What I Look for in a Dividend Growth Stock

In 2015, I began a series on Daily Trade Alert called Dividend Growth Stock of the Month (DGSM).

I am happy to report that DTA and I have agreed to continue this series into 2016. I enjoy writing these articles, and I hope that they have been helpful to you.

[ad#Google Adsense 336×280-IA]If you have read any of them, you probably have some idea of what I look for in a company and its stock.

I try only to focus on high-quality companies that seem worthwhile for a dividend growth investor to consider.

The stocks I have written about are stocks that I would like to own.

And in fact, I either did own every one at the time of writing, or purchased it shortly after each article appeared.

My December stock, Main Street Capital (MAIN), cost too much when I wrote the article.

But shortly after, its price dipped, and now I own it along with the rest.

When I look at potential DGSM stocks, I want to find several things:

• A decent yield. For my own investing, I require a current yield of 2.7% or more. Some investors will accept a lower yield if the stock has a high dividend growth rate (DGR), while other investors may demand more income immediately with yields of 3.0% or higher.
• A decent history of increasing the dividend. I require at least 4% DGR per year for the preceding 5 years. I will make exceptions for stocks with high yields (over 5% or so).
• An understandable business. If I can’t understand how a business makes money, I won’t invest in it. It’s as simple as that. Warren Buffett famously has a “too-hard” pile. It’s a good idea.
• Favorable financials. I look at a series of metrics. They don’t all have to be great, but the overall picture must be good. You want to buy companies with sustainable financial growth prospects, because that is where your dividends will come from.
• Good valuation. Stocks, no matter what they are worth, are priced by the market. Sometimes they simply cost too much for the value that you get, and most of the time you want to stay away from those. Sometimes stocks are priced fairly, and other times they seem to be “on sale.” Those are the ones we want.

OK. Let’s go back through that list and put some meat on the bones.

Dividend Characteristics

I score each of the following:

Yield. As mentioned above, I personally want at least a 2.7% yield when I buy a stock. I grade yields along a scale where 2% would be called below average, 3% = good, 4% = above average, and 5% or higher = excellent.
Dividend growth rate. I look at the 5-year DGR, as well as the current year’s increase (if it has happened yet) and last year’s increase. I think 4% growth per year is OK; something around 7% is good; and 10% or more is excellent. I also look at the trend; I do not like to see a downward trend, although if the yield is high, that may not be much of a concern.
Years of increases. David Fish’s Dividend Champions, Contenders, and Challengers document (CCC) shows how many consecutive years the company has increased its dividend. The minimum is 5 years, which is just OK, particularly considering that 5 years no longer includes the Great recession of 2007-2009. A streak over 10 years = good, and >25 years = excellent.
Payout ratio. The payout ratio means what percentage of profits (or cash flow) the company pays out as dividends. Grading may vary by business type, but for an “average” company, a payout ratio below 40% might be excellent, <60% = OK, and >80% = danger zone. Certain companies can pay out more, because their financial models allow it. Tobacco companies are a good example.

I typically use a table like this to display these statistics. It is designed to give you an overview at a glance. I supplement the table with a discussion of noteworthy points.

CaptureCompany Fundamentals and Quality

Next comes a discussion of the company’s quality. This is a nebulous term, but I focus on several financial metrics as well as third-party opinions to get a handle on it.

• Return on equity (ROE). This is a measure of management effectiveness. It is the ratio of profits (return) to the total value of the company (equity). A ratio of 15% is generally considered to be pretty good. Anything above 25% is excellent (and not seen very often). I also take a look at the number of years out of the last 5 that ROE exceeded 14%. I like to see consistency.

• 5-Year Earnings Growth Rate. Company earnings (which means official profits) sometimes hop around, with declines in a few years and increases in the majority of years. Some companies display steady growth. I look at the past 5 years’ growth rate, because it usually catches a decent sample of good, average, and poor years. A steadily declining growth rate may be a red flag. Many good dividend growth stocks are relatively slow growers, and therefore I consider 7-8% growth per year to be OK, 10% to be good, and 20% to be excellent.

Projected Earnings Growth Rate. Stock analysts (employed by brokerage houses and the like) project expected earnings growth looking forward 3-5 years, and these estimates are collected and averaged out by data providers such as S&P Capital IQ and Morningstar. The estimates really are educated guesswork, but the average may help give you an idea of the company’s future outlook.

Debt/Equity Ratio. Many companies operate with debt as normal operating procedure. They carry debt coninually. In fact debt-free companies are rare. The average company on David Fish’s CCC carries a D/E ratio of 1.2 (or 120%). That number has climbed in recent years with the extremely low intrest rates available for borrowing. It will be interesting to see whether the ratio drops as the Fed slowly increases interest rates.

• Independent Quality Ratings. I track at least 3 ratings for quality from independent companies: S&P’s credit rating; S&P Capital IQ’s quality rating; and Morningstar’s moat rating. (A moat is a sustainable competitive advantage.) All of these are opinions, of course, but again they can create a foundation for understanding, especially when they point in the same direction.

Again I use a table to summarize the factors and provide additional discussion for furhter insight.

Here is how I summarized these factors for Microsoft (MSFT) earlier this year.

CaptureThe Company’s Story: How Does It Make Money?

It is common when you read stock analyst reports to encounter rote descriptions of the company’s business, how it is organized, when it was founded, what its brands are, and so on.

That’s not enough to know, and indeed many analyst reports go well beyond that. My own rule is that I require myself to understand how a company makes money and why it might be expected to continue to do so.

Some companies’ business models are too hard to understand, or they do not stand up to sensible scrutiny. Or they are outside the area where you have confidence in your own ability to understand.

Every investor’s area of competence and understanding may differ. A business model that makes perfect sense to me may sound ridiculous to you, and vice-versa. Warren Buffett has repeatedly made a great point about this:

There’s a whole bunch of things I don’t know a thing about. I just stay away from those. I stay within what I call my circle of competence. Tom Watson [founder of IBM] said it best. He said, “I’m no genius, but I’m smart in spots, and I stay around those spots.”

To figure out the company’s Story, I research analyst reports, the company’s website, articles about the company, and the like.

When I say “understand” how the company makes money, I don’t mean that I need to understand all the technical details about its products. I do not need to understand much about software coding to make an informed assessment about Microsoft, for example. But I do need to understand Microsoft’s market position, the likelihood that they can maintain a dominant position, and the like.

Stock Valuation

This is the last area for inquiry, and it is very important. In the earlier areas, we were looking at the company: Its business, characteristics, prospects, and the like.

In valuation, we are looking at the stock. In particular, we want to compare what we think it is worth to the actual price that it is selling for.

You might be thinking, the market determines the price, so the price must be right, because all these people and institutions are trading the stock. Doesn’t the “wisdom of crowds” take over and determine the proper price?

Over long periods of time, that seems to be generally true.

But sometimes a particular company’s stock, or even the entire market, can undershoot or overshoot intrinsic value. All of those traders are emotional beings working with future projections (or algorithms based on short-term price movements). As a result, the wisdom of crowds can be wrong.

I use a 4-step process for valuing companies. It is described in Dividend Growth Investing Lesson 11: Valuation. I will not repeat all of that information here.

I just want to illustrate what I mean by a stock’s actual price departing from its intrinsic value. The following is a FASTGraph for the stock that I wrote about in December: Main Street Capital (MAIN). On this chart, the fair price (or intrinsic value) of the stock is shown by the blue line, while the stock’s actual price is the black line. The chart covers 2008 to the present. The gray shaded area at the left is the Great Recession, which ended in 2009.

CaptureYou can see that over the years, MAIN’s price has wandered back and forth through the fair-value price. The actual price is sometimes above fair value, other times below it. But the fact that it keeps wandering through the fair price suggests that, indeed, the wisdom of crowds does work over the long haul.

But you can also see that MAIN’s price is rarely on its fair value. Practically all of the time, it is not.

That is why I suggest buying stocks at good valuations. If the forecasts and your own analysis point toward continued business success – meaning that you expect earnings to continue to rise – then buying at fair value or below improves your chances of success. The “gravitational pull” of fair value will more likely pull the stock’s price upwards.

Earlier I mentioned that when I wrote about MAIN earlier in December, I did not own it. But in my rollover IRA account, I placed a limit order for it, with a trigger price of $29.00, a little less than when I wrote the article.

I wanted the stock, but at a better valuation. As you can see by the dip at the right end of the graph, the stock momentarily hit the price I wanted, and my order was executed.

I look at 3 areas in evaluating what stocks to buy:

• Dividend characteristics.
• The company’s quality and financial situation.
• Valuation.

If all 3 seem positive, I will consider buying the stock. I need all 3. A negtive picture in any one of the areas is enough to knock a stock out of contention.

I hope that you have enjoyed this overview of what I look for in dividend growth stocks. I invite you to follow the Dividend Growth Stock of the Month series in 2016.

— Dave Van Knapp