Investing in Stocks (Part 3)

Last week I shared two rules that experts agree we should follow when investing in stocks: (1) invest long-term, and (2) diversify. Now let’s talk about some rules that I follow in my personal investments, but that some would disagree with.

Rule #3 – Go for the dividends. Companies that are successful often reward their shareholders for investing in the company by giving them dividends. Most dividends are cash payments based on the number of shares of stock a person owns. For example, if a company pays $1.00 per share in dividends, a shareholder who holds 100 shares would receive $100.00. Dividing the annual dividends by the stock price gives you a percentage known as the “dividend yield.” For example, a company that pays annual dividends of $2.00 per share and has a stock price of $100.00 would have a yield of 2%. Compare that to the interest rate banks are paying for a savings account. Of course, stocks also carry more risk than a bank account—if the company goes under, the FDIC isn’t going to reimburse you for the cost of your shares.

Dividends can also be paid in stock—that is, instead of cash the company gives you additional shares of stock. This allows the company to reward its shareholders without surrendering large amounts of cash which the company may want to keep for further growth and investment.

My strong preference is to only buy stocks which pay cash dividends. I adopted my father’s preference for dividend-paying stocks because I believe they are generally less risky than non-dividend-paying stocks. If a company is able to pay dividends, it usually means the company is on a firm financial footing and has been around long enough to establish a strong customer base. I also like companies that raise their dividends at least annually, because when a company’s dividends are continually rising its stock price is likely to follow. Nevertheless, some people prefer “growth” stocks—that is, companies with rapidly growing sales and profits—even if they don’t pay dividends. If it’s a good company, a growth stock can be a fine investment, especially if you don’t need dividend income any time soon.

If a company stops raising its dividends, reduces its dividends, or stops paying dividends entirely, that often means it’s having financial difficulties. The problem could be something that is affecting the entire economy, such as a recession, or it could be something particular to that industry or that company, like declining sales or a cash flow problem. If I own stock in a company that stops raising dividends, I will at least consider selling that stock. And if the company stops paying dividends entirely, I will almost always sell so I can reinvest that money in a company that pays dividends.

Choosing the “ideal” stock. Every investor has their own criteria for choosing a good stock. In addition to seeking dividend-paying stocks which consistently raise their dividends, my criteria are based on what experts say are strong historical indicators that a stock is fairly valued and will do well. Most brokerage firms give their customers access to an online “stock screener” that you can use to narrow the universe of stocks to those that meet your own criteria. Here are a few of my mine:

            a.         Low Price to Earnings Ratio (P/E): Historically, the median average P/E is about 18.0. This means that the stock’s price is about eighteen times the stock’s earnings per share (measured over the preceding twelve months). I will seldom buy a stock with a P/E above 20, because that tells me the stock may be overvalued. However, growth stocks often have a higher P/E than the average.

            b.         Low Price to Sales Ratio (P/S): Many investors like the P/S ratio better than P/E because sales are less easily manipulated than earnings. A P/S of less than 1.0 is ideal. Less than 2.0 is considered good. More than 4.0 is generally poor.

            c.         Low PEG ratio: The PEG is the P/E divided by the company’s projected growth rate. A PEG less than or equal to 1.0 is ideal.

            d.         Low Price to Book Value (P/BV): The “book value” is the value of all of the company’s property, less the money the company owes to creditors, according to the company’s balance sheet.[1] Theoretically, the book value reflects what shareholders—people who own the company’s stock—could expect to receive if the company were to be liquidated and the proceeds distributed to shareholders. A low P/BV means the company is less likely to be overvalued. The ideal P/BV is probably less than 2.0, although at least one source I value considers anything under 3.0 to be good.

            e.         I do rely to some extent on broker ratings, many of which you can obtain from your broker’s website and/or their stock screener. Brokers usually give stocks one of five ratings: “Strong Buy,” “Buy,” “Hold,” “Sell,” and “Strong Sell.” I’m sure different brokers use somewhat different criteria, but these ratings generally reflect a broker’s opinion of how the stock’s price will perform in comparison to other stocks. For example, “Strong Buy” or “Buy” means the broker believes the stock price will do well compared to that of most other stocks. (Be sure you determine whether the broker’s ratings are designed for short-term or long-term price performance.) Obviously, I would hesitate to buy a stock that was rated “Sell” or “Strong Sell,” since that indicates the broker expects the stock price to drop.

Very few stocks will rate well on all of the above criteria, so if you are looking to buy you may have to be flexible. I have found that when few or no stocks meet all of these criteria, it often means the market is overvalued, which may not be the best time to buy. On the other hand, when ten or more stocks match these criteria, it is generally a good time to buy.

One final note: If you are fortunate enough to have some money you won’t need for a while, a recession is a great time to buy stocks, because they’re comparatively cheap. Imagine if you had bought stocks in 2008 during the Great Recession, or in March 2020 right after the pandemic stock market crash. But even if you buy stocks when the market is high, you’re still very likely to make money, so long as you follow Rules #1 and #2.

Happy investing.

[1] The balance sheet lists the value of the company’s property, debts, and equity at a particular point in time. An income statement reflects the company’s annual income and expenses. These two documents are the minimum financial documents required to be made available to shareholders annually by every company listed on one of the major stock exchanges.