How it’s made: Dividend Edition

How it’s made: Dividend Edition

Over 18 years and 416 episodes, the hit TV show “How it’s made” took viewers into the manufacturing facilities of the world’s most popular goods from Aluminum Foil to Crayons. In this quarter’s letter, we’ve attempted to do the same for the process we follow in our Dividend Growth strategies; providing an in-depth look at the people, process, and decisions that comprise the investments we manage on your behalf.

Popular Products and New Business Lines

Within an individual business, an executive is usually tasked with both evaluating the current set of products as well as considering what new product lines would add value to their existing mix. Much the same, we look at our strategies through two lenses: our current companies and potential new additions; each with their own unique points of analysis.

For our current holdings, we focus on confirming our companies are performing in a way that’s consistent with generating durable long-term dividend growth. The most important way we do this is through participating in the quarterly earnings calls of our strategy companies. As of this writing there are 86 companies that we follow each quarter (344 per year!). Dr. Lyle Bowlin leads this process for our Investment Committee and generates hundreds of pages of research and commentary each quarter; summarized on a weekly basis with our entire investment committee. The second way we evaluate our current holdings is through ongoing quantitative screening; looking at several metrics including:

1. Revenue Growth
2. Current Dividend Yield
3. Dividend growth rate
4. Dividend payout ratio
5. Company priorities in reinvesting profits

To boil this large amount of data down into an actionable conclusion, there are two items we look the closest at:

First, for each earnings report, Dr. Bowlin provides the investment committee with a “So What” conclusion on the report with a color code matching a stop light… Green means all systems are go. Yellow means likely a miss on sales or profits or items to monitor moving ahead, and Red means a report that stands in opposition to the reason we bought & own the stock.

The final piece of the quarterly process is to update our numbers in our fair value analysis and compare the company’s stock price to our opinion of its value. Once again, we apply a stoplight system of “Cheap” (green) “Fair” (Yellow) and “Expensive” (Red). With each report and quarter we finally consider whether any of our “Red” stocks should be candidates for removal, and if any of our “Green” stocks should be added to.

Fresh Ideas

The reality of the life cycle of businesses means that over time the outlook for some of our holdings will weaken. Just as important as exiting a weak position is how we reinvest dollars when changes are made. Importantly, our process of idea generation is never-ending; regardless of whether we expect to sell a position or not.

Our process begins by performing a series of screens on a large set of over 3,200 companies, providing us with a baseline list of companies that meet our screening criteria including:

• Companies domiciled or with their principal operation in the US
• Market Cap over $2 Billion
• Daily Trading Volume sufficient to buy or sell a stock without moving the market
• Long-Term track record of paying or growing dividends (length dependent on the specific dividend strategy)

In addition to evaluating common items such as a company’s sector and industry, we also place stocks into one of four buckets. Specific to each of our strategies, we will add additional screens for revenue growth, profitability, dividend yield, and stock price performance to group companies in one of the four following ways:

1. “Growth Engines” – Low current yield, high potential dividend growth
2. “Steady Eddies” – mature businesses with fairly consistent growth and average dividend yields
3. “Accidental High Yielders” – Companies that due to stock price decline are paying higher than average yields.
4. “Cash Flow Kings” – Companies with low growth prospects but high dividend yields.

As of this writing, our initial screens filter our overall universe from 3,200 companies to 69 Large Cap stocks (above $30 Billion Market Cap) and 109 Small & Mid Cap Stocks ($2 to $30 Billion). After refining our starting list by over 94%(!) we sort them according to the groups outlined above and start our research process.

Our next step is to filter out businesses that don’t match our requirements for industry quality and stability. It is during this step, businesses like Coal Producers, Investment Banking Firms, and Homebuilders are removed from consideration.

Once we’ve determined the list of companies for our research project, we work to answer the following questions about each:

• Does the company have a business model that is proven and repeatable?
• Are the goods and services this company provides differentiated in the marketplace?
• Is the balance sheet of the company strong enough to withstand an economic recession with a low probability of cutting their dividend?
• Is management highly committed to the dividend and/or growing it?

If a company passes our scrutiny through all of these steps we will make a formal determination if the stock possesses the merits of being on our “Go-List” for the strategies.

Go Time!

While the companies resulting from this rigorous research process we feel are quality enough to own in the strategies, unfortunately we don’t get to choose the price each company’s shares trade at. So, our final step is to value the company and determine at what price we would be willing to buy shares in one of our Dividend Strategies. Fair Value is as much art as it is science, but at the end of the day the two most important inputs to the model are what our opinion is of the current profitability for the business, and how quickly we expect it to grow in the future. While somewhat oversimplified, taking these inputs and incorporating the current market interest rates allows us to assign a fair value to what we think the stock *should* be trading for.

After applying a discount to fair value that incorporates the risks we may have erred in our analysis, a formal buy price for one of our watch list stocks is set.

Being Nimble in a fast-paced world:

Heavyweight Boxing champion Mike Tyson has a famous quote “Everyone has a plan until they get punched in the face”. Open each day from 9:30 to 4:00, the stock market is an unrelenting mechanism of pricing the outlook for companies. As a result, while we are long-term investors, we’ve built a process designed to be dynamic. Our goal is to add value to our long-term strategy returns by trimming our positions when market prices are rich and by adding to or initiating positions when prices are on sale. Sometimes, this means targeting specific sectors to add to, and others (including recently) it means letting dividends accumulate for a more opportune time to invest.

Stocks & Football

I wanted to close this quarter’s note by articulating how we define success for the strategies that we manage. To do this, I point readers to one of the most competitive professions: College Football. If you were to ask Kirby Smart, the head football coach at the University of Georgia, what defines success, he wouldn’t say winning an SEC or College Football Playoff Championship. He would (and does) say instead his goal is to have his team and players perform at the highest level possible. Extending a step further, those that are truly successful in the profession are rarely those that define their focus by an end result. Instead it’s the process that coaches obsesses over; each day trying to refine the process 1% better. Compounded over decades, this relentless focus on the process is what creates success.

While we have targets for our strategies including dividend growth and performance relative to benchmarks, as well as targets for our business like Assets Under Management, our goal is to constantly refine our process; giving us the best opportunity to meet your goals and objectives. It is to this end that we work.

May 2023