Criteria Related to Stock Trading
- Spread out stock purchases over time. The aim is to complete at least one purchase per month to avoid investing too heavily at this point in time, especially now when the stock market is at an all time high.
- As long as a company's earnings potential doesn't change considerably and there is no better alternative I don't sell. I have found it difficult to stick to this in the past and sold off shares way too early to make a quick profit.
- Carry out as few transactions as possible to keep down costs associated with buying and selling stocks.
- I will not try to predict where the macro economy is heading or try to "time" the market. I don't consider myself competent enough to predict future market trends and act upon them. If there is a significant drop in the global markets I will however intensify my buying habits.
- I want the number of stocks I own to be between 14-20 since I don't feel I have the competence to pick only one or two winners and keep them for the long haul. At the same time I don't feel I have the time to follow more than 20 companies no matter how stable of business they have.
- No single company should represent more than 15% of the stock portfolio, or less than 5%.
- At the most I want 75% of my total capital invested in the stock market at one particular time. The reason for this is that I want to have money laying around to cover unforeseen events or if the markets suddenly start to drop.
- Shares listed in a individual country's currency should not exceed 50% of the stock portfolio.
- Sectors such as finance, IT and commodities should not represent more than 20% of the portfolio each. Other industries may each represent not more than 40% of the stock portfolio.
I have divided the criteria associated with stock picking into three categories - quantitavie criteria, qualitative criteria and valuation criteria.
Quantitative Criteria
A Dividend That Has On Average Risen Over The Period of 10 Years.
The reason I opted for a 10-year period is that I want to get the whole business cycle in my assessment. Dividend growth may vary from year to year, but the important thing is that the dividend has increased on average over the period.
Rising Earnings Per Share (EPS), That Have Grown on Average at Least in Line with the Dividend for 10 Years.
Unless EPS grows at least at the same rate as the dividend, the dividend growth will have to slow down sooner or later, or even worse altogether stop.
A Company With Financial Strength
An equity ratio of more than 40% over the entire 10-year period. This to ensure my self of that the profit growth is not being facilitated at the expense of higher leverage. The reason why I only defined a lower limit is because what constitutes an optimal equity ratio differs between industries. Businesses in for the example the retail industry often have large accounts payable, real estate businesses in turn often have large investment needs and borrow with real estate as collateral. In both cases, the equity ratio will tend to be in the lower range.
I want to the current assets to be twice as large as current liabilities and cover total liabilities.
An interest coverage ratio above 500%. The intrest coverage ratio tells us the number of times the profit covers the financial expenses that a company has. This measure provides an indication about whether a company has taken on too much debt and how resilient the business is the interest rate increases.
The percentage of goodwill corresponds to no more than 50% of shareholders equity. Goodwill arises when a company buys another company at a higher price than the book value of the company's equity. Goodwill often consists of the value of trademarks and other intellectual assets like know how. Valuation of Goodwill is often based on subjective assumptions about growth and profitability in connection with acquisitions. The risk with goodwill is that it can be written down a few years after buying and charged profits while eroding the equity.
The free cash flow should ideally cover the dividend. Free cash flow is simply put the money that is left over after the company spent the cash needed to conduct daily operations and to generate returns through investment. Free cash flow is an important parameter for us dividend investors because it shows how much cash available from operations for distribution. Free cash flow may vary, but the important thing is that the free cash flow generally cover the dividend.
Qualitative Criteria
A Diversified Business
Companies with diversified areas of business are generally less vulnerable than companies that rely heavily on single business area. On the other hand if a company has too many business areas management run the risk of losing focus of what is important. As a rule I'd rather own a company with multiple sources of profit than one that depends on a single business area it's profits, all things equal.
Strong Owners
I'd like to se a business that I own to have strong owner behind it with financial muscle. I usually prefer a company that is family owned, since you tend to take better care of things close to home.
Risks And Uncertainties That May Affect Future Earnings
I want to assure myself that political, regulatory, business and other specific risks that may affect a company's future earnings are as few as possible and preferably manageable.
Distinct Competitive Advantage (Moat)
A company that has a clear competitive advantage will in general have more sustainable earnings than a company with out the same competitive strengths.
A Business That Is Easy To Understand
If I understand the business the likelihood increases that I can determine whether or not the company will be successful in the future or not. The risk of investing in value traps is reduced also reduced.
A Truly Global business
Besides the fact that a multinational company ins't dependent on a single market, the currency risk significantly is reduced if the business operates on a global stage. For example, should the dollar lose value, revenues from other regions to compensate for global players like McDonald's and Coca Cola.
Valuation Criteria
The following criteria will be used to get a sense of a particular company's valuation.
Fair Price 1 - Based on the Current Yield and the Expected Dividend Growth
I look at how the dividend growth has developed on average annually over the past ten years, which gives me a benchmark to work from. Based on the historical dividend growth together with my other investment criteria I make an estimate of how high dividend growth I can expect in the coming 20 years.
I use the table below to determine the yield that my estimated dividend growth requires of a potential investment.
| Yield Today | Yearly Dividend Growth Over a Period of 20 Years |
| 0,5 % | 28 % |
| 1 % | 22 % |
| 1,5 % | 17 % |
| 2 % | 16 % |
| 2,5 % | 14 % |
| 3 % | 12,5 % |
| 3,5 % | 11 % |
| 4 % | 10 % |
| 4,5 % | 9 % |
| 5 % | 8 % |
| 5,5 % | 7 % |
| 6 % | 6 % |
| 6,5 % | 5 % |
| 7 % | 4,3 % |
| 7,5 % | 3,5 % |
| 8 % | 3 % |
| 8,5 % | 2,5 % |
| 9 % | 1,5 % |
| 9,5 % | 1 % |
| 10 % | 0,5 % |
| 10,5 % or more |
No growth is need
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While the dividend level today and dividend growth is central to our strategy, we also need to look at sustainable earnings per share and P/E ratio to hopefully make a more balanced judgment about the stocks fair price.
Fair Price 2 - Based on Sustainable Earnings Per Share (EPS) and P/E ratio.
Sustainable EPS consists of an estimate of what I consider to be a sustainable level of earnings per share. I look at how earnings per share have developed historically which gives me a benchmark to work from. Based on the historical EPS data together with my other investment criteria I then determine what I think is a sustainable level of EPS is in the long run.
Sustainable P/E ratio an estimate of what I consider to be a sustainable level in the long run for the company in question. That which determines what I consider to be a sustainable P/E ratio is how well the company responds to my company specific criteria such as the strength of the balance sheet, competitive advantages, future EPS growth, risks associated with the Company's business, etc.
When I have determined sustainable EPS and sustainable P/E ratio I multiply them and get what I call Fair Price 2.
Price Cap (Mean of Fair Price 1 & 2)
The Price Cap constitutes the price I'm willing to pay at the most for a given stock. The price is the average value obtained when Fair Price 1 (based on dividend growth and dividend yield) and Fair Price 2 (based on sustainable EPS and Sustainable P/E ratio) are compared.
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