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How to Pick the Best Dividend Growers

I formed my methodology for picking dividend growing stocks over a year ago and practically all of my own stock purchases since then have been based on it. This is the initial presentation of the system, and I intend to improve and enhance it, possibly incorporating suggestions from commenters, and repost if any changes are made. Also, I intend to post the updated list of stocks produced by the system on a monthly basis.

But first I would like to give credit and express my appreciation to David Fish, without whose efforts in creating and regularly updating his CCC List (spreadsheet) this article may not have been possible.

Countless books and articles have been written about how to pick winning stocks and countless strategies have been offered for doing so. Strategies are as diverse as growth investing, value investing, income investing, technical analysis investing, momentum investing, dividend investing, Graham investing, Buffet investing, Dogs of the Dow, GARP, CAN-SLIM, Magic formula, Call/Put options selling, etc., just to name a few. I have been playing the stock market for about twenty years and over the years searched for "sure" ways to "beat the market." In my travails I jumped from strategy to strategy and at times made lots of money only to lose most of it during a following unexpected market event or trend. Seems to me most strategies revolve around timing the market in one way or another. I've learned that in the long run market timing as a primary strategy will not work, at least not for me. However, ever since I adopted the concept of dividend growth investing, I firmly believe it is one of the best ways to build wealth over time and with the least effort. And yes, I do use timing in my strategy to a limited extent in specific situations.

The system's goal: Find dividend growing stocks that have the best potential to achieve a 10% or higher yield-on-cost in 7 years

Why 7 years? It's a pretty good intermediate period for the long-term investor in my opinion (and for the system as well as for my own situation). Long enough to see some meaningful results, but not too long to make the system's findings too unreliable due to long-term market unpredictability.

The system will produce, by quantitative means (explained below), a list of stocks ranked by what I like to call the "Potency Score". This number is basically a forecast of a stock's 7-year yield-on-cost (abbreviated as 7YYoC). It goes without saying that no one can predict with any certainty what the market or a stock will do in the future; we are all making educated guesses mostly based on past demonstrated performance and results.

The system is best suited for longer term investors (5+ year horizon) and probably not very useful to short term investors or traders.

The Methodology

I start with the CCC List. This is the list of stocks that have been paying dividends and increasing their dividends annually for at least five consecutive years. The list has already done a good portion of the task for us and has separated the wheat from the chaff. It has reduced the several thousand stocks traded on U.S. exchanges down to 450. Furthermore, I removed the REITs and MLPs since metrics used are not appropriate for these sectors. I will not deal with MLPs here but will list the REITs separately, factoring in only the DGRs and the EPS growth rate. The system will start with the reduced list and will pick the stocks it forecasts would achieve a 10%+ yield-on-cost in 7 years.

The key to the methodology is to come up with a single best estimate - what I've named the Normalized annual DGR (NDGR); a metric to be use with the current dividend yield to calculate the Normalized 7YYoC (the Potency Score).

The parameters the system uses to calculate the Potency Score are:

  • The Dividend Growth Rate (DGR) for 10-, 5-, 3-, and 1-year periods
  • The estimated annual Earnings per Share (EPS) growth rate for the next five years
  • The Payout Ratio
  • The P/E Ratio
  • The current dividend yield

I'm also considering incorporating the long term ROE in the system as it's been shown to have a major predictive value in a company's ability to sustain and raise its dividend.

1. Dividend Growth Rates (DGR)

The four DGRs (for 10-yr, 5-yr, 3-yr, and 1-yr periods) are used as the core metrics for the calculation of the Normalized DGR (NDGR). I first "smooth-out" the four DGRs. If the DGR for any of the four periods is greater than 20%, then assume the DGR is:

20 + (DGR - 20)/8. Otherwise use the actual DGR.

The need for smoothing is due to the fact that large DGRs such as 50% or more are clearly unsustainable for several consecutive years and will produce unrealistic, erroneous results. I experimented with 15%, 25%, 30% and 40% cut-offs and found the 20% most suitable. I also tried various divisors and settled on 8. Furthermore, using different values for DGR cut-off and the divisor would still produce practically the same stocks and the same rankings, albeit with all higher (or all lower) DGRs. The significant effects would be only on a few stocks with very high standard deviation and extreme high/low DGRs.

Once the four "smoothed" DGRs are calculated, I give each a weighting depending on its period:

10-year x 3

5-year x 6

3-year x 7

1-year x 6

The logic behind these specific multipliers is to incorporate the acceleration/deceleration effect of the dividend growth. That is, the more recent DGRs have more weight. So, the 3-yr DGR is weighted more than the 5-year DGR, which is weighted more than the 10-year. The 1-year DGR's weighting is still high but a little de-emphasized due to its shorter period and volatility.

2. The EPS Growth Rate

I incorporate the EPS growth rate as if it were a fifth DGR, with a weighting factor of 10.

The combination of steps 1 and 2 will produce the un-adjusted Normalized DGR.

3. The Payout Ratio (PR)

I smooth out the Payout Ratio and add it to the above un-adjusted Normalized DGR value from step 2.

If PR <= 150 Add the following to the Normalized DGR: (50 - PR)/20

If PR >150 I use a somewhat more complex smoothing formula to calculate the PR adjustment.

4. The P/E Ratio

I smooth out the P/E Ratio and add it to the above partially adjusted normalized DGR value from step 3.

If P/E >0 Add the following to the Normalized DGR: (15 - PE)/8

This is the final adjustment and now we have our key metric: the adjusted Normalized annual DGR, or simply the Normalized DGR (NDGR).

5. Calculate the Normalized 7YYoC

Using NDGR and the current dividend yield we calculate the Normalized 7YYoC.

The calculation assumes a dividend reinvestment compounding of four times a year.

The Results

The Current Top 50 Stocks

Payout

TTM

Est. 5-Yr

Normalized

Normalized

Symbol

Yield%

Ratio%

P/E

Growth

DGR

7-Yr YoC

TEF

10.36

69.00

6.66

n/a

13.52

26.27

NPK

9.49

98.45

10.37

n/a

13.61

24.22

PNNT

12.11

87.80

7.25

4.2

9.72

23.72

CTL

8.76

142.86

16.32

9.7

12.86

21.24

TGH

6.51

41.25

6.34

11.4

16.47

20.15

STRA

5.22

41.07

7.87

7.7

19.01

19.14

LMT

5.51

50.06

9.09

9.6

16.14

16.67

TWGP

3.28

24.35

7.42

19.0

23.73

16.47

NC

3.36

13.32

3.96

56.4

22.66

15.71

RCI

4.15

56.57

13.63

6.6

18.79

15.00

DRI

4.02

50.74

12.61

12.6

18.76

14.52

EOC

4.78

58.97

12.35

2.5

16.14

14.46

AZN

6.09

46.71

7.67

2.0

11.66

13.60

RTN

4.21

31.62

7.51

8.9

15.63

12.31

HAS

3.68

45.63

12.40

14.8

17.53

12.23

VIVO

4.83

122.58

25.39

18.4

13.28

12.05

WSO

4.46

87.36

19.58

19.1

14.42

12.03

SJR

4.55

83.63

18.36

10.0

14.03

11.96

MO

6.12

100.00

16.35

8.1

9.49

11.79

UNS

4.66

62.22

13.37

3.0

13.49

11.79

SWY

3.49

40.28

11.55

9.6

17.72

11.74

BBL

3.81

23.65

6.22

9.1

16.00

11.41

GEF

3.92

34.36

8.77

8.7

15.54

11.39

BR

3.18

48.48

15.26

8.9

18.44

11.23

SBSI

4.00

32.00

8.00

1.9

14.91

11.14

HRS

3.28

24.35

7.43

9.3

17.64

10.97

AVA

4.61

61.11

13.25

4.6

12.20

10.70

BHP

3.04

23.65

7.78

16.8

18.36

10.69

LEG

5.66

94.92

16.77

14.4

8.99

10.54

THG

3.10

46.41

14.98

10.9

17.88

10.54

ACI

3.02

45.83

15.19

27.8

18.14

10.45

INTC

3.94

38.53

9.78

10.6

14.13

10.41

HCSG

3.93

119.81

30.45

16.4

14.06

10.35

NUE

4.58

97.97

21.38

11.7

11.62

10.22

NVS

4.22

55.49

13.15

4.7

12.79

10.18

TAC

5.14

82.21

16.01

20.9

9.63

10.00

RDS.A

5.46

37.46

6.86

n/a

8.67

9.96

RDS.B

5.41

37.46

6.92

n/a

8.67

9.87

CEO

4.00

27.18

6.79

7.3

13.08

9.85

WAG

2.74

35.43

12.95

12.4

18.49

9.70

PBI

7.87

89.16

11.33

8.1

2.90

9.64

JCS

4.62

40.54

8.78

n/a

10.29

9.40

INFY

2.65

49.67

18.78

16.0

18.12

9.15

RBCAA

3.48

14.10

4.05

10.1

13.99

9.11

LOW

2.90

38.36

13.25

12.3

16.67

9.09

NTT

3.05

29.20

9.58

8.0

15.83

9.04

AFL

3.43

31.58

9.20

11.8

14.07

9.04

EGAS

4.91

62.79

12.78

n/a

8.79

9.03

LLL

2.90

21.03

7.24

6.9

16.15

8.80

PPDI

2.34

41.96

17.94

16.8

19.31

8.75

The REITs

Payout

TTM

Est. 5-Yr

Normalized

Normalized

Symbol

Yield%

Ratio%

P/E

Growth

DGR

7-Yr YoC

OHI

10.04

666.67

66.38

5.1

8.24

17.77

DLR

4.93

259.05

52.53

11.8

16.97

15.78

SNH

6.87

138.32

20.13

8.3

4.16

9.18

UHT

7.20

198.36

27.55

2.4

2.03

8.30

NHI

5.84

87.23

14.94

5.9

5.00

8.27

UBA

6.14

148.48

24.20

5.0

2.72

7.42

ELS

2.39

110.29

46.10

8.9

15.85

7.10

HCP

5.48

91.00

16.62

7.8

3.59

7.03

NNN

5.73

181.18

31.61

4.8

2.93

7.03

O

5.40

165.93

30.70

4.3

3.09

6.70

Some Popular Stocks


Payout

TTM

Est. 5-Yr

Normalized

Normalized

Symbol

Yield%

Ratio%

P/E

Growth

DGR

7-Yr YoC

MCD

3.19

56.68

17.78

9.9

13.40

8.02

WMT

2.81

31.06

11.04

10.1

14.11

7.42

ABT

3.75

58.54

15.59

9.0

9.18

7.09

MSFT

3.21

29.74

9.25

9.7

11.11

6.92

YUM

2.31

45.78

19.84

12.6

15.59

6.73

GIS

3.17

46.74

14.75

7.5

10.74

6.65

CAT

2.49

30.41

12.20

22.4

14.27

6.65

PG

3.32

53.44

16.08

8.8

9.96

6.62

PEP

3.33

52.42

15.75

8.4

9.85

6.58

JNJ

3.58

54.55

15.24

5.6

8.46

6.43

KMB

3.94

66.04

16.75

7.3

6.85

6.35

CVX

3.37

27.25

8.09

4.4

9.05

6.30

CL

2.62

47.54

18.17

8.9

12.33

6.12

KO

2.78

35.01

12.58

7.8

9.54

5.38

The Overall Dividend Growth Investing Strategy

The primary objective of this article is to present a system for the stock picking aspect of dividend growth investing, but I will also summarize in brief bullet points my view on the overall strategy to make the article a one-stop shop. This is how I'm investing - almost a note to self.

  • Buy a large, diverse basket of these stocks, i.e. at least 30, in various sectors, including REITs. Both high starting dividend yields and lower yield, higher growers; both large caps and small caps; both foreign and domestic.
  • Buy gradually and over time, not all at once. Keep a watch list with your price targets and buy some as your target prices are hit. Keep adding to existing positions or buy new names as cash in the account accumulates. Dollar-cost-averaging is built in.
  • Dividends are allowed to accumulate and combine with fresh cash contributions, if any, to make new purchases. I prefer this over DRiP since I can put the money into my best idea at the time. However, I can not argue with the soundness of DRiPping.
  • When a stock has become cheap enough to hit your target is when you must decide whether the stock is accidentally cheap or cheap for a reason - this is where due diligence comes in. Even though the thesis for the stock was good when you added it to your watch list, it's time to re-examine.
  • I prefer the accumulated amount to be at least $2000 to initiate a purchase. For larger accounts, a reasonable minimum would be 1% of the portfolio value. This is to limit both the commission costs and more importantly the frequency of trades.
  • When to sell. Most would agree that one of the toughest things in investing is deciding when to sell and what to sell. With regards to dividend growth stocks there is a surprisingly simple method when it comes to stocks that have been performing too well. Compare the stock's current P/E ratio with its 3- or 5-year average. If the P/E has gone up dramatically, that could be an indication it may be a good time to sell and put the money into your current best idea. The same conclusion can be drawn by using the current dividend yield (not your yield-on-cost!) instead of P/E. This is the minimal market timing I hinted at earlier. But of course more often the reason for wanting to sell a stock is unpleasant, such as a dividend cut, declining revenues, weakening competitive edge, unexpected quarterly losses, etc. Each situation will require a case by case analysis and a final decision.

Conclusion

The system distills some of the most important metrics for dividend growth stocks into a single number, producing a ranked list of stocks with the best potential to achieve a 10%+ yield-on-cost in 7 years. Even though the stock picking methodology is purely quantitative, a certain amount of fundamental soundness is built into the system since it starts with the CCC List. I believe an important benefit of the system is it dramatically reduces one's research time. But still one should not simply jump in and buy the highest ranked names. Naturally company situations constantly change and one must use due diligence and additional research before committing to any investment.

The system is equally useful to investors who favor higher starting dividend yields with lower DGR as well as those who prefer higher growth over initial yield. It allows both groups to potentially achieve their target 7YYoC while choosing very different stocks. One can even choose to swing for the fences by going for the high yield, high DGR names.

I hope the readers can take away some benefits from this article, and again all constructive comments are welcomed.

Source: A System For Picking The Best Long-Term Dividend Growers