Wednesday, March 19, 2014

Analyzing Dividend Stocks with Vitaliy Katsenelson's Quality, Valuation, Growth Framework

Vitaliy Katsenelson has written two books,  that cover a similar theme: how to deal with flat, range bound markets that sort meander around nowhere in particular. The first is called Active Value Investing and the follow up The Little Book of Sideways Markets.

The author has a knack for illustrating concepts with examples such as using Tevye the milkman to look at how to value a business. Vitaliy Katsenelson is a very good writer, but what appeals to me the most is the clarity of his thought in developing frameworks for how to think about investing. Like a chess teacher explaining big picture strategy (opening, middle game, end game) and connecting them to little picture tactics (forks, pins), the clarity Active Value Investing comes in how the author distills investing strategy into an overall strategic framework and then illustrates how to analyze each area. So its a mix of top down and bottom up.

The main framework that he uses is called QVG - Quality, Valuation, Growth. The basic idea is to use these three factors to manage the effects of range bound markets - avoiding P/E compression and so on.

I think the basic components in the QVG framework are useful beyond value investing, they serve well in analyzing dividend stocks, too. In fact, one the themes of the books is on the role of dividends in range bound markets.

In terms of the value of dividends, the Active Value Investing book shows some compelling data on the source of total returns and the role that dividends play.

Source of Total Returns for S&P 500 from 1/31/1900-12/31/2000

  • Price: 4.6%
  • Dividends: 5.5%
  • Total Return: 10.4%
  • % of Total Return from Dividends: 45%
Those numbers highlight the importance of dividends in long term investing. Now let's look at QVG framework as an analytical tool for how it can inform selecting better dividend stocks.

The overall approach in range bound markets in Katsenelson's view, which I agree with, is to remain defensive. Losses always hurt, but in a bull market you can make it back in theory. In a range bound market, a loss can really gut your returns. To protect against losses, Katsenelson factors in three adjustments:
  1. Increasing the required margin of safety
  2. Increasing earnings (cash flows) growth rates
  3. Increasing dividend yield requirements for stocks in the portfolio
The analytics used in QVG are defensive in nature. Some of them apply directly to dividends, others indirectly, and the overall approach dovetails quite nicely with analysis a dividend investor needs to do. Let's dive in.

For Katsenelson, quality begins with having a moat - a long term competitive advantage. He discusses many of the major types and why they matter. That's probably the biggest factor, its qualitative though, what about quantitative factors? In terms of quality metrics: 
  • Predictable earnings - look for companies with recurring revenues. A great example is Becton Dickenson, even in 2008 hospitals didn't reuse syringes! Use, throw away, reorder. Rinse, repeat - that's recurring revenue. 
  • Strong balance sheet - Katsenelson makes allowances for companies to have debt assuming they can afford it - meaning stable earnings and cash flow with high return on capital. He does not discuss Clorox but that seems to me to be a good example of a company high debt that meets the other requirements. Otherwise, seek to avoid companies that have the combination of high debt and volatile cash flows.
  • Free Cash Flow  - here we come to the single most important metric for dividend investors. Katsenelson describes other benefits of FCF - ability to weather economic storms, not relying on outside financing for operations, and relatively low capital intensive. The main thing for dividend investors to add to QVG is the FCF Cover for the dividend
  • Return on Capital - high return on capital is a good indicator of a strong competitive advantage
Each of the quality metrics and the moat concept should be factored in to any dividend investing decision. We are off to a good start with using QVG to analyze dividend stocks, let's look at Growth.

Quality is sort of intuitively obvious that its something dividend investors should care about, but growth? Growth? That's for biotech investors! 

Well not exactly. As Neil Woodford said, dividend growth matters:

"In the short-term, share prices are buffeted by all sorts of influences, but over longer-time periods fundamentals shine through. Dividend growth is the key determinant of long-term share price movements, the rest is sentiment."

In the short term in range bond markets, Katsenelson finds that the importance of dividends quadruples. So even in the short run, you can have cases where most of the total return is from the dividend. He also describes the tradeoffs of buybacks and dividends, concluding that the former can be beneficial but only if certain conditions, i.e. cheap price, are met.

Valuation depends in large part on margin of safety. Katsenelson shows two distinct properties that are derived from the margin of safety. First as a source of returns. Assuming you are correct then the price should return to somewhere close to your estimate. And second, as a risk absorber.

Active Value Investing describes is an in depth analysis of the Absolute P/E and margin of safety to arrive at a Buy price (on a P/E basis).

Of course,  unless we are talking March 2009, its not very likely that you can find a high quality, high growth, low price company. Mostly we are talking about tow out of three at best. Active Value Investing makes the case that one out of three QVG factors is a non-starter. Quality and Growth by themselves are worth considering. Quality and Value as well. However, the most dangerous combination is Valuation and Growth, this is the combination to avoid and may indicate an eroding moat, over leverage, and/or undependable revenue stream.

Applying QVG to Dividend Stocks
While QVG wasn't designed an income investor framework, with some minor tweaks and additions, I see QVG framework as extremely applicable to dividend investors. Its a great addition to the analytical tool box. Dividend coverage and dividend growth specifically need to be brought in, but they fit in well alongside the other quality and growth metrics.

Active Value Investing is a very well written, well thought out book. The author's clarity of thought shows through in the framework, and the practical experience is demonstrated in the numerous detailed examples. The author clearly has "time in cockpit" with the many concepts as is evidenced by the discussions of second and third order effects that fall out of various decisions taken. The framework can be used to improve a portfolio's defensiveness and long term total return through value and income.

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