When selecting individual stocks to invest in there are literally tens of thousands to choose from. In order to find the best investment opportunities it is necessary to filter out the stocks that don't serve our investment objectives.
Using a website like www.digitallook.com the task can be reasonably quick and simple.
There are certain sectors I avoid due to the fact I don't understand the business model or I feel the competition and profits in these sectors hinder their investment attractiveness. Examples of areas I avoid include Banking and Insurance (too complex) and Travel and Leisure (cyclical and highly competitive). Other areas such as REITs and Oil and Mining companies I usually prefer to invest in ETF or ETC of the commodities they are associated with.
I also want to invest in industries I see having a future. A chain of shops that sell CDs is in a dying industry and best to be avoided.
Investing in smaller stocks gives the investor the potential to make more money (it's much more possible a $100m company can double in value than a $100b company). Smaller stocks do carry more risk and should not make up a large proportion of your portfolio. Filtering out companies with a market cap below $500m is probably a good starting point.
I tend to demand a dividend yield above 4%. Currently in the FTSE100 33 stocks yield more than 4% so there are plenty of decent opportunities.
Check that the dividend is sustainable and secure. Make sure there is some cover to the dividend and that the company can afford to keep paying it in the future. Also check that the dividend is consistent and has been steady of rising over the last 3 years. Avoid any company that has reduced its dividend.
Check analyst forecasts for future dividend and make sure they are steady or rising. Again avoid any stocks that show falling future dividends.
As a final check I like to see what the insiders are doing. Directors of the company have to disclose by law every time they buy or sell stock in their company. These guys clearly know a lot more about the company than the average investor does. If they are selling then it is a clear warning sign not to invest.
So now you've found a promising stock in a sector you are comfortable with and the directors aren't running for the hills. The dividend looks stable/rising. How can we estimate the expected future returns of the investment.
The first part is the yield. I prefer to use the 3 year average dividend to calculate the yield. Admittedly this penalises growth companies but I see these as being less predictable so I can live with that. To calculate the 3 year average dividend you simply divide the total of the last 3 years of dividends by 3.
Dividend 2011 40p
Dividend 2010 35p
Dividend 2009 30p
The above company would have an average 3 year dividend of 35p. If the current share price is 500p then the 3 year average dividend is 7%.
For the growth rate I use analyst estimates. I assume analysts know something but I don't trust them 100% so I will adjust their growth estimates to more conservative levels. Depending on the size of the company I will use between 33% and 40% of analyst growth estimates. For example if analysts estimate an average 10% annual dividend growth per year for the next 3 years I will use a 4% growth for a big company and 3.3% for a smaller stock. This gives us a margin of safety on the growth rates.
Finally comes what I call adjustment. Stocks have been fairly expensive in comparison to the past. There are a number of reasons for this but I want to include an adjustment in my model to reflect a reversion to the mean. I set the mean as being a 5.5% average dividend yield. So for a stock with a 2.75% dividend it would need to half in price to give a 5.5% dividend. I would then discount this over 20 years:
Using the three factors above we can come to a conservative estimate of the future returns we expect from such an investment.
Expected Return = Dividend Yield + Growth Estimate + Adjustment
Our margin of safety comes from using a 3 year average dividend yield, which if we are only investing in stocks with rising or steady dividends will always be less or equal to the current yield. The growth estimate is reduced by 60-67% of analyst estimates giving us some breathing space if the company misses its targets. The adjustment factor ensures that we avoid over priced companies. Even growth companies have to eventually revert to more modest valuations as they mature and this takes into account this factor.