The Margin of Safety Dividend 30 is designed to find roughly 30 domestic companies that offer both dividend safety and future growth. We also maintain an International Dividend Dozen focus stock list.
Our goal is to find about 30 companies, maybe a few more, that can support their current dividends and provide growth of dividends in the future. Growth is the operative word. Companies must increase revenues and profitability to grow their profits.
Investors often "chase yield." Too many of the "high yield" companies investors have invested in, though, have relied on cheap debt and financial engineering to pay high dividends. That puts those stocks at enormous risk in the next recession.
We believe that about one-third of the companies in the S&P 500 (SPY) in coming years will cut their dividends. The majority of those companies will go through painful rebuilding or reorganization processes. Some will "go to zero" and liquidate.
Many dividend investors claim they will "buy more" if their stocks fall in price. That's great if they hold quality companies. Our Dividend 30 is built on quality and growth catalysts. We started with a meticulous screening process.
The Dividend Stock Universe
The first step to investing is deciding how to build your asset allocation. This step is painfully missed by most investors. Here is our step by step approach to screening for dividend stocks to invest in.
The first step to defining our investment universe is to decide on a market cap range. Do we want small companies in our mix? Our answer is yes. Our broad universe then is the Russell 3000 (IWV), though, in the end, we are heavily skewed towards stocks also in the S&P 500 (SPY). We include smaller companies to try to uncover a few hidden gems.
Our next step is to screen for all stocks with at least a 1% dividend yield, or about half the expected inflation rate. There are 1,277 stocks paying at least a 1% dividend in the Russell 3000.
Margin of Safety Investing uses a 4-step process to pick out investments. These include:
- analyzing secular and macro trends,
- understanding the impact of government and central bank policy,
- digging into fundamental valuations and moats,
- quantifying price trend analysis.
The next step for use after finding all of the dividend payers is to identify the sectors and industries that will provide us intermediate to long-term tailwinds. We have found this is best done by simply not considering companies in the sectors and industries that have the most risk from persistent headwinds.
Excluding Sectors and Industries
Zacks has done research demonstrating that, by investing in only the top half of sector and industry segments, you can outperform the S&P 500 by up to 80%. Zacks, however, has a shorter-term time horizon than most dividend investors and often rotates sectors once or twice per year.
At Margin of Safety Investing, we believe that avoiding sectors and industries that are showing less growth than the inflation rate makes sense. We also want to stay away from the sectors with the most risk in a financial crisis or from government regulation.
With those ideas in mind, we have eliminated certain industry segments from our universe of stocks to invest in. We are not investing in:
- most of the financial sector, except for select asset managers (those benefiting from the shift to ETFs) and regional banks, because we feel counterparty risk is underappreciated.
- most of the healthcare sector, except for biotech and diagnostics, as we feel there is a government policy storm on the horizon.
- the entire consumer staples sector which has slow to no growth.
- parts of the energy, basic materials and utilities sectors - though we want some exposure to the best opportunities due to scarcity issues and the capital cycle.
We are focused on finding most of our stocks in the technology, consumer discretionary, communications, industrial and real estate sectors. These are the sectors with the best secular growth.
If we are wrong to exclude an industry, such as healthcare, then we can use an ETF to add to our asset allocation, while we look for specific stocks.
Screening for Dividend Stocks
Our next step is to apply financial metrics that we think are most important. It is our belief that growth is underappreciated by many dividend investors.
Growth is necessary to support existing dividends and grow dividends in the future. Growth is a core component for us.
Our first financial screen is to look for revenue growth of at least 4%. This is double the anticipated inflation rate and generally sufficient to grow the dividend, as well as provide other measures of shareholder yield (debt reduction and buybacks).
We use revenue growth screens based on different time frames. This brings our investment universe from 1,277 dividend payers to 530 with consistent and recent revenue growth.
We certainly could have set a higher bar for growth but want to look at other metrics as complimentary pieces to our relatively simple screening process.
Our next screen is to find companies that are increasing their dividend by at least 4% per year. Again, about twice the inflation rate. This metric lowers the number of companies in our universe to 367 (our full dividend stock watchlist is roughly these companies, plus a few dozen selected additions).
Finally, we apply a measure of management effectiveness that shows a strong correlation to positive long-term returns. Shareholder Yield measures dividends plus stock buybacks plus debt repayment.
We are looking for shareholder yield of at least 5% (or two-and-a-half times the expected inflation rate), which lowers our universe to 107 stocks. Again, we could set the bar higher but are only whittling down to a narrow enough range to do more granular research.
Stock Valuation Measures
We use several measures of valuation from there. Many are industry-specific. No one measure suits all. My favorite is the PEG ratio which was championed by Peter Lynch.
The pure PE ratio has a problem because it does not discriminate for slower or higher growth rates. Ask a simple question: among two companies with the same PE, and all other things roughly equal, would I pay more for, the higher growth company or the lower growth company? It is an easy question to answer.
By adding the growth component to a stock's PE ratio, we can get a more true sense of what a reasonable price is to pay for a stock. In short, we are looking for PEG ratios under 2 and close to 1. That would mean a stock with a 20PE should have a growth rate of at least 10% and preferably 20%.
More circumspectly, the PE and the growth rate should be similar. If we find a stock with a PE significantly above the growth rate, then we know that stock is currently, most likely, overpriced.
The CAPE ratio is also useful if we consider it in the context of capital spending cycles. The CAPE or PE10 tries to create a broader look at PE ratio over a full cycle.
Criticisms of CAPE include that it does not give a true picture of "on the ground" economic conditions and has limited use in "timing the market." I agree. What CAPE does is give a good "30,000 foot view" for historical context.
I will be writing more about CAPE soon.
As investors, we need to understand that the "on time" and getting smarter economy may have changed the nature of valuation itself. Eventually, true value wins out, but eventually can be a mighty long time.
Exceptions To Screening
There are certainly exceptions to our screening. Many of those companies are turnaround situations. Here, we remember what Warren Buffett said about turnarounds in his 1979 letter to shareholders:
Both our operating and investment experience cause us to conclude that turnarounds seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
That said, we still try to find a good turnaround story. Why? Because the ones that do turn typically turn in a big way.
At the moment, we feature only one turnaround in Kinder Morgan (KMI). I wrote about Kinder Morgan recently, as well as, gave an interview to Seeking Alpha about the company. Ultimately, Kinder Morgan is an execution story now.
It's not just turnarounds that are the exceptions to our screening. When we loosen our screens a bit, sometimes we find companies in favorable industries that are just hitting a slightly higher point early in their "S-curve."
These are usually midsize companies that have recently started paying a dividend and are growing significantly faster than 4%. Sometimes, these higher growth companies are not quite meeting our shareholder yield benchmark yet as they might have taken on debt recently. These situations are usually reserved for our Growth 30 list, though sometimes sneak into our Dividend 30 list.
Other companies with otherwise good metrics that fall short on shareholder yield are those that have recently acquired another company. Often, there is a digestion period of a year or two that throws off the shareholder yield numbers. This is often a good time to get involved as mergers and acquisitions often have positive results.
Screening often fails for REITs (real estate investment trusts) due to the financial structure. Dividend Sleuth, one of our contributing analysts, is spending the next couple quarters analyzing our top dozen REIT candidates. Currently, we feel REITs are at least slightly overvalued as a group and susceptible to significant recession risk that could hurt property values and tax-code risk that could reduce demand for the securities.
Deep Diving Into Companies
After all of our screening, we take a deep dive into the companies behind the stocks. This is time-consuming and, more often than not, leads us to a company not being included on our list.
A common bias among investors is to get invested in a stock based on the time you have spent studying the company. Here, I think investors make two parallel mistakes. The first is becoming biased because you did the work.
The second mistake is thinking the amount of work you did was the right amount. We study companies for quarters and years before making investments sometimes. A few hours or days is not getting to know a company, that's background information.
I look for two key features when researching a company:
- Durable comparative advantage versus competitors, that is, a moat of some sort.
- An honest, intelligent, and forward-looking management team. You'd be surprised how often I am disappointed here.
We also look at other business circumstances the best we can, such as M&A activity, one-time events, bad luck, international conflict, new or pending legislation, changing credit conditions, cycle of the economy, capital spending patterns, emerging competition, etc.
The Dividend 30 Today
Here is our current Dividend 30 list. These are the dividend paying companies we want the most if the price is right. Other than after a major stock market correction, it is rare we own all at once.
What we anticipate is we will accumulate these stocks as "rolling corrections" strike different parts of the economy. Right now, energy and semiconductors are becoming attractive on trade war and economic slowdown narratives.
We expect to make a handful of changes to this list per quarter. Managements will sometimes let us down, the company changes in some way, or our analysis didn't make the cut. Often, there is just a better company available.
We believe that each of these companies can be added to your asset allocation at certain price levels and within your asset allocation guidelines.
Members of Margin of Safety Investing get buy levels and ongoing analysis of each company. We have included a note on a growth driver for each company. Our expanded REIT analysis will be coming out over the next few months with many landing on our "Alternative Income" list.
|Company||Symbol||Growth Driver Notes|
|Apple||(AAPL)||Enterprise to offset slower iPhone sales, new subscription services|
|Albemarle Corp.||(ALB)||EV revolution, lithium|
|Applied Materials||(AMAT)||"Smart Everything World," semiconductor equipment, engineering & services|
|Analog Devices||(ADI)||5G, "Smart Everything World," M&A candidate|
|Broadcom||(AVGO)||"Smart Everything World," semiconductors, software, IP|
|Caterpillar||(CAT)||Metals mining for EV revolution, agricultural modernization|
|Cisco||(CSCO)||5G and data, "Smart Everything World"|
|Dominion||(D)||Natural gas exports|
|Disney||(DIS)||Hulu and Disney+|
|EPR Properties||(EPR)||Entertainment, recreation, and education|
|Intel Corp.||(INTC)||"Smart Everything World"|
|Invesco||(IVZ)||QQQ, diversified ETF platform, merger synergies|
|Johnson Controls||(JCI)||Building efficiency and security|
|Kinder Morgan||(KMI)||Natural gas, Permian oil & CO2|
|Lam Research||(LRCX)||"Smart Everything World," semiconductors|
|Lockheed Martin||(LMT)||"Smart Everything World," water|
|Marathon Petroleum Corp.||(MPC)||shale oil, IMO2020|
|Microsoft||(MSFT)||Cloud. enterprise, "Smart Everything World"|
|Newmont Mining||(NEM)||Gold mining consolidation, global debt|
|Nutrien||(NTR)||diminishing arable land, increasing food needs, merger synergies|
|Occidental Petroleum||(OXY)||Carbon capture, EOR, Permian, asset sales|
|Parker-Hannifin||(PH)||Sensors, water filtration|
|PotlatchDeltic||(PCH)||Timber, land sales & repurposing, eventual residential building boom|
|Rockwell Automation||(ROK)||Automating manufacturing|
|Qualcomm||(QCOM)||5G, IP, "Smart Everything World"|
|Starbucks||(SBUX)||Coffee and crypto|
|Steel Dynamics||(STLD)||Recycled steel, infrastructure|
|STOR Capital||(STOR)||Prime real estate, business model moat|
|AT&T||(T)||5G, entertainment streaming, advertising|
|Texas Instruments||(TXN)||"Smart Everything World"|
|Westlake Chemical||(WLK)||water treatment, housing|
|Xilinx||(XLNX)||AI, "Smart Everything World"|
There are certainly more "good stocks" out there. To build in a margin of safety to our portfolios, we look for better than good. A few dozen companies barely missed the cut and will remain on our watchlists. We will "position trade" those periodically based on prices and catalysts.
What Are Your Highest Conviction Dividend Stocks?
I am interested to know what your highest conviction dividend stocks are and why. Don't just throw out a name. Tell us why you think the company you are in can offer a double in total return the next five or so years. Post in the conversation below.
Disclosure: I am/we are long AAPL, CSCO, D, DIS, INTC, KMI, OXY, NTR, STOR, T. 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.
Additional disclosure: I am also engaged in options trades to generate income, enhance returns and hedge downside. --- I own a Registered Investment Advisor, Bluemound Asset Management, LLC, but publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.