When I ask my members what their #1 investing struggle is, there are usually two answers right off the top:
#1 What and when to buy shares.
#2 What and when to sell shares!
After a crazy 2020, the market has now reached new highs each month in 2021. The same question keeps coming: Should I invest at the all-time high?
I want to dedicate this newsletter to my buy process. It is not perfect, but it is clear and detailed, and hopefully helps to minimize errors. I think this is the most important part. Without clarity and focus, one can become confused and either err or get stuck in paralysis by analysis.
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Have you ever noticed that most of the difficult challenges in life come with very simple solutions?
You want to lose weight? Eat less and focus on healthy foods, and train more.
You want to build a business? Identify a problem and offer a solution.
You want to retire stress-free? Pay yourself first and invest systematically.
You want to travel the world in your 30’s? Buy a RV, quit your job and start your adventure!
Those goals are all considered “difficult” to achieve because they require you to follow a simple methodology for a long, long time! Consistency is the factor most people ignore when going after a specific goal.
You must always eat healthy food and workout 4 days a week.
You must work relentlessly to improve your solution and spread your message.
Paying yourself or going on vacation and fancy yourself with some cool clothes?
All right, my last example was just a crazy tip! Yet it was simple and still difficult to achieve!
Investing is no different. To succeed, you must follow a simple solution. The clearer and more detailed your methodology is, the easier it is to stick to it and avoid mistakes. Here is how I screen the market and make my decisions.
Let us start with the dividend triangle
If you have been following me for a while, you know that I am a big fan of what I call the Dividend Triangle. This simple focus on three metrics will reduce your search time rapidly and help you target companies with robust financials. I start all my searches with a look at companies showing strong revenue growth, earnings growth, and dividend growth over the past 5 years. The detailed explanation is found in our recession-proof workbook I invite you to read and re-read if necessary.
I use the DSR stock screener to find those great companies and it will take you just a few minutes.
In a few simple clicks, you can set the filters and begin hunting for the best stocks:
- Minimum Pro Rating 3
- Minimum Dividend Safety Score 3
- Minimum 5yr EPS 1%
- Minimum 5yr revenue 1%
- Minimum 5yr dividend 1%
By selecting only companies showing positive numbers in the 5yr Rev growth, 5yr EPS growth and 5yr Div. growth columns, you will find those companies with a positive dividend triangle.
This methodology covers all “regular companies”, but not REITs and other businesses that use non-conventional metrics instead of EPS. We will address those types of companies later in this letter.
As of June 2021, these simple filters would bring down the dividend universe to 228 candidates for your portfolio. You can slash this list by 64% by selecting only companies with a Pro rating of 4.
You can then, select the “columns” button and add as many financial metrics as you want. While the stock screener is limited for the number of metrics it can show on your screen, you can export the file as “csv”, which is an excel spreadsheet.
You will be able to search through several metrics and identify the cream of the crop for each sector and each market.
Priority to dividend growth, not yield
Now that you have narrowed the number of stocks to consider, it is time to trim that list further. Throughout the years, most of my best stock picks have been found amongst the strongest dividend growers. When you think about it, it totally makes sense. Those companies must earn increasing cash flows and show several growth vectors to be confident enough to offer a 5%+ dividend increase year after year.
Past dividend growth is a result of several good metrics at the same time. This usually means stronger revenue, consistent earnings growth, increasing cash flow and debt that is under control. We will dig into the other metrics later, but at first glance, a strong dividend grower will likely come with other robust metrics.
While not all my holdings show such strong dividend growth, I always search for the strongest dividend growers when selecting a new stock for my portfolio. In other words, I am trying to maintain my “Chowder score” above 10 for most of my holdings.
Focus on the sector you need
Whenever you isolate certain metrics, you will notice that certain sectors will be generally strong. This is because each sector thrives or faces tailwinds at different times. The timing of your research will determine which sector offers you the best opportunities. Unfortunately, you cannot buy all your stocks from the same sector. The DSR recession-proof workbook will guide you in this regard.
When you run a stock screener at a specific time, you will likely find many companies from the same sector showing a robust dividend triangle. This only tells you this sector is thriving now. While it does not mean you should ignore it, going on a shopping spree and buying 5-6 stocks from that single sector won’t help you build a well-diversified portfolio either.
I would rather buy the best of breed from each sector than buy 4 stocks from the same industry. This will help my diversification and smooth my total returns over time. For example, the fact that I had many tech stocks in my portfolio protected me to some extent from the March 2020 crash. Tech, utilities, and consumer defensive stocks held the fort while my financials, industrials and consumer cyclicals were getting killed. Even more importantly, that diversification helped my portfolio bounce back relatively quickly.
Dividend safety metrics
I will not start the dividend safety metrics with the classic discussion of payout ratios. In fact, I am a big believer that offense is the best defense. If you want to make sure your holdings will continue to increase their dividends, look for companies with strong revenues, earnings, and cash flow generation. While we provide the first two metrics, cash flow from operations and free cash flow can be found in the company’s quarterly and annual statements. I am working on a project to secure those metrics for our stock cards, but it may be a long-term project.
Then, you can move to the dividend growth section of the stock card. It will show you the overall dividend appreciation and the infamous payout and cash payout ratios.
There is some confusion around the cash payout ratio. Here is the formula used by Ycharts:
Common Stock Dividends / (Cash Flow from Operations - Capital Expenditures - Preferred Dividends Paid).
If a company has high Capital Expenditures, they may end-up with a high (or even negative) dividend cash payout ratio. The company, however, will usually finance its CAPEX and use its cash flow to pay its dividends. You obviously want stocks with payout ratios under 80%, but from time to time, more digging will explain high ratios and the dividend will remain safe.
Understand the business model
Once you have finished with the first screeners including the dividend triangle and spot checks on the dividend safety, you are slowly entering into the “art part” of the buying process. We may still rely on some metrics for the downsides and growth potential issues, but for now, your investing process requires you to become an artist.
If you do not understand how a company makes money and how it will grow in the future, just skip to the next one. We make great efforts to define the company’s business model in the name section and you will find more information about it in the investment thesis. The point is to be able to explain what a company does (and how it will grow) to a 12-year-old. If you cannot put it in simple words, chances are you do not fully grasp what is happening. If you cannot, do not feel bad (it happens to me too!) and just focus on the stocks you can fully grasp.
Growth potential and potential downsides
Once we fully understand what a company does (and what it does best!), we can now focus on potential growth and potential downsides. Identifying headwinds and what could go wrong is probably more important than thinking of growth. Being positive about a company at this stage is easy. You have already found companies with strong metrics and the ability to increase their dividends. It is now time to put on your “gloom and doom” hat and look at potential downsides for each company you are considering.
At this point, its half science, and half art. The science part will require that you look at growth trends (dividend triangle) and identify if it is slowing down or not. Then, you can look at debt over the past 5 to 10 years. Identify if the company keeps borrowing more or if it is paying down on its debt. This will require that you dig inside financial statements to understand the full story. You can also use the current ratio on the stock card page.
A current ratio of one means that the book value of current assets is the same as the book value of current liabilities. In general, investors look for a company with a current ratio of 2:1, meaning current assets are twice as large as current liabilities.
A final point about identifying potential downsides is to read bear theses around the web. Look at why some investors dislike the stock you are about to purchase. This may give you other reasons to pursue additional information.
Once you get really depressed about the stock you were so hyped about, it is time to identify growth vectors. It is better to do it in this order, so you don’t paint everything in pink and start looking for unicorns. Too many times, investors forget to identify how the company will thrive in the future. It is not that easy. There is competition, recessions, price of raw materials, inflation, etc. Making a clear list of how the company can grow in any environment is crucial. Do not go for the easy “it’s a great business” thesis. In a capitalist world, companies either grow and thrive or they mature, slowdown and eventually tumble. Do I have to remind you that JC Penney and Sears were growing and solid stocks at one point many years ago?
Valuation does play a major role in the buying process. However, this should not be the single factor that determines whether you buy. This is one factor among many. To be honest, I would rather buy an “overvalued stock” with a strong dividend triangle, great growth vectors and lots of potential for the next 10 years than buying an “undervalued stock” that has nothing else but a good yield and a poor valuation.
When I find a company I really like, but the valuation seems to be ridiculous, I will be tempted to put it on a watch list and wait for a while. I usually build this watch list on the side and when I am done with one of my current holdings (the company does not meet my investment thesis anymore), I pull out the watch list and check if valuations have changed. Once again, I will choose any “Microsoft” (overvalued, strong growth) over any “Exxon Mobil” (undervalued, modest growth) of this world.
At DSR, we use mostly two methodologies to determine the stock valuation. The first one is to consider the past 10 years of price-earnings (PE) ratios. This will tell you how the stock is valued by the market over a full economic cycle. You can determine if the company shares enjoyed a PE expansion (price grows faster than earnings) or if the company follows a similar multiple year after year.
When you look at stocks offering a yield of over 3% with a stable business model, the dividend discount model (DDM) can be most useful. Keep in mind the DDM gives you the value of a stock based solely on the company’s ability to pay (and grow) dividends. Therefore, you will find strange valuations when you look at fast-growing companies with low yields (e.g., Visa!).
While the idea of receiving dividends each month is seducing, this is not what makes dividend growth investing magic. It is the combination of capital growth and dividend growth (read total return) that truly generates the magic in your portfolio.
Time to write your investment thesis… and click the buy button!
Let us do a recap of what we have learned so far.
Many investors have difficulty determining which company shares to buy and when to buy them. At DSR, we focus on businesses with a strong dividend triangle. This means we are looking at businesses with strong growth vectors for the future, posting consistent earnings growth and with a sustainable dividend growth policy. The stronger the dividend triangle, the stronger the dividend growth policy should be.
When we find such businesses, we dig into their earnings to understand the business model and write down a complete investment thesis. The investment thesis includes both the reasons why we think this company is great and the potential downsides. It is important to fully understand where the company is going and what could possibly go wrong. Then, and only then do we press the buy button.
How much to invest in a new position… how many holdings in a portfolio anyway?
Personally, I like it when my investments matter. For this reason, I try to keep the number of different holdings between 30 and 40 for any portfolios over 100K. If I were starting all over again with a 20-50K portfolio, I’d go with 20-25 positions. I would then add more as I grow my portfolio to 100K.
I also like to have equally weighted positions at the start. If you do the math, a “full position” would equal between 2.50% (40 positions) and 3.33% (30) of your portfolio.
In an ideal world, I would pull the trigger for the full amount right away. It is not proven by any studies but making 1 buy transaction will kill all dilemma and confusion on what to do next. Once I identify my target, I go get it. End of the story. The whole idea of having a clear buy process is to cut the noise, reduce the doubts and improve your conviction level.
If you prefer going with a “half position” and keep the cash for another transaction, you open the door to doubts and paralysis by analysis. You have already done the work so why bother waiting?
Finally, I like to keep 5%-10% of my holdings for speculative plays. Between 2020 and 2021, I have used this “play money” to buy Brookfield Property Partners (BPY.UN.TO / BPY / BPYU). I later sold it to buy more of CAE (CAE.TO / CAE) in October. Each time I make these trades, I use the profits from my play money to boost my positions in strong dividend growers such as Alimentation Couche-Tard and Telus. I try to keep the same 5-10% of my portfolio value in speculative play. At the time of writing this newsletter, my speculative plays are worth 6% of all my holdings. Keep in mind this is “play money” and it should never replace your main strategy. Always remain cautious!
Here is my process in a few steps:
#1 Use a stock screener based on the dividend triangle to prepare your buy list.
#2 Highlight stocks with stronger dividend growth over the past 5 years.
#3 Select only the sectors you are interested in and understand.
#4 Select stocks with strong dividend safety.
#5 Dig inside each company to understand their business model.
#6 Do further research to identify potential downsides (risk) and potential upsides (growth).
#7 Look at valuations to determine if it is an immediate buy or if you should add the stock to a “watch list”.
#8 Write down your investment thesis and click on the buy button.
This process is a great start to select companies that meet certain screening standards and then, and only then, do your own personal due diligence.
Mike Heroux, Passionate Investor & founder of Dividend Stocks Rock
P.S. Are you concerned by the current state of the market? I recently hosted a free webinar on What To Buy In This Overvalued Market? Know What to Buy, Know When to Sell. Watch the replay here!
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**Please do your own due-diligence before investing in any stocks we discuss in this article**
I may hold shares of companies discussed in this article.
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