I’ve been scouring through financial statements these days in search of good businesses that I can showcase on DivGrow. My partner thinks that I am quite lame for doing this (with love of course), but nonetheless, I seem to enjoy it for some reason, so i’ll continue to do so. If you’ve checked out this site before (or have been unfortunately subjected to my ‘lecturing’ on investing in person), you probably know already that I always start my stock picking process with an initial screen that filters out all companies that aren’t growing their dividend. I figure that in my life, my “easiest” shot at getting wealthy is over the long term, not the short term, through buying and holding good, profitable companies that grow their payouts enough so I can eventually retire on dividend checks. While a lot of people I talk to have correctly pointed out that there are plenty of good businesses out there that don’t pay dividends, I still choose to focus on companies that do because frankly, I like getting paid NOW and also because it is a good way to narrow down the list of stocks I need to follow.
Once I determine the universe of stocks that meet my screen, I then sift through financial statements looking for companies within this universe that I want to buy and hold for my own portfolio. Importantly, just because a company is a dividend grower does not mean I necessarily want to own it because as I pointed out in my last post, I am quite young, and therefore I prefer to overweight companies that are growing their dividends the fastest, subject to the constraint that they can continue to finance their growing dividend with free cash flow and NOT debt or new equity, within reason. Luckily there are many of these companies out there, which is good because rule #3 of the 8 timeless investing rules says not to bet all your pounds on one pony.
Long Term Track Record
The markets these days are fixated on the short term. This is evidenced by the fact that virtually all analyst reports on companies you’ll read come with a one year price target, or something to that respect. I pay virtually no attention to these target prices because my plan is to buy and hold the right companies for the long term and I therefore couldn’t care less about where the stock trades next year. Maybe it goes up, maybe it goes down, but if the underlying fundamentals remain solid and earnings and dividends keep growing, over the long term, chances are it will eventually trade higher than today.
Instead I like to focus on a companies long term financial track record and look for promising trends that help me conclude on how well a company has executed their business strategy over time. When looking at a companies financial statements, I like to look back as far as there is information available. I am fortunate to have access to a Bloomberg portal, which typically gives me 20+ years of financial statements for most companies. Lucky me!
This brings me to the point of this post. As mentioned above, once I have my universe of stocks, I then sift through the long term financial statements of companies within this universe and look for promising trends. There are many good checks you should look for, but to keep this post to a reasonable length, I am going to focus on five trends that I always look for when studying a companies long term financial statements.
The easiest way to demonstrate is on an actual company, so for the rest of this post I am going to study the long term financials of dividend grower Hormel Foods, (“Hormel”), a $14 billion food company that owns popular food brands like “Spam” and “Skippy.” Hormel trades on the NYSE under symbol “HRL“.
Trend #1 – Dividend Growth
Not surprisingly, the first thing I look at is dividends paid over time. In particular, I look to see (1) if dividends are growing and (2) if the rate of dividend growth is attractive. Hormel is solid dividend grower that announced its last dividend hike in November 2013 for the 48th consecutive year in a row. Consistent dividend hikes are obviously great, but not only is Hormel’s dividend growing, since 2005 it has been growing at an accelerated rate. For the 15, 10 and 5 years ending in 2013, Hormel grew their dividend at 10%, 12% and 13%, respectively. In fact, in November 2013 they hiked their dividend another 18% from 0.68 to 0.80 per share! I love to see an acceleration of dividend growth, because that tends to imply that management expects the company to continue to grow quickly going forward.
Here is graph that shows Hormel’s dividends paid per share since 1993. Notice that dividend year over year growth (red line) has increased on average since 2005.
Trend #2 – Stable Payout Ratio
What good is buying a company to harvest their dividends if dividends are not sustainable? To check on dividend sustenance, I look at the payout ratio. Since 1993, Hormel has managed to quickly grow their dividend and also maintain a low payout ratio of approximately 30% of earnings (33% as of 2013). Dividend growth along with a stable payout ratio can only mean one thing, earnings growth, which is truly what I am after because dividends are only one driver of total shareholder returns. Earnings growth is the other.
I don’t really have a rule of thumb for payout ratios, I just look for consistency. Companies of different sizes and in different industries have varying average payout ratios. For instance, utility companies which tend to have very predictable cash flows, can afford to have a higher payout ratio.
Here is a graph that shows Hormel’s earnings and dividends paid per share since 1993 along with the payout ratio (red line). This graph highlights that Hormel has grown its dividend in lock step with its earnings, which is exactly what I am after.
Trend #3 – Growing Revenue & Stable Margins
Sales growth is paramount. Without sales growth it is very hard to grow earnings and cash flow over the long term which will in turn, limit dividend growth. I therefore always look at how the company has managed to grow their revenue over time and also, if margins have remained stable or even better, improved. Often when a company gets too big or loses something important like a large account for example, revenue growth slows down. If revenue growth becomes stale, in order to maintain earnings and dividend growth, the company would need to cut costs, sell assets, restructure etc., which is often quite difficult. Therefore consistent, growing revenues, coupled with stable and improving margins is the recipe for long term earnings and dividend growth.
Here is a chart of Hormel’s revenues over time, along with two lines (1) EBITDA margin (red line) and (2) free cash flow margin (blue line). EBITDA margin only includes operating costs and doesn’t take into account capex, interest, taxes and working capital impacts on cash flow, so I expect to see this metric be more stable than free cash flow. However to get a full sense of cash generation as a percent of revenue, I look for a consistently positive, stable and growing free cash flow margin which indicates that the company is able to generate an increasing amount of cash as revenue grows over time. The company can then use this cash to fund things like dividend payments, share buybacks and also reinvest in the business to fund future growth. As per the graph below, Hormel looks good on both measures.
Trend #4 – Stable or Falling Share Count
This one is simple and meant to check that management does not have a history of diluting shareholders. Further, you can get a sense of management’s commitment to returning capital to shareholders if the company has a history of buying back shares.
As you can see from the below graph, Hormel has bought back their shares over time. This is fantastic to see because it means (1) management likes to reward shareholders and (2) if debt balances haven’t grown (which they haven’t), then the business must have grown via internal cash flow generation.
Trend #5 – Balance Sheet Strength
Last but not least, I always, ALWAYS study a companies balance sheet to understand their capital structure. Leverage when used effectively, can enhance a companies shareholder returns. However, just like people, if a business gets into to much debt, that can spell serious trouble. Like payout ratios, I don’t have a general rule of thumb for how much debt is appropriate as different types of businesses and industries have different ‘typical’ capital structures. For instance, a utility can handle higher leverage because of the stability of its cash flows. In contrast, a more cyclical company like an auto parts manufacturer should have lower debt levels so they can manage debt service payments in booms and busts. For me, I prefer as little debt as possible in the companies I buy so they can maintain maximum discretion over their free cash flow, but I also know that debt can sometimes be a good thing and accretive to shareholders if used effectively, so reasonable debt levels don’t scare me away.
To check on long term debt trends, I like to look at two ratios: net debt/equity and EBIT/interest expense. Net debt/equity is a ratio of the companies uncovered debt obligations relative to owners equity. It is best to check this ratio for stability over time and also compare it to companies within the same industry. EBIT/interest measures a companies ability to fund ongoing interest payments from operating earnings. Here, the higher the ratio, the better and like net debt/equity, it is also best to watch this ratio over time for stability and benchmark it against industry peers.
In the below graph, notice that Hormel has de-levered over time as net debt/equity has decreased. Not surprisingly, EBIT/interest has increased as debt levels and interest payments have come down. As a result, Hormel has a very healthy balance sheet with net debt of -$180m as of the end of 2013 and interest coverage of greater than 60 times.
A Few Final Thoughts
As you can tell from the five above graphs, Hormel looks like a profitable, healthy, stable dividend grower. Further, Hormel has been accelerating their dividend growth in recent years! This is exactly the type of business that I look to buy and hold. Hormel is company with a track record of rewarding shareholders, a stable of strong brands, solid underlying fundamentals, and one that I can easily imagine being around long after I die. After all, people got to eat right?
I must point out however, that my research doesn’t end after I look at these five trends. I also check out things like current management, their product lines, how they stack up against their peers etc., as there might be something that has changed within the last few years that isn’t apparent just by looking at financials, that may push off a company.
Further, it is important to highlight that there are plenty of companies that have similar track records as Hormel. Knowing this, I look to add as many companies with solid financial track records to my portfolio as I can in order to maximize diversification. This way I will always live to fight another day.
Well friends, that’s all for now. Until next time, follow the growing dividends!
Disclosure: I don’t own HRL, I will look to initiate a position in the future.