How to find Top Dividend Stocks to generate long lasting income.
By Sam Kovacs & Robert Kovacs
If you are here, you want to find top dividend stocks We have developed the S.A.F.E framework to consistently find top dividend stocks. It is a straightforward framework which leaves no room for guesswork. The four-step process outlined below includes:
At the heart of dividend growth investing, one metric stands out: The dividend yield. After all, it is the constant stream of cashflows that makes this investment method attractive.
Most dividend growth investors know they should look beyond chasing yields to avoid being in the awkward situation where the dividend is slashed, because it was unsustainable.
It is very easy to say that you will sell a stock if the dividend is slashed, but in so doing one runs the risk of capital depreciation due to the sudden price drop as the market follows suit.
Investors also choose to focus on the safety of the dividend. By acting as a cautious creditor, eager to receive their payments on time, they first look at the company’s ability to pay stakeholders with priority over them: employees, suppliers and debtors.
A quick glance at the current and quick ratios gives you an idea of the company’s capability to repay its short-term liabilities. A popular way of assessing the company’s ability to repay debtors is by looking at the interest coverage ratio, thus answering the question – does the company have enough income to service its debt?
Good values on these metrics are an encouraging start. The investors may also ask themselves what are the chances of the situation changing? By looking at the degree of total leverage (DTL), investors can get a grasp of the sensitivity of net earnings in relation to revenues. The DTL is an elasticity measure which reflects the change in earnings for a 1% change in revenues.
Highly leveraged stocks will have more volatile earnings which can put the dividend at risk, if revenues decrease. By closely monitoring both the DTL and the payout ratio (dividend/net income) investors have a firm grasp of the company’s ability to continue paying dividends, as well as the room for potential dividend growth.
Finally, they might look at the company’s dividend streak. For how many consecutive years has the company increased its dividend? Some companies have been increasing dividends for more than 50 years (a monthly document tracking them is published by David Fish). For these companies, the opportunity cost of not increasing the dividend even by $0.01 is too high
If investors systematically analyzed all the previously metrics and ratios, they would invariably end up with high-performing companies.
Once high quality dividend paying stocks have been identified, the next step is buying them. Many investors do not attempt to identify an advantageous point of entry but instead they decide to dollar cost average into a full position. This fits with the nature of most retail investors’ cashflows: They will have a portion of their paycheck to invest every month. Invariably, this results in less than optimal performance. Buying stocks when they are priced too high also dramatically decreases the potential for capital appreciation.
Our framework doesn’t assume an ability to time the market perfectly, but it does aim to identify high-quality dividend stocks, when they are attractively priced.
The objective of S.A.F.E. is to find the best dividend stocks at any given time. To do so the framework analyzes the evolution of metrics and ratios, assigns a value to the stream of cashflows, choose optimal entry points and make sure that there is no better alternative lurking around the corner, or dangerous macroeconomic headwinds which have not yet been reflected in the stock price.
By screening for the best dividend stocks, a good part of the grunt work is automated. We recommend sorting the screen results into 3 categories: New Entrants / Current / Exits. This allows you to keep a track of stocks which no longer fit your screening criteria, to monitor your existing positions, as well as give you a shortlist of new stocks to inspect.
We are strong believers that the best screeners are the simplest, which is why only 5 simple criterion make the cut in our screener. The S.A.F.E. screener returns stocks who have been paying dividends consecutively for at least 5 years, have positive earnings and an attractive dividend yield with room to grow.
Since the purpose is to find attractively priced dividend stocks we screen in this manner:
Dividend Yield > 3%:
For the dividend yield we will make sure we only have stocks which yield at least 3%. Our opinion is that below this threshold, we can get better risk adjusted returns in the fixed income space, but that assessment is subjective.
1 year dividend growth > 2%:
We will expect at least 2% growth in dividend payments over the last year. Dividend growth is what will increase your yield on cost in years to come.
Payout ratio < 70%:
We will also only keep stocks whose dividend payout ratio are less than 70%, which in theory leaves room for the dividends to increase in the future.
Dividend streak >= 5 years:
We will only keep stocks who have a history of increasing dividends for at least 5 years. This ensures the companies have at least some history of paying dividends which is important for dividend investors who expect their cashflows to increase over time. This reduces the list of potential candidates to about 800 stocks in the US, which is plenty to pick from.
Price Earnings > 0:
Which is just a fancy way of saying that the company’s earnings are positive on a TTM basis.
That’s it. We believe in simple screeners since over complicating them can lead to a reduction in the pool of stocks and therefore potentially exclude top dividend stocks. From here we have a pool of potential top dividend stocks to pick from. If you already have a portfolio of dividend stocks, we advise you to run this screen weekly to monitor for new entrants and exits.
The screener is the automated part of the analysis: either a stock enters the list, or it does not. From there, everything becomes subjective. Our analysis is a 3-step process: First, we assess the evolution of key financial data, then we assign a dollar valuation to the stream of cashflows, and finally we analyze the stock prices' relative attractiveness.
First we will draw graphs to look at the evolution of the company’s revenues, net margin, dividend yield, dividend payments, and payout ratio.
Looking at the evolution of revenues, net margin and payout ratio over time gives you a better sense of whether the firms still have room to grow their dividends. For top dividend stocks,revenues should be growing, net margins are constant or expanding and payout ratio is stable or declining.
Next, we assess the dividend yield in relation to the dividend payments. How stable is the yield? Does it tend to remain stable despite increases in dividends (remember our sample only includes stocks whose dividends increase)? Or does the dividend yield fluctuate erratically?
What we are trying to determine here is whether the stock’s price is driven mainly by its dividends or whether other elements drive the stock price.
With the increasing popularity of dividend growth investing over the last few years, some blue-chip stocks tend to have very stable yields. These can be interesting for your portfolio, because the stock price will be relatively stable over extended periods of time.
On the other hand, stocks with more volatile prices will provide interesting entry points when the market exerts selling pressure for whatever reason. No stocks are excluded here – we just analyze price action from an angle which interests dividend investors.
We will then look at the evolution of the DOL, DFL and DTL to assess how exposed the company’s earnings are. The purpose is to spot overall trends.
Are these values increasing, stable or decreasing over time? A changing DOL could imply significant changes in the company’s cost structure. An increasing DFL could be a warning that a company is significantly increasing its borrowings.
But what matters here is to look at what decrease in revenues would be required to eliminate the ability to pay the dividend? And what decrease would be required to eliminate earnings?
For example, if a company has a DTL of 10 and a payout ratio of 50%, anything beyond a 5% decline in revenues would slash the company’s ability to finance the dividend through their operations, and anything beyond a 10% decline would wipe out all earnings. Top dividend stocks should have some room to maneuver.
Subsequently, we run a simple dividend discount model (DDM) to value the stream of cashflows.
We do not consider the dividend discount model to be a sound basis for valuating the companies, yet it is viable for evaluating the value of your expected stream of cashflows.
There are 3 elements to the Dividend discount model:
1. The annualized dividend.
This could be an annualized form of the most recent quarterly or monthly dividend.
2. The dividend growth rate.
It could be based upon the historical average growth in the dividends over 5 or 10 years. Since extremely high growth rates are unattainable in perpetuity (which is what this model is calculating), we cap the growth rate at 6%, which is just above the average dividend growth rate of the S&P 500 over the last 25 years. We advise you do the same.
3. The discount rate.
Many investors tend to over complicate this, and ask what they should use as a discount rate. The WACC is used by default although is ultimately irrelevant if you don’t believe that the CAPM holds. But if we go back to the basics, the discount rate is the rate of return which you would expect to have to give up money now. We choose to discount dividends at 10%, which is a conservative amount.
We will then run the model 3 times, first using the growth rate determined above, then by removing 1% and finally by adding 1%.
This output will give us 3 values. What we are interested in doing is dividing these values by the stock price, to see what portion of the price can be attributed to the dividends and the implied necessary growth to pay out these dividends.
We establish a range rather than pinpoint a value, since the model is highly dependent on the chosen values for growth. The remaining portion of the price is what can be attributed to the rest of the business (retained earnings, net assets, etc.).
This implies that if the prime objective of your portfolio is to receive dividend income, you should focus on top dividend stocks which have higher values of dividend streams as a percentage of price.
Remember, earlier we mentioned that some stocks prices are driven mostly by factors other than dividend increases or decreases. In some instances, you will find a stock where the value of the dividend stream is greater than the stock price which can be a wonderful opportunity. However, you do need to be cautious in these cases, since other risks are being discounted into the price, and the rest of your analysis should back up, whether this is an opportunity or a trap.
You can back this up by using Peter Lunch’s price/earnings (PE) lines. The basic idea of a PE line is to compare the stock price to a hypothetical price over time. We will usually draw 3 PE line overlays. One at the 5-year average PE, one at the 5-year maximal PE, and one at the 5-year minimal PE.
Perhaps you realize a trend here, we use ranges consistently. We believe investing is part art, part science, and pinpointing an exact number is futile. What we are looking for here is to find a sense of continuity in the analysis.
If the value of a company’s dividend stream is high in relation to the stock price (80%+), and the price is below the average PE, the company might simply be out of favor. If the dividend seems safe, this could prove to be an interesting entry point.
Friends and foes refers to other dividend stocks and industry competition respectively. However, we needed to find a synonym of peers which started by F for the acronym to make sense. Calling it the S.A.P.E method would be less memorable.
What needs stressing with the “friends” term are other top dividend stocks, which might be more attractive. Picking the top dividend stocks is a relative exercise. There is a pool of very high quality dividend growth stocks, but at any given time some will be attractively priced compared to others.
Always consider how adding a certain security to a portfolio will impact you. Will you be overexposed to a certain sector? Are the dividends monthly, quarterly or yearly? And does this put a strain on your need for cashflows?
The “foes” part refers to peer analysis. The underlying idea is that all stocks within an industry are impacted in a similar way by macroeconomic factors. Drawing a comparison table will give you key insights on the company you are analyzing’s cost structure and pricing relative to it’s peers.
Elements for consideration are: PE, 5-year average PE, Enterprise Value/Sales, Enterprise Value/EBITDA and debt to equity. If you don’t want to calculate Enterprise Value, you could always just use market cap even if it isn’t correct. The advantage of this framework is that you can quickly see divergence in pricing across the industry.
For two companies with the same EV/Sales but different EV/EBITDA, you instantly know which one has higher margins. With the debt to equity you know which stocks are more leveraged than others.
The 5-year average PE lets you know, if certain stocks have historically commanded a premium or a discount. It is also an easy indicator to see if the industry is priced at different multiples than historically.
This will give you clear insights into whether divergences in pricing are mostly due to micro or macro influences. Top dividend stocks could fall into any of these two baskets.
It is no surprise to hear that different industries perform differently due to macroeconomic factors, the first of which is the general economic environment. Some sectors are favored depending on what stage of the business cycle we are in. This is important to us as investors because according to a study by McKinsey up to 54% of company returns can be attributed to what they call the “industry effect” as opposed to the “company effect”.
In other words, even the best stock picking can lead to lackluster results if the industry takes a plunge.
Historically, these are the sectors which performed well throughout different phases of the economic cycle.
At the end of the expansion, and throughout the beginning of an early recession services have been favored, as the recession escalates utilities perform better. As the recession hits, full speed cyclicals are popular, finally as we hit the bottom of the cycle, technology stocks perform better. As the recession turns into early recovery, industrials shine brighter.
As the economy picks up, basic materials take off as investors pile their hopes into the pick up of economic activity. When the economy expands energy stocks, then consumer staples perform at their best. Markets discount the future, since investors anticipate the future. Therefore, the market cycle leads the economic cycle.
Furthermore, you can look at the market dynamics of the underlying sectors to understand how supply and demand might influence the future. For example, if you were analyzing telephone providers, you would look at the percentage of population who has a cell phone in key geographies.
Since Americans have on average 1.1 cell phones each, you can question capacity to grow within the geographical area. If the business is mostly concentrated in North America, you would want to look at the payout ratio to see what room the firm has to maintain and grow the dividend.
You would also look at whether the firm have been leveraging themselves to boost returns in a maturing market.
The idea is to look at key data for each sector to further your understanding of how safe a dividend really is.
You can tweak this system, inspire yourself from it, or discard it totally. What is important is that you are able to determine a process which you use to select stocks. Not only will it save you time, but it will also help deal with your personal biases when investing in the market.
If you have any questions for either of us you can get in touch, we usually reply within a few days.
Robert Kovacs, CTO & CO-CEO
Rob is behind all of the technology that goes into uuptick.
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Sam Kovacs, CMO & CO-CEO
Sam is in command of marketing and customer relations
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