Reading time: approx. 15min
Lately I have been reading questions about which criteria are particularly important when selecting dividend stocks. The question "Which dividend stocks are worth buying?" is also a somewhat less specific one. Of course, this can never be answered in general terms. Every potential purchase of a share involves intensive research, a personal investment strategy and your own investment horizon. Since both the investment strategy and the investment horizon are individual, I focus on the research before the purchase. This post should serve as a guide for you. Of course, this is initially completely subjective and tailored to my investment strategy and investment horizon, but with a little abstraction it can also be generalized to your needs.
1) THE IDEA
A potential share purchase starts with an idea. This is probably the part that can be handled the least "algorithmically", because it requires creativity, attention in everyday life or possible specialized knowledge about a "hidden champion" in an industry. As a result, I can only advise you to go through your everyday life with your eyes open. 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 free rein to your creativity to come up with possible exciting companies. Very few of these ideas will be so exciting that you end up investing in them. It's more about building up a pool of ideas so that you can invest in the most promising companies after a detailed analysis.
How did I come across Costco $COST (+0,3 %) come about? It was a combination of small things: while researching dividend stocks in the retail sector, I first came across Walmart $WMT (+0 %) and Target $TGT (+0,63 %). I didn't look at them too closely, but I put them on my watchlist as a precaution so that I could take a closer look at them later.
A few days later I saw that Walmart and Target were deeply in the red and I wondered why both were falling rapidly at the same time. Then I read a small news article which said that one of the two had published poor quarterly figures and that the whole retail sector was sliding into the red. Among other things, the article mentioned a retailer called Costco Wholesale and a few others that were now facing hard times. I had only been vaguely aware of Costco and decided to take a closer look. Among all the other retailers, Costco piqued my interest mainly because it still seemed absurdly expensive with a P/E ratio of over 30, despite the high loss on that day.
2) UNDERSTANDING THE BUSINESS MODEL & RECOGNIZING THE COMPETITION
OK, so we have an idea: Costco Wholesale it should be. The idea is there, but what exactly do I do now?
In the next step, I always take a close look at the company's business model and competition. 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 people seem to be negligent. Costco is a supermarket chain, right? So they buy their goods from the producers, put a solid margin on top and then sell them en masse in their own stores. That's it. So why bother with the business model when I already understood it?
As always, the devil is in the detail. Costco sells goods in its own department stores, of course, but there are also many other things that are particularly interesting and in which they stand out from the competition. The starting point for my research is simple Google searches of the form "Why do 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]. The quintessence of my research is as follows:
1) Retail As A Service! Before you can shop in the Costco stores, you have to take out a membership. This currently costs $60 in the cheapest version and $120 per year in the premium version and is renewed by around 91% of existing members [4]. New members are added every year, so that the number of members grows by around 5-7% each year. With the Premium membership, you also receive a 2% cashback reward for purchases at Costco and are rewarded for buying more at Costco.
2) The customer is king! It is mentioned again and again that Costco employees are considered to be particularly friendly. This may be self-evident, but we all know stores where customers tend to be treated rudely or dismissively. There is also a one hundred percent money-back guarantee that keeps its promises. For example, a woman who brought her Christmas tree, which she had bought at Costco, dried out to a Costco store in January and got her money back without any problems made headlines [5]. There are similar reports about worn tires or used food packages. In all cases, the goods were taken back and the customers got their money back. Of course, word gets around and gives customers the feeling that they can buy something if they are unsure whether they will be satisfied with the product they have bought. If in doubt, they can simply return it. The fact that this rarely happens on the customer side is of course planned by Costco.
3) Unbeatably cheap! Costco buys its goods in huge quantities and thus receives large discounts. These favorable purchase prices are deliberately passed on to 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 customer. As a result, customers know that they will most likely not be able to shop anywhere cheaper than at Costco. The low price is also achieved through larger containers and the low-cost private label "Kirkland". In addition, Costco relies on a rather reduced range with "only" 4,000 products, whereas Walmart has over 142,000 different products in its range [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, as employee acquisition and unfilled vacancies also cost a lot of money. This is why Costco is consistently among the highest 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 in which access to a unique range of products is granted at particularly 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 also ensures customer loyalty and predictable, growing cash flows. Thanks to low margins on the sale of goods and other clever means, Costco is usually the cheapest supermarket despite its well-paid employees and thus attracts many new customers.
This sets Costco apart from the competition. Speaking of the competition: this is relatively easy to research, as it involves well-known retail giants such as the aforementioned Walmart $WMT (+0 %) and Target $TGT (+0,63 %)but also Kroger $KR (-0,07 %) and Dollar General $DG (+0 %). A closer look at the business models of the competition should also be taken, 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 & CHECK KEY FIGURES
We now think we have understood the business model and recognized what differentiates Costco from the competition. Admittedly, all of the previous points are rather subjective. So it's time to look at the hard facts. After all, if Costco is really doing so many things better, this must be reflected in various key figures.
Of course, the right choice of metrics depends on the type of company and personal strategy. Personally, I mainly focus on companies that pay solid dividends over a long period of time and have above-average dividend growth. In addition, there should be stable sales and profit growth so that you can afford the continuously rising dividends. The business model should be as crisis-proof and non-cyclical as possible and the income generated should be able to be reinvested profitably in the company.
These requirements lead me to the following selection of fundamental data:
- Sales and profit growth
- Dividend history and dividend growth
- ROCE
- Payout ratio dividend / free cash flow
- Lowest possible debt
Now let's work through all the key figures in sequence. I always make industry-specific comparisons and compare Costco's figures with those of its competitors Walmart and Target. All figures required for the calculation were taken from [8].
Sales growth
Sales growth over the last 5 years totaled
Costco 63.2% | Walmart 19.9% | Target 49.4%
This corresponds to a compound annual growth rate (CAGR) of
Costco 10.3% | Walmart 3.7% | Target 8.4%
Costco and Target sales are growing the most, with Costco growing the fastest. At around 10% per year, this is also impressive across all sectors.
Profit growth
EBIT growth over the last 5 years has totaled
Costco 72.6% | Walmart 14.9% | Target 11.6%
This corresponds to average annual EBIT growth (CAGR) of
Costco 11.5% | Walmart 2.8% | Target 2.2%
Costco is also ahead here, and quite clearly so. Apparently, Walmart and Target are able to increase their sales, but 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 has increased it every year so far. The current dividend yield is 0.72% and the annual dividend growth over the last 5 years is 12.4%, and 12.6% over the last 10 years. In addition, high special dividends are paid to shareholders at irregular intervals.
Walmart has been paying a dividend for 49 years, which has been increased every year so far. The current dividend yield is 1.53% and the annual dividend growth over the last 5 years is 1.89%, and 3.56% over the last 10 years.
Target has been paying a dividend for 54 years, which has been increased every year. The current dividend yield is 2.49%. Annual dividend growth over the last 5 years has been 10.2%, and 11.6% over the last 10 years.
Of course, Target and Walmart score points here with their very long and impeccable dividend history. However, I have nothing to criticize about Costco's dividend history either, because like the other two, the dividend has been increased every year since its introduction. In terms of current dividend yield, Target is ahead of Walmart, with Costco in last place. However, I don't attach too much importance to this point as my personal focus is more on dividend growth. I prefer a fast dividend growth as I can benefit more from it in the future. In this respect, Costco shows stable dividend growth of around 12.5% annually. Target is almost as good here, with only Walmart falling slightly behind with its meagre dividend growth.
ROCE
The ROCE - i.e. Return on Capital Employed - is a measure (in %) of the efficiency of the capital employed for business activities. A high ROCE indicates that the income generated can be profitably reinvested in business activities. It has become an indispensable key figure 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 lower than the company's own cost of capital.
For a detailed definition and interpretation of ROCE, I refer you to a post I recently wrote -> https://app.getquin.com/activity/FLcMGnxVnO?lang=de&utm_source=sharing. Simply and briefly summarized: the higher the ROCE, the better.
The average ROCE over the last 6 years is
Costco: 22.1% | Walmart: 15.9% | Target: 19.1%
Target is still close to Costco, but Walmart is already significantly worse than Costco. True to the common interpretation of ROCE, Costco has the most capital-efficient business model of the three companies. Together with Costco's high EBIT growth, the high ROCE becomes doubly interesting: ever higher earnings can be efficiently reinvested in business activities and thus enable increasing earnings in the future.
Payout ratio dividend / free cash flow
Costco currently pays out around 21% of its free cash flow in dividends to shareholders. This figure is 23.5% for Walmart and 33.7% for Target. This means that dividend payments at all three companies are reliably covered by the cash flow generated. This leaves enough cash flow for investments in business activities.
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 free cash flow. This already excludes all companies with negative free cash flow. 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 is possible that this is a one-off effect and that things will normalize again afterwards. If not, a dividend cut could soon be on the cards as dividends could soon no longer be covered by cash flow. The situation is somewhat different with REITs in particular, as they are obliged by tax law to have high payout ratios. In this respect, my limits are different for REITs.
Debt and cash
It is not only since the rise in interest rates - but now all the more so - that attention should be paid to companies' long-term debt. Excessive debt results in a high interest burden, which can have a negative impact on future earnings and potential investments in business activities. Rising refinancing costs in particular then create 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. In the worst case, the debt can be paid out of the company's earnings within three years (exceptions also apply here for REITs, as the business model of REITs is based on taking on debt to finance real estate).
Costco has almost twice as much cash reserves as it has long-term debt. Theoretically, they could pay off all their debts immediately and still have cash reserves left over. The debt to EBIT ratio is also particularly low at 0.8, as all debts could be paid off within one year from the profit from operations.
Walmart has around three times as much debt as cash reserves. This means that around a third of the debt could be paid off from the available cash. At 1.5, the ratio of debt to EBIT is in order and 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. Debt is about three times EBIT, so Target would need about 3 fiscal years to pay debt out of earnings.
All three are not overindebted, but Costco scores again with such a low level of debt that all debts could be paid directly. The existing cash reserves are also an advantage if larger investments are required in the future. Nevertheless, it should not go unmentioned that both Walmart and Target are not overly indebted.
4) INVESTMENT THESIS
If we now summarize the analysis of the business model and the fundamental data, a coherent and clear picture emerges for me:
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) The dividend payments are securely covered by free cash flow and there is consistently high dividend growth. Dividend growth roughly corresponds to EBIT growth.
3) Costco is more capital efficient than the competition. The higher ROCE enables Costco to reinvest its earnings profitably in its own business activities.
4) Costco can finance its growth almost without debt and has a large financial scope for future expansion. Higher capital procurement costs will have hardly any 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 you formulate this directly at the time of purchase can it be checked later on the basis of facts whether our original thesis is still intact at the time of purchase.
My investment thesis for Costco is as follows:
1.) Customer loyalty: Memberships and thus the number of customers continue 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 around 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 financial year, I will not throw everything overboard. The overall picture over a longer period of time is always important. In this respect, the points individually are rather "soft" criteria. However, if all the 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 fundamental data. This summarizes in the form of criteria why we have invested in the company and is at the same time a guideline for the expected 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 have noticed that we have not yet discussed the price of a share. The company may be great as it is, but at what price do I buy a share? This is a completely different topic from choosing the right company. If you are interested, I can also prepare a post on this topic. I would also like to thank the readers who have 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
