Every month I screen for possibly undervalued dividend growth stocks using very specific metrics which are described below and then make a purchase or two. While the metrics change every year or two, I have been doing this process for a long, long time. The reason that the metrics change every so often is that I don’t feel strong enough in one thought process, that I figure if I can build the portfolio using some of the best ideas from multiple people, I’ll end up in a pretty damn good place.
My goal by the end of the first quarter 2020 is to take a look at my metrics and determine what, if anything, would I like to change.
Screening for Undervalued Dividend Growth Companies
Dividend Growth History
The very first hurdle that a company has to pass is whether it has increased its dividend for 20 or more years. I am looking to build a sustainable income stream, and it is my hope (and all it is a hope) that if they have paid dividends for 2+ decades it is part of their DNA and so they’ll continue to do so. I use the Dividend Champion List (25+ years of dividend growth) and part of the Dividend Contender List (10 to 24 years of dividend growth). The lists are maintained by The DRiP Resource Center.
Price to Earnings
The first metric I screen for is Price to Earnings. Price to earnings is defined as,
the ratio for valuing a company that measures its current share price relative to its per-share earnings.
P/E is probably the most popular way to value stocks. If you are reading this post you should probably already know that price in it of itself is not a measure of a company’s value. In the past I have used different ratios (under 20, under industry average, under both 20 and industry average, under 20 CAPE P/E, etc.) for calendar year 2019 I am going to focus on those stocks with a P/E under 15.
Dividend Yield and Payout Ratio
I am not dividend hunting, but I do want to get paid to have money invested with the company, so I am going to use a dividend yield of at least 2% for calendar year 2019. Much more important than the yield is the Dividend Payout Ratio which is simply the amount of earnings per share that is being used to support the dividend. While sources will have different views on the topic I like Dividends.com guidelines,
A range of 35% to 55% is considered healthy and appropriate from a dividend investor’s point of view. A company that is likely to distribute roughly half of its earnings as dividends means that the company is well established and a leader in its industry. It’s also reinvesting half of its earnings for growth, which is welcome.
Over the past six months or so, I found that I was eliminating some otherwise investable stocks just because they were under 35% and that didn’t/doesn’t make a whole lot of sense to me. So anything over 55% is eliminated.
Free Cash Flow Yield
New for 2019 is Free Cash Flow Yield.
Free cash flow measures the cash available to shareholders after a company has paid all of its bills in full. Buffett relies heavily on a similar metric that he dubs “owner earnings.”
One way to gauge a firm’s cash flow production is to examine its free cash flow yield. This is calculated by dividing free cash flow by market capitalization, or the inverse of the Price/FCF ratio. A firm with a free cash flow yield of 10%, for example, generates 10% of its total market value in cash each year. That cash, in turn, can be used to pay dividends or fund share buybacks — items that enhance shareholder returns.
Having seen a bunch of a different articles on the topic I liked this one best explaining where my gauge should be:
Having used the Free Cash Flow Yield a zillion times over the years, I have come up with these conservative parameters for my own investing.
For the more Aggressive, as well as the “Buy and Hold” investor, I would adjust everything down a notch, and for example, would make the hold from 2% to 5.9% and the buy from 6% to 9.9% and sell anything under 2%. As for shorting a stock that would be any result under zero, including any negative result. Here is a listing of those parameters for easy reference.
Since this is a pure buy and hold account I set my screener at 6%+ for Free Cash Flow Yield.
My January 2020 Watch List and Purchase
After all that I reduced thousands of companies to 6 stocks:
- Aflac – AFL
- Eaton Vance – EV
- Helmerich & Payne – HP
- Nucor – NUE
- Old Republic International – ORI
- Cardinal Health – CAH
Normally, I would start to look deeper into each and every company to further reduce my options. Sometimes I would look at share buyback charts, reviewing what metrics dropped to allow them to show up on the screen, etc. Instead I am going to do something a bit different. I currently own a position in each of the companies except HP, however, I have watched HP go from $35 to it’s current price of $46 b/c I am involved in a rolling naked put which got away from me. I am not particularly interested in any part of the company at the current time as it’s share price seems to be tied to oil and the turmoil in the middle east.
Currently, I define a lot as a $500 investment, so this month I am going to go in for 2 lots but instead of putting them concentrated on one or two companies I am going to evenly split it up between the remaining five ($200 per company). I would never have considered this if trades weren’t free! This will add to the existing positions, some of which I have had for 5+ years.
Its funny, there really isn’t much value out there, is there? Finding great undervalued dividend growth stocks is not easy. But I do like AFL and will take another look at them. CAH was also on my January watch list!
It is crazy how few get past a relatively modest screen! I am thinking I am may be missing some growth opportunities by focusing too much on value metrics.