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What do I want to buy? When should I buy it?

I can't answer these questions until I know what my goals are. Let me share my goals with you. I am 56 years old. I plan to retire in 10 years. I want to have a portfolio that will provide a stream of income. I want the amount of income to rise every year, to counteract the erosion of purchasing power due to inflation. I do not want to have to sell assets in order to produce cash to pay my expenses - I do not want to have to depend on the whims of Mr. Market. I can and will achieve my goals with a portfolio of dividend growth companies.

Back to the original questions: Which dividend growth companies do I want to buy, and when should I buy them?

I want dividend growth companies that will raise their dividends by 5% or more each year (inflation has averaged slightly over 3% per year since 1926). How do I know which companies will do that? I start by looking at which companies have done that. Yes, I know, past performance does not guarantee future performance, but even if history doesn't repeat itself, it does rhyme.

I could look for companies that have raised their dividends by an average of 5% or more each year. In other words, there could be a small increase one year, and a large increase another year, such that the average increase is 5% or more. This is called the Compound Average Growth Rate (CAGR), sometimes called Dividend Growth Rate (DGR). Here is a good explanation of CAGR. Here is a spreadsheet listing 361 companies that have a 10-year CAGR of 5% or more.

The bad news is that "average" hides a lot of sins. 109 out of 361 have had a dividend freeze or dividend cut. I don't want my retirement income to lose purchasing power (because of a dividend freeze), or decrease (because of a dividend cut), so I use David Fish's lists of Dividend Champions, Contenders, and Challengers, which are available here, to weed out freezers and cutters. Here is a spreadsheet listing 201 companies that have a 10-year CAGR of 5% or more, and have never had a dividend freeze or dividend cut.

The bad news is that even companies with only dividend raises could still have a small raise one year, which would cause me to lose purchasing power. For example, Nucor Corp (NUE) has a 10-year CAGR of 24.28, which looks very impressive, but when you look at its dividend history, its two most recent raises are only 2.857% followed by 0.694%. Here is a spreadsheet listing 49 companies that have raised their dividend by 5% or more each and every year for the past 10 years.

How do I know that these companies will raise their dividends by 5% or more in the future? I can't know for sure, but I can look at analysts' expectations. I use Chuck Carnevale's F.A.S.T. Graphs™ to find the Estimated Earnings Growth (EEG) for each company. If a company's graph doesn't show an EEG, then I look at FinViz for Earnings Per Share (EPS) for the next 5 years. Dividends are paid out of earnings, so if a company grows their earnings by 5% or more, it seems to me that they should be able to grow their dividends by 5% or more. Here is a spreadsheet listing the EEG and the EPS for 49 companies. Atlantic Tele-Network Inc (ATNI) and Computer Services Inc (OTCQX:CSVI) had an EEG of 0.0; ATNI had an EPS of 3.0, which is below my minimum of 5.0; I couldn't find CSVI on FinViz. Harris Corp (HRS) and Unisource Energy Corp (UNS) had an EEG of 3.0, which is below my minimum, but their EPS was above my minimum. Eliminating ATNI and CSVI leaves 47 companies.

Now I know which dividend growth companies I want to buy.

When should I buy them?

I don't want to buy when a company is over-valued. Where do I look for valuation? Chuck Carnevale's F.A.S.T. Graphs™ show, for each company, its price (black line), its earnings-justified valuation (orange line), and its value corridor (second diagram). Here is a spreadsheet showing valuations. I will consider a company if the black line is at or below the orange line, because this indicates that the yield represented by the earnings you are purchasing compensates you for the risk you are assuming. The same applies to the forecasting graphs; however, as this is an estimate, this diagram shows the black line in or below a value corridor. Eliminating the others leaves 22 companies.

The following graphs for Air Products & Chemicals (APD) represent one example of a company in value:

Historical Graph for Air Products & Chemicals (<a href='http://seekingalpha.com/symbol/apd' title='Air Products and Chemicals, Inc.'>APD</a>)
(Click to enlarge)

Estimated Earnings Graph for Air Products & Chemicals

I also don't want to buy when a company's current dividend yield is below 3%. Bunge Ltd (BG), Teva Pharmaceuticals (TEVA), and Medtronic Inc (MDT) are all currently undervalued, but their current dividend yields are below 3%, so I will wait to buy them until their prices drop far enough to meet my yield minimum. Here is a spreadsheet showing the 9 companies that are undervalued and yield at least 3% (as of when the prices were captured, on Wednesday June 13, 2012).

Now I know when to buy them.

Please note that these 9 companies are not "likes" or "picks" -- they are merely the survivors of several screens. Every investor should do their own due diligence before they invest. For example: ABT is about to split into two companies; BBL is an ADR from the UK (as far as I know, there is no withholding on dividends from UK companies into tax-sheltered U.S. accounts); DCM is an ADR from Japan (I don't know about withholding from Japanese companies); GD depends heavily on U.S. defense spending, which might be cut; HRS has a payout ratio of 93.64% (FinViz) or 1,425.00% (Yahoo! Finance); Johnson & Johnson (JNJ) has had many product recalls, and a recent change of management; and RBCAA is a bank, and I haven't bought banks since the 2008 implosion of the banking industry.

Here is a spreadsheet containing all of the original data, subsets of which were presented above.

I am grateful to Chuck Carnevale for his review of this article, for his help with the description of the F.A.S.T. Graphs™, and for the two F.A.S.T. Graphs™ that he created for this article.

Source: What Do I Want To Buy? When Should I Buy It?