I believe every investor should have all of their stocks in the ranking. A rating system makes your buying and selling decisions easier and avoids dilemmas. To inspire you, I’ve decided to share my own rating system that I use for my portfolio and at Dividend Stocks Rock.
First, the dividend triangle
I focus on dividend enhancing stocks. I choose companies that have a strong dividend triangle (sales, earnings, and dividend growth potential) and make sure I understand their business model. It is sometimes frustrating to pursue such a clear but rigorous strategy. At DSR, we sometimes have to ignore big investment opportunities because they don’t fit 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 consists of three metrics
I discussed the dividend triangle on The Dividend Guy’s blog podcast. Basically, these three metrics simplify your stock selection. It will help you narrow down your research or review your stocks to see if they still fit into a dividend growth investment strategy.
revenues: A company is not a company without income. What is the difference between a company that has growing sales and one that has stagnant results? We are looking for companies with multiple growth vectors that guarantee constant sales increases year after year.
Merits: You can’t pay dividends if you don’t make money. On the other hand, this is a very simple statement. However, unless earnings grow strongly, there is no reason to believe that the dividend payment will increase indefinitely. Note that the EPS is based on a GAAP calculation. The accounting principles are not adjusted to the cash flow. This means that you should better look at the EPS trend over 3, 5, and 10 years. Use a customized EPS that takes into account the one-time events uncovered by the company to get a clear picture of what happened.
DividendsLast but not least, dividend payments are the * obvious * backbone of any dividend growth investment strategy. But I don’t mind real dollar amounts or returns, my focus is solely on dividend growth. Dividend producers show confidence in their business model. This is a statement claiming that the company has enough cash to grow its business and reward shareholders at the same time. This also shows you that the company can meet its financial obligations and invest in new projects (CAPEX). No management team would raise their dividend if they didn’t have the money to run their business.
Companies that lose market share due to a lack of competitive advantage will see their story based on their sales trends. It is very rare for a publishing company to have growing sales year after year when it is losing market share. A company could post weaker results for many reasons. It could be the end of a cycle, a change in business model, or simply a slowdown in the economy. However, if this situation lasts for several years and management cannot find growth vectors, the red flag must be thrown.
The same logic applies to the result. Since the profit calculations are based on GAAP, it is not real money. This number is far from perfect. In fact, it is better if you combine it with free cash flow or cash flow from operations to see what is really going on. However, if a company is unable to achieve growing EPS over a long period of time (5 to 10 years), the chances are that dividend growth will not occur.
Remember, 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 that are generating strong free cash flows? They usually offer a reliable dividend growth policy and their stock price tends to go up over the long term, making you a richer investor. At DSR, we classify dividends and stocks into 5 categories. We use two simple methods:
The DSR PRO rating
The DSR PRO rating is based on a classic 1 to 5 buy and sell model. I don’t focus very much on timing though. I prefer to consider the following points:
5 = Exceptional purchase – everything is there; a strong business model, multiple growth vectors, and an undervalued price.
4 = Buy – It’s a good company, the short term upward trend is good but not startling.
3 = Hold – A classic “right company at the right price”.
2 = Sell – If we were you we would be seriously thinking about getting rid of this one.
1 = Screaming Sell – Enough said.
I have detailed the DSR PRO assessment method in the video below:
The DSR Dividend Safety Score
This score from 1 to 5 indicates what kind of dividend policy to expect. It can be interpreted as follows:
5 = Excellent Dividend – The prospects for past, present and future dividend growth are excellent.
4 = Good dividend – The company shows sustainable prospects for dividend growth.
3 = decent dividend – don’t expect dividend growth of more than 3-5%.
2 = dividend is safe, but – probably not going to increase this year. May suffer from a dividend cut.
1 = dividend garbage – it has been cut or this situation is unsustainable.
When reviewing your portfolio, you can easily evaluate all of your holdings using a similar method. Then you should seriously try to justify why you are keeping all “1” and “2” in your portfolio. If you can’t make a solid investment thesis, these should probably be sold … not sometime, but now.
Remember, the best time to make changes to your portfolio is now. What is lost is lost. However, you will be able to redistribute your money better in the future.
I’ve valued my shares, now what?
The dividend junk has cut or is about to cut its dividend in the past 12 months. They are usually lost causes and you should get rid of them right away. Given the impact COVID-19 has on the economy, some companies have decided to temporarily suspend their dividends. It’s hard to make money when your business is closed. Because of this, you can keep companies that had a strong dividend triangle before 2020. Take a look at each company and determine if they are likely to resume their dividend growth policies once this extraordinary event is over.
The dividend of “2’s” shows no dividend growth for a while. Remember, the absence of dividend growth is the first step before a dividend cut. On some rare occasions, you can find companies that use all of their money to buy new businesses. We still prefer those who can do both (acquisitions and increasing their dividend), but you may want to keep a few “2’s”.
Then “3’s” should be checked quarterly to ensure that the situation does not change. Decent dividend stocks offer modest prospects for dividend growth that should beat inflation. We will often see them in the “income sector” as returns tend to be higher. If a REIT can increase its dividend by 2-3% annually, that’s fine. However, keep an eye on them to make sure management keeps its promise every year.
Dividend values of “4” and “5” offer excellent prospects for dividend growth. They usually have strong dividend history and payout ratios that are under control for the future. Dividend security is not just about the past, it is also about the company’s ability to sustain its dividend growth streak well into the future. The stronger the dividend triangle, the stronger the score should be.
When choosing new positions for your portfolio, I would only prefer companies with a score of “4” or “5”. These companies won’t let you down if the market gets rocky for a while. You can rely on these payments to pave the path that leads you into retirement.
Again, valuing your inventory using a simple but efficient set of metrics solves your buying and selling dilemma. You automatically identify the strong and weak companies in your portfolio.
Having a buy or potential replacement list ready is great for taking action. It’s a lot easier to sell when you feel the excitement for a better hold.