Battle Loyal3: Round2 Elimination

In the first part, I examined all of the dividend paying stocks in the Loyal3 brokerage service.  After eliminating based on PE, Yield and Dividend Streak, I was left with a third of the original list.  Today, I dive a little deeper and attempt to reduce the remaining positions to three or so.

The remaining companies are:

AAPL, BBY, BUD, DPS, K, INTC, KSS, MAT, MCD, MSFT, TGT, WMT

AAPL : Eliminated

I am dropping AAPL out of the running for the simple reason that their current yield is below 2.5 (it was close during the initial screening).  AAPL is a good company with a brightish future ahead of them.  The main concern I have is whether or not they will still keep innovating.  They basically refurb their main product, the IPhone, each year.  Android phones are catching up in quality and I don’t know if they will be able to maintain market share.  Their market share will not erode overnight, but will be long drawn out affair.

BBY : Eliminated

They are struggling against their online competitors.  This can be seen in the steady deterioration of the following:

  • Operating Margin: 5.6 (2007) to 2.7 (2013)
  • Net/Operating Income have been declining since 2008
  • Free cash flow has been erratic.
  • Long term debt has grown.

BBY doesn’t provide the steady growth that I like and I do not like their future prospects.  This feels a lot like Circuit City to me. Remember them?

BUD : Watch list addition

I am eliminating BUD due to their lack of a dividend buyback and being a net issuer of shares. I do not want my ownership diluted.  Additionally, BUD has a FCF payout ratio of ~63%.  This is higher than I would like to see (60%).  However, I will keep an eye on BUD.

DPS : Maybe

DPS meets all of my criteria for a buy, including FCF Payout ratio <60, Payout Ratio <60, Interest Coverage Ratio > 9.  I currently have a small position in DPS, the only thing that concerns me is the current valuation.  DPS has less market penetration than KO or PEP and I feel like they could have steady growth.  I may be biased because my favorite soda is  Dr. Pepper.

K : Eliminated

The Kellogg Company has a tendency to buyback just a little bit more than they issue.  In fact, total shares outstanding went up from 2012 to 2013.   With my addition of GIS, I do not feel that adding more K at this time would be the best use of the available funds.  From a valuation standpoint, K is trading at a premium to most of it’s metrics.

INTC : Eliminated

I currently have a reasonable amount of Intel.  However, that is not the reason I will be eliminating INTC from contention.  INTC has not raised their dividend since mid 2012.  I may sell INTC if they do not raise the dividend or show demonstrable progress in revenue stabilization/growth.  INTC is at best a hold.

KSS: Eliminated

I think Kohl’s has some promise.  The main concern I have is that they are largely a clothing retailer (some home goods).  I know nothing about fashion and only go to Kohl’s when I can’t find it at WMT or TGT.  Relying as much on clothing/household goods may be hard when the consumer is more constrained.  During 2008, KSS FCF dipped into a negative value and has been inconsistent since.  Even though I do not necessarily require a 5 year or longer dividend history, I would like to see what happens when they hit a rough patch since they began their dividend policy in 2012.

MAT : Eliminated

Who doesn’t love toys?  MAT overall looks pretty good.  However, their cash flow has been pretty erratic over the last few years.  The FCF payout ratio was over 100% at the end of the most recent year, which is higher than I would like it to be.

MCD : Elmininated

I like MCD and would love to own more, but I am trying to avoid adding to my larger positions (over 4%).  MCD is in my Roth (which I am dripping right now), so I do not want to add additional funds at this time.  If MCD was trading significantly below my cost basis, then I would have considered it anyway.

MSFT : Eliminated

Microsoft has promise.  I like the moves the new CEO made with regards to Office on the IPad and releasing some of the software for free.  If you haven’t tried OneNote, you may like it.  It is a very useful product.  On the fundamental side, MSFT has a strong balance sheet and strong cash flow.  I would like to add to MSFT, however after the current run up, MSFT is over 4% of my portfolio.

TGT : Maybe

TGT has been beaten down this year.  They have suffered from a credit card breach that doesn’t seem to end.  Target is the kind of retailer I like. They sell a variety of necessities and other higher margin products.

WMT : Eliminated

For reasons discussed in my analysis of WMT, I will not be adding to this position at this time.

Two remain

TGT and DPS remain.  As of today, I have about 53 dollars in the Loyal3 account.  I will split the investment between these two positions.  Once this has completed, I will provide a post update!

Conclusion

It takes time to deploy capital in the most cost efficient strategy.  I spent a fair amount of time analyzing all of the possible candidates for my next investment.  This was a lengthy and instructive process for me.  The watch list of Loyal3 is somewhat of a random list (which isn’t how my actual watch list came to be), but it was good to familiarize myself with all of the dividend payers that are available in Loyal3.

Disclaimer: Long DPS, GIS, INTC, K MAT MCD, MSFT, TGT, WMT

 

Battle Loyal3: Round I Screening

I have finally been paid enough dividends in my Loyal3 account to purchase some shares.  Loyal3 is a fee free brokerage that allows an individual investor to purchase partial shares with as little as $10.  This enables someone who can only save a few dollars at a time to invest in high quality companies.

Setup

How do they offer fee free trades?  Loyal3 keeps their costs low by batching as many trades as possible before execution.  How does this work?  Suppose you, our ten best friends and myself all place an order for Coca-Cola(KO) tomorrow.  Loyal3 will take all of our money, plus some other peoples and at some time over the next few days buy shares of KO.  Lack of execution speed is the cost of being free.  In addition to this restriction, you can only invest in about 53 companies at the moment and purchase a total of $2500 per stock each month.  You can fund the purchase with either a credit card or bank account.  If you use a credit card you get an instant discount depending on your rewards.

Purchase Criteria

The following criteria will be used to filter the less appealing payers from the list:

  • Dividend growth of three years minimum.
  • Dividend Yield greater than or equal to 2.5 (reasonable yield)
  • PE Less than 20 (protect against overvaluation)
  • Payout Ratio less than 60% (I want room for the dividend to grow).

The most important criteria that a position can have is the desire to create shareholder value through dividends.  This unfortunately cannot be describe in terms of metrics, but in terms of action.  A history of raising the dividend is one action that demonstrates this commitment.  However, this act in and of itself is a bit misleading.  It is great to own a company that has raised dividends for so long, but that is merely an example of what could be.  Still a company with a history of raising dividends will hopefully have a culture that continues regardless of who is running it.

Fortunately, those of us investing over the last decade have been through good and bad times.  The recession weeded out the weak and gave companies the opportunity to demonstrate their commitment to dividends.  This is a valuable demonstration of whether they were committed to dividends and creating shareholder value without extreme methods.

Candidates

I have provided a table of all the dividend payers in L3.  Included is some additional information that will enable us to eliminate those that do not meet our entry criteria.  The table is rather long and includes 38 different companies.  The data in this chart is provided by Google Finance, it may be a little old. It is sufficient for this exercise though.

TickerPriceDiv/shareYield (%)Growth StreakPEPayout Ratio
FOX30.970.250.81%113.7111%
ANF37.840.82.11%222.648%
AEO12.120.524.29%028.54122%
BUD104.253.022.90%412.5536%
AAPL537.4612.22.27%313.3330%
BBY25.730.682.64%313.0234%
ATVI20.250.190.94%421.4120%
BKW25.930.281.08%239.743%
KO38.821.223.14%5220.464%
DIS78.480.861.10%421.5224%
DPS53.721.643.05%517.5654%
DNKN48.910.921.88%236.0368%
FTR5.540.47.22%049.97361%
GPS39.880.882.21%914.5732%
HSY102.771.961.91%428.3854%
K61.761.842.98%912.4637%
HAS54.511.723.16%1125.2480%
INTC25.310.93.56%1013.4348%
KSS56.51.562.76%313.9639%
MAT39.431.523.85%515.2259%
MCD96.163.243.37%3817.3158%
MSFT39.361.122.85%1114.5441%
LB561.362.43%018.344%
M58.411.71%614.9826%
MDLZ34.210.561.64%126.6144%
NKE73.320.961.31%1224.7532%
PEP82.542.623.17%4219.161%
PVH123.080.160.13%070.69%
RL156.981.81.15%519.3422%
SBUX73.41.041.42%4567.98805%
TGT59.741.722.88%4619.4256%
UL41.61.43.37%518.2361%
TWX63.471.282.02%416.7934%
VFC60.861.041.71%4122.6839%
VIAB841.21.43%116.2523%
WWE27.350.481.76%0756.151327%
WMT76.141.922.52%4015.6940%
YUM73.21.482.02%1031.1563%

First thing to notice is that all of these companies are in the Consumer Goods category.  The exceptions being AAPL, INTC, MSFT and FTR.  I would have added diversification to the list above, but that is a relatively futile exercise here.  This is okay, as my accounts work together, so I will just buy other sectors to balance this out.

Let the filtering begin!

The following stocks will be removed because they fail to meet any of the criteria above.

DNKN, WWE, SBUX, YUM

A few takeaways from this bunch.  First, I didn’t realize that the World Wrestling Entertainment (WWE) paid a dividend, but it feels appropriate for them to have a gigantic PE! I am a little surprised at Starbucks (SBUX), I followed (and owned, sold last year) them for years.  After reading the 2013 annual report, SBUX had a $2.25 per share pretax charge relating to some litigation with Kraft.   After adjusting for this accounting change SBUX has a high PE, but a reasonable payout ratio.

Next, I will remove any stocks that do not have a history of raising dividends by at least three years.

AEO, ANF, FOX, FTR, LB, MDLZ, PVH, VIAB

These companies either recently initiated a dividend or have held the payout steady.  A steady dividend is better than no dividend IMO, but there are plenty of quality companies in each industry that have a habit of raising their dividends.

The following companies are being excluded due to their drastically low dividend yield.

 ATVI, BKW, DIS, GPS, HSY, M, NKE,  RL, TWX, VFC

I was surprised to learn that so many clothing companies pay dividends.  Some of them are relatively high (American Eagle Outfitters (AEO) and the GAP (GPS)), while others are low (Ralph Lauren(RL) and Nike (NKE)).  There is even one that has payed dividends for 40+ years in VFC Corp (VFC).

Having the capability of raising a dividend is one of the most important characteristics.  The following companies have a higher payout ratio which may limit the ability to raise dividends and make them less secure.

HAS, KO, PEP, UL

A couple of these positions have a higher payout ratio because they recently raised their dividends and we are using the prior years EPS and not the upcoming years.  With this in mind, I may not necessarily kick these positions out depending on what is discovered with the remaining stocks.

The remaining candidates

At this point in time, we have 12 remaining companies.  

AAPL, BBD, BUD, DPS, K, INTC, KSS, MAT, MCD, MSFT, TGT, WMT

In the next round, I will be looking a little bit deeper and attempt to whittle this number down to three companies or less.  This may seem like an excessive exercise for investing 50 to 60 dollars, but I feel like it is worth it.  I have additional funds to invest and I may uncover a hidden gem among these and at a minimum find some candidates for further research.

Watch list additions

Even though the following didn’t make the cut this time, I will be adding them to my watch list for future research:

GPS, VFC

Summary

This has been an interesting exercise.  I have uncovered some previously unknown dividend payers and then eliminated them based on some of the more basic criteria I am interested in.  In part 2, I will look a little deeper into each position and attempt to reduce the number further.

Disclaimer: Long KO, PEP, MCD, MSFT, INTC, K, HAS, MAT, TGT, WMT, DPS, UL 

Interesting Metrics: Which payout ratio?

There are three payout ratios that are used most often with dividend investing: payout ratio, forward payout ratio, and free cash flow payout ratio.  What are they and which ones should I use?

A payout ratio is a way to attempt to show the safety and possible growth of a dividend.  The lower the payout ratio, the better potential dividend growth.  During times of economic stress, a low payout ratio can be used as one piece in the puzzle to help determine the safety of a dividend.  The other pieces being expenses, free cash flow and other fun metrics.

What are they?

There are several types of payout ratios I use.  They are:

  1. Payout Ratio: This payout ratio takes the current 12 month dividend and divides it by the trailing twelve months (TTM) of earnings per share (EPS).
  2. Forward Payout Ratio:  This payout ratio takes into account the current 12 month dividend and divides it by the projected EPS over the next twelve months.
  3. Free Cash Flow Payout Ratio:  Takes the amount paid in dividends over the previous twelve months and divides it by the Free Cash Flow (FCF) generated during the TTM.

The payout ratio that should be used depends on the industry.  Generally, I try to stay below a 60% payout ratio (this number is a matter of individual choice).  However, some sectors will have a higher payout ratio because there is only so much they can reinvest in the business.  Two sectors that come into mind are utilities and tobacco companies.

Issues with each

Payout Ratio

The main issue with the payout ratio is the fact that it uses earnings per share (EPS).  EPS can be affected by charges that are not necessarily accrued at one time or by charges that are merely an accounting requirement.  Take Starbucks (SBUX) for example.  According to SBUX 2013 annual report they earned $.01 per share. Or did they?  It turns out in Q4 2013 they finished arbitration with Kraft, which resulted in a $2.25 charge to earnings.  The claim was not paid in Q4 2013, but will be funded with cash and debt at a later date.

SBUX is currently paying .26 per quarter ($1.04 per year). So which do you use? .01 or 2.26? Or in terms of Payout Ratio 1.04 / .01 = 10400%? or 1.04/2.26 = 46%? This case is a drastic example, but suppose SBUX only had a charge of $1.  Then the payout ratio would be 1.04/1.26 = 82%, still high but not necessarily high enough to make you want look deeper.   For this kind of investment, one falls below my 60% rule and the others are well above.  It takes some due diligence to make sure that a charge off doesn’t skew your results, or you could miss out on a good investment opportunity.

After reading enough reports, you will see that charge offs are fairly common.  Generally, the bulk of what I have seen are a couple pennies. It is only in the rare case that one is much larger.  The SBUX write off is the largest I have personally seen.

Forward Payout Ratio

The Forward Payout Ratio has only one main issue that concerns me, that is the nature of telling the future.  This ratio uses earnings projections for the next year to determine what the payout ratio is today.  In order to use this number and be confident in it, you must understand the business and what is possible in terms of earnings growth.  Earnings growth can be affected by a large number of things.  The economy, share buybacks (almost artificial earnings growth), issuing shares, etc.

Free Cash Flow Payout Ratio

The Free Cash Flow payout ratio is my preferred ratio.  This divides the previous TTM dividend with the actual cash the was generated after paying expenses and capital expenditures.  I like this ratio the most because it uses money the company actually made as part of the ratio.  Like the payout ratio, I would like this to be below 60%.  If this ratio is above 100%, then that will require some additional digging to figure out why.

On the plus side, the free cash flow of a business is less affected by many of the same problems that arise when calculating EPS (charge offs, accounting gimmicks, etc).  It is the cold hard case that the company generated.  The main issue with this ratio is that it is a historical number.  It’s a measurement of what was done and as we all know in investing “past performance does not guarantee future results.”

Conclusion

Using a combination of the Payout Ratio, Forward Payout Ratio and Free Cash Flow ratios can be part of the process for helping to determine the safety, sustainability and growth potential of a dividend.  Each has their flaws, but provide insight into the overall picture.

 Disclaimer: None

Interesting Metrics: Dividend Yield and Growth

This article is the first in the series of articles I will use to describe my investing method.  These are meant to be informational and contain information that will help me as I invest.  I have tendency to forget what a metric means.  The research in this series will provide the basic information and examples that will help me.  Many of these articles will be basic, but I have friends/family reading this that are new to investing. Hopefully it helps them and you too!

Now for Dividend Yield and Growth!

Definitions

What is a dividend? A dividend is a payment that a company pays to its shareholders from profits. This is a way for the owners to share in the spoils of the business.  

What is a dividend yield?  The dividend yield is the market price of the stock divided by the total amount of dividends paid in a year.  For example, if ACME’s current market value is 100$ per share and they pay 2.5$ per year in dividends,  their yield is 2.5/100 = 2.5%.

What is a dividend growth rate? Percentage at which the dividend changes over a period of time. Commonly, you will see 5-year, 10 year and most recent growth rates.  These rates are calculated using the Compound Annual Growth Rate (CAGR).

How I use them:

When I look for dividend investments, I attempt to look for stocks with an entry yield higher than 2.5%.   When I use a stock screener, I usually set the lowest yield to 2.0.  While I may not purchase a stock below 2.5, I like to keep track of which stocks are near it and keep them on a watch list.  As the price of a stock fluctuates, individual securities move up or down around my dividend entry criteria.  Walmart, for example, has a tendency to stay in the 2.3 to 2.6 range.

Next, I attempt to find stocks with a minimum dividend growth.  It must be positive with no dividend cuts and three or more years of growth.   Three years isn’t enough to demonstrate to a potential shareholder the commitment to pay a dividend, but it can yield hidden gems that will potentially raise their dividends quicker. Most of my large positions will have dividend growth streaks over 10 years.  A fantastic resource for finding these types of dividend stocks  is the U.S. Dividend Champion spreadsheets created and maintained by Dave Fish.

Given a combination of growth and yield, I generally like to start with yields closer to 3 and 5 year growth of 8-10.  I do not mind having some strong dividend growers in the portfolio with lower yields.  There are plenty of high quality companies yielding more than 2.5 (KO, PEP and PM for example), this higher yield criteria is not hard to find.  On the flip side of the coin, I will have some stocks with larger yields and slower growth like AT&T(T) and Realty Income (O).  It’s a matter of balance.  A few higher yielding investments enable me to accumulate funds faster to buy securities that grow faster.

Illustration of dividend growth:

I will examine three scenarios, each with a different yield and growth rate. What do you think will perform the best? Higher growth/lower yield or higher yield/lower growth? Let’s see.

ScenarioRate (%)Dividend Growth (%)Years to reach $1549
High Growth3109
Realistic Growth3.589.1
Minimal Growth4610.5

Interesting!  The 3 and 3.5% scenarios are neck in neck to reach 1549 dividends per year, while the larger yield of 4%, but lower growth, is years behind.  This demonstrates the importance of dividend growth, even with portfolios that start at a higher yield.

Dividend Growth Investing
Comparison between different yields and growth.

The graph demonstrates how a low yield with high growth can overcome the initial gap between yields.  The scenarios I chose seem somewhat arbitrary, but I wanted to illustrate that getting the highest starting yield possible can be defeated by a strong consistent growth rate.  Dividend growth rates do not stay this constant and will vary over the years as companies go through peaks and troughs.

The next question that you may be asking yourself is, what is the difference in dividends earned per year and what are the overall dividends?

ScenarioDivs @ 30Total Divs @ 30Divs @ 30 reinvestTot. Divs reinvest
High Growth10,708111,03311,029114,344
Realistic Growth7,33789,2107,59492,305
Minimal Growth4,87671,1525,07173,962

As the years go on, the High Growth scenario destroys the other two.  At year 30, you would receive 10,708 in dividends per year (which is calculated by initial-divs * (1+ growth rate) ^ number of years).  Hopefully my math is right!  This value is more than double the highest yielding yet slowest growth.

The final two columns demonstrate the effects of reinvesting your interest.  As your investments pay you, you can either save the money or reinvest.  These columns demonstrate what happens if you reinvest those dividends at the start of the next year (compounded annually).  Basically, you get two raises.  The dividend growth that happens during the year and the reinvestment of the dividends.  The reinvestment numbers may be low because once you have accrued enough, you will reinvest the dividends instead of waiting until the end of the year (compound quarterly or monthly vs. annually).  This was merely for demonstration purposes and simplicity.

What if I just started with a higher yield? You definitely could have and there are yields with enough growth that would beat all the scenarios demonstrated above.  However, with great reward comes greater risks.  The goal is to keep risk as low as realistically possible, given the nature of these investments.  A high yielding dividend isn’t necessarily unsafe, but maintaining the dividend may be hard when a rough patch is hit.  Due diligence is key!

There is no fixed yield/growth rate that will work for everyone.  Depending on your circumstances, you may need more yield or growth.  I have a long time till I want to live off of the income, so I can make due with a lower starting yield and higher growth.  Over the years, my research has lead me to believe that the “realistic” scenario of 3.5% with 8 percent dividend growth is an achievable long term goal.  Only time will tell!

Wrap-up

The provided examples make a strong case for dividend growth investing.  There is more to investing than pretty charts and stock prices.   These examples are illustrative of the potential of dividend growth investing, but unlike numbers the market doesn’t behave in a consistent fashion. Good investments go down and bad go up.  I feel this strategy will give me the best opportunity to reach my financial goals.

Thanks for reading!

Disclaimer: Long KO, O, PEP, PM,T,WMT