DGI Lesson 14: Buying

Important Note from Daily Trade Alert: For dividend growth investors, the following lesson from Dave Van Knapp could be the most important information we publish this year. In short, it lays out the key steps you should take when deciding what stocks to buy and when to buy them. Our suggestion is to print out this lesson, keep it close by, and review it before you buy your next stock.

Dividend growth investing is largely about buying excellent companies and holding onto them.

Unlike other styles of investing, dividend growth investing is not about buying low and selling high. It is about buying low and then (in the ideal case) never selling. You are a collector. First you collect shares of stock. Then you collect the ever-rising streams of dividends from the companies that you own.

A good analogy is that it’s like being a landlord. Some people buy real estate properties so that they can flip them for a profit.

[ad#Google Adsense 336×280-IA] There is nothing wrong with that, but it’s not what a landlord does.

The landlord buys properties so that he can rent them.

Rents are like dividends. You collect them.

You can use them as spending money, or you can reinvest them into your properties to grow your assets and collect more rents in the future.

The key is that to a landlord, the focus is far more on the rents than it is on the market value of the real estate.

He is not intending to sell it.

A landlord typically looks for good tenants that he thinks will pay the rent reliably. A great tenant is someone who the landlord often wants to hold onto for years.

With dividend stocks, you look for great companies. In my Dividend Growth Stock of the Month articles, I evaluate companies for possible purchase. I am looking for great companies that will reliably send me “rents” (dividends) every quarter and raise them every year.

The following are the basic steps in deciding what stocks to buy.

Dividend Record

I expect to see at least 5 straight years of uninterrupted dividend growth, preferably more. I also want an initial yield of at least 2.7%, and a 5-year dividend growth rate (DGR) of 4% per year. I make exceptions to the latter requirement if the stock has a high yield, say above 4.5% or so.

On these metrics, more is always better, so the actual stocks that I purchase usually exceed those minimums. Here is what the values were on the first 4 stocks in the DGSM series:

CaptureApplying my minimum requirements eliminates all but 200-300 of all the stocks in the world.

We’re only going to look further at perhaps 2% of all the companies in existence. The companies that we are interested in are truly unique. That befits our buy-and-collect philosophy. Hopefully, we will own these for a long time. Therefore, we want the best.

Company Quality

The next step is to think about company quality. The dividend requirements above have already weeded out thousands of companies, but now we want to thin the field further.

I look at several factors for company quality. They are illustrated in this graphic from my recent article on Coca-Cola:

CaptureThere are 8 factors that I look at, and I grade them all.

• Return on equity (ROE) is a measure of a company’s efficiency and profitability. Anything above 12% is decent, anything below 6% is not too good. The higher the percentage, the higher the score. In the first row of the table, I rate the company’s ROE. In the second row, I rate how consistently the company has delivered its ROE. Coke has a good ROE and has been extraordinarily consistent in achieving it.

• In row 3, we examine earnings growth. Dividends come from earnings. No earnings, no dividends. The faster a company grows its earnings, the faster it can grow its dividends. As you can see, Coke has been challenged in this area recently, so it got a low score. The low score does not eliminate Coke, but it means that we look for better scores in other areas.

• Row 4: How much debt a company carries is part of its capital structure. Companies need to finance their operations, and the three major sources of financing are their own cash, debt (they issue bonds), and equity (they issue shares). Many companies have D/E ratios higher than 1, especially in this era of low interest rates when debt is cheap. On this factor, lower is better. Coke’s ratio of 0.8 is OK.

• In row 5, we go back to earnings again. This time we look at estimated earnings growth. The estimates come from analysts that cover the company. For a huge company like Coke, 5% per year estimated earnings growth is fair. It’s not outstanding, but it is acceptable.

• In the next two rows, we look at qualitative ratings from Standard & Poor’s. I score both S&P’s familiar credit ratings and what they call their Quality rankings. Higher is better on both. Coke did well on these assessments.

• In the last row, we look at another qualitative rating, this one from Morningstar. A moat is a sustainable competitive advantage. Examples of moats include strong brand names, patent protection, massive delivery systems, legal monopolies (like utilities), and product “stickiness.” In short, a moat is anything that helps the company keep its competitors at bay. Coke has a wide moat, in Morningstar’s estimation, meaning that it is unlikely to be dislodged by a competitor.

I score everything on a 5-point scale, and I use colors to indicate the score. Red is bad, yellow is OK, and green is good.

In determining what stocks to buy, I look for lots of green in that table. Coke has mostly green. All-in-all, I view Coke as a very high quality company. (Disclosure: I own KO.)

The Company’s Story

CaptureFamed investor Peter Lynch insisted that you should understand – at a macro level – the business model of any company before you consider investing in it. He thought that you should be able to reduce any investment’s core idea to a simple story.

If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.

I try to do that. If I were interested in Intel, for example, that does not mean that I need to understand the science or complex processes behind making semiconductors. But it does mean that I ought to be able to explain, in simple language, why Intel’s business is a good one and is likely to be successful for a long while.

You can see any of my DGSM articles for examples of Company Stories. For Coke, these were the major factors:

• It is the world’s largest producer of soft drinks.
• “Coca-Cola” and “Coke” are two of the best-known brands in the world, and many of the company’s product brands (like Minute Maid) are well known in their own right.
• Its huge scale gives it cost advantages that help lead to its superior ROE. Scale also gives you some pricing power.
• It controls one of the finest distribution systems in the world.
• It has been steadily reducing the number of outstanding shares for over a decade. Share reductions mean that each share represents a little bigger piece of the whole company.
• It has more than $21 Billion in cash.

It would be easy enough to write those out with a crayon.

Stock Valuation

The final step in deciding what to buy is valuation, which means deciding whether you can obtain the stock at a bargain price or a fair price, or whether it simply costs too much.

A good price helps you in at least two ways.

• Over the long term, it means that you are more likely to preserve your capital or make a profit than to lose money. Even losses “just on paper” can be psychologically difficult. Keeping them down helps you to stay the course.

• The lower the price, the higher the dividend yield. Here is the simple equation:

Yield = Dividends / Price

As you can see, as price goes down, the yield goes up (and vice-versa). The relationship is inverse. All else equal, you would rather have a lower price and a higher yield than vice-versa.

I have prepared a separate lesson on how I value stocks: DGI Lesson 11: Valuation. Different valuation methods yield different results, so I average out the results of 4 different approaches.

It is not hard to do, and the process is explained in Lesson 11.

Please note that just because a stock’s price has dropped recently does not mean that it is a bargain, and just because its price has risen recently does not mean that it is overvalued. Use valuation rather than price comparisons to determine what true value is. Price in a vacuum tells you nothing about valuation.

Takeaways from this Lesson

1. Dividend growth investing is largely about buying and holding high quality companies, so you want to take care in deciding what to buy.

2. An obvious area to examine is the company’s dividend record. Look for companies that show a long record of paying rising dividends each year, a good yield, and a good dividend growth rate.

3. Then evaluate the company’s quality. Since you intend to hold your stocks for a long time, you want to be sure that you own companies with great business models, wonderful financials, and sustainable competitive advantages. You are not looking for flash-in-the-pan companies. You want companies that have proven themselves over time and look to be able to continue to flourish.

4. Understand what the company does – how it makes money — well enough that you can explain it to someone else in a few simple sentences. If you cannot do that, think twice about whether you want to own it. This is a good defense against buying a stock on a hot tip or because its product is the latest fad.

5. Value before you buy. Try to purchase stock at a favorable or at least fair value. Do not pay more than fair value. Fairly valued stocks are almost always available, even when the market as a whole is generally overvalued. Try to find them. Be patient in waiting for good valuations to come along, they almost always do.

Dave Van Knapp