Sunday, July 8, 2012

10 Point Checklist for Dividend Ideas

The number of free stock screening tools has increased significantly in recent years. And while some screens are certainly better than others, investors often remain overwhelmed by the number of stocks these screens spit out, requiring yet further sorting for the best ideas.

I've put together a ten point checklist that I use when considering new dividend ideas for my portfolio. There are always exceptions to these rules, but I've found that discarding ideas that don't match these criteria have more often than not saved me from making some big mistakes.

1.) Dividend yield above 2%
To make a stock worthwhile for a dividend-focused portfolio, it needs to yield at least 2% otherwise it will likely take too long for the income generated by that stock to have an impact. Moreover, the lower the yield the more you're banking on high dividend growth rates to be maintained over the longer-term and that's not always a sure thing. A lot can happen to a company's fortunes in ten years that would reduce its ability to sustain an annual double-digit growth rate.

2.) Dividend yield below 8%

Because the market has historically returned about 8-9% over the longer-term, any stock that's paying out approximately that rate each year in dividends is probably too good to be true. The market isn't likely to give away those types of opportunities without some major strings attached. If it were that easy, everyone would simply buy that stock to enjoy low-risk 8% annual returns, which would serve to drive the stock price up and the yield down anyway.

3.) Dividend track record of at least five years

In 2011, 22 S&P 500 companies initiated a dividend program. A handful of others have started programs in 2012, most notably Apple. While it's encouraging to see more companies paying dividends, individual investors should be skeptical of these stocks when considering them for inclusion in a dividend-focused portfolio. Most of them don't pay a high enough yield to begin with, but unless the company has established a firm dividend policy (30-35% of earnings, for example) it's unclear how the dividend will be managed over a full business cycle. Will the company hold the payout flat during temporary downturns or will they manage it based on anticipated longer-term growth? All else equal, I'd prefer to see how a company handled its payout across a number of scenarios and macro-environments before buying.

4.) 5 year dividend growth above 3% annualized

Even companies with enviable track records of raising dividend payouts can run into trouble and the dividend put in jeopardy, as we saw quite clearly during the financial crisis. Watch out for companies whose dividend growth rates have slowed considerably in recent years -- a company that used to increase payouts at 10% per annum and now increases at 3% may be indicating trouble ahead. Indeed, 1-3% annual increases may be token increases aimed at maintaining a consecutive increase streak and may not be economically justified. Similarly, a company that used to steadily increase its payout but has held it flat year-over-year is usually an indication that the dividend is under pressure.

5.) Return on equity above 10%

Companies that consistently post returns on equity below 10% are probably poor places for your money. Given that the cost of equity for most firms is above 10%, firms that consistently generate ROE below 10% are more likely to destroy shareholder value.

6.) EBIT interest coverage over 3x

Equity owners are below creditors on the totem pole, so it's important to make sure that creditors are being taken care of before we can even think about dividends. In fact, creditors often attach covenants to their loans to ensure that the company will pay them back in full. If the company breaks those covenants (the details of which can be found in annual filings, if they exist), the creditors may have the right to restrict dividend payments to equity owners. Companies that cover each dollar of interest expense with more than $3 of operating profit (EBIT) are typically well ahead of their minimum covenant requirements. The higher the interest coverage the better. Interest coverage ratio standards can vary by sector -- utilities, for instance, can afford to have lower coverage ratios -- so it's wise to compare the company's interest coverage versus major peers.

Another balance sheet metric to pay attention to, as it's often one used in covenants, is net debt-to-EBITDA (earnings before interest taxes and depreciation and amortization). Net debt is equal to total debt minus cash. Aim to buy companies with net debt-to-EBITDA ratios below 2x.

7.) Pension deficit less than 2x net income

While many companies have closed their defined benefit plans to new employees, there's a good chance that mature dividend paying companies are still on the hook for paying benefits to former and older current employees into retirement. If the company's pension is significantly underfunded, the company will likely need to shovel cash into the plan each year to keep it solvent and this is cash that may have otherwise been returned as dividends. Pension deficit figures can be found in annual filings. If the most recently reported pension deficit is more than twice the previous year's net income, the pension could remain a millstone around the company's neck for many years and weigh down its ability to pay dividends.

8.) Consistent free cash flow cover of at least 1.5x

We'll define FCF as cash generated from operations minus capital expenditures here -- both figures can be found in company filings on the cash flow statement. FCF is the cash left over after the company has made the investments necessary to maintain and grow the business, and it's with FCF that the company can pay dividends, buyback stock, reduce debt, etc. A firm that generates $80 million in free cash flow and pays out $100 million in dividends needs to make up that gap by borrowing or selling assets and both are unsustainable practices. To avoid such situations, aim to find firms that consistently generate at least $1.50 in free cash for each $1 they pay in dividends. This 1.5x level also provides a margin of safety in case the firm falls on a weak year or two.

9.) Diluted share count growth less than 2% annualized

Firms issue new shares for three reasons -- to buy other companies, raise capital, or reward employees -- and none of them are particularly appetizing to common stockholders. Most large acquisitions destroy shareholder value, raising equity capital is typically the most expensive form of financing, and in the last case your stake in the company is being diluted as employees and executives cash in on options. Of the three reasons, I'm most likely to be fine with employees cashing in on the company's success (as long as the company is, in fact, successful), but I still don't want to see my stake diluted at more than a 2% annualized rate. If that's the case, the company is likely being too aggressive with option grants, running into financial trouble, or making too many (or too large) acquisitions.

10.) Avoid companies with a history of "funny stuff."

Of the ten points, this is the most subjective and requires a little sleuthing. Does the company frequently take impairment or restructuring charges? That might be a sign that the company does not make good capital allocation decisions or could be covering up bad moves. At the very least, it makes the company very difficult to value and it's probably worth looking elsewhere.

Beyond the ten points

Once a stock idea has made it through the ten-point checklist, it's time to do put it on your watchlist and do some more research on competitive positioning and valuation. Also, read the latest proxies to get a feel for management's compensation and incentive metrics. These are all topics for future posts, but I hope that the ten point checklist helps you separate the wheat from the chaff on your screening results.


@toddwenning on Twitter