Updated by BM on October 4, 2023
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
Safety is not in the number of stocks you own but in the quality. In our three-step dividend growth investing process, looking for ‘quality’ companies is where we start. Without a quality company to invest in, not much else matters. Here is a list of ‘quality’ indicators that we use:
Cyclicality
To assess a company’s quality, we begin by examining its historical earnings pattern. We evaluate whether the company has consistently achieved substantial earnings growth over the past decade or two. Companies that have maintained such growth are deemed more reliable and stable in comparison to those with erratic earnings during the same timeframe. This is primarily because companies with unpredictable earnings can often lead to misleading signals in terms of their valuation.
To steer clear of valuation errors and the necessity for precise market timing, our focus is directed towards companies whose earnings patterns are non-cyclical. This means we prefer businesses whose earnings are not significantly influenced by economic cycles or market fluctuations.
Dividend Growth Streak
Once we establish that a company exhibits the historical earnings pattern we prefer, which is typically non-cyclical, we then shift our focus to identifying a streak of dividend increases lasting at least 10 years. The longer this streak persists, the higher we consider the quality of the company.
Payout Ratios (Dividends vs Earnings) (Dividends vs Cash Flow; OCF and FCF)
Companies pay growing dividends from their growing cash flows. To ensure that the company can actually afford the dividends that it pays out we look at payout ratios. After all, we do not want to be the victims of a dividend cut that reduces our incomes and probably causes the stock price to decline.
Low payout dividend payers have traditionally done better than companies with high or negative payout ratios. Figure out the industry average and measure against it.
Dividend Growth Rates (5YR and 10YR)
We are looking for consistent dividend increases. The lower the starting yield, the higher the growth rate and time horizon required to achieve our income goals.
Growth Yield
Growth yield refers to the acquisition yield on cost of a stock, which takes into account the current annualized dividend payments in relation to the original cost basis of the investment. We like the term growth yield better as it proves that growth (a key part of our strategy) has indeed happened and highlights the yield you are now making on dividends alone.
Based on our experience, creating a stock portfolio with an average estimated growth yield and historical growth yield of greater than 7% after ten years has proven to be a reliable indicator of quality. Many of the companies we invest in beat the market on yield alone after only ten years
Recent Dividend Increase
A recent dividend increase is a positive statement by management that they have confidence in the business going forward.
Dividend Growth and Price Growth Alignment
Identifying companies whose dividend growth aligns closely with price growth can considerably enhance the predictability of future returns. Dividend growth investors know that the dividend drives the price in a predictable way, not the other way around.
Market Cap
Market capitalization is also an important indicator to consider when evaluating a company’s quality. It represents the total value of a company’s outstanding shares of stock and is calculated by multiplying the number of outstanding shares by the current market price per share. Companies with larger market capitalizations generally have more resources, a more established track record, and less volatility than smaller companies.
Although we review the above indicators as they are readily available for all the stocks we invest in, we find the independent research from services that sell information for a living to be the most informative.
Here are three additional ‘quality’ indicators we use when they are available:
Value Line’s Safety Rank
Measures the total risk of a stock relative to approximately 1,700 other stocks covered by Value Line. The safest stocks are assigned a rank of 1, whereas the riskiest ones are assigned a 5.
Value Line Financial Strength
Ratings, from A++ to C in nine steps. The lowest rating is reserved for companies in serious financial difficulty. Factors considered in assigning ratings include balance sheet strength, corporate performance, market capitalization, and stability of returns.
S&P Credit Ratings
Help investors determine investment risks. Ratings are either investment grade (AAA through BBB–) or speculative (BB+ through D).
A good practice is to rank your watch list of dividend growth companies by quality based on a combination of the metrics above. This along with your income goals and time horizon will help you with your position sizing as you build your portfolios.
