NORTHVILLE, MI (Sept. 22, 1998) --I get asked a lot, whether in person or by e-mail, which stocks I think would make good DRPs. Rather than list off names, I thought tonight I'd share some of the attributes that I feel make a company an excellent DRP candidate.
Naturally, some of this will be redundant to previous articles, but I think it's good to reinforce these points and gain different perspectives. For the purposes of this column, I'll only be discussing qualities of the business and its management, and not things such as DRP fees or ease of participation in the various plans that would also weigh in on the decision.
Before diving right in, I'd like to suggest there may be instances where loosening the reins of criteria are warranted. For instance, last night we talked about getting kids involved in the stock market and we explained the ins and outs of stock accounts for minors. I think perhaps a company that the child is familiar with and fond of should sometimes gain an immediate edge. Just as a good teacher helps us learn by making subjects interesting, the right stock for a child would certainly improve the chances of developing strong interest and encourage active participation in growing their money.
Okay, so what should a Fool look for in a DRP candidate? I've identified what I feel are key ingredients that will go a long way toward insuring that the DRP pie that you remove from the oven decades from now will have baked to a crisp golden delectable treat. I call them the Eight Tempting Traits of an Ideal DRP Candidate (we Fools can't resist rhymes).
- Longevity. This first one is somewhat subjective and fairly obvious, but nonetheless critical. You want to have a very high degree of confidence that if you went to sleep today and woke up twenty years from now (after hitting snooze about 10,000 times), your company would not only be still standing, but thriving. With this in mind, businesses that are trend oriented or cyclical should be viewed with a cautious eye. Lava Lamps R Us (Nasdaq: HTGOO) would probably not make a good DRP.
- Earnings Growth. Not only consistent and sustainable, but also market-beating earnings growth is desired. Seek out companies that have demonstrated year after year the ability to grow earnings at a rate above historical market growth (10.5% annually), then peer forward at their projected growth rates. Is that growth predicted to continue at above market-average rates?
- Healthy Margins. You want your DRP companies to be profitable. When making outright purchases of smaller, riskier companies, currently unprofitable companies can be acceptable, and sometimes even desirable. Ah, but we're talking about a different scope here with DRP investing. When banking on an investment over the next two decades or longer, you want a robustly profitable enterprise already in place and a strong indication that this trend will continue.
- Wads of Cash. Cash is good. Cash is King. Cash fuels growth. 'Nuf said.
- Low Debt. Debt is the enemy. Debt is a marker against future earnings.
- Sturdy Dividends. Consistent dividend growth reflects a sound business history, as well as confidence exhibited by management. A company would be hesitant to hike dividends without an inclination that profits will grow in sympathy. Dividend growth outpacing that of profit can cut into cash, leaving less capital to expand and grow.
- Share Repurchase. This one is often overlooked by investment shoppers. Much noise is made about stock-splits even though they add no value to your investment, but comparatively little focus is placed on share repurchase, which increases earnings per share. Come across a company that is consistently repurchasing shares and you've found management that has high confidence in its business, values its own stock, and is generating enough cash to consistently buy back shares. Nothing but good news associated with the words "stock repurchase."
A worthy question to ask of any potential investment is what could cause a decrease in the demand for its products and services and how likely is such an event to occur? The greater difficulty you have identifying reasonable threats to an enterprise, the more comfortable you can be entering into with it a long-term marriage.
A long history of sequential market-beating growth and projections of continuing that trend bode well for the growth of your company and its stock.
Gross Margins (sales minus cost of goods sold / revenues) are a good indicator of efficient, low cost production. A gross margin of zero would indicate that the cost of producing goods and services is equal to revenue derived from those sales. That's not good. Can you smell the stench of wheels spinning in place?
In the immortal words of Gordon Gekko, "If something's worth doing, it's worth doing for money." Therefore, a ratio of double or higher revenue compared to cost of production (gross margins greater than 50%) is appealing.
Net Margins are pure profit -- what's left after all expenses are deducted. We like money. We like money leftover. We like profit.
A net margin of 10% or higher means two things: The company is among the most profitable in America (why settle for less?), and it's going to produce for us number four...
An established, well-managed company shouldn't rely too heavily on debt to maintain operations. However, a large number of companies will, at some point, need to take on some long-term debt. That's okay, as long as it's used to grow the business and it's kept under control.
What's control? Long-term debt vastly outweighing cash on hand is about as controlled as a sparrow flying in a tornado. We want cash to exceed debt by a significant degree. Our friends over at the Cash-King Portfolio point to a ratio of cash being at least 1.5x LT Debt. I think that adequately demonstrates control and similar ratios should be sought.
Because of this I resist the notion that bigger is better when it comes to dividends and DRPs. With too large a dividend, business growth may be sacrificed. When comparing companies, I don't feel a larger dividend is always a selling point.
Cash Management. In current assets you have three primary components: cash, inventory, and accounts receivable. We all know that cash is good, but the latter two, eh... not so much. In fact, left unmanaged, these assets become quite a detriment.
Growing inventories represent products or eventual products that are not yet being turned into cash. While it's true in most cases inventory is necessary, idle inventory costs money to store and represents cash still in the cocoon. Let that butterfly loose!
Accounts receivable is an IOU -- payments for products or services that have yet to be paid to your company. Just like idle inventory, accounts receivables are potential cash not yet available to grow a business.
Management of these "assets" can be measured by comparing similar time periods from past to present. Level or declining inventory and accounts receivable show good cash management, whereas the reverse could spell trouble down the road.
The other side of the cash management coin is current liabilities. These are costs that are waiting to be paid by the company in the coming year. In this regard, you like your company to be a deadbeat to a great extent, delaying payments as long as possible. In doing this cash is kept on-hand longer and is available for business purposes. The check's in the mail! (Wink, wink.)
Like current assets, it's useful to gage current liabilities as a trend over time, but in this case, an increase is desirable. Effective cash management means getting cash in the door as soon as possible and locking it up as long as plausible -- until using it for the best returns possible.
Finished. Anyone still awake?
These eight items, to me, are the makings of a great long-term investment, and thus, an ideal DRP candidate. Jeff and I will see you on the message boards (linked in the top right of this page).