Here is another question I have gathered from my recent survey:
‘What are factors that make stocks good for dividend investing?’
Thus, in this write-up, I’ll share 5 characteristics of stocks that would be ideal to be invested for recurring dividend income. They are as follows:
#1: Recurring Income
The first step to dividend is not to calculate dividend yields but to study and get an understanding of the stocks’ business models. So, if my intention to invest in a stock is to earn recurring dividends, then, it is obvious that I should be finding stocks that have business models that enable them to earn recurring income.
Let me illustrate this by comparing two business models in the property sector.
First, we have property developers. Typically, they buy land, draw a masterplan, obtain permits, hire contractors … etc to develop real estates for sale. For these property developers, they earn income from property sales and after the entire development had completed and handed over to their buyers, this would mean the end of this source of income. If property developers do not find new land in the market to develop, they would have no income.
Second, we have property holding companies or REITs. They buy, own, and rent out their investment properties to commercial tenants for a period of time that could range between 3 years to as long as 30 years. The business models would allow them to earn recurring income and pay out recurring dividend income for the long-term.
#2: Big Pool of Customers
Are the stocks that you wish to invest in have a large pool of customers?
Let me give you an example of two stocks: A Ltd and B Ltd.
Both A Ltd and B Ltd had reported $500 million in revenues in a single year. But, the difference between the two stocks are as follows:
A Ltd generated $500 million in revenues from 10 million customers.
B Ltd generated most of its $500 million in revenues from 10 key customers.
So, which of the two stocks do you prefer to invest in?
For me, I would opt for A Ltd as it has a larger pool of customers than B Ltd. The advantage of having stocks like A Ltd is that they are less financially impacted in the event of a loss or a payment default of 1 customer. So, it is less risky to me.
#3: Cash-Sale Business
I prefer cash-sale businesses over credit-sale businesses. Here is the difference:
For instance, when I do grocery shopping, I would pay the grocer in cash for the merchandise that I wish to buy. Thus, the grocer is doing a cash-sale business.
However, when I engaged a web developer to develop a new eCommerce site, I was given a credit term of 60 days to make payment to him. Therefore, my web developer is doing a credit-sale business.
Stocks that tend to be good in collecting cash from customers would be ideal to dividend investors as they have the cash to reward shareholders with dividends over the long-term. Meanwhile, stocks that are bad in cash collection could end up in a tight cash flow situation and thus, could not pay dividends consistently.
#4: Increase Profits Consistently
We need stocks to generate consistent growth in earnings to pay out consistent growth in dividends to shareholders over the long-term (10 years).
Personally, I use 10 years as a benchmark to measure consistency. This is due to the fact there are many incidents which would happen in a 10-year period. This includes the following:
– The rise or fall of RM, SGD, RMB, USD, … etc.
– The rise or fall in prices of crude oil, crude palm oil, and essential materials.
– The rise or fall in interest rates, including Fed rates.
– The changes in political leadership in many nations, including ours.
– The changes in national economic and social policies, including ours.
– Technological advancements and changes in consumer behaviours.
– US-China trade tensions, terrorist attacks, pandemics, … etc.
If a stock could deliver consistent growth in earnings despite all the above, then to me, that would be the stock that I like to invest in.
I do not really predict world events or react by buying or selling stocks based on what might happen or what might not in the future. I leave that kind of stuff for people who have such foresights like traders and speculators.
I am not in the business of market predictions.
Rather, my business is in the accumulation of good businesses. That is my game and I think I should just focus on that.
#5: Positive Operating Cash Flows
To me, the consistent growth in earnings (stated in Point 4) has to be backed by years of positive cash flows from operations.
So, if I found a stock to have consistent growth in earnings for the past 10 years and it has negative operating cash flows in most of these 10 years, I would raise a red flag on this stock and would pass on the opportunity to invest in it.
However, the exception is only for stocks that are bankers or financiers.
Banks and financiers are special for they need to offer financing to borrowers. If they do not do so, they would be out of business.
Just to explain. Banks and financiers would be recording operating cash outflow once they disburse loans to their borrowers. Thus, the more loans they give out to clients, the better they are for them. Hence, it is acceptable for them to have delivered consistent growth in profits but have years of operating cash outflows in their financial reports.
But for other stocks, profits must be backed with positive cash flows.
So, there you have it, the 5 characteristics for a stock to be suitable for dividend investing:
#1: Businesses that Generate Recurring Income.
#2: Businesses that Have Large Pool of Customers.
#3: Cash-Sale Businesses.
#4: Businesses that Consistently Grown in Earnings in the last 10 Years.
#5: Generation of Positive Operating Cash Flows in the last 10 Years.
Alright, that is it for this week.
If you have any questions / feedback, please post them to email@example.com.
Stay tuned for my latest next week.