Most of my articles involve analysis of a company or two. I usually offer my readers an analysis of a specific company from a specific sector. Sometimes I offer a comparison between two similar companies, as I try to offer my insights about both, and which one of them is more attractive. I analyze the companies with a very consistent methodology.
In some articles I choose to share my methodology based on my experience as an investor. These articles offer wider insights, that depict the execution of my long-term strategy. I find writing and reading articles like these very helpful, as it helps to reflect on my past decisions, and analyze them thoroughly.
In this article I am going to share my filtering and screening strategy. Analyzing a company requires its own methodology. However, the stock market contains thousands of shares, and we can only analyze a limited number of companies. Therefore, filtering and screening is a crucial part of the process.
The S&P 500 is divided to 11 sectors. The index isn't equally divided between these 11 sectors, but every company in the index can fit one of the sectors. The sectors are: financials, consumer staples, consumer discretionary, healthcare, industrials, utilities, energy, technology, telecom, materials and real estate. A well-diversified portfolio should include companies from each sector.
First, I choose a sector that I lack exposure to. When one builds a portfolio, he should choose a sector allocation that he is comfortable with. There are sectors that tend to be more volatile than others, while other are more defensive. I wrote an article discussing the way to build your sector allocation. After a sector was chosen investors should create a shortlist of companies in the sector.
The first step of getting familiar with leading companies in the sector is to look at the largest components of the sector's ETF. There are ETFs for every sector, and you can see the stocks that are held by the ETF. For example, Health Care Select Sector SPDR ETF (XLV), is a leading ETF in the healthcare sector, and its main components are: Johnson & Johnson (JNJ), Pfizer (PFE), United Health (UNH) and Merck (MRK).
Another method of making a shortlist of companies is using the U.S Dividend Champions list that was created by Dave Fish, and maintained by Justin Law. You can filter the companies according to sectors, and find dividend paying companies in every sector. The list also gives you additional information like dividend growth rate, dividend yield and payout ratio.
At the end of the first phase, you have a chosen sector that you lack exposure to, and you have a list of companies that are possible candidates for your dividend growth portfolio. In the second phase it's time to screen the list of sectors and create a shortlist.
The screening within the sectors include basic parameters that include fundamentals and valuation. I don’t analyze thoroughly every stock, but I will analyze the leading candidates. At this point you have a list of market leaders that are the main components of the ETF, and a longer list of companies that belong to the sector and pay dividends. I try to give preference to market leaders when I screen. With this list I start the screening process.
I first screen for companies that pay dividend, this is relevant if you use the ETF components, as some market leaders don't pay dividends. The Dividend Aristocrats list obviously include only dividend paying companies. My only exception to this rule is if company doesn't pay a dividend, but it offers growing earnings and free cash flow.
Now I combine both lists. I mark the market leaders that have the highest weight in the ETF and pay dividends in the Dividend Aristocrat list. I usually paint their cell in yellow. Now I will remove from my list companies with short dividend streaks. Usually I use 10 years as a rule of thumb, but I sometimes make exceptions. For example, some great companies with great dividend growth don't have a long track record and shouldn't be ignore. Disney (DIS), Apple (AAPL) and Visa (V) are just some of the names.
Now I look for the payout ratio. I will usually remove companies with payout ratio higher than 70%. However, some sectors and sub-sectors tend to have higher or lower payout ratios. The main example is Altria (MO) that keeps its payout ratio at 80%, so if its current ratio is over 70% it's according to the management's plan.
Now I will look at the valuation. I am looking for companies with P/E ratio lower than 20. Again, some industries trade for higher valuation than others and it should be taken into account. If all the companies in the list trade for a higher P/E I will look for the more attractive valuations. Another tool I use a lot is Fastgraphs.com which allows me to see company's valuation compared to its historical valuation.
At this point I have a list of dividends paying companies with fair valuation, sustainable payout and long dividend growth history with the market leaders are marked in yellow. If the list is still too long, I will screen again in a stricter manner. For example, will look for longer dividend streaks and lower payout ratios. The goals are to remove enough companies until I have a reasonable amount of companies to look at. I will not remove market leaders from the list as I am always looking to add the leading names in the industry.
The case of Johnson & Johnson
An investor who lacks exposure to the healthcare sector will look for sector leaders in a healthcare ETF. He will then mark them at the Dividend Aristocrats list and start screening according to the criteria I wrote. The goal is to find candidates for a more thorough analysis, and eventually add a company or two to their portfolio.
Together with Johnson & Johnson he will find some other great companies. Examples to companies that will appear both in the ETF and the list: Abbott Laboratories (ABT), AbbVie (ABBV), and Medtronic (MDT). The dividend Aristocrats list will also offer lesser known names.
At this point the investor will start screening and removing irrelevant companies. Johnson & Johnson will suit all the criteria. The payout ratio is lower than 70%, it lower than 50%. The dividend growth streak is higher than 10 years, the P/E ratio is lower than 20 and its current valuation is lower than its historical valuation.
Other companies like Medtronic, and Becton Dickinson (BDX) will also suit the same screening criteria. Now, the investor has a shortlist of 4-6 companies. Some of them are sector leaders, and all of them are stable dividend payer with history of growth and fair valuation. At this point an investor should start analyzing each company to better understand its fundamentals, valuation, growth opportunities and risks.
The stock market is massive, and it contains countless options to create great value to investors. One of the problems that investors have to face is that even if you analyze a company well, you can still only analyze a small friction of the companies that are traded. Therefore, investors must look for a shorter list of companies to analyze. The criteria I wrote about help me in my investment strategy and allow me to find great investment opportunities.
After the screening, investors should start analyzing the companies in their shortlist. They don't even have to analyze them all. if they find a suitable candidate to add to the portfolio, and the company fits the strategy, investors can just initiate a position. You can always analyze one more company, but from my experience, when you find a good company that fits your goals, you should acquire it.