My recommendation criteria

One of the key elements to being a successful investor is to have a repeatable, quantifiable, investment process, which makes recommendations to buy/sell/hold based on sound fundamental values.  This removes any emotion from the stock picking process, and allows you to easy trace your decisions, when reviewing your portfolio holdings.

As part of my research process, I have built up a number of models based on various books I have read, as well as courses I have taken on investing.  The lion’s share of my criteria are actually taken from Benjamin Graham’s The Intelligent Investor, and have been tweaked to fit my own investment style. Specifically, when I am looking at an investment, I review six quantifiable tests, and make a recommendation for Buy/Hold/Sell based on how many of those tests pass. As of August 2016, here is my recommendation matrix:

Recommendation Financial Strength Earnings Stability Dividend Growth Share Price Growth EPS Growth Undervalued
Strong Buy Pass Pass Pass Pass Pass Pass
Buy N/A Cond1 Pass n/a Cond1 Pass
Hold N/A Cond1 Pass n/a Cond1 Fail
Sell Fail Cond1 Fail n/a Cond1 Fail
Strong Sell Fail Fail Fail n/a Fail Fail

In the above, Cond1 means any of those tests pass. As an example, for a stock to receive a Buy recommendation, it must pass the Dividend Growth test, the Undervalued Test, and at least one of the Earnings Stability or EPS Growth tests.

But, what do each of those tests mean?

Financial Strength

Financial Strength is driven by the current ratio for a stock, which is defined as the Current Assets divided by the Current Liabilities. This measurement is always based on the most recent year of analysis, and a company will pass this test if this ratio is less than or equal to 1.50. The test is meant to ascertain whether a company can make its current liability obligations (e.g. short term loans, accounts payable, etc.).

Earnings Stability

This test is made of up two sub tests: the most recent number of years of positive EPS growth, and the number of consecutive years of negative EPS growth.

Realistically speaking, a company may experience negative EPS growth for any number of reasons. For example, they may have faced currency headwinds which had a short term (negative) affect on their bottom line. Or they may have wound down a division, and experienced an abnormal charge for severance pay to employees of that division. However, over a lengthy time period (>= 10 years), negative EPS growth should not be a recurring theme for any firm. This test is designed to examine how many years in a row we have had consecutive negative growth. If a company has had more than one year of negative growth, this indicates that there may be other underlying issues leading to that growth, or that the company is not learning from its mistakes.

The number of recent years of positive EPS growth is another indicator of a companies ability to build on its mistakes. For this test, I look for firms where the most recent three years of EPS growth have been positive. Passing this test shows that (i) a company hasn’t had negative growth in the past 3 years, and that (ii) the company has been in an upward trend for the past three years.

Dividend Growth

Dividend Growth by itself is not a key metric referenced in The Intelligent Investor, but since my personal investing style is on dividends, it is one which deserves a test on its own. For this test, we look for a compound annual growth rate of at least 2.00% over the past 10 years. Designing this test this way has two key benefits:

  • It removes growth only (i.e. those who do not pay a dividend) companies. I am a firm believer that if you are to hold a company, you should gain some current premium for holding it, and dividends are one of the only ways for a company to give you a current return for holding their stock.
  • It smooths out periods of slow or flat growth. Depending on the dividend investment methodology being used (e.g. US Dividend Aristocrats, Canadian Dividend Aristocrats, dividend achievers, etc), you may subject yourself to rules such as “increasing dividends every year, but one year of no growth is acceptable.” Because I am looking to invest for the long term (e.g. 10+ years), I expect the total dividend payout (in absolute dollars, not yield), to grow at a rate of at least inflation. Right now, that means I am using a target of 2.00% growth per year, compounded annually. By taking the CAGR over a 10 year horizon, we do not inadvertently screen out companies which have not had stellar dividend growth over the analysis period (10 years).  For example, High Liner Foods Ltd. had zero dividend growth for four years, but still has a hefty 14.99% dividend CAGR for the past 10 years.

Share Price Growth

All things considered, we still want the share price to be going up over time. For this test, I am looking for compound annual share price growth of at least 3.00%. This also indirectly screens out chasing after yields: if my dividend growth threshold is 3.00%, and my dividend growth threshold is 2.00%, then I am asking for my share price to grow faster than my dividend. This forces out high yielding firms (i.e. dividend remain high or stable while share price falls), since I am explicitly screening out firms whose share price may be falling, yielding to increasing dividend yields.

EPS Growth

One could include this test with Earnings Stability, but I prefer to separate it out, since there are also separate tests for share price and (absolute) dividends. EPS growth also has a minimum threshold of 3.00%. This builds an at-a-glance screen to ensure that dividend payout ratios (i.e. dividends divided by EPS) do not outpace EPS: since my EPS must grow faster than dividends, this ensures that our dividend payout ratio does not become too unwieldy.

Tied with the earnings stability, this gives a fuller picture of EPS: we are checking that companies have consistent growth, are recovering from bad periods, and have a minimum allowable EPS growth over time.

Undervalued

All things being equal, I would rather buy a good stock for a good price, and a great stock for more than it is worth. Leveraging two classic criteria, the P/E ratio and the P/BV (BV=Book Value), we can build a simple screen of P/E × P/BV. In this test, I check that P/E is less than 15, P/BV is less than 1.5, and that their combination is less than 22.5 (i.e. 15 × 1.5). This allows us to reduce the universe of stocks which are too expensive, but still allowing for stocks which may be too expensive on only one metric (e.g. if a stock has a high P/E ratio, but it is trading at less than book value, all things being equal it is likely still a good buy; by applying P/E × P/BV, we can handle these situations).

Caveats

The tests are meant to be a simple way to quickly quantify a recommendation, however they should not be taken as gospel. Even when evaluating firms, I challenge myself if a company looks like a good (bad) prospect, but my model tells me to not buy it (or to buy it). For example, a company may have more than one year of negative EPS growth, but this could be due to a string of restructuring or spinoffs from the beginning of a 10 year analysis window; and since then, they have had nothing but positive growth.

Future considerations

This model is a work in progress, and as I am focused on dividend investing, it still ignores some key criteria:

  • Dividend Growth Trajectory. Looking at dividend CAGR of 10 years is meant to smooth out periods of no growth. However, it also allows periods of negative growth. All things being equal, we want a company who has had positive or flat dividend growth, but not one which has cut dividends in its 10 year history, and made up for the cuts at a later date.
  • Dividend Payout Ratio. This model does not check for our dividend payout ratio. While my analysis inspects this in general by (visual) inspection of the dividend payout graph, the model itself does not test for it. This means that some companies may pass all of the tests, even though they have dividend payout ratios in excess of EPS or Free Cash Flow.

This year I will be re-tweaking the model as I become more involved in my investing again. Stay tuned!



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