3 Challenging Scenarios for Quality-Value Investors

One night a few weeks ago, I sketched out my investment philosophy in a “one pager” format. 

I found the process to be useful, so I shared it on Twitter before heading to bed, thinking others might give it a try themselves.

Tried my hand at a one-pager of my investment philosophy. Nothing revolutionary, but an enjoyable exercise. pic.twitter.com/gEklvqr96a

— Todd Wenning (@ToddWenning) September 1, 2017

In the morning, I discovered the post was going viral - at least FinTwit's version of viral. 

The feedback on the post was overwhelmingly positive, which, while appreciated, also made me a little nervous. A cheery consensus around a company or a strategy doesn’t lend itself well to outperformance.

That said, there’s a difference between prescription and practice. Advocating regular exercise is sound and non-controversial, yet the temptation to be remain sedentary can be hard to overcome.

Indeed, part of the motivation for doing the one-pager was to hold myself accountable and stay focused during a bull market when there's pressure to relax standards.

The one-pager isn't meant to be a magic formula of any sort. No company will check off all the boxes. Instead, it serves as a personal framework for evaluating businesses and investment opportunities.

Peeling back a layer

Most of the questions I received about the one-pager regarded the three highlighted sections below.

To be a “strong buy,” I want the company to have an economic moat, be managed by excellent stewards of shareholder capital, and trade at an attractive valuation. 

These opportunities are rare, to be sure, but it's good to know when you might have a "fat pitch" heading your way. 

The highlighted sections address three challenging - and comparatively more common - scenarios that quality-value investors encounter.

In each case, two of the three requirements are present, but one is missing. Here, I’ll address the problem, pitfall, potential, and process for analyzing companies within the three scenarios.

“Quality at any price” (Moat and Management only)

• Problem: Great companies don’t always make great investments.
• Pitfall:  Even if the underlying business performs well, if the company doesn’t live up to high market expectations, you’re in for a bumpy ride. Consider an investor who bought shares of Wal-Mart in September 1999 when the stock traded with a price-earnings ratio over 30 times. Though Wal-Mart as a business grew earnings and dividends per share at an impressive rate over the next decade, the stock price didn't fully follow suit because the business performance wasn’t enough to match lofty initial expectations. Formidable competitors like Costco, Target, and Amazon were also chipping away at Wal-Mart's competitive position. Ultimately, Wal-Mart's price-earnings multiple contracted and the 10-year total return was about 2.4%.
• Potential: Investors can underestimate optionality in a well-run business. Those that considered Amazon, Facebook, or Google wildly overvalued early in their public market histories, for instance, didn’t foresee the new opportunities these businesses would create or discover in the subsequent years. Similarly, firms with existing moats may look expensive now, but if management can further widen the moat, today's price may look cheap in hindsight. 
• Process: Don’t rely solely on relative valuation and market multiples. Instead, make explicit forecasts to determine what the market price might imply. Then, consider whether or not you think management is capable of beating those expectations by introducing new products, entering new markets, becoming more efficient operators, or adding new lines of business.

“Beware quality traps” (Moat and Price only)

• Problem: The market knows something you don’t.
• Pitfall:  Though the stock's premium may have diminished, there could be good reason. The company’s legacy moat could be under assault by new and motivated competition or a disruptive technology. If management is incentivized to protect the old cash-flow-rich operations or if the corporate culture is bureaucratic and stagnant, there could be further to fall. Kodak is a classic example – a former blue-chip darling that had a dominant market position, saw the coming of digital photography in plenty of time, but its culture refused to embrace the change.
• Potential: A management transition could lead to cultural change, which could reinvigorate the business and make it more competitive. To illustrate, a positive cultural change happened at Sealed Air after the board brought in a new executive team following the controversial $4.3 billion acquisition of Diversey in 2011. In the twelve months following the deal's announcement, Sealed Air's stock price dropped about 60%. Despite the poor M&A decision by prior management, Sealed Air (makers of Bubble Wrap) and Diversey still had some durable competitive advantages. The new management team overhauled the corporate culture and got the company back on solid footing.
• Process: Ask yourself if the company has a culture of innovation and change. Could a new management team realistically step in or is the board too close to the CEO and CFO? Review management’s incentives and the board structure and determine whether or not they have enough skin in the game to want to improve operations.

“Avoid turnaround traps” (Management and Price only)

• Problem: Even excellent capital allocators can struggle to fix a broken business.
• Pitfall: Turnarounds have low odds of success. Ultimately, management facing such a situation needs to identify a potential moat source and attack it full force. Then, hope for a lucky break or two. When there are massive secular headwinds in place, this becomes a near-impossible task, even for great management teams. Eddie Lampert at Sears Holdings is a good example. Lampert has done a remarkable job playing a tough hand, but the long-rumored turnaround has struggled as department stores face immense competitive pressures from changing consumer tastes and from online retail.
• Potential: When turnarounds happen, the rewards can be enormous. Steve Jobs' second stint at Apple is one of the best – if not the best – turnaround story of our generation. Though the full story is more complex than this, what Jobs did was make Apple (traditionally a beloved niche personal computer maker) into a premium global consumer brand, starting with the iPod and later the iPhone and iPad. Jobs' efforts, along with the rest of Apple's staff, spawned a brand (intangible asset) advantage that, when paired with the switching costs created by the iTunes platform, led to a solid economic moat.
• Process: Is management facing secular headwinds in their core operations? Are industry dynamics stable and asset growth slow or is capital flooding the industry? Does management attempting a turnaround have to reckon with a debt-laden balance sheet or an under-funded pension plan? 

Bottom line

Rarely will the stars align so that management, moat, and price are all clear and a strong buy is evident. Much more frequently, quality-value investors must wrestle with one of these three scenarios where one factor is missing - or at least isn't obvious. 

As such, it's helpful to approach the scenarios with both the pitfalls and potential in mind. Weigh the pros and cons, make a decision, and then be patient!

Stay patient, stay focused.

Best,

Todd

The opinions expressed here are the author's and not those of his employer. Todd's family owns shares of Amazon and Costco. For a full disclaimer, please click here. 

A Fresh Look at the Simple Formula

Earlier this week, a reader* of the blog had a look at the formula I laid out in "A Simple Formula for Investing Success" and cleverly suggested that the formula should be rearranged from:

Investment + Good Company + Right Price + Patience

to...

Good Company + Right Price + Investment + Patience

How did I miss that? 

Clearly, "GRIP" is much more memorable than "IGRP", and more importantly, it's the correct order of operations when investing. I don't know many successful investors who invest first and learn about the company later. 

So while we're on this topic, let's review the formula in the proper order.

Good company: Continuously learning about the business over the life of the investment is an essential component to investing success. Initially, your focus should be on determining whether or not the company possesses durable competitive advantages (i.e. an economic moat), what it's growth runway looks like, the skill with which management allocates shareholder capital, the company's culture, the strength of its financials, and so on.  

Even after you've invested in the company, it's important to stay on top of these items and review the business's progress at least twice a year. After a few years of following a business, you'll be surprised how much of an expert you'll become on its operations relative to the average investor, which itself, in turn, becomes an advantage.

Right price: Even a good company can make for a bad investment if you overpay for it, so it's important to consider valuation before making any investment. That said, investing is about dealing with uncertainty and no valuation model will be perfect. In my experience, the simpler the model, the better. Each investor has his or her own approach to valuation, but the key is to get a feel for the range of potential valuation outcomes and look to invest when you think the market price provides a suitable margin of safety. 

Investment: This may seem to be an obvious point, but I have a feeling that most of us have done a lot of research in a company, liked what we saw, but failed to actually make the investment for one reason or another. 

I know I've done that before, the most painful example being Tractor Supply (TSCO) in March 2009 -- a company I failed to invest in even after doing extensive due diligence and liking what I saw. As the market began to rapidly recover from the depths of the financial crisis, I got cold feet and waited for a pullback that never came. The stock's since gone up over 1,000% and has been the costliest mistake of my investing career. The lesson here is that investing success is impossible unless money is actually put to work.

Patience: If you've followed through with the first three steps -- you have a good company, think it's trading at the right price, and make an investment -- the only thing left to do is be patient. Patience, of course, also happens to be the hardest part of the formula, but it's critical to give the business a chance to compound your capital over time. 

Bottom line

Following this simple formula is far from easy; however, if you can consistently apply it over a long investing career, I truly believe it will produce very satisfactory results indeed. 


*Many thanks to Dev at the Stable Investor blog in India for pointing this out!  

Quote of the week:

What I've been reading/watching this week:

• What Seth Klarman has learned from Warren Buffett - FT
• What to do when your stock plummets - Ed Croft
• What's better -- ETFs or index funds? - Monevator
• Five stock ideas for the future - Richard Beddard
• Ben Graham's greatest gift - Matt Brice 
• 41 things I've learned in the past ten years - Brian Richards
• Investing in foreign dividend payers - Josh Peters
• The future of iron ore - Joe Magyer

Stay patient, stay focused.

Best,

Todd

When to Stop Researching a Stock

1. Don't look for perfect companies -you'll never find them. Just look for imperfectly priced ones.
— Amni Rusli (@AmniRusli) June 6, 2014

The above tweet from Amni Rusli (you can follow her on Twitter and I recommend doing so) struck a chord with me. In my eleven years of researching stocks, I have yet to come across a "perfect" one.

There's always something you won't like about the company you're researching. More to the point, if you can't find anything wrong with the company, you're not looking hard enough.

Some of the most common negative factors that I come across in my research are:

• Concerns about the company's durable competitive advantage (if it has one)
• Misaligned management incentives
• A bad recent capital allocation decision (e.g. paying too much for an acquisition)

Sometimes these factors are enough for me to walk away from the research idea, yet if I like most everything else about the company, I'll keep researching. 

WD-40 Company (WDFC) is a good example of this -- I love the business, think management is doing a fine job, but really don't like that it uses EBITDA as a performance and bonus measure. Still, I wouldn't not buy WD-40 at the right price simply because it uses EBITDA. 

If the company you're researching meets at least 80% of the criteria you look for in a stock and is trading at a good to fair price, that's an attractive opportunity. Don't let perfect be the enemy of good, as the saying goes, and miss the opportunity because you're looking for that last 20%.

But watch out for these red flags

It's one thing if the negatives are fairly benign, but there are a few negatives that I consider massive red flags and will immediately stop researching the stock if I find one of them. 

1. Untrustworthy management: If there's anything in management's background that is particularly off-putting to you, just walk away. A common exercise is to ask yourself if you'd trust them to watch your kids/dog/cat while you were away on vaction. 
2. Blackbox revenue stream: To borrow a phrase from Peter Lynch, if you can't illustrate with a crayon how the business makes its money, you shouldn't own the stock. 
3. Aggressive accounting: This can be tricky to detect. Here's a tip I picked up from my friends John DelVecchio and Tom Jacobs who wrote What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio -- focus on revenue recognition as it is crucial to confidence in everything below it on the income statement and, by extension, the cash flow statement. One simple test you can run is looking at Days Sales Outstanding (DSO), explained here. 
4. Government entity as a major shareholder: Government owners have different motivations than regular shareholders.
5. Unethical actions: Similar to the first point, but different in the sense that the unethical action could have been made by someone outside the executive suite. This speaks to a lack of risk management within the company and reflects poorly on management.

When do you stop researching a company? I'm curious to know. You can let me know in the comments section below or on Twitter.

Stay patient, stay focused.

Best,

Todd

@toddwenning on Twitter

5 Ways to Avoid Permanent Losses

Earlier this week on Twitter, Carl Richards (+Behavior Gap) -- who you really should be following if you're not already -- started an interesting conversation about investing and risk:

As Homer Simpson would say: "It's funny 'cause it's true." And for two reasons. First, and most obviously, because statistics can be confusing and second because the industry's statistical definition of risk is too academic and doesn't get at the root of what keeps investors up at night.

Finance textbooks and trading models might define risk in statistical terms based on volatility, but such definitions are incomplete for patient, business-focused investors.

If we've done our homework, purchased a stock at a good price, and remain confident in our thesis, how the quoted stock price moves on a day-to-day or month-to-month basis shouldn't be of any concern. You'd be hard pressed to find an investor who cared about the following type of volatility:

Different definition

Instead, what long term investors are really concerned about is permanent loss of capital. As the name implies, a permanent loss of capital differs from a temporary loss of capital that's due to market volatility and it occurs when an investment's value has declined so much that getting back to break-even within a few years is unlikely. Effectively, an unrecoverable loss.

As the following table shows, when a stock loses 40% or more of its value, it takes a substantial recovery to get back to even:

To put this in some perspective, consider a 50% paper loss on an investment. While it's certainly possible for the stock to stage a huge recovery and double in value over the next year, if we assume historical equity returns of 9% per year, it would take about eight years for the stock to get back to even on a nominal basis.

Though you might patiently wait for this to happen, that investment from eight years prior was in essence wasted capital that could have been invested more effectively elsewhere.

How to avoid such a fate

Invest long enough and you'll have a permanent loss of capital at some point. It's bound to happen as we're all human, but it's critical to make large losses infrequent events as they can seriously weigh on your portfolio's long-term returns.

Here are five things you can apply to your investment process to reduce the likelihood of permanent losses of capital:

1. Buy with an appropriate margin of safety. This may seem obvious -- buy a stock for less than it's worth and you'll reduce the odds of permanent losses -- but (a) we as investors are prone to buying into stories, individual attributes (high yields, low PE, etc.), or a hot tip and fully disregarding valuation and (b) when we do adequate valuation work we often make inappropriate margin of safety assessments before buying. 

What I mean by the latter point is that we should demand a larger margin of safety when buying a business with a higher degree of uncertainty and vice versa. It's one thing to buy a large cap defensive company like Coca-Cola with a 10% discount to fair value, but a 10% margin of safety isn't likely enough for a small-cap stock in a cyclical industry. You're more likely to lose your shirt feeling too confident in your assessment of the small-cap's value than you are of Coca-Cola, so a larger margin of safety is required.

2. Use a checklist. Online investing and low-commissions, as great as they are, also cater to impulsive decision-making. It's easy to read a few company filings, get excited about what you're reading, and press the buy button. As a check on your emotions, make use of an investing checklist (like this one) before placing a trade. If the latest idea doesn't check off all the boxes on your list, figure out why that's the case. There could be a good explanation, but if there's not, consider passing on the idea for now. 

The important point here is that checklists can save us from making stupid decisions based on emotion. For more checklist ideas, +Stockopedia has a great set of checklists based on different styles of investing.

3. Ask the right questions. Before buying a stock, fully consider alternative theses and perhaps more importantly what other bulls are thinking, as this can save you from missing giant red flags and blindly following the herd. In other words, we need to ask different questions than our fellow market participants if we aim to make good investments and avoid permanent losses of capital. 

Howard Marks of Oaktree Capital calls this "second-level thinking". In his book The Most Important Thing, he provides the following example:

First-level thinking says, "It's a good company; let's buy the stock." Second-level thinking says, "It's a good company, but everyone thinks it's a great company, and it's not. So the stock's overrated and overpriced; let's sell."

Each investment will have specific questions to ask, but if you're looking for a good place to start, here's my list of five questions to ask before buying a stock.

4. Focus on trends in competitive advantages. The market has become incredibly focused on the short-term. For example, the average stock mutual fund turnover rate have jumped from an average of 17% between 1945 and 1965 (implying an average holding period of about five years) closer to 100% today (implying an average holding period of about one year). Naturally, then, market participants seek short-term information advantages -- e.g. "Will this company beat next quarter's consensus estimates?" -- at the expense of gathering helpful long-term information.

In his book More Than You Know: Finding Financial Wisdom in Unconventional Places, Michael Mauboussin notes:

My fear is that much of what passes as incremental information adds little or no value, because investors don't properly weight information, rely on unsound samples, and fail to recognize what the market already knows. In contrast, I find that thoughtful discussions about a firm's or an industry's medium- to long-term competitive outlook are extremely rare.

Spend more time in your research process thinking about where this company might be three- to five-years from now. A simple way to get started is with a "SWOT" analysis -- listing the company's strengths, weaknesses, opportunities, and threats. Then ask how the company might enhance its current strengths, reduce its weaknesses, capitalize on opportunities, and respond to competitive threats.

5. Avoid cult stocks & sectors that are in the market spotlight. Jason Zweig had a great post for the WSJ this week on his mission to save investors from themselves by helping them avoid speculative periods in the market. Also the commentator on the revised edition of Benjamin Graham's Intelligent Investor, Zweig has the rare ability to spot market irrationality and stand behind his convictions even when they're not popular at the time.

The perennial refrain from critics is: You just don’t get it. Internet stocks / housing / energy prices / financial stocks / gold / silver / bonds / high-yield stocks / you-name-it can’t go down. This time is different, and here’s why.

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor. (My emphasis)

Bingo. Can't say it any better than that. Consistently follow this advice and it will help you avoid permanent losses of capital.

Bottom line

The best definition of risk for long-term investors isn't volatility, but permanent loss of capital. Every investor will have permanent losses over his or her investing career, but the key is to minimize their frequency. Hopefully these five suggestions will help you avoid some of them. 

Good reads/videos this week:

• Howard Marks on the proper definition of risk (a must-read)
• The aforementioned Carl Richards on avoiding behavioral investing traps (video)
• Michael Mauboussin on the roles of skill and luck in investing (video)

Have a great weekend!

Best,

Todd

@toddwenning

Applying Investing Lessons from Three Great Books

After re-reading The Great Gatsby and finishing Franklin and Winston earlier this fall, I jumped into another round of investing books. The three investing books I happened to read in recent weeks have also been some of my favorites.

Today I'd like to highlight one great lesson from each of these books and show how we can immediately apply them to our research processes.

What's Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge in Your Portfolio (Amazon) by John Del Vecchio and +Tom Jacobs 

John and Tom are former colleagues of mine from +The Motley Fool, and being familiar with the quality of their work, I went in with very high expectations and still came away extremely impressed. Their book provides a thorough overview of some important yet often overlooked topics including earnings quality analysis, short-selling, deep value investing, long/short portfolio construction, and technical analysis.

The book provides dozens of great formulas and tips, but John and Tom emphasize the importance of one particular metric:

"Here are some of the factors that we analyze to determine the quality of the company's revenue. At the top is a metric you should have burned into your memory: days sales outstanding."

DSO = 91.25 x (Accounts Receivable / Quarterly Revenue)

This formula measures the number of days it takes the company to collect revenue after it makes a sale. If that figure is trending higher, for instance, it could be a sign that the company is offering more liberal payment terms to its customers in hopes of booking more sales now. A higher DSO alone doesn't necessarily mean something serious is afoot, but it can be a tip-off to look more closely at earnings quality.

To use a real-world example, let's take a look at the quarterly revenue and receivables of Sun Hydraulics* (SNHY)

Source: Company Filings, in thousands of $ except DSO

As we can see, SNHY's DSO has been pretty steady between 32 and 39 days over the past ten quarters, and there hasn't been any substantial increase in any year-over-year figure. If DSO had been trending upward -- to say, 45 or 50 days -- it could be a sign that management had been "stuffing the channel" to make short-term results look better and could come at the expense of longer-term results.

The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Amazon) by Michael Mauboussin

While this book is not completely about investing, Mauboussin is the Chief Investment Strategist at Legg Mason and an adjunct professor of finance at Columbia, so there is naturally quite a bit of investing discussed along with some great discussion about the roles that skill and luck play in our favorite sports and games.

Perhaps unsurprisingly to us as investors, Mauboussin argues that luck plays a more significant role than skill in investing -- particularly in the short-run. As such, Mauboussin emphasizes the importance of a good process over short term results:

"Luck may or may not smile on us, but if we stick to a good process for making decisions, then we can learn to accept the outcomes of our decisions with equanimity."

One way we might improve our investing process is to create checklists and review them before making buy and sell decisions, particularly in stressful situations like the one illustrated in this example from the book:

"A friend at a prominent hedge fund told me that his firm has developed a checklist for responding when a company suddenly announces bad news. While the stocks of those companies always go down at first, sometimes the drop is nothing more than an opportunity to buy more shares. At other times, it's best to sell the position. The checklist helps the employees keep their heads cool as they decide which is the better decision."

Reading this particular paragraph inspired me to write the post What to Do When a Sell-Off Strikes Your Stock. To review, my "bad news" checklist is:

1. It's important to stay as calm as possible. Breathe and scan. 
2. Rather than read or watch news reports, which are typically sensationalized, go straight to the source. Read the company's press release and any associated presentation materials.
3. After you've gathered the facts, develop your own take on the event.
4. Revisit your original investment thesis, paying close attention to how the new information might impact the company's longer-term competitive position.
5. Ask yourself, "Does this development fundamentally alter my thesis?" If so, consider selling and don't anchor into the price you originally paid for the stock.
6. Consider buying more if your thesis remains intact, bearing in mind your current exposure to the investment and how the new share price compares with your fair value estimate. 
7. Remember that doing nothing is doing something. As such, know why you're deciding not to take an action. 

Consider putting your own buy or sell checklist together. I think you'll find it to be a helpful exercise. 

Deals from Hell: M&A Lessons that Rise Above the Ashes (Amazon) by Robert F Bruner

Many individual investors have mixed feelings about M&A, particularly if its your company doing the acquiring. Misguided M&A decisions can destroy value, muddle financial statements, and can alter your original investment thesis. In short, they can be a real pain in the neck.

Bruner, who is the Dean of the Darden School of Business at the University of Virginia, makes the point early on, however, that:

"M&A failures amount to a small percentage of the total volume of M&A activity. Investments through acquisition appear to pay about as well as other forms of corporate investment. The mass of research suggests that on average, buyers earn a reasonable return relative to their risks."

Fair enough, but investors should still approach significant M&A deals with skepticism until proven otherwise. And, to Bruner's credit, this book does equip you with a good framework for evaluating M&A deals, featuring case studies of some of the worst deals in modern financial history -- i.e. Enron/Dynegy, Quaker Oats/Snapple, AOL/Time Warner, etc.

Bruner's list of common red flags includes:

1. The business and/or the deal was complicated -- An acquired company that is difficult to understand or has a complex business model will likely be a difficult one to integrate.
2. Flexibility was at a minimum -- A company that overpays for a deal and/or over-leverages its balance sheet to make the deal happen has little room for error. 
3. The deal elevated risk exposure of the new firm -- The additional risk could come from a number of sources (legal issues, lower credit ratings, too much leverage, declining end-markets, etc.). 
4. Decision-making process was biased -- An example here would be an overconfident management team that was willing to pay anything to make the deal happen. 
5. Business was not as usual -- The deal creates a significant departure from the company's routine and/or expertise. 
6. Cultural differences -- If two companies with very different cultures (i.e. regional customs, level of bureaucracy, etc.) merge, it could lead to the departure of key individuals at the acquired company.

As Bruner notes in the book, the "deals from hell" tend to occur when all six red flags are present.

To help us identify a poor M&A decision, Bruner provides this helpful summary of good and bad M&A traits:

Return to buyers likely higher if…	Return to buyers likely lower if…
Strategic motivation	Opportunistic motivation
Value acquiring	Momentum growth/glamour acquiring
Focused/related acquiring	Lack of focus/unrelated diversification
Credible synergies	Incredible synergies
To use excess cash profitably	Just to use excess cash
Negotiated purchases of private firms	Auctions of public firms
Cross borders for special advantage	Cross boarders naively
Go hostile	Negotiate with resistant target
Buy during cold M&A markets	Buy during hot M&A markets
Pay with cash	Pay with stock
High tax benefits to buyer	Low tax benefits to buyer
Finance with debt judiciously	Over-lever
Stage the payments (earnouts)	Pay fully up-front
Merger of equals	Not a merger of equals
Managers have significant stake	Managers have low or no stake
Shareholder-oriented management	Entrenched management
Active investors	Passive investors

If your company has just announced a major acquisition, turn to this table and see how many boxes fit the left column versus the right column. The more check marks on the right hand column, the more you should be skeptical of the deal.

Merry Christmas and Happy New Year!

As always, thanks for reading.

Todd
@toddwenning on Twitter


*I own shares of SNHY

What to Do When a Sell-Off Strikes Your Stock

We've all been there. You check your stocks in the morning, take a sip of coffee, only to find -- spppittt! -- one of your stocks is down big, real big.

At this point many questions begin to race through your mind -- What happened? Did I miss something? Should I sell? Should I buy? It feels like the clock is ticking and that you need to make a decision now.

These are the times that try patient investors' souls*, and they're important ones to manage properly. Knee-jerk reactions are rarely rewarded in the stock market.

So let's explore ways that we might become better at handling these situations. Here are seven steps that I've come up with over the years:

1. It's important to stay as calm as possible. Breathe and scan. 
2. Rather than read or watch news reports, which are typically sensationalized, go straight to the source. Read the company's press release and any associated presentation materials.
3. After you've gathered the facts, develop your own take on the event.
4. Revisit your original investment thesis, paying close attention to how the new information might impact the company's longer-term competitive position.
5. Ask yourself, "Does this development fundamentally alter my thesis?" If so, consider selling and don't anchor into the price you originally paid for the stock.
6. Consider buying more if your thesis remains intact, bearing in mind your current exposure to the investment and how the new share price compares with your fair value estimate. 
7. Remember that doing nothing is doing something. As such, know why you're deciding not to take an action. 

What do you think? Have one to add to the list? Please post your thoughts in the comments section below.

Best,

Todd 

@toddwenning on Twitter

*Hat-tip to Mr. Paine

10 Point Checklist for Dividend Ideas

The number of free stock screening tools has increased significantly in recent years. And while some screens are certainly better than others, investors often remain overwhelmed by the number of stocks these screens spit out, requiring yet further sorting for the best ideas.

I've put together a ten point checklist that I use when considering new dividend ideas for my portfolio. There are always exceptions to these rules, but I've found that discarding ideas that don't match these criteria have more often than not saved me from making some big mistakes.

1.) Dividend yield above 2%
 
To make a stock worthwhile for a dividend-focused portfolio, it needs to yield at least 2% otherwise it will likely take too long for the income generated by that stock to have an impact. Moreover, the lower the yield the more you're banking on high dividend growth rates to be maintained over the longer-term and that's not always a sure thing. A lot can happen to a company's fortunes in ten years that would reduce its ability to sustain an annual double-digit growth rate.

2.) Dividend yield below 8%

Because the market has historically returned about 8-9% over the longer-term, any stock that's paying out approximately that rate each year in dividends is probably too good to be true. The market isn't likely to give away those types of opportunities without some major strings attached. If it were that easy, everyone would simply buy that stock to enjoy low-risk 8% annual returns, which would serve to drive the stock price up and the yield down anyway.

3.) Dividend track record of at least five years

In 2011, 22 S&P 500 companies initiated a dividend program. A handful of others have started programs in 2012, most notably Apple. While it's encouraging to see more companies paying dividends, individual investors should be skeptical of these stocks when considering them for inclusion in a dividend-focused portfolio. Most of them don't pay a high enough yield to begin with, but unless the company has established a firm dividend policy (30-35% of earnings, for example) it's unclear how the dividend will be managed over a full business cycle. Will the company hold the payout flat during temporary downturns or will they manage it based on anticipated longer-term growth? All else equal, I'd prefer to see how a company handled its payout across a number of scenarios and macro-environments before buying.

4.) 5 year dividend growth above 3% annualized

Even companies with enviable track records of raising dividend payouts can run into trouble and the dividend put in jeopardy, as we saw quite clearly during the financial crisis. Watch out for companies whose dividend growth rates have slowed considerably in recent years -- a company that used to increase payouts at 10% per annum and now increases at 3% may be indicating trouble ahead. Indeed, 1-3% annual increases may be token increases aimed at maintaining a consecutive increase streak and may not be economically justified. Similarly, a company that used to steadily increase its payout but has held it flat year-over-year is usually an indication that the dividend is under pressure.

5.) Return on equity above 10%

Companies that consistently post returns on equity below 10% are probably poor places for your money. Given that the cost of equity for most firms is above 10%, firms that consistently generate ROE below 10% are more likely to destroy shareholder value.

6.) EBIT interest coverage over 3x

Equity owners are below creditors on the totem pole, so it's important to make sure that creditors are being taken care of before we can even think about dividends. In fact, creditors often attach covenants to their loans to ensure that the company will pay them back in full. If the company breaks those covenants (the details of which can be found in annual filings, if they exist), the creditors may have the right to restrict dividend payments to equity owners. Companies that cover each dollar of interest expense with more than $3 of operating profit (EBIT) are typically well ahead of their minimum covenant requirements. The higher the interest coverage the better. Interest coverage ratio standards can vary by sector -- utilities, for instance, can afford to have lower coverage ratios -- so it's wise to compare the company's interest coverage versus major peers.

Another balance sheet metric to pay attention to, as it's often one used in covenants, is net debt-to-EBITDA (earnings before interest taxes and depreciation and amortization). Net debt is equal to total debt minus cash. Aim to buy companies with net debt-to-EBITDA ratios below 2x.

7.) Pension deficit less than 2x net income

While many companies have closed their defined benefit plans to new employees, there's a good chance that mature dividend paying companies are still on the hook for paying benefits to former and older current employees into retirement. If the company's pension is significantly underfunded, the company will likely need to shovel cash into the plan each year to keep it solvent and this is cash that may have otherwise been returned as dividends. Pension deficit figures can be found in annual filings. If the most recently reported pension deficit is more than twice the previous year's net income, the pension could remain a millstone around the company's neck for many years and weigh down its ability to pay dividends.

8.) Consistent free cash flow cover of at least 1.5x

We'll define FCF as cash generated from operations minus capital expenditures here -- both figures can be found in company filings on the cash flow statement. FCF is the cash left over after the company has made the investments necessary to maintain and grow the business, and it's with FCF that the company can pay dividends, buyback stock, reduce debt, etc. A firm that generates $80 million in free cash flow and pays out $100 million in dividends needs to make up that gap by borrowing or selling assets and both are unsustainable practices. To avoid such situations, aim to find firms that consistently generate at least $1.50 in free cash for each $1 they pay in dividends. This 1.5x level also provides a margin of safety in case the firm falls on a weak year or two.

9.) Diluted share count growth less than 2% annualized

Firms issue new shares for three reasons -- to buy other companies, raise capital, or reward employees -- and none of them are particularly appetizing to common stockholders. Most large acquisitions destroy shareholder value, raising equity capital is typically the most expensive form of financing, and in the last case your stake in the company is being diluted as employees and executives cash in on options. Of the three reasons, I'm most likely to be fine with employees cashing in on the company's success (as long as the company is, in fact, successful), but I still don't want to see my stake diluted at more than a 2% annualized rate. If that's the case, the company is likely being too aggressive with option grants, running into financial trouble, or making too many (or too large) acquisitions.

10.) Avoid companies with a history of "funny stuff."

Of the ten points, this is the most subjective and requires a little sleuthing. Does the company frequently take impairment or restructuring charges? That might be a sign that the company does not make good capital allocation decisions or could be covering up bad moves. At the very least, it makes the company very difficult to value and it's probably worth looking elsewhere.

Beyond the ten points

Once a stock idea has made it through the ten-point checklist, it's time to do put it on your watchlist and do some more research on competitive positioning and valuation. Also, read the latest proxies to get a feel for management's compensation and incentive metrics. These are all topics for future posts, but I hope that the ten point checklist helps you separate the wheat from the chaff on your screening results.

Best,

Todd
@toddwenning on Twitter

5 Rules for Building a Dividend-Focused Portfolio

So you want to build a dividend-focused portfolio...

To borrow a phrase from Dickens, it may be the best of times and the worst of times to do so. You can still build a dividend portfolio with a respectable average yield today, but strong market performance in the first quarter considerably shrunk the pool of opportunities. Since yields and share price have an inverse relationship, suffice it to say there are slimmer pickin's now. With that said, here are five rules for building a dividend-focused portfolio in today's market, or any market for that matter.

1. Build patiently

When you've resolved to build a dividend-focused portfolio, it's natural to want to get fully invested right away and get your money working -- especially when cash and money markets pay you effectively nothing. Resist that temptation.

Remember, patience is the individual investor's greatest advantage over the market.

Unlike a mutual fund manager who may feel compelled to be fully invested at all times to keep up with peers or the market, or may be restricted by the fund's objectives, you have no such pressures or obligations to get fully invested straight away. Only pull the trigger on a new investment when the opportunity is right (see rule #2). If it takes six months or a year to get fully invested, that's better than going all-in on potentially over-valued stocks. A scatter-shot approach to portfolio construction may be effective when the market has been depressed (late 2008/early 2009), but when the markets have been on a run as they have, it's more important to be selective and deliberate.

2. Don't buy for yield alone

A stock's yield can be used as a value indicator, but yield alone tells us very little about a stock's value (think about banks' high yields pre-financial crisis and pre-dividend cuts). As such, investors should consider yield alongside other value indicators when making investment decisions.

Each investor has his or her own way of valuing a stock (DCF, DDM, comparing multiples, etc.), but whatever your preference it's important to estimate a fair value before buying a dividend-paying stock (and any stock for that matter). Repeatedly paying $1.20 for $1, of course, is a quick way to sub-par investment performance. Even if the overvalued stock is paying 3%, with a little patience you'll likely get a chance to buy it below its intrinsic value with a higher yield, to boot. Bottom line: always demand a margin-of-safety before investing -- even in a dividend-paying stock.

3. Stay diversified 

High yield stocks tend to cluster in a few sectors. Utilities and telecoms, for instance, tend to feature higher yields than technology and energy stocks, so they tend to carry more weight in yield-based portfolios than in the market portfolio. It's easy to fall into the trap of loading up on high-yielding stocks in just a few sectors in order to maximize yield.

That model can fall apart quickly, however, if one of those sectors falls on hard times (again, financials in 2008/09). Even if you need to sacrifice a little yield today by investing in some lower-yielding stocks from other sectors, don't be afraid to do so as long as those stocks meet your investment criteria and fit your portfolio objective (see rule #4).

4. Set a portfolio objective

Dividend investors tend to have one of two objectives -- maximize current income or generate a longer-term growing income stream. The former group prefers high-yield today at the expense of income growth potential; the latter willing to sacrifice a little jam today for more jam tomorrow. Both approaches have their merits -- a mix of both is fine, too -- but it's critical to define your objective to help you structure your portfolio to meet your needs. Most importantly, write down your objective, keep it next to your work station, and review it every time you make an investment decision.

Because you're in charge of your portfolio, you can tailor your portfolio weightings to meet your unique situation. Want more current yield? Increase your portfolio weight toward the higher-yielding shares. Want more income growth? Put more cash toward companies growing their payouts at double-digit annual rates.

By setting a portfolio objective (i.e. "Generate a current yield >25% above the market average and grow income three points above CPI inflation"), you'll be more likely to stay the course, make prudent investment choices, and improve your chances of satisfactory returns.

5. Keep track of your income

Most broker websites don't do a great job of tracking portfolio income growth -- normally income growth is lumped in with total returns. If you're building a dividend-focused portfolio, then, it's easy to lose track of your income performance if you rely on brokers to keep records for you. And the whole point of building a dividend-focused portfolio is watching the income flow in. You may need to build your own Excel spreadsheet or manually keep tabs on a notepad, but the important thing is to keep records so you can remain focused on your income. Keep track of quarterly and annual income received and review performance periodically.

Hope this was helpful. More to come.

Happy Easter!