STOCK INVESTMENT THE OPTIMUM APPROACH – IDENTIFYING STOCKS

Once an investor has settled on an approach / strategy built around dividend-paying stocks, the initial task is to survey the universe of stocks available for purchase and narrow down the choices to a much smaller subset of superior companies. What we want to identify are the most successful, financially strong companies available that pay a reasonable dividend. At this point, we will disregard current prices and whether a company can be purchased today at a reasonable price. Many will not. This will be addressed in the essay on acquisition strategies. For now we just want a list of the best dividend-paying companies out there. There are many characteristics to consider, but they essentially boil down to two issues: the company must have an attractive dividend policy (management wants to pay meaningful dividends), and must be judged as a financially strong, successful business (the company is able to pay meaningful dividends). Thus, first and foremost, the company must pay a meaningful dividend, which is one that results in a yield of 3% or more based on the current market price. A slightly lower yield may be acceptable for the strongest, most attractive companies, but not much lower. Further, the company must have a history of steady dividend payments, extending back years in many cases. Also, dividends must be seen to have been increased regularly, ideally annually. A long history of dividends extending back 20 years or more, with dividends being increased more or less regularly over that time frame, is a very good sign. Still, it does not guarantee that the policy will continue. To determine the likelihood of that, we must evaluate the company as a business and try to ascertain how well the business supports the dividend now and whether it will be able to support the dividend in the future. Of course, there is always the chance that going forward management may veer away from an attractive dividend policy even though the company can afford it, but in actuality this rarely happens – a company that has a history of dividends is unlikely to change this policy in the absence of financial distress. So we will assume that if the company can continue to pay dividends, it will continue to pay them. So the task is really one of determining financial strength and future prospects of the business.

Again, at this point, we are not evaluating value in the sense of the price at which the stock can be purchased. That comes later. We just want to evaluate the health of the business. Available on various free financial web sites and brokerage sites are recent quarterly and annual income statements, cash flow statements, balance sheets, dividend payout and growth data, key ratios, and much more. Evaluating a company’s financial state is a vast undertaking, and is covered in numerous books and articles for the investor that wants to know more. Most mere mortal investors tend to rely on subscription advisory services, myself included. I will have more to say on this shortly. Although going it alone is probably not the way to go for the non-professional, it is helpful to at least know a little about what to look for when evaluating a company’s financial strength and ability to continue to pay a dividend.

Earnings are required for dividends. It’s pretty much that simple. Probably the most important statistic regarding how well the dividend is supported at present is the payout ratio, the per cent of earnings paid out as dividends. (For MLPs, payout should be calculated using "Distributable Cash Flow" (DCF) instead of earnings, while for REITs, it should be based on "Funds from Operations" (FFO) instead of earnings.)  Based on the previous 12 months earnings (or other metrics, for MLPs and REITs) and dividends, if it is near or over 100%, the dividend is not supported, and unless earnings improve significantly, a cut is likely. Above 80% is cutting it close, but may be acceptable for businesses with relatively steady earnings and not much need for capital to put back into the business. A ratio in the 50% to 70% range is good for a relatively high-yielding stock, while less than 40% is obviously safer yet, though as you go further down it may indicate dividends are not a priority for management. Payout ratio is thus a function of earnings, relating earnings to the dividend they support. Earnings that are steady are better for dividends, although some cyclical companies are dividend payers. Earnings history should therefore be considered when viewing the safety of the dividend. Some analysts prefer to look at the ratio of free cash flow to dividends instead of earnings, since dividends require cash to be available, plus cash flow cannot be affected by non-cash items like earnings sometimes can.

Another factor that could impact the company’s ability to pay dividends is debt. The potential risk posed by debt is best evaluated by considering several ratios. The debt/equity ratio compares total debt to shareholder’s equity. A value of .50 or less is good, while 1.00 or more implies high debt. Another ratio is the interest coverage ratio, which is the earnings before interest and taxes for a period divided by the interest expense (from bonds the company has issued) for the period. In this case, higher is better. Values of 1.5 or less means earnings barely support the ongoing interest expense. A dividend-paying company should have a value many times 1.5, in the 25 to 50 range, indicating there is little risk of debt payments crowding out the dividend. If the company has a lot of preferred stock outstanding, the burden of the preferred dividends needs to be considered, since preferred dividends are senior to common dividends. An all-encompassing debt ratio is the leverage ratio, which compares total assets to shareholder’s equity. A value of 1 would signify no debt. A typical large, healthy, dividend-paying company will have a leverage ratio below 2. A dividend-paying company should not have a value over 5. In addition to ratios, the S&P or other rating agency's rating of a company’s debt should be considered. A rating of "A" or better is best.

Qualitative factors to consider are many. What is the size of the company? Most dividend-payers are large-cap, with a capitalization over $10 billion. What about the existence or lack thereof of an economic "moat", or barrier to competition? A large fixed-cost requirement can mean new entrants are not likely to appear overnight. Is the company vulnerable to technological obsolescence? The demise of film camera icon Eastman Kodak is one example. Is the company dependent on income from a single source, be it a single customer or product, or is the companies’ revenue diversified?

As can be seen, the universe of things to consider when evaluating a company is almost limitless. To assist in this task, there are many advisory services available catering to the individual investor. Costs range from less than $100/year, to many times that amount. If there has ever been a field where the phrase "let the buyer beware" applies, this is it. Be especially wary of outlandish claims regarding returns. There are also many free resources available from the Internet. In all cases, consider recommendations as ideas to consider for adding to your list, not to be immediately accepted. Before subscribing to a service, be sure the service is focused on dividend stocks, not stocks in general. Anything priced over $200/year is too much. Quality does not necessarily increase as cost increases. Avoid services that focus on just one sector, such as utilities. Insist that the service provide maximum prices for buying and ideally, for "full value". A price that represents "full value" is the maximum price that the advisory believes the stock is worth, above which you might consider selling. At least two services should be subscribed to for balance and perspective, but not more than three.

Your beginning list should be 40 to 50 stocks, and may be expanded to 100 to 150 or more. This is an active watch list. Stocks will be added or dropped as time progresses. These are the stocks to be considered for purchase. Once you are fully invested, which under my approach is seldom more than 80% stock vs. 20% cash, you will own between 20 and 40 stocks. This includes all positions. These will be in various stages of acquisition, either partial, full, or over-subscribed (with some excess "inventory" to sell).

Some investment authorities would say that is too many, that an individual should only own 5 to 10 stocks. I believe that would have the investor over-exposed to individual companies. No matter how much study you put in, how knowledgeable you become, you cannot expect to see the future. Any stock can be affected by a "black swan" event,. In cases I have experienced, the event has been a strategic decision by management that had catastrophic results, a decision and change in direction that could not have been predicted. Sometimes it seems that a stock has an endless supply of closets with skeletons. Sure, you can always sell and take the loss, but if the stock is 15% to 25% of your portfolio, both the capital loss and the loss of income will deliver a huge blow to your portfolio and your ego. Also, with the risk from this over-concentration at such a high level, you will tend to sell early and often, often panicking out of a good long-term holding that did not have to be sold. Another argument I would make is that with the online tools available today and the productivity they offer, there is no reason why an investor cannot keep up with 30 or 40 stocks owned, and that many more on a watch list.

The next step is to determine your own buy and "full value" prices for each stock. I am purposefully using the term "full value" price instead of sell price, since a stock moving into this range is not necessarily ready to be sold. Handling buys and sells is the topic of the next essay, Acquisition and Selling Strategies.