The easiest way to invest, which will probably work for everyone, is using cheap mutual funds that encompasses most of the market. You can buy these mutual funds or ETFs, and pay very low fees for them. You will achieve returns that are similar or very close to the market. As almost no investor can beat the market over long period of time, it should be suitable for most people.
So why do I pick single stocks? As a dividend growth investor, I am not looking to beat the market. I am looking for a strong and reliable stream of dividends. The dividend income is income that has nothing to do with my job. It allows me to get some extra cash, or save it for the long run, until it can replace my day job income. Personally, I am not looking to stop working, and I keep investing the dividends.
I am aware to the fact that I will not beat the market. It is not my goal. I have my investment plan, and beating the market is not in my goal list. I am looking to increase the stream of dividends, achieve higher passive income. If my portfolio value didn't move, but my income grew by let's say 7%, I will be very happy.
As the goal is to achieve a growing stream of dividends, it is important to find a system that will drive you to your goals. Dividends are made of free cash flow that the company can spare to pay its shareholders. As Professor Robert Shiller explains, the dividends are the way companies reward shareholders. If dividends come from free cash flow, then FCF and EPS are the most important metrics.
I will show my analysis methods using Johnson & Johnson (NYSE:JNJ) and Disney (NYSE:DIS). I own both and trust both for the long term. I will show how I analyze them both, I will compare the two, but the most important issue will be presenting my method for analyzing stocks.
The most important fundamentals are free cash flow (FCF), and earnings per share (EPS). The growth of net income, and the creation of free cash flow, are crucial for the ability of a company to pay dividends for the long run. You can use debt to pay dividends in the short term, but over a longer period of time, the income and FCF must grow. Pick only stocks where you can see positive long-term trend. As you can see in the charts, while Disney shows higher growth over the past 5 years, both companies show healthy growth in their income and cash flow. Both pass the first step.
After I look at the FCF and income, and before I analyze the dividends, I check the revenues. EPS can be boosted with buybacks, but eventually in order to grow the bottom line, the company must grow its top line. I look at the revenues as secondary, because they must come with the ability to translate them into EPS. Many companies in the information technology, for example, show massive growth in revenues, but little or no EPS. Acquisitions are another way in which companies grow revenues, but not necessarily the bottom line. As you can see in the chart, both companies grow their top line. While the growth is not as fast the bottom line, it will still support further earnings and dividend growth.
After seeing that the trend is positive in the EPS, FCF and revenues, I analyze the dividend. As a dividend growth investor, it is crucial for me. I am looking for three main aspects. Dividend growth - the longer the better - dividend payout ratio and dividend yield. The payout should be lower than 70%, and I prefer it lower than 55%. As you can see in the charts, both companies grew their payments over the past five years. JNJ has a much longer dividend growth streak and a more appealing yield. On the other hand, DIS managed to grow its dividend much faster. Different investors will have different preferences. Those who prefer reliable income will go with JNJ, and those who prefer stronger growth will pick DIS.
Other metrics such as buybacks are less important to me, but I also check them out. I also look at the leverage and the debt ratios. Other investors might have different priorities of course. They might be more concerned with the debt levels for example.
Even the best company, that shows tremendous growth in EPS, FCF, revenues and dividends, shouldn't be bought if the price is too high. The basic metric I use is P/E ratio. My rule of thumb is to look for companies with P/E that is lower than 20. However, I take into consideration the business environment. As the interest rate is low, I will look for P/E lower than 20. If the interest rate goes higher, I will lower my P/E threshold. Again, it is a rule of thumb, and I wouldn't ignore automatically a company that trades for P/E higher than 20. If the stock is too expensive, I will keep the company in my watch list, and look at the valuation again in several months.
As you can see in the chart below, both companies are traded for attractive valuations. At the moment, DIS is trading at lower valuation, even though it shows higher growth. In my opinion, at the moment Disney is more attractive, as it offers stronger fundamentals and better valuation.
When I analyze different companies, I use different metrics together with the traditional P/E. I also use P/S ratio together with the P/E. I like using the P/B ratio when I analyze financial institutions. Many of them had one-time litigation expenses, and they were not making significant income. The P/B is great for valuation companies that lose money at the moment. Other investors prefer the EV/EBITDA ratio, as it ignores the amortization and depreciation that influence the net income and P/E ratio.
In every valuation metric, Disney is more attractive. Some investors like using models to find the fair value. I sometimes use the DCF model, but I don't like using target prices or fair prices. Sometimes, I read people writing, for example, that Disney should be bought at $90. Well, what is the difference between $90, $91 or $95? Do you think that in 20 years there will be significant difference between the three options? I don't think so.
So we have a company that grew dividends, FCF and EPS in the past. It can also be purchased at fair valuation. However, these figures are based on the past. I want to see what will drive FCF and EPS forward in the future. I am buying the stock for the future earnings. I usually look for opportunities while I read the company's reports. You should take them with a grain of salt because companies tend to be very optimistic. I also try to understand the business environment to find growth opportunities. For example, quick growth in the population of a certain state will serve as a catalyst for utility companies.
When you look for growth opportunities, try to make a list and arrange it according to how much each opportunity can affect the growth. Concentrate on analyzing and understanding the top 3-4 opportunities. Put your emphasis on growth prospects for the long run, and try to ignore the short-term growth, as it is not necessarily sustainable.
Disney, for example, has several growth prospects. The parks and the movies will drive the company forward. The new park in China started a little bit slower than expected, but with huge traffic, I believe it will bring stronger results. It is the first park in China, and it takes time to adapt. Moreover, with Star Wars and Marvel Cinematic Universe, Disney is expected to bring many blockbusters on a annual basis. Its ability to cope with the declining number of subscribers in ESPN will also allow the company to grow its earnings quicker.
Johnson & Johnson is twice the size of Disney, so it is much harder for it to show quick growth. While the company does have some organic growth, it supports it with occasional acquisitions like the current bid for Actelion (OTCPK:ALIOF). Moreover, the company is changing, and it puts more emphasis on the pharmaceutical segment. The management believes that the margins there will be higher, and it will support future earning growth.
While growth opportunities are important, risks are crucial. A company can survive several years, and sometimes decades without major growth catalyst. Sure, earnings might become stagnated or grow slowly, but it won't necessarily lead to the failure of the company. Systematic risks can destroy a company. Always look for financial risks like debt, and to other risks such as fierce competition and business environment.
When you analyze oil companies, you have to remember that they are price takers. They cannot decide what the crude oil price will be. They also tend to be influenced by the harsher environment and low prices. They have to take more debt in order to keep funding the capex and dividends, while the oil price is very low. These are major risks, that must be taken into consideration. This sector is a great example for the need to understand both financial risks that eliminated the dividends paid by Kinder Morgan (NYSE:KMI), and current prices that eliminated the dividends paid by ConocoPhillips (NYSE:COP).
Disney has one major long-term risk, and it is the media networks segment. This segment is roughly 50% of the revenues. The fact that the number of subscribers is dwindling while the price for television rights is soaring is very concerning. This segment is supposed to be a leading one, and what soothes investors is the fact the management is aware of the problem and dealing with it.
Johnson & Johnson is putting more emphasis on the pharmaceuticals segment. While it should drive earnings in the short term, it might make the company more vulnerable in the long run. Its strength is in its diversification, and the pharmaceutical sector is riskier. I believe that the management has enough experience and knowledge to deal with it, but it should be noted.
I will start with the comparison that I brought as an example. While both companies are attractive right now, I prefer Disney over Johnson & Johnson at the moment. It shows stronger growth, lower valuation, and I believe the risks are overblown with plenty of opportunities. Still, JNJ is probably your best anchor in the healthcare sector and will offer great returns for the long run.
While I prefer DIS, it really depends on investors. Do you need more income right now? Go for JNJ. You have plenty of healthcare exposure? Go for DIS. Choosing the right stock is more complicated than just analyzing it. You have to look at your portfolio and examine the sector allocation, current dividend yield, and try to pick stocks that will bring you closer to your goals.
The chart below is the summary of this article. Use it, edit it to fit your thesis and make sure you stick to you investment plan, and goals. I use this chart and other tools to make sure that I have a clear system which helps to reach my goals. This chart should be simple, as it helps to filter stocks according to the thesis I showed in this article. I perfected this method over the past decade, and it works pretty well to me. Feel free to use it.
Disclosure: I am/we are long DIS, JNJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.