Narrow Down Your Stock Search With The Dividend Triangle

This is a simple yet quite efficient guide to identify strong companies.
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Fellow dividend investors, I’m honored to share a part of your investing journey with this column. My name is Mike Heroux and I’m the author of The Dividend Guy Blog, The Dividend Monk, and the founder of Dividend Stocks Rock (DSR) (yes, I thrive on staying busy!). I have an unusual sense of humor for a “nerdy finance guy”.

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After working over a decade in the financial industry, first as a certified financial planner and then as a private banker, I decided to leave everything behind and go for a 1-year RV trip across North America and Central America with our kids. We made it all the way down to Costa Rica. Upon our return in 2017, I decided to leave my job as a private banker and invested all my energy in my fledgling online business. I wanted to live from my passion and help other investors to do the same. I cannot stop talking about the stock market!

Through this column, I’ll discuss stock picks to give you fresh ideas, but I’ll also walk you through my investing process and thoughts about the market. My goal is to help you achieve three things:

  • Invest with conviction and address most all your buy/sell questions.
  • Build and manage your portfolio through difficult times.
  • Enjoy your retirement.

I thought of starting this introductory article with the fundamental screener I use for every stock research. This is a simple yet quite efficient guide to identify strong companies.

To Stay Focused, You Must Have a Clear Strategy

When we left in our small RV to drive down to Costa Rica, we lived the adventure of a lifetime. It was a wonderful experience because we had a clear strategy. We knew where we were going, why we were doing it and even had ways to handle more challenging days. The market will keep throwing you curveballs, so let’s make sure you don’t whiff on them.

For my portfolio, I also have a clear strategy: I focus on dividend-growing stocks (we will have the time to address high-yielding stocks later). I handpick companies showing a strong dividend triangle (more on that in a minute) and make sure I understand their business model. It is sometimes frustrating to follow such a clear but strict strategy. I sometimes must ignore great investing opportunities because they don’t fit in our model. For example, I sat on the sideline when Tesla (TSLA) was on the rise. I didn’t even flinch… even if my portfolio return couldn’t match such exponential growth. Since my model is relatively easy to understand and I know why I am using it, I never doubt myself. Investing with a clear state of mind is worth a lot more than making money on a “lucky” trade.

While there is a world of metrics and other factors to consider. I like to narrow down my search by using three simple metrics. Combined, they create a triangle, the foundation of my investing strategy. Therefore, I named it “The Dividend Triangle”.

The Dividend Triangle is Composed of Three Metrics

Revenues: A business is not a business without revenues. What is the difference between a company making growing revenues versus a company showing stagnating results? We are looking for companies with several growth vectors that will ensure consistent sales increases year after year. I’m a big believer in “offense is the best defense”. Whenever we are about to face a recession, I want to make sure I had companies that showed past revenue growth. This is an excellent indicator that their business model is doing well, and they don’t enter the recession in a position of weakness.

Earnings: You cannot pay dividends if you don’t earn money. Then again, this is a very simple statement. Still, if earnings don’t grow strongly, there is no point of thinking that the dividend payment will increase indefinitely. Keep in mind that the EPS is based on a GAAP calculation. This is what makes EPS imperfect, as accounting principles are not aligned with cash flow. This means you are better off looking at the EPS trend over 3, 5, and 10 years. Use an adjusted EPS that takes off those one-time events revealed by the company to have a clear view of what is happening. Some companies could “play around” with earnings for a year or two, but you can’t create a trend out of thin air.

Dividends: Last but not least, dividend payments are the *obvious* backbone of any dividend growth investing strategy. But I don’t mind the real dollar amounts or the yield, I focus solely on dividend growth. Dividend growers show confidence in their business model. This is a statement claiming that the company has enough money to both grow their business and reward shareholders at the same time. This also tells you that the business can pay off its financial obligations and invest in new projects (CAPEX). No management team will increase their dividend if they lack the cash to run their business.

What a Strong Dividend Triangle Looks Like?

It’s one thing to put those metrics in a stock screener, it’s another to know what to do with them. The problem I face with a simple stock screener is that it will give me the 3year or 5year annualized growth, but I can’t see the trend.

Once I identify a company with a strong dividend triangle, my second step will be to look at the trend over the past 5 years for each metric. This period is long enough to show the current trend and highlight some jumps or drops that I must investigate. For example, I’ll pulled the dividend triangle of one my favorite stock; Microsoft (MSFT).

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As you can see, there is an earnings drop between 2018 and 2019. While this does not look like a big deal, it’s worth paying attention to. I went back to this year and read quarterly earnings. I realized the decrease in EPS was related to the Tax Bill that was passed on that year. This explains why 12 months later, the EPS trend went back on track. It’s also a great example demonstrating EPS will not always show the reality but rather stick to generally accepted accounting principles.

The Dividend Triangle is Used as a Protection for Your Capital

If there is one thing I hate, it is to lose money. We work hard to earn it, we make the sacrifice to save and invest some, it would be unfair to see the market get away with the fruits of our labors. The dividend triangle helps me protect my portfolio from potential windfall.

Companies losing market share due to their lack of competitive advantages will see their story unfold through their revenue trends. It is very rare to see any business publishing growing revenues year after year if they are losing market share. For many reasons, a company could publish weaker results. It could be the end of a cycle, a change in the business model, or simply the economy slowing down. However, if this situation persists for several years and management can’t find growth vectors, the red flag must be thrown.

The same logic applies to earnings. Since earnings calculations are based on GAAP, we are not talking about real money. This number is far from being perfect. In fact, you are better off combining it with free cash flow or cash flow from operations to see what is really going on. Nonetheless, if a company is unable to generate growing EPS over a long period of time (5 to 10 years), chances are dividend growth will not happen.

Keep in mind dividends aren’t magic; they are the result of strong free cash flows, not the cause of good free cash flows.

What usually happens when you find companies generating strong free cash flows? They usually offer a reliable dividend growth policy and their share price tends to rise over the long haul making you a richer investor. You know what? Studies also show that dividend growers then to outperform the market.

Why The Focus on Dividend Growth Instead of Dividend Yield?

My entire portfolio is invested in dividend growing stocks. Some holdings act as “fixed income” as they offer a stable dividend yield and can weather market storms. Some others are my “growth equity” as they offer lower yield, but strong dividend growth and stock price appreciation potential. The combination of various dividend growers will create a balance where your portfolio will help you retire stress-free.

Strangely enough, even Vanguard (a pioneer in ETF investing) conducted its own studies on the recent market history and concluded that dividend growers are among the best performing assets.

Source: Vanguard

Source: Vanguard

According to Vanguard’s study over this 20-year period, dividend growth stocks not only beat the market, but they did it with less volatility. While dividend growers usually provide investors with less volatility, you will still go through challenging periods where your favorite holdings will show red numbers. This is where you may start losing confidence and start wondering if it would be appropriate to cash your profits and protect your capital.

Instead of looking at your investment performance over the past 3 months or 12 months, you may want to look at your dividend payments over the same period? Whenever I do that with my portfolio, I smile as I made more money in the past 3 months than I did a year ago. I would bet you do too. Here’s my question now:

“If you made more money in dividends than last year, why would you want to change anything?”

I hope this have given you some food for thoughts for your own dividend investing process. Until the next article, stay invested 😉

Cheers,

Mike Heroux

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