Valuentum Exclusive Analysis for the Discerning Investor

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A version of this article appeared on our website November 2015. Article last updated June 2017. Republished May 7, 2019.

The following questions cover the following topics:

1) Can you explain what the Dividend Cushion ratio measures and what it doesn’t?

2) Can you explain the difference between the raw, unadjusted Dividend Cushion ratio and the adjusted Dividend Cushion ratio?

3) Can you talk more about the Valuentum Buying Index (VBI) ratings? Why do some of your favorite ideas in the newsletter portfolios have lower VBI ratings than ones that are not in the newsletter portfolios?

4) Can you explain why you don’t always include companies in the newsletter portfolios that have strong Economic Castles, solid Dividend Cushion ratios and that are undervalued?

1Q: Question regarding your ratings for dividend growth. I was checking out your recent list of stocks listed by Dividend Cushion ratio and reading dividend report for the top one (CIR); you give it a dividend growth rating of "GOOD". Though the company’s Dividend Cushion ratio is good, how do you justify this rating since management has not seen fit to raise the dividend in the past 15 years, and your own projection table at the right of the page projects 0% dividend growth in future years? By your own records and this history, wouldn't this stock warrant a Dividend Growth rating of 'VERY POOR"? Interested in your response. Thanks.

1A: This is a great question because it allows us to explain the layers embedded within our analysis, and what exactly the Dividend Cushion ratio measures, and what it doesn’t.

First, your question is probably more appropriately phrased as: why is CIR's Dividend Growth Potential GOOD (emphasis on “potential”), as it is the title that corresponds to the GOOD rating and what the rating applies to. In many ways, this answers your question: the Dividend Cushion ratio is strong, and therefore the company has tremendous potential to raise the dividend if it so chooses.

In particular, the Dividend Cushion ratio measures the capacity of the company to keep raising the dividend in the future. It does not measure the board’s willingness to keep raising the dividend, which is another important consideration, something best expressed with an assessment of the company’s historical dividend track record. Both capacity and willingness must be present to uncover the best dividend growth ideas for the coming years, in our view. That’s why CIR doesn’t make the cut for the Dividend Growth Newsletter portfolio. CIR has a relatively small dividend yield as well; in this light, it should be no surprise that the company has the capacity to cover such a minor payout given that it is a rather small financial obligation.

Perhaps most importantly, management and the board can do whatever they want with the dividend; we see cases all the time where a company puts up terrible performance and raises the dividend on hopes that investors will be satisfied with an increased payout that theoretically they already own. The Dividend Cushion ratio is a pure reflection of the financials used to assess the dividend growth potential of the company in the context of a firm’s balance sheet and future financial forecasts. It is not a measure of willingness. Sometimes the board stretches too much with the payout; sometimes the board falls short. The Dividend Cushion ratio is the yardstick that measures the dividend growth potential of each entity.

It perhaps goes without saying, however, that the Dividend Cushion ratio is not all that we provide with respect to dividend analysis. We publish our assessment of the company’s dividend track record, too, and we're doing tons more beyond the dividend analysis itself. Hope this helps clarify.

Tickerized for several companies with high Dividend Cushion ratios but with small dividend yields.

Coverage universe ranked by Dividend Cushion ratio here >>

2Q: I'm a subscriber. I'm looking at your dividend report for Enterprise Product Partners (EPD). It says your Valuentum Dividend Cushion ratio for EPD is 2, but several lines below it says the unadjusted Dividend Cushion ratio is 0.25. Please explain the difference between the two ratios, and what is considered a good score for the unadjusted Dividend Cushion ratio, what is an excellent score, what is neutral and what is poor? Also, how much relative importance should I give to each score?

Also, further down in the section on unadjusted Dividend Cushion, the chart of EPD has a large negative number in the blue bar, and your text says: "Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend." So that means that EPD's dividend isn't durable, yet your report earlier says that EPD's Dividend Safety rating is GOOD. Can you elaborate?

2A: Thank you for your question. It is a great one because it hits at the heart of the capital-market-dependency risk inherent to MLPs.

First, the raw, unadjusted Dividend Cushion ratio adds a firm's net cash position to the sum of its future free cash flows (cash flow from operations less all capital spending) over the next five years and takes that sum and divides it by the sum of the company's expected cash dividends paid and growth in them over the next five years. The Dividend Cushion ratio is essentially a coverage ratio -- the higher the ratio above 1, the better able the company will be able to cover dividend payments in the future, in our view. For most of our coverage and for most corporates, the qualitative ratings for safety and growth are a function of the raw, unadjusted Dividend Cushion ratio, as shown below.

For MLPs, REITs, and some utilities, however, we make modifications to the raw, unadjusted Dividend Cushion ratio in deriving the adjusted Dividend Cushion ratio. For example, with MLPs, we add back future equity issuance to the numerator and mitigate the company's debt load to a degree on account of assuming ongoing refinancing capacity for such entities. These adjustments result in a sharp upward revision to the raw, unadjusted Dividend Cushion ratio. For MLPs, REITs, and some utilities, we base the qualitative rating on this enhanced adjusted Dividend Cushion ratio, but we also disclose the raw, unadjusted Dividend Cushion ratio in each case.

In short, we believe both the raw, unadjusted Dividend Cushion ratio and the adjusted Dividend Cushion ratio offer insights. The former reveals the capital-market-dependency risks inherent to MLPs, for example, while the latter acknowledges that under benign market conditions, continued funding of the distribution/dividend would ensue. We place greater emphasis on the raw, unadjusted Dividend Cushion ratio because it is more of a pure risk measure than the adjusted one, which considers a variety of incremental funding sources, which cannot be guaranteed during difficult credit conditions. We don't include any individual MLPs in the Dividend Growth Newsletter portfolio (as of early 2017, we did include an ETF holding energy MLPs, however).

Though we may make qualitative adjustments to the ratings themselves on account of other factors, the assigned breakpoints are as follows for both measures (they can be found on the definitions page in the Dividend report in the back):

Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion™. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.

Please let us know if we can elaborate further.

A video that talks more about the raw, unadjusted Dividend Cushion ratio and the adjusted Dividend Cushion ratio can be found here >>

3Q: First of all, I want to say thank you for all the work that you and the Valuentum team does. I really appreciate the amount of time and effort that must go into all of the information that you provide.

I have had a question for a while which I was always curious about, and finally decided to send it in to get your take. How should an individual use the Valuentum Buying Index rating when they just start using this indicator as input on new positions?  In other words, how does someone build their own portfolio? The VBI rating on the majority of the best ideas would not indicate a time to buy. For example, is "AIG" currently a better idea than "AAPL" for a new investor based on their VBI indicators?

There is clearly more going into the transactions then just VBI rating. The website indicates that the Best Ideas Newsletter portfolio contains the best ideas at any point in time, but the VBI rating on many of them would not indicate that someone should start a new position in them. I understand that portfolio management is a different topic then valuation, but I was interested to know how the Valuentum team would go about building a new portfolio if they were to start today.

3A: Thank you very much for your email and membership.

As you mentioned, we primarily use the Valuentum Buying Index as a screening mechanism to surface new ideas for consideration. The rating is not absolute within the investment-decision making process, meaning that there are other factors beyond the rating that we consider before a company is added to the newsletter portfolios, the most important of which is approval from the Valuentum team (a precursor to adding the company to the newsletter portfolios). Our research indicates that the VBI rating is highly effective across large sample sets, but we take greater care when running the concentrated newsletter portfolios which target 15-20 holdings, not 500+ as in the published case study.

To your question in particular: "How should an individual use the VBI rating when they just start using this indicator as input on new positions?"

We're not aware of your personal goals or risk tolerances, so we don't have a basis for suggesting how you should build a portfolio, or phase into holdings over time. We can never give any personal financial advice in that regard. That said, we use the VBI as a screening mechanism to surface ideas we want to add to the existing newsletter portfolios, to augment the existing positions in the newsletter portfolios in order to achieve the goals of both newsletter portfolios. We tend to add most 9s and 10s to the newsletter portfolios, but not all of them, and hold the ones that we add until they surpass fair value and begin to "roll over" from a technical standpoint, usually registering a 1 or 2 at that time.

We take a disciplined approach to new idea generation, so 9s and 10s don't come up too frequently. Apple is a holding in both newsletter portfolios, while AIG is not included, so we prefer the former despite its relatively lower VBI rating. The latter, however, is still highlighted as an idea, but it's just not for the Valuentum newsletter portfolios. Here's why: http://www.valuentum.com/articles/20120805. There's a lot that goes into adding a company to the newsletter portfolios. Portfolio additions undergo a rigorous analyst-driven qualitative process, while the VBI rating is largely a quantitative output, though it, too, is driven by analyst expectations. The following goes into why we consider the holdings in the newsletter portfolios the best ideas at any given time, and why at times non-portfolio holdings can have higher weightings than portfolio holdings: http://www.valuentum.com/articles/20151026_1.

Also pasted below is another link as to how many members use our services, and the goals that we strive to achieve with respect to the newsletter portfolios:

http://www.valuentum.com/articles/How_to_Use_Valuentums_Investment_Services

Please let us know if we can elaborate further.

4Q: I don't understand why Oracle (ORCL)--with a very attractive Economic Castle and a Dividend Cushion of 5.3 doesn't deserve a prominent place in the Valuentum portfolios.

Why has the Economic Castle changed from "highest rated" to "very attractive"? Despite your article "Oracle's Cloud Performance Leaves a Hazy Overall Outlook" dated June 22, the fair value was not updapted in the September report. A lot of fuss about nothing?

4A: This is a great question because it hits at the heart of the difficult portfolio allocation decisions in managing the newsletter portfolios. We imagine that many members have similar questions about companies that they like, too: why aren't they part of the newsletter portfolios? 

In short, you are correct. Oracle is a fantastic business, has a strong Economic Castle rating, and fantastic dividend coverage. Shares are also undervalued (at the time of this writing), though the company's Valuentum Buying Index rating, which considers a 'market conviction' assessment through an evaluation of pricing strength, is not that great; part of the reason why we're not pushing to add it to the newsletter portfolios right now. 

That said, Oracle is a top consideration. The primary reason why Oracle, and many other top-rated companies, are not included in the newsletter portfolios may have nothing to do with them at all, and everything to do with the opportunity cost of investing. In the case of Oracle, for one, we're already quite tech-heavy in the newsletter portfolios, and it's difficult to argue with the fantastic performance of Apple and Microsoft the past few years. We like Oracle; we've just liked a few tech names better, but Oracle has done well, too.

In many ways, it comes down to the idea that we can't include every company we like in the newsletter portfolios, mostly due to sector weighting considerations. In all cases, however, we do our best to highlight those that may not be in there via their attractive price/fair values, Economic Castle ratings, and Dividend Cushion ratios, an oftentimes, their better-than-average Valuentum Buying Index ratings.

As for fair value changes and updates, they can occur for a number of reasons, but generally speaking, incremental news that impacts the near term may not have as great of an impact as news that may impact our long-term thesis and mid-cycle expectations. We comment frequently on companies in our coverage, and our fair value estimates are updated to reflect the ongoing evolution of our thoughts.

Here is more on what causes fair value changes >>

Please feel free to reach out to us at any time at info@valuentum.com. Thank you for your questions!

A version of this article appeared on our website November 2015. Article last updated June 2017. Republished May 7, 2019.