Thursday, November 19, 2020

My General Philosophy on Dividend Growth Stocks

In my previous article, I discussed in brief how I come up with investment ideas. I also wanted to share with you my general philosophy on understanding dividend growth stocks. 

In general, I look for a history of annual dividend increases. This is indicative of a business that generates a lot of free cash flow, which is a sign of a successful business model. 

I then dig into that business, in order to understand if it has some competitive advantages, which would allow it to continue succeeding. I also dig further into the business fundamentals, in order to determine if the rise in dividends per share was supported by a growth of earnings per share, and not because the dividend payout ratio was increasing. 

I look to understand how cyclical the business model is, which is a fancy way of saying that I want earnings that do not decline by a lot during recessions, but still participate on the upside during economic growth. Sustainable earnings can pay sustainable dividends through the ups and downs of the economic cycle. I want to buy companies at an attractive valuation, which can continue growing earnings, raising dividends and hopefully grow in value as well. 

I focus on valuation, although valuation is more art than science these days. A company with a low P/E is not necessarily cheap, because it is probably not growing earnings and dividends by much. If it pays a high portion of earnings as dividends, it may have a place in my portfolio, but I would not expect high returns.

For a company with a high P/E ratio, I expect high earnings and dividends growth over time. That company could find its place in my portfolio too.

I also evaluate how defensible or sustainable those earnings are too. I take a higher preference for defensible earnings streams, the types that consumer staples companies or healthcare and some utilities generate. It seems like the whole world has awaken to these valuable earnings streams however, and has bid them up. I am patient, and on the lookout to add to these companies that millions of consumers worldwide use on a daily basis, and have them ingrained into their recurring purchasing decisions.

Speaking of analyzing companies, I have shared with you my screening process over the past 12 – 13 years on my regular website. My screening process goes hand in hand with stock analysis, at least the quantitative side of it. It goes something like this:

1) A long track record of annual dividend increases. I use 25 years, but could go as low as 10 years

2) A minimum dividend growth of 6%/year over the past decade. I can fiddle around with this 
percentage too, and can go as low as 3%, or the annual inflation rate over the past decade. I want the past 1, 3, 5, and 10 years to have that minimum percentage of annualized dividend growth.

3) A dividend payout ratio below 60%. I want a lower payout ratio in general, in order to minimize the risk of a dividend cut during temporary earnings hit during the next recession. This ratio also needs to be adjusted for certain industries such as Utilities and Tobacco, which tend to distribute most of their earnings as dividends. You also need to use FFO for REITs, and be more comfortable with higher payouts. In my dividend analyses, I review trends in payout ratios, but for screening purposes, that would be a little tough to do.

4) A history of earnings growth. I find it helpful to observe trends in earnings per share over the past decade, and identify whether I like a company or not. In general, I want a consistent growth in earnings, and want to avoid companies that are no longer growing the bottom line. Sometimes you need to do additional research to gain comfort behind the trends however.

5) A P/E ratio that is below a certain number. This number varies, depending on the underlying conditions we are in. That means interest rates, the P/E of the stock market etc. When rates were 8% - 10%, a P/E of 10 would have been a good yardstick. When rates on 30 year Treasury Bonds are lower than 2%, even a P/E of 25 or 30 could signify a relatively cheap stock.

6) I used to have a minimum yield requirement, but I have dropped those when I realized that some of the best dividend growth stocks in the past were low yielding but high growth ones. I do follow the principle of building a portfolio of companies in the three types of dividend yield/growth.

Of course, I do not look at each one of these parameters in isolation. I try to combine all of these parameters into one full understanding of a company.

Armed with this knowledge, you can take a stab at the list of dividend aristocrats for example, and start digging further.

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