As with any investment, a Fool should know very well what he or she is getting into before mailing in even one red cent. With DRP investing, you're setting up a long-term relationship with your investments, perhaps even more so than when using a traditional broker. You're beginning to invest slowly, steadily, and it will be several years -- most likely -- until you have a substantial position in your companies. If you begin to invest in the wrong companies using this method, you lose valuable time and you also lose the powers of dollar cost averaging into a great company over the years. Dollar cost averaging into a stock that is going nowhere (or only down) isn't helpful or Foolish, and it both hurts your pocket book and dismantles the advantages offered by Father Time -- the advantages offered if you find a successful stock from the beginning with which to begin a relationship.
The Drip Portfolio found its first two investments over the course of three months. It aims to have a portfolio of four to five stocks in a year, and perhaps seven or so in a few years. As you can see, it's a slow process, as investing Foolishly should be. Warren Buffett didn't just open the stock pages one day and buy a handful of companies. It can take him several years to find a single investment that he likes. So should it be with you. If these are truly long-term or hopefully life-long investments, you need to choose them carefully -- Foolishly. The Drip Portfolio has a list of initial criteria that it likes to consider in its investments. But keep in mind that these are only guidelines, and should never lead to any decision by themselves. These are just some useful, Foolish things to look for in your potential long-term investments:
1. Sustainable Market-Beating Earnings and Sales Growth Rates. You want to invest in leading companies that have historically grown earnings and sales (both top-line and bottom-line numbers) at market-beating paces. You want this growth to be sustainable going forward. Check out the expected growth rates of your companies. See how they've done in the past. Johnson & Johnson has had 64 years of consecutive sales growth. Pfizer has had 34 years of the same. Both companies are poised, here in late 1997, to be market-beating investments over the coming years, too. They're expected to grow earnings around 15% annually over the next five years. The market has historically returned about 10.5% percent annually. Find leading companies that have sales and earnings growth that is sustainable at levels above 11% annually, ideally -- and don't forget to include the dividend if it's substantial. In order to know how sustainable growth is, you need to understand the business, the markets, and your company, including its strategies. As with any long-term investment, this will take some research. Be Foolish about it: enjoy it! Have fun with it. Do as much of it online with others -- in the Drip message boards for instance -- as is possible. You're not alone.
2. Respectable and Industry Leading Management. If Johnson & Johnson didn't attract some of the brightest in its industry, it wouldn't have had 64 years (and counting) of consecutive sales growth. That's no small feat. One slip, one bad year (the Tylenol disaster could have hurt Johnson & Johnson much more than it did, if not for the quick action taken by management) and the company's record is down the drain. Much more important than records, though, is that your companies attract and retain industry leading people. Without the right people, your company can't very well be the best in the business. Buy companies that have respected management, that hire the brightest in their industry, and that have excellent programs in place that pass leadership from one generation of employees to the next, without missing a beat.
3. Double Digit Net Profit Margins. Along with strong management comes, hopefully, profits. You probably want to reconsider investing or "dripping" into any company that hasn't yet made consistent profits. Instead, the Drip Portfolio aims to invest in companies that have a long history of profitability, every likelihood of that continuing, and are not just profitable, but highly profitable. The Drip Port likes companies that have net profit margins of 10% or higher. This means that for every dollar in sales, the company keeps 10 cents, even after taxes. Intel has net profit margins above 20%, as does Coca-Cola. Johnson & Johnson is around 15%. All are outstanding profit margins. Most companies never get above 10%. You want to invest in the best. You want to invest in companies that are highly profitable and becoming more profitable. Which leads to point four.
4. Ever-improving Business Performance. With a great business, great management, and profits should hopefully come improving performance over the years. If a company is a leader, it should be able to lead with ever-increasing efficiency. You want to invest in companies that have historically improved their return on equity for shareholders, that consistently increase operating and profit margins, that build up cash rather than non-beneficial or non business-building debt, and that have improved any other measures of the business that you follow. More of these measures can be learned of in depth in the Fool's School in How to Value Stocks. You want to consider companies that are improving over the years on all measures possible. Coca-Cola has improved net profit margins from 10% to over 20% in the last 10 years. That's nearly unheard of, and is simply excellent. Its return on equity to shareholders has also gone through the roof. Find companies with great management that know how to get the most value out of every sales dollar, and continually improve upon that.
5. A History of Dividend Growth, and Every Indication That This Will Continue. In a long-term dividend reinvestment plan, the dividends that you are paid but that go to purchase more stock automatically can add a great amount of value to your total investment. Over the course of a few decades, the value of your dividends and the value of the shares bought with dividends can easily surpass in value your initial investment made in the stock, or your initial few year's worth of investments.
The dividends reinvested from one single share of Coca-Cola stock since 1919 are now worth well over a quarter of a million dollars. One of the great advantages of dividend reinvestment plans is that each reinvested dividend payment is much like receiving free stock. Thus, the higher yield your investment pays in a dividend (as long as the company itself is growing -- we're leery of buying utility stocks for the 5% yield alone, because the stock price itself is rarely appreciating) the better chance you have of building extra value over the years. Also, companies that have increased dividends every year for decades are an indication of a great business. Johnson & Johnson's dividend has grown at a compounded growth rate of 16% annually over the past ten years. The stock has returned 22% annually since 1986 -- doubling the historic market return. The dividend growth has helped tremendously. That said, The Drip Port also invested in Intel, which pays almost no dividend, and which isn't likely to grow its dividend any substantial amount. Here the portfolio is looking for stock price appreciation alone. With J&J, it's looking for both stock apprecation and dividend growth.
Look at consistent dividend growth as a sign of a strong business in the past, and try to see if that trend will continue going forward. Management at strong companies try to commit to a policy of increasing dividends every year, as long as business goes as planned.
6. A Company that is Consistently Repurchasing its own Shares. Perhaps more important than the act of a company purchasing its own shares is what this represents. It usually means that the company is generating cash -- substantial cash -- and that it sees enough value in its own stock to repurchase it, which in turn decreases the shares outstanding and increases the earnings per share granted to shareholders. Repurchasing shares also is usually an indication of a mature business. A company often repurchases shares when it doesn't believe that it can earn a better return on its capital through other investments, or expansion. But in the best companies, both expansion of the business and the repurchasing of shares with the cash generated through business is possible. A company that is able to repurchase shares each year is usually operating a successful, cash generating business, and has confidence in its own stock and business going forward. The repurchasing of shares also increases the earnings power of the shares left outstanding.
7. A Strong Balance Sheet. The balance sheet represents a company's current position of health. This "snapshot" coupled with the recent annual income statement and growth rate give a powerful picture into the viability of a business. You want a growing business that is allowing that growth to add value to the balance sheet, rather than waste away. You want companies that have more than enough cash to fund future operations and expansion, and that have little or no debt, unless that debt is the result of recent aquisitions or expansion that will increase future earnings power. You want a business that invests its money Foolishly, that runs its business with a strong but not too constraining upper-hand, and that has an eye out for opportunity and the resources to pursue it. Avoid companies that are struggling under a heavy debt load and that keep investors' hopes up with merely the promise of a big future. Companies with strong cash positions and that avoid debt -- or only take it on as a beneficial avenue towards growth -- are far more worth your consideration than those swimming in debt and hoping to one day develop a successful market.
8. All of the Above, Alongside with Industry Leadership and Long-Term Viability. When all of the above or as much of it as possible is met, you will usually find behind the criteria a leading company. You want to invest in industry leaders, and you want to invest in companies that are likely to be leading their industry 10, 20, or 30 years from now. You want to find all of the attractive criteria above, and especially industry leadership, and you want all of that to be sustainable as well as you can possibly tell, and for as long as you can tell. You also want to invest only in business models and companies that you understand. If this means that you can only buy consumer friendly companies such as Coca-Cola and Gillette, than so be it. You'll be joining Mr. Buffett. If you work for an airline company and live and love airplanes, consider a technology company like Boeing. (Believe me, they're a technology company more than anything else.) Do you like NBC? Consider General Electric, the parent company of NBC. Sure, David Letterman used to make fun of GE all the time, but it's been a world-leading stock for all of this century.
Invest in industry leaders that have the strong possibility of continuing to lead, and invest in what you know and understand. Over the long run, you'll sleep well, and you'll be Foolishly rewarded -- ten times over -- if you find market-beating stocks and hold and add to them for years, and for decades; and then maybe some day you'll pass as least some of your wealth down to your children. You can't get much more Foolish than that.