Dividend growth stocks usually have solid fundamentals. Astute investors watch everything. A company which is able to raise its dividend for decades on end must have solid financials as the pay-out ratio invariably would spike if this is not the case. The pay-out ratio is basically what the company is paying out in dividends compared to what the company is actually bringing in in net income. In saying this, valuation is a critical issue here as quality dividend growth stocks rarely come cheap so we always must make sure we are not overpaying for any respective investment.
Therefore the main valuation ratios that investors use to value a stock are price to book, price to sales, price to earnings and price to cash flow. Now if you really pushed me and asked what quantifies a true value investment, I would say the following. The earnings multiple (or price to earnings ratio) would be under 15, the price to sales and book ratios would be both under 1 and the price to cash flow ratio would be under 10. If you can find a stock with these ratios which also is expected to grow its earnings going forward, you are definitely on the right foot. However what you will find is that true “value” or “fundamental analysis” investors will do an awful lot of research to see how correct analysts or consensus is in expecting earnings growth. This is really the crux of the issue especially if the company in question has traded at much higher valuations and with much higher earnings numbers in the past. So the value investor would do research on what caused the earnings decline. Is it temporary? What will be the catalysts for earnings growth going forward, etc. The problem with analysts is that they usually go with what is safe but this necessarily may not always be true. Just because a company has a consistent track record doesn’t mean this trend will continue. Value investors need to constantly “dig” to make sure the fundamentals stack up..
Another major metric is the company’s debt. True value investors would look for debt to equity ratios under 1. Don’t overlook debt as usually it is the major reason why companies go to the wall no matter how potentially attractive an investment may appear at any given time. A positive earnings history and a paying dividend would be my last two requirements for a potential value investment.
However in saying all of the above, I would be very surprised if a stock that fitted this description had strong compelling competitive advantages, What do I mean by this you are probably asking. I am talking about companies which have demonstrated (through either their economies of scale, brand power, network effect, switching costs or cost advantage), that they can keep competitors at bay for an extended period of time. Scale is an obvious advantage as it can bring down costs over time. Brand power also is a competitive advantage as successful brands like Coca Cola (NYSE:KO) and McDonald’s (NYSE:MCD) cannot be built overnight. A “Network Effect” is another powerful competitive advantage that companies use to beat their competition. Amazon (NASDAQ:AMZN) for example has a very powerful third party division where buyers and sellers come together to use its platform. Amazon basically makes money from the popularity of its brand and from letting third party users use its portals. This is leverage in its truest form as the e-commerce company is using external people to build up its website and getting paid in the process of doing so!
Switching costs are also crucial in determining whether a company has strong competitive advantages or not. For example, General Electric (NYSE:GE) comes to mind here straight away. Why? Well this company sells airplane engines to the respective airplane manufacturers. Apart from this, maintenance contracts can span up to 20 years in some cases in this sector. So when you consider the equipment GE already has installed all over the world plus the huge maintenance needed to service this equipment, you can get an idea why sometimes customers are very reluctant to leave existing suppliers. Cisco (NASDAQ:CSCO) is another company that comes to the mind due to the enormous amount of gear this company has installed down through the years. Furthermore when companies get so used to high-tech equipment as in these two companies, their equipment becomes the standard or the benchmark in their respective sectors which means that on many occasions, there is more risk in leaving an existing supplier than to change maybe to a cheaper one.
Stocks with compelling competitive advantages rarely sell on the cheap. Yes they can from time to time sell at a discount but selling for example with a sales and book ratio under 1 would be extremely rare. For our particular income strategy we want to concentrate on companies with strong competitive advantages. Why? Because the downside is protected to a large degree whether it be either the respective company’s switching costs or network effect. Furthermore when you add a growing safe dividend to the mix, you are left with a company that invariably will be bought aggressively if at any time the stock sells off more than it usually should. Basically stocks with strong competitive advantages, positive growth fundamentals and a growing dividend is what we are looking for. Usually as mentioned these set-ups do not come cheap so we must always be on the alert to pick them up when they present themselves.