Many financial gurus out there would say that dividend investing is a sub-category or sub-strategy to value investing. According to Investopedia - Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale. This is how most millionaires and billionaires make their bucks and set out their financial goals. Value investing is just another way of saying “when can I invest in a very good company that has excellent management; good cash flow; goes in line with my investing strategy; but right now is at a cheap price and after a few years I know the price would bounce back to its true value so I can reap the capital appreciation of that stock?”
However, dividend investing applies the same principles as you would by value investing but putting the stock’s historical performance in dividend payout each month/quarter/year as the main pillar of choosing whether to invest in that stock or not. What this means is, company A may have a great intrinsic value, and most financial guru would advise to buy that stock due to its past performance, great management, and prospects of that company/industry. However, if that company has very low dividend payout to investors, dividend investors would not buy that company. Based on my experience, these types of stocks are very projects driven. Meaning if suddenly this company successfully secured a tender bid to provide a service for a project, many financial experts would recommend buying this stock as it secures the cash flow of that company. Most technological companies are like this in my opinion. This is because most technological companies are very cash and credit driven. That means their business strategies require a substantial amount of credit to secure that plan smoothly. Thus, this type of strategy pulls back their funds to acquire investors confidence by giving high dividend payout, but they secure investor’s confidence by showing their quarterly reports of positive cashflow.
So, how do you categorize a stock that can pay you a good amount of dividend while still have a good intrinsic value? Below are the types of questions you need to ask yourself to create a watchlist of stocks that you can monitor or set a target to buy when the price go down so you can buy it at a discount:
1. Is the mission of the company go in line with your individual mission for the development of Malaysia?
a. Meaning if you do not like smoking, you do not need to look at tobacco companies such as BAT (British American Tobacco). Even if these companies can provide you a good amount of returns.
b. If you do not like gambling, then you do not need to look at companies like Magnum.
c. If you like green energy, maybe solar panel manufacturers are a step to go.
d. If you are a pure capitalist, then all these matters will not bother you.
2. The PE ratio is acceptable or not?
a. PE ratio (Price of share to earnings per share ratio) is the indicator most value investors use to see whether that company is either over-bought or over-sold by investors. What it essentially means is how much would investors willing to pay for the price of the stocks relative to the earnings per share (EPS) of the company. If for example, the stock is traded at RM10, but the EPS is RM1. That means, the PE ratio is at 10 (or 10X of the EPS). Your job as a good investor to figure out whether that sector is stable at what levels of PER. For example, tech companies may have higher PER when compared to other sectors as mentioned above, tech companies rely on projects, cash, and credits. Thus, investor’s confidence may drive the PER to high as 20 to 30. However, sectors such as construction or REITS are mostly comfortable around 10 to 15 (which I personally like as well).
3. How is the historical performance of the company’s dividend payout?
a. Is it stable?
b. Is it highly driven by the price per share of the company? Directly proportional?
c. If the company is facing some turbulence, how much efforts would the company give to pay dividend? Is that effort alarming that it could affect the company’s business model?
d. How did the company solve their financial issues when they faced a turbulence in the economy? I.e.: 2008 financial crisis, how low did stock price drop?
e. How high is the dividend yield for the past 1, 3, 5, 10 years of the company?
4. How much can the industry weather during a financial crisis?
a. Is there a policy for that company that needs to fulfill to continue paying dividends even when there is a crisis? I.e.: REITS requires to pay 90% of their revenue to the investors (in the form of dividends) to avoid extra taxes by the government.
5. How good is the intrinsic value of the stock?
a. Is the board of directors and management playing a good role?
b. Is there any corruption involved? if so, how are they managing it?
c. Is there a competitive advantage (i.e.: brand recognition; intellectual property; interactive ecosystem of products; etc.) of that company compared to its competitors? If not, how high would you hedge against them (hedging is another topic I can share in future posts).
d. What new projects is the company taking? If there is not any, how is the current project’s progress? What is the company doing to get more projects coming in?
6. How is the balance sheet of the company?
a. Is it taking any debt/loans? If so, what is their plan to pay it back?
b. Is the cashflow good? What is the profit margin? Is it better than previous quarter or last year’s quarter?
c. What is the profit after tax? Is it in line with past performance?
d. How is the return on equity?
e. Are they giving out dividends more than their earnings (huge flag to me)? Why?
f. Is the price to book ratio okay?
After you have answered these questions and are happy with the decision you’ve made, I would advise you to create your own watchlist of stocks for you to carefully analyze the stocks throughout your investing journey. The quantity of stocks that you need to keep track is totally up to you. Me personally, I have a watchlist of around 20 to 30 stocks (30 as of 2020) for dividend investments, and an additional 10 for capital appreciation/market movers’ stocks (just for fun).
I know it would be quite hard for us to pick a stock that ticks all the boxes above, but when there is some wisdom, you would forgive some boxes that is not ticking. I will probably do a comprehensive review of each stock in my watchlist as to why I believe they are a good pick in my future posts. But it pretty much goes in line with the 6 main questions above.