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Sunday, February 10, 2013

Selection Criteria

I've designed selection criteria for dividend paying stocks to help me identify appropriate candidates for DivGro. My main goal is to generate a reliable and growing dividend income stream. Reliable income comes from companies that not only pay dividends regularly, but can be counted on to pay the same (or increasing) dividends regularly. Of course, I prefer dividend payers that increase their dividends over time. Such companies generate enough cash to pay dividends and they grow earnings over time to afford dividend increases.

The often cited disclaimer that "past performance is no guarantee for future results" has a counterpart for dividends: "there is no guarantee that dividend paying companies will continue to pay or increase their dividends". Several companies with long histories of paying dividends broke those streaks during the recent financial crisis. For example, in 2009, both General Electric (GE) and Pfizer (PFE) cut their dividends for the first time in decades, and many companies eliminated their dividend payments altogether.

Despite the above mentioned disclaimer, a long streak of dividend increases is a great indicator of financial security and continued dividend growth. If a company has a long track record op paying increasing dividends, chances are it has the ability to continue doing so. And if a company has a long track record of increasing dividend payments, it would have a strong aversion to decreasing or eliminating dividend payments.

My selection criteria considers the size, growth rate, and sustainability of dividend payments. Most of these criteria are quantifiable and use readily available metrics. My overall goals are to achieve a 12% yield on cost (YoC) within ten years of inception and to exceed the performance of the S&P 500 index in total returns.

1. Dividend yield exceeds 2.75%

I require a dividend yield of at least 2.75%. There are solid dividend payers with yields less than 2.75%. However, smaller dividend yields require substantially larger (sustained) dividend growth rates to achieve a 12% YoC within ten years.

2. Dividend yield and growth rate together target 12% yield on cost

According to the Chowder Dividend Rule (CDR), a stock presents a good entry point if the sum of its dividend yield and the 5-year compound annual growth rate (CAGR) is at least 12%. In my view, stocks that conform to the CDR have a good chance of delivering a 12% YoC in ten years, assuming dividends are reinvested.

3. A streak of at least 5 years of dividend increases

I like to see evidence that a company intends to increase their dividends over time. Although a streak of 5 years is not significant, it indicates that further increases could be forthcoming. The longer the streak, the greater the expectation that dividend increases will continue. Dave Fish maintains a spreadsheet of USA companies by consecutive annual dividend increases: Champions (25+ years), Contenders (10-24 years) and Challengers (5-9 years). See also the S&P 500 Dividend Aristocrats index, which measures the performance of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years.

4. Price discount is at least 5% of fair value

One measure of a stock's fundamental value is the Graham Number, which is based on the company's earnings per share and book value per share. I use this measure and collect two more opinions of the fair value of a candidate stock. S&P Capital IQ and Morningstar provide fair value estimates for dividend paying stocks. I require that a stock's current price be discounted by at least 5% to the median of these fair value estimates.

5. Dividend payout ratio is below 65%

Simply stated, the dividend payout ratio is the percentage of earnings paid to shareholders as dividends. It indicates how well earnings support dividend payments. If the dividend payout ratio is too high, future dividend payments or increases could be compromised. I require a percentage below 65%.

6. Debt to equity ratio is below 50%

The debt to equity ratio is an important metric in evaluating the financial strength of a company. A high ratio could mean that a company has been aggressive in financing its business operations with debt. This could lead to increased earnings volatility. Debt to equity ratios depend on the industry in which a company operates. Capital-intensive industries such as auto manufacturing tend to have debt to equity ratios higher than 2.0. Generally, I prefer companies with debt to equity ratios below 0.5, or below 1.0 for companies in capital-intensive industries.

7. Dividend growth rate averages at least 7% over last 7 years

As mentioned earlier, a dividend growth rate of 7.2% means dividend payments would double every ten years. I use a weighted average growth rate calculation to favor more recent dividend increases. Without real justification, I assign a weight of 7 to the most recent increase, 6 to the second most recent increase, and so forth. Thus, the dividend increase 7 years ago gets a weight of only 1.

8. Price to earnings ratio is less than 16

The price to earnings (P/E) ratio is the current share price divided by earnings per share (EPS). A higher P/E ratio means that investors are paying more per unit of earnings than for a lower P/E ratio. It is more useful to compare the P/E ratios of one company to other companies in the same industry, or to the market in general. I prefer the P/E ratio to be less than 16.

9. Estimated 5-yr total payback percentage is at least 16%

The payback period of an investment is the length of time required to recover the original cost. For dividend paying stocks, we can consider the dividends received per share as payback of the original cost, namely the per share price. I require a 5-year total payback percentage of at least 16%. Since this criterium is based on forward-looking data, I use the current dividend yield and assume no dividend growth. If, the 5-year total payback percentage is at least 16%, then it should easily exceed 16% when accounting for dividend growth.

10. Reasonable confidence in continued dividend growth

This criterium is not directly quantifiable. I consider additional metrics such as a stock's PEG Ratio, Price to Sales Ratio, Price to Book Ratio, Market Capitalization, and estimated current year, next year, and 5-year EPS increases.

See my selection criteria in context in my summary of DivGro's constitution and investment strategy.

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