Stockles Risk Rating and What’s High Quality?

One of the most common questions I get is what do I mean by high quality? When I held the presentation about Dividend Growth Investment at The Norwegian School of Economics, I outlined a few factors which I focus on. Still, there is so much more to the term quality.

In the book Zen and the Art of Motorcycle Maintainance the author tries to figure out what quality really means. How do you know the difference between a bad poem and a good poem? Is it the rhythm that makes it high quality? The complex vocabulary? Most likely, you will say that it’s the combination of many factors and that’s how it is with high quality companies too. It’s not just about a wide moat, a great brand, a strong track-record and a visionary CEO. It’s the total package and in this post, I’ll show you what I mean by high quality.

 The Four Factors I Look For

  • Profitability
  • Management
  • Financials / Debt
  • Dividend Growth

Enduring Competitive Advantages

By Enduring competitive advantages, I mean either a wide or a narrow moat. Buffet uses the word economic moat and explains that a company can have different kinds of moats

  • Brand Moat such as Apple making them able to charge 15 % higher per phone even though the software is pretty much the same
  • Switching Cost such as Microsoft were so many companies have the Microsoft Package that it’s almost impossible to go to something else or at least the struggle isn’t worth it unless there’s a product which totally disrupts the business.
  • Establishing Costs such as AT&T or Dominion Energy were the cost of building the infrastructure needed to operate is so high that it’s basically impossible to enter the segment.
  • Patents such as J&J where they have the only permission to sell a drug, causing them to have a short-term monopoly.

A great way to see if a company has any kind of moat is to look at the return of equity (ROE). Imagine that someone opened a store selling hot-dogs and you can get 30% return on your invested capital. In just a couple of years, you would have doubled your money and each year you’d earn more and more. Surely someone else would find a way to sell hot-dogs, causing prices to drop. New companies would start to compete and the new mission would be to try to find the perfect balance between price and quantity.

But if a company can operate for a long time without having any significant competition, we might be talking about a company with a strong moat. An example would be my favorite company, namely Rollins (ROL). For decades they have been able to maintain a ROE close to 30%. Btw, Rollins is the first company I’m going to buy in a recession.

Long Operating History

By long operating history I want to able to check that the management has shown great leadership in depressed times as well as times with high growth (like now). I want to know that they have been smart with their money and invested in a proper way. As for management, I check that the Return on Invested Capital (ROIC) has been high for a long time. If it turns out the ROIC has been high for a long time, it shows that the management can find ways to inject capital and earn more money / profits. Again, if we use Rollins they have had ROIC above 40% since 2008. Simply astonishing.

Shareholder-Aligned Management

By shareholder-aligned management I mean that I want the company to pay respect to me as a shareholder. In many ways, this is where most dividend investors fail. They think that management should pay a dividend no matter what, and they also want it to be as high as possible. Probably, many would prefer two digit yield. The problem is that a dividend payment isn’t something magical. A company can choose to spend the capital from the positive revenue on new assets such as machine,  creating even grander growth in the future. They can choose to reduce debt which might not be a bad idea in a super low-interest rate environment. Lastly, they can choose to pay a dividend to shareholders.

For stocks such as AT&T, where the market is very saturated and there aren’t many ways to grow, I want to have a high dividend as my return for taking risk in this company instead of just owning a bond or placing my money on a saving account. For REITs it’s quite different since they are by law forced to pay most of their earnings as a dividend to shareholders. Still, I want to see that the company don’t have to increase debt in order to pay me. That might be sweet in the short-term, but it will surely end up bad. For stocks such as Visa, Medtronic or Hormel, I want a combination of high debt control, yield above or close to inflation as well as investment in growth-opportunities.

So, in total I want management to be risk-averse, not paying me a dividend just because people want them to pay. In USA, they operate with dividend aristocrats and dividend kings. Sure, many of these companies are great, but one need to notice and be aware that they have a high pressure of not freezing the dividend or cutting the dividend. Many people invest in those lists without having a clue what the company do and demand money even though the company would be better of holding the dividend payment for a while.

As for reasonable payout ratios, consistent free cash flow and healthy balance sheet, I normally aim at a payout ratio for American firms at maximum 70%. For REIT’s I look at the industry standard and the sector standard, but I’m not too eager when I see payout ratios above 100%. Since the free cash flow is in some ways the tool for a company to operate smoothly, being able to grow, invest and pay dividends, I want this to grow over time. Nothing is better than a consistent free cash flow year over year. It basically means that they get more and more money after paying their expenses to increase shareholder value.

As for balance sheets, I’m mostly focus on short-term debt, not that much on long-term debt. Debt is necessary to grow, but not being able to pay the short-term debt is dangerous. Here I want to current ratio, which is the total assets divided by liabilities to be above or close to 1. A current ratio less than 1 means that the company might find other raise money to pay the debt.

 

When I have a general idea of how the company might be, I go on to the Stockles Risk Rating

The Stockles Risk Rating is created with the purpose of getting to know the business. I think that the best way to stay rational and calm in a stressful market is to know what you own and know what its good for. This Risk Rating is not absolute and a company can fit my portfolio even if a few questions are negative. I do this Risk Rating every time I buy a new company to make sure I know what this partnership truly means.

About the Company

  1. Geopolitical Risk: Is this company free of meaningful geopolitical risk?
  2. Market Cap: Is the market cap greater than $1 billion?
  3. Repeat Business: Does the business have high repeat customer usage?
  4. Brand 1: Does the company have brand strength with passionate advocates?
  5. Brand 2: Does the company’s business rely on recognizable branding truly valued by its buyer base?
  6. Safety: Is the safety score from SSD more than 75?
  7. Growth: Is the growth score from SSD more than 75?
  8. Yield: Is the yield score from SSD more than 75?
  9. Is the company recession proof?

Financials

10. Does the company have a good recent record of revenue growth? (Revenue CAGR)
11. Growth: Did the company increase its sales by 10% to 40% annually in the previous three years?
12.Profitability: Was the company profitable during the past year? 
13. Consistency: Has this company shown consistent profits each of the last five years? 
14. Cash Flow: Was the company cash-flow positive for the previous quarter, the last 12 months? Two of the last three years? 
15. Diversification: Is the company free of any customer or supplier that accounts for more than 10% of sales? 
16. Independence: Can the company execute its business plan without relying on external funding? 
17. Leverage: Is the company’s debt-to-equity ratio less than 1.0? 
18. Current Ratio: Is the current ratio more than 1.0? 
19. Net debt / EBIT: Is the net debt / EBIT lower than 2.0? 
20. Financial Transparency: Are the financials easy to understand? 
21. Return on Equity: Is the ROE/ROIC greater than 12% each year for the past five years?

Dividend

22. Yield: Does the company yield more than inflation?
23. Dividend CAGR: Is the CAGR more than 5%
24. Payout Ratio: Is the payout ratio less than 70%?
25. Dividend status: Is the company a king, aristocrat, contender…?

The Competition

26. Underdog: Is it free from stronger competitors?
27. Goliath: Is it free from disruptive upstarts?
28. Moat: Are there signs of strong competitive advantage?
29.Is the company likely to avoid disruption and see most of its key markets continue?
30. Is the company Amazon Proof?

The Stock

31. Market cap: Does the stock have a market cap of more than $750 million?
32.Beta: Is this stock’s beta less than 1.3 for the past 12 months?
33. P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30?
34. Forward P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30?
35. P/B ratio (financials): Does the stock have a price-to-book multiple around 1?
36. Forward P/B ratio: Does the stock have a price-to-book multiple around 1?
37. P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 – 2 or less than 1?
38. Forward P/S ratio (growth): Does the stock have a price-to-sales multiple around 1 – 2 or less than 1?

Management

39. Insider Stake: Do founders and top executives have at least a 5% stake in the company?
40. Management: Is the management trustworthy? (Do as they say and ROIC?)

 

What do you think? What’s your definition of high quality? Please do tell. 

Until then, take care

Stockes

14 comments

    1. Thanks! No, I haven’t but I think I have a deal with them that they will publish posts from my blog if they find something interesting. Maybe I’ll send it anyways.

  1. Veldig oversiktlig og interessant! Takk for at du deler såpass detaljrikt Jeg har dårlig erfaring med gjeld, tidligere var jeg investert i selskaper som har gått dårlig på grunn av det, og bryr meg derfor om hele gjeldssiden av balansen, ikke bare kortsiktig gjeld. Setter ekstra pris på at selskaper har mulighet til å kvitte seg med hele gjelden sin, hvis de trenger.

    1. Hei Investorkilden!

      Tusen takk for det. Jeg er helt enig med deg at langsiktig gjeld også er viktig i det totale bildet. Bare se på General Mills eller Dominion Energy. Men, når man skal vurdere sikkerheten til utbytte 1- 3 år frem i tid blir det fort den kortsiktige gjelden som er viktigst av de to.

      Som du sikkert så snakker jeg om current ratio, og den inkluderer all gjeld.

      Artig at du deler dine tanker og erfaringer!

  2. Excellent article. SA will for sure pick this one up. I agree with a lot of your points. I don’t want a company to take out debt just to pay a higher dividend. That makes them more risky over all. I still want enough left in retained earnings they can grow and keep my investment growing over the long term. Also paying a high cash dividend isn’t the only way a company can be “shareholder-aligned”. They can also do things like share repurchases to align themselves in a better position for the future.

    1. Hi Daze!

      Thank you 🙂 And a valid point about share repurchases as another way of measuring how shareholder friendly the management is. While I do like to see that the company decreases the amount of shares rather than increasing it, it’s only a promise and hard to track prior to the actual repurchase.It’s definitly a good thing, and should be included in the total evaluation.

  3. Thanks for sharing – Great article and good points to check before purchasing shares of a company. I couldn’t agree more. If you want to invest money for the long run – not playing roulette – it’s essential to know the companies you want to be a “part-owner”.
    I do these checks too and in most cases i invest only in companies i can identify with (to a certain degree), because i plan to hold them for a very long time, maybe forever and for future generations. And when you know what kind of company you own, you can be confident, even if the markets go crazy for a while.

    Greet’s
    DividendSolutions

    1. Hi DividendSolutions,

      Right. It’s the part about “part-owner” that so many people miss. Looking forward to seeing how people think and feel when the market turns and companies start to reduce their guidance and news are negative. Should be interesting for sure. Thanks for commenting!

  4. Hei, har lest bloggen din i rundt et halvt år. Den er veldig oversiktelig og informativ. Ble inspirert til selv å lage en investeringsblogg for å informere, og hjelpe folk unngå feil . Hadde vært veldig hyggelig hvis du tok en titt og muligens ga meg noen tips.
    Mvh

    thecashflowinvestor

    1. Hei Jon Kristian,

      Takk for det og hyggelig at du ble insperert til å lage en blogg selv. Ser at du har tatt deg litt kunstneriske friheter og direkte kopiert min disclaimer og nesten min porteføljetabell. Forsåvidt greit det, men fint med en liten melding bare for å forsikre deg om at det er okei.

  5. Great writeup. Finding a company with a lengthy operating history and several time-tested advantages is a solid approach, although not so easy in today’s fast-changing world. Keep up your nice work!

    Brian

    1. Hi Brian,

      You’re totally right. The previous winner isn’t sure to be the future winner. One can just look at the difference between 10 largest companies in market-cap during the latest decades. Thanks for always inspiring and sharing your knowledge Brian.

  6. Great analysis Stockles. It’s sometimes difficult for a beginner to evaluate the quality of a company they are interested in. There are so many metrics and things to consider. But looking at the profitability, management, financials and dividend growth of the company are definite factors one should consider before investing their hard earned money. Good post man.
    Dividend Portfolio recently posted…M1 Finance For Dividend InvestingMy Profile

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