Key Ideas

1. An explanation of what dividend stocks can help you accomplish.
2. 5 steps to better dividend stock investing.
3. How to use the quadrant strategy.

Editor Note: This is a guest post from Mike who manages dividend growth stocks portfolios. (affiliate link) He reveals his entire dividend stock investment model for free in this extremely valuable, educational article. It is a complete system for dividend growth stock selection. Take it away Mike

I started investing back in 2003 when the bull market made everything easy.

Between 2003 and 2006, I made enough money to buy my first house with a 25% down payment. Those were the good years.

While I spent numerous hours in front of my computer analyzing trends and company fundamentals to become a successful investor, many other investors just picked stocks based on the news and made almost the same returns. The economy was booming, and we were able to find stocks doubling within the year.

Then 2008 Happened

I was somewhat lucky when the 2008 bear market occurred because most of my investments were cashed out in 2007 to buy my second house. Even though I was still hit by a -27% drop in my portfolio, the total dollar loss wasn’t too bad because my account was much smaller.

Anyway, I was too busy working my way up the corporate ladder and completing my MBA to worry about it. I didn’t have much time to invest my money.

From 2003 to 2008, I had a very aggressive investing model making a few trades per month on average. I was fast on pulling the buy and sell trigger in order to generate more profit.

But after 2008, the game changed and I didn’t have enough time to continue with my original investing plan. Plus, losing 27% of my portfolio in one quarter had left a sour taste in my mouth. This is what drove me, in 2010, to develop the dividend investing strategy I share with you here.

How I Developed My Own Dividend Growth Model

Over the past 4 years, I’ve continuously tweaked my dividend investing strategy to achieve two goals:

1. Build a powerful portfolio – able to generate both capital and dividend growth
2. Keep it simple but efficient – I wanted to build a simple investing system that works consistently

I’ll tell you upfront, I don’t hold the key to becoming a millionaire through dividend investing. I still make mistakes, but they are rarer and smaller than most investors. This is how I was able to beat the market in 2012 & 2013 with my dividend stock picks.

In 2012, I wrote a very popular book about dividend growth investing, Dividend Growth: Freedom Through Passive Income , and received hundreds of emails. People wanted to take charge of their investment portfolio because they were upset about their advisors inability to answer their questions and/or the high fees they were paying. And while I received many different questions, two main points kept coming up:

1. The lack of time to build and manage a solid dividend stocks portfolio
2. A systematic method for buying and selling dividend stocks.

This is when I realized that I had battled with  the same issues and found a way to solve these two essential investing problems. Over the past four years, I’ve worked on an investing strategy that doesn’t take me forever to apply and tells me when to buy and when to sell stocks.

Below I will share that same dividend growth model with you. Its the same model I’ve used that has performed so well over the past few years.

A Dividend Growth Model That Works

As I’ve previously mentioned, my investing strategy is built on a simple but efficient model. It is relatively straightforward and easy to implement, but it requires discipline. That is the success of my strategy.

Let me break it down step-by-step for you:

Step 1 Start with Stock Filter Research

I start the investment selection process with a stock filter. I use a paid subscription to Ycharts (no affiliate link here) as it provides an enormous quantity of information. But you can achieve almost the same results with a free stock filter called FinViz .

FIN VIZ stock filter doesn’t provide the 5 year dividend growth metric. This is one of the reasons I use Ychart (and the fact that I can create multiple charts to compare several metrics at the same time!) But if you prefer the free way, you can still select other metrics to pick stocks that will show great dividend growth. Below are the metrics I use:

• Dividend yield: over 3%
• P/E Ratio: under 20
• Forward P/E Ratio: under 20

Company Fundamentals:

• EPS Growth next 5 years: positive
• Return on Equity: over 10%
• Sales Growth past 5 years: positive
• EPS Growth past 5 years: positive
• Payout ratio: under 70%

This is enough to give you a good list to work with. It’s not perfect, but you will discard several bad stocks in a blink of an eye with these filters. (Editor Note: This approach is called stock factor modelling. It will be discussed in greater depth in future posts and podcasts. )

Step 2 Sort For Sales and Earnings Per Share

Everyone first wants to look at dividend payouts, but I think it’s more important to look at revenues and earnings. If sales are not up, chances are profits won’t keep an uptrend. Its really common sense: if you can’t generate sufficient cash then how can you pay dividends?

The relationship between sales evolution and earning per shares will tell you 3 things:

1. How is the company ’ s main market doing  (are sales growing?)
2. How are the company ’ s profits growing  (are they making more profit or not?)
3. How are the company ’ s margins doing  (if the sales and EPS graph don’t head in the same direction that can be a red flag)

Below is an example of a combination of EPS and Revenues graph with two different companies in the same industry.

The first is Procter & Gamble (PG)

As you can see right away, there is a call to action to dig deeper inside the financial statements; the sales are going up but the EPS is trailing behind. There must be something hurting the margins or special expenses that won’t happen in the future. You need to get these facts straight before you can consider buying this stock.

However, if you look at Colgate-Palmolive (CL) you will find a more consistent trend (but not perfect):

Step 3 Analyze Dividend Growth History

Now that youve created a list of companies able to pay dividends over the long haul, it’s time to perform some deeper analysis.

The process of choosing final buy candidates from your screener list cant be formulated in a rules-based structure here because it will be different for every investor based on risk preferences, portfolio objectives, and personal preferences. Instead, what I will do is provide several ideas for you to consider in developing a selection process that specifically matches your objectives.

The first thing to do when choosing final buy candidates is to download the company’s financial statements. Often, you will find an “Investor Fact Sheet” or “Recap” giving you some key ratios such as Earnings per Share, Sales, Profit, and Dividend Payouts over past years.

If you can’t access this information from investor fact sheets then you’ll have to dig inside the company financial statements. Another alternative is the annual report because it will provide more than one year of information with all the necessary numbers already calculated for you.

I like to use the past 5 years when analyzing dividend growth history. Also, I suggest you make a quick graph of the past 5 years dividend payouts instead of simply calculating the dividend annualized growth rate. This will give you a clear idea of which stocks have a strong dividend payout strategy compared to the others. The graph can be as simple as the following:

Which looks a lot better than the following:

The first graph is a good indication of a solid company that is looking to consistently increase its dividend year after year. You want to invest in companies with a favorable dividend policy.

Step 4 Examine For Sustainability

If this seems like a lot of work, it is important to note that we are only halfway through the process. That is why I offer an affordable alternative that does all of this for you for just $15 per month. (Affiliate link) After all, if picking double digit dividend growth stocks was easy, we would all be rich!

As a quick recap, what weve done so far is examined past data with stock screeners and financial statements as an efficient way to clear out the most “unreliable” stocks. Your next step in this process is to examine current information about the company to see if it will be able to increase and sustain its dividend.

Something that is ignored too often is the current management team. Have members been there for a while and are they responsible for the previous performance? If so, are they still on board to continue their good work, or are they just trying to get their golden parachute?

The management compensation system explained in the financial statements along with the longevity of the board will help you make up your mind about their competence. If you are lucky, they might even disclose their dividend payout philosophy for the upcoming years. If they put a lot of emphasis on the dividend in their financial statement then that’s a great sign it is a focus that will continue into the future.

• How Does the Company’s Recent Quarterly Performance Look?

Besides pure metrics, which we analyzed in Step #2, recent quarterly results will tell you if the company has been beating analysts’ expectations. In addition to analysts’ opinions, you can check to see if the company is confirming their previous sales guidance. A good site to get this information quickly is Reuters because they usually report when companies comment about their outlook for the upcoming year. This is a good way to interpret the current and forward results.

Your objective in this step is to find companies confirming or increasing their earnings and sales guidance for the upcoming quarters.

• What Projects Are They Currently Pursuing?

While you are looking for financial ratios within the financial statements, also look at their current and future projects as well. A company dominating its sector must always look towards the future. For example, Intel (INTC) has been dominant in the PC world. However, they are experiencing problems entering the tablet and smartphone sectors. Since PC sales are slowing down and INTC is still not able to expand into other markets, future growth will be harder to achieve and margins will likely be reduced.

I personally looked into INTC and saw that they are multiplying their efforts in order to expand their niche into other markets. Following these current projects will tell me if INTC can successfully transition their previous business model (being the leader in processor chips for PCs) to a new business model (which not only includes tablets and smartphones but also servers and hosting services). Again, the goal is sustainability of the dividend and this is yet another quality indicator.

Step 5 Look To The Future

All of this analysis of past data and company fundamentals serves one purpose to figure out if the company can continue its dividend payout strategy. It is not a Crystal Ball, but it’s your best indication of future results.

A stable evolution of past sales, earnings and dividend payout ratio are all positive indications for the future dividend. If the company has a proven ability to generate growth and manage earnings then chances are good that their payout ratio will remain stable over time. It’s important to form your own opinion about the company instead of blindly believing what you read.

However, even if everything looks good, it is still important to remember that market and technology innovations can cause bad things to happen to good companies. Thats why you want to determine:

• If the company is solid enough to weather a recession?
• What kind of impact would a sales slowdown and pressure on margins have on the dividend payout?
• Is the company distributing all their profits (i.e. high dividend payout ratio) or is there room for bad luck?

Once you reach this point in the analysis then these questions are easily answered. That’s why it is so important to have your own opinion with the economic facts to back it up.

From Stocks Picks To Dividend Portfolio

Now that you’ve had fun screening stocks and sorting for fundamentals, it’s time to get serious: how do you build your portfolio?

Do you simply invest in a random selection of 20-30 stocks from your list and rake in the dividends? You can certainly do that (I know investors that have a few Dividend Aristocrats and just wait for their quarterly payout), but my experience says you can do a lot better with proper selection.

The purpose of the rest of this article is to provide you with the tools you need to build your portfolio from your final list. These techniques don’t contain the absolute truth, but they will prevent you from mistakenly chasing too much yield or too much growth without properly considering investment fundamentals.

My favorite technique is to build quadrants to compare stocks, use diversification to your advantage and as a bonus I’ll also show you how to cheat on your investing strategy.

How To Use The 4 Quadrant Strategy

The first thing you should do when building your portfolio is to test the stocks that passed the screening criteria against 4 different types of quadrant analysis.

Quadrant analysis techniques are used to quickly compare how stocks rank relative to each other. It also reveals specific shortcomings not easily found through other analysis techniques. What is cool about quadrants is that they are easy to use, easy to understand, and don’t require much time.

The idea of building a quadrant system is quite simple: first, you select two characteristics you want to compare (consider dividend yield and dividend payout ratio). Next, you compile the data for both characteristics for all stocks on your shopping list that passed the earlier screens. Once you have all the data, you simply position each stock according to its yield (on the X Axis) and their payout ratio (on the Y Axis). Here’s a quick example:

In this example, it is quite obvious that you would like to see as many of your stock picks in the #4 quadrant (high dividend yield with low payout ratio) as possible. The least attractive quadrant is #1 (low dividend yield with high dividend payout ratio). Within minutes, you can determine which stocks are a good addition to your portfolio and which are not.

Different quadrants can be used to cross-compare related data to see contradictions and inconsistencies thus allowing you to further narrow your shopping list. Companies use quadrants to position their products (high-end vs low-end, mass consumer vs. niche, etc.) We will use them to position your stock.

For example, if you hope to live off dividends one day, you need stocks that:

• Provide a healthy dividend from day one.
• Grow their dividend over time.
• Grow their income over time (so they can keep up with their dividend and provide you with capital growth at the same time).

In order to find those stocks, you would want to use the following four quadrant models

Dividend Yield Vs. Dividend Payout Ratio

The next quadrant we will look at compares the stock’s dividend yield to its ability to continue paying the dividend (the dividend payout ratio). In other words, most dividend investors first look at dividend yield. But instead of chasing yield blindly, like a dog running after a cat that just crossed a boulevard, you should check the dividend payout ratio to make sure your dividend (or your dog) doesn’t get squished!

Using an actual example, I’ve pulled 10 stocks from the S&P 500 and the NASDAQ to show you how they compare using this first quadrant analysis. Here’s my data compilation: