By Mark Bern, CPA CFA
This article is intended as the first of a series of articles about the selection process I use to create my master list of companies that, if combined in a diversified portfolio with attention to risk, return and sustainability, will provide a rising stream of dividend income combined with long-term capital gains to keep investors well ahead of the historic, long-term rate of inflation. My theory is that if an investor chooses wisely and builds a diversified portfolio of companies run by quality management teams with a history of successful growth and dominant positions in their respective industries the investor has a good chance of attaining his/her investment goals as long as those goals are reasonable. What is reasonable? Well, I don't know what is reasonable over the short-term so I won't even attempt to quantify that. But, over the long-term (five years or longer) I think that most investors can reasonably expect to attain a total return of ten percent per year and a little more if the investor is willing and able to reinvest dividends consistently.
The idea of getting a return of ten percent per year on average over the long term may sound pedestrian to some. But it is the risk adjusted rate of return that is of the greatest importance to me. Beating the S&P 500 index returns consistently without accepting additional levels of risk relative to the index is what I believe to be a good investing goal. And that is what we should be trying to achieve by selecting the right combination of stocks from a list that has been screened and analyzed, mainly by the process of elimination of the weaker stocks in favor of those with durable long-term potential and above average resiliency. In other words, if the market crashes the stocks on my list are, in my opinion, the most likely to weather the storms of economic malaise and rebound faster than their peers.
The process that I use to create the list may seem simple to some and complex to others; whatever your persuasion, I hope you will comment on my rules both in the positive and negative so that I can further refine my list and improve my process for the future. With that said, I'll start with my list of rules that companies must meet to keep from being eliminated from my list. Remember, it is a process of elimination to get down to less than 100 stocks from which to make our investing choices. The actual decisions depend upon the best value(s) available and the best fit for diversification purposes when we both have the funds available to invest and the confidence in the current market trends to pull the trigger.
Rule # 1: I only consider stocks that pay a dividend. If you don't like this rule, please refer back to the title of this article. This is about dividend-paying stocks. This does not mean that investors should only hold stocks that pay dividends. What it does mean is that this article only applies to those stocks that pay dividends and that the author is an advocate in favor of holding high quality, dividend-paying companies for the long-term making up the majority of an investment portfolio. In more normal times, I would also recommend significant holdings in fixed income instruments, as well. But we are not living in normal times. The main reason that I focus on companies that pay dividends is that over the long haul (since at least 1930) a significant portion of total returns on both the DJIA and S&P 500 have come from dividends. To put it into perspective the average dividend for the S&P 500 since the late 1800s is 4.39 percent. Of course, the index didn't exist until 1957, but this data represents a reconstructed index of the 500 largest U.S. companies over that period and came from S&P and Robert Shiller, so I believe it to be an accurate portrayal. In another article I found that according Standard and Poor's dividends accounted for 44 percent of total return from stocks over the last 80 years. What ever the percentage, it seems to me that it should not be overlooked because it makes enough difference to be considered very relevant to long-term investors.
Rule # 2: I don't like a company that has much debt in excess of the average debt-to-capital ratio of its respective industry. I compare only to other companies within the industry because to do otherwise would tend to elevate or degrade companies that do not deserve it. Each industry has unique attributes. Some are labor intensive and require less capital investment and, therefore, less debt. A good example of this is the computer software industry where the most important input is intellectual capital. Other industries require very large capital investments in plant and equipment and, thus, tend to be more capital intensive than others. The obvious example here is the electric utility industry. Then there are industries that require high capital investments but also have relatively high margins and, in turn, relatively low debt to capital ratios. The computer hardware industry, in its current form, is a good example of this group. The point is that to compare the debt level of a regulated electric utility to that of a computer software company would create a false perception of good management performance. I prefer the debt to capital ratio to be at or below the industry average. I will allow a little leeway here for a proven company, especially under certain circumstances such as in the case of a company that makes frequent acquisitions and has a good history of successful integrations.
Rule # 3: I like companies that generally maintain a payout ratio near or below the industry average. Again, I will make an exception here and there (but not many) in instances where a company has maintained a relatively stable payout ratio over a long time or one that has a proven history of being able to manage the payout ratio during times of economic stress by lowering the rate of dividend growth during both good and bad times until the historical average is once again attained. Usually, these companies will also reduce the payout ratio during good economic times to below the industry average providing a buffer to help weather any future storms. Again, there are very few companies that pass enough of my other rules and also have the history of successfully managing the payout ratio, but there are a two or three.
Rule # 4: I prefer companies that increase dividends with regularity. However, I do consider companies that step the dividend up every few years more in tune with economic cycles to keep the payout ratio from getting too high. This, as in rule # 3, must be persistent over more than a decade to indicate management's abilities and intent in this area. The only real exception to this rule is the company that already pays an exceptionally high dividend that is sustainable and the source of the majority of our expected future returns. I believe that there is only one company that has garnered such an exception to this rule and remained on my list
Rule # 5: I require companies to have a positive free cash flow. I will tolerate occasional, temporary deviations from this rule, but I define temporary as a maximum of two consecutive years. Even just one year of not meeting this requirement lands the company on my probationary list. If I already own it, I may not sell during the probationary period, but I'll keep a close eye on the company fundamentals until free cash flow turns positive again. How I calculate free cash flow is simple in most instances: cash flow available after dividends, taxes, interest, scheduled debt principal repayments, and capital investments. Of course, I do cut a little slack for companies with very high credit ratings that regularly role over a portion of debt as it comes due. That is a common occurrence in some industries, such as utilities and telecommunications. I look at each company in terms of what is a normal practice within its industry and by my personal assessment of how credible it is to assume that the company would get financing during an extended period of tight credit such as the one we recently experienced. General Motors (NYSE:GM) in 2008 would not have passed this test while AT&T (NYSE:T) would have. I keep track of the credit rating from S&P and Moody's on all companies that end up on the list by performing a review at least twice each year, if not quarterly.
Rule # 6: I want the net profit margin to be equal to or greater than the industry average. I do allow for exceptions that are, in my view, temporary or a part of a successful, sustainable business model. For instance, AT&T made large payments to terminate its offer to buy T-Mobile last year. The initial decision may have been a bad one but the instance would still fall into my temporary category. Archer Daniels Midland (NYSE:ADM) falls into the food processing industry where net profit margins average 6.3 percent. But ADM is in the commodities end of the business where margins are much smaller. It also has a significant presence in the ethanol production industry which also has low margins. But the company has consistently maintained profitability with margins between 1.4 percent and 3.5 percent; thus the lower margin does not eliminate ADM from consideration by itself.
Rule # 7: I want relatively consistent growth in both sales and earnings per share. I say relatively because, once again I am comparing each company to its peers within its respective industry. Also, I realize that during economic downturns sales and income of most companies will decline so I look for those that tend to decline less relative to industry peers and rebound more quickly. I can't stress how important this factor is to me. I believe strongly that stock prices are generally determined by two factors over the long term, dividends and earnings per share. If those two rise consistently, the price will eventually catch up. It is our job to recognize when certain quality companies are mispriced relative to their long-term potential for earnings and dividend increases.
Rule # 8: I prefer, but do not require, dividend rates that are equal to or above the industry average. The reason I do not require this rule is because there are some companies that have the ability to increase sales and earnings faster than the growth rate of the industry in which they compete. In other words, if I determine that management's ability to deploy capital back within the company's operations will provide a much higher total return, I'll let the dividend rate be slightly below the average. But once a company's earnings growth rate and future prospects mature I want the sure thing called dividends to become a greater focus by management. To me, it's all about the most efficient method of returning value to the shareholders.
Note: For those readers who have previously read my article entitled, "My Long-Term, Enhanced Investing for Income Strategy" you will find that I have increased the number of rules within my selection process since that article was written. But these rules apply to both series, so don't be alarmed.
Rule # 9: I prefer companies that maintain a return on total capital that is greater than the respective industry average. I have been asked several times why I prefer return on total capital over return on assets. It is my contention, right or wrong, that profitability can be manipulated more readily when using only assets, or part of the balance sheet as the denominator. It is more obvious when using equity as the denominator in that after a year in which the company had a loss, since equity drops accordingly, it requires a lower level of profitability to show an increase in the return on equity. Return on assets is less subject to manipulation by management over the long term, but it does present short term opportunities, such as by reducing inventories or receivables in the short term. While the ratio will average out, it gives a less dependable, and less complete snapshot of management results at any given point in time than when one uses the larger (and more complete, in my opinion) denominator of total capital. The larger, more inclusive the denominator, the less potential there is for short-term "improvements" of a significant size. The more one excludes from the denominator (making it smaller) the more manageable the ratio becomes. Having said that, I don't believe that return on assets is necessarily a bad measure. I just think that return on total capital is better.
Rule # 10: This is the most subjective of my rules. I want a company to demonstrate its sustainability through industry or geographic dominance, cost advantages, consistent product differentiation through quality, marketing, service and customer loyalties, or due to sustainable barriers to entry or competition. Utility monopolies would fall into that first category of geographic dominance through regulatory monopolies and also benefit from significant barriers to entry. Wal-Mart (NYSE:WMT) has cost advantages as well as a dominant industry position; it also appeals and caters to a large demographic group of consumers. Coca Cola (NYSE:KO) is an example of a company that has built defensible brand loyalties. Apple is the current king of product differentiation. We'll see how long that lasts (I actually think the company still has some legs for future growth). Microsoft (NASDAQ:MSFT) would be a good example of a company that has built barriers to competition; while not unassailable; the company has been able to preserve its dominance and appears capable of retaining its edge for the foreseeable future while at the same time the company is building other income streams to dominate, as well.
As noted earlier the number of rules has been expanded from the original seven to ten. Each rule acts as another filter used to remove the weaker companies from the list. The end result is a list of companies that I feel represents the best of the best in each industry that I follow. Having made that statement I already know that some of my choices will be contested and that readers will offer up alternatives they believe to be better. I invite all to ask questions and make recommendations that differ from mine as I truly believe that only through respectful, disagreement and discussion can we all become better investors able to make better decisions in our future investments. Sharing our experiences and knowledge leads all to a better understanding of the art we call investing. While I don't believe that there is any one set of rules that is the best for every investor, I offer up this list that works for me and gives me greater confidence in my selection process. A year from now I hope to have improved even more and I hope that through our discussion within this series we can all learn something beneficial.
The following articles in the series will be more focused upon one to three companies within a specific industry that have made the cut, including a short summary of my views on the respective industry and its future prospects. I will also include one or more companies from the same industry that did not make the list in each article. The articles will explain why companies made the list, why I follow the industry and why the other companies were eliminated. From that I hope to generate some lively discussions.