Our Model Portfolio contains companies that have attained a status referred to as an SDG. But what is that? How does a company attain such a status?
An SDG is a company that pays a dividend which increases, on average, at the rate of 8%-10% per year for many years. Such companies are usually large, successful, growing multi-national companies that are at the top of their peer groups, have a global footprint, and are in expanding areas of economic activity.
They also have a long and continuous history of excess free cash flow and a corporate investment policy that involves a commitment to increasing the dividend by 8%-10% per year, every year.
The simple notion would be to put a group of such companies into a portfolio, and begin living off of the growing income stream generated.
All that would be required is that such companies really do exist, and they are relatively easy to identify. But such is not the case.
First, there is a strong argument that “pure” SDGs do not really exist.
Secondly, even if some companies come close, there is no acceptable valid way to select just those companies that possess the “correct” characteristics.
We have spent many years trying to identify metrics that would describe companies that would qualify for SDG status. The companies that are currently in the Model Portfolio come closest to being an SDG.
Each company attains SDG status to varying degrees. Also, some companies that may not be the “best” SDGs, are in the portfolio because of diversification efforts and concomitant risk reduction efforts.
The result of years of research has led to the conclusion that the perfect SDG, indeed, does not exist. But some companies come close, and a group of such companies can provide a reliable, growing income stream.
The current specific criteria for selecting and judging companies are subject to further research and development. This effort seeks to find metrics that are more closely related to long-term dividend increases at the 8%-10% level.
All investors should remember that identifying companies that satisfy SDG criteria is not based on any replicated, accepted scientific basis.
There are hundreds of stock selection strategies whose goal is to create safe growing income streams, other than our strategy. The criteria and statistics that we currently use are probably not the best.
However, given the lack of empirical, well-accepted strategies, we use the actual income growth of various portfolios to gauge how well our current strategy is working. We provide such data in the Income Performance Chart for our Model Portfolio.
Characteristics of SDGs:
Below is a list of the major characteristics of an SDG. This listing is a more detailed statement regarding our discussion of what an SDG might be.
Each of these eight characteristics of will be discussed in future posts and will be linkable here as they become available.
- It pays a dividend that has an extensive, consistent history of a CAGR of 8%-10% per year.
- It is successful and growing.
- It has an extensive, established global footprint, and is therefore probably very large.
- It operates in an expanding area of economic activity.
- It has lots of extra money (excess free cash flow), and has had this feature for some time.
- It is at the top of its sector or peer group with respect to market share for most of its products.
- It is committed to an active cash management philosophy that can maintain dividend growth during both good times and bad, and its history reflects this.
- It is doing things that are very similar to what it did five years, or even 10 years, ago.
Preconditions for Portfolio Status
There are SDGs that (adequately) meet all eight of these characteristics, but they will not be placed in the portfolio for either, or both, of the following two reasons.
Either it does not meet the precondition for an “adequate” current yield, or because it is currently valued at a significant premium to its historical/average levels.
It is highly preferable that a SDG have a current yield (yearly dividend/current price) equal to or greater than the 10 year average of CPI-based inflation rate (about 2.69% in early 2013).
There are many dividend growers that do not meet this precondition, and they can be put on a wait list until the current yield approaches this level.
Another precondition has to do with valuation or how pricey a company may be in the current market.
We use a “relative valuation method” by looking at the current Price/Earnings (P/E) ratio, compared to its history for that company, using historical charts such as those at www.bigcharts.marketwatch.com.
How to use this website, and rules for comparing P/Es, are given in this article.
In summary, a company must have the above eight characteristics and meet the two preconditions before it can be placed in the portfolio. Some times we stretch these requirements for what are considered to be good reasons at the time.
Measurement Issues for SDGs:
- How can each of these eight characteristics be evaluated?
- How close to these criteria does a company have to be in order to be granted SDG status?
- Is there a reliable data source that can be used for one or more of these characteristics?
- Can the SDG status of a company be “ranked” or compared to the SDG status of another company?
- For example, would Colgate-Palmolive have a higher SDG status than Proctor & Gamble? Over what time frame? How can * this be answered in some valid manner? How important is a particular characteristic?
- These are all questions that will try to be answered in future posts, as each of the characteristics are discussed in more
detail. It should be clearly noted that we do not have all of the answers to all of these questions.
Some assessments are dependent on corporate cultures, which are always changing. Some answers are dependent on the state of academic research, especially those questions that surround corporate policy making and corporate financial strategies. Still other answers depend on reliable data sources, which sometimes are difficult to discover.
In spite of these difficulties, for each characteristic of an SDG, the discussion will focus on what data is relevant, where are the reliable data sources, what statistical measures are meaningful, what macroeconomic factors are currently being used and why, and finally the development of various scoring algorithms that might be used to rank companies with respect to their SDG status.
There is always an emphasis on the most easily available data, given that it is reliable. For different measures of financial metrics, there is an equal emphasis on simplicity and easily calculated measures.
In some cases, of course, easily available data and simple calculations are not sufficient or they do not exist.
For statistical measures and various scoring algorithms, the simplest and easiest to calculate will always be preferred, so long as they are robust and reflect the feature of interest.
Thanks for reading! See this post on our blog.
An SDG is a company that pays a dividend which increases, on average, at the rate of 8%-10% per year for many years.
I have a question. How do you protect your portfolio In the event of a company that fulfills this condition but is an unknown fraud (I am thinking Enron) Would your models have picked up on the problem? I know a lot of people that bought into its amazing and fake numbers.
The reason I am asking is most frauds post excellent fake numbers and my number one priority in investing is to avoid fraud. Thanks
Thanks for answering! To answer your question: I would imagine that the deep dive required when digging into a company's financials and determining whether or not it is an SDG would also reveal any fraudulent activities. Also keep in mind that SDGs are the largest and most well-known companies in the world. They are regularly recognized brands and they are in a variety of sectors. Even if a company was ever revealed to be fraudulent, the portfolio would have so many diverse holdings that the 1 case of fraudulence wouldn't have a very significant impact. Hope that answers your question! Thanks for asking it!
Diversification is the only free lunch in investing they say : ) I completely agree that any investment requires a deep dive, that's why I only own 3 crypto's, I won't invest until I understand them and I am a slow learner!
Understanding and patience are key! Keep at it my friend!
Interesting question that I wanted to ask as well.
My personal view is to invest in well-regulated markets only, plus to invest in what I know well. Shops that I see on the street, brands that I buy, etc. Feels less dodgy than buying something I virtually know anything at all.
Curious to know what others think.
Exactly right. as I mentioned in my response, the companies that qualify as SDGs are well-known and well-respected - the largest in their respected industries and operating under very strict financial laws regarding information. Even still, our portfolio is very well-diversified over a variety of sectors and 1 outlier event wouldn't have much of an impact.
I agree that using a product is an amazing way to gauge an investment. I just avoid companies that make a good product but burn cash like its going out of fashion (thinking Tesla) By only investing in companies that are paying dividends then you can completely avoid cash burners
Exactly, companies who pay growing dividends over long-periods of time are those who have great cash flow management and are not going anywhere anytime soon.
I am a fan of Warren Buffet. Would Berkshire Hathaway be in this category of SDG? The company seems to have growing rates beyond any company I seen and they continuously rise steadily. I do not own any of their shares so I do not know if they payout dividends but I think they do not pay any. Instead Buffet pulls the money earned and invest on buying out well to do companies. With the share prices rising due to the successful buyouts I think this inherently is a dividend built into the investment.
Often times when people talk about dividend they think of money they take out but I think there are other ways to equate dividends. Thanks.
You are right. I own a really tiny portion of Berkshire shares (BRK.B of course, A is beyond my financial capability at this moment) and they do not pay dividends. You are also correct that they use this money to reinvest elsewhere, which in turn drives company growth.
Dividend payment and retention are two extremes - if you pay all of your earnings and keep none then you have no potential to growth (well, unless you finance elsewhere, which is another story then). It is always about striving a good balance.
But one thing to keep in mind is the cash flow! This cash flow due to dividend is so, so important for many dividend investors! Yes, some good companies are keeping money in their pockets for growth. But don’t forget many of them rely on dividend paying stocks to generate monthly incomes! Think of the retirees, for instance.
It’s just best of both worlds. :)
I agree! Cash flow is also a very important metric when it comes to measuring the potential viability of an SDG candidate.
You are correct, Berkshire Hathaway doesn't pay a dividend because Buffet believes that it is in the shareholders interest for profits to be reinvested. Therefore, Berkshire does not qualify as an SDG. Whenever we speak of "growth" we're referring to growth in dividend income. Thus, an 8-10% increase in income over long-periods of time is the key to long-term wealth creation and actually how Warren Buffet has built his empire. Thanks for sharing your thoughtful comment!
This article has provided a very decent and comprehensive summary. It is also worthwhile to mention Buffet prefers buying back of shares over dividend, and the article has explained why.
http://www.businessinsider.com/warren-buffett-on-dividends-2013-3
Thanks for sharing that, I'll check it out!
The answer is a company that pays a dividend which increases, on average, at the rate of 8%-10% per year for many years.
Great job! Thanks for answering!
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Thanks for reading my friend!
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