As an investor, I see myself as a part owner in a business. My goal is to acquire ownership in businesses, which share their excess cashflows with me in the form of growing dividends. In order to achieve that stream of dividend income, I focus on growth in earnings per share. Since dividend income is more stable that share prices, I tend to ignore stock price fluctuations. The only exception I make is when I have money to invest every month. Other than that, I would be fine sitting on my collection of businesses and enjoying the growing stream of passive dividend income even if they closed the stock market for a decade.
I am a long-term buy and hold investor in the accumulation phase. I invest money every month in a collection of several companies I have identified during my research. The concepts discussed in this article are the ones I follow in my real money stock portfolio.
As an investor in the accumulation phase, I like to acquire ownership interests in great businesses at lower prices. Whether we are talking about socks or stocks, it is better to buy them on sale. When it comes to equities, lower entry prices mean higher entry yields.
The stock market is finally starting to decline over the past couple of months. It is quite possible that we may be entering a long-awaited bear market. This is good news for buyers of equities today. Investors should be praying for even lower prices during their working careers. Retired investors on the other hand should ignore the day to day noise and focus on the stability of their dividend incomes.
As a result, it is time to run my screening criteria against the list of dividend champions, in order to identify any bargains for further research. I updated the December Dividend Champions list before, and decided to run my criteria against it.
The list of dividend champions includes 127 companies which have managed to raise dividends each year for at least a quarter of a century. I view this track record of annual dividend increases as an achievement, which prompts me to use that list as a starting point in my research to identify quality companies.
The first step in the process involves focusing on all companies that sell for less than 20 times forward earnings. This yardstick is helpful in my process to value dividend stocks. I gathered the information on forward earnings estimates in the past week, but those should not be changing as quickly. I use forward earnings, in order to eliminate the one-off accounting charges that make trailing earnings difficult to use. While forward earnings are usually overly optimistic, I still find them helpful in the initial stages of the screening process. I also find a P/E of 20 to be a good yardstick, because it translates into an earnings yield of 5%. While interest rates are low today, they will likely get to a 4% - 5% rate on longer dated US Treasuries at some point in the future. This provides some built-in margin of safety in valuation for the times when rising rates can depress the relative interest in US stocks.
The second step in the process involves looking at companies that have managed to grow dividends by at least 5%/year over the past five and ten years. While there is a trade-off between yield and growth, I want to see companies that can grow distributions over time above the rate of inflation. I have found that dividend growth can bail the investor out if inflation spikes or valuations become more pessimistic.
The third step in the process is to focus on companies with a forward dividend payout ratio below 60%. I want a good coverage from earnings, in order to provide for some margin of safety in case of short-term turbulence. An adequate payout ratio is a good indicator of dividend safety. I follow this step in order to reduce the risk of dividend cuts.
The fourth step in the process involves reviewing the earnings for each company that my screen spit out in steps 1 through 3. I try to select companies that can grow earnings per share over time. A rising stream of earnings per share is the fuel behind future dividend increases- and increases in intrinsic value for the businesses I invest in.
After going through this process, I ended up with the following list of dividend champions for further research:
I wanted to include a disclaimer that this list is not an automatic buy recommendation. I do not buy stocks based on a few screening criteria. Rather, I analyze each company, in order to gain a better feel for the business. I bought shares in ten dividend growth stocks last week. I plan to invest in ten more dividend growth stocks later this month.