My Entry Criteria

I haven’t previously discussed my entry criteria before on this blog. I wanted to put “pen to paper” on this one and officially publish what I look for before I enter in to a position. Every investor has a certain set of criteria that a stock must meet before he or she will enter in to a position. I’m no different in that respect, but my overall entry requirements aren’t really set in stone. Investing isn’t a science as much as it is an art form. Stock prices aren’t set by any kind of scientific measure and I don’t engage in buying stocks in such a manner either.

Basically, I have seven entry requirements.

P/E Ratio

I look for a stock to have a current P/E ratio below 20. I define current price-earnings ratios by the ttm (trailing twelve months) figures. Forward P/E ratios are also helpful, but of course future EPS figures can only be analyzed and guessed, as nobody can tell the future. This is one criteria that I’m pretty firm on. A P/E ratio higher than 20 likely means the stock is overpriced for some reason.

5-year growth of dividend

I am a little more lax than other investors when it comes to dividend growth. A lot of dividend growth investors require 10 years or more of dividend growth. I’m not that strict, as that would preclude a lot of great companies that have less than 10 years of growth, but have clearly shown shareholders a commitment to dividend growth. When I look at companies that have less than 10 years of dividend growth I’m a little stricter in other departments and I will research a little further to feel confident that continued growth of EPS and dividends can be sustained.

A wonderful product

This goes without saying. Any company I invest in must have a wonderful product that people either need, or want so badly that they are not willing to go without it. It should be a product that people loathe to go without. Once people drink a can of Coke and fall in love, it’s very hard to switch to store-brand cola products. Once you taste a Big Mac and love it, you are unlikely to stop buying Big Macs in the future. If you’re addicted to Marlboro’s, it’s likely that you are going to keep buying them…even if the price goes up. We all know of our dependence on oil. And this leads me to my next piece of criteria…

Pricing Power

Any company that produces a wonderful product naturally has a degree of pricing power. They have the ability to raise prices with inflation to keep margins healthy. If McDonald’s raises the price of a #1 meal tomorrow by five cents, that is probably going to have no effect on my decision to purchase that meal. I would think that most of the population would agree with me on that. Yet, that five cent increase means a big boost to margins for McDonald’s when you consider how many customers they serve worldwide on a daily basis.

Entry Yield

I am pretty strict with this one. I’m more strict with this one than other criteria. I will rarely invest in a company with an entry yield below 2.5%. I actually prefer an entry yield of 3% or higher, but there are many great companies that I’m interested in that currently have an entry yield below 3%, and I’m still interested in them. However, 2.5% entry yield is generally my absolute limit when I’m considering entering a position with a company. Any lower than that, and the price is either too high or the dividend growth must be lacking.There has to be an outstanding and exceptional reason for me to invest in a company with an entry yield below 2.5%, as it will take a long time to reach an acceptable YOC (yield-on-cost).

Payout Ratio

I generally like a company to have a payout ratio of 50% or less. I’m not super strict on this, and a lot of high-quality companies can ebb up and down and this number can vary quite a bit over a number of years. If a company continually pays out close to 80% or more of earnings, then that would probably be a signal for me to either stay away or look elsewhere for opportunities. In my personal portfolio, the exception for this is my investments in tobacco companies, which are well known to pay out a high amount of earnings due to a lack of need to reinvest capital. If a high payout ratio is continually sustained that could be a signal that the company is looking to cut the dividend or at least stop raising it to get it under control. A high payout ratio could also indicate that a company is having a hard time raising earnings. Either way, it tells me to look elsewhere.

Dividend Growth %

I generally like to see a 10-year dividend growth of at least 6% (annualized) before I’ll commit money to a position. I’m not extremely strict with this one and I will consider companies with slightly less growth, but not much. I prefer growth in the double digits when I can get it. For companies with less than 10 years of growth I shoot for a higher growth rate to compensate for the lack of record.

This is basically a list that I like to refer to, as I like to continually remind myself why I want to invest in a company. For my current portfolio, I like to review my holdings occasionally to make sure that these companies are staying true to the requirements I held when I first purchased.

What is your entry criteria?

Thanks for reading.

Comments

  1. says

    My entry criteria is very similar. For the P/E ratio I like to compare it to competitors to help determine valuation. I also like to use the 5 year dividend yield average to help determine value. If the yield is below it’s 5 year average then it can be considered undervalued.

    I’d just add income growth rate because I want to invest in a company that has a history of growing their net over the last 3 to 5 years.

  2. says

    DSO,

    I agree with you on income growth rate. I naturally look at EPS and revenue growth through the nature of rising dividends and flat payout ratios. Without rising EPS you can’t have those two. Generally, over any 5-year frame I like to see EPS growth outpace dividend growth by a safe margin.

    I also agree comparing the P/E (and price/book, price/sales) to industry competitors is always helpful. Morningstar has a great tool for that on their homepage that I use often.

    Thanks for stopping by!

  3. says

    I’ve been to quite a few other dividend investing sites, and yours is the first one that actually gave a valid reason for why you want a yield greater than ‘x’ amount; specifically the effect or reaching a decent yield on cost. Up till now I thought it was just an arbitrary number sites were throwing around.

  4. says

    Past Expiry,

    Thanks for stopping by and commenting. For me, reaching a yield-on-cost of 10% or higher is the ultimate goal. Once you get to double digits YOC, you are in cruise control.

  5. Joe says

    I like your investing criteria, but I’m personally stuck on the pricing power. To me, McDonalds doesn’t have pricing power because if their hamburgers get expensive, I’ll stop buying the product or go somewhere cheaper. Same thing with Walmart. There is an Aldi near me which has consistently cheaper prices so I no longer shop at Walmart unless Aldi doesn’t have it. This is one of the reasons I’m having a hard time finding companies to invest in. I don’t see moats where others do. Coke, Pepsi, Lays, McDonalds, etc, I don’t understand how they’re moats. I wonder if my cheapness and immunity to branding is clouding my investing judgement?

    • says

      Joe,

      I’m not quite sure I follow. Pricing power for Coca-Cola isn’t comparable to what you have with Walmart. Walmart is a low-cost provider. That’s their moat. They’re generally able to provide quality goods at lower prices than others due to their bargaining power. Getting into a Walmart is a massive advantage for many companies, especially compared to Aldi. So they’re able to negotiate lower prices, which is designed to increase traffic to their stores. I’m not sure how Walmart compares to Aldi because I don’t have any around here to compare to. I believe Aldi sells mostly store branded products, so I’m not sure if we’re comparing apples to apples. I can tell you that the Walmart near me is substantially cheaper than the other stores, like Publix, that are nearby.

      Coca-Cola’s pricing power is there because they provide a certain product with a certain taste. If you like Coca-Cola and want to continue drinking it (a lot of people do), then you’ll likely continue buying as the price increases. After all, you can’t get a bottle of Coke for 5 cents anymore, can you? Now, you can buy a 12-pack of Aldi cola or whatever for cheaper, but it’s not Coca-Cola. Whether or not that premium is worth the product is really a choice each consumer must make for themselves. However, there’s a reason why they are where they are.

      I hope that helps! :)

      Best regards.

  6. Joe says

    Wow, fast reply, especially for an article a couple years old, thanks! I’ve re-read your response and you’re right, maybe I’m not comparing apples to apples. I think you are saying that if I specifically want a bag of Doritos I can go to Albertsons, Publix, Safeway, or Walmart and Walmart will likely have the best price.

    What I meant was that I just want a great tasting chip for the least amount of money. Here is an example with Aldi. I just bought a 11 oz. bag of Clancy nacho chips for $1.19 (regular price, not sale price), which is the identical taste to a $3+ bag of Cool Ranch Doritos that sells at Walmart. Aldi items are typical of that, unknown brands of equal quality (in my opinion) to brand-name products but cheaper. I no longer go to Walmart for groceries unless it’s something Aldi doesn’t have, as do other people I know.

    I think I understand what you mean by big brands wanting to be in Walmart because they sell more, but even then, with Great Value brands next to many branded items, I don’t understand why people choose the more expensive option. With Coke, I love Coke, but to me if there’s a cheaper cola of comparable taste I just go for the cheaper option (I actually don’t know if Aldi carries a cheaper cola, I don’t drink soda much).

    “Whether or not that premium is worth the product is really a choice each consumer must make for themselves. However, there’s a reason why they are where they are.” I know you must be right, reality agrees with you. It’s just from a consumer perspective I don’t understand why people pay more for branded items (at least for groceries). Maybe I’m just a cheapskate with no taste ha ha! Oh, btw, I’m a fan of your articles. You’re one of the few financial writers that can make complex investing ideas easier to understand.

    • says

      Joe,

      I don’t think you’re crazy. I’ve read studies about how marketing can actually change people’s perception of reality, including their own taste for something. Now, if that is the case then you’ve got a further argument for a wide moat behind some of these brands.

      However, tastes are tastes. My girlfriend and I love this local little restaurant downtown here in Sarasota. No marketing. Just good food at a good price. Are there cheaper options? Yes. Are those cheaper options a better value? That’s subjective, but we don’t think so. There’s an opportunity cost with everything in life, food included. So every meal we eat at a different place where the food costs slightly less but we think tastes noticeably worse is a meal we’ll never have back.

      As far as chips go, I can tell you this. Ever since I stumbled upon the Tostitos Cantina Thin & Crispy chips, no other tortilla chip tastes the same. It’s worth it to me to eat a great tortilla chip. I’m frugal, and I don’t spend a lot on food. So I’m willing to splurge when it comes time for certain foods.

      Just my $0.02. Anecdotes are just that, and everyone’s experience will vary. But world-class brands become world class because they offer something people want at a price/value/taste/experience proposition that others can’t really match. That creates pricing power which begets further profits and more success.

      Appreciate the support! :)

      Best regards.

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