Our Model Portfolio contains companies that have attained a status referred to as an SDG. But what is that? How does a company attain such a status?

An SDG is a company that pays a dividend which increases, on average, at the rate of 8%-10% per year for many years. Such companies are usually large, successful, growing multi-national companies that are at the top of their peer groups, have a global footprint, and are in expanding areas of economic activity.

They also have a long and continuous history of excess free cash flow and a corporate investment policy that involves a commitment to increasing the dividend by 8%-10% per year, every year.

The simple notion would be to put a group of such companies into a portfolio, and begin living off of the growing income stream generated.

All that would be required is that such companies really do exist, and they are relatively easy to identify. But such is not the case.

First, there is a strong argument that “pure” SDGs do not really exist.

Secondly, even if some companies come close, there is no acceptable valid way to select just those companies that possess the “correct” characteristics.

We have spent many years trying to identify metrics that would describe companies that would qualify for SDG status. The companies that are currently in the Model Portfolio come closest to being an SDG.

Each company attains SDG status to varying degrees. Also, some companies that may not be the “best” SDGs, are in the portfolio because of diversification efforts and concomitant risk reduction efforts.

The result of years of research has led to the conclusion that the perfect SDG, indeed, does not exist. But some companies come close, and a group of such companies can provide a reliable, growing income stream.

The current specific criteria for selecting and judging companies are subject to further research and development. This effort seeks to find metrics that are more closely related to long-term dividend increases at the 8%-10% level.

All investors should remember that identifying companies that satisfy SDG criteria is not based on any replicated, accepted scientific basis.

There are hundreds of stock selection strategies whose goal is to create safe growing income streams, other than our strategy. The criteria and statistics that we currently use are probably not the best.

However, given the lack of empirical, well-accepted strategies, we use the actual income growth of various portfolios to gauge how well our current strategy is working. We provide such data in the Income Performance Chart for our Model Portfolio.

Characteristics of SDGs:

Below is a list of the major characteristics of an SDG. This listing is a more detailed statement regarding our discussion of what an SDG might be.

Each of these eight characteristics of will be discussed in future posts and will be linkable here as they become available.

1. It pays a dividend that has an extensive, consistent history of a CAGR of 8%-10% per year.
2. It is successful and growing.
3. It has an extensive, established global footprint, and is therefore probably very large.
4. It operates in an expanding area of economic activity.
5. It has lots of extra money (excess free cash flow), and has had this feature for some time.
6. It is at the top of its sector or peer group with respect to market share for most of its products.
7. It is committed to an active cash management philosophy that can maintain dividend growth during both good times and bad, and its history reflects this.
8. It is doing things that are very similar to what it did five years, or even 10 years, ago.

Preconditions for Portfolio Status

There are SDGs that (adequately) meet all eight of these characteristics, but they will not be placed in the portfolio for either, or both, of the following two reasons.

Either it does not meet the precondition for an “adequate” current yield, or because it is currently valued at a significant premium to its historical/average levels.

It is highly preferable that a SDG have a current yield (yearly dividend/current price) equal to or greater than the 10 year average of CPI-based inflation rate (about 2.69% in early 2013).

There are many dividend growers that do not meet this precondition, and they can be put on a wait list until the current yield approaches this level.

Another precondition has to do with valuation or how pricey a company may be in the current market.

We use a “relative valuation method” by looking at the current Price/Earnings (P/E) ratio, compared to its history for that company, using historical charts such as those at www.bigcharts.marketwatch.com.

How to use this website, and rules for comparing P/Es, are given in this article.

In summary, a company must have the above eight characteristics and meet the two preconditions before it can be placed in the portfolio. Some times we stretch these requirements for what are considered to be good reasons at the time.

Measurement Issues for SDGs:

• How can each of these eight characteristics be evaluated?
• How close to these criteria does a company have to be in order to be granted SDG status?
• Is there a reliable data source that can be used for one or more of these characteristics?
• Can the SDG status of a company be “ranked” or compared to the SDG status of another company?
• For example, would Colgate-Palmolive have a higher SDG status than Proctor & Gamble? Over what time frame? How can * this be answered in some valid manner? How important is a particular characteristic?
• These are all questions that will try to be answered in future posts, as each of the characteristics are discussed in more
  detail. It should be clearly noted that we do not have all of the answers to all of these questions.

Some assessments are dependent on corporate cultures, which are always changing. Some answers are dependent on the state of academic research, especially those questions that surround corporate policy making and corporate financial strategies. Still other answers depend on reliable data sources, which sometimes are difficult to discover.

In spite of these difficulties, for each characteristic of an SDG, the discussion will focus on what data is relevant, where are the reliable data sources, what statistical measures are meaningful, what macroeconomic factors are currently being used and why, and finally the development of various scoring algorithms that might be used to rank companies with respect to their SDG status.

There is always an emphasis on the most easily available data, given that it is reliable. For different measures of financial metrics, there is an equal emphasis on simplicity and easily calculated measures.

In some cases, of course, easily available data and simple calculations are not sufficient or they do not exist.

For statistical measures and various scoring algorithms, the simplest and easiest to calculate will always be preferred, so long as they are robust and reflect the feature of interest.

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Question of the Day:

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QOTD: What is a Superior Dividend Grower?