Monday, January 4, 2016

M* 2016 Stock Picking Criteria


Happy New Year everyone.  Let's make this a prosperous year for income investors.  Interest rates increased a touch last year but not enough to make me recommend bonds.  If I find one that looks compelling, I will write about it but for now I will concentrate on stocks.  As you know, I do not write about preferred stock, municipal bonds, or real estate in this blog.



Debt to Equity (D/E) ratio

Stocks that I buy and that I write about need to be safe so I still place significant emphasis on D/E ratio.   D/E ratios are easy to find.   Click on any of the symbols in my ticker and you will go to MacroAxis where you can get D/E ratios for free.  Here is a link. https://www.macroaxis.com/invest/ratio/WMT--Debt_to_Equity    MSN money also provides the data for free or you can go to other proprietary sites that charge for that information.  

I like D/E ratios to be as low as possible.  Zero debt is always nice but that metric would be too limiting.   If a company does not have to service debt, they are more likely to be able to fund a dividend.   Moreover, low debt suggests a company will be less likely to go bankrupt.

Some debt is okay. Generally, a ratio of 1 or less is desirable.  Industries that are capital intensive require more debt and thereby a higher D/E ratio.   If I like a stock in one of these industries, I look for the D/E ratio to be the lowest of the industry.

Dividend Yield

The 2015 M* model portfolio suffers from too many energy stocks.   Energy stocks, as you know are in a terrible spot.   I have confidence that energy holdings will regain some mojo in the future and are not likely to go bankrupt, but the fundamentals of the energy sector could see flattening of dividend increases or even dividend cuts or suspensions.    The reason, I think, that so many energy stocks are part of the 2015 portfolio is due to my requirement for a 3.5% dividend yield.   The first stocks I would come to when I did my screens tended to be energy stocks.

This year I will pick stocks that have at least a 2.75% dividend yield so that I know we are beating the 10 year U.S. Treasury.   This will also increase the number of stocks for consideration.  

Income is still the major focus of this blog and income that grows is essential for retirees of which I am one.   Dividend yield increases of at least 4% per year for at least five years is a criteria I will use to select stocks to profile in this blog.

Revenue Growth

I have thought carefully about what additional criteria I would use to select stocks that deliver growing income.  In 2011, the four criteria I used to pick stocks, produced a portfolio that has over the past five years delivered a total of 60% capital gain and over 26% dividend increase.

Revenue drives earnings and earnings drive dividends.  Therefore, this year I will pick stocks with revenue growth over the past 3 years of at least 4%.    This will shrink the universe of stocks from which to pick, but should help to weed out those stocks that might limit their dividend increases.

Covered Call Opportunities

Since my emphasis is on income that grows and I am lowering the dividend yield bar to 2.75%, I need to boost basic income and I will do that by selling covered calls.

The premium from selling covered calls, can double your income.  Call buyers expect the stock they seek to buy to deliver capital gains.  We, therefore, need to pick stocks that have the potential for capital gains, and that pay us a dividend while we wait for those gains.   By selling covered calls into that expectation, we can get paid the dividend while we wait and bank the call premium.

I want to sell at least one call per year on the stock I pick.   I may sell the call on the day I buy the stock or I may wait for a later time.   Call premiums need to be at least 1% on the basis.   That means if I pay $50 for a stock, the call premium needs to be no less than $.50.

I always want to secure a capital gain on my shares should they be assigned and therefore, I look for a strike price at least 8% above my basis.

You are fooling yourself about income from a stock if you sell a call with an expiration that does not include the next dividend.    Dividends are not like bond interest.  With a bond, you earn interest on every day you own the bond.   With a stock you only get the dividend if you own it on the ex-dividend date.   When you sell a covered call, pick an expiration that is later than the next ex-dividend date.   For instance if you buy a stock on January 4, 2016 and their next ex dividend date is March 15, 2016, your call should not expire until after March 15, 2016.  

M* 2016 Portfolio

In 2016 I will monitor the stocks that I pick for income.  I will report on each position profiled including the income from dividends and the income from covered calls.   I will track the capital gains from calls being assigned and the capital gains or losses from those position we hold.   The rules will be that in this portfolio, like the past portfolios, I will not sell a stock unless it is assigned.  Since assignment cannot be theoretical, you know I hold each position about which I write.

Summary of 2016 Criteria

Listed in the table below are the criteria I will use to pick stocks for 2016.





Good income investing.  Let the trading begin.  May your selections deliver ever increasing income and good capital gains.

M*  TheMoneyMadam