"Look for your choices, pick the best one, then go with it" (Pat Riley, former Head Coach of the NBA champion Miami Heat)
Today many investors are chasing dividend-paying stocks no matter what price the stock is selling for. With interest rates so low it's understandable that a healthy dividend is major consideration when choosing a stock. Yet this is a stock-picker's market and we all need reasonable criteria for choosing stocks while aiming for bargain prices.
The purpose of this article is to remind us that there are 3 essential considerations (or rules) for choosing stocks that offer dividends. Investors can use them (Buy the best companies, Buy at the lowest price possible, and Buy stocks with rising dividends) to enhance the chances of experiencing the positive total returns investors desire.
Buying Season in the Investment Markets
We've apparently entered the stock market correction season. Pullbacks will likely be similar to what investors experienced in the last two weeks in June. The "window of opportunity" to buy opportunistically opens and closes faster than ever before.
That's why these investment considerations are important to know and understand now before the next leg of this ongoing bull market takes off. It's important to know what we want to own and why before the best companies pull back to more reasonable price levels. It's a "ready, get set, not quite yet" approach that I'm suggesting. The following 3 "rules" are not only helpful but critical to having a greater chance of investing success.
Buy Quality: When choosing a stock to buy, whether it's for capital gains or dividend income, pick the best companies you can find. It really isn't rocket science but I'm not saying it's easy either. Choosing the best companies in a sector that have a long track record of profitability and have increased the dividends year-after-year is a good place to begin. It's also important that the company has a product or service that its customers can't live without.
A good example is California Water Services Group (NYSE:CWT). Founded in 1926 and headquartered in San Jose, California, CWT provides water utility and other related services in California, Washington, New Mexico, and Hawaii. It engages in the production, purchase, storage, treatment, testing, distribution, and sale of water for domestic, industrial, public, and irrigation uses, as well as for fire protection.
The company is also involved in non-regulated water-related activities, including operating water and waste water systems; providing operating and maintenance, meter reading, and billing services to municipalities and private companies, as well as lab services for water quality testing.
To make sure it is diversified enough CWT also makes money leasing communication antenna sites on its properties to telecommunication companies and operates recycled water systems. It also provides sewer and refuse billing services to various municipalities.
No wonder CWT is on an elite list of dividend-paying companies that have raised dividends for at least 25 consecutive years. Its current 64 cent-per-year dividend represents a sustainable payout ratio of 57%.
One of the key financial metrics I like to look at for a company like CWT is its operating margin. It measures how much of a company's revenue is left after subtracting for operating expenses and the cost of goods sold.
Another way to determine the operating margin is to divide the operating earnings by the company's revenue. This equates to a percentage that indicates its profitability. CTW had a 16.44% operating margin as of the end of the first quarter of 2013.
Yet before I would buy shares of CTW I'd want to compare its financial statistics with a peer who also has a similar record of raising its dividends for at least 25 consecutive years. The only company that fits that description is American States Water Company (NYSE:AWR).
Since 1929 this San Dimas, CA headquartered company, together with its subsidiaries, provides water, electric, and contracted services in 75 communities in 10 counties throughout the state of California. AWR pays a $1.62 annual dividend which represents a sustainable payout ratio of 45%.
Its operating margin is nearly 50% higher than that of CTW. As of the end of the first quarter of 2013 it was a whopping 24.66%. Another key metric is the year-over-year quarterly earnings-per-share (EPS) growth.
As of March 31, 2013 AWR reported quarterly EPS growth of 33.1%. CTW in the same quarter had a slight loss. The analysts who cover CTW look for total annual sales growth (revenue) in 2013 of only 2.1%.
Sales and revenue growth for AWR for 2013 is projected to be around 3.6%. What popped out at me when comparing AWR versus CTW is that AWR has surprised to the upside in EPS the past 4 quarters by an average surprise percentage of 31%. CTW surprised to the downside regarding EPS in at least 2 of the last four quarters.
Here's a 1-year comparative chart showing AWR's stock performance versus CTW's. AWR is clearly the "quality" winner from this perspective too.
Now it's time to introduce the second consideration or "rule". It's secondary to choosing the kind of quality companies that offer both growth and the potential for higher dividends.
Buy Low: As the father of value investing, the late Benjamin Graham believed, waiting to buy a stock after a correction offers what he called a "margin of safety" for the investor. It also offers a dividend-paying stock with a higher price-to-yield.
For example, if an investor waited to buy AWR until it corrected on June 24, 2013 intraday low of $51.29 the dividend yield-to-price would increase to 3.16%. AWR closed on Friday June 28th at $53.67 with a yield-to-price of 3.02%. So by waiting patiently to buy low an investor has more upside potential for capital gains plus a higher yield which is likely to increase with companies that take pride in raising dividends annually.
An auspicious way to set a buy limit price is to consider a chart like the following of AWR which illustrates its annual trading range and its Bollinger Bands. Bollinger Bands give a current snapshot of when a stock may be perceived as either overbought or oversold and on sale.
Keep in mind that Bollinger Bands are a technical indicator of volatility as well as a way to measure the "highness" or "lowness" of the stock price relative to previous trades. Looking back at the prior year we can see the periods when AWR corrected before moving to the higher Bollinger Band level. Looking at historical pricing may be helpful for finding low entry points.
The essential takeaway for us all is that we are well-advised NOT TO CHASE STOCKS. Carefully choose a buy-limit price that seems reasonable and possible. Why not buy at the lowest prices possible? While you're at it, why not...
Insist on Stocks with Increasing Dividends:
As long as revenue and EPS are growing and the company's operating margin is healthy it should be able to increase the dividend each year without excessive borrowing or leveraging tactics. That goes for any of the best dividend-growing companies.
What I call "The Minimum 25-year Dividend Increasing Champions" are a qualitative list that I'll be writing more about in future articles. This list includes a number of pairs from the same sectors.
Another example of this would be Johnson & Johnson (NYSE:JNJ), which is one of the "Dividend Increasing Champions" and Medtronics (NYSE:MDT) which is another one. JNJ is a more diversified company but both compete in the medical devices arena.
Apply similar qualitative comparisons like I did above with CWT and AWR. Look at each company's debt load, payout ratio, revenue and EPS projections and its operating margin. Then go to the company website and read the latest annual and quarterly reports. Examine the analysts' estimates for the quarters ahead as well as the full year. Then study the historical prices of the stock you're considering. This is the uncommonly sensible approach to carefully choosing the stock candidates that you want to own.
Then be patient, exceedingly patient. Consider that the best times to buy the best dividend-paying companies is when the group is being sold off during a gut-wrenching market correction. Perhaps we'll experience one of those between now and the end of November. In fact, July through November are historically the months where stock market pullbacks are common. September and October are historically the most vulnerable months for significant corrections.
The Bottom Line: If you're determined to buy quality companies that are shareholder-friendly with a tradition of increasing dividends and stock buybacks now's the time to make your plans and set targets. Then if you're willing to wait as long as necessary until those stocks go "on sale" you'll give yourself the additional margin of safety that increases your chances of a satisfyingly positive investment outcome.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AWR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.