History Of The Smell Test
My wife is an excellent cook and she cooks quite often, which may help explain my less than trim figure. I can generally tell by the smell of something cooking whether I will like it or not. It's not 100% accurate but I'd say it's pretty close. I call it my smell test. If I don't like the smell, I'm probably not going to like the food. If it smells really good, I'm usually the first one at the table. Now I use my smell test in my dividend investing to see if I want to sit down at the company table.
I try to take things I learn in one area and apply them in other areas in which I'm involved. For instance, I'm now retired but in my previous career I negotiated and managed contracts for a large company. As a negotiator there were two things that I always wanted to have in my hip pocket. One was what I referred to as a "deal breaker," i.e. what thing (there could be more than one) would make me call off negotiations, or even walk away from an agreement already reached.
The second thing was what I called my "walk away price" which was a certain price or amount to which if I couldn't get the other entity to agree, then I walked away from the negotiations. I always wanted to know these up front because if I didn't I increased my chances of having an unhappy customer (my company), and entering a poor deal, or as my Dad used to say, getting my pants leg rolled up. I've found that I need to know the same two things in my investing and need to know them up front. Not knowing them before I invest increases the probability of me, and/or my wife, being the unhappy customer. I might be able to live with it but when "Mama ain't happy," well you know the ending.
These two things now make up my dividend investing smell test. I established multiple deal breakers and walk away points for my stock evaluations. If a particular company doesn't meet those two things, I don't consider investing in that company. If they do, then I go on to the other criteria that I use, which is a combination of fundamental analysis and technical indicators. I want to make a reasonably intelligent decision before buying stock in a particular company so I do an extensive analysis. But it first has to pass the smell test.
The Deal Breakers
My first deal breaker is to ask if the dividend is safe. To determine this I use the dividend payout ratio. I like it to be below 50% and if it's above 75% I won't even consider buying it. That's my danger zone. I want to know that my investment is safe and that I will continue receiving my dividends (I also consult David Fish's CCC spreadsheet). A number of financial sites, such as Finviz.com, show the payout but I prefer to calculate it myself. Most sites calculate it based on earnings (net income) but I had rather use operating cash flow (I give credit to Marc Lichtenfeld for this technique). I think I get a more realistic picture by looking at how much cash the company has coming in and how much it's then paying out in dividends. To get the cash flow I'll use Morningstar, Google Finance, Reuters, Yahoo Finance, or the annual/quarterly reports from the company's website.
When I first started doing it this way, I was surprised at how different the numbers could be. For example AT&T (T), a dividend champion, and in which I've been wanting to take a position, shows a payout ratio of 232% on Finviz. That stinks I thought, no way they could keep paying a 4.6% dividend yield. But when I calculated it on cash flow, the payout was 29.49%. Sweet! Conversely, Mercury General Corporation (MCY), another dividend champion, shows a payout of 64% on Finviz. I considered buying on the recent drop in price. But using cash flow, the payout is 115.6% for the trailing twelve months. It didn't look much better over the past several years. That flunked my test.
The Walk-Away Points
My second item, the walk away point, is when the price for entry is at an unacceptable level (a dividend cut is another one if I'm already long). Admittedly, determining the entry price is as much art as science. I also realize that a number of companies often seem to be over-valued, such as Coca-Cola (KO) and Colgate-Palmolive (CL). But I refuse to buy when it's at its 52 week high, or when the price is so high it drops the yield below my minimum threshold. Does that mean I miss some entries on excellent companies? Yes it does, but being patient also helps me get a better position when it does pull back, and ultimately helps me get a better return on my limited funds, and higher income in the long term. I've learned that the hard way. I'm not looking for a 50% discount I just want it to be at what I consider a reasonable or fair value and decent entry. I want to own AT&T, I use their products and service, but first it has to come back my way in order to pass the smell test. Its' passed part 1 of the test but not part 2.
I realize there are literally hundreds of techniques used to evaluate stocks in order to arrive at a final decision to invest in certain companies, as well as when to pull the buy trigger. You can find quite a few here at Seeking Alpha. There are a lot of highly educated and very knowledgeable people here. I learn a lot just reading comments to articles. But quite frankly I've read some articles on stock evaluations that made my head hurt. I'm not interested in learning about exponential linear regressive equity derivative analysis (okay, I made that up but you get my point).
The Simple Life
I like simple things, things I can understand and enjoy. Is it a good company, is the dividend growing, is there plenty of cash on hand to pay it? Simple things like that. I enjoy drinking Coke and I like owning Coca-Cola. I brush with Crest and own Procter-Gamble (PG), like hamburgers and own McDonald's (MCD), typed this with MS Word and own Microsoft (MSFT), and get my medicine at Walgreen and own (WAG). I understand over-simplifying things, but I also understand "paralysis by analysis." I want to own good companies that I bought at good prices without getting my pants leg rolled up. My bony old legs don't need any more exposure than necessary. So I use my smell test.
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.