Picking Stocks for Our Dividend Growth “ETF”

November 16, 2016
By

Welcome back to our project to build a general-purpose dividend growth “ETF” at Motif Investing. We hope to launch the new portfolio on January 1.

For background, please see these two previous articles about the project:

We’re Building a Dividend Growth “ETF” that Anyone Can Invest In!
Our Dividend Growth “ETF”: Business Plan

Today, we get into the fun part of investing: Picking stocks. We start to put the strategies into action.

Pre-Existing Lists

Because we are following the 5-year rule – all stocks in the Motif portfolio must have at least 5 straight years of dividend increases – all of our candidates appear on the Dividend Champions, Contenders, and Challengers list.

But that’s more than 750 stocks, an overwhelming number. We need to find the best candidates among them.

To start to pare them down, I turned to some pre-analyzed stock selections:

• My own Dividend Growth Stocks of the Month
• Mike Nadel’s Dividend Growth 50
• Jason Fieber’s Undervalued Dividend Growth Stocks of the Week
• Brian Bollinger’s various portfolios at Simply Safe Dividends, such as his Top 20 and portfolios for conservative retirees and long-term growth.

After combining all those sources, plus a few others, I had a list of around 200 dividend growth candidates that had been identified by researchers that I respect. In compiling those, I encountered some other worthy names that I added to the candidates.

That’s a good start, but the number is still far too large for our portfolio. A Motif portfolio can contain a maximum of 30 stocks.

So it is time to subject them to our own criteria.

Scoring Factors

I have been scoring or grading stocks for years. I love to do it. Scoring or grading allows us to play different factors off against each other. No company is perfect. Grading companies helps us find the best ones for our goals.

Our scoring guidelines divide into 2 categories:

• Metrics that can eliminate a stock if minimum values are not met; and
• Metrics that cannot eliminate stocks on their own, but are used in the scoring system.

The idea is that some factors are so important that if a stock falls short of our minimums, we don’t want to waste any more time on it. Minimum yield is an example; an unsafe dividend is another.

Other factors, while important, don’t warrant elimination of the company on their own. An example would be high debt. While we don’t like high debt, some companies are superb at managing debt, especially in the low interest rate environment of the past few years. So we will keep them in the running, scoring them on all the factors to see whether they might qualify on overall strength.

Here are the scoring factors.

1. Metrics that can eliminate a stock

Based on the minimum requirements stated in the last article, these metrics can eliminate a stock. If not eliminated, the stock scores the number of points indicated. In scoring, some of these factors count double.

a. Yield (counts double)
1

b. Years of Consecutive Increases
2c. 5-Year Dividend Growth Rate (counts double)
3

d. Dividend Safety Grades (counts double)

These are Simply Safe Dividend’s scoring ranges.

captureHowever, for our purposes, we will tighten up the system.

4e. S&P Credit Ratings

S&P is the best known of the credit agencies. Their ratings range from AAA (the best) to C (the worst). The ratings can be further nuanced by adding a plus or a minus.

The lowest “investment grade” rating is BBB-. We will require all qualifying stocks to be investment grade. This display from S&P defines the grades. As you can see, grades of BB and below are not investment grade ratings.

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This is how we score them.

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2. Metrics that don’t eliminate a stock but play a role in scoring

a. Moat

A moat is a sustainable competitive advantage. Morningstar assigns moat ratings.

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b. S&P Capital IQ Quality Ratings

S&P is one of many analysis providers that grade companies on various factors. I like to use their quality ratings, because they are an independent source.

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c. Return on Equity (ROE)

Return on Equity is a standard measure of efficiency in a company. It indicates how much return a company is generating per dollar invested in it.

captured. 5-year Estimated EPS Growth

The 5-year projected EPS (earnings per share) growth is an average figure taken from analysts that cover the company. I use the same scale as used earlier for DGR, because all else equal, a mature company will probably grow its dividend at about the same rate that its profits are growing.

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 e. Debt/Equity

A company’s debt-to-equity ratio compares how much debt it carries to the value represented in shareholders’ equity. It is a measure of how the company has set its capital structure: How does it finance itself?

My belief is that a reasonable amount of debt can be a good thing. It is the familiar “leverage” that you hear about. But too much debt –known as over-leveraging – can strangle a company.

Also, a high debt load can give a company a high ROE number. We credited high ROEs earlier. So if the company is achieving a high ROE via high debt, we penalize it for the high debt to balance things out.

capturef. Beta

Beta measures a stock’s price volatility vs. the S&P 500’s volatility. 1.0 is defined as equal volatility. So if a stock has a beta of 0.7, its price tends to move only 70% as much as the market, on average.

Generally, I prefer lower-volatility stocks, because they tend to give you fewer reasons to worry about price swings. There is also research that suggests that low-volatility stocks produce higher total returns.
captureStocks Already Eliminated

Based on their failure in one or more of the categories that can eliminate stocks, the following well-known companies have been eliminated from consideration. I won’t spend any more time analyzing them.
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It should be noted that I follow the convention that “raise” is measured in U.S. dollars. So stocks such as Royal Bank of Canada and Toronto Dominion Bank may have long enough streaks in their own currency, but not in U.S dollars (because of exchange rates).

Sneak Preview

Just briefly, I want to give you a glance at the scoresheets I am using along with a few examples of how the factors above work to separate the wheat from the chaff when it comes to dividend growth stocks.

Important note: The data below was recorded pre-election. It will be updated prior to the final selection of stocks for our “ETF.” The “X2” at the bottom of 3 columns indicates that those scores are doubled.

captureThe main takeaway from this sneak preview is how the scoring system uncovers significant differences among dividend growth companies. It forces you to consider all of the factors that we have elected to use.

The top-rated company in this sample – Nike – scores 26 points more than the lowest-rated companies.

Size of company makes no difference.

One of the lowest-rated companies, American Water Works, is a mid-cap utility, but the other is the giant bank JPMorgan Chase.

And Nike scores highly despite a low yield (1.2%).

Rather than size, fame, or yield, what causes the separation is a series of better values in important business metrics.

This shows up in the colors. The best companies at the top show almost all green. As you move toward the bottom, green turns to yellow and yellow turns to orange.

When you add it all up, the cream rises to the top.

I am going on vacation, so the next installment in this series will come in mid-December. At that time, we will update the data, re-score the stocks, and make our final selections. We still seem to be on target to launch the Motif “ETF” on January 1.

In the meantime, I would love to hear your ideas. If you want to give me some input, please email the editors at DailyTradeAlert. Let them know your thoughts, and they will pass them along to me. When I get back, I will consider everything and maybe add something to the model based on what I hear from you.

– Dave Van Knapp

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