Originally published September 21st, 2015
Updated December 21st, 2015 (added dividend cushion ratio)
As I plod along on my journey towards financial independence, I intend to post an investment thesis for every stock purchase I make. The intent is twofold: 1) It will hopefully serve as a reminder for my future self to look back on and remember why I own however many shares of whatever in the first place. I hope to make sound investment decisions that will not require much future selling of stocks. However the time will come when I will second guess my decisions. And writing down the argument in favor is good way to memorialize the thinking that went into the investment. 2) It will serve as a record of my decisions for everyone to see. I’ll either make good ones or bad ones, but there won’t be any re-writing of history. Hopefully this will give credibility to future opinions I may have.
I want to be consistent with my process for selecting the stocks I invest in, so when I decide to invest, I should be able to make the case in a consistent format. This is that format. I’ve outlined it here because I don’t want these posts to be too long or repetitive. That’s why I discuss each of the components of the analysis here. My philosophy isn’t going to change, the parameters and metric values I look for aren’t going to change, so there’s no sense bringing it up every single time I analyze a stock.
One thing that I’m not going to do is copy and paste the “Company Profile” from Yahoo Finance. There will be references to what they do, what industry they’re in, what sets them apart from their competition, etc. in the narrative of the thesis, but if you don’t recognize the company, you’ll need to go ahead and google it. There’re plenty of other things I want to focus on, and I’m trying to keep these relatively short, remember?
So the format will be roughly this:
Section 1 – Dividend Cycle
When is the next ex-dividend date? What is the current dividend situation, and how many consecutive years have they raised dividends? I generally use David Fish’s U.S. Dividend CCC’s list as my “universe” of stocks to filter from. CCC stands for Champions, Contenders and Challengers.
Dividend Champion – has raised dividends for 25 or more consecutive years
Dividend Contender – has raised dividends for 10-24 consecutive years
Dividend Challenger – has raised dividends for 5-10 consecutive years.
Occasionally I might come across a stock some other way, but generally speaking I start with the CCC list.
The ex-dividend date is important, because the whole point of my strategy centers on collecting dividends. If I make an investment in a stock that won’t go ex-dividend for a long time, the value of that investment is tied up in imaginary paper gains or losses. Yes, it’s a long-term investment and a few percentage points off the purchase price and a couple months more or less holding time seems insignificant. But I’ve already fully confessed to trying to time the market. This is part of that. For more on why I’m committed to Gaff Fishing, please see that related article.
Section 2 – The Investment Details
This section outlines how many shares, at what price for a total investment of $X including commission. I place limit orders because 1) I’m trying to time the market by gaff fishing and 2) I want to know exactly how much I’m going to spend on the transaction, and market orders don’t let you do that. More on that philosophy can be found at the previously mentioned article on Gaff Fishing. The difference between the current market price and the limit order price should be noted here.
Section 3 – The Quantitative Case (QC)
I tend to gravitate towards stocks with a yield over at least 2%. There are definitely good dividend growth stocks with lower yields, but 2% is the threshold where I tend to get interested. The market yield is something that I look at, and might consider in terms of target purchase price. But it is totally irrelevant to my investment decision.
There are two much more important questions: How safe is that yield? How likely is it to continue to grow and at what rate? No one can predict the future, myself included, so I can’t really be sure of what will happen to the dividends of a particular stock. But I can look at the current health of the company to make an educated guess. I look at key fundamental metrics to make that educated guess. These fundamentals are summarized in tabular form.
It’s worth noting that these fundamentals are applicable to what I will call conventional business structures. In other words I use different metrics to analyze, REITs, MLPs, insurance companies, utilities etc. This is because these companies all have to use the same Generally Accepted Accounting Practices (GAAP) definition of “earnings” as everyone else, but because of their structure, the “earnings” ratios will probably look a little goofy. I will write another post on alternate metrics for alternate company structures sometime in the future.
Any time a metric is outside of my target parameters it will be highlighted on this table in the investment thesis. I don’t need every single fundamental to meet my criteria, but most of them should and if they’re out of range, it should at least be close.
Fundamental 1: Payout Ratio – EPS, FCF Target: 60% or less
Investopedia has an excellent definition and introduction to the concept of payout ratio, and it can be found here: http://www.investopedia.com/terms/p/payoutratio.asp
All financial metrics are kind of made up numbers, but I guess between the two I kind of think Free Cash Flow (FCF) is slightly more concrete than Earnings Per Share (EPS), and it certainly has a lot more to do with the dividend. A lot of people really care about earnings though, so I guess that’s why I look at both. At least if there’s a discrepancy it’s like a flag telling me I need to dig deeper.
Generally speaking I want to see a payout ratio less than 60%. A higher payout ratio isn’t a deal breaker, but it raises a red flag. I put a lot of value in cash because that’s what I need to pay my bills. I want to invest in companies that pay me cash now and will continue to pay me even more cash in the future, which means they need to be able to comfortably afford the current dividend. If 90% of their cash is going to shareholders as a dividend, that only leaves 10% for the company to invest in itself. That is not a recipe for growth.
Fundamental 2: 10 Year Revenue CAGR Target: 3% or better
I believe that companies who have demonstrated a consistent history of growth are more likely to continue to grow in the future than companies with a poor history of growth. CAGR stands for Compounded Annual Growth Rate. I get this information from Morningstar.com who publishes historical key ratios for the last 10 years. My formula for 10 yr CAGR is as follows: [(most recent revenue – revenue from 10 years ago)/(revenue from 10 years ago)]*100% divided by 10 years to get an annualized rate.
This could also be referred to as “top line” growth. A lot of the companies that have a long history of increasing dividends are big companies, which means they make a lot of revenue. It’s tough to “move the needle”. Exxon Mobile for example has raised dividends for the last 33 years in a row. At time of writing their ttm (trailing twelve month) revenue was ~$300B. When you make more revenue than the GDP of a lot of small countries, it’s pretty tough to get a lot of growth in percentage terms. My target 10 year revenue CAGR is 3% or better.
Fundamental 3: 10 Year EPS CAGR Target: 5% or better
More important than top line growth is bottom line growth. If you make a lot of money, but have to spend most of it in the process, you’re really just spinning your wheels. Earnings per share (EPS) growth is a key driver for dividend growth, since dividends are also paid per share. There are a number of ways to achieve EPS growth, the simplest of which is top line growth. But you can also increase operating efficiency, reduce the share count (buybacks), divest from less profitable endeavors, etc. Whatever a company may do, if they have a history of increasing their EPS, I believe they’re more likely to be able to increase their dividend, and that’s what matters most to me. The bar is set higher for EPS growth than revenue growth. I like to see 5% EPS growth or better. The EPS growth also informs the assumed DGR (dividend growth rate), which I’ll talk about later.
Fundamental 4: Delta between 5year average P/E ratio and current P/E ratio Target: >0
The price to earnings (P/E) ratio is a very common and powerful valuation metric. Companies exist to earn money. So how much is the share price in relation to the amount they earn per share? That is a fantastic question. A more pointed question in my opinion is “what is the difference between the current P/E ratio and the historical average P/E for the stock?” I use the 5 year average because that’s readily available for pretty much every stock on the market on Morningstar.com. Comparing the current P/E to the stock’s average P/E for the last 5 years is a more meaningful comparison in my opinion than comparing it to an arbitrary value, like 15. Some stocks trade at a higher or lower P/E than others. That has to do with the industry they’re in, macroeconomic factors, all sorts of things. Why try to use a fixed number for all stocks? Why try to compare it to an industry average? There’s a lot of industry overlap anyway. If the 5 year average P/E is more than the current P/E, than the stock is relatively cheaper than it’s been, on average, for the last 5 years. Works for me.
Fundamental 5: Delta between 5year average yield and current yield Target: <0
I’m all about yield. I want more bang for my buck. This is the same argument as described above for P/E but with a different metric, and the target is a negative delta in this case. If a stock has historically yielded 2.5% but is currently yielding 3%, I’m getting a better deal than I would have on average over the last 5 years.
Fundamental 6: Historical DGR Target: As much as possible, so long as it’s reasonable.
DGR stands for Dividend Growth Rate. The “mean” (average) DGR comes from David Fish’s CCC spreadsheet, and the more the better. For dividend Champions I use the 15 year average since they’ve raised dividends at least 25 years. For Contenders or Challengers I will use the 15 or 10 year average if they’ve gotten past 15 or 10 years of consecutive raises, or I will use whatever number of years they’ve actually raised dividends so that any zeroes from the past life don’t affect the mean. DGR is a key variable in determining “fair value” based on the DDM (dividend discount model). The historical DGR is a starting point for coming up with a future DGR projection. Rather than look for a specific target, this metric is more of a barometer for me. I want to see healthy dividend growth and ideally it will jive somewhat with EPS growth. Crazy high or low numbers need a second look and need to be put in context.
Fundamental 7: Debt/Market Cap Target: 33% or less
Debt is bad…mmkay? Well it’s not bad, but it can be dangerous. Creditors want their money back, plus interest. Those debt payments come out of earnings, and generally need to be covered before dividends are paid. And while there are ways to get out of paying them back, it usually involves bankruptcy or other scenarios that are all really, really bad for shareholders who are expecting a dividend payment. There are all kinds of ways to “measure” a company’s debt situation, and plenty of different ratios, metrics and calculations. Most of them involve a lot of digging into complicated financial statements. “Total Debt” is easy to find. “Market Capitalization” is equally easy to find. Taking a quick ratio of how much a company owes divided by how much it’s allegedly worth is really easy. If a company is outside of my target range, I may dig deeper to find out the rest of the story, but if they’re below this 33% threshold it’s a pretty quick way for me to feel comfortable about not worrying too much about the debt situation.
Fundamental 8: Total Cash Target: $1B or more
Call me Doctor Evil, but I think $1B is a lot of money. I call my cash reserves my “war chest”. I want a company to have a healthy war chest and I think $1B is pretty healthy. I also compare total cash on hand to total debt. If cash on hand exceeds total debt, that’s as good as $1B for me.
Fundamental 9: Return on Assets Target: double digits
How good is management at making money with what it has (its assets)? Investopedia defines ROA here: http://www.investopedia.com/terms/r/returnonassets.asp
If management can get a double digit return from their assets, they should be able to grow the dividend, and that’s what I’m looking for. There is a lot of industry variance in this metric. If ROA is in the single digits, I will compare it to the company’s historical average over the last 10 years as a sanity check. The historical ROA for the last 10 years can be found on Morningstar.com under “key ratios”.
Fundamental 10: Return on Equity Target: double digits
This is supposedly Warren Buffets preferred valuation metric. If he pays attention to it, then so should I right? It makes sense. Equity in this sense is “shareholder equity”. As a shareholder I want to know that management is getting a good return on my investment. It’s like P/E but it’s presented as a percentage in the context of a return rather than a dimensionless ratio. The Investopedia definition can be found here and is worth reading: http://www.investopedia.com/terms/r/returnonequity.asp
Fundamental 11: Profit Margin Target: >0
I don’t know who said it, but it’s one of my favorite quotes: “Profit is an illusion, cash flow is a fact.” That’s why I don’t really have a specific profit margin target, other than I want it to be greater than zero. It may be an imaginary number subject to all different forms of financial engineering, but at the end of the day, you need to make more than you spend. Negative profit margins aren’t good, even if they’re imaginary. If a company actually states that they have a negative profit, it’s either because of one-off cost reconciliation, or it’s worse than it actually looks. Either way, I don’t want anything to do with the company. If it’s a one-off that may be fine, but why isn’t there a buffer built in? You’re clearly walking a fine line. If it’s worse than it really is, then forget it. I’ll save my capital for companies that can show a profit. Thanks.
Fundamental 12: EBIDTA/Total Revenue Target: Double Digits
I’ve worked for several privately held companies and let me tell you: private investors care a lot about EBITDA. A definition of the acronym can be found on Investopedia here: http://www.investopedia.com/terms/e/ebitda.asp
This a non-GAAP metric, and as such comes with all the caveats associated with made up financial metrics. But I have to say, that I kind of get it. As long as we’ve filtered out companies that have serious debt problems (fundamental #7) ignoring costs like interest, taxes, depreciation and amortization (for the life of me, I still don’t understand the difference between amortization and depreciation even though the definitions are clearly different: http://www.investopedia.com/terms/a/amortization.asphttp://www.investopedia.com/terms/d/depreciation.asp ) we should get a pretty good idea of the fundamental profitability of the business’ operations. You can’t control taxes. And assets that make you money lose value over time, and that loss in value has to fit into the spreadsheet somewhere, but it hurts your GAAP earnings calculation. EBITDA cuts through all of that, and dividing by the total revenue is another way to define “operating profit”. I like it because it gives me an indication of how efficient a company is. Taxes are taxes and we all have to pay them. So long as interest payments aren’t crazy, the D&A which I think are basically the same thing will all get written off, and we can cut to the chase regarding how much a company makes on its business activities.
Valuation Metric 1: Reverse DDM Fair Value DGR at Buy Price Target: Varies
This is my own metric. DDM stands for Dividend Discount Model and it’s one way to calculate a hypothetical “fair value” of a stock by discounting the current and future dividends back to their current “value” based on the anticipated dividend growth. Again, Investopedia offers a great definition of DDM (with a formula) here: http://www.investopedia.com/terms/d/ddm.asp
My problem with DDM valuations is that the assumed DGR has a huge impact on the “fair value” share price. This is because of the incredible power of compounding growth. Using a 10% “discount rate” a stock with a current dividend of $1.00 has a “fair value” of $50/share if the DGR is assumed to be 8%. But if we use an assumed DGR of 7%, the “fair value” of the stock is only $33.33/share. That is a 50% swing for a 1% difference in the assumed growth rate. It makes a lot of sense given the power of compounding growth (the growth rate exponentially influences the current value of the dividend.) But how can you feel confident in a projected growth rate, when we’ve already established that it’s just a guess? A table:
Well, that’s how I came up with “Reverse DDM Fair Value”. Knowing the dividend and the current market price, you can calculate a theoretical assumed DGR in the context of DDM analysis. In other words: if Mr. Market were using DDM, what is his assumed DGR? I prefer to look at my limit order purchase price per share in the context of what kind of DGR would be needed to make that price a “fair value”. I calculate my “margin of safety” (http://www.investopedia.com/terms/m/marginofsafety.asp) based on the difference between my assumed DGR and the implied DGR assumption of my purchase price. A couple of dollars difference in share price usually reflects a miniscule difference in assumed DGR. By comparing the difference between the implied DGR of the purchase price to the DGR I think the company can achieve, I’ve put my margin of safety in the context of the metric I care the most about: Dividend Growth.
Valuation Metric 2: Assumed DGR Target: More than Reverse DDM Fair Value DGR at Buy Price
See above. My DGR assumption is based on the historical DGR in the context of EPS growth (fundamental #3) and whatever other red flags my fundamental and qualitative analysis may have uncovered. I recognize it is totally a guess and slight changes between the actual results and my guess have a big impact on the implied value of my investment. That said, I will not make an investment without some DGR margin of safety. If I think the future DGR is less than the implied DGR of the market price, I will wait for the price to change.
Valuation Metric 3: DGR Margin of Safety Target: Varies but generally .5% or greater
Since the DGR Margin of Safety (also my own metric) is something of a sliding scale compared to the assumed DGR reflected in the purchase price there’s no sense putting a fixed value on the necessary delta. But 0.5% is a good number to use considering the kind of stocks I want to invest in. Regardless of what the current yield may be, I want to see it outperform inflation, which for the purposes of valuation I use an inflation rate of 3% which is higher than the Fed’s target rate. The difference between a 3% and a 4% assumed DGR is roughly equivalent to a 17% difference in share price.
Because I want both a high yield and high growth of that yield, I really want to invest in companies that I expect to grow their dividend at a 6% or better clip, which is twice the rate of my assumed inflation. At those kind of growth rates, a 0.5% difference between implied DGR and assumed DGR represents a ~15% or better “conventional” margin of safety (market share price versus “fair value” share price).
Valuation Metric 4: Dividend Cushion Ratio Target: greater than 1.0
Many thanks to Valuentum for introducing me to this metric. I discovered this concept on a “slow day” in October when I was clicking around the innerwebs instead of investing since prices were up. I now calculate the dividend cushion ratio for any new potential investment. My equation which is slightly different than the inventors’ equation is as follows:
[Cash from operations]x5 – [cash from investments]x5 + total cash – total debt = “projected cash”
[Cash dividends paid]x(1+DGR) + [cash dividends paid]x(1+DGR)^2 + [cash dividends paid]x(1+DGR)^3 +…+ [cash dividends paid]x(1+DGR)^5 = Sum of dividends paid over next 5 years (with assumed DGR)
“Projected cash” over next 5 years / Sum of dividends paid over next 5 years = Dividend Cushion Ratio
I try to use TTM numbers for all the inputs to the ratio calculation. If there’s some weird anomalous thing in the TTM cash flow (like a special dividend or an asset sale), I might make an adjustment. If there is some guidance on what actual Capex spending or actual dividend payments might be over the next 5 years, I might use those numbers instead of just multiplying the current numbers by 5. But basically my version calculates the cushion if todays numbers are exactly flat for 5 years, which I think presents a conservative scenario.
I don’t factor the reduction of shares through buybacks into the dividend portion of the equation even though buybacks could meaningfully affect the output. For example, the company could invest in itself through buybacks which would reduce the share count. Although the dividend may subsequently grow on a per share basis, the total cash spent on dividends would not increase at the same rate since there are now less shares. I don’t account for this because 1) it’s hard to know excatly how many shares will be bought since the share price is constantly fluctuating and 2) leaving it out only errs to the conservative side anyway.
It’s also worth mentioning that the calculation factors in ALL of the company’s long term debt. If a company has a cushion ratio less than 1.0 it doesn’t necessarily mean it can’t cover growing dividends. But it does mean it can’t cover growing dividends AND pay off 100% of its long term debt. This is inherently a very conservative metric.
Valuation Metric 5: Cash from Ops Cushion Target: less than zero, the bigger the negative, the better.
The value of this “cushion” is essentially how much of a hit the company could take to its current cash from operations and still maintain a dividend cushion ratio of 1.0. If this number is positive, it means the ratio is less than 1.0 and the company needs to generate more cash if it’s going to maintain capex levels and fund the dividend at the projected amounts. So a big negative number, means the company could face much leaner years and still comfortably pay the dividend. Essentially this seeks to answer the question, how much could cash from operations decline from current levels without affecting the dividend prospects.
Valuation Metric 6: Capex Cushion Target: greater than zero. The bigger the better.
The value of this “cushion” is essentially how much the company could increase capex spending for the next 5 years and still maintain a dividend cushion ratio of 1.0. If the number is negative, it means the ratio is less than 1.0 and the company needs to lower capex spending if cash flow isn’t going to increase and the dividend is going to continue to grow. So a big positive number means means the company could ramp up capex spending and still cover the dividend. Essentially this seeks to answer the question, how much more could the company comfortably spend on capex without affecting the dividend prospects?
Valuation Metric 7: DGR Cushion Target (delta): greater than zero. The bigger the better.
This tells us how much the company could increase dividends over the next 5 years and maintain a cushion ratio of 1.0. If the number is negative, it means the ratio is less than 1.0 and the company can’t raise dividends at the assumed DGR with current cash flow (and completely pay off long term debt). If it’s a big positive number, then excess cash flow could potentially go towards a larger DGR.
It’s worth noting this is expressed in percentage points, but it’s a delta, not a percentage increase. In other words if the assumed DGR is 7.5%. But the company could “afford” a DGR of 20.5% and still maintain a cushion ratio of 1.0, then DGR cushion (delta) would be 13%.
Valuation Metrics 5-7 are really meant to put the Dividend Cushion Ratio into context. Just because a company could raise the dividend at a 20% growth rate, doesn’t mean it will or should. The money might be better spent on capex or simply “saved” for a down cycle. The point though is to see how much wiggle room there is in the variables that make up the cushion.
Section 4 – LOL (Limit Order Logic)
I’m the first one to admit that I’m trying to time the market. To be fair I’m really only trying to time it on one side…it’s not like I’m trying to buy low and then sell high. I’m just trying to buy as low as possible. I disingenuously refer to it as bottom fishing. Investopedia’s definition can be found here: http://www.investopedia.com/terms/b/bottom-fishing.asp
My father-in-law called it gaff fishing. Maybe I’ll use that term instead. Theoretically the quantitative case (QC) outlined above makes a strong argument in favor of the stock price coming back up, but anytime you try to catch a falling knife, you run the risk of getting cut. My goal is to identify strong companies, that should be able to grow in the future, but whose share price is currently depressed by irrational, unfavorable market sentiment. I want to exploit market inefficiencies. Since I have a day-job and can’t sit in front of my computer all day waiting for the perfect opportunity, I use limit orders which lie in wait of temporary dips in the market price. It doesn’t cost me any more commission to set a limit order than a market order, and the order is “good until cancelled” meaning it can lie in wait for perpetuity. I’m a realist though, and I realize that there is a limit to how far a stock’s share price may vary during day-to-day market activities, so I set my limit orders based on some kind of “logic” as flawed as that logic may be. I use price charts to look for “support” and “resistance” levels. I factor in things like wave patterns and my gut feelings. These are horrible variables to consider in a long-term investment strategy. I don’t care. I maintain that “investing” is still fundamentally “gambling” at its core. This is how I make it fun. Don’t judge me.
Section 5 – QWaF (Qualitative Warm and Fuzzy)
Every stock pick has a qualitative element. This is the argument that, regardless of what the fundamental analysis may say, reinforces the investment decision. The market may have temporary inefficiencies, which I try to exploit by limit orders, but at the end of the day, we all have to have the “hand waving” argument, where we disregard the raw numbers and say, “this is a good idea because of blank.” The QWF is where I wave my hands and say, “this is a good idea because of blank.”
Section 6 – CPR (Cold and Prickly Risks)
What’s the opposite of warm and fuzzy? Cold and prickly. Every reward is offset by a risk, and I need to acknowledge the risk I’m taking with each investment. To make an investment the benefit must outweigh the risk, so any discussion of the cold and prickly must conclude with the specific conviction I have that compels me to accept that risk. Period end of story.