards long-term shareholders with more dividends over time. Many companies that have managed to grow dividends for less than a decade tend to have a more cyclical business model that results in dividend freezes or dividend cuts when the business environment becomes more challenging. This requirement helps me avoid companies that have managed to grow dividends simply by expanding their payout ratio, which ultimately results in a dividend freeze after a few years. Again, my goal is to find companies that can grow the dividend for years down the road.

4) A positive dividend growth over the past decade

I want to get a positive dividend growth over the past decade. I look at the most recent dividend increase, and compare it to the five year and ten year rates of annual dividend growth. In general, I want a company that is able to produce reliable dividend growth over time. This achievement is possible only when the underlying business is able to deliver long-term results for the shareholders. I am not placing a numeric amount for dividend growth, because of the trade-off between dividend yield and dividend growth. A company like Verizon or Con Edison will have slower rates of dividend growth, but will compensate with higher yields. On the other hand, companies like Visa may have lower current yields, but will more than compensate with higher dividend growth over time.

5) A history of earnings growth over the past decade

This is the last step in the screening process. It is intertwined with the stock analysis process I follow. I want to buy companies that can grow earnings per share over time. Rising earnings per share can lead to higher dividend payments over time. If a business earns more over time, it should also be more valuable as well. This earnings growth provides ample margin of safety if the stock market decides to value equities at 10 times earnings, which is down from a purchase price of 20 times earnings for example. The rising stream of earnings will eventually bail out the investor, while also pocketing higher dividends along the way. I also look at earnings because I want to avoid purchasing a company which won’t be able to grow dividends in the future, due to high payout ratios, and stagnant or declining earnings per share.

I ran a screen of attractively valued dividend champions back in July 2018. I am presenting it again today for illustrative purposes only.

My screening process has evolved over time. I used to have a minimum yield requirement, which I have subsequently dropped. My screening process will also change based on the environment in which I operate. For example, if stocks are depressed, I may focus on securities with a P/E below 15 for example. I may also ignore companies that sell at a P/E of 19 if the industry group historically sells at 10 or 15 times earnings for example. My dividend growth requirements also vary, because of the yield/growth trade-off. At the end of the day, it really is about understanding each business and acting appropriately. Long-term readers know that I like Altria (MO), despite the fact that the company has a dividend payout ratio of close to 80%. That’s because the company has showed the ability to pay and grow dividends and earnings, despite the high payout ratio.

I wanted to reiterate that screening is just the first part of the process of evaluating dividend growth stocks. I also wanted to reiterate that I look at those criteria in tandem, and not in isolation. I may find a stock that fits all criteria, and still not buy it, because I do not understand the business well enough or because I may find another company that has a better score. I have also found that I am willing to tweak the parameters I am looking for. When you develop a strategy from scratch, you know when it may be a good idea not to follow it precisely ( as if precision ever existed in investing).

The next step of the process is to evaluate the companies, one at a time, in order to gain and understanding of whether they can continue delivering solid dividend growth for my portfolio. This step somewhat overlaps with step five above. In the process of reviewing earnings, dividends, payout ratios, I review the companies and tend to discard the ones that don’t fit my requirements. I try to focus on the remaining companies that grow earnings and dividends, have a sufficient track record of annual dividend increases, while having a sustainable dividend payout ratio and are available at an attractive valuation today.

Relevant Articles:

Rising Earnings – The Source of Future Dividend Growth
The ten year dividend growth requirement
Margin of Safety in Dividends
How to read my stock analysis reports

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