Situation: Owning individual stocks in a taxable account is an important way to supplement retirement income. But first you have to decide which stocks have dividend payouts that are both sustainable and substantial. The trick lies in knowing how much and how consistently those companies will grow their earnings. So, it’s useful to keep an eye on the Compound Annual Growth Rate (CAGR) of the dividend over the past 5 years (Column L in the Table) and the estimated earnings growth over the next 3-5 years (Column N in the Table).
Mission: Start with two indexes: the Vanguard High Dividend Yield ETF (VYM) and the iShares Russell Top 200 ETF (IWL). List all stocks found in both. Narrow that list by excluding any with a) a 5-year Beta higher than 1.00, and/or b) a 10-year RRR (Required Rate of Return) higher than the 10-year Actual Rate of Return. Remove stocks with a lower Finance Value (Column G in the Table) than the S&P 500 Index, and stocks with a 5-yr Beta over 0.7 that have a lower 10-yr Actual Rate of Return/yr than the S&P 500 Index ETF SPY (see Column E in the Table). Exclude companies with an S&P stock rating lower than B and/or an S&P bond rating lower than BBB+; also those with less than a 20 year trading history.
Execution: see Table of 18 companies.
Analysis: Warren Buffett’s favorite metric is found in Column T of the Table: Return on Tangible Capital Employed. He thinks a 20% return for the last fiscal year is a good number. Eight companies do so: MRK, LMT, AMGN, PEP, JNJ, MCD, PG, PFE. His second point (that the company be run by able and honest managers) is addressed in Morningstar reports (see Column AQ) and is negatively impacted by the degree to which managers choose to capitalize the company by issuing long-term bonds (see Column Z). Six companies have a BUY rating from Morningstar (GD, AMGN, AEP, APD, HON, PFE), and 7 companies have a Long-term Debt to Equity ratio lower than 1.0 (MRK, GD, AEP, JNJ, WMT, PG, PFE). Mr. Buffett also states that a high Free Cash Flow Yield (Column K) reflects good management because Retained Earnings allow the company to expand operations (or pay down debt) at zero cost; 13 companies meet that standard (MRK, LMT, GD, CAT, AMGN, HON, JNJ, MCD, WM, WMT, PG, PFE, UNP). His third point (that the stock be available “at a sensible price”) is addressed by one and 3 year Forward PEG ratios (see Columns O and P); two companies (GD and AMGN) have PEGs under 2.0 at both intervals. Eleven companies are A-rated (MRK, LMT, GD, AEP, APD, HON, JNJ, WMT, NEE, PG, PFE). Six companies are cited at least 4 times (MRK, GD, AMGN, JNJ, PG, PFE).
Bottom Line: These stocks have an average dividend growth rate (for the past 5 years) of 7.7%/yr, and a projected average earnings growth rate (for the next 3-5 years) of 7.0%/yr. Their dividend yield is 2.8%/yr.
Risk Rating: 5 (where 10-year Treasury Notes = 1, S&P 500 = 5, and gold = 10).
Full Disclosure: I dollar-average into MRK, LMT, CAT, AEP, PEP, SO, JNJ, MCD, WMT, NEE, PG, PFE and UNP, and also own shares of GD, AMGN, APD, HON and WM.
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