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While any portfolio of stocks can be successful in the right circumstances, we each attempt to find the best system for determining which stocks we want to purchase to make money. I have found that, for me, buying high quality dividend growth stocks at the proper time has the best results and fits best with my personal requirements. While the definition of quality varies, sometimes greatly, there are certain similar criteria that most quality driven portfolios utilize. I will be using the criteria I have found best to start a portfolio of dividend growth stocks that will be chosen based on quality and proper timing. This is not to say that we will attempt to time the market. But just as there are times where buying a low quality stock makes money, there are times that buying even a high quality stock does not make sense.
The goal of this and subsequent articles will be to identify stocks that meet the quality and buy criteria so that readers can make a decision of whether inclusion into their portfolio is appropriate. We will also create a model portfolio using this criteria in order to test it's effectiveness. As the effectiveness becomes clear, future articles will make necessary changes to the criteria outlined here in an attempt for continuous improvement.
The system will consist of the following:
- $100K of initial funding
- Model Portfolio of purchased stocks limited to a maximum of 20
- Approved List of stocks that currently pass the quality evaluation but have not been purchased due to the buy criteria not being met or lack of cash availability in the portfolio
- Contender List of stocks that have passed the criteria for inclusion but have not made it to the Approved List
Stocks will be evaluated and given a quality and buy score. Each score will have a range of 0 to 100. The quality score will determine which stocks make it to the Approved List. Once on the Approved List, the buy score will determine which stocks are purchased into the Model. Cutoff values for quality and buying will determine whether stocks move between lists. Initial cutoff values are based on preliminary tests of the quality scoring system and will be set purposely to only allow a small number of the highest quality scores to make the Approved List. I plan to adjust cutoff numbers in the future when more data is available based normal distributions and standard deviations.
This will likely be some form of mean score plus one standard deviation for inclusion (qualified and buy cutoffs) and minus one standard deviation for exclusion (unqualified and sell cutoffs). Based on normal distributions, this will mean about 16% of the highest scores will move up and 16% of low scores will move down and the middle 68% will stay put. The initial cutoff values are 58.50 for quality and 57.00 for buy. Dividends will not be reinvested via DRIPS buy will be used to fund future purchases based on the rules outlined here.
The evaluation process will follow these steps:
- Check for stocks to include into the Contender List based on Yield > 0%, EPS > 0, Predicted Return > 5%, Moody's Score > Baa3 and Morningstar Financial Health > Weak. Those that qualify will be added to the Contender List.
- Update the quality score of each stock in the Contender List and move stocks with scores above the qualified cutoff to the Approved List.
- Update the Quality Score for each stock in the Approved List and move stocks with scores below the unqualified cutoff back to the Contender List.
- Update the Buy Score of each stock in the Model Portfolio and move stocks with scores below the sell cutoff back to the Approved List.
- Update the Quality Score of each stock in the Model Portfolio and move stocks with scores below the unqualified cutoff back to the Contender List.
- Update the Buy Score of each stock in the Approved List.
- If the number of stocks in the Model < 20 and the cash available is > $5K, buy $5K worth of the stock with the highest Buy Score in the Approved List.
- If the number of stocks in the Model = 20 and the cash available is > $1000, buy $1000 worth of the stock with highest buy score in the Model that is not already > 10% of the portfolio.
As with any system, adjustments will be made as we go through this process. I do not plan for it to be stagnant especially since there will inevitably be good suggestions made by readers. So bring on the feedback and suggestions. I cannot promise I will utilize all of them, but I will evaluate any given.
Note: The definitions for quality and buy scoring can be found here.
|Revenue/Income - Data|
|Weighted Revenue Growth||7.55%||6.32%||1.01%||15.08%||6.58%|
|Weighted Operating Income Growth||5.04%||7.43%||16.79%||6.92%||4.63|
|Revenue/Income - Scoring|
|Revenue Growth (0-4)||3.02||2.53||0.40||4.00||2.63|
Operating Income Growth (0-4)
|Total (0-8)||5.03||5.50||4.40||6.77|| |
|Ratios - Data|
|Ratios - Scoring|
|Current Ratio (0-4)||4.00||2.11||2.73||2.65||4.00|
|Profitability - Data|
|Gross Margin Industry Avg||33.37%||46.58%||22.28%||27.93%||60.72%|
|Operating Margin Industry Avg||7.35%||12.22%||12.95%||10.25%||10.31%|
|Profitability - Scoring|
|Gross Margin (0-5)||0.00||5.00||0.00||4.02||2.26|
Operating Margin (0-5)
|Dividends - Data|
|Weighted Dividend Growth||24.3%||12.41%||25.00%||8.08%||10.38%|
|Payback Period (Years)||14.75||19.00||13.25||59.50||20.25|
|EPS Payout Ratio||39.39%||36.89%||66.41%||22.83%||41.93%|
|FCF Payout Ratio||44.70%||36.02%||32.88%||22.28%||75.76%|
|Dividends - Scoring|
|Yield (0-2)|| |
Weighted Dividend Growth (0-2)
|Payback Period (0-8)||6.10||4.40||6.70||0.00||3.90|
|EPS Payout Ratio (0-5)||4.59||4.71||0.00||4.97||4.44|
|FCF Payout Ratio (0-3)||2.54||2.84||2.90||2.99||0.00|
|Miscellaneous Financial - Data|
|Miscellaneous Financial - Scoring|
Financial Health (0-2)
Moody's Rating (0-4)
Fundamental Rating (0-2)
Risk Rating (0-2)
|Total (0-15)||11.27||9.66||8.42|| |
|Management Effectiveness - Data|
|ROA Industry Avg||5.40%||4.80%||4.70%||5.70%||6.30%|
|ROE Industry Avg||12.00%||13.30%||11.30%||11.10%||12.70%|
|Management Effectiveness - Scoring|
|Debt - Data|
|Debt - Scoring|
|Earnings - Data|
|Weighted Earnings Growth||19.52%||25.00%||25.00%||25.00%||-7.46%|
|Earnings - Scoring|
|Weighted Earnings Growth (0-7)||4.42||7.00||7.00||7.00||0.00|
PEG Ratio (0-7)
|Predicted Return - Data|
|Predicted Return - Scoring|
|Predicted Return (0-12)||6.29||12.00||8.41||11.23||3.59|
|Revenue/Income Score (0-8)||5.03||5.50||4.40||6.77||4.48|
|Ratios Score (0-10)||5.76||5.06||3.51||2.81||5.61|
|Profitability Score (0-10)||1.75||9.32||0.00||4.53||7.26|
|Dividends Score (0-20)||15.23||13.19||11.60||8.64||9.41|
|Miscellaneous Financial Score (0-15)||11.27||9.66||8.42||5.88||8.83|
|Management Effectiveness Score (0-8)||8.00||7.00||6.52||8.00||1.00|
Debt Score (0-3)
|Earnings Score (0-14)||6.80||11.17||10.98||10.10||0.00|
|Predicted Return Score (0-12)||6.29||12.00||8.41||11.23||3.59|
|5 Year Historical P/E||21.10||19.00||20.50||27.50||26.90|
|5 Year Historical Yield||1.17%||1.57%||2.18%||1.01%||2.01%|
|TIPS Rating||Moderate Buy||Moderate Buy||Moderate Buy||Strong Buy||Strong Buy|
|Valuation #1 (0-10)||0.00||3.23||0.00||0.00||3.25|
Valuation #2 (0-10)
Price Momentum (0-15)
|Relative Valuation (0-10)||4.00||10.00||6.00||5.00||2.00|
P/E Versus Historical (0-10)
Predicted Return (0-25)
Yield Versus Historical (0-10)
TIPS Rating (0-10)
|Total (0-100)||44.06||64.57||43.03||52.98|| |
Moves Between Lists
TJX and CMCSA will move to the Approved list based on the quality scores of 62.98 and 72.90, respectively, versus the cutoff of 58.50.
Buys and Sells
CMCSA will be purchased into the Model based on the buy score of 64.57 versus the cutoff of 57.00.
|Stock||Purchase Price||Shares||Total Cost|
Cash Available: $95,000
|Stock||Quality Score||Buy Score|
|Stock||Quality Score||Buy Score|
Of the five stocks in this initial evaluation, only 2 received passing grades to move to the approved list and only 1 of those 2 had a buy score high enough to be purchased into the model. This is not unexpected since the scoring is purposely set to allow only the highest scores to move up.
CMCSA scored in the middle to upper areas of all categories except debt where its debt/equity ratio of 0.96 lost points. The other stock that made the approved list, TJX, did so with middle to upper scores in all areas except profitability where it's gross margin was less than the industry average and it's operating margin was not much above the industry average.
BA missed the cutoff in part due to mediocre scores in most categories but also low scoring in the profitability and debt categories. Boeing's gross margin was less than the industry average of 22.28% and it's operating margin was 11.62% which is also lower than the industry average. Debt was also an issue for Boeing as it's debt/equity ratio was 10.19. The best categories for BA were management effectiveness where is scored 6.52 out of 8 and earnings with a score of 10.98 out of 14.
SHW did poorly in the debt, dividends and ratios categories where it received a total of 11.45 out of a possible 27 with ratios affecting it the most. It scored well in revenue/income, management effectiveness, earnings and predicted return where it garnered a total of 36.10 out of 42.00.
MDT scored the lowest in management effectiveness, earnings and predicted return where it received scores of 1.00, 0.00 and 3.59 for a total of 4.59 out of a possible 34. It scored particularly low in the earnings category where it's negative earnings growth over 1 year, 3 year and 5 years and high PEG ratio adversely affected the score. It's best areas were profitability and debt.
Obviously, there are not enough evaluated stocks here to fill the Model Portfolio. The expectation is that, over several articles, the number of stocks evaluated will increase to the point where the model will fill up. I will be reading any comments and reviewing any suggested changes. No promises on using them, but my hope is to make this a better system over time in part due to your input.
Note: All data used in scoring is current as of the date when the article was written. Some of it, such as prices, have likely changed by the time the article is actually published.
Disclaimer: None of my articles including this one are investment advice of any kind. The purpose here is to define a system and see how it might work. If you like what you see and decide to invest based on it, do you own due diligence to make sure you are spending money in a way suitable for you. I am neither an investment professional nor plan to be. This is an academic exercise for the benefit of all involved. I hope all readers find benefit but there are no guarantees of success or performance in any way with what is outlined in any article I write.
Disclosure: I am/we are long BA.
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.