Investing in dividend growth stocks is a pretty robust process for long-term wealth building. While individual stock selection does require a degree of economic and business understanding, the majority of it rests on common sense and psychological fortitude to keep adding capital and to appreciate down markets for what they are rather than to dread them.
Because it is a suitable investment strategy for individual investors, there also tend to be a few mistakes that I've witnessed novice investors make. This article discusses two of those mistakes, and presents a number of stock picks that may be off of the radar of some investors due to perceived weakness related to these mistakes.
Not all debt is equal
One mistake is to focus on just one debt ratio when analyzing stocks. I've seen investors dismiss strong companies based on perceived balance sheet weakness when just the opposite is true.
The most common debt ratios I look at to get a quick glimpse of overall financial strength in a company are total debt/equity, total debt/income, total goodwill/equity, and the interest coverage ratio. If there's any doubt about financial strength after that, then the current ratio is useful, and so is looking years ahead through the debt maturities. There are also other ratios or things to check that investors may rightly develop an interest with.
What one doesn't want to do, is to dismiss a balance sheet without understanding the industry it operates in, and the factors that contribute to the financial situation.
International Business Machines (IBM)
For example, IBM has a total debt/equity ratio of over 150%, and goodwill/equity ratio of 130%. So the company has quite a bit of debt, and without goodwill, shareholder equity would be negative.
But IBM certainly does not have a weak balance sheet. Technology companies tend to not need a great deal of assets to generate large revenues and profits. It's not a very asset-heavy business, especially since IBM has transitioned away from hardware and more towards software and services. Total debt is only 2x net income, and debt/FCF is even lower, meaning that the company could direct incoming profits towards paying off any debt very quickly if management were so inclined. Not that they should rationally want to, considering that IBM's income covers its debt interest almost 50 times over, and the market has assigned an extremely low interest rate on IBM debt. Few large companies have such strong coverage of their debt interest.
IBM may or may not make a good investment at the current time. The valuation is a bit high for my liking, and declines in hardware revenue offset increases in software revenue, but in an increasingly integrated and technology-driven world, the company's portfolio of products and services looks strong for the foreseeable future. Regardless, if there's one weakness this company doesn't have, it's the balance sheet.
Philip Morris International (PM)
Tobacco companies tend to have a lot of debt. The reason is, their products are addictive, brand preference is strong, there are low capital costs, and there are often laws regulating advertising which can "lock in" the existing brands without much advertising expenditure, so their revenues can be fairly resilient and they can withstand a degree of leverage.
I always look for strong balance sheets, and debt loads do lead me to reduce my fair value estimates for tobacco stocks relative to what they would be without debt, but all things considered, many of them are in good financial shape.
Philip Morris International, for example, has a total debt/equity ratio that's off the charts, because equity is near zero and total debt is around $20 billion. That's enough to give an investor pause.
Total debt/income, however, is less than 2.5x, and free cash flow is particularly strong. Much like IBM, the company could direct significant incoming profits towards debt reduction if management decided that was optimal. However, the interest coverage ratio is over 17, which while not as strong as IBM, is extremely healthy. It's comparable to the interest coverage of McDonald's (MCD) or Procter & Gamble (PG). Most of PM's poor debt metrics are due to its low worth of property. PM's asset requirements are small compared to the revenue and cash flows it can generate from its facilities.
Philip Morris represents appropriate use of leverage. While not an extremely strong buy, I do believe PM represents an acceptable value at current prices.
Don't put too much weight on erratic earnings
The second mistake to quickly cover here is to recommend not taking earnings statements or reported valuation ratios at face value. If a reported P/E ratio or a sudden drop in EPS from a blue-chip company looks odd, it probably is.
The other day, I read an article that mentioned that AT&T has a P/E of over 50, claiming it was higher than the market average, due to investor confidence. While investors may indeed have confidence, is AT&T really trading at 50 times earnings, and does it really have a higher valuation than the market average?
Technically yes, but really no. AT&T reported one-time losses due to its failed acquisition attempt at T-Mobile, which regulators didn't think too fondly of. This resulted in very low reported EPS for 2011 after billions in losses, which results in the currently calculated price to earnings ratio of over 50.
While investors may be confident, they're not that confident. The forward P/E is a more reasonable 14 or so, which based on AT&T's particular business, makes sense. AT&T stock is a bit ahead of itself in my view, but still in the fair zone. The valuation of a large and stable company like AT&T is not going to fluctuate wildly in response to one-time losses due to a failed acquisition, so when EPS dropped temporarily, the stock price held (and later went up). When investing in this scenario, one must look past the face values reported on stock screeners and the like.
The Coca Cola Company (KO)
A bit over a year ago in 2010, KO stock had the opposite issue of AT&T; a one-time EPS increase related to its large bottler acquisition resulted in an abnormally high EPS, and therefore a P/E of only 12. So is the company way too expensive today at a P/E of 20?
Not necessarily. In 2010, Coca Cola's real P/E after one-time events were taken out, was in line with what it is today. Twenty times earnings is by no means cheap, and not a clear bargain, but it's not unreasonable. In return for the full price, an investor receives a stock with global exposure, a long-term stable and growing dividend, steady volume growth, and clear goals to accelerate volume growth to reach 3 billion daily servings by 2020 as China and other high population countries with low numbers of per capita annual servings of Coca Cola products hit critical points of market penetration.
Full Disclosure: As of this writing, I am long MCD, KO and PG. You can see my dividend portfolio here.