Dividend Growth Investing Quality-Part 3

We discussed the ideas behind Dividend Growth Investing strategy (DGI) in Part 1. Then looked at how to find investments and evaluate them in Part 2. Here we look more at the quality measures to consider with a Dividend Growth Investing strategy along with the value and growth paradigms.

The most significant decisions an investor makes is what company to buy and at what price. The question can become overwhelming for investors wondering where to invest their hard-earned money.

The Champions, Challengers, and Contenders list is an excellent starting point for ideas. Starting with that list while considering the following quality measures will lead you to better equity investing.

1) Creates Returns for Shareholders

Dividend Champions, Challengers and Contenders (the CCC list) already meet this requirement to varying degrees. Their extended policy of increasing dividends demonstrates management’s efforts to create returns for shareholders.

They accomplished this through regular dividend increases and the resultant share price appreciation. These well-established companies are stable and easy to understand.  And, this behavior shows respect for their shareholders, the company owners, and is a true quality measure.

2) Management is Successful

It is essential for investors to consider the past behavior of management. Their actions should create positive outcomes for investors. By making the CCC list Management already demonstrated varying degrees of success here.

But, past performance doesn’t guarantee future results. So, an individual investor needs to follow the company’s press releases, quarterly conference calls, and the annual reports. This following is to understand management’s current performance better and help us judge if past performance will continue.

3) It’s a Good Business with a Durable Competitive Advantage

A good business is essential, along with a successful management team.

Warren Buffett once quipped; “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Here we turn to the best investors in the world for guidance. In the 10-step Guide to Stock Investments, we discuss their principles and methods to help us find companies with a durable advantage. Perhaps the most important Dividend Growth Investing quality measure.

4) S&P Credit Rating

S&P classifies the debt of companies as either investment grade or non-investment grade. If the company’s bonds are investment-grade, S&P feels there is a strong likelihood that the company will be able to repay the debt.

Non-investment grade debt is where S&P determines the company may have a difficult time repaying the debt.

The S&P ratings are useful in understanding the creditworthiness of bonds and the bond issuers or companies. So, the ratings are a good measure of the overall financial health of a company for Dividend Investors as well.

Investment-grade companies have a high capacity to repay their debt. And those that S&P is uncertain about are rated as non-investment grade.

S&P classifies the debt issuing entities using the following scale:

• AAA, AA+, AA, and AA- (Very High Capacity to Repay Loans). Companies with AA+, AA, and AA- ratings do not meet the criteria to earn an AAA rating. But they still have a very high capacity to repay their loans due to their financial position.
• A+, A, and A- (Strong Capacity to Repay Loans). These borrowers are financially stable under current economic conditions. However, although durable, they will have more difficulty repaying their loans if economic conditions change.
• BBB+, BBB, and BBB- (Adequate Capacity to Repay Loans). These borrowers demonstrated they are committed to repaying their loans and are capable of doing so. These are the lowest investment-grade bond ratings S&P assigns. However, the companies are more vulnerable to changing economic conditions than the higher scores.

The Dividend Growth Investor should consider an S&P rating scale of BBB- or higher as the credit standard quality measure for Dividend Growth Investing. This helps avoid more speculative companies and their potential risks.

5) Low Debt To Total Capital

Too much debt can limit the ability of a company to continue paying the dividend. Because debt holders have a much stronger claim on the company’s cash reserves than equity holders.

Avoid companies with too much debt. And, although this will vary by industry, a good starting point is to limit debt to total capital at less than 50%.

6) Selling At or Below a Fair Value

Quality companies purchased at or below a “fair value” provide very satisfactory returns over the long term. Thanks to the power of Dividend Growth Investment and compounding.

Whether a company is purchased at or below fair value is a function of either the investors’ patience in waiting for the market to offer a bargain or the willingness of the investor to “bank on the future.”

In either case, knowing the intrinsic value of an investment candidate helps reduce risk and maximize returns by taking advantage of Mr. Market.

“Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to.”                        –Benjamin Graham

Two Paradigms

For ease of discussion, we’ll divide investors into two broad groups. Those that use the “Value Paradigm” and buy companies on sale or below fair value. And, those that use the “Growth Paradigm” and buy companies at or near the fair value.

A paradigm is how we view the world to make quick, easy, and comfortable decisions that help navigate us through investing.

The Value Paradigm

Value investing is a strategy of buying stocks that trade for less than the intrinsic or underlying economic value of the company. Recall, price is what you pay, and value is what you get.

Those with a value orientation need to know the intrinsic value of the company to purchase the stock when the market price falls below the fair value. The price discount creates a margin of safety to help offset any errors made by the investor. And, provides an opportunity to purchase a higher-yielding stock.

Since the company’s stock price decline is believed to be temporary, the risk with the Value Paradigm is the setback may not be temporary, and the price never recovers.

The Growth Paradigm

Growth Investing is a strategy that focuses more on identifying great companies with promising futures and purchasing them at a fair price.

These companies that rarely sell at a discount, so investors have to pay the fair price. Those with a growth orientation need to know the intrinsic value of the company to purchase the stock near but not above fair value.

Dividend Investors who focus on growth rely on the consistent historical dividend growth continuing. They believe the growth will continue in the future and more than justify the fair price paid.

The risk with the Growth Paradigm is paying too much for the past performance. Or, the past performance does not continue. The investor then must wait a long time for the company’s future performance to catch up to their expectations.

Both paradigms will get us to our investing destination. And, although seen as “different strategies,” they are very compatible. By considering both paradigms value can create greater returns for growth and growth can create greater returns for value.

What we have learned:

Dividend Growth Investors should consider companies on the Champion, Challenger, and Contender list. They will more than likely have most if not all of these essential Dividend Growth Investing quality measures:

1. Creates shareholder returns;
2. Run by successful management;
3. With a durable competitive advantage.
4. Have an S&P Credit Rating Above BBB-
5. Low Debt to Total Capital ratio below 50%
6. Selling At or Below a Fair Value

The value and growth paradigms can be thought of as a continuum ranging from value to growth with varying degrees in between. Any individual investor can find a point on the continuum that best fits their style of investing.

Is your preference for finding those rare companies when they are on sale? Are you willing to bank on the growth companies to continue their excellent performance into the future? Or, do you prefer a combination of both value and growth?

Purchasing “below fair value” or “at fair value” requires the investor to know the intrinsic value of the company. And that brings us to the next article where we discuss the tools to calculate the intrinsic value.