Dividend Farming: Selecting Investments

Dividend Farmer highlighted 4 things needed to be successful:  Ground, Seed, Time, and Patience.  Explanations were given for each providing a launch point for your dividend farming operation.

Carrying the outline a step further means walking through the farming process in greater detail.  This post steps through an investment selection process you may consider.

Many would-be investors think stock selection takes great sophistication, skill, or maybe nerve.  Consequently, they’re ready to pay the trading class to make the decision for them or opt for the tried-and-true index mutual fund with little thought required.  However, these are not the only options.  A third path is possible.  Does it require diligence?  Yes.  Expert level skill and knowledge?  Not necessarily.

Below is an outline of an investment selection process I move through.

Investment Selection

Stock Screening:  

I begin with Dividend Champions, Challengers, and Contenders (CCC) from Dripinvesting.org.  Any investor starts with a screening process whether he knows it or not.  A screen might be a list of the top performing funds during the past 12 months, selecting only from a specific sector, or looking at companies with long histories of consecutive dividend payments.  The point is to take the universe of investment options and whittle it down to manageable size.  Dripinvesting.org provides a list of dividend paying firms so that’s where I start.

Since my portfolio goal is a 4% yield or better, I start looking for CCC firms paying at or close to 4%.  Depending on whether my portfolio needs more balance at the time, I may look for 4% firms in a particular industry first.  

For instance, if my portfolio seems light in manufacturing holdings, I may look for firms in that segment before any others.  If I can’t find good prospects, I’ll look at my next smallest portfolio sector to see if I might add there instead.  Should no options be available at 4% in those sectors, I’ll consider whether to add something below 4% in one of those segments if doing so helps balance my portfolio.  Case in point, I recently conducted this exercise adding an investment with a 3% yield since it was in the agriculture sector and I needed weight in that category.  If I’m not in need of rebalancing, I’m apt to seek out the highest yielding CCC firm that meets my other criteria.

Company Profiling:

After I’ve worked through my initial screen and established a short list of potential investment candidates, I profile them so I understand what they do, where, and how.  This part of the exercise usually takes me to Yahoo.finance.  

I’ll pull up each firm to read through the company summary and profile.  I’ll also peruse news articles and commentary surrounding the firm to get a feel for its operations and management team.  In doing so I’m not looking for a particular reason to invest, but for market, industry, or operational items that cause me concern and require additional analysis.  To be specific, I want to know if there are big picture concerns of which I should be aware rather than short-term, media-driven events making the news this week but which are likely to be absent from the radar in six months.  For instance, I’d like to know if my prospect might implode the way GE is currently or the way Enron did in 2001.

Financial Profiling:

Thus far, the process as outlined may not seem daunting to the DIY investor.  However, I think it’s safe to say many feel less than adequate for the task when considering the financial analysis component.  It’s at this point investors can fall prey to the siren song of “professional managers” or opt for the relative safety of index funds.  Fortunately, this binary isn’t the only option.

From a financial analysis standpoint, I start with Ben Graham’s guidance in his tome, Intelligent Investor.  He advocates that investors look for firms with the following characteristics:

1. Noteworthy, industry leader:  This isn’t too difficult for an investor to understand.  For example, is Coke foremost in its space or is Dr. Pepper?
2. Large:  Large generally means having a significant revenue stream and being well capitalized.  To put into perspective, the smallest Fortune 1000 firm in 2018 generated nearly $2B in revenue with a market cap north of $13B. 
3. Price to Earnings:  Graham stated a firm should have a P/E less than 25 and less than 20 over the preceding 12 months.  I normally look at price to trailing twelve months earnings since those are closer to fact than forecast.  Seldom do I select a firm with a P/E above 20.
4. Dividend History:  Graham likes firms with a history of paying successive dividends for 10 years or more.  I like it if they’ve done so for 25 or more (Dividend Champions).  Even better if that record includes numerous dividend increases.

Two of the first three items noted above are readily available through Yahoo.finance.  When you pull up the company name and click on the Financials link, the information is provided in an easy-to-use format.  The dividend history can be found within the CCC list.  As a result, if I start with that list, I will have addressed Graham’s item #4 before I get to the financials.

In addition to Graham’s items, I’ll also look at the following metrics:

1. Price to Book value of the firm.  Ideally, my investment will have a P / B close to 1 and certainly not greater than 2.  I’d prefer not to buy a lot of blue sky or “good will” if I can help it.  This metric is one in which Warren Buffett and Charlie Munger appear fond.  Hard to argue with their success.
2. Debt to Equity of the firm.  As with the Price-to-Book, I’m looking for something close to 1.   I don’t consider it favorable if the debt is several multiples of the equity; it’s generally a comfort level perspective on my part since I'm not a fan of big leverage.

Last, but not least, I’ll look at the 12-month price range for the stock under consideration.  In a perfect world, the metrics above will be where I’d like them to be and the stock will be closer to its 12-month low than high.  I’d rather buy what I believe to be a quality company toward the lower end of a price range if possible.

In the past, I’ve also looked at things like the quick ratio.  Although the quick ratio can be useful, it generally represents a company’s ability to immediately pay off short term debt with liquid assets.  Since my investments are predominantly large and for long duration, a short-term metric, while helpful, is not among the major decision criteria.

For dividend firms, many investors also look at the payout ratio.  This is the percentage of earnings paid as dividends.  A company with a high payout ratio is paying most of its earnings to investors as a dividend.  The argument is that companies with high payout ratios don’t have room to increase the dividend payments in the future.  However, as I’ll discuss in a future post, a high dividend, high payout ratio firm may be distinctly better than a low dividend, low payout ratio firm despite the upside of dividend increases perceived to be available with the latter.

Once I’ve screened my options, profiled the firms, and conducted basic financial analysis using the metrics provided mostly by Messrs. Graham and Buffett, I’ll complete a side-by-side matrix of the items using an excel spreadsheet. 

It’s highly unusual for a single firm to be superior to all others in every respect noted above.  However, it’s not uncommon for a firm to be superior in several categories and rank well in others.  When this happens, my process of elimination points to the option with the best overall “score” if you will.  From that point, I’ll let the analysis settle for a day or so to ensure I’m not missing anything.  After that fermentation process is complete, I’ll allocate the money I’ve saved up and make the investment or, in Dividend Farming terms, plant the seed in the ground I’ve identified then start the time and patience segment of my farming operation.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and should not be considered as investment advice. The information is presented for consideration and entertainment only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.