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Evaluation Of The 12 Rules In “The Single Best Investment” To Our DGI Stocks

I recently finished reading SBI (The Single Best Investment by Jeremy Miller) and decided to scrutinize our portfolio of stocks to see how they measure up to the rules presented in Chapter 11. We currently have 27 "core" and 28 "supporting" stocks, for a total of 55 companies. I'd like to consolidate our list to end up with about 50 stocks; however, I have no specific requirement for a set number of stocks. This exercise will help me determine how well our stocks meet the guidelines presented by Mr. Miller. It will also help me identify if there are a few companies that I should consider removing from our portfolio.

The following summarizes the 12 Rules and how I'm applying and evaluating them.

The 12 Rules Presented in SBI

1. The company must be financially strong. I'm using the S&P credit rating provided by FAST Graphs as an indicator. I mostly use a BBB+ credit rating as our desired cutoff, but will consider BBB if other metrics are good.

2. The company must offer a relatively high current yield. SBI recommends at least 150% of the average yield of the S&P 500.

It's important to consider market conditions, and the S&P yield has been on an upward trend over the past 5 years. In addition, the bull market has resulted in increased (many would say inflated) stock prices for high quality companies. I typically want 2.5% yield or more, with preference for 3% or more. However, I'll consider a yield below 2.5% for high quality, faster growth stocks. Some of our stocks currently have a yield lower than 2.5% because of their price growth, but that doesn't automatically mean we would sell.

3. The yield must be expected to grow substantially in the future. SBI recommends at least 5% to assure growth in excess of inflation. The dividend payout ratio should be less than 50% (except utilities, REITs and MLPs).

Given the current market condition, I'm using 5% growth rate for all but the highest yields (over 4%) and payout ratio of 65% (higher for utilities/REITs).

4. The company should offer consistent historic and prospective earnings growth. SBI recommends earnings growth in the range of 5% to 10%.

I'm using projected EPS (Earnings Per Share) provided by FAST Graphs for years 2017 through 2019 for my evaluation.

5. Management must be excellent. A long record of success is one mark of good management.

I'm using Morningstar's "Stewardship Rating" to evaluate this rule.

6. Give weight to valuation measures. Price/sales (P/S) ratio should be less than 1.5, and ideally less than 1.0. P/E and Book Value ratios should be less than market.

I've decided that it's not very useful to evaluate P/S ratio for my evaluation because it fluctuates widely across sectors. As an example JNJ has a P/S ratio of 4.78 (3 times higher than the recommendation) for what I view as the safest DGI stock (the only one with AAA credit). For that reason, I'm not evaluating this rule.

7. Consider the "story." Number one or number two market share in the companyʼs industry is a positive.

I strive to buy the top 1 or 2 companies in each industry (e.g., KO/PEP, LOW/HD.). I'm also using the Morningstar "moat" rating as part of the evaluation.

8. Use charts to help your buying. Mr. Miller states: "Thereʼs much thatʼs useless in technical analysis, but evaluating relative strength is useful."

I've decided that evaluating relative strength is not very useful for this evaluation, as it indicates shorter term price momentum. It can be useful to help select a company for initial purchase, but for the purpose of evaluating stocks we already hold, I'm ignoring this rule.

9. Picture the future. "Does the company provide a necessity of life, and execute well? Is it likely to continue to be needed in society twenty or forty years from now? Has it defeated challengers to its market in the past? Are margins improving? Is the size of its market growing? Does it dominate?"

This rule is subjective, but I have and will continue to consider the questions presented in SBI. More than 50% of our portfolio is consumer staples, utilities, and telecom, (necessity of life products/services) and virtually all of our core positions have a 10+ year record of increasing dividends (successful past history). The projected EPS I am using to evaluate rule 4 provides some data helpful to "picture the future" (at least for the shorter term).

10. Hold with equanimity. Successful investing is about the cultivation of rational patience. Focus on the unfolding story, not quarterly earnings reports or brokerage recommendations.

My interpretation of this rule is don't sell when a company is facing headwinds if you believe the company will persevere in the long run.

11. Sell when the dividend is in jeopardy, when the dividend has not been increased in the past 12 months without an excuse, or the "story" has changed.

Although this is related to a sell decision, the data evaluated for rule 3 also supports evaluating this rule.

12. Diversify among many stocks that qualify as Single Best Investment stocks. SBI recommends about thirty stocks with equal dollar amounts as the minimum. We feel more comfortable with closer to 50 to provide a little more diversity.

I didn't score this rule, but we do apply it. It's one of the reasons we hold some cyclical even though they don't always measure up to every rule (e.g., XOM and CVX). The last column in my table lists the sector and demonstrates diversification.

Extra metric: SBI discusses low volatility, and makes the point that SBI stocks, by nature, have lower volatility. So, I also look at Beta as a measure of volatility, but didn't "score" it.

How I Applied my Scoring

I've scored rules 1, 2, 3, 4, 5, 7, 9, and 11 in the tables that follow this scoring discussion. As stated earlier, I thought rule 6 was too complicated to apply because of sector variations. Rule 8 (related to price momentum) also wasn't used. Rule 10 isn't based on specific measurable metrics, and was therefore excluded.

In the following tables, I attempted to highlight both positive and negative information, using pink for negative and green for positive. In cases where I would normally score something negative but felt it was closer to neutral given specific circumstances, I shaded the table cell yellow. An example is when the dividend yield is high (>4%) but growth is slower than the recommended 5%. For those situations, the cell in the yield column is green and the cells in the growth columns are yellow.

Rule 1: I applied green to credit rating of A or above, pink to credit rating of BBB- or below, and yellow to BBB (below my preferred criteria but still investment grade.

Rule 2: I applied green to yield above 4% and yellow to yield below my preferred yield of 2.5% (purely subjective for me). Also applied yellow to yields above 7%, which I think is moving towards a danger zone of unsustainable yield (again, my subjective rating).

Rules 3 and 11: For Rule 3, I applied green to dividend growth greater than 10% and pink to dividend growth less than 5% (unless the yield is high, for which I used yellow). I included 1, 3, and 5 year growth numbers to be able to see if the yields are decreasing, increasing, or holding steady over time (however, I didn't score this trend).

The data also apply to Rule 11, since a negative dividend growth number means the dividend was already cut and a high payout ratio means the dividend could be in jeopardy

Rules 4 and 9: To evaluate Rule 4, I applied green to projected EPS growth greater than 10% and pink to projected growth less than 5% (unless the yield is high, for which I used yellow). I included 2017, 2018, and 2019 data from FAST Graphs to be able to see trends.

Showing multiple years is useful to help evaluate if projected EPS growth is indicating a temporary headwind (which has likely already affected the stock price) or if the trend is expected to be long term (which could indicate a secular decline in the company's current business). The projected EPS data also supports evaluating Rule 9 to "predict the future."

Rule 5: I applied green to "Exemplary" stewardship and pink to "Poor" stewardship. "Standard" stewardship was rated neutral (no color applied).

Rule 7: I applied green to "Wide" moat.

"Extra" Rule: While I didn't score Beta, I calculated the weighted average. The core list of stocks has a weighted average of 0.65 and the Supporting list of stocks has a weighted average of 0.73. The scores indicate that we can expect lower than average volatility.

Rule 12: I maintain an Excel spreadsheet that calculates a weighted average by sector based on current price. The table below shows the data. I combine REITs and Financial (as well as BDCs) into one "financial" category and include a category for "MLP-like" companies (I used to hold two MLPs, but sold them). This sector list is mostly a remnant of how I initially set up my sector categories when I developed my spreadsheet. Sector definitions vary somewhat from company to company, so this table is would also vary from person to person. As with many DGI investors, we are heavily weighted in staples and utilities.

The tables below show how each of our stocks measure up with the scoring criteria I devised (based on the SBI rules, but with my own judgement applied).

Evaluation Table 1. Core Stocks

Results of Core Stocks Evaluation

As stated in SBI, it isn't necessary to rigidly stick to every single rule. Mr. Miller stated "there are always changes in the marketplace and there are always stocks whose special circumstances argue for purchase despite the fact that they may miss out on one or two points." I'm not going to provide a synopsis of every stock in this article, but the analysis does raise a few concerns. First, payout ratios are rather high for quite a few companies. Some (e.g., CVX and XOM) are at the bottom (we hope!) of the energy cycle and have deep debt. Others have been facing FOREX issues for the past few years (e.g., PG, GIS), are currently restructuring (e.g., KO), or are dealing with price wars (e.g., T, VZ). AT&T's poor stewardship rating is the result of their recent acquisitions, and the question is will they pay off in the future? I don't know the answer to this, but I think most people would agree that they need to find some growth in a new area, and that's what AT&T's latest acquisitions are trying to accomplish.

Another general area of potential concern is the sluggish projected EPS growth of some companies, especially WMT. They have ramped up online sales and recently acquired jet.com, which may help turn this trend around. A few companies ended up with a pink mark or two (e.g., MCD, KMB) that I'm not overly concerned about. In their case, dividend growth and/or earnings are a little shy of the 5% mark, but not alarming.

Evaluation Table 2. Supporting Stocks

Results of Supporting Stock Evaluation

The analysis of this group also raises a few concerns. First, there are three companies with BBB- credit ratings, which I consider the most important metric (Rule 1).

  • KMI gets a lot of additional pink marks beyond the credit score. I probably should have sold it as soon as the dividend was cut (SBI recommends selling as Rule 11). But, I hesitated on taking action and by the time I would have sold, I figured most or all of the negatives were probably already baked into the share price. So, I decided to take a wait and see attitude. It's only a 1/3 position and less than 1% of our portfolio, so I can afford to wait.
  • OHI has a high yield (one that makes me a little nervous) as well as the low credit score, so I am considering selling. I will evaluate in greater detail before deciding.
  • KHC has a low credit score, but I'm planning to just watch it for now. It is only about a 1/4 position.

The three years of negative projected EPS growth for GILD also concerns me, although the payout ratio is so low, I don't expect a dividend cut any time soon. However, I'm thinking about selling it since I want to reduce our total number of positions.

IBM also has low projected EPS growth, but the growth is positive, is improving, and it's paying me a decent yield to wait.

GSK is another that I'm thinking about selling. The negative trend in dividend yield is mostly due to FOREX, but the payout ratio is alarmingly high. Since it's only about a 1/3 position and it's not a high conviction stock for me, I may sell it. Despite its declining price, I can actually sell at a small profit.

Conclusion

While I'm not necessarily taking specific actions immediately based on my evaluation, this exercise was useful in showing me what to keep track of more carefully going forward and where I might want to dig a little deeper to gain a better understanding of the current circumstances. As a result of this study, I identified three stocks to evaluate more closely to determine if I should sell (OHI, GILD, and GSK). I was a little surprised at the number of pink marks for some of our core stocks, but also relieved that most of the results of this evaluation do not merit a high level of concern.

Since many DGIs hold a lot of the same stocks that we have in our portfolio, I'm interested in seeing others' opinions about whether they think this evaluation is worthwhile, and if they drew similar or different conclusions. Thanks for reading and happy investing!

Disclosure: I am/we are long ALL STOCKS SHOWN IN EVALUATION TABLES.