- Buying quality companies is very important in today’s volatile market.
- In this piece, I use Apple’s stock to highlight the steps I take to determine whether or not a DGI stock meets my quality standards.
- Determining quality is a fairly objective process, in my opinion; valuation, on the other hand, is more tricky.
- This idea was discussed in more depth with members of my private investing community, The Dividend Kings. Get started today »
I recently had one of my readers ask me, “What do you mean when you say ‘high quality dividend growth stock’?”
This made me realize, that I use the term “high quality” when describing stocks all of the time. I must write the words “high quality” 100+ times a week when putting together articles and interacting with subscribers in the various chat rooms that we have across the Wide Moat Research universe. And yet, now that I take a step back and think about it, this term is pretty vague, isn’t it?
So, with that in mind, I decided to put together an article describing what exactly I mean when I say, “high quality dividend growth stock.”
Being that I’m maintaining my conservative stance in the market these days due to what I believe to be an irrational bubble when looking at macro valuations, I’m happy to sit down and write a more philosophical/strategic-oriented piece like this rather than spend time producing focus ticker analysis because frankly put, I’m not all that interested in putting my remaining cash to use before we see a significant pullback.
This week in our Dividend Kings podcast about uncertainty and volatility in the markets and how to deal with these things mentally so that you avoid mistakes, I talked about the importance of preparation. I spoke about the importance of understanding why it is that we do the things that we do in the markets. I discussed the necessity of taking the time to understand one’s long-term financial goals and formulating a plan to achieve them. As a part of this plan, I thought it as paramount that investors maintain a watch list/buy list that is fundamentally driven and includes fair value estimations and price targets that ensure an acceptable margin of safety. And, I highlighted the fact that it’s best to do these things when the market is calm and spirits are high because when negative volatility occurs, that will bring along stress, anxiety, and fear along with it, and these emotions make sound decision making very difficult for most individuals.
At a basic level, I think understanding what qualifies an equity as a potential high quality dividend growth investment is the root of all things related to a watch list.
So often, I talk about the risks and threats to your financial well being that can come along with doing things like chasing unsafe yields and/or speculating on companies whose valuations cannot be justified by their underlying fundamentals. At this point, I wouldn’t be surprised if our subscribers at The Dividend Kings, iREIT, and The Intelligent Dividend Investor feel as if I’m part investment analyst and part broken record.
I preach: quality, quality, quality, over and over again, because in my view, partnering with the very best companies in the world as a shareholder provides investors with the best chance to generate wealth over the long-term, while also helping to protect invested capital.
In the equity market, we all face risks. This cannot be avoided. However, by focusing on the quality our holdings (or the stocks on our watch lists) and the valuations at which we buy them, we can mitigate risk and set ourselves up to not only succeed in the market, but also sleep well at night.
When thinking about how to highlight my quality standards for dividend growth equities, I thought that using a single stock example would result in the easiest to follow along presentation.
So, I decided to use my largest individual holding: Apple. Right now, Apple makes up roughly 14% of my portfolio. My AAPL position is more than 3x larger than the second largest holding in my portfolio. Needless to say, I’m heavily overweight this name. And, with that in mind, I must think that AAPL is a high quality dividend growth name, right?
Right. Needless to say, I think it’s one of the highest quality dividend growth names in the entire market.
So, let’s use this company as an example of how I go about equity analysis in terms of both quality standards and valuation. I will write this article as if I am performing an initial due diligence on the company to show the steps that I take when attempting to identify quality and value.
At the most basic, rudimentary level, here’s how I define a high quality dividend growth stock: a company that provides reliable and predictable dividend growth prospects moving forward.
That’s simple enough, isn’t it? Our goal as dividend growth investors is to create a reliably increasing passive income stream. But, being that there are no guarantees in the market, it becomes a bit more complex that it seems on the surface because to gauge reliability, investors have to begin to look at a company’s history, its present performance, and its future outlook.
Investors have to consider a myriad of variables at play to determine whether or not a company is likely to help them meet their income-oriented goals. With that in mind, here’s where I start.
First and foremost, I look at past dividend growth performance. This is easy to do. It is data-driven and 100% objective. Simply put, has a company shown the willingness to generously reward its shareholders with an increasing dividend? While the past cannot be used as a perfect gauge to accurately predict the future, the way I see it, a history of dividend growth shows that the management team and board of directions believes in a corporate culture that is aligned with my priorities and goals as a dividend growth investor.
To check dividend growth histories, my first stop is always the CCC List. This resource shows that AAPL is currently on a 9-year dividend growth streak. In the grand scheme of things, this isn’t great. There are many companies in my coverage spectrum with multiple decade-long dividend growth streaks. However, the CCC does show me that AAPL has been generous with its annual increases, with 5-year, 3-year and 1-year dividend growth rates of 10.5%, 10.9%, and 7.8%. Anytime I see double-digit dividend growth over the medium to long term, I am pleased because this is the type of growth that results in massive compounding for those who’re patient enough to hold shares over the long-term.
These days, anytime I see a dividend streak less than 10 years, I immediately wonder if the streak is short because of a dividend freeze and/or cut during the Great Recession in 2008/09. When I think about reliably increasing income, I think about dividends that can growth throughout a wide variety of market conditions. I don’t want to own companies that only perform well during bull markets. I want to feel confident that even when times get tough and economic growth slows, the companies that I own have strong enough business models to generate the cash flows necessary to not only maintain, but continue to grow their dividend.
So, the next thing I did was go to AAPL’s investor relations website to track its long-term dividend history. Here’s the data I found. It shows that AAPL did not freeze/cut its dividend during the Great Recession. Instead, it simply initiated its dividend fairly recently. The company began paying its current dividend in 2012 and has not missed a quarterly payment and/or annual increase since.
So, as far as income-oriented past goes, AAPL has checked all of the boxes that it possibly could with its relatively short dividend growth history.
Up next, when thinking about the past, I like to go look at a company’s performance. AAPL’s high dividend growth rate implies that the company has produced adequate fundamental growth to sustain it over a nearly 10-year period, but it certainly doesn’t hurt to check and make sure.
When looking at fundamental metrics to track dividend safety, I go to the bottom-line first. A sustainable dividend is paid out of a company’s earnings/free cash flows. In AAPL’s case, the numbers look good. As you can see in the chart below, over the last 5 years, AAPL’s earnings per share and its FCF per share have both consistently covered the growing dividend by a wide margin. In the chart I’ve provided, you’ll see that all 3 metrics are trending up in the right direction.
Acceptable EPS/FCF payout ratios vary from industry to industry due to the implied volatility/disruption risks and the historical reliability of cash flows. In AAPL’s case, as a proven leader in the technology space, I like to see a payout ratio in the 50% or below area. As you can see, the company has exceeded that target by a wide margin.
Right now, AAPL’s forward EPS payout ratio, when comparing its current annual dividend of $3.28/share to the current consensus estimate for 2020 EPS of $12.36/share is just 26.5%. This low payout ratio implies a high degree of dividend safety and a strong margin of safety with regard to the company being able to meet my dividend growth expectations moving forward, even in the unlikely event that its bottom-line experiences significant short-term headwinds.
Another thing that I like to see, when thinking about high quality dividend growth opportunities, is an outstanding share count that decreases over time. As a long-term shareholder, supply and demand means that a decreasing share count increases the value of my holdings ever so slightly. What’s more, when thinking about consistent dividend increases over time, by retirement shares in the present, a management team is not only improving a company’s per share profitability metrics that help to lower is payout ratio, but they are also reducing the burden of the dividend on the company’s cash flows.
I like to think of it like this: every time a share is retired, the dividend payment associated with that share is retired as well. And, when we think about dividend growth compounding over the long term, by retiring shares in the present, the future cost savings with regard to expected dividend payments can become enormous. In short, a reduced share count is a boon for dividend growth names because it makes increasing payments to the holders of the remaining shares more sustainable over time.
As you can see on the graphic below, AAPL has done an amazing job of using its large cash flows to retire shares during Tim Cook’s reign as CEO.
Since AAPL’s dividend was initiated in 2012, the company has returned $454.2 to its shareholders. This is a simply amazing feat and the fact that the company has been able to do this sustainably shows the strength of its cash flows and ultimately, its business model.
While bottom-line performance is paramount to a safe dividend, I don’t just rely on the EPS/FCF figures. Why? Because it is possible to sort of boost these figures artificially via financial engineering. But, what cannot be financially engineered are sales figures.
To me, revenue growth is also a necessary component to the “high quality” definition with regard to a dividend growth stock. Regular and reliable sales growth imply strong demand for a company’s products and/or services. Furthermore, when sales increase regularly over a long period of time, it speaks highly of the quality of a company’s management team because it shows that a company is able to successfully compete in an ever-changing market, constantly evolving and ultimately, winning, in the minds of potential customers.
As a long-term investor, I want to partner with proven winners. One of my favorite phrases is excellence doesn’t happen on accident. Regular and reliable success implies a winning culture and a high level of talent. Success oftentimes begets success. The most successful companies in the world can spend more on R&D, M&A, and talent acquisition. These capabilities contribute to the virtuous cycle of compounding over time that I want to benefit from as a shareholder.
In terms of past top-line performance, AAPL also checks the box.
Sales growth can be difficult to predict moving forward; however, I think it is possible to identify and track secular growth trends. Secular growth prospects imply that a company has tailwinds that will continue to push it higher regardless of the macroeconomic conditions. These trends are rare and powerful and as a long-term shareholder, I want to partner with companies that have shown leadership in the markets that are expected to benefit from them.
Historically, AAPL has benefited from several powerful secular growth trends. Mobility is probably the largest of them all. The rise of the smartphone has been steep and enormous and AAPL is one of the world’s leaders in this market. Today, we’re seeing growth in the handset market slow, yet AAPL has adapted, shifting its focus away from a purely hardware-driven mindset and onto the services that it can provide to consumers living within its ecosystem. Apple’s active device count is in the billions, globally. Software as a service, or SaaS, and cloud storage, are a couple of the more recent secular trends that AAPL is benefitting from.
What’s more, the company is doing work in areas surrounding augmented reality, virtual reality, artificial intelligence, autonomy, and cyber security, which are all major themes of the ongoing digital evolution that we’re still in the early innings of. AAPL is set to benefit from the coming 5G revolution. And finally, the company has some of the biggest cash flows and cash hoards on Earth. This cash, combined with the astute capabilities of AAPL’s talented management team, results in a lot of flexibility and upside potential with regard to the company’s ongoing ability to re-invent itself and compete in a rapidly changing marketplace.
Lastly, when looking at sales, I like to look at the margins attached to them. Increasing margins also signify strong demand. As you can see below, AAPL’s margins have been fairly flat overall. This data set is neutral; however, I will say that the company’s services segment is generating much higher margins (in the 60%+ range) and as the company continues to shift further away from being a pure-play in the hardware space, I suspect that its margins will begin to grow.
Once I’ve looked at the past/present results, I then move onto company guidance and consensus analyst estimates with regard to future growth prospects. In short, if I expect a dividend to grow, I need to expect to see growth on the top and bottom line. And, in AAPL’s case, the analyst community is certainly bullish on the company’s prospects in the coming years.
My go-to resource for checking future projections is F.A.S.T. Graphs. As you can see of the graphic below, the analyst estimate for 2020, 2021, and 2022 are clearly shown along the EPS row at the bottom of the chart.
Analysts’ estimates are not meant to be taken as gospel. The professionals on Wall Street are certainly prone to mistakes. Yet, when we’re talking about a well-covered stock like AAPL that is widely covered by analysts (right now, according to Yahoo Finance, there are 37 price targets for AAPL stock on Wall Street) I feel comfortable using the collective power of the institutional research when gauging future growth.
What’s more, most of the year, management provides forward-looking sales and EPS guidance as well. Right now, we’re living in fairly unprecedented times with regard to the COVID-19 virus and the economic uncertainty that social distancing has inspired, so many companies have pulled 2020 guidance. But, for the most part, I think these forward estimates provided by management can be relied upon as well, when looking for a ballpark estimate of the future growth trajectory, because who knows these companies better than the people who’re running them?
As you can see on the F.A.S.T. Graph above, AAPL is expected to post mid single-digit EPS growth this year, followed up by a big 20% growth year in 2021. These 2021 estimates appear to be based off of the idea of a 5G super cycle of sorts, with regard to iPhone sales. Looking back at AAPL’s EPS growth over the long-term, we see that the company has posted somewhat cyclical results because of the iPhone refresh cycles. With that in mind, I think it’s certainly possible for the stock to post a big earnings growth year in 2021 like it did in 2018. But, even if the stock doesn’t hit that 20% growth estimate, it’s still clear that sentiment is positive here and that bodes well for continued dividend growth.
And last, but certainly now least, when talking about the quality of a dividend growth investment, we arrive at the balance sheet. Simply put, if a company does not have a strong and clean balance sheet, then it is very difficult to say that it can provide reliable dividend growth. Dividends are great, but they are never guaranteed. If a company has issues with a cash flow crunch and a rising debt load, the dividend is something that can be cut to prioritize debt/interest rate payments.
In today’s low rate environment, rising debt loads are a common occurrence. This isn’t necessarily a bad thing. Apple, for instance, has been able to lock in incredibly low rates on debt issuances historically that it makes perfect sense for the company to do things like raising debt to simply buy back shares. Doing so has generated significant returns on investment for AAPL’s management team in the past. I say this because when looking at debt, I believe it is equally important to track cash flows and the company’s debt ratios. What’s more, the credit tracking agencies can do a lot of the legwork here for you. The F.A.S.T. Graph above shows that AAPL maintains an AA+ Standard and Poor’s credit score. This means that the company’s balances sheet is one of the strongest in the entire world.
Generally speaking, the highest the credit score the better, in my point of view. And, when thinking about quality, generally look for stocks with BBB+ ratings or better. I have made exceptions to this rule in the past when managing my personal portfolio; however, I think it’s safe to say, at the very least, that any company that does not maintain an investment grade credit rating is not likely to be a high quality DGI stock.
In conclusion, here are the 10 questions that I ask myself when thinking about quality.
- Does the company have a history of reliable and generous dividend growth?
- Has the company shown the ability to reliably increase its dividend throughout a wide variety of economic environments?
- Are the company’s profit related metrics growing?
- Are the company’s sales growing?
- Are margins headed in the right direction?
- Is the payout ratio acceptable?
- Does the company benefit from secular growth tailwinds?
- Is the company’s balance sheet sound?
- Is management conservative with the debt load?
- Does the company have a history of reducing its share count?
If you can answer “yes” to all of these, then chances are, you’ve come across a very high quality dividend growth stock.
Once you’ve determined that a company meets your quality standards, you’re halfway through the due diligence process. Buying high-quality companies is important, but doing so at a fair or better valuation is also critical to success as a dividend growth investor. However, equity evaluation involves a lot more speculation and subjectivity than a dividend quality and safety check does and therefore, that is a topic for an entirely different article.
Stock valuations are based upon expectations of future cash flows. And, because no one ever knows for certain what is going to happen in the future, where fair value lies, what multiple to pay for relevant profitability metrics, or even which metrics to prioritize over time, it’s impossible to say where a company should trade at any given point in time.
This doesn’t mean to give up and simply ignore valuation when accumulating high-quality stocks. Overpaying for equities is a great way to underperform in the market. Furthermore, paying too high of a price for equities lowers one’s yield on cost and reduces the amount of shares that a finite amount of cash can purchase. Both of these aspects of buying expensive shares reduce one’s passive income/compounding potential.
Maybe in my next article I will break down my thoughts regarding AAPL’s valuation right now (spoiler alert: personally, I think it’s pretty expensive).
But, I think it’s most important to note that before I ever even begin to evaluate an equity, I first make sure that it meets my quality standards because time is also a finite resource and it doesn’t make much sense to waste it doing due diligence on subpar companies.
Identifying quality was the focus on this article and hopefully, nearly 3,500 words or so later, you have a better idea of what to look for when attempting to identify high quality dividend growth investments.
Author: Nicholas Ward
Source: Seeking Alpha: How To Identify A High Quality Dividend Growth Stock