Wait. What.

Nelson, I thought you crapped on buying dividend paying stocks on every opportunity. 

Nah. You must be thinking of my evil twin, Smellson. Here’s his picture.

flexo

No. Really. I remember. You did it here

That was Smellson.

And you did it here, saying dividends don’t matter.

Are you going to keep doing this?

How about this article saying how useless yield on cost is, which is a metric often used by dividend growth investors?

You gotta get a hobby man. Have you tried weed? That tends to keep people busy.

Allow me to explain myself more clearly for at least the one of you above who talks in all italics, a voice that’s a cross between Fran Drescher, Joan Rivers, Pee-Wee Herman, and Michael Cera.

It’s not that I’m opposed to dividends. I’m just opposed to the very specific form of dividend growth investing that’s sprung up today. Basically, these folks limit themselves to a certain number of stocks with a history of growing the dividend annually.

There are a few problems with this strategy. Firstly, it’s very crowded. Everybody knows Coca-Cola, Johnson and Johnson, and Fortis are great dividend stocks. Investors have flooded into them which has pushed valuations higher than your average 2am visitor to 7-11. There’s very little value in traditional dividend growth stocks today.

These stocks also predominately belong to just a few sectors. It’s easy to find good dividend growth stocks in the consumer sector or the telecom space. Utilities are pretty easy too. But how many good dividend growth casino stocks are there? Or resource companies? Pickings are far more slim.

And finally, the whole strategy is built on looking backwards. Philip Morris is my favorite example. The cigarette business was fantastic over the last century. It’s unlikely to be anywhere close to as good over the next few decades. Even your dimmest friend knows smoking is bad for him. Knowing that might not stop him, but it does successfully dissuade millions of others.

How I do it differently

I used to refer to myself as dividend agnostic, not really caring if a stock paid a dividend or not. As long as value was there, I couldn’t really care less. I still have this attitude today, but it’s evolved to the point where I really prefer getting dividends. I’ll still invest in something that doesn’t pay a dividend, but it has to be really compelling.

My evolution started back when I blindly picked a bunch of high-yielding stocks for a list of 10%+ yielders. That was in late 2011. In the middle of 2014 I decided to take a look at how that blindly picked list of stocks did. It turns out it beat the TSX Composite Index (just barely, but still), only losing out to the S&P 500.

And that was picking blindly. I figured I could do better if I analyzed said stocks.

The first thing I look for is value. Value can come from one of two places. You can either pay a cheap multiple for a stock based on its earning power or its assets. Ideally, you want some sort of combination of both, but many dividend stocks just won’t be trading anywhere close to book value for a number of reasons.

Secondly, you look at the dependability of earnings. Benjamin Graham used to tell investors to look at a 10-year average of earnings, which is really easy to do using Morningstar. All you do is type in a ticker and then go to the key stats page. All the info is right there.

What a time to be alive.

Earnings are important, but free cash flow is more important. Companies with huge amortization or depreciation expenses can have very healthy cash flows and terrible earnings.

Let’s look at a real life example. Directcash, a stock I own, is in the ATM business. If you’re Canadian, you probably recognize the name as you pay $2.50 to withdraw cash at some bar or casino or strip club.

Hey, we’re not here to judge.

When Directcash acquired a bunch of Australian assets back in 2014, it mostly paid for the relationships the ATM operator had with customers and not for physical assets. Thus, most of the value paid was in these intangible assets.

Directcash is now aggressively writing off these intangible assets because accounting rules say that’s what you do. This move is making net income look terrible but it doesn’t affect free cash flow. From Google Finance, first the income statement and then the cash flow statement.

DCI income statement

See how a full 25% of revenue is dedicated to depreciation and amortization? That turns a profitable company into an unprofitable one. But it doesn’t affect free cash flow. 

dci cash flow

Free cash flow is cash from operating activities (ignoring changes in working capital) less capital expenditures. So for Directcash, we’d figure out free cash flow as:

(Cash from operating activities + changes in working capital) – capital expenditures. If the changes in working capital worked to the company’s advantage, we’d subtract these changes. Basically, we’re looking to ignore any changes in working capital.

It turns out Directcash generated $11.7 million in free cash flow in the first quarter, which is traditionally a crummy quarter for the company. Even after the worst quarter of the year, the company generated far more in cash flow than it costs to pay the dividend. Free cash flow was $11.7 million. Dividends were 6.3 million. That’s a payout ratio of 54%.

Annually, the payout ratio is even lower. Here are 2015’s full year numbers.

dci 2015 cash flow

So remember, free cash flow for the year would be: $52.87M + $21.07M – $12.59M for a total of $61.35 million. Dividends were $25.31 million. That’s a payout ratio of 41.26%.

Here’s where Directcash gets interesting. The stock has a 10.87% yield as I write this.

Normally, stocks with yields above 5% are considered a little risky. Anything above 10% is basically being priced by the market as extremely risky. And yet, we’ve just established that Directcash can easily afford to pay its dividend.

So why the discounted price?

There are a couple of reasons. The first is Directcash has a lot of debt. That’s bad for dividend investors for a number of reasons. And secondly, everyone is convinced Apple Pay and other digital solutions will eventually turn ATMs everywhere into expensive pieces of scrap metal.

Investors everywhere look at price-to-earnings multiples. If you figure out how to read a cash flow statement and use it instead, you’ll automatically be ahead of 50-80% of retail investors.

Other things

Basically, it comes down to this. I like to buy stocks that trade at low price-to-free cash flow multiples.

In 2015, Directcash generated $61.35 million in free cash flow. It has a market cap of $237.82 million. Thus, shares trade at 3.87 times free cash flow. Or, to put it another way, the company has a free cash flow yield of approximately 26%.

Directcash is probably the cheapest stock in Canada on a price-to-free cash flow basis. There are other cheap ones too, like Corus (has a 15.4% free cash flow yield), Capital Power (16.6% free cash flow yield), and Aimia (14.1% free cash flow yield). These stocks pay dividends of 8.3%, 7.5%, and 10.0%, respectively.

Full disclosure: I own all stocks mentioned in this article

Buffett talks a lot about finding companies with a moat, a sustainable competitive advantage. I prefer to look for stocks with a niche, an area of business they do well. Think of the difference between the cell phone business and the ATM business. I could make Directcash’s life miserable with $100 million. I’d barely register if I took $200 million and tried to take on Telus.

Everybody knows the telecom sector is a good one. Hardly anybody knows the ins and outs of ATMs.

If rule #1 is get a good free cash flow yield, rule #2 is stick to the fringes of the market.

The last rule is to diversify. I have little doubt some of the companies I own will be in danger of cutting their dividends. The hope is the winners more than make up for the losers. Just in case there are many losers, I keep exposure to each individual name small. That way I can still have a nice income stream without taking on a huge amount of risk.

Tell everyone, yo!