Detect Losers and Find Winners with The Dividend Triangle

 

We all want our portfolio to perform well, but how? Detect losers and find winners with the dividend triangle. It’s an easy way to understand why stocks underperform and detect other risks in your portfolio, like dividend traps or potential dividend cutters.

The dividend triangle also proves invaluable to find strong dividend growers that will more than make up for the few rotten apples you might have bought.

What is the Dividend Triangle?

I coined the term Dividend Triangle to refer to a trio of metrics for which there has to be a growth trend for a company to be a potential dividend grower: revenue, earnings per share (EPS), and dividend amount.

The dividend triangle is a strong indicator of the likelihood of a dividend cut and can, at a glance, reveal the cause of a stock’s performance, good or bad. It also makes finding good stocks much easier. Searching for a great combination of its three metrics quickly narrows down your search from thousands of stocks to hundreds, which you narrow down further using other criteria.

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Why These Three Metrics Specifically?

Revenue, EPS, and dividend payments are the three pillars that quickly reveal whether a company might be a worthwhile investment for a dividend growth strategy.

Revenue

I want to invest in growing and market-leading companies that benefit from innovation, R&D, solid marketing, and/or economies of scale. Revenue growth is a good indicator of such qualities.

Series of growing seedlings from the shortest to the tallest
It’s all about sustained growth

So, I look for companies with several growth vectors that ensure consistent sales increases year after year. Revenue growth in the recent past signals that the business model is doing well and that, should a recession arise, it wouldn’t enter it in a position of weakness.

Earnings per share

Companies can’t pay dividends if they don’t earn profits. If earnings don’t grow, dividends won’t increase indefinitely. The EPS trend gives a quick picture of what’s going with a company’s profit; is it increasing, falling, flat?

EPS is flawed in that it’s calculated based on accounting principles (GAAP), which include non-cash charges and irregular expenses unlikely to recur, such as a product recall. Consequently, EPS can be misleading. To compensate for this:

  • Review the EPS trend over 3 and 5 years. Some companies might “play around” with earnings for a year or two, but they can’t create a trend out of thin air.
  • Review Adjusted EPS; it disregards irregular items, thus reflecting more accurately profit recurring from the company’s operations.

Dividends

I want to invest in companies that share their wealth. Dividend growth points precisely to that and shows that the company is robust and its management confident. I focus on how the dividend grows year after year, not on dividend amounts or yields.

Dividend growers are confident in their business model. They make enough money to grow their business, reward shareholders, meet their financial obligations, and invest in new projects. A responsible management team won’t increase the dividend if they lack the cash to run the business.

What Does a Strong Dividend Triangle Look Like?

With a stock screener, it’s easy to find companies with positive and high 3-year or 5-year growth for revenue, EPS, and dividend. Does that mean their dividend triangle is strong? Not necessarily. The dividend triangle is really about the trend for each of its metrics over the past 5 years, not just whether there was growth between the start and end of the 5-year period.

Microsoft's strong dividend triangle
Microsoft’s strong dividend triangle

Here, we see a near-perfect dividend triangle, Microsoft’s. Steady growth over 5 years for revenue, EPS, and dividend payment.

Five years is long enough to see the relevant trend and notice unusual jumps or drops. To find out what caused these anomalies in the trends, consult the company’s quarterly results.

What if one Metric Isn’t as Good as the Others?

The three metrics don’t always trend the same way: for example, revenue growth but flat EPS, a rising dividend despite flat EPS, etc.

Dividend growth reigns supreme over other trends. If dividend growth slows down or pauses, I find out why and keep an eye on that stock. When a dividend is cut, I rarely keep the stock.

Lagging revenue growth, but healthy EPS and dividend growth show the company’s improving its margins through cost measures or restructuring, rather than revenue growth. This could be temporary because of a slowing economy. I’d verify that the company has growth vectors. If not, revenue growth is in jeopardy.

What about new Dividend Payers?

It’s hard to assess the dividend growth potential of new dividend payers. Many dividend investors won’t consider them at all. However, if revenue growth is such that a company starts paying dividends and keeps wiggle room with a healthy payout ratio, e.g., 50 to 60%, its management is confident. Might be worth a look.

Dividend Triangle more Important than Yield?

Absolutely! I prefer companies that increase my paycheck. Don’t we all? A high yield stock that doesn’t grow its dividend much or at all makes me miss out on better growth elsewhere and might be headed toward a dividend cut.

I prefer a growth stock’s lower yield dividend that keeps growing, and the capital appreciation that goes with it.

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Can you Find a Perfect Dividend Triangle?

We’d all love perfect dividend triangles over 5 and even 10 years. Our cyclical economy and the market’s many surprises make such perfection quite rare, and short-lived.

Most triangles, even very strong ones, show the occasional slow down in growth, or declining revenue or EPS. They might be temporary, caused by unusual or external factors such as pandemic lockdowns and recessions, or by mistakes the company made but that it can fix. The triangle gives you hints on what went well and what didn’t go as planned during that period.

After reading quarterly results on a company’s website, you’re better equipped to understand where the company is headed. You don’t need an accounting degree to understand quarterly updates. You’ll find most answers in the press release and the investors presentation.

Protector of your Capital

Sculpture of animal protecting an ornate ancient building

If you’re like me, you hate losing your hard-earned money. The dividend triangle helps me protect my portfolio from the inevitable storms.

Revenue trends reveal when companies are losing market share. It’s very rare to report growing revenues year after year when losing market share. There are justifiable reasons for weaker results; end of a cycle, a change in the business model, or simply the economy slowing down. However, if this persists for years and management can’t find growth vectors, that’s a red flag.

The same goes for EPS. If, for several years, a company cannot generate growing EPS, odds are dividend growth won’t happen either. Because of the flaws of the EPS, it’s good to also review cash flow metrics to see what’s really going on. What happens with companies generating strong free cash flows? They tend to have a rising stock price over the long haul, a reliable dividend growth policy, and make you a richer investor.

The post Detect Losers and Find Winners with The Dividend Triangle appeared first on The Dividend Guy Blog.

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