This is a slightly controversial metric to include as many believe and some studies have shown that buying growth stocks or focussing on historic growth is not necessarily a winning strategy. However, in income investing it can be appropriate if you are trying to secure a growing income which can protect both your income and capital in real terms. Other studies and as highlighted on this site show that compounding your income can also greatly increase your returns and speed the recovery from draw downs (declines).
So what is the evidence for looking at dividend growth? Well specifically in the UK in 2008 there was an interesting working paper titled Consistent Dividend Growth Investment Strategies by Gwilym, Clare, Seaton and Thomas from the Cass Buisness School. In the abstract from this they said:
"We investigate whether firms in the United Kingdom that have a long, uninterrupted history of dividend growth outperform the broader equity market. It is observed that firms with in excess of 10-years consistent growth have returned considerably more than the equity market as a whole, with the additional benefits of lower volatility and smaller draw downs. A size effect exists amongst these firms with lower market-capitalization firms demonstrating improved risk-adjusted returns."
They also highlighted some of the other research which suggests that looking at dividend growth history is a good idea as follows:
"There are a number of good reasons why investors should favour companies that have a consistent history of increasing dividends.
Indeed S & P even produce what they call Dividend Aristocrat indices based on this concept and a number of ETF's have been launched based on these and other indices with a similar concept. See the link above for a useful site (buyupside) which details the US qualifiers and has lots of other useful free information for investors.
So it seems that there is some value in looking at dividend growth history although they found that it worked best in smaller and mid cap names, which again fits well if you are running a concentrated portfolio and not closet indexing. Indeed the authors of the above paper said:
"The conclusion is rapidly drawn that for consistent dividend portfolios to be successful they should be formed on an equally weighted basis; otherwise there is no real advantage in diverting from the benchmark. The equal versus value-weighted issue might in itself explain some of the out performance of comparable US ETFs versus the market-capitalization approach of the S&P 500 described by Walker (2005)."
Thus dividend growth history is one of the factors I take into account when scoring Compound Income stocks. It could also be argued that this is another way of measuring or assessing quality as those companies with a long history of rising dividend presumably are well managed and have a business which can generate rising returns for shareholders over time. So in a way it follows on well from the operational quality measures I looked at in part 4. Similarly here a steadily rising profile is likely to indicate a better quality / managed business, whereas weaker or more cyclical ones are more likely to have pauses in their growth or even dividend cuts which obviously you would want to avoid.
With that in mind and with an eye to the future I also factor in the one year forecast dividend growth alongside the dividend history for a combined dividend growth score as I like to know that growth is still forecast and how it compares with the past. In the next part I'll look at another indicator which helps to back this up.
Finally, the other take away I had from this paper was the fact that they found that "a significant portion of the improvement in absolute return of the consistent dividend growth stocks can be attributed to the avoidance of non-paying firms." So when compiling a list of Compound Income stocks to compare I make a point of generally excluding zero yielding stocks as I'm not interested in them and as the authors observed:
"The most immediate observation is the exceptionally poor performance of the zero-dividend firms, particularly those larger ones that were in the All-Share Index. Not only were returns comparatively low but also the volatility was much higher relative to the dividend paying firms. The maximum draw down was an eye-watering 85% for the All-Share constituents, with accompanying extreme Ulcer index levels." Ouch - buy zero yielding stocks if you like but I just say No !
Here we are going to look at how to go about assessing the operational quality of a stock or is it a good business which can generate returns for shareholders. Since we have used current profitability, cash flow and dividends in the value scoring I like to focus here on longer term measures to get a feel for stability and sustainability in these metrics.
I use five year average operating margin and five year average return on capital employed (ROCE) as indicators of the quality of a business. See the highlighted links for further discussions on these from Investopedia which is itself a useful resource for education and more about investing, albeit US centric.
Thus a Company with high and stable margins and returns will score more highly than one that sees lower figures on these measures that are volatile. For example a pharmaceutical stock would likely score well on this, as you might expect, given their high research & development spend which provides patent protected products. Whereas a house builder which might be earning good margins and ROCE today probably wasn't a few years ago, so this will have a lower score despite the current profitability to reflect the variability of it profits.
Using longer term averages therefore helps to identify, to an extent, those that have high and stable returns over those with lower and more volatile returns or cyclical companies - which should in any event be fairly obvious based on what they do. However, if we get into another extended economic cycle then some cyclical companies may appear to have high and stable margins and returns so you would then need to interpret this score with a bit of care and use your common sense.
In addition it will penalise those stocks that have seen margins and returns decline, so again you would need to do more research to see the reasons behind this, whether they are at cyclical low or if they are on a recovering trend or even moving into new areas under new management, which might lead to higher returns and can be a good thing for a value / recovery situation.
In this section we are going to be looking at ways of assessing the finances of Companies. For this I use two main measures, the first one is more complicated and is called the Piotroski F score, named after the professor who devised it. The second is more simple - interest cover, the number of times interest payable is covered by operating profits see highlighted link for more details.
The Piotroski F Score comes from an academic paper in which he aimed to use historic financial data to separate winners and losers in value portfolios. This looks at profitability, leverage, liquidity and sources of funds and operating efficiency as explained in brief here. Thus it seems a suitable metric to use as I am using a value based screen when trying to identify Compound Income stocks. In addition since the research was most effective in small and medium sized firms and those with low share turnover and no analyst coverage it is helpful as my portfolio is biased in that direction generally. It may also be helpful in providing reassurance or a warning on small unknown stocks that might score well or badly on this measure. It also touches on other aspects of the business operations, apart from just the financing, which is also useful. The other way in which the Piotroski score can be used is in conjunction with valuation based models as a filter for selecting the best stocks (those scoring 8 to 9) or excluding the most vulnerable stocks (those scoring 2 or less).
You can read the original research by clicking the highlighted link above. Others have also found that by using this measure with other valuation metrics that they can improve their performance. It is generally used to identify the stronger and weaker companies. By combining this with interest cover and scoring it accordingly I can get a quick handle on the financial strength or weakness of a company. This can then act as a green or red flag for further investigation and confirmation when doing further research.
In addition it is worth pointing out that interest cover may flatter some stocks like retailers or other companies who have lots of leased premises or equipment. Then you will need to look at fixed charge coverage to get a better feel for their financial viability going forward, but in any event it always worth doing more research whatever a particular indicator says. It is also worth noting that interest cover is not that instructive with financial companies either so you will need to asses them on their own merits and understand the nature of the business, although in some cases they may not have any debt.
Other than that you can of course use more traditional measures of gearing such as debt to equity where you should normally be wary of anything over 50% depending on the nature of the business. You could also consider the debt to Enterprise Value to see what proportion of the financing is coming from debt, as debt to a certain extent can be beneficial for shareholders, but it does increase the risks. Debt to EBITDA multiples are also often used in debt covenants and sometimes companies may disclose this figure as a way of showing how much headroom they have.
In this part i will briefly look at the security of income from dividend stocks which is quite commonly measured by the extent to which dividends are covered by earnings. This is probably conventional wisdom, quite sensible and there was research to back up why it is a good idea when selecting yield stocks provided by CSFB, which you can view by clicking on the link if that is of interest to you.
In addition, I combine this with the level of cover by free cash flow, again fairly obvious as the more free cash flow a company has the greater leeway or discretion they will have over maintaining or increasing the dividend and considering share buy backs or paying off debt.
Indeed share buy back and changes in debt levels are also worth noting as Mebane Faber has found in his research and book titled: Shareholder Yield: A Better Approach to Dividend Investing that looking at total shareholder yield, including buy backs can be more productive than just selecting yield stocks. While Jack Vogel, who works with Wesley Gray the author of Quantitative Value, has come up with similar findings in his research looking at this but including buy backs and debt pay down in the calculation of shareholder yield. He also explored whether it was better using longer term data rather than one year data. You can read a summary of his findings at their useful site called Alpha Architect where you can also sign up for updates from them if that is of interest to you.
I don't screen for these factors (buy backs and change in debt) specifically, as I have not been able to find a way of easily tracking this for all stocks. However, using cash flow does help to identify those companies that have the flexibility to provide a greater shareholder yield overall which is why I use it in my scoring of dividend cover. Since a score system is just a starting point for identifying attractive stocks, one can then go onto examine if the company is undertaking buybacks and paying down debt / building up cash when you do you further due diligence research.
In Part 3 I will discuss how I go beyond the security of the dividend and what I use to monitor the strength of the balance sheet or the financial security of a company.
This is the first part in a series of post where I will explain what I use in my scoring system when seeking stocks to compound my income.
The most obvious place to start is with the dividend yield which is certainly one factor which I use. However, when it comes to picking value stocks more generally this is not necessarily the best way to identify value stocks. Even though yield covers this to to a certain extent as often higher yielding shares tend to offer value as they have got onto a high yield by being beaten up or neglected. I do however like to check other valuation and financial metrics when considering yield shares to ensure that I am buying value and not just an expensive, low quality and financially challenged high yield stock.
Research carried out in the Book Quantitative Value by Gray & Carlisle suggested that the best measure for this was earnings yield or EBIT/EV which is calculated by taking the operating earnings (operating margin x turnover) and dividing this by the Enterprise Value of the company (Market Capitalisation + Net Debt) which better reflects what it would cost to buy the whole company based on its existing financing arrangements. In the book they also examined combining value measures and found that this could also do a good job of identifying value stocks.
Therefore I combine earnings yield and dividend yield or EYDY as a way of scoring the value offered by a stock as I am interested in buying cheap (value) stocks with a decent yield. I do then also look at other measures such as the P/E to get a feel for how expensive a stock is overall.
In Parts 2 and 3 to I will look at how I assess the security of the likely income and the financial security of the stock.