How do I pick my dividend stocks? A step by step guide using the example of $COST (+1.8%)
Reading time: approx. 15min
Lately, I read again and again questions about which criteria are considered particularly important for the selection of dividend stocks. Somewhat more unspecifically, one also reads the question "Which dividend stocks are worth buying?" again and again. Of course, this can never be answered in a general way. Every potential purchase of a stock involves intensive research, the personal investment strategy and the investor's own investment horizon. Since both investment strategy and investment horizon are individual, I'll focus on research before buying. This post is meant to serve as a guide for that. Of course, this is first completely subjective to my investment strategy and horizon, but with a little abstraction it can be generalized to your needs.
1) THE IDEA
At the beginning of a possible stock purchase there is an idea. This is probably the part that can be handled least "algorithmically", because it requires creativity, attention in everyday life or possible special knowledge about a "hidden champion" in an industry. Therefore, I can only advise you to go through your everyday life with open eyes. Possible starting points are for example:
- What products are there to buy? Who manufactures them?
- What kind of products do I work with in my everyday life and at work?
- which product could I not do without in my everyday life?
- what is so expensive that you don't really want to buy it, but you keep buying it anyway?
Of course, these are just a few possible questions. Give your creativity free rein to come up with possible exciting companies. Very few of these ideas will really be so exciting that you end up investing in them. It is more about building up a pool of ideas and investing in the most promising companies after a detailed analysis.
How did I come to Costco $COST (+1.8%) come to me? It was a combination of little things: through research on dividend stocks in the retailer space, I first came across Walmart $WMT (+1.88%) and Target $TGT (+2.27%). I didn't look at them that closely, but prophylactically put them on my watch list to look at more closely later.
A few days later I saw that Walmart and Target were deep in the red and I wondered why they were both falling rapidly at the same time. Then I read a small news article that said that one of them had published bad quarterly figures and that the whole retail sector was sliding mightily into the red. Among others, the article mentioned a retailer called Costco Wholesale and a few others who were now facing hard times. Costco I had been vaguely aware of before and I decided to take a closer look. Among all the other retailers, Costco caught my interest mainly because it still seemed absurdly expensive with a P/E ratio over 30, despite the heavy loss that day.
2) UNDERSTAND BUSINESS MODEL & RECOGNIZE COMPETITION
Alright, so we have an idea: Costco Wholesale it shall be. The idea is there, but how exactly do I move forward?
In the next step, I always and extensively deal with the business model and the competition of the company. I want to understand the business model understand and find points that make the company different from the competition. This may sound trivial but unfortunately many seem to be negligent. Costco is a supermarket chain, right? So they buy their goods from producers, pack a solid margin on top and then sell them en masse in their own stores. Done. So why bother with business model when I already understood it?
As always, the devil is in the details. Costco sells goods in its own department stores, of course, but in addition there are many things that are particularly interesting and where they stand out from the competition. The starting point for my research is provided by simple Google searches of the form "Why customers prefer Costco?", "How does Costco earn money?" or similar. Examples of the results of such a search can be found in [1], [2] and [3]. For me, the bottom line of the search is this:
1.) Retail As A Service! Before you can shop in Costco stores, you have to sign up for a membership. This currently costs $60 per year in the cheapest version and $120 per year in the premium version, and is renewed by about 91% of existing members [4]. In addition, new members join every year, so that the number of members grows by about 5-7% every year. With the premium membership, one also receives a 2% cashback rewards for purchases at Costco and is rewarded for buying more at Costco.
2) The customer is king! It is mentioned time and time again that Costco employees are considered to be especially friendly. This may be self-evident, however, each of us knows stores in which one is treated as a customer rather rudely or dismissively. In addition, there is a one hundred percent money-back guarantee that delivers what it promises. Headlines were made, for example, by a woman who brought her Christmas tree purchased at Costco to a Costco store in January, dried out, and got her money back for the purchase without any fuss [5]. There have been similar reports of worn tires or used-up food packages. In all cases, the merchandise was taken back and the customers got their money back. Of course, this gets around and gives customers the feeling that they can buy something if they are unsure whether they will be satisfied with a purchased product. If in doubt, it can be returned. Of course, Costco has planned for the fact that this rarely happens on the part of the customer.
3) Unbeatably cheap! Costco buys its goods in huge quantities and thus receives large discounts. These low purchase prices are deliberately passed on to the customers with a small margin in order to be cheaper than the competition around Walmart, Target and Co. [6] This is also openly communicated by Costco to the customers. As a result, customers know that they will most likely not be able to shop anywhere cheaper than Costco. The low price is also achieved, among other things, through larger containers and the low-priced private label "Kirkland". In addition, Costco focuses on a rather reduced assortment with "only" 4,000 products, whereas Walmart has over 142,000 different products in its assortment [6].
4) Top employer! Costco pays its employees a relatively high average hourly wage of $15 (Target $13, Walmart $11). This and other details ensure a high level of satisfaction and identification among employees and a lower frequency of job changes. As a result, Costco even saves costs, because employee acquisition and unfilled vacancies also cost a lot of money. That is why Costco is consistently among the best-rated employers, alongside employers such as Microsoft, Alphabet or T-Mobile [7].
In summary, Costco's business model can be seen as a kind of subscription model, granting access to a unique assortment of products at especially low prices. The company is unconditionally committed to customer satisfaction and ensures customer loyalty through means such as a money-back guarantee and cashback programs. The subscription model additionally ensures customer loyalty and predictable growing cash flows. Due to low margins on the sale of goods and other clever means, Costco is usually the cheapest supermarket despite the well-paid employees and thus attracts many new customers.
This sets Costco apart from the competition. Speaking of competition, it's relatively easy to research, as it involves well-known retail giants like the aforementioned Walmart $WMT (+1.88%) and Target $TGT (+2.27%), but also Kroger $KR (+1.67%) and Dollar General $DG (+1.94%). A closer look at the business models of the competition should also take place, but is beyond the scope of this post, so I will spare you a similarly detailed analysis of the business models of the competition at this point.
3) SELECT & REVIEW KEY FIGURES
We now think we understand the business model and have identified what differentiates Costco from the competition. Admittedly, all of the previous points are rather subjective. So it's time to deal with hard facts. After all, if Costco is really doing so many things better, it has to be reflected in various metrics.
Of course, the right choice of metrics depends on the type of business and personal strategy. Personally, I focus my stocks mainly on companies that pay solid dividends over a long period of time and have above-average dividend growth to boot. In addition, there should be a stable growth in sales and profits so that one can afford the continuously increasing dividends. The business model should be as crisis-proof and non-cyclical as possible and the generated earnings should be profitably reinvested in the own company.
These requirements lead me to the following selection of fundamental data:
- Sales and earnings growth
- Dividend history and growth
- ROCE
- Payout ratio dividend / free cash flow
- Lowest possible debt
Now we work through all the metrics in order. I always compare on an industry-specific basis, putting Costco's numbers in relation to those of its competitors at Walmart and Target. All figures needed for the calculation were taken from [8].
Sales growth
The sales growth of the last 5 years amounts to a total of
Costco 63.2% | Walmart 19.9% | Target 49.4%
This corresponds to a compound annual sales growth rate (CAGR) of
Costco 10.3% | Walmart 3.7% | Target 8.4%
Costco and Target sales are growing the fastest, with Costco growing the fastest. At around 10% per annum, this is quite respectable even irrespective of the sector.
Profit growth
EBIT growth over the past 5 years totals
Costco 72.6% | Walmart 14.9% | Target 11.6%
This corresponds to a compound annual EBIT growth rate (CAGR) of
Costco 11.5% | Walmart 2.8% | Target 2.2%
Again, Costco is ahead of the pack, and quite significantly so. Apparently, while Walmart and Target can definitely grow their sales, their earnings are not growing at the same rate. At Costco, profits are actually growing faster than sales, which indicates a healthy and scalable business model.
Dividend History & Growth
Costco has been paying a dividend for 18 years, and it has been increased every year so far. Currently the dividend yield is 0.72% and the annual dividend growth of the last 5 years is 12.4%, that of the last 10 years is 12.6%. In addition, high special dividends are paid out to shareholders at irregular intervals.
Walmart has been paying a dividend for 49 years, which has been increased every year so far. Currently, the dividend yield is 1.53% and the annual dividend growth of the last 5 years is 1.89%, that of the last 10 years is 3.56%.
Target has paid a dividend for 54 years, which has been increased every year. Currently, the dividend yield is 2.49%. The annual dividend growth of the last 5 years is 10.2%, that of the last 10 years is 11.6%.
Here, of course, Target and Walmart score with their very long and impeccable dividend history. However, I don't find fault with Costco's dividend history either, because like the other two, the dividend has been increased every year since inception. In terms of current dividend yield, Target is ahead of Walmart, with Costco following in last place. However, I don't attach undue importance to this point as my personal focus is more on dividend growth. I prefer fast dividend growth, as it allows me to benefit more in the future. On this point, Costco shows stable dividend growth of about 12.5% annually. Target is almost equally good here, only Walmart falls off a bit with its meager dividend growth.
ROCE
The ROCE - i.e. return on capital employed - is a measure (in %) of the efficiency of the capital employed in operating activities. A high ROCE indicates that generated earnings can be profitably reinvested in the business activity. It has become an indispensable ratio for me, as it is a very good indicator of a company's efficiency. A low ROCE is even an exclusion criterion for me; especially if the ROCE is smaller than the company's own cost of capital.
For a detailed definition and interpretation of ROCE, I refer you to a post I wrote recently -> https://app.getquin.com/activity/FLcMGnxVnO?lang=de&utm_source=sharing. Simply and briefly summarized: the higher the ROCE the better.
The average ROCE of the last 6 years is as follows
Costco: 22.1% | Walmart: 15.9% | Target: 19.1%
Target is still close to Costco, but Walmart is already significantly worse than Costco. So, true to the common interpretation of ROCE, Costco has the most capital efficient business model of the three companies. Combined with Costco's high EBIT growth, the high ROCE becomes doubly interesting: ever higher earnings can be efficiently reinvested in the business and thus enable rising earnings in the future.
Payout ratio dividend / free cash flow
Currently, Costco pays out about 21% of its free cash flow in dividends to shareholders. At Walmart, this figure is 23.5% and at Target 33.7%. Thus, the dividend payments at all three companies are safely covered by the cash flow generated. This leaves enough cash flow for investments in business operations.
In order to be able to form this payout ratio at all, a company must of course pay a dividend that is generated in some way from the free cash flow. This already excludes all companies that are free cash flow negative. For companies with a higher dividend yield, the payout ratio is usually somewhat higher. Personally, I think anything up to 80% is still ok; anything above that should be looked at more closely. It may be that this is a one-time effect and it will normalize again afterwards. If not, a dividend cut could be imminent as the dividends could soon no longer be covered by the cash flow. Especially with REITs it is a bit different, because they are obliged by tax law to have high payout ratios. In this respect, my limits are different for REITs.
Debt and cash
Not only since the rise in interest rates - but even more so now - attention should be paid to the long-term debt of companies. Too much debt creates a high interest burden, which can have a negative impact on future earnings and potential investments in the business. Rising refinancing costs in particular then provide negative leverage, which can have a massive impact on the debt burden even if interest rates rise only slightly.
For me, a healthy level of total debt is anything below three times EBIT/EBITDA. Here, in the worst case, the debt can be paid out of the company's earnings within three years (here, too, exceptions apply to REITs, because the business model of REITs thrives on borrowing to finance real estate).
Costco has almost twice as much cash reserves as it has long-term debt. So, theoretically, they could pay off all debt immediately and still have cash reserves left over. The debt to EBIT ratio is also particularly low at 0.8, because all debt could be paid off within a year from the profit of the business.
Walmart has about three times as much debt as cash reserves. So about one-third of the debt could be paid off from existing cash. The ratio of debt to EBIT is 1.5, which is in the green zone.
Target has about 20 times more debt than cash reserves and therefore only 5% of the debt could be paid directly from cash. The debt is about three times the EBIT, so Target would need about 3 fiscal years to pay the debt from earnings.
All three are not overleveraged, yet again Costco scores with such low debt that all debt could be paid directly. The existing cash reserves are also an advantage in the event of larger investments in the future. Nevertheless, it should not go unmentioned that both Walmart and Target are not excessively indebted.
4) INVESTMENT THESIS
If we now summarize the analysis of the business model and the fundamental data, I see a coherent and clear picture:
1.) The business model in the form of a "Retail As a Service" model sets Costco apart from the competition. Costco is growing fast, is more efficient than the competition and generates strong customer loyalty with many factors.
2) Dividend payments are safely covered by free cash flow and there is continuously high dividend growth. Dividend growth is roughly in line with EBIT growth.
3.) Costco is more capital efficient than its peers. The higher ROCE enables Costco to profitably reinvest its earnings into its own operations.
4) Costco can finance growth with virtually no debt and has ample financial flexibility for future expansion. Higher capital raising costs will have little impact.
In conclusion, I formulate my investment thesiswhich I regularly check for plausibility after the purchase: "Buy, Hold and Check" is the motto here. Only if one formulates this directly for the purchase, it can be checked later on the basis of facts whether our original thesis is still intact at the time of purchase.
My investment thesis at Costco is as follows:
1.) Customer loyalty: the memberships and consequently the number of customers continues to grow.
2) Capital efficiency: a ROCE of at least 20%. Ideally higher.
3) Dividend growth: dividend growth should average at least 8% per year.
4) Sales/profit growthBoth should grow at an average rate of about 8% per year so that dividend growth is covered by rising earnings.
I will review these 4 points at regular intervals after the purchase. If there is a bad business year, I will not throw everything overboard. What always remains important is the overall picture over a longer period of time. In this respect, the points individually are rather "soft" criteria. However, if all points point in the wrong direction, the investment thesis would no longer be intact and the business model assumed at the time of purchase would no longer work.
5) SUMMARY & OUTLOOK
We have now formulated an investment thesis step by step starting with the idea, analyzing the business model and analyzing the fundamentals. This summarizes for us in the form of criteria why we have invested in the company and is at the same time a guideline for the hoped-for future development of the company. The resulting "checklist" provides an exit criterion in case of doubt.
What is still missing here? The attentive reader will not have failed to notice that we have not yet discussed the price of a share at all. The company may be as great as it is, but at what price do I buy a share? That is a completely different topic than choosing the right company. If you are interested, I can prepare a post about that as well. I would also like to thank the readers who made it this far for their attentive reading. As always, questions and criticism are welcome.
#costco
#dividenden
#dividendenwachstum
SOURCES:
[1] https://www.eatthis.com/costco-shoppers-obsessed/
[2] https://www.huffpost.com/entry/12-costco-secrets-you-didnt-know-y_n_55e70a56e4b0c818f619dc20
[3] https://www.businessinsider.com/why-people-love-costco-and-kirkland-private-label-2019-9?op=1
[5] https://clark.com/family-lifestyle/costco-christmas-tree-return-january/
[6] https://www.mashed.com/158143/the-truth-about-costcos-really-low-prices/
[7] https://www.businessinsider.com/comparably-big-companies-with-the-happiest-employees?op=1
