If you're a dividend growth investor you should first look at profits and profit growth not yield or dividend growth rates.
A growing stream of profits provides far more income protection than dividend increases or dividend yield, plus the opportunity for capital appreciation is shifted in your favor.
The New Chowder Rule provides dividend growth investors with a simple view of owner earnings strength and owner earnings growth in one number.
Profits Are Oxygen, Dividends Are Fire
About eight months ago I read this article about the Chowder Rule. In that article, there's a great reference to Lowell Miller's book, "The Single Best Investment" which boils down to this:
"...the hidden key to the single best investment is dividend growth. The reason dividend growth is so important for long-term investors is because dividend growth is what drives the compounding machine in a way that is certain and inevitable. Dividend growth is an authoritative force that compels higher returns regardless of other factors affecting the stock market."
This idea really struck me as being true, in a deep sense.
But, since reading about the Chowder Rule and Miller's book, something else struck me. It seems that most people like to focus on the certainty and inevitability of the payments.
I understand this focus because dividend growth investors appreciate income. A steady flow of cash from dividends is quite reassuring, like Mom's hug.
Many dividend growth investors care about fundamentals but it's not their focus. It's almost a badge of courage to ignore what's happening to the fundamentals of the business. While price of entry often matters, along with yield, the core success of the business doesn't always get close attention.
Now, I love dividends but I've realized that I love compounding more. I'm not talking about growth investing, or chasing glamour stocks like (NASDAQ:AMZN), (NASDAQ:FB) or (NASDAQ:TSLA). I'm talking about companies that reliably compound owner earnings over time. Even better, I like dividend paying companies that compound profits like King Kong.
Dividends Come from Profits
Dividends don't exist in a vacuum; they are derived from the profits of the company, or through debt which cannot go on indefinitely. So, it's profits that ultimately matter to your dividends flowing, not debt.
That said, the compounding machine inside a business is more important than the dividends themselves. You can't have dividends without profits, although you can have profits without dividends.
Therefore, profits are superior to dividends.
In cold logical terms, profits are necessary whereas dividends are merely sufficient. You can have only have "fire" (dividends) if you have "oxygen" (profits).
Chowder Rule, Redux
I respect the Chowder Rule and I think it's a wonderful shorthand for identifying strong dividend cashflows based on strong companies. But, by definition, it's all about dividends.
This got me thinking. Since dividends require profits, maybe there's a way to create a Chowder Rule for profits?
So, here's what I did. I "replaced" dividends with profits and dividend growth with profit growth. Very specifically, I started looking at Owner Earnings and Owner Earnings Growth Rates.
To keep everything super simple in my brain, and for illustration purposes here, let's use two tools: Gurufocus 10-Yr Financials (EBIT per Share) and F.A.S.T. Graphs Adjusted Operating Earnings Growth.
(When doing my own deeper analysis, I also heavily use the Old School Value Stock Screener.)
DISCLAIMER: Ideally, we'd use "pure" owner earnings numbers and owner earnings growth rates, but they are hard to come by and they are imprecise. EBIT certainly isn't the pure Warren Buffett Owner Earnings number, but it's in the ballpark and it's "good enough" for wagging my thumb in the air. And, I know the F.A.S.T. Graphs operating earnings growth number isn't perfect. But again, it's "good enough" and acts as a reasonable proxy of owner earnings growth, especially for our purposes here.
To keep everything blunt and simple for the sake of clarity, we're looking at EBIT per share + Owner Earnings Growth Rate to give us our "New Chowder" number.
So, for PetSmart (NASDAQ:PETM) the calculation would be $6.78 EBIT divided by current share price of $59.24, then multiplied by 100 to get our Normalized EBIT Share Value of 11.4. And, we get 20.4 for our Growth Rate Number from F.A.S.T. Graphs. Then, we add those two numbers together for a total of 31.8 for our New Chowder number.
This calculation gives the profit per share (Normalized EBIT Share Value) plus the profit growth per share (OE Growth Rate Number). If you squint, this a calculation that is like the Chowder Rule. But here, our calculation is based on profits versus dividends.
Ranking 10 Stocks in My Portfolio
As a quick reminder, the EBIT Share Number tells us how much profit we're getting for the share price. I've just normalized it so that we can easily add that number to the Owner Earnings Growth Rate.
You might also notice that all 10 of these stocks are on David Fish's CCC List. Most of the stocks in my portfolio are on that list.
As a matter of reference, it looks like according to F.A.S.T. Graphs, NOV, PETM, CVX, IBM and AFL are undervalued. CMI, VZ and WMT are fairly valued, PM and KO are slightly overvalued.
I think it's interesting that higher New Chowder Numbers line up with undervaluation and lower New Chowder numbers line up with fair value and overvaluation, per F.A.S.T. Graphs.
The New Chowder Rule isn't meant to replace the original Chowder Rule. Instead, it's meant to allow investors to peel back one layer of the onion so that we can quickly get a feel for company profits and growth, which is the key driver of dividends. A pleasant side effect is that I've found several undervalued companies in this bull market by looking closely at owner earnings and owner earning growth rates.
I've increased my conviction that I've got the right stocks in my portfolio because they are profitable and growing those profits. Most of my stocks also pay a growing dividend, and I have confidence they have room to grow those dividends because the earnings are strong and growing. I also believe the New Chowder Number gives me strong clues about capital gains but that's a topic for another article.
Disclosure: The author is long NOV, PETM, AFL, CMI, VZ, CVX, WMT, IBM, PM, KO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.