Saturday, September 15, 2012

My Entry Criteria

I haven't previously discussed my entry criteria before on this blog. I wanted to put "pen to paper" on this one and officially publish what I look for before I enter in to a position. Every investor has a certain set of criteria that a stock must meet before he or she will enter in to a position. I'm no different in that respect, but my overall entry requirements aren't really set in stone. Investing isn't a science as much as it is an art form. Stock prices aren't set by any kind of scientific measure and I don't engage in buying stocks in such a manner either.


Basically, I have seven entry requirements.

P/E Ratio

I look for a stock to have a current P/E ratio below 20. I define current price-earnings ratios by the ttm (trailing twelve months) figures. Forward P/E ratios are also helpful, but of course future EPS figures can only be analyzed and guessed, as nobody can tell the future. This is one criteria that I'm pretty firm on. A P/E ratio higher than 20 likely means the stock is overpriced for some reason. 

5-year growth of dividend

I am a little more lax than other investors when it comes to dividend growth. A lot of dividend growth investors require 10 years or more of dividend growth. I'm not that strict, as that would preclude a lot of great companies that have less than 10 years of growth, but have clearly shown shareholders a commitment to dividend growth. When I look at companies that have less than 10 years of dividend growth I'm a little stricter in other departments and I will research a little further to feel confident that continued growth of EPS and dividends can be sustained. 

A wonderful product

This goes without saying. Any company I invest in must have a wonderful product that people either need, or want so badly that they are not willing to go without it. It should be a product that people loathe to go without. Once people drink a can of Coke and fall in love, it's very hard to switch to store-brand cola products. Once you taste a Big Mac and love it, you are unlikely to stop buying Big Macs in the future. If you're addicted to Marlboro's, it's likely that you are going to keep buying them...even if the price goes up. We all know of our dependence on oil. And this leads me to my next piece of criteria...

Pricing Power

Any company that produces a wonderful product naturally has a degree of pricing power. They have the ability to raise prices with inflation to keep margins healthy. If McDonald's raises the price of a #1 meal tomorrow by five cents, that is probably going to have no effect on my decision to purchase that meal. I would think that most of the population would agree with me on that. Yet, that five cent increase means a big boost to margins for McDonald's when you consider how many customers they serve worldwide on a daily basis.

Entry Yield

I am pretty strict with this one. I'm more strict with this one than other criteria. I will rarely invest in a company with an entry yield below 2.5%. I actually prefer an entry yield of 3% or higher, but there are many great companies that I'm interested in that currently have an entry yield below 3%, and I'm still interested in them. However, 2.5% entry yield is generally my absolute limit when I'm considering entering a position with a company. Any lower than that, and the price is either too high or the dividend growth must be lacking.There has to be an outstanding and exceptional reason for me to invest in a company with an entry yield below 2.5%, as it will take a long time to reach an acceptable YOC (yield-on-cost). 

Payout Ratio

I generally like a company to have a payout ratio of 50% or less. I'm not super strict on this, and a lot of high-quality companies can ebb up and down and this number can vary quite a bit over a number of years. If a company continually pays out close to 80% or more of earnings, then that would probably be a signal for me to either stay away or look elsewhere for opportunities. In my personal portfolio, the exception for this is my investments in tobacco companies, which are well known to pay out a high amount of earnings due to a lack of need to reinvest capital. If a high payout ratio is continually sustained that could be a signal that the company is looking to cut the dividend or at least stop raising it to get it under control. A high payout ratio could also indicate that a company is having a hard time raising earnings. Either way, it tells me to look elsewhere. 

Dividend Growth %

I generally like to see a 10-year dividend growth of at least 6% (annualized) before I'll commit money to a position. I'm not extremely strict with this one and I will consider companies with slightly less growth, but not much. I prefer growth in the double digits when I can get it. For companies with less than 10 years of growth I shoot for a higher growth rate to compensate for the lack of record.


This is basically a list that I like to refer to, as I like to continually remind myself why I want to invest in a company. For my current portfolio, I like to review my holdings occasionally to make sure that these companies are staying true to the requirements I held when I first purchased.

What is your entry criteria?

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3 comments:

  1. I am new to Dividend Investing (less than a year). I use one of the online discount brokerage sites. While they have a screener, they don't have anything that would allow me to enter all your criteria (I understand good product is not a criteria that can be entered). I checked Google and Yahoo, and they have ones that are close but don't exactly allow me to enter all your criteria. My question is, is there an online screener that you use, or are you just able to determine this yourself when you look at individual stocks?

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    Replies
    1. If you visit the "DRiP Investing Resource Center" website (http://www.dripinvesting.org/Tools/Tools.asp) you'll find among the other useful tools David Fish's "CCC Spreadsheet". This is a great tool which provides quite a bit of information about the companies that pay dividends. Among other details, it provides the price, yield, payout ratio and average dividend growth rates for 1, 3, 5 and 10 years for each of the currently 471 stocks it tracks.

      Companies have to have a minimum of 5 years of increasing dividends to make the "Challengers" portion of the spreadsheet, 10 years to be considered a "Contender" and 25+ years of increasing dividends to make the "Champions" list. Companies that cut or fail to raise their dividends are noted.

      Mr. Fish updates this spreadsheet at the end of each month and is kind enough to make it available for free.

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  2. I don't really have minimums or maximums, just goals, and I don't reach all those goals with every buy. I most like a P/E ratio below 15, a debt/equity ratio below 50%, a dividend yield above 3%, and a price that is less than 80% of its highest price over the last year.

    Lots of years of dividend growth and a high dividend growth rate can make up for a lower dividend rate. A good price/book value ratio can make up for a high p/e ratio and high relative price for the year--I've heard I should look for less than 1.33 or, at most, less than 2. I've also read I should look for an ROE of more than 10 or more than 20--I'm not clear on what that really means, though.

    I don't look at product quality (it's too subjective, and that would make me eliminate virtually everything). Although it makes sense to look for an addictive product, which seems like what you mean by "wonderful." (In this article you talk about Coke, McDonald's and tobacco; I would not call any of these wonderful!) I do occasionally hear rumours from my friends about companies in industries they are familiar with doing something stupid--that doesn't necessarily mean their dividends will be affected any time soon, if ever, but I tend not to buy those companies. (Though would I sell? Not sure.)

    I do not look at anything involving growth estimates, either, because that's just people making stuff up. (Maybe all these numbers except for the dividend ratio and dividend growth rate have at least an element of fiction to them, though.)

    Also, as a fairly new dividend growth investor, I'm not clear on the various exceptions. I know banks are an exception for some numbers, and you've explained how tobacco companies are an exception for the payout ratio.

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