I often get asked about my approach to investing in stocks. Well, here it is.
Overall, I try to look for companies that pay increasing dividends over time – in other words, dividend growth stocks. Dividends are a passive income stream that you can use to live your life. You can also use dividends to invest in other stocks, harnessing the power of compounding and making yourself rich over time. Warren Buffett retained earnings within Berkshire Hathaway and created one of the greatest compounding machines the world has ever seen. In 51 years, the Company’s book value has compounded at an annualized rate of 19.2%! While the price of the Company’s stock has compounded at an annualized rate of over 21%! Just to put this in perspective, if you had invested $10,000 in Berkshire Hathaway 51 years ago, your Berkshire shares would be worth nearly $167,000,000 today! This shows the awesome power of compounding which Albert Einstein once called the 8th wonder of the world.
With that said though, I’m not averse to investing in companies that pay no dividends but have an outstanding business and strong management. Think about what Berkshire Hathaway has done – as noted in the paragraph above. Berkshire does not pay a dividend and hasn’t since 1967. I also don’t mind if a Company cuts or maintains a dividend under appropriate circumstances. For example, due to the oil price slump, some oil companies have frozen or cut dividends. This a natural part of the cycle and if you sell due to this, you’re probably selling low and buying high. Nestle is another example of where you don’t see linear growth in dividends because of foreign exchange. Some people may not invest in Nestle because of this. But if you actually look at what the Company sells and its financials, it is one of the best companies in the world to own.
So how do you identify a company that’s a worthy investment prospect? I’ve broken down my approach below. I used this approach when identifying the companies that I currently own.
- Focus on industries that have had high relative historical returns. Think health care, consumer staples, food, alcohol, tobacco, energy (oil), and railroads. Within each industry, look for the companies that dominate based on market share and have the strongest brand name. For example, Johnson & Johnson dominates health care. Diageo PLC has some of the best alcohol brands in the world. Exxon Mobil is the largest player in the oil industry. Coca-Cola and Pepsi dominate consumer staples and soft drinks. Often times, you’ll know these companies without doing any research because their brand is so popular and prevalent throughout the world. Sometimes you have to dig a little. You could even do a quick Google search and look for the top companies in a specific industry and focus on those companies. Another good source is the US and Canadian Dividend Champions lists maintained here. These lists are updated monthly and include many of the top companies in each industry.
- After identifying some companies, I try to look at the big picture to see if their brand is strong enough to maintain a competitive advantage. Do they operate in a fast moving industry that is prone to rapid technological changes? If so, I generally try to stay away. Sometimes, the greatest investments are in companies that dominate boring industries. These industries are often slow moving and there’s usually low competition meaning the dominant players can generate significant returns for their shareholders.
- After getting comfortable with a Company’s qualitative picture, I start looking at the numbers. A good source for financial information is Morningstar. All you do is type in the company’s stock ticker, click on Key Stats, and the most important financial metrics should be available. Metrics I focus on include:
- Price/earnings (P/E) ratio. Is the Company trading at a reasonable price compared to earnings? For Companies with strong brands such as Nike, Coca-Cola, and Johnson & Johnson, I like to see a P/E ratio anywhere between 15 to 22 depending on what the Company’s growth looks like. I think once you have a P/E ratio of 25 or 30 or beyond, you’re going to see P/E compression in the future which will probably lead to reduced returns. I think you could see this with Facebook and Amazon.
- I also like to look at the price/free cash flow (P/FCF) ratio to ensure that it’s within a reasonable range. Depending on Company’s ability to convert earnings into cash – sometimes this is slow because cash is received by the Company much later than the earnings are booked. I like to see a P/FCF of 15 to 25 for Company’s with strong brands.
- Dividend growth. What’s been the dividend growth over the last 1, 5, 10, 15, 20 years? How fast has the dividend grown? If there’s been a cut or freeze, why has this happened? If the dividend has fluctuated, maybe this is because the Company is foreign and does not report in Canadian or US dollars (depending on what your home currency is).
- Dividend payout ratio. Is it sustainable? Does it have room to grow?
- Earnings growth. Has the Company grown earnings over the years? At what rate? What growth is projected for the future? This is important for sustaining dividend growth. I put more emphasis on earnings growth than dividend growth because without earnings growth, you won’t get an increase in dividends.
- Revenue growth. Is the Company actually selling more of its product and not just undertaking financial engineering to boost its bottom line?
- Outstanding share count. Is management diluting its shareholders? Or are they repurchasing shares when the Company’s stock price is low, thus, adding value?
- Net profit margin. What’s the net profit margin? What’s the net profit margin relative to competitors? Take a look at Coca-Cola’s net profit margin and compare it to Pepsi’s. Coca-Cola’s is much superior. Don’t get me wrong, Pepsi is a great company and I own shares but Coca-cola has such strong brand power that gives it this edge. When people want a soft drink, most of the time they ask for a Coke, not a Pepsi.
- Look at Return on Equity and Return on Capital to see how management is doing with the Company’s assets. Anything above 20% is great.
- Look at the interest coverage ratio to make sure there is enough operating income to cover off interest payments.
- Look at free cash flow. I like to see a free cash flow to net income ratio of close to 1. This lets me know that the Company is converting its income into actual cash which can be paid out in dividends.
- Look at balance sheet metrics such as:
- The current and quick ratios to make sure the Company is liquid enough to survive a credit squeeze or a slowdown in operations.
- Look at the debt to equity ratio to make sure the Company isn’t too leveraged.
- If you think the debt to equity ratio is too high or borderline, look at when the Company’s debt is due. If the debt isn’t due for a while (e.g., 5, 10, 15 years down the road), this is generally good – assuming the Company uses earnings to pay down some of the debt load.
- Watch out for huge pension liabilities on the balance sheet. This can cause issues down the road. Think General Motors before and during the Great Recession.
Once I like a Company based on qualitative and quantitative measures, I pull the trigger on a purchase. I like to buy in tax-deferred accounts so that I don’t have to fork anything over to the tax man each year. Taxes can be a huge drag on your returns. If you’re a Canadian, focus on TFSAs and RRSPs. If you’re an American, focus on 401(K)s, IRAs, ROTH IRAs, and SEP IRAs.
When do I sell an investment ? NEVER – unless I see a permanent deterioration in the Company’s earnings power. My goal is to buy a piece of the business, not a piece of paper. Once you buy shares in a Company, you are a part owner. If you own shares of Coca-cola, you are entitled to a part of the profits of each Coke can sold. I take pride in this ownership. I don’t do all of my research just to flip the stock the next day or week for a quick profit. I’m in it for the long run. If you own your business, you’re not going to turn around and sell it the day after buying it. So why should you do the same with your stocks? I like to own my stocks forever and my goal is to pass them down to my children. I haven’t sold a single stock in the last three years. This is called buy and hold investing. If you buy the right companies and diversify (not too much diversification otherwise it becomes diworsification), I believe you can become rich by just buying and holding great companies. You can add to them as they become undervalued but other than that you just sit back and let the Company do its thing. Proof that this can work?
Check out Joshua Kennon’s post on Jack MacDonald who accumulated a $188 Million fortune in stocks through buy and hold investing. At the bottom of the post, you will find other investors who did the same. These people weren’t geniuses with astronomical IQs. Instead what they believed in was the power of compounding, the power the great companies, they had outstanding patience, and a great temperament. Their achievement is a testament that anyone can make a fortune doing this. The hardest part is the upfront commitment to identifying great companies but even this isn’t that hard since they are often in plain sight and the tools for analyzing them are so readily available nowadays. The hardest part is holding onto investments through thick and thin when the stock market takes a dive even when the companies you own continue to make money. This is where your mettle will be tested.