Income Investing by the Poolside

You know you have found a pretty simple investing process when the whole thing fits inside a single tweet. Eddy Elfenbein distilled a pretty interesting investment screen into less than 140 characters when he tweeted:

It's hard to get much simpler than that, but even in this ultra-simple process, Elfenbein manages to cover two of the most important and often overlooked areas of a good investment case. One, make sure you get paid by the company. After all, as a shareholder you are a part owner and insisting on a dividend in return for your cash is just common sense. Two, make sure the company does not operate with too much leverage. Debt works until it doesn't, and we saw in 2008 what happens when it doesn't. Be safe out there Fools.

I ran a "Poolside" screen to see how well Eddy Elfenbein's idea works in practice. I screened for companies with at least a 3% yield, and as for reasonable debt I used no more than a 0.7 debt/equity ratio. This filter turns up some interesting companies 

Source: Morningstar

For such a simple screen that is a pretty intriguing list of companies. All of these companies have simple to understand business models and sustainable customer demand.

Taking a look at some counterexamples, instead of owning shares in the above companies, an investor could buy shares of Twitter. Unfortunately for Twitter investors, the company does not pay a dividend, so its investors are 100% reliant on price appreciation to deliver investment returns. 

In the case of debt, with proper usage it can amplify returns, however if things turn against the company and the company cannot pay its obligations then debt becomes a boat anchor. Seadrill (SDRL) pays an incredibly high yield at 9.9%, but investors have to question the sustainability of this because of Seadrill's high debt/equity ratio of 1.2. If the tides turn against offshore drilling suddenly Seadrill's business and dividend will be at risk.

By insisting on a 3% dividend you limit your choices to companies that pay out over 50% more than the current S&P 500 dividend payout. Furthermore, this helps investors avoid speculative situations. Checking the debt level gives the investor a margin of safety, as the company's balance sheet should be ready to weather tough times.

But of course it's never quite as simple as just blindly running the screen and counting your dough. For one thing, as great as a 3% dividend is these days, a dividend that is too high should give you pause. Seadrill's dividend is a function of investors' confidence in its ability to execute and service its debt. As a safety measure, in addition to screening out companies with too much debt, before you head for the pool it makes sense to eliminate companies with dividends that are too high. The screen I ran showed 43 companies with a yield of 10% or higher.

The highest was from an OTC traded medical device manufacturer with a $7 million market cap that reported a 65% dividend. I have never heard of it (or most of the +10% payers) but I would be willing to bet that it will cut its dividend before you jump off the diving board. The filtering process is important both on the inbound side, or what to include, and the outbound side -- or what to exclude.

Adding some basic safety checks to make sure the dividend is at least 3% but perhaps no higher than the 6%-7% range makes sense. It's also worth including a check that the dividend is well covered, so look for a payout ratio below 70%. This screens out AstraZeneca (171.8%). 

That leaves two companies -- Procter & Gamble and Unilever. If they are equally weighted you wind up with a 3.15% yield from companies operating with low leverage, with products that billions of people use all over the globe every day. 

The revised process:

1. Screen for 3%-7% dividends

2. Delete companies with too much debt

3. Delete companies with payout ratios above 70%

4. Sit by the pool

Not sure if all of that can still fit into 140 characters, but it's not that complicated of a process. Now, can we go to the pool, already?