I believe every investor should have all of its stocks ranked. Having a rating system will ease your buy & sell decisions and avoid dilemmas. To get you inspired, I’ve decided to share my own rating system, the I use for my portfolio and at Dividend Stocks Rock.
First, The Dividend Triangle
I focus on dividend growing stocks. I handpick companies showing a strong dividend triangle (revenue, earnings and dividend growth potential) and make sure I understand their business model. It is sometimes frustrating to follow such a clear, but strict strategy. At DSR, we sometimes must ignore great investing opportunities because they don’t fit in our model. Since our model is quite easy to understand and we know why we are using it, we never doubt ourselves.
The Dividend Triangle is composed of three metrics
I discussed the dividend triangle in The Dividend Guy Blog Podcast. But basically, these three metrics will make your stock selection simple. It will help you to narrow down your research or to review your stocks to see if they still fit in a dividend growth investing strategy.
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 businesses with several growth vectors that will ensure consistent sales increases year after year.
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. 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 which takes off those one-time events revealed by the company in order to have a clear view of what is happening.
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 would increase their dividend if they lack the cash to run their business.
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. At DSR, we classify dividends and stocks in 5 categories. We use two simple methodologies:
The DSR PRO Rating
The DSR PRO Rating is based on a classic 1 to 5 buy & sell model. However, I don’t focus much on timing. I prefer considering the following points:
5 = Exceptional Buy – Everything is there; a strong business model, several growth vectors and an undervalued price.
4 = Buy – It’s a good company, the short-term upside is good but not flabbergasting.
3 = Hold – A classic “right company at the right price”.
2 = Sell – If we were you, we would seriously consider getting rid of this one.
1 = Screaming Sell – Enough said.
I detailed the DSR PRO Rating methodology in the video below:
The DSR Dividend Safety Score
This score, from 1 to 5, tells you which kind of dividend policy you should expect. It can be interpreted as follows:
5 = Stellar dividend – Past, present, and future dividend growth perspectives are marvelous.
4 = Good dividend – The company shows sustainable dividend growth perspectives.
3 = Decent dividend – Don’t expect more than a 3-5% dividend growth.
2 = Dividend is safe but – Not likely to increase this year. May suffer from a dividend cut.
1 = Dividend Trash – It has been cut, or is this situation is not sustainable.
When reviewing your portfolio, you can easily rate all your holdings using a similar methodology. Then, you should seriously try to justify why you keep all “1’s” and “2’s” in your portfolio. If you can’t come up with a strong investment thesis, chances are those should be sold… not eventually, but now.
Remember, the best time to make changes to your portfolio is now. What is lost is lost. However, you can reallocate your money in a better way going forward.
I Rated My Stocks, Now What?
Dividend trash has cut their dividend within the past 12 months or are about to do it. They are usually lost causes and you should get rid of them right away. Considering the COVID-19 impact on the economy, some businesses have decided to suspend their dividend temporarily. It’s hard to make money when your business is closed. For this reason, you can keep companies that used to have a strong dividend triangle prior to 2020. Look at each of them and determine if they are likely to resume their dividend growth policy once this exceptional event is over.
The dividend of “2’s” show no dividend growth for a while. Remember, an absence of dividend growth is the first step before a dividend cut. In some rare occasions, you will find companies using all their money to acquire new businesses. We still prefer those who can do both (acquisitions and increase their dividend), but you may want to hold on to a few “2’s”.
Then, “3’s” should be reviewed quarterly to make sure the situation doesn’t change. “Decent dividend” rated stocks offer a modest dividend growth perspective that should beat inflation. We will often see them in the “income sector” as the yields tend to be higher. If a REIT can increase its dividend by 2-3% yearly, I’m good with that. However, keep an eye on them to make sure management keeps its promise each year.
Dividend scores of “4” and “5” offer great dividend growth perspectives. They usually show a strong dividend history and payout ratios that are under control for the future. The dividend safety is not only about the past, but also about the company’s ability to maintain its dividend growth streak going forward. The stronger the dividend triangle is, the stronger the score should be.
When selecting new holdings for your portfolio, I would favor only companies with a score of “4” or “5”. Those companies won’t let you down should the market turn rocky for a while. You can count on those payments to smooth the path that leads you to retirement.
Again, rating your holdings according to a simple, but efficient set of metrics will solve your buy & sell dilemma. You will automatically identify the strong companies and weak companies in your portfolio.
Having a buy list or a potential replacement list ready is great in order to take action. It is much easier to sell when you feel the excitement for a better holding.