In this article, we explain our method for building a wish list of dividend growth stocks worth considering. In future articles, we will suggest good target entry prices and options strategies to efficiently build and manage a long-term portfolio.
The main metric we use to identify good Dividend Growth Investing candidates is our Dividend Score. The score is both backward and forward looking. Past performance and track record gives confidence and guides expectations regarding the future, but only the actual future performance will reward an investor.
The Dividend Score is instrumental in assessing the current attractiveness of a dividend growth stock and the likelihood that the dividend continues to increase in the future. It is computed based on several metrics:
Years of consecutive dividend increases.
Dividend growth rate over various time frames.
Next Year and Next 5-Year Earnings growth forecasts.
Payout Ratio relative to earnings and to free cash flows.
Financial health indicators.
The decision to purchase a stock is made based on a strong Dividend Score AND an attractive valuation.
- A dividend Growth Stock is only worthy of consideration for a purchase if its current Dividend Score is above 60. A score above 70 is considered strong. Among all the stocks in David Fish's cleaned CCC list as of December 31, 2012, the two stocks with the best Dividend Score are Lockheed Martin (NYSE:LMT) and McDonald's (NYSE:MCD) with a score of 86. Fourteen have a Score above 70.
- An attractive valuation can be assessed by comparing Price/Operating Earnings to their historic value and their fair value. One tool among many that we find extremely useful in this regard is Mr. Chuck Carnevale's FastGraphs.
So what does the ranking method give at the current juncture? You will find in the table below the Top 20 stocks with the highest Score. Note: only stocks with a yield above 2.5%, composite dividend growth rate (DGR) above 5% and market cap above $10 billion are considered. Years refer to the years of consecutive increases.
|4||Procter & Gamble||PG||84||3.31||56||9.7|
|8||Automatic Data Proc.||ADP||76||3.06||38||10.2|
|9||Johnson & Johnson||JNJ||74||3.48||50||7.8|
There are a few things worth noting:
First, there is little surprise in the list, which means the Dividend Score is doing its job. But it also means that there are less and less "hidden gems" for dividend growth investors in this market right now.
Second, the recent rally has compressed Dividend Scores, which are generally lower than a few month ago. You can see in the September ranking that there were 29 companies with a Score above 70, three of which with a score higher than the current top one of the list: Walgreen, Altria (MO), and Emerson Electric.
Third, everything else being equal, if a stock on the wish list established thanks to the Dividend Score decreases in price, its score will mechanically be boosted.
So now that we have a wish list, what's next? Well, this is all about opening positions only when valuation is fair. In other words, what is the target price to get in? Indeed, the experienced reader will have noticed that a number of stocks in the list are currently overvalued. The best examples from the list below would be Nucor, or Procter & Gamble. In spite of the company's strong fundamentals, we believe that the price of PG is currently 10 to 15% higher than what would be an attractive entry price.
Rather than entering a limit order and wait, we believe the best way to act here would be to sell cash-secured puts on PG. As a purely illustrative example (it is always better to sell a put after a few down days, given that these are generally associated with an increase in volatility, hence in option premium), one may consider selling the January 2014 put with a strike of $62.50. As of yesterday's close, it quoted $2.37. An option controlling 100 shares, this means that you would receive $237 for accepting the obligation to purchase 100 shares of PG at a price of $62.50 (more than 10% the last close). The yield on this trade is 3.79%, which is higher than the current dividend yield on PG!
We will offer more details and examples of this kind of strategies for stocks on our Top 20 list in the coming weeks and months.